CIA Annual Meeting LOOKING BACK…focused on the future

CIA Annual Meeting Session 5609 – Sources of Earnings Speaker:Trevor Howes GGY Speaker:Trevor Howes GGY LOOKING BACK…focused on the future

My perspective… A software vendor with many Canadian clients System used for Individual life, disability, critical illness, LTC and annuity products, Group life and disability claim reserves Commenced development of “Earnings by Source” features over 7 years ago Sources of Earnings

What was SOE experience in 2004? Top-down vs. bottom-up approach Challenges and questions in implementing a bottom-up approach to SOE

What was the experience with required SOE disclosures for 2004 … Quality of result? Approach to development? Cost of delivery? Anticipated benefits realized? Sources of Earnings

High level issues: Aggregation and coordination Approach to analysis for “non-traditional” lines Top-down vs. bottom-up approach for “traditional” PPM reserve lines Sources of Earnings

Top-down approach Establish general formula for analysis of aggregate earnings by distributing the change in PPM reserve Calculate or estimate each component at line of business or block level Allocate residual balancing amounts Sources of Earnings

Bottom up approach Each seriatim policy in force in year theoretically contributes to total actual reserve movement and to actual profit components Software builds total change in PPM reserve and resulting earnings for modeled business with no residual unexplained value Sources of Earnings

Characteristics of a “good” Sources of Earnings analysis process: Easy for users to understand Can be produced in timely manner Well documented and validated Consistently applied from period to period …. Sources of Earnings

Characteristics of a “good” Sources of Earnings analysis process: Technically robust; consistent explanations of earnings from period to period Include all material components of earnings Identifies the fundamental drivers of earnings Sources of Earnings

Management use of a good SOE: 1.High level reports of overall trends by line of business and major assumption. 2.Drill down to major blocks for contributions to each gain or loss 3.Experience analysis studies to support revised reserve assumptions Sources of Earnings

CIA recommended SOE report: Expected Profit on InforceXXX Impact of New BusinessXXX Experience Gains and LossesXXX Changes in AssumptionsXXX Other ChangesXXX Pre-tax Operating EarningsXXX Earnings on SurplusXXX Net Income before TaxXXX TaxesXXX Operating EarningsXXX Sources of Earnings

Advantages of bottom up approach: Technically robust Components add up with no approximations Consistency from period to period Enables timely production Assures validity vs. reported reserves (provided process uses same software or consistency is regularly verified) Sources of Earnings

Advantages of bottom up approach Contributions to earnings available at any level below reported lines of business Meaningful experience gains available by assumption Seriatim expected and actual movements available for experience studies Sources of Earnings

Software issues of bottom-up approach Applying the traditional source of earnings formula to real business Handle all business lines and all assumptions Reconcile actual movements of business Include new business Cope with reporting delays Sources of Earnings

Other challenges of bottom-up approach Acquiring timely, valid and useable transaction data consistent with ledger data to feed movement analysis Maintaining cost benefit balance in modelling actual business movements Applying bottom up approach consistently across business units Sources of Earnings

Reconciling actual business movements Actual vs. actuarial movements (e.g. reinstatements, NTU, RPU &ETI, policy changes) Processing delays within period or over reporting dates Fund transactions for fund-based products Sources of Earnings

Handling new business Including early terminations in model Time zero reserve impact (with/without PFADs element) vs. experience gains Reflecting processing delays Actual issue costs vs. expected Adjusting investment income Sources of Earnings

SOE analysis based on traditional reserve accumulation formula: V [0] + VP + II – E – q*DB = V [0]+1 *(1–q) Sources of Earnings

After rearrangement, each profit component in traditional approach is: Gain = expected benefit cost less actual benefit cost plusactual release of PFAD where, cost = benefit cashflow less reserve released from decrements Sources of Earnings

For traditional (guaranteed cost) products, profit is mainly experience vs. reserve assumptions The primary benefits of SOE analysis are validating reserve methodology and assumptions, identifying assumptions needing review Sources of Earnings

SOE for fund-based products reserves are more complex movements are less predictable profit is driven by spreads achieved more sensitive to management action reserve is largely driven by the size of the policyholder fund inconsistent with traditional products and requires a different approach to SOE Sources of Earnings

For Universal Life PPM reserve can be restated as: Reserve = Fund less PV of future spreads Changes in Fund portion may or may not impact profit Sources of Earnings

SOE for Universal Life Gain = actual spread gain less expected spread gain plus actual release of PFADs where, spread gain = charges deducted less cost of related benefits (i.e. benefits paid net of fund released less PV of future spreads released) Sources of Earnings

Challenges of SOE for UL Reconciliation of actual fund and reserve movement “Revaluation” at period end Compromise vs. exact replication of fund movement in model PV of spreads with level COI Sources of Earnings

SOE for Disability Income is like traditional life, except for morbidity Separate incidence from termination gains Actual incidence cost based on PV of claim on DLR basis at date of claim Termination experience on opening and new claims reflected in claim payment gain Recovery to active status with new ALR Sources of Earnings

Disability income requires special movement transactions: incidence by 2 causes claim terminations by death, recovery, or settlement claim adjustments, suspensions, re-opens? Sources of Earnings

A bottom-up approach to SOE enables the full benefit of the analysis is complex and costly to implement may pose questions of consistency across lines of business, or between companies involves both theoretical and practical issues not answered in existing guidance SOE will evolve over next few years Sources of Earnings

CIA Annual Meeting LOOKING BACK…focused on the future