Insurer Investment Forum XIII Investing for Insurers Review

Insurer Investment Forum XIII Investing for Insurers: Review and Preview Alton Cogert, CFA, CPA, CAIA, CGMA President & CEO March 21 st, 2013

The #1 Investment Challenge in Over 30 Years: “Low Rates for Longer” 2

U. S. Financial Repression Source: Federal Reserve, J. P. Morgan Asset Management 3

Where We Are Today • Book Yields Continue Downward Path • Insurers Grappling with Risk • Insurers Grappling with Product Pricing • Insurers Grappling with ERM “A further unpleasant reality adds to the industry’s dim prospects: Insurance earnings are now benefiting from “legacy” bond portfolio that deliver much higher yields than will be available when funds are reinvested during the next few years - and perhaps for many years beyond that. Today’s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over. ” - Berkshire Hathaway Shareholders’ Letter, March, 2013 4

Improving Investment Income - It Takes Planning Improved Investment Income - It is possible. . . 5

Key Long-Term Asset Class Return Assumptions Source: JP Morgan 2013 Long-Term Capital Market Return Assumptions 6

Key Long-Term Asset Class Risk Assumptions Source: JP Morgan 2013 Long-Term Capital Market Return Assumptions 7

Risk/Return/Correlation Expectations vs. Aggregate Investment Grade Bond 8

What Does “Low Rates for Longer” Mean? • How Long? NOV, 2009 “Federal Reserve Chairman Bernanke said interest rates will remain low for an extended period as the U. S. economy still faces considerable challenges. ” FEB, 2010 “Chairman Bernanke told Congress on Wednesday a weak job market and tame inflation warrant low interest rates for an extended period. ” JAN, 2012, “The Federal Reserve anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. ” FEB 2013 - “It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6. 5 percent. ” 9

What Does “Low Rates for Longer” Mean? Until Unemployment Rate Hits 6. 5%, which will be. . . It would take an average job-growth rate of 250, 000 each of the next 13 months to arrive at a 6. 5% unemployment rate. But if increases were just 125, 000, the average trend rate for the last 30 years, it would take 96 months — or eight full years — before unemployment got to 6. 5%. (This isn’t just job additions, mind you, but net job creation; that’s why simply jumping from 125, 000 to 250, 000 cuts the time down so dramatically. ) So bond bulls and dollar bears take heart. It looks like Helicopter Ben will be hovering for some time to come. - http: //blogs. wsj. com/marketbeat/2013/01/04/when-the-unemployment-rate-hit-6 -5 -calculate-it/ Here’s the Atlanta Fed’s calculator to help answer this question: http: //www. frbatlanta. org/chcs/calculator/ 10

What Does “Low Rates for Longer” Mean? Comparison with Japan - 15 Years and counting? 10 year JGB: Jan, 1990 to March, 2013 11

How About ‘Black Swans’ - Very Low Probability/Very High Impact? Inflation - according to the ‘experts Keynesians - Demand/pull - increased economic activity - Cost push - supply side disruptions - Built-in inflation - wage/price spiral Monetarists - Quantity Theory of Money - Long run inflation = Money supply growth rate + Rate of change in Velocity of Money - Growth rate in Real Output 12

How About ‘Black Swans’ - Very Low Probability/Very High Impact? 13

The Fed says, “Take More Risk”. . . Should You? What is Your Risk Appetite? 14

The Fed says, “Take More Risk”. . . Should You? Over the long run, Process determines Results. Thus, Process becomes more important than Results. Positive Result Negative Result Good Quality Process Expected Bad Luck Bad Quality Process Good Luck Expected 15

What about Luck versus Skill? Text http: //insurercio. com/content/how-much-ones-success-or-failure-skill-or-luck Text 16

What about Luck versus Skill? Paradox of Skill: Standard deviation of skill decreases as expertise increases, which means Luck has more to do with results And that means Difficult to rely upon historical performance More important to rely upon process Counter-intuitively, process is more important than results 17

From the London Business School. . . • Decisions Are More Important Than Results • Results don’t necessarily reflect a high-quality process • Ultimate criteria for good decision making is tied to: • What are we trying to achieve with this decision? (Criteria) • What can we feasibly do? (Alternatives) • What do we have to watch out for? (Consequences) • It’s not enough to measure leaders on results; How they are achieved is equally important. • Implement a good process; Manage risks - http: //bsr. london. edu/lbs-article/407/index. html 18

