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Investment Symposium March 2010

F4: ALM in Today's Environment

Pin Johnny Chung Axel Andre

Moderator Frank Zhang

1

ALM in Today’s Environment

Dr. Pin Chung, March 22nd, 2010g, ,

AgendaALM and ERM in today’s environment

ERM defined, framework, definitions and key risksERM defined, framework, definitions and key risks

More on ERM, modeling approaches, effective factors

ALM in ERM

ALM processes, workflow, tasks, analysis, and models

ALM enterprise partners and applications

Conclusions

2

Conclusions

2

ALM and ERM in today’s environment

ERM is the strategy that aligns the firm’s business with the risk factors of its environment in the pursuit of strategic objectives

Tillinghast-Towers Perrin survey reveals 80% of survey participants consider ERM useful in pursuing earnings growth, revenue growth, return on capital, and expense control

ALM is the core activity of ERM for financial institution

3

ERM defined

Strategyalignment of a firm with its environmentalignment of a firm with its environment

ERMaligns business with risk factors of its environment in pursuit of business goals

A firm’s goal: to create economic value

A framework links strategy, process, organizational forms, human

4

resources, IT, and other areas to improve performance

The general ERM goal:to identify drivers of performance; to plan a path for managerial actions to improve performance metrics

3

ERM framework

Organizationapproaches

Conceptualframework

•Market risk•Credit risk•Liquidity risk•Operational risk•Business risk•Other risks

Firm’s Objectives

5

Tools

Some definitionsFinancial risk

Unpredictable event results in a financial lossA fi ill t t ifi d fi i l lA firm will not meet some specified financial goals

RiskRisk is more of a choice than a chance

Risk ManagementProvides tools to measure risks and techniques to make rational decisions

BusinessPackage and sell risks by designing pricing capitalizing funding and marketing

6

Package and sell risks by designing, pricing, capitalizing, funding, and marketing financial products

ObjectiveUse cash flows generated from business activities, with leverage debt or equity capital to enhance economic value through growth of earning, cash flow stability, and reduced costs of financial distress

4

Key risks

Liquidity riskFunding risk: when an institution is unable to raise cash to fund its activitiesgTrading risk: unable to execute a transaction at the prevailing market prices

Market riskRisk arising from changes in financial market prices and rates

Credit riskRisk of an un-kept payment promise when an obligor defaults, or rating changes

7

Operational riskLosses due to human error, fraud, management failure, systems, data or legal actions

Business riskDue to volatility of volumes, margins, or costs when engaging in the firm’s business

More on ERM

ERM takes a global view of the firm on the enterprise level

ERM takes a global view on the risks the firm is exposed to

ERM takes an integrated view of the business processes to achieve the goal of alignment efficiency and adding value

For example, integrated financial product management of its product

8

For example, integrated financial product management of its product design, pricing, capitalizing, funding and marketing

5

Two approaches

To manage the risk adjusted return across: product design, pricing, and funding by looking at the following 3Ps of ERM (Lo’90):1. Probability of extreme events2. Process of asset risk and return profile3. Preference towards risk

1. Single line business: Repackage financial risks, price them, transfer to other market participants

or hold them in a portfolio

9

2. Multiple financial products: Manage the business portfolio problemFind appropriate product mix and allocate the firm’s capital, taking an

integrated view of risks and returns of competing lines of business

Single line business

Marketing

Product Design

Optimal asset

allocation

Asset class 1

Asset class 2

…

Asset class N

PricingALM SAA

10

ALM and Inforce Management

Liability profile

Asset return profile

6

Multiple financial products

Design, Pricing, Funding, and Inforce Management

St t i t f b i fil f lti l d diStrategic management of business profile of multiple and diverse products

Strategic Objective:allocate capital among LoBs; consistent with risk-adjusted ROE (or other metrics)satisfying risk based capital and all other regulatory requirements

Integration of design, pricing and funding of each product will result into

11

a process that maximizes risk-adjusted return for each product

Note that risk-adjusted return of a product is not independent from the composition of the overall portfolio which leads to “portfolio choice problem”

