Current Issues in Stochastic Modeling of Segregated Fund Guarantee Products Michael Bean FCAS, FSA, FCIA Director, Capital Division Seminar for the Appointed Actuary September 22, 2006

Outline of Presentation Context Rationale for review Key issues –Summary –Discussion Update of hedging guidelines Conclusion

Context

Segregated fund guarantee liability and capital requirements currently based on: –Stochastic framework developed by CIA Task Force on Segregated Fund Investment Guarantees OSFI has identified a number of issues with the current framework that need to be addressed

Context OSFI document describing key issues recently sent to: –CIA Actuarial Standards Board –CIA Practice Council OSFI has requested that the CIA: –Review the document –Provide initial views on priorities, project plans and timelines for addressing the issues identified

Context Purpose of this presentation: –Highlight the key issues –Initiate discussion of the issues with the wider actuarial community

Rationale for Review

Over 5 years since the work of the CIA Task Force was completed Many significant changes in the industry and marketplace since then

Rationale for Review Significant changes: –Demutualization and consolidation –Greater interest in reported financials and methods used to determine them –Development and growth of new products –Foreign expansion –Serious interest in implementing sophisticated hedging strategies

Rationale for Review Much experience with segregated fund models has been gained over the past few years This experience has revealed a number of potential shortcomings with the current framework

Key Issues

Key Issues: Summary 1.Asset model calibration 2.Premiums allowable as offsets 3.Bond fund and fixed income modeling 4.Modeling of foreign indexes and currency risk in foreign & domestic subsidiaries

Key Issues: Summary 5.Discount rates & assets backing the guarantees 6.Surrenders, resets & fund transfers 7.Contract aging & market-based valuation 8.Contract grouping

Issue #1: Asset Model Calibration

Issue: –No calibration requirements for right tail of asset return distributions –No calibration of scenarios actually used in the valuation (only model is tested) –No explicit calibration requirements for indexes of different types (e.g., equity v. bond v. real estate, Canada v. US v. Asia, large v. mid v. small cap)

Issue #1: Asset Model Calibration Why this is an issue: –New product designs (e.g., embedded options of call type) –Material exposures to foreign equity and bond markets, and currency risk –Sophisticated hedging strategies

Issue #2: Premiums Allowable as Offsets

Issue: –Amounts of future guarantee premium allowable as offsets to future benefit payments not defined with sufficient precision –Possibility of insufficient resources to fund benefit payments as they come due if premiums collected after a benefit payment date are allowed to offset that benefit payment

Issue #2: Premiums Allowable as Offsets Why this is an issue: –Sophisticated hedging programs require the portion of MER considered guarantee premium to be fixed –Peculiarities of segregated fund contract design

Issue #2: Premiums Allowable as Offsets Peculiarities of seg fund products: –Individual contracts can have multiple benefit payments –Premium amounts collected after a benefit payment often exceed the size of such a payment (even with discounting) –Premiums collected over the life of a contract can vary inversely with the level of risk

Issue #2: Premiums Allowable as Offset Basic requirement: –At given confidence level, must be sufficient assets to fund all future benefit payments as they come due Applies to: –Individual contracts –Portfolios of contracts with different maturity-renewal dates

Issue #3: Bond Fund & Fixed Income Modeling

Issue: –No guidance on stochastic modeling of bond funds or interest rates

Issue #3: Bond Fund & Fixed Income Modeling Why this is an issue: –Material fixed income exposures (e.g., Hong Kong Mandatory Provident Fund) –Dynamic hedging requires interest rate scenarios –Standard equity models not really appropriate for bonds

Issue #3: Bond Fund & Fixed Income Modeling Additional considerations: –Equity-interest rate correlation –Consistency with yield environment present on valuation date –Bond funds of different durations consistent with one another

Issue #4: Modeling of Foreign Indexes & Currency Risk in Foreign & Domestic Subs

Issue #4: Foreign Indexes & Currency Risk Issue: –Insufficient guidance on modeling of foreign indexes in either foreign or domestic subs –Insufficient guidance on modeling of currency risk, whether hedged or unhedged –Task Force Report silent on currency risk modeling & cost of currency hedging

Issue #4: Foreign Indexes & Currency Risk Why this is an issue: –Segregated fund guarantee risk exposures in foreign (e.g., Asian) subs now material –Asian markets are different: Models that work well for Canada & US may not be appropriate

Issue #4: Foreign Indexes & Currency Risk Why this is an issue: –Asian subs have more currency risk: Exposure to US markets Greater fluctuation of US dollar vis-à- vis yen, euro, etc –Currency hedging embedded in some products Need to model interest rate spreads

Issue #5: Discount Rates & Assets Backing the Guarantees

Issue #5: Discount Rates, etc Issue: –Insufficient guidance on discount rates to be used –No explicit link between discount rates and assets backing unhedged portion of liabilities and capital, or recognition of asset-liability mismatch –No explicit link between discount rate and DAC earnings rate (when applicable)

Issue #5: Discount Rates, etc Implicit assumptions in liability and capital calculation: –General account assets backing unhedged portion of liabilities and capital are risk-free –General account assets able to grow at rates used to discount future benefits and premiums

