The Canadian Experience with Principle
Based Valuation and Fair Values
Simon Curtis
Executive Vice President & Chief Actuary
Manulife Financial
September, 2008

Significant Scale
N. American Life Insurers

Global Life Insurers
7866

68

Market Cap in US$ billions

65
55

55
50
36

36
30
2227

26

AFL

30

26

AVIVA

2619

Market data as at July 31, 2008. Source: Thomson Reuters

PRU

METGenerali

MFC

AXA

AIG

ING

China Life

11PFG

LNC

HIG

SLF

GWO

AFL

PRU

MET

MFC

12

AIG
261

Manulife Financial – Operating in over 19
different Countries and Territories GloballyAsia
Canada• Individual Insurance• Individual Wealth Management• Group Benefits• Group Pensions

United States• Insurance• Long Term Care
• Annuities• Group Pensions• Mutual Funds• Fixed Products

Investments

Hong Kong, Philippines, Singapore,
Indonesia, Vietnam, Malaysia, Thailand,
Taiwan, China• Individual Life Insurance• Group Life & Health Insurance• Variable Annuities• Pension Products• Mutual Funds

Japan• Individual Insurance
United States, Canada,• Variable Annuities
United Kingdom, Japan,Australia, Hong Kong,
Southeast Asia
Reinsurance
United StatesCanadaEuropeAsia

3Manulife Financial - Diverse Earnings
Base
2007 - #1 in market sharefor North American ind. life
retrocession market

Corporate & Other
5%Reinsurance
6%

US Insurance
18%

2007 Sales Rank:• #1 Individual life
• #1 Group LTC• #1 Variable life
• #2 Retail LTC

Asia & Japan
20%•2007 Sales Rank:• #3 Vietnam• #4 Shanghai• #5 Singapore• #6 Japan VA• #6 Philippines• #7 Hong Kong

2007 Sales Rank:•#1 Group Health• #1 Individual Seg Funds• #2 Group Pensions• #2 Ind. Fixed Annuities• #2 Individual Life
• #3 Group Life
4US WealthManagement
25%

Canada26%

Based on 2007 shareholders’ earnings in C$.

2007 Sales Rank:• #1 Small case 401(k)• #3 Variable Annuities

Canadian GAAP
Canadian GAAP today applies many of the principles that are likely
to emerge in IFRS
¾ Assets are largely valued on fair value basis on balance sheet¾ Policy liabilities are valued on three building blocks
 Best estimate assumption
 Explicit margins
 Time value of money based on current market yields¾ All assumptions for policy liability valuation unlock and are updated onongoing basis

5

Canadian GAAPAll financial instruments (assets and liabilities) must be classified
into one of the following based on intention, not type oftransaction:
Category
Accounting Treatment
Held for Trading

Fair value: gains/losses included in income
Cannot reclassify a financial instrument into or outof this category while held

Available for Sale(AFS)

Fair value: unrealized gains/losses included inOther Comprehensive Income (OCI)

Held to Maturity (HTM)

Amortized cost

¾ Loans and receivables – Amortized cost however subject to fair value option¾ Real Estate – move to fair value at 3% per quarter¾ Fair Value Option (FVO) – Allows an entity to designate any financial
instrument as “trading” at inception¾ Derivatives – Fair Value: Gains/losses included in income unless part ofhedge relationship6¾ Insurance contracts excluded and valued under CALM method prescribed by
Canadian Institute of Actuaries

Canadian GAAPIn Practice:¾ Held to maturity designation is not used because ofportfolio tainting rules¾ Held for trading designation is used for assets
supporting liabilities to avoid accounting mismatch asliabilities must be based on balance sheet value ofassets¾ Available for sale designation is used for assets
supporting surplus to avoid undue income volatility(unrealized gains/losses not in income)7

Canadian Insurance Contract Valuation¾ Basic method is CALM

CANADIAN ASSET LIABILITY METHOD

THE POLICY LIABILITY IS THE STATEMENT VALUE OFASSETS WHOSE CASHFLOWS ARE JUST SUFFICIENT TOSETTLE THE LIABILITY CASHFLOWS

8How does CALM work?
To apply the method:
1) Start with projected liability cashflows on expectedassumptions
2) Add conservatism to liability cashflows by adding a margin
directly to best estimate assumption
Margin is generally 5-20% of expected assumption

3) Project existing asset cashflows and re-investment of net
cashflows using re-investment strategy
4) A number of reinvestment strategy scenarios are tested and“worst” scenario is identified
5) Add/subtract assets until assets are just sufficient toextinguish liability cashflows
6) Policy liability is statement value of these assets in 5)
9

Expected Valuation Assumptions¾ Actuary uses judgment under professional standards to establishbest estimate assumptions¾ Best estimate assumptions are reviewed each period and“unlocked” as necessary to keep them consistent with current
experience¾ This approach is used for all key assumptions impacting liability
and asset cashflows Mortality/morbidity
 Lapses/withdrawals
 Premium persistency
 Expenses
 Asset re-investment strategies
 Asset credit loss assumptions
10

