Reprt f the American Academy f Actuaries Annuity Reserve Wrk Grup Presented t the Natinal Assciatin f Insurance Cmmissiners Life and Health Actuarial Task Frce Seattle, WA August 2010 The American Academy f Actuaries is a 16,000-member prfessinal assciatin whse missin is t serve the public n behalf f the U.S. actuarial prfessin. The Academy assists public plicymakers n all levels by prviding leadership, bjective expertise, and actuarial advice n risk and financial security issues. The Academy als sets qualificatin, practice, and prfessinalism standards fr actuaries in the United States. Depsit Fund Subgrup f the Annuity Reserve Wrk Grup Kristina L. Kennedy, F.S.A., M.A.A.A., Chair Dnald R. Kruse, F.S.A., M.A.A.A. James W. Lamsn, F.S.A., M.A.A.A. Albert B. Manning, F.S.A., M.A.A.A. Dean M. Miller, F.S.A., M.A.A.A. Keith D. Osinski, F.S.A., M.A.A.A. William M. Sayre, F.S.A., M.A.A.A. Jared T. Schlten, A.S.A., C.E.R.A., M.A.A.A. Charles J. Suza, C.E.R.A., F.S.A., M.A.A.A. Michael C. Ward, F.S.A., M.A.A.A. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 1
TABLE OF CONTENTS I. Backgrund II. Overview f the Apprach t Statutry Valuatin f Depsit Fund Cntracts III. Guiding Cnsideratins IV. Methdlgy Cnsideratins V. Stchastic Simulatin Cnsideratins 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 2
I. Backgrund In 2009, the Life Health and Actuarial Task Frce (LHATF) f the Natinal Assciatin f Insurance Cmmissiners (NAIC) requested that the Annuity Reserve Wrking Grup (ARWG) f the American Academy f Actuaries (Academy) recmmend a valuatin methdlgy fr depsit fund cntracts that addresses the risks underlying the cntracts and the insurer s administratin f them. The ARWG initially gathered current requirements fr depsit fund cntracts, learned abut the types f prducts and their risk prfile and decided t frm a smaller grup t develp the recmmendatin. In April 2010, a subgrup f the ARWG, the Depsit Fund Subgrup, was frmed t develp a recmmendatin. Examples f depsit fund cntracts include: Guaranteed Interest Cntracts (GIC) Synthetic GICs Premium Depsit Funds Guaranteed Separate Accunt Grup Annuities Certain Dividend Accumulatins Cntracts Funding Agreements Supplemental Cntracts Lttery Payuts Grup Annuity purchased under a retirement plan In frming the recmmendatin, the grup primarily fcused n GICs, funding agreements, guaranteed separate accunt grup cntracts, and synthetic GICs. The purpse f this dcument is t prvide LHATF with an verview f the directin the Depsit Fund Subgrup f the ARWG is taking regarding develpment f recmmendatins t LHATF fr the statutry valuatin f depsit fund cntracts in a principle-based envirnment. The Subgrup is seeking feedback frm LHATF n this directin. While the Subgrup is aware f the need t ultimately address the subject f a reserve that may serve as a tax reserve as well as a reserve t be used by the regulatr t cmpare results n a cnsistent basis fr depsit fund cntracts, this reprt deals slely with suggestins fr a high level directin fr develpment f statutry reserves as nted abve and may need t be mdified nce taxes are cnsidered. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 3
II. Overview f the Apprach t Statutry Valuatin f Depsit Fund Cntracts The Depsit Fund Subgrup f the ARWG has cmpleted a preliminary analysis f valuatin methdlgies fr depsit fund cntracts. As a result f the analysis, the subgrup recmmends a principle-based apprach t the statutry valuatin f depsit fund cntracts where the cmpany is respnsible fr the fllwing: Determining the apprpriate valuatin methdlgy based n the risk prfile f each depsit fund prduct; Utilizing Guiding Cnsideratins (see sectin III) in determining the apprpriate valuatin methdlgy; and Preparing dcumentatin t supprt the valuatin methdlgy utilized fr the prduct and f the resulting reserve determinatin. Within the cntext f this reprt, it is assumed that the actuary f the cmpany will be acting n behalf f the cmpany and thus perfrming the functins and bearing the respnsibility fr making actuarial judgments. As such, this reprt addresses thse respnsibilities as if they were thse f the actuary. The valuatin methdlgy selected by the actuary fr a given prduct culd be slely f a deterministic nature, a deterministic apprach that als invlves stress testing, r ne invlving stchastic simulatins in sme manner. In evaluating the risk prfile f a depsit fund prduct, the actuary shuld cnsider the prduct s features as well as hw the cmpany manages the risks assciated with the prduct. This recmmendatin is based n a belief that n single methdlgy wuld be apprpriate t impse n particular classes f