From Gross Premium From Gross Premium Reserves to Stochastic Asset Reserves to Stochastic Asset

Adequacy AnalysesAdequacy Analyses

Practical Cash Flow Testing Issues in TaiwanYek Cheng – ALM and CFT Seminar

Taipei – July 1, 2005

Scope and DisclaimerScope and Disclaimer

The appointed actuary regulations in Taiwan require testing for premiums, reserves, and dividends.This presentation is focused on adequacy testing for reserves only.Standard disclaimer: Opinions expressed herein are my own and NOT those of my employers or the AIRC

Development Path for Taiwan AAADevelopment Path for Taiwan AAA

GPR allowed for 2003 to 2005 submissions – a transitional provisionMulti-scenario cash flow testing after 2005Stochastic AAA by 2010Significant learning curve in a relatively short period of time

Compared to USCompared to USUS development path:– NY Reg 126 for annuities (1986)– 1991 AOMR (with section 7 for small cos.)– 2001 AOMR (stochastic; not in all states yet)

Taiwan compared to US– Shorter time frame– Broader scope– Risk: Can Taiwan actuaries catch up in time?

The time to start preparing is NOW!!

AAA TopicsAAA Topics

Cash flow testingScenario and sensitivity testingLiability assumptions“Reserve adequacy” vs. asset adequacyAsset modelsAsset assumptionsStochastic or deterministic

GPR vs. CFTGPR vs. CFT

GPR & CFT are conceptually “equatable”GPR = PV of benefits/expenses less PV of gross premiumsRoughly stated, “CFT PV of Surplus” = Reserves less “GPR”But mindsets underlying the two concepts are significantly different

GPR vs. CFTGPR vs. CFT

GPR focuses on a single scenario– Assumptions reflect averages over time– Considers only the sufficiency of margins over

product lifetime– Some sensitivity testing

CFT focuses intensely on multi-scenario and sensitivity testing

CFT FocusCFT FocusLooks at events on yearly basis– Assumptions change to reflect yearly

movements– Considers yearly interrelationship of assets and

liabilities– Surplus or deficiency at the end of each year

Considers how assumptions might interactStudies all assumptions whose changes can materially affect PV of surplus

Why do CFT/AAA?Why do CFT/AAA?It is natural to think of AAA as regulatory compliance. (Also true in the US)More helpful view: Perform CFT/AAA analyses for the benefit of the company; disclose key results to regulators.“To inform management of actions or possible problems that may arise due to current management of the business.”(AAA Practice Notes Dec 2004)

Examples of Things to Examples of Things to Consider in AAAConsider in AAA

Consider all situations where the company might be vulnerable. Examples:– Interest rate changes and their effects on

liabilities and assets– Potential pricing inadequacy (e.g. claim rates)– Expense control issues

Liability AssumptionsLiability Assumptions

Consider possibilities for anti-selectionDynamic lapse rates– Reactions to interest effects and benefit terms– Do policyholders have contractual choices?

Lapse effects in Taiwan might be counterintuitiveConsistency of assumptions between basic policies and ridersActual morbidity rates may be worse than pricing.Different assumptions for different channels?

Discount RatesDiscount Rates

CFT does not use pricing discount rate (or hurdle rate)Most common choice is after-tax earnings rate, usually including policy loan interestSome methods (e.g., the NY method) derive implied earnings by running two or more model iterationsTest for sensitivity

Reserve Adequacy? Reserve Adequacy? Or Asset AdequacyOr Asset Adequacy

The stated purpose of the Taiwan AA regulation with respect to reserves is to “determine reserve adequacy.”But adequacy cannot be determined by looking at reserves aloneReserves are only adequate if the assets backing up the reserves are adequate to provide for future benefits and expenses under moderately adverse scenarios

Asset Adequacy AnalysisAsset Adequacy Analysis

Choose assets = BV of liabilities being testedAnalyze cash flows (asset, policy, liability) to determine adequacyIf additional assets are needed to “pass the test”, then additional reserves = BV of additional assetsNew business usually not factored in

Asset MattersAsset Matters

Why do we need asset models?Without asset models, portfolio rates have to be estimated. Such estimates are not adequate in many CFT/AAA situations.Often, it is necessary to take into account the actual assets being held and the reinvestment strategies that would be used under different investment environments.