Multiple line portfolio problem

ALM Marketing

Pricing SAA

Product DesignN

Optimal asset

allocationN

Asset class 1N

Asset class 2N

…

Asset class NN

Markowitz solutionEnterprise level

12

ALM and Inforce Management

Liability profiles

Asset return profiles

Markowitz solutionEnterprise level

7

Effective ERM factors

Risk MeasurementMetrics include: VaR, CTE, Duration, Convexity, Key Rate Durationy y

Risk ManagementSupports diversification, hedging, risk transferProvides portfolio compression, risk decomposition, what if analysis, hedging and optimization of complex portfolios

Performance Measuref f f ’ f

13

Estimate contribution of each risk factor to the firm’s overall risk profile

Corporate GovernanceMake sure components of ERM are in place; function properly; and are aligned with each other and with the objective of the enterprise risk management strategy

ALM in ERM

Management of firm’s balance sheet is at the core of ERM

Th b l h t fl t th i k f th i t f th tThe balance sheet reflects the risks of the environment from the asset side and most of the business risks from the liability side

To align these risks is the goal of ALM

ALM provides tools for risk measurement and risk management

ALM takes a more focused view of risks than ERMAsset side: market, credit and liquidity risks

14

, q yLiability side: volatility of margins and cost

ALM: Markowitz’52, Asset Allocation; Sharpe and Tint’90, Liabilities

8

ALM processes and ALM charterALM processes:

1 E t bli h h i ALM li1. Establish a comprehensive ALM policy

2. Define risk tolerances by integrating with the firm’s business strategies

3. Monitor risk metrics relative to defined tolerances

4. Initiate corrective actions when metrics break policy limits

5 P i di ll i ALM li d k dj t t h d d

15

5. Periodically review ALM policy and make adjustments when needed

ALM charter members:CEO, CFO, CIO, Chief Actuary, CRO, Asset Manager, Hedging Head

ALM workflow

Data Storage contractual obligations, scenarios, risk assumptions, new business, marketing

i b h i i

Analytic Tools

assumptions, behavior assumptions

Risk Measurement: market valuation, option adjusted analysis, Value-at-risk, Scenario analysis

Risk Management: active dynamic analysis, Hedging, Portfolio optimization

16

Results

ReportingProvide report to regulators, rating agencies, and shareholders: earnings, EaR, VaR, what if analysis

9

ALM tasks

ALM TasksCurrent and future valuation Align the asset and Current and future valuation

Earnings and balance sheet simulation

Sensitivity and scenario analysis

liability sides of balance sheet through

asset allocation or capital allocation

When “neutralized”:

17

Dynamic balance sheet modeling

alignment of assets and liabilities is achieved. E.g., duration matching to neutralize market risk due to parallel shifts of the term structure

ALM analysisBase economic environment:

Conduct cash flow analysis, duration and convexity calculations

Other Economic Environment:Forecast or simulate of interest rates, exchange rates and credit spreads

Simulate the balance sheet by reporting the assets and liabilities under assumed scenarios

Dynamic analysis:Passive: time evolution of the current balance sheet

18

Active: focus on explicit ALM strategies

Simulation:Future, dynamic across time

10

ALM example

Effective Duration10 Effective Convexity1 5

0

2

4

6

8

Year

s

Liabilities (1)

AssetsxMBS (2)

Assets (3)

MBS (4)(1 0)

(0.5)

0.0

0.5

1.0

1.5

-100 0 100 200Yea

rs

Liabilities (1)

19

0-100 0 100 200

Parallel Shift in Yield Curve (BP) (1.5)

(1.0)

Parallel Shift in Yield Curve (BP)

Liabilities (1)AssetsxMBS (2)Assets (3)MBS (4)

ALM modelsQuestion is:

How to address risk measurement and risk management problems with respect to time and uncertainty?respect to time and uncertainty?

