Pricing/Valuation Issues Underlying FIAs and ULs (3 presentations) J. Adam Olive, PhD Bryan Pinsky, FSA, CFA Karthik Yadatore, FSA

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1 Pricing/Valuation Issues Underlying FIAs and ULs (3 presentations) J. Adam Olive, PhD Bryan Pinsky, FSA, CFA Karthik Yadatore, FSA

2 Index Annuity Modeling and Design Issues J. Adam Olive, PhD

3 2016 Equity-Based Insurance Guarantees Conference Index Annuity Modeling and Design Issues Dr J Adam Olive MD-MRM, AIG Individual Retirement Products aolive@sunamerica.com Annuities issued by American General Life Insurance Company (AGL), The United States Life Insurance Company in the City of New York (US Life). Guarantees are backed by the claims-paying ability of the issuing insurance company. For Financial Professional use only. Not for public distribution.

4 Topics Index Annuities with LBs vs Index Annuities without LBs Adding living benefits to Index Annuities fundamentally changes their risk characteristics and this has important implications for asset portfolios and pricing. Different methodologies for renewal rate setting (how the cap, spread, participation rate of the index credits are set) over the life of an IA contract lead to very different risk characteristics and to more or less sensitivity to lapse assumptions. Demonstrate these issues by analyzing some example policies in a market consistent hybrid stochastic volatility model. Briefly discuss design and pricing implications. For Financial Professional use only. Not for public distribution. 2

5 IAs with LBs vs IAs without LBs: Lapse Modelling For IAs without LBs dynamic lapse is driven by how the index credits (spreads/caps/participation rates) of the policy compare with those of newly issued policies. By contrast for IAs with LBs the dynamic lapse is driven by the difference between the Present Value of the benefit and surrender value of the contract. PP llllllllll = ff IIIIII tt, tt IIIIII tt = CCCCCC tt PPPPPP tt There is an interaction between lapse and how the index credits are set. For Financial Professional use only. Not for public distribution. 3

6 IAs with LBs vs IAs without LBs: Risk Characteristics Example 10yr Index Annuity with SPX point to point (capped) index crediting. LB Income base rolls 7% and doubles after 10yrs, MAWP 4.25% at 60, 5.0% at 65 & 5.5% at 70 60yr old single male policyholder Index credit parameters set assuming constant option budget. Wait period until withdrawals Effective Duration Convexity Delta No LB yrs yrs yrs For Financial Professional use only. Not for public distribution. 4

7 Impact of different methodologies for setting index crediting parameters :1 Example 10yr Index Annuity with SPX point to point (capped) index crediting. No Living Benefit 60yr old single male policyholder Renewal Rate Setting Strategy Constant Option Budget Effective Duration Convexity Delta Hysteresis New money rate For Financial Professional use only. Not for public distribution. 5

8 Impact of different methodologies for setting index crediting parameters :2 Example 10yr Index Annuity with SPX point to point (capped) index crediting. LB Income base rolls 7% and doubles after 10yrs, MAWP 4.25% at 60, 5.0% at 65 & 5.5% at 70 60yr old single male policyholder, waits 5 yrs before starting withdrawals Renewal Rate Setting Strategy Constant Option Budget Effective Duration Convexity Delta Hysteresis Current Bond yield For Financial Professional use only. Not for public distribution. 6

9 Summary of Design and Pricing Implications Adding a LB to an IA generally extends the liability duration and reduces the required hedging of the index credits. This has important implications for the asset portfolio and how renewal rates should be set compared to how they are set for IAs with no LB. Different renewal rate setting strategies lead to different liability risk profiles, sensitivity to lapse assumptions and asset portfolios. May want to choose a renewal rate setting strategy that minimizes sensitivity to lapse assumptions. Simple index crediting options (ptp with a cap, spread or participation rate) on total return indices make modelling much simpler and faster whilst also making hedging cheaper and easier. For Financial Professional use only. Not for public distribution. 7

