Canadian Life Insurance Company Asset/Liability Management Summary Report as at: 31-Jan-08 interest rates as of: 29-Feb-08 Run: 2-Apr-08 20:07 Book

Transcription

1 Canadian Life Insurance Company Asset/Liability Management Summary Report as at: 31Jan08 interest rates as of: 29Feb08 Run: 2Apr08 20:07 Book Book Present Modified Effective Projected change in net present value Value Yield Value Duration Convexity shift up shift down short up short down long up long down ($ million) 1% 1% 1% 1% 1% 1% Participating Life Net Assets , liabilities as of: 31Dec07 Total Liabilities (975) (1,077) Net economic value, April 2 interest rates: (1) (0) (2) 1 Change in economic value due to interest rates; 0 Traditional Non Par Life Net Assets (0.15) 5 liabilities as of: 31Dec07 Total Liabilities (581) (601) Net economic value, April 2 interest rates: Change in economic value due to interest rates: 6 11 (24) (2) (29) 14 Universal Life Net Assets liabilities as of: 31Dec07 Intersegment Notes (160) (163) Linked Account Assets Total Liabilities (1,181) (1,150) Net economic value, April 2 interest rates: (24.70) 27 (38) (15) (63) Change in economic value due to interest rates: (10) Annuities Net Assets liabilities as of: 31Dec07 Total Liabilities (934) (939) Net economic value, April 2 interest rates: (1) 1 (0) 0 (1) 1 Change in economic value due to interest rates: 0 Surplus Net Assets Total Liabilities (6) (6) Net economic value, April 2 interes (13) 14 (10) 10 (3) 3 Change in economic value due to interest rates: 4 Combined Total Assets 4, , Liabilities (3,677) (3,773) Net Economic Value Total: (12) (12) (20) 33 8 (44) Change 1 Business Lines: 1 (25) (10) (48) Business lines excluding Par Life: 3 (26) (11) (49)

2 Life Insurance of Canada Total Company Projections as of: 31Jan08 Interest rates as of: 29Feb08 31Mar08 20:08 Book Book Present Modified Effective Value Yield Value Duration Convexity MCCSR ('000) ('000) ('000) Cash/Shortterm % Gov't of Canada % InterSegment Notes Bought % InterSegment Notes Sold (306) (311) (7.4%) Provincial AAA % Provincial AA 1, , % Provincial A % Municipal AAA % Municipal AA % Municipal A Municipal BBB % Corporate AAA % Corporate AA % Corporate A % Corporate BBB % Preferred Shares P % Preferred Shares P2 CMHC MBS % Equities % Residential Mortgages % Commercial Mortgages % Misc Assets % Swaps receive fixed Swaps net pay floating Accrued Interest % Policy Loans % Real Estate % UL Linked Account Assets % Future expenses (100) Net Assets 4, , %... Policyholder Account Liabilities (1,010) 30 (1,011) Accrued Liabilities/Payables (4) (4) Actuarial Reserves (2,523) 31 (2,593) Other Actuarial Liabilities (79) (70) Dividend Provision (20) (20) Future Tax Liability (85) (65) Deferred Tax Adjustment 53 (2) Other Liabilities (8) (8) Equity of subsidiary policyholders Total Liabilities (3,677) (3,773) Net, 31Jan

3 spot rates year 28Sep07 31Dec07 change 29Feb08 change (0.24) 3.00 (0.82) (0.35) 2.93 (0.91) (0.35) 2.98 (0.85) (0.33) 3.07 (0.78) (0.32) 3.18 (0.70) (0.33) 3.29 (0.61) (0.34) 3.40 (0.52) (0.34) 3.51 (0.44) (0.34) 3.62 (0.36) (0.34) 3.73 (0.28) (0.34) 3.83 (0.21) (0.34) 3.93 (0.14) (0.34) 4.02 (0.08) (0.34) 4.10 (0.03) (0.34) (0.33) (0.33) (0.33) (0.33) (0.33) (0.33) (0.34) (0.34) (0.35) (0.35) (0.36) (0.36) (0.36) (0.35) (0.33) Canadian Life Insurance Company RiskFree Spot Interest Rates 28Sep07 31Dec07 29Feb term (years) 34

