test

Bye, bye AAB

Before starting, I have to admit to the following:
I work for ABN AMRO, if only as a contractor, currently for their BU Europe. And I've enjoyed the last 3 years tremendously, learning a lot in a great and inspiring environment. So whoever stumbles over this post, don't expect anything fair and balanced - personally, although working in finance for a long time, I'm pissed by the way the battle for ABN AMRO went as well as by shareholders who traded a sound long term investment against a quick and slick Euro, bill being payed later.

That said,well / since last week it's official. ABN AMRO has been taken over by a consortium, consisting of Royal Bank of Scotland, Banco Santander and, believe it or not, the Belgian Fortis Bank, of all. And Fortis, this sorry excuse for an ill-managed bank aims to integrate the whole Netherlands business of ABN into its Benelux business. Anybody can spell chuzpe for them? But seriously, having private account, business account and a securities depot with ABN Netherlands I'm seriously worried and currently have no clue to which other bank in the Netherlands I could turn. ING probably, who knows.

I know only one thing and that for sure - I'm not having Fortis manage my account for one day and I'd recommend it to anybody (and in fact effectively go forward and try to convince everybody I know privately) to do the same thing. Only the little bit of information I've got from sources in their Basel II Programme regarding the state of affairs regarding regulatory relations and compliance as a whole convinced me to not only reject a couple of advances to work in that Basel II project but also made me sure to not continue any business relationships with Fortis Bank. Actively hiding risk from their own risk managers, obviously with full knowledge and approval of senior management tends to blow up not only in the bank´s but also in the faces of their customers. As the saying goes± If somebody goes great lengths to hide something, he might do so for a reason...

Fortunately this does not effect my business life as the unit I work for will be attached to RBS which is an excellently managed enterprise, albeit with a more Anglo-American touch to it than ABN had. This need not be so bad though, I'd take the chance and give it a try, should I get an offer to extend my contract

ABN AMRO BU Europe Basel II Programme on tour

offsite impressions

BU Europe - Offsite

Austrians vs. Californians through Ingrid's eyes

Austrians vs. Californians through Ingrid's eyes

Austrians vs Californians

Austrians plan things; Californians do things. Austrians have a tendency to think things over till they can think of enough reasons to drop them. Californians don’t waste time planning the details. They solve any problem along the way. This explains why Hans Maier is still re-re-redrafting plans for a house while John Smith is moving into his new mobile home. Austrians prepare to live tomorrow. Californians live today. If Hans Maier wants a new car he works excessively, quits doing anything that consumes money (which is basically everything besides working) and comforts himself with the promise of a better tomorrow. If John Smith desires a new set of wheels, he goes to the bank, gets a loan, and spends his time blissfully driving down the freeway and forgetting about the loan.Austrians fear the problems of the future, and as a result, glorify the past. Californians see the opportunities of tomorrow and forget about yesterday. Unhappy with his job, Hans Maier drowns himself in memories of past delights. In the same situation, John Smith does not waste time and energy reminiscing about past happiness. He gets a new job and feels fine again.Austrians believe in the better judgement of others. Californians believe in themselves. Originally, Hans Maier wanted to become an actor, marry a gorgeous woman, drive a Ferrari and live in Paris. But his mother told him actors were only cheap clowns. His father assured him that he would be better off without a wife. Some friends convinced him of the advantages of a Volkswagen Bug, and the media informed him that the French were snobby and arrogant. Now Hans Maier is an unmarried civil servant who drives a VW and lives in Hintertupfing. John Smith, on the other hand, is married to a living equivalent of the Barbie doll and driving a Ferrari through Paris (the loan he has successfully forgotten about). He’s still trying to make it big in showbiz – but at least he’s trying.Austrians fear the unknown and therefore conform to the norms. Californians relish the unknown and try the uncertain. Hans Maier would love to own his own business but he (successfully) reflects on his fears of going bankrupt until his negativism kills off his wish to open a business. John Smith not only starts up a business, but insists on something new and unique. He establishes the first dating service for dogs.Finally, Austrians complain about their boring, average, and indistinguishable lives and jealously look at Californians. Hans Maier only forgets (or ignores) that having an idea is not enough. You have to act upon it. John Smith did what it takes (or at least tries his best) – and so both get what they deserve. After all, as the Swiss psychiatrist C.G. Jung said, “Everything had to come about the way it did because I am as I am."

Core test cases revisited

testing is mess - that much is sure

VAR Week

 

This is VaR Week (ISSN 1534-1054) for 03/31/2007 - 04/06/2007
Risk management information and news >from GloriaMundi.org.

Risk Management News This Week

New Resources Added This Week

1
Title
Modeling Portfolio Defaults Using Hidden Markov Models with Covariates

Authors
Banachewicz, Konrad; van der Vaart, Aad; Lucas, Andre;

Date
October 2006

Category
Credit Risk
Click above to see all GloriaMundi resources from these categories

Abstract
We extend the Hidden Markov Model for defaults of Crowder, Davis, and Giampieri (2005) to include covariates. The covariates enhance the prediction of transition probabilities from high to low default regimes. To estimate the model, we extend the EM estimating equations to account for the time varying nature of the conditional likelihoods due to sample attrition and extension. Using empirical U.S. default data, we find that GDP growth, the term structure of interest rates and stock market returns impact the state transition probabilities. The impact, however, is not uniform across industries. We only find a weak correspondence between industry credit cycle dynamics and general business cycles.

Links
view complete description on GloriaMundi
download this resource from GloriaMundi

2
Title
Pricing Functions and Risk Measures in Incomplete Markets

Authors
Bion-Nadal, Jocelyne;

Date
June 2005

Category
Properties of VaR
Click above to see all GloriaMundi resources from these categories

Abstract
We present a new approach for pricing and making decisions of investment in incomplete markets. This we do without fixing in advance any probability measure. The key concept that we introduce is a notion of pricing function compatible with a family of bid and ask prices observed in the market. This method links the theory of asset pricing and the theory of risk measuring.

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3
Title
Mathematics in Financial Risk Management

Authors
Eberlein, Ernst; Frey, Rudiger; Kalkbrener, Michael; Overbeck, Ludger ;

Date
March 2007

Category
Credit Risk
Click above to see all GloriaMundi resources from these categories

Abstract
The paper gives an overview of mathematical models and methods used in financial risk management; the main area of application is credit risk. A brief introduction explains the mathematical issues arising in the risk management of a portfolio of loans. The paper continues with a formal overview of credit risk management models and discusses axiomatic approaches to risk measurement. We close with a section on dynamic credit risk models used in the pricing of credit derivatives. Mathematical techniques used stem >from probability theory, statistics, convex analysis and stochastic process theory.

Links
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4
Title
A Remark on Law Invariant Convex Risk Measures

Authors
Kusuoka, Shigeo;

Date
October 2006

Category
Properties of VaR
Click above to see all GloriaMundi resources from these categories

Abstract
The author gives a simple proof of the representation theorem for law invariant convex risk measures which was obtained by Kusuoka [6], Frittelli-Gianin [3] and Jouini- Schachermayer-Touzi [5].

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5
Title
The Predictive Performance of Asymetric Normal Mixture GARCH in Risk Management: Evidence From Turkey

Authors
Çifter, Atilla; Ozun, Alper;

Date
January 2007

Category
Backtesting
Click above to see all GloriaMundi resources from these categories

Abstract
The purpose of this study is to test predictive performance of Asymmetric Normal Mixture Garch (NMAGARCH) and other Garch models based on Kupiec and Christoffersen tests for Turkish equity market. The empirical results show that the NMAGARCH perform better based on %99 CI out-of-sample forecasting Christoffersen test where Garch with normal and student-t distribution perform better based on %95 Cl out-of-sample forecasting Christoffersen test and Kupiec test. These results show that none of the model including NMAGARCH outperforms other models in all cases as trading position or confidence intervals and these results shows that volatility model should be chosen according to confidence interval and trading positions. Besides, NMAGARCH increases predictive performance for higher confidence internal as Basel requires.

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6
Title
The Level and Quality of Value-at-Risk Disclosure by Commercial Banks

Authors
Perignon, Christophe; Smith, Daniel R.;

Date
December 2006

Category
Risk Reporting
Click above to see all GloriaMundi resources from these categories

Abstract
We study (1) the level of Value-at-Risk (VaR) disclosure and (2) the accuracy of the disclosed VaR figures for a sample of US and international commercial banks. To measure the level of VaR disclosures, we develop a VaR disclosure index that captures many different facets of market risk disclosure. Using panel data over the period 1996-2005, we find large differences in the level of disclosure between US commercial banks and an overall upward trend in the quantity of information released to the public. Our cross-sectional analysis of the largest banks in the world indicates that the US disclosures are below the average, although some banks, such as Bank of America and Wachovia, score very high on our 15-point VaR disclosure scale. We also find that Historical Simulation is by far the most popular VaR method. We assess the accuracy of the disclosed VaR figures by studying whether actual daily VaRs contain information about the volatility of subsequent trading revenues. We find that VaR, especially if it is computed using Historical Simulation, contains very little information about future trading revenue volatility and that a simple GARCH model often dominates bank proprietary VaR models.

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7
Title
Estimation Risk Effects on Backtesting for Parametric Value-at-Risk Models

Authors
Escanciano, J. Carlos; Olmo, Jose;

Date
March 2007

Category
Backtesting
Click above to see all GloriaMundi resources from these categories

Abstract
One of the implications of the creation of Basel Committee on Banking Supervision was the implementation of Value-at-Risk (VaR) as the standard tool for measuring market risk. Thereby the correct specification of parametric VaR models became of crucial importance in order to provide accurate and reliable risk measures. If the underlying risk model is not correctly specified, VaR estimates understate/overstate risk exposure. This can have dramatic consequences on stability and reputation of financial institutions or lead to sub-optimal capital allocation. We show that the use of the standard unconditional backtesting procedures to assess VaR models is completely misleading. These tests do not consider the impact of estimation risk and therefore use wrong critical values to assess market risk. The purpose of this paper is to quantify such estimation risk in a very general class of dynamic parametric VaR models and to correct standard backtesting procedures to provide valid inference in specification analyses. A Monte Carlo study illustrates our theoretical findings in finite-samples. Finally, an application to S&P500 Index shows the importance of this correction and its impact on capital requirements as imposed by Basel Accord, and on the choice of dynamic parametric models for risk management.

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New in the GloriaMundi Risk Management Career Center

Risk Quantitative Analyst
The D. E. Shaw Group
Salary: Attractive
USA-NY-New York City
05 Apr

The D. E. Shaw group, a global investment and technology development firm with approximately US $29 billion in aggregate inve...

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On the question, whether testers are human

Get a grip, that's what one would like to shout periodically. What happened to judgement?

Managers tend to substitute processes for sensible judgement, testers rather use expected results. But both groups continue insisting quite happily on not using the organ between their ears. Presumably because it could become dirty or bnecause 1..n of them use one brain on a time sharing basis, similar to the summer domicile in southern Spain...

Just one hilarious piece of incredible ignorance for the knowledgable:
What happens when adding a commited credit facility on top of a security position?
Or more graphic:
Bank A invests in Russian government bonds, hereby taking - for the sake of the argument - 1000 of these onto its banking book. What exactly would be the resulting effect when putting this investment under a credit facility?

Nature gave us a brain but 'he, who giveth is holier than he, who taketh'. Come here to Amstelveen - >brain, nearly new, rarely used for sale...

Understanding the risk of Credit Derivatives, especially Credit Default Swaps

Credit derivatives offer unique opportunities and risks to investors. They allow investors to have exposure to a firm without actually buying a security or loan issued by that firm. Because the exposure is synthetic, the transaction can be tailored to meet investors' needs with respect to currency, cash flow, and tenor, among other things. However, if the transaction is not structured carefully, it may pass along unintended risks to investors. Significantly, it may expose investors to higher frequency and severity of losses than if they held an equivalent cash position.

Moody's has rated numerous structured transactions - mostly synthetic collateralized debt obligations (CDOs) and credit-linked notes (CLNs--whose key feature is a cash-settled credit default swap. (1) Under the swap, losses to investors are determined synthetically, based on "credit events" occurring in a reference portfolio. Investors' risk, thus) is driven largely by the definition of "credit events" in the swap. The broader the definition, the broader the risk.

