INTRODUCTION RESERVING CONTEXT. CHRIS DAYKIN Government Actuary GAD, United Kingdom

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1 CHRIS DAYKIN Government Actuary GAD, United Kingdom INTRODUCTION In discussing the principles of reserving for annuity business, attention needs to be paid to the purpose of the reserving exercise. It may be to support the sound and prudent management of the insurer, to underpin provisions which give a true and fair view of the liabilities of the insurer for the purpose of the accounts, to permit the identification of profit on which tax might be payable or to meet the requirements of a system of prudential supervision. The level of reserves required by the supervisor may have a material effect on the rate at which profit may be released and hence needs to be taken into account in pricing annuities by means of profit-testing procedures. This presentation concentrates on the principles of reserving for prudential supervision purposes, which normally reflect a requirement for prudent provision to be made in respect of all liabilities. Prudential supervisors also focus on prudent investment strategy, prudent evaluation of assets, the relationship of assets to liabilities and necessary capital requirements. RESERVING CONTEXT Reserving is different in every country according to the culture and background. The context of reserving is very important in determining the approach which is to be adopted. Reserving is something which insurance companies and other financial institutions have to do for a number of different reasons. Sound and Prudent Management The first reason is in exercise of what the European Union Insurance directives call "Sound and Prudent Management". The key responsibility of managers is to manage the business in a sound and prudent manner. If they take in money in respect of premiums or considerations for any future payments of annuity, then they need to set up appropriate provisions for the expected cost of those payments in future years. The insurance industry and the pensions industry must set aside money now for the liabilities which they have taken on and for the resulting expenditure which they expect to arise in future years throughout the contract. True and Fair Accounting Another approach to reserving is driven by accounting requirements. Management must ensure that appropriate accounts are maintained, which give a true and fair view of the affairs of the company. This must include appropriate provision for future liabilities. However, such provision should not be excessively prudent, or the accounts will not give a true and fair view. Identify profits The tax authorities may also have an interest in the level of reserving, in so far as it plays a role in identifying taxable profits. In situations where profit is taxable, the revenue authorities are likely to take a weaker view on reserving requirements in order to bring out profits more quickly. They would like to have reserves as low as possible, which may be in conflict with normal accounting requirements or the need for prudential reserves. 32

2 Prudential Supervision At the other end of the spectrum are the prudential supervisors, who will be seeking to have high reserves maintained, because their focus is on the ability of the organization to meet its future liabilities with a high probability in virtually any conceivable circumstance. Prudential reserving requirements are generally more stringent than the requirements of accounting principles, which are in turn more stringent than the requirements of the tax authority. Impact on pricing (through profit testing) Then there is the question of how all this impacts on the pricing of the product. With the pricing methodologies adopted in the UK and in many other developed insurance markets, the method of reserving and prudence of the provisions have direct impact on the price through the profit testing process. SUPERVISION OF ANNUITY BUSINESS Whether annuity business is carried on as a separate business through a pension annuity company, as part of the business of a diversified insurance company or as part of the business of a pension fund, there are a number of aspects which need to be considered and incorporated within the regulatory rules or practices of the appropriate supervisor. - Prudent Provision for Liabilities - Prudent Asset Valuation - Prudent Investment Strategy, to ensure that there is an appropriate balance of risk and reward. - Relationships between the Assets and Liabilities, since the assets are held specifically for the purpose of meeting the liabilities and risk can be reduced by appropriate asset/liability management. - Additional Capital Requirements, i.e. a margin of assets over liabilities which is required in order to give the entity resilience against possible circumstances that may arise in the future. - Intervention Mechanisms, with trigger points that will allow the supervisor to intervene in the affairs of the entity when things are not going too well. - Procedures for picking up the pieces - winding up, etc., guarantee funds or compensation arrangements when the company fails or is unable to deliver what it has promised. RESERVING ASSUMPTIONS Reserving in accordance with the requirements of prudential supervisors will normally be carried out by means of a prospective assessment of the liabilities under contracts which have been undertaken by the insurer prior to the effective date of the assessment. Most types of annuity do not present any particularly difficult methodological issues, but prudent assumptions are needed for the future mortality experience of the annuitants in question, for a rate of discount to be adopted (this will most likely be dependent on the investments held to back the liabilities), for future expenses of administering the contracts and possibly certain other assumptions. Special consideration may need to be given to cases where there is a material mismatch between the expected cash flows of the assets and liabilities or where the contracts contain guarantees, or options exercisable by the annuitant. Mortality The historical mortality experience is something which is in principle measurable, if you know the population you are dealing with. However, in many markets the annuity portfolio is still quite small. In the case of a country trying to set up a new pension system involving annuities, it may be non existent. So there may not be a population of annuitants where the mortality experience can be measured. In the case of a country such as the UK where there is a long established annuity 33