business in scpe due t the changing nature f the prducts ffered in the GIC and Funding Agreement marketplace and the wide range f risks accepted by insurers, frm very minimal t ptentially significant. Because f this diversity, we think it is apprpriate fr LHATF t rely n applicatin f the judgment f the actuary as applied t an analysis f the specific risks inherent in the cmpany s business. This apprach t the statutry valuatin f depsit fund cntracts is recmmended t be applicable t plicies issued n r after the perative date f the valuatin manual. Hwever, we suggest that LHATF cnsider pssible mdificatins t the existing statutry requirements applicable t business in frce as well. The Depsit Funds Subgrup stands ready t assist LHATF in investigating the need fr, and nature f, any such mdificatins. Refer t sectin IV fr suggested mdificatins. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 4
III. Guiding Cnsideratins In determining the apprpriate valuatin methdlgy fr a depsit fund prduct, the actuary shuld cnsider, at a minimum, each f the fllwing: Prduct classificatin Cntract cntains guaranteed elements unable t fully pass unfavrable experience t plicyhlder Cntract cntains nn-guaranteed elements ability t fully pass unfavrable experience t plicyhlder Cntract cntains guaranteed elements and nn-guaranteed elements Types f guarantees prvided in the prduct Guarantee f interest Length f guarantee Guarantee f benefits Freign-currency based guarantee Annuity purchase rate guarantee Any ther guarantee Types f discretinary plicyhlder withdrawal prvisins Nt available Subject t market value adjustment At bk value subject t minimum ntice perid At bk value At market value Types f nn-plicyhlder (i.e., plan participant) withdrawal prvisins Nt available Subject t market value adjustment At bk value At market value Respnsibility fr lsses, if any, assciated with bk value withdrawals Insurance Cmpany Plicyhlder Use f cntractual prvisins t reduce interest rate risk Assciated with cash flws int the prduct Assciated with cash flws ut f the prduct Existence f investment plicy statement r guidelines and peridic review f investment guideline cmpliance Asset Adequacy Analysis methd utilized t demnstrate reserve adequacy Existence and efficacy f a clearly defined risk management plan t manage the interest rate risk, credit risk, mrtality risk and freign currency risk assciated with the prduct and peridic reprting t cmpany management t demnstrate the effectiveness f the risk management plan. Further, the dcumentatin prepared by the actuary t supprt the valuatin methdlgy shuld address each Guiding Cnsideratin and dcument the extent t which each either applies r des nt apply and fr thse that apply, hw the chsen methdlgy may address them. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 5
IV. Methdlgy Cnsideratins While the actuary wuld have the respnsibility t determine the apprpriate reserve methdlgy based n the risk prfile f the prduct, a pssible starting pint fr cnstructing a reserve methdlgy f a deterministic nature culd be derived frm the fllwing summary f existing regulatins as applicable t depsit fund cntracts: Prduct Type General Accunt Prducts Synthetic GIC Guaranteed Separate Accunt Existing Regulatin NAIC Standard Valuatin Law NAIC Mdel Law Appendix A-695 f the APPM NY Regulatin 128 CA Bulletin 95-10 NE Title 210 Chapter 80 NAIC Mdel Law Appendix A-200 f the APPM NY Regulatin 128 CA Bulletin 95-8 With respect t general accunt prducts, the NAIC Standard Valuatin Law prvides a fundamental framewrk fr the actuary t cnsider as the basis fr cnstructing a deterministic reserve methdlgy. With respect t Synthetic GICs and Guaranteed Separate Accunts, revisins t the existing statutry requirements may merit cnsideratin under a principle-based apprach t valuatin and perhaps t business in frce, as well. They include: Pssible eliminatin f the asset haircut based n AVR factrs resulting in a cmparisn f the market value f the assets t the value f the guaranteed cntract liabilities. The asset haircut may be redundant when the market value f assets is used t determine asset maintenance requirements. Further, fr prducts with interest rate reset frmulas, the insurance cmpany is able t pass unfavrable credit lsses thrugh t the plicyhlder and this shuld perhaps be taken int cnsideratin. Cnsider changing the liability discunt rate frm a functin f the U.S. Treasury rate t a rate that crrespnds with the underlying asset prtfli r a benchmark index assciated with the investment plicy statement r guideline f the prduct/cntract. The existing liability discunt rate f 105% f