CIA Annual Meeting LOOKING BACK…focused on the future

CIA Annual Meeting Session: 1401 ALM With/Without MFADs Executing ALM with and without MFADS Moderator Ted Steven Speaker Don E. C. Fischer Executing ALM with and without MFADS Moderator Ted Steven Speaker Don E. C. Fischer

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Why this particular topic? ALM Working Group ALM Practitioners Association March 30, 2005 Special ALM PA Meeting Why this particular topic? ALM Working Group ALM Practitioners Association March 30, 2005 Special ALM PA Meeting

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Why this particular topic? ALM Working Group ALM Practitioners Association March 30, 2005 Special ALM PA Meeting What is best practice? Theoretical Considerations Practical Considerations Why this particular topic? ALM Working Group ALM Practitioners Association March 30, 2005 Special ALM PA Meeting What is best practice? Theoretical Considerations Practical Considerations

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Why this particular topic? ALM Working Group ALM Practitioners Association March 30, 2005 Special ALM PA Meeting What is best practice? Theoretical Considerations Practical Considerations Who is your teacher today? Why this particular topic? ALM Working Group ALM Practitioners Association March 30, 2005 Special ALM PA Meeting What is best practice? Theoretical Considerations Practical Considerations Who is your teacher today?

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs MFADs in CALM- Liability or Appropriated Surplus CSOP calls for reserve testing using CALM. CALM tests the adequacy of the asset cashflows to service the liability. CALM requires the inclusion of Margins For Adverse Deviations (MFADs) MFADs increase the required assets What is an appropriate investment policy ? MFADs in CALM- Liability or Appropriated Surplus CSOP calls for reserve testing using CALM. CALM tests the adequacy of the asset cashflows to service the liability. CALM requires the inclusion of Margins For Adverse Deviations (MFADs) MFADs increase the required assets What is an appropriate investment policy ?

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Alternative Views of the MFADs Expected cashflows for the LOB/company Appropriated future surplus Investment Policies: 1)Fixed income assets that cashflow match the expected release of MFADs 2)Invest the MFADs as if they represented surplus Alternative Views of the MFADs Expected cashflows for the LOB/company Appropriated future surplus Investment Policies: 1)Fixed income assets that cashflow match the expected release of MFADs 2)Invest the MFADs as if they represented surplus

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Testing: To examine the financial impact of alternative investment policies for the assets backing MFADs in CALM valuation Testing: To examine the financial impact of alternative investment policies for the assets backing MFADs in CALM valuation

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Testing Approach Test a simple policyholder liability A 5 Year Compound GIC Priced the 5 Year GIC using a spot yield curve Investments in Zero-coupon bonds Prepared Financial Statements for 5 Years Cashflow Statement (Source and Use of Funds) Income Statement Balance Sheet Testing Approach Test a simple policyholder liability A 5 Year Compound GIC Priced the 5 Year GIC using a spot yield curve Investments in Zero-coupon bonds Prepared Financial Statements for 5 Years Cashflow Statement (Source and Use of Funds) Income Statement Balance Sheet

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Testing Approach (Continued) Used 3 different scenarios for the actual interest rate movement 1)Initial spot rate curve persists 2)Parallel shift upward annually of 80 basis points (B.P) 3)Parallel shift downwards annually of 40 basis points Annual CALM testing using 20 different future interest rate scenarios Tested several investment strategies for MFADs 1)Matching Strategy - Cashflow Matching with fixed income assets 2)Mismatched Long 10 Year Strategy - Investment in 10 Year Zero-coupon bonds Testing Approach (Continued) Used 3 different scenarios for the actual interest rate movement 1)Initial spot rate curve persists 2)Parallel shift upward annually of 80 basis points (B.P) 3)Parallel shift downwards annually of 40 basis points Annual CALM testing using 20 different future interest rate scenarios Tested several investment strategies for MFADs 1)Matching Strategy - Cashflow Matching with fixed income assets 2)Mismatched Long 10 Year Strategy - Investment in 10 Year Zero-coupon bonds

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Assumptions Reporting year = Policy year All (internal or external) asset sales at market value Shareholder dividends payout a fixed % of company earnings Liability segment at maturity reports through reserves gain/(loss) on sale of any remaining assets MFADs = Profit Objective Higher investment returns expected under a “surplus investment strategy” than a “matching” strategy Assumptions Reporting year = Policy year All (internal or external) asset sales at market value Shareholder dividends payout a fixed % of company earnings Liability segment at maturity reports through reserves gain/(loss) on sale of any remaining assets MFADs = Profit Objective Higher investment returns expected under a “surplus investment strategy” than a “matching” strategy

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Pricing Model for 5 Year GIC

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Summary 5 Year Compound GIC Single Premium $100,000 Credited Rate3.00% Maturity Benefit$115,927 Liability Summary 5 Year Compound GIC Single Premium $100,000 Credited Rate3.00% Maturity Benefit$115,927