 Asset non-fixed income returns

Margins for Adverse Deviation¾ Margins for adverse deviation applied to each assumption by
one of two methods
 Direct increase/decrease in level of expected assumption(typically range of 5% to 20%)
 Scenario testing the assumption (typically used only for reinvestment assumptions)¾ Professional guidance establishes range of margins with generalguidance on when to use a high/medium/low margin

11Re-investment Scenario Testing¾ Re-investment strategies for assets reflect company reinvestment strategies¾ 9 CIA-prescribed scenarios + Internally defined scenarios
 Scenarios relate to the assumption of future re-investment
rates for fixed income assets¾ For non-fixed interest assets, return assumption is based onlong term expected return less a margin less a one time market
correction assumption12

Re-investment Strategy Testing
Implications¾ CGAAP valuation fully reflects returns on actual assets
supporting reserves at each valuation date
 Asset trading impacts reserves¾ CGAAP valuation reflects interest rate and ALM mismatch Impact of interest rate movements and changes in non-fixedincome fair values fully reflected¾ CGAAP valuation reflects asset default risk
 Impact of changes in credit quality fully reflected in reserves¾ The use of insurer specific re-investment/dis-investment
strategies introduces significant judgment into the valuation
13Profit Emergence¾ For new business there can be gain/loss at issue
 If value of margins greater than expected profit margins,loss at issue reflected If value of margins less than expected profit margins, gain
at issue reflected In practice, insurers using Canadian GAAP generally show
break-even or small loss at issue (significant profit is notupfronted)¾ For in-force business Expected profit released over time as released from risk (PfAD release) Experience gains/losses for actual experience different from expected Gain/loss from capitalizing changes in assumptions
14

Observations on Canadian Experience
Use of current best estimate assumptions with continuous
unlocking and detailed incorporation of asset/liability mismatch has
several positive impacts
1)

Improves insurer risk management by closely linking current pricing,current financial reporting and current experience

2)

Reduces solvency risks, as “holes” are not allowed to emerge on thebalance sheet

3)

Creates a detailed focus on management of ALM risk

4)

Results in earnings that are directly reconcilable to embedded value/value
creation in the period

15

Observations on Canadian Experience(cont’d)But there are challenges

161)

Volatility in income statement/balance sheet can be significant because ofunlocking and capitalization

2)

Significant supplementary disclosure can be needed to “explain” earnings
and changes in financial position to external audiences3)

Principle based approach with judgment requires strong actuarial
professionals with strong supporting governance infra-structure4)The Canadian approach of linking policy liability valuation to actual asset
portfolios and reinvestment strategies makes financial reporting extremely
sensitive to day to day investment management decisions5)

Use of insurer specific re-investment strategies introduces significant
company specific aspects to the valuation

Canadian GAAP vs. IASB Proposals¾ Canadian valuation model for life insurance policy liabilities is a“principles based” and is considered by many to be most similar
to emerging IFRS phase 2 model¾ Framework has worked well in practice in Canada¾ While there are many similarities, there are also key differences,most important of which is recognition of asset/liability
interdependence in Canadian valuation model, versus
independent valuation of assets/liabilities under IFRS proposals

17

Canadian GAAP vs. IASB Proposals
Key Similarities¾ Principles based framework¾ Three Building Block Approach Best estimate cashflows
 Margin for risk
 Discounting for time value of money¾ Continuously unlocking assumptions¾ Gains/Loss at issue permitted [IFRS direction unclear]

18

Canadian GAAP vs. IASB Proposals
Key Differences¾ Treatment of asset/liability interdependence (mismatch risk)¾ Discount rate used in valuation¾ Exit value versus settlement value¾ Exclusion of “commercial” cashflows in IASB model¾ Inclusion of own credit standing in IASB model¾ Margin framework¾ Application to insurance contracts versus all policy related
liabilities

19

Comparison of CGAAP (CALM) vs. IFRS- FrameworkCGAAP

IFRS

Principles based (i.e. not rules based)√√

Prospective cashflow valuation√√Based on best estimate cashflows plus explicit
margins for all key variables√√(value settlement
perspective percentile
margins)(exit value perspective
cost of capital margins)

Best estimate cashflows and margins unlock and are
kept current with changes capitalized in current
income√√Gain/Loss permitted at contract inception√√

Acquisition costs expensed with reserve offset toextend recoverable over valuation term√√

No cash value floors√√

Use of full “commercial” cash flows in valuation√x(limits on discretionarypremium)20

Comparison of CGAAP (CALM) vs. IFRS
- Framework (cont’d)
CGAAP
Cost of options/guarantees reflected√IFRS√(more rigorous)

Valuation reflects par dividends and contract
adjustment features√√(but potentially significantrestrictions)

Discount rates based on economics underlying
contract√(asset earned rate)

Liabilities include asset/liability mismatch risk√

Standard applies to all policy liabilities of insurancecompany√

Own credit standing adjustment to liabilitiesxx(risk free)xx(insurance contracts only)√21(limits on discretionarypremium)

Is IFRS A Step Forward or Backwards?
Limitations on recognition of“discretionary” future premiums underIFRS

