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Fair value measurement (Market-consistent accounting (Challenges (It…
Fair value measurement
VA Basics
Income sources
Mortality & Expense
charged against
AV
; low when market tanks
(Ben base - AV) increases; higher claims
Low fee income & High claims
Fund fees
charged against AV
Rider charges
charged against
benefit base
; usually increasing
Separate account => SEC-regulated
GMXB's => embedded put options sold to policyholders
Market-consistent accounting
Fair value guarantees in GAAP & IFRS
MCEV
Solvency II & Solvency Modernization Initiative
Intention
Account for business on the same basis
Increase transparency & consistency
Challenges
It includes ambiguous elements (liquidity premium) that interfere consistency
Not reflective of long-term nature of life insurance
Companies don't believe this increases transparency
Create short-term results that are out of management's control
GAAP&IFRS vs MCEV
Risk margin vs. cost of capital
Non-performance risk vs liquidity premium
Income taxes
VA Stat. reserves & Req. capital
Stat => AG43
CARVM
Max of
CTE70
Basic reserves
C3 Phase II => RBC
Max of
CTE90
Basic reserves
RM techniques for fair value liabilities
Accept financial risk in liabilities
Product mix
Decide if it wants to have business exposed to systematic market risk
Product design
Decide the extent of guarantees
Immunizing financial risks
ALM
Duration or CF matching
Hedging
Subset of ALM, enter into derivatives that offset financial exposure in liability guarantees
Reinsurance
Retain business, indemnified by reinsurer, replaced by reinsurer's credit risk
Product mix and development
Trends in VA prod design
Fee structures
no longer are tied to
account value
Cost of hedging
considered in
pricing
process
Restrictive in the types of available funds =>
tradable indices
to limit
basis risk
Policyholder behavior be considered in pricing
=> reaction on market cond. & eliminate hard-to-predict guarantees
Severely reduce
rollups
and
ratchets
Hedging
Common practices
Interest rate risk
EIA & EIUL
Purchase options to replicate policyholder option
VA products
Greeks
Delta
Gamma
Vega
Rho
VA Hedging
Hedging effectiveness
Against overall financial risk
Against hedging target
Challenges
Hard to offset mkt exposure in funds
Uncertainty in policyholders behavior
Make judgment on illiquid instruments
Hard to interpret accounting movements
Req. resources & coordination
Investment; skill sets; models & controls
IT
Computing capacity
Features
Dynamic hedging
Rebalance periodically
Overnight calc greeks
Exclude nonperformance risk & risk margins
Use unadjusted implied volatilities
Reinsurance
Why lack reinsurance for VA?
No economy of scales
Companies with hedging prog is large enough
Law of large number doesn't apply
VA financial risks are systemic risks; LLN only applies to indep. variables
Need higher cost & refuse extra risks
Reinsurance includes policyholder behavior risk
Pricing gap & info asymmetry
Company sell VA at a loss on MCEV, but reinsurer doesn't want
Ceding company unwilling to lock in future loss
SOP03 reserves < fair value; but reinsurance pricing close to fair value
Why reinsurance may still happen?
Lower RBC
Underweight on C-2 but overweight on C-3 => gain RBC efficiency
Full credit in Stat. reporting
Hedging can't materially reduce AG43 & C3P2 req.
Economy of scales
Small companies have a need to issue VA but incapable of setting up hedging prog.
Potential drivers for change (VA)
Rising interest rates => reinsurance pricing more in line with insurance company pricing
Fair value pricing => If more common to price a positive MCVNB
More active reinsurance marketplace => easier to obtain reinsurance
New forms of reinsurance => in hopes of limiting tail risk exposure to policyholder behavior
Better understanding of tail risk