Implication of Asset in liabilities valuation and capital requirement Kin Chung Chan, FSA, FCIA, FLMI VP Actuary Cor

1. Implication of Asset in liabilities valuation andcapital requirementKin Chung Chan, FSA, FCIA, FLMIVP & ActuaryCorporate Actuarial

2. Topics for discussion Implication of assets and investment strategy in Canadian Valuation Methodology : Canadian Asset Liability Method (CALM) Asset capital requirement under Canadian Capital Framework : Minimum Continuing Capital and Surplus Requirements (MCCSR) IFRS brings unknown changes

3. CALM Policy liabilities calculated under CALM (CIA SOP 2320.02) The amount of the policy liabilities calculated under CALM for a particular scenario is equal to the amount of supporting assets at the balance sheet date which are forecasted to reduce to zero at the last liability cash flow in that scenario Liability grouping and asset segmentation (CIA SOP 2320.09) The actuary would usually apply the Canadian asset liability method to policies in groups which reflect the insurer’s asset-liability management practice for allocation of assets to liabilities and investment strategy. That application is a convenience, however, which would not militate against calculation of policy liabilities that, in the aggregate, reflect the risks to which the insurer is exposed

4. CALM (continued) Forecast of cash flow (CIA SOP 2320.41) In calculating policy liabilities, the actuary would allocate assets to the liabilities at the balance sheet date, forecast their cash flow after that date, and, by trial and error, adjust the allocated assets so that they reduce to zero at the last cash flow.

5. CALM (continued) Scenario assumptions: Interest rates (CIA Sop 2330) 2330.01 : An interest rate scenario comprises, for each forecast period between the balance sheet date and the last cash flow, An investment strategy, and An interest rate for each risk-free asset and the corresponding premium for each asset subject to default 2330.04 : The investment strategy defines reinvestment and disinvestment practice for each type, default risk classification, and the term of the invested assets which support policy liabilities. Assumption of the insurer’s current investment strategy implies investment decisions of reinvestment and disinvestment in accordance with that strategy and hence the risk inherent in that strategy.

6. CALM (continued) Prescribed scenarios 2330.10 : Because future investment returns and inflation rates are so conjectural, it is desirable that the calculation of policy liabilities for all insurers take account of certain common assumptions. There are therefore nine prescribed scenarios which follow. 2330.15 : the prescribed scenarios provide guidance on interest rates for sale and purchase of investments and on the type and term of investments purchased, but provide no guidance on the type and term of investments sold.

7. CALM (continued) Implication of integrating asset and investment strategy in CALM Market value changes in assets The CALM reserve is a cash flow reserve, the changes in market value of debt assets in accounting statement would not introduce gain/loss as the level of reserve is reported at the market value of the Hold-for-trading assets required in calculating the CALM reserve Change in market value of equity assets does affect the calculation of CALM reserve as selling of such assets is per schedule of selling in the CALM model Change in credit spread will be reflected in asset modeling in CALM and hence impact cash flows in investing and disinvesting on debt assets

8. CALM (continued) Implication of integrating asset and investment strategy in CALM (continued) Importance of a dynamic governance framework to ensure investment practice and investment strategy are synchronised Given the impact of reinvesting and disinvesting of assets in the model, a strong governance is needed to protect the integrity of the reserve calculation, yet allow a sound and dynamic investment practice Two examples In a highly depressed equity market and with a further stressed test on the equity by dropping the market value by another 40%, it would be considered an unusual situation that warrants judgment to change asset purchasing and selling strategy to be inline with investment practice A temporary over-investment in risk free government bonds at a time when investing in corporate bonds are deemed risky

9. Overview of MCCSR Minimum Continuing Capital and Solvency Requirement Capital Required 5 main categories plus others Evolving over time as investment assets and insurance products changes Available Capital Permanent, free of mandatory fixed charges against earnings, and subordinated legal position to the rights of policyholders Separate into Tier 1 and Tier 2, Tier 1 capital with a supervisory target ratio of 105% MCCSR Ratio Supervisory target is 150%

10. Overview of MCCSR (continued) Minimum Continuing Capital and Solvency Requirement Unregistered Reinsurance treatment Cannot take solvency credit unless dedicated asset available to back ceded liabilities Opinion of the Appointed Actuary Covers both capital required and available capital calculation

11. Overview of MCCSR (continued) Available Capital Tier 1 Surplus Appropriations (subtracted) Goodwill (subtracted) Innovative instrument OCI (negative) Tier 2 OCI (positive) Subordinated debt Appropriations (added) Out of Canada Terminal Dividend Non-life investments and other (subtracted)

12. Overview of MCCSR (continued) Required capital asset default risk (C-1) mortality/morbidity/lapse Risk interest margin pricing risk changes in interest rate environment risk segregated funds risk other risk off balance sheet exposures indexed linked pass through products

13. Asset default risk (C-1) Asset default factor Short-term securities (original maturities of less than one year) 0% - 2% Bonds/Loans/Private Placements Rating based 0% - 16% Can use company internal rating if external rating not available

14. Asset default risk (C-1) (continued) Asset default factors Mortgages By type of mortgaged property 2% - 8% asset default risk (C-1) Equity and Mutual Fund Instruments Preferred stocks: from 1% to 15% Common stocks: 15%

15. Asset default risk (C-1) (continued) Asset Replicated Synthetically and Derivatives Transactions Credit Protection Provided Same as holding the security directly Short Positions in Equities Same as holding the net exposure of the underlying equity Futures, Forwards and Swaps Report the equivalent of the spot position Futures contract to purchase equities will report the market value of the equities underlying the futures contract Swap will report the long position

16. Asset default risk (C-1) (continued) Asset Replicated Synthetically and Derivatives Transactions Options on Equities Capital charge determined by a 2-dimensional matrix of changes in the value of the option position under various market scenarios Alternative treatment for purchased option is to deduct the carrying value of the option from the available capital Options hedge recognition Allowed if option’s reference asset is exactly the same as the asset held

17. Asset default risk (C-1) (continued) Asset Replicated Synthetically and Derivatives Transactions Equity-Linked Notes Need to be decomposed into the sum of a fixed-income amount, and the value of the option embedded within the note Convertible bonds Capital charge is equal to the charge for the bond’s fixed-income component plus the equity option charge for the bond’s embedded warrant Alternative is treat the full carrying amount of the convertible bond as an equity exposure

18. Evolving capital framework Based on November 2008 document Target Assets Requirement equals best estimate of its insurance obligations plus a solvency buffer Four risk categories Credit Market Insurance Operational Issued draft for calculation of solvency buffer for market risk in November 2008

19. Evolving capital framework (continued) Approach to calculate solvency buffer for market risk Same risk same solvency buffer Consistent with future modeling approach Deterministic stress tests Calibration Measure risk by legal entity Hedging

20. Evolving capital framework (continued) Market risk categories Interest rate Interest rate spread Equities Real estate Currency Market option Liability market option Asset market option

21. Evolving capital framework (continued) Procedure to calculate the solvency buffer No reinvestment of cash flows Assume cash flow from non-interest sensitive assets are teir market value at time zero Base scenario is the net present value of the asset and liability cash flows Calculate the net present value of the asset and liability cash flow under 5 prescribed scenarios The solvency buffer is the largest negative difference between the base scenario and the net present value of the cash flow mismatches

22. Conclusion Valuation in phase 2 of IFRS suggested that reserve will be calculated using a discounting method instead of CALM Asset will not be part of the valuation model Capital framework will be changed significantly Modeling is needed for calibration Total balance sheet approach Implications for product design Classification of insurance contracts vs. investment contracts Capital and income implication

23. Questions ??