C3 Phase II Risk-Based Capital for Variable Annuities: Pre-Packaged Scenarios

Presented by the American Academy of Actuaries’ Life Capital Adequacy Subcommittees’

C-3 Phase 2 Work Group to the National Association of Insurance Commissioners’
Capital Adequacy Task Force

March 2005

The American Academy of Actuaries is the public policy organization for actuaries practicing in all
specialties within the United States. A major purpose of the Academy is to act as the public
information organization for the profession. The Academy is non-partisan and assists the public
policy process through the presentation of clear and objective actuarial analysis. The Academy
regularly prepares testimony for Congress, provides information to federal elected officials,
comments on proposed federal regulations, and works closely with state officials on issues related to
insurance. The Academy also develops and upholds actuarial standards of conduct, qualification and
practice and the Code of Professional Conduct for all actuaries practicing in the United States.

Larry M. Gorski, F.S.A., M.A.A.A., Chair

Robert A. Brown, F.S.A., M.A.A.A., Vice-Chair

Gerald A. Anderson, F.S.A., M.A.A.A. Keith D. Osinski, F.S.A., M.A.A.A.

Jeffrey M. Brown, F.S.A., M.A.A.A. Jan L. Pollnow, F.S.A., M.A.A.A.
Martin R. Claire, F.S.A., M.A.A.A. Craig R. Raymond, F.S.A., M.A.A.A
Todd H. Erkis, F.S.A., M.A.A.A. Mark C. Rowley, F.S.A., M.A.A.A.
Luke N. Girard, F.S.A., M.A.A.A. Max J. Rudolph, F.S.A., M.A.A.A.
Arnold N. Greenspoon, F.S.A., M.A.A.A. George M. Wahle, F.S.A., M.A.A.A.
Ann L Kallus, F.S.A., M.A.A.A. William H. Wilton, F.S.A., M.A.A.A.
Robert G. Meilander, F.S.A., M.A.A.A. Michael L. Zurcher, F.S.A., M.A.A.A.
Hubert B. Mueller, F.S.A., M.A.A.A.

1100 Seventeenth Street NW Seventh Floor Washington, DC 20036 Telephone 202 223 8196 Facsimile 202 872 1948 www.actuary.org
The following report is a follow up to a proposal from March 2002 and was prepared by the Life
Capital Adequacy Subcommittee’s C-3 Phase 2 Work Group* (chaired by Bob Brown). The work
group is made up of several members of the subcommittee as well as Mike Akers, Frederick
Andersen, Robert Berendsen, Tom Campbell, Andrew Eastman, Jack Gies, Geoff Hancock, Jeff
Krygiel, Jim Lamson, Jeffrey Leitz, Craig Morrow, John O'Sullivan, Link Richardson, Jim Reiskytl,
Dave Sandberg, Van Villaruz, and Albert Zlogar. The work group would also like to thank Philip
Barlow, Jan Brown, Bill Carmello, Michael Cebula, Allen Elstein, Mark Evans, Dennis Lauzon, and
Mark Tenney for their helpful suggestions and feedback.

(*It should also be noted, that since this project has been on-going for several years, many other individuals contributed to
the work that paved the way for this report.)

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 2 of 19
Background

Over the past two years, the AAA Life Capital Adequacy Subcommittee (“LCAS”) has issued several versions
of a report entitled “Recommended Approach for Setting Regulatory Risk-Based Capital Requirements for
Variable Annuities and Similar Products”1 that recommends implementing “C3 Phase II RBC” to address both
the interest rate and equity risk associated with variable annuity products with guaranteed benefits.

The LCAS recommendation indicates that the American Academy of Actuaries will provide 10,000 “pre-
packaged” scenarios for the common asset classes typically needed in the stochastic cashflow projections of
variable annuities. This report documents the models and parameters used to develop the “pre-packaged”
scenarios2. Guidance is also provided on the use of the pre-packaged scenarios, including a utility that allows
companies to select (“pick”) a subset of representative scenarios from the full sample of 10,000.

While the LCAS proposal encourages companies to develop their own stochastic models for scenario testing,
companies may choose to use the pre-packaged scenarios as an alternative. Also, the “Alternative Method”
factors and formulas for GMDB risks have been developed from stochastic testing using these scenarios.
More information on the scenario files is provided later in this document under “Pre-packaged Scenario Files”.

1
Variations on this title include “Recommended Approach for Setting Regulatory Risk-Based Capital Requirements for
Variable Products with Guarantees (Excluding Index Guarantees)”
2
Note: This document and the accompanying “pre-packaged” scenarios replace those provided in 2004.

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Scenario Files

Scenario files are provided for the economic variables (“asset classes”) shown in Table 1.