4 Canadian Life Insurance Company Participating Life Projections as of: 28Sep07 Interest rates as of: 31Dec07 Liability data as of: 31Dec07 Book Book Present Modified Modified 35 Value Yield Value Duration Convexity MCCSR Cash/Shortterm % Government of Canada % Provincial AAA % Provincial AA % Provincial A % Municipal AAA % Municipal AA % Municipal A Corporate AAA % Corporate AA % Corporate A % Corporate BBB % Preferred Shares P % Preferred Shares P2 Residential Mortgages % Commercial Mortgages % Common Equities % Real Estate % Policy Loans % Accrued Interest 8 0.9% Investment expenses (22) Net Assets , % Premiums (36.2%) Benefits (1,086) % Ceded Premiums (68) % Ceded Benefits (7.8%) Commissions (6) % Expenses (99) % Ceded Expenses (0.5%) Premium Taxes (12) % Investment Inc. Tax (38) % Dividends (126) % Actuarial Liabilities (880) 36 (955) % Other Reserves (51) (51) % Total Reserves (931) (1,006) % Future Tax Liability (50) (50) % Dividend Provision (20) (20) 1.9% Deferred Tax Adjustment 27 Total Liabilities (975) (1,077) % Net economic value, March 25 interest rates: (6.64) 15 Net economic value, April 2 interest rates: (6.72) 15 Change in economic value due to interest rates; 0 ALM scenario results change in net economic value: Parallel shift, rates + 1.0% (1) Parallel shift, rates 1.0% 1 Curve tilt, short rates + 1.0% 0 Curve tilt, short rates 1.0% (0) Curve tilt, long rates + 1.0% (2) Curve tilt, long rates 1.0% 1 Reserve estimates using LSOP Scenarios: 39 Base 821 Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario 7 785

5 Par Life 1.5 Key Rate Sensitivity 40 Change In Net Position ($million) per.01% Increase in Rate (0.5) (1.0) Term Years Asset/Liability Cash Flows by Month ($million) 41 (1) Dec07 Dec17 Dec27 Dec37 Dec47 Dec57 Dec Net (left axis) & Cumulative (right axis) Cash Flows by Year ($million) (2) (5) (4) (10)

6 Canadian Life Insurance Company Non Par Life Projections as of: 28Sep07 Interest rates as of: 31Dec07 Liability data as of: 31Dec07 Book Book Present Modified Modified Value Yield Value Duration Convexity MCCSR Cash/Shortterm % Gov't of Canada Provincial AA % Provincial A % Municipal AAA Municipal AA % Municipal A Corporate AAA Corporate AA % Corporate A % Common Equities % Real Estate Policy Loans % Accrued Interest Investment expenses (36.41) InterSegment Notes (146) (148.43) (25.1%) Net Assets (0.152) % Premiums 1, %) Benefits (3,001) % Ceded Premiums (1,188) % Ceded Benefits 1, %) Commissions (45) % Expenses (111) % Ceded Expenses %) Premium Taxes (13) (0.668) 2.1% IIT (59) % Actuarial Liabilities (555) (578) % Other Reserves (18) (9) 1.5% Total Reserves (573) (587) % Deferred Tax Adjustment 28 Future Tax Liability (35) (15) % Total Liabilities (581) (601) % Net economic value, March 25 interest rates: (29.77) 4 Net economic value, April 2 interest rates: (30.62) 44 4 Change in economic value due to interest rates: 6 ALM scenario results change in net economic value: Parallel shift, rates + 1.0% (24) Parallel shift, rates 1.0% 11 Curve tilt, short rates + 1.0% 5 Curve tilt, short rates 1.0% (2) Curve tilt, long rates + 1.0% (29) 45 Curve tilt, long rates 1.0% 14 Reserve estimates using LSOP Scenarios: Base 558 Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario 7 501

7 Non Par Life Key Rate Sensitivity Change In Net Position ('000) per.01% Increase in Rate Term Years Asset/Liability Cash Flows by Month ($million) (5) (10) Dec07 Dec17 Dec27 Dec37 Dec47 Dec57 Dec67 Net (left axis) & Cumulative (right axis) Cash Flows by Year ($million) (5) (30) (15) (90)

