current issues in stochastic modeling of segregated fund guarantee products michael bean fcas, fsa,...

Current Issues in Stochastic Modeling of Segregated Fund Guarantee Products

Michael Bean FCAS, FSA, FCIA

Director, Capital Division

Seminar for the Appointed Actuary

September 22, 2006

Outline of Presentation

• Context• Rationale for review• Key issues

– Summary– Discussion

• Update of hedging guidelines• Conclusion

Context

Context

• Segregated fund guarantee liability and capital requirements currently based on:

– Stochastic framework developed by CIA Task Force on Segregated Fund Investment Guarantees

• OSFI has identified a number of issues with the current framework that need to be addressed

Context

• OSFI document describing key issues recently sent to:

– CIA Actuarial Standards Board– CIA Practice Council

• OSFI has requested that the CIA:– Review the document– Provide initial views on priorities, project

plans and timelines for addressing the issues identified

Context

• Purpose of this presentation:– Highlight the key issues– Initiate discussion of the issues with the

wider actuarial community

Rationale for Review


• Over 5 years since the work of the CIA Task Force was completed

• Many significant changes in the industry and marketplace since then


• Significant changes:– Demutualization and consolidation– Greater interest in reported financials

and methods used to determine them– Development and growth of new

products– Foreign expansion– Serious interest in implementing

sophisticated hedging strategies


• Much experience with segregated fund models has been gained over the past few years

• This experience has revealed a number of potential shortcomings with the current framework

Key Issues

Key Issues: Summary

1. Asset model calibration

2. Premiums allowable as offsets

3. Bond fund and fixed income modeling

4. Modeling of foreign indexes and currency risk in foreign & domestic subsidiaries

Key Issues: Summary

5. Discount rates & assets backing the guarantees

6. Surrenders, resets & fund transfers

7. Contract aging & market-based valuation

8. Contract grouping

Issue #1:Asset Model Calibration

Issue #1: Asset Model Calibration

• Issue:– No calibration requirements for right tail

of asset return distributions

– No calibration of scenarios actually used in the valuation (only model is tested)

– No explicit calibration requirements for indexes of different types (e.g., equity v. bond v. real estate, Canada v. US v. Asia, large v. mid v. small cap)

Issue #1:Asset Model Calibration

• Why this is an issue:– New product designs (e.g., embedded

options of call type)

– Material exposures to foreign equity and bond markets, and currency risk

– Sophisticated hedging strategies

Issue #2:Premiums Allowable as Offsets

Issue #2: Premiums Allowable as Offsets

• Issue:– Amounts of future guarantee premium

allowable as offsets to future benefit payments not defined with sufficient precision

– Possibility of insufficient resources to fund benefit payments as they come due if premiums collected after a benefit payment date are allowed to offset that benefit payment


• Why this is an issue:– Sophisticated hedging programs require

the portion of MER considered guarantee premium to be fixed

– Peculiarities of segregated fund contract design


• Peculiarities of seg fund products:– Individual contracts can have multiple

benefit payments

– Premium amounts collected after a benefit payment often exceed the size of such a payment (even with discounting)

– Premiums collected over the life of a contract can vary inversely with the level of risk

Issue #2: Premiums Allowable as Offset

• Basic requirement:– At given confidence level, must be

sufficient assets to fund all future benefit payments as they come due

• Applies to:– Individual contracts– Portfolios of contracts with different

maturity-renewal dates

Issue #3:Bond Fund & Fixed Income Modeling

Issue #3: Bond Fund & Fixed Income Modeling

• Issue:– No guidance on stochastic modeling of

bond funds or interest rates


• Why this is an issue:– Material fixed income exposures (e.g.,

Hong Kong Mandatory Provident Fund)

– Dynamic hedging requires interest rate scenarios

– Standard equity models not really appropriate for bonds


• Additional considerations:– Equity-interest rate correlation

– Consistency with yield environment present on valuation date

– Bond funds of different durations consistent with one another

Issue #4:Modeling of Foreign Indexes & Currency Risk in Foreign & Domestic Subs

Issue #4: Foreign Indexes & Currency Risk

• Issue:– Insufficient guidance on modeling of

foreign indexes in either foreign or domestic subs

– Insufficient guidance on modeling of currency risk, whether hedged or unhedged

– Task Force Report silent on currency risk modeling & cost of currency hedging


• Why this is an issue:– Segregated fund guarantee risk

exposures in foreign (e.g., Asian) subs now material

– Asian markets are different:• Models that work well for Canada &

US may not be appropriate


• Why this is an issue:– Asian subs have more currency risk:

• Exposure to US markets• Greater fluctuation of US dollar vis-à-

vis yen, euro, etc

– Currency hedging embedded in some products

• Need to model interest rate spreads

Issue #5:Discount Rates & Assets Backing the Guarantees

Issue #5: Discount Rates, etc

• Issue:– Insufficient guidance on discount rates to

be used

– No explicit link between discount rates and assets backing unhedged portion of liabilities and capital, or recognition of asset-liability mismatch

