Source of Earnings

Hong Kong Appointed Actuaries SeminarNovember 17, 2004

Keith WeaverSenior Vice-President & CFO, Asia

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Agenda

• What is the SOE Analysis?• Canadian GAAP Examples• USGAAP considerations• How is SOE used?• Draft Canadian Standards• Use with other Accounting Bases• Issues and Complications

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What is the SOE Analysis?• SOE is a methodology for identifying &

quantifying the various sources ofincome

• Presentation of net income in a formatwith emphasis on these sources ofincome

• Besides CGAAP, SOE is also used inUGAAP

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Canadian GAAP Examples• CGAAP uses a gross premium valuation

basis• Reserve is best estimate liability with

provision for adverse deviation (PfAD)• Most actuarial assumptions are explicitly

valued including:• Mortality, morbidity, lapses, surrenders• Expenses (both acquisition and maintenance)• Interest, policyholder dividends

• The SOE has a separate line for eachassumption, comparing the actual to theexpected

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Sample CGAAP SOE

Manulife Financial 2003 Annual Report

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Source of EarningsComponents• Expected earnings on inforce• New business impact• Experience gains & losses• Changes in actuarial methods and

assumptions• Earnings on surplus funds• Income taxes• Net income attributed to shareholders

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Expected Earnings on Inforce

Canadian GAAP• Expected income from inforce business

based on the achievement of expectedassumptions

• Expected PfAD release on insurance products• Expected net fee income on “DAC”

products• Expected profit margins on short duration

products• Growth in inforce should result in increasing

trend of this line

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Expected Earnings on InforceUS GAAP• Expected profit margins on premiums

(FAS 60) / expected gross profits (FAS97 UL) / expected gross margins (FAS120)

• Net of DAC amortization, deferredprofit impact (URL, DPL, etc)

• Net of overhead expenses (Manulife’sapproach)

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New Business Impact

CGAAP• Point-of-sale impact• Minus increase in “time zero”

reserve on insurance products• Minus non-deferrable acquisition

expenses on DAC products• Include gains / losses from acquisition

expenses

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New Business ImpactCGAAP “time zero reserve”• CGAAP values on a Gross Premium basis

using best estimate explicit assumptions withmargin for adverse deviation (MfAD)

• At policy issue, the “time zero” reserveequals the capitalized profits less thecapitalized impact of MfAD

• “Time zero” reserve could be +/- vedepending on the profitability VS the impactof valuation margins (PfAD)

• Actual acquisition may be different fromassumed in “time zero” reserve & thevariance is included in new business impact

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New Business Impact

USGAAP• Similar to Canadian GAAP• “Time zero” reserve is zero by

definition of net premium• Minus non-deferrable acquisition

expenses

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Experience gains & losses

CGAAP• Variance between actual experience

and expected assumptions oninsurance products

• Variance between actual & expectednet fee income on DAC product

• Conservative assumptions shouldresult in experience gains

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Experience gains & losses

CGAAP• Experience gains could be broken

down into mortality & morbidity,lapses, expenses, investments,currency changes

• Lapse gains could be broken down intofrom lapse supported products & fromnon-lapse supported products

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Experience gains & lossesUSGAAP• Similar to CGAAP• Expected assumption would be pricing for

FAS 60 products• In effect, capture the impact of actual net

profit margins on premium/ EGP/ EGM lessthat of expected

• Net of DAC amortization, deferred profitimpact (DPL, URL, etc)

• For investment gains, may split out therealized gains impact

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Changes in actuarial methodsand assumptionsCGAAP• Measure the capitalized impact of changes in

future estimates on current period income• Management actions• Changes in best estimate assumptions• Changes in margins for adverse deviations• Changes in valuation methodology• Correction of errors

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Changes in actuarial methodsand assumptionsUSGAAP• Similar to CGAAP• DAC unlocking impact• Loss recognition impact

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Earnings on Surplus FundsCGAAP• Net investment income on surplus

asset

USGAAP• Ditto, but investment income & surplus

are different from GAAP to GAAP• May split out the capital gains impact

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Income Taxes

CGAAP• Equals current taxes plus deferred

taxes

USGAAP• Similar to CGAAP

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Source of EarningsComponents• Expected earnings on inforce• New business impact• Experience gains & losses• Changes in actuarial methods and

assumptions• Earnings on surplus funds• Income taxes• Net income attributed to shareholders

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Use with Other AccountingBases• SOE would reflect how profit emerges• For CGAAP, earnings are assumed to

emerge as a PfAD release• For USGAAP, earnings are assumed to

emerge in proportion to grosspremiums (FAS 60) , EGP (FAS 97UL)or EGM (FAS 120)

• For Australian GAAP, earnings areassumed to emerge in proportion toprofit carriers

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How is SOE Used?• Manulife: quarterly earnings by product line

are analyzed using the SOE• Errors in reserve calculations are identified• Problems with experience and pricing are identified

• Management can review simplified forms andidentify trends in business.• Distinguish underlying trends from volatility of

experience gains & losses• The earning impact of new business & policy lapse

is identified, which are not trivial from the incomestatement

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How is SOE Used?• Canadian Life Companies: Simplified

SOE is disclosed at the company ormajor segment level• Allows investment analysts to gain

confidence in the profit margins andearnings emergence

• Greater transparency & betterunderstanding

• Peer company comparison• Highlights basis changes: no surprise if

consistent gains/ losses were shown

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Draft Canadian Standards

• OSFI draft guideline no. D9Sources of Earnings : Disclosure (lifeinsurance companies)

• CIA draft education notesSources of earnings : Determinationand disclosure

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Issues and Complications

• Different product lines may havedifferent source of earnings,generating unique SOE lines• e.g. USGAAP FAS60, FAS 97, FAS 120

• SOE may not naturally fit with otheraccounting basis, adding complexity

• Complexity can reduce value tomanagement

• Calculations are complex

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Issues and Complications

• Maintain consistency over time &between line of business

• Balance the need of internal user &external user

• Par business : impact of past-throughgains/ losses

• Group business : determination of newbusiness impact

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Conclusion

• SOE is a useful analytical tool• Benefits are improved control of the

reserve mechanism and enhancedunderstanding of the dynamics of theearnings stream of the business

• Calculations are complex

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Questions andAnswer Session