Table 1: Scenario Files

Economic Variable / Asset Class Short Name Scenario File

3-month U.S. Treasury yields UST_3m UST_3m.csv

6-month U.S. Treasury yields UST_6m UST_6m.csv
1-year U.S. Treasury yields UST_1y UST_1y.csv
2-year U.S. Treasury yields UST_2y UST_2y.csv
3-year U.S. Treasury yields UST_3y UST_3y.csv
5-year U.S. Treasury yields UST_5y UST_5y.csv
7-year U.S. Treasury yields UST_7y UST_7y.csv
10-year U.S. Treasury yields UST_10y UST_10y.csv
20-year U.S. Treasury yields UST_20y UST_20y.csv
30-year U.S. Treasury yields UST_30y UST_30y.csv
Money Market / Short-Term MONEY MONEY.csv
U.S. Intermediate Term Government Bonds U.S. ITGVT ITGVT.csv
U.S. Long Term Corporate Bonds U.S. LTCORP LTCORP.csv
Diversified Fixed Income FIXED FIXED.csv
Diversified Balanced Allocation BALANCED BALANCED.csv
Diversified Large Capitalized U.S. Equity US US.csv
Diversified International Equity INTL INTL.csv
Intermediate Risk Equity SMALL SMALL.csv
Aggressive or Specialized Equity AGGR AGGR.csv

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 4 of 19
Market Data

Table 2 indicates the source data or composition of each asset class. Parameters are determined by fitting the
models to data over the specified historic periods.

Table 2: Asset Classes for Scenario Modeling

Asset Class Market Proxies Historic Period

U.S. Treasury Yields U.S. Treasury Yield Curves 1951.01 – 1995.12

Money Market 3 Month Treasury returns 1955.12 – 2003.12

U.S. ITGVT U.S. Intermediate Term Government Bonds 1955.12 – 2003.12

U.S. LTCORP U.S. Long Term Corporate Bonds 1955.12 – 2003.12

Fixed Income 65% ITGVT + 35% LTCORP n/a

Balanced Allocation 60% Diversified Equity + 40% Fixed Income n/a

Diversified Large Cap U.S. Equity S&P500 Total Return Index 1955.12 – 2003.12

Diversified International Equity MSCI-EAFE $USD Total Return Index 1969.12 – 2003.12

Intermediate Risk Equity U.S. Small Capitalization Index 1955.12 – 2003.12

Aggressive Equity Emerging Markets, NASDAQ, Hang Seng 1984.12 – 2003.12

Model Descriptions and Notes

Pseudo-random numbers are generated using the Mersenne Twister algorithm3. Variance reduction
techniques were not used.
All models use a one-month interval as the time increment (i.e., 12 periods per year).
For simplicity, the correlation matrix is constant.
The random “shocks” that drive changes in interest rates are independent (i.e., zero correlation) of all other
model factors, including equity and bond returns.
Additional scenarios may be created by blending the accumulation factors for the market proxies.
The Treasury yields can be used to project credited rates on fixed accounts and annuity purchase rates
under GMIB options. The Treasury yields are also suitable for testing C-3 Phase I RBC (“interest rate
risk”) on the assets and liabilities underlying the fixed account. See the section entitled “U.S. Treasury
Yields” for further information.
Bond index returns (“Money Market”, “U.S. ITGVT” and “U.S. LTCORP”) are modeled as a function of
interest rates. See later under “Bond Index Returns”.
Equity returns are generated from a monthly stochastic log volatility model (“SLV”). Additional details
are given in the section “Equity Market Returns”. The S&P500 TR scenarios (Diversified Equity) satisfy
the calibration criteria within sampling error.

3
The Mersenne Twister is a well documented and robust algorithm with extremely high periodicity.

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 5 of 19
 Parameters for “Diversified International Equity” are estimated from data denominated in $US currency.
The hypothetical ‘Aggressive/Exotic Equity’ index was constructed by blending returns for the NASDAQ,
Emerging Markets and Hang Seng indices. This proxy has an unconditional annualized volatility of
approximately 25%. This market mix is not meant to suggest a representative asset profile for this class,
but used merely to build an historic index with high volatility and sufficient history.
The estimation of the SLV model parameters for “U.S. Diversified Equity” imposed some subjective
restrictions to ensure an unconditional expected total annualized return of 8.75% effective. Appendix 2 of
the LCAS report includes complete details on the development of the SLV model and associated
calibration criteria.

Parameters for the other equity markets were determined by ‘constrained’ maximum likelihood estimation
whereby the Sharpe ratio ψ must satisfy the following relationship:
E [ R] − r
ψ * ≤ ψ ≤ 1.05 ×ψ * , where ψ =
σ
E [ R ] and σ are respectively the annualized unconditional expected return (effective) and standard
deviation (volatility) of market returns. For simplicity, we assume that the risk-free rate r = 5.25%
(annual effective) for all markets, roughly equal to the average 3-month U.S. Treasury yield over the past
50 years. ψ * = 0.232 is the Sharpe ratio for the S&P500 Total Return index (1955.12 – 2003.12).

