Synthetic GIC Proposal 11-28-12 - American Academy Of .

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Synthetic GIC Reserve ProposalDeposit Fund Subgroup of the ARWGPresented to the National Association of Insurance Commissioners’Life Actuarial Task ForceWashington, DC - November 2012The American Academy of Actuaries is a 17,000-member professional association whosemission is to serve the public and the U.S. actuarial profession. The Academy assists publicpolicymakers on all levels by providing leadership, objective expertise, and actuarial advice onrisk and financial security issues. The Academy also sets qualification, practice, andprofessionalism standards for actuaries in the United States.Deposit Fund SubgroupTina Kennedy, F.S.A., M.A.A.A., ChairDonald Krouse, F.S.A., M.A.A.A.James Lamson, F.S.A., M.A.A.A.June Lu, F.S.A., M.A.A.A.Albert Manning, F.S.A., M.A.A.A.Richard Mattison, F.S.A., M.A.A.A.James McNicholas, F.S.A., M.A.A.A.Jaime Mosquera, F.S.A., M.A.A.A.George Quillan, F.S.A., M.A.A.A.Jared Scholten, C.E.R.A, F.S.A, M.A.A.A.Charles Souza, C.E.R.A, F.S.A.,M.A.A.A.David Sowers, A.S.A., M.A.A.A.Michael Ward, F.S.A., M.A.A.A.Marc Whinston, F.S.A., M.A.A.A.Matthew Wininger, F.S.A., M.A.A.A.11850 M Street NW Suite 300 Washington, DC 20036Telephone 202 223 8196Facsimile 202 872 1948www.actuary.org

BackgroundIn August 2010, the Life Health and Actuarial Task Force (“LHATF”) of the National Association ofInsurance Commissioners (“NAIC”) requested that the Deposit Fund Subgroup of the AmericanAcademy of Actuaries’ Annuity Reserve Work Group (“Subgroup”) investigate and recommendmodifications to the existing statutory regulations applicable to in-force business based on the reportpresented at the 2010 NAIC National meeting in Seattle. The August 2010 report highlighted possibleareas to review, including the valuation methodology for synthetic guaranteed investment contracts(“Synthetic GICs”) and guaranteed separate accounts.The purpose of this document is to provide the Life Actuarial Task Force (“LATF”), the group whichhas assumed the responsibilities of LHATF with respect to life insurance, with a recommendation tomodify the existing statutory valuation methodology for Synthetic GICs. The Subgroup intends toprovide a separate document with recommendations for a principle-based approach to the statutoryvaluation methodology.For reference, the NAIC Synthetic Guaranteed Investment Contract Model Regulation1 (the “NAICModel”) defines a Synthetic GIC (in Section 4W) as a “group annuity contract or other agreement thatin whole or in part establishes the insurer’s obligations by reference to a segregated portfolio of assetsthat is not owned by the insurer.”For additional reference, the NAIC Model provides, in pertinent part, in Section 10A(1):At all times an insurer shall hold minimum reserves in the general account or one or moreseparate accounts, as appropriate, equal to the excess, if any, of the value of the guaranteedcontract liabilities determined in accordance with Paragraphs (6) and (7) of this subsection,over the market value of the assets in the segregated portfolio less the deductions provided forin Paragraph (2)2 of this subsection. These reserve requirements shall be applied on a contractby-contract basis.Paragraph (6) (referred to above) provides in pertinent part: the minimum value of guaranteed contract liabilities is defined to be the sum of the expectedguaranteed contract benefits, each discounted at a rate corresponding to the expected time ofpayment of the contract benefit that is not greater than the maximum multiple of the spot ratesupportable by the expected return from the segregated portfolio assets, and in no event greaterthan 105 percent of the spot rate as described in the plan of operation .“Spot rate” as used in Paragraph (6) above is defined in Section 4(V) of the NAIC Model in pertinentpart as follows:“Spot rate” corresponding to a given time of benefit payment means the yield on a zero-couponnon-callable and non-prepayable United States government obligation maturing at that time, orthe zero-coupon yield implied by the price of a representative sampling of coupon-bearing,non-callable and non-prepayable United States government obligations .1The NAIC Model’s reserve mechanism is incorporated into the NAIC Accounting Practices and ProceduresManual in appendix A-695 (“NAIC APPM A-695”) by means of the partial reproduction of the NAIC Modeltherein.2Paragraph (2) of Section 10A provides for a series of reductions from the market value of segregated portfolioassets.2

