Considerations in the Valuation of Segregated Fund Products

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• Considerations in the Valuation of Segregated
  Fund Products

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• Sub-Committee of CLIFR formed late in 2005
• Members of Sub-Committee
• Jacques Boudreau, Byron Corner, Greg Lawrence,
  Dale Mathews
• Mandate
• Review areas where additional guidance could be
  provided to ensure compliance with standards and
  to narrow the range of practice
• Status early draft, looking for feedback
• Expected Completion Spring 2007

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• Content of note
• Methodology Bifurcated versus Whole Contract
• What is a PFAD?
• Discount rate
• Term of the Liability Issues
• Hedging
• Level of Aggregation
• Recoverability Testing for AAE
• Policyholder Behaviour

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• Methodology
• There is currently a range of practice across the
  industry
• Were reviewing the general approaches in use
• The main differentiation is bifurcated versus
  whole contract approaches

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• Methodology Bifurcated vs. Whole Contract
• Bifurcated
• Revenue is allocated between recoverability
  testing of the Allowance for Acquisition Expense
  (AAE) and the liability for the guarantee
• Allocation does not change from period to period
• Policy liability for the guarantee is calculated
  separately using revenue based on this allocation

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• Methodology Bifurcated vs. Whole Contract
• Bifurcated
• Allocation of revenue to the guarantee would
  generally be related to the additional charge
  priced into the product for the guarantee

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• Methodology Bifurcated vs. Whole
• Contract
• Whole Contract Approach 1
• Total policy liability is determined using all
  net cashflows available
• Deterioration in market conditions could cause
  liability to increase and DAC implicitly written
  down

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• Methodology Bifurcated vs. Whole
• Contract
• Whole Contract Approach 1
• Future market improvements could result in
  reduction of liability and implicit writing up of
  AAE which is inconsistent with standards
• This method should not be used for Canadian GAAP
  purposes

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• Methodology Bifurcated vs. Whole
• Contract- Whole Contract Approach 2 DAC
  Focus
• AAE is first tested to ensure recoverability
  using all fee income
• In order to calculate the liability for the
  guarantees, the AAE balance is added to the
  stochastic result
• Mathematically equivalent to backing out a PV of
  fee income equal to the AAE balance

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• Methodology Bifurcated vs. Whole
• Contract- Whole Contract Approach 2 DAC
  Focus
• This method is consistent with Standards
• For the remainder of the presentation we will
  simply call this the whole contract approach

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• Methodology Bifurcated vs. Whole
• ContractUnder both methods
• If the AAE becomes unrecoverable it is written
  down to the extent it is recoverable
• Future amortization is reduced accordingly and
  locked in consistent with SOP Section 2320.24
• Once the AAE is written down it may not be
  written back up.

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• Methodology Bifurcated vs. Whole
• ContractUnder both methods a zero floor on
  the liability is generally applied at some level
  of aggregation.
• Reflection of SOP section 2320.25 which suggests
  that the term ends at the balance sheet date
  unless extending the term increases the liability

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• Methodology Example
• - Cohort of variable annuity policies with an
  initial
• AAE of 50
• Policies priced with 5 basis points of revenue
  plus additional charge of 2 basis points for a 10
  year maturity guarantee
• Bifurcated Method
• Recoverability testing for the AAE is done
  assuming 5 basis points of revenue. The liability
  for the guarantee is calculated assuming 2 basis
  points of revenue.
• Allocation doe not change period to period.

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• Methodology Example
• -Whole Contract Method
• The entire 7 basis points is first made available
  to recover the AAE.
• To the extent it is not entirely required, the
  excess is reflected in the liability for the
  guarantee.

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Methodology Example
0.04
3.42
Total
-43.44
-40.0
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• Methodology Considerations
• Total liability under Whole Contract method will
  be less than or equal to that under the
  Bifurcated method
• Whole Contract method will defer possible writing
  down of the AAE as long as possible as the AAE
  has first priority on future revenue.
• Once the liability for the guarantee has become
  positive the liability may become more volatile
  under the Whole Contract method as the allocation
  of revenue can change period to period.