10 Tax-qualified contracts such as IRAs, 401(k)s, etc., are tax deferred regardless of whether or not they are funded with an annuity. If you are considering funding a tax-qualified retirement plan with an annuity, you should know that an annuity does not provide any additional tax-deferred treatment of earnings beyond the treatment by the tax-qualified retirement plan itself. However, annuities do provide other features and benefits such as income options. This information is general in nature and may be subject to change. American General Life Insurance Company, The United States Life Insurance Company in the City of New York, their agents and representatives are not authorized to give legal, tax or accounting advice. Applicable laws and regulations are complex and subject to change. Any tax statements in this material are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. For advice concerning your situation, consult your professional attorney, tax advisor or accountant. Annuities are long-term retirement savings vehicles. Withdrawals may reduce benefits and/or contract value; and may be subject to withdrawal or surrender charges, federal and/or state income taxes. A 10% federal early withdrawal tax penalty may apply if taken before age 59½ in addition to ordinary income tax. Index annuities are not a direct investment in the stock market. They are long-term insurance products with guarantees backed by the claims-paying ability of the issuing insurance company. They provide the potential for interest to be credited based in part on the performance of the specified index, without the risk of loss of premium due to market downturns or fluctuations. Index annuities may not be suitable or appropriate for all individuals. Guarantees are backed by the claims-paying ability of the issuing insurance company. Annuities issued by American General Life Insurance Company (AGL) except in New York, where issued by The United States Life Insurance Company in the City of New York (US Life). Issuing companies AGL and US Life are responsible for financial obligations of insurance products and are members of American International Group, Inc. (AIG). American General Life Insurance Company 2727-A Allen Parkway Houston, Texas The United States Life Insurance Company in the City of New York One World Financial Center, 200 Liberty Street New York, New York Products may not be available in all states and product features may vary by state. 8

11 Index Annuity Product Offerings, Design and Pricing Considerations, DOL Bryan Pinsky, FSA, CFA

12 2016 Equity-Based Insurance Guarantees Conference 14 November 2016 ( hours) Index Annuity Product Offerings, Design and Pricing Considerations, DOL Bryan Pinsky SVP, AIG Individual Retirement Products Annuities issued by American General Life Insurance Company (AGL), The United States Life Insurance Company in the City of New York (US Life). Guarantees are backed by the claims-paying ability of the issuing insurance company. For Financial Professional use only. Not for public distribution.

13 Guaranteed Income Levels Annuity Offerings Higher SPIA/DIA Fixed Annuity Index Annuity Variable Annuity Lower Lower Upside Potential, Flexibility, Risk/Profitability Higher For Financial Professional use only. Not for public distribution. 2

14 Index Annuities Accumulation Account Value Protection Broad index and strategy availability for upside opportunity Diverse indices that are hedgeable for insurers Income Accumulation considerations, plus: Guaranteed Income Participating Income Cap and spread structures prevalent For Financial Professional use only. Not for public distribution. 3

15 Design: Key Considerations Balance allocation of cost between client (crediting rate), advisors (compensation), and insurers (profit): challenged in this low rate environment AV protection with reasonable upside opportunity Understandable offering (non-registered) Competitive crediting rates DOL / Reasonable Compensation / Best Interest Client expectations vs. illustrations (compliance with illustration standards) Withdrawals and interest credits: harmonization For Financial Professional use only. Not for public distribution. 4

16 What s Next More Hybrid Indices? Other forms of indices/crediting strategies? Advisory IA solutions Index / Structured Note comparisons For Financial Professional use only. Not for public distribution. 5

17 Pricing: Key Considerations Asset yield / riskiness of general account portfolio Renewal rate strategy Policyholder behavior Current and future hedge availability For Financial Professional use only. Not for public distribution. 6

18 DOL Fiduciary Rule provides an opportunity to enhance consumer awareness of and advisor obligation to present guaranteed income solutions Focused execution on compliance (disclosures, data feeds, etc.) Emerging guidance from distributors for delivery methods and compliance needs Enhanced and ongoing communication with distributors for product needs IMO distribution: Financial Institution role and monitoring duties For Financial Professional use only. Not for public distribution. 7