Moreover, Section 10D(1) of the NAIC Model provides in pertinent part:(1) Reserves for synthetic investment contracts subject to this regulation shall be an amountequal to the sum of the following:(a) The amounts determined as the minimum reserve as required under Section10A(1);(b) Any additional amount determined by the insurer’s valuation actuary asnecessary to make adequate provision for all contract liabilities.Note that Synthetic GICs may also be subject to the requirements of: State of California Department of Insurance Bulletin No. 95-10 New York State Department of Financial Services Regulation No. 128 Nebraska Department of Insurance, Title 210, Chapter 80 Connecticut Regulation 38a-459RecommendationThe Subgroup recommends changes to existing model/statutory regulations applicable to in-forceSynthetic GIC business with respect to the determination of the discount rate and, for certain types ofcontracts, to the deduction from the market value of assets. The proposed changes are as follows: Determine the present value of guaranteed contract liabilities by substituting spot rates derivedfrom a blend of U.S. Treasury-based spot rates and spot rates derived from the Barclays ShortTerm Corporate Index and U.S. Corporate Investment Grade Bond Index rates for 105 percentof the Treasury-based spot rate in Paragraph (6) of Section 10A of the NAIC Model.Eliminate the deduction from the market value of assets required by Paragraph (2) of Section10A of the NAIC Model provided that under the Synthetic GIC the asset default risk is borneby the policyholder.The proposed methodology results in a reserve equal to the greater of zero and the excess of the presentvalue of guaranteed contract liabilities over the market value of assets.The proposed methodology recognizes that the guaranteed contract liabilities are supported by theunderlying segregated assets and to the extent that segregated assets are not sufficient, by assets of theinsurance company held in the general account or in a separate account, if the reserve is established in aseparate account as provided for in Section 10A(1) of the NAIC Model. The proposal contrasts withthe existing Synthetic GIC valuation methodology which caps the discount rate at a rate “ in no eventgreater than 105 percent of the spot rate.”The segregated portfolio of assets is managed under a set of investment guidelines that is included aspart of the Synthetic GIC. The investment guidelines generally include permissible investments, nonpermissible investments and activities, portfolio characteristics with respect to duration, asset quality,diversification and liquidity, and changes in investment guidelines upon a book value termination event.Permissible investments typically include cash or equivalents, Treasuries, government agencysecurities, asset-backed securities, mortgage-backed securities, commercial mortgage-backed securities,publicly-traded corporate bonds, and private placements. The investment guidelines may also include abenchmark against which the performance of the segregated portfolio of assets is to be measured.3

Based on the Stable Value Investment Association’s (“SVIA”) Stable Value Funds’ QuarterlyCharacteristics Survey dated February 6, 2012 with participation from 24 stable value managers,wrapped stable value assets as of December 31, 2011 of 440 billion had the following weightedaverage characteristics: crediting rate of 2.86%; duration of 2.74; and AA credit quality.The proposed discount rate incorporates a reference to two indices of U.S. corporate grade bonds(collectively referred to herein as the “Bond Index”) as the proxy for the yield on the underlyingsegregated assets and the recommendation is a blend of the Bond Index with the existing Treasurybased spot rate. The Barclays U.S. Corporate Investment Grade Bond Index was selected as acomponent of the Bond Index because: (1) it is widely used in portfolio management; (2) it iscommonly used as a component of the benchmark for the segregated asset portfolio; (3) it providesmore reference rates across the maturity spectrum than alternative indices; and (4) it does not includestructured notes, Treasuries or government agency securities. In addition, Barclays Capital also offers ashort-term index, which is important since the Barclays U.S. Corporate Investment Grade Bond Indexhas a minimum constraint of one-year to maturity. The combination of the Barclays Short Term Indexand the U.S. Corporate Investment Grade Bond Index (again, collectively referred to herein as the“Bond Index”) provides reference rates across the maturity spectrum.The Subgroup’s recommended blend is 50% of the existing Treasury-based spot rate and 50% of thespot rate derived from the Bond Index. The blend was derived from three sources: (1) principles fromthe general account valuation interest rate methodology; (2) the Barclays historical spread-to-Treasuriesdecomposition for the U.S. Corporate Investment Grade Bond Index; and (3) a review of historicalTreasury rates and index reference rates. The proposed blending factors are consistent with the use ofplan type for on-balance sheet products to address interest rate risk associated with policyholderwithdrawal options. The proposed blending factors are also consistent with recent historical short-termaverage default cost. The Barclays historical spread decomposition study separates the credit spreadinto three components: default cost, risk premium and liquidity cost. The most recent study over theperiod January 2007 through May 2012 reveals that the average default cost, risk premium and liquiditycost as a percent of the total spread were 46%, 35% and 19%, respectively. Therefore, 54% of the totalspread contributed to the net yield. The use of a recent short-term average default cost is reasonable fora Synthetic GIC as the underlying segregated asset portfolio duration typically ranges from 2 to 4 years,with the average from the SVIA survey cited above at 2.74 years. Further, the proposed blendingfactors generally produce results consistent with a constant percentage of the Treasury rate in a majorityof interest rate environments and provide a more reasonable result in the recent historical financialmarket environments of low Treasury rates and wide investment spreads. Refer to Attachment 1 for ahistorical comparison of 105% of the U.S. Treasury spot rate and a 50/50 blend of an intermediatecorporate index and the 5-7 year U.S. Treasury index.In addition, the proposed methodology provides for a liability valuation that is more consistent witha market value asset valuation. In the existing methodology, assets are reflected at market valuewhile the present value of guaranteed contract liabilities is determined using the expected returnfrom the segregated portfolio assets subject to a cap (i.e. 105% of the Treasury-based spot rate).The discount rate in the existing methodology does not necessarily reflect the market environmentand may result in a disparity between the valuation of assets and the valuation of liabilities ifspreads widen, as the expected return increases and the market value of the assets falls. Theproposed methodology utilizes a top-down approach to determine the discount rate and is similar tothe deterministic reserve computation in the proposed VM20 section of the Standard Valuation Lawthat utilizes the path of net asset earned rates as the discount rate.4

