Assessing principles-based reserving and the C-3, Phase II project

At press time, life reinsurers are among those watching for the outcome of a regulatory vote that would establish risk-based capital requirements for variable annuities with guarantees.

That anticipated vote on Oct. 14 by regulators of the National Association of Insurance Commissioners, Kansas City, Mo., as well as the outcome of two other projects still under development, could impact reinsurers’ business, according to interviews with National Underwriter.

These interviews suggest a general impression that the NAIC’s executive committee and plenary will adopt the measure, which places more emphasis on modeling than do traditional formulaic RBC requirements.

A second component of the C-3, Phase II project, which deals with reserving for variable annuities with guarantees, could be in place by year-end 2006 or in 2007. A newer project that creates a principles-based reserving framework is scheduled for a March 2007 completion.

Life reinsurers say that until the details of these proposals become clearer, it is difficult to say for sure what the impact on the reinsurance community will be. But they did discuss 3 general areas of change: direct writers’ future need for reinsurance; the impact on business that reinsurers hold; and, direct writers’ need for reinsurers’ advice.

For direct writers, the use of reinsurance as well as hedging techniques determine the type of risk management program a company has, and, consequently, the degree of risk that will be captured in modeling, says Tom Campbell, chairman of the variable annuity working group of the Academy of Actuaries, Washington, and a vice president and corporate actuary with Hartford Life Insurance Company, Simsbury, Conn. The working group is looking at the reserving component of the C-3 project.

To the extent that risk management becomes more important in the modeling process, companies will be encouraged to take a fresh look at how reinsurance is used, Campbell explains. It is one more element that will be looked at in the risk mitigation process, he adds.

And, to the extent that reinsurers are diversifying the business they hold, that will also be reflected in modeling, he says.

Arnold Dicke, senior manager with KPMG in New York, says that if regulatory changes become effective, there will be a need for advice either internally or externally on issues such as the use of reinsurance and clearly defined hedging strategies. If C-3 reserving requirements are adopted, they will take “a considerable amount of effort to comply with,” he says. “A great deal of modeling will be required.”

But he also notes that presently, there are few reinsurers that are assuming VAs with guarantees. And, in the case of C-3 RBC, there is a phase-in of the new approach, Dicke adds.

The impact of the principles-based project is more difficult to determine because at this point it is conceptual and “there are many different players and many different hopes for this,” Dicke says. But, depending on how the project develops, reserving for direct writers and to a corresponding degree for reinsurers would change, he notes.

Although the reinsurance market for VAs with guarantees has “significantly dried up,” to the extent that a direct writer uses hedging effectively, it can reduce its need for reinsurance and benefit from treatment under the new C-3 project, says Keith Floman, a senior actuarial advisor with Insurance and Actuarial Advisory Services practice of Ernst & Young, New York.

The impact of C-3, Phase II will vary by company depending on how conservative management is, says Ari Lindner, president of ACE Tempest Life Reinsurance, Ltd., a life reinsurance unit of ACE Group, Hamilton, Bermuda, one of the few reinsurers who write VAs with guarantees. He says he already has received a few calls on the issue. For many companies, introducing volatility into capital reporting may not be something that excites them too much, Lindner adds.

Jim Sweeney, executive vice president and COO with Munich American Reassurance Corp., Atlanta, says it is too early to say what the impact of principles-based reserving will be on reinsurers. There is reason for some optimism, he adds, but until details of the proposals are developed, it is difficult to say how much is justified.

To the extent that reinsurers provide capital and there is less need for that capital, then that could lower the amounts of reinsurance needed, he says.

And, it is also possible, he continues, that reinsurers’ reserving could be lowered. If that happens, reinsurers will have to redeploy that capital. So, for instance, in MARC’s case, it would be up to parent Munich Reinsurance Company, Munich, Germany, to decide whether that should be reflected in the shareholders’ dividend or whether the money would be invested in new ventures that MARC identified.

Jeff Burt, vice president of marketing with Hannover Life Re, Orlando, Fla., a unit of Hannover Re Group, Hannover, Germany, says the impact of principles-based reserving has been raised at several meetings he has attended.

But, he continues, the optimism over the impact of this new approach may be overestimated. Ultimately, reserving may be just a little lower than reserving under the current formulaic approach, Burt says. What will determine the level of reserving is the level of padding required to ensure adequate solvency protection, he adds. Insurers and reinsurers may not receive the release of reserves they are anticipating, Burt says.

And, even if reserving is lowered, Burt says there will still be a need for reinsurance. As evidence of this, he notes that direct writers continue using domestic reinsurers when they currently have the option of moving business offshore.

Where reinsurers will be able to help direct writers, he says, is in working on their assumptions for best estimates. Companies are going to need to explain to auditors and state regulators how they arrived at lapse, morbidity and mortality, and other assumptions, Burt continues.

The impact of principles-based reserving on reinsurers may be different from direct writers because reinsuring different direct writers may diversify the blocks of business a reinsurer holds, Burt notes.

The project could benefit both insurers and reinsurers who could establish more realistic reserves for business on the books, says Mike Stein, a senior vice president and COO with Reinsurance Group of America, Chesterfield, Mo. Reserves would better match risk that was transferred, he explains.

But, he cautions, “there are a lot of toll gates to go through,” with many actuarial and regulatory details still to be worked out.

If the project does advance, he says he believes there will still be a strong need for reinsurance and that the new framework could lead to more reinsurance choices.

Reinsurance product lines themselves could be expanded, says Mark Buehrer, a senior vice president and valuation actuary with RGA. Currently, most reinsurance is either co-insurance with mirror reserving or yearly renewable term in which a reinsurer takes only the mortality piece and renews each year. Other types of reinsurance are permitted but are not extensively used because there is not favorable reserving treatment, Buehrer explains.

Ultimately, Stein and Buehrer say, even if a principles-based system is put in place, there will always be a need for reinsurance if the true motivation of the direct writer is to transfer risk.

Carl Friedrich and Tim Hill, both consulting actuaries with Milliman, Inc., Chicago, say that even though, in general, reinsurers are not reinsuring new sales of VAs with guarantees, for those reinsurers that already have such business on their books, the covariance calculation will be a major driver of the C-3, Phase II impact. If there is diversification of business, then the C-3, Phase II impact should be reduced, they add. But, if they are not diversified or they sold the wrong guarantee during the wrong periods, then those considerations will be factored into their C-3, Phase II calculation.

Hill says that if principles-based reserving reduces reinsurers’ reserves, by allowing reinsurers to reflect a strong hedging program for instance, then they may be more willing to take on risk.