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A Rating Agency Perspective On Life Insurer Risk Management


Guarantees have crept into life insurance products - e.g., UL no lapse guarantees (AXXX) ... Mortality assumptions for life insurance policies. 18 ... – PowerPoint PPT presentation

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Title: A Rating Agency Perspective On Life Insurer Risk Management

A Rating Agency Perspective OnLife Insurer Risk
  • Presented by
  • Joel LevineVice President Senior AnalystLife
    Insurance Group

April 26, 2004
Presentation Outline
  • Usefulness of available risk management
    information - rating agency focus versus
    management information and regulatory reporting
  • What rating agencies worry about
  • Lessons from past failures
  • Growing complexity of business GMDB and UL no
    lapse guarantees
  • Secondary market for insurance contracts
  • Hedging VA guaranteed living benefits
  • Conclusions

A Lot Of Data,Not Enough Information
Rating Agency Focus
  • Credit analysis focuses on operating entity and
    enterprise level (holding co.) financial
  • Analyzes the organizations ability to withstand
    stress from multiple sources of risk
  • Comprehensive in scope liquidity, asset default,
    concentration, interest rate, market, inflation,
    actuarial, competitive, reputation, regulatory,
    litigation, merger/business integration, etc.
  • Ongoing concern point of view, except for
  • Compound interaction among risk factors, not just
    one at a time
  • Medium term horizon

Issuer Management Reporting Focus
  • Many issuers are managed as decentralized
    business segments with fragmented reporting
  • Separately managed investment portfolios with
    tailored ALM requirements
  • Management reports (e.g., scenario projections)
    are produced on an independent, business segment
  • Surplus assets are generally ignored
  • Corporate (holding co) balance sheet and income
    components are ignored
  • Affiliated entities are excluded
  • Scenario analysis on a run-off basis

Regulatory Reporting Focus
  • Cash flow testing provides useful information,
    but has its limitations
  • Reserve adequacy focus as opposed to company
    performance (e.g., capitalization level over
  • Not all businesses/products are included
  • Performed on a run-off basis
  • Surplus assets are ignored
  • Corporate (holding co) balance sheet and income
    components are ignored
  • Affiliated entities are excluded
  • Primarily focused on interest rate risk (except
    for NAIC C-3 Phase II)
  • SAP only, no GAAP information

Desirable Supplementary Risk Mgt Reporting
  • Goal is to achieve a clearer understanding of the
    drivers of performance and the potential for
    significant losses tail risk
  • Break-even scenario analysis - what it would take
    to impair the organization over a given time
  • Stress economic scenario analysis
  • VaR/EaR analysis a more comprehensive analysis
    of risk that would reflect compound interaction
    of various risk factors
  • Fair value accounting
  • Embedded value sensitivity analysis

What Do Rating Agency Analysts Worry About?
Lessons From Past Failures
  • General American (1999) liquidity risk of 7-day
    putable funding agreements, reinsurance with a
    weak company, loss of confidence by institutional
  • Confederation Life (1994) heavy investment
    portfolio losses in real estate and commercial
    mortgages, unsuccessful acquisition strategy
  • First Capital Holding (1991) and First Executive
    (1991) losses on high yield bonds, increase in
    policy surrenders impairing company liquidity

The Business Is Getting More Complex and Risky
  • Increasingly, new products are being created with
    a focus on guarantee elements
  • Equity market uncertainty has made investors more
    receptive to floors on returns
  • Guarantees have become huge drivers of annuity
    sales (GMWB, GMIB)
  • Guarantees have crept into life insurance
    products - e.g., UL no lapse guarantees (AXXX)
  • New embedded risks are extremely complex and
    require sophisticated modeling in order to
    understand and hedge them
  • Some companies are developing me-too designs
    without having a full appreciation of the risk

What Keeps A Rating Agency Analyst Up At Night?
  • Issuers that engage in products/activities that
    require undemonstrated competencies and/or that
    lack a cohesive process to manage them
  • Does the issuer recognize the risks it has
    assumed e.g., dollar for dollar partial
  • VA secondary guarantees when did life insurers
    become expert managers/traders of market risk?
  • Does the issuer currently have or can it acquire
    sufficient resources to manage the risks?
  • Is senior management committed?
  • Whos accountable for the process
    nobody/everybody, multiple committees, CRO?

