Transcript Canadian Institute of Actuaries L’Institut canadien des

Canadian
Institute
of
Actuaries
2007 General Meeting
Assemblée générale 2007
Montréal, Québec
L’Institut
canadien
des
actuaires
2007 General Meeting
Assemblée générale 2007
Pricing for Cost of Capital
Issues for Long Term Disability (LTD)
Presenter: Jeff Neufeld, FCIA, FSA
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
MCCSR
•
Traditionally, Pricing relies on OSFI MCCSR
formulas for the calculation of required capital.
For LTD, this includes components for:
–
–
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new claims risk
asset default risk (C1)
changes in interest rate environment (C3)
continuing claim risk
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
New Claims Risk
• The LTD “New Claims Risk” MCCSR component
is calculated as a function of premium.
• This makes it fairly simple to derive an explicit
percent of premium profit charge to cover the cost
of this required capital item.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Other MCCSR Components
•
In contrast, the MCCSR components for C1, C3 and
Continuing Claims Risk remain long after the
associated premium has been paid.
•
To match reported income with actual cost of
capital patterns, a company must depend on
Provision for Adverse Deviation (PfAD) releases.
•
However, current CIA Standards of Practice PfAD
guidelines pay no attention to cost of capital
requirements.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
C1 & C3 MCCSR
•
C1 & C3 MCCSR are asset related, so the hope is the
PfAD’s in the Canadian Asset/Liability Method
(CALM) cover the cost of capital for these
components.
•
The cost of capital for these components can be
covered by a margin in the pricing discount rate.
•
However CALM dictates the actual runoff pattern of
this margin, which may not match the cost of capital.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Continuing Claims MCCSR
•
The Continuing Claims MCCSR is a function of
DLR’s (Disabled Life Reserves), so the hope is the
DLR morbidity PfAD releases cover the cost of
capital for this component.
•
The cost of capital for this component can be covered
by pricing for initial DLR’s which include a
sufficient PfAD.
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2007 General Meeting
Assemblée générale 2007
Morbidity PfAD Release vs. Continuing Claim Cost of Capital
(% of DLR)
Claim
Duration
Sample
12.5% DLR
PfAD Release
Sample Continuing
Claim MCCSR
Cost of Capital
11+
0.2%
0.9%
6 – 10
0.3%
0.9%
5
0.5%
1.1%
4
0.8%
1.3%
3
2.5%
1.3%
2
5.8%
1.5%
1
8.8%
1.7%
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Unreasonable PfAD Requirement?
•
The table illustrates that using the 12.5% midpoint of
the CIA recommended PfAD range results in huge
PfAD releases in the early claim durations.
•
However the PfAD release in later claim durations is
so small, the PfAD is almost meaningless.
•
A more appropriate PfAD recommendation would
recognize the significant durational differences.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Unreasonable Capital Requirement?
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The 4% of DLR MCCSR factor may be excessive for
late duration claims.
•
The expected termination rate is very low in late
durations.
•
Even with no terminations (worst case scenario), the
resulting loss may be less than 4% of the DLR in late
durations.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Emergence Pattern Mismatch
•
The DLR morbidity PfAD release may be sufficient
to cover the Continuing Claims MCCSR cost of
capital in total.
•
However, the pattern may not be a good fit. The
PfAD release may not cover the cost of capital at
later durations.
•
This could be a problem for the claims run-off of
terminated business, where no additional premium
can be collected.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Potential Pricing Stumbling Blocks
•
Group pricing normally depends heavily on current
experience to set rates.
•
A stable or growing Group LTD carrier might believe
their current level of premium is adequate because
their current profit is covering the current cost of
capital. However it may not be sustainable due to the
shortfall on the claims run-off.
•
Or, if care is not used, a carrier may price LTD at an
initial loss (strain) based on the assumption that current
large PfAD releases will continue into the future to pay
for the strain and associated cost of capital.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
International Accounting Standards
•
The mismatch problem may be addressed in the future
with international accounting standards.
•
The Risk Margin Working Group (RMWG) of the
International Actuarial Association (IAA) is giving
consideration to a cost of capital approach for deriving
PfAD’s (see RMWG Exposure Draft).
•
This may be more appropriate in the future if MCCSR
moves away from the current factor approach to
something that better models the actual risk.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Refund Accounting
•
Refund accounting presents additional challenges.
