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2007 General Meeting Assemblée générale 2007 Montréal, Québec 2007 General Meeting Assemblée générale 2007 Montréal, Québec Canadian Institute of Actuaries.

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Presentation on theme: "2007 General Meeting Assemblée générale 2007 Montréal, Québec 2007 General Meeting Assemblée générale 2007 Montréal, Québec Canadian Institute of Actuaries."— Presentation transcript:

1 2007 General Meeting Assemblée générale 2007 Montréal, Québec 2007 General Meeting Assemblée générale 2007 Montréal, Québec Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

2 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital Issues for Long Term Disability (LTD) Presenter: Jeff Neufeld, FCIA, FSA

3 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD MCCSR Traditionally, Pricing relies on OSFI MCCSR formulas for the calculation of required capital. For LTD, this includes components for: – new claims risk – asset default risk (C1) – changes in interest rate environment (C3) – continuing claim risk

4 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD New Claims Risk The LTD “New Claims Risk” MCCSR component is calculated as a function of premium. This makes it fairly simple to derive an explicit percent of premium profit charge to cover the cost of this required capital item.

5 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Other MCCSR Components In contrast, the MCCSR components for C1, C3 and Continuing Claims Risk remain long after the associated premium has been paid. To match reported income with actual cost of capital patterns, a company must depend on Provision for Adverse Deviation (PfAD) releases. However, current CIA Standards of Practice PfAD guidelines pay no attention to cost of capital requirements.

6 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD C1 & C3 MCCSR C1 & C3 MCCSR are asset related, so the hope is the PfAD’s in the Canadian Asset/Liability Method (CALM) cover the cost of capital for these components. The cost of capital for these components can be covered by a margin in the pricing discount rate. However CALM dictates the actual runoff pattern of this margin, which may not match the cost of capital.

7 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Continuing Claims MCCSR The Continuing Claims MCCSR is a function of DLR’s (Disabled Life Reserves), so the hope is the DLR morbidity PfAD releases cover the cost of capital for this component. The cost of capital for this component can be covered by pricing for initial DLR’s which include a sufficient PfAD.

8 2007 General Meeting Assemblée générale General Meeting Assemblée générale Morbidity PfAD Release vs. Continuing Claim Cost of Capital (% of DLR) Claim Duration Sample 12.5% DLR PfAD Release Sample Continuing Claim MCCSR Cost of Capital %0.9% 6 – 100.3%0.9% 50.5%1.1% 40.8%1.3% 32.5%1.3% 25.8%1.5% 18.8%1.7%

9 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Unreasonable PfAD Requirement? The table illustrates that using the 12.5% midpoint of the CIA recommended PfAD range results in huge PfAD releases in the early claim durations. However the PfAD release in later claim durations is so small, the PfAD is almost meaningless. A more appropriate PfAD recommendation would recognize the significant durational differences.

10 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Unreasonable Capital Requirement? The 4% of DLR MCCSR factor may be excessive for late duration claims. The expected termination rate is very low in late durations. Even with no terminations (worst case scenario), the resulting loss may be less than 4% of the DLR in late durations.

11 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Emergence Pattern Mismatch The DLR morbidity PfAD release may be sufficient to cover the Continuing Claims MCCSR cost of capital in total. However, the pattern may not be a good fit. The PfAD release may not cover the cost of capital at later durations. This could be a problem for the claims run-off of terminated business, where no additional premium can be collected.

12 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Potential Pricing Stumbling Blocks Group pricing normally depends heavily on current experience to set rates. A stable or growing Group LTD carrier might believe their current level of premium is adequate because their current profit is covering the current cost of capital. However it may not be sustainable due to the shortfall on the claims run-off. Or, if care is not used, a carrier may price LTD at an initial loss (strain) based on the assumption that current large PfAD releases will continue into the future to pay for the strain and associated cost of capital.

13 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD International Accounting Standards The mismatch problem may be addressed in the future with international accounting standards. The Risk Margin Working Group (RMWG) of the International Actuarial Association (IAA) is giving consideration to a cost of capital approach for deriving PfAD’s (see RMWG Exposure Draft). This may be more appropriate in the future if MCCSR moves away from the current factor approach to something that better models the actual risk.