Time:Single-period: static time model; t = 0, only one decision is madeMultiple-period: dynamic time model; portfolio decisions will be made at t =1,

2, …, T, and these decisions are explicitly modeled

Risk factors:St ti th i t t t d l tiliti t

20

Static: the economy environment, asset returns and volatilities, term structure of interest rates will remain at their current state and change with small shifts

Stochastic: evolve with time according to some probability distributions; scenarios drawn from this distribution are explicitly incorporated in the model

11

ALM model clarification table

Risk

Single periodStochastic Model

Multiple periodStochastic Model

Time

21

Multiple periodStatic Model

Single periodStatic Model

ALM enterprise partners

Senior Management

Finance

Corporate Tax

Investment Product

Portfolio Managers, Asset Managers

Risk Management

Senior Management

ALM

22

Accounting

Investment Operations Financial

Reporting

Product Development

Management

12

ALM applications

Corporate

Personal WealthManagement

Real Estate Companies

Pension PlansAlternative

Asset Managers

Equity analyst and Investors

function

ALM

23

Pension Plans

Life and P&C

Credit Unions

Depository Institutions

Investments

Conclusions

Risk is opportunity

ALM is the current and future cornerstone of an effective ERM

ALM is one of the best tools to implement a firm’s strategies

24

Thank you! Q&A!Dr. Pin Chung, [email protected], 763-765-7647

13

Appendix

Handbook of Fixed Income Securities, 7th edition, F.J. Fabozzi, McGraw Hill Professional, 2008Handbook of Asset and Liability Management, S.A. Zenios and W.T. Ziemba, Elsevier, 2006H.M. Markowitz, Portfolio Selection, Journal of Finance, 7, 77-91, 1952W.F. Sharpe and L.G. Tint, Liabilities -- a new approach, Journal of Portfolio Management, 5-10, Winter, 1990A.W. Lo, The three P’s of total risk management, Financial Analyst Journal, 51-57, January/February, 1999

25

Private conversation: Duane Gajewski, Steve Thiel, Darryl Johnson, Matt Gray, Ross Bowen

1

SOA Investment Symposiumy pALM in Today’s EnvironmentAxel André, Goldman Sachs Asset Management

March 22, 2010

Goldman Sachs Asset Management

Insurers face risks from various parts of their business• Asset portfolio risks• Liability risks• Interaction between assets and liabilities

Asset portfolio risks include:

What is Asset Liability Management (ALM)?

p• interest rate• credit spread• credit downgrade• credit default• equity market

Liability risks include:• mortality / morbidity• longevity• policyholder behavior

catastrophe risk

1

• catastrophe riskRisks arising from interaction between assets and liabilities include

• disintermediation risk (e.g. disinvestment, reinvestment)• liquidity risk• surplus volatility

– must maintain adequate level of regulatory surplus to ensure solvency– must maintain adequate level of rating agency capital to prevent downgrades

ALM establishes a framework for measuring and managing asset and liability risk exposures systematically

2


Typical ALM mismatch risks are:• Disinvestment Risk arises when fixed-income assets must be sold prior to maturity to meet cash flow needs

– Exposes the insurer to the risk of rising interest rates / credit spreads, potentially triggering the realization of losses when assets are sold

• Reinvestment Risk arises when cash flows have to be reinvested

Why is ALM Important?General ALM Risks

– Exposes the insurer to the risk that available yields fall below the yield assumed / guaranteed for pricing of the liability

90

100

110

120

130

140

Liability duration 5.2 / Asset duration 8.0

Disinvestment Risk

90

100

110

120

130

140

Liability duration 12.1 / Asset duration 8.0

Reinvestment Risk

2For illustrative purposes only.

70

80

90

-2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5%

Change in Yield

MV of Assets MV of Liability

70

80

90

-2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5%

Change in Yield

MV of Assets MV of Liability


Technique Description Considerations

Duration Matching Match duration of liabilities with asset portfolio (within reasonable tolerance limits)

May not eliminate liquidity risk + ignores credit spread duration

Typical ALM Techniques & Considerations

( t easo ab e to e a ce ts) c ed t sp ead du at o

Key Rate Duration Matching

Construct a portfolio that matches KRD of liability More effective than matching duration alone but ignores credit spread duration

Cash Flow Matching

Design an asset portfolio to replicate liability cash flows (within some tolerance)

