1. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Considerations in the Valuation of Segregated Fund Products

2. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Sub-Committee of CLIFR formed late in 2005 Members of Sub-Committee: –Jacques Boudreau, Byron Corner, Greg Lawrence, Dale Mathews Mandate –Review areas where additional guidance could be provided to ensure compliance with standards and to narrow the range of practice Status – early draft, looking for feedback Expected Completion – Spring 2007

3. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Content of note –Methodology – Bifurcated versus Whole Contract –What is a PFAD? –Discount rate –Term of the Liability – Issues Hedging Level of Aggregation –Recoverability Testing for AAE –Policyholder Behaviour

4. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology –There is currently a range of practice across the industry –We’re reviewing the general approaches in use –The main differentiation is bifurcated versus whole contract approaches

5. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract –Bifurcated Revenue is allocated between recoverability testing of the Allowance for Acquisition Expense (AAE) and the liability for the guarantee Allocation does not change from period to period Policy liability for the guarantee is calculated separately using revenue based on this allocation

6. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract –Bifurcated Allocation of revenue to the guarantee would generally be related to the additional charge priced into the product for the guarantee

7. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract Whole Contract – Approach 1 Total policy liability is determined using all net cashflows available Deterioration in market conditions could cause liability to increase and DAC implicitly written down

8. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract Whole Contract – Approach 1 Future market improvements could result in reduction of liability and implicit writing up of AAE which is inconsistent with standards This method should not be used for Canadian GAAP purposes

9. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract - Whole Contract Approach 2 – DAC Focus AAE is first tested to ensure recoverability using all fee income In order to calculate the liability for the guarantees, the AAE balance is added to the stochastic result Mathematically equivalent to backing out a PV of fee income equal to the AAE balance

10. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract - Whole Contract Approach 2 – DAC Focus This method is consistent with Standards For the remainder of the presentation we will simply call this the whole contract approach

11. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract Under both methods If the AAE becomes unrecoverable it is written down to the extent it is recoverable Future amortization is reduced accordingly and locked in consistent with SOP Section 2320.24 Once the AAE is written down it may not be written back up.

12. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Bifurcated vs. Whole Contract Under both methods a zero floor on the liability is generally applied at some level of aggregation. Reflection of SOP section 2320.25 which suggests that the term ends at the balance sheet date unless extending the term increases the liability

13. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Example - Cohort of variable annuity policies with an initial AAE of $50 –Policies priced with 5 basis points of revenue plus additional charge of 2 basis points for a 10 year maturity guarantee –Bifurcated Method Recoverability testing for the AAE is done assuming 5 basis points of revenue. The liability for the guarantee is calculated assuming 2 basis points of revenue. Allocation doe not change period to period.

14. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Example -Whole Contract Method The entire 7 basis points is first made available to recover the AAE. To the extent it is not entirely required, the excess is reflected in the liability for the guarantee.

15. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology Example Total -43.44 3.42 0.04 -40.0

16. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Considerations Total liability under Whole Contract method will be less than or equal to that under the Bifurcated method Whole Contract method will defer possible writing down of the AAE as long as possible as the AAE has first priority on future revenue. Once the liability for the guarantee has become positive the liability may become more volatile under the Whole Contract method as the allocation of revenue can change period to period.

17. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Methodology – Considerations At this time CLIFR is not recommending one method over the other Both methods consistent with standards Currently the whole contract method is more commonly used Direction of international standards appears to be toward bifurcated approach When the direction of international standards becomes clearer we will move in that direction.

18. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 What is a PfAD? We are responding to members’ request for guidance as per the OSFI survey requested guidance Essentially a disclosure issue SOP Section 1110.39: “Provision for adverse deviations is the difference between the actual result of a calculation and the corresponding result using best estimate assumptions.” The term of the liability for segregated fund products has resulted in different interpretations as to the period over which the calculation extends

19. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 What is a PfAD? CLIFR’s initial thinking done in the context of quantification of PfADs in AAR Issue has been elevated with companies starting to disclose PfADs externally This has now been identified as an issue by the Committee on the Role of the Appointed Actuary and we will be working with them on this.

20. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Term of the Liability Section 2320.27 “…the term of the liability ends at the balance sheet date for….the general account portion of a deferred annuity with segregated fund liabilities but without guarantees;” Section 2320.23 “The actuary would extend such term solely to permit recognition of cash flow to offset acquisition or similar expenses whose recovery from cash flow that would otherwise be beyond such term was contemplated by the insurer in pricing…

21. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Term of the Liability Add Guarantee: –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

22. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Term of the Liability What to Conclude 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 –With the addition of a guarantee, additional revenue may be recognized, but only enough to cover additional costs

23. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Term of the Liability: Practical Challenges

24. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 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

25. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Hedging Example Description –Example reflects the guarantee reserve only, no AAE –Hedging is accomplished via short position in futures –Initial calculated liability is negative on both hedged and unhedged basis, so zero floor is applied –Expected market growth over the length of the contract is around 10%

26. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Hedging Example Earnings on a hedged basis are Fee income – claims + interest on reserve + change in FMV of derivative – change in reserve Change in reserve is Change in CTEx (liability cashflows + hedge g/l)

27. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Hedging Example - Emergence of Earnings Year 1 Market Growth Hedged Zero floor Hedged No floor Unhedged Zero floor 0%1106285 10%347492 20%-487493

28. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Hedging Example - Emergence of Earnings Details – 20% Growth Hedged Zero floor Hedged No floor Unhedged Zero Floor Fee Income 93 Investment Income -141-1490 Claims 000 Change in liability 0-1300 Total pre-tax -487493

29. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Challenge 1 – Hedging –Summary Change in FMV goes though income on asset side Expect offsets (not exact) on liability side but this may not occur if constrained by zero floor CLIFR believes is would be appropriate to allow liability for guarantee to become negative in the context of hedging –Subject to avoiding capitalizing more future profit than in the absence of hedging

30. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Challenge 2 – Cashflow Asymmetry / Level of Aggregation 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”

31. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Level of Aggregation Term of the liability reads literally as a seriatim concept Common/accepted practice thought to be at portfolio-wide or product level However, care must be taken if the level of aggregation combines blocks with significantly different risk profiles..

32. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 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?

33. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 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?

34. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Example (cont’d) 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/SeriatimAggregateNo Floor Scenario 10-1,0000 Scenario 20-3000

35. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Level of Aggregation Conclusion –An important consideration in determining the appropriate level of aggregation is the homogeneity of policies

36. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Recoverability Testing Non economic assumptions Use MfADded assumptions Direction chosen appropriate in aggregate –High lapse favours guarantee –Low lapse favours AAE

37. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Choice of CTE Level 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?

38. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Choice of CTE Level (cont’d) CTE 80In range of SOP Awkward (?) if CTE level for guarantees is lower than 80 CTE 95Solvency-oriented  Expect Ed. note will endorse two methods: –CTE 60 –CTE X where X is between 60 and 80

39. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Policyholder Behaviour – Summary 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

40. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 Guiding Principles Option exercise correlated with in-moneyness Anti-selection Consider reasonable expectations PH sophistication & perceived financial interest in policy < 100% efficiency