Variable Annuities (VA) Managing the Dichotomy between Hedging Goals and Accounting Rules
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1 Variable Annuities (VA) Managing the Dichotomy between Hedging Goals and Accounting Rules Joint Regional Seminars, Asia June 18-22, 2007 Hubert Mueller, Principal 2007 Towers Perrin
2 Agenda The US GAAP Perspective The Economic Perspective Fair Value Implications of Hedging on Required Capital 2007 Towers Perrin 2
3 THE US GAAP PERSPECTIVE US GAAP financial reporting tends to levelize earnings over time Example: Profit Recognition for New Business Using Various Financial Reporting Methods Embedded Value Statutory US GAAP When using EV reporting methods, the value of improved sales shows up in the current period With US statutory reporting, a loss emerges in the year of issue With US GAAP reporting, the value of improved sales is spread over all future periods, resulting in little improvement in the current year s results 2007 Towers Perrin 3
4 THE US GAAP PERSPECTIVE VA guarantees are subject to a variety of GAAP regulations Guarantees without life contingencies are subject to FAS 133 Includes GMAB and GMWB, and EIAs Assets and liabilities are marked to market, in line with hedging Guarantees with life contingencies are subject to SOP03-1 Includes GMDB, GMIB and parts of GMWB for life Assets are marked to market, while the liabilities are not disconnect with hedging FAS 141 Goodwill impairment testing 2007 Towers Perrin 4
5 THE US GAAP PERSPECTIVE Consequences of current GAAP regulations Most US VA players hedge GMAB and GMWB only Few companies hedge GMDB or GMIB features Opportunity for reinsurance, but general lack of availability Some new reinsurance entrants in US recently Treatment of GMWB for life benefit varies Non-life contingent portion is typically hedged (FAS 133) Life-contingent portion falls under SOP 03-1 Typically not hedged Disconnect between hedging and accounting 2007 Towers Perrin 5
6 Agenda The US GAAP Perspective The Economic Perspective Fair Value Implications of Hedging on Required Capital 2007 Towers Perrin 6
7 THE ECONOMIC PERSPECTIVE Companies typically focus on hedging the economic risk first, to minimize risk-based capital 0.60% Comparison Hedged vs Naked - Annualized Profit/Loss as a % of Fund Value 0.40% 0.20% Hedged (Gain) Loss 0.00% -0.20% % Naked (Gain) Loss -0.60% Hedged (Gain) Loss with 2X trades -0.80% -1.00% -1.20% -1.40% -1.60% Scenario 2007 Towers Perrin 7
8 THE ECONOMIC PERSPECTIVE Most US stock companies focus on hedging both tail risk and GAAP earnings volatility Hedge tightly matches changes in GAAP liability. Hedge significantly reduces GAAP net income volatility. Source: Hartford Life Based on $10 billion block of new business with GMWB benefits issued in 1st quarter of Towers Perrin 8
9 THE ECONOMIC PERSPECTIVE Example: Hartford Life is now using more than 1,000 servers for grid computing, mainly in their VA business Hartford s Analytical Computing Facts From 35 CPU s in our original Hedging release, the platform has grown to > 1,000 We have the capacity to process hundreds of millions of calculations per second Newly optimized version of the hedging analytics runs times faster than before Hedging process alone consumes enough data monthly to fill the Library of Congress Analytics can run on any desktop, any server, any operating system at the same time ensuring massive expandability Grid computing environment runs seamlessly across multiple data centers, ensuring business continuity Exploring expansion to computing grid with commercial technology partners Source: Hartford Life Towers Perrin 9
10 Agenda The US GAAP Perspective The Economic Perspective Fair Value Implications of Hedging on Required Capital 2007 Towers Perrin 10
11 FAIR VALUE What is fair value? There is no active market for insurance liabilities SFAS 157 Defines fair value and provides guidance on how to measure assets and liabilities at fair value Fair Value = Exit Value: The price that would be received to sell an asset or paid to transfer a liability between market participants IASB has varying views on this subject IAS 39: Fair Value = Entry Value, but: IASB Discussion Paper now favors exit value for insurance liabilities MCEV Fair Value = Hedging Cost (Exit Value concept) 2007 Towers Perrin 11
