SFSC’s Credit risk working group update Development of internal model methodology for regulatory capital (Credit Risk Only) September 25, 2008

Contents Introduction to working group members Scope and criteria for credit risk capital Summary of regulatory solvency models compared CRWG’s draft proposal Implementation considerations

Introduction to credit risk working group (CRWG) Section 1

List of members of Credit Risk Working Group (CRWG) Bryan Rowe, Director, Economic Capital, SunLife Financial Cam MacDougall, VP, Credit Risk Management, Manulife Financial David Ayers, Director Bond Investments (Risk Management) , Great West Life Erik Von Schilling, Senior Manager , TD Life Jean- Guy Lapointe, Capital Division, OSFI Karim Nanji, Director, Strategic Planning, Munich Re Mark Austin, Vice President, RBC Simone Brathwaite, Principal, Oliver Wyman

Scope and criteria for credit risk capital Section 2

Scope: Possible working definitions of credit risk Broad definition (aligned with Solvency II – includes market liquidity risk) Credit risk is the risk of loss or of adverse change in the financial situation resulting from fluctuations in the price or value of securities and counterparty debt due to: Adverse fluctuation in credit quality of issuers, counterparties and debtors (specific risk) Adverse fluctuation in market liquidity (systemic risk or generic spread-widening) Stricter definition (aligned with Basel II IRB – excludes market liquidity risk) Credit risk is the risk of loss or of adverse change in the financial situation resulting from fluctuations in the credit standing of issuers, counterparties, and any debtors CRWG favoured the treatment of “market liquidity risk” under a separate risk model Note – “Market” liquidity risk is also referred to as generic spread risk

Objectives of internal solvency model for credit risk Consistent with over-arching principles for all risks, such as Confidence level 1 year time horizon Captures all material risk drivers appropriately – without unnecessary complexity Relevant and useful for managing risk – incentives risk management Appropriate reflection of risk mitigation techniques Appropriate capture of diversification and correlations Widely-recognized and vetted industry approach – an approach which is compatible internationally

Summary of regulatory solvency models reviewed Section 3

Capital held for default losses over 1 year time horizon CRWG reviewed 2 regulatory frameworks 1. Basel II formula-based approach Basel II approach – pillar 1: Advanced Internal Ratings Based formula-based approaches Credit risk capital is determined using a closed-form analytical formula: Advanced IRB - certain input parameters are determined internally at a transaction-level Key advantages: Widely recognized by global financial industry and Canadian regulator Captures pure credit risk - loss of value due to defaults and migrations at Excludes systemic risk (market liquidity risk/generic spread widening) Consistent with the one-year time horizon Key disadvantages: Single factor correlations (the economy or portfolio taken as the single factor) Also assumes infinite granularity and maturity multiplier cap of 5 years Unclear if it will integrate well with proposed model approaches on other risks Basel Capital = (Worst case loss – Expected Loss) x Maturity Multiplier Capital held for default losses over 1 year time horizon Capital held for value loss from credit migrations over 1 year time horizon

…and 2. proposed Solvency II model for credit risk 2. Proposed Solvency II approach for European insurers Credit risk capital also determined using a closed form analytical approach Where credit risk is expressed primarily by the volatility of credit spreads, and Movements in credit spreads assumed to capture pure credit risk and market liquidity risk Includes an additional explicit recognition of specific risk arising from high concentrations Key advantages: A theoretically fully integrated model which captures both credit and market liquidity risk Disadvantages: Cannot be used to manage risk at transaction level (grouped by public rating) Theoretically fully integrated, but unclear as to whether available data can appropriately parameterize model (e.g. not clear that data captures default risk- over 1 yr time horizon) Not used industry wide as sole approach – SST uses this approach in combination with a default loss Basel II type model

CRWG’s preference is for a Basel II modified approach In addition to existing regulatory models – CRWG discussed the option of using stochastic portfolio models However, despite possible advantages, during discussions it was determined that neither the insurance industry nor the regulator would be ready for this option over the next 5-8 years As a result CRWG is in favour of using the Basel II advanced IRB analytical formula approach with possible enhancements to address: Restricted maturity under Basell II Assumption of infinite granularity Integration with other proposed risk models Next steps: MAC to prioritize modifications and investigate resources to specify model modifications

CRWG’s draft proposal Section 4

Overview of IRB formula based approach The formula is based on 5 key parameters: PD – Probability of default LGD – Loss given default EAD – Exposure at default Correlation (Asset Correlation) Effective Maturity (similar to duration) The capital formulas determine Basel II capital net of EL: Basel capital is intended to cover the unexpected loss portion of the loss distribution, whereas balance sheet asset values are intended to cover the expected loss portion Under the AIRB, financial institutions provide the PD, LGD, EAD and Effective Maturity parameters The correlation parameter is based on standardized formulas Relative to the Standardized approach, the IRB approaches are designed to yield a capital benefit via lower PDs

The Basel II capital formula computes a capital requirement for each holding individually . . . Transaction level credit capital ‘Worst case’ loss1 Expected loss = – Transaction level credit capital ‘Worst case’ default loss Expected default loss Maturity multiplier = – x Capital held against loss due to default Multiplier accounts for value loss due to credit migration Transaction level credit capital ‘Worst case’ Probability of default (PDwc) Expected Probability of default (PD) – Loss given default2 (LGD) Exposure at default2 (EAD) Maturity multiplier = x x x ‘Worst case’ losses are those that occur for the 99.95% worst case of the economy. Basel II assumes static LGD and EAD—the same values are used for the ‘worst case’ and ‘expected’ scenarios

Portfolio level credit capital Transaction level credit capital . . . and sums the transaction level numbers to generate a portfolio level capital requirement Portfolio level credit capital Σ Transaction level credit capital = Portfolio capital represents the aggregate ‘worst case’ loss minus the aggregate expected loss by summing transaction-level capital The Basel methodology assumes infinite granularity in the portfolio, not capturing the effects of single-name concentration

Implementation considerations Section 4

What to expect for internal approval OSFI will expect a rigorous validation framework to confirm the accuracy and consistency of the Company’s internal rating system Approval will also depend on the robustness of quantification, corporate governance oversight, quality of documentation, and the use test For further details - See CAR A-1 (Chapter 5) and Implementation notes for IRB institutions on OSFI’s website http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?articleid=1218 http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/guidelines/capital/guidelines/CAR_A1_e.pdf For companies planning to seek approval on implementation date (2014) Provide statement of intent before Oct 14, 2008 Gap analysis, implementation planning (with OSFI) before 2011 Formal application by 2012 Parallel reporting 2012-2014 Full internal model approval by 2014 (and ongoing compliance)