8I-U - Valuation and Financial Statements
Book:Valuation of Life Insurance Liabilities - Chapter 1 - TYPES OF VALUATIONS AND BASIC REQUIREMENTS
Book:Valuation of Life Insurance Liabilities - Chapter 2 - RESERVE METHODOLOGIES AND BASES
Book:Valuation of Life Insurance Liabilities - Chapter 3 - TYPES OF RESERVE FACTORS
Book:Valuation of Life Insurance Liabilities - Chapter 4 - VALUATION OF INTEREST SENSITIVE LIFE PRODUCTS
Book:Valuation of Life Insurance Liabilities - Chapter 5 - VALUATION OF ANNUITIES
Book:Valuation of Life Insurance Liabilities - Chapter 6 - VALUATION OF VARIABLE PRODUCTS
Book:Valuation of Life Insurance Liabilities - Chapter 7 - MISCELLANEOUS RESERVES
Book:Valuation of Life Insurance Liabilities - Chapter 8 - CASH FLOW TESTING
Book:U.S. GAAP - Chapter 3 - EXPENSES AND CAPITALIZATION
Book:U.S. GAAP - Chapter 4 - TRADITIONAL LIFE INSURANCE (SFAS 60 AND SFAS 97)
Book:U.S. GAAP - Chapter 5 - TRAD LIFE (SFAS 120)
Book:U.S. GAAP - Chapter 6 - UNIVERSAL LIFE INSURANCE
Book:U.S. GAAP - Chapter 7 - DEFERRED ANNUITIES
Book:U.S. GAAP - Chapter 8 - VARIABLE AND EQUITY-BASED PRODUCTS
Book:U.S. GAAP - Chapter 9 - ANNUITIES IN PAYMENT STATUS
Book:Study Notes and Published Refences - Note SN 8I-309-01 - MANAGEMENT REPORTS AND REPORTS TO REGULATORY BODIES
Book:Study Notes and Published Refences - Note TSA XXXVIII - STRATEGIC MANAGEMENT OF LIFE INS CO SURPLUS
Book:Study Notes and Published Refences - Note SN 81-303 - ACTUARIAL REVIEW OF RESERVES AND OTHER A.S. LIABILITIES
Book:Study Notes and Published Refences - Note SN 8I-304-00 - VALUE BASED FINANCIAL MEASUREMENT
Book:Study Notes and Published Refences - Note 8I-306-00 - CASH FLOW ANALYSIS TECHNIQUES
Book:Study Notes and Published Refences - Note SN 8I-308-00 - REGULATORS' PERSPECTIVE ON ACTUARIAL OPINIONS AND VALUATIONS
Book:Study Notes and Published Refences - Note SN 8IU-310-04 - VALN OF LIVING AND DEATH BENEFIT GUARANTEES FOR VARIABLE ANNUITIES
Valuation of Life Insurance Liabilities - Chapter 1 - TYPES OF VALUATIONS AND BASIC REQUIREMENTS
Overview
- principle liablilities of a LIC are due to contingent benfits granted on its long term policies and contracts
- small cahnge if value can have significant impact on co's earnings
- reserves - liablilities for amts inc co is boligate to pay in accordance w/ policy
- amts usually uncertain or contingent as to exact amt and/or time of payment
- some reserves for incurred but unknown to ins co - claim (or loss) reserves
- some reserves for event not yet happened but ins co obligated to pay - policy reserves
- actuarial reserves = policy reserves (as far as text is concerned)
- actuarial valuation - process of determining actuarial reserves
- theory behind reserves (law of large numbers) only true for blocks of policies, not at the indiv policy level
Types of Valuations
- Statutory Valuations
- used to help regulators assess financial health of the company
- conservative assumptions since emphasis on solvency
- in US - assumptions and methodology very explicit in the law
- US rules based on old practical decisons made in pre-computer era
- trend toward more than just "cookbook" - need to ensure liabilities good and sufficient
- GAAP Valuations
- required if stock is publicly traded or owned by a apublicly traded co
- objective: accurate allocation of income to period earned
- assumptions required to be reasonable and conservative, not as conservative as stat
- Canada - GAAP = Stat (using PPM)
- incorporates explicit lapse/surrender assumptions
- Gross Premium Valuations
- used to produce "best estimate" value of co's liabilities
- less conservative than GAAP
- may be appropriate to determin co value for acquisition/merger
- incorporates explicit lapse assumption
- PV future gross prems - PV future benefits
- PPM is a gross prem valn
- value-added financial measurement - offshoot of GP Valn
- uses stat reserves, but future values of stat profits recognized in valn
- Tax Reserve Valuations
- used to calc reserves for determing taxable income
- Canada - 1.5 yr FPT w/ csv floor
- may be > or < statement Vx
- US - 1958-1984 based on stat Vx w/ adjustments
- 1984+ - FPTR (Fed Prescribed Tax Reserves)
Effects of Stat Reserve Requirements
- Gross Premium Levels
- indirectly affect since guar prems typically set at level to avoid def reserves
- take into account cost of capital required
- Product Design
- guar rates to avoid def reserves
- avoid product features too difficult to reerve
- int guarantees on annuities affected by CARVM
- FIT
- FPTR make it fairly insensitive to Stat
- if unspecified in tax code - follow stat practices
- Tax Vx <= Stat Vx
- Divs to PO
- if div formula uses Stat Vx, significant impact
- if doesn't use Stat Vx, still probably uses some stat info to allocate surplus
- Stat Earnings
- obvious - stat Vx affects Stat earnings
- US: divs to stockholders limited to accum stat earnings of Co
- Important Indicators
- several industry measures are based on Stat Financial Measures (like rating agencies)
- Other Considerations
- pricing profit objectives might be accum surplus / stat Vx > y% at year z
- reserving methods do not directly affect total profitability of a product, only emergence of profit by year (pre-tax)
Valuation Requirements
- 3 major components - math calc, verification of results, actuarial opinion
- Mathematical Calculations
- PV of excess of future benefits over future premiums
- based on assumptions for lapses, mortality, interest, etc
- Verification of Results
- demonstration that assumptions are reasonable
- interest given more scrutiny o flate
- structure of assets need to be viewed together w/ structure of liab
- Actuarial Opinion
- qualified actuary signs opinion re: appropriatness of Vx
Valuation Requirements in the US
- SVL
- Opinion shoudl list items and amounts for which expressing an opinion
- OK to have sep opinions for separate blocks
- indicated reliance on others
- requires an actuarial analysis of reserve and assets supporting reserves
- Opinion as to Non-Guaranteed Elements
- includes contracts such as (if they contain non-guar elements)
- single and periodic premium DAs
- UL contracts w/ fixed and/or flex prems
- indeterminate premium life contracts
- single and periodic premium ilfe contracts
- ren and conv term ins contract which do not guar the prems payable on renewal or which provide fo rrenewal on teh then current basis
- if contract ahs charges or benefits which vary at co discretion (excl divs and sep acct based contracts) then A.S. aslo needs
- statement containing determination procedure for non-guar elements
- 8 interrogatories dealing w/ determination of non-guar elements, supportibility and relationship of current non-guar elements to those used in sales illustrations
- actuarial opinion related to non-guar elements signed by a MAAA
- RBC Requirements
- Four components
- Asset quality and payment default risk
- Insurance Risk (pricing)
- Interest Rate risk (disintermediation, reinvestment)
- Business risk
- represents "minimum" capital and surplus level for a particular co
Valuation Requirements in Canada
- big gap here since 8I-U and not 8I-C
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Valuation of Life Insurance Liabilities - Chapter 2 - RESERVE METHODOLOGIES AND BASES
Valuation Standards in the US
- determined as of policy issue date by state valn laws then in effect
- most state laws based on SVL
- min Vx defined in terms of net prem valn
- defines minimum standards of mortality and interest
- 1980 amendments - dynamic valn int rate - allows automatic adjustments to int rate changes
Valuation Bases in the US
- Valn Mortality
- Pre-80 SVL Amendments
- AA mortality tables w/ setbacks for females
- 80 SVL Amendments
- adopted 80 CSO table
- had to choose from
- 80 CSO M/F
- smoker/ns versions of both 80 CSO M/F
- Unisex 80CSO
- Unisex S/NS 80 CSO
- ANB/ALB
- 10/15 year select factors
- all states allow unisex for nonf
- some states require M/F for valn
- Int Rates
- 1947-1974 most states used 3.5% for all classes
- max was a problem as investment rates increased
- rates were increased
- 80 amendments - changed to dynamic max valn rate - linked to Moody's Corp
- resulted in rates that ary by duration of contract guarantees
Reserve Methods in teh US
- NLP Reserve Method
- designed to cover benefits only
- no explicit recognition of any expenses is made
- for a plan/issue age, net prem = constant % of gross prem
- sum(k*GP(t)v^(t-1)*l(x+t-1)/l(x)) = sum(DB(t)v^t*d(x+t-)/l(x))
- NP(t) = k*GP(t)
- if WL then NP = P(x) = A(x)/adue(x)
- typically produces highest Vx
- typically requires significant V(1) therefore avoided by surplus conscious cos
- Expense Allowances
- used to reflect large first year expenses intended to be recovered from future margins
- Modified Reserves - basically NL reserves less an unamortized expense allowance
- note:DAC is essentially an expense allowance
- EA = beta_mod(x) - alpha_mod(x)
- beta_mod(x) = renewal net premium for modified Vx method
- alpha_mod(x) - 1st year net premium
- V_mod = V_nl - EA*adue(x+t)/adue(x)
- FPT Reserves - 1st year net prem = 1 year term net prem & renewal net prem = NLP for remaining coverage @ IA + 1
- for WL, EA = A(x+1)/adue(x+1) - c(x) (c(x) = A'(x:1|) results is V(1) = 0
- for stat valuations, expense allowance is limited to a max
- expense allowance is formula based and not limited by actual first year expenses incurred
- CRVM
- FPT reserves if FPT adj NP < 20 pay life adj FPT prems
- if DB non-level, then DB = AvgDB(2-10) per AG17
- valn NP for years 2+ are constant % (k) of gross prems
- sum(k*GP(t)v^(t-1)l(x+t-1)/l(x)) = sum[t=1](DB(t)v^td(x+t-1)/l(x)) + 19P(x+1) - DB(1)c(x) (P_FPT > 19P(x+1))
- sum(k*GP(t)v^(t-1)l(x+t-1)/l(x)) = sum[t=2](DB(t)v^td(x+t-1)/l(x)) (P_FPT <= 19P(x+1))
- AG21 - if beta - alpha < 0, excess to be taken as 0
- AG25 - COLA policies to be reserved w/ increases = i_valn - contanst based on type of guarantee
- CRMV produces 0 V(1) from most policies which helps surplus strain on NB
- Other Methods
- Grade from CRVM to NL after x years (typically 20 years)
- reason: to offer products w/ higher (than min) 20yr CV by < Vx
- (P_G - P_NL)*adue(x+1:19|) = EA_CRVM*adue(x+1)/adue(x)
- in general, NL reserve method defined by magnitude of EA and period over which it is amortized
- Other Alternatives
- Arguments for a change to SVL
- based on artificial, predetermined i, fixed for life of contract
- embedded conservatism deliberately adds a solvency margin ~ volume business transacted
- this is in addition to RBC
- several insolvencies illustrate weaknesses in current system
Valuatino Standards in Canada (mostly skipping b/c Canada)
- < 1978 - similar to US
- 1978-1991 - Valn Actuary - modified NP
- PPM - expenses treated explicitly therefore gross prem valn
Valuation of Life Insurance Liabilities - Chapter 3 - TYPES OF RESERVE FACTORS
Mean and Mid-Terminal Reserves and Their Relationshiop to Deferred and Unearned Premiums
- Mean Reserves
- Interpolated Mean Reserve - (1-h)([t-1]V(x) + [t]P(x)) + h*[t]V(x)
- Mean Reserve h = 1/2 -> [t]MV(x) = 0.5*([t-1]V(x) + P(x) + [t]V(x))
- Deferred Premiums
- modal premiums due after valn date & befroe next policy anniv
- an Asset in US (neg liab in Canada)
- b/c mean reserves based on annual net prem payment @ boy overstate reserves on policies w/ more freq modes of payment
- use net prems since reserves based on net prem
- usually calced using an inventory
- can use avg def premium (m-)/2m * P(x)
- using avg def prem, net liab = 0.5*([t-1]V(x) + [t]V(x)) + 1/2m*P(x) (mean reserve - net def prem)
- Mid-Terminal Reseres and Unearned Premiums
- interpolated terminal reserve (1-h)[t-1]V(x) + h*[t]V(x)
- mid-terminal reserve 0.5([t-1]V(x) + [t]V(x))
- used by some companies instead of mean reserves
- understates reserves unles sprems paid very frequently
- Unearned Premium Liablility - used as an adjustmetn
- usual practice - 1/2 modal prm for each policy
- can also calc exact for each policy
- or estimate as 1/2m * P(x)
- net liability is saem as formula shown under def prems
Graphic Representatin of Reserves
- show start-step of modal premium reserves
Other Reserve Adjustments and Alternative Types of Factors
- Curtate and SemiContinuous Factors
- reserve formulas assume prems payable at BOY and claims paid at EOY
- reality: prems paid modally and claims paid at death
- Immediate Payment of CLaims Reserve (IPC)
- AG32 - need to establish IPC reserve if basic reserves calculated using curtate functin
- IPC reserve = i/2*death portion of basic reserve (term portion if an endowment) if policy credits interest from DOD to date of payment
- i/3 if payment made immediately upon receipt of due proof of death
- 0 if payments made @ EOY or Vx calculated using continuous or semi-cont or disc cont
- Semi-Continuous Reserves - prems payable @ BOY, claims paid at moment of death
- P(Abar(x)) = Abar(x)/adue(x) [t]V(Abar(x)) = Abar(x+t) - P(Abar(x))*adue(x+t)
- Fully Continuous and Discounted Continuous Factors
- Fully Continuous - continuous prems adn IPC
- Discounted Continuous - prems paid BOY, IPC and refund of unearned portion of Px @ death
- two net prems - one for terminal reserves and one for mean reserves
- discounted continuous is what most cos using "continuous" actually use
- difference between fully continuous and dicounted continuous
- fully cont based on NP payable continuously throughout the year
- reserve factors are mid-terminals adn unearned prem reserve must be set up for prems paid beyond valn date
- disc cont terminal reserves = full continuous terminals
- mean reserves calculated using annual NP = continuous NP discounted w/ int only
- def prem reserve calculated if mode <> annual
- Relationship of the Expense Allowance to type of Reserve Factor
- NP under semi-cont and cont methods > curtate
- SOA published tables using abar(1|)*Pbar(Abar(x)) + (P(x+1) - c(x))/adue(x) <- cont renewal prem for WL
- theoretically correct s/b abar(1|)*Pbar(Abar(x+1)) <- s/b used per AG18
- Nondeduction Reserve
- under curate or semi-cont - assumes full annual premium collected each year
- not true since std practice is to not collect modals due after death
- reserve for this -> term insurance for avg # remaining def prems @ date of death
- for endowment, this woudl be[t]V'(x:n|)*((m-1)/2m * P_modal(x:n|))
- Refund Reserve
- many cos refund pro-rata share of prems for periods beyond DOD
- reserve for both this and non-ded reserve -> 0.5*P_modal(x:n|)*[t]V'(x:n|)
- where P_modal(x:n|) approx = P(x:n|) / (1 = (m-1)/2m*d - 0.5P(x:n|))
- co's often omit (m-1)*d/2m term so 1 factor applies regardless of mode
- these reserves not necessary for fully and discounted coint reserves - already built in
-
- nice grid goes here showing various reserve components for curtate, fully, disc and semi cont
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Valuation of Life Insurance Liabilities - Chapter 4 - VALUATION OF INTEREST SENSITIVE LIFE PRODUCTS
overview
- policies develop CSV based on retrospective accum of (flex) prems less mort and expense charges at a declared or indexed rate
- this makes them not compatible w/ trad valn procedures
Flexible Premium UL
- premiums less expense charges credited to fund
- int credits credited to fund
- mort and expense charges deducted from fund
- CSV = fund value - SC
- Minimum Reserves
- 1983 - NAIC rules - to make UL work w/ trad valn formulas
- GMP - guaranteed maturity premium - level gross premium that provides for an endowment at the latest possible maturity date
- calculated at issue using policy guarantees for expesne and mortality charges adn int credits
- GMF - guaranteed maturity fund - calced as of issued date assuming GMPs are paid
- r = min(actual fund value / GMF, 1)
- policy fund projected forward using max(GMF, Actual Fund Value) assuming GMPs paid
- this produces guaranteed DBs and Guar Maturity benefit for valn purposes
- PV of these benefits calced on the valn basis
- NL reserve = r*(PV projected DB - PV projected GMPs) (assuming GMPs paid from issue (not valn))
- CRVM reserve = NL Reserve - r*unamort CRVM allowance for plan of ins generated at issue on guar basis assuming GMPs paid
- Simplified: Model Reg assumes all UL plans are permanent plans @ issue
- "r" factor to measure if policy is "on track" as permanent plan
- if CV > Vx, excess held elsewhere on statement (was 8G)
- Alternative Minimum Reserves (AMR)
- may be req'd if GMP < valn net premiums
- if req'd - max(a,b)
- a - reserve calculated using reserve method, mort basis and valn i actually used for policy
- b - reserve calced usnig reserve method actually used, but using min stds of mort and i allowable for V_def(x) & replacing valn net prem w/ GMP
- valn net prem (VNP) not explicity defined in model reg
- most cos interpret VNP = P_NL + EA/adue
- Features that lead to AMR
- no load products if guar COI and i similar to valn basis
- Guar COIs < valn mort (esp if i_guar = i_valn adn low/no fe loads)
- i_guar > i_valn
- any product features that lower GMPs
- Examples
- [t]V_NL = r*(PVFB(t) - P_NL*adue(x+t)
- PVFB(t) - PV based on project of policy funds using policy guarantees where initial value is max(actual fund, GMF)
- for CRVM - [t]V_NL reduced by r*EA_CRVM*adue(x+t)/adue(x)
- for monthly pay policies, DB incr monthly, for PV, use avg annual DB and continuous commutatoin functions
Fixed Prem UL
- key difference for fixed vs flexible premium
- GMP = gross prem
- EA adn rate of amort determined by plan of ins guaranteeed at issue
- r = 1
- to calc CRVM
- project future benefits on guar basis - take secondary guar into acct
- value benefits using valn mort and int
- subtract PV cuture CRVM net prems for plan of ins guar at issue
Secondary Guarantees
- provides teh PO a guar set of CVs, DB and/or mat benefits regardless of fund performance
- 1995 valn model reg - if secondary guarantee keeps policy in force 5+ years, reserves = form implied by secondary guar
Off Anniversary Reserves
- UL Model Reg defined terminal , but not off-anniv
- issues
- r - should it be as of valn date, prior or next anniv
- how to calc GMF on valn date if r is calced on valn date
- use first priciples or mean/mid-terminal/interpolated reserve
- generally considered appropriate to calc r as of valn date
- use annual GMPs or GMPs consistent w/ planned prem mode? - be consistent w/ reserve method used
- advantage if using first principles - avoid net def and unearned prems
Possible Changes and California UL Regulation
- some resistance to change since UL tax reserves defined in terms of existnig UL Model Reg (UL-CRVM)
- if change, might need to calc using 2 different methods into the future
- Guaranteed Maturity Premium Method (GMP Method)
- Calc GMP, GMF, r
- [t]V_GMP = r*[t]V_CRVM where [t]V_CRVM is reserve for traditional CRVM based product (perm ins w/ mat date = latest possible date under UL plan)
- if Fund(t) <= GMF(t) then (above)
- else [t]V_GMP = [t]V_CRVM + Fund(t) - GMF(t) (if Fund(t) > GMF(t))
- if r < 1, this generates save value as model reg
- if r > 1, felt this is a reasonable approx for most products
- California Method (1991 for 1992+ issues)
- simmilar to UL model reg exept valn i <= credited rate guar in contract or alt reserve = mean(CV,fund value)
- NY147 (1994) - allows CA method as elective alt basis for UL reserves
- SVL - reserves >= min aggregate amt req'd by state statement if filed, therefore if filing in CA, need to test for this
- even if use CA reserve, need model reg calc for tax reserves
Minimum vs Adequate Reserves
- using CV as reserve for flex prem UL can effectively defer losses to later years
- CV can become > CRVM reserves once SC wear off
- renewal losses can occurr when CV increases not supportable by the gross prem
- this would fall under unusal CSV provision of Model Reg of Trad, but UL is specifically exempt
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Valuation of Life Insurance Liabilities - Chapter 5 - VALUATION OF ANNUITIES
Overview
- Commissioners Annuity Reserve Valuation Method (CARVM) - 1976 amendments
- Vx = greatest excess of PV @ valn date of future guar benefits @ end of each contract year over PV future considerations from future gross considerations
- many companies slow to adopt CARVM and held more conservative reserves
- tax law changed to say use CARVM as methodology for FPTR
- cos forced to implement at that point
Basic Application of CARVM to SPDAs
- project fund balcne forward at guar basis in policy, then calc all future benfits guar under policy
- take PV of all these possible benefit streams
- subtract out PV required considerations
- considered a "worst case" valn method
- ususually possible to determine which benefit produces the greatest PV eliminating most paths
- accumulation phase uses policy guarantees
- how to determine which dur will produce largest PV (for SPDA)
- if guar annuity purchase rates less liberal thatn valn basis and CSV used to calc guar annuity payments, future guar annuity payments will never be used in CARVM b/c PV(future annuity pmts) < CV @ annuitization
- if contract has no SC, guar fund accum rate < i_valn, then CV @ valn date is largest CV
- if contract has no SC, guar fund accum rate > i_valn for n years after valn, CV @ last year i_guar > i_valn
- if contract has no SC, guar fund accum rate always > i_valn , CV @ latest mat date
- if SC, combined effect of i_guar & reduction in SC > i_valn for n years, CV @ end of year n
- if this is ignored @ product design, might have to do complete CARVM w/ each valn
- Mid-Policy Year Values and Continuous CARVM
- projecting 1 more day causes cash values to jump b/c of SC changing day after valn
- CARVM specifically state EOY
- NY reg states any point during year aka Continuous CARVM
- other states now following NY example
Common Product Features
- Contingent Benefits (not elected by annuitant)
- Death Benefits in Excess of CSV
- such as SC waived at death or min DB = sum(prems paid)
- AG33 - each benefit be considered in calc of CARVM Vx
- in practice - DB reserve calsed as an add-on as PV excess DB over CSV
- common approx - mort Vx = sum(PV(DB-CSV)) @ valn int and mort
- more exact - only do above calc to policy year w/ largest CARVM reserve
- Nursing Home Waiver
- SC waived if annuitant enters nursing home
- reserved similar to DV but using q_nursinghome instead of q_valn
- Bailout Provisions
- surrender charge waived if i_credited fall more than a specified amt below initial rate
- if bailout provision is in effect, SC s/b ignored for CARVM
- AG13 - 1985 - can't include "significant" contingent SC in CARVM calc
- NY126 - Vx if contract as significant SC = max(a,d) where
- a = fund @ valn w/o SC
- b = CARVM reserve w/o SC
- "signficant" SC - SC% > i_guar
- Market Value Adjustments (MVAs)
- MVAs expressed as formulas
- questions
- should MVAs be include in CV calc @ valn if operable
- possible future MVAs, shoudl they be taken into account
- if assets in general account, ignore MVAs in CARVM calc since GA assets not revalued under SAP
- Modified Guar Annuity Reg - MVA annuity assets s/b in sep account
- min Vx - CSV including MVA effect
- NY127 has specific definitions
- max(a,b) where a = CSV @ valn including MVA and b = PV guar contract benefits
- where PV(b) - i =
- annual mkt yeild S/A assets - inv expenses - 2.5% for junk - 0.25% PADs
- Moody's Corp Bond Yield Avg (month - 1)
- if assets held at book, max(a,b) where
