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CFOs Support Principle-Based Reserving, But Have Concerns

By Jim Connolly

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While 80% of CFOs in a new survey support the concept of principle-based reserving, fewer than 40% favor the way it is currently being defined and implemented while 26% are opposed, according to the survey by Towers Perrin’s Tillinghast unit.

A principle-based approach to reserving is a “watershed event,” according to Hubert Mueller, a principal with Towers Perrin, Hartford, and CFO survey leader. “This is the biggest thing since the early 1980s when the valuation laws changed.”

But the survey suggested that CFOs think it might take a while to implement. Some 64% said they anticipate it will be fully implemented by 2009 or later for life insurance products and half of those surveyed saw the same timeframe for annuities.

The survey listed changes to the competitive landscape that CFOs anticipated. Some 90% said a principle-based approach will create a need for hedging programs; 82% that greater flexibility will lead to new ways to manipulate the system; 81% that it would create a lack of comparability of results across companies; and 70% that it will significantly reduce reserve redundancies for term and UL with secondary guarantee products.

The survey found that 8% had largely implemented preparations for the new approach; 4% were setting up committees; 17% had planning well under way; 46% are just starting to analyze; and 25% currently are in a “wait and see” mode.

Among the anticipated changes respondents noted were unanimous agreement that there will be a greater need for company resources as well as the recognition that companies will see an increase in expense levels.

For instance, Mueller says hedging requirements that companies implement will take a while before they start producing benefits for companies. Typically, he explains, it takes 3-5 years to get real experience and only one company has been doing it for 3 years. Companies will have to treat implementation of such programs as an investment, he continues.

But, for companies that want to offer new products with different risk profiles, and offer “more competitive pricing and lower cost for consumers,” time and investment in the new approach will be worth the effort, the report says.

For instance, Mueller says companies offering living benefits with variable annuities are experiencing increases in sales and, for such companies, investments in hedging programs will be necessary to remain competitive.

Distributors are requiring that companies offer living benefits in order to work with them, Mueller says. “You need those features to play. If you don’t have those features, you can’t play,” he adds.

Smaller companies that cannot afford hedging programs or other requirements needed for a principle-based system might have to ultimately leave the business, he notes. This would not be solely as the result of a shift to principle-based reserving, Mueller says, but it would be part of a process that is occurring now. And, it will not be a “big bang” shift but a more gradual shift, he adds.

Mueller says that although many companies are just starting the process of looking at principle-based reserving, development of the new system is already well under way. For instance, he notes that capital for VAs with guarantees is already captured in C3 Phase II reserving and reserving using VA-CARVM is well under way.

Capital and reserving for life products and then for annuities will be additional components of the total project, he adds.

Scott Harrison, executive director of Affordable Life Insurance Alliance, Washington, says the principle-based effort is progressing well. Among the efforts he cites are: putting an interim solution in place so that a focus can turn to long-term work; working to change the standard valuation law so that a principle-based system can be put in place; and putting the longer-term principle-based solution in place.

Among the points in the survey that he notes is the potential to lower cost of capital and reserves and offer more competitive pricing and lower cost to consumers.

The concerns that CFOs registered in their responses, he says, are currently being addressed by regulators and actuaries at the American Academy of Actuaries, Washington.

Harrison notes that the 25 CFOs who responded to the survey is a small sample base.

The survey, as described by Towers Perrin-Tillinghast, was a Web-based survey that culled responses from 25 CFOs from large and midsize North American life insurers. Of these, 61% had assets of $5 billion or more and 12% were multinationals.