The definitions published by the International Swaps and Derivatives Association (ISDA) are, in many respects, broader than the common understanding of "default," and thus impose risk of loss from events that are not defaults. For example, Moody's--and much of the market--considers certain types of "restructuring" events to be "defaults." However, the current ISDA definition of "restructuring" is broader than Moody's definition of "default," and includes events that would not be captured by a Moody's rating.

Likewise, the ISDA definitions for other credit events-- e.g., bankruptcy, obligation acceleration, and obligation default--are broader than Moody's definition of "default." For the Moody's rating of a reference portfolio to capture the risks to investors, the "credit events" should be narrowed such that they are consistent with "defaults"--the events captured by a Moody's rating.

Many of the risks in these transactions are driven by moral hazard--the inherent conflict of interest that exists because the sponsoring financial institution (which is buying protection from investors) determines when a loss event has occurred as well as how much loss is imposed on investors. The sponsor's incentive, of course, is to construe "credit events" as expansively as possible and to calculate losses as generously as possible. Moody's considers these risks carefully when issuing its ratings. In addition to tightening the credit event and loss calculation provisions, these risks can be addressed by increasing transparency and providing mechanisms for objectively verifying loss determinations and calculations.

Setting aside moral hazard, risks also arise based on the inherent difficulty in valuing a defaulted credit to determine the extent of loss to investors. Calculated losses may vary based on liquidity, market conditions, and the identity of the parties supplying bids. In analyzing a credit default swap, Moody's looks carefully at the methods and procedures for calculating loss given default, to ensure that all calculations are meaningful, realistic, and fair.

The ISDA Credit Derivatives definitions, as currently drafted, do not effectively unbundle "credit risk" from other risks. If not structured carefully, a credit default swap using the ISDA definitions can pass along risks other than "credit risk." For example, the swap may pass along the risk of loss following credit deterioration short of default. Such a risk is not necessarily captured by a Moody's rating of the reference portfolio, and, with some exceptions (e.g., when the loss event is a rating downgrade) is not readily capable of being measured.

The capital markets have an enormous capacity for absorbing credit risk, and this capacity has only been partially tapped by the credit derivatives market. In Moody's opinion, for capital markets investors to participate fully in the credit derivatives market, the risks inherent in credit default swaps must be more precisely defined, more transparently managed, and more readily quantifiable.

This special report will describe the typical cash-settled credit default swap underlying a synthetic CDO or CLN, compare Moody's definition of default with the credit event definitions currently used in the International Swaps and Derivatives Association (ISDA) documentation, and discuss how different structural features and parameters of a credit default swap can affect risks to investors and impact Moody's analysis and ratings.

II. CREDIT DEFAULT SWAPS

Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits). The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."

A swap can be structured to provide for either physical settlement or cash settlement following a credit event. In a physically settled swap, the buyer of protection delivers to the seller an obligation of the reference entity that has experienced a credit event. The seller pays par for that asset, thus reimbursing the buyer for any default-related loss that it would otherwise suffer. In a cash-settled swap, the buyer of protection is not required to deliver the defaulted credit, but values the credit--for example, by marking it to market or by using a final workout value--and is reimbursed for the loss (measured by the difference between par and the value following default). Because most of the synthetic CDOs and CLNs that Moody's rates are supported by cash-settled swaps, this special comment will focus on cash-settled credit default swaps.

Example of Cash-Settlement Under a Credit Default Swap

Thirty days after a company defaults (e.g., it fails to make a bond coupon payment), its bonds are valued at 30 cents on the dollar. If the notional of a cash-settled credit default swap referencing that entity's bonds is $10 million, the protection "seller" would be required to make a payment of $7 million to the protection "buyer."

III. THE TYPICAL STRUCTURE

Through synthetic CDOs or CLNs, financial institutions utilize credit default swaps to "buy" credit protection--usually from the capital markets in the form of issued securities, but also directly from counterparties in the form of over-the-counter swap transactions. The structure allows financial institutions to remove credit exposure from their balance sheets while retaining ownership of the assets, and thus (1) manage risk more efficiently, and (2) obtain economic and/or regulatory capital relief.

In the typical structure, the sponsoring financial institution (the entity seeking protection against credit losses) sets up a special purpose vehicle (SPV) to serve as counterparty to the credit default swap (making the SPV the provider of protection). The SPV is funded with the proceeds of notes issued to investors; it will use those proceeds to make credit event payments to the financial institution, and to return any remaining principal to investors at the deal's maturity. The proceeds of the securities are typically invested in highly rated securities in such a way that the ratings of the notes can be "de-linked" from the rating of the sponsoring institution.

Under the swap, the SPV is the "seller" of protection, and the financial institution is the "buyer." The swap references a credit exposure, or portfolio of credit exposures, for which protection is being provided. The arrangement is similar to an insurance policy, in which the financial institution is buying insurance against losses due to default in its portfolio. The credit exposures can be assets physically owned by the sponsor (e.g., loans, bonds, other securities), exposures to counterparties (e.g., byway of currency or interest rate swaps), or synthetic exposures (e.g., if the sponsor has sold protection on particular assets by way of credit default swaps). (2) Typically, in a synthetic CDO, the financial institution retains the first-loss piece, and the mezzanine tranches are securitized and sold to investors. There is often a "super-senior" piece that is either retained by the sponsor or passed off to a counterparty by way of a swap.

There are a number of key variations on the structure that can have a significant impact on the analysis of the transaction:

* The reference pool can be static--remaining the same throughout the life of the transaction--or it can be dynamic, permitting removal and substitution of the individual reference credits pursuant to portfolio guidelines.

* The swap can provide for ongoing cash settlement -- as defaults happen and losses are incurred--or it can provide for cash settlement only at the maturity of the deal.

* The procedure and timing for determining severity of loss on a defaulted credit reference can vary--from a bidding procedure that takes place shortly after a default, to reliance on a final "work-out" value established after the formal workout process has been completed.

* The swap can reference specific credits, or it can reference the general, unsecured debt of a reference entity.

* If the swap references the general, unsecured debt of an entity, credit events under the swap can be triggered by defaults only on "bonds or loans", on a broader class of "borrowed money," or on an even broader class of "payment obligations."

* Perhaps most significantly, the definition of "credit event" can be tailored to meet the needs of the various parties to the transaction.

While each of these variations is important, the most heavily negotiated component is most often the designation and characteristics of the "credit events" that will trigger a cash settlement under the swap.

IV. ISOLATING THE REFERENCE PORTFOLIO'S CREDIT RISK

A. Measurable "Credit Risk"

"Credit risk" is generally viewed as the risk of loss following default. The risk of loss following other events-- other than "default"--is not captured by "credit risk." It is defined this way largely for practical reasons-- because "default" is an event that can be predicted based on historical data. A number of institutions have extensive data on defaults. Moody's, for example, has compiled data on corporate defaults spanning more than 80 years. This data permits Moody's to assign a probability of default to each rating category over a given time period. For example, based on historical data, Moody's can estimate that a firm rated Baa3 has a 6.1% chance of defaulting over a 10-year period. Moody's can also estimate the severity of loss given default for a given instrument using historical data.

The market does not have comparable data for corporate events other than "default." (3) For example, Moody's does not have data concerning breaches of certain covenants, loan accelerations, or certain types of debt restructurings. Thus, Moody's cannot assess the probability of these events occurring with the same accuracy that it can for "defaults." "Credit risk" could be defined with respect to these events, but it would be very difficult to measure that risk without more data.

Rating Downgrade as a "Credit Event"

While Moody's does not have data concerning corporate level events (e.g., covenant breaches, accelerations) other than "default," Moody's does have data on ratings transitions. With this data, it is possible to determine the likelihood of an entity transitioning from one rating category to another. For example, based on historical data, it is possible to determine the likelihood of a corporate obligor being downgraded from Baa3 to Bal over a certain period of time. Moreover, there is data concerning (1) spreads at the various rating categories, and (2) the widening of spreads following downgrade. Thus, it may be possible to assign a severity of loss, as well as a probability, to various downgrade events. Moody's has not been asked to rate a structure where the "credit event" is a rating downgrade, but it is theoretically possible to do so.

B. Isolating the Risk

The basic assumptions underlying a synthetic CDO or CLN are that (1) only the credit risk--i.e., the risk of loss given "default"--of the reference portfolio is passed through to investors, (4) and (2) the risk of loss on the reference portfolio can be measured by the rating of the portfolio. Thus, when analyzing a transaction, Moody's must confirm that these assumptions are correct:

* Credit risk must be truly isolated from other risks inherent in the reference portfolio. In its purest form, the swap should not transfer risks other than credit risk. Significantly, it should not pass through the risk of loss following credit deterioration short of default.

* The definition of "credit event" under the swap--the event that requires valuing a reference credit and calculating a loss--should be consistent with a well understood and measurable definition of default. For a Moody's rating of the portfolio to be used to assess the risk of the portfolio, the definition of "credit event" should be consistent with Moody's definition of "default." In addition, the methods for calculating loss following default under the swap should be consistent with the market standard.

If any of these assumptions are incorrect, a Moody's rating of the reference portfolio will not capture the risk to investors. For example, if the loss trigger events under the swap are broader than the events Moody's considers to be "defaults," the actual expected loss posed to investors may be greater than the expected loss incorporated in the Moody's rating of the reference portfolio. Synthetic CDO and CLN investors may be subject to greater risks than if they actually owned the reference portfolio and held each reference asset to maturity.

V. MOODY'S DEFINITION OF DEFAULT AND LOSS

In assigning ratings and compiling its historical default statistics, Moody's considers the following events to be defaults:

* any missed or delayed disbursement of interest and/or principal;

* bankruptcy or receivership; and

* distressed exchange where (i) the borrower offers debtholders a new security or package of securities that amount to a diminished financial obligation (such as preferred or common stock, or debt with a lower coupon or par amount), or (ii) the exchange has the apparent purpose of helping the borrower avoid default.

Severity of loss is defined as the difference between par and the recovery rate - measured as a percentage of par - following default. Moody's uses the market value of defaulted instruments, approximately one month after default, as an estimate of recovery rate. (5) These are the events that constitute "defaults" in Moody's historical studies, and these are the events that can be predicted by a Moody's rating.

VI. ISDA CREDIT EVENTS

The 1999 ISDA Credit Derivatives Definitions (6) currently list six "credit events" that can be incorporated into credit swaps:

* bankruptcy,

* failure to pay,

* restructuring,

* repudiation/moratorium,

* obligation default, and

* obligation acceleration.

While these are the so-called "standard" credit events, their inclusion and scope are always heavily negotiated in the context of Moody's-rated synthetic CDOs and CLNs. The choice and characterization of these events is crucial, because they determine the probability of a loss occurring under the swap, as well as the extent of any such loss. Some of the ISDA credit events are consistent with Moody's definition of "default," and some are not.

A. Bankruptcy

The definition of "Bankruptcy" in the ISDA Credit Derivatives Definitions was copied wholesale from the ISDA Master Agreement. Thus, while most of the definition is consistent with a "default," there are some components that are not.

The last clause of the definition, a catchall provision, is problematic because it makes a "credit event" any action by the reference entity "in furtherance of or indicating its consent to, approval of or acquiescence in" one of the listed bankruptcy events. This clause exposes investors to potentially greater risks, because it includes events that are vague, difficult to identify, and do not clearly indicate default. (7)

The ISDA "Bankruptcy" Definition

The "in furtherance of" provision could be construed very broadly--for example, the act of planning for, or even considering, a bankruptcy filing (such as hiring bankruptcy advisors to discuss options) might be in furtherance of bankruptcy, but would not generally be considered a bankruptcy event. If publicly reported, such exploratory steps could trigger a loss payment under the swap, even if the obligor does not ultimately enter bankruptcy.

Another potentially troublesome item in the ISDA bankruptcy definition is "insolvency." The ISDA definition does not specify what is intended by "insolvency." However, there are different definitions - for example, by reference to balance sheet or income statement tests--and, depending on the definition used, the timing of an insolvency "credit event" could vary. Under a very broad definition, it is conceivable that an "insolvency" could occur without being followed by an actual bankruptcy or failure to pay. Thus, a broad interpretation could lead to a "credit event" being called under the swap when no "default" has actually occurred.

