1. CIA Annual Meeting Assemblée annuelle de l’ICA June 29 & 30, 2006  Les 29 et 30 juin 2006 Ottawa, Ontario Session Val-5 CLIFR Part II

2. Term of the Liability CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

3. CIA Annual Meeting  Assemblée annuelle de l’ICA Standards 2320.16 through.27 Highlights: –2320.16 => if element of policy operates independently of the policy, it has its own term –2320.18 defines “renewal”, “adjustment” and “constraint” –2320.19 => may take account of one or more renewals / adjustments after B/S date –2320.20 => extend term with caution Session Val-5 CLIFR Part II SOP Summary

4. CIA Annual Meeting  Assemblée annuelle de l’ICA Highlights: –2320.22 => 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 –2320.23 => term extension to offset acquisition or similar expenses –2320.24 => write-down of AAE and recoverability testing Session Val-5 CLIFR Part II SOP Summary (cont’d)

5. CIA Annual Meeting  Assemblée annuelle de l’ICA 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 But at what level of aggregation? Session Val-5 CLIFR Part II What to Conclude

6. Term of the Liability – Practical Challenges CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

7. 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 (see examples) –For simplicity, assume no AAE! CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

8. Hedging Example Product –10-year 100% return-of-premium maturity guarantee –No death benefit guarantees –No resets –Total MER = 200 bps –Fund expenses = 135 bps –Fund mapped 100% to S&P 500 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

9. Hedging Example Hedging details –Put options purchased on S&P 500 –Structured to match the guarantee payable on the maturity date –Valued using Black-Scholes calibrated to current market prices CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

10. Hedging Example Valuation method & assumptions –S&P 500 projected under 1,000 calibrated scenarios –Account values and cashflows projected off the S&P 500 up to contract maturity date Fees less expenses Guarantee costs less put option payoffs (net to ~ 0) –Discounted at 5%, no lapses or deaths for simplicity –CTE 80 Reserve from this method is equivalent to PV expenses – PV fees at 5% / CTE 80 + cost of guarantee (=MV of puts) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

11. Hedging Example – Liability Data CohortIssue DateS&P 500 @IssDt Deposit 1Jul-1-20011,224.3810,000 2Jul-1-2002968.6510,000 3Jul-1-2003982.3210,000 4Jul-1-20041,128.9410,000 5Jul-1-20051,194.4410,000 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

12. Hedging Example – S&P 500 tCalendar DateAssumed S&P 500 Steady RiseRise & Fall 02006-Jun-301250 12007-Jun-3014001500 22008-Jun-3015001700 32009-Jun-3016751850 42010-Jun-3018001600 52011-Jun-3019501500 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

13. CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 1 9,2325(234)1,6401,406 211,9636(352)892540 312,0337(410)943533 410,6558(414)1,303890 510,2659(447)1,430983 LiabilityAsset = MV Puts Cohort/Seriatim Floor4,352 6,208 Aggregate Floor4,352 No Floor4,352 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Steady Rise Scenario – At June 30, 2006 (t=0 / S&P=1250) Session Val-5 CLIFR Part II

14. CIA Annual Meeting  Assemblée annuelle de l’ICA Cohor t AVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts 110,1564(208)1,144 213,1595(324)545 313,2376(388)617 411,7217(399)956 511,2928(438)1,098 LiabilityAsset = MV Puts Cohort/Seriatim Floor2,602 4,359 Aggregate Floor2,602 No Floor2,602 Balance Sheet Summary Steady Rise Scenario – At June 30, 2007 (t=1 / S&P=1400) Session Val-5 CLIFR Part II Liability Before Floor 935 221 229 556 660

15. CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts 110,6793(168)853 213,8364(276)358 313,9185(342)442 412,3246(362)770 511,8737(404)925 LiabilityAsset = MV Puts Cohort/Seriatim Floor1,795 3,348 Aggregate Floor1,795 No Floor1,795 Balance Sheet Summary Steady Rise Scenario – At June 30, 2008 (t=2 / S&P=1500) Session Val-5 CLIFR Part II Liability Before Floor 686 82 99 407 520

16. CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts 111,7122(124)418 215,1743(228)146 315,2634(302)224 413,5165(333)494 513,0206(382)650 LiabilityAsset = MV Puts Cohort/Seriatim Floor723 1,932 Aggregate Floor563 No Floor563 Balance Sheet Summary Steady Rise Scenario – At June 30, 2009 (t=3 / S&P=1675) Session Val-5 CLIFR Part II Liability Before Floor 294 (82) (78) 161 268

17. Steady Rise Scenario – At June 30, 2010 (t=4 / S&P=1800) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 112,3521(66)12055 216,0032(163)40(122) 316,0973(241)100(142) 414,2544(284)31329 513,7325(338)465127 LiabilityAsset = MV Puts Cohort/Seriatim Floor211 1,038 Aggregate Floor0 No Floor(52) Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

18. Steady Rise Scenario – At June 30, 2011 (t=5 / S&P=1950) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 113,1340000 217,0161(94)1(93) 317,1162(180)21(159) 415,1573(234)147(87) 514,6014(296)279(17) LiabilityAsset = MV Puts Cohort/Seriatim Floor0 448 Aggregate Floor0 No Floor(356) Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

19. Steady Rise Scenario – 5 Year Summary tFees – Exp LiabilityAsset = MV Puts Income SeriatimAggregateNo FloorSeriatimAggregateNo Floor 04,352 6,208 13702,602 4,359271 23971,795 3,348192 3427723563 1,93283243 44592110(52)1,03876128180 548600(356)448107(104)199 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

20. CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 19,2325(234)1,6401,406 211,9636(352)892540 312,0337(410)943533 410,6558(414)1,303890 510,2659(447)1,430983 LiabilityAsset = MV Puts Cohort/Seriatim Floor4,352 6,208 Aggregate Floor4,352 No Floor4,352 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Rise & Fall Scenario – At June 30, 2006 (t=0 / S&P=1250) Session Val-5 CLIFR Part II

21. CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 110,8974(226)914688 214,1185(353)41865 314,2006(420)48867 412,5757(433)793361 512,1148(474)932458 LiabilityAsset = MV Puts Cohort/Seriatim Floor1,639 3,545 Aggregate Floor1,639 No Floor1,639 Balance Sheet Summary Rise & Fall Scenario – At June 30, 2007 (t=1 / S&P=1500) Session Val-5 CLIFR Part II

22. CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 112,1333(191)495304 215,7184(317)193(124) 315,8105(393)261(132) 414,0006(415)51298 513,4877(463)650187 LiabilityAsset = MV Puts Cohort/Seriatim Floor589 2,111 Aggregate Floor332 No Floor332 Balance Sheet Summary Rise & Fall Scenario – At June 30, 2008 (t=2 / S&P=1700) Session Val-5 CLIFR Part II

23. CIA Annual Meeting  Assemblée annuelle de l’ICA CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 112,9612(139)22081 216,7903(258)75(184) 316,8894(340)131(209) 414,9555(373)331(42) 514,4076(426)46438 LiabilityAsset = MV Puts Cohort/Seriatim Floor118 1,220 Aggregate Floor0 No Floor(317) Balance Sheet Summary Rise & Fall Scenario – At June 30, 2009 (t=3 / S&P=1850) Session Val-5 CLIFR Part II

24. Rise & Fall Scenario – At June 30, 2010 (t=4 / S&P=1600) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 110,9541(65)363298 214,1932(151)113(38) 314,2773(221)211(10) 412,6424(259)528269 512,1795(307)714407 LiabilityAsset = MV Puts Cohort/Seriatim Floor973 1,929 Aggregate Floor925 No Floor925 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

25. Rise & Fall Scenario – At June 30, 2011 (t=5 / S&P=1500) CohortAVYrs to Mat PV Expenses less Fees Guarantee Cost = MV Puts Liability Before Floor 110,0510000 213,0241(74)67(7) 313,1012(141)20463 411,6003(184)607423 511,1754(231)839607 LiabilityAsset = MV Puts Cohort/Seriatim Floor1,093 1,717 Aggregate Floor1,086 No Floor1,086 Balance Sheet Summary CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

