ERM. Variable Annuities. Aymeric KALIFE, Head of Savings & Variable Annuities Group Risk Management, AXA GIE

Transcription

1 ERM Variable Annuities Aymeric KALIFE, Head of Savings & Variable Annuities Group Risk Management, AXA GIE

2 Recent VA market trends In the U.S. insurance issued annuity products are the main vehicle for retirement saving on a tax deferred basis. The U.S. is the largest Variable Annuity ( VA ) market in the world with $1.7 trillion assets under management this is comparable to the size of the hedge fund industry A key attraction and an important driver is that annuities offer equity market participation with clear downside protection. This has made annuities a preferred choice of retirement product in those markets In Non-Japan Asia and in Europe the Variable Annuity market is still nascent Growth in the last 10 years was mainly driven by unprotected unit linked product unit. However, the recent experience of substantial equity market volatility may increase and accelerate retail demand for protected equity solutions Financials: Large VA hedging losses during the crisis, albeit successful sales Most companies have to increase GMxB reserves and required capital, 2 Changes: Most reinsurance companies exited the VA market Some companies stopped writing VA guarantees in certain markets Most VA writers modified products by increasing fees, reducing guarantees, and more restrictive asset allocations Hedging programs are being modified and strengthened

3 Contents Introduction to Accumulators Pricing issues Hedging issues 2008 Experience 3

4 Life & Savings A new retirement reality

5 A Significant and Growing Retirement Opportunity around the world Social trends indicate growth in Asia s Life insurance market: estimated current pension market in Asia is US$5.1 trillion: Australia US$1.0 trillion, Japan US$2.9 trillion, Asia excluding Japan US$1.2 trillion. Between the big three regions, Asia has the highest near retirement population with more than 7 times that in the U.S. Asia s aging population is also growing faster than the U.S. Asia is attractive for growth opportunities due to its high levels of economic activity thus increasing level of personal wealth, disposable incomes and propensity to save. 5

6 Variable Annuities in AXA Group Retirement strategy Variable Annuities Variable Annuities - US term for unit-linked products with secondary guarantees such as death or income benefits Investment portfolios in equity and fixed income funds Provides options for guaranteed payment upon death Provides options for guaranteed stream of income Often tax-deferred Policyholder benefits Participation in equity market Guarantees at key life moments: retirement, death Tax deferral in some countries Insurer benefits Good margin products, clients pay for guarantees Competition driven by product features, distribution, service & risk management Competitive advantage vs. asset managers who do not offer guarantees VAs cover the fundamental risk of outliving one s assets Important products to address the retirement gap market

7 Variable Annuities in AXA Group Retirement strategy Variable Annuities Variable Annuity product = Unit Linked + Guarantee(s) Policyholder can benefit from equity markets up-side.. Variable Annuity A Unit-Linked investment Guarantees Guaranteed Minimum Benefits (GMxB) depending on life/ death + Investment portfolios in equity and fixed income funds...with a limited risk, as guarantees protect his capital. Guaranteed Minimum Accumulation Benefit (GMAB) Guaranteed Minimum Income Benefit (GMIB) Guaranteed Minimum Withdrawal Benefit (GMWB) Guaranteed Minimum Death Benefit (GMDB) Retirees need equity markets investmen ts with guarantee d income 7 VA s are not only annuities. They are called so because first GMxB guarantees provided in the products were annuities! At AXA they are also called Accumulator type products

8 Variable Annuities in AXA Group Value proposition of VA for insured customers GMWB Life or GMIB GMAB or GMWB + DB GMWB GMAB or GMWB GMAB 8

9 Variable Annuities in AXA Group GMDB option GMDB Death Benefit Options Return of Premium: higher of total premium or account value, adjusted for withdrawals Roll-up: premiums paid accumulated at guaranteed rate, adjusted for withdrawals Ratchet: highest account value at contract anniversary dates, adjusted for withdrawals Greater of Ratchet or Roll-up: greater of annual ratchet or roll-up amount GMDB Example Ratchet Upfront fees Account Value Guarantee Term Lump Sum payment at insured death

