CIA Annual Meeting Assemblée annuelle de l’ICA June 29 & 30, 2006  Les 29 et 30 juin 2006 Ottawa, Ontario Session Val-5 CLIFR Part II

Term of the Liability CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

CIA Annual Meeting  Assemblée annuelle de l’ICA Standards through.27 Highlights: – => if element of policy operates independently of the policy, it has its own term – defines “renewal”, “adjustment” and “constraint” – => may take account of one or more renewals / adjustments after B/S date – => extend term with caution Session Val-5 CLIFR Part II SOP Summary

CIA Annual Meeting  Assemblée annuelle de l’ICA Highlights: – => 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 – => term extension to offset acquisition or similar expenses – => write-down of AAE and recoverability testing Session Val-5 CLIFR Part II SOP Summary (cont’d)

CIA Annual Meeting  Assemblée annuelle de l’ICA 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? Session Val-5 CLIFR Part II What to Conclude

Term of the Liability – Practical Challenges CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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! CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Hedging Example – Liability Data CohortIssue DateS&P Deposit 1Jul , ,000 2Jul ,000 3Jul ,000 4Jul , ,000 5Jul , ,000 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Hedging Example – S&P 500 tCalendar DateAssumed S&P 500 Steady RiseRise & Fall Jun Jun Jun Jun Jun Jun CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 1 9,2325(234)1,6401, ,9636(352) ,0337(410) ,6558(414)1, ,2659(447)1, LiabilityAsset = MV Puts Cohort/Seriatim Floor4,352 6,208 Aggregate Floor4,352 No Floor4,352 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Steady Rise Scenario – At June 30, 2006 (t=0 / S&P=1250) Session Val-5 CLIFR Part II

CIA Annual Meeting  Assemblée annuelle de l’ICA Cohor t AVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts 110,1564(208)1, ,1595(324) ,2376(388) ,7217(399) ,2928(438)1,098 LiabilityAsset = MV Puts Cohort/Seriatim Floor2,602 4,359 Aggregate Floor2,602 No Floor2,602 Balance Sheet Summary Steady Rise Scenario – At June 30, 2007 (t=1 / S&P=1400) Session Val-5 CLIFR Part II Liability Before Floor

CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts 110,6793(168) ,8364(276) ,9185(342) ,3246(362) ,8737(404)925 LiabilityAsset = MV Puts Cohort/Seriatim Floor1,795 3,348 Aggregate Floor1,795 No Floor1,795 Balance Sheet Summary Steady Rise Scenario – At June 30, 2008 (t=2 / S&P=1500) Session Val-5 CLIFR Part II Liability Before Floor

CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts 111,7122(124) ,1743(228) ,2634(302) ,5165(333) ,0206(382)650 LiabilityAsset = MV Puts Cohort/Seriatim Floor723 1,932 Aggregate Floor563 No Floor563 Balance Sheet Summary Steady Rise Scenario – At June 30, 2009 (t=3 / S&P=1675) Session Val-5 CLIFR Part II Liability Before Floor 294 (82) (78)

Steady Rise Scenario – At June 30, 2010 (t=4 / S&P=1800) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 112,3521(66) ,0032(163)40(122) 316,0973(241)100(142) 414,2544(284) ,7325(338) LiabilityAsset = MV Puts Cohort/Seriatim Floor211 1,038 Aggregate Floor0 No Floor(52) Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Steady Rise Scenario – At June 30, 2011 (t=5 / S&P=1950) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 113, ,0161(94)1(93) 317,1162(180)21(159) 415,1573(234)147(87) 514,6014(296)279(17) LiabilityAsset = MV Puts Cohort/Seriatim Floor0 448 Aggregate Floor0 No Floor(356) Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Steady Rise Scenario – 5 Year Summary tFees – Exp LiabilityAsset = MV Puts Income SeriatimAggregateNo FloorSeriatimAggregateNo Floor 04,352 6, ,602 4, ,795 3, , (52)1, (356)448107(104)199 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 19,2325(234)1,6401, ,9636(352) ,0337(410) ,6558(414)1, ,2659(447)1, LiabilityAsset = MV Puts Cohort/Seriatim Floor4,352 6,208 Aggregate Floor4,352 No Floor4,352 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Rise & Fall Scenario – At June 30, 2006 (t=0 / S&P=1250) Session Val-5 CLIFR Part II

CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 110,8974(226) ,1185(353) ,2006(420) ,5757(433) ,1148(474) LiabilityAsset = MV Puts Cohort/Seriatim Floor1,639 3,545 Aggregate Floor1,639 No Floor1,639 Balance Sheet Summary Rise & Fall Scenario – At June 30, 2007 (t=1 / S&P=1500) Session Val-5 CLIFR Part II

CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 112,1333(191) ,7184(317)193(124) 315,8105(393)261(132) 414,0006(415) ,4877(463) LiabilityAsset = MV Puts Cohort/Seriatim Floor589 2,111 Aggregate Floor332 No Floor332 Balance Sheet Summary Rise & Fall Scenario – At June 30, 2008 (t=2 / S&P=1700) Session Val-5 CLIFR Part II

CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 112,9612(139) ,7903(258)75(184) 316,8894(340)131(209) 414,9555(373)331(42) 514,4076(426)46438 LiabilityAsset = MV Puts Cohort/Seriatim Floor118 1,220 Aggregate Floor0 No Floor(317) Balance Sheet Summary Rise & Fall Scenario – At June 30, 2009 (t=3 / S&P=1850) Session Val-5 CLIFR Part II

Rise & Fall Scenario – At June 30, 2010 (t=4 / S&P=1600) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 110,9541(65) ,1932(151)113(38) 314,2773(221)211(10) 412,6424(259) ,1795(307) LiabilityAsset = MV Puts Cohort/Seriatim Floor973 1,929 Aggregate Floor925 No Floor925 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Rise & Fall Scenario – At June 30, 2011 (t=5 / S&P=1500) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 110, ,0241(74)67(7) 313,1012(141) ,6003(184) ,1754(231) LiabilityAsset = MV Puts Cohort/Seriatim Floor1,093 1,717 Aggregate Floor1,086 No Floor1,086 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Rise & Fall Scenario – 5 Year Summary tFees – Exp LiabilityAsset = MV Puts Income SeriatimAggregateNo FloorSeriatimAggregateNo Floor 04,352 6, ,639 3, , (317)1,22058(80) , (77) 54001,0931,086 1, CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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? CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II 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” CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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? CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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? CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Cohort/SeriatimAggregateNo Floor Scenario 10-1,0000 Scenario 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) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Observations

Recoverability Testing for AAE CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Use MfADded assumptions Direction chosen appropriate in aggregate –High lapse favours guarantee –Low lapse favours AAE CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Non-Economic Assumptions

CIA Annual Meeting  Assemblée annuelle de l’ICA CTE 0Accounting view? Compare with similar accounting items subject to impairment testing CTE 60Actuarial view? Divorces considerations for AAE recoverability from those for guarantees CTE XAligns considerations for AAE recoverability from those for guarantees Whole contract view? Session Val-5 CLIFR Part II Choice of CTE Level

CTE 80In range of SOP Awkward (?) if CTE level for guarantees is lower than 80 CTE 95Solvency-oriented  Ed note will endorse two methods: –CTE 60 –CTE X Session Val-5 CLIFR Part II CIA Annual Meeting  Assemblée annuelle de l’ICA Choice of CTE Level (cont’d)

CIA Annual Meeting  Assemblée annuelle de l’ICA 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) Session Val-5 CLIFR Part II Level of Aggregation

Level of Aggregation – Example Policy APolicy B Remaining AAE100 Term of liability35 PV of cashflows over 3 years90105 PV of cashflows over 5 years CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Level of Aggregation – Revised Example Policy APolicy B original Policy B revised Remaining AAE100 Term of liability355 PV of cashflows over 3 years PV of cashflows over 5 years CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

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 ( ) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

Policyholder Behaviour CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

CIA Annual Meeting  Assemblée annuelle de l’ICA 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 Session Val-5 CLIFR Part II Summary

CIA Annual Meeting  Assemblée annuelle de l’ICA Option exercise correlated with in- moneyness Anti-selection Consider reasonable expectations PH sophistication & perceived financial interest in policy < 100% efficiency Session Val-5 CLIFR Part II Guiding Principles

Questions? (or comments, criticisms, accusations, threats, or even accolades) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II