NAIC VA Reserve and Capital Reform: Overview of Proposed Revisions. Aaron Sarfatti

Transcription

1 NAIC VA Reserve and Capital Reform: Overview of Proposed Revisions Aaron Sarfatti

2 NAIC VA RESERVE AND CAPITAL REFORM OVERVIEW OF PROPOSED REVISIONS NOVEMBER 4, 06 Aaron Sarfatti, Partner

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4 Agenda Provide background of the NAIC VA reserve and capital reform initiative Recap proposed revisions to AG4 and CP Outline the reasoning behind the most salient proposed revisions

5 Recent history of VA statutory reserve and capital standards Timeline Enactment of RBC C Phase II Enactment of AG 4 NAIC commissions VA reform initiative Oliver Wyman presents recommendations Rise of VA captives QIS Poor alignment of statutory risk factors with economic and GAAP risk profile Increasing variation in company hedging objectives (Nearly) continuously falling interest rates

6 We conducted a Quantitative Impact Study ( QIS ) in from Q to Q of 06 Overview of QIS timeline The QIS included 5 participant companies December, 05 Draft QIS Specifications released for comment February 5, 06 Final QIS Specifications released; QIS commences August, 06 Oliver Wyman proposal presented December January February March April May June July August Jan-Feb Participant comment period on draft QIS Specifications February-May Company calculation, data collection period QIS Working Group discussions on hedge accounting and Standard Scenario June-July Company-specific results circulated 4

7 Overview of the current VA statutory reserve and capital framework Total Funding Requirement MAX Difference between TAR and reserves, if positive, is the RBC C charge Total Asset Req. Reserves (CP) (AG4) MAX MAX CP Standard Scenario CP Stochastic AG4 Stochastic AG4 Standard Scenario Weighted avg. Weighted avg. CTE 90 CTE 90 CTE 70 CTE 70 Best-efforts run Adjusted run Best-efforts run Adjusted run 5

8 The VA statutory balance sheet under the existing framework Sample statutory VA balance sheet GA assets Fixed income: amortized cost Other GA assets Surplus 4 Volatile boundary Required capital for market risk Derivatives: fair value Statutory reserves and TAR Low interest rate sensitivity Wide range of practices in scenario generation and other assumptions Fair value of hedge assets Statutory reserves Total Asset Requirement ( TAR ) Volatile interactions between: Standard Scenario and stochastic TAR and reserves 4 Required capital for market risk SA value Arithmetic difference between TAR and reserves (including voluntary) Companies incentivized to increase reserves up to TAR Assets Liabilities 6

9 Shortcomings in the current VA statutory framework and ideas for revision Shortcomings in the current framework Ideas for revision Economic-based hedging can adversely impact statutory financials Align economicallyfocused hedge assets with liability valuations Volatile interactions between stochastic and Standard Scenario calculations Standard Scenario is excessively conservative in some areas and aggressive in others Reform Standard Scenarios (AG4 and C Phase II) Volatile interactions between reserves and TAR, incentivizing voluntary reserves Align TAR and reserves Derivative admissibility limits prevent hedging benefit from being fully recognized DTA admissibility limits exacerbate mismatches between statutory and tax accounting 4 Revise asset admissibility for derivatives and DTAs Companies use different capital markets assumptions for scenario generation 5 Standardize capital markets assumptions 7

10 Our recommended framework revisions follow five enhancement objectives Enhancement objectives Description Ensure robustness of funding requirements Funding should be adequate to ensure liability defeasance with reasonable confidence Promote sound risk management Risk mitigation should reduce funding requirements and minimize balance sheet volatility Promote comparability across insurers, products Standardize assumptions across companies and products where appropriate Ensure comparable level of conservatism in framework provisions Preserve current construct where feasible Retain core constructs of the current framework, where possible e.g., Adherence to principles-based reserving Book value approach to valuation using real world scenarios Minimize implementation complexity Reduce computational complexity, improve interpretability, and minimize model risk 8

11 Industry and regulator feedback further guided design of proposed revisions Comments Regulators QIS participants Overall Robust funding requirements in all markets Accurate and consistent management of IR risk Ensure adequate time to study and potentially revise current proposals On balance sheet marketsensitivity On stochastic calculation On Standard Scenario On tax considerations Incentives for interest rate risk management Simplicity Support a framework that promotes Interest rate-sensitivity of funding requirements A more uniform, positive cost of equity risk Maintain at least one Standard Scenario Inform non-market assumptions with emerging experience Regulatory considerations are the foremost objective Align market-sensitivity of assets and liabilities Align hedge assets closer to liability valuation Improve consistency of IR scenario generation Harmonize asset modeling throughout PBR Focus Standard Scenario on minimum reserves Align Standard Scenario with stochastic construct Inform non-market assumptions with emerging experience Tax reserve discussions unclear (industry, IRS, and Treasury) Developments must be considered in designing VA reserves 9

