Capital Management Key Learnings from Current Market Turmoil/Volatility Simon Curtis Executive Vice President & Chief Actuary June 25 th, 2009 Halifax

2 Economic Turmoil Has Highlighted Need To Re- think Capital Management In Several Areas Increasing Capital Adequacy MIS Pro-cyclicality of Regulatory Capital Regime Importance and Role of Stress Testing Role of Regulatory vs. Internal Capital Models Volatility of Capital Models Risk Diversification and Risk Mitigation Increasing the Focus on Downstream Silo Capital IFRS Phase 2 Implications

3 Increasing Capital Adequacy MIS  MIS needs to support regulatory capital management have increased significantly Company Example Before Economic Turmoil Began New World Annual 5 year “DCAT” projection of consolidated capital ratios under base and stress scenarios with some local ratio stress testing 5 year annual DCAT stress testing will now comprehensively reflect all consolidated and local ratios Ability to run ad hoc tests between DCATs Actual capital ratios updated quarterly Key capital ratios all estimated weekly or monthly Ad Hoc ability to do limited capital projections between DCAT cycles Monthly 5 quarter rolling forecast of all key capital ratios

4 Pro-Cyclicality of Regulatory Capital Regime  External environment (regulators, analysts, rating agencies, etc.) are demanding higher capital ratios after severe shock than before the shock  effectively requiring immediate capitalization for second shock  requiring significant capital raises at time in cycle when capital is scarce/expensive  Regulatory formulas, particularly stochastic or model based components, are significantly increasing underlying requirements based on point in time risk measurement  Result is that regulatory capital requirements are increasing significantly at time balance sheets are stressed  Go forward implications  companies should modify practices to systematically operate at capital ratios above long term “target” in good times to provide internal flexibility for bad times  regulatory formulas that avoid or dampen pro-cyclicality would be desirable  OSFI action of segregated fund CTE levels is a good example  introducing explicit ops risk and other components and eliminating arbitrary MCCSR scale up requirements would be beneficial

5 Importance and Role of Stress Testing  Recent economic turmoil appears to be highlighting a fundamental difference between professional requirements of stress testing (e.g. DCAT) and regulatory/management focus Professional Focus Regulatory Focus Ability to honour policy obligations in stressed scenarios (e.g. positive equity in stress scenarios for clear opinion) Ability to maintain capital at levels to meet targets in stressed scenarios Single catastrophe focusEffectively double catastrophe focus Significant focus on management plans to restore capital

6 Role of Regulatory vs. Internal Capital Models  In recent years, companies (with regulator encouragement) have spent considerable time and resources on developing economic capital models with decreased focus on regulatory models  many companies believed they were significantly over-capitalized based on economic models  In current turmoil, all regulatory and external focus (including rating agencies) has been on regulatory capital ratios and adequacy with economic capital largely ignored  companies have been raising capital to support regulatory requirements  Economic capital models typically have components fundamentally inconsistent with regulatory framework  full diversification credits  full risk mitigation credits  lower scale ups for ops risk/other non-inventoried risks  more model reliance and volatility  focus on single catastrophe (not being capitalized to have strong ratios after first catastrophe)  Is the role of economic models to establish risk appetite and risk adjusted return requirements rather than level of capitalization required?

7 Volatility of Capital Models  Current equity market meltdown is shown inherent volatility of advanced stochastic models  current models and literature do not calibrate models to where you are in the economic cycle  catastrophic scenario imposed on top of catastrophic scenario  Outcome is that model based requirements immediately release significant amounts of capital in good cycles and force immediate accrual of need for significant additional resources in poor cycles  this creates rather than mitigates stability and solvency risk in the system

8 Volatility of Capital Models [cont’d]  There are several potential solutions  introduce reversion to mean assumptions in the models (counter cyclicality)  create more dynamic capital targets and minimums  Are stochastic models the right approach to setting capital?  clearly the best approach to understand risk profiles and potential ranges of outcomes, including catastrophic exposures  unclear if they are appropriate when imposed on a specific point of time environment given nature of how assumptions are developed  long term “average” market conditions (real world) OR  sentiment based liquidation perspective (risk neutral)

9 Risk Diversification & Risk Mitigation  Regulators have resisted calls for risk diversification credit in capital formulas – are they correct?  current crisis is example that there may be limited diversification within investment risks (credit/market) in a true “tail” event  diversification between investment risks and other risks (ops risks, insurance risks, policyholder behaviour risks) has been robust in current crisis, but would this be true in pandemic  Regulators have also resisted calls for risk mitigation credits for dynamic strategies (e.g. dynamic hedging of equity guarantees)  Ultimately, risk mitigation and risk diversification are important, and some incentive to encourage this in regulatory capital framework is desirable

10 Increasing the Focus on Downstream Silo Capital  In benign market conditions, managing interactions of multiple levels of regulatory requirements (consolidated versus local regulatory solvency versus rating agency) is a relatively stable exercise  However, in a volatile/stressed environment the multiple levels of constraints:  introduce complexity issues in accurately modeling complex interactions  create pockets of trapped capital/unexpected capital calls that can make consolidated capital requirements higher than may be perceived by looking to p-down  create real issues in moving capital around the organization  Key learning is that models/tools focus on downstream needs and fungability not just top down requirements

11 IFRS Phase 2 Implications  If stress tested against economic conditions of last 6 months the IAIS direction on solvency would likely have led to widespread statutory insolvency, internationally and in Canada  risk neutral rates went down considerably leading to shock increase in liability values  extreme spread widening caused significant shock decrease in fixed interest asset values (compounding equity shocks) The Phase 2 model does not survive a real event stress test IFRS Phase 2 Current Proposal IAIS Direction Assets: Assets: Largely Fair Value Assets: Largely Fair Value Liabilities: Liabilities: Cashflow Discounted at Risk Neutral Rates plus own credit standing Liabilities: Liabilities: Cashflows Discounted at Risk Neutral Rates excluding own credit standing