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Expected Liability Cashflows (End of Year)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs 5 Year GIC Investment Strategy Full Match including MFADs Duration of MFADS = 3.0 years Match liability and expense Duration of asset for MFADs = 10 years Durational mismatch for MFADs = 7.0 years 5 Year GIC Investment Strategy Full Match including MFADs Duration of MFADS = 3.0 years Match liability and expense Duration of asset for MFADs = 10 years Durational mismatch for MFADs = 7.0 years

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Statement of Cashflow at T = 0 (Matched) Statement of Cashflow at T = 0 (Matched)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Statement of Cashflow at T = 0 (Mismatched) Statement of Cashflow at T = 0 (Mismatched)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Income Statement at T = 1 (Matched - Increasing Rates) Income Statement at T = 1 (Matched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Income Statement at T =1 (Income Comparison - Increasing Rates) Income Statement at T =1 (Income Comparison - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Statement of Cashflow at T = 1 (Matched - Increasing Rates) Statement of Cashflow at T = 1 (Matched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Statement of Cashflow at T = 1 (Matched - Increasing Rates) Statement of Cashflow at T = 1 (Matched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Statement of Cashflow at T = 1 (Mismatched - Increasing Rates) Statement of Cashflow at T = 1 (Mismatched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Statement of Cashflow at T = 1 (Mismatched - Increasing Rates) Statement of Cashflow at T = 1 (Mismatched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Required Reserves as determined by CALM

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Required Reserves as determined by CALM

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Balance Sheet (Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Balance Sheet (Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Profit Summary (Matched - Increasing Rates) Liability Profit Summary (Matched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Profit Summary (Mismatched - Increasing Rates) Liability Profit Summary (Mismatched - Increasing Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Income Statement at T = 1 (Matched - Stable Rates) Income Statement at T = 1 (Matched - Stable Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Income Statement at T = 1 (Mismatched - Stable Rates) Income Statement at T = 1 (Mismatched - Stable Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Required Reserves as determined by CALM

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Required Reserves as determined by CALM

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Profit Summary (Matched - Stable Rates) Liability Profit Summary (Matched - Stable Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Profit Summary (Mismatched - Stable Rates) Liability Profit Summary (Mismatched - Stable Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Balance Sheet (Stable Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Balance Sheet (Stable Rates)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Reserve Comparison

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Reserve Comparison

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Profit Comparison

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Profit Comparison

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Company Profit Comparison

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Company Profit Comparison

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liquidation Value Summary

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liquidation Value Summary

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Observations Asset Activity Mismatch strategy requires liability segment to sell assets at end of each reporting period GIC Reserves Mismatch strategy requires higher reserves for first 2 years in all interest rate scenarios Mismatch strategy results in lower reserve at year 5 if rates decline or are stable Mismatch strategy results in higher reserve at year 5 if rates increase Observations Asset Activity Mismatch strategy requires liability segment to sell assets at end of each reporting period GIC Reserves Mismatch strategy requires higher reserves for first 2 years in all interest rate scenarios Mismatch strategy results in lower reserve at year 5 if rates decline or are stable Mismatch strategy results in higher reserve at year 5 if rates increase

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Observations GIC LOB Profit Profit over the 5 year horizon is increased if interest rates are stable or decline under a mismatched strategy Profit over the 5 year horizon is reduced if interest rates are increasing under a mismatched strategy Observations GIC LOB Profit Profit over the 5 year horizon is increased if interest rates are stable or decline under a mismatched strategy Profit over the 5 year horizon is reduced if interest rates are increasing under a mismatched strategy

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Observations Company Profit under a mismatched strategy Profit over the term of the liability is increased if interest rates are stable Profit over the term of the liability is reduced if interest rates are increasing Observations Company Profit under a mismatched strategy Profit over the term of the liability is increased if interest rates are stable Profit over the term of the liability is reduced if interest rates are increasing

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Observations Shareholder Dividends Fixed 50% distribution policy results in volatile dividends (likely unacceptable) under mismatch strategy Liquidation Value Varies depending on interest rate movements Varies more using a Mismatched strategy Observations Shareholder Dividends Fixed 50% distribution policy results in volatile dividends (likely unacceptable) under mismatch strategy Liquidation Value Varies depending on interest rate movements Varies more using a Mismatched strategy

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Comments Impact of Mismatching MFADs Modestly more income with greater volatility in earnings Probably less income in first policy year Dividends or retained surplus (& capital ratio) could be more variable Results dependent on Additional yield expected from Surplus Investment Strategy Experienced change in interest rates The total company investment policy should be appropriate Comments Impact of Mismatching MFADs Modestly more income with greater volatility in earnings Probably less income in first policy year Dividends or retained surplus (& capital ratio) could be more variable Results dependent on Additional yield expected from Surplus Investment Strategy Experienced change in interest rates The total company investment policy should be appropriate

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Comments A more/less conservative investment policy for liability allows a less/more aggressive policy for surplus If liability investment policy doesn’t provide the cash for dividends, surplus policy should Retained earnings from existing liabilities may need to be in cash form to finance new business Is it better to be aggressive with surplus rather than liability investment strategy? Comments A more/less conservative investment policy for liability allows a less/more aggressive policy for surplus If liability investment policy doesn’t provide the cash for dividends, surplus policy should Retained earnings from existing liabilities may need to be in cash form to finance new business Is it better to be aggressive with surplus rather than liability investment strategy?

