1. Economic Capital and Risk Modeling February 22, 2008 • Iowa Actuaries Club Session #2 Jeff Fitch, Senior Actuary - Corporate

2. Outline • Principal’s Risk Metric and Economic Capital Framework • Lesson’s Learned from Principal’s Implementation • Applications of Economic Capital models • Emerging Industry Economic Capital Trends 2

3. Principal’s Risk Metrics and Economic Capital Framework • Background • Where we were • Where we are at now • Looking forward • My role in the process 3

4. Driving Forces & Objectives • Better understanding of risk exposures and incorporate into decision making process • Improve our ability to measure and manage risk and return • Appropriate capital level and capital allocation • Competitive Pressures • Economic Uncertainty • Rating Agencies • Board 4

5. Principal’s Economic Risk Metrics 3 Primary Risk Metrics • Earnings at Risk (EaR) • Embedded Value at Risk (EVaR) • Economic Total Asset Requirement 5

6. Earnings at Risk (EaR) • Measures short-term volatility of GAAP Operating Earnings • Difference between: • Best Estimate (baseline) GAAP Operating Earnings; and • 90th percentile confidence level GAAP Operating Earnings • Difference expressed as percent of Best Estimate (baseline) GAAP Operating Earnings • Time horizon of one year GAAP Operating Earnings • New business included in projection • Also look at GAAP Net Income 6

7. Earnings at Risk (EaR) Example1 year EaR at 90th Percentile • Run 1,000 scenarios of 1 year operating earnings • Rank them from best to worst • EaR is difference between Best Estimate and 900th scenario 7

8. Embedded Value (EV) and Embedded Value at Risk (EVaR) • Measures value of inforce business – doesn’t reflect new business or intangibles (brand, reputation) • Present Value of Distributable Earnings • Embedded Value at Risk measures potential volatility in value • Difference between: • Best Estimate (baseline) Embedded Value; and • 90th percentile confidence level Embedded Value 8

9. Economic Total Asset Requirement • Economic Total Asset Requirement is the amount of assets needed to cover our obligations at a given risk tolerance level over a specified time horizon. • 99.5% risk tolerance level for a AA rated company • 30 year time horizon • Economic Total Asset Requirement = Economic Reserves (cover obligations based on our best estimate of claims plus a margin) + Economic Capital (cushion on top of Economic Reserves to cover potential obligations from unanticipated adverse experience) • Our external Total Asset Requirement is equal to statutory regulatory reserves plus rating agency required capital. • Trapped Capital is the difference between external Total Asset Requirement and our Economic Total Asset Requirement. 9

10. Economic Total Asset Requirement (cont.)Reconstruction of Economic Balance Sheet 10

11. Principal’s Economic Risk Metrics - Recap 11

12. Steps in quantifying Economic Capital • Identify and categorize risks • Credit • Market • Product / Pricing • Operational / Business • Quantify each risk individually • Deterministic Stress Test and / or stochastic modeling • Aggregate risks and capture any diversification impact 12

13. Risk Hierarchy – Deeper Dive Mortality Risk, for example, can be broken down into 4 components • Volatility – statistical mortality fluctuation • Level – misestimation of mortality mean • Trend – misestimation of mortality improvement • Calamity – 1 time spike mortality (flu pandemic) 13

14. Hypothetical Example of Risk Aggregation 14

15. Top 10 Lessons Learned from Principal’s Implementation • Importance of Quick Wins • Simplify • It isn’t all about modeling • Involve all parties in the process • Set up guiding principles up front 15

16. Top 10 Lessons Learned from Principal’s Implementation (cont.) • Set up risk appetite and tolerances up front. • Not a project. Never really done. • Look at entire distribution of results (don’t focus only on the downside) • Use lots of pictures • Communication, communication, communication. 16

17. Applications of Economic Capital Models (if you build it they will come) Initial Uses: • Product / Business Unit decision making • Hedging / Reinsurance • Internal Risk Reporting Medium Term Uses: • Strategic Decision Making • Capital Allocation • Performance Measurement • External Reporting Long Term Uses: • Pricing • Incentive Compensation 17

18. Emerging Industry Trends – Economic Capital Two methods have emerged as the most common: • Liability Run Off Approach • Level of starting assets needed to pay all future policyholder obligations at a chosen confidence level • Approach used for RBC C3 Phase 2 • One Year Mark to Market Approach • Level of assets needed to cover a fall in the market value of net assets over a one-year time horizon at a chosen confidence level • Approach used for Solvency 2 18

19. Lots of different variations in approaches • Many decisions to make: • Time Horizon • Confidence Level • What risks to include and how to measure • Stochastic vs. Stress Testing Many possible combinations! 19

20. One Year Mark to Market Approach • Emerging as most common method to calculate Economic Capital • Driven by emerging solvency standards, particularly in Europe (Basel II, Swiss Solvency Test, Solvency II) • Consistent with emerging international accounting and solvency standards • US principles based approach for reserves and capital is more of a liability runoff approach • Although use of one year market-to-market for EC is increasing in the US 20

21. One Year Mark To Market Approach Diagram 21

22. Is One Year Enough? • Since our products have a long duration, how can you capture the risk using a 1 year approach? • You are still projecting your cash flows out to maturity and factoring in the residual impact of that 1 year event. • Confidence interval on a 1 year approach is likely higher than a multi-year approach • Ex: 99.95% instead of 99.5% for a AA Rated Company • After one year company can likely recapitalize and take other management action 22

23. Market Consistent Valuation • Market price to transfer a liability between willing participants • Applies capital market principles to liabilities • No arbitrage (identical cash flows must have the same value) • Uses risk neutral scenarios, discount at risk free rates • Calibrated to current market conditions & prices • Captures embedded options & guarantees • Add an additional margin for non-hedgeable risks (Market Value Margin) • Percentile Method • Cost of Capital Method 23

24. In a Market Consistent Embedded Value Framework, selecting assets does not create value Example: Company has Capital of 25, Borrows 75 at 4%, and invests 100 in equities expected to earn 8% • Using traditional EV techniques, the 30 might be discounted at say 9%, giving a value of 27.5 on day 1. • Under MCEV the asset CFs are discounted at 8% and the liability CFs at 4%, giving a value of 25 on day 1. • The effective discount rate on capital is 20%. • The risk discount rate is an output of the MCEV valuation, and not an input. • Under a Market Consistent Framework you can’t take credit up front for taking market risk. 24

25. Questions? 25