•
Morbidity PfAD releases become part of the client
refund and are not available to cover the continuing
claims MCCSR cost of capital.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Refund Accounting Solutions
•
One alternative is to charge an extra profit charge in
the premium to cover the continuing claims cost of
capital.
•
However this is a poor fit since premium is received
up front and continuing claims cost of capital is
incurred over the life of the claim.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Refund Accounting Solutions
•
A second possible solution could be to have an
explicit profit charge which is expressed as a percent
of client reserves.
•
This would be a better fit with the pattern of
continuing claim MCCSR cost of capital.
•
However, clients and consultants focus heavily on
explicit profit charges, and are more likely to
pressure the insurance company to reduce them.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Refund Accounting Solutions
•
Another solution to this problem is to subtract a
margin in the client credited interest rate.
•
The credited interest rate margin could cover the
continuing claim MCCSR cost of capital, in
addition to the C1 & C3 capital cost.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Deficits – Pricing Pitfalls
•
It can be shown mathematically that an appropriate
risk charge must be high enough to cover aggregate
deficit increases (not just deficit write-offs).
•
If it is not, deficit increases are partially financed by
company capital.
•
If the capital financing is expected to be temporary,
the company will need a way in which to charge for
the use of this capital.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Deficits – Pricing Pitfalls
•
A solution may be to add a margin to the interest rate
used to charge the client for the deficit.
•
However, this could require a fairly large margin.
•
Also, the margin would simply increase the size of the
deficit, further reducing the probability of preserving
the client and recovering the deficit in the future.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Deficits – Pricing Pitfalls
•
To assume the capital financing is temporary
requires an assumption that aggregate deficits will
decrease in the future. However, this may be
unlikely without significant pricing action.
•
The company may have a bigger problem recovering
the initial capital financing than simply covering the
ongoing cost.
•
A better solution may be to set an appropriate risk
charge, to avoid the initial capital financing.
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Pricing for Cost of Capital - LTD
Hold Harmless Agreements
2007 General Meeting
Assemblée générale 2007
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•
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Cases with “Hold Harmless” agreements present
additional complexities.
In this case, any emerging deficit is not funded by
risk charges nor by company capital.
Rather, a “Receivable” is established as an asset to
recognize that the client has undertaken to fund any
deficit.
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Pricing for Cost of Capital - LTD
Hold Harmless Receivables
2007 General Meeting
Assemblée générale 2007
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A “Receivable” asset attracts a C1 MCCSR factor of
8%. This is higher than the average factor for other
financial assets normally used to back insurance
liabilities.
•
In this case, adding a margin to the deficit interest
rate to cover this extra C1 cost of capital is a
workable solution.
•
While the deficit is increased by the extra interest
charged, it is still recoverable through the Hold
Harmless agreement.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Clients Minimizing Cost of Capital Charges
•
Some clients are focused on the cost of capital and
require their profit charge to be no higher than a
specific percentage of the MCCSR attributable to their
case.
•
Morbidity MCCSR for their case is then eliminated by
maintaining a sufficient level of CFR (Claims
Fluctuation Reserve).
•
C1 MCCSR is eliminated by requiring an investment
policy consisting entirely of government bonds.
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Clients Minimizing Cost of Capital Charges
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With only a small C3 MCCSR component
remaining, the resulting profit charge is very small,
even for a large case.
•
But is this a true representation of the cost of actual
company capital required for these cases?
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Pricing for Cost of Capital - LTD
Other Company Capital Requirements
2007 General Meeting
Assemblée générale 2007
•
For cases with minimal MCCSR as well as ASO
(Admin. Services Only) cases with no MCCSR,
pricing should consider other investments made by
the insurance company such as:
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Capital expenditure on company infrastructure to enable
it to administer the contract
Any pre-payment of claims and administration expenses
Initial sales and marketing costs
Investment in expertise
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Other Company Risks
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For cases with minimal or no MCCSR, it may be
more appropriate for pricing to consider risks not
identified by MCCSR, such as:
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risk of administrative error resulting in costs not
recoverable from the client
litigation risk
risk of expense pricing error
risk of future client default
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Pricing for Cost of Capital - LTD
2007 General Meeting
Assemblée générale 2007
Summary:
•
Emergence of profit through PfAD releases does
not always follow the same pattern as cost of
capital. This may need to be considered in pricing.
•
Group Refund Accounting presents some unique
challenges in pricing for cost of capital which
should be carefully considered.
•
MCCSR may be a useful calculation for use in
pricing for cost of capital, but it does not address all
situations.
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