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• Methodology Considerations
• At this time CLIFR is not recommending one method
  over the other
• Both methods consistent with standards
• Currently the whole contract method is more
  commonly used
• Direction of international standards appears to
  be toward bifurcated approach
• When the direction of international standards
  becomes clearer we will move in that direction.

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• What is a PfAD?

• We are responding to members request for
  guidance as per the OSFI survey requested
  guidance
• Essentially a disclosure issue
• SOP Section 1110.39 Provision for adverse
  deviations is the difference between the actual
  result of a calculation and the corresponding
  result using best estimate assumptions.
• The term of the liability for segregated fund
  products has resulted in different
  interpretations as to the period over which the
  calculation extends

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• What is a PfAD?

• CLIFRs initial thinking done in the context of
  quantification of PfADs in AAR
• Issue has been elevated with companies starting
  to disclose PfADs externally
• This has now been identified as an issue by the
  Committee on the Role of the Appointed Actuary
  and we will be working with them on this.

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• Term of the Liability

• Section 2320.27
• the term of the liability ends at the balance
  sheet date for.the general account portion of a
  deferred annuity with segregated fund liabilities
  but without guarantees
• Section 2320.23
• The actuary would extend such term solely to
  permit recognition of cash flow to offset
  acquisition or similar expenses whose recovery
  from cash flow that would otherwise be beyond
  such term was contemplated by the insurer in
  pricing

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• Term of the Liability

• Add Guarantee
• 2320.22 gt 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

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• Term of the Liability

What to Conclude

• 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
• With the addition of a guarantee, additional
  revenue may be recognized, but only enough to
  cover additional costs

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• Term of the Liability Practical Challenges

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• Challenge 1 Hedging
• 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

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• Hedging Example
• Description
• Example reflects the guarantee reserve only, no
  AAE
• Hedging is accomplished via short position in
  futures
• Initial calculated liability is negative on both
  hedged and unhedged basis, so zero floor is
  applied
• Expected market growth over the length of the
  contract is around 10

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• Hedging Example
• Earnings on a hedged basis areFee income
  claims interest on reserve change in FMV of
  derivative change in reserve
• Change in reserve isChange in CTEx (liability
  cashflows hedge g/l)

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• Hedging Example - Emergence of Earnings
• Year 1

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• Hedging Example - Emergence of Earnings
• Details 20 Growth

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• Challenge 1 Hedging
• Summary
• Change in FMV goes though income on asset side
• Expect offsets (not exact) on liability side but
  this may not occur if constrained by zero floor
• CLIFR believes is would be appropriate to allow
  liability for guarantee to become negative in the
  context of hedging
• Subject to avoiding capitalizing more future
  profit than in the absence of hedging

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• Challenge 2 Cashflow Asymmetry / Level of
  Aggregation
• 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

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• Level of Aggregation
• Term of the liability reads literally as a
  seriatim concept
• Common/accepted practice thought to be at
  portfolio-wide or product level
• However, care must be taken if the level of
  aggregation combines blocks with significantly
  different risk profiles..

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• Example
• Two cohorts
• Cohort 1 sold in 1999 (SP 500 1,455)
• Cohort 2 sold in 2002 (SP 500 975)
• Current SP 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?

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• Example (contd)
• 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?

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• Example (contd)

• 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

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Level of Aggregation

• Conclusion
• An important consideration in determining the
  appropriate level of aggregation is the
  homogeneity of policies

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• Recoverability TestingNon economic
  assumptions
• Use MfADded assumptions
• Direction chosen appropriate in aggregate
• High lapse favours guarantee
• Low lapse favours AAE

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• Choice of CTE Level

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• Choice of CTE Level (contd)

• Expect Ed. note will endorse two methods
• CTE 60
• CTE X where X is between 60 and 80

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• Policyholder Behaviour Summary
  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

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• Guiding Principles
• Option exercise correlated with in-moneyness
• Anti-selection
• Consider reasonable expectations
• PH sophistication perceived financial interest
  in policy
• lt 100 efficiency