U.S. Treasury Yields

The U.S. Treasury yields are generated using the “C-3 Phase I” interest rate model designed by the American
Academy of Actuaries' C-3 Subgroup of the Life Risk Based Capital Task Force. The model simulates
Treasury bond yields according to a stochastic variance process with mean reversion under the real-world4
probability measure. For full details, please see “Appendix III – Technical Aspects of the Scenario Generator
and the Scenario Selection Process” in the October 1999 report to the NAIC Life RBC Working Group.

The starting yield curve5 (December 2004) for the interest rate model is given in Table 3. All rates are
expressed as semi-annual bond equivalent yields.

Interest rate movements are uncorrelated6 with other model factors. Before using the integrated set of
prepackaged scenarios, the actuary should be confident that an assumption of independence is reasonable and
does not lead to a material understatement of the risk exposure.

Table 3: Starting U.S. Treasury Yield Curve – December 2004 Semi-Annual Bond Equivalent Yields
Maturity
0.25 0.5 1 2 3 5 7 10 20 30
(in years)
S/A Yield 2.22% 2.50% 2.67% 3.01% 3.21% 3.60% 3.93% 4.23% 4.88% 5.00%

4
The interest rate model is designed for cash flow projections only. It is not arbitrage-free and could give inappropriate
values if used to price options and other derivatives as part of an asset/liability management strategy.
5
The 30-year maturity was estimated by fitting the rest of the curve to a power function. It is not used in the modeling.
6
The historic data tend to suggest a weak negative correlation between interest rate movements and equity returns.

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Bond Index Returns

The monthly returns on money market and fixed income (e.g., bond) investments are generated according to:

rt = β 0 × ( itm + κ ) − β1 × ( itm − itm−1 ) + σ ⋅ it −1 ⋅ Z t

where Z t is a standard normal variate and itm is the m-year Treasury yield in period t. The money market
process is a function of the 3-month yield, while the ITGVT and LTCORP bond index returns are respectively
modeled from the 7-year and 10-year maturities. The model parameters are provided in Table 4.

The Fixed Income scenarios (“FIXED.csv”) assume a constant asset mix of 65% ITGVT and 35% LTCORP.
U.S. ITGVT and U.S. LTCORP are published indices (not managed funds) which respectively represent
diversified portfolios of intermediate-term government bonds and long-term investment grade corporate bonds.

Table 4: Model Parameters for Bond Index Returns

m β0 κ β1 σ
Money Market 0.25 0.083333 −0.00445 −0.07148 0.00370

U.S. ITGVT 7 0.083333 −0.00153 3.65043 0.05239

U.S. LTCORP 10 0.083333 0.00704 5.81293 0.08282

Although this is a simple empirical model, it has a plausible (and intuitive) interpretation and fits the observed
data extremely well. Consistent with our expectations, the monthly return is composed of three elements:

An income component, equal to one-twelfth of the reference yield rate plus a “credit/liquidity spread”.
A price movement term, equal to the duration of the index multiplied by the net increase in interest rates.
A random shock, which reflects the relative level of interest rates and other extraneous factors.

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Equity Market Returns

The equity return scenarios are generated from a monthly SLV model wherein the natural logarithm of the
annualized volatility follows a strong mean-reverting stochastic process and the annualized drift7 is a
deterministic quadratic function of volatility. This model is not prescribed or ‘preferred’ above others, but was
chosen because it captures many of the dynamics observed in the equity market data, including:

Negative skewness and positive kurtosis (“fat tails”) over short holding periods;
Time-varying volatility and volatility clustering; and
Increased volatility in bear markets.

The monthly SLV model is governed by the equations shown in Table 5. The model parameters (including
descriptions) for each equity market are given in Table 6.

Table 5: SLV Model Processes

v% ( t ) = Min  v + , (1 − φ ) × v ( t − 1) + φ × ln (τ )  + σ v × v Z t

{
v ( t ) = Max v − , Min v* , v% ( t ) }
µ (t ) = A + B ×σ (t ) + C ×σ 2 (t )
 S (t )  µ (t ) σ (t )
ln  = + × s Zt
 S ( t − 1)  12 12
S ( t ) = stock index level at time t
v ( t ) = natural logarithm of annualized volatility in month t
σ ( t ) = annualized volatility of stock return process in month t = exp v ( t ) 
µ ( t ) = mean annualized log return ("drift") in month t
v − = lower bound for log volatility = ln σ −
v + = upper bound for log volatility (before random component) = ln σ +
v* = absolute upper bound for log volatility = ln σ *

vZ t and s Z t are correlated standard normal random samples, where v Z t is the random “shock” to the log
volatility process and s Z t is the random component for the stock index return. As noted previously, the drift
term µ ( t ) is a deterministic quadratic function of σ ( t ) . In Table 6, v − = ln σ − , v + = ln σ + and v* = ln σ * .
From the foregoing, it should be clear that given σ ( t ) , the log (i.e., continuous) returns in any month are
µ (t ) σ (t )
normally distributed with mean and standard deviation .
12 12