- a = CSV @ valn excluding MVA and b = PV guaranteed benefits assuming "B" type contract
- Free Partial Withdrawals (FPWs)
- PO can w/d % of fund w/o SC
- sometimes limited to x days after anniversary
- need to reflect this free % in actual SC
- for valn, two approaches
- aggregate - adjust SC% (ie 5% SC adjusted to 5.0% - 0.5%free = 4.5%)
- seriatim - test each and every partial w/d that could be made
- some state ins depts have taken issue w/ aggregate approach and require seriatim
- Annuity Purchase Rates
- often purchase rate incentives to encourage annuitization
- purchase rates more favorable than guarantees
- typically use current rates which are more favorable than guarantees
- discontinuities in CARVM reserve
- AG33 - if co guarantees that PO can annuitize @ then current rates, then CARVM Vx >= 93% of contracts fund value @ valn
- waiver of SC
- take into account when valuing
- often limited to 10 yr+ options
- two-tiered interest credits
- one fund for nonf values and DB
- one for for annuitization (and possibly DB)
- second fund typically has higher int rate
- first fund used for CARVM CVs
- second fund for CARVM annuity purchase funds
- if 93% rule in effect, then it is used against second fund
- Interest Index
- if indexed - NAIC Int-indexed Model Reg says
- future int crediting rates = stat int rate for contracts defined in SVL
- if actuarial opinion not filed, a 115% rule is in effect
- reg not adopted by all states
- most cos ignore indexing unless in effect @ valn
- except to extent CFT indicated need for additional reserves
Practical Considerations in Calculation of CARVM Reserves
- Calendar Year Valuations
- same basic principles apply
- even though cal year, fund balances need to be accum to end of policy year
- some co's calc CARVM @ end of next policy year and discount back
- Current Cash Values
- NAIC blank requires max(CV, CARVM Vx)
- even though CARVM doesnt specify off anniv CVs, it is necessary b/c of this
- when comparing CV vx CARVM, CARVM needs to include any DB reserve
- Grouping Methods
- common and accepted to calc Vx on a group basis (vs seriatim)
- assume groups of policies occur mid-year (unless known skewing)
- SVL says OK
- may not be appropriate for two-tiered or toher complicated product designs
- Change-in-fund Valuation Basis
- SVL allows either issue-year or change-in-fund basis for PVFB calc
- issue year basis - i_valn determined based on issue date of policy
- change-in-fund basis - different discount rate depending on when increase in funds occured. Looks like IYM
- AG33 - election of method @ issuance of contract and cant' be changed w/o written approval of ins commissioner
Annual Premium Annuities under CARVM
- same basic principles apply
- difference - PV appropriate future "valuation considerations" is subtracted from PV of each of the future benefits
- "valuation considerations" - portions of teh respective gross considerations applied under the contract
- not as easy to "analytically" determine where CARVM reserve will be, therefore lots of calcs
Flexible Premium Annuities Under CARVM
- since prems flexible, they aren't "req'd by the terms of such contract"
- reserved as SPDAs
- if contract has no SC, guar fund accum rate > i_valn for n years after valn, CV @ last year i_guar > i_valn
- Valn Actuary should still use judgement
Immediate Annuities
- generally no problem under CARVM
- AG9 and AG9B define Immediate Annuity
- 1st payment due not more than 13 mos from issue date
- suceeding payments at least annually for at least 5 years
- pattern of payments due in any contract year not > 115% of those in prior contract year
- can value annuity as settlement option or annuitized DA using immediate annuity rate from original contract issue or current rate
- AG9A and AG9B have special guidelines for structured settlements
Determination of Appropriate Int Rates under SVL
- 80 amendments introduced annuity valn int rate categories
- SPIAs and annuity benefits w/ life cont arising from other annuities w/ cash settlement options and GICS w/ cash settlement options
- Other ANnuities
- whether or not policy offers cash settlement options
- issue year or change-in-fund basis
- whether or not policy contains future int guarantees applicable to future considerations (future > 1 year off)
- w/ cash settlement options - # years int guar in excess of long life rates (guarantee duration)
- and w/o cash settlement option - # years from purchase date to 1st payment date
- plan type
- A) at any time the PO may w/d funds only
- 1) w/ adjustment to reflect i or assets values changes since reciept of funds
- 2) w/o adjustment, but in installments over 5+ years
- 3) immediate life annuity
- 4) no w/d permitted
- B) Before expiriation of int rate guarantee, PO may w/d funds
- 1) same as a1)
- 2) same as a2)
- 3) no w/d permitted
- at end of int rate guar, funds may be w/d w/o such adjustment in single sum or installments < 5 years
- C) before expiration of int rate guarantees, PO may w/d funds in single sum or installments < 5 years
- 1) w/o adjustments to reflect i or asset value changes since reciept of funds
- 2) subject only to fixes surrender charge stipulated in contract as % of fund
- AG33 - different benefits under SPDA may be valued assuming different plan types
- defines guarantee duration as # years from contract issue to date of annuitization
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Valuation of Life Insurance Liabilities - Chapter 6 - VALUATION OF VARIABLE PRODUCTS
Overview
- Variable products - policies whose cash values matched by assets held in sep account of the LIC
- CRVM adn CARVM are prospective methods
- variable products don't have future guarantees
- Variable Life Ins Model Reg - 1983 - w/ actuarial principles that recognize variable nature of benefits proivided and any mortality guarantees
- similar to VA Model Reg
- Reserve methodology dependent upon product type
Flexible Premium and Bybrid Variable Life
- Flexible Premium Variable life aka VUL
- main diff between VUL and UL - accum fund - VUL - bears investment risk since tied to fund
- Hybrid Products - scheduled premium concept is used
- if VUL products fully front-end loaded, CV is generally deemed to be sufficient reserve
- if FY loads > renewal year loads by more than EA_CRVM, CV as reserve is questionable
- if back-end loaded, typically use UL Model Reg type reserve with one of following for i
- if has fixed-acct option, long term guar rate in teh fixed acct
- valuation rate less some (or all) of contractual asset-based charges
- 4% (rate specified in tax law)
- rate credited to policy loans
- SEC adn Model Reg require asses in Sep Acct >= acct value
- Stat Vx on back-end loaded can be < account val to reflect SC
- suplus in sep acct >= sum VUL EA credits taken
- Additional reserve req'd if product has GMDB
Fixed Premium Variable Life
- Typically FEL
- DB adjusted to reflect performance in one of two ways
- NY Life Design
- DB = Orig Face * Actual CV / hypothetical tabular CV
- hypothetical CV calced using AIR (assumed int rate)
- GMDB = orig face
- reserves = trad reserves fro policy if @ current DB, IA, dur
- Equitable Design
- net investemnt earning > AIR used to purchase PUA @ NSP using AIR
- negative buys negative PUAs
- if PUA balance < 0, negatives carried forward againt future PUAs, but DB never drops below initial face
- reserve base as if traditional
- PUAs like normal PUAs
- additional reserves for GMDB risk
Single Premium Variable Life
- Flexible Single Premium
- marketed as single premium, but PO can make additional prem payments
- reserved as if VUL
- Fixed Single Premium
- GMDB w/ gross premiums based on AIR
- can be of Equitable or NY Life method or may use UL-type mechanics to generate CVs
- reserved identical to regular permanent contracts of same type
- Tax law changes in 1988 have virtually eliminated teh market for these
Variable Annuities
- FEL - CV is good and sufficient reserve (in general)
- BEL - subject to debate - same methods as proposed for VUL
- SA surplus s/b >= excess of acct value over reserves
GMDB Reserves: Flexible PRemium Life Products
- Variable Life Model Reg requires reserves if product has GMDB
- GMDB reserve carried on general acct
- different calcs for fixed premium and flexible premium VL contracts
- flexible premium - GMDB only for grace period when funds insufficient to support deductions to maintain coverage infoce
- term cost of GMDB assuming immediate 1/3 drop in current value of SA assets followed by net investment return = i_valn
GMDB Reserves: Fixed Premium Life Products
- GMDB typically DB never less than orig face
- V_GMDB(x) = max(OYT & AA Level reserve)
- OYT Reserve - term cost of GMDB covering 1 full year assuming immediate 1/3 drop inSA assets value followed by investment return = AIR
- AA Level Reserve = "residue" of prior years AA level reserve +/- current "payment"
- can not be < 0
- "residue" = prior year's AA level reserve increase @ i_valn - tabular mort for GMDB / tabular probability of survival
- "payment" = (A_GMDB(x+t) - A_SADB(x+t) - residue)/adue(x+t:n|)
- SADB = sep acct DB calced using actuary chosen i (but <= max valn rate)
- for VUL - GMDB = OYT reserves except measure over GMDB period instead of 1 year
GMDB Reserves: Annuity Products
- Method 1 - OYT cost of the shortfall w/ or w/o 1/3 drop
- Method 2 - allocate an annual contribution (% of acct value, vary by dur) to GMDB Vx
- any DB in excess of basic reserves deducted from GMDB reserve fund
-
Valuation of Life Insurance Liabilities - Chapter 7 - MISCELLANEOUS RESERVES
Overview
- may misc reserves quite small and tedious/difficult to calculate exactly
- in practice - less precise techniques used, such as
- single average age
- single set of factors for range of policy forms
- Valn Actuary must be prepared to show that these approximations do not significantly overstate reserve liabs
Deficiency Reserves
- reserves in attidion to basic reserves w/ gross premiums < certain level
- US
- prior to 1976 - SVL stated V_def(x) req'd if gross prem < valn net prem (if valn net prem used)
- criticisms
- reserve strengthening could cause basic policy reserve to increase. GP could be sufficient at old rate and not under lowered rate
- having conservative reserve basis sometimes caused def reserves and wouldn't be req'd w/ more agressive reserves
- V_def(x) not allowed as a tax reserve
- 76 amendments removed specific references to V_def(x), but basic reserves req'd to be increased in certain instances
- reserve is max(a,b)
- a - Vx calculated according to method, mort table and int rate actually used for policy
- b - Vx calculated by policy method, using min valn standards for mort, int and max(valn net prem, gross prem) each year
- excess of b over a is referred to as V_def(x) everywhere except SVL
- since part of Vx definition, gets tax credit
- Def Reserves don't follow usual pattern of prem paying life reerves
- generally have max value at issue and decrease w/ time
- because of resulting surplus strain - try to design product w/o (or minimal) def Vx
- Practical Considerations of Def Reserves
- GP is total annualized GP for policy, including modal loading and policy fee
- premiums for benefit/riders not included, but deficiencies in base can be offset by sufficiencies in riders
- because of these complications, usually calc these reserves via seriatim method
- many co's continue to calc using the old method. Produces teh exact same reserve in typical case
- Def Reserves for Renewable Term Policies
- old school - series of sep policies for reserve purposes - never V_def(x) for ART until mid-70s
- late 70s - early 80s - lower ART rates, regulators concerned, state regs said to consider it an ongoing policy
- 2 methods for looking at valn prems for ART
- Unitary Method - considers entire stream of future gross prems & develops proportional set of valn net prems
- Term Method - looks at each renewal period separately
- Unitary Method fell into disfavor w/ regulators since ultra high prem @ old ages offset deficiencies at early ages
- AG4 (1984) - term policies w/o CV - req'd add'l reserve if future guar prems < valn net prems as calced using a special basis in AG4
- Valn Model Reg (1995) - Contract Segmentation Method
- G(t) = GP(x+k+t) / GP(x+k+t-1)
- R(t) = q(x+k+t) / q(x+k+t-1)
- GP is guar gross prem w/o policy fee (if pol fee is level) - NY says uses current prem
- q(x+t) = valn mort rate for def reserves
- each time G(t) > R(t) a new segement is created +/-1% on R(t) to avoid new segments b/c of rounding
- basic reserves calced for each segment, EA_CRVM only for first segment
- Valn net prems a constant % of gross
- ex. 10 yr renewable term - CRVM first seg, NL thereafter
- Valn Model Reg - Vx = max(unitary, segmented) for each dur
- n-year renewable term w/ non-deficient guar prems exempt & some AA YRT
- Def reserves calculated as per 76 amendments using gross instead of net
- 5 year safe harbor if 1st segment < 5 years, don't have to use gross, even if deficient
- actuary must opine that reserves are sufficient
- Valn Model Reg allows updated selection factors in calc of basic reserves
- even lower selection factors OK for def reserves
- Canadian Practice for Renewable Term Policies
- Valn Tech Paper #2
- valued to end of benefit period, not renewal
- excess of heaped @ renewal over normal renew comm may be treated as issue expense
- how-to calc valn net prem if gross not level is described
- lapse rates can spike @ renewals if prem increases
- re-entry proportion (% of PO who will requalify for select @ rentry)
- Alternative Min Reserves for UL (AMR)
- these are UL equiv to def reserves and covered in Chapter 4
Accidental Death Benefit
- Usually calced using 1959 ADB tables
- calced using same methodology
- [t]V_ADB(x) = [1000*(M_ADB(x+t)-M_ADB(x+n)) - P_ADB(x)(N(x) - N(x+m)]/D(x+t)
- P_ADB(x) = [1000(M_ADB(x)-M_ADB(x+n)]/(N(x) - N(x+m))
- M_ADB(x) = sum(v*q_adb(x)*D(x))
- many approximations used, often w/ age and plan groupings
Disability Waiver of Prmeium Benefits
- SVL - reserve using Period 2 disablement rates of SOA 1952 disability study
- Active Life Reserves
- what prem to waive - gross or net w/ or w/o wvr prem w/ or w/o other (ADB etc) prems
- usually gross since commissions and what not still paid & ususally other benefits as well
- many approximations used
- reserves shoudl reflect prems (ex increasing if ART)
- UL policies - two types
- waiver of COI
- waiver of planned premium
- Disabled Life Reserves
- consists of 4 types of claims
- approved, in course of settlement (ICOS), resisted, incurred but not reported (IBNR)
- ICOS, resisted, IBNR considered policy claim liabilities
- valuation of approved claims
- disabled life annuities using tables mentioned in SVL and appropriate valn int rate
- these factors applied to amount being waived
- adue([x+0.5]+n-.5:t-.5|) where
- x - insurance anniv prior to dis
- n - policy year of dis
- t - # years benefits run, from pol anniv in year of valn
- normally use a seriatim valuation
- Disability and Death of Payor Benefits
- typically waives prem to child's age 21 or 25
- theoretical reserve complicated since 2 lives involved
- if dis payor, both death and dis must be considered
- essentially decreasing term so small or negative reserves expected
- approximations normally used
- usually ignore child's mortality
- often hold 1/2 gross prem of payor benefit as reserve
- reserve after death of payor is an annuity for remaining premiums
- often mortality is ignored and annuity certain used
Nondeduction of Deferred Fractional Premiums at Death
- term reserve for amt of ins = (m-1)/2m * P_modal <- net prem
- once common approximation
- for each reserve basis, select a few major plans or key ages
- calc S_tot (amt of ins) G_tot (gross AP) P_tot (net AP) and V_tot (base reserve)
- Gbar = G_tot / S_tot Pbar = P_tot / S_tot (avg gross and net prem per $1m)
- pick xbar where Pbar and Gbar are approx the same (find age that has these prems)
- Vbar = V_tot / S_tot using xbar and Vbar, find approx tbar (dur)
- using xbar, tbar calc [tbar]V'(xbar:n|) where n is orig prem pay period of paln (term reserve factor)
- multiply term reserve factor by P_tot
- after doing for each grouping
- avg non-ded reserve factor is b/a
- a = sum(P_tot) and b = sum(P_tot*[tbar]V'(xbar:n|)) across all plans
- this factor applied to total net def prems for all plans w/in reserve basis
- Surrender Values in Excess of Reserves
- excess of SV over Vx needs to be carried in 8G
- based on seriatim, no offsetting overage w/ underages
Canadian Lapse-Supported Policies
- Valn Technique Paper #1 - Valn of Lapse-Supported Products
- established b/c Canadian Actuaries can recognize lapses in valn
- <maybe revisit this if applicable to 8I-U>
Last-To-Die Policies
- Traditional
- pays small db or becomes paid up @ first death
- valued as single life after first death
- Frasier-Type
- no change of status @ first death
- valued independently of wheter a death death has occurred
- Reserves for Traditional Policies
- if paid up @ first death A(x+t:y+t)bar - P*adue(x+t:y+t)
- if pays x% @ first death and 100% at second death A(x+t:y+t)bar + xA(x+t:y+t) - P*adue(x+t:y+t)bar
- after first death A(y_t) if paid up, A(y+t) - P*adue(y+t) otherwise
- Reserves for Frasier-Type Policies
- l([x]+t:[y]+t)bar = l(xy)bar*([t]p(x) + [t]p(y) - [t]p(xy)
- A([x]+t:[y]+t)bar - P*adue([x]+t:[y]+t)bar
- joint equal age (JEA) often used to simplify calculation
- AG20 - acceptable rules for JEA 80CSO for First-to-Die
- many cos use these same rules for Last-to-Die
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Valuation of Life Insurance Liabilities - Chapter 8 - CASH FLOW TESTING
Overview
- Good and Sufficient - used to be OK to just do a GP valuatin
- GP valuation used to cover following situations
- stat Valn was deficient - did not consider w/d or expenses
- experience mortality higher than stat valn standard
- reserve strengtening needed due to investment yields not supporting valn i
- Now relies on Valn Actuary concept
- CFT includes interaction between A/L under differernt int scenarios
- impact of epidemics on co's resources
- impact of mortality deterioration due to selective lapsation
Definition of CFT
- projection of cash flows in which specific timing of asset and liab cash flows is considered
- CFT generally recognizes the following factors
- interrelationship between assumptions
- competitors i & div rates
- investment yields available in marketplace in general
- company assumptions w/r to non-guar elements in different economic environments
Assumptions Needed
- Future Economic Environments
- must choose a set of future economic scenarios to test under
- Handpicked Scenarios (aka Deterministic Approach)
- 1990 SVL adn NY126
- Advantages
- teset is more comfortable w/ reviewing results since he constructed them
- scenarios tend to be easy to describe (up/down, rapidly increaseing, etc)
- Disadvantages
- disagrement over probability of a scenario
- cumbersome to generate a large # of hadnpicked scenarios
- need a lot of scenarios for statistical credibility
- tens to produce more favorable restults than expected statistically
- Log-Normal Model
- basic assumptions
- ln(i(t+1)/i(t)) is Normal RV
- mean (mu) = 0 and std dev (sigma) is measure of volatility to be expected
- used to generate future s/t and l/t in rate
- usually 90 day and 10 yr
- other rates through interpolation or functional relationships
- Transitional Probability Approach
- define universe of yield curves
- probability matrix - probabilities of one yield curve following another
- start w/ current yield curve and run monte carlos to generate future yield curves
- Competitor Rate or Market Rate Assumption
- important since many CFT funtional relationships key off relationship between credited int rates , mkt int rates and lapse rates
- mkt rate assumptions often bases as function of current int rates and a moving avg of an int rate
- Nonguaranteed Elements Practices
- Typical CFT strategies include
- credit earned rate less investment margin
- credit some function of market rate
- hybrid approach
- Lapse Rates
- little experience w/r to interaction between lapse rates and credited rates on life and annuities
- lapse assumption based on common sense argument - as other options become more attractive, more likely to surrender policy
- things to consider
- presence and level of SC
- mktg techniques and loyalty of field force
- prominence of i in mktg and maint of policy
- duration from issue
- type of products sold - SPDAs more int rate lapse sensitive than trad life
- Reinvestment Strategies
- actuary and investemetn officer work together to understand/define how positive cash flows invested in future
- ex. % of pos cash flows into each type of security or a blance of each type w/in total portfolio
- need to define what mkt conditions might change this strategy
- negative cash flows
- sell assets
- negative assets (borrowing between lines)
- borrowing @ s/t rate
Case Study
U.S. GAAP - Chapter 3 - EXPENSES AND CAPITALIZATION
Background
- Statements of Financial Concepts (SFAC)
- SFAC5 - Recognition & Measurement in Financial Statements
- Guidance for expenses and losses in intended to recognize
- consumption of benefit - expenses recognized when economic benefit is consumed
- Loss or Lack of Benefit - losses recognized if it becomes evident taht prev recognized future benefits have been reduced
- SFAC6 - Elements of Financial Statements
- Expenses - outflows incurred in producing or other activities central to ongong operations
- expenses represent actual or expected cash outflows that have or will occur as a result of ongoing central operations
- implications - cost not an expense until it is recongnized in co's fin statement
- example - DAC
- amortization of the cost, not the original cost that becomes the expense
- Statements of Financial Accountnig Standards (SFAS)
- SFAS60 - covers all contract except those reclassified by other standards
- SFAS97 - covers most life and annuity products w/ account values
- UL/VUL/most fixed def annuities and VA in teh accum stage
- SFAS60 w/ prems payable < coverage period
- SFAS91 - investment contracts defined in SFAS97
- in general DAC for GICS, Funding Agreements & DAs w/ minimal SC
- SFAS120 - Par Trad
- Terminology
- DAC - amt of capitalized expenses remaining in balance sheet at any reporting date
- aka Unamortized Aquisition Costs (UAC), Def Pol Acq Cost (DPAC), Unamort Expense Asset (UEA) and expense reserves
Categorization Stipulated by SFAS 60
- P26 - maint expenses s/b part of benefit reserve (suggested)
- some co's segregate main exp and report separate reserve
- P27 - general expenes not related to acq s/b expensed as incurred
- P28 - acq costs ~ acq of new & renewal ins contracts
- 1994 audits P 8.38 - separate deferral for expenses w/ substantial future utility and recoverable from future revenues => future utility expenses
- 6 expense categories - mutually exclusive
- Expense Category Asset or Liab Affected
- 1 Deferrable Acq DAC
- 2 Non Def Acq None
- 3 Direct Maint Benefit Reserve
- 4 Investment Expenses DAC & Benefit Reserve
- 5 Future Utility Expense Unique Asset
- 6 Overhead None
- Deferrable Acq Costs - expenses considered to vary w/ and primarily relate to acq of new business
- NonDeferrable Acq Costs - expenses associated w/ NB funtion that dont relate to or vary w/ securing of new policies.