10 Lump Sum Benefit Variable Annuities in AXA Group GMAB product GMAB guarantees a flat or contractually increasing accumulated lump sum amount after a specified period Return of Premium: higher of total premium or account value, adjusted for withdrawals Roll-up: premiums paid accumulated at guaranteed rate, adjusted for withdrawals Ratchet: highest account value at contract anniversary dates, adjusted for withdrawals Greater of Ratchet or Roll-up: greater of annual ratchet or roll-up amount GMAB is similar to a put: the account value is the underlying and the benefit base is the strike. GMAB Example Ratchet Roll up: the guaranteed amount being equal to the initial savings capitalized at the roll-up rate T BB max( S 0 e, S T ) Upfront fees Account Value Guarantee Term Ratchet: the guaranteed amount being equal to the maximum between values of the savings at anniversary dates of the contract and the initial premium. BB max (max S K K T, S T )

11 Annuity Conversion Variable Annuities in AXA Group GMIB product GMIB guarantees minimum annual income when annuitization option elected Guaranteed Minimum Income Benefit calculated based upon Benefit Base Benefit Base is not an account value - only used to calculate guaranteed annual income if policyholder elects to annuitize after waiting period Benefit Base is the greater of 6% roll-up and annual ratchet, adjusted for withdrawals, up to certain attained age Benefit in-the-money when guaranteed benefit exceeds what Account Value could purchase at the then current interest environment GMIB Example Ratchet Account Value Lifetime Income Stream Investment term Waiting period

12 Variable Annuities in AXA Group GMWB product GMWB provides return of principal through periodic withdrawals over a number of years Guaranteed Amount: the value that will be returned over time through withdrawals is equal to the initial deposit or contract value at time of election, even if account value drops to zero GMWB rider: includes reset options in which the remaining guaranteed amount may be stepped up to the account value Benefit payment amount: equal to a pre-stated percentage, is maximum withdrawal that may be taken each year GMWB Example Ratchet Withdrawal phase Account Value Waiting period Lifetime or fixed term Income Stream

13 VA address client needs (1/2) Product GMAB GMWB GMIB GMDB Definition Guarantees a flat or contractually increasing Provides return through periodic withdrawals Guarantees minimum annual income when Guarantees a flat or contractually increasing accumulated amount after a Guaranteed Amount annuitization option elected death benefit specified waiting period returned over time through Guaranteed Minimum withdrawals is equal to the initial deposit / contract Income Benefit calculated based upon Benefit Base value at time of election Responding to client needs for ALL CLIENTS MASS AFFLUENT Guarantee on capital on income on income Flexibility Simplicity (Education) Transparency Surrender Limited flexibility with regards to surrender, withdrawal and annuitization no no no YES, on the options of the product (riders), WITH LIMITS for upside potential (market development vs. costs of the product) Yes, but limited to current account value and frequently associated with high penalty costs Yes, but limited for surviving Annuitization no yes (withdrawals) no spouse's pension Pricing and costs of the guarantee is accepted if value for money is clearly communicated, For mass market and young Costs affluents, minimum investment requested is often too high Personalization Differentiation In terms of market and product Not yet adapted to specific client segment s needs in most markets capital in case of death no No (too similar to Yes (ex-us) Yes (ex-us) No (death guarantee structured funds) usual offer) 13

14 VA address client needs (2/2) Savings Security Capital Protection Total return Investment + Guarantee, liquidity Simplicity,well known by customer, guarantee, strength of general account in financial market Capital guarantee, strong upside in good market conditions Strong upside in good markets, tax advantages, long term benefit Strong upside in good market conditions Drawbacks - Limited upside potential, less tax advantages Limited upside potential, limited transparency on participation in main account revenues Transparency of communication, costs of guarantee, lack of liquidity Lack of guarantee, risk aversion of customers Downsides, no tax advantage Mass Affluent Mass Market Highly secure products for yearly savings and investment Demand for liquidity Less risk-adverse in terms of investment, more financially aware Large range of insurance products demanded Require personalized service 14