The proposed methodology uses the market value of the assets on the valuation date, and eliminates thededuction to assets to the extent the asset default risk is borne by the policyholders. This is analogous tothe current asset valuation reserve (“AVR”) requirement for separate accounts when asset defaults arepassed directly to the policyholders. The elimination of the deduction is appropriate when thecontractual provisions pass the asset default risk to the policyholder. If the asset default risk is borne bythe insurance company, then the existing deduction from the assets remains appropriate in the valuationmethodology.The Subgroup believes the proposed valuation methodology is a significant improvement over thecurrent valuation methodology because it reflects the asset segregation, recognizes the default riskretention by the policyholder, appropriately aligns the liability relationship to the underlying assets, andshould reduce the asset and liability valuation basis mismatch. The Subgroup recommends that LATFmodify the existing statutory valuation for Synthetic GICs to be consistent with the proposed valuationmethodology described in this document.Illustrative ResultsFor the illustration, we have assumed that the Synthetic GIC is a participating evergreen (no fixedmaturity) contract that provides for quarterly rate resets subject to a floor of 0%, is designed to passmost investment and plan cash flow experience, and default risk to the policyholder, is benefitresponsive with respect to most participant initiated payouts, and provides a market value payout attermination or a delayed book value payout at the election of the policyholder if book value exceedsmarket value at termination. Refer to Attachment 2 for specifications of the sample Synthetic GIC usedto illustrate the reserve requirements.In addition, the illustration reflects 5 of the 7 historical valuation dates for which yield curve graphs areprovided in Appendix F. These graphs show that there have been valuation dates when 105% of theTreasury-based rate and the recommended 50% Barclays, 50% Treasury rate were reasonablycomparable over all maturities. This was true when the NAIC Model and New York State InsuranceDepartment Regulation 128 were introduced and prior to the financial market crisis in 2008; refer to thegraphs for December 31, 1990 through December 31, 2006. On the other hand, there were valuationdates, notably September 30, 2008 and December 31, 2008, when the two quantities divergeddramatically, after which they again converged, but not to the pre-2008 levels.Attachment 3 illustrates the reserve requirements for the above sample contract under the NAIC APPMA-695, New York State (“NYS”) Regulation No. 128 and the ARWG proposal, as well as the impact toeach reserve based on the recommendation. The illustrative reserves are computed using a book valueof 100 million on the valuation date, and assumptions with respect to contract duration, currentcrediting rate and the market value of the segregated portfolio of assets. Contract duration assumptionswere 2, 3 and 4 years. Current crediting rate assumptions were 2%, 3% and 4%. Market valueassumptions were 90 million, 95 million and 100 million, which translate to 90%, 95% and 100%market value to book value (“MV/BV”) ratios, respectively.Using the illustrative contract and assumptions, and the results in Attachment 3, the impact to thereserve is most significant on historical valuation dates when Treasury rates are low and credit spreadsare relatively wide. This is attributed to the value of the guaranteed contract benefits reacting tochanges in market conditions to a greater degree than in existing regulation. With respect to the threeassumptions (contract duration, current crediting rate and market value of assets), the pattern of reserves5

is similar under the current methodology and the proposed methodology That is, the reserve increasesas the MV/BV ratio deteriorates, as current crediting rates increase and as duration shortens.6