Could we make understanding risk any more complicated? Text Text 19

8 Steps to Answering: “Should You Take More Risk? ” • Step 1 - What do you mean by ‘risk’? • Probability of Not Meeting a Goal • Not Va. R • What Goal? • Return on Surplus, • Net Income Text • Spread Over Liability Text • PV Enterprise Value • Drawdown • Step 2 - Quantify Risk • Single, multi periods, 1 yr. 5 yr. ? 20

8 Steps to Answering: “Should You Take More Risk? ” • Step 3 • How do different asset mixes impact risk metric Text Text 21

8 Steps to Answering: “Should You Take More Risk? ” • Step 4 - Implementation Issues • Strategic or Tactical Strategic Entry Text Board OK Text Tactical Parameters Set for Entry Execution Slowly, Over Time Active Management Exit Board Decision Parameters Set for Exit 22

8 Steps to Answering: “Should You Take More Risk? ” • Step 5 - Consider Game Theory Impact Risk Assets Rise Increase Risk Maintain Risk Decrease Risk Assets Fall Text Bad Good Text Text Opportunity Cost/Gain Opportunity Gain/Cost Good Bad 23

8 Steps to Answering: “Should You Take More Risk? ” • Step 6 • Know your Board/Senior Management Team • Step 7 • Make a Decision - Even if it is to make no decision • Step 8 • Monitor the Impact of the. Text Decision Text • Stewardship Report Text 24

What has SAA seen so far? Text Text 25

Goldman Sachs Insurance CIO Survey - July, 2012 Insurers expecting to increase risk: 26% Insurers expecting to decrease risk: 14% Asset Class % Who Expect to Increase Allocation High Yield 36 IG Corporates 35 Real Estate 34 Emerging Market Debt 31 Private Equity 27 Bank Loans 25 Mezzanine Debt 23 Asset Class Text Text Cash/Short Term Text European Financial Credit % Who Expect to Decrease Allocation 39 24 http: //www. goldmansachs. com/s/GMe. T_othermailings_attachments/6347837329351787503251. pdf 26

Asset Classes - a Layer Cake of Choices Tex The Next Layer Text • Lower investment. Text grade mandates for Text munis (where applicable) Text • Below investment grade in various guises t The Basics • Make certain (public/private) all IG asset classes are included • Diversified equity allocation • High yield/growing dividend slant 27

Asset Classes - a Layer Cake of Choices Text • Tex The Next/Next Layer Text • More complex. Text strategies Text using Text derivatives explicitly or implicitly t Text • The Next/Next Layer • Non-equity exposures • More illiquid asset classes • What your manager may suggest, based upon their proven expertise 28

The Risk Trap • Always ask, “Who is on the other side of the trade? And why? ” • Too easy to see well groomed, credentialed person in a suit as authority figure. • It could still be snake oil. • If presenter is too confident, walk out of the room. • Investment management is a humbling activity. Text • Ask more questions - the “dumber” the better until. . . Textof the asset class • You fully understand ALL aspects Text • Remember: • There is NEVER a dumb question, especially in a Committee or Board setting. 29

The Risk Trap • Other Questions: • Will this play in Oldwick? • Ask for ideas from your peers, independent third parties, etc. • There is no way you are expected to know it all. Text Text 30

The #1 Investment Challenge in Over 30 Years 31

The #1 Investment Challenge in Over 30 Years • Low rates for longer gives us the opportunity to • Reassess our asset allocation • Shed the blinders of ‘we’ve always done it this way’ • Reassess the relationship between investments and reserves • Reassess the relationship between investments and product pricing Take a deep breath, step back Text and review the overall investment Text process Textchallenges • Be better prepared for meeting future Text • • Improve profitability over what it might have been • Get a ‘leg up’ over competitors - succeed where others may fail • Develop a process for constantly improving your company 32

The #1 Investment Challenge in Over 30 Years Thank You More updates at: Text Text Linked. In: www. linkedin. com/in/acogert Text Twitter: www. twitter. com/saa 123 www. insurercio. com www. twitter. com/saa 123 i. com 33