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European Embedded Value, first year application. Alberto Minali March 10th, 2005. Introduction. Group. A newly established set of principles for EV calculations provides a better valuation of all risk components, in particular of embedded options

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European Embedded Value, first year application


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slide2

Introduction

Group

A newly established set of principles for EV calculations provides a better valuation of all risk components, in particular of embedded options

Ras is one of the first international companies and the first Italian company to publish EEV in compliance with CFO forum principles

Values and methodology have been certified by Tillinghast-Towers Perrin

The 2003 discount rate has been recalculated for comparative purposes only; 2003 results have not been restated

1

slide3

Agenda

Italy

Methodology and main results

Portfolios characteristics

Cost of options

Financial risk margin

Non-Financial Risk Margin

Conclusions

2

the alternatives
The alternatives

Practice widely used by competitors, with risks partially captured in the discount rate and partially in projected inflows. Overlapping of stochastic and deterministic frameworks

Discount rate not diversified by product, highly subjective (top-down risk premium) and based on market information (beta)

Top-down discount rate based on WACC or CAPM methodology, with one single risk premium and cost of options deducted from total In-force value

Discount rate tailored to the specific risk factors of different products and different companies, with bottom-up valuation of risk premiums. Important impact on risk management

Consistent link between stochastic and deterministic frameworks

Bottom-up discount rate based on valuation of risk factors, with differentiated risk premiums by Line of business and country

Ras

choice

3

slide5

Further details on methodology

Group

  • Risk premium is obtained as the sum of different risk components on top of the risk-free rate. Ras has identified and measured the following ones:
    • Margin for embedded options: the time value of the put option cost sold to policyholders (calculated in a stochastic environment) is expressed as basis points of risk premium
    • Margin for financial risk: neutralises the equity component assumed in projected investment returns. Linked to equity exposure and equity risk premium
    • Non-financial risks: associated with lapses, mortality, longevity and business risks, calculated using the Ras Risk Capital Model

The risk premium obtained is company-specific, business-specific, valuation-dependent. Ras calculates a different discount rate for Traditional Life, unit linked and Asset management business in Italy

4

slide6

Traditional products discount rate

Italy

Risk free equivalent to 10 year bond yield - data in %

Remarks

Decrease of overall discount rate arises from the risk free rate reduction of 75 bp

Stable financial risk margin is consistent with unchanged equity exposure and risk premium

Strong increase in time value component of put options is due to the term structure shift

Higher non-financial risk premium driven by an increase of lapses risk

6.61

-31

6.30

Non-financial risks

1.15

+26

1.41

Financial Risk margin

0.89

0.79

-10

Time Value of options

0.15

0.35

+20

Risk free

4.50

-75

3.75

Change

in bp

2003

2004

5

slide7

Unit Linked discount rate

Italy

Risk free equivalent to 10 year bond yield - data in %

Remarks

75 bp decrease in risk free rate is partially compensated by the increase of other risk factors

Higher financial risk margin is linked to the higher average equity exposure

Higher non-financial risk premium driven by lapses risk

6.75

6.55

Non-financial risks

-20

1.78

2.03

+25

0.47

Financial Risk margin

0.77

+30

Risk free

4.50

-75

3.75

Change

in bp

2003

2004

6

slide8

Asset Management discount rate

Italy

Risk free equivalent to 10 year bond yield - data in %

Remarks

75 bp decrease in risk free rate is partially compensated by the increase in other risk factors

Higher financial risk margin is linked to the higher average portfolio duration and equity risk premium

Higher non-financial risk premium driven by volumes and higher capital absorption

7.30

7.00

Non-financial risks

-30

1.45

1.65

+20

1.35

Financial Risk margin

1.60

+25

Risk free

4.50

-75

3.75

Change

in bp

2003

2004

7

slide9

Preliminary conclusion

Group

2003 old

2003 new

2004 new

  • The new methodology enables:
    • to measure the immediate impact of different ALM strategies on the risk profile of our business and therefore on the EV
    • to assess the impact of different technical product features (e.g., redemption or penalty fees) on the discount rate and therefore on pricing

Traditional

2.50%

2.11%

2.55%

Unit Linked

2.50%

2.25%

2.80%

Asset Mgmt

2.50%

2.80%

3.25%

With this new methodology in place Ras can now enhance both risk and value mgmt

8

slide10

Agenda

Italy

Methodology and main results

Portfolios characteristics

Cost of options

Financial risk margin

Non-Financial Risk Margin

Conclusions

9

slide11

Ras portfolios

Group

Traditional products: the tight Asset-Liability strategy reflects Ras long-term expertise in AL techniques, with very limited A-L cash flow mismatch and low equity exposure

Unit-linked: very conservative equity exposure of high volatility periods; in 2004 Ras took advantage of better financial market conditions to slightly increase investment risk profile

Asset Management: a good balance of equity and bond exposure, almost unchanged during 2004, due to the still cautious approach of clients to financial mkts

10

slide12

Traditional portfolio

Italy

Ras Vitariv - starting year 2005 - equity exposure 6%, corporate bond 19.2%, 2004 recorded return 5.02% of which 4.96% ordinary

