1. CIA Annual Meeting Assemblée annuelle de l’ICA June 29 & 30, 2006  Les 29 et 30 juin 2006 Ottawa, Ontario Session Val-5 CLIFR Part II

2. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

3. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

4. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

5. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

6. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

7. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

8. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

9. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

10. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

11. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

12. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

13. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

14. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

15. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(1000) Basis points allocated to AAE2550 Liability for guarantee255 Total Liability(975)(995) Example 1 – State 1: Initial – 75 basis points needed to amortize AAE Whole Contract method produces a lower liability as all revenue is reflected.

16. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(1000) Basis points allocated to AAE2535 Liability for guarantee4030 Total Liability(960)(970) Change from previous state1525 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.

17. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(870)(1000) Basis points allocated to AAE2510 Liability for guarantee60150 Total Liability(810)(850) 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.

18. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(714)(893) Basis points allocated to AAE250 Liability for guarantee80225 Total Liability(634)(668) 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.

19. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(714)(893) Basis points allocated to AAE2522 Liability for guarantee6080 Total Liability(654)(813) Change from previous state(20)(145) 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.

20. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(1000) Basis points allocated to AAE2550 Liability for guarantee(50)(125) Liability for gtee. after floor00 Total Liability(1000) Example 2 – State 1: Initial – 75 basis points needed to amortize AAE but calculated liability for the guarantee is now negative.

21. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(1000) Basis points allocated to AAE2535 Liability for guarantee(10)(65) Liability for gtee. after floor00 Total Liability(1000) 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.

22. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Bifurcated Whole Contract AAE(1000) Basis points allocated to AAE2530 Liability for guarantee15(40) Liability for gtee. after floor1500 Total Liability(995)(1000) 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.

23. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

24. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

25. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

26. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

27. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

28. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

29. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

30. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

31. CIA Annual Meeting  Assemblée annuelle de l’ICA Considerations 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

32. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Gtee – CTE0(27.35) Gtee - CTE80 (16.67) Amt. Booked0 Gtee Margin27.35 AAE CTE0(67.89) AAE CTE60(50.37) Booked(50.00) AAE Margin17.89 Total Margin45.24 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

33. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Gtee – CTE0(27.35) Gtee - CTE80 (16.67) Amt. Booked0 Gtee Margin27.35 AAE CTE0(67.89) AAE CTE60(50.37) Booked(50.00) AAE Margin17.89 Total Margin45.24 Best Estimate Result Guarantee0 AAE(50.00) Total(50.00) Actual Result Guarantee0 AAE(50.00) Total(50.00) PfAD0 Additional Margin45.24 Example 1 – Bifurcated Approach Calculation of PfAD

34. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II 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 Test AAE AAE CTE60(96.18) Booked(50.00) Calculate Liability – total margins CTE0(94.11) CTE80(58.07) Add AAE50.00 Booked0

35. CIA Annual Meeting  Assemblée annuelle de l’ICA Best Estimate Result Guarantee0 AAE(50.00) Total(50.00) Actual Result Guarantee0 AAE(50.00) Total(50.00) PfAD0 Additional Margin = 0 – (94.11) - 50.00 44.11 Example 1 – Whole Contract Approach Calculation of PfAD Test AAE AAE CTE60(96.18) Booked(50.00) Calculate Liability – total margins CTE0(94.11) CTE80(58.07) Add AAE50.00 Booked0

36. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Gtee – CTE0(18.86) Gtee - CTE80 38.30 Amt. Booked38.30 Gtee Margin57.16 AAE CTE0(47.93) AAE CTE60(34.88) Booked(34.88) AAE Margin13.05 Total Margin70.21 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

37. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Gtee – CTE0(18.86) Gtee - CTE80 38.30 Amt. Booked38.30 Gtee Margin57.16 AAE CTE0(47.93) AAE CTE60(34.88) Booked(34.88) AAE Margin13.05 Total Margin70.21 Best Estimate Result Guarantee0 AAE(47.93) Total(47.93) Actual Result Guarantee38.30 AAE(34.88) Total3.42 PfAD51.35 Additional Margin18.86 Example 2 – Bifurcated Approach Calculation of PfAD

38. CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II 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 Test AAE AAE CTE60(49.36) Booked(49.36) Calculate Liability – total margins CTE0(66.64) CTE809.98 Add AAE49.36 Booked59.34

39. CIA Annual Meeting  Assemblée annuelle de l’ICA Best Estimate Result Guarantee0 AAE(50.00) Total(50.00) Actual Result Guarantee59.34 AAE(49.36) Total9.98 PfAD59.98 Additional Margin = 0 – (66.64) - 49.36 16.64 Example 2 – Whole Contract Approach Calculation of PfAD Test AAE AAE CTE60(49.36) Booked(49.36) Calculate Liability – total margins CTE0(66.64) CTE809.98 Add AAE49.36 Booked59.34