A5 Valuation Outlines

CALM
Implica-ons of AcSB Sec-on 3855 Financial Instruments!
CALM Implica-on of AcSB

Sec-on 3855 Financial Instruments
Source: CIA Educa/onal Note: CALM Implica/ons of AcSB Sec/on 3855 Financial
Instruments – Recogni/on and Measurement (June 2006)!
By Peter Chong, FSA, FCIA!
!
!
CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 1!

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments!
Cross reference lessons:

•  Approxima-ons to CALM
•  Beginners Guide to CALM

Purpose and Key Topics in This Lesson

Purpose:
Understand implica-ons of CICA 3855 (mainly for CALM)
Key Topics:
1.  Issues and challenges
2.  Guidance and considera-ons
3.  Appendices
4.  Review ques-on
5.  Key takeaways
Text Colour Reference

•  Black – Normal text
•  Green – Defini-on
•  Blue – Cross-reference
lesson
Introduc-on

•  Principles of CALM remain unchanged
•  CALM reserve = amount of suppor-ng assets which are forecasted to

reduce the last liability cash flow to zero
•  Pre-3855
•  Asset:
•  Historical cost
•  Realized gains/losses are deferred and amor-zed
•  Liability: defined by SoP (aka CALM reserve)
•  Hedge accoun-ng: off balance sheet
•  Post-3855
•  Asset:
•  Some are not good for suppor-ng liabili-es
•  Realized gains/losses are recognized immediately
•  Unrealized gains/losses flow through OCI
•  Liability: no change
•  Hedge accoun-ng: all deriva-ves @ fair value
Issues and challenges

•  HFT and FVO
•  Balance sheet: fair value
•  Income statement: regular income
•  Classifica-on requirement:
•  HFT
•  Deriva-ves, unless for hedging
•  Short-term profit taking
•  FVO
•  Eliminates or significantly reduces accoun-ng
mismatch
•  Risk mgmt or investment strategy
•  Issues and challenges:
•  Approximate CALM and true-up process
•  US GAAP vs CGAAP differences
•  Line item vola-lity
Issues and challenges

•  AFS
•  Balance sheet: fair value
•  Income statement:
•  Regular:
•  Investment income
•  Changes in amor-zed cost (i.e. Book value)
•  Realized gains/losses
•  OCI:
•  Unrealized gains/losses (or its changes)
•  Creates disconnect
•  Income variability
•  Issues and challenges:
•  Does not reflect linkage between assets and liabili-es
under CALM
•  Approx CALM and true-up process
•  US GAAP vs CGAAP differences

Guidance and considera-ons

•  Data
•  FV of instruments not predictable
•  Asset classifica-on is very important
•  Book yields more variable
•  HFT and FVO vola-lity

•  In theory, perfect with CALM
•  In prac-ce, approxima-on methods may lead to inaccurate
true-ups


•  AFS
•  Investment income à income statement
•  Unrealized gains/losses à OCI
•  Change in liability à income statement
•  Asset and liability mismatch

•  Dura-on of assets
•  Future tax
•  May cause addi-onal tax -ming differences


Income statement $ ('000)

Investment income - AFS assets 50
Change in book value - AFS assets 700
Change in liability
- 1,000
OCI $ ('000)
Unrealized gains/losses - AFS assets 250


•  Controls
•  Current
•  Policy liability trend, roll-forward and movement
analysis
•  Analysis of changes in book yield and dura-on
•  Asset movement analysis
•  Inclusion controls
•  New controls
•  Es-mated FV vs SV
•  Real--me asset movement analysis
•  Controls on manual adjustments
•  Repor-ng and disclosure

Appendices

•  HTM
•  Must have posi-ve inten-on
•  Determinable cash flows
•  Pro
•  Same as pre-3855
•  Defini-on and condi-ons as under US GAAP
•  Con
•  Sale or reclassifica-on of significant amount will have
penalty
•  L&R and real estate

•  Same as pre-3855

Review ques-on

Q: LFV-C 2014 Oct Q9

Review ques-on

A:

HFT:
Investment income = 100
Changes in FV = 27,000 – 26,000 = 1,000

Net income
AFS:
= 100 + 1,000 + 300 + 1,200 + 200 – 200
= 2,600
Changes in BV = 50,000 – 48,800 = 1,200

HTM:

Changes in BV = 20,000 – 20,200 = -200

Review ques-on

A:

AFS OCI:
= Unrealized gains/losses (2013) – unrealized gains/losses (2012)
= (70,000 – 50,000) – (69,000 – 48,800)
= 20,000 – 20,200
= -200

Key takeaways

1.  Issues and challenges (HFT and FVO and AFS)
2.  Guidance and considera-ons
•  Data
•  Controls
3.  Income statement treatment
•  Regular income statement
•  OCI

Accounting for Financial Instruments Designated as FVO
Source
• ILA-C618-13: OSFI Guideline D-10: Accounting for Financial Instruments Designated as Fair Value
Option
Basel Committee Guidance
• OSFI expects institutions using FVO to follow Basel Committee principles

• OSFI’s regulation of companies using FVO will also be based on Basel Committee principles
IAS 39 Guidance on FVO
May use FVO under IAS 39 if
• Consistent with a documented risk management strategy

• Eliminates or significantly reduces measurement or recognition inconsistency
• Fair values are reliable for the life of the instrument
Fair values should be based on IAS 39 criteria
Using FVO for loans and receivables
• Generally should not use if gross revenue from loans is less than $62.5 million
© 2011 The Infinite Actuary, LLC ! ! ! ! ! ! ! 1

IFRS: Classification of Contracts
Source
• Educational Note: Classification of Contracts under International Reporting Standards
Scope
© 2010 The Infinite Actuary, LLC 1

Classification of Contracts - General Process

For Insurance and Investments. . .
1. If there is an embedded derivative:

- Separate from host and measure E.D. at fair value
2. If there is a service component:

- Acquisition / service expenses accounted for under IAS 18
3. If there is a deposit component. . .

- Apply IAS 39 to deposit component separately
- Also may need to unbundle service component from deposit
★Apply IFRS 4 to the remaining insurance component

★Apply IAS 32 and 39 to remaining investment component
For Investments Only. . .
1. Does contract have a discretionary participation feature (DPF)?

- YES: apply IFRS 4 and IAS 32
- No: IAS 32 and IAS 39

Summary
You start with some contract and potentially split it into these pieces:
• Insurance
• Investment
• Embedded derivative
• Service contract
• Deposit
• DPF

The 9 Steps - More Detail
Step 1 - obtain relevant information
• Entity’s products, services
Step 2 - Definition of a contract for accounting purposes
• Clear economic consequences; enforceable at law

• Reasons may want to separate parts for accounting purposes
- parts managed separately
- parts held in different pools for risk equalization
- parts treated differently for participation or prem adjustment
- parts can be transferred or canceled separately
- parts have different counter-parties
- parts sold on standalone basis
• Reason to combine contracts for accounting purposes
- fully negatively correlated cash flows
- formal sales programs to sell agreements together
- joint consideration in internal procedures

Step 3 – Classification of stand-alone service contracts
• Service contracts that

- do not create financial assets or liabilities
- do not transfer insurance risk
- provide a fee for service
Step 4 - Classification as an insurance contract
• Insurance is contract where

- insurer accepts significant insurance risk from policyholder and compensate policyholder if insured
event adversely affects policyholder
• “Significant” = benefits that are paid under any scenario except those that lack commercial substance
- “Commercial” = discernible effect on the economics of transaction
• Decision is made contract by contract
Step 5 - Classification as an investment contract
• Must give rise to financial asset or liability