8 Canadian Life Insurance Company Universal Life ALM Report Projections as of: 28Sep07 Interest rates as of: 31Dec07 Liability data as of: 31Dec07 Book Book Present Effective Effective MCCSR Value Yield Value Duration Convexity Cash/Shortterm % Canada Bonds Provincial AAA Provincial AA % Provincial A % Corporate AAA % Corporate AA % Corporate A % Corporate BBB % Common Equities % Real Estate % Fixedrate Policy Loans Variablerate Policy Loans % Accrued interest 0 0.0% Other Assets % Investment Expenses (27) Non Policyholder Fund Assets % Intersegment Notes (160) (163) (13.6%) Externally managed equity % Internally managed equity % Externally managed fixed income % Externally managed balanced % Linked Account Assets % Total Assets 1,181 1, % Term GICs (112) (113) Variable Interest Deposits (51) (51) Fund #1 (23) (23) Fund #2 (92) (92) Fund #3 (500) (500) Fund #4 (122) (122) Fund #5 (23) (23) 46 Fund #6 (16) (16) Fund #7 (12) (12) Fund #8 (6) (6) Fund #9 (52) (52) Policyholder Account Liabilities (1,010) (1,011) Death Benefits (1,611) Surrender Charges Ceded Benefits 1, Risk Charges 1, Ceded Premiums (1,002) Policy Admin. Charges Commissions (102) Supplementary Benefits (12) (0.565) "Fixed" Cash Flow Liabilities (253) (45.864) Crediting Rate Margin Admin. Expenses 48 (133) Bonus Interest (108) Investment Income Tax (91) (4.336) (3.175) Future Taxes 4 (12.123) (37.218) Variable Cash Flow Liabilities (9.712) Insurance Reserves (154) (122) ( ) Other Amounts due under Policies (9) (9) Other Liabilities (8) (8) Total Liabilities (1,181) (1,150) Net economic value, March 25 interest rates: 134 (23.694) 22 Net economic value, April 2 interest rates: 124 (24.704) 22 Change in economic value due to interest rates: (10)

9 Universal Life Projection as of: 28Sep07 Liability data as of: 31Dec07 Interest Rate Scenarios: 1% 1% impact of 20% equity market decline: Parallel shift, rates 27 (38) (23) equities backing policy benefits Curve tilt, short rates (15) 25 (44) crediting rate spread & IIT Curve tilt, long rates 43 (63) (66) total Impact of 15% real estate decline: (6) Reserve estimates using LSOP Scenarios: Scenario 0 1,027 Scenario 4 1,073 Scenario Scenario 1 1,141 Scenario 5 1,084 Scenario 9 1,152 Scenario Scenario 6 1,073 Scenario 10 1,037 Scenario 3 1,084 Scenario 7 1, Key Rate Sensitivity Fixed Cash Flows Change in Net Position ('000) per.01% Change in Rate Fixed Insurance Cash Flows by Month ($million) (1) (2) (3) (4) Dec07 Dec17 Dec27 Dec37 Dec47 Dec57 Dec67 PV: (253) Static duration Variable Insurance Cash Flows by Month ('000) (expenses, spread, IIT) (20) Dec07 Dec17 Dec27 Dec37 Dec47 Dec57 Dec67 PV: 131 Static duration Net (left axis) & Cumulative (right axis) Cash Flows by Year ($million) 40, ,000 20, ,000 (50) (10,000) (20,000) (100) (30,000) (150) (40,000)

10 Canadian Life Insurance Company Annuities Projections as of: 28Sep07 Interest rates as of: 31Dec07 Liability data as of: 31Dec07 Book Book Present Modified Modified Value Yield Value Duration Convexity MCCSR Cash/Shortterm % Gov't of Canada % InterSegment Notes % Provincial AAA Provincial AA % Provincial A Municipal AAA Municipal AA Municipal A Municipal BBB Corporate AAA % Corporate AA % Corporate A Corporate BBB Preferred Shares P % Preferred Shares P2 CMHC MBS % Equities Residential Mortgages % Commercial Mortgages % Swaps pay fixed Swaps receive fixed Swaps net pay floating Accrued Interest 6 0.6% Policy Loans Investment expenses (7) Net Assets % Immediate Annuities (458) Deferred Annuities (451) Expenses (22) Actuarial Liabilities (926) (931) Other Liabilities (8) (8) Total Liabilities (934) (939) Net economic value, March 25 interest rates: (2.847) 6 Net economic value, April 2 interest rates: (2.847) 6 Change in economic value due to interest rates: 0 ALM scenario results change in net economic value: Parallel shift, rates + 1.0% (0.8) Parallel shift, rates 1.0% 0.8 Curve tilt, short rates + 1.0% (0.2) 51 Curve tilt, short rates 1.0% 0.2 Curve tilt, long rates + 1.0% (0.6) Curve tilt, long rates 1.0% Key Rate Sensitivity Change In Net Position ('000) per.01% Increase in Rate Term Years