Projected financial returns and avg. min. guaranteed

Asset and Liability cash flow

Yield

1,250

990

5.0%

750

500

Assets

3.4%

4.7%

-600

-800

-850

-700

Liability

years

2005

2015

2.9%

Cash flow

Mismatch

years

2015

2005

+400

+190

+150

-200

11

slide13

Unit linked and Asset Management

Italy

Asset Management

Unit Linked

Equity

24%

26%

43%

43%

7%

Balanced funds

76%

7%

74%

50%

50%

Bond and liquidity

2003

2004

2003

2004

12

slide14

Agenda

Italy

Methodology and main results

Portfolios characteristics

Cost of options

Financial risk margin

Non-Financial Risk Margin

Conclusions

13

slide15

Further details on methodology

Group

The stochastic model projects portfolio financial returns in a neutral risk probability environment

The model is calibrated on the interest rate structure at valuation date and on implied market volatility

Projected financial returns consider: existing assets; management options to steer financial returns; accounting rules

Cost of options is very limited due to tight ALM and conservative equity exposure

Financial returns are still higher than minimum guaranteed rates

Cost of options increased in 2004 due to lower interest rates; this offsets the positive effect of new products with non-cliquet options

14

slide16

36.3

16.8

16.8

5.4

Time Value component of cost of option

Italy

Total Italian portfolio

Total Cost of time value

Total group in Italy

Ras-Vitariv

Absolute value

mln euro

Non-financial risks

Time Value of options

0.15

0.35

Financial Risk margin

In % of traditional Reserves

0.29

0.27

Risk free

0.16

0.11

2003

2004

2003

2004

2003

2004

Ras Vitariv

0.37

0.17

15

projected financial scenarios and returns
Projected Financial scenarios and returns

Financial returns of segregated funds generated by stochastic model

Financial returns of segregated funds are determined considering the accounting rules and management rule

Accounting rules: financial returns credited to policyholders are not marked to market but based on accruals + dividends + realised capital gains

Management rule: the possibility for management to steer financial returns and to reduce their volatility

Scenarios

Financial returns

Best estimate

years

16

price of the put option
Price of the put option

The stochastic model runs 5,000 scenarios and therefore 5,000 financial returns are generated

For each financial return below the minimum guaranteed rate, the model calculates losses incurred by the shareholder

The net present value of these losses, weighted for the probability of the individual scenario, determines the cost of the put option

The put option has two components. Intrinsic value and Time value

Scenarios

Financial returns

Minimum

guarateed rate layers

years

Cost of option

NPV weighted

for probability

years

17

put option breakdown in intrinsic and time value
Put option breakdown in intrinsic and time value

2004 data

Scenarios

Financial returns

Minimum guarateed rate

Best estimate

years

years

years

Time value

Put value

Intrinsic value

36.3

-

Mln euro

=

107.3

71.0

16.8

Ras Vitariv

47.0

30.2

Already captured into the deterministic EV

18

impact of accounting rule and mgmt option

Financial returns

years

Impact of accounting rule and mgmt option

2004 data - Ras Vitariv

With accounting and Mgmt rules

Base Value

47.0

Put option

Time value

Margin for Embedded options

16.8

0.37%

Marked to mkt

Mk to Mkt

207.2

Put option

Time value

Margin for Embedded options

71.3

Financial returns

1.67%

years

19

slide21

Time value of option sensitivity

Italy

2004 data - Rasvitariv

Sensitivity

Base case assumptions

Absolute value

mln euro

Base premium

16.8

0.37%

Increase of Equity exposure at 10%

5.9%

21.2

0.46%

Bond Duration at 4 years

0.85%

6 years

38.8

Equity at 10% and bond duration at 4 years

0.96%

43.2

10y bond 3.75%

50 bp decrease of interest rate

(1)

0.55%

24.1

Increase of equity volatility at 20%

0.41%

19.5

10%

20

(1) Increase of 50 bp interest rate reduces time value risk margin to 0.23%

slide22

Agenda

Italy

Methodology and main results

Portfolios characteristics

Cost of options

Financial risk margin

Non-Financial Risk Margin

Conclusions

21

slide23

Financial risk margin: summary

Italy

Stochastic EV works in a risk-neutral framework, without any extra return for equity or other non-bond asset classes

Deterministic EV takes into account equity risk premiums and the equity exposure of the company (deterministic assumptions)

In a non-arbitrage framework, deterministic assumptions of extra returns must be compensated by an increased discount rate

The old EV methodology achieved this compensation by adding a comprehensive risk premium (2.5%) to the risk-free

The new methodology calculates the risk premium in accordance with the specific characteristics of the company portfolio