B. Failure to Pay

The ISDA "failure to pay" definition is consistent with Moody's definition of "default." The key issue under this definition is materiality--i.e., the missed payment should be in an amount that is material, such that it would be captured by a Moody's rating.

To ensure that a credit event is not triggered by the failure to pay a trivial amount, a minimum amount-- referred to as the "Payment Amount" in the ISDA definitions--should be specified under the swap. While there is a standard minimum amount, that amount may not be appropriate in all transactions, and it should be considered carefully for each swap. In some cases, the choice of a Payment Amount will depend on whether the swap is referencing (1) a specific obligation, (2) bonds or loans, (3) borrowed money, or (4) the more general "payment obligations"--all of which are options under the current ISDA documentation.

A Moody's rating will capture the risk of a "failure to pay" on the obligations rated by Moody's--usually bonds and loans. However, it may not capture the risk of nonpayment on all of an entity's payment obligations--e.g., disputed trade obligations, certain fees, etc. An entity may choose not to make a payment on one of its "payment obligations" for reasons other than credit problems. To ensure that a Moody's rating will capture the risk of payment default, the category of obligations being referenced should be carefully considered. In some circumstances, a higher minimum payment amount may be appropriate.

C. Restructuring

Moody's considers certain types of "restructuring" events--known as "distressed exchanges"--to be defaults, and captures those events in its ratings. Thus, Moody's does not believe that "restructuring," as a concept, needs to be excluded from the credit derivatives definitions. In many respects, however, the current ISDA definition of "restructuring" is broader than Moody's definition of "distressed exchange," and includes events that are not captured by a Moody's rating. (8) Thus, for a Moody's rating of the reference portfolio to capture the risk to investors, the definition of "restructuring" should be tightened to make it consistent with "distressed exchange."

Criteria for a "Distressed Exchange" Default

Whether a "distressed exchange" default has occurred can be a subjective, fact-specific determination. In general, Moody's looks to three factors: (1) the extent to which the restructured obligation is a "diminished financial obligation"--i.e., the degree of monetary impairment suffered by investors, (2) the extent to which the restructuring was involuntary for all investors, and (3) the extent to which the restructuring was done to avoid an imminent payment default.

Under the current ISDA "restructuring" definition, five events can qualify as a "restructuring." Each event must meet the following requirements to qualify as a "credit event:" the restructuring (1) must not have been provided for in the original terms of the obligation, and (2) must be the result of a deterioration in the obligor's creditworthiness or financial condition. While these requirements are helpful in restricting the events that could constitute "credit events," they are not sufficient to prevent overbroad applications of the definition.

The first three events under the definition--restructuring of an obligation that leads to (1) a reduction in interest payment amounts, (2) a reduction in principal repayment amounts, or (3) a postponement or deferral of interest or principal payments-can constitute "distressed exchange" defaults under Moody's definition. Any one of these events, by itself, would arguably lead to a "diminished financial obligation." However, if combined with other changes to the obligation, they may not. For example, an obligation that has been restructured to defer principal payments may not be considered a "diminished financial obligation"--and thus not a "distressed exchange"--if the lender has been compensated for the deferral.

A Real Life Example

In August 2000, Conseco's bank debt was restructured. While the restructuring included a deferral of the loan's maturity by three months, it also included an increased coupon, a new corporate guarantee, and additional covenants in favor of the lenders. Thus, because lenders were compensated for the maturity extension, Moody's did not consider the restructured debt to be a "diminished financial obligation," and thus not a "distressed exchange" default. (Indeed, the senior unsecured rating was downgraded only to B1). However, because of the maturity extension, the restructuring was considered a "credit event" under the ISDA "restructuring" definition and triggered loss payments under the credit default swaps written on Conseco. This is a perfect example of a loss event under the ISDA "restructuring" definition that Moody's did not consider to be a default.

Thus, any "restructuring" definition should look at the totality of the circumstances--e.g., whether the lenders/investors have been compensated for the reduction or deferral - to determine whether the restructured obligation is truly a "diminished financial obligation."

The fourth ISDA "restructuring" event--a restructuring that leads to a change in an obligation's priority, causing it to be subordinated--can be overbroad. The subordination of a debt obligation to equity or preferred stock would clearly be a "default." (It would probably lead to a failure to pay as well--thus, rendering this "restructuring" event unnecessary). However, a restructuring that merely lowers an obligation from a senior to a subordinated position in the capital structure (but not to equity) could also trigger a "credit event" under the current ISDA definition. In addition, the event could be triggered in a scenario where an entity takes on senior debt that effectively subordinates other debt in its capital structure. While these events may lead to a downgrade of the affected obligations, they would not necessarily render the obligations "diminished financial obligations" and thus not be a "default" in Moody's view. (9)

Finally, the fifth event in the ISDA definition--"any change in the currency or composition of any payment of interest or principal"--is also potentially overbroad. Apparently, the provision was intended to apply to scenarios where a restructuring leads to debt being repaid in a currency that is non-convertible or highly volatile - e.g., an emerging market currency - that ultimately leads to the lender receiving an amount that is lower than the promised interest or principle. (10) Such a scenario might render the restructured obligation a "diminished financial obligation." (Arguably, it would constitute a "failure to pay" as well). However, the definition would also include restructurings where the foreign exchange risk to the lender is hedged, or otherwise eliminated, such that the lender ultimately receives precisely what it was promised. Although such a scenario may not be a "default," it would nonetheless trigger a "credit event" payment under the swap. Incorporating a notion of "diminished financial obl igation" into the "restructuring" definition would address this problem as well.

Any definition should also consider the extent to which the restructuring was "involuntary" to lenders/investors. Under the current ISDA definition, a "credit event" can be triggered if the lender voluntarily agreed to the restructuring (so long as it is the direct or indirect result of credit deterioration). However, Moody's might not consider such an event to be a default, even if it results in a "diminished financial obligation." Bank loans are restructured quite frequently - especially loans that are not syndicated-and not all such events would be considered defaults.

Voluntary Restructuring Not Necessarily a "Default"

For example, at the request of a borrower whose credit has deteriorated somewhat, a bank might agree to less favorable terms (e.g., a lower coupon) on an existing loan. However, the primary motivation for the restructuring may be something other than credit: for example, the bank might want to preserve its business relationship with a borrower--if the bank did not agree to the restructuring, the borrower might pay down the loan immediately and take its business elsewhere--because it believes the borrower's credit will ultimately improve. This type of restructuring might not constitute a default, but would trigger a credit event under the current ISDA definitions.

"Credit risk" is risk imposed on lenders by an obligor. It does not include, and a Moody's rating does not address, risks that lenders impose on themselves--i.e., the possibility that lenders will voluntarily take losses that are not forced on them by obligors.

Unfortunately, it is not easy to define "involuntary," or to determine whether a restructuring was indeed "involuntary." One possible means of capturing "involuntariness"--or at least increasing the likelihood that a restructuring was indeed involuntary--is to limit restructuring credit events to situations where there are a minimum number of lenders. "Restructuring" thus would only be available for reference obligations that are bonds, or syndicated loans with a minimum number of syndicate members. With a larger number of lenders (as opposed to a bilateral loan), it is less likely that an obligation would be restructured for non-credit reasons. (11)

The third factor that Moody's considers in assessing "distressed exchange" defaults--the extent to which the restructuring was done to avoid an imminent payment default-also provides some indication of "involuntariness." If a lender is faced with the choice of taking a potentially smaller loss now, by way of a restructuring, or a larger loss later, due to an actual payment default or bankruptcy, it is a fairly good indication that the restructuring was "involuntary." Unfortunately, in many cases it will not be easy to determine whether there would have been a default but for the restructuring. Moreover, this standard goes to the obligor's motives in carrying out the restructuring - a subjective factor that may not always be evident.

With Restructuring more than any other credit event, the need for a precise, objective definition is often at odds with the need for accuracy and predictability. Any objective definition risks being over-inclusive (e.g., Conseco), because the determination of whether a "restructuring" constitutes a default is often fact-based and subjective. However, it is possible to refine the current ISDA definition based on the factors discussed above such that it more accurately reflects a true "default" event.

D. Repudlation/Moratorlum

Repudiation/moratorium was included in the ISDA definitions mainly to address actions by sovereign lenders, and thus, is not included in many synthetic CDO's, where the exposure is primarily to corporate credit. When applied to corporate credits, repudiation/moratorium is generally consistent with Moody's views of default - although it is unclear how it would be different from "failure to pay.

However, there is concern with respect to the provision that includes as a credit event when a borrower "challenges the validity of... one or more Obligations." This provision could be construed overbroadly to include situations where there is a legal dispute over a borrowing--in which, for example, the borrower unsuccessfully challenges some terms of the borrowing--that does not ultimately lead to a failure to pay interest or principal. Moody's would not necessarily consider such an event to be a default.

In addition, if this event is to be included, the "Default Amount," or minimum amount that can be subject to a repudiation in order to trigger a credit event, should be material, so that the repudiation of a trivial amount will not trigger a credit event.

E. Obligation Default

ISDA defines "Obligation Default" as a non-payment default--i.e., a default other than a failure to pay--that renders an obligation capable of being accelerated. Moody's has not been asked to rate a transaction that includes this credit event, and the market has moved away from including it. This is because the event is much broader than Moody's--and most of the market's--definition of "default."

Most bonds and loans contain representations, warranties, financial covenants, and non-financial covenants, the violation of which can give lenders the right to accelerate. While such violations can indicate credit deterioration (e.g., failure to maintain a minimum financial ratio, taking on additional debt, etc.), many such violations can be technical (e.g., failure to send a report).

Of course, Moody's ratings do not capture the probability of a technical violation occurring. Moreover, even a covenant violation that represents serious credit deterioration would not be captured if the obligation is still current on interest and principal, and has not carried out a "distressed exchange" or become bankrupt. Moody's simply does not have data concerning such events that would allow it to assign a rating to them.

Because inclusion of this event forces counterparties to mark-to-market an obligation before a payment default occurs, it will cause investors (i.e., "sellers" of credit protection) to take losses that they would not incur if they actually bought and held the obligation.

For example, even though an obligation has suffered credit deterioration giving rise to a financial covenant violation, there is still a good chance that the obligation will pay both interest and principal in full. However, at the time of the violation, market bids will likely come in below par, because of concerns about the credit, or because of market sentiment, interest rate movements, or other systematic factors. Thus, while an investor that actually holds the obligation to maturity will get out whole, the investor "selling" protection will not.

F. Obligation Acceleration

"Obligation acceleration" is similar to "obligation default." However, to trigger a credit event, the nonpayment default--i.e., default other than a failure to pay--must lead to a reference loan, bond, or other obligation actually being accelerated. Like obligation default, an acceleration, by itself would not be captured by a Moody's rating. A failure to pay, bankruptcy, or distressed exchange following acceleration would be captured, but the acceleration itself would not.

Acceleration is simply a lender's exercise of its contractual right, under certain circumstances, to declare a debt immediately due and payable. (12) As with "obligation default," the events giving rise to a right to accelerate under "obligation acceleration"--defaults other than a failure to pay--are not considered by Moody's to be "defaults" and would not be captured by a Moody's rating. Consequently, a lender's decision to exercise its acceleration right following such events is not captured either.

There are three possible outcomes following an acceleration: (1) the borrower repays less than it owes (or becomes bankrupt), (2) the debt is renegotiated, or (3) the borrower repays everything that it owes. The first outcome is already captured by other credit events--failure to pay and bankruptcy. The second outcome, depending on the circumstances, may be a "distressed exchange" restructuring. The third outcome--the lender receives everything it is owed--is not a default.

Because the first and second outcomes are already captured by other credit events, and the third outcome is not a default, it is unclear what additional scenarios this "credit event" is intended to capture. (13) It has been suggested that the purpose of this credit event is "timing" -- i.e., because many accelerations are followed closely by either a payment default, bankruptcy, or restructuring, (14) including this event allows credit protection payments to be made earlier than they otherwise would. However, if the acceleration precipitates a true default, the default is likely to occur, at most, two or three months later, and it is difficult to justify why a counterparty cannot wait until it has suffered a true credit event to be compensated.

