S.3855 Actuarial Challenges Igor Afanassiev Prepared by Lesley Thomson

2 Changes to Asset Reporting  New reporting depends on asset designation  No more deferral of realized gains  “Fair value option” (FVO) with OSFI restrictions Asset ClassBalance SheetUnrealized Gains HTMAmortized costNI HFTFair valueNI AFSFair valueOCI LoansAmortized costNI

3 Other Comprehensive Income  “Other Comprehensive Income” is new to Canadian GAAP (US GAAP has it)  OCI is a below-the-line item of income –Income that hasn’t been recognized yet  Unrealized gains/losses on AFS assets go to OCI, creating a disconnect between balance sheet and income statement –Never before in Canadian GAAP  Realized gains/losses on AFS assets are transferred from OCI to “real” income

4 CALM Valuation  Policy Liabilities = Statement value of assets needed to discharge the obligations –Based on analysis of asset and liability cash flows  If statement value of assets changes (all else being equal), the liabilities change by exactly the same amount –CALM gets the balance sheet right  So why is 3855 a problem?

5 CALM Valuation  The disconnect between the balance sheet and income statement for AFS assets is the problem  The liability valuation gets the balance sheet right, but income will be wrong –Income + OCI will be OK, but nobody will care  If we changed to get the income right, then the balance sheet would be wrong

6 Illustrative Example  AFS asset (MV=$1000) whose cash flows perfectly match liability cash flows. Liability value = $1000  Nothing changes except asset MV rises to $1100. Still a perfect match, so liability value = $1100  Income statement: –Increase in asset value goes to OCI (not income) –Increase in liability value goes to income –$100 loss shown on income statement!

7 Solutions?  Discussed a number of possible solutions with CICA, but all were rejected  Problem is unique to insurance industry, and CICA will not create “special” rules for one industry  End result is that life insurance companies won’t use AFS assets to back liabilities  Creates a minor annoyance – different asset designations for Canadian and US GAAP

8 Issue – Valuation Timing  CALM valuation usually done a quarter in arrears  Increased volatility of asset values means using the Q3 information to set Q4 liabilities is more difficult  Different approaches for different blocks

9 Issue – Valuation Timing (a) PPM with FV adjustment  Post-3855 liability = Pre-3855 liability X (Post-3855 statement value of assets) (Pre-3855 statement value of assets)  Pre-3855 statement value adjusted for DRG etc.  Pre-3855 statement value need not be exactly the same as today –Need any stable “book value” approach

10 Issue – Valuation Timing (a) PPM with FV adjustment  Approach requires a “book value” of assets to be maintained –Not in G/L, so watch out for control issues  BV may be useful for other purposes –SOE analysis –Dividend management for par business –Credited rates on UL

11 Issue – Valuation Timing (b) FV liabilities with Q4 adjustment – 2 approaches  Solve for spread (j) at Q3 such that FV liability = pv liability cash flows at Q3 spot rates + j –Q4 liability = pv liability cash flows at Q4 spot rates + j  Solve for PPM-type interest vector at Q3 such that FV liability = pv Q3 liability cash flows –Q4 liability = pv liability cash flows + change in fair value of bonds backing liabilities

12 Issue – Valuation Timing (c) CFVM  Determine C-3 provision in basis points from CALM testing  Liability = Statement value of assets + pv liability cash flows (including C-3) - pv asset cash flows  Only appropriate for certain annuity blocks

13 Issue – Valuation Timing  Availability of required information in time to do the valuation  Materiality of adjustments required to account for changes in asset quality, mix, duration, matching etc. during the quarter  Materiality of adjustments required for new business issued during the quarter  Commingled assets (par/non-par; surplus/liabilities) can add complications

14 Issue – Taxes  Complicated!  Changes to timing differences must be reflected in valuation  In Canada, 3855 causes projected income to change –Attributable to tax impacts  In Canada, 3855 causes projected income to be more volatile –Attributable to tax impacts

15 Issue – Taxes Pre-1996 life insurance example (40% tax rate):  Start with pre-3855 balance sheet:  Asset BV(=TV) = $1000  Total after-tax liability (with DDTL) = $1000  Tax Reserve = $1060  DTL = $40 (=.4 x ( ))  Statement liability = $960 (= )

