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PENSION SEMINAR PS-5: OUTSIDER S VIEW ON PENSIONS April 25, 2006, Montreal

Standard Appointed Actuary's Report - Excerpts. I have valued the policy liabilities and their change in the statement of income for the year then ended in accordance with accepted actuarial practice, including selection of appropriate assumptions and methods.In my opinion, the amount of polic

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PENSION SEMINAR PS-5: OUTSIDER S VIEW ON PENSIONS April 25, 2006, Montreal

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    1. PENSION SEMINAR PS-5: OUTSIDER’S VIEW ON PENSIONS April 25, 2006, Montreal LIFE INSURANCE VIEW PAUL M. WINOKUR

    2. Standard Appointed Actuary’s Report - Excerpts I have valued the policy liabilities … and their change in the statement of income for the year then ended in accordance with accepted actuarial practice, including selection of appropriate assumptions and methods. In my opinion, the amount of policy liabilities makes appropriate provision for all policyholder obligations and the financial statements fairly present the results of the valuation. This is the opinion which appears in the audited financial statements, as well as in the OSFI statement. It is very public, and there is no counterpart for this under US GAAP, although there is a public opinion for US Statutory,This is the opinion which appears in the audited financial statements, as well as in the OSFI statement. It is very public, and there is no counterpart for this under US GAAP, although there is a public opinion for US Statutory,

    3. Guidance – Sampling only - in addition to S.O.P’S Annual Memorandum to the AA from OSFI – over 50 pages Annual Guidance Memo to the AA from the Committee on Life Insurance Financial Reporting (CLIFR) – over 10 pages OSFI Guideline on External Peer Review - 2003 -10 pages CIA Educational Notes – Sampling: - Margins for Adverse Deviation – 2005 – 27 pages - Best Estimate Assumption for Expenses – 2005 – 47 pages More CIA Educational Notes Selection of Interest Rate Models – 2003 – 4 pages Aggregation and Allocation of Liabilities – 2003 – 13 pages Future Income and Alternative Taxes – 2002 – 22 pages Sources of Earnings: Determination and Disclosure – 2004 – 16 pages Approximations to CALM – 2004 - 10 pages Segregated Fund Investment Guarantees-2005; refers to two CIA Papers totaling 144 pages Review of the Work of Another Actuary – 2003 – 10 pages More CIA Educational Notes Selection of Interest Rate Models – 2003 – 4 pages Aggregation and Allocation of Liabilities – 2003 – 13 pages Future Income and Alternative Taxes – 2002 – 22 pages Sources of Earnings: Determination and Disclosure – 2004 – 16 pages Approximations to CALM – 2004 - 10 pages Segregated Fund Investment Guarantees-2005; refers to two CIA Papers totaling 144 pages Review of the Work of Another Actuary – 2003 – 10 pages

    4. Policyholder Reasonable Expectations (PRE) Policyholder reasonable expectations are the expectations which may be imputed to policyholders as their reasonable expectations of the insurer’s exercise of discretion, and arise from the insurer’s : communication in marketing and administration, past practice, current policy, and general standards of market conduct. The valuation must take PRE’s into account. i.e. if policyholders can select against the company, then assume that they do. The insurer’s policies define contractually its obligations to its policyholders. The contractual definition may leave certain matters to the insurer’s discretion, such as the determination of policyholder dividends, experience-rating refunds, and the right to adjust premiums Matters left to the insurer’s discretion implicitly include underwriting and claim practices, and the right to waive contractual rights and to create extra-contractual obligations. The insurer’s policies define contractually its obligations to its policyholders. The contractual definition may leave certain matters to the insurer’s discretion, such as the determination of policyholder dividends, experience-rating refunds, and the right to adjust premiums Matters left to the insurer’s discretion implicitly include underwriting and claim practices, and the right to waive contractual rights and to create extra-contractual obligations.

