Sun Life 2012 Annual Report Download - page 67

(iii) The value of guarantees decreased due to exclusion of the Discontinued Operations and the strengthening of the Canadian dollar
against the U.S. dollar.
(iv) Insurance contract liabilities decreased due to the exclusion of the Discontinued Operations and favourable equity market
movements.
Segregated Fund Hedging
We have implemented hedging programs, involving the use of derivative instruments, to mitigate a portion of the cost of interest rate
and equity market-related volatility in providing for segregated fund guarantees. As at December 31, 2012, over 90% of our segregated
fund contracts, as measured by associated fund values, were included in a hedging program. While a large percentage of contracts are
included in the hedging program, not all of our equity and interest rate exposure related to these contracts is hedged. For those
segregated fund contracts included in the hedging program, we generally hedge the value of expected future net claims costs and a
portion of the policy fees as we are primarily focused on hedging the expected economic costs associated with providing these
guarantees.
The following table illustrates the impact of our hedging program related to our sensitivity to a 50 basis point and 100 basis point
decrease in interest rates and 10% and 25% decrease in equity markets for segregated fund contracts as at December 31, 2012.
Impact of Segregated Fund Hedging for Continuing Operations ($ millions)
Changes in Interest Rates(3) Changes in Equity Markets(4)
Net income sensitivity(1)(2) 50 basis point
decrease
100 basis point
decrease 10% decrease 25% decrease
Before hedging (200) (400) (200) (650)
Hedging impact 200 400 200 600
Net of hedging ––– (50)
(1) Since the fair value of benefits being hedged will generally differ from the financial statement value (due to different valuation methods and the inclusion of valuation margins
in respect of financial statement values), this approach will result in residual volatility to interest rate and equity market shocks in reported income and capital. The general
availability and cost of these hedging instruments may be adversely impacted by a number of factors, including volatile and declining equity and interest rate market
conditions.
(2) Amounts as at December 31, 2012 do not include the impact of assets and liabilities of the Discontinued Operations. Net income sensitivities have been rounded to the
nearest $50 million.
(3) Represents a parallel shift in assumed interest rates across the entire yield curve as at December 31, 2012. Variations in realized yields based on factors such as different
terms to maturity and geographies may result in realized sensitivities being significantly different from those illustrated above. Sensitivities include the impact of re-balancing
interest rate hedges for segregated funds at 10 basis point intervals (for 50 basis point changes in interest rates) and at 20 basis point intervals (for 100 basis point changes
in interest rates).
(4) Represents the change across all equity markets as at December 31, 2012. Assumes that actual equity exposures consistently and precisely track the broader equity
markets. Since in actual practice equity-related exposures generally differ from broad market indices (due to the impact of active management, basis risk and other factors),
realized sensitivities may differ significantly from those illustrated above. Sensitivities include the impact of re-balancing equity hedges for segregated funds at 2% intervals
(for 10% changes in equity markets) and at 5% intervals (for 25% changes in equity markets).
Our hedging strategy is applied both at the line of business/product level and enterprise level using a combination of longer-dated put
options and dynamic hedging techniques (i.e. frequent re-balancing of short-dated interest rate and equity derivative contracts). We
actively monitor our overall market exposure and may implement tactical hedge overlay strategies (primarily in the form of futures
contracts) in order to align expected earnings sensitivities with enterprise risk management objectives.
Real Estate Risk
We are exposed to real estate risk arising from fluctuations in the value of, or future cash flows on real estate classified as investment
properties. We may experience financial losses resulting from the direct ownership of real estate investments or indirectly through fixed
income investments secured by real estate property, leasehold interests, ground rents and purchase and leaseback transactions. Real
estate price risk may arise from external market conditions, inadequate property analysis, inadequate insurance coverage,
inappropriate real estate appraisals or from environmental risk exposures. We hold direct real estate investments that support general
account liabilities and surplus, and fluctuations in value will impact our profitability and financial position. An instantaneous 10%
decrease in the value of our direct real estate investments as at December 31, 2012 would decrease net income by approximately
$150 million. Conversely, an instantaneous 10% increase in the value of our direct real estate investments as at December 31, 2012
would increase net income by approximately $150 million.
Additional Cautionary Language and Key Assumptions Related to Sensitivities
Our market risk sensitivities are forward-looking information. They are measures of our estimated net income and OCI, to changes in
interest rate and equity market price levels described above, based on interest rates, equity market prices and business mix in place
as at the respective calculation dates. These sensitivities are calculated independently for each risk factor, generally assuming that all
other risk variables stay constant. The sensitivities do not take into account indirect effects such as potential impacts on goodwill
impairment or the valuation allowance on deferred tax assets. The sensitivities are provided for the consolidated entity and may not be
proportional across all reporting segments. Actual results can differ materially from these estimates for a variety of reasons, including
differences in the pattern or distribution of the market shocks, the interaction between these risk factors, model error, or changes in
other assumptions such as business mix, effective tax rates, policyholder behaviour, currency exchange rates and other market
variables relative to those underlying the calculation of these sensitivities. The potential extent to which actual results may differ from
the indicative ranges will generally increase with larger capital market movements. Our sensitivities as at December 31, 2011 have
been included for comparative purposes only.
We have also provided measures of our net income sensitivity to instantaneous changes in credit spreads, swap spreads, real estate
price levels and capital sensitivities to changes in interest rates and equity price levels. These sensitivities are also forward-looking
statements and MCCSR ratio sensitivities are non-IFRS financial measures. For additional information, see Use of Non-IFRS Financial
Measures. The cautionary language which appears in this section is also applicable to the credit spread, swap spread, real estate and
MCCSR ratio sensitivities. In particular, these sensitivities are based on interest rates, credit and swap spreads, equity market and real
estate price levels as at the respective calculation dates and assume that all other risk variables remain constant. Changes in interest
rates, credit and swap spreads, equity market and real estate prices in excess of the ranges illustrated may result in other-than-
proportionate impacts.
Management’s Discussion and Analysis Sun Life Financial Inc. Annual Report 2012 65