19 Tax-qualified contracts such as IRAs, 401(k)s, etc., are tax deferred regardless of whether or not they are funded with an annuity. If you are considering funding a tax-qualified retirement plan with an annuity, you should know that an annuity does not provide any additional tax-deferred treatment of earnings beyond the treatment by the tax-qualified retirement plan itself. However, annuities do provide other features and benefits such as income options. This information is general in nature and may be subject to change. American General Life Insurance Company, The United States Life Insurance Company in the City of New York, their agents and representatives are not authorized to give legal, tax or accounting advice. Applicable laws and regulations are complex and subject to change. Any tax statements in this material are not intended to suggest the avoidance of U.S. federal, state or local tax penalties. For advice concerning your situation, consult your professional attorney, tax advisor or accountant. Annuities are long-term retirement savings vehicles. Withdrawals may reduce benefits and/or contract value; and may be subject to withdrawal or surrender charges, federal and/or state income taxes. A 10% federal early withdrawal tax penalty may apply if taken before age 59½ in addition to ordinary income tax. Index annuities are not a direct investment in the stock market. They are long-term insurance products with guarantees backed by the claims-paying ability of the issuing insurance company. They provide the potential for interest to be credited based in part on the performance of the specified index, without the risk of loss of premium due to market downturns or fluctuations. Index annuities may not be suitable or appropriate for all individuals. Guarantees are backed by the claims-paying ability of the issuing insurance company. Annuities issued by American General Life Insurance Company (AGL) except in New York, where issued by The United States Life Insurance Company in the City of New York (US Life). Issuing companies AGL and US Life are responsible for financial obligations of insurance products and are members of American International Group, Inc. (AIG). American General Life Insurance Company 2727-A Allen Parkway Houston, Texas The United States Life Insurance Company in the City of New York One World Financial Center, 200 Liberty Street New York, New York Products may not be available in all states and product features may vary by state. For Financial Professional use only. Not for public distribution. 8

20 Fixed Indexed Annuities and Indexed Universal Life - Survey Karthik Yadatore, FSA

21 Fixed Indexed Annuities - Survey Equity Based Insurance Guarantees Conference - Session 1B Karthik Yadatore November 14, 2016 ( hours)

22 Fixed Indexed Annuity Product Features XXX Single premium products are most common Declared cap rate can be reset annually or guaranteed over a multiyear period Non-forfeiture requirements are similar to declared-rate fixed annuity No SC deduction from account value upon death Nursing home benefits and bail-out features are not uncommon Annuitization option typically available upon surrender or death MVA feature widely prevalen t Sales inducement premium bonus and persistency bonus not uncommon GLWB and GMDB riders may be added to the base product 2

23 Index Annuity Option Types Option Type Description Vanilla Point to Point Can be replicated from European options Exotic Averaging Binary Monthly Cliquet Rainbow Payoff is a function of arithmetic average of daily or monthly index levels during crediting term Payoff is a fixed amount if index increases during year Payoff is a sum of monthly returns of index during crediting term, subject to cap (but no floor) each month Payoff is based on performance of 3 separate indices, typically paying x% of the highest return and y% of the 2 nd highest return 3

24 ($ billions) Fixed Index Annuity Sales Trend Fixed Indexed Annuities (FIA) have been the fastest growing segment in the asset accumulation market. Riders has added has added substantially to the complexity of product pricing and asset liability management (ALM) Variable Indexed % 65% 60% 55% 50% 45% 40% 35% 30% 58% 42% 60% 40% 62% 62% 38% 38% 63% 37% 65% 35% Qualified Non Qualified Sales in $ billions sales are annualized based on 2016 Q2 YTD sales Source: LIMRA 4