Typically costly strategy to implement + may not be achievable

Minimizes interest rate risk, but ignores credit spread duration

Liquidity Planning

Cash flow needs must be monitored closely to avoid liquidity issues

Insufficient liquidity may force insurer to sell assets and realize gains/losses

Uncertainty in structured products cash

3

Uncertainty in structured products cash flows

Capital Considerations

Insurers need to be mindful of regulatory, rating agency, and economic capital

Some regulatory capital methodologies penalize ALM mismatch

Economic capital is becoming more important + Solvency II in EU

3


estm

ent

Con

stra

ints Define objectives: total return, yield, capital efficiency, surplus

volatilityDetermine insurance specific constraints:• Tolerance for ALM mismatch

ALM Step by Step Process: Objectives & Constraints

Target Investment Return 5.5%Risk apetite / Volatility 4.5%Duration mismatch tolerance (yrs) 0.2KRD mismatch tolerance (yrs) 0.1

Objectives & ConstraintsSt

ep 1

: Inv

eO

bjec

tives

& C • Exposure limits by asset class

• Regulatory / Statutory / Rating Agencies• EconomicSet risk appetite: portfolio volatility (asset-only), surplus volatility (assets net of liability), earnings volatility…etc

Uni

vers

etio

ns

Choose from broad set of investible assets to maximize the risk-adjusted return

• Asset classes’ risk-return profile are key to finding the mostCred Aa LongCred A Long

Cred Baa Long HY BB Int

HY BB Long

CMBS

5%

6%

7%

8%

9%

ld

Investment Grade Credit A & higher 80%Investment Grade Credit BBB 30%High Yield Credit BB 10%MBS / ABS / CMBS 25%

Exposure Limits

4

Step

2:

Asse

t U&

Ass

umpt • Asset classes risk-return profile are key to finding the most

suitable solution

Correlations between asset classes and correlation of asset classes with liability profile are key to find risk-optimal solution

For illustrative purposes only. Investment objectives and constraints may vary for each client.

Govt Int

Govt Long

Cred Aa Int

Cred A IntCred Baa Int

MBS

ABS

1%

2%

3%

4%

5%

0% 5% 10% 15% 20%

Yie

Total Return Volatility


ty C

ash

Flow

ile

Best estimate liability cash flows help construct portfolios

• Maturity profile of portfolio

• For products with embedded options, a dynamic approach

ALM Step by Step Process: Liability Profile

80

120

160

ash

Flow

($m

m)

Step

3:

Liab

ilit

Prof

iy

Key

Rat

e ro

file

should be used to reflect the variability of cash flows in different market scenarios

Liability key rate durations (KRD) provide more granular view of interest rate risk and help allocate the total duration risk to the relevant maturity buckets

Asset portfolios that match liability KRD will minimize interest rate

-

40

2010 2015 2020 2025 2030 2035 2040

Liab

ility

Ca

Year

1.5

2.0

2.5

urat

ion

(yrs

)

5

Step

4:

Liab

ility

Dur

atio

n Pr risk

• Better than duration match but not necessarily a cash flow match

For illustrative purposes only

-

0.5

1.0

6m 2y 5y 10y 20y 30y

Key

Rat

e D

u

Key Rate

4


ALM Step by Step Process: Strategic Asset Allocation

us E

ffici

ent

tier

Find portfolios that achieve target return and minimize the risk• Surplus volatility measures the volatility of assets net of

liabilities • Surplus volatility captures the impact of ALM (mis)match:5.0%

5.5%

6.0%

6.5%

folio

Yie

ld

Step

5: S

urpl

uFr

ont

gic

Asse

t on

– ALM mismatch more surplus volatility– Can be thought of as ALM mismatch tolerance on an

economic basis• Risk-return tradeoffs can be evaluated with and without

constraints (duration mismatch tolerance, exposure limits…etc)

Overall strategic asset allocation (SAA) decision should reflect insurers’ objectives and constraints and incorporate ALM objectives as well

Govt5%

Cred AA15%

Securitized19%

3.5%

4.0%

4.5%

0.0% 1.0% 2.0% 3.0% 4.0%

Port

f

Surplus Volatility

6For illustrative purposes only. Portfolio construction will vary for each client based on constraints and objectives.

