1. 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

2. 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

3. 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

4. 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

5. 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

6. 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)

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. Questions