25 Milliman FIA Survey Participant Profiles Milliman conducted two surveys Accounting Principles and Reinsurance Survey The survey covering Accounting and Reinsurance had fourteen respondents. Fund Values of the participants ranged from $1 billion to $50 billion. Total Fund Value of the Participants was $156 billion (vs Industry total of $274 billion per LIMRA). All but one company had living benefits inforce in their portfolios Pricing and ALM Survey The Pricing and ALM survey has sixteen respondents The total FIA sales of the respondents were about 50% of all FIA Industry Sales in The portfolios of 75% of the participants had living benefits in force at the time of the survey 5

26 Industry Survey Highlights - Accounting Statutory reserve based on AG33; Index based interest credited in accordance to AG35 SFAS133 requires bifurcation of base contract between host and embedded derivative (ED) Everyone we surveyed use option budget method to calculate VED Contract guarantee value for host calculation is usually the greater of premium inforce and non forfeiture value For SOP03-1, almost an even distribution of companies choosing between stochastic equity, stochastic equity and interest, and deterministic scenarios U.S. GAAP reserves: SFAS133 for base contact, SOP03-1 for GLWB and GMDB Host accretion rate: 71 % of survey participants unlock host accretion rate For the assessment component of SOP03-1 reserve calculation, most companies use revenue only items only. However, using revenue net of expenses is not uncommon April 6,

27 Reserving Methodologies SOP 03-1 was the overwhelming response of participants when asked about reserving methodology for living benefits. Less than one third of the respondents have considered using FAS 157. More than half of the respondents use only revenue items when calculating assessments for SOP 03-1; the remaining use revenue net of expenses. When calculating SOP 03-1 reserves for living benefits, companies used a variety of different approaches for scenarios. Deterministic Scenario, 28% Stochastic Equity Scenarios, 36% Stochastic Interest & Equity Scenarios, 36% 7

28 Reserving Methodologies - Supplemental Benefits In our experience, the addition of nursing home confinement benefits is a relatively recent product development. Historically, a waiver of surrender charge benefit was offered for such confinements. Less than half of the respondents offer living benefit enhancements that are due to nursing home confinement. Very few participants make additional reserving provision for the benefit, using Actuarial Guideline (AG) 33 for statutory and SOP 03-1 for GAAP. 8

29 Earnings Volatility Management Thirty-six percent of the respondents do not use any special techniques to address earnings volatility The following were some techniques used by companies to manage earnings volatility: Changes in VED that are due to interest rates and associated DAC amortization are moved out operational (core) earnings. Above the line (internal reporting) = fund value. Below the line (internal reporting) = FAS 133/157 less Fund Value Volatility that is due to market fluctuations removed and replaced with expected cost of crediting Remove impact of risk-free rates Back out three impacts: Equity market, discount rates, and option budget assumption changes Host interest is presented as part of interest credited. All other FAS 133 amounts are excluded Operating income excludes all capital gains and losses, including the VED and associated hedges 9

30 Industry Survey Highlights - Reinsurance Capital and surplus relief are primary purposes of reinsurance Reinsurance becoming more common Reinsurance primarily driven by presence of GLWBs which lead to onerous statutory reserves Risk relief not a material component of re-insurance plans 10

31 ALM and Risk Management Duration matching is primary goal of ALM Addressing liquidity concerns was another important goal Addressing tailrisk and convexity matching as key consideration of ALM program is not uncommon All companies surveyed hedge index based interest credited Hedging of GLWB is rare, and is limited to Rho hedging 11

32 Prevailing Low Interest Rates About half of the survey respondents have scaled back benefit features in the last 18 months. Majority of participants have made product changes along the lines of the following themes: Regular Credited Rate Updates Lower Spread Requirements Addition of MVA Features Lower Commission Rates Reduce Richness of Benefits Reduce Richness of Bonus Increase Rider Charges Reducing Sales Closing Sales of some Products 12

33 Industry Survey Highlights - Pricing MCVNB or other market consistent techniques not widely used IRR is most A combination of popular choice, cost of capital, acceptable earned rates and range is usually risk free rates between 8 used in product 12% Other popular pricing pricing metrics are profit margin, break-even year, GAAP ROE, stat ROA 13

