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.