7
In this document, the term “drift” refers to the expected instantaneous return.

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 8 of 19
 Table 6: Stochastic Log Volatility Model Parameters (Monthly) – Equity Markets
Description U.S. INTL SMALL AGGR

τ Long-run target volatility (annualized) 0.12515 0.14506 0.16341 0.20201

φ Strength of mean reversion 0.35229 0.41676 0.3632 0.35277

σv Standard deviation of the log volatility process (monthly) 0.32645 0.32634 0.35789 0.34302

ρ Correlation co-efficient between v Zt , s Zt −0.2488 −0.1572 −0.2756 −0.2843

A Drift of stock return process as σ (t ) → 0 (i.e., intercept) 0.055 0.055 0.055 0.055

B Co-efficient of quadratic function for µ (t ) 0.56 0.466 0.67 0.715

C Co-efficient of quadratic function for µ (t ) −0.9 −0.9 −0.95 −1

σ (0) Starting volatility (annualized) 0.1476 0.1688 0.2049 0.2496

σ− Minimum volatility (annualized) 0.0305 0.0354 0.0403 0.0492

σ+ Maximum volatility (annualized), before random component 0.3 0.3 0.4 0.55

σ* Maximum volatility (annualized), after random component 0.7988 0.4519 0.9463 1.1387

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Table 7 provides some statistics for the simulated (“model”) annualized volatilities compared to the historic
data. For each market, an historic “volatility series” was constructed by calculating the 6-month rolling
standard deviations of the monthly log returns. Table 8 shows statistics for the monthly log returns8.

Table 7: Statistics for Annualized Volatility

U.S. Diversified International Intermediate Risk Aggressive / Exotic
Equity Diversified Equity Equity Equity
History Model History Model History Model History Model

Minimum 0.014 0.031 0.042 0.035 0.041 0.040 0.071 0.049

TH
10 Percentile 0.068 0.072 0.080 0.087 0.088 0.090 0.113 0.114

25TH Percentile 0.093 0.094 0.103 0.111 0.117 0.120 0.136 0.150

Median 0.122 0.125 0.146 0.145 0.162 0.164 0.177 0.202

TH
75 Percentile 0.164 0.167 0.194 0.190 0.213 0.224 0.280 0.274

90TH Percentile 0.200 0.217 0.237 0.243 0.292 0.296 0.360 0.360

Maximum 0.408 0.799 0.398 0.452 0.584 0.946 0.748 1.139

Average 0.133 0.137 0.153 0.157 0.181 0.182 0.221 0.224

Standard Deviation 0.062 0.062 0.064 0.065 0.094 0.089 0.125 0.106

Skewness 1.436 1.426 0.694 1.175 1.672 1.544 1.999 1.505

Kurtosis 3.810 3.756 0.496 1.980 3.902 4.242 5.161 4.090

Table 8: Statistics for Monthly Log Returns

U.S. Diversified International Intermediate Risk Aggressive / Exotic
Equity Diversified Equity Equity Equity
History Model History Model History Model History Model
TH
0.1 Percentile −0.2423 −0.2199 −0.1553 −0.2268 −0.3452 −0.3219 −0.4541 −0.3944
TH
10 Percentile −0.0451 −0.0447 −0.0519 −0.0518 −0.0577 −0.0612 −0.0662 −0.0769

25TH Percentile −0.0155 −0.0156 −0.0176 −0.0197 −0.0212 −0.0211 −0.0190 −0.0275

Median 0.0110 0.0086 0.0103 0.0081 0.0148 0.0105 0.0164 0.0119

75TH Percentile 0.0374 0.0309 0.0385 0.0345 0.0452 0.0391 0.0575 0.0473
TH
90 Percentile 0.0549 0.0540 0.0637 0.0619 0.0783 0.0694 0.0899 0.0842
TH
99.9 Percentile 0.1533 0.1691 0.1644 0.1953 0.2443 0.2258 0.2112 0.2707

Average 0.0084 0.0060 0.0086 0.0062 0.0112 0.0063 0.0120 0.0065

Standard Deviation 0.0426 0.0436 0.0487 0.0492 0.0598 0.0590 0.0721 0.0724

Skewness −0.59 −0.67 −0.33 −0.40 −0.72 −0.89 −1.47 −0.91

Kurtosis 2.42 4.02 0.78 2.69 4.16 5.33 7.84 5.20

8
In Table 8, the 0.1% and 99.9% values for history are respectively the minimum and maximum monthly returns over the
observation period

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Correlations

The correlation matrix governing the stochastic processes is given in Table 9. The matrix is decomposed using
the standard technique of Cholesky9 factorization in order to generate correlated normal samples.

