1. S.3855 Actuarial Challenges Igor Afanassiev Prepared by Lesley Thomson

2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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 (1060-960))  Statement liability = $960 (=1000-40)

16. 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 (1150-1000))  Total after-tax liability (with DDTL) = $1150  Tax Reserve = $1060  DTL (related to liabilities) = $-20 (=.4x (1060-1110))  Statement liability = $1110 (=1150-40)

17. 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. 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. 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. 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 (1150-1000))  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 (=1090-60)

21. 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. 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. 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. 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. 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. 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. 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. 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. 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. 30 Issue – AuG43  Additional AuG43 audit requirements coming at the same time  Approach to valuation will need to be well documented

31. 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. 32 Issue – Reporting Changes  DCAT  SOE  EV, VNB  Business Plans  AAR  Notes, MD&A Disclosures

33. 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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