Underlying the feasibility and price of any insurance product are the concepts of statutory reserve and the additional capital insurers need to back the product guarantees.
If the reserve and capital standards are too inflexible, a product design may not be feasible or the price may be too high (because excessive capital would be needed to meet regulatory requirements).
If the standards are inadequate, the risk increases that some insurers will be unable to meet their promises in tough times, damaging industry credibility.
Changes to reserve and capital standards now being considered are fundamental to both future product innovation and financial soundness. This is especially so, as the insurance industry tackles the unique needs of graying America.
Following is an overview of the developments, showing why the changes are needed and the likely outcome. It focuses on the variable annuity initiative, which is closest to implementation. But similar initiatives are well under way for life insurance products (including variable life and level premium term products) and are at the early stages for fixed annuities.
The problem being addressed is the very rigid nature of the current framework, which is based on the use of formulas and mandated assumptions and which does not automatically address new benefits (such as VA guaranteed living benefits).
Adapting this formulaic framework for the new product features is time-consuming, can lag a product’s acceptance in the marketplace considerably, and may do a poor job in measuring actual risk associated with a product feature.
By contrast, the new approach is quite flexible. It is based on principles rather than specific formulas. It involves projecting future revenue, benefits and expenses over a wide range of possible scenarios (i.e., stochastic modeling). Statutory reserves would be based on average results over the worst 25% to 35% of scenarios, while capital needs would be based on results of the worst 10% of scenarios.
One underlying principle is to measure risk in any scenario on an aggregate basis across all the contracts, allowing for the natural offset of risks. This is analogous to measuring investment risk at the portfolio level rather than measuring each asset’s risk on a stand-alone basis.