Report Financial Economics and Canadian Life Insurance Valuation Task Force on Financial Economics September 2006 Document 206103 Ce document est disponible en français 2006 Canadian Institute of Actuaries
Memorandum To: From: All Fellows, Affiliates, Associates and Correspondents of the Canadian Institute of Actuaries Robert Stapleford, Chairperson Task Force on Financial Economics Date: September 20, 2006 Subject: Financial Economics and Canadian Life Insurance Valuation The Task Force on Financial Economics presented its final report at the June 28, 2006 meeting of the CIA Board. The report contains papers that address the application of financial economics to life insurance and defined benefit pension plans. The executive summary presents the key issues raised in the two papers that will be made available to CIA members. Defined Benefit Pension Plans The task force supports the adoption of financial principles in the valuation of defined benefit pension liabilities. A key factor in the task force s thinking is that employees provide their services with the expectation that they will receive the promised pension benefit. The value of this promise must be recognized with a high degree of certainty and should be determined using yields on high quality fixed income instruments with minimal expectation of credit loss. We believe that this position is consistent with the expectations of members and regulators. This position has the following implications: The valuation of pension liabilities on a wind-up basis needs greater prominence in pension valuation work. The role of the traditional going concern valuation would become a long-term contribution budget to recognize the need for more stable funding calculations than the wind-up basis would generate. Funding of pension plans would target the wind-up position with prescribed amortization periods to achieve full funding on a wind-up basis when deficits result.
The basis for calculating pension transfer values that was adopted in February 2005 embodies the market principles of financial economics including the use of long-term yields on high quality fixed income instruments. This standard is under review. The task force report supports the continued application of these principles to determine transfer values. Adoption of financial principles is made more difficult by the asymmetrical treatment of surplus which results in a position of those who accept financial risk are not necessarily the ones who benefit when such positions produce gains. The CIA should continue its efforts to work with pension stakeholders to develop a more consistent approach to the acceptance of risk and utilization of surplus as well as development of margins like Minimum Continuing Capital Surplus Requirements (MCCSR) for life insurance. Life Insurance The paper discusses alternate approaches to calculate reserves based on efficient market financial economics principles. The approaches are not consistent with or allowed within the current Canadian Generally Accepted Accounting Principles (GAAP) accounting framework. In particular, the task force supported the fundamental principle that the valuation of insurance liabilities should be independent of the underlying investments. This position is not consistent with current methods to value life insurance liabilities in Canada. During the course of its deliberations, the task force heard from several actuaries who have taken lead roles in the development of proposed new international accounting standards for life insurance. Many of the issues considered by the task force are being considered globally. Changes to international accounting standards are expected in three to five years. Although Canadian valuation standards will need to change when international standards are adopted, it would be premature to make changes before international standards are introduced. Accordingly, the task force does not propose any changes to the current basis for valuing Canadian insurance liabilities. The task force encourages the CIA to plan for the adoption of international standards that are expected to employ financial economics principles. Adoption of these principles will likely lead to concurrent changes in how MCCSR is determined. The task force was chaired by Rob Stapleford and the members were John Duralia, Steve Easson, John Gilfoyle, Vivek Gupta, Larry Miller, Bill Moore and Phil Watson. RS
TABLE OF CONTENTS INTRODUCTION... 5 FINANCIAL ECONOMICS GENERAL METHODS OF DETERMINING PRICE... 5 FINANCIAL ECONOMICS APPLIED TO LIFE INSURANCE VALUATION... 6 COMPARING FINANCIAL ECONOMICS APPROACHES TO CANADIAN GAAP APPROACHES... 7 CONCLUSIONS... 9 RECOMMENDATIONS... 10 4
INTRODUCTION This report has been prepared by the Task Force on Financial Economics, which was created by the CIA Board to address the applicability of financial economics to insurance company liabilities, consistent with parts 1(a) and 2 of the following motion passed at the April 6, 2005 Board meeting: Motion: That the Board approves the revised mandate for the Task Force on Financial Economics as follows: 1) Determine the applicability of financial economics to actuarial work, starting with: a) the valuation of insurance company liabilities, and b) the valuation of pension plan liabilities 2) Where financial economics is applicable, determine where changes (ideally what changes) need to be made to: a) education of members, b) standards of practice, c) educational notes, and d) anything else. Proposed by: Charles McLeod Seconded by: Claudette Cantin Carried Given this