15 GMWB from a customer perspective

16 VA Market trends: US $1.7 trillion assets under management, comparable to the size of the hedge fund industry Top 5 players accounted for 50% of VA market, Top 10 80%, Top 20 90% Majority of the carriers have de-emphasized the sale of VA products to balance the risk associated with guaranteed living benefits. VA market indicates a shift towards more fee-based products

17 Evolution of GMxB Market Evolution driven by customer demand Evolution driven by market liquidity / risk management technology 17

18 Variable annuities have offered sophisticated guarantees to meet customer needs Guarantees provide financial protection for customers B E N E F I T S Enhanced GMDB (annual ratchet 5% roll-up) One-time ratchet GMDB 1985 Living benefits GMIB GMWB GMAB GMWB for life with ratchet GMWB/GMAB combinations 18 GMDB: Guaranteed Minimum Death Benefit GMIB: Guaranteed Minimum Income Benefit GMWB: Guaranteed Minimum Withdrawal Benefit

19 The two markets have come together Regulatory frameworks are converging Market liquidity and risk management technology has caught up / overtaken 19

20 Contents Quick introduction to Accumulators Pricing issues Hedging issues 2008 Experience 20

21 VA guarantees are derivatives All VA guarantees should be priced as derivatives (typically hybrid ones) All derivatives should be hedged All assumptions (implied volatility, risk free rate, asset growth rates, asset expected volatility, policyholder behavior, and asset correlations) should be consistent between risk management and pricing design Determine trade-offs between: Earnings volatility and capital optimization Marked-to-market P/L (forward-looking implied or expected volatility) and trading P/L (realized volatility) Leave enough room for unknown risks and price conservatively If you can not get reinsurance or fully hedge, the guarantees are probably priced too low or you are making major bets 21

22 Pricing of Financial and non-financial Risks Interest rates Assets correlation Financial risks Volatility Equity returns Funds choice Lapses Non financial risks Election rates Business Mix Deaths Risk neutral valuation Historical valuation Using suitable assumptions for both financial and nonfinancial risks, and their interaction, is crucial to price the guarantee. 22

23 Steps in Pricing process 1. Analyze the guarantee Identify the key financial and non-financial risks that need to be priced and analysed Determine the fair value drivers of these risks eg. US equity, European interest rates Find the derivatives closest to the GMXB eg. US equity option, European swaption 2. Choose Economic Scenario Generator (ESG) to model the financial risks 3. Define calibration target - Calibration targets should depend on implied/market values, and historical performance 4. Calibrate the ESG according to calibration target - minimum thresholds should be satisfied before moving to the next phase 5. Set assumptions for non-financial risks based on historical company and industry experience, assume some level of rational behaviour 6. Price using the DFA model Stochastic model of the guarantee using a sufficient number of monte-carlo scenarios to ensure convergence of a risk neutral value 7. Analyse and sign-off as a part of the PAP process including sensitivities to all key financial and non-financial assumptions 8. Determine the final price taking into account commercial as well as financial and risk constraints (including GRM minimum requirements) 23

24 Impact of lower risk-free rate on risk-neutral pricing of derivatives Rho risk is significant and, unfortunately today, some consider it too late or too costly to hedge when rates are very low. Generally, the roll-up or bonus rate of guaranteed amount or base can not be hedged away. Don t expect magic from the hedging team when the risk-free rate is 3% but the roll-up rate is 5-6%. If the roll-up or bonus rate is significantly higher than the risk free rate, it is not sustainable. Some designs have floating roll-up rates linked to risk-free rates. 24

