S.3855 Actuarial Challenges

1. S.3855 Actuarial Challenges Igor Afanassiev Prepared by Lesley Thomson

2. Changes to Asset Reporting • New reporting depends on asset designation • No more deferral of realized gains • “Fair value option” (FVO) with OSFI restrictions

3. Other Comprehensive Income • “Other Comprehensive Income” is new to Canadian GAAP (US GAAP has it) • OCI is a below-the-line item of income • Income that hasn’t been recognized yet • Unrealized gains/losses on AFS assets go to OCI, creating a disconnect between balance sheet and income statement • Never before in Canadian GAAP • Realized gains/losses on AFS assets are transferred from OCI to “real” income

4. CALM Valuation • Policy Liabilities = Statement value of assets needed to discharge the obligations • Based on analysis of asset and liability cash flows • If statement value of assets changes (all else being equal), the liabilities change by exactly the same amount • CALM gets the balance sheet right • So why is 3855 a problem?

5. CALM Valuation • The disconnect between the balance sheet and income statement for AFS assets is the problem • The liability valuation gets the balance sheet right, but income will be wrong • Income + OCI will be OK, but nobody will care • If we changed to get the income right, then the balance sheet would be wrong

6. Illustrative Example • AFS asset (MV=$1000) whose cash flows perfectly match liability cash flows. Liability value = $1000 • Nothing changes except asset MV rises to $1100. Still a perfect match, so liability value = $1100 • Income statement: • Increase in asset value goes to OCI (not income) • Increase in liability value goes to income • $100 loss shown on income statement!

7. Solutions? • Discussed a number of possible solutions with CICA, but all were rejected • Problem is unique to insurance industry, and CICA will not create “special” rules for one industry • End result is that life insurance companies won’t use AFS assets to back liabilities • Creates a minor annoyance – different asset designations for Canadian and US GAAP

8. Issue – Valuation Timing • CALM valuation usually done a quarter in arrears • Increased volatility of asset values means using the Q3 information to set Q4 liabilities is more difficult • Different approaches for different blocks

9. Issue – Valuation Timing (a) PPM with FV adjustment • Post-3855 liability = Pre-3855 liability X (Post-3855 statement value of assets) (Pre-3855 statement value of assets) • Pre-3855 statement value adjusted for DRG etc. • Pre-3855 statement value need not be exactly the same as today • Need any stable “book value” approach

10. Issue – Valuation Timing (a) PPM with FV adjustment • Approach requires a “book value” of assets to be maintained • Not in G/L, so watch out for control issues • BV may be useful for other purposes • SOE analysis • Dividend management for par business • Credited rates on UL

11. Issue – Valuation Timing (b) FV liabilities with Q4 adjustment – 2 approaches • Solve for spread (j) at Q3 such that FV liability = pv liability cash flows at Q3 spot rates + j • Q4 liability = pv liability cash flows at Q4 spot rates + j • Solve for PPM-type interest vector at Q3 such that FV liability = pv Q3 liability cash flows • Q4 liability = pv liability cash flows + change in fair value of bonds backing liabilities

12. Issue – Valuation Timing (c) CFVM • Determine C-3 provision in basis points from CALM testing • Liability = Statement value of assets + pv liability cash flows (including C-3) - pv asset cash flows • Only appropriate for certain annuity blocks

13. Issue – Valuation Timing • Availability of required information in time to do the valuation • Materiality of adjustments required to account for changes in asset quality, mix, duration, matching etc. during the quarter • Materiality of adjustments required for new business issued during the quarter • Commingled assets (par/non-par; surplus/liabilities) can add complications

14. Issue – Taxes • Complicated! • Changes to timing differences must be reflected in valuation • In Canada, 3855 causes projected income to change • Attributable to tax impacts • In Canada, 3855 causes projected income to be more volatile • Attributable to tax impacts

15. Issue – Taxes Pre-1996 life insurance example (40% tax rate): • Start with pre-3855 balance sheet: • Asset BV(=TV) = $1000 • Total after-tax liability (with DDTL) = $1000 • Tax Reserve = $1060 • DTL = $40 (=.4 x (1060-960)) • Statement liability = $960 (=1000-40)

16. Issue – Taxes Post-3855 balance sheet (say asset value is $1150): • Asset FV = $1150; Asset TV = $1000 • DTL (related to assets) = $60 (=.4 x (1150-1000)) • Total after-tax liability (with DDTL) = $1150 • Tax Reserve = $1060 • DTL (related to liabilities) = $-20 (=.4x (1060-1110)) • Statement liability = $1110 (=1150-40)