Appendices Appendix A - Calculation of Discount Rates Appendix B - Alternative Indices including Comparison of Metrics Appendix C - Comparison of Metrics from Bond Indices considered Appendix D - Information about the Barclays U.S. Corporate Investment Grade Bond Index Appendix E - Information about the Barclays Short Term Corporate Index Appendix F - Yield Curve Graphs for multiple historical dates7

Attachment 18

Attachment 2 – Illustrative Synthetic GICInterest - for Crediting RateCR {(1 Y) * (MV/BV) (1/D)} - 1 - F, whereCR the crediting rate, the effective annual rate of interest,Y the dollar weighted average yield of the securities in thesegregated portfolio as of the calculation date,MV the market value of the segregated portfolio as of thecalculation date,BV the book value account as of the calculation date,D the effective duration of the securities in the segregatedportfolio as of the calculation date, andF the effective annual rate of the fees, which may include thefollowing:(1) administration and risk fee(2) investment management feeIn the event the MV/BV ratio falls within any of the followingranges as of any rate reset date, the insurer has the right to adjust Din the crediting rate formula, as follows:MV/BV95% MV/BV 97.5%92.5% MV/BV 95%90% MV/BV 92.5%MV/BV 90%Permitted Adjustment of D90% or more of D85% or more of D75% or more of D50% or more of DRate reset date - 1st day of each quarterRisk / AdministrativeInvestment ManagementThe crediting rate is subject to a 0% floor. by applying an annual effective rate of 0.25% to the balance inthe book value account as of the end of the prior day. by applying an annual effective rate to the balance in the bookvalue account as of the end of the prior day in accordance with thefollowing schedule:0.18% of the first 100 million, plus0.13% of the next 100 million, plus0.10% of the excess over 200 million9

Termination ProvisionsBy the policyholder: on 10 days’ notice, option of:1. Lump sum at MV2. Lump sum at BV at end of 5 years. If, as of any rate reset dateduring the extension period prior to the end of 5 years, the MVequals or exceeds the BV Account, the contract terminates with nopayment by the insurance company. Investment guidelines willchange during the winding down period.By the insurer: on 90 days’ notice, lump sum at BV at end of 5years. If, as of any rate reset date during the extension period priorto the end of 5 years, the MV equals or exceeds the BV Account,the contract terminates with no payment by the insurance company.Investment guidelines will change during the winding down period.DefaultsBenefit ResponsivePaymentsThe policyholder will absorb market value losses through thecrediting rate reset mechanism, subject to the 0% floor, and defaultrisk is passed through to the policyholder through an impairedsecurity provision.For plan participants upon death, retirement, disability, terminationof employment, or for providing in-service and hardshipwithdrawals or loans to active participants in accordance with theprovisions of the plan.The contract allows transfers to other plan-offered investmentoptions, including competing options, but any transfers tocompeting options must first go through a non-competing planoption and reside there for at least 90 days.The following order of withdrawal from the stable value fund is tobe followed by the policyholder:(i) first, from the current cash flow to the extent sufficient;(ii) second, from the cash buffer assets, if any; and(iii) third, from the book value account on a pro-rata basis amongthe contract and other book value instruments held in the fund.10

Attachment 3Blend of 50% Treasury – 50% Bond IndexIllustrative Synthetic GIC Reserve Requirements(in millions)Source: Deposit Fund Subgroup of the Annuity Reserve Working Group11

Attachment 3(continued)Blend of 50% Treasury – 50% Bond IndexIllustrative Synthetic GIC Reserve Requirements(in millions)Source: Deposit Fund Subgroup of the Annuity Res

has assumed the responsibilities of LHATF with respect to life insurance, with a recommendation to modify the existing statutory valuation methodology for Synthetic GICs. The Subgroup intends to provide a separate document with recommendations for a principle-based approach to the statutory valuation methodology.

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