1. Economic Capital at Manulife
Sara Wattling, Manager, Integrated Risk Measurement
Date: November 20, 2009

2. Economic Capital Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions

3. Economic Capital Project Overview
Goals of internal Economic Capital (EC) model:
Provide an improved measure of risk-based required capital
Allow management to better attribute capital to sources of risk and manage overall risk profile
Be an important tool to help management make better decisions about optimizing risk-adjusted returns
Internal EC is not intended to:
Replace sound business judgment in decision making
Replace regulatory capital

4. Economic Capital Project Overview
Expected uses of Economic Capital include:
In-force Risk Measurement
Defining Risk Appetite and setting Risk Targets
Allocating capital to business units
Risk/Return Business Decisions:
Investment and ALM decisions
In-force Management
Product Pricing

5. Economic Capital Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions

6. Manulife’s General Framework
Total Asset Requirement (TAR) Approach
EC = TAR less Reserves
TAR is purely “economic”
One Year Time Horizon
But coupled with Terminal Provision that reflects lifetime risk horizon
Measure EC at two First Year Probability Levels:
BBB level: CTE99
AA level: higher internal target CL
TAR = CTEx [PV(Year 1 Cashflow + Terminal Provision)]

7. Manulife’s General Framework
TAR reflects extremely adverse experience over risk horizon, and …
… have sufficient assets at end of horizon to hedge or retain risk as appropriate
The more sophisticated models use stochastic modeling which is simply
Create a large set of economic scenarios (e.g. yield curves)
Run those scenarios through a cash flow model
This provides distribution of risk measure from which you can pick off chosen probability level
In fact – most EC definitions imply stochastic upon stochastic simulations
Extremely adverse over one year (eg worst in 200)
Where each scn includes a lifetime stochastic valuation at the end of the year that depends on the that scn’s EOY I state
Probability level of Second stochastic process is less severe – e.g. 3 rd worst of 4 – still need some cushion to compensate the insurer that takes over the block
Computationally huge!
Requires banks of PC’s
Requires approximations
Scenario reduction
Model compression
Closed form solutions
Time 0
Time 1
Lifetime
Risk Horizon

8. Terminal Provision Two Practices Calculation By Risk
Assume risk is hedged or closed at the end of year 1
Assume risk is retained
Calculation
Market Value for risks assumed to be hedged at end of year
CTEx for risks assumed to be retained for lifetime
Either way, reflects first year stress scenario
By Risk
All insurance risks assumed retained
Treatment of market and credit risks varies by circumstance

9. Economic Capital Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions

10. Framework by Risk

11. Framework by Risk Pass-Through Products Other Products
All risks measured on a combined basis to ensure constraints on pass-through features are captured
Other Products
Each risk measured separately
Following sections describe risk framework for non Pass-Through products

12. Market Risk

13. Market Risk Experience simulated by stochastic return generators
Interest rates, public equity indices, bond funds, private equities, real estate, timber, agriculture, oil & gas, and currency
Across all geographical markets on a correlated basis
Incorporate dynamic policyholder behavior functions where appropriate
Asset-sensitive liabilities are valued using integrated asset/liability models
Use scenario reduction techniques to avoid full stochastic on stochastic calculations

14. Interest Rate Risk

15. Interest Rate Risk: General Interest Rates
Assume positions hedged or closed at end of year
Where hedged
Assume yield curve is extended past 30 years
Discount lifetime net asset and liability cash flows at point-in-time projected forward rates resulting from each shocked one year experience scenario

16. Interest Rate Risk: Interest Spreads
Calculation is similar to that for Interest Rates
Assume assets are rebalanced to target quality mix at end of stressed first year

17. Public Equity & Other NFI Risk

18. Public Equity & Other NFI Risk
NFI includes: Private Equity, Real Estate, Timber, Agriculture, Oil & Gas
Assume assets are retained for longer than one year
At the end of year one, determine the market value of non fixed income assets required to meet the liabilities on CTEx go-forward lifetime experience scenario returns
Assume future NFI return distribution starting at the end of year one is independent of prior performance over first year