3 market, there will often be a process of collecting and analyzing mortality data from the insurance companies or pension funds. Nevertheless the experience of mortality in that group may be changing significantly as the nature of the annuitant population changes, for example as it becomes closer to the overall population rather than being a selfselected group. Unlike life insurance, prudence in annuitant mortality assumptions means assuming a greater expectation of life. Difficulties may arise because of the absence of reliable data on the mortality experience of the relevant annuitant population, which will often be significantly different from that of the general population. This is because annuitants are generally those who have been long term members of the working population, and may be drawn from particular sectors thereof with better than average mortality experience. Even if a satisfactory prudent estimate can be made of current mortality experience, the likely rate at which mortality will improve in future is difficult to estimate, albeit crucial for the reserving exercise. Another factor of course, will be whether it is compulsory to take out such annuities or whether you have the choice of not taking out an annuity, for example taking the money in cash form or by means of programmed withdrawal. If that is the case then you will get selection taking place, which is where those who choose to buy an annuity tend to be those with better than average expectation of life. A key issue for mortality, beyond that of determining the particular mortality of the population that you are dealing with, is how it might develop in the future. In most countries mortality has reduced dramatically over the last 100 years and continues to do so. Allowing for future mortality improvement could easily increase annuity values at age 60 by 10% or so, even on quite modest assumptions. Experience of developed annuity markets also suggests that those with larger annuities are likely to have a higher expectation of life. Allowing for mortality rates to be set with an appropriate weighting for the size of the annuity can of itself increase the annuity values at age 60 by 5% or more. So it is important to exercise a fair degree of caution and conservatism about what might happen to mortality in the future in setting appropriate reserves. Expectation of life at birth Figure 11: Expectation of Life based on Mortality in the United Kingdom 90 Projected 85 Females 80 Males Year The expectations of life in the graph are purely taken from the life tables year by year. So, they represent a snap shot of the mortality experience in each year over the 20th century from 1900 and how we envision it will continue to develop in the next century. We can see the expectation of life increasing by about a year in every 4 or 5 years. That is quite an appreciable amount when you start to look at the effect on annuities. Table 2: Expectations of Life, Males Projected to 2031 Age ELT The table shows expectations of life from a published UK life table, based on the mortality experience of the whole population in , compared with expectations of life for the population on the basis of 34