Table 9: Correlation Matrix for Integrated Scenario Model

US US INTL INTL SMALL SMALL AGGR AGGR MONEY ITGVT LTCORP
LogVol LogRet LogVol LogRet LogVol LogRet LogVol LogRet Return Return Return

US
1 −0.249 0.318 −0.082 0.625 −0.169 0.309 −0.183 0.023 0.075 0.080
LogVol

US
−0.249 1 −0.046 0.630 −0.123 0.829 −0.136 0.665 −0.120 0.192 0.393
LogRet

INTL
0.318 −0.046 1 −0.157 0.259 −0.050 0.236 −0.074 −0.066 0.034 0.044
LogVol

INTL
−0.082 0.630 −0.157 1 −0.063 0.515 −0.098 0.558 −0.105 0.130 0.234
LogRet

SMALL
0.625 −0.123 0.259 −0.063 1 −0.276 0.377 −0.180 0.034 0.028 0.054
LogVol

SMALL
−0.169 0.829 −0.050 0.515 −0.276 1 −0.142 0.649 −0.106 0.067 0.267
LogRet

AGGR
0.309 −0.136 0.236 −0.098 0.377 −0.142 1 −0.284 0.026 0.006 0.045
LogVol

AGGR
−0.183 0.665 −0.074 0.558 −0.180 0.649 −0.284 1 0.034 −0.091 −0.002
LogRet

MONEY
0.023 −0.120 −0.066 −0.105 0.034 −0.106 0.026 0.034 1 0.047 −0.028
Return

ITGVT
0.075 0.192 0.034 0.130 0.028 0.067 0.006 −0.091 0.047 1 0.697
Return

LTCORP
0.080 0.393 0.044 0.234 0.054 0.267 0.045 −0.002 -0.028 0.697 1
Return

9
The Cholesky decomposition method works when the matrix is positive semi-definite (i.e., has non-negative
eigenvalues). The correlation matrix in Table 9 satisfies this property.

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 11 of 19
Tables 10 and 11 respectively show the historic (“observed”) and sample (from the 10,000 prepackaged
scenarios) correlations for the monthly log returns.

Table 10: Historic Correlations for Monthly Log Returns

MSCI-EAFE U.S. Aggressive Money U.S. U.S.
S&P500
$USD SmallCap Equity Market ITGVT LTCORP

S&P500 1

MSCI-EAFE
0.560 1
$USD

U.S.
0.759 0.447 1
SmallCap

Aggressive
0.595 0.488 0.579 1
Equity

Money
−0.046 −0.059 −0.053 0.002 1
Market

U.S.
0.137 0.091 0.042 −0.064 0.113 1
ITGVT

U.S.
0.280 0.171 0.184 −0.005 0.026 0.822 1
LTCORP

Table 11: Model Correlations (10,000 Scenarios) for Monthly Log Returns

U.S. INTL SMALL AGGR MONEY ITGVT LTCORP

U.S. 1

INTL 0.558 1

SMALL 0.762 0.445 1

AGGR 0.577 0.481 0.565 1

MONEY −0.036 −0.031 −0.030 0.009 1

ITGVT 0.143 0.099 0.048 −0.067 0.084 1

LTCORP 0.303 0.184 0.201 −0.002 0.015 0.775 1

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 12 of 19
Scenario Statistics – Accumulation Factors

Tables 12 through 15 provide sample statistics for the accumulation factors (gross wealth ratios) over various
holding periods. For reference, the calibration points10 (applicable to U.S. Diversified Equity) are also shown.
Within sampling error, the statistics for the U.S. Equity scenarios satisfy these criteria.

Table 12: Statistics for 1-Year Accumulation Factors

Calibration
MONEY ITGVT LTCORP U.S. INTL SMALL AGGR
Point
0.5% 1.003 0.909 0.848 0.658 0.649 0.549 0.470
1.0% 1.004 0.921 0.865 0.700 0.694 0.603 0.531
2.5% 0.78 1.006 0.937 0.893 0.756 0.760 0.679 0.612
5.0% 0.84 1.008 0.953 0.915 0.818 0.810 0.748 0.695
10.0% 0.90 1.011 0.970 0.941 0.886 0.872 0.827 0.787
50.0% 1.022 1.027 1.033 1.089 1.083 1.096 1.102
90.0% 1.28 1.034 1.085 1.130 1.297 1.330 1.382 1.461
95.0% 1.35 1.038 1.101 1.156 1.370 1.408 1.485 1.584
97.5% 1.42 1.041 1.115 1.177 1.437 1.494 1.572 1.711
99.0% 1.044 1.132 1.205 1.518 1.596 1.707 1.880
99.5% 1.046 1.144 1.226 1.590 1.658 1.827 2.016
Mean 1.022 1.027 1.034 1.089 1.095 1.103 1.117
Stdev 0.009 0.045 0.073 0.166 0.185 0.226 0.275