Step

6:

Stra

teg

Allo

catio SAA can be used as benchmark for security-level portfolio

construction

Cred A28%

Cred BBB23%

Cred BIG10%


Risk of Rising Interest Rates, Steep Yield Curve and ALM

4.34%3.75%

5.00%

4.0%

5.0%

6.0%

Yiel

d

Current steep yield curve implies a forward rise in interest rates

• 10y Treasury yield implied to rise to 4.1%

0.0%

1.0%

2.0%

3.0%

0 5 10 15 20 25 30

Trea

sury

Y

Term (yrs)

YE 2009 YE 2010

YE 2011 WSJ Forecasting survey - mean

WSJ Forecasting survey - 10th pctile WSJ Forecasting survey - 90th pctile

10y Treasury yield implied to rise to 4.1% by 12/31/2010 (29bps yoy rise) and 4.6% by 12/31/2011 (48bps yoy rise)

• 30y Treasury yield implied to rise to 4.9% by YE2010 (21bps yoy rise) and 5.1% by YE2011 (24bps yoy rise)

WSJ economists forecasting survey forecasts 10y Treasury yield at 4.34% by YE2009

7

Historically low yields difficult to meet net investment income targets without investing longer than the liability

Risk of rising interest rates should one take a view and invest shorter than the liability ?

Source: Wall Street Journal Online Forecasting Survey, January 2010For illustrative purposes only.

5


Case StudySPIA Block 8.2 yrs Duration

160

m) 2.5

Liability Cash Flows Liability Key Rate Durations

-

40

80

120

2010 2015 2020 2025 2030 2035 2040

Liab

ility

Cas

h Fl

ow ($

mm

Year

-

0.5

1.0

1.5

2.0

2.5

6m 2y 5y 10y 20y 30y

Key

Rat

e D

urat

ion

(yrs

)

Key Rate

8

Liability duration = 8.2 yrs

• KRD help construct portfolios that minimize interest rate risk need long duration (15y+ maturity), intermediateduration (5-15y), and short duration assets

Liability discount rate for statutory reserving / pricing of product

• Target yield that matches liability discount rate / minimizes shortfall

For illustrative purposes only.


Case StudyPortfolio Construction – Economic View

6.0%

6.5%

3.5%

4.0%

4.5%

5.0%

5.5%

0.0% 1.0% 2.0% 3.0% 4.0%

Port

folio

Yie

ld

Surplus Volatility

9

At each target portfolio yield, minimize the surplus volatility, i.e. risk of assets net of liabilities

• Interest rate risk from liability is partially offset from asset portfolio duration

Interest rate duration

• Should Duration / KRD match be a constraint of optimization ?

• Should KRD (mis)match be a result of optimization (i.e. optimal net risk allocation may be slight long/short IRduration + slight long credit risk)

For illustrative purposes only. Performance results vary depending on the client’s investment goals, objectives, and constraints. There can be no assurance that the same or similarresults to those presented above can or will be achieved.

6


Case StudyIR Duration Risk: Should KRD match be a Constraint?

1.5

2.0

(yrs

) Net long duration

6.0%

6.5%

d

(1.5)

(1.0)

(0.5)

-

0.5

1.0

3.5% 4.0% 4.5% 5.0% 5.5%

Asse

t -Li

abili

ty D

urat

ion

Portfolio Yield

KRD matched KRD constraint relaxed

Net short duration

3.5%

4.0%

4.5%

5.0%

5.5%

0.0% 1.0% 2.0% 3.0% 4.0%

Port

folio

Yie

ld

Surplus Volatility


Less efficient due to KRD constraint

10

Imposing KRD match as a constraint implies that the only net risk between assets and liabilities is credit risk

• May result in less diversified results than allowing for some rate risk + some credit risk + diversification benefit

• Minimizing surplus volatility “naturally” results in approximately matched duration