11 Annuities Reserve estimates using LSOP Scenarios: Base scenario 17 Scenario 4 18 Scenario 8 18 Scenario 1 18 Scenario 5 18 Scenario 9 18 Scenario 2 18 Scenario 6 18 Scenario 3 19 Scenario Asset/Liability Cash Flows by Month ($million) Dec07 Dec12 Dec17 Dec22 Dec27 Dec32 Dec37 Net (left axis) & Cumulative (right axis) Cash Flows by Year ($million) (50) (100) (150) (50) (100) (150)

12 Canadian Life Insurance Company Surplus Projections as of: 28Sep07 Interest rates as of: 31Dec07 Liability data as of: 31Dec07 Book Book Present Modified Modified Value Yield Value Duration Convexity MCCSR Cash/Shortterm % Gov't of Canada % InterSegment Notes % Provincial AAA % Provincial AA % Provincial A % Municipal AAA Municipal AA Municipal A Municipal BBB Corporate AAA % Corporate AA % Corporate A % Corporate BBB Corporate BB Preferred Shares P1 Preferred Shares P2 CMHC MBS Common Equities Residential Mortgages Commercial Mortgages Misc. Assets % Real Estate % Accrued Interest 6 1.2% Policy Loans Investment expenses (7) Net Assets % IncomeTax Liability (2) (2) Accounts Payable (4) (4) Total Liabilities 6 (6) (6) Net economic value, March 25 interest rates: Net economic value, April 2 interest rates: Change in economic value due to interest rates: 4 ALM scenario results change in net economic value: Parallel shift, rates + 1.0% (13) Parallel shift, rates 1.0% 14 Curve tilt, short rates + 1.0% (10) Curve tilt, short rates 1.0% 10 Curve tilt, long rates + 1.0% (3) Curve tilt, long rates 1.0% Key Rate Sensitivity Change In Net Position ('000) per.01% Increase in Rate Term Years

13 Surplus Asset/Liability Cash Flows by Month ($million) (10) Dec07 Dec17 Dec27 Dec37 Dec47 Net Cash Flows by Year (20)

14 Notes to Help You Read the ALM Report General notes: The ALM model uses capital market techniques (discounted cash flows) to model the balance sheet. But it also incorporates actuarial conventions such as provisions for adverse deviation (PfADs, otherwise known as safety margins) and future investment expenses as well as credit loss allowances that differ significantly from market credit spreads. It has long been debated whether ALM should be conducted with or without these actuarial provisions. Including the actuarial assumptions allows the asset/liability manager to use the model to test the reserve (and therefore income statement) impact of different asset allocation strategies or specific asset trades. The majority of ALM practitioners include PfADs. It is useful to run the model, on a regular basis, without PfADs (and with projected mortality improvement) to identify the impact of these nonmarket based factors on true economic value. It is also advisable to quantify the impact of changes in the other liability variables (mortality, morbidity, early surrender rates, renewal rates, longterm lapse rates, administration expense) on economic value in the same manner as risk is evaluated on the asset side (changes in interest rates, equity markets, credit spreads, upgrade/downgrade/default probabilities, etc.). The specific challenge here is in estimating the potential range of movement (volatility) of these liability variables. The following notes are highlighted on the ALM report and are intended to give some insight into the process and the issues that typically arise: 1. This is the financial statement value of assets. This figure is used primarily to balance with the financial statements, to ensure that no assets or liabilities have been missed. 2. The weighted average asset yield, converted to a semiannual equivalent rate (bond equivalent yield). 3. The present value of asset cash flows, after deducting the same credit loss and investment expense allowances as used in calculating reserves. The cash flows are discounted using current market riskfree spot interest rates. Actuarial credit loss provisions are used here (rather than market spreads) to highlight the value of the excess spread (market credit spread less actuarial credit loss provisions and expenses). Excess spread is the difference between present value and book value and it acts (in the actuarial valuation process) to lower reserves and therefore increase reported income. Note that this spread effect on reserves may well disappear when valuation rules change, some time in the next 5 years. 4. The sensitivity of present value to changes in interest rates, expressed as percent change per 1% movement in rates. Modified duration is calculated by shifting the spot rate curve 1 basis point, calculating the percentage change in PV and multiplying by 100. A duration of means that the present value will change by approximately 25.32% for a 1% movement in interest rates. By market convention, a positive duration means that present value will decrease as interest rates increase (as is the case with bonds). 5. Effective convexity, as used here, refers to the change in duration as interest rates change. A figure of minus 0.15 means that duration will change by 0.15 if interest rates move up