    5. Canadian Asset Liability Method (CALM) The amount of policy liabilities 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. Note: The Policy Premium Method is really a form of CALM. The valuation is a “going-concern” i.e. assume we are open to new business, but new business is not directly used in the valuation. Under CALM or Policy Premium Method (PPM), front ending of profits can occur, but this is infrequent, once PFAD’s are reflected. Reserves can also be negative, which is largely due to an offset against deferred acquisition costs, which are generally not used under Canadian GAAP for life companies. CALM, by its very nature can result in great volatility, since the present values can change dramatically as assumptions change. There is some offset on income from the asset valuation methods (which are changing effective in 2007, per the CICA). The CIA guidance allows from some adjustment for Cyclicality in assumption setting, where there is credible evidence in nature, such as in asset defaults and disability incidence rates. The valuation is a “going-concern” i.e. assume we are open to new business, but new business is not directly used in the valuation. Under CALM or Policy Premium Method (PPM), front ending of profits can occur, but this is infrequent, once PFAD’s are reflected. Reserves can also be negative, which is largely due to an offset against deferred acquisition costs, which are generally not used under Canadian GAAP for life companies. CALM, by its very nature can result in great volatility, since the present values can change dramatically as assumptions change. There is some offset on income from the asset valuation methods (which are changing effective in 2007, per the CICA). The CIA guidance allows from some adjustment for Cyclicality in assumption setting, where there is credible evidence in nature, such as in asset defaults and disability incidence rates.

    6. CIA Task Force Report on Actuarial Liability Consistency – May 2003 - Excerpts Appropriate Volatility includes a change in liabilities that reflects a reasonable change in the future expected experience or in the level of risk assumed. Inappropriate Volatility arises whenever the change in liabilities is not commensurate with a reasonable change in the future expected experience or in the level of risk. Considerations of limiting inappropriate volatility suggest the use of some form of an averaging process or a smoothing mechanism when setting assumptions. Several commonly used methods to reduce in appropriate volatility are discussed in the report. Examples of inappropriate volatility are: The change in liabilities reflects the assumption that an incurred event is permanent when the actuary has sufficient reason to believe it is temporary. There is change in expected assumption without the occurrence of an event that changes expected future experience. There is a change in the provision for adverse deviation which is not related to a change in the level of risk. There is a great deal of disclosure in the audited financials and in the AA Report to OSFI regarding changes in assumptions. Consistency from one year to the next is considered to be very important, so that there is no hint of manipulating earnings. Several commonly used methods to reduce in appropriate volatility are discussed in the report. Examples of inappropriate volatility are: The change in liabilities reflects the assumption that an incurred event is permanent when the actuary has sufficient reason to believe it is temporary. There is change in expected assumption without the occurrence of an event that changes expected future experience. There is a change in the provision for adverse deviation which is not related to a change in the level of risk. There is a great deal of disclosure in the audited financials and in the AA Report to OSFI regarding changes in assumptions. Consistency from one year to the next is considered to be very important, so that there is no hint of manipulating earnings.

    7. Statement of Principles Regarding Selection of Independently Reasonable Assumptions: To All Fellows - Feb 21, 2006 from Practice Standards Council; Comment Deadline: April 3, 2006 In general, each actuarial assumption will be independently reasonable. When an actuarial assumption is not independently reasonable, the justification will arise from a list of narrow exceptions. Thus, actuaries will be rigorous and transparent in their assumption-setting. Users will know when, and understand why, any chosen assumptions are not independently reasonable, with common-sense exceptions. Thus, actuaries will be rigorous and transparent in their assumption-setting. Users will know when, and understand why, any chosen assumptions are not independently reasonable, with common-sense exceptions.

    8. Provisions For Adverse Deviation (PFAD’s) Each assumption requires a separately disclosed and quantified margin for adverse deviation Expenses: 2.5% to 10% of expected Insurance Mortality: 3.75 to 15.0 per 1,000 rate divided by attained age life expectation Annuitant Mortality: 5% to 15% of expected Morbidity: 5% to 20% of expected Lapsation: 5% to 20% of expected Asset default: 25% to 100% of expected These PFAD’s cover everything except interest rate and equity margins. The margins for the latter are discussed later under CALM. Overall solvency is achieved by the combination of PFAD’s and minimum surplus requirements. Based on a CIA Survey in 2000, mean total PFAD’s as a % of liabilities were: -Par Life: 10% -Non-Par Adjustable: 15% -Universal Life: 19% -Non-Par, Non-Adjustable: 56% * Group Life: 15% - Group A&S: 5% - Deferred Annuities: 1.2 % -Payout Annuities: 2.6% * this is likely very high due to the relatively new books of business at the time.. The % declines as the book matures. Also, the median for this line was 25%, rather than 56%. These PFAD’s cover everything except interest rate and equity margins. The margins for the latter are discussed later under CALM. Overall solvency is achieved by the combination of PFAD’s and minimum surplus requirements. Based on a CIA Survey in 2000, mean total PFAD’s as a % of liabilities were: -Par Life: 10% -Non-Par Adjustable: 15% -Universal Life: 19% -Non-Par, Non-Adjustable: 56% * Group Life: 15% - Group A&S: 5% - Deferred Annuities: 1.2 % -Payout Annuities: 2.6% * this is likely very high due to the relatively new books of business at the time.. The % declines as the book matures. Also, the median for this line was 25%, rather than 56%.

