Risks Involved in the Prospective Downturn of Interest Rates in the Light of the Emerging Economic Stabilization

January 23, 1995 SEC-BED * MEMORANDUM CIRCULAR NO. 01-95 TO : All Pre-Need Plan Companies RE : Taking into account the risks involved in the prospective downturn of interest rates in the light of the emerging economic stabilization of the country. We realize that in the light of changing economic environments, its effects are now being felt by the financial markets, thus, also affecting the prices and yields of financial instruments including those of pre-need securities. We also realize that old policy contracts issued prior to January 1, 1995, net interest yields assumptions that were utilized ranged from 12% 15% and as such, they would be seriously impacted by the aforementioned expected economic development. These effects may be taken into consideration when the Actuary values the Actuarial Reserves as of December 31, 1994, by determining and assuring that the assets of the Trust Fund sufficiently covers the obligations of the contracts previously issued in accordance with their actuarial assumptions. Although we recognize that a portfolio net yield rate of 12% which has been the most widely used assumption in the pricing of the securities may be realizable in the near term (5-8 years), we feel that prospectively it may not be a viable yield assumption to maturity. Hence, the Trustee Bank in coordination with the Company management particularly the Finance Officer and the Resident Actuary or Consulting Actuary should now have a closer look into the Funds continued viability. In view of these considerations, the following steps or directions which would serve as safety nets should now be done for those requesting releases for registration/licensing of additional securities, new securities on account of re-pricing, or for new applicants to establish a new pre-need company: 1. In order that an application for Registration/Licensing of New/Additional Securities can be acted upon for processing, all the requirements of SEC-BED Circular #5 series of 1994 should be complied with, copy attached. 2. The Trustee Bank should prepare a recommended portfolio adjustment that should consider an asset re-allocation process and a portfolio risk management policy. We are attaching herewith a sample procedure adopted by a foreign trustee bank for one of its local client for a similar purpose. Of course, the figures will have to be altered or developed to suit your company's experience or portfolio. Or, your Trustee Bank may have its own way or form of addressing the problem. Initially, however, your Trustee Bank should have a clear understanding of your company's objectives in terms of risks and returns expectations. An investment strategy should also be formulated every year thereafter in order to always place the Trust Fund in a state of equilibrium for as long as the Trustee Bank deems it possible. 3. The Actuary/Consulting Actuary should be able to undertake a study using a matrix of assumptions for various interest rate paths leading to the period when the probable economic stabilization (downward movement of interest rates) would have started to show its effects and also the movements of asset and liability cash flows in response to such changes. These then should provide a basis for setting up a program for a yearly build-up of contingency surplus provisions to meet the adverse financial effects of the optimum interest rate chosen from the various assumptions. 4. In this connection, contingency surplus provision is defined contextually as a dedicated surplus that is allocated in the retained earnings of the Company. However, some pre-need companies may be severely limited in the amount of surplus they have available to support this need. Furthermore, there may be some surplus requirements for inflation and new product development. Thus, what level of contingency surplus should be held to support the overall Company contingency surplus requirements is a very important judgment for the Company's Resident Actuary or Consulting Actuary. 5. This dedicated yearly surplus provision which the Actuary should recommend would be a yearly appropriation on the accumulated retained earnings of the company in any particular year. The accumulated yearly surplus provision could serve as a buffer for the impact of any adverse fluctuations in the actuarial assumptions. An Actuarial Certification would have to be accomplished in a form herewith attached. 6. Considering the time required to undertake these requirements, the Commission shall allow a temporary release of security requests that would be sufficient for a 3-month use pending the accomplishment of these requirements. 