CIA Annual Meeting Assemblée annuelle de l’ICA

CIA Annual MeetingAssemblée annuelle de l’ICA June 29 & 30, 2006 Ÿ Les 29 et 30 juin 2006 Ottawa, Ontario Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Term of the Liability Session Val-5 CLIFR Part II

Standards 2320.16 through .27 Highlights: 2320.16 => if element of policy operates independently of the policy, it has its own term 2320.18 defines “renewal”, “adjustment” and “constraint” 2320.19 => may take account of one or more renewals / adjustments after B/S date 2320.20 => extend term with caution CIA Annual Meeting ŸAssemblée annuelle de l’ICA SOP Summary Session Val-5 CLIFR Part II

Highlights: 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 2320.23 => term extension to offset acquisition or similar expenses 2320.24 => write-down of AAE and recoverability testing CIA Annual Meeting ŸAssemblée annuelle de l’ICA SOP Summary (cont’d) Session Val-5 CLIFR Part II

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 But at what level of aggregation? CIA Annual Meeting ŸAssemblée annuelle de l’ICA What to Conclude Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Term of the Liability – Practical Challenges Session Val-5 CLIFR Part II

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 (see examples) For simplicity, assume no AAE! CIA Annual Meeting ŸAssemblée annuelle de l’ICA Challenge 1 – Hedging Session Val-5 CLIFR Part II

Product 10-year 100% return-of-premium maturity guarantee No death benefit guarantees No resets Total MER = 200 bps Fund expenses = 135 bps Fund mapped 100% to S&P 500 CIA Annual Meeting ŸAssemblée annuelle de l’ICA Hedging Example Session Val-5 CLIFR Part II

Hedging details Put options purchased on S&P 500 Structured to match the guarantee payable on the maturity date Valued using Black-Scholes calibrated to current market prices CIA Annual Meeting ŸAssemblée annuelle de l’ICA Hedging Example Session Val-5 CLIFR Part II

Valuation method & assumptions S&P 500 projected under 1,000 calibrated scenarios Account values and cashflows projected off the S&P 500 up to contract maturity date Fees less expenses Guarantee costs less put option payoffs (net to ~ 0) Discounted at 5%, no lapses or deaths for simplicity CTE 80 Reserve from this method is equivalent to PV expenses – PV fees at 5% / CTE 80 + cost of guarantee (=MV of puts) CIA Annual Meeting ŸAssemblée annuelle de l’ICA Hedging Example Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Hedging Example – Liability Data Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Hedging Example – S&P 500 Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Steady Rise Scenario – At June 30, 2006 (t=0 / S&P=1250) Balance Sheet Summary Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Steady Rise Scenario – 5 Year Summary Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Rise & Fall Scenario – At June 30, 2006 (t=0 / S&P=1250) Balance Sheet Summary Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Rise & Fall Scenario – 5 Year Summary Session Val-5 CLIFR Part II

How to apply zero floor at a finer level of aggregation than hedging portfolio? Options aren’t allocated to cohorts in practice Value of options added to reserve “drops off” when total reserve becomes negative Since term becomes zero Is the balance sheet position appropriate? How do you explain earnings when zero floor kicks in, given change in the stock market? CIA Annual Meeting ŸAssemblée annuelle de l’ICA Observations Session Val-5 CLIFR Part II

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” CIA Annual Meeting ŸAssemblée annuelle de l’ICA Challenge 2 – Cashflow Asymmetry Session Val-5 CLIFR Part II

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? CIA Annual Meeting ŸAssemblée annuelle de l’ICA Example Session Val-5 CLIFR Part II

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? CIA Annual Meeting ŸAssemblée annuelle de l’ICA Example (cont’d) Session Val-5 CLIFR Part II

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 CIA Annual Meeting ŸAssemblée annuelle de l’ICA Example (cont’d) Income (after claim payment) Session Val-5 CLIFR Part II

Here the issue is more significant if you don’t hedge Is the balance sheet position appropriate? With seriatim floor? With aggregate floor? No floor? One option is to choose the term on an aggregate level by choosing the term that maximizes liability (may involve renewing cohort 1) CIA Annual Meeting ŸAssemblée annuelle de l’ICA Observations Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Recoverability Testing for AAE Session Val-5 CLIFR Part II

Use MfADded assumptions Direction chosen appropriate in aggregate High lapse favours guarantee Low lapse favours AAE CIA Annual Meeting ŸAssemblée annuelle de l’ICA Non-Economic Assumptions Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Choice of CTE Level Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICAChoice of CTE Level (cont’d) • Ed note will endorse two methods: • CTE 60 • CTE X Session Val-5 CLIFR Part II

Term of the liability reads literally as a seriatim concept However, common/accepted practice thought to be at portfolio-wide level Banks, mutual funds Consistent with US GAAP and International GAAP No recognition of cash flows for a policy beyond its term of the liability, but deficiencies can offset excesses (see example) CIA Annual Meeting ŸAssemblée annuelle de l’ICA Level of Aggregation Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Level of Aggregation– Example Session Val-5 CLIFR Part II

Acceptable practice: Aggregate across policies A and B Total AAE = 200 Total PV cashflow (TOL) = 205 (90+115) Test is satisfied CIA Annual Meeting ŸAssemblée annuelle de l’ICA Level of Aggregation– Example (cont’d) Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Level of Aggregation– Revised Example Session Val-5 CLIFR Part II

Same level of aggregation yields: Total AAE = 200 Total PV cashflow (over TOL) = 195 (90+105) Test is not satisfied It is not acceptable to extend Policy A to 5 years to satisfy the test as follows: Total AAE = 200 Total PV cashflow (over 5 yrs) = 205 (100+105) CIA Annual Meeting ŸAssemblée annuelle de l’ICA Level of Aggregation – Revised Example (cont’d) Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Policyholder Behaviour Session Val-5 CLIFR Part II

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 CIA Annual Meeting ŸAssemblée annuelle de l’ICA Summary Session Val-5 CLIFR Part II

Option exercise correlated with in-moneyness Anti-selection Consider reasonable expectations PH sophistication & perceived financial interest in policy < 100% efficiency CIA Annual Meeting ŸAssemblée annuelle de l’ICA Guiding Principles Session Val-5 CLIFR Part II

CIA Annual Meeting ŸAssemblée annuelle de l’ICA Questions?(or comments, criticisms, accusations, threats, or even accolades) Session Val-5 CLIFR Part II

CIA Annual Meeting Assemblée annuelle de l’ICA