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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– We’re 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 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.

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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

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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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-60

-40

-20

0

20

40

60

Lia

bilit

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100% 90% 80% 70%

MV/GV

Bif AAE Bif Gtee Whole AAE Whole Gtee

Methodology ExampleMethodology Example

Total

-43.44

3.42

0.04

-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?

•CLIFR’s 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 => 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 LiabilityWhat 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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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

Market

Growth

HedgedZero floor

Hedged

No floor

UnhedgedZero floor

0% 110 62 85

10% 34 74 92

20% -48 74 93

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Hedging Example - Emergence of Earnings

Details – 20% Growth

Hedged

Zero floor

Hedged

No floor

Unhedged

Zero Floor

Fee Income 93 93 93Investment Income

-141 -149 0

Claims 0 0 0Change in liability

0 -130 0

Total pre-tax -48 74 93

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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 (S&P 500 = 1,455)

– Cohort 2 sold in 2002 (S&P 500 = 975)

• Current S&P 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 (cont’d)

• 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 (cont’d)

• 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

Cohort/Seriatim Aggregate No Floor

Scenario 1 0 -1,000 0

Scenario 2 0 -300 0

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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

CTE 0 •Accounting view?

•Compare with similar accounting items subject to impairment testing

CTE 60 •Actuarial view?

•Divorces considerations for AAE recoverability from those for guarantees

CTE X •Aligns considerations for AAE recoverability from those for guarantees

•Whole contract view?

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Choice of CTE Level (cont’d)

CTE 80 •In range of SOP

•Awkward (?) if CTE level for guarantees is lower than 80

CTE 95 •Solvency-oriented

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

• < 100% efficiency