    9. Mortality Improvement - in addition to margins for adverse deviation Deferred and Payout Annuities minimum recommended rates (modified Scale AA) “It is prescribed that the actuary’s best estimate includes a secular trend toward lower mortality rates as promulgated from time to time.” (Consolidated Standards of Practice, Section 2350.11) “It is prescribed that the actuary’s best estimate includes a secular trend toward lower mortality rates as promulgated from time to time.” (Consolidated Standards of Practice, Section 2350.11)

    10. Mortality Improvement Life Insurance can assume future improvements in best-estimate rates but must be offset by higher margin for adverse deviation, so no actual reduction in liabilities results “If the actuary’s best estimate assumption includes a secular trend toward lower mortality rates whose effect is to reduce the policy liabilities, then it is prescribed that the actuary negate that trend by an offsetting increase or decrease in what the actuary would otherwise select as a margin for adverse deviations.” (Consolidated Standards of Practice, Section 2350.05) “If the actuary’s best estimate assumption includes a secular trend toward lower mortality rates whose effect is to reduce the policy liabilities, then it is prescribed that the actuary negate that trend by an offsetting increase or decrease in what the actuary would otherwise select as a margin for adverse deviations.” (Consolidated Standards of Practice, Section 2350.05)

    11. CALM Prescribed Scenarios – Interest Rates Base Scenario – current yield curve 7 Prescribed Scenarios tests increases, decreases, non-parallel most adverse used to calculate liabilities “plausible range” 5% to 12% for long rates “plausible range” 3% to 10% for short rates Future: plausible range based on formula The current yield curve is key. If it happens to plunge as of the valuation date, that is still what must be used. There is no smoothing on this assumption. But, there is judgment allowed in setting the overall margin.The current yield curve is key. If it happens to plunge as of the valuation date, that is still what must be used. There is no smoothing on this assumption. But, there is judgment allowed in setting the overall margin.

    12. CALM Prescribed Scenarios (cont’d) Reinvestment / disinvestment Based on insurer’s own investment policy After 20 yrs reinvest into gov’t bonds only Equity (non-fixed income) investments Margin on assumed income: 5% to 20% Margin on assumed capital gains: 20% Also assume 25% to 40% market value drop at time when most adverse Fixed Income reinvestments are restricted between years 2 and 20 as to type and term. e.g. If current policy is to buy lots of very long strips and corporates, the valuation must assume that over 20 years, the reinvestments gradually move to only conventional governments and with a maximum term of 15 years. Equity spreads over bonds have to be based on reliable. Long term, historical evidence. For general fund products. i.e other than Segregated Funds, there are effective limits to Investments backing liabilities generally as follows: -life products: max. of 25% equities, a max. of 15% in real estate, and no more than 40% for equities an real estate combined (or for non-par business, a max, of 20% combined) -annuity and disability products: max. of 5% equities, a max. of 5% in real estate, and no more than 5% for equities and real estate combined For assets backing surplus, equities cannot exceed 70%,and real estate cannot exceed 70%. Fixed Income reinvestments are restricted between years 2 and 20 as to type and term. e.g. If current policy is to buy lots of very long strips and corporates, the valuation must assume that over 20 years, the reinvestments gradually move to only conventional governments and with a maximum term of 15 years. Equity spreads over bonds have to be based on reliable. Long term, historical evidence. For general fund products. i.e other than Segregated Funds, there are effective limits to Investments backing liabilities generally as follows: -life products: max. of 25% equities, a max. of 15% in real estate, and no more than 40% for equities an real estate combined (or for non-par business, a max, of 20% combined) -annuity and disability products: max. of 5% equities, a max. of 5% in real estate, and no more than 5% for equities and real estate combined For assets backing surplus, equities cannot exceed 70%,and real estate cannot exceed 70%.

