Getting a Grip on Key Investment Issues

Alton R Cogert, CFA, CPA, CAIAPresident and Chief Executive Officer

Excerpted from presentation toThe Conference for Risk Retention PoolsOrganized by Aon Global Risk Consulting

La Jolla, CAAugust 4, 2009

Getting a Grip on Key Investment Issues

Today’s Investment Environment

Your Pool’s Investment Process

What to Watch For in the Near Future

2

Not Very Long Ago…

Prior to 2008 Interest rates fell – lower yields for risk free securities Spreads narrowed – less compensation for credit risk &

prepayment risks Housing prices had been rising

Investors Reached for yield, took more risk, with less compensation Found “attractive” yield in sub-prime mortgages

Investment Banks Created new structure to create more yield with leverage and less

transparency Packaged sub-prime mortgages & utilized those securities within

their structured vehicles to provide more yield Rating agencies

Accommodated by giving higher ratings in structures where the risks were not fully understood

3

How did this turn into a crisis?

In 2008, when interest rates started to rise Sub-prime mortgages increased default Structured products unraveled Leveraged financial institutions brought close to collapse Lehman bankruptcy seized credit markets – trading halted Credit problems extended into a global markets crisis Developed into deepest recession since the Great Depression

“Spread-products” (corporate bonds, mortgage-backed bonds, and structured products) underperformed risk-free (Treasury) bonds as spreads widened through March of 2009 2nd quarter 2009 spreads narrowed & corporate bonds recovered

Yet, defaults and bankruptcies increased Defaults increased in sub-prime mortgages Some structured products (backed by sub-prime & defaulted

bonds) have not recovered

4

And Today…

Spreads still historically above averages, but what average should be used?

US Government spending like drunken sailors…but is it enough?

Unusually steep ‘risk free’ US Treasury yield curve…but how risk free is it?

Concerns about inflation….and deflation. Equities – too high or the deal of the decade?

Rating agencies…on the prowl, trying to justify their improper business model. Few have 100% trust in rating agencies, but no investment policy excludes ratings from their list of limits.

Regulators…accommodative (fair value, ‘permitted practices’) but still concerned about some insurers.

Accountants…the politicization FASB potentially means anything can be ‘up for grabs’.

5

History of 5-year Treasury Note Yields – Yield changes over time

6

History of Yield Curves – Yields on 2 and 10-year US Treasuries – changing shape of the curve

7

Deutsche Bank Indices of yield spreads for BBB (blue) A (yellow), and AA (red) rated bonds

8

Your Pool’s Investment Process

9

Consistent Investment Results REQUIRE aConsistent Investment Process

10

What to Watch For in the Near Future

Greater Emphasis on Risk Management, because Uncertainty Will Grow not Subside Over Time

Look for hidden risk. It’s there, but not being discussed to any great degree.

Consider the ‘next shoes to drop’

Linked Effects of Investments – ‘Hidden’ Correlations

Continued Politicization of Accounting

Continued/Increased Board Interest in the Investment Process

Expect to Hear More of ‘We’ve Never Seen This Before in Our Lifetimes’….Is Your Pool Prepared?