15 or down by 1%. Negative convexity means that duration will change in an unfavorable way (will decrease as interest rates fall, increase as interest rates rise). Convexity is calculated by shifting the spot rate curve another basis point (after calculating duration) and calculating the change in duration. 6. This is the present value of the liability cash flows, which are provided by the valuation actuary. It is general practice to use cash flows including provisions for adverse deviation (PfADs) as this allows the ALM model to be used to optimize reserves and net income. 7. Liability cash flows can change substantially due to movements in interest rates. For example: a. Higher interest rates lead to higher policy admin. expenses due to the inflation that typically accompanies (causes) high interest rates. b. Lower interest rates generally lead to lower fixedincome returns (over the very long run) and less investment income tax. c. In lines of business such as Universal Life, with spread income from a fixedincome (GIC or bond fund) policyholder account, higher interest rates generally lead to higher spread (or MER) income. d. In some products, such as Term to 100 (where the same premium level applies for life), declining interest rates can leave policies underpriced. This can lead to a reduction in the number of people who allow their policy to lapse. Lapses of such policies after the first 10 years are profitable for the insurer (and are included when setting prices). Lower than planned lapses in T100 policies can therefore significantly increase benefit cash flows over the long term. When calculating the duration of liabilities, this cash flow variability needs to be addressed. This usually means asking the valuation actuaries to generate liability cash flows for current market interest rates as well as (at the minimum) scenarios where interest rates move up or down by 1%. A 1% movement (rather than 1 basis point) is preferred with liabilities, since it covers a more plausible range of movements and tends to capture the effects of any options embedded in the liabilities. 8. Liability convexity is calculated in a similar manner to the assets, but using the +/1% (rather than +/1 bp) interest rate movements (and cash flows). 9. This is the present value of net cash flows and represents profit embedded in the balance sheet. Additional profits (in the form of PfADs) are embedded in the asset and liability PVs. One of the principal goals of ALM is to protect net economic value from movements in interest rates. 10. This is the sensitivity of net economic value to changes in interest rates. A figure of implies that economic value will decrease by 43% if interest rates rise by 1% (convexity effects may increase or decrease this). The duration of economic value can be huge (>100) for some lines of business. 11. It is useful to monitor how actual movements in interest rates, from period to period, impact net economic value. This provides a rough scorecard for ALM activities over time and gives managers a better feel for the magnitude of the interest rate risks involved. In the example here, economic value has increased by $6 million due to the combined effect of positive duration and falling interest rates. 12. Scenario analysis involves shifting the yield curve and measuring the impact on net economic value. A range of significant, but possible, yield curve movements should be