4 mortality rates projected for 2011 and At age 60, a common retirement age in many countries, the expectation of life for males is projected to increase by 4 years, from almost 18 years to almost 22 years, whereas the expectation of life for females is projected to rise by 3½ years, to 25½ years. Similar levels would apply for other European Union countries and for the United States, with expectations of life in Japan being a little higher. Table 3: Expectations of Life, Females Projected to 2031 Age ELT The expectation of life is essentially the undiscounted future expected value of a payment of 1 each year for the rest of life, which is equivalent to an annuity at 0% rate of interest. The next graph helps demonstrate the difference between establishing annuities on the basis of population mortality, assumptions about the mortality of annuities and the effect of allowing for future mortality improvements. Rates Figure 12: Annuity rates at 5%, calculated on various mortality bases - Males Age ELT15 Projected population PML80 (C=2025) PML92 () PMA92 () population mortality in 1990 to The annuity value at age 60 is about 11 with that population mortality and an interest rate of 5%, which means that you would have to pay a multiple of 11 years of pension in order to buy an immediate annuity at age 60 for a man, on the assumption that the mortality experienced will be the same as the population mortality in those years. If we now allow for future mortality improvements at the rate allowed for in the UK national population projections, we in effect assume that that 60 year old cohort will experience improving mortality as they age. This moves the annuity rates up to the dotted line, which is quite an appreciable increase. In fact it adds about one to the annuity values at age 60, pushing them up from 11 to 12. The other two lines which are bunched close to this line in the middle include a line based on the latest insurers' pensioners experience from the early 1990's, projected up to the 2010, which is more or less the same as that based on projected population mortality. So the unweighted insurance experience, simply on the basis of the lives in that experience, is expected to be about the same as that anticipated for the population as a whole. Where we get a further big difference is in the top line, which is based on the insured lives experience but weighted by the amounts of the annuities that they receive. This is usually what the insurance companies or pension funds are most interested in. Allowing for mortality weighted by amounts adds another year to the value of the annuity at age 60, so in broad terms we have 11 based on current population mortality, 12 allowing for future improvement and 13 allowing for the weighting of the mortality experience by the amount of annuities. The following table shows the underlying figures, ranging at age 60 from 11 up to 13, and at age 70 from 8 to 9½. The lowest of the five lines that appear in the graph reflects the annuity values based on the 35

5 Table 4: Comparison of Annuity Values - Males Age ELT15 Pop. Mort. w/improv. PML92 PMA The next table shows the relative values looking at the second column, based on population mortality allowing for future improvement. You can see about a 10% increase in the value of the annuity as a result of allowing for future improvements. The next columns show that there is a further increase of about 5 to 6% in the value of the annuity as a result of shifting from weighting by lives to weighting by amounts. Table 5: Relative Values of Annuities - Males Age ELT15 Pop. Mort. w/improv. PML92 PMA The relative values of annuities shown are the annuity values on the alternative basis as a percentage of the annuity values on the population basis. This gives something like 16 to 20% increased cost in excess of that based on current population mortality, in order to allow for what annuitants mortality experience may be in the future. That does not include any margin for prudence, but is a best estimate of the cost of annuities. For reserving purposes we would expect companies and pension funds to introduce further margins for conservatism. In the next graph, for females, the differences caused by the alternative mortality assumptions are not quite as great. Rates Figure 13: Annuity rates at 5%, calculated on various mortality bases - Females Table 6: Comparison of Annuity Values - Females Age ELT15 Pop. Mort. w/improv. PFL92 PFA For females the annuity values are not quite as spread as for men, and the impact of moving from lives to weighting by amounts is not as great as it is for men, partly because there is not such a wide spread of amounts in the case of females as there is in the case of men. Table 7: Comparison of Annuity Values - Females Age ELT15 Pop. Mort. with Impt. PFL92 PFA The table of relative values of annuities gives a quick way of assessing the increase from column to column, allowing first for future mortality improvement and then for the experience of the insured pensioners and in the right hand column for weighting of mortality by amount of annuity. Age ELT15 Projected population PFA80 (C=2025) PFL92 () PFA92 () 36