26. Rise & Fall Scenario – 5 Year Summary tFees – Exp LiabilityAsset = MV Puts Income SeriatimAggregateNo FloorSeriatimAggregateNo Floor 04,352 6,208 13841,639 3,545433 2439589332 2,11155312 34781180(317)1,22058(80)236 4456973925 1,929310240(77) 54001,0931,086 1,7176827 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

27. How to apply zero floor at a finer level of aggregation than hedging portfolio? –Options aren’t allocated to cohorts in practice Value of options added to reserve “drops off” when total reserve becomes negative –Since term becomes zero Is the balance sheet position appropriate? How do you explain earnings when zero floor kicks in, given change in the stock market? CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Observations

28. Challenge 2 – Cashflow Asymmetry 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” CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

29. Example Two cohorts –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? CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

30. 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? CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

31. 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 1 liability = 1,000 –Cohort 2 liability = -300 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Cohort/SeriatimAggregateNo Floor Scenario 10-1,0000 Scenario 20-3000 Income (after claim payment) Example (cont’d)

32. Here the issue is more significant if you don’t hedge Is the balance sheet position appropriate? –With seriatim floor? –With aggregate floor? –No floor? One option is to choose the term on an aggregate level by choosing the term that maximizes liability (may involve renewing cohort 1) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Observations

33. Recoverability Testing for AAE CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

34. Use MfADded assumptions Direction chosen appropriate in aggregate –High lapse favours guarantee –Low lapse favours AAE CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II Non-Economic Assumptions

35. CIA Annual Meeting  Assemblée annuelle de l’ICA CTE 0Accounting view? Compare with similar accounting items subject to impairment testing CTE 60Actuarial view? Divorces considerations for AAE recoverability from those for guarantees CTE XAligns considerations for AAE recoverability from those for guarantees Whole contract view? Session Val-5 CLIFR Part II Choice of CTE Level

36. CTE 80In range of SOP Awkward (?) if CTE level for guarantees is lower than 80 CTE 95Solvency-oriented  Ed note will endorse two methods: –CTE 60 –CTE X Session Val-5 CLIFR Part II CIA Annual Meeting  Assemblée annuelle de l’ICA Choice of CTE Level (cont’d)

37. CIA Annual Meeting  Assemblée annuelle de l’ICA Term of the liability reads literally as a seriatim concept However, common/accepted practice thought to be at portfolio-wide level –Banks, mutual funds –Consistent with US GAAP and International GAAP No recognition of cash flows for a policy beyond its term of the liability, but deficiencies can offset excesses (see example) Session Val-5 CLIFR Part II Level of Aggregation

38. Level of Aggregation – Example Policy APolicy B Remaining AAE100 Term of liability35 PV of cashflows over 3 years90105 PV of cashflows over 5 years100115 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

39. Level of Aggregation – Example (cont’d) Acceptable practice: –Aggregate across policies A and B –Total AAE = 200 –Total PV cashflow (TOL) = 205 (90+115)  Test is satisfied CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

40. Level of Aggregation – Revised Example Policy APolicy B original Policy B revised Remaining AAE100 Term of liability355 PV of cashflows over 3 years9010595 PV of cashflows over 5 years100115105 CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

41. Level of Aggregation – Revised Example (cont’d) Same level of aggregation yields: –Total AAE = 200 –Total PV cashflow (over TOL) = 195 (90+105)  Test is not satisfied It is not acceptable to extend Policy A to 5 years to satisfy the test as follows: –Total AAE = 200 –Total PV cashflow (over 5 yrs) = 205 (100+105) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

42. Policyholder Behaviour CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II

43. CIA Annual Meeting  Assemblée annuelle de l’ICA 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 Session Val-5 CLIFR Part II Summary

44. CIA Annual Meeting  Assemblée annuelle de l’ICA Option exercise correlated with in- moneyness Anti-selection Consider reasonable expectations PH sophistication & perceived financial interest in policy < 100% efficiency Session Val-5 CLIFR Part II Guiding Principles

45. Questions? (or comments, criticisms, accusations, threats, or even accolades) CIA Annual Meeting  Assemblée annuelle de l’ICA Session Val-5 CLIFR Part II