mandate, the task force has completed its review of insurance company liabilities. The process was to have group discussions and then create a sub-group to draft a paper on the Applicability of Financial Economics (FE) to Canadian Insurance Valuation. After a draft was completed, several industry experts were invited to review the paper and participate in a discussion. Participants Jeremy Gold, Mary Hardy, Ted Steven and Paul McCrossan provided feedback. The feedback was incorporated into the final version of this report. Late in the discussion process, it was noted that the group had focused more on the Efficient Market Hypothesis and related FE theories as opposed to some FE theories on behavioural economics. The report examines alternate approaches to calculate reserves based on efficient market financial economics principles. The approaches would not be consistent with or allowed within the current Canadian Generally Accepted Accounting Principles (GAAP) framework. FINANCIAL ECONOMICS GENERAL METHODS OF DETERMINING PRICE This section has focused more on the Efficient Market Hypothesis and related FE theories as opposed to FE theories on behavioural economics. These theories rely on the existence of an efficient market which does not exist for insurance liabilities. There are economic 5
theories regarding incomplete markets which are not discussed within this paper. When the term FE is used in this paper it is meant to mean Efficient Market related FE principles. The law of one price is a fundamental concept within FE and states that if you have streams of cash flows with the same amount, timing and certainty of payment traded within an efficient market, then any securities that are composed of these cash flows must have the same price. FE principles dictate that deep and liquid markets determine the price of a stream of payments. These markets assess the various risks associated with these cash flows and set the price accordingly. Clearly, there is not a deep and liquid market for life insurance policies, so the value of the liability cannot be set by observing market prices. 1, 2 In the absence of deep and liquid insurance markets, one would attempt to create a replicating portfolio that matches the amount, timing and certainty of the various liability payments. This portfolio would be composed of assets that are traded in a deep and liquid market. The market value of this replicating asset portfolio would then represent the market value of the liability. As actuaries, we project a cash flow stream for all future liabilities. If these cash flows were all fixed and did not exceed the longest asset traded in a deep market, the replicating portfolio approach could be applied directly. If the replicating portfolio approach cannot be applied, we are left to use more complicated methods such as stochastic models, binomial lattices or other FE valuation techniques. FINANCIAL ECONOMICS APPLIED TO LIFE INSURANCE VALUATION The first issues faced by actuaries in applying these FE principles are that most cash flows are not fixed and that no asset exists with the same probabilities of payment; so one could argue strictly that FE cannot be applied. This is a weak argument from the profession s perspective as actuaries are the ones (or perhaps the market is) who created products that have cash flows that cannot be matched by traded financial instruments. 3 If one can get past the point above and agree that it is not a valid reason to ignore FE principles then the exercise becomes one of figuring out how to apply FE in this situation. The key question then becomes how do we project and value each risk component of the liability. Although one cannot totally separate and isolate different risks in practice, it is useful to consider how FE would be applied if one could. This leads to the consideration of the two different types of risk. The first set of risks is those risks that are believed to be totally uncorrelated with market risk (e.g., mortality). The second set of risks is those risks that would vary with markets and economic conditions. These two types of risks are considered separately below. 1 Some texts contend that the premium paid for a insurance contract in some cases represents a market price for the risk and should be factored into the valuation. 2 For some risks such as mortality, there is a market made up of reinsurers willing to quote on business. This market, however, would not be considered deep or liquid. 3 On the other hand, in the infancy stages there was not a deep and liquid market for the trading of MBS/CMO products that have complex path dependent cash flows but over time such a deep and liquid market did develop. 6
If one believes mortality risk is totally independent of market and interest rate risk for a particular product, then the actuary could, in theory, create a stream of cash flows associated with the mortality components of the liability. The question is how should this stream be created and how should it be valued? From an FE perspective, there are several different views on this, with some overlap. a) Mortality risk is orthogonal to the market risk, so there should be no risk premium associated with these cash flows and one should use only the best estimate projections. This is a theoretical purist viewpoint. b) In a similar vein, one could possibly argue that all mortality risk is diversifiable and thus any risk can be diversified away with enough policies and there is no risk premium. c) Alternatively, one could argue that mortality risk is a real risk and not all of it can be diversified away. If one were to sell mortality risk on the open market, then a risk premium would be required. Thus, the best estimate cash flow stream would be adjusted for this risk. Furthermore, when you add an uncorrelated risk to the market portfolio, the market portfolio is expanded to include that risk and unless the variance of the risk that is added is zero then the beta of the added risk against the new market portfolio is greater than zero, hence, there is a risk premium for the added risk Once a risk adjusted cash flow stream has been established, it could then be discounted at the risk free rate to arrive at the value of the stream. 