• Unconstrained net duration gap may range from short ~ 1 yrs to long ~1.5 yrs



Case StudyKRD Matching Efficient Portfolios

5 5%

6.0%

6.5%

eld 80%

90%

100% Securitized

HY BB Long

HY BB Int

3.5%

4.0%

4.5%

5.0%

5.5%

0.0% 1.0% 2.0% 3.0% 4.0%

Port

folio

Yie

Surplus Volatility


0%

10%

20%

30%

40%

50%

60%

70%

3.7%

3.8%

3.9%

4.0%

4.1%

4.2%

4.3%

4.4%

4.5%

4.6%

4.7%

4.8%

4.9%

5.0%

5.1%

5.2%

5.3%

5.4%

5.5%

5.6%

Cred Baa LongCred Baa IntCred A LongCred A Int

Cred Aa LongCred Aa Int

Govt Long

Govt Int

11

All portfolios match liability KRD within 0.1 yrs tolerance (and 0.2 yrs for overall duration)

• Exposure limits set maximum exposures to e.g. Corp Credit BBB, below investment grade credit (BIG),Securitized products (ABS/MBS/CMBS)

Is it “worth” taking some IR duration risk and increasing the available yield for a given level of surplus risk ?


7


Case StudyTo Match or Not To Match ?

80%

90%

100%

Securitized

HY BB LongA

B

5.5%

6.0%

6.5%ie

ldImpact of +50bps rise in rates

Is it “worth” taking some IR duration risk and increasing the available yield for a given level of surplus risk ?

0%

10%

20%

30%

40%

50%

60%

70%

A B

HY BB Int

Cred Baa Long

Cred Baa Int

Cred A Long

Cred A Int

Cred Aa Long

Cred Aa Int

Govt Long

Govt Int

3.5%

4.0%

4.5%

5.0%

0.0% 1.0% 2.0% 3.0% 4.0%

Port

folio

Yi

Surplus Volatility


KRD matched +50bps impact KRD constraint relaxed + 50bps impact

12

g g y g p

Taking interest rate duration risk by investing longer than the liability may result in higher or lower returns

• Not KRD matched = more risk = (much) wider range of potential outcomes

Insurer’s statutory balance sheet does not coincide with pure economic / mark-to-market view

C-3 Phase I and Cash Flow Testing will pick up ALM mismatch

Does the “economic” risk of being net long duration lead to any statutory balance sheet impact ?

Which portfolio is better: A or B?



Case StudyPortfolio A (KRD matched) vs. Portfolio B (mismatched)

Portfolio A: 8.2 yr duration / 5.7% yield Portfolio B: 9.7 yr duration / 6.2% yield

120

160

mm

)

120

160

mm

)

0

40

80

120

2010 2015 2020 2025 2030 2035

Cash

Flo

ws

($m

YearLiability Assets (not default-adjusted)

0

40

80

120

2010 2015 2020 2025 2030 2035

Cash

Flo

ws

($m

YearLiability Assets (not default-adjusted)

0 0

1.0

2.0

3.0

urat

ion

(yrs

)

-

1.0

2.0

3.0

urat

ion

(yrs

)

13

(3.0)

(2.0)

(1.0)

0.0 6m 2y 5y 10y 20y 30y

Key

Rat

e D

u

Key Rate

Liability Assets Net

Is the extra 50bps in yield worth the risk of running a 1.5 yrs duration mismatch ?

(3.0)

(2.0)

(1.0) 6m 2y 5y 10y 20y 30y

Key

Rat

e D

u

Key Rate

Liability Assets Net


8


Case StudyPortfolio A vs. Portfolio B: Unrealized Gains & Losses


2

4

mm

)

2

4

mm

)

Assets and Liability cash flows, book value, market value are projected forward for Portfolio A & B

Di i t t / R i t t ti d t d id hi h t t ll / h t t i t i

(8)

(6)

(4)

(2)

-

2

2010

2015

2020

2025

2030

2035

2040

Unr

ealiz

ed g

ain/

loss

($m

Maturity Year

Total URG/L URG/L non-Fin URG/L Fin

(8)

(6)

(4)

(2)

-

2

2010

2015

2020

2025

2030

2035

2040

Unr

ealiz

ed g

ain/

loss

($m

Maturity Year

Total URG/L URG/L non-Fin URG/L Fin

14

Disinvestment / Reinvestment assumptions used to decide which assets to sell / what to reinvest in

