From capital allocation to risk management

Alberto Minali, CFA

Head of Capital Allocation and Embedded Value

CSFB Conference - March 21st, 2005

Introduction

2001: development of Ras risk capital model

Since 2002: strategic action to optimize capital, with special focus on ALM tools

2003: set-up of value-based system and integration of Capital and Value into MBO system

2004: determination of EV in line with CFO Forum Principles

1

Risk

Mgmt

ALM EEV

Profit

Test

Risk

Capital

These tools provide a comprehensive framework for enterprise-wide risk management

Group

Risk Capital

2

Ras Risk Capital management

The Risk Capital model was developed with a bottom-up approach, based on the A-L portfolios of the group’s business units

Risk Capital is the amount of resources needed to meet unexpected losses, defined as an adverse variation of net worth in respect of its expected value, with a predefined probability level

Risk Capital is actively managed in order to optimize the risk profile of each business unit

Earnings shift to capital-light business units, with positive impact on overall RORAC

3

Italy

The Risk Capital model

Basic concepts

Dynamic financial analysis driven by Montecarlo simulation with multiple randomness sources (interest rates, equity volatility)

Stochastic approach

Asset / Liability framework

1 year time horizon

Liabilities modeling

Fair value is computed for both assets and liabilities

Consistent with a strategic financial management view (not a control model)

Liabilities are modeled as structured securities, thus highlighting embedded options

Risk-adjusted view

Consistent measures for risk (Risk Capital) and profitability (Embedded Value and Embedded Value Earnings)

4

Italy

“Risk Driver”-based analysis

Business Units LIFELIFE P&CP&C PFSPFS

Risk categories

Reserve

FINANCIAL RISKS

ACTUARIAL

RISKS

OTHER RISKS

Premium

Cat exposure

Expense

Demographic

Calamity

Lapse

Renewal

Expense

HOLDINGHOLDING

BUSINESS

RISKS

Interest rate

Equity

Exchange rate

Credit

Interest rate

Equity

Exchange rate

Credit

Lapse

Interest rate

Equity

Operational

Expense

Interest rate

Equity

Exchange rate

Credit

Operational Operational Operational

= modelled

6

Italy

Risk Capital development

Mln euro - Italy

2000 2001 2002

2,814

2,4622,534

2003

2,283

2004

2,390

2001 - greater financial market volatility (due to Sep. 11), partially offset by lower equity

2002 - further decrease in equity exposure and reduction of Asset-Liability mismatch for Life business

2003 - Launch of traditional product with guarantees at maturity, rather than with yearly consolidation

2004 - Purchase of Mega-cat cover for Cat business

7

Italy

Risk Capital by line of business

Italy

8

56

30

8

7

60

24

5

11

46

29

5

20

57

24

4

15

2001 2002 2003 2004

P+C% on GPWP+C

% on Reserves

Traditional

Unit Linked6.1 4.1

54 47

3.7

42

4.5

42

2001 2002 2003 2004

Life

1.6 2.2 1.7 1.3

100%

PFS

Strategic Stakes and divers.

Italy

Earnings breakdown

20042003

385

Net Income breakdown Italy

P&C63%

5%PFS

450

43%

9%

2004 RORAC

19%

32%Life 48% 33%

28%

13%

9

(1)

(1) Including BNLI integration for 32 mln euro; (2) Net income on Avg. Risk capital

Earnings shift from capital-heavy to capital-light lines of business

Capital investment toward capital-light business units (Life and PFS)

Positive overall impact on total RORAC result

Mln euro

(2)

Italy

Return on capital - Life business Italy

Expected profit

176

Traditional Products 69%

31%Unit-linked products

706

83%

17%

Implied RORAC (1)

46%

21%

10

31% of expected embedded value profit comes from unit-linked products

17% of Risk Capital is invested in unit-linked products

Unit-linked RORAC is 2.2 times traditional RORAC

Mln euro - embedded value figures

Risk Capital

(1) Expected profit on 2004 Risk capital

European Embedded Value

11

Preliminary comments

The new principles for EV calculation provide better valuation of all risk components

The new method of pricing option guarantees on Life books is our risk management tool-bag

Investment decisions, Life product concepts and pricing can be better assessed with this new tool

This framework provided the basis for our Life Asset-Liability strategy and Life traditional product reengineering

12

Italy

EEV methodology

Risk premium is obtained as the sum of a number of risk components on top of the risk-free rate. Ras has identified and measured the following risk components:

• Margin for embedded options: the time value of the put option cost sold to policyholders (calculated with a stochastic model) is expressed as basis points of risk premium

• Margin for financial risk: neutralizes the equity component assumed in projected investment returns. Linked to equity exposure and equity risk premium

• Non-financial risks: associated with lapses, mortality, longevity and business risks, calculated using the Ras Risk Capital Model

The risk premium obtained is company-specific, business-specific, valuation-dependent. Ras calculates a specific discount rate for Traditional Life, unit-linked and Asset management in Italy

13

Italy

Traditional products discount rate Risk-free equivalent to 10 year swap rate - data in %