• Must not be insurance
• Exception: DPFs

Step 6 - Discretionary participation features
• Contract contains guaranteed elements

• May or may not recognize guaranteed elements separately
• Purpose of splitting off DPF would be so guarantees would be appropriately assessed
Step 7 - Service components
• Does not create financial assets or liabilities

• Is not insurance
• Involves contractually agreed tasks
• A service is provided for a fee
Step 8 - Embedded derivatives
• separate PG identifies embedded derivatives

Step 9 - Unbundling of a contract into components
• “Component” = smallest part of contract that

- has separable feature
- contains economic features of stand-alone contract
• Remaining portion must also be stand-alone
• Pricing and design of components must be the same as if were stand-alone
• Deposit component
- permitted if deposit can be measured ignoring other components
‣ e.g. UL with fixed DB
- required if
‣ some obligations of deposit would not be recognized
‣ deposit can be measured ignoring insurance component
• Insurance component
- may unbundle insurance component from non-insurance contract
• Service component
- okay to unbundle from investment contracts
- not okay from insurance contracts

IFRS: Disclosure Requirements for Life Insurers!
IFRS: Disclosure Requirements

for Life Insurers
Source: CIA Research Paper,
IFRS: Disclosure Requirements for Life Insurers (December 2010)!
!
!
IFRS: Disclosure Requirements for Life Insurers! 1!


Purpose:
Know the different disclosure requirements for IFRS 4 and IFRS 7
Key Topics:
1.  IFRS 4
2.  IFRS 7
3.  Other disclosures
4.  Key takeaways
Text Colour Reference

•  Red – Important note
•  Blue – Cross-reference
lesson
IntroducMon

•  IFRS requires addiMonal disclosures
•  Purpose:

•  ID actuarial disclosures
•  Analyze impacts
•  Provide guidance
•  IFRS 4 = insurance contracts
•  IFRS 7 = investment contracts and embedded derivaMves

IFRS disclosure requirements

Comments and illustraDve examples
IntroducMon


IFRS 4 – insurance contracts

37(a) AccounMng policies for insurance contracts

Disclose info for amounts from insurance contracts
Disclose accounDng policies for insurance contracts
•  Accountants primarily responsible

•  Actuaries to provide input
•  QualitaDve descripDon only
•  DescripDon of accounDng policies for:
•  Premiums
•  Fees
•  AcquisiDon costs
•  Claims
•  PfAD


37(b) Breakdown of liability balances

Disclose gains/losses from reinsurance

•  Appropriate to report liabiliDes net of reinsurance if reinsurance is not

material





Cross reference lesson:

•  ValuaMon of Gross Policy LiabiliMes and Reinsurance
Recoverables


37(c) AssumpMons

Disclose the process used to determine the
assumpDons that have the greatest effect on
measurement of the recognized amounts

•  QuanDtaDve disclosures
•  Elements discussed:
•  Types of assumpDons used
•  DescripDon
•  AssumpDon delineaDon
•  AssumpDon determinaDon
•  Frequency of review
•  How changes are made
•  Purpose of margins and how they’re set
•  Taxes
•  Reinsurance asset

37(d) Effects of changes in assumpMons

Disclose the effect of changes in assumpDons that
have a material effect on financial statements
•  Rather than disclose the impact on gross liabiliDes

•  QualitaDve discussions include:
•  Discussion of each change
•  Reason for change
•  Impact of each change
•  Observed trends




37(e) Roll-forward of insurance contracts

Disclose the reconciliaDon of changes in insurance
liabiliDes, reinsurance assets and any related DAC
•  Gross liabiliDes, reinsurance asset and net liabiliDes shown separately




39(a) Risk objecMves and policies for managing risk

Disclose informaDon to evaluate the nature and extent
of risks arising from insurance contract liabiliDes, as
well as risk mgmt objecDves, policies and processes

•  QualitaDve descripDon of main risks and risk mgmt strategy
•  No quanDtaDve disclosure required
•  Examples of risk for consideraDon:
•  Longevity risk
•  Mortality and morbidity risk
•  Market risk
•  Persistency risk
•  Expense risk
•  Product design and pricing risk
•  Catastrophe


39(c)(i) Insurance risk - sensiMviMes

Disclose informaDon about insurance risk before
and aQer reinsurance, including informaDon about
sensiDvity analysis on profit or loss and equity
•  Disclosures can be quanDtaDve or qualitaDve

•  Primarily prepared by CRO, risk managers or CFO




39(c)(ii) Insurance risk - concentraMon

Disclose concentraDons of insurance risk,
including a descripDon of how mgmt determines
concentraDon
•  QuanDtaDve disclosure is not required

•  Historical experience from catastrophes


39(c)(iii) Insurance risk - claims

Disclose actual vs expected claims (i.e. claims
development)
•  Not required for life insurance and annuiDes


39(d) Credit risk, market risk and liquidity risk

Disclose informaDon about esDmated Dming of
net cash ouUlows resulDng from recognized
insurance liabiliDes

•  Within scope of IFRS 7
•  Asset-related info is outside scope (with few excepDons)




39(e) Embedded derivaMves

Disclose informaDon about exposures to market
risk from ED in a host contract if it is not
measured at FV

•  Disclosures can be quanDtaDve or qualitaDve

IFRS 7 – investment contracts and EDs

8 Carrying amounts of financial liabiliMes

Disclose carrying amounts for each of the following categories:
Financial liabiliDes at FV
Financial liabiliDes at amorDzed cost
•  Roll-forward for investment contracts

•  FV or AC
•  With or without DPF


Cross reference lesson:

•  IFRS Measurement of Investment and Service Contracts


Investment contracts with or without DPF – measured at FV

Investment contracts without DPF – measured at AC


21 & 27 AccounMng policies & methods and assumpMons

Disclose accounDng policies and measurement bases
Disclose methods and assumpDons applied in
determining FV
•  DescripDon for the following could be provided:

•  Contract classificaDon
•  Nature of contracts
•  DeterminaDon of FV
•  Disclosure of where FV could not be esDmated
•  Carrying value vs FV
•  AccounDng policies used for premiums, fees, claims, reinsurance etc
•  QualitaDve discussions include:
•  Discussion of each change
•  Reason for change
•  Impact of each change
•  Observed trends




25 FV vs carrying value

Disclose the FV such that it can be compared with
its carrying value


31 Risk qualitaMve and quanMtaMve disclosure

Disclose informaDon to evaluate the nature and
extent of risks arising from financial instruments
•  QualitaDve and quanDtaDve disclosure

•  Overlaps with IFRS 4
•  Credit
•  Reinsurance counterparty risk
•  Liquidity risk
•  ObligaDons by maturity date
•  Currency
•  SensiDvity


34(c) ConcentraMon risk for insurance and investment contracts

Disclose concentraDons of risk if not apparent
from risk exposure quanDtaDve disclosure
•  QualitaDve and quanDtaDve disclosure

•  Overlaps with IFRS 4

Other disclosures

•  Assets supporMng liabiliMes
•  Provision for credit losses


Key takeaways

1.  Key word – DISCLOSURE
2.  IFRS 4 – insurance contracts
3.  IFRS 7 – investment contracts and ED
4.  Detailed disclosures and transparency!

IFRS: Measurement of Investment and Service Contracts!
IFRS: Measurement of Investment and

Service Contracts
Source: CIA Educa/onal note: Measurement of Investment
Contracts and Service Contracts under IFRS (June 2009)!
!
!
IFRS: Measurement of Investment and Service Contracts! 1!