- ex. new ratebooks, product dev costs (Vx factors, etc)
- costs in period incurred
- Direct Maintenance Costs - costs associated w/ maintaining records relating to ins contracts & processing of premium collections & commissions
- Investment Expenses - expenses properly chargable against inv income
- included transaction costs that cannot be capitalized into cost of asset being purchased
- Future Utility Expenses
- costs of start-up activities, including organization costs s/b expenses as incurred (AICPA SOP 98-5)
- certain computer hardware and software may qualify for capitalization (AICPA SOP 98-1)
- Overhead - aka indirect cost - balancing item
Expense Categorization Under Other Pronouncements
- SFAS91 - Investment Contracts
- tightens rules on loans (compared to SFAS60)
- SFAS97 - same expense categories as SFAS60
- % of premium expenses (commis & prem tax) must be separated between deferrable acq and direct maint
- P23-24 - excludes from deferrable category acq costs that tend to be level or recurring => maint expenses instead
- Practice Bulletin 8 (AICPA)
- P25 identifies contract admin charges to be included in calc of EGPs as those from P23-24 of SFAS97 (ex ult renewal comm adn recurring prem tax)
- SOP 95-1 (AICPA) & SFAS 120
- guidance for mutual co's Par policies
- similar guidance as SFAS97
Line of Business and Category Analysis
- studies must be done to allocate expense to 6 categories
- LOB allocation - first, group expenses by LOB, then to appropriate accounting model
- Category determination - costs assigned to appropriate category
- Then some converted to "unit" basis to make calcs easier
- Categorization
- example in book illustrates allocations
- total expenses should tie to statement
- Percentage of premium expense allocation
- prem taxes usually removed from study since they can be directly assigned @ policy level
- prem tax and commissions usually stated as % prem in reserve formulas
- Allocations of Salary & Other Expenses
- salaries important allocation b/c other expenses (such as EE benefits) can use same allocation
- utilities & rent can be allocated by # EE/ # pol inforce/% prem income
- Distinction between Direct Maintenance and Overhead Expenses
- requires judgment
- non-level direct maint expenses (claims settlement exp & limited pay policies after prem period) affect benefit reserve
- level % of revenue expenses do not affect benefit reserve (prem collection expenses)
- entire direct maint cost s/b included in developing benefits reserves
- SFAS97/120 policies - level maint expenses can affect either benefit reserves or DAC
- General Practice - include entire direct maint costs in generating GAAP A & L
- Investment Expenses
- if investments allocate to products w/in LOB, easy to directly assign expenses
- usually expressed as a reduction of investment income
- Inv Income and Expenses generally expressed as % of underlying assets
- % is what is generally used in formulas for benefit reserve & GAAP
- Selection of Units of Measurements & Unitization of Expenses
- Types of Per Unit Measures - per policy, per current face amt, per unit issued, % prem
- use judgement in determing most appropriate unit of measurement
- p. 43 - table w/ common choices
- investment expenses - % of underlying assets - bps
- investmetn expenses/(avg cash and invested asset balances)
- can use muliple units for an expense ex. $150/policy + $2/unit
- u/w cost on a per app basis (not per policy issued) - needs to be converted to per policy
- DI claims adjustment expenses - per $claims paid
- if converting to GAAP, need to develop expense assumptions for earlier years
- Other Issues
- some deferrable expense occur prior to policy issue (u/w costs) - could be in separate reporting period
- record as prepaid expense, then wehn policy issued, release and capitalize expense
- backdating - soem cos restate prior period, other include in current cohort
- related party service agreements typically transparent
- expense reimbursements tied to production of business usually deferrable
- tied to avg # pols inforce - ????
- w/r to large non-recurring expenses, little guidance, but actuary s/b soncsitent between years
- carve out development expenses from overhead to minimize earning distortions
- this distortions would accelerate earnings
- little experience when starting a new LOB - usually expensed too high and refined as necessary
- re S/A products - expenses associated w/ product should follow the product
Determination of Deferrability of Acquisition Costs
- All expenses capitalized are subject to recoverability testing
- Commissions
- short duration contracts - entire comm is capitalized
- long duration - excess of first year over ultimate level is deferrable
- excess of renewal over ultimate is deferrable in renewal years
- ultimate level - direct maint expense
- question on excess for flex prem F97 products - "facts and circumstances" of each case govern
- beware of commission advancing and chargebacks
- agent financing costs often capitalized
- if loans - accounted as receivables adn not a DAC element
- commission trailers - usually considered maint
- commission vesting schedule - declining over times - creates higher initial DAC
- Expenses Similar to Commissions
- volume bonuses, sales contests, etc - if based on purely new production ,then deferrable
- persistency bonus - grey area, but normally considered deferrable, at least in part
- facts and circumstances should determine
- commission overrides - if % of premium, treated same as commission
- salary-plus-bonus basis - allocation less clear
- agency recruitment and training not deferrable
- sales lead creation and sales illustrations are deferrable
- agency expense allowances & expense reimbursments - if vary w/ production, deferrable
- Home Office Expenses
- some mktg and sales expenses deferrable, some not. Are if closely related to selling
- most u/w expenses are deferrable - includes support staff to a degree
- most policy issue expenses are deferrable
- some HO services in support of policy issue (sales illustrations) usually deferrable
Timing of Deferrability
- actuary should ensure that expense in reserve formula correlate to actual in financial statement
- True-Up
- amount capitalized shoudl equal DAC incurred in financial statement
- SFAS60 P31 - estimated costs can be usded if difference not significant
- Two general techniques
- direct input of actual quantified dollars
- conversion and expression of actual dollar values to units for entry into actuarial reserve formulas
- reserve factors normally used for F60 and limited pay F97
- assumptions locked at issue, basic benefits and guar values don't change w/ time
- F97 & F120 products - easier to use direct input dollars
- SFAS60 P31 i) and II) not significantly different
- i) implied capitalization derived from reserve formulas
- ii) actual def acq costs incurred
- approaches used to demonstarte this equality
- re-enter deferrable cost assumptions preiodically from recently performed studies
- apply modification factors to certain policies based on issue date (pp 50-52 for details)
- Commission Timing
- must be consistent w/ recognition of commissions as a cost in the income statement
- if due premium, commission would have been payable - liab established for cost of collecting unpaid prem and asset for due prem
- if mid-terminal, unearned prem is established. Associated commission is re-established as an asset (aka equity in the unearned prem) and is part of total DAC
- for worksheet approaches, amount is input directly from general ledger
- will include some prior period commissions, but assumed to be nota significant concern
- Anticipation of Future Deferrable Expenses
- future deferrable expenses must be anticipated and estimated in the DAC calc from the issue date forward (ex - heaped renewal commissions)
Recoverability Testing and Loss Recognition
- Authority and Definitions
- SFAS60 P32-37 - establish a liability or decrease DAC to provide for probable future losses in a LOB reducing the chance of a loss emerging in the future
- Recoverability - whether a DACable expense is deferrable from exonomic perspective
- PVGP >= PV (Benefits + Direct Maint Costs + DAC Expenses)
- if not, remove or reduce PADs and retest
- Loss Recognition - testing fro probable loss on entire LOB
- prospective recoverability testing on entire LOB of existing business
- best-estimate assumptions
- Level of Aggregation for Testing
- consistency - once groupings defined, classifications maintained
- recoverability - accounting period cohort
- loss recognition - entire LOB inforce
- guidance for groupings - SFAS60 P32
- manner of acquiring - major sales type (direct vs agency)
- manner of servicing
- manner of measurement of profitability - F60 vs F97
- Gross Premium Valuation Test and teh Order of Adjustments to the Balance Sheet
- compares gross prem valn w/ GAAP net liabilities
- if GAAP net liab < Gross Prem Valn, probable loss - prem def = difference
- Gross Prem Reserve (ASOP22) actuarial value future CF disbursements - future CF receipts
- pre-tax
- if a premium deficiency from recoverability resting, order of adjustments
- F60 - sufficient margins for deviation removed until def eliminated
- no PADs for 97/120 so this step skipped
- reclassify expense from def to non-def until deficiency eliminated
- premium def reserve established such that net gaap liab = gross prem reserve
- if premium def from loss recognition testing, order of adjustments
- eliminate PADs until deficiency eliminated (F60, no PADs for F97/120)
- reduce DAC asset until deficiency eliminated
- prem def reserve established
- once F60 loss recognition occurs, revised assumptions locked in place, unless future loss recognition
- can't adjust for future improvments
- 20-30 years is usual lifetime of policies modeled (as approx to keep spreadsheets managable)
- Exclusion of Interest on Surplus from the Testing
- aka interest on prior profits - should we count it for testing?
- GPV (gross prem reserve) = net GAAP liab - PV future GAAP book profits
- formulas do not include Int on Surplus
- Int for GPV traditionally level, but can be graded if that is Actuary's best estimate
- exclusion of int can result in some unexpected GAAP losses in preiods of declining int rates
- due to int related gains on asset sales (not a SAP problem because of IMR)
Relation fo GAAP Expense Assumptions to Pricing Expense Assumptions
- start w/ same baseline expense assumptions
- potential different classifications across line for pricing, GAAP will have more aggregation
- variation in allocation of costs between base/rider/supp benefits
- expense assumptions can vary by dur for non-level prem (and some other) palns
Special Expense Issues
- Internal Replacements
- DAC asset is NOT carried over from old contract to new contract (SFAS97 P26)
- Reinsurance
- SFAS60 P39 - coins allowance apply a negative to DAC to obtain net capitalized position (converse for assuming party)
- timing may differ between direct and reinsured block
- Purchase Acctg
- VOBA (Value of Business Acquired) - asset established at purchase
- might be reduced in anticipation of paying future commissions (1st yr & heaped renewal)
- these commissions s/b reflected in DAC (even though pre-purchase business) & not in VOBA
- Discontinued Operations
- APB30 - segregate infrequent transactoins from typical results
- if difficult to allocate expenses to the segment being disposed, transaction should NOT be classified as a disposal trx
- if a loss recognition, GPV @ measurement date indicates loss for block, provide for future losses
- expense assumptions may change due to segregation of assets assigned to a block
- fully allocate expenses to block, including severance etc
- need a way to deal w/ expenses in fun-off mode when block becomes very small
Worksheet Approaches to DAC Calc
- works best w/ non-commission acq expenses
- if comm included, need to estimate future (heaped renewal) commissions
- Static Worksheets
- initial DAC established
- expected inforce schedule created using mortality and lapse rates
- terminal duration selected and amortized to zero
- example p. 65
- drawbacks
- remaining DAC may be behind/ahead depending on actual persistency
- no convenient byproduct that extablishes recoverability or facilitates loss recognition
- Dynamic Worksheets
- resolve ahead/behind drawback of static worksheets
- takes static results and adjusts by ration of actual/expected cumulative persistency
- F97/120 worksheet (vs F60) would use EGP ro EGM instead of GP as amort basis
-
U.S. GAAP - Chapter 4 - TRADITIONAL LIFE INSURANCE (SFAS 60 AND SFAS 97)
Overview
- non-par trax fixed-premium policies
- F60 products need to be classified as short or long duration contracts
- short-dur - fixed period of short duration
- insurer can cancel contract or adjust provisions
- ex. P&C (most) and some term life (like credit life)
- long-dur - generally not subject to unilateral changes in provisions
Product Features
- Normal stuff here WL/Endow/Term
Benefit Reserve Methodology
- short-dur - different chapter
- long-dur
- prems as revenue when due
- net GAAP reserves accrued when prem revenue is recognized
- based on assumptions applicable at issue
- unpaid claims and claim adj expesed accrued when insured event occurs
- loading - diff between gross and net prem - portion of gross prem that emerges as profit
- if no loss recognition or loading, net prem a constant percent of gross prem
Expense Recognition
- Acquisition costs s/b capitalized and charged to expense in proportion to prem revenue recognition
- other expenses charged as incurred
- can only defer expenses to the degree they don't create a loss in later years (recoverability)
- thorough discussion in chapter 3
- DAC - hold as deferred cost on asset side of balance sheet (negative reserve)
- using an inflation assumption on maint costs WOULD generate a maint exp reserve
- for limited-pay policies, establish reserve for maint expenses incurred after prem pay period
Selection of Assumptions
- GAAP Assumption Eras
- era where assumptions are appropriate for new issues
- sometimes known as a "ratebook"
- Provisions for Adverse Deviation (PADs)
- s/b included when setting assumptions
- broad guidance as to level of PADs
- same product @ 2 different cos w/ identical experience
- ultimate profitability same, but emergence will be split between level % of prem and release of PADs
- likely different between two companies
- ASP10 provides some guidance
- two types of assumptions
- best estimate assumptions - s/b reasonable
- PADs - the riskier the assumption, the higher the PAD
- should not raise net prem > gross prem
- 1994 Audit Guide
- PADS will cause profits to emerge from release of risks
- in relation to NAR
- invested funds or investment income
- w/d in relation to excess of (benefit reserve - unamort acq expense) over CV
- expenses less than estimated
- profit in premium
- PADs should apply to interest, mortality, w/d & settlement expenses
- "reasonable and realistic"
- Investment Earnings Rate
- typically assume declining int rate in later policy durations
- F60 - based on estimates of inv yields expected at issue
- shoudl be consistent w/ co portfolio
- Mortality and Morbidity Rates
- PADs typically 5-10% above best estimate
- expected mortality @ issue + PADs
- f60 - include risk of anti-selection
- GAAP actuary need to be aware of projected improvements Pricing Actuary is using
- Lapse Rates
- be careful of lapse supported policies - PADs are backwards from normal
- best-estimate w/o PADS may be good enough
- or PADs added in such a way that % prem profits decrease at all durations (vary PAD by dur)
- Expenses
- Ch 3 for most expense info
- No PADs for commissions since a controllable expense - we know the rates
- Taxes
- Lock-In
- Assumptions locked at issue
- some co's use factors and others use first-principles
- results calced from inforce
- not considered a violation of lock-in concept
- Loss Recognition
- Prem deficiency may result if experience emerges diferent from assumed
- prospective loss on a group of contracts = prem deficiency
- F60 - prem deficiency recognized as charge to income
- reduction of DAC or increase in future policy benefit liab
- future changes in liab based on revised assumptions
- adjust when first becomes apparent
- ASOP10 - use best estimate assumptions when testing for loss (no PADs)
- based on grouping of policies
- F60 amt of prem def = gross prem reserve - GAAP net reserve
- Numerical Examples p. 81
Limited-Payment Contracts
- income from limited pay contracts s/b recognized over period benefits are provided, not period payments collected - F97
- all other aspects same as F60
- F97 Limited Pay - life - ins in force as profit carrier
- annuity - expected future benefit payments
- profits emerge as level % of ins in force vs % of prems (f97 vs f60)
- Deferred Profit Liability (DPL) established (aka Unearned Revenue Liab/Unearned Profit reserve/unreleased profit reserve)
- Limited-Pay numerical example - pp. 95-97
Participating Products
- if NOT using contribution principle - use F60 methodology
- policyholder dividends a component of GAAP benefit reserve
- level and slope of PO divs also affect GAAP benefit NP
- divs an expense when incurred
- UPPEA - Undistributed Par PO Earning Account
- where profits in excess of what can be dividended to stockholder are put
- ASP10 describes distribution of this $
- example p. 99
Indeterminate Premium Products
- F97 - if policy is not essentiall a UL, treat it as F60
- assumptions may be "unlocked" at gross premium change dates - ASP10
- if adjusted, done prospectively, w/o change in liab as of valn date
- Indeterminte Premium Method (aka Prospective Unlocking)
- Res(t) = PVB(t) - PVP(t) t-> reporting date
- Res(t) = PVB'(t) - PVP'(t) = PVB'(t) - GP'(t)*level%'*Ann'(t)
- same applies to maint reserves and DAC
- if level% > 100, loss recognition testing s/b performed
Implications of Reserve Formula Selection
- Benefit Reserves
- Terminal Benefit Reserve
- TBR(t) = [(TBR(t-1)+NP(t))*(1+i) - DB(t)*q_d(x)*(1+i)^(1/2) - CV(t)*(1-q_d)*q_w] / [(1-q_d)*(1-q_w)]
- TBR(0) = 0
- lapses a significant part
- std practice -> policies only lapse on prem due date
- Final Reserve - reserve the moment before terminal (just before lapses assumed)
- FBR(t) = [(TBR(t-1)+NP(t))*(1+i) - DB(t)*q_d(x)*(1+i)^(1/2)] / (1-q_d)
- Mean Benefit Reserve MBR(t) = 1/2*(TBR(t-1) + NP(t) + TBR(t))
- MidTerminal Reserve midBR(t) = 1/2*(TBR(t-1) + TBR(t))
- sometimes use FBR(t) for end of year in above two formulas
- if MRB used, non-annual polices need a deferred prem assest
- if midBR used, unearned prem liability
- Expense Reserves
- same concept as benefit reserves
- Terminal Expense Reserve - TER(0) = 0
- TER(t) = [(TER(t-1)+Pol(t)+GP(t)*(Comm(t)+PT(t))-NP(t))*(1+i)] / [(1-q_d)*(1-q_w)]
- FER(t) - same at TER(t) but w/o (1-q_w) term - analagous to FBR
- MER(t) = 1/2*(TER(t-1) + Pol(t) + GP(t)*(Comm(t)+PT(t))-NP(t) + TER(t)) - Mean Expense Reserve
- similar to def prem asset, cost of collection liability - typically just the comm and PT payable on gross def prems
- midER(t) = 1/2*(TER(t-1)+Pol(t)+TER(t))
- similar to unearned prem loab, EUP asset - generally comm * PT payable on gross unearned premium
-
U.S. GAAP - Chapter 5 - TRAD LIFE (SFAS 120)
Overview
- mutual co's par products have similarities to both F60 and F97 UL products
- earnings emerge in a manner similar to UL
- product features are similar to Trad Life
- actively managed dividend scales cause earnings to emerge w/r to margins vs level of premiums
- F60 and by reference F97 specifically exclude mutuals
- SOP95-1 adn F120 address this
- model assumes dividend fund exists to determine divs
- Dividend Fund DF(t) = DF(t-1) + DP(t) + DI(t) - DQ(t) - DE(t)
- DF(0) = 0
- DI(t) - interest credited to DF
- DP(t) - gross prem credited to DF
- DE(t) - expense charges to DF
- DQ(t) - mort costs
- Div(t) - Dividend Paid
- M(t) - Margin to enterprise
- DF'(t) - same formula as DF(t) , but w/ actuals instead of modeled
- Div(t) - (DF'(t) - DF(t)) - M(t)
Scope and Applicability
- SOP95-1 - mutuals exected to pay divs to PO based on contribution principle
- only applicabel to mutuals
- F120 - stock cos can use it on blocks that meet provisions of SOP
- must be long duration, par and expected to pay divs based on "actual experience of ins enterprise"
- SOP model assumes earning emerge relative to earnings net of PO divs
- Par policy considered UL (F97) if any of the following are true
- PO may vary prems w/in contract limits w/o insurer consent
- stated account balance w/ credits and debits wehre amounts of cr/dr not guaranteed
- contract charges expected to be interest/market based rather than experience bases (group/block of pols)
- F120 specifically says to follow F60/F97 guidance if not par
Overview of Acct Model
- where F60 and F120 are the same
- prems recognized when due
- expenses - non-deferrable recognized when incurred
- benefits as incurred
- where F60/F120 are different
- Policyholder benefits - both use NLP to accrue PO benefit liab
- F60 - useing assumptions based on anticipated exp as issue
- F120 - only guar mort and div fund int assumptions
- Annual PO Divs
- F120 - recognized as such amounts are earned by PO
- F60 - either element of PO benefits and accrued based on NP
- or accrual of def div liab when profits to shareholders are limited
- Acq Costs - identification and deferral smae
- F120 - amortized based on constant % of PV of EGM expected to be realized over life of contract
- adjusted to reflect actual adn current estimates of future experience
- Terminal Divs - recognized as level amt w/r to EGM based on amt expected to be paid
- adjusted to reflect actual and current estimates of future experience
Amortization Methods
- EGMs - primary basis for recognizing earnings
- comparable to F97 EGPs
- EGMs shoud include estimates of (SOP95-1)
- + Expected Premiums GP(t)
- + INvestiment INcome on PO balances I(t)
- - Expected paid benefit claims B(t)
- - Contract Admin costs (incl nondef aqui costs) E(t)
- - Expected change NLP Benefit Reserve NLP(t) - NLP(t-1)
- - Expected PO Divs Div(t)
- +/- other expected assessments/credits
- NLP(t) = NLP(t-1) + P(t) + IR(t) - BR(t) where
- P => increase in reserves due to prems
- IR => increase in reserves due to interest
- BR => decrease in reserves due to benefits
- EGB(t) = GP(t) + I(t) - B(t) - E(t) - (NLP(t) - NLP(t-1))
- = (GP(t) - P(t)) + (I(t) - IR(t)) + (BR(t) - B(t)) - E(t) - Div(t)
- DE(t) => deferrable expenses
- PV()(t) => present value @ time t
- [t]EGM(t+1) => gross margins expected in period t+1 as projected # time t
- k(t) = [PV(DE(s>t)(0) = PV(DE'(s<=t)(0)] / [PV([t]EGM(s>t)(0) = PV([t]EGM'(s<=t)(0)]
- Amort(t) = k(t)*[t]EGM(t)
- if significant EGMs in any period, need to select alt amort base
- possible alternatives: PV(EGMs before divs), est gross prems, life inforce
Selection of Assumptions
- two main classes of assumptions:
- those underlying PO benefit liab
- those for estimating future gross margins
- Benefit Reserve Assumptions
- NLP method - requires mortality and interest assumption
- SOP95-1
- use div fund int rate (if determinable)
- mort - rateas guar in contract for calcing CV
- Mortality - contractually specified
- if substd - include extra liab
- Interest - hierarchy - if not avail, drop to next level
- div fund rate at issue
- guar csv rate
- NAIC min nonf rates
- if rates vary by duration, then reflect that in reserve calc
- Method
- NLP
- timing s/b consistent w/ financials
- Estimate Gross Margin Assumptions
- best estimate basis w/o PADs
- Mortality - best estimate mort assumptions
- look at div scale mort/pricing mort/recent co experience
- Interest
- div fund int rate
- inv int rate on PO liabs
- base on yield rate on invested assets
- net of inv expenses
- int rate used to discount future EGMs
- rate used to estimate gross margins in first year of contract is expected inv yield
- discount rate - once chosen, must stick with it
- either use inv yield rate at issue
- OR current yield each year
- Dividend
- Gross margins don't include expected terminal divs
- EGMs must show effect of elected div option (PUA/Accum/1YrTerm/Cash/ReducePrem)
- best estimate assumptions to show how PO expected to use divs
- Lapse Rates
- sensitive to changes in div scale
- if ETI/RPU are par, need to reflect that
- Expenses
- costs expected to be incurred for contract admin (including non-capitalized acq)
- Groupings
- policy-by-pol or group methods can be sued
- need grouping for recoverability testing and loss recognition
- groupings s/b consistent w/ way co acquires/services/etc LOBs etc
- issue year groupings at a minimum
- Example p. 123
True-up and Unlocking
- can be done at LOB level or lower level (consistent w/ groupings)
- EGMs adjusted to reflect actual results