6 Rate of interest The second dimension of the reserving basis is the rate of interest, which is closely related to the way in which the assets are invested for this type of business. Good practice in managing an annuity portfolio will normally be to invest to provide as good a hedge as possible against the expected liability cash-flows. With level immediate annuities it may be possible to achieve a high level of immunisation. In simple terms this can be achieved by designing investment portfolios to generate cash flows equal to the expected outflows under the annuity payments. Immunisation theory demonstrates that a broader range of portfolios will achieve the desired effect, whereby the adequacy of the assets to meet the liabilities will not be adversely affected by changes in market yields on investments. If that is the case, for reserving purposes the assets can be taken at market value and the valuation rate of interest for the liabilities can be close to the weighted market redemption yield on the matching portfolio of assets. The policy of the UK insurance industry is to invest as closely as possible to the immunized position. If we are talking about an immediate annuity which pays out a flat amount each year, or an amount that goes up by a fixed percentage each year, immunization can be achieved on the basis of ordinary fixed interest bonds with valuation at what we would call nominal rates of interest. If the annuity payments increase with inflation, as is sometimes the case for liabilities which are substituting for social security benefits, then the investments which provide a match for those payments will be index-linked bonds and the interest rates we are concerned about will be real rates (i.e. discounting the impact of price rises). Expenses For reserving purposes, expenses should be allowed for on the basis of covering the full expected cost of administering the outstanding payments on all the annuity contracts which have been sold. Many regulatory systems insist on this being done on a closed fund basis, i.e. assuming that no further business is written which would provide additional margins to cover some of the expenses. Moreover, in such a scenario, reserves need to be set up to cover the full overheads of the business during a transitional period from operating as a going concern to achieving a slimmed down structure suitable for running off the accrued liabilities as cost-effectively as possible. In drawing up accounts which are required to give a true and fair view, the traditional assumption is that of a going concern, where you can rely to some extent on new business coming in and helping to finance the company's overheads. In the case of prudential reserving that may not be allowed, as you should not be able to place any reliance on the future business to support the cost of running off the liabilities. So you need to reserve for a full allowance for the expenses of running off the business in terms of making the annuity payments and managing the investments, as well as covering the overheads and allowing for inflation. Asset/liability mismatching Problems arise, both for risk management and for reserving, if proper matching of assets and liabilities is not possible, for example because of a limited range of maturity dates on bonds, and particularly if there are no medium to long-dated bonds. In this case prudent allowance needs to be made for the risk that reinvestment of the assets in later years may only be possible at much lower yields. This can be done explicitly through a dynamic cash-flow model, or implicitly by reducing the rate of discount applied to the liabilities. Special mismatching reserves may be required, based on stochastic asset/liability modelling, when the profile of the assets if very different from that of the liabilities (e.g. when some of the assets are in equities). 37

7 Mismatch situations arise in many countries because of the absence of very long-dated securities. In the UK it is possible to buy bonds that have a maturity date 30 years into the future so that it may be possible to immunize a portfolio of annuities. If you are in a country, such as in most parts of South America and Eastern Europe, where longdated bonds are usually at most ten year maturity, then you are in a different situation and full maturity of assets to liabilities may not be possible. Reserving must then allow for the reinvestment risk and the fact that in reinvesting that money in future years you may not be able to obtain the yields that you can today. We have seen that happening in East Asia recently, in China, for example, where interest rates have come down dramatically over the course of a short period of time. It would have been quite inappropriate to reserve on a basis of an assumed continuation of current yields unless you had matching assets to match the future liabilities on the whole annuity portfolio. And then overall one would expect a degree of prudence to be built into the interest assumption to reflect the fact that there is future uncertainty. There may also be a default risk if you invest in corporate bonds or even in some government bonds which are not entirely default free. Other Assumptions In addition to prudent technical reserves (or provisions) an annuity provider should maintain an appropriate level of capital and surplus (free reserves, sometimes known as solvency margin). This should be sufficient to ensure that the liabilities can be met with high probability in quite adverse scenarios. Although the intention is usually to keep the probability that the liabilities cannot all be met as low as possible, there is clearly a tradeoff between the cost of high capital requirements and the extent to which the insolvency risk can be reduced. Most supervisory régimes acknowledge that 100% security is not in practice achievable. RESILIENCE TESTING A useful discipline is for the board of management of the annuity provider to receive annual dynamic financial analysis reports from their actuary (also known sometimes as dynamic solvency testing, dynamic capital adequacy testing, scenario testing or stress testing). These reports focus on the implications of possible adverse scenarios with respect to all the key assumptions and assist the board to identify the most significant risks and put in place appropriate strategies for managing the risks. This is a technique increasingly used by actuaries in one way or another in many countries. It offers a more dynamic look at reserving, instead of just seeing a snap shot of the position today. A useful approach is to look at a range of future scenarios and to test the ability of the company to meet those scenarios. The actuary should report to the board on the impact of assuming different future scenarios, including testing the impact on the portfolio of future changes in the market, mortality improvement, expenses and so on. In the UK we have formalized one aspect of this, namely the interest reserving requirements. Reserves must be established so that if interest rates move by 300 basis points tomorrow (or market values of equities fall by 25%) then the company will still be able to set up adequate reserves in that new scenario. If the company has investments and liabilities well-matched, this requirement does not have much effect. If it is mismatched then this requirement throws up a substantial additional reserve and effectively throws the spotlight on the need to reserve adequately for any mismatch between the assets and the liabilities. PRUDENTIAL MARGINS The whole question of prudential margins is often debated between the industry and the supervisor. The supervisor would prefer lots of margins whilst the industry would argue 38