Purpose:
Understand the recogniCon and measurement of a financial instrument and
service component under IFRS

Key Topics:
1.  Measurement
2.  Financial instrument component
•  ApplicaCon for amorCzed cost model
•  Requirements for amorCzed cost model
•  ApplicaCon for FV model
•  Requirements for FV model
3.  Service component Text Colour Reference
•  ApplicaCon for service contracts •  Black – Normal text
•  Red – Important note
•  Requirements for service contracts •  Green – DefiniEon
4.  AllocaCon of expenses •  Blue – Cross-reference
lesson
5.  Key takeaways •  Purple – Formula
IntroducCon

•  Two objecCves:
1.  Determining the valuaCon of liabiliCes under the financial
instrument component
2.  Recognize revenue and expenses under the service
component

IntroducCon

•  Excludes:
•  Insurance contracts
•  Contracts with DPFs
•  Hedge accounCng for investment contracts
Financial
instrument Deposits
Investment
contract ReducEon
Service in liability
component
Service Service
component Revenue
contract

Measurement

•  Pro-rated
•  IniCal measurement of financial instrument = FV + transacCon
cost

Measurement

•  Financial instruments
•  TransacCon cost (financial instrument): incremental costs
that are directly a\ributable to the acquisiCon, issue or
disposal of a financial asset or liability
•  Cannot defer and amorCze transacCons costs
•  Host investment contract = iniCal FV – cost of ED
•  Cost of ED is standalone contract
•  Service components
•  TransacCon cost (service contract): incremental costs that
are directly a\ributable to securing an investment
management contract are recognized as an asset if they can
be idenCfied separately and measured reliably
•  Deferral is allowed

6!
Measurement

•  Subsequent measurement

Discounted
cash flow
Financial Service
instrument component

Asset categories
Financial Financial 1.  FV
liability asset 2.  HTM
3.  L&R
4.  AFS
AmorEzed cost FV - Profit and loss

- EffecCve interest method

ApplicaCon for amorCzed cost model

•  Approach
•  Based on expected surrender pa\erns
•  Fees are treated as cash flow
•  No margins
•  Inclusions
•  Cash flows
•  Renewal payments (judgment required)
•  Indeterminable elements:
•  Excess interest credits
•  Bonuses
•  OpCons and guaranteed cash flows
•  Exclusions
•  Admin costs
ApplicaCon for amorCzed cost model

•  DeterminaCon of amorCzed cost
•  AmorCzed cost is the amount measured at iniCal
recogniCon – principal repayments ± cumulaCve
amorCzaCon - reducCons
•  AmorCzaCon schedule
•  EffecCve interest rate = IRR
•  IniCal measurement
•  TransacCon costs
•  Amount and Cming of cash flows
•  EIR cannot be changed once determined

Requirements for amorCzed cost model

•  Floored at surrender value
•  Contract replacement
•  If modificaCon is considerable, original liability is replaced
•  If modificaCon changes PV of cash flows < 10%:
•  EIR does not change
•  Future cash flows would change
•  No allowance for tax

ApplicaCon for FV model

•  Quoted from acCve market
•  No acCve market, valuaCon techniques:
•  Arm’s length transacCons
•  FV of similar instruments
•  Discounted cash flow method
•  OpCon pricing models


•  Approach
•  Depend on investment and market
•  Discounted cash flow approach
1.  Develop models using risk principles
•  Calibrate to observed market
•  DeterminaCon of margins
2.  Apply IFRS rules
•  No commonly accepted pracCce


•  Margins for risk and uncertainty
•  Reflected for material assumpEons
•  Account for effects of uncertainty
•  EsCmaCon errors
•  DeterioraCon
•  FluctuaCon
•  Larger margin if:
•  Low confidence
•  Event is further in the future (increase uncertainty)
•  PotenCally severe consequences
•  Occurrence is more subject to staCsCcal fluctuaCon
•  Risk is not diversifiable
•  Not meant to cover short-term fluctuaCons

13!

•  CalibraCon
•  Apply direct adjustment to provisions
•  Similar approach for stochasCc model

Requirements for FV model

•  Discount rate à yield on replicaCng poriolio
•  Adjust to reflect risk of default:
1.  Direct à include probability of default
2.  Indirect à Increase discount rate
•  Minimum deposit floor
•  No allowance for tax

ApplicaCon for service contracts

•  Revenue is recognized by stage of compleCon
•  CondiCons for reliable esCmates:
•  Revenue can be measured reliably
•  Should financially benefit the company
•  Stage of compleCon can be measured reliably
•  Costs can be measured reliably
•  ImplicaCons:
•  Accurate allocaCon of fees
•  Reliable cash flows and stage of compleCon
•  No margins for risk and uncertainty
•  Determine expected cash flows and PDF
•  IFRS requirements apply
•  TransacCon costs capitalized on b/s

Requirement for service contracts

•  Recoverability test for deferred transacCon costs


AllocaCon of expenses

•  Overview
•  Expense allocated amongst:
•  Each classificaCon and subdivision of contracts
•  Each category of expense
•  Each related product group
•  Non-recurrent expenses
•  Criteria for non-recurrent expenses:

•  Material
•  Not part of ongoing operaCons
•  Not regularly recurring


Key takeaways

1.  Measurement
2.  Financial instrument
•  AmorCzed cost model
•  Fair value model
3.  Service components

IFRS: Embedded Deriva1ves and Deriva1ves!
IFRS: Embedded Deriva1ves and

Deriva1ves
Source: CIA Research Paper: Embedded Deriva9ves and Deriva9ves (December 2009)!
!
!
IFRS: Embedded Deriva1ves and Deriva1ves! 1!


Purpose:
Focus on recogni1on, measurement and disclosure of deriva1ves
and EDs
Key Topics:
1.  Defini1on
2.  ID of components
3.  Deriva1ves according to IAS 39
4.  Iden1fica1on of EDs
5.  Separa1on of EDs Text Colour Reference
6.  Measurement/disclosure issues •  Red – Important note
•  Orange – List to
7.  Key takeaways memorize
•  Green – Defini1on
Introduc1on

•  IAS 32, IAS 39, IFRS 4, IFRS 7
•  IAS 39:
•  Criteria for iden1fying a deriva1ve
•  Condi1ons for separa1on from host contract
•  IFRS 4:
•  Financial repor1ng purposes
•  Addi1onal condi1ons for separa1on
•  Special disclosure requirements

Defini1on

•  Deriva1ves

•  Defini1on: a deriva1ve is a financial instrument whose
value changes in response to the change in a financial
index, but does not include the rights to the investment
contract
•  Contain market risk

•  Measured at fair value
•  Contracts meets defini1on of deriva1ve and insurance
contract, then it’s treated under IFRS 4

Defini1on

•  Embedded deriva1ves (ED)

•  Defini1on: an embedded deriva1ve is a feature within a
contract, such that the cash flows associated with that
feature behave in a similar fashion to a stand-alone
deriva1ve
•  Condi1ons to separate an ED from its host:

•  Host contract is not measured at fair value
•  Not related to other parts of the contract
•  Meets stand-alone defini1on of a deriva1ve
•  ED containing significant insurance risk are not separated

ID of components

•  Flow chart for separa1ng ED
from host contract

•  A few things to note:
•  Only IFRS 4
•  Can be outside the scope of
IFRS 4 but within the scope
of IAS 39
•  If component meets criteria
of deriva1ve, the accoun1ng
criteria for separa1on of ED
are met