12 FAIR VALUE What is the fair value option ( FVO )? FAS 159 provides a one time option to make an irrevocable election to mark certain financial assets and liabilities to market Allows entities to measure eligible financial instruments at fair value Available only for the first 120 days of a fiscal year Developed in response to the problems with FAS 133 and SOP03-1 Designed to achieve convergence with IAS 39 Effective for fiscal years beginning after 11/15/2007 US GAAP is starting to move towards IFRS 2007 Towers Perrin 12
13 FAIR VALUE Implications for industry projected timeline for fair value reporting US GAAP deliverables First FAS 159 sub-annual accounts First full FAS 159 accounts IFRS implementation deliverables Comparative figures First sub-annual accounts First full accounts Possible stages of an IFRS implementation project Knowledge build-up Impact study Implementation Dry runs Calculations IFRS phase II timeline Discussion paper 3 May 2007 End of comment period 16 November 2007 Exposure draft End 2008 Final standard 2010 Effective date [1 January 2011] 2007 Towers Perrin 13
14 FAIR VALUE Implementation of the FVO Opportunity to achieve consistency between hedge (economic) goals and accounting treatment Will encourage companies to hedge life-contingent benefits Increased international convergence between FASB and IASB Adopting fair value provides a better transition to the adoption of the new IFRS (implementation expected for ) Reporting and disclosure requirements Expecting more announcements from FASB 2007 Towers Perrin 14
15 FAIR VALUE Possible valuation techniques Market Approach Income Approach Cost Approach Uses prices and other relevant information by identical or comparable market transactions (e.g. market prices, M&A transactions, reinsurance quotes) Uses valuation techniques to convert future amounts (e.g. cash flows) to a single, present, discounted amount (e.g. present value techniques, option pricing) Based on the amount that currently would be required to replace (i.e., replacement cost) the service capacity of an asset (e.g. simulated hedging) Inputs to these techniques should maximize use of observable inputs 2007 Towers Perrin 15
16 FAIR VALUE VA Case Study: Electing FVO and hedging the M&E fee can minimize earnings volatility 140 GMDB Scenarios ($ millions) Earnings Impact from Fair Value Changes ($ millions) % -20% -10% 0% 10% 20% 30% S&P Market Movements Scenario 1: GMDB hedge under SOP03-1 Scenario 2: GMDB hedge under FVO Scenario 3: GMDB and M&E fee hedge under FVO 2007 Towers Perrin 16
17 FAIR VALUE Impact of credit standing on fair value FAS 157 An entity s credit standing should be taken into account in valuing its liabilities IAS 39 is consistent with FAS 157 on this point MCEV incorporates the concept of the limited liability put option Higher risk discount rate for lower credit standing Not yet commonly applied by companies reporting on MCEV basis 2007 Towers Perrin 17
18 Agenda The US GAAP Perspective The Economic Perspective Fair Value Implications of Hedging on Required Capital 2007 Towers Perrin 18
19 IMPLICATIONS OF HEDGING ON REQUIRED CAPITAL Case Study: Hedging typically reduces capital, but may increase reserves Total Assets for No hedge VA Total Assets for Hedged VA 80,000 80,000 70,000 70,000 60,000 60,000 50,000 50,000 TAR 40,000 Capital Reserve TAR 40,000 Capital Reserve 30,000 30,000 20,000 20,000 10,000 10, Projection Year Projection Year Key points Hedging reduces capital but increases reserves (=CTE65) at time 0, TAR (=CTE90) is lower with hedging Capital (=CTE90 CTE65) reduces over time for both, eventually going to 0 due to moneyness of GMAB and overall fee revenue 2007 Towers Perrin 19
20 IMPLICATIONS OF HEDGING ON REQUIRED CAPITAL Lessons learned to date Even the larger companies have only been hedging VA guarantees for a few years, mainly in a bull market Most companies only hedge Delta risk Ability to assess/improve hedge effectiveness will become a key differentiator for success Regulators and rating agencies are only allowing partial credit for hedging when defining capital requirements Typically, only 50% credit is allowed Need to weigh costs versus benefits Hedging may enable a reduction in capital (maybe 20 30%), but may increase reserves Need to take into account in pricing and valuation Implementing smart modeling techniques will expedite processing of large stochastic models 2007 Towers Perrin 20
21 Questions and Comments Hubert Mueller, Principal Towers Perrin Hartford, Connecticut (USA) Phone: (860) Towers Perrin 21
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