22

slide24

Financial risk margin: main data

Italy

Mln euro - Individual business only

Unit linked

Traditional products

Asset Management

Equity risk premium

3.0%

2.5%

3.0%

2.5%

3.0%

2.5%

Equity exposure

5.9%

6.0%

24%

43%

26%

43%

Financial risk premium

0.79%

0.82%

0.77%

0.47%

1.60%

1.35%

2003

2004

2003

2004

2003

2004

23

financial risk margin methodology
Financial risk margin: methodology

Stochastic EV

Portfolio financial returns

mean

The stochastic model determines average financial return in a risk- neutral environment (projecting portfolio returns utilising risk-free rates and discounting at risk-free rate)

The Stochastic mean EV is equal to the deterministic Certainty Equivalent EV (projecting mean financial return and discounting at risk-free rate)

Probability

Stochastic EV

Financial returns

mean

years

EV

Best estimate EV-risk neutral equal to CE

24

the bridge from stochastic to deterministic
The bridge from stochastic to deterministic

Stochastic EV

Portfolio financial returns

In deterministic EV, the financial return stream of the stochastic model is adjusted to take equity risk premium into account

The financial risk margin is the risk premium that neutralises the extra return introduced in the deterministic EV due to equity exposure

mean

Probabilty

Stochastic EV

Financial returns

mean

EV

years

Financial risk margin

EV with equity risk premium, discounted at risk free

Equity risk premium

Deterministic EV

Financial returns

Best estimate EV-risk neutral = CE

EV

years

25

slide27

Financial risk margin sensitivity

Italy

2004 data - Ras Vitariv

Base case assumptions

Traditional products

Unit linked

Total Base premium

0.79%

0.77%

Vitariv Base premium

0.71%

6% Tradit.

29% Unit L.

Increase of Equity exposure by 5%

0.91%

0.90%

Increase of Equity risk premium by 50 bp

3.00%

0.73%

0.95%

26

slide28

Agenda

Italy

Methodology and main results

Portfolios characteristics

Cost of options

Financial risk margin

Non-Financial Risk Margin

Conclusions

27

slide29

Non-financial risks margin: summary

Italy

The non-financial risk margin captures all risk factors of a non-financial nature

Since all expected potential losses are already factored in the deterministic assumptions (e.g. lapses curve), there is the need to measure unexpected losses

The framework used by Ras to model unexpected losses is the Risk Capital Model, which it has been using since 2001

The cost of capital needed to cover unexpected losses can be considered a correct pricing for these risks

28

slide30

Non-Financial risks margin: main data

Italy

Mln euro - Individual business only

Unit linked

Traditional products

Asset Management

Non-financial risk margin

1.41%

1.63%

2.03%

1.78%

1.65%

1.45%

RC as % of reserves or assets

2.5%

1.6%

1.1%

1.1%

1.14%

1.06%

Total risk capital

160

79

88

137

69

78

Of which in %

12

32

17

21

  • Mortality
  • lapses
  • business

73

69

76

20

67

30

27

31

12

48

16

49

2003

2004

2003

2004

2003

2004

29

slide31

Non-Financial risks margin: lapses example

Risk capital stochastic model

  • The lapses curve used in the deterministic EV is shocked by company/portfolio specific factors (Worst Case EV)
  • The RC is determined as the difference between Best Estimate EV and Worst Case EV
  • The cost of holding this capital is deducted from the earnings stream to calculate the CE EV-CoC
  • The non-financial risk premium makes the new EV equal to the CE EV

Worst case

x 2

Lapses

Determisitic EV Assumptions

Best estimate

years

Best estimate EV = CE

Non financial margin

Risk capital for lapses

Probability

Best estimate EV = CE

CE - Cost of Risk capital

Worst case

EV

EV

30

slide32

Agenda

Italy

Methodology and main results

Portfolios characteristics

Cost of options

Financial risk margin

Non-Financial Risk Margin

Conclusions

31

slide33

Final remarks

Group

Ras figures data are based on a stochastic model developed with the assistance of ALEF. Tillinghast has provided an independent opinion on and review of the EEV and discount rate decomposition

To compare Ras results with competitors, Tillinghast measured also a CAPM-like discount rate, which is equal to 6.50%, based on 0.9 Beta and 3.00% Risk Premium

The new system further enhances our existing risk management capabilities, which has been an historical competitive advantage. Now we can even better manage what has been measured

32

slide34

Cautionary Note Regarding Forward-Looking Statements

Certain of the statements contained herein may be statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. In addition to statements which are forward-looking by reason of context, the words “may, will, should, expects, plans, intends, anticipates, believes, estimates, predicts, potential, or continue” and similar expressions identify forward-looking statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (i) general economic conditions, including in particular economic conditions in RAS Spa’s core business and core markets, (ii) performance of financial markets, including emerging markets, (iii) the frequency and severity of insured loss events, (iv) mortality and morbidity levels and trends, (v) persistency levels, (vi) interest rate levels, (vii) currency exchange rates including the Euro - U.S. dollar exchange rate, (viii) changing levels of competition, (ix) changes in law and regulations, including monetary convergence and the European Monetary Union, (x) changing in the policies of central banks and/or global basis.

The matters discussed in this release may also involve risks and uncertainties described from time to time in Allianz’s filings with the U.S. Securities and Exchange Commission Allianz assumes no obligation to update any forward-looking information contained in this release.

33