 Clear step backwards as valuation
diverges from commercial reality (bothsettlement and exit value perspective)

Limitations on recognition of “passthrough” or adjustability features
under IFRS Clear step backwards as valuation
diverges from commercial reality (bothsettlement and exit value perspective)

Use of risk free discount rates with nodirect consideration of asset/liability
match Considered more “market consistent” byadvocates and clearly less subjective
but:
9 brings liquidation perspective – market
liquidity volatility into financial statements
for non-liquid liabilities
9 no observable risk neutral parameters inmany instances
9 ALM and assets supporting liabilities are
key driver of liability profitability andhence key drive of price in true exit/
settlement calculation

 Overall Canadian actuaries would
consider current proposed framework astep backwards
22

Is IFRS A Step Forward or Backwards?
Margin framework different under
IFRS (cost of capital) Generates more theoretical
discussion than true practicalconcern, both with respect to profit
emergence and gain/loss at issue

Own credit standing reflected inIFRS valuation

 A step backwards

CURRENT PHASE II PROPOSALS ARE CONSIDEREDA STEP BACKWARDS IN A NUMBER OF AREAS

23

Governance of Principal Based Valuation Has
Five Pillars• Policy liabilities are subject to extensive oversight,
including areas where discretion is exercised

Certifying
AppointedActuary

24

Professional
Guidance

Internal
Controls
and Processes

IndependentReview

Internal &ExternalDisclosurePillar 1 – Certifying Appointed Actuary¾ Company must have Appointed Actuary who oversees theactuarial valuation of policy liabilities¾ Appointed Actuary must be approved by regulator (OSFI)¾ Appointed Actuary must provide signed written opinion in GAAP
and regulatory statements that
 Valuation complies with accepted actuarial practice Valuation makes appropriate provision for policyholder
obligations
 Financial statements fairly present results of the valuation¾ In practice Appointed Actuaries are the gatekeepers ofapplication of judgment and updating of assumptions

25Pillar 2 – Professional GuidanceProfessional
Structure (CIA)Independent Actuarial
Standards Board sets
standards

Outline valuation method tobe followed (CALM)

CIA has Practice Council thatissues supplementaryguidance

Outline assumptions to becovered and how
assumptions to be
developed

Professional Discipline
Process in place

Outline appropriate ranges
for margins for adverse
deviation

Continuing Education
requirements
26

Professional
Standards

Pillar 3 – Internal Controls and Processes¾ Chief Actuary office oversees global valuation, including valuation policies(approximately 25 professional staff)¾ Valuation performed in businesses, overseen by designated valuationactuaries¾ Internal policy database supplements professional guidance¾ All valuation processes have documented and tested control infrastructure (equivalent to US Sarbanes-Oxley)

27

Pillar 4 - Independent Review of CGAAP
Actuarial Liabilities
InternalAudit

Canadian Regulator(OSFI)• Reviews Business• Reviews all
Units with onsite audits regulatory/GAAP filingson 3-5 year cycle• Periodic onsite audits ofBusiness units• Significant
completeness and• Specific filingaccuracy testing
requirements including
detailed AppointedActuary
Report (2000 pages)

28

Independent Review(OSFI Mandated)

ExternalAuditors• Reviews all actuarial
work requiring Appointed
Actuary certification
including valuation on 3year cycle• Use own actuarial
specialists tocorroborate Appointed
Actuary valuation workeach year

• Provides more feedback
on company practices
versus peer and external
best practices• Provide independent
opinion• Extensive validation ofmodels and data,
including supporting
experience studies

Pillar 5 – Disclosure¾ Quarterly Source of Earnings by geographic territory – Key disclosure Traditional Income Statement presentation is not useful to users¾ Disclosure in financial statement notes or MD&A of Changes in methods and assumptions
 Valuation sensitivity to changes in assumptions
 Level of actual versus expected experience Level and composition of provisions foreclose deviation

29

Canadian Source of Earnings Disclosure
Components of the Source OfEarnings

Expected Earnings on In-force

Explanation of Component
Risk margin release

Strain on New Business

Gain/Loss on new policy
issuance

Experience Gains/Losses

Actual – Expected experienceon Policyholder liabilities

Management Actions andChanges in Assumptions

Capitalized impact of changes
in actuarial assumptions

Earnings on Surplus

Interest and other income onsurplus assets

Income Taxes

Tax effect of above items

Net Income attributable to Shareholders
30Source of Earnings
Consolidated Source of Earnings – Manulife Financial Example(C$ millions)

For the Year Ended December

2007

2006

2005

Expected Profit from In-force Business

3,249

3,070

2,806

Impact of New Business

(286)

(218)

(303)

Experience Gains

1,359

1,434

650

Management Actions & Changes inAssumptions

11942(49)

Earnings on Surplus Funds

1,250

1,013

1,133

Other(12)1088

Income before Income Taxes

5,6795,351

4,325

Income Taxes(1,377)(1,366)(1,031)New Income attributed toShareholders

4,302

3985

3,294

31

Questions andAnswers

32