    13. CALM Additional Scenarios Actuary must select other scenarios “appropriate to the circumstances of the insurer” For testing and disclosure only These would often be more adverse than prescribed scenarios Not required to base liabilities on these, but permitted to do so Typical margins for fixed income fall within a range of 50 to 200 basis points per annum. The high end of the range was more prevalent when prevailing rates were much higher. These margins are in addition to future default provisions. Examples of mean future annual default provisions , inclusive of margins for adverse deviation, from a 2004 CIA Survey are: AA Provincial Bonds: 11 bp’s BBB Provincials: 27 bp’s AA Corporate Bonds: 23 bp’s BBB Corporates: 60 bp’s AA Private Placements: 29 bp’s BBB Private Placements: 65 bp’s If a line of business is extremely well matched and there are no long term guarantees , nor interest rate floors, then the CALM interest rate margins held can be quite low. This is especially common for participating business or fully adjustable non-par business. Typical margins for fixed income fall within a range of 50 to 200 basis points per annum. The high end of the range was more prevalent when prevailing rates were much higher. These margins are in addition to future default provisions. Examples of mean future annual default provisions , inclusive of margins for adverse deviation, from a 2004 CIA Survey are: AA Provincial Bonds: 11 bp’s BBB Provincials: 27 bp’s AA Corporate Bonds: 23 bp’s BBB Corporates: 60 bp’s AA Private Placements: 29 bp’s BBB Private Placements: 65 bp’s If a line of business is extremely well matched and there are no long term guarantees , nor interest rate floors, then the CALM interest rate margins held can be quite low. This is especially common for participating business or fully adjustable non-par business.

    14. CALM Additional Scenarios (cont’d) The Actuary is encouraged to: Test scenarios outside “plausible range” Especially low-interest scenarios Other recommended scenarios (2005): CLIFR – drop to 75% of current yields, then recover over 20 yrs to 3% (short), 5%(long) OSFI – flat 4% yield curve The actuary is not permitted to assume that interest rates will increase after the valuation date, even if rates are 40 year lows. Indeed, even if rates are at 40 year lows, the AA is required to assume that the rates will decrease further, through the CALM margin setting process. The actuary is not permitted to assume that interest rates will increase after the valuation date, even if rates are 40 year lows. Indeed, even if rates are at 40 year lows, the AA is required to assume that the rates will decrease further, through the CALM margin setting process.

    15. CALM Stochastic Testing May calculate liabilities stochastically Liabilities in range CTE(60) to CTE(80) Must be greater than under worst prescribed scenario (future: if not, justify) No formal model calibration criteria yet Stochastic Testing is required for material blocks of Segregated Fund business, but is not yet required for General Fund products. CIA Guidance emphasizes that changes in CTE coverage levels from period to period cannot be changed in a way to manipulate current period earnings. Any changes need to be actuarially sound by producing a change in the PFAD that is consistent with a change in the level of risk, and it must be well documented. Stochastic Testing is required for material blocks of Segregated Fund business, but is not yet required for General Fund products. CIA Guidance emphasizes that changes in CTE coverage levels from period to period cannot be changed in a way to manipulate current period earnings. Any changes need to be actuarially sound by producing a change in the PFAD that is consistent with a change in the level of risk, and it must be well documented.