Deriva1ves according to IAS 39

•  3 characteris1cs of a deriva1ve:
a)  Value changes in response to change in a specific
underlying price or interest rate (called underlying)
b)  Requires ini1al investment
c)  Se_led at future date


•  Interpreta1on of a): impact of market factors:
•  Characteris1cs for a market factor:
•  Specific
•  Variable
•  It is a financial variable or, if its not a financial variable,
it is not specific to a party
•  Market factors must affect the contract financially


•  Interpreta1on of b): alterna1ve investments:
•  Alterna1ve investments are other types of contracts with
similar responses to changes in market factors
•  Examples:
•  Private equity
•  Managed funds
•  Real estate
•  If alterna1ve investment is not available, is it not
considered a deriva1ve
•  Should have the features of a deriva1ve but cannot be a
deriva1ve



Iden1fica1on of EDs

•  EDs are deriva1ves embedded in a contract (duh!)
•  Must have the following characteris1cs:
•  Combined with a non-deriva1ve host contract
•  Combined (hybrid) contracts have a clause to change cash
flows that are otherwise payable
•  The change in cash flow is in response to market factors
•  Only consider components wri_en in the contract

•  Ar1ficial split – split the contract for understanding
•  Policyholder op1on – should not be split if there are no
underlying market factor risks
•  Foreign currency – implicit contract clause is an ED

Iden1fica1on of EDs

•  Iden1fica1on of ED cash flows
•  Effects on cash flow include:
1.  Direct trigger from market factors
2.  Compound market factors
3.  Double triggers
4.  Market factors that influence counter-par1es
•  Iden1fica1on the component

•  Do not split if the following condi1ons are not met:
•  Explicit contract clause
•  Split cash flow between host and ED
•  Must not contain cash flows from host
•  No exclusions or double coun1ng

Separa1on of EDs

•  Measured separately from host, at FV, if condi1ons for
separa1on are met:
a)  ED and host do not have similar economic characteris1cs
and risks
b)  A separate instrument would meet the defini1on of a
deriva1ve
c)  Hybrid (combined) instrument is not measured at FV

Separa1on of EDs

•  Interpreta1on of a): close rela1onship:
•  ED and host are considered closely related if:
•  If splicng risk not possible
•  If pricing of ED is similar to host
•  If they have same 1me variables
•  Interest rate caps/floors would not be separated

Separa1on of EDs

•  Interpreta1on of c): FV measurement of hybrid contract:
•  Separa1on of an ED that is measured at FV is not allowed
•  No guidance on FV insurance risk

Measurement/disclosure issues

•  Measurement issues
•  Separated ED is measured at FV
•  Host contract is measured depending on IFRS 4
•  Disclosure issues
•  Disclosure included in IFRS 4 and IFRS 7
•  ED in hybrid contracts not measured at FV under IFRS 4
•  Otherwise, no specific requirements

Key takeaways

1.  Defini1ons
2.  Lots of lists!!!
1.  Characteris1cs of a deriva1ve (slide 7)
•  Characteris1cs for a market factor (slide 8)
2.  Characteris1cs for iden1fying an ED (slide 11)
3.  Condi1ons to separate an ED from its host (slide 5 and 13)
•  How to determine if ED and host are closely related
(slide 14)
4.  Effects on ED cash flows (slide 12)
IFRS: Embedded Deriva1ves and Deriva1ves!

