ChingLan Lee Chief Investment Officer AEGON Life, Taiwan The Applications of Derivative Products for Insurance Companies Investment and Risk Management July 15, 2006

2 Investment and Risk Management Risk manager Product manager Product manager Investment manager Investment manager Investment PolicyPortfolio Limits

3 Investment Objectives To achieve a portfolio yield that is at least sufficient to support product pricing, to reward the risk taken, and To do so without taking inordinate credit, market, or liquidity risk

4 Product Liabilities Traditional life, long-term health Variable universal life Variable annuity Interest sensitive annuity Short-term products Other products

5 Required Investment Yield The primary objective is to achieve the required investment yield, while striving for a diversified portfolio and taking prudent levels of risk. “Required investment yield” is defined to be the portfolio yield that, along with expected results in mortality, lapse, expense, and other key margin sources, will support desired future returns on capital on in force business.

6 Liability Duration Effective duration v.s. modified duration Minimum guarantee credited rate v.s. prevailing market rate Single premium v.s. renewal premiums Positive convexity of liabilities v.s. negative convexity of assets

7 Product-Driven Portfolio Guidelines In light of the product description, investment requirements, and reserve balances, the investment portfolio should be constructed to achieve the required minimum investment yield of the company, while abiding by certain investment guidelines.

8 One of the guidelines - Use of Derivatives Clearly stated objectives, acceptable risk profiles, and prescribed monitoring requirements Pertinent accounting treatments should be researched and understood

9 Investment Portfolio Asset liability match - Core portfolio Return enhancement – Active management Core Portfolio Alternatives Alpha Options strategy Options strategy Active trading Active trading

10 More than assets hedge Under low interest rate environment, there are more needs to enhance investment yield by using derivatives Assets Hedge – allowed and defined by regulation Return Enhancement – recently allowed and defined Liabilities Hedge – TBA

11 Asset Hedge and Return Enhancement DerivativesStrategyAsset Hedge Return Enhancement OptionsLong call ˇ Long put ˇ Short call ˇˇ Short put ˇ

12 Asset Hedge and Return Enhancement - continue DerivativesStrategyAsset Hedge Return Enhancement FuturesLong ˇ Short ˇ IRSPay fixed ˇ Receive fixed ˇ CDSPay ˇ Receive ˇ IRS: interest rate swap, CDS: credit default swap

13 Liabilities hedge FSC planned to adopt a new” Insurance Supervisory System” (Solvency two) which was under study and discussion with insurance companies and other insurance institutions. The earliest possible implementation time will be in 2008 and companies may need to set up more reserve. (June 14, 2006 Commercial Daily) Note: Once implemented, insurance companies will need to enhance their investment risk management and set up more efficient risk control mechanism.

14 Liabilities hedge - continue The gap between assets and liabilities - 1 The minimum guarantee v.s. market interest rate Single premium - hedged by spot curve Recurring premium - hedged by forward curve If there is no efficient forward curve to hedge future cash flow, change the product mix. Regulation should re-define the hedge.

15 Liabilities hedge - continue The gap between assets and liabilities - 2 If liabilities duration is longer than assets’, and if effective duration matters, the duration gap will cause HUGE under-reserve. Derivative will help – for example, receive fixed IRS could extend assets duration However, it, to certain extent, did not comply with the regulation

16 Wrap-up To meet the requirements of reserve and capital adequacy under “new supervisory system”, insurance companies need to enhance their investment risk management and set up more efficient risk control mechanism. The use of derivatives will not only for assets hedge and enhancing investment return, but also for liabilities. More change of regulation would be needed.

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