- future EGMs s/b adjusted if necessary as well
- True-up - current period effect on amort of DAC or accrual of term div liabs
- difference between actual and expected Gross Margins for period, w/ k held constant
- Unlocking - current period effect on amort of DAC or accrual of term div liabs of a change in k
- caused by current period true-up or change in estimated EGMs
- DAC(t+1) = DAC(t) + AmountsCapitalized(t) + Interest(t) - Amort(t)
- Interest(t) = DAC(t)*i(t)
- k(t) = [PV(DE(s>t)(0) = PV(DE'(s<=t)(0)] / [PV([t]EGM(s>t)(0) = PV([t]EGM'(s<=t)(0)]
- Amort(t) = k(t)*[t]EGM(t) + [k(t+1)*[t+1]EGM'(t) - k(t)*[t]EGM(t)] <- true up term
- +(1+I){k(t+1)*[v*[t+1]EGM'(t) + PV([t+1]EGM(s>t)(t)] - k(t)*PV([t]EGM(s>t+1)(t)} <- unlocking term
- DAC(t) = k(t)*PV(EGM(s>t)(t) - PV(DE(s>t))(t)
- if we assume no deferrable expenses after year 1
- DAC(t+1) = DAC(t) + i(t)*DAC(t) - Amort(t)
- Unlocking = k(t+1)*PV([t+1]EGM(s>t+1))(t+1) - k(t)*PV([t]EGM(s>t+1))(t+1)
- first term reflects revused future expectaions
- True-Up = k(t)*([t+1]EGM'(t) - [t]EGM(t))
- if both unlocking and true-up, allocation of amort among components is judgemental
Realized Capital Gains
- an element of gross margin
- will affect the amortization charge
- p. 128 for example of impact of realized capital gain
Recoverability and Loss Recognition
- recoverability testing - PV amts to be capitalized vs PV EGMs
- Loss recognition - ongoing evaluation
- k(0) < 100% - amts being capitalized are recoverable
- for terminal div liab accural, k_DAC(0) + k_TermDiv(0) < 100%, then recoverable
- Loss recognition
- evaluating whether existng net liab combined w/ anticipated future revenues is adequate to provide future obligations
- if not adequate, premium deficiency
- SOP95-1 - liab for future policy benefits = sum of
- NLP reserve for death & endow policy benefits
- liability for terminal dividends
- any probable loss (prem def)
- Prem Def must be recognized if defiency exists on an entire LOB (minimum)
- Test for Prem Def
- + PV future benefit pmts & related settlement/maint costs using revised assumptions based on actual and anticipated experience
- - PV future gross premiums - using revised assumptions
- = liab for future policy benefit using revised assumptions
- - (liab for future policy benefits @ valn - unamortized acq costs)
- = premium deficency
- for par products, divs can be reduced to adjust for adverse experience making a prem def unlikely
Policyholder Benefit Liabilities
- SOP95-1 - PO benefit liabs be calced using NLP
- net prem ratio - levelp proportion of each gross premium payment necessary to provide contract benefits
- only considers mortality and interest
- use guaranteed mortality and div fund int rate
DAC and Terminal Div Liabilities
- Acq costs both variable and directly related to acq new and renewa ins/ann contracts are capitalized and amortized into income over life of assoc contract
- amort determined relative to PV EGMs
- terminal div payments and accrual of term div liab excluded from EGM calc
- terminal div payments charged against accrued liablity
Additional Considerations
- Policy Riders
- not specifically addressed in SOP95-1
- if rider viewd as sep contract, may have features that place them w/in scope of F120 and SOP95-1
- if rider intertwined w/ policy
- consider them one and include all acq costs etc from both coverages
- develop benefit Vx sep and add together
- w/ PUA divs to purchase PUAs, EGMs show divs as expense and income
- later durs, EGMs reflect CV surrender from PUA to purchase Term Ins
- if rider not intertwined and not w/in scope, treat it under F60 or whatever is appropriate
- if rider detached from base for acctg purposes, not part of same block
- Reinsurance
- depends on contract adn treaty
- paying ceding commission - use to offset acq costs otherwise capitalized
Examples p. 137+
- Base Case
- Dividend fund different than NLP reserve
- Experience diffent than best-estimate assumptions
- alternate discount rates
-
U.S. GAAP - Chapter 6 - UNIVERSAL LIFE INSURANCE
Background
- Account for UL - 198 AAA
- AICPA 1984 Issues Paper
Applicability
- UL-type contracts, investment contracts adn limited pay long dur contracts that would be F60 if not mentioned in F97
- EOY1998 w/ restatements for prior years fin statements
- amended F60 for reporting req for realized g/l
- AICPA Practice Bulletin 8 - 1990 - provided guidance
- only looking at fixed (general acct) UL
Definition
- UL - long dur contract w/ death or annuity benefits w/ terms that are not fixed and guaranteed
- contract assessments made by insurer that are not fixed and guar by terms of contract
- amounts that accrue to benefit of PO that are nto fixed and guar by terms of contract
- prems that may be varied by the PO w/o consent fo the insurer
- sometimes requires judgement
- some normal looking contracts s/b accounted for as UL
- existence of account balance for which amounts assessed or credited is not fixed & guar
- expectation fo insurer that changes in any contract elemetn woudl be based onchanges in mkt conditions or int rate and not group experience
- par contracts w/ ability of PO to vary prems w/o consent fo insurer
Typical Product Designs
- prems treated as deposits
- credited rate - rate used to increase fund balance (account balance) aka account value
- surrender charege - penalty for w/d funds
- cash surr value = fund value - surrender charge
- fund is decreased w/ various charges (mort, maint, risk, etc)
- partial surrenders usually allowed
- prems may be fixed or variable - sometimes has a Target Prem that guarantees a certain level of benefits if paid
- many allow extra "dump-in" prems
- may be FEL, left % load, no load (fees taken from account balances)
- enough mortality benefit is provided to qualify as Life Ins under IRC
- mort benefit can be level (Type A) or level NAR (type B) or other pattern
- COI charge - normally monthly to NAR
- might have persistency bonus
Presentation of Results
- retrospective deposit method must be used to account for UL
- benefit reserve - F60: PVFB - PVFP F97:Account Balance (plus adjustments)
- Balance sheet - similar to F60
- Income statement - significantly different
- prems are not revenue
- payments to PO that are return of PO balances not reported as expenses
- revenue
- amounts assessed against PO (COI charges, SC, pol fees, other charges)
- reported in period rec'd - unless deferrable, then repoarted as URL and amortized into income using same methods/assumptions as DAC
- expenses
- benefit claims in excess of acct balances
- costs of contract admin
- int credited to PO balances
- amortization of DAC
Benefit Reserves
- liab for future benefits must be established on balance sheet
- account balance products - retro deposit method
- account balance is basic benefit reserve liab
- UER balance and refundable assesments must be held as liab
- additional liab if prem def exists
- unearned COI held as liab by some co's (not mentioned in F97)
- other products
- if no explicit acct balance, benefit reserve is implicit acct balance or CV
Capitalization and Amortization of Acquisition Expenses
- Amortization method used EGPs
- Estimated Gross Profits (EGPs)
- made up of margins from mort and contract admin, inv earnings spread, SC and other expected assessments/credits
- Mortality
- mort margin - excess of COI over amt paid as benefit claims (in excess of PO balances)
- can estimate if admin system doesn't split DB between NAR and AV
- if level COI or "reverse S&U", excess over std COI needs to be deferred and amortized as URL
- Costs of Contract Admin
- margin - excess of expected admin assessments over expected admin costs
- contract admin costs
- non-DAC policy related costs (policy admin, settlement and maint costs)
- non-DAC acq costs (prem tax and ult ren commission)
- DO NOT include non-DAC, non-policy costs such as mktg and adv
- Investment Earnings
- spread - amount expected to be earned from PO balances - int credited to PO balances
- expected realized g/l s/b estimated and included
- includes amortization of discount or premium on bonds
- includes estimates of equity growth rates
- Surrender Charges
- total SC expected to be collected each year
- diff between account balance for surrendered pol and CSV paid in each year
- product design taken into account when estimating future SC
- Other Assessments and Credits
- rider charges
- reinsurance - consider excess claim recoveries & ceding allowances voer reins prems in EGPs (historically and prospectively)
- treatment varies in practice
- some treat as F60 offset
- Nondeferred Acq Costs
- expensed in year incurred
- if policy related, they affect gross margins
- Expense Capitalization
- same expenses as F60
- except acq costs that vary in constant relationshiop to prems or ins inforce and recurring in nature shall be charged to expenses in period incurred
- under F60, since prems are amort basis, this isn't an issue
- commissions in excess of ultimate level are capitalized
- Amortization of DAC
- k-factor - ratio of present value of deferrable expenses to EGPs usnig int rate that accres to PO balances - at issue
- after issue - actual gross profits replace EGPs and future projections are reviewed/updated
- realized g/l included in investment earnings
- k-factor is recalculated
- all changes in DAC reported in the period
- unlocking - this cumulative catchup amount
- common to use 30 years instead of life of contract
- Negative Gross profits
- est gross revenues, gross costs, or balance of ins inforce substituted for gross profits
- if significant neg gross profits expected for any period
- example p. 154-161
- Selection of Assumptions and Unlocking
- selectoin of assumptions
- best estimates w/o PADs
- includes mort, persistency, prem persistency (or future prem pattern), expenses,future inv earnings, future crediting strategy
- at issue, pricing assumptions generally used as best estimates
- need to understand what underlies pricing assumptions
- if policy maintained at acct value/face levels similar to term, expect persistency to be similar to term
- FIT is not part of DAC process or benefit reserves
- True-up for Actual Experience/Retrospective Unlocking
- replace projected w/ actual at end of each reporting period
- include realized g/l
- unrealized g/l needed for F115
- w/o changing future assumptions - retrospective unlocking
- assumptions and prospective unlocking
- updating future assumptions - prospective unlocking
- retro/pro unlocking examples p 164-165
Deferral of Unearned Revenue
- unearned revenue liab (URL)
- front end loads (FEL) or excess COIs - deferred as unearned revenue and grought into income during period earned
- done via same logic as DAC
- example p. 166
Treatment of Bonuses and Other Special Benefits
- types of special benfits
- day-one bonuses/persistency bonuses/enhanced int rate bonuses
- initial bonuses most common w/ single prem or rollover products
- persistency bonuses are usually either retro int rate increase or refund of COI
- examples
- calculate two streams to establish a liab for the special benfit
Recoverability and Loss Recognition
- same principles as F60
- discount rate for recoverability testing s/b best estimate of earned rate, not crediting rate
- once recoverability has occurred or loss recognition - appropriate to use earned rate to amortize any remaining DAC
- DAC is reduced until k-factor is 100% using earned rate and gross prem approach appropriate thereafter
-
U.S. GAAP - Chapter 7 - DEFERRED ANNUITIES
Overview
- characteristics of current DAs
- premium pattern - SPDA & FPDA
- load structure - FEL, BEL (SC) or combo. BEL most common
- surrender Value - typically prems rec'd + credited int - prior partial w/d - SC
- typically has 10-15% free partial w/d provision
- int guarantee structure - guaranteed for a year or less subject to floor.
- based on co experience and competitive considerations
- sometimes guaranteed longer (SPDA products)
- taxable nature - tax-qual or nontax-qual.
- tax-qual deposits deductible on taxes
- both - int not taxed until w/d
- all w/d taxed to extent not previously taxed
- features
- db = max(fund value, prems paid)
- bailout - SC waived if actual rate credited falls below a set limit
- MVA annuities - normally SPDAs
- if early surr, SC and MVA
- adjustment normally defined in contract
- bonus annuities - either extra $ added to fund value or bonus int rate - typically 1st year only
- two-tiered annuities - one int rate for accum to annuitizaton, one rate for accum to surrender
Accounting Model Classification
- older annuities fall under f60 - issued before F97, prems fixed by contract, int guarantees and benefits bundled (similar to trad life)
- prems considered revenue
- reserves calced vial NLP
- DAC amortized w/r to premium revenue
- most modern DAs dont qualify for F60 for 2 reasons
- product features unbundled - excess int, expense charges & SC explicitly defined by contract
- prems not fixed - can be varied w/o insurer consent (w/in contract limits)
- to classify properly, need to know
- accum and payout phase - single contract or two contracts
- if contract contains significant mort guarantees
- significant sources of revenue other than investment of contractholder funds
- "significant" mort risk - generally disregard the presence of guaranteed purchase options in DA contracts as significant mort risk
- usually defined as an Investment Contract
- AICPA Practice Bulletin 8 reinforces thinking - most DAs either F97 or F91
Benefit Reserves
- F97 for Investment Contracts
- generally use UL guidance for defining reserves and DAC asset
- liab for policy benfit = account value
- + amounts assessed for future services (fees, FELs)(URL)
- + previously assessed amounts refundable at termination [seldom applicable to DAs]
- + any probably loss (prem def)[n/a to inv contracts]
- URL accrues in direct proportoin to gross profits
- accrual s/b made for int bonuses (& accrual s/b part of gross profit calc)
- F91
- DAs w/ little or no SC & no add'l DB other than account value
- policy liab = account value using retrospective deposit method
- if no explict acct value, prospective method using best-estimate assumptions w/o PADs
- DAC and FEL considerations
- Practice Bulletin 8 - DA F97 DAC s/b treated as an asset like UL
- not explicitly stated, but same method used for F91
- Commissions and CREs are primary acq costs, but anything else that qualifies under F60 s/b OK
- FEL in excess of ongoing service loads s/b deferred as Unearned Revenue
- DAC amortizes and URL accrues w/r to EGP for F97, int method for F91
- DAC Amortizatoin under F97
- uses saem revenue defintion as F97 UL
- use gross profits as revenue for amortizing DAC and accruing URL
- Definition of Gross Profits
- F97 P23 includes the following EGP items
- amounts expected to be assessed for mortality less benefit claims in excess of PO balances
- amounts expected to be assessed for contract admin less costs incurred for contract admin
- amounts expected to be earned from investment of PO balances less int credited to PO balances (int margin)
- amounts expected to be assessed against PO balances upon contract termination (SC)
- other expected assessements and credits
- best estimates over life of contract w/o PADs
- for DAs, admin, int and SC are most significant items (particularly int margin)
- mort margin usually trivial unless rider w/ significant mort charges included
- other includes things like contingent bonus accruals
- Excluded items: DAC, deferred excess FEL, FIT
- Included : recurring acq expenses, ultimate level of commissions, PT
- Overhead is excluded
- Int Margin is to include realized g/l
- AICPA Practice Bulletin 8 - Expected G/L s/b included since projected future income should include expected total yield from these investments
- int margins should include impact of policy loans if applicable
- DAC Amortization Process
- F97 DAC - amortized in proportion to EGP revenue each accounting period over the period that such revenue is recognized (often capped at x years)
- many co's use worksheet approach
- some co's use valn systems that calc DAC at contract level
- amort process can be expressed using eithe retrospective or prospective approach
- k(0) = pv(DAC)(0) / PV(EGP)
- assumptions not locked - replace EGP w/ actual each acctg period (true-up)
- update best estimate assumptions if warranted
- k(t) updated each accting period
- recalc is as of original issue date
- adjustments to balance made to current and future balances - don't restate past financials
- if k(0) > 1 at issue, recoverability problem may exist
- k(0) recalced using estimated earned rate (instead of credited rate)
- confirms earnings will be available if needed and maintain consistency w/ loss recognition concepts
- if still > 1, reduce DAC until k(0) = 1
- reduction charged against earnings in current acctg period
- F60 procedures for handling recoverability problmes
- if PV(EGP)(0) < 0, no DAC is established
- no additional reserve req'd to make up deficiency
- possible for GAAP loss in all future years for F97 DAs
- adhere to general guidance in F60
- if significant profits expected in one or more periods
- PV(EGR, Gross Costs, or balance of Ins inforce) s/b substituted as base
- int rate for k(t) is either
- rate in effect at contract inception
- actual prior credited rates and latest revised rate for future periods
- int rate choice must be used consistently for all future years for cohort
- EGP & DAC formulas
- assumptions
- EGP derived from investment and expense margins and SC
- all commission expressed as % of prem
- Definitions
- t - contract or calendar year
- n - # years to end of revenue period
- GP(t) - expected GP collected in year t
- m - # prem payments per year
- C(t) - deferrable commision rate in year t
- i(t) - credited int rate for year t
- I_E(t)/AI_E(t) - expected/actual earned rate
- I_C(t)/AI_C(t) - expected/actual credited rate
- E_A(t)/AE_A(t) - expected/actual admin costs
- E_C(t)/AE_C(t) - expected/actual admin contract charges
- SC_E(t)/SC_A(t) - excpected/actual SC
- EGP(t) - EOY value of EGP(revenue) in year t
- AGP(t) - EOY value of AGP in year t
- DAE(0) - non commission deferrable expenses @ issue
- CAP(t) - BOY cap acq costs
- = DAE(0) + C(1)*GP(1)*(1+i(1))^{-(m-1)/2m} in year 1
- = C(t)*GP(t)*(1+i(t))^{-(m-1)/2m} in renewal years
- DAC(t) - DAC asset at end of policy year t
- DAC_CY(t) - DAC asset at EOY t
- k(t) - amort factor for AGP/EGP in year t
- Formulas
- EGP(t) = (I_E(t) - I_C(t)) + (E_C(t) - E_A(t)) + SC_E(t)
- k(0) = sum(CAP(s)/prod(1+i(p))) / sum(EGP(s)/prod(1+i(r))) for s=1 to n; p=0 to s-1; r=1 to s
- assume CAP(s) - BOY value and EGP(s) - EOY value
- k(t) = sum(CAP(s)/prod(1+i(p))) / [sum(AGP(v)/prod(1+i(v))) + sum(EGP(w)/prod(1+i(w)))] for s=1 to n; p=0 to s-1; v = 1 to t; w=t+1 to n
- Retrospective formula for DAC (end of contact year)
- DAC(t) = (DAC(t-1) + CAP(t))*(1+i(t)) - k(t)*AGP(t)
- Prospective
- DAC(t) = k(t)*PV(future EGP revenues) - PV(future deferrable costs)
- Calendar year apporx
- DAC_CY(t) = 0.5*(DAC(t-1) + DAC(t))
- if amort schedule developed from first principles, validatoin of model data w/actual inforce data s/b done
- validate account value, commissions, policy count, & premium at a minimum
DAC Amortization under SFAS91
- Practice Bulletin 8 - recognize acq and int costs as expenses @ constant rate applied to net policy liab
- interest method
- generally defined as diff between policy liab and notional account value, calced @ solved for BE rate
- BE rate - rate where policy liab @ issue = notialnal account value + PV(est DAC) <- @ assumed credited rate
- after issue, notional acct valued calced using original BE rate and remaining DAC is diff between notional acct value and policy liab @ valn
- Int method generally used when policy liab calced under prospective method
- if contract has explicit account value, retrospective method used in practice & handled more like F97 product, including using EGPs
- F91 Inv Contracts not subject or recoverability analysis or loss recognition testing
- in practice, amt of DAC allowed @ issue is limited if BE rate exceeds co's best estimate of investment rate
- if DAC is eliminated and best est rate is still < BE rate
- NO add'l reserve req'd & losses each year earned rate < BE rate
Accrual of Unearned Revenue Liability (URL)
- FEL in excess of level renewal service loads are deferred
- F97 P20 FEL - amt assessed that represnt compensation to insurance enterprise for services to be provided in future periods
- FEL genearlly associated w/ DAs subject to F97 investment contract acctg model
- recognition of deferrable FEL reseults in establishment of URL
- excess loads deferred each acct period as incurred and realased into earning in proportion to AGP realized each period (similar to DAC capitalization adn amortizatoin)
- release rate factor developed similar to k factor
- k(0) = PV future URL / PV future EGP sicounted as assumed credited rate
Selection of Assumptions
- need to select appropriate assumptions at issue and periodically thereafter as necessary
- best estimates w/o pads
- often pricing assumptions w/ PADs removed
- historic prem patterns s/b reviewd since PO can vary FPDA prem payments
- exonomic trends can alos affect payment history
- assumed earned and credited rates - two of most important assumptoins for DAs
- take into account
- investment strategy
- asset type and quality
- asset duration
- liquidity
- disintermediation risk
- provisions for default cost - by quality rating
- int crediting strategy can change over tiem
- strongly influenced by competition and desired spread
- new LOB probably very competitive
- runoff block probably large spread to maximize profits
- reflect prem taxes
- gross of FIT (no tax assumption)
Loss Recognition Tests
- adverse experinece over a period of time reduces AGP and can cause future assumption changes
- these can lead to doubts as to remaining DAC recoverability
- Practice Bulletin 8 - if portion of DAC balance is probably not recoverable, it should be written off
- necessary to conduct preiodic tests of recoverability
- if k(t) ? 1, may not be adequate future revenues to amortize remaining DAC
- need to reduce DAC balance until k(t) <= 1
- F97 investment contracts never need a def reserve
- cannot reinstate written off DAC if experience improves
Examples pp 186 - 190
Presentation of Results
- income statement considerably different from US Stat and F60
- s/b reported in form similar to F97 UL
- F97 revenue
- investment income
- COIs
- SC
- expense charges
- released URL
- DA expenses
- benefit claims in excess of acct value
- admin expenses
- int credited
- amort of DAC
- accrual of special liab (ex. accrued liab for contingent bonus features)
- primary differences - prems, surr benefits, resv incr, credited int
Acconting for Special Features
- MVA Annuities
- product description
- allows companies to guar a competitive crediting rate in exchange for additinal surrender penalty
- MVA designed to cover g/l when surrenders occur @ times when int rates are higher/lower than when contract was issued
- change in intended discourange disintermediation and to recover the realized g/l on those surrenders that do take place
- accounting issues
- when and how MVA adjustments and realized g/l s/b included in EGP calc
- what discount rate s/b used when int rates change
- at contract issue - most co' do not anticipate future MVA adj or realized g/l
- credited rate set equal to guar rate and earned rate = (for guar period) earned rate on assets underlying assets @ issue
- when int rates change, need to decide if need to adjust rates going forward (recalc EGP)
- which int rate to use to recalc VP EGP in DAC amortization factor calc
- crediting rate in effect @ inception OR
- latest revised rate applied to remaining benefit period
- example pp 194-195
- Bonus Annuities
- Product Description
- two bonus designs
- immediate fund enhancement of % of first yr prem (or single prem)
- additional int enhancement in one or more years early in contract
- both usually accomplished by reducing commissions
- usually increases early persistency
- bonus may or may not be immediately vested
- Accounting Issues
- some argue that bonus is a mktg related cost adn s/b a sales expense like commmission
- some co's designate the benefit as contingent and not guaranteed to occur and accrue liab over a period of years, commonly in relation to EGP
- AICPA had not yet rendered an opinion on this yet
- Example 196-197
- Two-Tiered ANnuities
- Product Description
- two tiers
- one w/ lower rate for surrenders (liquid fund)
- one w/ higher rate for annuitization (income fund)
- usually between 100-300 bps difference between rates
- liquid fund typically FEL (5-10%)
- some use SC (BEL) 5-10 yrs grading to 0
- int usually near guar rate until end of SC period (or approx 10 years if FEL)
- then usually same as income fund
