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

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

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Institute

of

Actuaries

L’Institutcanadien

des

actuaires

2009 Seminar for the Appointed Actuary

Colloque pour l’actuaire désigné 2009

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

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

Overview2009 Seminar for the Appointed Actuary

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Continued . . .

Pricing methodology believed to be generally applicable on Seg Fund products as well

Overview2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

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 Environment2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

Also, risk free rates fell to very low levels challenges for VA/Seg Fund products over the past 12 months

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 Environment2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

Required companies to rethink their approach on how to approach new product design/pricing

Economic Environment2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

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 Features2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

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 Features2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

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 Features2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

Variations on approach typically made by assuming hedging replaces 1 – HE% of real world claims

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 Features2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

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 Scenarios2009 Seminar for the Appointed Actuary

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Continued . . .

Considerations the risk neutral scenarios

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 Scenarios2009 Seminar for the Appointed Actuary

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Continued . . .

Risk Neutral Scenarios the risk neutral scenarios

2009 Seminar for the Appointed Actuary

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Source: Bloomberg for swap rates, investment banker quotes for implied volatility

We suggest a two-pronged approach to testing is appropriate the risk neutral scenarios

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 Testing2009 Seminar for the Appointed Actuary

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Continued . . .

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 Testing2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

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 Testing2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

Industry practice tends to favor current market conditions ultimate but difficult to capture in one set of scenarios

50% assume current market conditions at time of pricing

20% use long-term estimates

30% use other methods generally both or blend

Approach to Testing2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

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 Assumptions2009 Seminar for the Appointed Actuary

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Continued . . .

Implied Volatility Assumptions assumptions past last observable period

2009 Seminar for the Appointed Actuary

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- Industry results (mean) as of 3/31/09 for S&P

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 Hedging2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

Considerations hedging

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 Hedging2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Industry practices on assumed level of hedge effectiveness vary results from GMWB Pricing and Hedging Survey

Hedge Effectiveness2009 Seminar for the Appointed Actuary

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Continued . . .

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 Effectiveness2009 Seminar for the Appointed Actuary

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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 Levels2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

Lots of issues methodology; perhaps blending in internal economic capital as well

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 Levels2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

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 Levels2009 Seminar for the Appointed Actuary

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Continued . . .

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 Withdrawals2009 Seminar for the Appointed Actuary

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Continued . . .

Assumed mix by cohort varies by issue age becoming standard industry practice

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 Withdrawals2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

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 ITM2009 Seminar for the Appointed Actuary

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Continued . . .

We favor the benefit base approach for in-the-moneyness, used primarily for dynamic lapse

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 ITM2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

Continued . . .

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 ITM2009 Seminar for the Appointed Actuary

Colloque pour l’actuairedésigné 2009

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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