CIA Annual Meeting Assemblée annuelle de l’ICA

CIA Annual MeetingAssemblée annuelle de l’ICA

June 29 & 30, 2006 Ÿ Les 29 et 30 juin 2006Ottawa, Ontario

Session Val-5 CLIFR Part II

Term of the Liability

CIA Annual Meeting Ÿ Assemblée annuelle de l’ICA



• Standards 2320.16 through .27

• Highlights:

– 2320.16 => if element of policy operates independently of the policy, it has its own term

– 2320.18 defines “renewal”, “adjustment” and “constraint”

– 2320.19 => may take account of one or more renewals / adjustments after B/S date

– 2320.20 => extend term with caution


SOP Summary


• Highlights:

– 2320.22 => term ends at the earlier of:• First renewal or adjustment date at or after B/S date at which

there is no constraint

• Renewal / adjustment date after the B/S date which maximizes policy liabilities

– 2320.23 => term extension to offset acquisition or similar expenses

– 2320.24 => write-down of AAE and recoverability testing


SOP Summary (cont’d)


• The phrase “maximizes policy liabilities” suggests the term reduces to zero if liabilities would otherwise be negative.

– Assuming product is continually renewable and no AAE

• Corollary to this is the liability for the guarantees has a floor of zero

• But at what level of aggregation?


What to Conclude

Term of the Liability – Practical Challenges



Challenge 1 – Hedging

• Segregated funds have significant insurance risk and are often hedged

• Hedging is managed on a portfolio basis– Trading in options is costly

• Zero floor can disrupt parity between asset and liability sides of the balance sheet (see examples)

– For simplicity, assume no AAE!



Hedging Example

• Product

– 10-year 100% return-of-premium maturity guarantee

– No death benefit guarantees

– No resets

– Total MER = 200 bps

– Fund expenses = 135 bps

– Fund mapped 100% to S&P 500



Hedging Example

• Hedging details

– Put options purchased on S&P 500

– Structured to match the guarantee payable on the maturity date

– Valued using Black-Scholes calibrated to current market prices



Hedging Example• Valuation method & assumptions

– S&P 500 projected under 1,000 calibrated scenarios

– Account values and cashflows projected off the S&P 500 up to contract maturity date

• Fees less expenses• Guarantee costs less put option payoffs (net to ~ 0)

– Discounted at 5%, no lapses or deaths for simplicity

– CTE 80

• Reserve from this method is equivalent to PV expenses – PV fees at 5% / CTE 80 + cost of guarantee (=MV of puts)



Hedging Example – Liability Data

Cohort Issue Date S&P 500 @IssDt

Deposit

1 Jul-1-2001 1,224.38 10,000

2 Jul-1-2002 968.65 10,000

3 Jul-1-2003 982.32 10,000

4 Jul-1-2004 1,128.94 10,000

5 Jul-1-2005 1,194.44 10,000



Hedging Example – S&P 500

t Calendar Date Assumed S&P 500

Steady Rise Rise & Fall

0 2006-Jun-30 1250 1250

1 2007-Jun-30 1400 1500

2 2008-Jun-30 1500 1700

3 2009-Jun-30 1675 1850

4 2010-Jun-30 1800 1600

5 2011-Jun-30 1950 1500



Cohort AV Yrs to

Mat

PV Expenses less Fees

Guarantee Cost = MV Puts

Liability Before Floor

1 9,232 5 (234) 1,640 1,406

2 11,963 6 (352) 892 540

3 12,033 7 (410) 943 533

4 10,655 8 (414) 1,303 890

5 10,265 9 (447) 1,430 983

Liability Asset = MV Puts

Cohort/Seriatim Floor 4,352

6,208Aggregate Floor 4,352

No Floor 4,352

Balance Sheet Summary


Steady Rise Scenario – At June 30, 2006 (t=0 / S&P=1250)



Cohort

AV Yrs to

Mat



1 10,156 4 (208) 1,144

2 13,159 5 (324) 545

3 13,237 6 (388) 617

4 11,721 7 (399) 956

5 11,292 8 (438) 1,098




No Floor 2,602





935

221

229

556

660


Cohort AV Yrs to

Mat



1 10,679 3 (168) 853

2 13,836 4 (276) 358

3 13,918 5 (342) 442

4 12,324 6 (362) 770

5 11,873 7 (404) 925




No Floor 1,795





686

82

99

407

520


Cohort AV Yrs to

Mat



1 11,712 2 (124) 418

2 15,174 3 (228) 146

3 15,263 4 (302) 224

4 13,516 5 (333) 494

5 13,020 6 (382) 650


Cohort/Seriatim Floor 723

1,932Aggregate Floor 563

No Floor 563





294

(82)

