1. Considerations in the Valuation of Segregated Fund Products

2. 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, looking for feedback
Expected Completion – Spring 2007

3. Content of note Methodology – Bifurcated versus Whole Contract
What is a PFAD?
Discount rate
Term of the Liability – Issues
Hedging
Level of Aggregation
Recoverability Testing for AAE
Policyholder Behaviour

4. 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

5. Methodology – Bifurcated vs. Whole Contract
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

6. Methodology – Bifurcated vs. Whole Contract
Allocation of revenue to the guarantee would generally be related to the additional charge priced into the product for the guarantee

7. 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

8. 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

9. 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

10. Methodology – Bifurcated vs. Whole
Contract - Whole Contract Approach 2 – DAC Focus
This method is consistent with Standards
For the remainder of the presentation we will simply call this the whole contract approach

11. 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
Once the AAE is written down it may not be written back up.

12. 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 which suggests that the term ends at the balance sheet date unless extending the term increases the liability

13. Bifurcated Method AAE of $50
Methodology – Example
- Cohort of variable annuity policies with an initial
AAE of $50
Policies priced with 5 basis points of revenue plus additional charge of 2 basis points for a 10 year maturity guarantee
Bifurcated Method
Recoverability testing for the AAE is done assuming 5 basis points of revenue. The liability for the guarantee is calculated assuming 2 basis points of revenue.
Allocation doe not change period to period.

14. -Whole Contract Method
Methodology – Example
-Whole Contract Method
The entire 7 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.

15. Methodology Example
0.04
3.42
Total
-43.44
-40.0

16. 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.

17. Methodology – Considerations
At this time CLIFR is not recommending one method over the other
Both methods consistent with standards
Currently the whole contract method is more commonly used
Direction of international standards appears to be toward bifurcated approach
When the direction of international standards becomes clearer we will move in that direction.

18. What is a PfAD?
We are responding to members’ request for guidance as per the OSFI survey requested guidance
Essentially a disclosure issue
SOP Section : “Provision for adverse deviations is the difference between the actual result of a calculation and the corresponding result using best estimate assumptions.”
The term of the liability for segregated fund products has resulted in different interpretations as to the period over which the calculation extends

19. What is a PfAD?
CLIFR’s initial thinking done in the context of quantification of PfADs in AAR
Issue has been elevated with companies starting to disclose PfADs externally
This has now been identified as an issue by the Committee on the Role of the Appointed Actuary and we will be working with them on this.

20. Term of the Liability Section 2320.27 Section 2320.23
“…the term of the liability ends at the balance sheet date for….the general account portion of a deferred annuity with segregated fund liabilities but without guarantees;”
Section
“The actuary would extend such term solely to permit recognition of cash flow to offset acquisition or similar expenses whose recovery from cash flow that would otherwise be beyond such term was contemplated by the insurer in pricing…

21. Term of the Liability Add Guarantee:
=> term ends at the earlier of:
First renewal or adjustment date at or after B/S date at which there is no constraint
Renewal / adjustment date after the B/S date which maximizes policy liabilities

22. Term of the Liability What to Conclude
The phrase “maximizes policy liabilities” suggests the term reduces to zero if liabilities would otherwise be negative.
Assuming product is continually renewable and no AAE
Corollary to this is the liability for the guarantees has a floor of zero
With the addition of a guarantee, additional revenue may be recognized, but only enough to cover additional costs

23. Term of the Liability Practical Challenges

24. Challenge 1 – Hedging
Segregated funds have significant insurance risk and are often hedged
Hedging is managed on a portfolio basis
Trading in options is costly
Zero floor can disrupt parity between asset and liability sides of the balance sheet

25. Hedging Example Description
Example reflects the guarantee reserve only, no AAE
Hedging is accomplished via short position in futures
Initial calculated liability is negative on both hedged and unhedged basis, so zero floor is applied
Expected market growth over the length of the contract is around 10%