16 Issue – Taxes Post-3855 balance sheet (say asset value is $1150):  Asset FV = $1150; Asset TV = $1000 –DTL (related to assets) = $60 (=.4 x ( ))  Total after-tax liability (with DDTL) = $1150  Tax Reserve = $1060  DTL (related to liabilities) = $-20 (=.4x ( ))  Statement liability = $1110 (= )

17 Issue – Taxes Pre-1996 observations:  Total DTL has not changed, and the new timing differences on assets are offset by changed timing differences on liabilities –No change to tax cash flows  The assets backing the new DDTL are now held at fair value, so the corresponding liability value must reflect this –E.g., if using PPM with FV adjustment, must apply (MV/BV) ratio to total liability including DDTL

18 Issue – Taxes Pre-1996 observations:  Equivalently, assets backing the statement liability + DTL are held at fair value –DTL balance won’t reflect this directly, so the actuarial liability must make up the difference  Will be many variations –Some back DTL with cash –Some use no-tax liability to determine DTL

19 Issue – Taxes Post-1996 life insurance example:  Start with pre-3855 balance sheet:  Asset BV(=TV) = $1000  Total liability = Statement liability = $1000 (no DDTL)  Tax Reserve = $1000  DTL = $0

20 Issue – Taxes Post-3855 balance sheet (say asset value is $1150):  Asset FV = $1150; Asset TV = $1000 –DTL (related to assets) = $60 (=.4 x ( ))  Additional $150 liability is deductible (and increase in asset value is not taxable), so assuming immediate recoverability:  Total liability (with DDTL) = $1090  Statement liability = $1030 (= )

21 Issue – Taxes Post-1996 observations:  Gain at transition = $60 for tax benefits  CLHIA has proposed spreading this transition impact over time  Total future projected income will be reduced as the $60 timing difference is reversed –“gain” at transition is reversed

22 Issue – Taxes Post-1996 observations:  Each period, tax on the change in fair value of assets backing post-1996 liabilities will show up as a gain/loss –Change in liability value is deductible while corresponding change in asset value is not taxable –Complicated by changing projections of asset values  So income will be more volatile, but only because of taxes

23 Issue – Deposit Valuation  Liability value for amounts on deposit has been equal to the account value  No longer automatic for deposits where earned rate is paid to policyholders (e.g., dividends on deposit)  Liability should be (approximately) statement value of assets if higher than account value –Recognizes that all will be paid out, so should be no surplus

24 Issue – MCCSR  MCCSR required capital will increase  Asset values increasing and liability values increasing  Some required capital factors are a simple percentage of assets or liabilities  Some OCI will be Tier 2 instead of Tier 1 capital

25 Issue – Dividends  Policyholder dividends in many countries are set based on book rates of return  Book rates of return will no longer be easily available  Same problem for setting credited rates of interest on UL- type business

26 Issue – Sources of Earnings  SOE analysis is more complex when using market values  One solution is to continue SOE analysis on “book value” basis and add a line for impacts due to MV fluctuations  Analysts are beginning to react, and may want additional disclosures

27 Issue – Intersegment Trading  Intersegment trading of assets is done at market value –Creates a “notional” realization of gains/losses for internal reporting –Adjustments net to zero for external reporting  Too difficult to do this for AFS assets (notional accounting is far more complex with OCI)  Sun Life solution is to prohibit intersegment trading of AFS assets

28 Issue – Hybrid Segments  “Hybrid” segments containing both AFS and HFT assets will generally be prohibited at Sun Life  Accounting is too complex  So no mixing of liabilities and surplus, except for immaterial amounts

29 Issue – SOX Compliance  SOX processes will need to be reviewed for 3855 changes  Additional disclosures at transition (e.g., statement of balance sheet changes) may require special SOX controls

30 Issue – AuG43  Additional AuG43 audit requirements coming at the same time  Approach to valuation will need to be well documented

31 Issue – Disclosure  Disclosure requirements likely to increase  Both to OSFI (e.g., to satisfy FVO) and externally  Recent analyst report indicated they wanted disclosure of change in policy liabilities caused by changes in interest rates –“Investment income” line of won’t be as meaningful as before

32 Issue – Reporting Changes  DCAT  SOE  EV, VNB  Business Plans  AAR  Notes, MD&A Disclosures

33 Issue - Transition  Tax, capital transition rules not yet finalized  DNRG balances written off, so never get to report the income on the balance sheet (only for surplus assets)  Treatment of deferred unrealized gains on equities still unresolved  Change from book to market value booked to retained earnings, not income –Except AFS goes to OCI, and later to NI

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