More fundamentally, an acceleration where the lender receives everything it is owed--clearly not a "default"-- would trigger a credit event under the ISDA definition. While historically rare, there have been instances of bond accelerations where investors have been paid par, thus leaving them with no loss. Moody's has not compiled its own data on such events, because they are not "defaults." Moreover, while Moody's is unaware of any data with respect to accelerations of loans and private placements, anecdotal evidence suggests that acceleration followed by total recovery--i.e., the lender gets all of its money back-is more common.

Inclusion of "obligation acceleration" as a credit event would not be as problematic if the market value of an obligation is always par when the lender will be fully paid off following acceleration. If that were the case, there would never be any loss following such credit events. However, it is very possible that the market value would come in at less than par--even if the accelerated debt is fully repaid.

For example, if only some of the borrower's outstanding debt is accelerated and the protection buyer is permitted to value the debt that remains outstanding, it is likely that the market value of the remaining debt will be valued at less than par. The acceleration is likely to have been triggered by some credit deterioration (though short of payment default), which would cause the remaining debt to trade at less than par. Even if the accelerated debt is valued, it is likely that a lender would agree to a grace period to allow the borrower to gather funds and make arrangements for paying down the debt, especially if the lender believed it could get par following acceleration. If bids on the accelerated debt come in during that grace period pursuant to the swap, it is possible that--because of market or interest rate movements or, more likely, because of uncertainty about the credit itself--the bids could come in below par, even if investors/lenders ultimately receive par following acceleration. (15)

Another concern with "obligation acceleration" is that its inclusion as a credit event may create additional incentives. A protection "buyer" that accelerates a reference obligation will be reimbursed regardless of the outcome. Indeed, the "buyer" could get all of its money back on the loan and get additional compensation if bids on the non-accelerated debt come in at less than par.

Example

A bank is considering whether to accelerate the loan of a borrower that has suffered some credit deterioration (and violated some covenants) but is not in imminent danger of defaulting on any payments. Consequently, the bank knows that it will get all of its money back if it accelerates. If the bank has bought protection on that borrower through a cash-settled credit default swap that includes "obligation acceleration" as a credit event, after it accelerates the loan, the bank could get bids on the remaining outstanding debt and get additional compensation. For example, if the remaining outstanding debt were bonds trading at 85cents. on the dollar, the bank will receive an additional 15% recovery. Without the swap, the recovery is 100% (from the par on the accelerated loan); with the swap, the recovery is 115%. The incentive to accelerate is obviously greater in the presence of the swap.

Because occurrence of the "obligation acceleration credit event is often within the protection "buyer's" control, the additional incentive means that the event is more likely to occur in the presence of a swap than under normal circumstances. If the "buyer" has the right to accelerate, it is more likely to exercise that right if it can receive additional compensation for doing so. Thus, any historical data regarding the likelihood of an acceleration would probably understate the likelihood of its occurring when it is covered by a swap. (16)

G. "Obligation Acceleration" and the Problem of Basis Risk

Sponsors of synthetic CDO and CLN transactions can fall under two different categories: (1) those who are credit default swap "end users," and (2) those who are not. The "end users" are buying protection on cash exposure to the reference credits. In other words, they have actual exposure to the credits through loans or other business relationships with the obligors. Sponsors that are not "end users" are buying protection on synthetic exposure to the reference credits. They are exposed to the credits by way of credit default swaps--i.e., they are "selling" protection on the credits to other counterparties, and if there is a credit event on those swaps they will be required to make a credit event payment to the other counterparties.

"End user" sponsors typically recognize that "obligation acceleration" is not necessary, and, unless required to do so by regulators, have typically not asked for its inclusion their transactions. However, institutions that are hedging, or buying protection on, synthetic exposure have argued that inclusion of this event is necessary, because most of the swaps giving rise to their exposure include "obligation acceleration." If the synthetic CDO or CLN does not include this credit event, there are potential loss events for which they are not hedged. Believing this additional risk to be significant, these institutions are often unwilling to take the incremental basis risk and have asked Moody's to rate the transactions with this event.

Moody's is reluctant to rate a credit event that is not a default and is only present because of a quirk in the ISDA definitions that has become "standard." (17) The optimal solution is to remove "obligation acceleration" all together, or for it no longer to be "standard." However, Moody's has been able to rate transactions including this event with the following modifications to the ISDA definition:

* Acceleration is only a "credit event" if, after the later of a minimum time period and the time to the next payment date on the obligor's obligations, the accelerated obligation has not been fully repaid. The rationale is that if the accelerated obligation is not fully repaid by the next payment date, it will likely never be fully repaid.

* Following acceleration, instead of cash settlement, the protection buyer delivers to the SPV an obligation of the reference entity (1) that has been accelerated, or (2) if the delivered obligation has not been accelerated, that matures earlier than the transaction matures. The SPV would only be permitted to sell the delivered obligation if it actually defaults; otherwise, it must hold it until it matures or is paid down. (18) This should remove the incremental market risk inherent in this event under a cash settled swap.

Moody's has considered numerous alternatives to these solutions, and additional solutions may be acceptable. (19) However, the best solution would be to exclude this event all together.

VII. THE PROBLEM OF "SOFT" CREDIT EVENTS:

SYNTHETIC vs. CASH

Credit default swaps are intended to mimic the default performance of a reference obligation. Thus, for example, owning a CLN is often considered equivalent to having a cash position in the underlying reference obligation, except that the maturity, coupon, or other cash flow characteristics may be different. If an investor holds the CLN to its maturity, it should have the same risk of loss as if it held the reference obligation to its maturity. (20) Put another way, the CLN should only default if the reference obligation defaults. However, if so-called "soft" credit events - events that are not truly "defaults"--are included in the swap, that will not be the case. Selling protection through a cash-settled credit default swap--e.g., owning a CLN (or a synthetic CDO) - can actually be more risky than actually owning the reference obligation(s).

This is because cash-settled credit default swaps essentially force investors to "cash out" of their position following a credit event. (21) If the swap includes credit events associated with credit deterioration short of default--e.g., a broadly defined restructuring or obligation acceleration--the CLN can default (the investor will receive less than the full par of the CLN) when the reference obligation has not.

Example: Synthetic Exposure Riskier Than Cash Position

Two investors have exposure to the bonds of XYZ. The first investor actually owns the bonds. The second investor owns a CLN that references XYZ. Because of credit deterioration, XYZ violates some covenants on its outstanding bank debt, which leads its bank to accelerate the loan. The bonds, however, are not accelerated, but are trading at 85cents on the dollar. The credit deterioration is not serious enough to lead to a default, and the bonds are ultimately paid off completely at maturity. Because the underlying swap includes "obligation acceleration" as a credit event (swaps typically allow a credit event to be triggered if a bond or loan has been accelerated), the CLN investor receives 85% of its par back and the CLN terminates. By contrast, the cash investor receives the coupon for the remaining term of the bonds and receives all of its principal back at the bond's maturity.

Thus, if a cash-settled credit default swap includes "soft" credit events, the investor may suffer losses that are not captured by a Moody's rating of the reference obligation(s), subjecting it to greater risk of loss than if it actually owned the reference obligation(s).

VIII. MORAL HAZARD

In virtually every synthetic CDO and CLN, the "buyer" of protection--the sponsoring financial institution--determines whether a credit event has occurred in the reference portfolio. More significantly, the "buyer" calculates the severity of its losses following a credit event, and how much the SPV will be required to pay under the swap (i.e., how much investors will lose under the transaction). Because of the moral hazard inherent in such an arrangement, credit swaps should be structured such that the occurrence and severity of losses can be objectively and independently identified, calculated, and verified.

Occurrence Of A Credit Event

Moody's generally believes that, in order for a credit event payment to be triggered, the occurrence of the event should be published in (1) a well-known news source, (2) a corporate filing, or (3) a court document. This should deter protection "buyers"--acting either alone or in collusion with a reference obligor--from staging credit events for the sole purpose of being reimbursed under the swap. The rationale is that parties will be less likely to assert spurious credit events if the events have to be made public.

There may be instances, however, where there is no published information available regarding a credit event. For example, the reference obligor may be a private, unrated company whose only outstanding debt is to a bank. There may be no press release, no public corporate filings, and no court documents to support the existence of the credit event. However, the sponsor should be able to get protection under the swap for that credit if there is a true default. Thus, in some limited circumstances, Moody's-rated synthetic CDO's provide that, for certain credit events, if there is no "publicly available information," at least one senior officer who is part of the sponsor's credit underwriting or monitoring department may provide written certification that the credit event has occurred and that the obligation has been treated internally as a defaulted asset. The certification may also contain contact information at the defaulted obligor so that the protection "seller" can verify the claim and, if necessary, dispute it. Here, too, the rationale is that a sponsor is less likely to assert a spurious credit event if a senior officer who is not directly involved with the transaction is required to sign a certification that the event occurred.

Loss Severity Following Credit Event

The amount of loss following default should be calculated either (1) by obtaining bids from third parties, or (2) by going through a formal workout process to arrive at a workout value. The former is the most common. Because it may not always be possible to obtain public bids, however, most transactions provide for contingency calculation methods. These methods can include a formal appraisal by an objective third party. The "buyer" should not be the sole source for determining its losses under the transaction. The existence of a meaningful dispute resolution mechanism will also help to eliminate the moral hazard inherent in these situations. In some cases, permitting investors to make firm bids--or designate other parties to make firm bids--for defaulted obligations can also be an effective solution.

The Case of Blind Pools

Occasionally, because of regulatory and/or legal restrictions, a bank may not be permitted to disclose certain names in a reference pool. Disclosure to Moody's has usually been permitted, but the bank is not permitted to disclose to investors or others associated with the deal. (22) This becomes a serious problem when a credit event occurs with respect to one of those names. It may be difficult to obtain a meaningful bid--and thus mark the defaulted name to market--without disclosing the name to potential bidders. The bank may also be unable to obtain an appraisal from an objective, unaffiliated third party. In these circumstances, it may be possible to get comfortable with an appraisal by the bank's auditors, so long as the bank retains a portion of loss (e.g., 10%) on each such name.

IX. MARKING-TO-MARKET/CALCULATION OF LOSSES

Recovery assumptions

The sponsor must determine which position in the capital structure--senior secured, senior unsecured, subordinated, etc.--it will reference and, more importantly, mark-to-market in order to calculate loss following default. Each priority position has different recoveries, and, in modeling loss scenarios, Moody's applies recovery assumptions based on the level of debt that is specified in the covenants. In addition, obligations from different jurisdictions will carry different recoveries, and Moody's will use assumptions based on the covenants pertaining to different jurisdictions in the transaction.

Obligation marked to market

If a specific obligation is referenced, that obligation, or an obligation that is pari passu in the capital structure (and has at least the same level of security), should be the one that is valued following a default. As mentioned above, this is necessary so that the actual recovery can be consistent with the assumptions used in modeling the transaction. In addition, many deals require that bids be obtained on the standard trading size of the reference obligation. This is important in transactions that reference very large amounts of reference obligations, where it is impossible to obtain meaningful bids on such large amounts.

Time to valuation following default

The timing of the mark-to-market following default may affect the calculation of losses. There is evidence that, in some cases, the longer the time between default and valuation, the higher the valuation will be. This is to be expected because, during the period immediately following default, there will be a relative lack of information about the credit and, therefore, uncertainty as to expected recoveries. Therefore, during this period we would expect higher volatility in pricing and, generally, lower valuations. In formulating recovery assumptions, Moody's looks at market value thirty days following default. It is expected that available information will have been priced into the market by this point, and prices will be relatively stable. Investors should look very carefully at any swap that calls for valuations earlier than thirty days after default, as investors will likely be exposed to higher pricing volatility and, potentially, greater losses.

Nature and number of bids obtained

The pricing process should be structured such that it produces meaningful valuations following default. Thus, the potential bidders should be entities that are actively involved in the market for the relevant asset (e.g., loans, bonds, derivatives exposures, structured finance securities, etc.) and are capable of providing meaningful bids. It is also important that bidders have access to enough information to be able to make informed bids. In addition, most transactions call for a minimum number of bids; The highest bid is usually used for valuing the obligation. If the protection "buyer" is unable to obtain the minimum number of bids--due, for example, to some sort of temporary market disruption--it is usually required to repeat the bid solicitation process two or more times until it is able to get the minimum number. (23) As mentioned above, there should be mechanisms for meaningfully pricing the defaulted obligation if the public bidding process is unsuccessful.