    16. Dynamic Capital Adequacy Testing (DCAT) The insurer’s financial condition is satisfactory if throughout the forecast period it is able to meet all its future obligations under the base scenario and all plausible adverse scenarios, and under the base scenario it meets the minimum regulatory capital requirement. DCAT Opinion – Standard Conclusion ….In my opinion, the financial condition of the company is satisfactory. DCAT Opinion-Extract I have analyzed the forecasted financial positions of the company during the five-year forecast period under a series of scenarios. A description of these scenarios and their impact on the company is included within this report. The analysis incorporates assumptions relating to business growth, investments, and other internal and external conditions during the forecast period as well as potential management responses to various plausible adverse scenarios. The most significant assumptions are described within this report. Unlike the valuation, DCAT makes explicit provisions for new business, for 5 years, under various sales scenarios. NOTE: this is not a public opinion, but the public audited financials state that “The AA is required each year to analyze the financial condition of the company and prepare a report for the Board.” In the 2005 financials, the following would also be included: “The 2005 analysis tested the capital adequacy of the company until December 31, 2009 under various economic and business conditions.” I should add that at one point , Council wanted the actual Opinion to be public, but many of us convinced Council that was not desired. DCAT Opinion-Extract I have analyzed the forecasted financial positions of the company during the five-year forecast period under a series of scenarios. A description of these scenarios and their impact on the company is included within this report. The analysis incorporates assumptions relating to business growth, investments, and other internal and external conditions during the forecast period as well as potential management responses to various plausible adverse scenarios. The most significant assumptions are described within this report. Unlike the valuation, DCAT makes explicit provisions for new business, for 5 years, under various sales scenarios. NOTE: this is not a public opinion, but the public audited financials state that “The AA is required each year to analyze the financial condition of the company and prepare a report for the Board.” In the 2005 financials, the following would also be included: “The 2005 analysis tested the capital adequacy of the company until December 31, 2009 under various economic and business conditions.” I should add that at one point , Council wanted the actual Opinion to be public, but many of us convinced Council that was not desired.

    17. Sensitivity Disclosure in Notes to Audited Financial Statements – Recent Example Policy Liabilities $80 Billion Capital and Surplus $15 Billion Increase (Decrease) in Earnings: Interest Rates - 1% increase $40 million - 1% decrease ($120) million Equities - 10% increase $110 million - 10% decrease ($120) million Interest Rate shift represents a 100 basis point parallel shift in assumed interest rates across the entire yield curve. Note: A typical DCAT scenario currently, could combine a 2% decrease in interest rates with a 25% to 30% decrease in equities. The DCAT results are not public. Interest Rate shift represents a 100 basis point parallel shift in assumed interest rates across the entire yield curve. Note: A typical DCAT scenario currently, could combine a 2% decrease in interest rates with a 25% to 30% decrease in equities. The DCAT results are not public.

    18. Investor Expectations Bill Chinery – CIA Bulletin – Dec. 1998 – “Many of the real returns we have seen in the past are not replicable.” “One thing that we find shocking is the real return expectations that investors use today in their asset allocation planning.” “Pension plan sponsors will gradually reshape their own expectations from 5%+ real returns for the typical balanced portfolio, to 2% to 4% real returns.” Note: For life AA’s, management’s and AA’s Base Scenarios ideally need to be the same The AA must use best estimates for each assumption, plus a margin for adverse deviation. If the AA and management have a different view of the future, such as future sales level, then that must be disclosed in the DCAT Report. In the extreme and hopefully very rare case, the AA would use a different base scenario in DCAT than management’s business plan. The AA must use best estimates for each assumption, plus a margin for adverse deviation. If the AA and management have a different view of the future, such as future sales level, then that must be disclosed in the DCAT Report. In the extreme and hopefully very rare case, the AA would use a different base scenario in DCAT than management’s business plan.

    19. CIA DCAT Survey of Appointed Actuaries - 2003 - Excerpts 92 replies - 60 life insurers + 32 P & C insurers Recommendations by the AA: Out of 25 comments received, 17 recommended significant actions; in their DCAT’s an average 1 to 3 was made. CIA-SOP requires AA to identify extraordinary management actions which could lessen the likelihood or threat to satisfactory financial condition. E.g. extreme case: (a) recommend to stop writing new business (b) Insurance Companies Act – Section 369 – AA’s role in“whistle blowing”on material adverse condition If the AA identifies a material adverse condition, then the AA cannot wait until the time of the annual DCAT Report. The AA must notify the CEO and CFO in writing of the financial condition and identify that rectification is required. The AA, who makes such a report, must also “forthwith provide a copy of it to the directors of the company”. Further, where in the AA’s opinion, suitable action is not taken to rectify, the AA “shall forthwith send a copy of the report to the Superintendent, and advise the directors that the AA has done so.”If the AA identifies a material adverse condition, then the AA cannot wait until the time of the annual DCAT Report. The AA must notify the CEO and CFO in writing of the financial condition and identify that rectification is required. The AA, who makes such a report, must also “forthwith provide a copy of it to the directors of the company”. Further, where in the AA’s opinion, suitable action is not taken to rectify, the AA “shall forthwith send a copy of the report to the Superintendent, and advise the directors that the AA has done so.”

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