INVESTMENT MANAGEMENT: ECONOMIC OUTLOOK

Alton Cogert, CFA, CPA, CAIA, CGMA

President and CEO

Strategic Asset Alliance

November 8th, 2012

www.saai.com

www.insurercio.com

WHERE ARE WE NOW? SUMMARY MARKET COMMENTARY FOR Q3-2012

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SAA Commentary – 3rd Quarter 2012

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MARKETS

Central bankers took center stage in the U.S. and Europe as both announced additional quantitative easing

measures to support the global economic recovery amid lower economic growth forecasts.

Given the additional monetary stimulus measures by both the ECB and Fed, riskier assets outperformed core

fixed income as investors sought out higher yielding alternatives in a low rate environment that looks to remain

stable in the intermediate term.

U.S. unemployment remains a significant issue as current job growth still fails to attain a level that will fully

replace the 4.3 million net jobs lost during the Great Recession. While this glut in the labor market keeps wage

growth/inflation under wraps, it also places a strain upon consumer spending growth.

LOOKING AHEAD

For U.S. core fixed income investors, financial repression will continue on the heels of QE3 and the flight to

quality away from Europe. The raw earnings power of core fixed income portfolios will continue to deteriorate

into 2013 and 2014 as reinvestment rates remain extremely low.

If organizations can come to terms with the increased risk and potential financial statement volatility,

making a case to explore and invest in higher yielding asset classes will be compelling.

The overhang of the Eurozone debt crisis will continue to intensify as recession continues.

Crisis resolution will be arduous as various cultural and structural issues must be deftly handled to truly

achieve any “grand bargain” for the Eurozone.

In some ways, it makes little difference who wins the oval office in November as the structural issues of

America’s deficit must be dealt with in some fashion. Regarding the most austere version of the fiscal cliff

($600B or potential 4% hit to GDP), the general consensus is that some deal will be hastily made before year

end to defer the first wave of reckoning until Q1-2013.

• UST yields fell slightly across shorter maturities (where the bulk of UST issuance is occurring), but overall UST yields remained largely unchanged from 6/30/2012.

• While longer-term inflationary pressures build, UST yields remain low reflecting both the global flight to quality away from Europe and continuing Fed stimulus actions.

U.S. TREASURIES AT 9/30/2012 LARGELY UNCHANGED FROM Q2-2012

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Source: Bloomberg

FIXED INCOME MARKET YIELDS DURING Q3-2012

4 Source: Bloomberg

• Using the fixed income market yields as of 6/30/2012 (Base = 100), the graphic above illustrates the relative change in interest rates for Q3-2012.

• Treasury yields were the most volatile but remained very low in absolute terms. Yields across spread sectors tightened as investors sought out higher yielding assets.

Yield-To-Worst (YTW) at 9/30/2012 • Barclay’s Aggregate (White): 1.61% YTW • Barclay’s Treasury (Red): 0.82% YTW • Barclay’s U.S. Credit (Blue): 2.64% YTW • Barclay’s High Yield (Green): 6.51% YTW

Fixed Income Sector Returns / Duration: QTD Through September 30, 2012

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• All broad, spread sectors

strongly outperformed

Treasuries during Q3-2012

INVESTORS REGROUP AND RETURN TO RISK ASSETS DURING Q3-2012

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• S&P 500 (White): +6.35% • EAFE (Red): +6.34% • EM (Violet): +7.42% • All World (Green): +6.42%

• Using the equity index values as of 6/30/2012 (Base = 100), the graphic above illustrates the relative performance across the world equity markets for Q3-2012.

• Two key themes spurred the rapid return of risk taking across the world equity markets during Q3-2012:

• The ECB announced an unlimited government bond-buying program boosted confidence; however, structural impediments continue to cast dark shadows over any

real and/or perceived progress in resolving the Eurozone debt crises.

• The Fed announced a third round of quantitative easing with additional MBS purchases and extended Operation Twist through 2012.

Source: Bloomberg

CAPITAL MARKETS’ PERFORMANCE DETAIL

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Fixed Income Performance – Trailing Returns

8 Source: Zephyr StyleAdvisor

• For Q3-2012, yields fell across non-

Treasury sectors as spreads

tightened on the heels of continued

Central Bank stimuli in both the

U.S. and Europe.

US Treasuries # of Issues Mkt. Value (bn$) Chg Qtr 9/30/2012 6/30/2012 3/31/2012 12/31/2011 9/30/2011 Q3-2012

2-Year -0.1% 0.2% 0.3% 0.3% 0.3% 0.3% 0.2%

5-Year -0.1% 0.6% 0.7% 1.1% 0.8% 1.0% 0.8%

10-Year 0.0% 1.6% 1.7% 2.2% 1.9% 1.9% 0.9%

30-Year 0.1% 2.8% 2.8% 3.4% 2.9% 2.9% -0.3%

Sector # of Issues Mkt. Value (bn$) Chg Qtr 9/30/2012 6/30/2012 3/31/2012 12/31/2011 9/30/2011 Q3-2012