Lesson Learned GMDB Is More Than Actuarial Risk
  • Historically, life insurers accumulated actuarial
    risks and managed them using risk selection,
    diversification, and reinsurance
  • GMDB reinsurers tried to diversify by writing
    new business at different points in time (over a
    market cycle) benefit payment on death only
    would provide diversification by exercise date
  • Back-testing using historical equity market
    prices validated the insignificant economic
    risk of GMDB risk neutral valuation not well
  • Ignored the systematic nature of market risk and
    the temporary impacts on statutory surplus

A Case Study UL No Lapse Guarantee
  • UL no-lapse guarantees expose issuers to
    potentially significant and systematic risks
  • Simultaneous occurrence of low lapse rates and
    low interest rates may produce very large losses
    moderate adverse deviations can create material
  • Moodys is concerned that issuers pricing lapse
    assumptions may be too high and rely upon
    naive/irrational policyholder behavior
  • Pattern of statutory earnings under adverse lapse
    scenario is for losses to emerge in later policy
    durations masking of the problem in the early

A Case Study UL No Lapse Guarantee (Contd)
A Case Study UL No Lapse Guarantee (Contd)
How Will Middle-Tier Issuers Cope?
  • VA secondary guarantee hedging requires a
    significant and expensive commitment of resources
  • Systems development to integrate policy admin
    system with new actuarial modeling systems
  • Hardware massive amount of policy records and
    many thousands of stochastic simulations
  • Accounting support and internal controls
  • Experienced traders
  • Outsource it? can I afford it? - actuarial
    consulting firm, derivatives dealer with a
    turnkey program, emerging reinsurance programs
  • Can a middle-tier issuer remain competitive?

Secondary Market For Insurance Contracts
  • Firms are being formed to facilitate a secondary
    market for annuity contracts and life insurance
    policies and arbitrage the irrational
    policyholder behavior pricing assumptions
  • IBuyAnnuities.com
  • CoventryFirst.com
  • Wall Street capital has not been deployed in a
    significant way to-date, but that could change
  • Potentially dire implications for some issuers
  • Lapse assumptions for in-the-money GMDB,
    GMWB/GMIB, for partial withdrawals
  • Mortality assumptions for life insurance policies

Analyze This Whats The Right Objective For A
Hedging Strategy?
VA Secondary Guarantee Hedging Objectives
  • Reduce the tail risk potential for large
    economic (pv of net cash flows) losses
  • But, subject to external constraints NAIC RBC,
    rating agency capital requirements, preserve
    company shareholder dividend capacity, maximum
    tolerable GAAP income loss, etc.
  • Competing constraints make it difficult to
    resolve analytically (e.g., with an optimizer)
  • For a rating agency, reported GAAP net income is
    not necessarily controlling economics are the
    primary concern

Secondary Guarantees Subject To FAS 133
  • Both assets and liabilities are marked-to-market,
    so GAAP results are reasonably predictable with
    one major exception
  • Popular dynamic hedging practice is to match the
    liability greeks delta, rho, gamma, vega,
    cross-sensitivities trade-off between
    effectiveness and cost
  • Arguments made that implied volatility for
    long-term derivatives fluctuates and tends to be
    mean-reverting makes it difficult to match the
    liabilities sensitivity to changes in volatility

Secondary Guarantees Subject To FAS 133 (Contd)
Secondary Guarantees Subject To FAS 133 (Contd)
  • If long-term implied volatility is noise, can
    it be safely ignored and could one hedge with
    futures only?
  • Maybe, but one shouldnt ignore the risk that
    delta may change significantly with large market
    moves (gamma) therefore, may need some option
  • Under NAIC C3 Phase II, stochastic simulations
    will be used to determine SAP reserve and RBC

Secondary Guarantees Subject To FAS 133 (Contd)
  • NAIC C3 Phase II methodology ignores spot market
    parameters such as implied volatility
  • Hedging vega will not necessarily produce a more
    stable SAP financial result
  • Responses of the hedge assets to changes in
    implied volatility will not be offset by
    corresponding changes in the values of the SAP

Emerging Direction Of Hedging VA Secondary
  • Index hedge long-term options covering well
    defined risks, while the insurer retains the
    uncertain, unhedgeable risks
  • Hedge payoff based upon an assumed basket of
    indices, with provision for basket changes over
    time, and pricing that varies accordingly
  • Insurer retains the basis risk basket vs actual
    fund performance
  • Long-tenor hedge whose payoff approximates the
    payoff pattern of the particular GLB design
    issuer would assume the basis risk between the
    actual VA GLB payoff and the approximation
  • Contractholder exercise efficiency would be
    another source of error

Future Direction Of Hedging VA Secondary
  • Index hedge (contd)
  • Rating implications would depend upon the
    effectiveness of the hedge
  • Insurer would need to demonstrate effectiveness
    through stochastic modeling that the basis risk
    would be manageable i.e., the tail risk
    (economic perspective) would not be excessive
  • SAP impact would need to be considered how
    would statutory surplus be impacted using such a
    hedge under various scenarios?
  • SAP surplus impact might be mitigated by using a
    combination reinsurance/derivatives structure

  • Life insurers are rapidly expanding into new
    types of less familiar risks e.g., trading
    market volatility
  • Management and regulatory reporting needs to
    catch up with the complexity of these new risks
    rapid strides are being made
  • Risk management processes have been developed and
    are evolving - but are untested under extreme
    market conditions
  • Basis risk and modeling risk inherent in hedging
    are difficult to quantify
  • Insurance business has become more risky -
    assessment of risk management skills has become
    more challenging and critical to the credit
    ratings process
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