17!
Actuary(vs(Accountants(
Future(Income(and(Alterna3ve(Tax(
Source:(CIA$Educa*onal$Note:$Future$Income$and$Alterna*ve$Taxes$excluding$Appendix$D$(December$2012)$$
Key(Takeaways:(
$
(
•  There$are$temporary$and$permanent$differences$in$income$as$determined$for$GAAP$
repor*ng$and$for$taxa*on$purposes$
•  Purpose$=$Discrepancy$in$projected$tax$reserves$between$Accountants$and$Actuaries,$need$
to$calculate$FTCO$and$DFTP$to$bridge$the$gap$$
•  Try$not$to$get$lost$in$all$the$formulas$and$focus$more$on$theory$
Text(Colour(Reference(
•  Black(–(Normal(text(
•  Green(–(Defini3on(
•  Red(–(Important(point(
•  Purple(G(Formula(
©$2015$The$Infinite$Actuary,$LLC$ 2$
1.(Background(
$
IFRS$phase$1$
•  Liability$is$required$for:$
•  Future$investment$income$tax$
•  Future$capital$tax$that$is$not$recoverable$or$cannot$be$offset$by$income$tax$
•  Permanent$or$temporary$future$income$tax$differences$
$
Income$tax$and$alterna*ve$tax$
•  Income$tax$is$tax$based$on$income$
•  Alterna*ve$tax$is$tax$that$interacts$with$income$tax$
•  Temporary$and$permanent$differences$results$in$the$need$to$include$projected$income$taxes$
•  *Assume(padded(GAAP(assump3ons(will(equal(future(experience((ie(no(experience(gain/loss)(
when(projec3ng(future(taxes.(This(means(there(is(no(future(profit(from(the(release(of(PfADs.(
Therefore,(there(is(no(need(to(hold(a(reserve(for(future(taxes(for(future(profit$
1.(Background((cont’d)(
$
Permanent$vs$Temporary$Differences$
•  Permanent$differences$–$difference$in$income$in$repor*ng$periods$between$tax$and$GAAP$are$
not(fully(reversed$over$the$life*me$of$the$item.$
•  Examples$include:$
•  Dividends$from$Canadian$stocks$
•  Net$capital$gains$on$real$estate$
•  Income$from$Canadian$subsidiaries$
•  NonZtaxable$investment$income$
$
•  Temporary$differences$–$difference$in$income$in$repor*ng$periods$between$tax$and$GAAP$which$
are(fully(reversed(over$the$life*me$of$the$item$(ie$*ming$differences).$
•  Examples$include:$
•  GAAP$and$tax$liabili*es$differences$
•  Real$estate$and$deriva*ves$–$valued$differently$for$tax$and$GAAP$purposes$
•  Policy$loans$
•  DAC$
$
2.(Development(of(insurance(contractGrelated(tax(cash(flows(
(
•  Reserves$should$include$provisions$for$insurance$related$tax$cash$flows$
•  Income$taxes$and$capital$taxes$form$differences$between$MTAR$and$GAAP$reserves$
•  Investment$income$related$tax$cash$flows$from$the$assets$that$support$the$policy$liabili*es.$
$
•  There$are$two$approaches$when$trea*ng$underclaims$and$loss$carryZforwards$(LCF)$
•  Underclaim$–$projected$tax$cash$flow$arising$from$differences$between$claimed$tax$liabili*es$and$
MTAR$
2.(Development(of(insurance(contractGrelated(tax(cash(flows((cont’d)(
$
•  There$are$two$approaches$when$trea*ng$underclaims$and$loss$carryZforwards$(LCF)$(cont’d)$
•  Method(1(is$to$project$taxes$associated$with$the$reversal$of$the$underclaims$and$amor*za*on$of$
LCF$that$are$not$insurance$contractZrelated$
•  MTAR$=$GAAP$policy$liabili*es$
•  Underclaim$and$LCF$are$ignored$in$the$GAAP$policy$liabili*es$
$
•  Method(2(is$to$use$the$original$source$of$the$underclaim$or$LCF$and$that$determines$whether$
the$associated$projected$taxes$are$insurance$contractZrelated$
•  More$complex$
3.(Calcula3on(of(the(future(tax(provision(
(
•  Insurance$Contract$Liability$Ignoring$Future$Taxes$(ICLIFT)$–$the$insurance$contract$liability$calculated$
excluding$future$income$and$capital$taxes.$Includes$provision$for$premium$taxes$and$investment$
income$taxes$
•  Discounted$Future$Tax$Provision$(DFTP)$–$the$provision$in$the$insurance$contract$liabili*es$for$future$
income$and$capital$tax$cash$flows$related$to$insurance$contract$liabili*es$and$suppor*ng$assets$
•  Insurance$Contract$Liability$Before$CarveZout$(ICLBCO)$=$ICLIFT$+$DFTP$
•  Future$Tax$CarveZout$(FTCO)$–$accoun3ng(provision$for$future$taxes$related$to$insurance$contract$
liabili*es.$This$is$the$amount$of$the$accoun*ng$future$tax$asset/liability$that$will$be$separately$reported$
on$the$CGAAP$balance$sheet.$
•  Insurance$Contract$Liability$Aeer$CarveZout$(ICLACO)$=$ICLBCO$–$FTCO.$This$is$the$amount$of$insurance$
contract$liabili*es$reported$on$the$CGAAP$balance$sheet.$$
•  Future$Tax$Liability$(FTL)$–$undiscounted$provision$for$future$taxes$related$to$insurance$contract$
liabili*es$determined$by$accountants.$FTL$=$FTCO.$
•  Net$Balance$Sheet$Posi*on$(NBSP)$=$ICLACO$+$FTL.$This$is$equivalent$to$the$ICLBCO$as$long$as$
temporary$differences$are$insurance$contractZrelated.$
$
General$Principles:$be$familiar$with$this$sec6on$but$the$formulas$will$not$be$reiterated$here.$
3.(Calcula3on(of(the(future(tax(provision((cont’d)(
(
Calcula*on$Method$1:$CALM$Tes*ng$
•  Project$tax$cash$flows$along$with$other$liability$cash$flows$.$
•  A$direct$method$to$incorporate$DFTP$in$the$insurance$contract$liabili*es.$
•  Steps:$
•  1.$Develop$liability$data$and$select$economic$assump*ons.$
•  2.$Perform$CALM$tes*ng$for$the$ICLIFT$excluding$future$income$and$capital$taxes.$
•  3.$Determine$tax$assump*ons$for$the$MTARs$and$corporate$tax$rates.$
•  4.$Perform$CALM$tes*ng$for$the$ICLBCO$by$projec*ng$future$tax$cash$flows$along$with$
liability$cash$flows$with$margins.$
•  The$resul*ng$liability$ICLBCO$=$ICLIFT$+$DFTP.$
$
$
Calcula*on$Method$2:$Discoun*ng$Approach$
•  An$approxima*on$to$CALM.$
•  DFTP$is$calculated$by$discoun*ng$the$future$tax$cash$flows$at$the$aeerZtax$GAAP$earned$rate$on$
the$addi*onal$assets$suppor*ng$the$future$tax$cash$flows.$
•  Steps$to$calculate$the$DFTP:$
•  1.$Develop$liability$data$and$select$economic$assump*ons.$
•  2.$Perform$CALM$tes*ng$for$the$ICLIFT$excluding$future$income$and$capital$taxes.$
•  3.$Determine$tax$assump*ons$for$the$MTARs$and$corporate$tax$rates.$
•  Steps$1;3$are$iden6cal$to$Method$1$
•  4.$Project$future$cash$flows$using$a$separate$model.$
•  5.$Calculate$the$DFTP$by$using$the$formula$below.$
•  DFTPk$=$Σt>k$vt–k$j$Tt$,$where$$
•  Tt$=$txt$j$PolTaxProfitt,$and$$
•  vt–k$=$Π$t>k$[1$+$it–k$j$(1$–$txt–k)]–1$$$
(
Calcula*on$Method$3:$Itera*ve$Approach$
•  An$approxima*on$to$CALM.$
•  DFTP$is$calculated$itera*vely$by$developing$future$tax$cash$flows$in$a$separate$model.$
•  CALM$tes*ng$is$performed$to$determine$the$liability.$
•  Several$itera*ons$are$required$to$ensure$accuracy.$
•  Steps$to$calculate$the$DFTP:$
•  Ini*al$steps$(1Z3)$are$the$same$as$the$discoun*ng$approach$and$produces$the$DFTP$using$a$
before$tax$discount$rate.$
•  1.$Develop$liability$data$and$select$economic$assump*ons$
•  2.$Perform$CALM$tes*ng$for$the$ICLIFT$excluding$future$income$and$capital$taxes$
•  3.$Determine$tax$assump*ons$for$the$MTARs$and$corporate$tax$rates$
•  The$following$itera*ve$steps$(4Z6)$replaces$the$DFTP$calcula*ons.$
•  4.$Project$future$tax$cash$flows$using$a$separate$model$based$on$previous$results$of$
the$CALM$tes*ng$for$tax$cash$flows$and$MTARs$
•  5.$Add$future$tax$cash$flows$to$liability$cash$flows$with$margins$
•  6.$Perform$CALM$tes*ng$for$the$ICLBCO$with$the$future$tax$cash$flows$and$liability$
cash$flows$with$margins$determined$in$step$5.$
(
4.(Insurance(contractGrelated(balance(sheet(items(
(
•  GAAP$reserves$would$be$adjusted$to$avoid$doubleZcoun*ng.$
•  If$the$actuary$and$accountant$have$consistent$views$on$future$recoverability$of$a$tax$asset,$the$only$
change$in$the$net$balance$sheet$posi*on$due$to$inclusion$of$future$taxes$in$the$GAAP$reserves$would$
be$due$to$the$impact(of(discoun3ng.$
(
5.(Calcula3on(of(future(tax(carveGout(
(
•  The$FTL$is$the$accoun3ng$liability$establish$on$the$balance$sheet$in$respect$of$the$temporary$difference$
between$MTAR$and$GAAP$insurance$contract$liabili*es$and$tax$and$GAAP$asset$values.$
•  The$FTL$is$“carvedZout”$of$the$GAAP$liability$to$avoid$doubleZcoun*ng.$
•  The$accountants$FTL$is$calculated$as:$
•  FTL$=$tx$j$[(MTAR$–$ICLACO)$+$(GAAP_A$–$Tx_A)]$
•  tx$=$tax$rate$
•  MTAR$–$ICLACO$=$liability$differences$
•  GAAP_A$–$Tx_A$=$asset$differences$
•  To$avoid$doubleZcoun*ng,$the$FTL$is$subtracted$from$the$GAAP$insurance$contract$liabili*es:$
•  ICLACO$=$ICLBCO$–$FTCO$$
$$$$$$$$$$$=$ICLIFT$+$DFTP$–$FTCO$$
•  Sub$in$ICLACO$into$the$FTL$equa*on:$
•  FTL$=$tx$j$[(MTAR$–$(ICLIFT$+$DFTP$–$FTCO))$+$(GAAP_A$–$Tx_A)].$$
•  Set$FTL$=$FTCO$and$solve$for$the$FTCO:$
•  FTCO$=$tx$j$[(MTAR$–$(ICLIFT$+$DFTP))$+$(GAAP_A$–$Tx_A)]$/$(1$–$tx).$
(
6.(Recoverability(
(
•  Possibility$of$projected$tax$savings$or$nega*ve$tax.$
•  To$benefit$from$a$tax$loss,$there$must$be$an$alterna*ve$source$of$income$that$is$taxable$otherwise.$
•  However,$the$sources$of$recoverability$is$different$between$the$accoun*ng$and$actuarial$perspec*ve.$
•  Must$only$consider$relevant$insurance$contracts$and$suppor*ng$assets.$
•  Projected$release$of$PfADs$are$not$considered$a$source$of$recoverability$
•  Surplus$that$is$used$for$recoverability$must$be$determined$based$on$exis3ng$sources.$
Sure!$I’ll$put$that$on$my$$
Let’s$grab$a$drink,$$ Accounts$Receivable$
$$$$$$$$I’ll$buy!$
LFV-102: Actuarial Review of Reserves
LFV-102: Actuarial Review of Reserves and Other Annual