(78)

161

268


Cohort AV Yrs to Mat




1 12,352 1 (66) 120 55

2 16,003 2 (163) 40 (122)

3 16,097 3 (241) 100 (142)

4 14,254 4 (284) 313 29

5 13,732 5 (338) 465 127




No Floor (52)





Cohort AV Yrs to

Mat




1 13,134 0 0 0 0

2 17,016 1 (94) 1 (93)

3 17,116 2 (180) 21 (159)

4 15,157 3 (234) 147 (87)

5 14,601 4 (296) 279 (17)



448Aggregate Floor 0

No Floor (356)




Steady Rise Scenario – 5 Year Summaryt Fees –

ExpLiability Asset =

MV Puts

Income

Seriatim Aggregate No Floor Seriatim Aggregate No Floor

0 4,352 4,352 4,352 6,208

1 370 2,602 2,602 2,602 4,359 271 271 271

2 397 1,795 1,795 1,795 3,348 192 192 192

3 427 723 563 563 1,932 83 243 243

4 459 211 0 (52) 1,038 76 128 180

5 486 0 0 (356) 448 107 (104) 199Income Summary

(150)

(100)

(50)

-

50

100

150

200

250

300

1 2 3 4 5

Year

Inco

me

-

500

1,000

1,500

2,000

2,500

S&

P 5

00

No Floor Aggregate Seriatim SP500



Cohort AV Yrs to

Mat




1 9,232 5 (234) 1,640 1,406

2 11,963 6 (352) 892 540

3 12,033 7 (410) 943 533

4 10,655 8 (414) 1,303 890

5 10,265 9 (447) 1,430 983




No Floor 4,352



Rise & Fall Scenario – At June 30, 2006 (t=0 / S&P=1250)



Cohort AV Yrs to

Mat




1 10,897 4 (226) 914 688

2 14,118 5 (353) 418 65

3 14,200 6 (420) 488 67

4 12,575 7 (433) 793 361

5 12,114 8 (474) 932 458




No Floor 1,639





Cohort AV Yrs to

Mat




1 12,133 3 (191) 495 304

2 15,718 4 (317) 193 (124)

3 15,810 5 (393) 261 (132)

4 14,000 6 (415) 512 98

5 13,487 7 (463) 650 187




No Floor 332





Cohort AV Yrs to

Mat




1 12,961 2 (139) 220 81

2 16,790 3 (258) 75 (184)

3 16,889 4 (340) 131 (209)

4 14,955 5 (373) 331 (42)

5 14,407 6 (426) 464 38




No Floor (317)





Cohort AV Yrs to Mat




1 10,954 1 (65) 363 298

2 14,193 2 (151) 113 (38)

3 14,277 3 (221) 211 (10)

4 12,642 4 (259) 528 269

5 12,179 5 (307) 714 407




No Floor 925





Cohort AV Yrs to

Mat




1 10,051 0 0 0 0

2 13,024 1 (74) 67 (7)

3 13,101 2 (141) 204 63

4 11,600 3 (184) 607 423

5 11,175 4 (231) 839 607




No Floor 1,086




Rise & Fall Scenario – 5 Year Summaryt Fees –

ExpLiability Asset =

MV Puts

Income

Seriatim Aggregate No Floor Seriatim Aggregate No Floor

0 4,352 4,352 4,352 6,208

1 384 1,639 1,639 1,639 3,545 433 433 433

2 439 589 332 332 2,111 55 312 312

3 478 118 0 (317) 1,220 58 (80) 236

4 456 973 925 925 1,929 310 240 (77)

5 400 1,093 1,086 1,086 1,717 68 27 27Income Summary

(200)

(100)

-

100

200

300

400

500

1 2 3 4 5

Year

Inco

me

-

200

400600

800

1,000

1,200

1,4001,600

1,800

2,000

S&

P 5

00

No Floor Aggregate Seriatim SP500



• How to apply zero floor at a finer level of aggregation than hedging portfolio?

