Reserving for Guarantees in Non-Participating Products

1. 24th India Fellowship Seminar Reserving for Guarantees in Non-Participating Products Mentor: AkshayDhand Presented by: RipudamanSethi Shilpi Jain KrithikaVerma Mumbai 10th – 11th December 2015 Indian Actuarial Profession Serving the Cause of Public Interest

2. Agenda www.actuariesindia.org Types of guarantees under non par products Why reserve for Guarantees? Professional and Regulatory considerations Different methods of reserving for Guarantees Other considerations

3. Types of Guarantees under Non Par Products www.actuariesindia.org • Non Par products or guarantees can be broadly classified into two categories • Containing an Embedded Derivative i.e. policy cash flows tend to vary according to an external factor such as interest rate. For Example: Guaranteed Annuity Option, Guaranteed return under a linked product, Insurability (Mortality) Options • Fully guaranteed i.e. policy cash flows are not modified according to an external factor For example: Fixed Maturity benefit under an Endowment

4. NP Guarantees with NO Embedded Derivative www.actuariesindia.org For some non-par products, the benefits are fully guaranteed and may thus be assumed to have no underlying embedded derivatives Hedging these guarantees using fixed assets of appropriate duration and currency- effectively no cost of hedging Reserve for Guarantees via Gross Premium Approach However, useful to test the impact of the guaranteed benefits as the assets are not always matching the liability perfectly- Possibly reserved through MAD or Mismatch provision But no explicit Cost of Guarantee required (as per GN 22) assuming insurance experience as expected

5. NP Guarantees with Embedded Derivatives www.actuariesindia.org For Capital Guarantee under Linked business, the cost of minimum guaranteed benefits is dependent on external factors e.g. stock price For Guaranteed Annuity Option, the cost of minimum guaranteed annuity is dependent on external factors e.g. bond yields Such guaranteed payout can be viewed as an embedded (put) option Gross Premium Valuation captures only intrinsic value of guarantees and hence may not capture the full cost of Guarantee Explicit Cost of Guarantee required – Recommended practice as per GN 22 Reserve = Base Reserve + (Time) Value of Embedded Derivative

6. Why Reserve for Guarantees ? www.actuariesindia.org • There is a cost of providing Guarantees which may arise due to • Asset Liability Mismatch • By Nature : Liabilities are fixed but Assets are not • By Duration: Longer for Liabilities than assets and hence potential re-investment risk • Inability of the insurer to increase premium/charges • Policyholder Behavior e.g. mass surrenders • Unfavorable insurance experience • Implicit Guarantees caused by Market Competition and PRE • Changes in external factors (affects the cost of embedded derivatives)

7. Professional and Regulatory Considerations www.actuariesindia.org

8. IRDA (Assets, Liabilities, and Solvency Margin of Insurers) Regulations, 2000 www.actuariesindia.org

9. • Market-Consistent or • Fair Valueof Embedded • Derivative • • Simulation-Based • Techniques • • Linked with Guarantees • • Based on most Recently available Market Data • • • Best Estimate of all • Contingencies • • Stochastic Models • Recommended • • Alternative Models • may be used in certain • Circumstances Guidance Note (GN) 22 Scope Assumptions • • Participating Business • • Other Lines of Business • with Embedded • Derivatives Method Models www.actuariesindia.org

10. Parameterization of the Model GN 22: Asset Models Economic Scenario Generators Calibration of the Tail of the Distribution Calibration of the Model Stochastically Model Investment Returns Number of Iterations www.actuariesindia.org

11. Asset Models Liability Models Reserve = Average across all Simulations Calculate Liabilities allowing for Policyholder Behavior Discount the shortfall to Valuation Date Project Assets allowing for Management Action GN 22: Calculating Reserves www.actuariesindia.org

12. Investment Guarantee - Alternatives • Company purchases assets to back the guarantees offered • Insufficiency or mismatch of assets and liability payouts can be hedged using derivatives • There arises a cost from purchasing & holding a derivative • Stochastic techniques are most suitable to explain the underlying variability & cost involved www.actuariesindia.org

13. Real World - Methodology • Future stock movements are predicted using “expected” real world scenarios • Cost/Strain arises when projected asset value > Liability Payout • The cost is discounted at the subjective “return required by the investor” • Owing to the subjective nature – This is a less popular approach www.actuariesindia.org

14. Risk Neutral - Methodology No arbitrage assumption made for risk neutral valuation • No discount rate assumption required www.actuariesindia.org

15. Other Considerations www.actuariesindia.org • Computational cost vs. Materiality on the Balance Sheet • Inclusion of Margins for prudence in VROI • Capital Support • Investment Strategy • Risk Management Strategy • Counterparty Risk

16. Questions www.actuariesindia.org