Statement Liabilities
Ed Robbins (2009)
Video By: J. Eddie Smith, IV, FSA, MAAA
LFV-102: Actuarial Review of Reserves 1 / 19
Key Exam Topics in This Lesson
Actuarial Reviews: Overview, Key Relationships, and Principles

Overview
Relevant Professional and Regulatory Publications
Relationship with Accountants in External Audits
Impact of Principles-Based Reserves on Reviews
General Principles of a Satisfactory Audit or Review
Reserve Assembly Process and Reviews
Actuarial Review Techniques
LFV-102: Actuarial Review of Reserves Actuarial Reviews: Overview, Key Relationships, and Principles 2 / 19
Overview of Actuarial Reviews
This reading is about “reviews,” not “audits” (sort of)
I Reviews involve verifying the accuracy of reserves and related financial
statement items
I “Audit” has a more precise meaning and may involve reviews
I Principles in this reading apply to audits though
I The more remote the review, the more critical the review should be
People involved in the review process
1. State insurance departments
2. External accounting firms
3. Independent reviewing actuaries
4. Internal staff: actuaries, accountants, etc.
Relevant Professional and Regulatory Publications

Several other ASOPs, but these appear on the LFV syllabus:
ASOP 11: Financial Statement Treatment of Reinsurance Transactions

ASOP 21: Responding to or Assisting Auditors/Examiners in Connection with Financial
Statements
ASOP 22: Statements of Opinion Based on Asset Adequacy Analysis
ASOP 41: Actuarial Communications
AAA publications
1. “Applicability Guidelines for Actuarial Standards of Practice”
2. “Qualification Standards for Actuaries Issuing Statements of Actuarial Opinion
in the United States”
NAIC Accounting Practices and Procedures Manual
Relationship with Accountants in External Audits
Context: actuary is part of an external audit team
“Using the Work of a Specialist” – guide written for CPAs
I Actuaries are a category of specialist (don’t blush)
I Auditor should recognize need for specialist
I Specialist should be competent and independent of client
I Auditor’s must evaluate specialist’s competence/findings

Rely on ASOP 21
I When using findings of a specialist, the auditor should
I Obtain an understanding of methods and assumptions

I Make appropriate tests of data provided by specialists
I Evaluate whether the findings support the assertions
I Apply additional procedures if findings unreasonable
Impact of Principles-Based Reserves on Reviews
I PBR will be less uniform than traditional rules-based stat reserves

I Entity-specific assumptions continually updated
I Multiple scenarios possible
I Actuarial reviews under PBR will required new techniques
I Creates new role: PBR Reviewing Actuary to review AA’s work
General Principles of a Satisfactory Audit or Review
Especially important for external reviews when actuary is not in charge
1. Courtesy and respect from reviewing actuary
2. Clear understanding of the objectives of the person requesting the review
3. Plan the review in advance
4. Write down all questions, issues, and concerns
I Address each one by end of review
5. Sampling principles:
I Explore all elements of chosen samples
I Representative samples seek to discover important errors
I Pay special attention to: new plans, new benefits, and operations changes
6. Reference previous review if periodic review
7. Customer should choose a single point of contact for large reviews
8. Examiner should have the item he/she is checking for numerical accuracy
9. Leave no links untested in the assembly trail
Reserve Assembly Process and Reviews
I Reviewing actuary should understand reserve assembly process

I Specific process varies by company
I Look at the trail from reserve calculations to balance sheet
I Create a schedule of deadlines, etc.
I Starting point for review process
LFV-102: Actuarial Review of Reserves
Actuarial Reviews: Overview, Key Relationships, and Principles
Actuarial Review Techniques

Key Overall Conclusions
6 Actuarial Review Techniques
Theory of Sampling
Types of Spot Checks
Tests of Aggregate Progress of Reserve
Analysis of Reserve Tests
Tests of Relationships of Items With Financial Items
Tests of Inventory
Tests of Reserve Adequacy
LFV-102: Actuarial Review of Reserves Actuarial Review Techniques 9 / 19
Key Overall Conclusions
Errors of principle are more important than clerical errors
Large items have more priority than small items

Give priority to
I Elements that haven’t been tested yet when spot checking
I New plans, new products, and recent procedural changes
I Final report before other work (get it done!)

6 Actuarial Review Techniques
1. Spot checks
I Theory of sampling
I Types
2. Independent full recomputations
I Completely recalculate reserves
I Easy if have factor files
3. Tests of aggregate progress of reserve
4. Tests of relationships of reserve items with financial items
5. Tests of inventory
6. Tests of reserve adequacy
Theory of Sampling
Systematic sampling: sort elements then take ever nth element
Stratified sampling: use a 2nd characteristic to group (more statistically precise)
s
SDM = p = standard deviation of the sample mean
N
✓ ◆2
nj
Total Stratified Variance = Â ⇥ SDM2j
j
N
p
Stratified SDM = Total Stratified Variance < SDM without stratification
Using Theory of Sampling to Actuarial Reviews

I Allows selection of elements for spot-checking
I Estimating the number of errors in the total block of business
I Estimating how errors of principle will effect the entire block (e.g. coding errors)
I Testing first-time computer runs
I Estimating the success of past improvements

Stratified Sampling Illustration
n 2
Region µ s n SDM SDM2 N ⇥ SDM2
1 80.00 20.00 14 5.345 28.570 0.560
2 175.00 37.00 15 9.553 91.270 2.050
3 96.00 24.00 29 4.457 18.860 1.670
4 300.00 60.00 42 9.258 85.740 15.120
190.91 106.56 100 19.400
SDM 10.66 4.40
106.56
SDM Without Strat = p = 10.66
100
p
SDM With Strat = 19.4 = 4.40
Types of Spot Checks
1. Tests of calculations
I Propriety of assumptions (experience based vs. prescribed)
I Methodology
I Check policy folder or contract language
I Contact the policyholder directly
I Validate model cells against actual company inventories
2. Transactional checks (policy counts, etc.)
3. Policy trace – check many non-ledger items at once at policy level

Tests of Aggregate Progress of Reserve
8
>
<0 M + P + I
> C VD VT for life insurance (“Formula I”)
1M = 0 M + P + I + (T A) Payments for life annuities (“Formula II”)
>
>
: M + P + I Payments for interest-only reserves (“Formula III”)
0
0 M, 1 M = beginning and ending reserves V D , V T = reserves released on death, other terminations

P = total valuation net premiums T = tabular reserve released on death
I = tabular interest A = actual reserve released on death
C = tabular cost of mortality Payments = payments to policyholders
Analysis of Reserve Tests

Formula I: Ratios for Life Insurance
C I C
Formula Ia: Formula Ib:
0 M + P/2 Average Amount at Risk
Precautions:
I Don’t use for fund-drive products
I Adjust if business mix has changed
Formula II: Analyze (T A) component of life annuity formula

T
I Analyze stability of Total Life Annuity Reserve
I T should be very stable
I A/T = overall actual-to-expected mortality ratio (tests mortality table adequacy)
Formula III: Deposit Accounts and Fund-Driven Products (UL, DAs)