16 included and the valuation actuaries should generate liability cash flows for each scenario. It would be desirable to test a wide range of random scenarios, but software that can accurately generate liability cash flows for a large number of scenarios with a reasonable effort and in a reasonable time is not widely available. 13. Some liability types (Term to 100 or Universal Life with level cost of insurance) have leveraged cash flows. There is an initial period, lasting for 20 years or more, of positive cash flows (where premiums or cost of insurance charges exceed death benefits). This is then followed by an even longer period of negative cash flows (where policyholders are older and death benefits are much higher). Inter segment notes are a means for such lines of business to sell the early positive cash flows, and use the cash to buy the long assets needed to match the period of high benefit cash flows. In this way, the line of business can lock in a reinvestment rate and lower the risk that future declines in interest rates may leave the line unprofitable. The line of business selling the intersegment note treats it like a negative asset. The line of business that buys the intersegment note, treats it like any other fixed income asset except that it cannot be sold outside the company. 14. A universal life policy is a combination of a life insurance policy and an investment account. The investment account may consist of GICs (or single premium deferred annuities) or deposits linked to external fixed income or equity indices. Generally, policyholders carry most or all of the market value risk in these linked investment accounts. The linked investment account liabilities and the matching assets are therefore shown with no duration for ALM purposes. 15. In Participating Life accounts, policyholders are paid a dividend. The dividend scale is adjusted, over time, to reflect the return on the assets in the line and, in some cases, on profits in other lines of business. Because of this adjustment process, gains or losses in economic value are less critical they can be passed through to the policyholders via the dividend scale. This would normally argue for a zero (or very low) duration of assets. However, experience shows that, when dividends are reduced, policy surrenders tend to increase. It is therefore generally desirable to have a positive asset duration, so that investment income will decline only slowly as interest rates fall. This logic also argues for more non fixed income assets (e.g. equities, real estate, etc.) in the Par line of business than in most other lines. 16. These scenarios are generally based on cash flows that reflect changes in expenses and investment income tax, but not dividends. If dividends were adjusted, all of the figures would, by definition, equal zero. These scenario results, on the other hand, give a sense for how much the dividend scales would have to be adjusted to offset the interest rate impact in each scenario. 17. Liabilities in Surplus are items, such as accounts payable or unpaid taxes, that cannot be reasonably allocated to a particular line of business. 18. Surplus represents the Company s capital, and the duration target is typically similar to that of a short or mediumterm bond fund. This allows the company to invest in that part of the yield curve where a wide variety of securities are available. In theory, a duration of zero would be desirable, but shortterm asset yields are typically not attractive. For many companies, the insurance lines of business are, in aggregate, exposed to falling interest rates. This can be partially offset by a longer duration in Surplus. In this way, if

17 interest rates fall and the insurance lines of business lose money, there will be a market value gain in Surplus. 19. Intersegment notes are usually priced so as to avoid transferring profits from one line of business to another. This means they are priced with the same credit risk as the assets the purchasing line would otherwise buy. In this example they are priced with the same spread as a single A provincial bond. The goal in pricing intersegment notes is to avoid transferring profits (via a toolarge or toosmall credit spread) from one line of business to another. 20. Lower grade credits typically exhibit a greater difference between book value (market value) and present value. That is because the credit spread in the market place is three or more times as wide as the credit loss allowance used in actuarial valuation. The remaining spread shows up as excess PV, which serves to reduce reserves (increase income) at the time the assets are put on the books. Once on the books, changes in credit spread have no impact on the income statement, under current valuation rules. This may well change when valuation rules are revised to more closely follow the international standards currently being implemented outside North America (e.g. IFRS phase II, Solvency II). 21. Preferred shares issue dividends which are not taxable in the hands of most Canadian corporations. Since valuation is carried out on a breakeven (zero income) basis, actuaries gross the dividends up to a pretax equivalent (less a small margin or PfAD). The yield shown here is calculated using these grossedup dividends. 22. Because they typically trade at a high taxadjusted yield, the PV of preferred shares typically exceeds the book value by a significant margin. 23. Mortgagebacked securities (like mortgages) are subject to prepayment, and prepayment rates tend to increase as interest rates decline. MBS also involve prepayment penalties, which tend to increase the yield (many homeowners prepay for nonfinancial reasons and pay a penalty). The yield shown here is calculated from the projected cash flows using the Rimcon MBS prepayment model. 24. The MBS duration is calculated by projecting cash flows at three different interest rates: current rates, rates up 1% and rates down 1%. Prepayment rates for each scenario are calculated using the Rimcon prepayment model. 25. Equities are modeled in various ways, depending on where they are held and on the planned investment strategy. The following are three common approaches (there are many more): a. In longdated lines of business such as Traditional Non Par Life or Universal Life, it is assumed that dividends will be reinvested and the holdings will be sold, piece by piece, after 3060 years. An equity portfolio is therefore modeled as a group of strip bonds earning the longterm expected equity return less a safety margin. b. In lines of business like Participating Life, it is assumed that some of the equity return will be used to pay policyholder dividends and that the equities holdings will be sold, piece by piece, after a 3060 year holding period. Here, equities are modeled as couponpaying bonds where the coupon rate is the longterm expected equity return. c. In Surplus, equities do not explicitly back any liabilities and are typically modeled as floating rate assets earning the longterm expected equity return.