26. Hedging Example
Earnings on a hedged basis are Fee income – claims + interest on reserve + change in FMV of derivative – change in reserve
Change in reserve is Change in CTEx (liability cashflows + hedge g/l)

27. Year 1 Market Growth Hedged No floor 0% 110 62 85 10% 34 74 92 20% -48
Hedging Example - Emergence of Earnings
Year 1
Market
Growth
Hedged
Zero floor
No floor
Unhedged 0%
110 62 85
10% 34 74 92
20%
-48 93

28. Hedging Example - Emergence of Earnings
Details – 20% Growth
Hedged
Zero floor
No floor
Unhedged
Zero Floor
Fee Income 93
Investment Income
-141
-149
Claims
Change in liability
-130
Total pre-tax
-48 74

29. Challenge 1 – Hedging Summary
Change in FMV goes though income on asset side
Expect offsets (not exact) on liability side but this may not occur if constrained by zero floor
CLIFR believes is would be appropriate to allow liability for guarantee to become negative in the context of hedging
Subject to avoiding capitalizing more future profit than in the absence of hedging

30. Challenge 2 – Cashflow Asymmetry / Level of Aggregation
Claims from segregated fund guarantees can come in waves
Depends on when sold and where market was at that time
Also depends on product design
Magnified if sales pattern is “chunky”

31. Level of Aggregation
Term of the liability reads literally as a seriatim concept
Common/accepted practice thought to be at portfolio-wide or product level
However, care must be taken if the level of aggregation combines blocks with significantly different risk profiles..

32. Example Two cohorts Current S&P 500 = 1,250
Cohort 1 sold in 1999 (S&P 500 = 1,455)
Cohort 2 sold in 2002 (S&P 500 = 975)
Current S&P 500 = 1,250
Cohort 1 is deep in the money with 1 year left to maturity
Cohort 2 is deep out of the money with 4 years left to maturity
What should the total liability be?

33. Example (cont’d)
Cohort 1 will likely pay out significant claims next year (assume no hedging)
Assume claims are imminent at 1,000 (reserve = 1,000)
How does total liability account for this?
What impact does zero floor have here?

34. Example (cont’d)
Scenario 1: Cohort 2 liability deeply negative before zero floor
Cohort 1 liability = 1,000
Cohort 2 liability = -1,200
Scenario 2: Cohort 2 liability slightly negative before zero floor
Cohort 2 liability = -300
Cohort/Seriatim
Aggregate
No Floor
Scenario 1
-1,000
Scenario 2
-300

35. Level of Aggregation Conclusion
An important consideration in determining the appropriate level of aggregation is the homogeneity of policies

36. Recoverability Testing Non economic assumptions
Use MfADded assumptions
Direction chosen appropriate in aggregate
High lapse favours guarantee
Low lapse favours AAE

37. Choice of CTE Level CTE 0 Accounting view?
Compare with similar accounting items subject to impairment testing
CTE 60
Actuarial view?
Divorces considerations for AAE recoverability from those for guarantees
CTE X
Aligns considerations for AAE recoverability from those for guarantees
Whole contract view?

38. Expect Ed. note will endorse two methods:
Choice of CTE Level (cont’d)
CTE 80
In range of SOP
Awkward (?) if CTE level for guarantees is lower than 80
CTE 95
Solvency-oriented
Expect Ed. note will endorse two methods:
CTE 60
CTE X where X is between 60 and 80

39. Policyholder Behaviour – Summary • Policyholder behaviour an important assumption for segregated funds:
Full and Partial Withdrawal
Resets
Fund transfers
Annuitizations if material
Consider interrelationships, particularly reaction to the scenario
Must combine experience data with common sense / intuition when modelling dynamic behaviour
Consider higher MfADs for these

40. Guiding Principles Option exercise correlated with in-moneyness
Anti-selection
Consider reasonable expectations
PH sophistication & perceived financial interest in policy
< 100% efficiency