Table 13: Statistics for 5-Year Accumulation Factors

Calibration
MONEY ITGVT LTCORP U.S. INTL SMALL AGGR
Point
0.5% 1.019 0.938 0.812 0.537 0.495 0.380 0.287
1.0% 1.025 0.961 0.848 0.620 0.568 0.441 0.348
2.5% 0.72 1.037 0.995 0.908 0.722 0.681 0.545 0.455
5.0% 0.81 1.052 1.024 0.955 0.807 0.772 0.664 0.565
10.0% 0.94 1.072 1.060 1.015 0.933 0.891 0.804 0.718
50.0% 1.160 1.194 1.234 1.452 1.464 1.491 1.525
90.0% 2.17 1.267 1.341 1.490 2.222 2.358 2.597 2.995
95.0% 2.45 1.305 1.389 1.569 2.481 2.677 3.038 3.619
97.5% 2.72 1.337 1.439 1.637 2.731 3.022 3.485 4.329
99.0% 1.381 1.485 1.731 3.063 3.417 4.084 5.116
99.5% 1.413 1.515 1.804 3.315 3.746 4.520 5.938
Mean 1.166 1.198 1.245 1.525 1.563 1.626 1.737
Stdev 0.077 0.111 0.188 0.520 0.606 0.760 1.005

10
The calibration points are taken from Table 1 in Appendix 2 of the March 2005 LCAS Report.

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 13 of 19
 Table 14: Statistics for 10-Year Accumulation Factors
Calibration
MONEY ITGVT LTCORP U.S. INTL SMALL AGGR
Point
0.5% 1.064 1.055 0.905 0.572 0.501 0.345 0.236
1.0% 1.081 1.087 0.956 0.653 0.573 0.429 0.302
2.5% 0.79 1.112 1.139 1.041 0.771 0.730 0.557 0.412
5.0% 0.94 1.146 1.190 1.118 0.923 0.865 0.718 0.561
10.0% 1.16 1.194 1.250 1.213 1.124 1.048 0.932 0.780
50.0% 1.409 1.487 1.596 2.089 2.120 2.191 2.219
90.0% 3.63 1.714 1.823 2.115 3.805 4.223 4.851 6.059
95.0% 4.36 1.834 1.941 2.297 4.441 5.077 6.042 7.851
97.5% 5.12 1.954 2.062 2.464 5.173 6.085 7.301 9.603
99.0% 2.097 2.233 2.694 6.182 7.316 9.472 12.633
99.5% 2.203 2.339 2.856 6.993 8.404 10.992 15.376
Mean 1.437 1.517 1.637 2.321 2.445 2.634 2.958
Stdev 0.214 0.235 0.364 1.147 1.401 1.823 2.599

Table 15: Statistics for 20-Year Accumulation Factors

Calibration
MONEY ITGVT LTCORP U.S. INTL SMALL AGGR
Point
0.5% 1.230 1.383 1.229 0.706 0.596 0.393 0.211
1.0% 1.270 1.446 1.348 0.830 0.732 0.491 0.298
2.5% 1.357 1.544 1.526 1.101 0.995 0.688 0.474
5.0% 1.51 1.441 1.646 1.672 1.411 1.251 0.953 0.730
10.0% 2.10 1.559 1.782 1.868 1.832 1.696 1.380 1.095
50.0% 2.165 2.473 2.841 4.274 4.442 4.618 4.851
90.0% 9.02 3.350 3.779 4.636 10.153 11.816 14.736 19.775
95.0% 11.70 3.939 4.385 5.459 12.926 15.475 19.866 29.577
97.5% 4.508 5.090 6.488 15.653 20.040 26.467 41.019
99.0% 5.402 6.264 7.922 20.586 26.076 37.184 62.771
99.5% 6.240 7.662 9.011 24.523 32.851 49.303 80.079
Mean 2.363 2.689 3.123 5.385 5.946 6.933 8.782
Stdev 0.881 0.995 1.317 4.065 5.301 7.687 12.479

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 14 of 19
Scenario Statistics – Returns

Tables 16 through 18 show statistics for the gross returns on each asset class over various holding periods (i.e.,
years 1 – 10, 11 – 20, etc.). As expected, the returns (and volatilities) on the fixed income funds rise over
time, consistent with the parameterization of the interest rate model. The returns and volatilities on the equity
funds are relatively constant (within sampling error) since the starting volatility (at “time zero” – see Table 6)
for each market is set roughly equal to the long-term average.

