The rules for setting reserves and the capital requirements for life insurance products sold in the U.S. are about to undergo a dramatic overhaul.

The new proposals follow a number of ad hoc changes to reserve rules that have occurred in recent years. The formulaic nature of these recently enacted reserve rules was widely felt to be unsatisfactory, especially since it appeared to lead to the development of products that were structured to provide minimum reserves based on literal–and, to some, aggressive–readings of the rules.

In response, the regulatory actuaries on the Life and Health Actuarial Task Force of the National Association of Insurance Commissioners asked the American Academy of Actuaries to develop a principles-based approach (PBA) to risk-based capital (RBC) for life insurance products. While the timing remains uncertain, it is quite possible that the RBC requirements will be effective for 2008; the reserves will likely require state-by-state adoption, which will increase the time to effectiveness.

In order to be ready for 2008, companies need to begin the process now with full involvement of financial executives (i.e., CFO, accounting professionals) and plan accordingly, having a full understanding of the various implications for their company.

The scope of the proposals is very broad. If adopted, the principles-based approach to reserves and risked-based capital will have implications for many aspects of a life insurer’s operations, including affecting a company’s short-and long-term strategic plans.

What are the implications of the PBA?

Internal Controls and Financial Executives. The company will need to adopt controls with respect to a principles-based valuation reasonably designed to assure that all material risks inherent in the liabilities and assets subject to such valuation are included in the valuation. The company’s qualified actuary, with the participation of the company’s CFO and other financial executives, shall annually evaluate the effectiveness of the adopted controls. They will report the evaluation to the company’s board of directors and the commissioner.

Model Risk and Controls. A vast set of models, some untested or used in a new way, will produce key statutory numbers. The framework for PBA reserves is based on company-specific modeling. The Reported Reserve, as the amount recorded in the statutory financial system is called in the PBA framework, is the greater of a Deterministic Reserve and a Stochastic Reserve. The Deterministic Reserve is calculated on a policy-by-policy basis, while the Stochastic Reserve is based on more aggregated cash flows from all policies. To calculate the Stochastic Reserve, a large number of projections of the cash flows must be made, each based on a different scenario of future interest rates and equity experience. For policies that are not sensitive to interest rates or equity movement, such as term insurance, the framework provides an exemption from the (probably costly) stochastic modeling.

Financial Results. The PBA framework will, of course, directly affect the statutory financial results of life insurance companies. Although statutory gain from operations is not usually used as a performance measure, the primary determinant of company solvency is statutory capital and the statutory RBC ratio. Both ratings agencies and regulators focus on these numbers, and the availability of capital for strategic purposes is limited by these considerations. Consequently, the financial executive needs to know how the new proposals will affect statutory financial results.

The Academy’s Life Reserve Work Group has developed some initial models based on representative products. For term products, the reserve “hump” is likely to be cut in half if the PBA is applied, but early reserves can be substantial, causing reserve strain on new sales. With respect to capital requirements, the required capital is likely to increase for products with significant tail risk, like universal life with secondary guarantees and certain variable products.

Financial Volatility. The volatility of financial results may be increased as assumptions must be reviewed annually and revised whenever anticipated experience differs significantly from underlying current assumptions. The resulting reserve changes could result in surprises: either increased or reduced reserves. Over a large block of business, the effects of assumption revision may cancel out in many cases. However, changes to risk factors that are correlated, such as those that are related to the overall market value of equities, could cause a large change in the aggregate reserve level and capital.

Financial Operations. The need to base important financial statement items on complex models has the potential to impact the ability to meet deadlines for financial close. The models will require significant effort both to run and to perform necessary controls. This is especially true for RBC, since all products, new and in force, must be modeled. Also, the need for an independent review of the reserve calculations adds another complex step to the process. For example, when the PBA was applied to capital requirements for variable annuities, computer time was as high as 240 hours.

Federal Income Tax. The treatment of life insurance reserves under the Internal Revenue Code was developed to fit the formulaic approach to reserves set forth in the Standard Valuation Law. Actuaries and industry tax professionals have stated it would be desirable for the PBA to fit within the current tax structure so that new tax legislation is not required. Knowledgeable observers have identified several challenges that must be faced in order to achieve this result.

Even though there are open issues regarding the form PBA reserves should take in order to fit into the current tax structure, some likely implications for insurance company taxes can be identified. First, because reserve decreases under the PBA are likely to be more significant than reserve increases, the overall reserve deduction is likely to be lower.

In addition, the requirement that assumptions be reviewed and potentially reset every year could have significant tax implications. Currently, tax reserves are “capped” by statutory reserves. If assumption changes cause reserve decreases, the allowable tax reserve deduction would also be reduced. However, if the statutory reserve increases, the deduction may not increase. This is because tax reserves are currently set using the assumptions that apply at time of issue. Thus, future reserve increases may not be recognized. The financial executive will need to follow, at least at a high level, the progress that is made in defining and resolving these and other open issues particularly on the tax front.

Pricing. Under a principles-based approach to reserves and RBC, decisions made in the pricing process can impact reserves and thus financial reporting, not only at issue, but also in later years. Pricing assumptions are based on the same experience studies as valuation assumptions. Any differences must be understood by the Qualified Actuary and may be analyzed in the report of the PBA Reviewer that goes to the board and the insurance commissioner. Thus, cooperation between the pricing actuary and Qualified Actuary may be essential to the smooth functioning of the PBA.

Given the wide-ranging impact of the decisions made in the pricing process, the CFO or other senior financial executive may find it useful to participate in order to understand the choices and the potential implications for financial reporting. Choice of investment strategy, for example, will affect the discount rates for reserves, as well as non-guaranteed elements and other cash flow items.

Product Development. Lower reserves could lead to a wave of replacement activity, with GAAP as well as statutory implications. The tools needed to carry out the PBA calculations may improve the ability of the company to manage strategically its risk profile, and the change in capital requirements resulting from the PBA will modify the strategic choices available to management and owners.

Enterprise Risk Management/Economic Capital. The PBA apparatus should facilitate the calculation of economic capital, including the analysis of the benefits of risk diversification. Even companies that already calculate economic capital often report using simplistic methods for determining diversification credit. The conditional tail expectation metric used in the PBA produces additive results when applied to multiple risk factors and thus is a useful tool for determining capital allocations to lines of business with correlated risks.

While many details remain to be resolved, there is a realistic possibility that the PBA for life insurance RBC with all the attendant drain on resources could be required for the 2008 Annual Statement. However, the timing of reserves is less certain as they will require a state by state adoption.