– No explicit link between discount rate and DAC earnings rate (when applicable)


• Implicit assumptions in liability and capital calculation:– General account assets backing

unhedged portion of liabilities and capital are risk-free

– General account assets able to grow at rates used to discount future benefits and premiums


• Implicit assumptions cont’d:– General account assets …

• when combined with future premiums and investment income

• are sufficient to fund future benefit payments as they come due

• about 98% of the time

(assumes CTE 95 corresponds to 98th percentile)


• Implications:– Discount rates consistent with yield

environment on valuation date

– Asset and liability cash flows “matched” (or provision for asset-liability mismatch added to liability and capital)

– Consistency of discount rate and DAC earnings rate when assets backing liabilities and capital “invested” in DAC


• Comments on asset-liability mismatch:– Current guidance does not preclude a

company from backing a put-type segregated fund guarantee with equities

– Significant mismatch possible even if assets invested in “risk-free” bonds (e.g., 30-year bonds backing 2-year liability)

Issue #6:Surrenders, Resets & Fund Transfers

Issue #6: Surrenders, Resets & Fund Transfers

• Issue:– Insufficient guidance on modeling of

surrenders, resets and fund transfers

– Interrelationships among these options not recognized

– In seg funds, surrender, reset and fund transfer are actually financial options


• Surrender:– Option to avoid making any future

premium payments when value of the embedded guarantee turns out to be low

• Reset:– Option to lock in gains– Equivalently: surrender without penalty

and reinvest in identical contract without sales commission


• Fund transfer:– Option to change risk profile of

underlying assets to the advantage of the policyholder

• Partial surrender:– Option to lock in a portion of gains

without invoking a reset


• Peculiarities of seg fund contracts that make these options valuable:– Premium paid over life of contract, not

up-front

– Premium varies with account balance

– Premium collected varies inversely with risk (put-type guarantees)

– Guarantee applies to account balance, not individual fund balances


• Partial surrender example:– Suppose AV = $200, GV = $100 and

guarantee values adjusted proportionately for withdrawals

– Suppose $80 is withdrawn and put into a risk-free savings account

– Effective guarantee after withdrawal is $140 ($80 + 60% of $100)

Issue #7:Contract Aging & Market-Based Valuation

Issue #7: Contract Aging & Market-Based Valuation

• Issue:– No mechanism to ensure consistency

with market valuation as:

• Contracts move closer to maturity and the embedded options become more similar to market-traded options

• Companies implement sophisticated risk management strategies like dynamic hedging


• Background:– Current framework uses real-world

rather than market-based (i.e., risk-neutral) valuation techniques

– Supporting argument:• If a company is not hedging the risk,

what matters is whether it has sufficient assets to fund guarantees in all but the most catastrophic market scenarios


• However, what happens when:

– A market for long-dated options emerges?

– The embedded options become short-dated options, comparable to market-traded options?

– Companies implement dynamic hedging, which is based on market valuations?


• Areas of particular concern:– Market-based values greater than

current approach (e.g., low risk-free rates, high implied volatilities, etc)

– Risk management strategies that transform a seg fund liability from one form to another and in so doing use actuarial valuation for a security that has an observable market value


• Areas of particular concern cont’d:– Inconsistencies between actuarial and

market-based valuation exploited to arbitrage capital requirements

Issue #8:Contract Grouping

Issue #8: Contract Grouping

• Issue:– Insufficient guidance on contract

grouping

– Simple validation tests (e.g., point-in-time matching values) insufficient

– Better grouping algorithms needed for dynamic hedging


• Why this is an issue:– Seg fund guarantee liabilities and capital

highly sensitive to changes in account value, interest rates and time to maturity

– Dynamic hedging requires accurate information on sensitivity to AV/GV, interest rates, time to maturity, volatility, etc to determine hedge parameters and implement an effective hedge


• Consequence:– Grouping algorithm needs to ensure that

synthetic and seriatim portfolios have similar sensitivities to AV/GV, interest rates, time to maturity, etc

– Small differences in sensitivities can result in large differences in liability and capital values, large tracking errors and ineffective hedges

– Point-in-time value matching insufficient!


• Important comment:– Ultimate test of any hedging program is

whether it mitigates the risk in the actual seriatim portfolio, not some synthetic proxy

Update of Hedging Guidelines


• Until a review of the stochastic modeling framework is completed and any deficiencies addressed, OSFI does not intend to:

– Update its general guidelines for hedging segregated fund guarantee risk

– Consider capital credit for anything other than the simplest hedges


• Important Note:– Hedging strategies that appear to

mitigate risk within the current framework may introduce additional risk when viewed in true economic terms

– A company implementing such a strategy may be required to hold additional capital, whether or not capital credit for the hedging strategy was requested

Conclusions

Conclusions

• OSFI has identified 8 key issues in the current segregated fund guarantee valuation framework that need to be addressed

• Important that these issues be resolved in a timely fashion

Questions?

current issues in stochastic modeling of segregated fund guarantee products michael bean fcas, fsa,...

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