17. Issue – Taxes Pre-1996 observations: • Total DTL has not changed, and the new timing differences on assets are offset by changed timing differences on liabilities • No change to tax cash flows • The assets backing the new DDTL are now held at fair value, so the corresponding liability value must reflect this • E.g., if using PPM with FV adjustment, must apply (MV/BV) ratio to total liability including DDTL

18. Issue – Taxes Pre-1996 observations: • Equivalently, assets backing the statement liability + DTL are held at fair value • DTL balance won’t reflect this directly, so the actuarial liability must make up the difference • Will be many variations • Some back DTL with cash • Some use no-tax liability to determine DTL

19. Issue – Taxes Post-1996 life insurance example: • Start with pre-3855 balance sheet: • Asset BV(=TV) = $1000 • Total liability = Statement liability = $1000 (no DDTL) • Tax Reserve = $1000 • DTL = $0

20. Issue – Taxes Post-3855 balance sheet (say asset value is $1150): • Asset FV = $1150; Asset TV = $1000 • DTL (related to assets) = $60 (=.4 x (1150-1000)) • Additional $150 liability is deductible (and increase in asset value is not taxable), so assuming immediate recoverability: • Total liability (with DDTL) = $1090 • Statement liability = $1030 (=1090-60)

21. Issue – Taxes Post-1996 observations: • Gain at transition = $60 for tax benefits • CLHIA has proposed spreading this transition impact over time • Total future projected income will be reduced as the $60 timing difference is reversed • “gain” at transition is reversed

22. Issue – Taxes Post-1996 observations: • Each period, tax on the change in fair value of assets backing post-1996 liabilities will show up as a gain/loss • Change in liability value is deductible while corresponding change in asset value is not taxable • Complicated by changing projections of asset values • So income will be more volatile, but only because of taxes

23. Issue – Deposit Valuation • Liability value for amounts on deposit has been equal to the account value • No longer automatic for deposits where earned rate is paid to policyholders (e.g., dividends on deposit) • Liability should be (approximately) statement value of assets if higher than account value • Recognizes that all will be paid out, so should be no surplus

24. Issue – MCCSR • MCCSR required capital will increase • Asset values increasing and liability values increasing • Some required capital factors are a simple percentage of assets or liabilities • Some OCI will be Tier 2 instead of Tier 1 capital

25. Issue – Dividends • Policyholder dividends in many countries are set based on book rates of return • Book rates of return will no longer be easily available • Same problem for setting credited rates of interest on UL-type business

26. Issue – Sources of Earnings • SOE analysis is more complex when using market values • One solution is to continue SOE analysis on “book value” basis and add a line for impacts due to MV fluctuations • Analysts are beginning to react, and may want additional disclosures

27. Issue – Intersegment Trading • Intersegment trading of assets is done at market value • Creates a “notional” realization of gains/losses for internal reporting • Adjustments net to zero for external reporting • Too difficult to do this for AFS assets (notional accounting is far more complex with OCI) • Sun Life solution is to prohibit intersegment trading of AFS assets

28. Issue – Hybrid Segments • “Hybrid” segments containing both AFS and HFT assets will generally be prohibited at Sun Life • Accounting is too complex • So no mixing of liabilities and surplus, except for immaterial amounts

29. Issue – SOX Compliance • SOX processes will need to be reviewed for 3855 changes • Additional disclosures at transition (e.g., statement of balance sheet changes) may require special SOX controls

30. Issue – AuG43 • Additional AuG43 audit requirements coming at the same time • Approach to valuation will need to be well documented

31. Issue – Disclosure • Disclosure requirements likely to increase • Both to OSFI (e.g., to satisfy FVO) and externally • Recent analyst report indicated they wanted disclosure of change in policy liabilities caused by changes in interest rates • “Investment income” line of won’t be as meaningful as before

32. Issue – Reporting Changes • DCAT • SOE • EV, VNB • Business Plans • AAR • Notes, MD&A Disclosures

33. Issue - Transition • Tax, capital transition rules not yet finalized • DNRG balances written off, so never get to report the income on the balance sheet (only for surplus assets) • Treatment of deferred unrealized gains on equities still unresolved • Change from book to market value booked to retained earnings, not income • Except AFS goes to OCI, and later to NI