25 Equity Volatility 35% S&P Historical Rolling Annual Volatility ( ) 35% DJ EUROSTOXX 50 - Historical Rolling Annual Volatility ( ) 30% 30% 25% 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% 12/28/1928 7/29/1938 2/27/1948 9/27/1957 4/28/ /26/1976 6/27/1986 Historical realized equity volatility Varies significantly over time Can be significantly different to implied volatility Varies by market global convergence? 1/26/1996 8/26/2005 0% 1/1/1988 6/9/ /16/1990 4/24/ /1/1993 Market Index Data Period 3/10/1995 8/16/1996 1/23/1998 Average Volatility 7/2/ /8/2000 5/17/ th perc of annual vol 10/24/2003 UK FTSE % 21.3% 22.9% US S&P % 23.4% 25.8% Japan Nikkei % 25.0% 21.4% Europe DJ EuroStoxx % 30.1% 23.7% 4/1/2005 Implied 10Y vol ATM April

26 Interest Rate Volatility GMIB with roll-up rate Guarantees the annuitization rate of the lifetime annuity Guarantees the Benefit base used to calculate the annuities subscription Account Value annuitization death This guarantee is a combination of a 20 year-maturity European put a 20 year-maturity European swaption 20 years forward. 20 years 20 years 26

27 Correlation One of the key risks for Accumulator products is that both equity and interest rates fall together i.e. they are correlated Including this assumption, there are many correlation assumptions to be made for financial risks which can have a significant impact on the price: Correlation between equity and interest rates Correlation between equity and bond funds Correlation between different equity funds etc However, we cannot observe a price for correlation in the market so need to do historical analyses and to get advice from banks about the correlation assumptions that they use 27

28 Customer Behaviour Not an exact science! Use all available information and use conservative approach where information is weak Mortality Based on Data Mortality improvement definitely observed and reflected Consistently different for male/female Lapse Rates Base rates based on observed experience Limited experience for shock lapse in wholesale channel Dynamic formula set Observed experience, although limited, shows dynamic function is conservative GMIB Election Rate Set election rate using prudent estimates based upon US annuitization experience Actual limited experience shows conservative assumptions Natural hedge GMDB/GMIB GMWB Withdrawal Rate Dynamic formula set Observed experience, although limited, shows dynamic function is conservative 28

29 Contents Quick introduction to Accumulators Pricing issues Hedging issues and mitigating actions 2008 Experience 29

30 Financial protection of the customer = risks for the insurer As an insurance company, we provide our customers with investment opportunities which can be coupled with financial protections depending on client risk appetite: the investor keeps significant upside exposure but pays a premium to ensure downside protection: Asset + Protective Put (as in Variable Annuities) the investor prefers lower but stable returns (through Bonds) but pays a premium to get potential upside (through Call options): CPPI, General Account, Euro Growth fund Such downside protection / stable return product values are subject to market uncertainties => In case of financial market turnmoil, AXA will suffer a loss instead of the client

31 Example One of the most simple investment product offering financial protection is the combination of a Fund and Put option In this example, we assume a client invest 100 in a given fund and AXA guarantees him a minimum of 80 at a 1year horizon The payoff from a client perspective is given by the blue line (which could be decomposed b/w the fund dotted blue and the Put dotted red) If the final fund value is above 100, the client makes a profit If the final fund value is b/w 80 and 100, the client suffers a loss b/w 0 and 20 If the final fund value is below 80, the put option is activated and the loss from a client perspective is limited to -20 => AXA pays the difference b/w the final fund value and 80 which can be significant in case of a crisis event for instance

32 What is Dynamic Hedging? Dynamic Hedging is a technique derived from option management techniques used by investment banks Assets Liabilities Hedge assets Guarantee Unit-linked Dynamic Hedging consists in building a portfolio of assets (hedge assets) that will vary like the guarantee of assets consistent with of liabilities It consists of : Modeling the embedded option in Accumulator Guarantees using standard option modeling techniques (Black and Scholes) 2. Analyzing the sensitivity of these options to market movement 3. Buying financial instruments to be immunized against these market movements

