Changes to Asset Reporting. S.3855 Actuarial Challenges. Other Comprehensive Income. CALM Valuation. Lesley Thomson

Transcription

1 Changes to Asset Reporting S.3855 Actuarial Challenges Lesley Thomson New reporting depends on asset designation Asset Class Balance Sheet HTM Amortized cost HFT Fair value AFS Fair value Loans Amortized cost Unrealized Gains NI NI OCI NI No more deferral of realized gains Fair value option (FVO) with OSFI restrictions 2 Other Comprehensive Income CALM Valuation Other Comprehensive Income is new to Canadian GAAP (US GAAP has it) OCI is a below-the-line item of income Income that hasn t been recognized yet Unrealized gains/losses on AFS assets go to OCI, creating a disconnect between balance sheet and income statement Never before in Canadian GAAP Realized gains/losses on AFS assets are transferred from OCI to real income Policy Liabilities = Statement value of assets needed to discharge the obligations Based on analysis of asset and liability cash flows If statement value of assets changes (all else being equal), the liabilities change by exactly the same amount CALM gets the balance sheet right So why is 3855 a problem? 3 4 1

2 CALM Valuation Illustrative Example The disconnect between the balance sheet and income statement for AFS assets is the problem The liability valuation gets the balance sheet right, but income will be wrong Income + OCI will be OK, but nobody will care If we changed to get the income right, then the balance sheet would be wrong AFS asset (MV=$1000) whose cash flows perfectly match liability cash flows. Liability value = $1000 Nothing changes except asset MV rises to $1100. Still a perfect match, so liability value = $1100 Income statement: Increase in asset value goes to OCI (not income) Increase in liability value goes to income $100 loss shown on income statement! 5 6 Solutions? Issue Valuation Timing Discussed a number of possible solutions with CICA, but all were rejected Problem is unique to insurance industry, and CICA will not create special rules for one industry End result is that life insurance companies won t use AFS assets to back liabilities CALM valuation usually done a quarter in arrears Increased volatility of asset values means using the Q3 information to set Q4 liabilities is more difficult Different approaches for different blocks Creates a minor annoyance different asset designations for Canadian and US GAAP 7 8 2

3 Issue Valuation Timing Issue Valuation Timing (a) PPM with FV adjustment Post-3855 liability = Pre-3855 liability X (Post-3855 statement value of assets) (Pre-3855 statement value of assets) Pre-3855 statement value adjusted for DRG etc. Pre-3855 statement value need not be exactly the same as today Need any stable book value approach (a) PPM with FV adjustment Approach requires a book value of assets to be maintained Not in G/L, so watch out for control issues BV may be useful for other purposes SOE analysis Dividend management for par business Credited rates on UL 9 10 Issue Valuation Timing Issue Valuation Timing (b) FV liabilities with Q4 adjustment 2 approaches Solve for spread (j) at Q3 such that FV liability = pv liability cash flows at Q3 spot rates + j Q4 liability = pv liability cash flows at Q4 spot rates + j Solve for PPM-type interest vector at Q3 such that FV liability = pv Q3 liability cash flows Q4 liability = pv liability cash flows + change in fair value of bonds backing liabilities (c) CFVM Determine C-3 provision in basis points from CALM testing Liability = Statement value of assets + pv liability cash flows (including C-3) - pv asset cash flows Only appropriate for certain annuity blocks

4 Issue Valuation Timing Availability of required information in time to do the valuation Materiality of adjustments required to account for changes in asset quality, mix, duration, matching etc. during the quarter Materiality of adjustments required for new business issued during the quarter Commingled assets (par/non-par; surplus/liabilities) can add complications Complicated! Changes to timing differences must be reflected in valuation In Canada, 3855 causes projected income to change Attributable to tax impacts In Canada, 3855 causes projected income to be more volatile Attributable to tax impacts Pre-1996 life insurance example (40% tax rate): Start with pre-3855 balance sheet: Asset BV(=TV) = $1000 Total after-tax liability (with DDTL) = $1000 Tax Reserve = $1060 DTL = $40 (=.4 x ( )) Statement liability = $960 (= ) Post-3855 balance sheet (say asset value is $1150): Asset FV = $1150; Asset TV = $1000 DTL (related to assets) = $60 (=.4 x ( )) Total after-tax liability (with DDTL) = $1150 Tax Reserve = $1060 DTL (related to liabilities) = $-20 (=.4x ( )) Statement liability = $1110 (= )

