Strategic Asset Alliance » Insurer Investment Strategies

January/February, 2008

Issue: 2008.1

Insurer Investment Strategies

There are numerous issues surrounding what many call the current “credit crunch” and what we like to call the “deleveraging” of the economy. While acknowledging the pervasiveness of this topic, we will focus on what you should be inquiring of your investment managers today as it relates to sub prime and related mortgages. In future issues, we expect to discuss how credit risk is taking hold as one of the key issues for insurer portfolios in 2008. We hope this elevates the quality of communication concerning this important, multi-faceted issue.

As always, please feel free to contact us with your comments and questions at saa@saai.com. Thank you.

(c)Copyright, 2008. Insurance Investment Strategies is published by Strategic Asset Alliance, the insurance investment specialist ™. Always contact a professional before acting on any recommendations or opinions noted within this newsletter.

Your Portfolio in a “Credit Crunch”

With a 60%+ chance of a recession, credit risk has and will continue to rear its ugly head throughout insurer investment portfolios.

The first, headline, risk has been sub prime mortgages. Thankfully, most insurers hold a very small, if any, percentage of their portfolio in these bonds. However, with a recession would come impacts throughout the portfolio: other ABS (asset backed securities) secured by credit cards, auto loans, etc; corporate credits; and even insured municipal bonds might be subject to downgrades.

Since many insurers are grappling with how best to describe, explain and monitor their exposure to sub prime mortgages, we will focus on this sector here. However, over the coming months, we expect to discuss other, more pervasive credit risk related issues.

Sub prime mortgage holdings are typically found in one of two guises: either as an investment in a tranche of a pool of sub prime (or Alt-A) mortgages, or as part of a CDO (Collateralized Debt Obligation) secured by a series of tranches of pools of sub prime mortgages.

In other words, you can either have direct exposure (tranche) or indirect exposure (CDO consisting of tranches). In fact, CDO’s are, in turn, set up into different tranches. In other words, CDOs are typically tranches of tranches of sub prime mortgages.

Because of this complexity (and their relative rarity on most insurer balance sheets) we will focus on the typical tranches in a pool of sub prime mortgages. However, in analyzing CDO’s, you should begin in much the same way as noted here. Understand the nature of the imbedded risks in the pool of sub prime mortgages.

Thus far, we would highly recommend that you request the following from your manager for all applicable sub-prime and Alt-A mortgage pools:

Adjustable v Fixed - As we have been saying for over a year now, the issue is not that sub prime mortgages are somehow ‘bad’, but that the repricing of all mortgages from a very low interest rate environment to the current environment places pressure on all borrowers to make timely payment. Thus, adjustable sub prime debt is significantly more troublesome than fixed debt.

Vintage - If the mortgage has already successfully gone through one or more adjustments, it is less likely to be a problem. However, it is the more recent vintage mortgages (2006-2007) that were not only originated in a low rate environment but in an environment of generally lax underwriting. Even fixed rate mortgages of this vintage should be carefully scrutinized.

Credit Enhancement - Most subprime pools use the directing of cash flow priority to different tranches (and/or bond insurance) to enhance credit ratings above that which would be given to a non-tranched pool of sub prime mortgages. The basic idea is that to the extent there are tranches subordinate in cash flow payment to your tranche, your position is credit enchanced. That is true, but it can be impaired to some degree if the underlying value of the real estate is less than the total of mortgages on that real estate. Should real estate values fall, as they are doing in various parts of the country, there exists the possibiilty that loan to value ratios, including your pool as well as other mortgages on the same properties, may not be as ‘conservative’ as first considered.

Thus, in order to get a good idea of the level of current credit enhancement, you should inquire as to what both current real estate values as well as ‘worst case’ values would do to loan to value ratios. The loan to value ratios should be calculated using the entire pool as well as the

effective exposure relative to your tranche in the pool. We would also recommend the loan to value ratio be calculated using all existing debt on the properties, as this will provide an idea of the economic incentives for existing homeowners to remain in their homes and maintain their payments.

FICO scores - At origination, FICO scores (credit scores of the borrowers) are made available. Unfortunately, after origination, this information is typically not provided. Thus, if you are unable to obtain updated FICO scores, other risk statistics must be used.

Cumulative Net losses - All sub prime mortgage pools have a certain amount of expected cumulative net losses built into their pricing. Knowing the cumulative net losses and how they compare to what was expected at this point in the life of the pool can provide a reference point for risk. Also, you should know what the cumulative loss ratio would need to reach before principal impairment for your tranche is assured.

60days+ delinquency - This includes mortgages in foreclosure and, once again, should be compared to what was built into the pool at its outset. In addition, a comparison to historical periods’ delinquency rates can also provide guidance on current risk profile.

Rating agency credit rating - Obviously, the agencies were a contributor to the sub prime mortgage problems of recent years. However, they have seen the light and are trying to be proactive on their subprime ratings. Most importantly, knowing the current rating’s date will let you know how timely their assessment is and, how much credence you can place in the rating.

Bond insurer - Some sub prime pools use bond insurance to obtain high ratings. With significant pressure being placed on bond insurers recently, it is important to understand the current credit risk assessment of the bond insurer. Some bond insurers will undoubtedly survive unscathed, but others will not.

Current pricing and source of pricing - Although this will not directly impact risk profile, understanding how current pricing was established will allow you to determine if the tranche is a Level 2 or 3 pricing under FAS 157. If Level 3, you can expect some pushback from auditors on the appropriateness of pricing, while even some Level 2 tranches may be similarly treated. This will ultimately relate to discussions about the appropriateness of Other Than Temporary Impairment.

These are just a few of the key questions you should consider having answered by your investment manager. Undoubtedly, the dialogue will continue throughout 2008.

Your comments and questions are much appreciated.

Thank you.

In This Issue

Your Portfolio in a “Credit Crunch”

Hot Topics “From the Northwest Quadrant”

Insurer Investment Forum VII: “The Times They Are A Changing”

Hot Topics “From the Northwest Quadrant”

Here’s a sampling of the latest From the Northwest Quadrant, our blog focused on current issues impacting insurers’ investment portfolios.

Paulson and Sisyphus: Strange Bedfellows

Hedging Death: Goldman Sachs at Your Service

Transparency: The Lubricant for Loosening the Grip of Fear

Insurer Investment Forum VIII:The Times They Are A Changin”

Although never written for this purpose, Bob Dylan’s “The Times They Are A-Changin” could apply to the landscape facing insurer investment professionals today.

Increasing financial market turbulence has produced a swing from greed to fear in the markets, while regulators react, rating agencies back pedal, and scared auditors change measurement standards.

At Insurer Investment Forum VIII, you can discuss this and other issues with your peers. Limited to 50 investment professionals at insurers, this unique event will be held at the Diplomat Country Club & Spa, Hallandale, FL, March 12-13, 2007.

Attendance is by invitation only. If you have not received your invitation, please contact Sharon Atkins.

Strategic Asset Alliance, 11 Bellwether Way, Suite 209, Bellingham, WA 98225

Phone: 360.255.2500 Fax: 360.734.2049