14 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Refund Accounting Refund accounting presents additional challenges. Morbidity PfAD releases become part of the client refund and are not available to cover the continuing claims MCCSR cost of capital.

15 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Refund Accounting Solutions One alternative is to charge an extra profit charge in the premium to cover the continuing claims cost of capital. However this is a poor fit since premium is received up front and continuing claims cost of capital is incurred over the life of the claim.

16 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Refund Accounting Solutions A second possible solution could be to have an explicit profit charge which is expressed as a percent of client reserves. This would be a better fit with the pattern of continuing claim MCCSR cost of capital. However, clients and consultants focus heavily on explicit profit charges, and are more likely to pressure the insurance company to reduce them.

17 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Refund Accounting Solutions Another solution to this problem is to subtract a margin in the client credited interest rate. The credited interest rate margin could cover the continuing claim MCCSR cost of capital, in addition to the C1 & C3 capital cost.

18 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Deficits – Pricing Pitfalls It can be shown mathematically that an appropriate risk charge must be high enough to cover aggregate deficit increases (not just deficit write-offs). If it is not, deficit increases are partially financed by company capital. If the capital financing is expected to be temporary, the company will need a way in which to charge for the use of this capital.

19 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Deficits – Pricing Pitfalls A solution may be to add a margin to the interest rate used to charge the client for the deficit. However, this could require a fairly large margin. Also, the margin would simply increase the size of the deficit, further reducing the probability of preserving the client and recovering the deficit in the future.

20 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Deficits – Pricing Pitfalls To assume the capital financing is temporary requires an assumption that aggregate deficits will decrease in the future. However, this may be unlikely without significant pricing action. The company may have a bigger problem recovering the initial capital financing than simply covering the ongoing cost. A better solution may be to set an appropriate risk charge, to avoid the initial capital financing.

21 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Hold Harmless Agreements Cases with “Hold Harmless” agreements present additional complexities. In this case, any emerging deficit is not funded by risk charges nor by company capital. Rather, a “Receivable” is established as an asset to recognize that the client has undertaken to fund any deficit.

22 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Hold Harmless Receivables A “Receivable” asset attracts a C1 MCCSR factor of 8%. This is higher than the average factor for other financial assets normally used to back insurance liabilities. In this case, adding a margin to the deficit interest rate to cover this extra C1 cost of capital is a workable solution. While the deficit is increased by the extra interest charged, it is still recoverable through the Hold Harmless agreement.

23 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Clients Minimizing Cost of Capital Charges Some clients are focused on the cost of capital and require their profit charge to be no higher than a specific percentage of the MCCSR attributable to their case. Morbidity MCCSR for their case is then eliminated by maintaining a sufficient level of CFR (Claims Fluctuation Reserve). C1 MCCSR is eliminated by requiring an investment policy consisting entirely of government bonds.

24 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Clients Minimizing Cost of Capital Charges With only a small C3 MCCSR component remaining, the resulting profit charge is very small, even for a large case. But is this a true representation of the cost of actual company capital required for these cases?

25 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Other Company Capital Requirements For cases with minimal MCCSR as well as ASO (Admin. Services Only) cases with no MCCSR, pricing should consider other investments made by the insurance company such as: – Capital expenditure on company infrastructure to enable it to administer the contract – Any pre-payment of claims and administration expenses – Initial sales and marketing costs – Investment in expertise

26 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Other Company Risks For cases with minimal or no MCCSR, it may be more appropriate for pricing to consider risks not identified by MCCSR, such as: – risk of administrative error resulting in costs not recoverable from the client – litigation risk – risk of expense pricing error – risk of future client default

27 2007 General Meeting Assemblée générale General Meeting Assemblée générale Pricing for Cost of Capital - LTD Summary: Emergence of profit through PfAD releases does not always follow the same pattern as cost of capital. This may need to be considered in pricing. Group Refund Accounting presents some unique challenges in pricing for cost of capital which should be carefully considered. MCCSR may be a useful calculation for use in pricing for cost of capital, but it does not address all situations.


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