I Obtain credited rates and calculate credited interest independently
I Roll AV forward with calculated credited interest ! compare to reported AV
I Compare computed credited interest to reported credited interest
Tests of Relationships of Items With Financial Items
Look at 3 years for unusual trends
Adjust out new business
Examples:
Reserve or Other Actuarial Item Unit of Measurement
Individual Life Insurance Reserves Insurance IF
Group Unearned Premium Reserve Incurred Group Premiums
Substandard Extra Premium Reserve Total Incurred Premium
Ordinary Disability (Active) Annual Premiums to Be Waived IF
ADB Reserve ADB IF
Disabled Life Reserves (Individual) Annual Premiums to Be Waived IF on Claim
Group Waiver Disable Life Reserves Amount of Insurance IF on Claim
Tests of Inventory
1. Static Validation (balance sheet items)

I Invested assets
I Face amounts
I Stat reserves
2. Dynamic Validation (income statement items)
I Compare income statement items with historical results
I More complex than static validation
I Project starting with last year-end ! compare to current year-end

Tests of Reserve Adequacy
1. Loss Ratio Tests (Group and A&H)
I Based on incurred claims and earned premiums
2. Adjusted Loss Ratio Tests (A&H portfolios with additional active life
reserves)
I Look at historical Incurred Claims + DActiveLifeRes
3. GPV Methods
I GPV = PV(Ben + Exp – Prem)
I PV(Book Profits) = (Stat Reserve – GPV) ) should be positive
4. Claim Runoff Tests (aka development method tests)
1) Compile claims by incurred date and paid date
2) Calculate claim reserve using claim development table
I Reserve = Expected Claims – Claims Paid To Date
I Precautions:
I Serious limitations for long-tailed claims
I There are many alternative approaches to linkage factors
I Recent incurral months are often NOT credible
I Company operations might adversely affect development test results
Supplement)to)LFV.102)Lesson:)Claim)Runoff)Test)
!
! Jan) Feb) Mar) Apr) May) Jun) Jul) Aug) Sep) Oct) Nov) Dec) (1)) (2))
1) 10! 25! 60! 80! 100! 120! 140! 155! 180! 195! 200! 200! ! !
2) ! 12! 30! 72! 96! 120! 144! 168! 186! 216! 234! 240! 200! 0!
3) ! ! 14! 36! 86! 115! 144! 173! 202! 223! 259! 281! 440! 200!
4) ! ! ! 17! 43! 104! 138! 173! 207! 242! 268! 311! 710! 429!
5) ! ! ! ! 21! 52! 124! 166! 207! 249! 290! 321! 966! 655!
6) ! ! ! ! ! 25! 62! 149! 199! 249! 299! 348! 1153! 832!
7) ! ! ! ! ! ! 30! 75! 179! 239! 299! 358! 1390! 1042!
8) ! ! ! ! ! ! ! 36! 90! 215! 287! 358! 1550! 1192!
9) ! ! ! ! ! ! ! ! 43! 107! 258! 344! 1650! 1292!
10) ! ! ! ! ! ! ! ! ! 52! 129! 310! 1664! 1320!
11) ! ! ! ! ! ! ! ! ! ! 62! 155! 1557! 1247!
12) ! ! ! ! ! ! ! ! ! ! ! 74! 804! 649!
) ! ! ! ! ! ! ! ! ! ! ! ! 396! 322!
! ! Page! 1!
!
) Compilation)of)Completion)Factors) Reserve)Calcs))@)Dec.)31)
Months) (1)) (2)) (3)) (4)) (5)) (6)) (7)) (8))

since)
incurral) ) ) Completion)Factors) Month) Paid) Total) Reserve)
Incurred) to) Exp)
date)
1) 396! 322! 2.497! 19.965! Dec! 74! 1477! 1403!
2) 804! 649! 2.399! 7.996! Nov! 155! 1239! 1084!
3) 1557! 1247! 1.334! 3.333! Oct! 310! 1033! 723!
4) 1664! 1320! 1.250! 2.498! Sep! 344! 859! 515!
5) 1650! 1292! 1.200! 1.998! Aug! 358! 715! 357!
6) 1550! 1192! 1.166! 1.666! Jul! 358! 596! 238!
7) 1390! 1042! 1.107! 1.428! Jun! 348! 497! 149!
8) 1153! 832! 1.161! 1.291! May! 321! 414! 93!
9) 966! 655! 1.084! 1.112! Apr! 311! 346! 35!
10) 710! 429! 1.026! 1.026! Mar! 281! 288! 7!
11) 440! 200! 1.000! 1.000! Feb!&!Prior! 240! 240! 0!
12) 200! 0! ! ! ! ! ! !
! ! ! ! ! ! 3100! 7706! 4606!
Calculations:!
•! Columns!(1)!and!(2)!are!the!same!columns!from!the!previous!table,!written!in!reverse!
order!
•! (3)j!=!(1)j+1/(2)j!These!are!the!linkage!factors!
•! (4)!contains!the!Completion!factors.!!Starting!at!the!bottom,!each!is!the!product!of!the!
Linkage!factors!from!the!end!to!that!month.!!!
•! The!product!of!the!completion!factor!and!the!claims!paid!to!date!for!an!incurral!duration!
gives!the!total!incurred!claims.!
•! (6)!is!the!December!column!from!Table!3,!written!in!reverse!order!
•! (7)!=!Total!Expected!Claims!=!(6)!x!(4)!
•! (8)!=!Reserve!=!Total!Expected!Claims!–!Claims!Paid!to!Date!=!(7)!–!(6)!
!
! ! Page! 2!
LFV-133: Cluster Analysis – A Spatial Approach
LFV-133: Cluster Analysis: A Spatial Approach to Actuarial

Modeling
Freedman and Reynolds (August 2008)
Video By: J. Eddie Smith, IV, FSA, MAAA
LFV-133: Cluster Analysis – A Spatial Approach 1 / 14
Key Exam Topics in This Lesson
Classic Modeling
The Problem: Nested Stochastic Modeling
Classic Approaches to Reducing Runtime
Modified Seriatim
Cluster Modeling
User Steps
Process Steps
Advantages Over Classic Modeling
Potential Applications
Specific Products
Validation
LFV-133: Cluster Analysis – A Spatial Approach 2 / 14

The Problem: Nested Stochastic Modeling
• IFRS
• PBA
• C-3 Phase II
• VA CARVM
• SOP 03-1
• FAS 133
• Dynamic hedging
Dramatically
increased
runtime
LFV-133: Cluster Analysis – A Spatial Approach Classic Modeling 3 / 14
Classic Approaches to Reducing Runtime
1. Give us FASTER computers!

2. Now give us MORE computers!
3. Let’s run fewer scenarios
Less
Or fewer paths
accuracy
Or fewer shocks
too
4. Let’s do less frequent re-balancing
Or let’s model fewer cells. . .