5 Pre-1996 observations: Total DTL has not changed, and the new timing differences on assets are offset by changed timing differences on liabilities No change to tax cash flows The assets backing the new DDTL are now held at fair value, so the corresponding liability value must reflect this E.g., if using PPM with FV adjustment, must apply (MV/BV) ratio to total liability including DDTL 17 Pre-1996 observations: Equivalently, assets backing the statement liability + DTL are held at fair value DTL balance won t reflect this directly, so the actuarial liability must make up the difference Will be many variations Some back DTL with cash Some use no-tax liability to determine DTL 18 Post-1996 life insurance example: Start with pre-3855 balance sheet: Asset BV(=TV) = $1000 Total liability = Statement liability = $1000 (no DDTL) Tax Reserve = $1000 DTL = $0 Post-3855 balance sheet (say asset value is $1150): Asset FV = $1150; Asset TV = $1000 DTL (related to assets) = $60 (=.4 x ( )) Additional $150 liability is deductible (and increase in asset value is not taxable), so assuming immediate recoverability: Total liability (with DDTL) = $1090 Statement liability = $1030 (= )

6 Post-1996 observations: Gain at transition = $60 for tax benefits CLHIA has proposed spreading this transition impact over time Total future projected income will be reduced as the $60 timing difference is reversed gain at transition is reversed Post-1996 observations: Each period, tax on the change in fair value of assets backing post-1996 liabilities will show up as a gain/loss Change in liability value is deductible while corresponding change in asset value is not taxable Complicated by changing projections of asset values So income will be more volatile, but only because of taxes Issue Deposit Valuation Issue MCCSR Liability value for amounts on deposit has been equal to the account value No longer automatic for deposits where earned rate is paid to policyholders (e.g., dividends on deposit) Liability should be (approximately) statement value of assets if higher than account value Recognizes that all will be paid out, so should be no surplus MCCSR required capital will increase Asset values increasing and liability values increasing Some required capital factors are are a simple percentage of assets or liabilities Some OCI will be Tier 2 instead of Tier 1 capital

7 Issue Dividends Issue Sources of Earnings Policyholder dividends in many countries are set based on book rates of return Book rates of return will no longer be easily available Same problem for setting credited rates of interest on ULtype business SOE analysis is more complex when using market values One solution is to continue SOE analysis on book value basis and add a line for impacts due to MV fluctuations Analysts are beginning to react, and may want additional disclosures Issue Intersegment Trading Issue Hybrid Segments Intersegment trading of assets is done at market value Creates a notional realization of gains/losses for internal reporting Adjustments net to zero for external reporting Too difficult to do this for AFS assets (notional accounting is far more complex with OCI) Hybrid segments containing both AFS and HFT assets will generally be prohibited at Sun Life Accounting is too complex So no mixing of liabilities and surplus, except for immaterial amounts Sun Life solution is to prohibit intersegment trading of AFS assets

8 Issue SOX Compliance Issue AuG43 SOX processes will need to be reviewed for 3855 changes Additional disclosures at transition (e.g., statement of balance sheet changes) may require special SOX controls Additional AuG43 audit requirements coming at the same time Approach to valuation will need to be well documented Issue Disclosure Issue Reporting Changes Disclosure requirements likely to increase Both to OSFI (e.g., to satisfy FVO) and externally Recent analyst report indicated they wanted disclosure of change in policy liabilities caused by changes in interest rates Investment income line of won t be as meaningful as before DCAT SOE EV, VNB Business Plans AAR Notes, MD&A Disclosures

9 Issue - Transition Tax, capital transition rules not yet finalized DNRG balances written off, so never get to report the income on the balance sheet (only for surplus assets) Treatment of deferred unrealized gains on equities still unresolved Change from book to market value booked to retained earnings, not income Except AFS goes to OCI, and later to NI 33 9