– Options aren’t allocated to cohorts in practice

• Value of options added to reserve “drops off” when total reserve becomes negative

– Since term becomes zero

• Is the balance sheet position appropriate?

• How do you explain earnings when zero floor kicks in, given change in the stock market?



Observations

Challenge 2 – Cashflow Asymmetry

• Claims from segregated fund guarantees can come in waves

– Depends on when sold and where market was at that time

– Also depends on product design

– Magnified if sales pattern is “chunky”



Example

• Two cohorts– Cohort 1 sold in 1999 (S&P 500 = 1,455)

– Cohort 2 sold in 2002 (S&P 500 = 975)

• Current S&P 500 = 1,250– Cohort 1 is deep in the money with 1 year left to

maturity – Cohort 2 is deep out of the money with 4 years left to

maturity

• What should the total liability be?



Example (cont’d)

• Cohort 1 will likely pay out significant claims next year (assume no hedging)Assume claims are imminent at 1,000 (reserve = 1,000)How does total liability account for this?

• What impact does zero floor have here?



• Scenario 1: Cohort 2 liability deeply negative before zero floor– Cohort 1 liability = 1,000– Cohort 2 liability = -1,200

• Scenario 2: Cohort 2 liability slightly negative before zero floor– Cohort 1 liability = 1,000– Cohort 2 liability = -300



Cohort/Seriatim Aggregate No Floor

Scenario 1 0 -1,000 0

Scenario 2 0 -300 0

Income (after claim payment)

Example (cont’d)

• Here the issue is more significant if you don’t hedge

• Is the balance sheet position appropriate?

– With seriatim floor?

– With aggregate floor?

– No floor?

• One option is to choose the term on an aggregate level by choosing the term that maximizes liability (may involve renewing cohort 1)



Observations

Recoverability Testing for AAE



• Use MfADded assumptions

• Direction chosen appropriate in aggregate– High lapse favours guarantee– Low lapse favours AAE



Non-Economic Assumptions


CTE 0 •Accounting view?

•Compare with similar accounting items subject to impairment testing

CTE 60 •Actuarial view?

•Divorces considerations for AAE recoverability from those for guarantees

CTE X •Aligns considerations for AAE recoverability from those for guarantees

•Whole contract view?


Choice of CTE Level

CTE 80 •In range of SOP

•Awkward (?) if CTE level for guarantees is lower than 80

CTE 95 •Solvency-oriented

Ed note will endorse two methods:– CTE 60– CTE X



Choice of CTE Level (cont’d)


• Term of the liability reads literally as a seriatim concept

• However, common/accepted practice thought to be at portfolio-wide level– Banks, mutual funds

– Consistent with US GAAP and International GAAP

• No recognition of cash flows for a policy beyond its term of the liability, but deficiencies can offset excesses (see example)


Level of Aggregation

Level of Aggregation – Example

Policy A Policy B

Remaining AAE 100 100

Term of liability 3 5

PV of cashflows over 3 years 90 105

PV of cashflows over 5 years 100 115



Level of Aggregation – Example (cont’d)

• Acceptable practice:

– Aggregate across policies A and B

– Total AAE = 200

– Total PV cashflow (TOL) = 205 (90+115)

Test is satisfied



Level of Aggregation – Revised Example

Policy A Policy B original

Policy B revised

Remaining AAE 100 100 100

Term of liability 3 5 5

PV of cashflows over 3 years 90 105 95

PV of cashflows over 5 years 100 115 105



Level of Aggregation – Revised Example (cont’d)

• Same level of aggregation yields:

– Total AAE = 200

– Total PV cashflow (over TOL) = 195 (90+105)

Test is not satisfied

• It is not acceptable to extend Policy A to 5 years to satisfy the test as follows:

– Total AAE = 200

– Total PV cashflow (over 5 yrs) = 205 (100+105)



Policyholder Behaviour




• Policyholder behaviour an important assumption for segregated funds:– Full and Partial Withdrawal – Resets– Fund transfers– Annuitizations if material

• Consider interrelationships, particularly reaction to the scenario– Must combine experience data with common sense /

intuition when modelling dynamic behaviour– Consider higher MfADs for these


Summary


• Option exercise correlated with in-moneyness

• Anti-selection

• Consider reasonable expectations

• PH sophistication & perceived financial interest in policy

• < 100% efficiency


Guiding Principles

Questions?(or comments, criticisms, accusations, threats, or even accolades)



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