- income fund typically enhanced by 5-10% 1st year prem bonus
- Accounting Issues
- fairly controversial for GAAP methodology
- typically considerred investment contracts (despite annuitization encouragment)
- two basic approaches - based on liquid fund and based on income fund
- some use a blended 3rd approach
- liquid fund reserve - liquid fund + accrual of add'l lib for diff between liquid and income funds
- URL for FEL established and released in proprtion to AGP
- add'l liab generally accrues ~ liquid fund or EGP
- income fund reserve = income fune (including any enhancements)
- DAC amortized in relation to EGP, defined by approach selected
- EGP for income fund approach -
- = excess inv income on assets supporting income fund
- + diff between two funds on surrender
- + expense load margins
- income fund bonuses - some co's capitalize tihs amt liek DAC and mortize w/r EGP
- some calc amt in same manner, but report it as a contra-liability instead of deferred asset
- some believe liquid fund approach yields a more reasonable GAAP earning pattern
- income fund leads toward over-reserving
- liquid fund approach doesn't have capitalized bounus issues
- example p 199-202
-
U.S. GAAP - Chapter 8 - VARIABLE AND EQUITY-BASED PRODUCTS
Introduction
- variable products - products that effectively provide for PO to bear substantially all the inv risk on all or a portion of the assets suporting the savings elemtn of their prem payments
- frequently acct model for variable version of product is same as non-variable version of product
Variable Products
- Product Descriptions
- VUL
- A UL product that allows PO to direct all or a portion of their acct balnce into an investment that effectivley passes risk/reward bask to PO
- Does not guarantee inv performance
- Despite added volatility, acctg for VUL saem as UL
- Extra accounting for extra features (secondary guarantees)
- Variable Deferred Annuities
- classified as investment contract unless significant mort benefits, then UL
- Lots of extra features
- GMDB
- Guar Min Maturity Value
- GMIB
- if any of these features establish significant mortality risk, then may require UL-type acctg
- Variable Payout Annuities
- Income benefit indexed to performance of investments underlying variable account
- Ins company may need to +/- assets backing block depending on emergence of mort experience
- Contract Classification
- Life Insurance
- variable feature prohibits classifying them as trad life
- trad life w/ variable features -> UL-type contract -> F97
- variable UL doesn't change it from being UL -> UL-type contract -> F97
- Deferred Annuities
- typically accounted for as investment contracts
- GMDB may cause it to be classified as UL-type contract
- F97 essentially considers GMIB & Guar Min mat value as pricing risk and not mort risk
- Payout Annuities
- limited pay contract w/ variable features can no longer be classified as limited pay contract & classified as UL-type
- since don't ahve stated account balance or explicit charge for mort benefits, accounting requires judgement
- PO Acct balance = PV expected income stream using pricing basis mortality adn discount rate = rate elected by PO @ annuitization
- mort assessments - expected benefit payments calced using same mort rates used to calc PO balances less amt annuity values incr through survivorship
- mort component of EGP - excess of actual benfits paid over amt of mort assessments, then reduced by amt of req'd additions to assets supportin gcontract due to mort exp different from pricing basis
- contract admin assessment based on purchase rate calc
- g/l relative to mort exp - considered part of mort component or "other expected assessments"
- Assumptions
- Contract Interest Rates
- the rate of int that accrues to PO balances (contract rate)
- this rate is then used
- in estimating the amt of future PO acct balances
- as rate credited to PO balances in investment element of EGP
- as discount rate used in determining PV of EGP
- variety of alternatives in developing int assumptinos
- range from estimating rate for all perods to a single rate for all future periods
- usually incorporate element of recent inv results in establishing assumptions for future periods
- regardless of method, needs to be actuary's best estimate of the future based on underlying investment
- one method uses investment horizons
- need to know lenght of investment horizon and est long term rate
- then need to estimate where we are in inv horizon to determine future yields
- Mortality Rates
- for VUL and Var Life, s/b same conderations as non-variable versions
- for Var DA w/ mort adn variable payout annuities
- since not u/w (generally) mort s/b similar to unselect populations (worse than u/w UL contracts)
- Other Assumptions
- expense assumptions s/b same as non variable forms
- may include expense elements for PO activity (moving funds, etc)
- Methods
- In general, consistent w/ nonvariable forms of contract
- exception: variable payout annuity classified as UL
- A - initial deposit x - contract IA
- t - time from contract initiation (t >= 0) i - premium int rate
- p(x+t) - prob surr x+1 to x+t+1 [t]p(x) - prob survival x to x+t
- v = 1/(1+i) s(x) = sum(v^t*[t]p(x))
- uv(t) = accum inv perforance from issue to time t
- I(t) - inv income rate earned on inv in var acct for period ending @ t
- I(t) = (uv(t) / uv(t-1)) - 1 uv(0) = 1
- P = (A - loading) / a(x) => income units purchased
- IUV - Income unit value IA(t) - ann income payable at t
- IA(0) = P*IUV(0) = P (IUV(0) = 1.00)
- IA(t) = P* IUV(t) IUV(t) = UV(t) / (1+i)^t
- PAB(t) - PO acct balance - principal element of liab for var payout ann
- = IUV(t)*P*a(x+t)
- rollforward of this acct balance generates elements of EGP used to amort DAC
- a(x+t+1) = [a(x+t) - 1]/(v*p(x+t))
- IUV(t+1) = IUV(t)*[UV(t+1)/UV(t)]/(1+i) = IUV(t)*(1+I(t))*v
- PAB(t+1) = IUV(t+1)*P*a(x+t+1)
- = PAB(t) - IUV(t)*(1+I(t+1))*P + I(t+1)*PAB(t) + [1/p(x+t) - 1]*[PAB(t) - IUV(t)*(1+I(t+1))*P + I(t+1)*PAB(t)]
- or
- mort assessent = (IUV(t)*P*PAB(t))/p(x+t) - PAB(t)
- int credited = I(t+1)*[(IUV(t) + P + PAB(t)) / p(x+t)]
- allocated inv performance on benefit payouts to int credited component
- methods may need to be developed for unearned mort assessments for any db features
- added to any variable def ann
- most common is to recognize revenue as assessments are deducted and recognize DB as they are paid
- examples p 215-240
Equity-Indexed Annuities
- Nature of Product
- simplest form - on SPDA chassis
- NAIC SNF - value fo policy @ any point = 90% of prems accum @ 3%
- equity indexing feature rides atop SPDA
- often a cap or participation rate to actual growth rate of index befroe applying to premium
- variations on indexing
- choice of index may be provided
- designated period may be changed
- SC may be applied to indexed value if not annuitized
- DB may or may not include unrealize gains in index @ time of death
- flex prems may be allowed (each prem has own indexing)
- equity indexing may be provided as transfer option w/in VA
- index growth may be averaged across several day/weeks/mo to prevent "all or nothing" scenarios
- the underlying (3%) floor my be reset periodically to the current index value
- may be blendingof indexed and guar values
- other index patterns may be used such as lowest value or highest value during designated period
- assets used to support contract primarily bonds to support the guarnatee
- this is lower than costs of bonds for a normal DA
- extra funds used to puchase call options to hedge index risk
- Acctg for Deriviatives
- SFAS133 (1998) - not only derivative assets, but derivatives embedded in host contracts
- embedded derivative object s/b separated from host contract & acct for as derivative
- once separated, host contract acctd based on non-derivative version
- g/l on derivative used as hedge adn hedged item recognized currently in earnings in same acctg period
- Derivatives Implementation Group (DIG) - formed to offer guidance on F133 Implementation
- intial value of host contract on fund-type cntract = premium paid less valued of embedded derivative
- Establish GAAP Methodology for DAC and Reserves
- F133 - EGPs s/b claced using F97 procedures - w/o consideration of equity benefit
- F115 - unrealized gains from assets available for sale s/b processed thorugh EGP calc to produce shadow DAC
- considerations for reporting EIAs
- host contract treated as F97 DA. Fund value = guar fund value
- when index credit is applied, fund value steps up to reflect
- unrealized g/l on embedded policy derivative and hedging assets become components of EGP
- in GAAP projection, assume exact hedge intent is accomplished
- since value of host contract is balancing item @ issue, unearned FEL normally created by 10% load at issue disappears
- open issues regarding reporting of EIAs under GAAP
- floor of csv or prem paid could emerge as floor for benefit reserve
- choices as to how derivatives enter EGP for amortizing DAC
- cost of underlying asset s/b amort linearly to 0 over life of mat period
- amortize cost using EGM prior to insertion of derivative
- only unrealized gains fo both asset and offsetting liab derivative shoudl only enter shadow DAC calc (consistent w/ many co's F115 practice)
- most F97 calcs can be generated using single set of expected values
- because of importance of value of options, may need to forcast multitude of scenarios and take advantage of results to generate DAC and related items
- Numerical Example 242-247
-
U.S. GAAP - Chapter 9 - ANNUITIES IN PAYMENT STATUS
Background
- Annuity in pay status come from many sources
- SPIA
- settlement options embedded in life/DA contracts
- structured settlement
- fund state lottery prizes
- others
- if payment of benefits contingent on continued survival of annuitant(s) - F97 limited pay contracts
- if investment contract (no significant life-cont payments), s/b accounted using methodologies consistent w/ those used for similar products offered by other fin services institutions
Contract Classification
- Annuity w/ no mort or morb risk - investment contracts
- Life w/ certain - ins contract unless
- prob life portion every being paid is remort
- PV life portion is insignificant
- Option to annuitize on a DA not a mort risk, a pricing risk
- once exercises, a mort risk, but accounted for as a separate policy
- rule of thumb - life contingent payments > 5-10% of PV of all payments -> not nominal mort risk
Investment Contracts
- F97 - little guidance
- amt rec'd as payments NOT reported as revenue, but liab and accounted for in manner consistent w/ acctg for int bearing or other fin instruments
- F91 - some insight via loans
- loan orig fees, purch prem, discounts recognized as an adjustment to yield
- generally by interest method based on contractual terms of loan
- Constant Yield Method (aka Prospective Deposit Method)
- project anticipated cash flows - best estimate assumptions w/o PADs
- solve for int rate where PV flows = net proceeds @ issue
- PV CF @ solved for rate on valn date is GAAP reserve
- net proceeds - consideration rec'd less comm or acq costs
- GAAP liab can be split into asset piece and liab piece for B/S presentation
- calc PV maint exp (maint Vx) adn PO benefit payments (benefit Vx) only
- where i is rate that gives PV @ issue = Prem Paid
- DAC balance = benefit reserve + maint reserve - net GAAP reserve
- Prems booked as deposits (consistent w/ other fin institutions)
- PO benefits not ded to income, merely return of deposit
- Appropriate I/S presentation
- + Inv Income
- - Maint Exp
- - Req'd/Credited Int
- - Incr Maint Exp Reserve
- + Increase in DAC
- = Pre-tax GAAP profit
- if actual main expense = expected, profit emerges as inv income earned on assets supporting net reserve @ BOP - req'd int of benefit and maint exp reserves + change in DAC
- if benefit paid and maint exp emerge as expected, profits emerge as difference between inv income earned and req'd int on net GAAP reserve
- appears that loss recognition is N/A to inv contracts
- AICPA Practice Bulletin 8 - write off DAC, if determined that not recoverable from future profits (written down to recoverable level)
- realized g/l not an issue since not being amortized over EGP
- Also no shadow DAC
- assumptions not locked-in
Limited-Pay Contracts
- once determined that enough mortality risk exists, contract s/b accounted for as F97 limited-pay contract
- premiums as revenue
- liab for policy benefits same basis as for other long dur contracts
- amt of gross prem in excess of net premium s/b deferred and recognized over period that services are provided
- initial prem is revenue
- acq expenses capitalized adn amortized over prem period (instantaneous in most cases)
- benefit and maint exp reserves established using assumptoins reflecting co's expectations, incl PADs
- any excess of gross prem over acq exp and initial benefit reserve and initial maint reserve is capitalized as a deferred profit liab (DPL)
- DPL amortized in proportion to expected annuity payments to be made
- since essentially treated as F60, assumptions locked at issue
- critical assumptions - mortality and inv earnings assumptions
- ok to grade inv earnings rate down over time as a PAD
- to include PAD in mortality, decrease (not increase) future mortality (usually projecting mortality improvement)
- loss recognition: PV pre-tax GAAP profits using pre-tax inv earnings rate
- if < 0, liab s/b increased by amt of deficiency
- DPL set to zero
- benefit adn maint reserves recalced using best-estimate assumptions
Conversion of Policy-Year Factors To Calendar-Year Factors
- reserve factors on dates other than policy-year ends typically done through interpolation
- alt: exact calc of PV of projected payments made on each valn date
- if benefit payments not uniform, exact calc s/b made
Study Notes and Published Refences - Note SN 8I-309-01 - MANAGEMENT REPORTS AND REPORTS TO REGULATORY BODIES
Intro
- mgmt reporting systems designed to satisfy 3 basic purposes
- external reporting to shareholders/policyholders/regulators
- internal reporting to mgmt for control and planning
- internal reporting to mgmt for non-routine decision making
Management Reporting
- comprises teh published reports of financial results for shareholders, PO, or other users of fin reports
- along with those used internally by mgmt for control and decision making
- Reports for External Readers
- frequency and form dependent on # factors
- stock vs mutual
- needs of co mgmt
- subject to SEC
- demands of others (credit rating agencies)
- Annual/Qtrly usually consist of
- balance sheet as of reporting date - usually w/ comparison to prev periods
- income statement since last report - usually w/ comparison to prev periods
- cash flow statement
- statement of changes in shareholder equity (or PO surplus)
- explanatory notes to fin statements (lots of disclosures)
- common to provide a narrative (MDA)
- Reporting for Mgmt Control
- provides mgmt w/ info necessary for planning and controlling current operations, making special decisions and formulating long-range plans
- Basic Objectives of Mgmt Reporting
- must be at a level of detail & freq to enable the user manager to accomplish the control or planning function
- shoudl focus on key controllale tiems on which a manager cna act
- distribution of reports s/b limited to those who can act on the info
- one mgmt reportng linnked to strategic objectives, mgmt comp can be lined (in part) to measurment of these metrics
- Economic Value Analysis - analyze economic value of various untis of co to determine capital allocation strategies & req'd rates of return
- Structure of Report
- system s/b single integrated multi-purpose reporting package taht provides all relevant data via fewest pages of reports
- all report elements s/b generated as a routine by-product of the acctg and info gathering process (ideally)
- data warehouse - allows mining
- top mgmt need less detail fo results of operations and more analysis from lower mgmt
- exception reporting - reports only detail matters that have varied from the plan
- reports sould include explanations for any deviations and propose corrective action (if needed)
- Reporting for Cost Control
- needs good historical data
- best accomplished through techniquies of responsiblity level reporting
- Elements of Responsibility Reporting
- forms basic design of complet mgmt control system
- focuses on individual manger who has primary responsibility for revenues/cost
- recognized cause and effect relationship between decisions made an dactions takes and economic results of such decisions and actions
- procedures shoudl provide for direct and indirect cost indentification and techniques for their allocation to benefiting functinos
- levels of cost containment shoudl take into account
- operational responsibilities of dept fro whom cost accumulated
- other cost centers from which work rec'd
- otehr cost centers benefiting from work performed
- plans of ins or major types of ins served by function
- Report Design for Responsibility Control
- only report results that can be directly controlled
- objective negated if info reported is outside their authority
- managers can only utilize a level of report detail commesurate w/ style of mgmt, authority and info needs
- many orgs re-designing chart of accts & cost centers so they "roll-up" better
- reports generally provide net operating results on
- contribution to income by LOB function or
- contribution to overhead
- reports show results for period, comparison w/ budget and forcasts and variances
- Analytical Reporting
- great deal of add'l info that is financial or statistical in nature
- add'l elements - control of performance
- policy counts and avg volumes
- w/ explanations for deviations (both fair and unfair)
- changes in acq costs - all deviations s/b explained
- trend analysis of Stat and GAAP reserve/$1m
- clerical cost control reports
- % of perforance std achieved for each work element, volume of processing, volume of backlog
- mgmt info systems control
- expansoin or decline of units of work completed for users, improvement or degradation of user value rec'd
- add'l elements - Planning
- historical trend analysis
- persistency
- comparison of ins inforce
- A/E mort and morb analysis
- model of sample block of business
- stratified A&H claims
- recoverability analysis of DAC
- investment yield analysis
- inv yield on new funds
- repayments and maturities of investments
- cash flow projections
Reporting to the SEC
- SEC
- one of their primary functions - examine registration statements and annual and periodic reports filed by publicly held co's to determine if appropriate disclosures made
- Reporting under Securities Act of 1933
- disclosure statute concerned primarily w/ registration and disclosure before public selling
- Securities Registration Statements
- approval of registration statement and prospectus prior to sale of securities
- public document (except for a few confidential sections)
- Form S-1
- principal registratoin statement
- Part I - same stuff as prospectus
- selected fin data - 5 year comparison revenue/income/assets/LT obligations/divs
- supplemental fin info - quarterly
- MDA
- financial statements
- Part II - stuff we don't care about
- Other Registration Forms
- Shelf Registrations
- Reg C allows registering early and waiting to sell
- Regulation S-X
- principle acctg regulation
- supplemented w/ FRRs (replace ASRs) and SABs
- same as GAAP w/ additional footnotes
- Important Parts
- Article 3 of S-X - fin stmt rules for when and what
- Article 4 Rule 4-08 - general notes - lists additional disclosures
- Article 7 - Inc Co Fin Statements - GAAP rules w/ addtional req's
- Application of Regulation S-K
- objective: standardize disclosure reqs for SEC filings
- 9 major sections - 8 relate to insurance
- buisness
- financial info
- securities of the registrant
- mgmt and certain security holdings
- registrant statemnt and prospectus provisions
- exhibits
- misc
- list of industry guides
- Significance of FRRs
- designed to communicate SEC's position on acctg and auditing principles and practices
- SABs - informal rulings and interpretations
- Reporting under Securites Exchange Act of 1934
- registration under 1934 act - certain public cos not on an exchange must register w/SEC if they meet size reqs
- Ins Cos exempt from 1934 act b/c under control of state depts/agencies
- annual reporting under 1934 Act - annually 10=K
- other periodic reporting - 10Q, 8K, proxy statement
- Regulation S-B
- small business
- forms SB-2 10QSB 10KSB 10-SB
- Electronic Filing
- EDGAR
- Reg S-T details reqs and procedures for electronic filing
Reporting to Other Regulatory Agencies
- Reporting to Stock Exchanges
- Form 10 to SEC and Applicatoin for original listing w/ exchange
- reqs for original listing
- varies for each exchange, most stringent for NYSE
- listing application
- original listing or subsequent issuance of additional securities
- periodic reporting reqs
- annual audited and quarterly unaudited w/ exchange and 10K to SEC
- Periodic Reporting to State Ins Depts
- annual and most states quarterly
- some states have reqs for special reports
- Statutory Codificatoin
- report beginning 1/1/2001 in accordance w/ revised NAIC Acctg Practices and Procedures Manual
- designed to provide consistency between cos and states
- 3 objectives: conservatism, consistency, recognition
- provides guidance where Stat had been silent and changes stat in some areas
- IRIS
- NAIC database designed to give early warning re: cos w/ fin difficulties
- Financial TEsts
- Ratio 1 - Net change in cap & surplus - delta cap & surplus / delta cap & surp (-1) >1/2 <-1/10 warning
- Ratio 1a - gross change in capital and surplus
- Ratio 2 - Net gain to Total Income - NGO (incl real g/l) / gross income <=0 warning
- Ratio 3 - Comm adn exp to Prems and Depostis - >60% - supplemental ratio only
- Ratio 4 - Adequacy of Inv Income - NII / Int Req'd <125% >900%
- Ratio 5 - Nonadmitted Assets to Admitted Assets - >= 100%
- Ratio 6 - Real Estate to Cap & Surplus >100% ($5mill or less of cap&surp), >200% rest
- Ratio 7 - Inv in Affiliates to cap and Surp - >100%
- Ratio 8 - Surplus Relief - net reins somm & exp allow / cap & surp - >10%<-10% smaller co >30%<-99% rest
- Stability Tests - exceptions require evaluation of mgmt strength to control dramatic change
- Ratio 9 - chagne in premium - >= 50% < -10%
- Ratio 10 - Change in product mix - >= 5%
- Ratio 11 - Change in Asset Mix - >= 5%
- Ratio 12 - Change in reserving ratio - agg incr indiv life resv / indiv life renewal and single prem - >= +/- 20%
- Co should monitor these ratios since automatically calculated from AS filings
- MDA
- include all material and significant changes and events
- specifically must address
- financial position
- results of operations - unusual or non-recurring events, favorable or unfavorable trends
- cash flow and liquidity - include any planned capital expenditures w/ purpose and funding
- Special Reporting to the IRS
- 1099 - reports int, divs and certain other payments and taxes withheld
- withholding rules - mandatory in some cases
- special rules
-
Study Notes and Published Refences - Note TSA XXXVIII - STRATEGIC MANAGEMENT OF LIFE INS CO SURPLUS
Strategic Planning
- "capital budgeting" process for allocating capital to various activities
- won't tell co if activity is worth doing in first place - strategic planning for that
- textbook approach to capital budgeting can result in random group of project w/ no clear stategic focus
- sometimes necessary to fund projects taht return less tahn the co's cost of captial to support co's strategic direction
- strategic planning - basic tool to evaluate attractiveness of each SBU for inv of copr resources
- "attractive" - both achieve sustained competitive advantage
- earn ROE >= cost of captial
Financial Planning
- Creating a Structure for Financial Planning
- necessary to determine amt of co surplus devoted to each business
- "business" s/b defined in a strategically significant way
- one technique for determining amt - "req'd surplus formulas"
- by applying formulas @ different points in time, possible to see amt fo surplus flowing into or out of each profit center
- residual surplus - unallocated surplus acct
- usually need to convert from Stat Req'd Surplus to GAAP to reflect investment in acq cost and surplus strain
- GAAP req'd surplus = Stat req'd surplus + unamort GAAP DAC + excess of stat benefit reserves over GAAP benefit reserves
- side benefit - meaning ROE can be calced for each profit center
- keep GAAP-ROE limitation in mind
- may or may not correspond to internal rate of return used in pricing
- differences
- some acq costs not deferrable under GAAP
- GAAP amortizatoin @ expected earned rate, pricing uses cost of captial, therefore different patter of profits and req'd surplus