the U.S. Treasury rate (r 104.5% f the U.S. Treasury rate in New Yrk) may bear little relatinship t the yield n the prtfli f assets r target prtfli f assets supprting the prduct and t credit spreads, especially during perids such as year-ends 2008 and 2009 when the Treasury yields were s very lw. Recnsider fee-based reserves. A fee-based reserve des nt bear a direct relatinship t the underlying risk. The same amunt is held regardless f asset quality, crediting rate strategy, liability cash flws, etc. The fee-based reserve grws in gd ecnmic envirnments and may nt be adequate in mderately adverse envirnments.. Thus, with certain mdificatins as nted t the existing regulatins fr Synthetic GICs and Guaranteed Separate Accunts, we believe the actuary culd have a gd fundamental framewrk t cnsider in cnstructing a reserve methdlgy f a deterministic nature. Hwever, mre research int the abve three 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 6
pssible mdificatins shuld be perfrmed if LHATF believes it wuld be prper t pursue these suggestins; the Depsit Funds Subgrup stands ready t assist LHATF in this endeavr. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 7
V. Stchastic Simulatin Cnsideratins Shuld the actuary cnclude that stchastic simulatins be used in develping the statutry reserve fr a particular depsit fund cntract (r grups f cntracts), the fllwing guiding cnsideratins shuld be taken int accunt when develping and using the cash flw mdel and when develping the stchastic reserve cmpnent. A general bjective is t be cnsistent with VM-20, where applicable, and with VM-22 when cmpleted. Cash Flw Mdels The cash flw prjectin mdel shuld cmply with applicable Actuarial Standards f Practice regarding the develpment f cash flw mdels and the prjectin f cash flws Prjectin mdels shuld reflect All significant prduct risks All material benefits, charges, and expenses Nnguaranteed elements, if any Interactin f assumptins (e.g., dynamic liability behavir) The Prjectin perid shuld be sufficiently lng that n materially greater reserve amunt wuld result frm a lnger prjectin perid. Certain types f depsit fund cntracts are evergreen in nature, s the guidance in VM-20 t prject cash flws fr a perid that extends far enugh int the future s that n bligatins remain is nt apprpriate. The justificatin fr any liability mdel pint r mdel cell grupings, as well as any significant apprximatins used in the mdel, shuld be given in the PBR Actuarial Reprt r in the supplemental reprts required under VM-31. The mdel shuld be validated using back-testing r anther apprpriate methd. Asset mdels Althugh sme depsit fund cntracts have specified investment prtflis and many cmpanies emply segmented r segregated prtflis, the actuary may need t segment assets fr mdeling purpses if neither exists. If s, guidance frm surces such as VM- 20, VM-22, and VM-30 shuld be fllwed. Asset mdels shuld reflect characteristics f any asset segments that back the prduct (either specifically r ntinally), including ptinality such as put r call ptins and prepayment. Asset mdels shuld reflect the investment accunt basis f the particular depsit fund cntract being mdeled. Fr example, it may be apprpriate fr sme types f cntracts t base the analysis n the market value f assets, which is smewhat f a departure frm the treatment f a typical GA annuity cntract subject t VM-22. Thus, if the statement value f the assets is bk value, then prjected bk values shuld be mdeled (and ptentially market value as well). Likewise if market value is the statement value, then prjected market values shuld be mdeled. If derivatives are used as part f the investment r risk management strategy, they shuld be reflected in the mdel. Requirements will be similar t VM-20 and VM-22, including the cncept f a Clearly Defined Hedging Strategy 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 8
Assumptins Certain types f depsit fund cntracts invlve multiple parties, sme cntractual and sme nt, the behavir f which can affect cash flws. The rights f the varius parties (e.g., plan participants) shuld be cnsidered when setting assumptins and develping the mdel. Reserves based n stchastic simulatins shuld use Prudent Estimate Assumptins fr nnmdeled risk factrs. Investment assumptins relating t reinvestment and disinvestment shuld reflect: Any cntractual investment plicy guidelines Any cmpany investment plicy guidelines fr the cntract r segment The cmpany s A/L strategy fr the segment Dynamic assumptins shuld be used where apprpriate. Aggregatin Decisins regarding the level f aggregatin may be required in three different cntexts: aggregatin f GA and SA cash flws fr a prduct within a mdel, aggregatin f prducts and cntracts within a mdel, and aggregatin fr the purpse f calculating the resulting reserve. Within the prjectin mdel, GA and SA cash flws may need t be aggregated in rder t develp the crrect GA reserve. Fr instance, this can arise fr a depsit fund cntract that prvides a guarantee f SA perfrmance thrugh the GA. This wuld be highly similar t the mdeling f a variable annuity with a guaranteed minimum benefit under AG43. Ultimately, the actuary will need t make certain decisins based n the nature f the liabilities and any future rules and regulatins regarding blue/green bk accunting and reprting. Aggregatin with ther depsit fund cntracts wuld be at the actuary s discretin, depending n the facts and circumstances. Existing practice regarding aggregatin in asset adequacy analysis and/r C-3 Phase I RBC culd be cnsidered, as well as hw the cmpany manages and measures the prfitability f the prducts. Aggregatin f depsit fund cntracts with ther GA liabilities (perhaps thse subject t VM-22) wuld be at the actuary s discretin, depending n the facts and circumstances. Existing practice regarding aggregatin in asset adequacy analysis and/r C-3 Phase I RBC culd be cnsidered, as well as hw the cmpany manages and measures the prfitability f the prducts. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 9
Reprting Guidance We recgnize that sme guidance may be needed in terms f allcating any stchastically derived reserve amunts. We are unsure whether this will be cvered elsewhere in the Valuatin Manual, but prvide sme preliminary thughts here. Allcatin f the reserve between GA and SA This may depend n whether the depsit fund cntract is an insulated r nn-insulated prduct. Fr mst depsit fund cntracts invlving bth the GA and SA, we envisage fllwing a practice similar t AG43/VM-21. Fr example, the fund balance wuld nrmally be held in the SA, with any reserve in excess f this amunt held in the GA. Allcatin f reserve amunts between different sectins f the (GA) blue bk (e.g., Exhibits 5 and 7) The need fr allcatin within and amng the varius blue bk exhibits will largely depend n the actuary s chsen apprach t aggregatin fr mdeling and reserve calculatin purpses. This will be at the discretin f the actuary, with pssible guidance fund in VM-20 and VM-22. Stchastic Scenaris and Ecnmic Assumptins Lking acrss the universe f depsit fund cntracts, sme may nly require Treasury interest rate scenaris, whereas sme may require LIBOR/swap rates, and sme may require equity scenaris as well. Treasury rates wuld be based n Academy scenaris, r, if ultimately allwed under PBR, cmpany-develped scenaris that meet calibratin criteria. Equity grwth wuld als be based n Academy scenaris, r, if allwed, cmpanydevelped scenaris that meet calibratin criteria. The actuary may need t cnsider develping LIBOR rates cnsistent with existing scenaris (e.g., as a functin f Treasury rates) r using cmpany-develped scenaris. Assumptins regarding asset credit spreads and defaults shuld be based n Prudent Estimate Assumptins. Reserves Based n Stchastic Simulatins Due t the varying nature f depsit fund cntracts, ne cannt prvide singular r abslute guidance in regard t the chice f starting assets fr a stchastic mdel. Fr sme depsit fund cntracts (r grups f cntracts), such as an immediate annuity certain, the actuary shuld select starting assets such that the aggregate value f the assets at the prjectin start date equals the estimated value f the reserve fr the cntract (r cntracts). Fr ther depsit fund cntracts, such as a synthetic GIC, the actuary may need t prject starting assets supprting bth the estimated value f the reserve and starting assets assciated with the ff balance sheet funds. Similar t VM-20 and VM-22, reserves wuld be based n the GPVAD measure, Scenari Amunts, and CTE 70. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 10
The actuary may add an additinal amunt t CTE 70 t capture any material risk included in the scpe f these requirements but nt already reflected in the cash flw mdels using an apprpriate and supprtable methd and supprting ratinale. Reserves are determined n a pretax basis, s cash flws and discunt rates wuld be pretax (cnsistent with VM-20, AG43/VM-21, and VM-22). Use f prir perid data shuld be acceptable (e.g., September 30th), with adjustment t reprting date. Dcumentatin The actuary shuld develp a reprt (memrandum) dcumenting results, methdlgies, prcesses, and assumptins. 1850 M Street NW Suite 300 Washingtn, DC 20036 Telephne 202 223 8196 Facsimile 202 872 1948 www.actuary.rg 11