Economic Capital at Manulife

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

2. Economic Capital

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

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 Time 0 Time 1 Lifetime Risk Horizon

8. Terminal Provision • Two Practices • 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

10. Framework by Risk

11. Framework by Risk • Pass-Through 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 • 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 • 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

32. Recap of Major Risks

33. Aggregation • Within Market • 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 • 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

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?