7. After all of the foregoing instructions have been undertaken and submitted to the Commission, the necessary subsequent requests for registration/licensing of securities as deemed proper by the Commission shall be immediately processed and released. It must, however, always be remembered that the company stays locked-in with all the contractual obligations they may accrue on account of any interest assumption that was and will be used in all the policies that were and will be issued, up to its maturity date. 8. The SEC Actuarial Consultant would be willing to provide initial guidance towards the achievement of this undertaking. cdlex For immediate strict compliance. (SGD.) ROSARIO N. LOPEZ Chairman Securities and Exchange Commission ATTACHMENT ACTUARIAL CERTIFICATION This certification which has been prepared in accordance with generally accepted actuarial principles and practices, I hereby state to the best of my knowledge and understanding, that: 1. I have totally complied with the requirements of SEC-BED Memorandum Circular 05, revised series of 1994. 2. In recognition of changing economic environments that may occur in the ensuing years within the period of coverage of this pre-need plan, I have undertaken an actuarial study of the probable adverse effects on the Trust Funds of the Company and as such have taken the following steps to strengthen the solidity of these Funds: a. took into consideration in the actuarial pricing assumptions the probable downturn of interest yield rates in the future, and b. recommended the allocation of a contingent yearly surplus provision in the retained earnings of the Company to serve as a buffer for the impact of any adverse fluctuation from the actuarial assumptions, more specifically the C-3 type risks. Signed: ________________________ Actuary/Consulting Actuary SEC Accreditation No.: Issued On: ______ PTR No.: _______ Issued At: ______ Date: __________ SAMPLE PROCEDURES In the formation of the recommended portfolio, we evaluated and ranked the returns and risks of each asset class using the following assumptions: 1. The expected returns for liquid assets is assumed at 11% per annum. This is based on the medium-term plan of the Philippine Government to lower interest rates to a range of 10-12% per annum; 2. The expected returns for fixed-income instruments is assumed at 100 basis points over the expected returns of liquid assets or 12%; 3. The medium-term expected return of investment in equities is assumed to be 20% to reflect the incremental risk of investing in this asset class. 4. The volatility of liquid assets is assumed to be equivalent to the volatility of the 91-day Treasury Bill for the last 5 years or 3.87%. 5. The volatility of fixed income assets is also assumed to be equivalent to the volatility of the 91-day Treasury Bill or 3.87%. This assumption is based on our observation that for the last 3 years, the interest rate of long-term instruments were mostly on a repricing basis and pegged to the 91-day T-Bill rates; 6. The volatility of equities is assumed to be equivalent to its volatility during the last 5 years or 30.69%; 7. The correlation coefficient between equities and liquid/fixed- income assets for the next 5 years was derived using a 5-year monthly time series. 8. Trust fee rate is assumed at 0.40% per annum. Based on the above assumptions, were derived the expected returns for the financial instruments considered in this proposal. We have also identified the appropriate benchmarks for the financial instruments. Please refer to Exhibit 1. Exhibit 1 BENCHMARKS & EXPECTED RETURNS Asset Class Expected Returns Benchmarks Liquid Assets 8.40% Moving WAIR of the 91-d T-Bills Fixed Income 9.20% 100 bp over the moving WAIR of the 91-d T-Bills Equities 19.35% Philippine Stock Exchange Composite Index * Net of taxes and trust fees We looked at 3 different asset allocation scenario which is presented as Exhibit 2. The resulting portfolio returns (net of trust fees and taxes) and volatilities are shown as Exhibit 3. Details are shown in Exhibit 4. Exhibit 2 NEUTRAL POSITION LIQUID FIXED-INCOME EQUITIES TOTAL Scenario 1 10% 55% 35% 100% Scenario 2 15% 45% 40% 100% Scenario 3 15% 35% 50% 100% Exhibit 3 PORTFOLIO RETURNS AND VOLATILITIES Portfolio Return Portfolio Volatility Scenario 1 12.67% 9.21% Scenario 2 13.14% 10.10% Scenario 3 14.16% 13.52% The portfolio return increase is due to the higher neutral position (NP) for equities starting from 35% in Scenario 1 to 50% in Scenario 3. Taking into consideration the investment objectives and our assessment of the risk-return characteristics of the different asset classes, the consideration of Scenario 2 is suggested. While Scenario 3 is projected to generate the highest return, the incremental increase in the return is not commensurate to the incremental increase in the volatility of the portfolio. prcd Exhibit 4 Scenario 1 Expected Neutral Weighted Volatility Returns Position Yield Liquid Asset 8.40% 10% 0.84% 3.87% Fixed Income 9.20% 55% 5.06% 3.87% Equities 19.35% 35% 6.77% 30.69% Portfolio Yield 12.67% Portfolio Volatility 9.21% Scenario 2 Expected Neutral Weighted Volatility Returns Position Yield Liquid Asset 8.40% 15% 1.26% 3.87% Fixed Income 9.20% 45% 4.14% 3.87% Equities 19.35% 40% 7.74% 30.69% Portfolio Yield 13.14% Portfolio Volatility 10.10% Scenario 3 Expected Neutral Weighted Volatility Returns Position Yield Liquid Asset 8.40% 10% 1.26% 3.87% Fixed Income 9.20% 35% 3.22% 3.87% Equities 19.35% 50% 9.68% 30.69% Portfolio Yield 14.16% Portfolio Volatility 13.52%