34 Lapse and GLWB Utilization Assumptions XXX GLWB viewed as a long put while the index based interest crediting is construed as short call Lower the credited rate compared to the competitor rate is assumed to produce higher lapses Higher GLWB ITM is assumed to increase persistency Dynamic lapses reflecting offsetting risk profile most commonly used GLWB utilization assumption usually based on cohort based approach Many assume a portion of population never elects GMWBs GMWBs utilization can be based of ITM, attained age, past withdrawal behavior 14

35 Key Reserve Drivers and Modeling Complexity Key reserve drivers Modeling complexity AG33 SOP03-1 In absence of GLWB, AG33 reserve less than account value and driven by SC schedule In presence of GLWB, reserves can be greater than account value Reserves in excess of account value driven by a combination of: - GLWB base growth basis, ex: rollup rate, roll-up period, reset options - GLWB wait period and withdrawal percent - Presence of GLWB DB benefits - Valuation discount rate Starts at zero and ends at zero; reserve growth pattern is of interest Reserve growth pattern usually a bell shaped curve Reserve pattern driven by emergence of revenue / assessments GLWB benefits determine amount of charges needed for reserving vs. charges that can be realized as profits GLWB benefits is GLWB payments in excess of account value GLWB benefits driven by richness of the GLWB rider, option budget assumption, scenarios used Revenue items include interest credited, surrender charges, GLWB rider charges and other assessments paid out of the account value Reserves be based on the greatest present value of all potential future guaranteed benefits Need to test all possible potential benefit streams including interaction between different benefits AG33 allows for assuming elective benefits incidence rates of 0% or 100% Typically tests the no free partial withdrawal path and full free partial withdrawal scenarios Under each of these scenarios, we test several GLWB election points Max PV can occur in any of the above scenarios Need to have a mechanism to tests several policyholder scenarios simultaneously to calculate reserves Calculation of reserves at future projection periods is effectively inner-loop projections Need ability to calculate option market value via Black-Scholes formula, risk neutral pricing Need ability to solve for option budget if it is not a model input Perform stochastic projections and arrive at average benefits and assessment vectors Need ability to perform inner-loop projection for projecting future reserves 15

36 Milliman UL/IUL Survey Results Equity Based Insurance Guarantees Conference -Session 1B Sue Saip Karthik Yadatore November 14, 2016 ( hours)

37 Milliman UL/IUL Issues Survey Comprehensive survey covering: ULSG, Cash Accumulation UL (AccumUL), Current Assumption UL (CAUL) IULSG, Cash Accumulation IUL (AccumIUL), Current Assumption IUL (CAIUL) Sales by UL/IUL Product Type Profit Measures By Distribution Channel Target Surplus By Issue Age Group Reserves By Premium Type Risk Management By Gender Underwriting By Underwriting Class Product Design By Death Benefit Option Compensation By Underwriting Class Pricing By 7702 Option (CVAT/GPT) Administration With Chronic Illness Riders Illustrations With LTC Riders 17

38 Milliman UL/IUL Issues Survey 35 Participants in the 2015/2016 survey Allianz Global Atlantic New York Life American Family John Hancock Ohio National Americo Kansas City Life Principal Ameriprise Legal & General America Protective Life Ameritas Liberty Mutual Securian AXA Lincoln Financial State Farm Bankers Life MetLife Symetra Columbus Life Midland National Thrivent Financial Equitrust Modern Woodmen of America TIAA-CREF Farm Bureau Mutual of Omaha Voya Financial Foresters National Life Washington National Genworth Nationwide 18

39 Percent of Total Individual UL Sales Percent of Total Individual IUL Sales UL/IUL Sales Summary Sales Mix by Year Universal Life Sales Mix Indexed UL Sales Mix 70% 60% 50% 40% 30% 20% 10% 0% 68% 61% 60% 61% 22% 22% 17% 19% 20% 18% 15% 17% YTD 9/30/15 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 87% 88% 81% 70% 18% 13% 6% 5% 8% 12% 5% 7% YTD 9/30/15 ULSG Cash Accumulation UL Current Assumption UL IULSG Cash Accumulation IUL Current Assumption IUL ULSG dominates Cash Accumulation IUL dominates 19