33 Hedging Strategy main principles (1/2) A hedging strategy consists in investing in assets whose variations with respect to economic variables offset the variation of the liability. In this example, we assume the guarantee liability variation is +0.2 for -1% (Delta = -20%) in asset variation Asset 5 (hedging assets) Liability 5 (guarantee) Option Value = +2 Asset 7 (hedging assets) Liability 7 (guarantee) After 10% drop in asset (fund (fund units) units) 90 (fund units) 90 (fund units) Option Value = +2 After a 10% drop, assets and liabilities are matched hedging assets is equal to the Option Value, the Insurance company P&L = 0 (-8 for Asset vs. -8 for Liab)

34 Dynamic Hedging (1/3) Dynamic hedging covers equity and interest rate risk but leaves an exposure to equity and interest rate volatility Dynamic hedging protects AXA by providing funds to pay for Guaranteed Benefits when markets underperform Dynamic hedging involves owning and rebalancing short futures positions Futures position gain is relative to risk free rate -> The lower the rate, the lower our gain in declining interest rate market. 34

35 35 Dynamic Hedging (2/3)

36 Example Mechanics of dynamic hedging

37 From Delta Hedging to Negative Convexity Hedging M M M About 70% only of the variation of the liability price is explained by the first order delta: the mismatch linked to volatility risk arises as the delta hedging is not continuous in practice as illustrated by discrete rebalancing frequency As the insurer is negative convexity, she loses whenever markets move Those mismatches are even further exacerbated by market gaps as illustrated by jumps in realized volatility, which requires dedicated gamma hedging strategies by using costly convex derivatives such as options and variance swaps that are impacted by implied volatility skew and term structures 37

38 Dynamic Hedging applied to Variable Annuities Hedges have linear payoff while reserve has a convex profile -> need to rebalance futures position to match the exposure of the IFRS reserve and / or to buy options Hedging Asset Futures, Swaps have linear payoffs Liability Value - GMxB have convex liabilities Net P&L Convexity impacts -x% x% 38 Equity Equity Equity

39 Second order hedging in practice We illustrated that Delta hedging might not be sufficient to cover the risk due to convexity of the Liabilities To provide a more resilient strategy to potential higher underlying asset variation, Delta-Gamma Hedging can be envisaged (e.g. strategy in place for Variable Annuity) A Delta-Gamma hedging strategy consists in: 1. Buying options to match the Liability convexity. As a reminder, these options could be: On equity markets: call,puts On interest rate markets: cap, floor, swaptions 2. Adjusting for the residual Delta existing on the net portfolio composed of the Option and the Liability, using Future contracts

40 Relationship between Delta, Theta and Gamma

41 Vega hedging

42 Option Portfolio Hedging Mechanics 1/3

43 Option Portfolio Hedging Mechanics 2/3

44 Option Portfolio Hedging Mechanics 3/3

45 45 From Greeks to P&L

46 Hedging Strategy Principles Option Value movement The movements of the Option Value is explained by the movements of 3 parameters and the associated sensitivities Time Theta Equity Delta and Gamma Interest rates Rho and Rho Convexity Volatility Vega impact Delta x ds Impact OV Theta x dt Impact AV ' AV AV ', r', t', ' OV AV, r, t, t' t 1 r' r ' 10 i 1 i i i Rho x dr Impact Vega x Vol Impact Gamma x ds² Impact i Equity rho i i 2 i 1 i 1 2 AV ' 1 AV AV ' AV 2 r' r DeltaRho r' r 1 i i i Rho Convexity x dr² Impact Cross Greeks x ds x dr Impact

47 Market Volatility & Rebalancing frequency of hedging assets Implementing an hedging strategy as a cost (price of hedging assets and transaction costs) In case of a dynamic hedging strategy using Futures, the higher the rebalancing frequency, the lower the residual risk However the higher the overall cost Such a cost is more or less proportional to the volatility observed on the market which can vary a lot over time. For instance, the volatility observed on the main US equity market index (S&P500) ranged from 10% to close to 60% between 2005 and early