- GAAP includes PADs, causes GAAP profits to be deferred
- these distortions can be prevented/lessened by selecting GAAP assumptions
- another soln - sep accting system for managment acctg
- stock - GAAP close enough w/ minor adjustments
- Mutual - gross prem valn techniques
- either case, new system can be $$ to implement
- Determing the Cost of Capital
- Cost of Capital - best benchmark for evaluating ROE from each profit center
- determined as weighted cost of each source of capital
- cost of equity capital - adding a risk prem to risk-free rate of return
- "risk prem" based on the additional yield req'd by investors to compentate for investing in co's common stock
- cost of debt capital - based on LT int rate could borrow bades on its credit rating
- since int of debt is tax deductible, appropriate to use after-tax rate
- cost of debt & equity capital weighted to determine overall cost of capital
- adjustemnts may be need to extent co incurrs corp expenses
- not allocated to profit centers
- Concept of Economic Value
- financial planning objective - increasing the economic value of co
- economic value - PV free cash flows, discounted using the co's cost of capital
- free cash flow - excess of increase in stat surplus (before shareholder divs) over increase in req'd stat surplus
- ignoring cap g/l, free cash flow can be approximated by excess of GAAP earnings over increase in req'd GAAP surplus
- GAAP def most useful for financial planning
- actuary can determine which product lines generating cash flow by comparing GAAP-ROE w/ GAAP equity growth rate
- GAAP equity growth rate - req'd GAAP Equity (EOY) / req'd GAAP Equity (BOY)
- if GAAP ROE > equity growth rate - generating free cash flow
- if GAAP ROE > cost of captial - growth is desirable
- if ROE < cost of capital - destroying economic value
- explore ways of improving ROE
- if not possible, amt of capital flowing in s/b minimized
- if > equity growth rate < cost of capital sometimes tolerated, esp if strategic
- if ROE < cost of capital and < equity growth rate - most destructive - "cash sinks"
- can have varying ROE for profit centers based on relative risk
- Financial Planning Process
- to manage surplus, process needed to ensure capital allocated to most attractive areas
- financial plan s/b developed annually for each profit center
- s/b more than 1 year plan
- 1st yr financial plan #s = objectives for following year
- often used for incentive compensation
- tend to be conservative
- years 2-3 often best representation of future financial performance
- first version of plan normally unacceptable to mgmt for variety of reasons
- uses more captial than available
- allocate too much to an area deemed unattractive
- insufficient ROE for co as whole
- should allow enough time to generate & discuss 2-4 different versions of plan
- important b/c provides insites to fin performance not possible otherwise
- simplified financial models often work best b/c of tight time frame
Company Organization
- profit centers should correspond to organizatoinal untis (SBUs)
- failure to use SBU, results in accountability issues
- shared business services - bill SBUs for services used
- each SBU should develop fin plans for its business
- this type of org gives many cos best framework to evaluate performance of each SBU and control resource allocation on relative attractiveness of each SBU
Evaluating Financial Performance
- commonly, SBUs not defined in a way that corresponds to co structure
- mgmt needs way to allocate current surplus among SBUs to monitor use of surplus
- if req'd surplus formula defined simply enough, can be done qtrly/monthly
- compare results to fin plan
- ROE determined and variance to plan analyzed
- mgmt can react quickly if things begin to go awry
-
Study Notes and Published Refences - Note SN 81-303 - ACTUARIAL REVIEW OF RESERVES AND OTHER A.S. LIABILITIES
Overview
- audit - "critical review" process of complex org, transaction, operation or inventory
- final objective of an audit - communicate clearly to the auditee an authoritative opinoin on such org (etc) being audited, in the least time, at the least cost, and with least disruption of operations
Applicable Professional Stds Regarding Actuarial Review of Reserves
- AAA yearbook discusses
- standards for "Qualified Actuary"
- Recommendation 7 - Statement of Actuarial Opinion
- Recommendation 9 - Materiality
- materiality is an important principle
- there comes a point wehre a small amt of increased accuracy may not justify the extra assembly or reviewing expense
- "a difficult professional judgement"
- Valuation Actuary - appointed by co board
- determines appropriate reserves
- render a report to mgmt of reserve determination techniques employed
- statement of appropriateness of assets supporting reserves
General Principles of a Satisfactory Audit
- Be certain of Audit Objectives
- communication is necessary to see if objectives consistent w/ estimated cost
- customer should know what audit will/won't include (scope of audit)
- attempt to communicate objective helps customer clarify and thefine the most efficient objective
- Plan Audit in Advance
- prior to beginning detail checks
- gain overall knowledge of components of inventory being audited
- develop plan of review for each component
- Sampling Principles to remember
- test each element fully (insofar as possible)
- pay extra attention to
- new plans, new benfits, operations that have undergone recent changes
- stratificatoin so that all methods and procedures used to obtain results included in sample adn tested
- Prior Audit s/b reviewed
- guide to planning current audit
- point out errors from past and where current review s/b concentrated
- Customer should have one audit coordinator through whom all Q&A funnel
- Have physical copy of document "checking to" for numerical audit
- Leave no links in audit trail untested
- Audit Report
- brief descr of review process used
- detailed decription in auditors own files
- nature of operation being audited (briefly described)
- should resemble previous reports (if periodic)
- comment on material observations and recommendations from last report
- Auditee s/b given draft to review
- State all objects adn recommendations resulting from audit in specific and measuralbe terms
Reserve Assembly Process
- financial provides schedule of tiems needed for completing annual statement
- date needed
- item needed
- person repsonsible for sending data
- distribution list showing recipients fo data
- typical co might have schedule which counts backwards
- main objectives of assembly process
- speed
- contril
- paying attention to official AS instructions
Auditing Life Insurance Reserves and Related Actuarial Items
- Five categories of effective reserve audit techniques
- spot checks
- independent full recomputations
- tests of aggregate progress of reserve from one fiscal period to another
- tests of relationships of reserve items to toher financial itmes and stability when comparing to previous periods
- tests of reserve adequacy
- first four test to see if calced as tehy are supposed to be calced
- fifth "good and sufficient" testing
- tests of approx valn method - could be in first, second or last test
Spot Checks (tests of inventory, test calcs, transactional checks and policy traces)
- sampling - random, systematic, stratified
- systematic - every nth element (after elements ordered)
- generally superior validity to random sample since form of stratification
- stratefied - "forced representativeness" sampling techinque
- closes confidence interval substantially
- when an error of principle is discovered, systematic (or otherwise stratefied) sample can be used to estimate effect of error on entire block of business
- tests that involve sampling
- tests of inventory are made to assure no major errors of ommission or commission
- depending on situation
- compare major reserve assemble worksheets to previous year to assure no categories omitted
- at same time, look for unusual growth/dimunition of amts
- check chain of process used to go from reserve detail to financial statement exhibit
- identify all pol # blocks
- select systematic sample of pols
- trace through orig records
- if inforce, what components and for what amounts
- tests of calculations (spot checks)
- same sample from inventory tests good starting point
- spot checks can include
- retrieval of folder and checking that all listed policy benefits reserved properly
- check of policy or contract language to see if reserveing methods proper and all inclusive
- direct contact w/ insured to verify policy elements
- transactional checks of reserves and due premiums
- if surrendered in current policy year, policy shouldn't be part of reserve inventory
- if life premium past due-date, s/b paid, loaned, or net due prem asset
- direct reserve s/b in sync w/ corresponding reins ceded reserve
- policy trace
- pick a policy and follow it through calendar year
- should be in inventory for
- EOY net def prem
- BOY net due prem
- EOY net due prem
- BOY SV due and unpaid
- EOY SV due and upaid
- BOY reserve
- EOY reserve
- BOY claim liab
- EOY claim liab
Independent Full Recomputations
- only done if it can be done in a cost efficient manner
Tests of Aggregate Progress of Reserve From One Fiscal Period to the Next
- Analysis of Increase in Reserve Checks
- Formula I
- C - tabular cost of mort for the year
- I - req'd int for the year
- (C-I) / ([0]m(x) + 1/2P) historically and check for smoothness of trend
- C / avt amt @ risk = approx qx => find x= avg attained age historically and analyze progress
- Formula II
- annuity type reserves
- separate by type - dis life, supp con, normal annuities
- reserves released by death or recovery (A) used to back into (T) tablular reserves released
- t/([0]m(x) + 1/2(P-Payments)) = approx death/recovery rate
- = approx avg decremental rate from underlying valn table
- review historical treand
- Formula III
- I s/b = approx (avg credited rate) * ([0]m + 1/2(P-Payments))
- "roll forward" approach
- + BOY acct value
- + net prem deposits
- - admin charges/pol fees
- - COI charges
- - benefit prems
- - acct values released by termination
- compare against acct value @ valn
- delta s/b int credited to block
- once roll forward proved
- create historical table of (act value - reserve) / acct value
- roll forward is test of engine that drives machine, not machine
- Check of Increase in Life reserve/$1m over time
- review smoothness of incremental progress
- when comparing current to prior, use current year renewal only (no current NB)
Tests of Relationships of Reserve Items to Other Financial Items (Units of Measurement) And Stability Therein From One Fiscal Period to Another
- examples
- Group Unearned Prem Reserve -> incurred group prems (collected & delta due prems)
- Substd Extra Prem reserve -> total incurred prem
- ADB reserves -> ADB inforce
- Ordinary Dis Reserve -> ann prems to be waived, inforce
- purpose: spot unusual trends
- well suited for
- net due and deferred prems
- ancillary benefit reserves
- reserves for nondeduction of fractional prems
Tests of Reserve Adequacy
- traditional definition of adequate - actuary's best estimates
- reserve plus future prems and int make good and sufficient provision for future benfits adn expenses
- three common tests of adequacy
- loss ratio tests
- gross prem valn methods
- claim runoff tests on dis life reserves, claim reserves, loss reserves
- Loss Ratio tests ("check students guide and see what they say"
- Gross Prem Valn (aka Prospective Asset Share)
- GPV(t) = sum([B(s)+E(s)-P(s)]*v^(s-t-1)*[s-t-1]p(x+t)) from s=?? to infinity
- PVBP(t) - pv book profit - Anderson's Method
- =[t]V - GPV(t) where [t]V = Stat Reserve
- > 0 -> reserve officially heald exceeds best estimate provision (a good thing)
- adjust cells for fractional durations for calendar year calc
- discount 1/2 year, add future gross due and def prems less expenses and expected benefit
- subtract mean reserve and net due & def prems - [t]V*v^(1/2)*[1/2]p(x+t-1/2)
- A&H blocks - adjusted loss ratio approach
- historical look at sum of incurred claims and incr active life reserves
- sufficient margin at EOY t woudl be
- + revised PV future profits
- - reserve according to an up-to-date standard
- + reserve actually held
- Claims Runoff Tests
- loss triangles
- gaining popularity due to high-speed computers -> multiple scenario CF surplus proj
- diff between GP valn and CF surplus proj
- indiv assets tracked as to actual income, redemptions, taxes
- multiple scenarios run, usually w/ different int rate paths
- diff int rate paths & assumed behavior patterns shoudl show consistent relationship
- as review of CF projections, two circumstances
- reviewer of another actuary's CF projections
- both methodology and experience assumptions s/b reviewed
- testing another actuary's reserve adequacy by performing own CF projections
- other "good and sufficient" test
- that an approx vlan method is accomplishing its goals
- approximating well the trad, more detailed method
- making good and sufficient provision for liability it purports to represent
- historical analysis of formula II type reserve (payment annuity) to see if T-A released generally positive
- if so, decrement assumption may render reserve inadequate
Conclusions
- remember certain priorities
- errors of principle more important than clerical errors/typos
- priority to large items vs smaller ones due to time restrictions
- when selelcting samples for spot checking, think diversity
- priority to new plans and products along w/ procedural changes
- once on-site audit finished, final reports s/b given priority over actuary's other work
Healthy Skepticism
- "developed a healthy skepticism concerning data and other info proffered by others"
- "apply a test of reasonableness to all figures you are given"
Appendix A - "Qualified Actuary" Standards
- Education
- pass exams and take CE
- genearl and actuarial math
- life and health policy forms and coverage
- divs, reins, and tax laws
- investment and valn of ins co assets
- valuatin and liabs
- valn and nonf laws for jurisdiction
- Experience
- 3 eyars responsible experience (recent) under qualified supervision
Appendix B - Recommendation 7 - Statement of Actuarial Opinion
- list items and amts on whch the actuary opines
- common stds adn sound actuarial principles - dictated by ASOPs, recommendations, etc
- contract provisions such as fractional prems paid beyond date of death, conversion rights, etc
- check valn reqs in state of domicile
- reserve adequacy - GP valns < reserves held => ok
- comments on changes in actuarial assumptions or methods
- include who you are and who you work for
Appendix C - Recommendation 9 - Materiality
- a difficult professional judgement
- consider decision-making framework of typical user of actuary's work and their probable response
- quantitative and qualitative consideration
Appendix E
- Analysis of degree of improvement in validity by changing from random to stratified
- blah blah blah
Appendix F - Analysis of Increse in Reserves
- Formula I - [0]M + P + I - C - V_D - V_T = [1]M (life)
- Formula II - [0]M + P + I + (T-A) - Pmts = [1]M (life annuities)
- Formula III - [0]M + P + I - Pmts - [1]M (int only reserves)
- Life Insurance
- [0]M,[1]M - 12/31 reserves
- P - tabular net prems collected
- I - req'd int for year
- C - tabular cost of mort for year
- V_D, V_T - reserves release by death/other than death
- (C-I) = ([0]M + P) - ([1]M + V_D + V_T)
- I = i*(1/2)*([0]M +[1]M + V_D + (C-I)) wehre i = reserve rate of int
- C is balancing item = (C-I) + I
- Life Annuities
- T - annuity reserves expected to be released by deaths of annuitants according to valn table
- A - annuity reserves actually released by death during year
- Pmts - actual amts paid to annuitants during year
- (T-A+I) = ([1]M + Pmts) - ([0]M + P)
- I = i*(1/2)*([0]M + [1]M - (T-A+I))
- (T-A) = (T-A+I) - I
- Int Only Reserves
- I = ([1]M + Pmts) - ([0]M + P)
-
Study Notes and Published Refences - Note SN 8I-304-00 - VALUE BASED FINANCIAL MEASUREMENT
Background
- rapidly changing business environment
- external forces
- megers/consolidation in fin services sector
- continues product revolution/evolution
- shrinking profit margins b/c incr competition and unbundling of services
- turbulence in inv mktplace
- significant internal/external replacements
- increased consumer sophistication
- shorter product life cycles
- frequent/major tax code changes
- restructuring of product delivery systems
- internal forces
- inadequate co performance (vs goals/expections)
- replacement of obsolete admin systems
- desire to measure g/l by source
- analysis of appropriate surplus levels
- pressure to lower acq and maint expense
- incr demand for incentive comp
- limited capital resources
- purpose/limitations - use of a value-based fin measurement system for internal/mgmt reporting purposes only
Concepts Underlying Value-Based Financial Measurement
- Key Elements of a Financial Measurement System
- Mgmt needs relevant and timely fin info
- assist making economic decisions
- evaluate fin condition and performance of co
- compare fin results w/ pre-determined goals
- allows appraisal of mgmt performance
- Desirable characteristics of fin system
- should reflect economic fundamentals w/ underly co's business
- results s/b available by profit center
- results s/b readily communicable to and understandable by senior mgmt
- Shortfalls of Stat and GAAP for Internal Reporting
- designed for external uses
- contrained by rules and guidelines
- hampers timely measurement of emerging experience and/or underlying profitabilty of a product
- Stat Reporting
- measured on a liquidation (vs ongoing) basis
- calced using prescribed conservative methods and assumptions
- NB production expenses charged 1st yr w/ limited relief
- non-admitted assets may have real utility/value to co
- causes anomalous situations relatvie to positive actions taken by ins co mgmt
- increase in NB can cause decrease in current year stat earnings b/c
- 1st yr expenses > 1st yr revenue
- modified reserve system only provides partial relief
- decrease in NB production may result in increase in CY stat income
- policy termations via lapse/surrender result in incr in stat earnings in year of termination b/c Vx > CV
- not usually best LT interest of CO since future stat profits won't be realized
- substantial capital expenditures charged in year incurred despite LT benefits of these expenditures
- enhanced IT capabilities or field force expansion
- GAAP Reporting
- F60 codified life ins GAAP acctg
- shortcomings have appeared
- best suited for periods of economic stability
- does not adapt on time basis to flucuations in int rates or lapse rates
- UL type products don't fit into F60 well - F97 developed
- 2 very different acctg methods depending on product types
- GAAP is transactional based - reflects earnings based on transactions central to co's operations
- inconsistent w/ way most cos price products
- several mechanical features of GAAP create distortions in measuring fin performance of co
- non-deferral of certain acq costs
- lock-in assumption @ issue
- PADs
- treatment of deferred taxes
- GAAP acctg often doesn't provide adequate "early warning" signs to mgmt until too late to react properly
Description of Value-Based Measurement
- utilized concepts and techniques consistent w/ Anderson pricing method
- reports earnings as change in economic value of life ins co over a specified period of time
- economic value - PV expected future cash flows discounted @ hurdle rate
- cash flows - defined as stat earnings for this purpose (aka book profits)
- includes delta stat Vx - a non CF item
- stat earnings best represent "free cash flows"
- can be dividended, reinvested, or RE
- economic value at YR = adj stat capital and surplus + value fo business inforce
- adj stat capital and surplus = stat capital and surplus + items which are allocations of surplus (MSVR) or reclassification of certin stat itmes (restoring non-admitted assets)
- value business inforce = PV future stat book profits @ hurdle rate
- delta economic value + shareholder divs = value based earnings for year
- consistent actuarial assumptions at both end points - so change is not due to change in assumptions
- consistent hurdle rate between endpoints
- then new calc showing difference due to change in hurdle rate
- 3 elements to value based earnings
- earnings on adjusted capital and surplus
- earnings on business inforce at BOY
- earnings on NB written during year
- if actual = expected
- earnings on adj cap and surplus = after tax investment earnings of assets supporting it
- earnings of BOY inforce = hurdle rate * value of inforce BOY
- earnings on NB depends on relationship to pricing ROI and hurdle rate
- pricing ROI = hurdle rate - no economic value b/c PV future renewal renewal book profits = 1st yr surplus strain
- pricing ROI < hurdle rate - economic value reduced
- pricing ROI > hurdle rate - economic value increased
- critical that new products priced and measured using realistic assumptions
- since actual rarely expected, variations would be reflected in value based system
- Determination of the Hurdle Rate
- viewed as desired, risk adjusted, rate-of-return on invested capital
- closely linked to co's cost of capital
- can use CAPM
- CAPM breaks expected returns into 3 components
- risk free rate of return
- rate of return on avg equity investments
- business risk factor - identifies variance in risks between different cos and industries
- ROR = (I + R(r)) + B(R(m)-I-R(r))
- I - inflation rate
- R(r) - real rate of return
- B (aka Beta) - business risk adj factor
- R(m) - rate of return on avg equity inv
- I + I(r) - risk free rate of return available to investors
- cost of debt capital - typically after-tax int expense paid on debt
- equty capital tend to be more expensive than debt capital
- may be appropriate to ahve different hurdle rates for different LOBs to reflect underlying risk of each LOB
Numerical Illustrations of Fin Measurement Systems
- Level Return on Equity
- special case of value-based-methodology
- hurdle rate = pricing ROI
- Policy Premium Method
- Gross Premium Reserve - based on best estimate assumptions
- less "limited adn reasonable" PAD
- all future benefits adn expenses accounted for
- can result in profit at issue
- similar to value-based - can have profts/loss at issue
- different - renewal years earnings from release of PADs
- regardless of method used - total earnings equal
- different reserving methods affect the incidence of profits, not amounts in total
- Comparison of Earning Emergence
- Stat - large first year loss followed by increasing profits
- US GAAP - smaller 1st yr loss followed by fairly level stream of profits
- PPM - fairly level streams of profits in all years
- Value-Based - level early, trailing off near end
- spread over life of product in proportion to equity employed
- not front-ended at issue
- Level ROE method - 1st year earnings = 0 by def
- earnings spread over lifetime of product in proportion to equity employed at Pricing ROI
- Comparative Observations
- Stat produces substantially different pattern of earnings that other methods compared
- methods which do not permit full deferral of acq costs generally report loss in year of issue
- even if product is profitable
- neither value-based nor PPM report all earnings at issue
- both methods accelerate reporting of earnings for profitably priced business
- value-based & PPM more responsive in reflecting underlying profitability of product
- reported earnings (except Stat) similar during middle years
- early and later years diverge => rapidly growing/contracting co would report signficantly different earnings depending on method used
Practical Considerations of Implementing a Value-Based System
- Model Office Projectinos
- basic tool req'd for value-based system
- 20-30 yrs of future stat projections needed
- PV s/b determined over period of time sufficient to allow runoff of significant portion of business inforce
- "HowTo Model" is discussed
- actuarial assumptions used s/b best estimates consistent w/ recent experience and pricing assumptions
- appropriate to use pricing over current experience for items when realistic improvement toward pricing assumptions can be made
- static validation - compares total beg reserve and prem inforce for each model plan to actual amounts
- shows how well plans and ages have been modeled
- dynamic validation - performed by projecting backward one year and comparing model to actual prev year results
- Other Lines of Business
- for smaller blocks, less refined modeling techniques can be used
- annuities - if major, cell-based model
- if relatively minor - project using aggregate int rate spread approach
- if most of stat profit in annuity line is from spread, shoudl be sucessfully modeled using aggregate appraisals