Broad Market 7,999 $16,815 -0.4% 1.6% 2.0% 2.2% 2.2% 2.4% 1.6%

MBS 838 5,052 -0.7% 1.8% 2.4% 2.7% 2.7% 2.8% 1.1%

CMBS 964 316 -0.9% 2.0% 2.9% 2.9% 3.7% 4.2% 3.8%

ABS 180 53 -0.3% 0.9% 1.2% 1.3% 1.6% 1.4% 1.2%

Corporates 4,313 3,551 -0.5% 2.8% 3.3% 3.4% 3.7% 3.8% 3.8%

Municipals 46,210 1,339 -0.3% 2.2% 2.5% 2.6% 2.8% 3.0% 2.3%

Emerging Debt 545 798 -0.8% 4.6% 5.4% 5.4% 6.1% 6.6% 6.8%

High Yield 1,961 1,082 -0.8% 6.5% 7.4% 7.2% 8.4% 9.5% 4.5%

Convertibles 520 210

Source: Barclays Capital

N/A

Total Return

Total Return

222 6,068

Yield-to-Worst

Yield-to-Worst

Fixed Income Market Yields: As of September 30th, 2012

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While longer-term inflationary pressures build, UST yields remain low reflecting both the global flight to quality away from Europe and continuing

Fed stimulus actions. Yields across the spread sectors tightened, spurred by investors seeking higher yielding assets.

Spread products’ excess returns performance was mixed for Q3-2012:

Aggregate Bond: +107 bps excess return

Corporates: +324 bps excess return

ABS: +77 bps excess return

MBS: +71 bps excess return

CMBS: +332 bps excess return

High Yield: +394 bps excess return

Equity Market Performance – Trailing Returns

10 Source: Zephyr StyleAdvisor

• Investors’ appetite for risk returned during Q3-2012 driven primarily by:

1. The ECB’s announcement of an unlimited government bond-buying program

boosted confidence; however, structural impediments continue to cast dark

shadows over any real and/or perceived progress in resolving the Eurozone

debt crises.

2. The Fed announcement of a third round of quantitative easing (i.e. QE3) with

additional MBS purchases and the extension of Operation Twist through

2012.

WHERE ARE WE GOING? KEY ISSUES - LOOKING AHEAD

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U.S. Financial Repression Will Continue

Source: Federal Reserve, J.P. Morgan Asset Management

• Financial repression allows governments to issue debt at lower interest rates than would otherwise be possible. A low nominal interest rate can help

governments reduce debt servicing costs, while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.

Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of

taxation.

• For U.S. core fixed income investors, financial repression will continue on the heels of QE3 and the flight to quality away from Europe. The raw earnings

power of core fixed income portfolios will continue to deteriorate into 2013 and 2014 as reinvestment rates remain extremely low.

• With current inflation assumptions (2.0-2.5%) at 9/30/2012, , the real yield of the Barclay’s Aggregate Index is between -0.39% and -0.89%)

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When Might Financial Repression End...FOMC Interest Rate Projections?

Source: Federal Reserve, J.P. Morgan Asset Management

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• What time period encompasses long-term and how might an

inflationary spike change Fed direction after stating a low rate

policy into 2015?

• If creditor nations stopped buying Treasuries at current yields,

what yield level would “clear the market”?

• What impact would this new yield level (read: increased

funds for debt service) have on Federal fiscal policy and

initiatives?

Unemployment

14 Source: BLS, Fact Set, J.P. Morgan Asset Management

• Unemployment remains a significant issue as current job growth still fails to attain a level that will fully replace the 4.3 million net jobs lost during the Great

Recession.

• While this glut in the labor market keeps wage growth/inflation under wraps, it also places a strain upon consumer spending growth.

European Crisis

Source: Fact Set, ECB , J.P. Morgan Asset Management

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• A monetary union effected in a neutral/good

economic environment.

• With no fiscal union or collective policies to address structural

imbalances post-Great Recession, the monetary union is effectively

undone via the government bond markets.

• Austerity without growth will not solve the Eurozone crisis.

• Crisis resolution will be arduous as various cultural and structural

issues must be deftly handled to truly achieve any “grand bargain” for

the Eurozone.

• Greece is bankrupt. The real issue is whether to let them fail in an

organized or unorganized manner.

U.S. Government Finances & The Fiscal Cliff

16 Source: U.S. Treasury, BEA, CBO, and J.P. Morgan Asset Management

• In some ways, it makes little difference who wins the oval office in November as the structural issues of America’s deficit must be dealt with in some

fashion. Regarding the most austere version of the fiscal cliff. the general consensus is that some deal will be hastily made before year end to defer the

first wave of reckoning until Q1-2013.

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Key Questions to Ask Now:

- What is our projected book yield (investment income) assuming interest rates do indeed stay low for longer?

- Can we consider changing our risk/reward profile?

- Duration

- Credit

- Liquidity

- ‘Risky Bucket’ Size and Diversification

- Should the change be strategic (preferred) or tactical (difficult to execute)?

- Do we have the right investment manager to execute the strategy?

- Do we have the right benchmark(s)?

- Most importantly: How do our current and proposed investment strategies dovetail with the Board’s/senior

management’s risk appetite? (Quantitatively and qualitatively)