19. Public Equity Risk on Off-Balance Sheet Products

20. Public Equity Risk on Off-Balance Sheet Products
Off-Balance Sheet Products Include
VAs / Segregated Funds
Mutual Funds
Group Pensions
VUL products
Measures Fund Performance Risk
Labeled as equity risk as this is the dominant risk
Not split by interest, equity, other-NFI, credit yet

21. Public Equity Risk on Off-Balance Sheet Products
Fee Income Risk
EC = DAC Balance – CTEx [PV(Year 1 Net Fees + Terminal Provision)]
Guaranteed Benefit Risk
EC = CTEx [PV(Year 1 Guarantee cash flow + Terminal Provision)] – Booked Reserves
Avoid full stochastic on stochastic by modeling terminal provision as a function of risk drivers

22. Credit Risk

23. Credit Risk Closed form analytic calculation TAR is present value of
Stressed Defaults in year 1
Cost of Defaults over remaining lifetime based on the stressed credit migration in year 1
Security by security calculation

24. Credit Risk Single factor model Counterparty Risk
Each security is correlated to a single general global economic factor
One common correlation factor is used for each individual ratings class
Key underlying assumption is that the portfolio is well diversified: no reflection of name concentrations
Counterparty Risk
Same methodology as for direct holdings except exposures at default are unknown and must be modeled

25. Insurance Risk

26. Insurance Risk Mortality/Longevity Morbidity Lapses Stress scenarios
Four risks: level, volatility, trend, catastrophe
Morbidity
Stress scenario
Based on external practices and internal expert judgment
Lapses
Retained MCCSR stress scenario

27. Par & Pass-Through Products

28. Par & Pass-Through Products
Calculate Market, Credit and Insurance EC for Pass-Through products separately
Reflect actual pass-through feature instead of using factor
Calculations are the same as for non pass-through products
Except assume all risks are retained at the end of year 1
Credited rates are adjusted based on scenario
Care must be taken to ensure that same pass-through room is not used for multiple risks

29. Operational & Strategic Risk

30. Operational & Strategic Risk
Factor-based
Currently use Basel II Basic Indicator approach
Low priority to develop stochastic model

31. Economic Capital Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions

32. Recap of Major Risks

33. Aggregation Within Market Within Credit Within Insurance
Different market risks aggregated directly based on integrated correlated economic scenarios
Within Credit
One-factor model reflects diversification benefits of a well diversified portfolio
Within Insurance
Stress tests reflect global diversification benefits for a given risk
Use correlation matrix to aggregate different insurance risks

34. Aggregation Within Operational Between Major Risks
Factor based approach assumed net of diversification benefits
Between Major Risks
Currently, aggregation between EC results of major risk categories performed using correlation matrices

35. Diversification Benefits
Within Credit, Insurance and Operational Risks
Post-diversification by nature
Within Market Risk
Risks aggregated by summing EC requirements across each scenario and taking the CTEx of the total market results across all scenarios
As underlying economic scenarios are correlated, diversification is explicitly reflected

36. Diversification Benefits
Within Market Risk, continued
Simple example where EC is the worst scenario out of 5:
In this example, the diversification benefit between Equity, Other NFI and Interest is 20
Between Major Risks
Second layer of diversification using correlation matrix

37. Economic Capital Economic Capital Project Overview
Manulife’s Framework
Market Risk
Credit, Insurance & Operations Risk
Aggregation & Diversification Benefits
Conclusions

38. Conclusions
EC better reflects relative contribution by risk element than MCCSR
Reflects specific risk profile & diversification of company
Same CL for each risk
EC provides quantitative framework to support existing initiatives
However results extremely sensitive to key assumptions
EC is an additional decision making tool, but does not replace sound business judgment nor regulatory capital

39. Questions?