Italy

20042003

6.61

Remarks

Risk-free

Financial Risk margin 0.89

4.50

1.15Non-financial risks

6.30

0.79

3.75

1.41

Decrease in overall discount rate arises from the 75 bp reduction in the risk-free rate

Stable financial risk margin is consistent with unchanged equity exposure and risk premium

Strong increase in time value component of put options is due to the term structure shift

Higher non-financial risk premium driven by greater lapses risk

Changein bp

-31

+26

0.15Time Value of options

0.35 +20

-10

-75

14

Unit-inked discount rate Italy

20042003

6.75

Risk-free

Financial Risk margin

0.47

4.50

1.78Non-financial risks

6.55

0.77

3.75

2.03

Changein bp

-20

+25

+30

-75

Remarks

75 bp decrease in risk-free rate is partially compensated by increases in other risk factors

Higher financial risk margin is linked to higher average equity exposure

Higher non-financial risk premium driven by lapses risk

15

Risk-free equivalent to 10 year swap rate - data in %

Asset Management discount rate Italy

20042003

7.30

Risk-free

Financial Risk margin

1.35

4.50

1.45Non-financial risks

7.00

1.60

3.75

1.65

Changein bp

-30

+20

+25

-75

Remarks

75 bp decrease in risk-free rate is partially compensated by increases in other risk factors

Higher financial risk margin is linked to higher average portfolio duration and equity risk premium

Higher non-financial risk premium driven by volumes and higher capital absorption

16

Risk-free equivalent to 10 year swap rate - data in %

Preliminary conclusion

The new methodology enables Ras:

• to measure the immediate impact of different ALM strategies on the risk profile of our business and therefore on EV

• to assess the impact of different technical product features (e.g., redemption or penalty fees) on the discount rate and therefore on pricing

With this new methodology in place, Ras can now enhance both risk and value management

2003 old

2003 new

2004 new

2.50% 2.11% 2.55%

Unit-Linked

Traditional

2.50% 2.25% 2.80%

Asset Mgmt

2.50% 2.80% 3.25%

17

Italy

Cost of options risk and non-financial risk margins

18

0.15

Time Value component of cost of option Total Italian portfolio

Italy

20042003

Risk-free

Financial Risk margin

Time Value of options

Non-financial risks

0.35In % of traditional Reserves

Absolute valuemln euro

16.8

36.3

20042003

0.29

0.16

Total Cost of time valueTotal group in Italy Ras-Vitariv

5.4

16.8

20042003

0.27

0.11

0.17Ras Vitariv 0.37

19

Projected financial scenarios and returns

Financial returns of segregated funds are determined on the basis of accounting rules and the management rule

Accounting rules: financial returns credited to policyholders are not marked to market but based on accruals + dividends + realized capital gains

Management rule: the possibility for management to steer financial returns and reduce their volatility

Financial returns of segregated funds generated by stochastic model

years

Financi

al re

turn

s

Best estimate

Scenarios

20

Italy

Cost of the put option

The stochastic model runs 5,000 scenarios and therefore 5,000 financial returns are generated

For each financial return below the minimum guaranteed rate, the model calculates losses incurred by the shareholder

The net present value of these losses, weighted for the probability of the individual scenario, determines the cost of the put option

The put option has two components. Intrinsic value and Time value

Cost of option years

Financi

al re

turn

s

Minimum guaranteed rate layers

Scenarios

years

NPV weighted

for probability

21

Italy

Put option breakdown by intrinsic and time value

years

Financi

al re

turn

s

Minimum guaranteed rate

Scenarios

years

Best estimate

Put value Intrinsic value Time value

Mln euro 107.3 71.0 36.3- =

2004 data

Ras Vitariv 47.0 30.2 16.8

years

Already captured in deterministic EV

22

Italy

2004 data - Rasvitariv

Sensitivity

Time value of option sensitivity

Base premium

Increase of Equity exposure

at 10%

Italy

Bond Duration at 4 years

Equity at 10% and bond duration at 4

years

50 bp decrease in interest rate

Absolute valuemln euro

16.8

21.2

38.8

43.2

24.1

Increase of equity volatility at 20%

0.46%

0.37%

0.85%

0.96%

0.55%

0.41% 19.5

Base case assumptions

5.9%

6 years

10y bond 3.75%

10%

(1)

(1) 50 bp increase in interest rate reduces time value risk margin to 0.23% 23

Asset allocation impact on cost of options

24

Increase of equity

exposure at 10%

50 bp increase in term structure

Current cost of

options risk premium

New cost of options risk premium

37bp -14bp

The upward shift in term structure gives greater room for manoeuvre on asset allocation

At the same time, duration mismatch can be widened dynamically and balanced with equity exposure

2004 data - Rasvitariv

+ 9bp 32bp

Italy

New traditional products

25

Min. guaranteed rate

0%

Cost of options as % of reserves

8 bp

2.5%

99 bp

Represented cost of options refer to the existing book, therefore they have different residual “time to maturity” (duration lengthening increases the cost of option)