40 Average Premium Per Policy (1000's) Average Face Amount Per Policy (1000's) UL/IUL Sales Summary IUL Average Amounts Per Policy IUL Weighted Average Premiums Per Policy IUL Weighted Average Face Amount Per Policy YTD 9/30/ YTD 9/30/15 Total Individual IUL IULSG Total Individual IUL IULSG Cash Accumulation IUL Current Assumption IUL Cash Accumulation IUL Current Assumption IUL Highest average => Cash Accumulation IUL Generally higher than UL products Highest average => Cash Accumulation IUL, except IULSG in 2012 Generally higher than UL products 20

41 UL/IUL Sales Summary UL Weighted Average Issue Ages Gender Total Individual Secondary Guarantee Cash Accumulation UL YTD 9/30/15 Weighted Average Age by Premium Current Assumption Male + Female Male Female UL YTD 9/30/15 Weighted Average Age by Face Amount Overall Male Female

42 UL/IUL Sales Summary IUL Weighted Average Issue Ages Gender Total Individual Secondary Guarantee Cash Accumulation IUL YTD 9/30/15 Weighted Average Age by Premium Current Assumption Male + Female Male Female IUL YTD 9/30/15 Weighted Average Age by Face Amount Male + Female Male Female

43 UL/IUL Sales Summary YTD 9/30/15 Distribution by Death Benefit Option UL by Premium UL by Face Amount IUL By Premium IUL by Face Amount 4.8% 0.2% <0.1% 0.8% 4.8% 0.2% <0.1% 0.4% 0.6% 0.4% 35.1% 36.7 % 94.1% 94.6% 64.4% 62.9 % Option A/Option 1 Option B/Option 2 Option C/Option 3 Other Option Can't Categorize 23

44 Milliman UL/IUL Issues Survey Reserves PBR implementation Timing 58% 3-year phase-in period 27% immediately 6% product dependent 9% don t know Rationale for timing primarily based on resources issues, financial impact/cost/benefits, impact on reserves and capital, the need for preparation and research, and competitive reasons 24

45 Milliman UL/IUL Issues Survey Underwriting Table-shaving programs are used by 8 of the 35 participants 18 of the participants use a credit program or other type of program that improves ratings for favorable risk factors Use of supplemental underwriting tools on fully underwritten business: Prescription drug database searches (34) Tele-underwriting/telephonic screening (24) Cognitive impairment testing (22) ADL measures (20) Additional questions on applications (11) 25

46 Milliman UL/IUL Issues Survey Profit Measures Predominant measure is after-tax, after-capital statutory ROI/IRR Median ROI/IRR is 10% for all UL products and IULSG Median ROI/IRR is 12% for AccumIUL and CAIUL For YTD 9/30/15, 61% of participants were short of their profit goals for ULSG, and 73% of participants were at least meeting their profit goals for all other UL/IUL products Primary reasons for not meeting goals were low interest earnings and expenses Target Surplus Majority set pricing assumptions as a percent of the NAIC company action level Ranged from 250% to 450%, with a median of 350% 26

47 Milliman UL/IUL Issues Survey Pricing Secondary Guarantee Products earned rates Item ULSG IULSG New Money vs. Portfolio Crediting Strategy 47% vs. 53% 22% vs. 78% Average Earned Rate: New Money Portfolio 4.39% 4.98% 4.41% 5.44% Change over the prior year (as a % of prior year rate): New Money Portfolio -0.43% -2.26% -0.90% -2.98% 27

48 Milliman UL/IUL Issues Survey Compensation Structures are quite varied among participants 45% that offer multiple UL/IUL products vary commissions and/or marketing allowables by product type, and 55% do not vary them First Year up to target: IUL is 100 to 105% compared to UL s 85 to 95% First Year excess of target: IUL is 3.5% compared to 3.75% + for UL Renewal commission: For IUL, usually is less than 3.5% compared to more than 3.5% for UL 28