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs View of MFADs Cash or Non-cash ? Corporate dividends and tax payments require cash Corporate dividends and tax payments are a function of earnings MFADS are expected to emerge as future before-tax earnings MFADs substantially represent future cash payment requirements If experience worse than expected, cash payments are for additional benefits or expense If experience as expected 40% of MFADs paid as tax 30% of MFADs paid as shareholder dividends 30% retained as surplus View of MFADs Cash or Non-cash ? Corporate dividends and tax payments require cash Corporate dividends and tax payments are a function of earnings MFADS are expected to emerge as future before-tax earnings MFADs substantially represent future cash payment requirements If experience worse than expected, cash payments are for additional benefits or expense If experience as expected 40% of MFADs paid as tax 30% of MFADs paid as shareholder dividends 30% retained as surplus

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Conclusions A Matching strategy for liability MFADs has the potential to deliver earnings exactly as priced provides greater stability in earnings, ROE, dividends, capital ratio permits more aggressive investment strategy for surplus assets allows corporate mismatch to be taken in surplus with less impact on reported earnings provides needed cash to handle adverse experience and/or for income tax and shareholder dividend payments Conclusions A Matching strategy for liability MFADs has the potential to deliver earnings exactly as priced provides greater stability in earnings, ROE, dividends, capital ratio permits more aggressive investment strategy for surplus assets allows corporate mismatch to be taken in surplus with less impact on reported earnings provides needed cash to handle adverse experience and/or for income tax and shareholder dividend payments

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Conclusions A “Quasi-Surplus” strategy for MFADs has potential to deliver higher earnings in the long-term is penalized by Canadian Asset Liability Method similar results occur if mismatch expense and liability payments could be employed for a portion of the MFADs more appropriate with a conservative investment strategy for surplus more aggressive investment strategies (15 year rather than 10 year) create more volatility with potential for greater earnings Conclusions A “Quasi-Surplus” strategy for MFADs has potential to deliver higher earnings in the long-term is penalized by Canadian Asset Liability Method similar results occur if mismatch expense and liability payments could be employed for a portion of the MFADs more appropriate with a conservative investment strategy for surplus more aggressive investment strategies (15 year rather than 10 year) create more volatility with potential for greater earnings

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Conclusions The investment strategy for MFADs should consider the company’s and the LOB’s objective for stable earnings and whether investment risk is better taken opposite liabilities or surplus Conclusions The investment strategy for MFADs should consider the company’s and the LOB’s objective for stable earnings and whether investment risk is better taken opposite liabilities or surplus

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Pricing Model for 25 year SPIA

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs Liability Summary 25 Year SPIA Premium $ 61,856,642 Benefit & Expense(annual) Yrs 1-10 (5,400,000) Yrs (2,700,000) Profit (annual) Yrs 1-10 (600,000) Yrs (300,000) Liability Summary 25 Year SPIA Premium $ 61,856,642 Benefit & Expense(annual) Yrs 1-10 (5,400,000) Yrs (2,700,000) Profit (annual) Yrs 1-10 (600,000) Yrs (300,000)

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs 25 Year SPIA Investment Strategy Full Match including MFADs Duration of MFADS = 8.1 years Match liability and expense MFADS invested in 15 year zero-coupon bond Duration of asset for MFADs = 15 years Durational mismatch for MFADs = 6.9 years 25 Year SPIA Investment Strategy Full Match including MFADs Duration of MFADS = 8.1 years Match liability and expense MFADS invested in 15 year zero-coupon bond Duration of asset for MFADs = 15 years Durational mismatch for MFADs = 6.9 years

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs SPIA - GIC Results Comparison Release of MFADs Actual/Target Mismatched with increasing Interest Rates Experienced SPIA - GIC Results Comparison Release of MFADs Actual/Target Mismatched with increasing Interest Rates Experienced

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs SPIA - GIC Results Comparison Release of MFADs Actual/Target Mismatched with increasing Interest Rates Experienced SPIA - GIC Results Comparison Release of MFADs Actual/Target Mismatched with increasing Interest Rates Experienced

LOOKING BACK…focused on the future CIA Annual Meeting ALM With/Without MFADs SPIA Observations LOB Profit First year Loss is likely (due to C3 provisioning) Compared to shorter term GIC, potential for larger shortfalls and volatility in reported profit SPIA Observations LOB Profit First year Loss is likely (due to C3 provisioning) Compared to shorter term GIC, potential for larger shortfalls and volatility in reported profit