- group life and health - if considered 1 year YRT, value of business inforce is zero
- most appraisals develp value by assuming business renews each year adn expected stat profits discounted to appraisal date to determine value
- unless large block, appropriate to assign no value to any expected future profits
- value-based earning = stat earnings
- if projections are made - aggregate expense and loss ratio approach w/ all items expressed as function of premium yields reasonable results
- indiv A&H - if significant, cell-based approach appropriate
- if line is immaterial or primarily coverage w/o active life reserves, aggregate approach similar to group is appropriate
- group pension - aggregate int rate spread, similar to annuities often adequate
- if major line - cell-based approach more appropriate
- misc line - two approaches
- assume no further stat profits => no value exists for business inforce
- project stat profits in aggregate adn spread between earn inv rate and stat int rate
- Pricing Assumptions vs Current Expereince
- if current exp <> pricing, may be appropriate to use pricing if a plan established to restore current experience to pricing over a reasonable timeframe
- typical approach in value-based syste for this situation
- calculate value of business inforce using pricing
- calculate difference between pricing assumptions and current expereince
- determine plan of action to make disappear ove a relatively short timeframe (3-5) years
- if you can't do this, s/b using current and not pricing
- calc PV of difference @ hurdle rate and deduct from prev calced value of business inforce (optional)
- Target or Required Surplus
- used to reflect need to maintain minimal level of surplus (in pricing and profit testing)
- for regulatory reasons and rating agencies
- if co does price incorporating target surplus formula, it should be recognized in value-based fin measurement system
- stat profits increased by inv income earned on target surplus adn decreased by increase target surplus
- further adjustments
- req'd surplus -> transferred from adj net worth component of value to value of business inforce component
- adj net worth becomes "free" surplus
- value of business inforce and value of business written during year calculated using "available profits" instead of stat book profits
- net reserves - state reserves + req'd surplus - PV future avail profits
- introduction of req'd surplus changes pattern of earnings reported in value-based fin measurement system
- comparison reveals lower earnings in first-year followed by higher earnings in renewal years
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Study Notes and Published Refences - Note 8I-306-00 - CASH FLOW ANALYSIS TECHNIQUES
Valuation Concepts
- Forms of Risk
- Interest rate duration risk - C-3
- insurance co can be selected against when int rates move
- if rates increase - disintermediation risk
- if rated decline - reinvestment risk
- Valn Actuary's concern - how to make good and sufficient opinion w/r to reserves when faced w/ C-3 risk
- Credit (or default) Risk - C-1
- real default in asset value or a mkt value change in the common stock
- Pricing Risk - C-2
- ins co can suffer loss due to unforseen changes in experience levels w/r to mortality, morbidity, expenses, etc
- Valuation Actuary's Job
- have skills and tools necessary to measure C1, C2 adn C3 risk
- understand and obey SOP established by profession adn regulations regarding messurement of risk
- recognize that need to rely on key indiv in co (COO, CEO, CIO (inv)) for continuation of stated policy and good business judgement in managing co's affairs
- let them take responsibility for what is theirs
- render an opinion as to adequacy of reserves, taking into account nature of assets supporting the reserves
- NOT the Valn Actuary's job to guarantee solvency
- Statement of Opinion
- two levels to the various opinions
- reasonable reserves
- reasonable reserve + designated surplus to cover plausible deviations
- current opinion
- reasonable - probability of reserves being inadequate < x% where x% > 1
- plausible - probability of reserves & designated surplus being inadequate < 1%
- actually probability of ruin
- Elements of Cash Flow
- insurance (liability) adn asset cash flows projected into future under various int rate scenarios
- some assumptions used in projection are dynamic (vary w/ int)
- main elements of cash flow
- liab side
- income components - premiums, policy loan repayments, policy loan interest
- outflow - benfit payments, surr, divs, comm, expenses, taxes, policy loans
- policy loans on liab side (asset on B/S) b/c investment people can't invest in policy loans
- asset side
- income - bond maturities, mort prin & int pmts, coupons, calls, prepayments, stock divs, real estate, rental income, liquidations adn borrowed money
- outflow - repayment of borrowed money and capital losses
Cash Flow Analysis for Valuation
- actuary must select: scenario set, lapse function, prepayment functions adn reinv function
- information on assets more extensive than traditional valuation methods
- Scenarios
- definitions
- int rate scenario defined as sequence of yield curves
- yield curves - function showing relationship of yield to duratino
- scenario - sequence of yield curves - one for each period-end in teh future
- cash flow analysis requires choosing a scenario set
- can arbitrarily select a set of scenarios that seem to cover possibilities (NY7)
- drawbacks
- # possible scenarios unlimited therefore no singel scenario likely to occur in real life
- no unique way to make probability statement about outcome of testing
- advised (in absense of regulation) to use approach that attempts to capture statistical meaning
- common methods: transitional probability and successive ratios
- Transitional Probability Approach
- begin by defining universe of std yield curves
- one approach, 10yr and 1yr rates w/ intermediate rates set by fitting exponential curve
- define matrix of transitional probabilities
- P(ij) -> prob c(j) follows c(i)
- often set in consultation w/ investment officers
- most of the time, probabilites equal and opposite moves set equal
- set c(0) to std yield curve most like current rates
- monte carlo simulation used to pick future yield curves
- repeat using same c(0) and transition matrix until adequate # scenarios choses
- Successive Ratios Model
- stochastic model of ratios of successive interest rates
- y(1)...y(n)... sequence of historical int rates
- ratio of y(n+1)/y(n) calculated for last 10 years for 1 long and 1 short dur
- dist function determined which models frequency values appear
- correlations between long and short rates studied historically
- bivariate dist w/ proper correlation coefficient constructed
- simulation performed on bivariate dist to get N pairs of rates for each scenario
- Morgan Stanley research shows promise using ln(y(n+1)/y(n))
- distribution not precisely normal
- close enough to justify simplifying assumption
Functional Relationship: The Liab Side
- significance of number 40 - can get 40-50 scenario results on a single sheet of paper
- when testing stochastically generated scenarios, quite a few boring ones and on a few exciting ones
- most extreme scenarios don't necessarily give most extreme results
- function relationships - formerly known as setting assumptions
- ways to choose assumptions
- dart board
- xerox - using someone else's assumptions
- rules of thumb - similar to Delphi technique
- key element sto consider when choosing functional relationships
- relationships
- consistency
- validation
- should validate reasonably to whatever experience is available
- should validate reasonable results (sniff test)
- Market Rate Assumption
- possibly most important functional relationship - between credited rates, mkt rates, and lapse rates
- mkt rate - rate PO can get by lapsing policy and buying comparable new policy
- generally rate competing co offering on similar products
- when defining mkt rate, keep in mind what mkt rate used for
- if intest to set credited rate = mkt rate, mkt rate definition for model should match definition for way intend to credit
- sometimes results very sensitive to mkt rate definition and sometimes not
- relationship between earned rate adn mkt rate may not be rational, but there is a relationship
- when choosing mkt rate assumption, dont give too much weight to current situation
- mkt does not always react as quickly as scenario rates doo
- assumption should make sence for the long term
- s/b consisten w/ historical past
- apply common sense when looking forward
- mkt rate assumption typically based on current int and sometimes a rolling avg int rate (for cos crediting based on portfolio rate)
- common assumption - mkt rate = max(current, rolling avg)
- Credited Rate Strategy
- not an assumption, but a strategy
- decide whether crediting strategy matches what in in CF projection
- strategies key off of one or more of 3 rates
- fixed rate - initial guar rate, bailout rate, min guar rate
- earned rate less spread
- mkt rate
- SC may complicate matters - somewhat safer to have lower credited rate if SC is present
- consider increasing spread for higher int rates
- applying relationship to mkt rate as well could produce some reasonable answers
- for UL, trend is credit current money rate for 3-5 years
- then roll into new money rate at end of period
- special considerations for div scales on par policies
- Lapse Rate Function
- largely based on intuition and judgement
- littel experience available for many types of plans
- considerations
- if product has SC, less sensitive to difference between credited and mkt
- PO/Agent characteristics important (stockbroker sold -> higher lapses)
- bailout
- "hidden" interest (not obvious to PO like Par WL pols)
- aging of business - possibility that excess lapses decrease over time
- core group of PO not sensitive to int rates
- sample SPDA laspe formulas
- 1982-C3 study - min(5%+ (M-C)^1.5,75%)
- VA Handbook ex - 15% + 2*(M-C)^2 - 3*SC
- Case Study - min(5%+2(M-C)^2, 50%)
- excess lapses increase dramatically as spread widens
- exponential term seems to be fairly well accepted
- Policy Loan Utilization
- policy loan environment changed a lot
- direct recognition and tax law changes
- less likely to take loan and more likely to lapse
- sample utilization rate (mkt rate - loan rate)^1.8
- function of % of unloaded values and % total avail CV
- SP policies w/ 0 net cost loans - loan assumption could be key assumption to CF analysis
- Premium Suspension
- very littel experience available
- new money product premium suspensions should nto be greatly interest sensitive
- lapses could be problem if PO looks at overall credited rate
- premium suspenstion can be very sensitive to credited rate of interest
- Expense Inflation
- generally a valuation concern only for effect on maint expenses
- common assumption - inflation = gov't bond int rate - spread
- overhead might not get appropriate weight in high lapse scenarios
- Mortality
- generally accepted - if extra lapses, future mortality will increase
- impaired lives more likely to keep life ins policy since unable to get equiv policy elsewhere
- several models available for calculating excess mortality due to excess lapse
- after assumptoins created, run through scenarios
- look at results and see if reasonable
Functional Relationships: The Asset Side
- Role of the actuary and the Investment Officer: A discussion
- no agreement on what exactly the Actuary's role s/b w/r to setting inv assumptions
- Larger role in determing investment philosophy
- actuary determining for LOB responsible for
- type of assets, type of maturities, type of risks willing to take
- quality of assets and probability of net realizing expected returns
- strong communications w/ investment dept a must
- actuary shoudl decide if CF volatility for a type of asset is acceptable
- Reliance Role
- one of jobs as Valn Actuary is to rely on other key people
- rely - work with them, not tell them what to do
- collaborative effort
- let the investment people select teh assets they deem appropriate given some guidelines w/ explanations of ramifications of choosing certain types of assets, maturity, structures
- investment people understand modeling, but modeling not "real world"
- inv people look at what's happening in mktplace daily and try to take advantage of mkt conditions
- What is an Investment Philosophy?
- used day-to-day basis by inv dept
- need assumptions re: investment philosophy in the future
- may not match what inv people doing today
- future inv philosophy is an actuarial assumption - actuary responsible for it
- ought to know current inv philosophy
- think about possibility that other philosophies will be used in the future
- inv philosophy may be different depending on purpose of projection
- stat solvency - only need a 1 year projection
- Valn Actuary's role is to evaluate effects of an investment philosophy
- Sr Mgmt's role is to choose the inv philosophy
- if not sure what your co is going to do in the future
- run projections w/ different inv philosophies
- one method - bring in Inv officer, show him the int scenarios and ask "How would you invest?"
- inv officer will buy into projection and feel comfortable with results
- Reinvestment Function
- Positive Cash Flows
- 3 methods
- continuatino of current strategy
- follow stated policy (set of rules)
- keep dur matched and x% to type A assets etc
- mkt timing - important to get investment person involved
- if mkt does A, invest in B
- inv officer will "do whatever is best"
- Negative Cash Flows
- borrow funds - reflect cost of borrowing in projections
- liquidate assets - pro-rata across all assets or involve specific assets
- Activeness of Asset Portfolio
- how will assets be managed
- buy and hold
- trading or purposeful disinvestment
- Valn Actuary needs ot deal w/ pos cash flows, neg cash flows and asset mgmt when doing cash flow analysis
Assets
- which assets backing products valuing?
- s/b consistent w/ investment philosophy statement filed w/ state
- if assets not segmented, either set up segmented pool or use pro-rata share of all assets
- obtain listing of current assets from inv dept (hopefully inv database)
- Treasuries
- 100% guar by govt adn non-callable
- perfect asset except don't earn enough interest to support credited rates
- amortization of prem or discount as CF item
- Donna Claire would not use since not real cash
- better to recognize prem/discount @ sale/maturity
- Corp Bonds
- used to be most popular asset for ins co investments
- major problem - generally callable
- range where very few bonds called - generally 1% of original int environment
- fairly simple approx - 2% greater than current coupon rate - it gets called
- another approx: .25*(coupon rate - current coupon rate - .25*call prem) min 0, max 1.0
- also check other provisions, such as sinking fund provisions
- Commercial Mortgages
- characteristics similar to bonds - take coupons and pay back principal at end
- some have sinking fund payments
- prepayment provision - some have very generous provisions
- current prepayment penalties - such that if investor took payment and invested it in T-bills for remaining period, still wind up w/ same amt int
- could be modeled as non-callable bonds since little reinvestment risk
- have a default risk
- depending on rating, C-1 default risk charge s/b subtracted (similar to corps)
- Agricultural Mortgages
- generally short mortgages
- can be variable int - appear to be well suited for I/S products
- problem: many are defaulting - approx 25% industry wide
- C-1 charge s/b enough to cover this type of default (worse than junk)
- charge must be large enough to cover
- int forfeited
- opportunity loss when owning property
- principal loss on sale of asset
- can be as high as 75bps
- Gov't Backed Mortgages
- GNMA, FNMA, FHLMC - some of most popular inv for ins cos
- give fairly high int rate
- major problem is duration risk
- very important to model correctly in terms of effect of int scenarios on GNMAs
- sample prepayment equation: 5% + 3*S + 2*S^2 where S and 5 <= P <= 60
- # factors affecting prepayments
- moving, years left on mort, general economy in area, employment stats
- Junk Bonds
- begun to play important role in portfolio
- subtract approx 2.5% of principal to cover default in models
- check diversification - very important in junk
- Real Estate
- becoming more popular in I/S portfolios b/c asset is inflation adaptive
- problems modeling real estate
- need to check w/ inv dept as to expected cash flows, not just expected avg returns over expected holding period
- when do you assume you sell property
- what will price be when real estate is sold
- good approx is that it appreciates at economic int rate + x% (typically around 3%)
- Case Study Life
- additional reserve req'd to make probably of inadequacies < 1%
- take PV of cashflows from each trian using that trials int rates
- assuming results normally distributed, use std dev and mean to determine point probability that PV < 0 is <= 1%
- generation of scenarios - monte carlo & lognormal method
- monte carlo - randomly generated using starting yield curve, yield curve universe and probability of movement matrix
- lognormal - randomly generated using starting yield curve, volatility factor and lognormal dist function
- differences between two not enough to say which is better
- reserves should cover reasonable deviations
- reserves and surplus should cover reasonable and plausible deviations
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Study Notes and Published Refences - Note SN 8I-308-00 - REGULATORS' PERSPECTIVE ON ACTUARIAL OPINIONS AND VALUATIONS
Valuation Methodology or Mythology - Robert J Callahan
- dynamic valn int rate 3% = 80% of excess of 12 months moody's avg over 3%
- if co mgmt decides to sell high yielding assets and replace them w/ lower yielding assets, valn actuary, in calcing stat formula reserves, shoudl ascertain whether yields of new supporting assets can still justify the valn int rate or whether he should lower the rate
- CF analysis might indicate need for more assets to support liabs
- Reg 126 allows actuary to rely on inv officer to some extent
- notes that either actuary or investment officer make adjustment for junk
- suggests adjusting CF of assets by reduction in annual income of 2.5% of principal of junk bonds
- valn actuaries work may serve as an audit of pricing
- junk bond study - recommended diversification
- Callahan feels MSVR insufficient for junk and s/b liability instead of earmarked surplus
- NY DOI prefers to place specific limits as to portion of total assets which may be invested into junk bonds
- Actuary cannot make any judgement as to adequacy of assets and future prems w/o considering u/w, mktg, contractual provisions and investments
- actuaries need to coordinate w/ other, rely on others, and advise others
- Callahan feels AAA stds need updating and effects of quality of assets cannot be ignored until standards are developed
- He prefers an objective std for reserves
- statement reserves s/b higher of formula reserves and those indicated as necessary by Valn Act
What Regulators Need - John O Montgomery
- The need
- regulators need to be aware of a deteriorating financial condition of an insurer in time to protect its PO from consequences of insolvency
- The Std Valn Law
- controversy has arisen over what is meant by "present value of future benefits"
- some regulators insist its PV future guar benfits, incl nonf benfits, thus requiring the greatest PV of these two to be used in above formulas
- analagous to CARVM for specified annuity and endowment contracts
- what is needed is a SVL which will define basic concepts and distinguish between reasonable and plausible assumptoins as to determinatino of reserves and margins in surplus which s/b held for plausible contingencies
- restated: SVL should define basis for reserve and min req'd suplus (risk assumed buffer)
- revised SVL will probalby include general rules - NLP and deposit fund approach, depending on nature of plan
- woudl require a redefinition of LOBs by valn method as well as by risk structure
- supporting regs woudl define specific requirements for documentation including int rates, mort, morbidity, persistency, and expense limitations
- actuary woudl be permitted to depart from such limitations if supported by actual experience demonstratoins acceptable to the regulator
- The need for specific guidelines or instructions
- less than 1/3 of US companies have one or more company actuaries
- rest rely on consultants
- if a US insurer has operated w/o actuarial advice, it is revealed at time of state ins exam
- Summary - What do Regulators Need
- practical procedures for projecting the development of reseves and teh effect of such developments on teh production of surplus
- practical procedures for probabilistic multivariate analysis of the various factors contributing to development of surplus and verifying the adequacy of reserves
- readily verifiable systems for testing credibility of projections
- if procedures for projecting surplus generation are not practically attainable for political reasons, system of credible surplus benchmark criteria
- financial stm that clearly shows financial progress of an ins cu, but retains sufficient info to validate teh proper accounting of ins transactions adn to verify projections made w/r to adequacy of reserves and suplus margins for plausible deviations
- revision of financial acctg procedures in conflict w/ concepts of analysis developed for the projection of cash flows and surplus generation
- b/c of large volume of cos to review, survellance procedures needed to distinguish those insurers requiring detailed indiv company analysis from those requiring only a perfunctory monitoring
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Study Notes and Published Refences - Note SN 8IU-310-04 - VALN OF LIVING AND DEATH BENEFIT GUARANTEES FOR VARIABLE ANNUITIES
Introduction
- key diff between VAs and mutual funds - guarantees
Types of Guarantees
- GMDB - payment on death of covered live - effective at time of sale
- Living Benefits guarantees
- GMIB - guaranteed minimum payment at annuitization
- usually constrained to a window after a defined waiting period
- GMWB - sum of w/d benefits paid = specified amt (such as prem paid)
- GMAB - guaranteed a minimum acct value after a specified waiting period
Characteristics of Living and Death Benefit Guarantees
- Common Characteristics
- Guarantee Amt - usually a function of premiums, w/d, and/or future acct values
- return of prem
- ratchet "X"
- x% rollup
- Reset "X" (unlike ratchet, can decrease)
- High Anniv value
- ratchet "Xth"
- x% simple
- Reset "Xth"
- NAR is difference between guarantee and actual acct value
- Limits on teh Guar amt
- guar may only adjust up to a certain AA
- guar may be capped by some absolute limit (such as twice starting value)
- guar may be n/a after certain age
- guar may not be offered beyond a certain age
- guar can be adjust on a $/$ basis or proportionally for w/d
- guar can be capped by a facter applied to prems less w/d
- Limits on Investment Options
- may require a specific fund allocation or exclude certain funds
- maximum annuitization age
- rider termination - if guar sold as a rider, PO may terminate benefit after x years
- Co may also place limits on sales and future contributions
- Characteristics Specific to a GMDB
- who is covered: owner, first to die of annuitant and owner, last surviving annuitant
- can spouse continue policy: sometimes spouse is given option of DB or continuing policy w/ same guar
- if accept DB, policy has no more guar and reverts to acct value
- what is effective date for DB calc: DOD or date all paperwork filed
- Characterisitcs Specific to a GMIB
- What is length of period before PO can annuitize and invoke guarantee?
- needs to be long enough for co to recoup acq expenses 7-10 yrs common
- What are assumptions for determining int rate in guar annuity?
- lower guar rate decreases cost of cuar. 3 and 3.5% common
- may be influenced (constrained) by stat minimums
- mkt competition and SNFL may influence
- What are assumptions for determining mort rate in guar annuity?
- lower mort reduces cost
- expected mort improvement between eff date and annuitization and between annuitization and end of payment period
- Does Guar Annuity have certain period
- longer certain periods lessen impact of projected mort improvements
- IRS min dist requirements
- Characteristics Specific to a GMAB and/or a GMWB
- deferral period for GMAB between time of sale and eligibility - 10 yrs common
- limits on amt of w/d in any yer (GMWB) - 7% common
- Can PO reset guar amt to current amt and how often?