18 26. Equities are assumed to earn a risk premium (5% or more above the riskfree interest rate), and the resulting cash flows are discounted at the riskfree interest rate. The PV of equities therefore exceeds book value by a factor of 2:1 or greater. The modeling assumptions can also attribute a very long duration to equity holdings. This is not the way capital markets value equities, but it does accurately reflect how equities are treated in actuarial valuation. In many cases, $2 (or more) of riskfree bonds can be replaced with $1 of equities, resulting in a $1 (or larger) reserve release. This then becomes a $1 improvement in the income statement. 27. Most policy loans fall into one of two classes: a. Intentional loans, where the policyholder has taken out a loan against the cash value of the policy. These loans are assumed to be repaid at a fixed future date (e.g. 10 years), based on the Company s experience with past loans. b. Automatic premium loans, where the policyholder has failed to pay one or more premiums. Rather than let the policy lapse the Company sets up a loan, backed by the cash value of the policy, to pay the premium. The value of the loan is eventually deducted from death benefits. Automatic premium loans are assumed to pay down at the same pace as death benefits. 28. Real estate is typically modeled as a couponpaying bond, with the coupon rate set equal to the expected return (which is slightly less than the expected equity return, but more than current bond yields). The real estate holding is assumed to mature in parts, after a period of 3060 years. This can result in PV figures that are 50% (or more) higher than book value. As with equities, this results in PVs that are not consistent with capital markets, but it does represent how real estate behaves in the valuation process. And the valuation process feeds directly into the income statement. 29. Accrued interest is an accounting entry that does not have any associated cash flows and therefore has no PV. All of the bond cash flows are already included in the bond PVs. It is included here only to allow reconciliation with the financial statements. 30. This represents the investment account part of Universal Life liabilities. It includes both accounts linked to external fixed income or equity indices (where the company also holds matching assets) and GIC deposits (where the company does not hold explicit matching assets). 31. These are the reserve figures, as calculated by the valuation actuaries. 32. The present value of liability cash flows, when discounted at the current riskfree interest rate. The PV figures may be larger (more negative) than the book value (reserve) figures because the reserve also reflects the excess spread on assets. It is important to examine liability cash flows in detail (see below) since the interest rate dynamics are often complex. 33. Accountants carry future tax liabilities at the nominal dollar amount, regardless of when they will be paid. Since they may be paid many years in the future, the PV is normally smaller than the book value. 34. A riskfree spot interest rate curve is a set of interest rates that, when used to discount the cash flows of a large group of Canada bonds, will produce present values that closely approximate the market values of those bonds. A universe of Canada bonds and a curvefitting algorithm (cubic spline function) are used to find the spot rate curve. 35. Because poor investment returns can be passed through to policyholders via a reduction in dividends, Par Life capital requirements are only half what they are in other lines of

