The C3P2 Project “Lessons Learned”

1. The C3P2 Project“Lessons Learned” Larry M. Gorski, FSA, MAAA Claire Thinking

2. US Regulatory RBC Formula Life Insurers • Regulators wanted a formula that : • Served as a minimum capital standard • As simple as possible • Objective • Auditable

3. US Regulatory RBC FormulaLife Insurers • Required capital calculation is primarily formulaic • Factors based on the practices of a “well-managed” company and industry-wide experience • In most cases, factors applied to values reported in the annual statement

4. C-3 (Interest Rate Risk) • Generally recognized that a factor based approach doesn’t work • RBC based on the results of stochastic modeling introduced into formula in CY 2000 • Most life insurers exempt from the requirement • Regulators unwilling to rely on company actuary • Industry argued that modeling “not needed” in all cases • Factor based floor and ceiling included in regulatory requirement

5. Variable Annuity Guarantees • Product variety and complexity of risk rules out use of factors • Regulators ask AAA to provide recommendations on a modeling approach • AAA accepts charge and begins work • Project expanded from RBC to include reserves

6. Practical Issues • All practical issues stem from: • Unwillingness of regulators to rely professionalism of actuary (“Asymmetric knowledge” issue) • Insurer concern over resources and cost • Concerns of the actuarial profession • (AAA) Finding resources to assist regulators • Dealing with constraints of corporate organizational structure (“Reliance” issue)

7. Regulatory Concerns/Solutions • Little experience with modeling of complex financial products • Single Standard Scenario • Training provided by AAA • Uncomfortable with “actuarial judgment” in conjunction with certain assumptions • Single Standard Scenario • Calibration points for distribution of equity fund returns for different time horizons • Mortality • 65% or 100% of 1994 MGDB Mortality Table

8. Regulatory Concerns/Solutions • Uncomfortable with “actuarial judgment” in conjunction with certain assumptions – Other possible solutions • Peer Review • Required PUBLIC disclosure of assumptions • Proprietary assumptions disclosed via actual to expected studies • Direct exposure of Non-proprietary assumptions • Distribution of equity fund returns for different time horizons • Interest rate paths

9. Insurer Concerns/Solutions • Volatility of Required Capital • Not yet resolved • Resources and cost • Alternative Methodology Factors • Factor picking tool • Pre-packaged scenarios • Research needed to determine acceptable “n” • Scenario picking tool

10. Professional Concerns/Solutions • Guidance needed • Number of scenarios • Variance of CTE estimator • Representative scenarios • Modeling dynamic hedging strategies • Updating assumptions in light of emerging experience • Bayesian methods

11. Lessons Learned • A solution to the “asymmetric knowledge” problem is needed • A more responsive, independent actuarial research program is needed • The “reliance” problem needs to solved

12. An Example – Dynamic Hedging • The AAA C3P2 Recommendation allows for required capital to be reduced as a result of hedging. • Open Questions • What techniques can be used to demonstrate that a dynamic hedging program is effective? • What assumptions should be used in this demonstration? • Who is responsible for the demonstration? • What methods should be used to reduce required capital for dynamic hedging programs that are partially effective? • How should required capital requirements deal with deviations from a dynamic hedging program?

13. An Example – Dynamic Hedging • Regulatory expectations and insurer hedge modeling abilities may be different. • Research that identifies and evaluates different approaches to dynamic hedging is needed. • Regulatory standards applicable to dynamic hedging whether person responsible is an actuary or other professional