48 Delta Hedging & Volatility risk (2) 48

49 Mitigating Tail Risks with Varswaps Efficient way to gain exposure to long-dated implied volatility (up to 10 years) pct skew structure Constant dollar gamma & vega profile Deep enough for the largest investors and low bid-ask spreads BNP Paribas

50 Mitigating Tail risks with VIX derivatives VIX future returns are convex relative to SPX returns but not for free VIX futures are typically higher than VIX during rallying markets More convexity and so higher cost Short-term futures have high reactivity to VIX movements but are costly to hold 50

51 Mitigating Tail Risks with capped volatility funds Capped volatility fund Risky basket - Equity exposure - Bonds exposure - Cash - Futures Safe basket - Bonds - Cash Cap Vol fund is composed by a risky and a safe basket Low volatility => High risky asset exposure High volatility => Lower risky asset exposure and high exposure to safe basket Cap Vol fund is dynamically rebalanced to control realized volatility Over the last 10y, tends to have identical performance during positive return periods Cap Vol fund fully invested in 30/70 basket Cap Vol fund shows interesting performance Cap vol fund slightly underperforms static basket Over the last 10y, tends to outperform during negative return period Cap Vol fund not fully invested in 30/70 basket

52 Mitigating Tail Risks with Gap options Ex: CPPIs

53 Need to consider hedge performance over lifetime of guarantees Typical hedging strategy has a saw-tooth pattern with a bleed during normal times and upward jumps during crisis

54 Risk Management improves Hedge Effectiveness

55 VA hedging derivatives use

56 Hedging process VA guarantees are equity put options. Standard option modeling techniques (Black & Scholes) can model the embedded options Mapping of policyholder accounts with hedge indices Hedge implementation with futures for equity and swaps for interest rates Daily valuation of liability options and market monitoring Weekly rebalancing of futures portfolio Very liquid instruments with no counterparty risk Hedging policy Delta: sensitivity to equity Rho: sensitivity to interest rates Daily rebalancing is possible if needed does not systematically hedge Vega (sensitivity to volatility), as risk mitigated by a constant prudent x th percentile volatility level for option pricing and due to the difficulty in forecasting the size of the delta. However for new business, where there is no volatility tool in place, Vega is hedged on a systematic and complete basis to secure margins at product launch.

57 From hedgeable to non-hedgeable risks

58 Managing non hedgeable risks through innovative Customer Centric Design Solutions Reduce guarantee richness Caps on guarantee base, ratchet, rollups, withdrawal rates Initialize benefit base OTM Favor ratchets over rollups Increase deferral periods / utilization ages Link guarantee to market inputs Bonus / rollups based on interest rates Control volatility via fund offering Minimize product subsidization Limit ongoing premiums Use Prudent assumptions Conservative assumptions, policyholder behavior (age restrictions) Margins for unknown risks Adequate fees that link to expenses, benefit 58

59 Contents Quick introduction to Accumulators Pricing issues Hedging issues 2008 Experience 59

60 The Recent Financial Crisis has been Severe Failure of well known financial institutions - Insurers financial strength into question Lehman Brothers, Merrill Lynch, Bear Stern Credit risk is brought to the fore Worldwide decline in equity market - 2nd worst S&P annual return in history (2008) S&P lost 47% Oct 2007 to Oct 2008: In October 2008 alone: S&P lost 17%, Japan: Topix dropped 21.3%; Europe: FTSE lost 11.7%; STOXX lost 12.5% Rapid reduction of interest rates - Short term interest rates near zero US Treasury price up and yield close to zero Flight to safety FED cut rates Bond price tumbled and yield high Credit spread widened Increased volatility: Realized vol tripled; Implied Vol at 40% by October 2008; Forced liquidation of hedge funds helped amplify the market volatilities Diversification has lost meaning 60

61 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 The risks: The extreme can happen and can happen extremely fast 183 years of equity markets Spread over swaps Itraxx Europe Main EUR ML Single A (asset swap) EUR ML Double A (asset swap) déc 98 déc 99 déc 00 déc 01 déc 02 déc 03 déc 04 déc 05 déc 06 déc 07 déc 08 Weekly volatility over a quarter on the S&P 500 Swap rate evolution 70% 8% 60% 7% 50% 40% 30% 6% 5% 20% 4% 10% 3% 0% 2% 1% Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan EUR - 10y USD - 10y