Given that a 2.5% non-cliquet option is equal to 0% cliquet guarantees, with the new product structure Ras will gradually save almost 70-80% of the original cost of option

Vitariv, cost of put option (time and intrinsic value)

CliquetNon-cliquet2.5%

37 bp

>4.0%

Avg. 77 bp

Italy

ItalyNon-financial risks margin

Mln euro - Individual business only

2003 2004

Traditional products

2003 2004

Unit-linked

Total risk capital

RC as % of reserves or assets

Mortality lapses business

Non-financial risk margin

Of which in %

1.63% 1.41% 1.78% 2.03%

1.6% 2.5% 1.1% 1.1%

32 21

78 137 69 88

20 3048 49

12 177612 16

67

26

In the unit-linked business, the lapses risk is an important non-financial risk component

This risk is related to the presence of redemption penalties, and could be mitigated by terminal bonuses and guarantees

Product pricing has to be adjusted accordingly

Total risk capital

RC as % of reserves

Non-financial risk margin

Asset Liability Management

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Asset liability strategy

• Protect existing In-force value, taking into account options and guarantees

• Maximize return on embedded value

• Maximize returns for both actuarial and financial risk capital

• Separate asset management decisions from liability dynamic, due to positive cash flow

Life business main goals

Asset Liability management has two operational constraints:

- Capital budget

- Liability structure (minimum guaranteed rate layers, and cliquet options)

Asset allocation uses RORAC as value function

More aggressive asset allocation in P&C than in Life, in terms of equity exposure and bond duration

P&C business main goals

28

Italy

Life asset liability management

Life embedded options generate risk aversion...

RORAC / ROEV curve

LifeP+C

Financial Risk Capital

RORAC - ROEV

…limiting opportunities for financial risks

Life: Asset allocation impact

95% bond5% equity

In-force net of option

Time value of options

351 16.8

Ras Vitariv – mln euro

90% bond10% equity 349 21.2

80% bond20% equity 347 25.6

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Italy

Life: Traditional portfolio ItalyRas Vitariv - starting year 2005 - equity exposure 6%, corporate bond 19.2%, 2004 recorded return 5.02% of which 4.96% ordinary

yearsYie

ld

Assets

Liabilities

2005 2015

4.7%

5.0%

2.9%

3.4%

Asset and Liability cash flow

1 2 3 4 5 6 7 8 9 10

Cash flow Mismatch

2005 2015years

990 1,250750 500

-800 -850 -600 -700

+190 +400+150

-200

Projected financial returns and avg. min. guaranteed

30

P&C: RORAC optimization

Asset allocation

in accordancewith RORACoptimization

Base - 100 - 2006 expected data

Financial Risk Capital

FinancialRORAC 9.8%

Technical RORAC 13.4%

Liability vsactuarial

department(cost

equal torisk-free

rate)

TotalRORAC 15.4%

Assets transfer

to Financialdepartment

(financialreturns equal to

risk-free rate) ActuarialRisk Capital

Reserves

Investments

Financial and Actuarial Risk

Capital

Reserves

Risk capital generated by asset allocation to maximize RORAC

Technical RORAC must have positive spread vs. cost of capital w/o any financial contribution

Total RORAC benefits from diversification between financial and technical risk

31

Italy

P&C: Risk capital budget

390390Risk capital

budget

Actual Asset allocation

Target asset allocation

305305

Expected financial income

Profit at 99% confidence

level

Loss at 99% confidence level

Stop-loss mechanism allows attainment of expected financial income of 216 mln euro, even in adverse market conditions

0

34

230

268

425

320

Stop loss 216216

Mln euro - 2004 Asset allocation: 5.5% equity, bond duration 4.6, corporate bond 23.8%

32

Italy

Conclusion

33

Final remarks Group

This model is the common language of our management and the backbone of the Ras decision-making process

The new set of tools enables Ras to control its risk profile and the risk drivers of each business unit

It is also a competitive factor in pricing the risk component of products and taking advantage of market opportunities, while benefiting from market inefficiency

The framework drives capital investment decisions with a view to maximizing capital return and therefore shareholder value

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Certain of the statements contained herein may be statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. In addition to statements which are forward-looking by reason of context, the words “may, will, should, expects, plans, intends, anticipates, believes, estimates, predicts, potential, or continue” and similar expressions identify forward-looking statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (i) general economic conditions, including in particular economic conditions in RAS Spa’s core business and core markets, (ii) performance of financial markets, including emerging markets, (iii) the frequency and severity of insured loss events, (iv) mortality and morbidity levels and trends, (v) persistency levels, (vi) interest rate levels, (vii) currency exchange rates including the Euro - U.S. dollar exchange rate, (viii) changing levels of competition, (ix) changes in law and regulations, including monetary convergence and the European Monetary Union, (x) changing in the policies of central banks and/or global basis.The matters discussed in this release may also involve risks and uncertainties described from time to time in Allianz’s filings with the U.S. Securities and Exchange Commission Allianz assumes no obligation to update any forward-looking information contained in this release.

Cautionary Note Regarding Forward-Looking Statements

35