19 business. This provides incentive to hold assets with high capital requirements (e.g. equities, real estate) in the Par segment. On the other hand, equities have a much larger reserve impact in other lines of business (e.g Traditional Non Par or Universal Life) because of the different modeling used there (see 25, above). 36. The reserve calculation in Par Life is different than that in other lines of business. In Par Life, liability cash flows are discounted at the yield of the assets in the line even though some of those assets may soon mature. Therefore a longterm asset has roughly the same reserve impact as a shortterm asset with the same yield. This creates some incentive to hold highspread, shortterm assets here and longerterm highspread assets in other lines of business. 37. Dividends can be issued in various forms: a. Cash dividends where a cheque is mailed out to the policyholder. This is not very common. b. Cash dividends where the money is left on deposit with the Company and the policyholder earns interest on the balance. The policyholder can access this cash by taking out a policy loan. Alternately, he/she can skip some premium payments and the money will be deducted from the dividends on deposit. c. Paidup additions, where the dividend is used to buy additional insurance. The dividends therefore show up as additional death (or maturity) benefits. Because the form of dividend varies from company to company, as well as from policy to policy, it is useful to model liability cash flows for several sets of interest rate (and therefore dividend) assumptions. 38. It is not unusual for net economic value to be negative in a Par Life line of business. This can happen in situations where dividends have not yet been reduced to reflect lower asset yields. 39. These are reserves calculated using a Non Participating Life assumption. The figures are useful in comparing lines of business and in estimating how far dividends need to be adjusted to reflect current asset yields. 40. This chart shows the sensitivity of net economic value to changes in interest rates (a 1 basis point increase) at particular points along the interest rate curve. The positive bar at year 40 indicates that there are significant liability cash flows, in that part of the curve, that are not matched by assets. The negative bar at year 20 indicates an excess of assets there. This profile is common for life insurance. There are often significant liabilities, but few assets, beyond year 30. It is therefore necessary to stack assets from year 25 to 30 in order that asset duration approaches liability duration. 41. Liability cash flows tend to be more uniformly distributed than asset cash flows (and therefore appear smaller on the monthly cash flow chart) and extend beyond 60 years (actuaries assume some people will live to 120). Asset cash flows are, by comparison, more concentrated. The asset spikes beyond 2037 represent cash flows from equities and real estate (piecewise sale of the holdings). 42. Annual cash flows give a better picture of the asset/liability balance. Note the unmatched liabilities at the right end of the chart, beyond year This is typical for several lines of business and in many insurance companies. The cumulative cash flow line is also an indicator of how well matched assets are with liabilities. A line that remains close to the horizontal axis indicates a good match.

20 43. The negative convexity arises primarily because of the intersegment notes, although the investment expenses contribute as well. 44. Economic value, in lines of business with long liability tails, frequently has negative convexity. The situation can be improved by adding very long singlecash flow assets (strip bonds or equities) or purchasing options on longdated bonds. Alternatively, the effects of negative convexity can be managed by adjusting duration as interest rates move (lengthen duration as interest rates fall, shorten duration as interest rates rise). This dynamic approach is more practical where there is growth in the line of business. For static lines of business, dynamic management can lead to significant trading costs. 45. Longtailed lines of business are typically exposed to falling interest rates (particularly at the long end of the yield curve), since it is very difficult to find enough long dated assets with an attractive yield. The problem becomes more difficult when interest rates are low (below those assumed in pricing) and where the only available long assets are provincial strip bonds (low credit spreads) or equities (high income statement volatility). An alternative strategy is to use long provincial strip bonds to lock in the interest rate protection and add a layer of credit default swaps (typically 5year terms) to pick up credit spread. 46. This breakdown of assets backing policyholder fund accounts is for information purposes only. Since policyholders bear all the investment risk, these assets (and the matching liabilities) have no ALM impact and are shown with zero duration. 47. Floating rate policyholder accounts and GICs (or singlepremium deferred annuities) are not usually backed by explicit assets and therefore do have to be modeled for ALM purposes. 48. These liability cash flows may vary, depending on future interest rates. Some cash flows, such as expenses, may even have zero duration if every 1% increase in interest rate results in a 1% increase in expenses (via higher inflation). Over the long run, changes in interest rates tend to be highly correlated with inflation since fixed income investors try to earn a real return (e.g. inflation + 2%). 49. Note the positive liability cash flows in the first 20 years (typical of most Term to 100 and many UL blocks). These are the cash flows that can be sold (using intersegment notes) to those lines of business (e.g. Annuities) that have shortdated liabilities, or to Surplus. 50. Deferred annuities are modeled as if they mature on the interest rate reset date. Immediate annuities (typically payable for life) have longer cash flows, extending beyond 50 years. 51. Because of the relatively short (compared to other life insurance types) term of liabilities, it is usually possible to asset/liability match an annuities block quite closely. Ironically, the annuities business was where many companies first became aware of ALM risk. In reality, Annuities is often the line of business with the least inherent asset/liability risk. 52. Surplus, having no significant liabilities, is often managed like a bond fund. There is significant incentive to carry a positive duration. It offers higher running yields when the yield curve is upward sloping (as it is the majority of the time). It also provides that, when interest rates decline and the longtailed lines of business lose money, surplus assets will appreciate, providing a partial offset. 53. Surplus is sometimes used to park longdated assets in anticipation of the sale of UL or Non Par policies. As the business comes in, the assets are moved from Surplus to the line

21 of business. It can take several months to reprice products when interest rates decline, and having an inventory of long assets at the current market yields provides some protection.