A Critical Review Of Triple-X Can Offer
A Solution To Greater Credit Risk
We believe that a more critical review of Guideline Triple-X and the reserves it produces can offer a solution to the industrywide problem of increasing credit risk due to future letter of credit costs.
It has been pointed out that the Valuation of Life Insurance Policies model regulation, more commonly called Guideline Triple-X, is causing immediate and future surplus strain that is usually solved by reinsurance. The regulation, applied to term and universal life insurance, is increasing the cost of reinsurance and slowing the decline in term premiums. This has become even more significant as the cost of letters of credit, financial instruments used to meet reserving requirements, increase.
Regulation Triple-X offers many options. The actuary calculating Triple-X reserves must make many choices, which have differing impacts on different products. If the choices are not made carefully, reserves can be much higher than necessary.
Some of these choices have been made by habit or custom rather than to minimize reserves. Some of the same choices are required to calculate reserves for products such as whole life insurance, but in this case, they cause a trivial reserve difference. However, when applied to term, the proportional increase is much larger. Decisions that could be made without much thought or impact on whole life deserve analysis on term.
Some actuaries may feel it is conservative to hold redundant reserves and then cede them. But what is really conservative about holding higher than necessary reserves and then ceding them, especially to offshore reinsurers? All it really accomplishes is to increase the cost of doing business.
While this applies to basic as well as minimum reserves, the choice of X-factors is of particular importance. X-factors are numbers multiplied times the valuation mortality rate that may reduce or eliminate deficiency reserves under Triple-X. They can better reflect a companys experience.
Few, if any, reasonably priced term products should generate deficiency reserves. In practice, many companies do hold deficiency reserves on their term products. Many cede them to reinsurers and thus incur additional costs, including direct or indirect letters of credit costs.
In many cases, the reinsurer realizes the deficiency reserves are unnecessary and simply does not hold them. Other reinsurers practice mirror reserving, in which the reinsurer holds the exact amount of reserves that the ceding company is taking as a reinsurance credit, and then charges for it. The reinsurers are central to this discussion. They profit from taking the extra reserves offshore. They could, however, do their clients a favor by helping them to first eliminate redundant reserves. Profitable clients are certainly good for the reinsurers.
Deficiency reserves are especially onerous because they are not used in the calculation of taxable income. Thus, a company holds them but cannot deduct them. If a product generates them, the deficiencies must be ceded in order to get reasonable after-tax profits. This may explain the comparison of direct writers dependence on reinsurance to drug addiction that has been referenced in at least one article.
The Society of Actuaries surveyed pricing and valuation actuaries about their X-factor practices in 2002. (Regulation XXX Survey Report, March 2002, www.soa.org/research/xxx_report.html.) They asked how X-factors were initially set and a small minority of 9% responded that they set X-factors to eliminate deficiency reserves. This small group is on the right track. Most of the other 91% set their X-factors in proportion to pricing or expected mortality. If these other approaches generate deficiency reserves, those reserves are quite likely unnecessary. It would seem that the 9% have found a way to take advantage of the industrywide problem rather than being its victims.
Regulation Triple-X permits the valuation actuary a lot of discretion in establishing X-factors. Companies can avoid most deficiency reserves by judiciously choosing these X-factors. This can be done while establishing adequate reserves, complying with all the requirements of Regulation Triple-X, and complying with the related Actuarial Standards of Practice.
What can a company do if it reviews its Triple-X calculations and discovers that it is holding unnecessary reserves? Changes in the calculation options under Triple-X often would be considered a change in the reserve basis and require more complex statutory accounting. However, adjustments to X-factors on in-force blocks carry no such burden. If unnecessary deficiency reserves are released, the impact is to statutory income, probably tax-free.
There are a number of ways to tackle a developing industry problem. Some may look to solve it with new laws or regulations. Others look for new sources of capital or letters of credit. Many expect the reinsurers to come up with new and creative solutions. We suggest that each company begin by taking a hard look at their Regulation Triple-X reserves, especially the deficiencies, and releasing what is unnecessary.
Jim Van Elsen is the owner and founder of Van Elsen Consulting, Pella, Iowa. Grant Hemphill is a consulting actuary with the firm and is based in Martinsville, Ind. They can be reached at veconsulting.
Reproduced from National Underwriter Edition, July 16, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.