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Enter Brave New Reserving World, But In Smaller Steps

A mechanism that would add a reserving floor to a new flexible reserving methodology for variable annuities is being opposed by a number of large life insurers as well as some insurance regulators.

The issue will receive more discussion at the summer meeting of the National Association of Insurance Commissioners, Kansas City, Mo. But initial reaction to a standard scenario reserving methodology which tries to add a degree of conservatism to stochastic modeling was that if the floor is used, it should be used only for informational and not for risk-based capital purposes. Stochastic modeling runs iterations of scenarios that may occur rather than relying on a deterministic, formulaic approach for reserving.

The issue arises as regulators and insurers search for a way that will create proper reserving for life insurance products while allowing for greater flexibility. That flexibility, according to discussions, makes it possible for regulators to safeguard solvency and insurers to develop new products and to use capital more efficiently. The C3-Phase II project, as it is called, is seen by many as a way to achieve this goal.

A number of large companies including Lincoln Financial Life Ins. Co., Pacific Life Ins. Co., and John Hancock Life Ins. Co. were part of the discussion.

Some of the points that were raised: the standard scenario would penalize companies that use dynamic hedging; the timing for implementing the C-3 Phase II project needs to be appropriate because of the amount of work that needs to be done for modeling; modeling for both stochastic scenarios and for the standard scenario could create additional expenses; and, the standard scenario would create more work but if regulators needed it, then it should be done.

But, both companies and several regulators are saying that if it is going to be done, then at least initially, it could be done as a point of information rather than as a component of the risk-based capital calculation.

And, New Mexico regulator Mike Batte says that his state opposes the standard scenario because while it might be valuable as an oversight tool, it could “punish companies that are using good risk management.”

However, a number of regulators feel that the best way to find out if something works is to do it.

At least one regulator, Allen Elstein of Connecticut, is stating the importance of having a degree of conservatism and balance, noting that there should be a floor to ensure that the risk of items such as derivatives are properly accounted for. Long Term Capital Management, a hedge fund that was bailed out of a financial crisis in 1998, was cited as an example by Elstein. “The curse of an option is that if you make a mistake, it is a big one,” he notes.

Another point that was raised during the discussion was the resources that states would have to oversee stochastic modeling would vary and a floor provided by a standard scenario could be useful.

Merits of a floor discussed as new stochastic approach is developed