24th India Fellowship Seminar Reserving for Guarantees in Non-Participating Products Mentor: Akshay Dhand Presented by: Ripudaman Sethi Shilpi Jain Krithika Verma Mumbai 10th – 11th December 2015 Indian Actuarial Profession Serving the Cause of Public Interest

Types of guarantees under non par products Why reserve for Guarantees? Agenda Types of guarantees under non par products Why reserve for Guarantees? Professional and Regulatory considerations Different methods of reserving for Guarantees Other considerations www.actuariesindia.org

Types of Guarantees under Non Par Products Non Par products or guarantees can be broadly classified into two categories Containing an Embedded Derivative i.e. policy cash flows tend to vary according to an external factor such as interest rate. For Example: Guaranteed Annuity Option, Guaranteed return under a linked product, Insurability (Mortality) Options Fully guaranteed i.e. policy cash flows are not modified according to an external factor For example: Fixed Maturity benefit under an Endowment www.actuariesindia.org

NP Guarantees with NO Embedded Derivative For some non-par products, the benefits are fully guaranteed and may thus be assumed to have no underlying embedded derivatives Hedging these guarantees using fixed assets of appropriate duration and currency- effectively no cost of hedging Reserve for Guarantees via Gross Premium Approach However, useful to test the impact of the guaranteed benefits as the assets are not always matching the liability perfectly- Possibly reserved through MAD or Mismatch provision But no explicit Cost of Guarantee required (as per GN 22) assuming insurance experience as expected www.actuariesindia.org

NP Guarantees with Embedded Derivatives For Capital Guarantee under Linked business, the cost of minimum guaranteed benefits is dependent on external factors e.g. stock price For Guaranteed Annuity Option, the cost of minimum guaranteed annuity is dependent on external factors e.g. bond yields Such guaranteed payout can be viewed as an embedded (put) option Gross Premium Valuation captures only intrinsic value of guarantees and hence may not capture the full cost of Guarantee Explicit Cost of Guarantee required – Recommended practice as per GN 22 Reserve = Base Reserve + (Time) Value of Embedded Derivative www.actuariesindia.org

Why Reserve for Guarantees ? There is a cost of providing Guarantees which may arise due to Asset Liability Mismatch By Nature : Liabilities are fixed but Assets are not By Duration: Longer for Liabilities than assets and hence potential re-investment risk Inability of the insurer to increase premium/charges Policyholder Behavior e.g. mass surrenders Unfavorable insurance experience Implicit Guarantees caused by Market Competition and PRE Changes in external factors (affects the cost of embedded derivatives) www.actuariesindia.org

Professional and Regulatory Considerations Guidance Notes Actuarial Practice Standards Regulations GN 22: Reserving for Guarantees in Life Assurance Business IRDA (Appointed Actuary) Regulations, 2000 IRDA (ALSM) Regulations, 2000 APS 2 - Prudent Reserving APS 1 - Maintaining Insurer’s Solvency www.actuariesindia.org

Reserves should be Floored to Guaranteed Surrender Values IRDA (Assets, Liabilities, and Solvency Margin of Insurers) Regulations, 2000 Reserves should be Floored to Guaranteed Surrender Values Additional Provision required to be held to cover the cost of Options and Guarantees Cost should be Treated as Special Cash Flows while calculating Mathematical Reserves www.actuariesindia.org

Guidance Note (GN) 22 Scope Assumptions Method Models • Linked with Guarantees • Participating Business • Other Lines of Business with Embedded Derivatives • Based on most Recently available Market Data • • Best Estimate of all Contingencies Method Models • Market-Consistent or Fair Value of Embedded Derivative • Simulation-Based Techniques • Stochastic Models Recommended • Alternative Models may be used in certain Circumstances www.actuariesindia.org

GN 22: Asset Models Economic Scenario Generators Parameterization of the Model Calibration of the Model Calibration of the Tail of the Distribution Economic Scenario Generators Stochastically Model Investment Returns Number of Iterations www.actuariesindia.org

GN 22: Calculating Reserves Asset Models Liability Models Project Assets allowing for Management Action Calculate Liabilities allowing for Policyholder Behavior Discount the shortfall to Valuation Date Reserve = Average across all Simulations www.actuariesindia.org

Computing cost of Guarantee Investment Guarantee - Alternatives Computing cost of Guarantee Methodology Real World Closed form Solutions ESG Risk Neutral Company purchases assets to back the guarantees offered Insufficiency or mismatch of assets and liability payouts can be hedged using derivatives There arises a cost from purchasing & holding a derivative Stochastic techniques are most suitable to explain the underlying variability & cost involved - Market Consistent is also known as risk Neutral www.actuariesindia.org

Real World - Methodology Future stock movements are predicted using “expected” real world scenarios Cost/Strain arises when projected asset value > Liability Payout The cost is discounted at the subjective “return required by the investor” Owing to the subjective nature – This is a less popular approach - ESG to generate number of samples adequate to give each scenario equal weightage www.actuariesindia.org

Risk Neutral - Methodology Stochastic Simulation Model Using observable prices: Compute implied volatility Observe results under various scenarios Discount using risk free rate No arbitrage assumption made for risk neutral valuation - ESG to generate number of samples adequate to give each scenario equal weightage No discount rate assumption required www.actuariesindia.org

Other Considerations Computational cost vs. Materiality on the Balance Sheet Inclusion of Margins for prudence in VROI Capital Support Investment Strategy Risk Management Strategy Counterparty Risk www.actuariesindia.org

Questions www.actuariesindia.org