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Proposed changes in the Economic Reinvestment Assumptions for Life Insurer Valuation

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### Proposed changes in the Economic Reinvestment Assumptions for Life Insurer Valuation

Presented by:

Ty Faulds , Alexis Gerbeau, Edward Gibson

March 20, 2013

Key Points from the NOI

The Actuarial Standards Board (ASB) proposes to revise:

- the Practice-Specific Standards on Insurance Contract Valuation: Life and Health (Accident and Sickness) Insurance (section 2300)
- withrespect to the economic reinvestment assumptions and investment strategies utilized for long-tail liability cash flows under the Canadian asset liability method (CALM).

The desired outcome

- maintain an appropriate range of practice for insurance contract liabilities
- whether calculated using deterministic or stochastic methodologies
- considers the current interest rate environment
- makes appropriate allowance for anticipated investment returns in excess of risk-free interest rates.

Target Dates

- exposure draft by June 2013
- final standards in 2013, with a proposed effective date of October 15, 2013.

Designated Group’s (DG) Process

Designated Group

Ty Faulds (chair), Michael Banks, Luc Farmer, Alexis Gerbeau, Edward Gibson, Jacques Tremblay

Sought input on a draft NOI from:

- Committee of the Appointed Actuary .
- Committee on Life Insurance Financial Reporting (CLIFR).
- Regulators.

NOI published reflected their input

Have been meeting weekly since December

- Working closely with and receiving strong support from CLIFR
- Chair of CLIFR is on the DG.
- CLIFR has working groups on Interest Rate Calibrations, Deterministic Scenario Design and Drafting Standards Wording actively supporting the DG.
- Periodically reaching out to the AA Committee and Regulators as research/thoughts develop

DG’s Approach - Stochastic

Encourage stochastic applications of CALM for economic assumptions.

- Focused on what changes to standards are appropriate to fully support the use of stochastic approaches for assets backing long tail liabilities.
- Calibration criteria for fixed income (including spreads) & non fixed income assets.
- Expanded guidance for appropriate positioning in the range (CTE 60 to CTE 80).

Simplify and/or clarify the constraints on recognition of entity specific or segment specific investment strategies.

- Purpose of CALM is to set the insurance contract liability to recognize the risks of the investment strategy employed to back the liability over its relevant term through cash flow testing and explicit margins for adverse deviations.
- Focus on consistent calibration across asset classes to recognize these risks.
- Where constraints still appropriate to narrow the range of practice keep conceptually simple and easy to understand.

DG’s Approach - Deterministic

Redesign current deterministic scenarios as an approximation to the stochastic applications.

- Conceptually targeted to approximate policy liabilities that would result from an integrated economic stochastic application at the higher end of the stochastic range (i.e. CTE 70 to CTE 80).
- Recognize asset diversification benefits through a stepped approach.
- Risk free fixed income scenarios on a stand alone basis to approximate the stochastic result in this range if only risk free assets were used.
- Fixed income asset spreads net of margins for adverse deviations to approximate the stochastic result in this range if only fixed income assets were used.
- Margins for adverse deviations for non fixed assets then added to approximate the stochastic result for an appropriate mix.

Simplify and/or clarify the constraints on recognition of entity specific or segment specific investment strategies.

- Same as Stochastic.

Proposed Changes - Stochastic

Assignment from the ASB (Notice of Intent):

- Review the calibration criteria for stochastic interest rate models
- Incorporate promulgated calibration criteria for stochastic interest rate models used for CALM.

Designated Group Discussions – Fixed assets, risk free

- Focus of our discussions has been on the appropriate range of scenarios for reinvestment.
- C3 risk is captured in the liabilities through the use of ‘real world’ models that reflect the ranges of interest rates historically observed and market expectations
- Supported Calibration group’s position to focus on nominal instead of real interest rates (primarily to avoid increased complexity).
- What period should we consider?
- By looking at long term historical interest rates (1936- current) are we capturing an appropriate range?
- Should we be focussing on recent history?
- Should we consider longer periods

Longer Period

http://www.ritholtz.com/blog/2012/01/222-years-of-long-term-interest-rates/ (US Interest Rates – 30 year where available

What Period?

Designated Group Discussions – Fixed assets, risk free

- For the ranges appropriate for policy liabilities the left tail criteria are not materially different for 10 years vs. longer period, main difference is on the right tail and mean.
- Designated group did not feel this longer right tail history should be ignored and supports the use of the historical period (1936+) suggested by the calibration working group to develop calibration criteria.
- In sustained periods of low interest rates this approach to calibration is reasonably responsive to current trends (averaging ‘20%-40% lowest’).

Proposed Changes - Stochastic

Assignment from the ASB – Calibration (Notice of Intent):

- To incorporate promulgated calibration criteria for stochastic interest rate models used for CALM.

Designated Group Current Thoughts – Fixed assets, risk free

- Current steady state calibration criteria do not look like a good fit to the chosen history (1936-2012) for the lower bound of the policy liabilities (i.e. CTE 60). Have asked the calibration group to consider and provide feedback and/or revised criteria.
- DG considering recommending range be restricted to CTE 70 to CTE 80 when rates are in the tails of the historical ranges and/or where companies are exposed to these reinvestment rates in the very long term.
- DG supports the rate of progression from current state to steady state in current calibration criteria (i.e. mean reversion strength)
- Discussed whether Base Scenario (before spread) should be consistent with CTE 0. DG proposing to retain the current structure of the Base Scenario (implied forwards) for the first 20-30 years, with grading to the long term historical median.

