2009 Seminar for the Appointed Actuary

Colloque pour l’actuaire désigné 2009

2009 Seminar for the Appointed Actuary

Colloque pour l’actuaire désigné 2009

Canadian Institute

of Actuaries

Canadian Institute

of Actuaries

L’Institut canadien desactuaires

L’Institut canadien desactuaires

Segregated Funds andMarket Volatility Session

“Pricing Living Benefits inSegregated Funds Products”

John Fenton

September 17, 2009

2009

Sem

inar

for

the

App

oint

ed A

ctua

ryC

ollo

que

pour

l’ac

tuai

re d

ésig

né 2

009

2009

Sem

inar

for

the

App

oint

ed A

ctua

ryC

ollo

que

pour

l’ac

tuai

re d

ésig

né 2

009

• This presentation provides an overview of methodology used to price living benefit features on U.S. VA products

• Developed based on our knowledge of the industry and results of recently completed 2009 Towers Perrin GMWB Pricing and Hedging Survey• Survey reflects results for 10 major U.S. VA

writers including U.S. subsidiaries of Canadian companies

Overview20

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Continued . . .

• Pricing methodology believed to be generally applicable on Seg Fund products as well

Overview20

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• The global economic environment has presented major challenges for VA/Seg Fund products over the past 12 months• Equity markets dropped > 50%• Daily realized volatility in S&P index

routinely exceeded 60% on annualized basis during most volatile periods

• Both contributed to very high levels of implied volatility

Economic Environment 20

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Continued . . .

• Also, risk free rates fell to very low levels

• Wreaked havoc on in-force VA portfolios• Became significantly ITM (now with some

recovery)• Hedging not as good as advertised

• Cost to hedge new business rose dramatically

Economic Environment 20

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Continued . . .

• Required companies to rethink their approach on how to approach new product design/pricing

Economic Environment 20

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• The approach to pricing WB features has become more standardized although major issues exist on choice of assumptions

• Pricing of WB riders now routinely makes provision for cost of hedging• Priced using risk neutral scenarios

Pricing WB Features 20

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Continued . . .

• Typical approach is to determine cost of rider separately, then incorporate into base product pricing• Often expressed as annual cost via PV

calculation

• Base product generally priced using real world scenarios a few companies moving to risk neutral to support MCEV pricing

Pricing WB Features 20

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Continued . . .

• Provision for hedge effectiveness (or ineffectiveness) is typically made by assuming hedging replaces 1 – HE% of real world claims

• Effectively assumes hedging is covering cost of claims as they emerge

Pricing WB Features 20

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Continued . . .

• Variations on approach• Attempt to model impact of hedging

directly can be difficult to do and requires stochastic-on-stochastic testing

• Vary timing of hedge payoff move from time of claim to spread over hedging period

Pricing WB Features 20

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• A key issue is what to assume for the parameters underlying the risk neutral scenarios

• Two ends of spectrum• Use today’s swap rates and implied

volatility• Use long-term estimates

Risk Neutral Scenarios20

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Continued . . .

• Considerations• Product priced today will not be available

for sale for several months, will then be sold over ensuing 6-12-18-24 months

• Not necessarily locking in hedging costs at time product is issued

• Becomes significant issue when economic conditions move around

Risk Neutral Scenarios20

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Continued . . .

Risk Neutral Scenarios20

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Swap Rate

Tenor 6/30/06 12/31/07 9/30/08 10/31/08 12/31/08 3/31/09 5/31/09

1 5.69% 4.22% 3.96% 3.17% 1.27% 1.18% .86%

5 5.65 4.18 4.09 3.84 2.10 2.23 2.85

10 5.73 4.67 4.49 4.46 2.49 2.90 3.78

Source: Bloomberg for swap rates, investment banker quotes for implied volatility

S&P Implied Volatility

Tenor 6/30/06 12/31/07 9/30/08 10/31/08 12/31/08 3/31/09 5/31/09

1 15% 22% 27% 41% 35% 37% 29%

5 16 25 28 36 35 35 29

10 19 27 30 36 34 34 30

• We suggest a two-pronged approach to testing is appropriate

• Set assumptions based on “long-term estimates” although these are re-assessed frequently

• Also test (at time of pricing as well as on ongoing basis) at current market condition levels

• Ensure profitability meets minimum threshold requirements

• Some would suggest current environment should meet target profit requirements as well

Approach to Testing20

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Continued . . .

• Depending on relationship between target and minimum threshold profit levels may require companies to set long-term estimates at fairly conservative levels

• Important to run lots of sensitivity tests to understand impact of varying economic conditions

Approach to Testing20

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Continued . . .