- Increase charge on reset
- waiting period also reset
- Can GMAB be renewed @ end of guar period
- GMAB: same guar and guar period apply to subsequent deposits
- GMWB: guar amt may be increased by add'l deposits or limited to deposits in certain contract years (2 to 4)
Theoretical and Practiacl Issues in Valuing Guar Benefits
- Policyholder Behavior
- PO may make decisions that are not in their best interests
- media publicity and broker advice can have large impact
- PO awareness can be increased w/ guaranteed amts shown regularly on statements
- more history needed to determine if "in the money" DBs result in anti-selective lapsation
- VA primarily used as a tax-favored investment to provide a lump sum for estate needs vs monthly income
- Lapse Rate
- very low during SC period (4-6%)
- spike after SC period (20-50%)
- then stabilize (10-15%)
- levels vary depending on dist channel and by company
- factors affecting lapse
- length of SC period and level of SC
- qual vs non-qual
- taxes
- distributor incentives
- cahnges in availability of different contract options and their associated prices
- does each deposit have its own SC schedule
- GMAB, GMIB option, especially if "in-teh-money"
- policy performance - relative to other investments and other VAs
- Annuitization Rate
- tend to be very low (<3%)
- GMIB - annuitizatoins have to be modeled separately - can't include w/ lapses
- final decision to exercise GMIB is complex balance
- sample assumption
- Range Annuitization Rate
- 0.00 <= Adj guar/AV < 1.25 2%
- 1.25 <= Adj guar/AV < 1.40 8%
- 1.40 <= Adj guar/AV < 1.55 16%
- 1.55 <= Adj guar/AV < 1.67 24%
- 1.67 <= Adj guar/AV 30%
- other factors affecting annuitization rates
- age
- other assets
- commissions
- volatile mkts
- taxes
Pre-Annuitization Mortality
- biggest impact on GMDB
- does presence of GMDB result in any anti-selection
Partial W/D and Contributions
- 10-15% w/d money on a regular basis
- usually w/in free w/d range - typically 2-3% of acct value each year
- some cos have systematic partial w/d programs
- gains assumed w/d first for tax purposes
- 3 situations cause w/d and contributions to have material impact on valn
- qualified paln @ age 70.5 - min dist - usually done via partial w/d
- benefit options no longer offered in mkt may incent add'l contributions
- may also be a corresponding drop in partial w/d from these plans
- potential anit-selection in $/$ w/d cases
- GMDB - w/d all but $1 av leaves "free" insurance for "in-the-money" portion
- GMIB - w/d all but excess and get free annuity. Even worse w/ guar roll-up
- taxes may be an issue to minimize this behavior
- simplifying assumption - future partial w/d and contributins will offset
- presence of GMWB may increase partial w/d experience over current levels
Grouped vs Seriatim Data
- higher accuracy w/ seriatim
- processing time/costs may force grouped
- beware grouping that an "in the money" and "out fo money" don't offset
Asset Allocation and Fund Transfers
- could project each fund separately - most models group funds into specific categories
- projected acct value is weighted avg return of diff asset categories
- transferes can be modeled static or dynamic basis
- static - transfers don't depend on how any of funds perform
- dynamic - transfers vary based on returns
- most models don't use dynamic due to extreme complexity
- ways to implement static fund transfer assumptions
- asset allocations entered (PO level) and rebalanced @ end of each period
- asset allocations @ PO level and NOT rebalanced @ EOP
- asset allocations @ group level and rebalanced @ EOP
- asset allocations @ group level and NOT rebalanced @ EOP
Future Economic Scenarios
- value of guaranteed benefits highly dependent on level and pattern of future asset category returns
- desire non-trivial reserve for conservative valuation of guar benefits
- if no specified scenarios - set reserves to at least minimum of accumulated fees collected for benefit
- valn can be based on specified scenarios designed to make guar amt > acct value
- valn done stochastically and reserve based on scenario avg
Statutory Valn
- general approach - define model and assumptions so that resulting reserves cover high proportion of possible outcomes
- AG34 adn the Stat Valn of GMDBs
- SVL defined CARVM for annuity contracts
- AG33 provides guidance for applying CARVM to annuities w/ multiple benefit streams
- handled PO behavior by basing reserves on assumption that PO woudl select teh worst case scenario for the co
- AG34 addressed the variablility of inv returns on reserve for GMDBs
- GMDBs projected assuming an immediate drop in underlying asset w/ subsequent recovery at a net assumed rate until maturity of contract
- Asset Class Immediate Drop Gross Assumed Return
- Equity 14% 14%
- Bonds 6.5 9.5
- Balanced 9 11.5
- Money Mkt 2.5 6.5
- Specialty 9 9.5
- table shows gross return - need to adjust for charges to get net return
- fixed acct - assume 0% drop and net return = guar rate
- GMDB reserve = integrated reserve (includes all benfits) - Sep Acct reserve (ignores GMDB)
- Integrated reserve is combo of 3 benefit streams
- projected NAR paid to those projected to die during calc period (valn mortality)
- projected unreduced AV paid to those expected to die during calc period (valn mortality)
- base benefit streams projected during calc period and discounted for survivorship baed on valn mort table
- does not assume drop adn recovery
- reserve is greatest PV at vlan int rate across all durations of the 3 integrated streams
- projected (reduced) acct value => (assets in class)*(1-immed drop%)*(1+net assumed return)^t using 1994 VA MGDB mortality table
- AG34 effective 12/31/1998
- Valuation of Living Benefit Guarantees
- AG34 not designed for living benfits
- LHATF too approach similar to AG34 and RBC C-3 task group
- looking at stochastic approach insted of formula based approach
- AG39 - interim solution until model-based approach could be developed
- total reserves for contracts w/ living benefits guarantees
- = reserve for VA after comparing to the CV and ingoring charges and claims assoc w/ living benfits
- + living benfit reserve (defined as aggregate charges after adjustment for adequacy analysis)
- impicit charges s/b used in not an explicit charge
- can be based on review of charges w/ and w/o benfit and/or modeling of the benfit
- aggregation is simply sum w/o interest
- AG39 implies seriatim calc of aggregated charges
- asset adequacy analysis done on aggregate basis for all contracs w/ living benefit guar
- AG39 does not require CF testing (according to Guidance and Practice notes) but ASOP 22 implies s/b done
- when selecting assets for analysis - consider asset segmentation scheme used for Actuarial Opinion adn presence of any hedges for the living benefit
- CF from hedges can only be used if hedging instruments part of selected assets
- Future Changes to Stat Valuation
- Equity Return Assumptions
- working groups focusing on stochastic distribution model
- val act s/b able to choose model, subject to a set of calibration points
- instead of ILN dist (Indep LogNormal), leaning towards RSLN2 (2 regime switching lognormal process) b/c ILN doesn't generate more extreme results seen in historical data
- old method - calc reserve for several scenarios and use highest result
- option 1 - use precentail of distribution of reseve based on each of scenarios tested
- option 2 - CTE (conditional tail expectation)
- results rank ordered from best to worst
- CTE at the x% level is avg result of worst (100-x)% of the results
- in general CTE x% > (x + 1/2(100-x)) percentile
- current proposals - CTE90 for total balance sheet adn CTE65 for stat reserving
- diff between CTE90 adn CTE65 => RBC (100% NAIC Co action level)
- Policyholder Behavior & Experience Assumptions
- 3 issues w/ CARVM
- always applying can result in very large reserves
- ignores past experience of PO elective behavior adn fact taht PO do not act w/ 100% efficiency
- ignores disincentives to PO for result dictated by CARVM (such as negative tax consequences)
- discussion re: using incidence rates based on prudent best estimates & using co specific data
US GAAP
- overview
- GAAP and Stat differ in several important aspects
- model assumptions are based on best estimates
- rules do not require 0% or 100% utilization on PO behavior
- certain liabs based on fair value (to reflect similarity to derivatives)
- reserves recalced each year due to unlocking of assumptions
- most rules in F97 w/ expanded direction in SOP 03-01
- US GAAP and GMDBs
- is contract an investment contract w/ nominal DB or insurance contract
- has significant mortality risk if benfit could vary significantly in response to changes in captial mkts
- determination based on comparison of benefit payments over acct value to PV of all amts expected to be assessed against PO
- s/b done at issue considering full range of scenarios based on volatility of assumptions (not best estimate)
- if DB deemed significnat and fees assessed or ins benefits not fixed, SOP requires liability if amts assessed in manor that generates profits inearly years and subsequent losses
- liab base on a/b
- a - PV total expected excess payments
- b - PV total expected assessments (gross)
- use same assumptions as for DAC
- add'l liab = benefit ration * cumulative assessments - cumulative amts pd
- test for unlocking as necessary
- US GAAP and GMIBs
- if GMIB can be not settled at annuitization - F133
- GMIB treated as embedded derivative
- F133 - written options be recorded @ fair value at issue and throughout accumulation phase of contract
- changes in fair value recognized in income
- for other GMIB or two-tiered annuities
- SOP requires add'l liability if PV expected annuitization payments @ annuitization date exceeds acct balance @ expected annuitization date
- reserve method is same as for GMDBs
- only difference is addition of an expected annuitization election rate
- US GAAP and GMAB & GMWB
- FASB Derivative Implementation Issue B8 specifies these are embedded derivatives subject to F133
- written options recorded @ fair value at inception and throughout
- changes in fair value recognized in income
Conclusion
Appendix A
Appendix B
Reinsurance - Tiller and Tiller
Chapter 4 - TRADITIONAL REINSURANCE
YRT (see html)
Coinsurance
- coverage is same form as individual policy
- reinsurer establishes proportionate share of policy reserves
- shares proportionately to excess mortality or morbidity, lapses, surrenders, etc.
- Coinsurance Premiums and Allowances
- premium usually proportionate to gross premium
- for banded policies, can
- - reins premium based on banded gross premium, then common set of allowances for all bands
- most common and easiest to understand
- - vary allowances by band
- complicates admin but allows consistent margins by band
- - reins prem and allowance for all bands is equal
- simplifies admin, increases margin for ceding co on smaller band sales
- ceding co typically retains 100% of policy fee
- coins typically follows u/w (S/NS etc)
- sometimes allowances vary by age and/or sex
- can be experience rating
- sometimes first year allowance > 100%
- Coinsurance Premium and Allowance Calculations
- allocances typically determined unique for each policy (product)
- typically paid on annual basis
- substd more complicated - vary by type of extra and length they apply
- WVR/GIO/Payor usually consured w/ generic allowances 75-85% 1st year, 10-15% renewal
- ADB usually flat rate YRT
- Uses of Coinsurance
- can be used on anything
- for life, common on Term where very little CV buildup, therefore minimal investment risk
- used w/ CV products to pass strain or investment risk to reinsurer
- Policyholder Dividends
- < 1990s, uncommon for reinsurer to share in PO divs
- may be a problem if big block w/ large portion ceded as co doesn't control those assets
- currently reinsurers SOMETIMES participate, but only in illustrated scale, not in up or down changes
- NY Reg 102 says reinsurer must participate in divs, including scale changes if ceding co wants reserve credit
- Other Considerations
- reinsurers rarely participate in policy loans
- reinsurer typically remburses for premium taxes on ceded portion
- RPU - reins is adjusted and no further premiums paid
- ETI - no more prems, but coverage for appropriate duration
- sometime at ETI/RPU, reinsurer will pay CSV to ceded co and terminate reins
- reserve credits if reins is admitted/accredited
- will pass deficiency reserve as well as std reserves
- admin is relatively complex since need to calc prem, pay db, calc expense allowance, reserves and apyments of cash surrenders
- Illustrations - p 89
Modified Coinsurance - ModCo
- diff from coinsurance is stat vx on ceded portion is obligation of and held by ceding co
- reinsurer has to fund reserve increases (less credit for investment income)
- Origins - Unknown
- ModCo Prems and Allowances
- ModCo Prem and Allowance Calculations
- similar to coins
- WVR/GIO/Payor typically coins even if base is ModCo
- ADB typically flat YRT rate
- ModCo Reserve Adjustment
- Ening Policy Reserves - Beginning Policy Reserves - Interest on Beg Pol Vx
- if >0 reinsurer pays ceding co. If < 0, other way
- historically an annual calc
- currently (typically) quarterly
- ModCo Int rate is defined in treaty
- - historically could be defined in terms of ceding co portfolio rate, rate of return on reinsured blocks assets, new money rate of return, or outside index
- - sometimes a fixed rate
- - if ModCo rate = ceding co rate of return, result to ceding co is same as if they used coins
- - if ModCo rate = reins co rate of return, result to reins is same as if they used coins
- cap g/l not shared w/ reinsurer
- - NAIC model reg changes that since ALL significant risk must be transfered
- Uses of ModCo
- primarily for products that develop CV - especially par
- in 80s, used to reduce FIT (transfered investment income to u/w income)
- - tax law changes stopped that
- Other Considerations
- Eliminates some problems w/ coins
- - no Vx credit questions since ceding co maintains policy Vx
- - eliminates problem of policy loan participation as well (same reason)
- - ceded co has more control over investments
- Main drawback
- more difficult to admin because of Reserve Adjustment Calculation
- Illustrations - p 100
-
Chapter 5 - FINANCIAL REINSURANCE
Uses of Financial Reinsurance
- based on diffences in timing for stat of tax earnings and on stat Vx redundancy
- usually structured so only cash that changes hands is for fees or risk charges
- Surplus Relief
- most common
- to improve current stat earnings and surplus position
- creates an increase in stat surplus for ceding co in year relief is given
- repayment of relief tied to future cash flow or stat earnings on reinsured block, therefore not guaranteed
- since risk is less than if trad reinsurance, less risk charge
- Tax Plannings
- not as much as before
- company cedes, creates a taxable gain, used to offset taxable loss
- - useful if company hasexpiring tax loss carryforwards
- translates more commonly permanent than with surplus relief
- gain to ceding co is loss to reinsurer
- company might also assume reins to create a loss to offset a gain
- ceding co can usually terminate reins once inital gain repaid
- comany may ced/assume life/health to change co status to/from life/non-life company
- Strategic Business Planning
- may wish to acquire reinsurance to
- - increase future profits
- - utilize excess admin capacity
- - assist co in entering a new market
- may cede to
- - exit a certain market
- - financing in a LBO
- typically permanent in nature
- recapture typically not a provision
- normally assumption reinsurance
Terminology
- Initial Reinsurance Premium
- typically = policy reserve
- Allowances
- used to adjust effective amount of renewal premium
- initial allowance provides first year gain
- stated as % of initial premium, amt/unit coverage, or flat amt/trx
- renewal allowances may provide for ceding co commission/maint and adjust expected results to agreed upon level
- higher allowances => longer for reinsurer to recover intial strain
- Risk Charge
- portion of reins premium retained (by reinsurer) for providing reins
- normally stated in terms of amt outstanding surplus/gain
- amt depends on
- - nature of risks assumed
- - size of trx
- - reinsurer's profit objective
- - mkt conditions at time of trx
- - ceding co's stability
- - tax considerations
- - company relationships
- - reinsurers expenses for analysis, administration, or intermediaries
- historically between 1 and 5% of outstanding surplus relief each year
- Experience Refund
- mechanism to identify and return a portion of stat earnings on rens business to ceding co
- typically not paid until inital allowance is recovered (for fin reins)
- negative experience refunds are uncommon
- - if part of treaty - usually disqualifies stat Vx credits
- loss deficit carryforwards (or similar provisions) OK as long as reinsurer can't terminate treaty to force ceding co into loss position
- Outstanding Surplus Account
- used to track the defined portion of stat gains on business reinsured
- - portion after risk charge, experience refund, and int accumulated on outstanding amount
- usually can't terminate treaty while this is in a deficit position (treaty says)
- ceding co can usually terminate treaty after deficit eliminated
Comparative Model - see book beginning p 112
Plans of Financial Reinsurance
- YRT
- Vx is relatively small, therefore doesn't provide significant relief unless reinsured product also YRT
- Uses of YRT
- most common: I/S Life product where reinsurer doesn't want to be involved in accum element
- if on YRT, typically create special YRT scale as % of policy prem rates
- if on YRT, little difference from coinsurance
- for surplus relief, most effective if reins prem scale has 0 1st yr prem
- - chargebacks for lapses may be appropriate
- could be used where ceding co wants to minimize asset transfer
- OK for health policies, NOT annuities
- Advantages
- limits reinsurer investment and lapse risk (no Vx or CV build-up)
- possibly lower ongoing cost than coins if risks limited to mort or morbid
- Disadvantages
- low cash limits amout of possible future profits (therefore limits allowance/bonuses reinsurer can offer)
- allowance limits limit financial reins applications
- relatively difficult to admin IN FIN REINS situations (fin reins commonly admin on simplified basis & YRT does not work well w/ this type of admin)
- rarely used in financial reins applications
Coinsurance
- Typical arrangement: inforce block, intial reins prem = Vx, reinsurer pays allowance which provides initial gain
- future years - allowance covers ceding co maint and commission expenses
- Alt Arrangement: initial prem = initial Vx - desired gain
- renewal premiums defined w/o reference to policcy gross prem or specific expense allowance
- same effect as typical arrangement, just stated differently
- Subsequest years - reins prems (net of allowances) used to
- pay claims
- fund Vx increases
- cover admin costs
- PADs
- included a charge to reimburse for year 1 investment
- pricing done same as a product actuary used to develop product
- current mkt highly competitive, therefore little PADs in pricing
- larger allowances preferrable to experience refunds for most companies
- in financial reins mkts, pricing not so precise
- in fin reins - usually has exp refund feature
- in fin reins - uses outstanding surplus account
- Advantages
- simplest to admin on a quota share method
- regulators like because no question of risk transfer
- Disadvantages
- primary - need to transfer assets
- can be significant if large inforce block
- if IS or Par, reinsurer has control over part of the div or int rate determination
- requires reinsurer to manage the assets, subject to additional investment risk
- if reins is terminated, reinsurer must transfer assets back and could generate g/l that could have a negative impact on financials
- loss of Vx credit if reinsurer not admitted
- additional insolvency risk to ceding co (ceding co responsible for claims even if reins is insolvent)
- Coins Illustrations - text p. 122
ModCo
- popular for fin reins since ceding co keeps reserve adn assets supporting reserves
- typical arrangement: inforce block, prem = Vx on portion reinsured, ren prems = portion of gross prems, reinsurer pays allowance
- anticipated gain at end of each accounting period
- Advantages
- applicable to all plans of ins
- avoids need to transfer assets
- ceding co retains control of investment policy
- eliminated Vx credit problem
- reinsurer may deduct entire Vx increase for FIT even if Vx not otherwise qualified as tax deduction
- reinsurer avoids necessity of managing assets
- Disadvantages
- more complicated to admin than coins because of mod-co adjustment
- special transactions for surrenders and death
- transfer of assets back to reinsurer @ treaty termination can create capital g/l for ceding co
- Mod-Co Illustrations - text p 131
Funds Withheld Coins
- looks like trad coins in many ways
- impossible to tell difference when looking at intial stat gain
- only difference in initial tranaction - reins retain allowance and ceding co retains intial prem
- if allowance exceeds initial premium, reinsurer sets up an accounts payable item adn ceding co sets up accounts recievable asset
- if initial premium exceeds allowance, reverse is true
- in subsequent periods, account balance increase/decrease as profit emerges, surplus repaid, & reserves increase/decrease
- no cash will change hands until initial account balance reaches zero
- ceded co maintains assets underlying reserves, reinsurer holds reserves on fin stmt, therefore int adjustment like mod-co adjustment is made
- Advantages
- no cash changes hands initially
- cash flow minimized throughout life of treaty
- lessens ceding co insolvency risk
- if reinsurer is non-admitted, ceding co can still take Vx credit up to amount of funds it is holding
- Disadvantages
- more complicated than regular coins
- receivables and payables must be tracked carefully
- int adjustment for net account receivable (foregone int income)
- may still result in Vx credit problem if reins is non-admitted (but somewhat alleviate by amount of funds held)
- Illustrations - text p 140
Funds Withheld ModCo
- looks like ModCo in initial transaction
- reinsurer retains initial allowance and creates payable item
- ceding co sets up corresponding receivable item
- Advantages
- reins retains initial allowance, therefore no need to liquidate assets to pay allowance
- reinsurer has lessened risk in event of ceding co insolvency
- Disadvantages
- one more layer of complexity to admin of treaty
- mod-co adjustment further complicate b/c ceding co doesn't get cash
- special adjustment b/c interest not earned by ceding co on the allowance
- may be viewed as violation of Model Reg
- Illustration - text p 148
Partially Modified Coins (PartCo)
- Initial Coinsurance Vx = initial reinsurance allowance
- remaining reserve liablities reinsured on mod-co basis
- no cash transfer at treaty inception
- renewal years: proportions of co and mod-co are adjusted
- adjustment may be scheduled of may float w/ increase in coins Vx
- Advantages
- no inital cash transaction
- eliminates need to create paper a/l (necessary in funds withheld)
- Disadvantages
- main: very complicated to comprehend and to admin
- if coins reserves float w/ outstanding surplus, 2 stat gain from operatoins calcs necessary
- 1) premlim stat gain from operations needed to calc surplus repaid
- 2) final to show change in Vx from co->mod-co (or vice versa)
- Illustrations - text p. 157
Regulation and Taxation
- < 1984, very little (effective) legislation on financial reins
- used often to reclassify components of taxable income & significant reductions in taxes
- TRA84 - Sectoin 845 - IRS can change an individual tax return if signifianct tax avoidance found
- reins transactions were used to mask true financial condition of company
- therefore State DOI now looks at treaties for significant risk transfer
- treaty terms that concern
- - schedule gains to reinsurer, regardless of actual experience of block
- - reinsurer never having to pay out benefits, just building up a payment due liability
- - reinsurer has right to terminate or automatic termination if
- + reinsured becomes insolvent
- + reinsured has mgmt change
- + business reinsured proves unprofitable
- some states challenge ALL "cashless" reinsurance
- conditions to include to keep regulators happy
- - reinsurer must pay benfits at certain experience level
- - gains to reinsrer based on actual experience of reinsurance
- - no event (insolvency/mgmt changes) can automatically terminate reins (may be terminated after certain level of earnings attained or warranty voided)
- - inforce reins cannot be unilateraly terminated by reinsurer - except for premium non-pmt
- - int paid/credited s/b reasonable w/r to invemenst mkts/assets involved
- - relevant significant risks s/b transferred to reins - including capital loss, disintermediation, and asset default risks (if relevant)
- - ceding co shoudl not be forced to pay back losses except for voluntary termination
- regulators object to Vx credits or receivable credits wehre risk transferred is disproportionate to reserve credit
Security Considerations
- "cashless" reins transactions under criticism
- led to use of trusts, escrow accounts and letters of credit
- also helps protect assets, preserve Vx credits, minimizes currency fluctuations and protects other party in insolvency
- Trusts and Escrow Accounts
- trusts used to secure amounts owed from co that secureds trust to co that is benef
- equitable title to the assets is in the trustee
- commoonly used to segregate assets related to Vx of an inforce block
- most common as alternative to funds withheld trx
- escrow accounts earmark assets w/o actually transferring ownership
- typically used to support funds withheld trx
- if certain stipulated events happen, assets held in escrow are transferred
- possible events include
- surplus dropping below agreed upon level
- change in mgmt
- financial performance of reins below expected levels
- if used to secure reserve credits, Trusts subject to Model Law on Credit for Reins
- Advantages
- - assets separate and identifiable
- - investment income can be limited to performance of specific assets
- - ceding co can still take Vx credit if reinsurer not admitted
- - if recaptured, assets of trust/escrow can be used to effect payment, reducing dispute over mkt values
- - trust is true transfer of ownership -> less suspect to IRS and state regulators
- - on default, benef has right to w/d assets as a secured creditor
- Disadvantages
- - creates additional expense
- - can result in restriction on investment mgmt
- - transfer of assets to trust may necessitate recognition of cap g/l for tax purposes or current mkt values for stat stmt purposes (agreement should state which party takes the cap g/l)
- - if trust, company giving up assets will see reduction in magnitude of assets it reports
- - if an asset transfer reversal occurs, depreciation in mkt values could create surplus straing
- Letters of Credit
- most states will allow Vx credits from non-admitted reinsurer if reinsurer provides a letter of credit for the amt of the reserves
- requires very little admin
- disadvantage (from Reins view) - ceding co and draw down on a letter of credit w/o warning
Copyright © 2004 Steve Welander.
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