U.S. Life Insurers Using More Robust Approaches to Measure Investment Risk

Stochastic Models Add Precision to Traditional Techniques

STAMFORD, CT., November 3, 2005 � More than two thirds of life insurance company CFOs (70%) use stochastic modeling techniques to model investment and other risks for many lines of business, according to the latest CFO survey by the Tillinghast business of Towers Perrin. In particular, over half (53%) of respondents use stochastic defaults or credit risk transition matrices to properly model credit risk.

�The increased use of stochastic modeling represents a real advance over more traditional modeling methods, such as deterministic stress tests,� said Jack Gibson, Managing Principal for the firm�s North American life insurance practice. �These newer, more robust approaches offer a depth of information that is unmatched by traditional approaches, putting companies in a better position to explore competitive product design alternatives and evaluate a wider range of options to mitigate their risk exposure. Leading-edge companies are taking this a step further, enhancing the sophistication of existing stochastic models to respond to the increased complexities in today�s life insurance products.�

The survey � the 12th in a Tillinghast series of periodic surveys among more than 70 North American life insurance CFOs � focused on how insurers measure and model investment risk. Investment risk, such as market volatility and credit risk, represents a major financial risk exposure for life insurers. Yet, nearly half (45%) of the companies surveyed reported that Board members do not sit on any of the investment-related committees. However, most Boards do provide input into the process, such as assessing investment policy and constraints (90%), establishing risk tolerances (60%) and determining derivatives policies (43%).

Investment Risk Management Strategy Trends

The survey showed that more than 90% of respondents still use primarily traditional asset-liability management approaches, such as duration/convexity (93%) and cash flow matching of assets and liabilities (90%), to incorporate liability-side risks into the investment policy process. However, more than half have begun to supplement these approaches with more robust and precise solutions such as hedging programs (57%) � most frequently, for annuity products.

Further, most respondents use fairly traditional methods to manage credit risk, including:

  • Investment policy constraints on the amount of assets held in each credit category (90%)

  • Analysis from an aggregated perspective to manage total portfolio credit risk (68%)

  • Seeking opportunities from movements in the credit cycle and changes in spreads over Treasuries (58%).

In contrast, many companies use a variety of methods to manage equity market risk, such as:

  • Modifying product design to reduce tail risk (67%)

  • Dynamic hedging (48%)

  • Reinsurance (24%).

�Increasingly, risk management is becoming a combination of product design, reinsurance and hedging solutions. It is critical for companies to be able to assess and manage tail risk by evaluating product design alternatives if they want to achieve a growing share in markets where guarantees on investment products play a key role,� said Hubert Mueller, Principal and survey leader. �This will allow them to hold less capital and avoid excessive losses, while providing better value at a lower cost to consumers.�

�A number of top companies have taken a major step forward in risk management,� Gibson said. �Increased scrutiny on risk management by analysts and rating agencies has made the use of enhanced risk management techniques a �must have� to succeed in the current marketplace.�

Positive Outlook for Third Quarter

Nearly three quarters of respondents predicted growth of at least 4% in new life and annuity premiums in the third quarter, compared with the same period last year, while 31% believed the increase would be more than 10%. Just over three quarters of respondents (76%) expected revenues to increase by at least 4% versus the same period last year, while 61% anticipated net income to increase at least 4% over the same period last year.

About Tillinghast�s Life Insurance CFO Survey

The Web-based survey was conducted in August and September 2005 and is the 12th in a series of Tillinghast pulse surveys, which explore issues important to the North American life insurance industry and its CFOs. This four-part survey focused on life insurers� investment risk management philosophy, the tools and techniques they use to model investment risk and the internal processes in place to address investment management risk, and had a respondent base of 31. Respondents primarily included CFOs from large and midsize North American life insurance companies; 59% had assets of $5 billion or more and 16% were multinationals. For more information on this survey program, please contact program leader Sarah Prevett at 212-309-3979 or sarah.prevett@towersperrin.com.

About Towers Perrin and Tillinghast

Towers Perrin is a global professional services firm that helps organizations improve their performance through effective people, risk and financial management. Through its Tillinghast business, Towers Perrin provides consulting and software solutions to insurance and financial services companies and advises other organizations on risk financing and self-insurance. Tillinghast helps clients improve business performance in areas related to their financial, risk, product, distribution and capital issues. The firm�s other businesses are HR Services, which provides human resource consulting, and Reinsurance, which provides reinsurance intermediary services. Together, these businesses have offices in 24 countries. More information about Tillinghast is available at http://www.towersperrin.com/tillinghast.