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2009 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2009

Canadian Institute of Actuaries. L’Institut canadien des actuaires. 2009 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2009. Segregated Funds and Market Volatility Session “Pricing Living Benefits in Segregated Funds Products” John Fenton September 17, 2009.

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2009 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2009

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  1. Canadian Institute of Actuaries L’Institutcanadien des actuaires 2009 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2009

  2. Segregated Funds andMarket Volatility Session “Pricing Living Benefits inSegregated Funds Products” John Fenton September 17, 2009 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  3. This presentation provides an overview of methodology used to price living benefit features on U.S. VA products Developed based on our knowledge of the industry and results of recently completed 2009 Towers Perrin GMWB Pricing and Hedging Survey Survey reflects results for 10 major U.S. VA writers  including U.S. subsidiaries of Canadian companies Overview 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  4. Pricing methodology believed to be generally applicable on Seg Fund products as well Overview 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  5. The global economic environment has presented major challenges for VA/Seg Fund products over the past 12 months Equity markets dropped > 50% Daily realized volatility in S&P index routinely exceeded 60% on annualized basis during most volatile periods Both contributed to very high levels of implied volatility Economic Environment 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  6. Also, risk free rates fell to very low levels Wreaked havoc on in-force VA portfolios Became significantly ITM (now with some recovery) Hedging not as good as advertised Cost to hedge new business rose dramatically Economic Environment 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  7. Required companies to rethink their approach on how to approach new product design/pricing Economic Environment 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  8. The approach to pricing WB features has become more standardized  although major issues exist on choice of assumptions Pricing of WB riders now routinely makes provision for cost of hedging Priced using risk neutral scenarios Pricing WB Features 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  9. Typical approach is to determine cost of rider separately, then incorporate into base product pricing Often expressed as annual cost via PV calculation Base product generally priced using real world scenarios  a few companies moving to risk neutral to support MCEV pricing Pricing WB Features 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  10. Provision for hedge effectiveness (or ineffectiveness) is typically made by assuming hedging replaces 1 – HE% of real world claims Effectively assumes hedging is covering cost of claims as they emerge Pricing WB Features 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  11. Variations on approach Attempt to model impact of hedging directly  can be difficult to do and requires stochastic-on-stochastic testing Vary timing of hedge payoff  move from time of claim to spread over hedging period Pricing WB Features 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  12. A key issue is what to assume for the parameters underlying the risk neutral scenarios Two ends of spectrum Use today’s swap rates and implied volatility Use long-term estimates Risk Neutral Scenarios 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  13. Considerations Product priced today will not be available for sale for several months, will then be sold over ensuing 6-12-18-24 months Not necessarily locking in hedging costs at time product is issued Becomes significant issue when economic conditions move around Risk Neutral Scenarios 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  14. Risk Neutral Scenarios 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Source: Bloomberg for swap rates, investment banker quotes for implied volatility

  15. We suggest a two-pronged approach to testing is appropriate Set assumptions based on “long-term estimates”  although these are re-assessed frequently Also test (at time of pricing as well as on ongoing basis) at current market condition levels Ensure profitability meets minimum threshold requirements Some would suggest current environment should meet target profit requirements as well Approach to Testing 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  16. Depending on relationship between target and minimum threshold profit levels may require companies to set long-term estimates at fairly conservative levels Important to run lots of sensitivity tests to understand impact of varying economic conditions Approach to Testing 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  17. Could also reflect current market conditions grading to ultimate  but difficult to capture in one set of scenarios Need to develop procedures to deal with sub-par profitability Accept below threshold for X days Product actions (i.e., pull product, increase rider fees  bracketed basis) Approach to Testing 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  18. Industry practice tends to favor current market conditions 50% assume current market conditions at time of pricing 20% use long-term estimates 30% use other methods  generally both or blend Approach to Testing 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  19. Another key issue is how to derive implied volatility assumptions past last observable period We see three approaches being used in the industry Grade to target ultimate (“mean reversion”)  generally historical realized volatility with margin or average of historical implied volatilities Hold level at last observable tenor Hold level throughout Implied Volatility Assumptions 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  20. Implied Volatility Assumptions 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 • Industry results (mean) as of 3/31/09 for S&P

  21. Choice of assumptions can/should be tailored to nature of hedging Consider both the type of hedging that you currently utilize, as well as the type of hedging that you may want to implement in future i.e., currently dynamically hedge only (i.e., hedging with delta via futures), but may want to add options for vega exposure Linking Assumptions with Hedging 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  22. Considerations Realized volatility; if dynamic hedging only Implied volatility up to N years, then realized; if only buying static options up to N years Is swap curve locked into? Linking Assumptions with Hedging 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  23. Industry practices on assumed level of hedge effectiveness vary  results from GMWB Pricing and Hedging Survey Hedge Effectiveness 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  24. Suggest that hedge effectiveness for tail calculation should be lower than mean pricing Hedge effectiveness would be expected to vary based on extent of basis risk Hedge Effectiveness 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  25. U.S. companies are generally leveraging off C3 Phase II methodology; perhaps blending in internal economic capital as well Many companies are reconsidering their approach Capital and Reserve Levels 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  26. Lots of issues Multiple of CTE90 level or higher CTE level Degree of diversification: single cell vs. total product vs. total VA block Assumed level of hedge effectiveness Capital and Reserve Levels 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  27. Ideally, calculation would be done via stochastic-on-stochastic testing (could involve stochastic cubed with hedging) However, not practical for many companies, so factor based Degree of factor sophistication varies Capital and Reserve Levels 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  28. Reflecting partial withdrawals via a cohort approach is becoming standard industry practice Typical cohorts: 1. Begin immediately 2. Deferred 5 years 3. Deferred 10-20 years 4. Withdrawals only if policyholder deep ITM (better choice than no withdrawals) Cohorts 2 and 3 generally set in consideration of specific products (e.g. bonus waiting period age tier) Partial Withdrawals 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  29. Assumed mix by cohort varies by issue age It may also be appropriate to assume withdrawals utilization triggered based on the in-the-moneyness Typical to assume full withdrawal Once started, typical to assume they last forever Partial Withdrawals 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  30. There are two primary approaches to defining perceived value for in-the-moneyness, used primarily for dynamic lapse PV of future payments Benefit base amount Prevalence in industry is roughly 50%-50% Defining Value for ITM 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  31. We favor the benefit base approach What policyholders see in their statement PV approach generally requires a 30%+ drop in funds before ITM kicks in  we think policyholders would place more value on a benefit they are paying 75-100 bp for Emerging experience (still limited) suggests lapse dampening happening at smaller levels of equity market drops Defining Value for ITM 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009 Continued . . .

  32. Remove additional shock lapse rate component (i.e., excess over ultimate lapse rate) when benefit ITM Consider floor lapse rate  2% is not unreasonable Defining Value for ITM 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

  33. Companies have moved to more conservative economic scenarios in their pricing Have led companies to charge more or “de-risk” WB riders More stringent asset allocation Less rich features Issue: when current market conditions become more favorable again, will companies revert back to prior practices? What is the impact? 2009 Seminar for the Appointed Actuary Colloque pour l’actuairedésigné 2009

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