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.

This aggregate approach is important in developing a realistic assessment of a company’s risk, since it recognizes a company’s diversification across different products/benefits, issue years, customer allocation decisions, and risk control measures (such as hedging). Of course, it also means the results will vary by company.

Unlike the formula-based approach, which is easy to calculate and verify, a principles-based approach has some complexity.

It entails determining and justifying various assumptions in the stochastic model as well as actually running the model. Moreover, to ensure integrity, it requires sufficient guidance and an effective oversight procedure. The activity is time-consuming, as many areas need careful thought and discussion.

As an example, some controls are needed on the scenarios that can be used. A “calibration” standard was developed for the scenarios that are used in modeling statutory reserves or required capital. This standard ensures that there are enough “bad” scenarios in the models.

For example, at the 10th duration, at least 2.5% of the scenarios for an equity class like the S&P 500 must use returns no better than obtained from an average gross annual return of -2.33%.

For most VAs, the calculation of required statutory capital for year-end 2005 used, in part, a principles-based calculation. Statutory reserves still are using the formula-based approach, but the expectation is statutory reserves will soon use a principle-based approach.

However, a number of issues still need to be resolved. Hopefully, discussions now under way will develop a consensus on these issues before the summer meeting of the National Association of Insurance Commissioners. This would allow the new reserve approach to be adopted in the very near future, possibly effective for year-end 2006. (See box for a review of the issues.)

Adoption of a principles-based approach, having a properly designed framework and effective regulatory oversight, would be a big step forward.

The flexibility in product design and the superior measure of guarantee-related risks would help the industry and its customers.