62 2008 Key Experience Drivers, Part 1: Basis Risk Tracking error: 60% of basis risk Eurostoxx 50 YTD Underperformance risk: 40% of basis risk Eurostoxx 50 YTD 0% 0% -10% -10% -20% -20% -30% -30% -40% -40% -50% Risk of not replicating the benchmark of the underlying fund Initial pricing assumption (R2 of 85%) appears not conservative enough in the financial crisis -50% Risk of a fund (equity and fixed income) underperforming its relative benchmark Initially, this risk was not seen as a potential source of cost and so not taken into account in the pricing assumptions 62 Basis risk is driven by The amount of sales The level of the guarantee offered How well our hedging replicates actual fund performance

63 2008 Key Experience Drivers, Part 2: Volatility Equity Market Realized Volatility Interest Rate Realized Volatility Historically realized equity volatility has been below our pricing assumption in most periods, but 2008 saw new high levels which have negatively impacted earnings Historically realized interest rate volatility has been below our pricing assumption as well, but 2008 saw new high levels here as well which have negatively impacted earnings P&L realized impact of volatility when realized volatility exceeds pricing assumptions Implied volatility levels impact EV, as well as economic costs if we extend hedging program to second order impacts 63

64 The 2008 financial crisis impact on VAs hedging First, the market crashed and the liability shot up with in-the-moneyness Changes in spot/rates/vol also increased delta and convexity sensitivities implying significant transaction costs, while basis risk became primary concern

65 Hedging Programs Have Performed Well It is estimated hedging has saved the insurance industry about $40 billion in September and October in 2008 Hedging programs are on average 93% effective in recouping the capital market losses that hedging programs were designed to protect Most hedging payoffs are due to movement in equity and exchange rates Hedging is not fool-proof In-depth understanding of risk management is required 65

66 Actions following 08 experience The Group has now affirmed a specific risk appetite for these products Key product offer actions to align with this appetite Reduction of guarantees offered to clients for new products which lowers overall exposure to risk Improvements in the lineup of funds (for both new products and existing products) to reduce basis risk Reductions in the equity portion of fund lineup to reduce volatility Increase in client charges (this would not be sufficient alone) Review of hedging strategies to lower risks when the cost is appropriate for the mitigation Reduction of distributor compensation Capital needs and liquidity remain key points of attention, with several aspects The capital required to support the business, including new business strain and the impact on inforce requirements of guarantees more in-the-money Cash liquidity needs to cover margin calls if the market should recover The sufficient availability of appropriate hedging instruments 66

67 Key risk management lessons from the crisis Clearly identify and timely report the risks What is the real exposure? Gross vs Net exposures must be monitored closely Basis risk on Variable Annuities in the US/ Derivatives (collateral, clearing house )/ Securitization (liquidity, bullet-proof structures )/ Reinsurance (deposits, limits on capacity ) -> e.g. AIG exposure on the liability side (insurance/ reinsurance) Have a stated risk appetite Looking at the 4 dimensions (earnings, value, solvency, liquidity) Ensure that decisions can be taken in order to mitigate/manage risks in accordance with the management view Which implies adequate governance (group/ local) to set the limits and review the breach Risk Management is much more than models Risk models are indispensable for managing the business, but having a model does not mean to overrely on it Lessons: Stress and scenario testing (inc. contingency plans) must also be used as a normal tool The crisis reinforces the case for an economic and risk-sensitive approach Relevance of its principle based, economic and risk-sensitive approach to protect the stability of the financial industry (non pro-cyclicality); even if, some areas (co-dependencies, calibration of Internal Model, etc.) are currently adapted/ reviewed in the light of the crisis Importance of a comprehensive scope for regulation Need of an harmonized regulation at least across Europe (group supervision)