Proposed Changes - Stochastic

Assignment from ASB – Spreads on Fixed Income (Notice of Intent):

- To establish maximum assumed net risk premiums (after provisions for default, market movements) over risk-free rates for specific asset classes and scenarios which may include:
- Replacing the maximum of 0 after 20 years for fixed income assets;
- Possible revision of the 20-year horizon and any transition to the horizon;

Designated Group Current Thoughts – Fixed assets, Spread

- DG supports establishing calibration criteria for spreads however do not expect this work to be completed in time to be in scope for this project.
- DG proposes to allow deterministic spreads to be layered on top of the stochastic interest rate models. Start with current spreads but grade reasonably quickly (e.g. 5 years) to long term historical averages with an appropriate MfAD. This MfAD may increase with duration.
- MfAD meant to approximate the appropriate range on an aggregated basis (i.e. long term goal would be CTE60 – CTE80 based on an integrated economic scenario generator – not CTE 60 – 80 on each assumption).
- DG considering whether to propose any investment strategy constraints on fixed assets.

Proposed Changes - Stochastic

Assignment from ASB – Non Fixed Income (Notice of Intent):

- To establish maximum assumed net risk premiums (after provisions for default, market movements) over risk-free rates for specific asset classes and scenarios which may include:
- Non-fixed income asset classes.

Designated Group Discussion – Non fixed income assets

- DG reviewed the guidance for stochastic testing for non fixed income
- Noted that promulgation within standards is specific to Segregated Funds.
- Noted that the historical period used for non fixed income guidance was shorter (not available for a number of the classes)
- may influence the resulting relative differentials as the period used for non fixed income had higher average interest rates
- Observed the low correlation between fixed income and non fixed income assets.

Proposed Changes -Stochastic

Assignment from ASB – Non Fixed Income (Notice of Intent):

- To establish maximum assumed net risk premiums (after provisions for default, market movements) over risk-free rates for specific asset classes and scenarios which may include:
- Non fixed income asset classes.

Designated Group Current Thoughts – Non fixed income assets

- No intent to review calibration criteria developed for non fixed income assets within this project.
- Consider expanding promulgated calibration criteria for segregated funds to apply to non fixed income backing long tail liabilities.
- Not pursuing a separate maximum net spread.
- Where used to back long tail liabilities considering restricting range to CTE 70 to CTE 80.
- Supports continuing to use investment strategy constraints as an additional margin for adverse deviations to address this

Proposed Changes - Deterministic

Notice of Intent:

To revise the deterministic scenarios specified for the calculation of insurance contract liabilities to produce results comparable to those provided by stochastic methodology using the prescribed calibration criteria.

Designated Group Discussion

- Deterministic interest rate scenarios being reviewed by the working group to approximate the stochastic guidance discussed above.
- Expect to discontinue scenario 9 (current rates forever) as inconsistent with stochastic guidance
- Given target dates likely to have quick fixes with further refinements to follow
- DG proposes to start with current spreads but grade reasonably quickly (e.g. 5 years) to long term historical averages with an appropriate MfAD in all scenarios, rather than the current grading to 0 in some.
- Deterministic scenarios for non fixed income are also being reviewed for consistency with stochastic scenario testing. This review has not been concluded but these may need to be strengthened.

Proposed ChangesInvestment Strategy Constraints

Notice of Intent:

- To establish limits on the extent to which investment in non-fixed income assets is assumed, which may include setting maximum percentages regardless of current investment strategy and/or establishing a prescribed reinvestment strategy beyond some future horizon point regardless of a company’s current investment strategy.

Designated Group Discussion

- Current constraints on ‘not considering new business’ and ‘percentage maximum on reinvestment cash flows’ are complicated and subject to wide interpretation.
- The current relative differentials between non fixed income and fixed income are large
- This has the potential to result in an inappropriately large range of practice dependent upon the investment strategy.

Proposed ChangesInvestment Strategy Constraints

Notice of Intent:

- To establish limits on the extent to which investment in non-fixed income assets is assumed, which may include setting maximum percentages regardless of current investment strategy and/or establishing a prescribed reinvestment strategy beyond some future horizon point regardless of a company’s current investment strategy.

Designated Group Current Thoughts

- DG feels some constraint as a margin for adverse deviation is still appropriate.
- Replace existing constraints on ‘not considering new business’ and ‘percentage maximum on reinvestment’.
- The MfAD currently under discussion is:
- Non fixed income asset cash flows may not exceed that required to support x% of the fixed net policy related cash outflows for the first y years from the valuation date (and at each future valuation date) and z% thereafter.
- Net outflows means claims and benefits exceed premiums
- Fixed outflows means not considering adjustable and/or policyholder dividend

Next Steps

- Review feedback received from the NOI and this webcast
- Continue discussions with CLIFR working groups
- Determine parameters to be tested
- Work with Appointed Actuary Committee and OSFI to test parameters
- Recommend Exposure Draft at the June ASB meeting
- Discuss Exposure Draft at the June CIA meeting

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