Sun Life 2012 Annual Report Download - page 63

We also have direct exposure to equity markets from the investments supporting other general account liabilities, surplus and
employee benefit plans. These exposures generally fall within our risk-taking philosophy and appetite and are therefore generally not
hedged.
Interest Rate and Spread Risk
Interest rate and spread risk is the potential for financial loss arising from changes or volatility in interest rates or spreads when asset
and liability cash flows do not coincide. We are exposed to interest rate risk when the cash flows from assets and the policy
obligations they support are significantly mismatched, as this may result in the need to either sell assets to meet policy payments and
expenses or reinvest excess asset cash flows in unfavourable interest rate or spread environments. The impact of changes or
volatility in interest rates or spreads is reflected in the valuation of our financial assets and liabilities for insurance contracts in respect
of insurance and annuity products.
Our primary exposure to interest rate and spread risk arises from certain general account products and segregated fund contracts,
which contain explicit or implicit investment guarantees in the form of minimum crediting rates, guaranteed premium rates, settlement
options and benefit guarantees. If investment returns fall below guaranteed levels, we may be required to increase liabilities or capital
in respect of these contracts. The guarantees attached to these products may be applicable to both past premiums collected and
future premiums we have not received. Segregated fund contracts provide benefit guarantees that are linked to underlying fund
performance and may be triggered upon death, maturity, withdrawal or annuitization. These products are included in our asset-liability
management program and the residual interest rate exposure is managed within our risk tolerance limits.
Declines in interest rates or narrowing spreads can result in compression of the net spread between interest earned on investments
and interest credited to policyholders. Declines in interest rates or narrowing spreads may also result in increased asset calls,
mortgage prepayments and net reinvestment of positive cash flows at lower yields, and therefore adversely impact our profitability and
financial position. In contrast, increases in interest rates or a widening of spreads may have a material impact on the value of fixed
income assets, resulting in depressed market values, and may lead to losses in the event of the liquidation of assets prior to maturity.
A sustained low interest rate environment may adversely impact our earnings, regulatory capital requirements and our ability to
implement our business strategy and plans in several ways, including:
• Lower sales of certain protection and wealth products, which can in turn pressure our operating expense levels.
• Shifts in the expected pattern of redemptions (surrenders) on existing policies.
• Higher equity hedging costs.
• Higher new business strain reflecting lower new business profitability.
• Reduced return on new fixed income asset purchases.
• The impact of changes in actuarial assumptions driven by capital market movements, including declines in fixed income
reinvestment rates in our insurance contract liabilities.
• Impairment of goodwill.
• Additional valuation allowances against our deferred tax assets.
Significant changes or volatility in interest rates or spreads could have a negative impact on sales of certain insurance and annuity
products, and adversely impact the expected pattern of redemptions (surrenders) on existing policies. Increases in interest rates or
widening spreads may increase the risk that policyholders will surrender their contracts, forcing us to liquidate investment assets at a
loss and accelerate recognition of certain acquisition expenses. While we have established hedging programs in place and our
insurance and annuity products often contain surrender mitigation features, these may not be sufficient to fully offset the adverse
impact of the underlying losses.
We also have direct exposure to interest rates and spreads from investments supporting other general account liabilities, surplus and
employee benefit plans. Lower interest rates or a narrowing of spreads will result in reduced investment income on new fixed income
asset purchases. Conversely, higher interest rates or wider spreads will reduce the value of our existing assets. These exposures
generally fall within our risk-taking philosophy and appetite and are therefore generally not hedged.
Market Risk Sensitivities
We utilize a variety of methods and measures to quantify our market risk exposures. These include duration management, key rate
duration techniques, convexity measures, cash flow gaps, scenario testing, and sensitivity testing of earnings and regulatory capital
ratios versus risk tolerance limits which are calibrated to our risk appetite.
Our earnings are affected by the determination of policyholder obligations under our annuity and insurance contracts. These amounts
are determined using internal valuation models and are recorded in our Consolidated Financial Statements, primarily as insurance
contract liabilities. The determination of these obligations requires management to make assumptions about the future level of equity
market performance, interest rates (including credit and swap spreads) and other factors over the life of our products. Differences
between our actual experience and our best estimate assumptions are reflected in our financial statements.
The market value of our investments in fixed income and equity securities fluctuate based on movements in interest rates and equity
markets. The market value of fixed income assets designated as AFS that are held primarily in our surplus segment increases
(decreases) with declining (rising) interest rates. Similarly, the market value of equities designated as AFS and held primarily in our
surplus segment increases (decreases) with rising (declining) equity markets. Changes in the market value of AFS assets flow through
OCI and are only recognized in net income when realized upon sale, or when considered impaired. The amount of realized gains
(losses) recorded in net income in any period is equal to the initial unrealized gains (losses) or OCI position at the start of the period
plus the change in market values during the current period up to the point of sale for those assets which were sold. The sale of AFS
assets held in surplus can therefore have the effect of modifying our net income sensitivity.
In 2012, we realized $126 million (pre-tax) in net gains on the sale of AFS assets for Continuing Operations. At December 31, 2012,
the net unrealized gains or OCI position on AFS fixed income and equity assets for Continuing Operations was $446 million and
$86 million, respectively, after-tax.
Management’s Discussion and Analysis Sun Life Financial Inc. Annual Report 2012 61