X. REFERENCE CREDITS OTHER THAN CORPORATE OBLIGATIONS

Some financial institutions are seeking to buy protection on credits other than corporate obligations e.g., structured finance obligations. This presents unique challenges for (1) classifying exactly what constitutes a credit event, and (2) applying recovery assumptions following a credit event.

For example, "failure to pay" may not be an appropriate credit event for all reference obligations, because certain payment failures are not considered defaults. Some structured finance securities (e.g., mezzanine tranches of collateralized debt obligations, and most ABS and MBS) can defer and capitalize missed interest payments without going into default. Under these structures, capitalized interest can be paid back subsequently through the deal's cash flow. However, interest can also continue to be deferred and capitalized, and the security is not considered defaulted until it reaches maturity and does not pay back original principal and all capitalized interest. A financial institution might like to buy protection against a CDO security deferring interest, or "paying in kind." However, a Moody's rating of the security does not capture the probability of that event occurring (it only captures the likelihood and extent to which it will not pay back principal and all capitalized interest by the final maturity date).

Moreover, it is not clear that investors would want to sell protection for a simple "payment in kind," because such events can vary in seriousness. As foreseen in these structures, a security could (1) defer interest for one or two periods and then pay it back (with interest) and be current for the rest of the transaction, or (2) defer interest until final maturity. While a mark to market following the first scenario would probably come in at less than par (and the credit default swap investor would suffer a loss), if an investor actually owned that security, it would ultimately get out whole. For a credit protection market to develop for these types of reference credits, market participants will have to determine what kinds of deferred interest scenarios should be considered "credit events" and how those scenarios can be modeled.

Similar issues arise with respect to structured finance securities that can have their principal "written down -- and subsequently reinstated -- without being in default. Market participants must consider very carefully what a rating on such a security addresses and how to model the various types of "credit events."

Finally, the use of structured finance securities as reference obligations raises issues concerning valuation following default. Recovery data for defaulted structured finance securities is extremely scant, as there have been very few defaults. Moreover, these securities -- especially the lower-rated, mezzanine securities -- can be highly illiquid when they are performing -- rendering a mark-to-market very difficult. It can be reasonably assumed that liquidity following default would only be worse. Given the lack of data concerning market values following default, it is not clear what recovery assumptions should be used. (24) Until there is sufficient data, recoveries assumed by Moody's are likely to be very low.

XI. GOOD FAITH OF THE SPONSOR

In addition to reviewing the definitions of credit events, the methods for calculating severity of loss following default, and other structural aspects of a transaction, Moody's looks very carefully at the sponsoring financial institution before assigning a rating. This is because, no matter how carefully the transaction is structured, an aggressive protection buyer can interpret credit events more broadly than the seller intended, or obtain pricing for defaulted obligations that is unrealistic or not meaningful. If the buyer/sponsoring financial institution does not approach the transaction in good faith, the structural protections can be rendered largely ineffective, and the risks to investors impossible to model. Moody's examines--and investors should consider:

* the sponsoring institution's size

* its reputation

* its past history as a credit default swap counterparty

* its commitment to the credit derivatives market--e.g., whether it intends to access the capital markets in the future to buy credit protection

* its default and recovery history

* its ability to manage and monitor the reference portfolio and abide by any portfolio guidelines

* its motivation for carrying out the transaction

* the separation between its credit underwriting/origination and portfolio management departments

* the people and resources allocated to managing the portfolio and administering the transaction.

If Moody's has concerns specific to the sponsor, we will often ask that additional structural protections be included to address those concerns.

XII. CONCLUSION

Securities backed by credit default swaps are a relatively new asset class. As the market matures, and market participants and Moody's gain additional experience, it is likely that the standards for rating these transactions will be refined. In all cases, however, the risks to investors who buy CLNs and synthetic CDOs should be risks that are capable of being measured. For a Moody's rating of the reference portfolio to capture the risks to investors, the credit default swap underlying the transaction should transfer only credit risk--the risk of loss following default--to investors. (The swap could theoretically transfer the risk of loss following credit deterioration--i.e., downgrade - but, as of yet, such a transaction has not been explicitly proposed).

The "standard" ISDA credit derivative definitions) as currently drafted, do not effectively unbundle credit risk from other risks. Investors should carefully examine the means of determining frequency and severity of loss events under any credit default swap. The ISDA definitions were designed primarily as a template for private, bilateral contracts between two counterparties - usually large, sophisticated financial institutions. Thus, it should not be surprising that some of the "standard" provisions are highly complicated, unpalatable to a range of capital markets investors, and require significant scrutiny and incremental analysis by Moody's. There is usually a price to pay for accessing the capital markets. In the case of credit default swaps, that price includes greater transparency, more precise loss event definitions, and tighter provisions to address moral hazard.

Forecast for 2007: Changes, Challenges Lie Ahead

Members of LOMA’s Board of Directors share their thoughts on up-and-coming products, regulatory and legislative issues, M&A activity, technology’s role in the industry’s evolution, and other key issues.

By Stephen Hall

With 2006 now officially a memory and 2007 a mystery waiting to be unraveled, the next 12 months are full of uncertainty, in terms of what lies ahead for the industry.

However, what is likely to occur with regard to key industry issues and concerns is something that members of LOMA’s Board of Directors have definite opinions about. Resource recently surveyed members of the board to solicit their views on where they see the industry headed for 2007. Among the major points of agreement were the following:

Sales and profits will likely remain flat or rise somewhat. Sales of universal, variable universal and term life products are expected to be strong performers in 2007, and possibly annuities as well. Sales of critical-illness insurance products will probably continue to trend downward.

The most critical regulatory and legislative issues in the new year will be the optional federal charter, the reform or repeal of the estate tax, principle-based reserve requirements, overseas travel underwriting, and annuity disclosures.

Merger and acquisition activity will probably continue, though not at the same rate that has transpired over the last few years.

Participating board members also had much to say about the imminent retirement of many members of the Baby Boomer generation and the many opportunities this phenomenon presents for the industry (Scroll down to see “Opportunities in the Boomer Retirement Market”.).
Board members who participated in the 2007 forecast are:

Lawrence J. Arth, CFA, chairman and CEO of the UNIFI Companies in Lincoln , Neb. , and LOMA chairman;

John M. Bremer, COO of Northwestern Mutual in Milwaukee , Wis. ;

Steve Briggs, CLU, ChFC, executive vice president of the Protective Life Insurance Co. in Birmingham , Ala. ;

Donald W. Britton, FSA, MAA, president of the life business group for ING U.S. Financial Services in Atlanta , Ga. ;

David M. Holland, FSA, MAAA, president and CEO of Munich American Reassurance Co. (MARC) in Atlanta, Ga.;

Mark E. Konen, FSA, president of individual markets for Lincoln Financial Group in Greensboro , N.C. ;

David J. McFarlane, FSA, FCIA, vice president and COO of Wawanesa Life Insurance Co. in Winnipeg, Manitoba;

Thomas H. MacLeay, FLMI, CFA, chairman, president and CEO of National Life Group in Montpelier, Vt.;

Al Meyer, CLU, ChFC, executive vice president of American Family Insurance in Madison , Wis. ;

George S. Mohacsi, FLMI, president and CEO of Foresters in Toronto , Ontario ;

Thomas E. Rattmann, CFA, chairman of the board, president and CEO of Columbian Mutual Life Insurance Co. in Binghampton, N.Y.;

John W. Wells, FLMI, CPA, CLU, ACS, senior vice president of operations at Bankers Life & Casualty in Chicago, Ill.;

Susan D. Waring, CLU, ChFC, executive vice president and CAO for State Farm Life Insurance Co. in Bloomington, Ill., vice president for State Farm Health, and LOMA vice chairman;

Lizabeth H. Zlatkus, president of international wealth management and group benefits for Hartford Life, Inc. in Hartford , Conn.

The questions and answers follow:



1) SALES. What is your overall prediction for sales, premiums and profits for our industry as a whole in 2007? What products look particularly strong or weak?

ART: For the life insurance industry, my outlook is for modest growth in both new sales and total premium, with good levels of profitability for the overall industry. Products that should show good growth include both life and annuity products that offer secondary guarantees at the expense of those products that don’t have secondary guarantee features.

BREMER: We expect the industry’s 2007 new life premium growth to be relatively flat, with a number of companies showing negative growth as they begin—or continue—to reduce sales of investor-owned life insurance (IOLI). Due to significant IOLI sales in the first half of 2006, some companies will be faced with difficult year-over-year sales comparisons in 2007. Sales growth of universal life with secondary guarantees (ULSG) is expected to continue to slow as more companies reprice their products and restrict issuance ages.

Uncertainty in the corporate owned life insurance (COLI) market was dissipated by the Pension Protection Act of 2006. Though a temporary pause may occur initially as companies adapt to the new administrative requirements, we expect that the COLI Best Practices provisions within the Act will actually help the industry longer-term, due to the certainty of the tax-free death benefit status.

Overall, we expect modest growth in the annuity business. If the equity markets remain favorable, we would expect to see additional growth in VUL and VA sales. Fixed annuities have had to compete within a rising interest rate environment, which can help sales, but we are also competing with other fixed instruments and a relatively healthy equity market, which have made sales growth difficult. We would also like to note that many articles in the popular press are beginning to tout the merits of using immediate annuities as part of a person’s retirement income strategy, and we expect that this product will enter a sustainable growth cycle in the not-too-distant future.

Disability income insurance sales have been growing moderately—3 to 4 percent—and we expect that trend to continue. Long-term care industry sales have been difficult to forecast and have been rather soft for some time as consumers wrestle with their understanding of and need for the product. Though we do not anticipate any significant industry growth in 2007, we believe that at some point, aging baby boomers will want to more actively pursue this type of risk management insurance.

Profits for the life industry in 2006 have been rather strong due to higher-than-expected sales growth, favorable financial markets, and a focus on cost controls. We expect profits to remain dependent on those three variables, but a moderation of the 2006 growth rate experienced is expected.

BRIGGS: We will see strong sales in UL and solid increases in VUL as companies add guarantees and other benefits to that line. Equity-indexed universal life
(EIUL) will continue to make advances above the average. Term will hold steady. Accumulation annuities will have a strong year, and income-based products will continue to get strong attention. Profitability will be mixed, with gains coming from expense management more than core products results, since most lines are highly competitive and margins continue to decline on new business while higher-margin products roll off the books.

BRITTON: The industry will still have limited sales growth. The number of new policies sold will continue to decline. Earnings will not have robust growth, and guaranteed premium universal life will still be the big seller.

HOLLAND : For the life insurance market, I expect recent trends to continue. Premium growth is being led by UL and variable UL products. Face amount is growing modestly, and the number of policies issued continues to decline. In 2005, the top 25 issuers wrote approximately 75 percent of the volume for the entire industry, and as a group, they experienced a decline in face amount for new issues of 1 percent for term and 3 percent for permanent. Although term insurance may grow overall, there will be substantial volatility amongst individual companies. Term products may experience a resurgence, should principle-based reserving and the interim reserving solutions result in more attractive pricing for the consumers.

With the Baby Boom generation nearing retirement age, there will continue to be a strong push for asset accumulation products, especially variable annuities and indexed annuities. The non-cancelable disability income market is relatively flat by premium, with most of the observed growth in the guaranteed renewable and multi-life product designs. As non-can dominates the established DI market with white-collar professions, some companies have shifted their focus to the underserved blue-collar market via guaranteed renewable designs. Although demographics demand that there will be a growth in the long-term care market, it may still be some time in the future before this occurs.

KONEN: Well, I think that from Lincoln ’s perspective, we see strong sales growth potential in both our life insurance and our annuity lines, particularly in the variable part of those products. And from a profit standpoint, I think we see stability and growth in the profits as well. I don’t think we see any products that are particularly weak in this environment.

MacLEAY Sales expectations for 2007 are mixed by product line, with overall life insurance sales growth expected to be in the low single digits, most likely led by universal life and perhaps a resurgence of variable universal life if equity markets remain healthy. Fixed annuity sales depend very much on the interest rate environment, especially the shape of the yield curve. If the curve returns to a positive slope in 2007, expect a resurgence in fixed annuity sales. If the curve remains flat to inverted, which is the more probable scenario, then fixed annuity sales will continue to struggle. Variable annuities with living benefit guarantees will most likely continue to be strong sellers as more companies compete on the basis of these specific features.