• Could also reflect current market conditions grading to ultimate but difficult to capture in one set of scenarios

• Need to develop procedures to deal with sub-par profitability • Accept below threshold for X days• Product actions (i.e., pull product,

increase rider fees bracketed basis)

Approach to Testing20

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Continued . . .

• Industry practice tends to favor current market conditions• 50% assume current market conditions at

time of pricing• 20% use long-term estimates• 30% use other methods generally both

or blend

Approach to Testing20

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• Another key issue is how to derive implied volatility assumptions past last observable period

• We see three approaches being used in the industry• Grade to target ultimate (“mean reversion”)

generally historical realized volatility with margin or average of historical implied volatilities

• Hold level at last observable tenor• Hold level throughout

Implied Volatility Assumptions 20

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Continued . . .

Implied Volatility Assumptions 20

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Tenor Target Ultimate Last Observable Level

1 35% 37% 28%

5 33 35 28

10 31 35 28

15 29 35 28

30 27 35 28

• Industry results (mean) as of 3/31/09 for S&P

• Choice of assumptions can/should be tailored to nature of hedging

• Consider both the type of hedging that you currently utilize, as well as the type of hedging that you may want to implement in future• i.e., currently dynamically hedge only (i.e.,

hedging with delta via futures), but may want to add options for vega exposure

Linking Assumptions with Hedging20

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Continued . . .

• Considerations • Realized volatility; if dynamic hedging

only • Implied volatility up to N years, then

realized; if only buying static options up to N years

• Is swap curve locked into?

Linking Assumptions with Hedging20

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• Industry practices on assumed level of hedge effectiveness vary results from GMWB Pricing and Hedging Survey

Hedge Effectiveness 20

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Hedge Effectiveness Mean Pricing Tail Pricing

< 75% 1 5

75% <= X < 90% 2 2

90% <= X < 100% 3 1

100% 4 2

Total 10 10

Continued . . .

• Suggest that hedge effectiveness for tail calculation should be lower than mean pricing

• Hedge effectiveness would be expected to vary based on extent of basis risk

Hedge Effectiveness 20

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• U.S. companies are generally leveraging off C3 Phase II methodology; perhaps blending in internal economic capital as well• Many companies are reconsidering their

approach

Capital and Reserve Levels 20

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Continued . . .

• Lots of issues• Multiple of CTE90 level or higher CTE level• Degree of diversification: single cell vs.

total product vs. total VA block• Assumed level of hedge effectiveness

Capital and Reserve Levels 20

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Continued . . .

• Ideally, calculation would be done via stochastic-on-stochastic testing (could involve stochastic cubed with hedging)• However, not practical for many

companies, so factor based• Degree of factor sophistication varies

Capital and Reserve Levels 20

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Continued . . .

• Reflecting partial withdrawals via a cohort approach is becoming standard industry practice

• Typical cohorts:1. Begin immediately

2. Deferred 5 years

3. Deferred 10-20 years

4. Withdrawals only if policyholder deep ITM (better choice than no withdrawals)

Cohorts 2 and 3 generally set in consideration of specific products (e.g. bonus waiting period age tier)

Partial Withdrawals 20

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Continued . . .

• Assumed mix by cohort varies by issue age

• It may also be appropriate to assume withdrawals utilization triggered based on the in-the-moneyness

• Typical to assume full withdrawal• Once started, typical to assume they

last forever

Partial Withdrawals 20

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• There are two primary approaches to defining perceived value for in-the-moneyness, used primarily for dynamic lapse• PV of future payments • Benefit base amount

Prevalence in industry is roughly 50%-50%

Defining Value for ITM 20

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Continued . . .

• We favor the benefit base approach• What policyholders see in their statement• PV approach generally requires a 30%+

drop in funds before ITM kicks in we think policyholders would place more value on a benefit they are paying 75-100 bp for

• Emerging experience (still limited) suggests lapse dampening happening at smaller levels of equity market drops

Defining Value for ITM 20

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Continued . . .

• Remove additional shock lapse rate component (i.e., excess over ultimate lapse rate) when benefit ITM

• Consider floor lapse rate 2% is not unreasonable

Defining Value for ITM 20

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• Companies have moved to more conservative economic scenarios in their pricing• Have led companies to charge more or “de-

risk” WB riders• More stringent asset allocation• Less rich features

• Issue: when current market conditions become more favorable again, will companies revert back to prior practices?

What is the impact? 20

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