• Disinvestment: rank assets by maturity year, then inside of each maturity bucket rank by size of unrealizedgains / losses

• Sell short maturity assets with least unrealized losses (most gains) first

• Reinvestments: reinvest in 10y A corporate bond (shorter if final maturity of 2040 is < 10y away)

Liability statutory discount rate assumed to be 6% for calculating statutory reserves and surplus



Statutory Surplus ProjectionPortfolio A vs. Portfolio B on Forward Rates Scenario


10

20

mm

)

10

20

mm

)

Portfolio A closely KRD matched but not completelycash flow matched

(40)

(30)

(20)

(10)

-2009 2014 2019 2024 2029 2034 2039

PV S

tatu

tory

Sur

plus

($

Forwards Forwards + 150bps steepness

(40)

(30)

(20)

(10)

-2009 2014 2019 2024 2029 2034 2039

PV S

tatu

tory

Sur

plus

($

Forwards Forwards + 150bps steepness

Portfolio B suffers cash flow shortfalls in early years

• Assets must be sold to meet liquidity needs

15

• Surplus initially dips: portfolio yield < liabilitydiscount rate

• Portfolio yield eventually overtakes liabilitydiscount rate

Rising rates lead to better statutory surplus

• Reinvested (slight) excess cash flows earnhigher yield


• Realized gains and higher portfolio yield leadto better result than A on the “Forwards”scenario

Rising rates reduce unrealized gains and forcedasset sales to meet liquidity needs result in realizedlosses much worse surplus result than A


9


Statutory Surplus ProjectionPortfolio A vs. Portfolio B in Rising/Falling Rates


100

$mm

)100

$mm

)

(100)

(50)

-

50

2009 2014 2019 2024 2029 2034 2039

PV S

tatu

tory

Sur

plus

($

Dec 5y Inc 5y ForwardsForwards + 150bps steepness Inc 5y Dec 5yLevel Pop DownPop Up Unif. Dec 10yUnif. Inc 10y

(100)

(50)

-

50

2009 2014 2019 2024 2029 2034 2039

PV S

tatu

tory

Sur

plus

($

Dec 5y Inc 5y ForwardsForwards + 150bps steepness Inc 5y Dec 5yLevel Pop DownPop Up Unif. Dec 10yUnif. Inc 10y

16

Portfolio A very closely cash flow matched

• No asset sales are required to meet cash flowneeds

• Low sensitivity to interest rates scenarios

• Lowest risk strategy

PV of ending surplus is $2mm on average with arange of +/- $4mm

Portfolio B suffers cash flow shortfalls in early years


• High sensitivity to interest rates scenarios

• Great results in falling rates scenarios

• Painful results in rising rates scenarios

PV of ending surplus is $8mm on average with arange of +/- $50mm



Case StudyConclusions

Rebalancing from portfolio B (duration mismatched but higher yield) to portfolio A (matched but lower yield)would result in (for $1bn book value):

R d ti i tf li i ld f 6 2% t 5 7%• Reduction in portfolio yield from 6.2% to 5.7%

• Sale of $261mm book value of assets (25% of portfolio), purchase of $257mm of assets

• Realized losses of $11mm (1.1% of book value)

• Day one net impact to statutory surplus of $(18)mm (1.8% of book value) [may be less due toIMR/AVR]

Resulting outcome of rebalancing from A to B is to lock-in a statutory loss of $(16)mm with a potential rangeof +/- $4mm

• Portfolio B results in a PV expected statutory surplus of $8mm with a potential range of +/-$50mm

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p y p $ p g $

Importance of defining / analyzing risk-return trade-offs and implications on economic, statutory, andaccounting basis

When deciding whether to take risk or not, risk-adjusted returns are key metric


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General DisclosuresTHIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

Copyright © 2010, Goldman, Sachs & Co. All rights reserved. Compliance Review #: 33601.NPS.OTUCopyright © 2010, Goldman, Sachs & Co. All rights reserved. Compliance Review #: 33601.NPS.OTU

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