In terms of profits, life companies will continue to be stressed by the low spreads available due to the expected continuing low interest-rate environment. Nonetheless, profit growth should continue to be healthy as many strong companies deliver new products to the market and contain expenses while benefiting from good mortality and positive investment results. This positive profit outlook could be compromised if there is a significant recession, especially if it is accompanied by a deterioration in credit quality and an upsurge in defaults. Also, companies with substantial exposure to products with embedded options, such as the VAs with guaranteed living benefits, could face earnings pressure if equity market volatility and the cost of hedging increases significantly.

McFARLANE: In Canada , I expect individual life sales to be relatively flat compared with 2006. Renewable term and universal life will be popular products, while term to 100 sales will continue to decrease as a result of companies either withdrawing the product or alternatively implementing rate increases, which has decreased the product’s attractiveness. Sales of critical illness insurance will continue to be weak, compared to the strong growth the market had seen up until 2006. This is due to the significant rate increases companies implemented in 2005 and the more complex underwriting (compared to life insurance), both of which have dampened broker enthusiasm for the product, despite an aging population and increasing needs.

Profitability should remain strong for the Canadian industry, especially for the large insurers who will continue to benefit from scale economies, their dominant Canadian market share, and their international business expansion. Smaller companies, especially those in the very competitive individual life market, will continue to see pressure on profitability as they manage the balance between market growth and the bottom line.

MEYER: In the multi-line industry, we expect the auto line to continue to be somewhat soft in both sales and premium growth. The fire line is in a similar position, but not quite like auto. Profits will be strong, but somewhat lower than 2006 due to rate flattening.

MOHACSI: I believe the industry will have a good year in 2007, with sales and profitability consistent with 2005 and 2006, although margins in new sales will still be very slim. Universal life and term sales are showing some growth, which should continue. Critical-illness sales are declining as pricing hardens in the market but are showing some signs of stabilizing. Sales of segregated funds, or segfunds, will continue to grow, as demographics would dictate, but will be volatile as equity markets rise and fall. Specialty riders added to life insurance products seem to be coming into favor.

RATTMANN: I expect that overall sales will rise modestly, in the low single digits. In-force premiums will rise while cost per $1,000 will continue to decline modestly. Industry profits should grow modestly due to higher sales and financial market returns.

WARING: I see overall life insurance and annuity sales being slightly up to relatively flat. Term insurance will show some growth in 2007 as the rollout of new 2001 CSO term products gain momentum, but permanent sales will be relatively flat.

We currently have a flat yield curve where the extra yield on a 10-year bond over a five-year bond is negligible. This flat yield curve hurts the competitiveness of fixed annuities vs. bank CDs. I cannot see a pickup in fixed annuities until we have a more traditional sloped yield curve.

The stock market has been up for the first 10 months of 2006. We need continued stock market increases to fuel further increases in variable sales. The task of evaluating risk in the sales of living benefits and secondary guarantees continues to be challenging and is a potential threat to industry profitability. With rising interest rates, portfolio interest rates should stop declining and fixed annuity margins could return to acceptable levels if the yield curve would steepen.

WELLS: Overall modest growth for these areas would be my view. In terms of sales, as baby boomers start to retire, fixed annuities seem to be an attractive product. On the strength of the stock market, sales of variable annuities will pick up, with life insurance sales relatively flat.

ZLATKUS: In the U.S. , the individual life insurance business is expected to finish with a mid-single-digit growth rate in 2006. In 2007, we anticipate industry sales will be relatively flat, with marginal growth at best. We expect universal and term life sales to lead the way, while whole life and variable universal will struggle to grow sales.

With respect to employee group benefits, we also anticipate mid-single-digit growth in the life and disability businesses. In 2007, we expect these growth trends to continue as employer spending on medical benefits continues to place pressure on ancillary products, such as group life and group disability insurance.

On the individual annuity side, we see the potential for continued future market growth as the Baby Boom generation rapidly approaches retirement here in the U.S. With 3 million Baby Boomers set to reach age 60 in the coming year alone, we anticipate growth in the VA industry to continue, as the demand for living benefit guarantees will remain strong. We do not anticipate growth in the fixed annuity industry; however, sales in this market will be largely dependent on the level of interest rates in 2007.

Internationally, we anticipate that the Japanese VA industry will continue its strong growth as the market continues to mature and the aging Japanese
population continues to shift its assets from cash to retirement investments. Additionally, 2007 will see further bank deregulation that will pave the way for
new life product offerings, as well as the very early initial stage of the privatization of Japan Post and its $3 trillion in assets.

2) REGULATION
What regulatory or legislative issues will be of the biggest concern to our industry in 2007, and why?

ART: The optional federal charter legislation at the federal level, along with principle-based reserving at the regulatory level, will be the bigger issues the industry will face in 2007. Additionally, federal and estate tax legislation proposals will likely surface. At the state level, we will likely see new regulations on required annuity disclosures and perhaps life insurance disclosures.

BREMER: Increasing regulatory pressure will continue with regard to the secondary life insurance markets as hedge funds and other investor groups pursue arbitrage opportunities. Some companies have stepped forward in an attempt to turn this growing tide within their own distribution channels. Sales in this market may moderate as regulatory discussions increase. We observed a similar cooling-off of sales when equity index annuities were subjected to more regulatory scrutiny. Actuaries and insurance regulators have devoted a lot of effort in 2006 to studying the appropriate level of reserves and new reserving mechanisms for life insurance products; that work is expected to continue into 2007. Finally, although results are unknown at the time of these comments, the November 2006 mid-term election results may affect our industry. Legislation regarding the tax treatment of capital gains, dividends and estates could all change dramatically. Any such reforms will significantly impact our industry. As firms begin to work through the changes presented by the Pension Protection Act, opportunities will arise. Looking beyond 2007, the Pension Protection Act will be the catalyst for the development of the next generation of products.

BRIGGS: The optional federal charter should continue to make solid progress next year. Principle-based reserves will make modest progress; annuity disclosure rules should come into focus next year as well.

BRITTON: The regulatory and legislative issues that will be of the biggest concern to our industry in 2007 will be reserves for guaranteed products. A move to principle-based reserves is very important to the industry.

HOLLAND : From a long-term perspective, there will be continued efforts to improve state insurance regulation while at the same time developing alternatives such as an optional federal charter. Due to broad recognition by the industry and regulators that the current formulaic reserving approaches inadequately capture all the material risks inherent in certain products, resulting in inappropriate reserves, significant support for principle-based reserving has been building. States are working to implement the interim reserving solution, and both the industry and regulators are diligently moving toward development of a comprehensive proposal that can be adopted by the NAIC and implemented by the states. The NAIC Reinsurance Task Force plans to review issues raised in connection with U.S. requirements regarding reinsurance collateral. Depending on the support for such a proposal, changes to the current collateralization requirements could be a significant topic of discussion in 2007.

Another issue is regulatory efforts to limit insurers’ ability to underwrite travel. The NAIC recently held a public hearing to discuss travel underwriting practices and is working on an amendment to the Unfair Trade Practices Model Act that would provide additional guidance regarding permissible underwriting of travel.

KONEN: I can think of a few major areas. The first area is the optional federal charter, and the continuing debate and possible resolution on that. It’s extremely important to our industry, in terms of making it easy for customers to do business with us and establishing a level playing field with other financial services industries. The second area is the possible repeal or reform of the estate tax, assuming anything happens with that. I would say the estate tax debate is a life insurance issue, and depending on which way that goes, it could have an impact, given the way life insurance is currently being marketed in many areas. It will create a need for our industry to refocus its attentions to other capabilities of life insurance, because life insurance can do a lot of things besides just estate tax planning.

MacLEAY At the national level, assuming there is no broad-based tax reform initiative, the two significant issues will be the estate tax and the optional federal charter. A compromise on the estate tax seems more likely as the complexion of Congress changes, while the optional federal charter is likely to move forward but not achieve closure in 2007. At the state level, continued progress on the interstate compact is likely as state regulators persist in their efforts to improve the state regulatory environment in hopes of defeating or reducing the need for a federal charter alternative. Also, expect movement at the state level toward a comprehensive regulatory approach to the burgeoning life settlements market, and more progress on annuity disclosure and principle-based reserving.

McFARLANE: In Canada , probably the most important issue next year is the revision to the Federal Bank Act, which is expected to be enacted in 2007. However, as to the impact on the insurance business, I don’t expect we’re going to see any major changes. Although the banks have been lobbying aggressively to have the government ease the present restrictions on bancassurance, it’s unlikely to happen with a minority federal government and the political risks due to negative reaction from consumers and brokers to any meaningful changes.

MEYER: The possibility of greater federal regulation will have a major impact on the P&C industry. If there is movement toward a national disaster plan, it will impact the fire line availability in disaster-prone areas. Also, any adverse ruling on the use of credit in the rating of policies will impact pricing.

MOHACSI: With a minority government in Canada , it is unlikely that there will be any major changes in financial services legislation. In particular, the prohibition on banks selling insurance in their bank branches will continue. Areas on which companies will need to focus include compliance with anti-money-laundering rules, privacy regulations, and general market conduct regulations.

RATTMANN: I believe the two largest insurance-specific issues will be principle-based reserving and the optional federal charter versus the current state-based regulation.

WARING: The impact of pension reform could help drive a continued move toward defined contribution plans. Restrictions on the underwriting of foreign travel may need to be accounted for in the pricing of new products. The likely requirement of the Commissioners Annuity Reserve Valuation Method for variable annuity reserves (VACARvm) and the move toward principle-based reserves in statutory accounting (although not an immediate concern for 2007) will require changes to actuarial computing capacity and the pricing process. Also, the continued movement toward compliance with the 2001 CSO mortality table requirements will continue and drive product development activity.

WELLS: The spate of accounting scandals will continue to lead to stricter enforcement by the regulators. The implementation of additional controls by companies will lead to increased costs of compliance, impacting profitability. Organizations that are proactive in implementing an effective enterprise approach in monitoring compliance at the highest levels of the company should have an advantage in working with the regulators.

Compliance issues relating to the sale of annuities to seniors will continue to emerge as an issue. Several states have adopted suitability requirements to ensure that sales of these products are appropriate. This trend is expected to continue. Some companies selling annuity products are being proactive on this issue and are making suitability an important component of the overall sales process.

ZLATKUS: In the U.S. , regulatory and legislative issues of concern to the industry include appropriate regulations on suitability in the sales process, questions of disclosure on compensation, and ever-changing proposals for the tax code. The industry has also been concerned about a potential lack of uniformity if various states impose new suitability rules on the life insurance or annuity sales process. The continued debate on potential changes to, or repeal of, the estate tax will also remain of considerable importance to life insurers.

Internationally, we expect current regulatory trends to continue as products become more complex and the marketplace evolves in terms of sophistication and customer needs. In the countries in which The Hartford operates, we see a continued emphasis on the structure of insurers, wherein regulators seek for insurers to maintain appropriate internal structures to ensure compliance, assess risk—including underwriting, financial and operating risk—and provide appropriate products for the marketplace. Regulators continue to look to the experiences of their colleagues in other countries and to share best practices among themselves. As a result, we will continue to see a measure of regulatory convergence among countries.



3) RESTRUCTURING
Do you believe industry restructuring through mergers, consolidations and alliances will continue? How is the industry likely to look 10 years from now?

ART: Mergers, consolidation, and strategic alliance activities will continue for the foreseeable future. For many companies, achieving scale is a significant challenge, and growth through internal activities will not be sufficient to reach scale. In 10 years, there will be fewer but larger companies in the life insurance industry.

BREMER: We continue to believe that the industry will be marked by mergers and acquisitions to some degree, though we did not witness any blockbuster activity in 2006. The industry is becoming more global as companies combine or form alliances across borders in pursuit of growth. We expect companies will continue to try to build scale in the business lines that they want to pursue while exiting others that no longer align with their company’s current focus. Looking out 10 years, we would expect to see a number of large global players along with some dominant niche players. Although fewer in number, we expect many small insurance companies to survive into the future.

BRIGGS: I certainly hope so—it is core to our strategy and skill set. Ten years from now, there will be somewhat fewer large companies (focused on scale improvement through a merger).