Table 16: Average Annualized Holding Period Return (Annual Effective)

MONEY ITGVT LTCORP U.S. INTL SMALL AGGR

1 – 10 3.69% 4.25% 5.05% 8.79% 9.35% 10.17% 11.45%

11 – 20 4.92% 5.85% 6.74% 8.76% 9.26% 10.09% 11.45%
21 – 30 5.36% 6.58% 7.60% 8.63% 9.16% 9.96% 11.31%
30 Years 4.87% 5.69% 6.49% 8.73% 9.26% 10.11% 11.37%

Table 17: Median Annualized Holding Period Return (Annual Effective)

MONEY ITGVT LTCORP U.S. INTL SMALL AGGR

1 – 10 3.49% 4.05% 4.79% 7.65% 7.81% 8.16% 8.30%

11 – 20 4.38% 5.11% 5.89% 7.69% 7.80% 8.07% 8.44%
21 – 30 4.68% 5.65% 6.49% 7.55% 7.76% 7.97% 8.39%
30 Years 4.21% 5.03% 5.79% 7.53% 7.73% 7.89% 8.18%

Table 18: Annualized Volatility

MONEY ITGVT LTCORP U.S. INTL SMALL AGGR

1 – 10 0.67% 4.66% 7.31% 15.15% 17.06% 20.48% 25.18%

11 – 20 0.84% 5.19% 8.09% 15.11% 17.04% 20.44% 25.10%
21 – 30 0.90% 5.42% 8.44% 15.05% 16.99% 20.40% 24.98%
30 Years 0.83% 5.10% 7.96% 15.10% 17.03% 20.44% 25.08%

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 15 of 19
Pre-packaged Scenario Files

The pre-packaged scenarios are available for download from the American Academy of Actuaries (“AAA”)
website http://www.actuary.org. The following files are provided in comma-separated value (*.csv) text
format (i.e., each scenario is terminated with a new line and line feed character).

It is important to note that the scenarios have been constructed so that the Kth scenario (path) for each asset
class must be used together and considered one “future investment return environment”. It is inappropriate to
misalign the ordering of scenarios (e.g., scenario J for “Diversified U.S. Equity” cannot be combined with
scenario K for “Diversified International Equity”, J ≠ K).

The scenario files provide monthly values for 30 years. The first column applies at “time zero”. For interest
rates, the first column in the scenario matrix is the yield at the start of the test. For all other files, the first
column is composed entirely of ones (certain software programs may require this column to be removed before
use). Hence, the size of the ‘scenario matrix’ in each file is 10,000 × ( 1 + 12 × 30 ) = 10,000 × 361.

The U.S. Treasury yields are expressed as nominal semi-annual bond equivalent yields in decimal format. All
other returns are expressed as periodic (not cumulative) market accumulation factors (i.e., monthly “gross
wealth ratios”). Interest rates are assumed to change at the start of each month, hence the value in column T
applies for month T−1. The market accumulation factor in column T represents the growth in month T−1.

Durations 0 through 9 (inclusive) for the first ten (10) scenarios in the Diversified U.S. Equity file are shown
below in Table 19. Table 20 gives the first ten scenarios for the 10-year U.S. Treasury yields. Using scenario
6 as an example, the yield in month 3 is 4.5164% and the monthly U.S. equity growth factor is 1.006528.

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 16 of 19
 Table 19: First 10 Scenarios for Diversified U.S. Equity (US.csv) – Monthly Accumulation Factors
0 1 2 3 4 5 6 7 8 9

1 1 1.092469 1.083986 1.006021 1.015863 1.020886 1.017517 1.033370 1.065896 1.014492

2 1 0.919721 0.974064 1.004553 1.010235 1.013128 0.996171 1.008690 0.979059 1.001054
3 1 1.017425 1.019115 1.026518 0.975530 1.006764 1.020923 0.956538 0.963677 0.985936
4 1 1.050778 1.009128 1.083217 0.956835 0.968311 1.042744 0.983705 1.045328 1.049569
5 1 0.980780 0.994217 1.019358 0.991551 1.120387 0.877891 1.049358 0.950271 1.005277
6 1 0.971779 0.978151 1.006528 1.005762 1.060561 1.058023 1.014724 0.972309 0.993515
7 1 0.925176 1.009579 1.062304 1.019200 1.050946 1.045153 1.015894 1.001342 1.000698
8 1 1.050359 0.995239 0.990647 1.013092 1.000848 1.004970 0.974614 1.024655 0.991690
9 1 1.035438 1.010034 1.009361 1.013842 1.022945 1.015931 1.020676 0.920945 1.063518
10 1 1.018519 1.162125 1.030109 1.052653 1.070173 1.025596 1.010738 0.958566 0.978353

Table 20: First 10 Scenarios for 10-year U.S. Treasury yield (UST_10y.csv) – Nominal S/A BEY
0 1 2 3 4 5 6 7 8 9

1 0.0423 0.042787 0.043649 0.043802 0.044557 0.046567 0.044913 0.044837 0.048417 0.049807
2 0.0423 0.043597 0.043754 0.045324 0.047070 0.048851 0.048940 0.047389 0.046302 0.046620
3 0.0423 0.042218 0.041209 0.042634 0.042988 0.041944 0.040294 0.038418 0.037532 0.038767
4 0.0423 0.043108 0.041918 0.042406 0.042604 0.041861 0.042539 0.044035 0.044223 0.042515
5 0.0423 0.043627 0.043071 0.041678 0.039150 0.035005 0.032911 0.033751 0.034600 0.034904
6 0.0423 0.043018 0.043928 0.045164 0.045187 0.043728 0.042704 0.044122 0.043114 0.041484
7 0.0423 0.044257 0.045586 0.046619 0.046970 0.044459 0.042934 0.044681 0.046048 0.046603
8 0.0423 0.042637 0.040846 0.040029 0.038512 0.037170 0.035555 0.035722 0.038985 0.040438
9 0.0423 0.042294 0.043150 0.045104 0.046244 0.048910 0.049638 0.050845 0.053803 0.054804
10 0.0423 0.042397 0.041191 0.042953 0.043788 0.043130 0.042707 0.042405 0.043704 0.044746