Classic Modeling: Modified Seriatim
Seriatim ) no “modeling” done ) include all policies as-is
Modified seriatim methods attempt to reduce the volume of data modeled

1. Combine policies with same issue month, plan, premium mode, etc.
10:1
2. Use quinquennial or decennial issue ages
3. Combine risk classes or map minor plans into major plans
Commonly done, but has drawbacks:
3.1 Must know something about minor plans
3.2 Mapping rules are subjective, hard to automate
3.3 Must update rules for new plans and as in-force changes
3.4 Projected values may not be valid
3.5 Hard to apply rules for multiple life policies and investment guarantees
LFV-133: Cluster Analysis – A Spatial Approach

Classic Modeling
Cluster Modeling
User Steps
Process Steps
Advantages Over Classic Modeling
Potential Applications
Specific Products
Validation
LFV-133: Cluster Analysis – A Spatial Approach Cluster Modeling 6 / 14

Cluster Modeling: User Steps
1. Define location variables and their weights

I Reserves, CSV, premium, PV guaranteed benefits, PV profit, Â Premiums
I Higher weight ) higher priority
2. Define a size variable (face, AV)
I Smaller policies get mapped first
3. Define segments that should not be mapped across
I Business that should not be mixed: plan code, issue year or GAAP era, etc.
I Reduces runtime
1
I Runtime for 10 equal segments = 10 ⇥ runtime for whole group
I Other reasons: reporting, reconciliation, LVs don’t sufficiently distinguish
policies
4. Specify a target number of clusters
Cluster Modeling: Process Steps

1. Calculate distance between any 2 policies
I n-dimensional sum-of-squares approach
q
3 LV case: (LV11 LV12 )2 + (LV21 LV22 )2 + (LV31 LV32 )2
I Normalize LVs by dividing by their size-weighted standard deviation

2. Determine importance of each policy
I Importance = policy size ⇥ distance from the nearest policy
I Higher importance ) less likely to be mapped
3. Create clusters
I Map policy with lowest importance to its nearest neighbor
I Process continues until cluster target is met
4. Determine representative policy for each cluster
I A single policy that is closest to cluster’s average location
I Gross up to reflect size of cluster

Visualizing Euclidean Distance in 2 Dimensions
LV1
a2 + b2 = c2
c
a
Destination policy
b
LV2
Cluster Model Advantages Over Classic
1. Applies to liabilities or even assets

2. Far better compression ratios for a given model-to-actual fit
3. Easily automated ) less manual effort
4. Can be maintained and applied at later valuation dates
5. Priority measures of model fit measures can be customized
6. Applies to seriatim in-force or to modeled in-force
7. Model points are easily adjusted to change for desired granularity
8. Allows on-the-fly analysis of model fit without rerunning a model

Potential Applications of Cluster Modeling
1. Medium-sized models
I Replacement for classic models: nearly reproduces seriatim results
I Uses a large number of segments or cells per segment
I Uses typical LVs: issue age, issue year, in-the-moneyness, etc.
2. Small models
I Can also reproduce seriatim results but with less accuracy
I Good for estimating CTEs
I May not be accurate enough for tail analysis
3. Very small models
I Not appropriate for tail analysis
I May be used to process many scenarios to select a smaller set for another model
I Could be used to quantify sensitivities to key assumptions
As model size falls, use more care in validating!
Cluster Modeling Applied to Traditional and Term Life

Traditional Life/Health Model
I LVs: reserve, FY premiums, FY claims, PV profits
I Segments: None
I Compression: 120,000 cells to 200 cells (60:1)
I Higher-weighted LVs nearly identical
I Close match (95–96%) on lower weighted LVs
Term Life Model
I LVs: reserves, PV various cash flow buckets, Â Premiums for various buckets
I Segments: Issue year-based, and LT period
I Compression: 1.1MM policies to 10,000 cells and 300 cells (110:1 and 3667:1)
I Results: both cluster models fit very well

Cluster Modeling Applied to a VA Block
“A VA model is only useful if it performs well under a variety of scenarios”
VAs are difficult to compress using traditional mapping
I Similar policies have different in-the-moneyness
I Policyholder behavior drives investment allocation ) future returns
Authors tested 2 cluster models against a 9000-cell classic model

1. 250-cell model
I Fit very well
I Could be used for tail analysis
2. 50-cell model
I Also fit well, but had more deviations
I Not appropriate for tail analysis
LVs: AV, PV DBs and other benefits, PV profits (highest weight)
Validating a Small(er) Model
1. Run a large model to obtain results for comparison

2. Do a static validation
I Compare starting balance sheet values
I Adjust weights as needed, make tradeoffs
3. Do a dynamic validation
I Compare projected income statement values
I Compare all components if replacing the large model
4. Run small model over a small scenario set
I Select scenarios of importance
I May only be needed initially and occasionally in the future

A5 Valuation Outlines

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CALM

Implica-ons of AcSB Sec-on 3855 Financial Instruments!

CALM Implica-on of AcSB

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 1!

Cross reference lessons:

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 2!

Text Colour Reference

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 6!

• HFT and FVO vola-lity

• Asset and liability mismatch

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 8!

Income statement $ ('000)

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 9!

• Repor-ng and disclosure

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 10!

• L&R and real estate

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 11!

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 12!

CALM Implica-ons of AcSB Sec-on 3855 Financial Instruments! 15!

Basel Committee Guidance

• OSFI expects institutions using FVO to follow Basel Committee principles

IAS 39 Guidance on FVO

May use FVO under IAS 39 if

• Consistent with a documented risk management strategy

Fair values should be based on IAS 39 criteria

Using FVO for loans and receivables

© 2011 The Infinite Actuary, LLC ! ! ! ! ! ! ! 1

• Educational Note: Classification of Contracts under International Reporting Standards

© 2010 The Infinite Actuary, LLC 1

Classification of Contracts - General Process

© 2010 The Infinite Actuary, LLC 2

For Insurance and Investments. . .

1. If there is an embedded derivative:

2. If there is a service component:

3. If there is a deposit component. . .

★Apply IFRS 4 to the remaining insurance component

For Investments Only. . .

1. Does contract have a discretionary participation feature (DPF)?

© 2010 The Infinite Actuary, LLC 3

© 2010 The Infinite Actuary, LLC 4

The 9 Steps - More Detail

Step 1 - obtain relevant information

• Entity’s products, services

Step 2 - Definition of a contract for accounting purposes

• Clear economic consequences; enforceable at law

© 2010 The Infinite Actuary, LLC 5

Step 3 – Classification of stand-alone service contracts

• Service contracts that

Step 4 - Classification as an insurance contract

• Insurance is contract where

Step 5 - Classification as an investment contract

• Must give rise to financial asset or liability

© 2010 The Infinite Actuary, LLC 6

Step 6 - Discretionary participation features

• Contract contains guaranteed elements

Step 7 - Service components

• Does not create financial assets or liabilities

Step 8 - Embedded derivatives

• separate PG identifies embedded derivatives

© 2010 The Infinite Actuary, LLC 7

Step 9 - Unbundling of a contract into components

• “Component” = smallest part of contract that

© 2010 The Infinite Actuary, LLC 8

IFRS: Disclosure Requirements

•  HFT and FVO vola-lity

•  Asset and liability mismatch

•  Repor-ng and disclosure

•  L&R and real estate

•  Accountants primarily responsible

•  Appropriate to report liabiliDes net of reinsurance if reinsurance is not

•  Rather than disclose the impact on gross liabiliDes

•  Gross liabiliDes, reinsurance asset and net liabiliDes shown separately

•  Disclosures can be quanDtaDve or qualitaDve

•  QuanDtaDve disclosure is not required

•  Not required for life insurance and annuiDes

•  Roll-forward for investment contracts

•  DescripDon for the following could be provided:

•  QualitaDve and quanDtaDve disclosure

•  QualitaDve and quanDtaDve disclosure

•  No commonly accepted pracCce

•  Criteria for non-recurrent expenses:

•  Contain market risk

•  Condi1ons to separate an ED from its host:

•  Market factors must aﬀect the contract ﬁnancially

•  Only consider components wri_en in the contract