8 this is unfair, making the costs to business too high or the profits too low for the shareholders. There is always a balance to be found for this structure, which offers the appropriate level of safety for the members. My experience in countries which are privatizing social security is that there is a real concern that something that was originally provided by the government is now going to be provided by private institutions. Supervisors cannot provide 100% certainty that the institution will be able to deliver, but there is a balance to be struck which will give as high a level of security as possible, without imposing unreasonable capital requirements on the industry. The reserving assumptions should be prudent, so that in most circumstances the reserve will be sufficient to meet the liabilities. In addition, the free assets (capital and surplus or asset margin) will cope with adverse circumstances beyond what one might expect the reserves to allow for. There should also be a process of dynamic financial analysis in order to assess the risk profile of the company, so that they can put in place appropriate measures to try to reduce those risks. WIDER IMPLICATIONS Setting up adequate, and preferable prudent, reserves is important for the sound management of the annuity business. The level of such reserves should be taken into account in pricing the product, as it effectively determines how capital intensive the business will be and hence the price which needs to be charged to give a reasonable return on that capital. Careful matching of assets and liabilities enables the reserves to be kept lower. Mismatching may be permitted (depending on the regulatory régime) or may be inevitable, if appropriate assets are not available, but will normally lead to a need for higher reserves, or additional capital requirements. Mismatching may be forced on the industry by virtue of the absence of long-dated securities or the absence of securities that would actually match the required payments on the annuities. For example, if indexation of annuities is required but you cannot find an investment that provides a hedge or where the company or pension fund or insurance company deliberately chooses to mismatch in order to enhance its return. Governments wishing to see the establishment of a sound annuity market should consider creating assets which match such liabilities e.g. by issuing debt with a wide variety of maturity dates, up to 30 to 40 years ahead, including index-linked debt. Another general principle is that, the higher the reserving requirements, the higher the price needs to be. This comes back to the principles of pricing and the need to take into account the reserves that have to be set up and the impact on the return of capital. There is clearly a need for a wide range of suitable assets, both in terms of maturities, and also in terms of liquidity and marketability. Another implication is that the annuity business needs to stand alone. It does not need to be carried out in a separate entity but the reserving for the annuity business needs to be sufficient on its own and not dependent on other business of the company. There could be a situation where the annuity business is low on reserves, relying on the fact that there is over-provision elsewhere or hidden reserves, for example in the way that the assets are valued. Unfortunately, some of these margins could slip away or the annuity business could become dominant as it has indeed already become in countries of Latin America, such as Chile and Mexico, so it needs to be fully able to stand on its own feet in terms of adequate reserves. The high volume of annuity business which can arise in the development of a funded pension system may result in a somewhat unhealthy concentration of risk in the 39

9 insurance industry, with a single dominant product. This will be exacerbated if pension annuity business is required to be written by specialist companies. Longevity risks cannot be avoided (although reinsurance may sometimes be a possible option) but can be protected against by prudent allowance for future improvement in both pricing and reserving. As indicated above, investment risk can be mitigated by matching assets and liabilities, provided that suitable investment vehicles are available. 40