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 17 of 19
Scenario Conversion

If a company chooses to make use of the scenarios, it will be the company’s responsibility to translate the
scenarios into the format required by its projection software. This could require a change to the periodicity
(i.e., timestep) and/or type of return. This conversion will normally be straightforward, but is clearly a critical
step in the scenario testing. The actuary will usually conduct or oversee the successful conversionof the
scenarios. For conversion purposes, the company should assume geometric averaging to transform the interest
rates.

Tables 21 and 22 show the conversion to a quarterly timestep for a variety of return types for scenario 6.

Table 21: Conversion of Diversified U.S. Equity Accumulation Factors to Quarterly Periodicity
Accumulation Accumulation Log Return Nominal
Month Quarter
Factor Factor (1) (2) Return (3)
1 0.971779
2 0.978151 1 0.956752 −0.044211 −0.043248
3 1.006528
4 1.005762
5 1.060561 2 1.128563 0.120946 0.128563

6 1.058023

(1) Product of the monthly accumulation factors.

(2) Natural logarithm of the quarterly accumulation factor = sum of monthly log returns.
(3) Quarterly accumulation factor − 1.

Table 22: Conversion of 10-year U.S. Treasury Yields to Quarterly Periodicity

Semi-Annual Semi-Annual Effective Rate Continuous
Month Quarter
Bond Yield Bond Yield (4) (5) Return (6)
1 0.043018
2 0.043928 1 0.0440365 0.0445213 0.0435587

3 0.045164
4 0.045187
5 0.043728 2 0.0438727 0.0443540 0.0433985

6 0.042704

 3 1

  i3( k −1) +t  3 
(4) For the k quarter, ik = 2 ×  ∏ 1 +
th *
  − 1 .
 t =1  

2

2
 i* 
(5) ik′ = 1 + k  − 1 .
 2
(6) Natural logarithm of (1 + ik′ ) .

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 18 of 19
Representative Scenarios

Recognizing that the company may wish to run fewer than 10,000 scenarios, we have created a utility in
Microsoft® Excel 2002 which selects a representative subset of size N (user-specified). The workbook
“Scenario Picking Tool (AAA LCAS C3 Phase II RBC) v6 Locked.xls” is available for download from the AAA
website.

A significance measure S (defined below) has been calculated for each scenario. The selection process ranks
(orders) the significance values and stratifies the sample, picking the mid-point of each stratum as the
representative. The selection process has been designed so that the representative scenarios are equally likely.

The significance S of an investment return path is defined as:

2
H
 t 1 
S = ∑  ∏ 
t =1  k =1 AFk 

where time is measured in months and AFk is the accumulation factor in month k. We have selected a horizon
H = 180 months (i.e., 15 years) in the calculations.

The workbook is fully documented and easy to use. Only a handful of fields (cells) are accessible; the rest of
the workbook is locked for protection. Input fields are identified by light yellow or ivory background shading
and blue font for text. The actuary simply selects an asset class for the scenario selection using the drop-down
list and inputs the desired number of scenarios (minimum 200). The selected asset class should closely
approximate the investment option (fund category) to which the company is most exposed. For most
companies, this would be the “Diversified U.S. Equity” class.

The representative scenarios are identified by scenario number. The significance measures are also provided.
This output is located in the cells with light green shading and may be copied and pasted into other
applications.

Sampling Error

Statistical measures estimated by simulation are always subject to sampling error. For tail measures (e.g.,
quantiles, CTE, etc.) the mis-estimation due to sampling error can be significant, especially when there are
fewer than 1000 scenarios. As such, the selection method to obtain representative scenarios should be used
with caution. As a general rule, the company should attempt to process as many scenarios as possible. If
fewer than 1000 scenarios are used, it is strongly advised that the company investigate the potential sampling
error and adjust the results according to prior sensitivity testing. Such analysis could include testing the
variability in results for a small, suitably chosen ‘representative portfolio’11.

11
Suppose the company wishes to use N scenarios (N < 10,000). It could adjust the total portfolio CTE(X) based on the
difference in CTE(X) results for a representative portfolio run over (1) all 10,000 pre-packaged scenarios and (2) the
selected subset of N paths.

AAA LCAS C3 Phase II RBC for Variable Annuities: Pre-Packaged Scenarios Mar 2005 Page 19 of 19