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CIA Annual Meeting Assemblée annuelle de l’ICA. June 29 & 30, 2006 Ÿ Les 29 et 30 juin 2006 Ottawa, Ontario. Session Val-5 CLIFR Part II. CIA Annual Meeting Ÿ Assemblée annuelle de l’ICA Considerations in the Valuation of Seg. Fund Products. Sub-Committee of CLIFR formed late in 2005

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cia annual meeting assembl e annuelle de l ica

CIA Annual MeetingAssemblée annuelle de l’ICA

June 29 & 30, 2006 Ÿ Les 29 et 30 juin 2006

Ottawa, Ontario

Session Val-5 CLIFR Part II

cia annual meeting assembl e annuelle de l ica considerations in the valuation of seg fund products
CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Agenda

Methodology – Bifurcated versus Whole Contract

Guarantee Reserve – Discounting and C3 MfAD

What is a PFAD?

Term of the Liability – Examples of Issues

Recoverability Testing for AAE

Policyholder Behaviour

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Methodology

There is currently a range of practice across the industry

We’re reviewing the general approaches in use

The main differentiation is bifurcated versus whole contract approaches

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Methodology – Bifurcated vs. Whole Contract

Whole Contract – Approach 2

This method is consistent with Standards

For the remainder of the presentation we will simply call this the whole contract approach

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Methodology – Bifurcated vs. Whole Contract

Under 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.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Methodology – Bifurcated vs. Whole Contract

Under 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

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Methodology – Examples

Cohort of variable annuity policies with an initial AAE of $1000

Policies priced with 100 basis points of revenue plus additional charge of 25 basis points for a maturity guarantee

Bifurcated Method

Recoverability testing for the AAE is done assuming 100 basis points of revenue. The liability for the guarantee is calculated assuming 25 basis points of revenue.

Allocation doe not change period to period.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Whole Contract Method

The entire 125 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.

Example 1 – Liability for the guarantee is always positive

Example 2 – Calculated liability for the guarantee is sometimes negative and zero floor comes into play

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – State 1: Initial – 75 basis points

needed to amortize AAE

Whole Contract method produces a lower liability as

all revenue is reflected.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – State 2: Modest Market Correction

– 90 basis points now needed to amortize AAE

Change in liability is larger under Whole Contract method

as revenue is shifted to recover AAE.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – State 3: Larger Market Correction

– 115 basis points now needed to amortize AAE

Under the Bifurcated method the AAE must now be written

down to a recoverable level. Under the Whole Contract

method the total revenue of 125 basis points is still sufficient

but less is available for the guarantee.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – State 4: Severe Market Correction

– 140 basis points now needed to amortize AAE

Total revenue of 125 basis points is now insufficient so

AAE must now be written down under the Whole Contract

method.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – State 5: Market Recovery to State 3

– 115 basis points now needed to amortize AAE

AAE may not be written up under either method.

Change in liability is greater under Whole Contract method

reflecting higher revenue allocated to the guarantee.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2 – State 1: Initial – 75 basis points

needed to amortize AAE but calculated liability

for the guarantee is now negative.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2 – State 2: Modest Market Correction

– 90 basis points now needed to amortize AAE

The calculated liability for the guarantee has remained negative

So the two methods produce the same result because of the

zero floor.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2 – State 3: Larger Market Correction

– 95 basis points now needed to amortize AAE

The Whole Contract method provides a more stable liability

as the calculated liability for the guarantee remains negative

for a longer period.

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

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.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Methodology – Considerations

At this time CLIFR is not recommending one method over the other

May be reconsidered as the direction of International Standards becomes clearer.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

CALM Methodology Issues

Application of CALM for the general account liability for the guarantees

Possible implications of Section 3855

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Guarantee Reserve - CALM Methodology

Using the CALM method for guarantee reserves likely impractical

Implies using stochastic or deterministic interest rate scenarios along each stochastic guarantee test path

Common approximation method is to use a discounted cashflow method

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Guarantee Reserve - CALM Methodology

Discount rate should be related to current statement value of supporting assets as reflected in current book yield

Under 3855, if assets are designated as Held for Trading (HFT) yield would be reflective of fair value and discount rate should be variable period to period

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Guarantee Reserve - Testing C3 MfAD

C3 MfAD is usually estimated as an adjustment to the Discount Rate

Theoretically should be calculated or justified by CALM testing

reflecting reinvestment or disinvestment exposure of liabilities and supporting assets

In practice tested after the fact on representative cash flows

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Guarantee Reserve - Testing C3 MfAD

Cashflows should be chosen carefully to be representative and appropriate, for example

Average of period by period cashflows for the 30% of scenarios producing the highest liability if CTE70 is used

A representative path chosen as most consistent with the key drivers of the liability

E.g. maturity guarantee payments for cohorts most in the money for a typical maturity guarantee

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

Guarantee Reserve - Testing C3 MfAD

Note that this is quite often not a material issue given the size of the liability for the guarantees

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICAConsiderations in the Valuation of Seg. Fund Products

What is a PfAD?

One of the areas in which respondents to 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.”

Additional margins could be disclosed separately….

The following examples show how this might work.

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1

Bifurcated Approach

Starting Position MV/GV = 100%

Initial AAE = 50

Assume:

Best Estimate = CTE0 without margins

Liability for gtee booked at CTE80

with margins

AAE recoverability testing at CTE60

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – Bifurcated Approach

Calculation of PfAD

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1

Whole Contract Approach

MV/GV = 100%

Initial AAE = 50

Assume:

Best Estimate = CTE0 without margins

Liability for gtee booked at CTE80

with margins

AAE recoverability testing at CTE60

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 1 – Whole Contract Approach

Calculation of PfAD

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2

Bifurcated Approach

MV/GV = 70%

Initial AAE = 50

AAE now written down

Assume:

Best Estimate = CTE0 without margins

Liability for gtee booked at CTE80

with margins

AAE recoverability testing at CTE60

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2 – Bifurcated Approach

Calculation of PfAD

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2

Whole Contract Approach

MV/GV = 70%

Initial AAE = 50

AAE now written down

Assume:

Best Estimate = CTE0 without margins

Liability for gtee booked at CTE80

with margins

AAE recoverability testing at CTE60

Session Val-5 CLIFR Part II

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CIA Annual Meeting ŸAssemblée annuelle de l’ICA

Example 2 – Whole Contract Approach

Calculation of PfAD