1. Mortgage Backed Securities and Capital of Life Insurers: Was the Industry prepared for the Credit Crunch of 2007-2008? Dr. Etti G. Baranoff Virginia Commonwealth University Thomas W. Sager The University of Texas at Austin

2. IIS Taiwan 20082 Objectives U.S. life insurance industry: What was the exposure to MBS? Were the risks of MBS anticipated? What capital adjustments would accommodate the risks of MBS? Benchmarking tool for individual insurers

3. IIS Taiwan 20083 Exposure to MBS

4. IIS Taiwan 20084 Exposure to MBS

5. IIS Taiwan 20085 Risk Recategorization of MBS Risk assessment measure RAR (Regulatory Asset Risk) Based on C-1 component of life insurer Risk- Based Capital “Penalty” weights for risky assets –Bond 1 = 0.3% - Bond 4 = 9% –Bond 2 = 1% - Bond 5 = 20% –Bond 3 = 4% - Bond 6 = 30% ------------------------------------------------ –Stocks = 30%, etc.

6. IIS Taiwan 20086 Recategorization Scenarios RAR1 = 25% of MBS from 1 to 5,6 equally RAR2 = RAR1 + 12.5% of MBS from 2 to 5,6 equally RAR3 = RAR1 + 25% of MBS from 2 to 5,6 equally RAR4 = 50% of MBS from 1 + 25% from 2 to 5,6 equally RAR5 = 75% of MBS from 1 + 25% from 2 to 6

7. IIS Taiwan 20087 Effect of Recategorizations on Asset Risk (2006) Median RAR i / SCENARIOMeanSt dev 25th %-ileMedian 75th %-ileMedian RAR0 RAR0 (no recateg.)2.59%4.27%0.47%1.14%2.57%100% RAR13.02%4.25%0.85%1.79%3.24%157% RAR23.26%4.28%0.90%2.07%3.69%182% RAR33.48%4.32%0.96%2.37%3.99%208% RAR43.93%4.48%1.06%2.83%4.88%248% RAR54.74%4.96%1.19%3.56%6.40%312%

8. IIS Taiwan 20088 Were MBS Risks Anticipated? Capital structure model Log Capital = a + b 0 log RAR0 + b i (log RARi – logRAR0) + ERM control variables b i > 0 implies prudent anticipation b i < 0 implies “irrational exuberance”

9. IIS Taiwan 20089 ERM Control Variables Product risk – life, health, annuities writings Regulation – RBC ratio Operations – ROC, use of derivatives Structure – stock vs mutual, affiliated group member Size – total assets, writings, liabilities --------------------------------------------------- Dropped insignificant control vars

10. IIS Taiwan 200810 Capital Model for 2006 (Table 4 Summary – Residential MBS only)

11. IIS Taiwan 200811 Adaptations to MBS Risks Capital structure model Log Capital = a + b log RAR0 + ERM control variables Capital adjustment controlled by b and change in RAR risk Adjustment ratio = (new RAR / old RAR) b

12. IIS Taiwan 200812 Adaptations to MBS Risk (2006 – Residential MBS only) For 2006, b = 0.10967 (p-value < 0.0001) ------------------------------------------------------------ Ex: Insurer A has RAR = 1.14% of invested assets; recategorizes MBS risk per scenario 1 => new RAR = 1.79%. Cap adjustment ratio = (1.79/1.14) 0.10967 = 1.0507 – a 5% increase in total capital. ------------------------------------------------------------ Ex: Insurer B has RAR = 1.14% of invested assets; recategorizes MBS risk per scenario 4 => new RAR = 2.83%. Cap adjustment ratio = (2.83/1.14) 0.10967 = 1.10486 – a 10.5% increase in total capital.

13. IIS Taiwan 200813 Benchmarking

14. IIS Taiwan 200814 Benchmarking Ex: Insurer A has (Residential) MBS = 20% of bond portfolio in 2006, scenario 1 cap adjustment of 1.3% vs. adjustment of 9% for its peer group Ex: Insurer B has (Residential) MBS = 20.4% of bond portfolio in 2006, scenario 1 cap adjustment of 19.4% vs. adjustment of 9% for its peer group