12 Detailed list of proposed revisions Ideas for revision Specific proposals Align economically-focused hedge assets with liability valuations A B Endorse hedge accounting for derivatives originated as part of a VA hedge program Remove the Working Reserve when calculating scenario GPVAD C Permit simplified reflection of hedging in liability projections D Allow higher credit for liability projections with modeled CDHS, but require back-testing Reform Standard Scenarios (AG4 and C Phase II) A B Align AG4 Standard Scenario calculations more closely to the stochastic CTE framework Remove the C Phase II Standard Scenario C Specify a fuller set of risk factors informed by prevailing conditions and test multiple paths D Refresh prescribed policyholder behavior assumptions to align with industry experience Align TAR and reserves A Require Starting Assets used in liability projections to remain close to the final reserve B Calculate C as the difference between reserves and a tail CTE on the same distribution 4 Revise asset admissibility for derivatives and DTAs 4A 4B Increase admissibility limit for designated VA hedges Increase admissibility limit for DTAs associated with VA portfolios 5 Standardize capital markets assumptions 5A 5B Harmonize interest rate and general account net investment income assumptions Evaluate alternative calibration criteria for equities and other market risk factors 0

13 The VA statutory balance sheet after the proposed revisions Sample statutory VA balance sheet GA assets (/4) 65% (CTE 98 Reserves) Hedge accounting for derivatives aligned with liability valuation Other GA assets Surplus 4 Required capital Harmonized IR and NII assumptions Less penalty for economic hedging Statutory reserves and CTE 98 Greater alignment between Fair value of hedge assets Statutory reserves CTE 98 funding level Standard Scenario and stochastic CTE 98 and reserves More realistic Standard Scenario behavioral assumptions SA value 4 Required capital for market risk Reduced volatility in required capital and RBC ratio Assets Liabilities Voluntary reserves only eliminate RBC charge if they reach CTE 98

14 Recap proposed Standard Scenario revisions and implications Proposed revisions Portfolios for which Standard Scenario is binding Align to stochastic construct Calculate Standard Scenario as if it were another stochastic scenario, but with a prescribed market path and behavioral assumptions Prescribe policyholder behavioral assumptions Revised assumptions reflect product features of modern VAs and emerging industry experience Prescribe three market paths Prescribe three drop and recovery market paths differing in initial stress but identical thereafter High Optimism of behavioral assumptions Most portfolios Young portfolios Some portfolios No portfolios Stress covers both equity and interest rate risk SS Amount is largest of three scenarios Low Low Degree of economic hedging reflected in calculations High Standard Scenario designed to promote hedging and guard against insufficient prudence in actuarial assumptions

15 Recap design of three capital markets paths S&P 500 index level Stress period (hedging and risk mitigation reflected) Recovery period - No hedging reflected - Risk mitigation not applicable - Assets earn risk-free rate Equity drop: equity drop.5%; no IR change Joint drop: equity drop ~0%; IR drop 5bps Interest rate drop: equity flat; IR drop 50bps Promotes sound risk management Promotes product design risk mitigation Provides margin to intrinsic value for adverse market move Ensures reserve floor at intrinsic value Eliminates difficult-to-govern company model choices (e.g. CDHS) Valuation Year Projection horizon Maturity / The Future

16 Background Value of a risky contract like a VA consists of three parts Market-consistent transfer price of liability Price at which a rational third-party would purchase a VA portfolio Cost of Non- Hedgeable Risks Time value of guarantees Intrinsic value Minimum assets required to hedge all market risk fully Assets required to maintain contract if account value earns risk-free rates and interest rates follow forward curve similar to a reserve for a fixed rate liability Intrinsic value of guarantee Present value of all future cash flows assuming that: Account value returns the risk-free rate (no volatility) Time value of guarantees AKA the option value Additional cost to hedge market risk of guarantees if the account value is invested in risky assets Value of the possibility that account value returns will exhibit volatility Cost of non-hedgeable risk Market cost of capital held against non-hedgeable risks e.g., behavioral and operational risks Economic Value 4

17 Illustrative How would standard scenario reserve compare to market-consistent value? Composition of market-consistent value elements by age of portfolio Comments Range of major industry portfolios today Market-consistent reserve value = intrinsic value + time value Excludes cost-of-non-hedgeable risks Reserves Intrinsic value Young portfolios intrinsic value well below market-consistent reserve More optionality associated with newer, at-the-money guarantees Time value Young (recent vintage) Age of portfolio Mature (deep ITM g tees) Mature portfolios intrinsic value close to market-consistent reserve Less optionality as deeply in-themoney guarantees are unlikely to ratchet or reset Revised standard scenario amount Standard scenario reserve is like the intrinsic value reserve after a modest and hedgeable market stress 5

18 Summary rationale for standard scenario capital markets paths Components of the Standard Scenario market path Initial market stress ~CTE 70-level market stress on equities and interest rates (one year time horizon) Recommended conducting three types of stresses in order to: Promote prudent management of both equity and interest rate risk as well as the risk of a joint event Ensure companies do not structure the hedge program around the Standard Scenario stress Companies with more complete economic hedging should project hedge payoffs equal or greater than the increase in the intrinsic value of the guarantee measured in the recovery period Market recovery Returns for all asset classes follow risk-free forward rates Assumes that regulators, after the market stress, would at the minimum pay the current intrinsic value of the portfolio 6

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