BRITTON: We still have a lot of supply. While there is a large population of people without life insurance, we are focused on the affluent market and neglecting the middle market. Alternative distribution models may be the answer to serving this market.

HOLLAND : The direct insurance market has already undergone considerable consolidation, and I expect it to continue over the next decade. Today, the top 100 companies control 97 percent of industry assets. Major companies will seek even larger scale, consolidators will continue to profit from putting together smaller companies which lack critical mass for today’s products, and international companies who want to be truly global will seek opportunities to expand in the U.S. market. There could also be interest from outside entities who want to move into the asset accumulation market associated with longevity-based products. However, the combination of high capital costs and low return on capital has made the industry fundamentally unattractive for outsiders.

KONEN: I do believe industry restructuring through mergers, consolidations and alliances will continue. There are still a lot of strong competitors in the insurance space, and I believe that this plethora of competitors will cause increased consolidation over the next decade. Ten years from now, there are going to be fewer of us, and the industry will be more concentrated.

MacLEAY Industry consolidation will certainly continue, but at a somewhat slower pace. Looking out 10 years, it is highly likely that there will be fewer independent companies and that the industry will have further bifurcated into a relatively small number of extremely large “scale players” and a group of smaller, niche-focused, high-quality organizations.

McFARLANE: In Canada , the life insurance industry has been through significant consolidation over the last 10 years. While there may be acquisitions in the coming years, it’s certainly not going to be at the pace we’ve seen in the past. I believe the next area of significant consolidation is going to be in mergers between insurance companies and banks. As for the timing, this is largely contingent on a change in the political environment to accommodate the required regulatory changes. With a minority federal government, I don’t see this happening in the short-term, but I would certainly expect it to occur in the next five to 10 years.

MEYER: Merger and acquisition activity will continue as companies look for greater scale to gain a competitive advantage. The challenge going forward will be companies’ ability to differentiate themselves in an industry that appears headed toward commoditization. Branding will be key in the next few years.

MOHACSI: In Canada , much of the major M&A activity is complete. The top five companies in the market have more than 80 percent of industry assets. While there are a number of mid-sized companies, they will need to focus on defined markets or product areas and be a major player in their chosen segment to be successful in the longer term. Otherwise, some of the mid-sized players will be purchased by the larger players.

RATTMANN: Yes, I believe industry restructuring will continue. I expect the number of companies to decline 30 to 50 percent over the next decade. Alliances will continue to grow. Both trends will be driven by the ongoing cost pressures of the industry, thin margins, and a declining agency force.

WARING: Few of the top 30 companies in our industry are obvious acquisition targets. Most activity could be by larger groups acquiring many small companies. To acquire economics of scale, many
medium- and smaller-sized companies will enter into alliances or merge to obtain critical mass. What’s less predictable is whether we will see mergers of the mega-companies. The latter is what has happened in the Canadian life insurance industry and the U.S. banking industry. Specialization will drive sales and acquisitions of specific blocks of business.

WELLS: Mergers and acquisitions will most likely continue in the years ahead. Sales of closed blocks of business will also continue as companies focus on their core product lines and markets. While it is likely that there will be fewer carriers in the years ahead, companies will continue to need to attract and retain talent. Our industry has a more difficult time than other financial services companies in this area, and this situation will continue to deteriorate as Baby Boomers retire. Companies will need to create unique ways for retirees to continue to contribute, as well as develop strategies to attract top new talent into the industry. For example, allowing employees to telecommute is growing in popularity, and some companies are seeing a noticeable increase in productivity as a result.

ZLATKUS: There will continue to be mergers, consolidations, and sales of blocks of business in our industry as the pursuit of growth in a mature industry such as ours requires scale and capital to satisfy regulatory and rating agency requirements, maintain and enhance internal risk management programs, invest in distribution, technology and service, and pursue global markets.

4) TECHNOLOGY
What new technologies have the greatest potential to help our industry, and how can they help?

ART: Web enablement of our producers and customers continues to offer significant opportunities to improve service levels at reduced costs. Wireless technology will expand access to producers and customers. Identity management will continue to present challenges.

BREMER: The explosion of educational material and planning tools available on the Internet has raised consumer awareness of various products, risks and costs. This proliferation of information provides yet another reason for companies to invest in the training of their financial representatives while providing them with the best tools available.

Looking forward, the convergence of account access, financial market data, and customer communication is happening here and now. Some of these technologies will impact and possibly enhance the sales process. As firms continue to develop straight-though processing, the efficiencies gained should empower representatives to grow their businesses.

Though perhaps not new, the mobile professional office is becoming a reality for many in the industry. Finding ways to support this new business model will certainly lead to additional technological investments.

BRIGGS: We see continued expansion of existing technologies, such as imaging and workflow, and we are developing voice signatures and electronic signatures as well as electronic policy delivery. We await breakthroughs in access to medical and other databases that will streamline the underwriting process but that will also result in reasonable mortality results.

BRITTON: The technologies that I believe have the greatest potential to help our industry are new front-end tools for underwriting and the application process, voice and e-signature, and drug database information.

HOLLAND : One of the significant trends in the industry has been a focus on information security and information controls related to security. The increasing frequency of reports of missing data due to lost or stolen laptops has made this issue prominent. The need to monitor data being copied from production data sources onto devices such as USB drives becomes more pressing, as these devices can store more and more information in a portable fashion. Today, an innocent-appearing digital camera or iPod can be a vehicle to copy and transport data from an office network. New systems that reside on company networks will need to track and monitor the movement of company data to ensure that it’s not being copied to an unauthorized location. These systems can restrict USB connections to only allow approved devices to connect to desktops and laptops. Some systems also incorporate human behavior analytical capabilities that seek unusual activities or behavior patterns on the corporate network that may indicate improper use or transport of data.

In contrast to limiting data for security reasons, companies need to make information readily available to clients, trading partners and employees. New business continuity challenges such as pandemics require that information be accessible remotely, but in a highly secure and controllable manner. Systems that provide disk drive encryption on laptops and workstations that can be centrally managed by IT staff are becoming increasingly popular. This technology encrypts local disk drives from a centrally controlled management system. Such technology enables companies to effectively deploy and enforce encryption without visiting every workstation.

KONEN: I think that in general, the new technologies that have the greatest potential to help our industry are what I call various business-to-business technologies—things that make it easier for our customers to do business with us. For a company like Lincoln , our customers are really financial intermediaries, whether they’re financial planners, people in a wirehouse or life insurance agents. And so the kinds of tools that can make it easier for those intermediaries to do business with us are the kinds of technologies that have the greatest potential to help us at Lincoln Financial, and I think the same thing is true of a lot of our competitors as well.

MacLEAY: Use of the Internet continues to evolve, and it still represents the single most significant technology breakthrough for the industry. Advanced communications technologies are especially important for the emerging younger affluent market, for penetrating the underserved middle market, and potentially for serving the in-retirement market.

McFARLANE: I believe what has the greatest potential to help our industry are continued expansion of current technologies to improve efficiencies and lower costs in customer and distribution Web services, wireless technology, electronic forms, and automated underwriting. At Wawanesa Life, we’re implementing Web capabilities for our group customers and brokers, as well as expanding wireless technology to enable staff to work from home in the event of a pandemic or some other major business disruption.

MEYER: The Web continues to impact business models. The insurance industry is playing catch-up to other industries. This gap will close in the next few years.

MOHACSI: Many areas come to mind. First, there are now more ways than ever to communicate with customers, advisors and employees. Obviously e-mail and Web sites are common. Message centers should become more common as companies address information security and privacy concerns. Companies are starting to experiment with such things as blogs and podcasts to get attention and target their message.

Second, there is still so much that technology can bring to improving critical business processes, particularly the new business process, which in many companies is still a paper-intensive, high-cost transaction. We should see automated underwriting scoring and electronic submission of business and delivery of policies in more companies. The industry and its business partners need to adopt the Accord standards more universally to communicate information efficiently through this and other processes.

RATTMANN: The Internet and wireless technology will continue to play a growing role in both the sale and servicing of policies. The continued growth of each will reduce the use of paper in both the sales and servicing activities. However, the requisite system investments will continue to strain companies financially and will further contribute to the consolidation trend.

WARING: The internet and wireless technology continue to hold great potential for our industry. Providing access to information and customer self-service through the Web gives our industry the opportunity to reach and respond to the customer in the time and manner most convenient for them. Further, the expanded use of electronic signatures and use of biometrics for customer authentication will simplify the sales and servicing processes and help to ensure customer privacy.

Underwriting technologies that eliminate the need for invasive procedures or streamline the process for obtaining pertinent information will speed up the underwriting process. Computer programming practices that employ the use of business models to capture business rules ensure consistent use across technical applications. This helps our industry by ensuring higher adherence to compliance and regulatory guidelines while simplifying the process for the end-user. Any solutions to relieve the burden of legacy systems will help the industry move forward.

WELLS: Technology-enabled solutions that provide the continued development of straight-through processing will add significant value. This is particularly true in the sales and new business areas. Processes like the electronic submission of applications and the ordering and follow-up of underwriting requirements will lead to more efficient processes and improved placement rates.

Replacement of expensive legacy systems continues to be a challenge for many companies, particularly those that have grown through acquisition. Finding cost-effective ways to convert these systems to new platforms, developing a surround system, or business process outsourcing are all options.

Technology that helps improve auto adjudication of health claims will continue to be popular. Also for health carriers, systems that support the use of claims data to help support financial modeling will be needed.

Finally, workflow systems and enhanced optical character recognition (OCR) technology will continue to help companies operate more efficiently in the back office. These tools also provide companies flexibility in moving work to and from multiple locations.

ZLATKUS: Several technology trends are helping the industry to lower costs and improve efficiency. These include Web-based customer service, streamlined electronic data interchange with distribution partners, wireless technologies for field support, electronic forms and signatures, imaging technology, automated workflow management, enhanced data mining (audio and video), and tool enhancements for security and compliance management. Grid computing and other technologies are becoming increasingly important for the hedging and risk management programs which support the product guarantees underlying many of the products being offered in the marketplace.

5) PROFITABILITY
How can our industry increase its profitability?

ART: The industry can improve its profitability by increasing the productivity of both field and home office associates. Also, it needs to find ways to increase top-line revenues at a rate greater than the increase in expenses.

BREMER: Simply put, the industry should focus on long-term profitability. There really is no substitute for rational product pricing and prudent risk management. Our organization expects to achieve long-term profitability by focusing on three priorities: growing our insurance revenue, strengthening our distribution system, and focusing on operating efficiencies. Overall, our goal remains the same: to create sustainable, organic, bottom-line growth.

BRIGGS: Expense management will be the primary tool in the coming year with some creative capital management opportunities (reserve securitizations, for example) for companies of enough size to execute, which will improve returns on capital.

BRITTON: We need to increase our productivity, but more importantly, we have to find a way to get real growth back into the industry. We need to find new ways to serve the underserved market that allows companies to build more scale in business, and we need better reserving methods that do not require big redundant reserves.

HOLLAND : Profitability can be increased by reducing structural costs that are specific to the insurance arena, such as the 50 sets of state regulatory laws. Critical rationalizing of risk capital is also of paramount importance to improving profitability. The struggle has begun with the introduction of the concept of principle-based reserving (PBR). If we cannot reduce the capital required by statutory reserving and risk-based capital (RBC) rules, redundant reserves will continue to drive down the returns of our products.

The industry has made the transition from mortality risk life products to asset accumulation products. This hasn’t been without pain, but it has been more or less successful and in line with demographic developments. Now the industry, along with other asset accumulators, must transition to longevity/income risk products. The transition is already under way. Unlike other asset accumulators, our industry has the knowledge and expertise to address longevity risk in tandem with investment risk. This is the next huge opportunity to reap the profits of managing risk for our customers.

For life insurance, all the demographics suggest that consumers age 65 and over make up a robust market, especially those who have money to spend. The key will be developing proper risk selection procedures, tests and protocols, along with the necessary risk management. The demand for LTC coverage has to increase as the Baby Boomer generation ages; there needs to be emphasis on product design and risk management techniques to make this a profitable product.