4 Alternatively, a replicating portfolio could be constructed by finding assets with the same expected cash flows as the risk adjusted cash flows. For risks that are market sensitive, the exercise becomes more challenging. Many insurance company cash flows are dependent on the future economic and market environment. It is improbable that these cash flows can be precisely replicated using combinations of bonds, derivatives and other asset classes such as CMOs. As such, the best that can be done currently in our illiquid market is to determine values representative of financial economics principles. Inherent in a sale of a block of business or reinsurance transaction involving an inforce block of business is a net asset value that the acquirer demands for assuming the liabilities. Alternatively, a stochastic model that reflects path dependent policyholder behaviour projects out total net cash flows and an optimization algorithm is used to determine the combination of tradable assets that best replicate the liability cash flows under the multiplicity of paths. Both approaches probably provide crude proxies. COMPARING FINANCIAL ECONOMICS APPROACHES TO CANADIAN GAAP APPROACHES Due to the nature of Canadian GAAP accounting for the insurance industry, one cannot directly compare the calculation of liabilities under FE approaches to the calculation of liabilities under the Canadian Asset Liability Method (CALM). FE values assets and 4 Discounting at a yield in line with the company s credit rating is also another proposed method for valuing this stream. 7
liabilities independently; Canadian GAAP liability valuation recognizes the assets backing the liabilities. Canadian GAAP reserving also makes provisions for asset/liability mismatch risk. Thus, it is important to look at the total balance sheet and income statement to understand how FE and actuarial practice relate. It is also important to consider the free surplus component, or some variant of free surplus. Alternatively, measures of assessing a company s value could be considered. From an FE perspective, the approach of the previous section could be used to determine the value of liabilities. Assets would be valued independently. In the life insurance world, regulators require a greater promise of certainty of payment and require capital to be held to provide additional protection. Since this capital is somewhat restricted in terms of other investments of the shareholder, it is also a consideration in the value of a company. From an FE perspective, one could argue that at the end of the day, we need to compare the value of free surplus (or some variant) or the value of a company under both the actuarial approach and the FE approach. Liabilities a) CALM uses the value and characteristics of the assets backing the liability to determine the value of the liability. Thus, the value of liability varies with the assets backing it. Under FE, the value of the liability is the same regardless of the assets backing it. b) CALM, through its use of scenarios, creates a provision for C-3 risk (asset liability mismatch risk). FE, makes no provision for C-3 risk in the liabilities since it ignores the assets. c) When CALM projects a bond or asset that is not risk free, it may result in payments above the risk free rate because actuaries set margins for asset default that can vary from the market. The end result is that these amounts serve to reduce or increase the amount of the liability (through the use of assets in the determination of the liability). FE would not allow for any future net risk premium to be taken into account in the current liability valuation. d) Actuarial principles define a best estimate assumption and a Margin for Adverse Deviations (MfAD). This results in a conservative cash flow. This is somewhat analogous to the concept of the market adjusting cash flows for the inherent risk and not up-fronting risk premium. In the final summation, this results in a higher liability and thus a lower free surplus (assuming one does not believe the risk is diversifiable or that market gives no premium for orthogonal risk). The manner in which this margin is set varies by type of risk and has some constraints in general. In FE, the market would establish this risk margin. e) Individual actuaries can look at similar risks and can come up with different assumptions for the same risks. Standards of practice would narrow the range of deviation but this technically does violate the theory of one price. This is more of a theoretical violation as no two products designs, markets and customer sales distributions are exactly alike. 8