Issue #5: Discount Rates, etc Implicit assumptions cont’d: –General account assets … when combined with future premiums and investment income are sufficient to fund future benefit payments as they come due about 98% of the time (assumes CTE 95 corresponds to 98 th percentile)

Issue #5: Discount Rates, etc Implications: –Discount rates consistent with yield environment on valuation date –Asset and liability cash flows “matched” (or provision for asset-liability mismatch added to liability and capital) –Consistency of discount rate and DAC earnings rate when assets backing liabilities and capital “invested” in DAC

Issue #5: Discount Rates, etc Comments on asset-liability mismatch: –Current guidance does not preclude a company from backing a put-type segregated fund guarantee with equities –Significant mismatch possible even if assets invested in “risk-free” bonds (e.g., 30-year bonds backing 2-year liability)

Issue #6: Surrenders, Resets & Fund Transfers

Issue: –Insufficient guidance on modeling of surrenders, resets and fund transfers –Interrelationships among these options not recognized –In seg funds, surrender, reset and fund transfer are actually financial options

Issue #6: Surrenders, Resets & Fund Transfers Surrender: –Option to avoid making any future premium payments when value of the embedded guarantee turns out to be low Reset: –Option to lock in gains –Equivalently: surrender without penalty and reinvest in identical contract without sales commission

Issue #6: Surrenders, Resets & Fund Transfers Fund transfer: –Option to change risk profile of underlying assets to the advantage of the policyholder Partial surrender: –Option to lock in a portion of gains without invoking a reset

Issue #6: Surrenders, Resets & Fund Transfers Peculiarities of seg fund contracts that make these options valuable: –Premium paid over life of contract, not up-front –Premium varies with account balance –Premium collected varies inversely with risk (put-type guarantees) –Guarantee applies to account balance, not individual fund balances

Issue #6: Surrenders, Resets & Fund Transfers Partial surrender example: –Suppose AV = $200, GV = $100 and guarantee values adjusted proportionately for withdrawals –Suppose $80 is withdrawn and put into a risk-free savings account – Effective guarantee after withdrawal is $140 ($ % of $100)

Issue #7: Contract Aging & Market- Based Valuation

Issue: –No mechanism to ensure consistency with market valuation as: Contracts move closer to maturity and the embedded options become more similar to market-traded options Companies implement sophisticated risk management strategies like dynamic hedging

Issue #7: Contract Aging & Market-Based Valuation Background: –Current framework uses real-world rather than market-based (i.e., risk- neutral) valuation techniques –Supporting argument: If a company is not hedging the risk, what matters is whether it has sufficient assets to fund guarantees in all but the most catastrophic market scenarios

Issue #7: Contract Aging & Market-Based Valuation However, what happens when: –A market for long-dated options emerges? –The embedded options become short- dated options, comparable to market- traded options? –Companies implement dynamic hedging, which is based on market valuations?

Issue #7: Contract Aging & Market-Based Valuation Areas of particular concern: –Market-based values greater than current approach (e.g., low risk-free rates, high implied volatilities, etc) –Risk management strategies that transform a seg fund liability from one form to another and in so doing use actuarial valuation for a security that has an observable market value

Issue #7: Contract Aging & Market-Based Valuation Areas of particular concern cont’d: –Inconsistencies between actuarial and market-based valuation exploited to arbitrage capital requirements

Issue #8: Contract Grouping

Issue: –Insufficient guidance on contract grouping –Simple validation tests (e.g., point-in- time matching values) insufficient –Better grouping algorithms needed for dynamic hedging

Issue #8: Contract Grouping Why this is an issue: –Seg fund guarantee liabilities and capital highly sensitive to changes in account value, interest rates and time to maturity –Dynamic hedging requires accurate information on sensitivity to AV/GV, interest rates, time to maturity, volatility, etc to determine hedge parameters and implement an effective hedge

Issue #8: Contract Grouping Consequence: –Grouping algorithm needs to ensure that synthetic and seriatim portfolios have similar sensitivities to AV/GV, interest rates, time to maturity, etc –Small differences in sensitivities can result in large differences in liability and capital values, large tracking errors and ineffective hedges – Point-in-time value matching insufficient!

Issue #8: Contract Grouping Important comment: –Ultimate test of any hedging program is whether it mitigates the risk in the actual seriatim portfolio, not some synthetic proxy

Update of Hedging Guidelines

Until a review of the stochastic modeling framework is completed and any deficiencies addressed, OSFI does not intend to: –Update its general guidelines for hedging segregated fund guarantee risk –Consider capital credit for anything other than the simplest hedges

Update of Hedging Guidelines Important Note: –Hedging strategies that appear to mitigate risk within the current framework may introduce additional risk when viewed in true economic terms –A company implementing such a strategy may be required to hold additional capital, whether or not capital credit for the hedging strategy was requested

Conclusions

OSFI has identified 8 key issues in the current segregated fund guarantee valuation framework that need to be addressed Important that these issues be resolved in a timely fashion

Questions?