There are profits and sales to be had in the middle market in the U.S. It continues to be neglected by the vast majority of carriers. As time goes on, I expect this part of the market to become oriented more toward ethnic groups, particularly groups of recent immigrants. Finding economical ways to serve that segment of the market will be profitable.

KONEN: Our industry can increase its profitability through understanding and managing prudently these risks we take. When I think about what we in the insurance industry have to offer that no one else does, I think about the “franchise rights” of being able to offer this security and these various types of guarantees. A robust understanding of exactly what benefits we are offering, and making sure those are appropriately priced and managed is the key to our industry’s profitability. This is an aspect that this industry can and must improve upon.

MacLEAY The key to increased profitability in any business is to offer soundly priced products that represent attractive value to consumers while continuously improving productivity and customer service. In the life insurance business, where products can be on the books for decades, it is very important to improve unit costs not just on new products, but on in-force business as well. Hence, continuous improvement in operations, adding scale to spread costs over a bigger base, and the effective leveraging of technology are all critical factors in improving profitability.

McFARLANE: Within the Canadian industry, one of the keys to improving profitability is cost containment and, where possible, expense reductions. Certainly the large Canadian companies have gained a significant cost advantage from their acquisitions and resulting scale economies when it comes to expenses.

For a small company like ours, increased profitability will come from growth, both organically and through acquisitions, as well as prudent expense management. Where we can, we will utilize technology not only to improve customer service, but also to improve cost efficiencies. In 2006, we installed a new administration system for our group division, which we expect will be a significant contributor to our growth and future profitability.

MEYER: The companies in our industry must maintain discipline in pricing.

MOHACSI: Two ways to increase profitability are to reduce expenses by making our business processes more efficient, and finding market niches that are underserved and where some reasonable margins can be priced. As stated above, the new business process is one that can be made much more efficient. As for underserved markets, the industry has acknowledged for many years that the middle market is underserved. Innovative low-cost, high-volume distribution channels need to be developed to get to this market more effectively.

RATTMANN: Our industry can increase its profitability through consolidation, a tight focus on the market or markets a company serves, and a relentless focus on reducing overall expenses.

WARING: We need to increase revenue while decreasing expenses. Ways that the industry is trying to increase revenue include increased penetration of the under- served markets and increasing sales to existing clients. Expenses can be lowered by aggressive expense control, outsourcing and managing risk. Alliances can provide access to products that are not able to be manufactured on a cost-efficient basis.

Disciplined pricing for an acceptable return on equity is crucial to increasing profitability. Effective risk management programs should be in place to ensure pricing expectations are realized.

WELLS: Continuing to manage margins through careful risk selection, managing expenses, and controlling claims costs will require more diligence than ever in order to compete effectively.

A key driver of improved profitability will be product innovation and speed of delivery to the distribution channel. Companies that are able to deliver these products to the market rapidly through streamlined product development and improved technology will be in the best position to capitalize on increased sales and profits.

One method by which many companies can improve profits is focusing on their own policyholders. Strategies that consider building relationships with existing customers through improved service and better communications will provide opportunities to cross-sell other products into the household. An effective conservation program should also be part of this strategy.

A relentless focus on expense reduction will also help. The industry should continue to consider outsourcing functions or tasks that are not considered core competencies, that are transactional in nature, and that are conducive to reducing expenses. These include data entry activities, certain high-volume back-office transactions, and mailroom activities.

ZLATKUS: To increase profitability, our industry should focus on developing rational product features that serve the current and future needs of our customers. When combined with strong underwriting, pricing to an appropriate return on capital, and excellent risk management, our industry will not only provide great value to our customers, but will also grow profitably.

In addition, effectiveness and efficiency in distribution and service, as well as careful staging of technology investments, are critical to sustaining a competitive advantage.

Opportunities in the Boomer Retirement Market
In the questionnaire that was sent out to LOMA’s board members for this article, one question asked participants to reflect on the fact that many Baby Boomers are rapidly approaching retirement age, and to share their thoughts on the opportunities this offers. The responses to this follow.

Q: As the huge Baby Boomer generation approaches retirement, what opportunities do they present to the industry?

ARTH: The Baby Boomer generation presents a tremendous opportunity for the life insurance industry to provide for secure retirements to that generation. The life insurance industry is uniquely positioned to provide “guaranteed” levels of retirement income to Baby Boomers through the development and marketing of products that feature distribution guarantees.

BREMER: Research has indicated that Boomers have concerns about the many risks they face in retirement—including health care expenses, long-term care, longevity, inflation and investments—and are interested in advice on how they can manage these risks. Risk management is a core competency of our industry. As such, we are well-positioned to help clients manage the many retirement risks they face through both existing products, such as annuities and long-term care, and new and innovative products, such as longevity insurance and combination products. Risk management education and advice is also a core competency of the industry’s distribution partners.

BRIGGS: We obviously can offer products that cannot be outlived, and our industry’s life and annuity products continue to exhibit creative income streaming benefits. We are working on consumer-friendly income benefits in the life and annuity lines and are developing packaged sales concepts focused on asset transfer and legacy planning.

BRITTON: Only our industry can provide guaranteed life incomes, and the SPIA (single-premium immediate annuity) market should grow. I am in the life segment of ING, and we are using life insurance as a tool to protect, accumulate and distribute wealth.

HOLLAND : Previous generations have been able to put a large reliance on company defined-benefit pension plans on top of a layer of Social Security pension. However, many of those in the Baby Boomer generation either do not have corporate pensions or have pensions that are not as rich as in the past. Thus, there is an increasing need to fill this void. For years, the financial industry has been predicting a large increase in immediate annuity sales. Although there has been significant focus regarding the advantages and challenges associated with financial guarantees on this business, there is also the challenge of the uncertainty regarding managing the longevity risk. In addition to annuities, products such as critical illness and long-term care can be of help to meet the needs of the Boomers. At MARC, we expect to draw upon our expertise as a global reinsurer to build best practices to turn risk into value.

KONEN: I think this is the greatest opportunity for the insurance industry, both in terms of life insurance and annuities products, that we’ve had in probably 30 years. First and foremost, Boomers are looking for security, and we are the only industry that has what I call the “franchise rights” to protect that security. A bank can’t protect someone financially from either dying too soon or living too long; neither can the securities industry. Only the insurance industry has the ability to do that. So we need to capitalize on that unique capability to help Boomers as they prepare for and move into retirement—not just the aspect of providing retirement income, but rather guaranteeing the security around that.

MacLEAY: The Baby Boomer generation has always presented huge opportunities for our business, and that opportunity is growing dramatically as the Boomers approach retirement. People in this generation are currently in their peak earning years, which makes them excellent prospects for our traditional suite of products and services. And the life insurance industry is in a very strong position to meet their evolving needs as they approach and then enter their retirement years. Not only are we the only industry that can offer guaranteed products as a foundation for a sound in-retirement financial strategy, but we also have the network of professional financial advisors needed to help people devise and execute a sound financial approach to their retirement years. This capability, plus the ability to provide effective estate planning products and services, puts the life insurance industry in a very favorable position to serve Baby Boomers’ needs.

The National Life Group is targeting Boomers as a critical part of its overall strategy of providing a diversified set of high-value products and service solutions appropriate for varying economic conditions and customer preferences. But we don’t believe that the nearly 80 million Americans born between 1946 and 1964 represent a monolithic and homogenous group. They vary significantly in age and across ethnic and economic lines, and their needs for the products we offer vary significantly as well. The diversity of Boomers represents the diversity of our entire society. However, we believe our companies are well-positioned to meet many of the financial and protection needs of many individuals in this extended generation, particularly as they move toward retirement.

McFARLANE: I see a couple of opportunities with the aging Baby Boomers. One is in the wealth management business, both in the demand for accumulation investment products as well as increasing interest in income payout vehicles as Boomers move from the wealth accumulation highway onto the exit ramp. One insurance company in Canada recently introduced the first guaranteed minimum withdrawal benefit in a segregated fund structure. I expect to see other companies follow their lead with these types of plans.

Another area where I see increasing opportunity for the retiree market is with Individual Supplementary Health plans. In the past, retirees could expect to get continued health insurance coverage through their company’s benefit plans. This is not as true today, however, as many companies have reduced or eliminated this type of coverage for retirees in an effort to control costs. Individuals leaving the workforce will need to purchase replacement coverage as an alternative to self-insurance. The individual health insurance market is a business our company is very interested in pursuing.

I also think that within 10 years, you will see a market developing in Canada for long-term care coverage. Although consumer demand for this type of insurance has yet to materialize, I feel that the Baby Boomers’ experience with aging parents in finding and funding appropriate care is going to accelerate demand for a product to insure their own future needs.

MEYER: We are seeing some of the impact as the Boomers enter their “safe driving” years. Both frequency and severity are trending downward for this group. We are targeting this group through greater cross-selling activity and product offerings.

MOHACSI: Boomers have tremendous financial resources and present many opportunities for our industry. The most obvious is their need for retirement savings and estate planning. However, as they age, Boomers will begin to recognize the need for LTC insurance, a product which should show some growth over the coming years. Boomers are also refinancing their homes to access the built-up equity. This could lead to mortgage insurance needs. Finally, many Boomers are underinsured, and basic final expense needs will become more apparent.

RATTMANN: Clearly there will be an ongoing focus on providing retirement income and wealth accumulation products to Boomers. Additionally, there will be a growing focus on estate planning. Our own company is targeting Boomers with our products in the final expense and pre-need areas. The use of these products will continue to grow as the realization of the Boomers’ own mortality risk sinks in, and as they continue to face the challenges of dealing with elderly parents.

WARING: The Baby Boomer generation presents many opportunities. The primary opportunity encompasses retirement planning—the continued accumulation of wealth and the eventual disbursement phase. The Boomer’s redefinition of retirement will provide opportunities for additional life insurance sales to cover income as many venture into second careers and/or purchase second homes. We have a retirement market segment defined and have established a retirement marketing strategy team to focus on the needs of this market.

WELLS: The aging of our population, rising medical costs, and the financial challenges with Medicare will require changes to be made in the Medicare system as it exists today in order to avoid further stress on this program. These changes are moving those in favor of managed care to programs like Medicare Advantage and Private Fee for Service programs. These changes will provide carriers, especially those selling Medicare supplement products, a natural opportunity to participate in these reforms over time. There also seems to be a greater demand by an aging population for fixed-income products. For the next 20 years, a record number of Americans will be 65 and over. As life expectancy continues to rise, fewer people will have sufficient investments to protect themselves against longevity risk. A possible solution for homeowners that is emerging involves a reverse mortgage product that allows seniors to access the equity of their home for a guaranteed monthly income. Finally, although individual long-term care insurance has seen moderate success, the aging of our population and legislative changes relating to the product will create a unique opportunity for carriers that can effectively manage profitability through careful risk selection and claims control.

ZLATKUS: With 77 million Boomers in the U.S. ready to step into retirement, many of whom do not have a holistic plan for living their senior years, the Baby Boom generation represents a $9 trillion opportunity for our industry—by far the largest business opportunity of the next two decades. In Japan , one-fourth of the population is age 60 and older, and that percentage is only expected to grow moving forward. In addition, 51 percent of the assets held in Japan —approximately $6 trillion—are in cash and deposits, which represents a significant opportunity to our industry.

Further fueling the opportunity, a recent Hartford-sponsored survey showed that people around the globe are anxious about their retirement. 58 percent of those polled in Japan , 28 percent in the U.K. and 31 percent in the U.S. were concerned they would not have enough money to get them through their retirement. Additionally, our survey showed that people no longer believe their governments will be able to sufficiently provide for their retirements. A staggering 89 percent of those polled in Japan and 77 percent of those polled in the U.K. were not at all confident that government-sponsored pension plans would provide them enough income to maintain their current standard of living. In the U.S. , half of all respondents felt similarly.

To target the Boomers in the U.S. , we are reaching out to them in a number of ways. We have appointed a team of retirement experts who provide coaching on financial planning concepts to The Hartford’s client advisors and their customers. The Hartford has always been a product innovator, and this group of retirement solution consultants will showcase our innovative new retirement solutions—such as lifetime income products and benefits like facility care benefits riders—to the market.

Internationally, we have brought our products and experience to markets in Japan , the U.K. and Brazil . As we continue to grow our presence in these markets, we will begin to offer more products to our international customers, as well as look to expand our operations geographically.