Required Capital Assets a) In actuarial practice, required capital components are set by the regulatory bodies. It is beyond the scope of this paper to evaluate the appropriateness of these requirements. These requirements, however, are not meant to cover risks such as misestimating or deterioration of the mean (these are included in the MfADs). b) From an FE perspective, one approach to establishing required capital would be to look at the company s rating and determine a ruin probability associated with this rating which would ensure that the required capital and liabilities would make sufficient provision that corresponds to this level of ruin. This would result in required capital capturing any risks not captured by the liability valuation. If an FE liability valuation did not capture any C-3 risk, then this approach to required capital would capture this risk. If equities were used to back liabilities, then this risk would be reflected in a higher required capital component. This may fit with the FE principle that an individual investor would not want a company to increase equity to back liabilities as they could do this on their own. In this case, free surplus would be reduced by the extra required capital set aside to recognize this risk. From an FE perspective, assets would be carried at market value. Currently, assets are carried at an adjusted book value under Canadian GAAP. This is somewhat offset by the method used to determine liabilities. If one looks at free surplus or some variant as the ultimate values to compare in order to avoid confusion between non-comparable values such as liabilities and assets, then FE and current Canadian life insurance practice may not be that divergent in actual values. More details on this are presented in the Conclusions section. CONCLUSIONS 1. There are many different viewpoints on the application of FE to insurance liabilities. There is no single comprehensive approach that all proponents agree upon (e.g., appropriate margin for insurance risk, appropriate discount rate for an insurer s liabilities, etc.). 5 2. The presentation of assets on an adjusted book basis and liabilities on a CALM basis differs from an FE perspective which would show both on a market or fair value basis. 3. Risk margins in liabilities and required surplus would be released each period as the risk passes, thus, the change in free surplus may be similar under both methods (once again ignoring MV impacts). Including some form of risk margin in the liability cash flows is consistent with some views of FE. 5 The North American Actuarial Journal Volume 6, Number 1 contains a number of articles on the various approaches and is a very worthwhile resource. 9
4. Although both methods may arrive at a similar endpoint for free surplus, the differences in approach can lead to undesirable results. In areas where the actuarial assumption is clearly inconsistent with FE market assumptions, it is fairly easy for a financial economist to identify a flaw. The most obvious example is in the area of asset defaults since different insurance companies could impact their free surplus in different ways for the same asset. This is a violation of the law of one price for deep and liquid securities. Capital markets in the future may create vehicles that would allow arbitrage opportunities. 5. The use of arbitrary constraints in valuation is inconsistent with FE principles, for example, account balance floors. 6. Stochastic valuation recognizing policyholder behaviour and incorporating FE principles and methods would be how a financial economist would value liabilities. There are a number of practical and theoretical challenges to this approach. The actuarial profession uses stochastic valuation for complex products with tail risk. This approach is generally consistent with FE, except that the discount rate used to discount cash flows is often inconsistent with the scenarios that generated those cash flows. Given the volatility and duration of these reserves, this is likely not a material consideration. In theory, CALM is also a conservative deterministic attempt to approximate stochastic valuation. 7. A move from the current CALM approach to one that is based more on FE principles would result in more volatility of reported results, especially for asset and liability portfolios where there is a significant degree of mismatch. RECOMMENDATIONS 1. The task force believes that in light of the inevitable international trend towards standardization and incorporating financial economics/fair value principles into insurance company valuation standards, tinkering with current asset, liability (i.e., CALM) and required capital (e.g., stochastic components) valuation standards in advance of gaining a full understanding of how these principles will be adopted internationally and the pros and cons of adopting these standards is ill advised. Rather, the CIA should proactively participate in the development of these international accounting standards and determine the public policy implications of adopting these principles (e.g., assessment of volatility, impact on investment policies, impact on capital markets, impact on shareholders and policyholders, etc.) 2. It is premature to address the topic of required capital in an FE framework, at least until global initiatives on the Total Balance Sheet approach are advanced further. 3. The creation of an educational note on FE was discussed. Life insurance valuation involves many complex issues including FE and creating a note specifically on FE that does not context FE in light of these values is not valuable or recommended at this time. 4. Education of the membership would be best approached by focusing on education around the developing International Accounting Standards with emphasis on FE principles applied therein. 10