Simple SPDA ExampleSimple SPDA Example

Simple SPDA portfolio; single issue year; analysis at the end of year 1Accumulation period = 10 years5 asset scenarios: 20-year, 9-year, 7-year, 5-year, & 3-year bondsRising yield curveDetailed spreadsheet available from cindy_deng@mail.mli.com.tw

Simple SPDA ExampleSimple SPDA Example

7091,0384.50%3-yr bonds

1,199

1,324

1,412

1,704

AV of Ending BV Surplus

AV = accumulated value; PV = present value; BV = book value; MV = market value

7035.20%5-yr bonds

9105.70%7-yr bonds

8386.03%9-yr bonds

1,1777.05%20-yr bonds

PV of EndingMV Surplus

Level earned rateScenario

Effects of 400bp StepEffects of 400bp Step--Up of Yield CurveUp of Yield Curve

3-yr bonds

5-yr bonds

7-yr bonds

9-yr bonds

20-yr bonds

Scenario

(51)659709

(264)439703

(388)522910

(611)226838

(2,057)(880)1,177

ChangePV of surplus -- +400bps

PV of surplus -- Level

Asset/Investment ModelingAsset/Investment Modeling

Goal to achieve: robust asset models that interact with liability modelsSimpler asset models or non-asset-model methodologies should be carefully validated.Key is to understand and reflect as best as possible the behaviors of the company’s asset portfolios under alternate scenarios.

Transition to Asset ModelsTransition to Asset Models

Initially, focus is on liability models; may have to do CFT without asset modelsOne simple method: project asset allocations and asset class earned ratesQuick way to roughly reflect company asset mix and investment strategiesTransitional methodology; not for long-term

Transition to Asset ModelsTransition to Asset ModelsUse of generic (bond) portfolios:– More sophisticated– Can model some asset behaviors– Need re-calibration and re-balancing

Asset models for selected product blocks– Priority given to products that are sensitive to

interest rate changes– Covers product up to x% of reserves or inforce;

increase % over time

Why Stochastic?Why Stochastic?

Deterministic models good for products that are:– Relatively interest-insensitive– Less discretion by policyholders (e.g., no cash-

withdrawal options)– Participating or interest-responsive products

Stochastic models do better for products with heavier investment focus or subject to active policyholder behaviors responding to interest rate changes

How to Use Deterministic ResultsHow to Use Deterministic ResultsBefore stochastic models, deterministic calculations are used to get a landscape of the impacts of alternate scenariosRun enough scenarios to get a good landscape view covering all relevant assumption changesTesting to pass under moderately adverse conditions, not remote extremesAlso good for determining the “limit points”of assumption movements

How to Use Deterministic ResultsHow to Use Deterministic ResultsConsider degree of liberalism/ conservatism of assumptions in each scenarioConsider number of scenarios run and the breadth of coverage over the landscapeForm overall judgment from the scenarios:– Pass “80%” of all scenarios?– 100% of all moderately adverse scenarios?

“Zen and the Art of Reserve and Asset Adequacy” Becker, Smith, Zurcher (1993)

>80% = >80% = Pass?Pass?

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Sensitivity testing

<80% = <80% = Fail?Fail?

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Degree of ConservatismDegree of Conservatism

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=adverse/extreme= moderately adverse= not adverse

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>>100% of Not adverse/moderately adverse = Pass?100% of Not adverse/moderately adverse = Pass?

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=adverse/extreme= moderately adverse= not adverse

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Supportive Environment for AAASupportive Environment for AAA

Support in the US– SOA: symposia, seminars, website, newsletters– AAA: ASOP, Practice Notes– Company: support employees’ memberships in

the industry actuarial community– Regulators: support SOA, AAA; many key

states have strong actuariesSupport in Taiwan: needs strengthening

No Company is an IslandNo Company is an IslandAAA learning curve is steep and arduousExpertise level across industry is unevenNot many companies have enough resources to achieve stochastic AAA without outside helpPeer reviews/sharing of industry practices can helpLearn from experiences of developed countriesIndustry/regulators should provide significantly more support to actuarial organizations like AIRC than they are doing now.

Key MessagesKey MessagesCFT/AAA benefits companies; should be understood and supported by managementStochastic AAA with asset models should be the long-term methodology for most Taiwan products. Should start to prepare NOWAAA is an industry-wide project; need collective efforts from all companies & regulatorsNeed strong focus on and significant investments in the training of well-qualified AA’s

Thank You for Inviting MeWrite me if I can be of further help

Yek Cheng, MassMutual Mercuries Lifeyekcheng@mail.mli.com.tw