Efforts to advance a more principles-based system for ensuring proper reserves and capital are occurring both on the regulatory and rating agency fronts.

During a discussion of its new PRISM capital model, Fitch Rating analysts detailed how it would fine-tune assessing capital adequacy.

PRISM is being introduced in the United States now and will be introduced in Europe during the summer, according to Keith Buckley, group managing director in Fitch’s Chicago office. It is being used to assess capital adequacy for both life insurers and property-casualty insurers. The model was initially introduced in June 2006.

The new capital model will not replace Fitch’s examination of companies’ internal capital models but rather will complement that examination and create a benchmark for comparison among companies, he explained during a conference call on April 25 to formally announce PRISM.

The new model goes beyond generating ratios and also creates a “probabilistic loss distribution of required capital,” according to Buckley.

The life insurance industry as measured by PRISM has excess capital of $45 billion above the PRISM “AAA”-rating threshold, added Doug Meyer, managing director and head of U.S. life ratings in Fitch’s Chicago office. This compares with actual industry statutory capital of $249 billion at year-end 2005, according to Fitch.

A Fitch report on PRISM noted that “capital requirements for many variable annuity products are higher under PRISM than in most factor-based models, as well as under the stochastic approach used in the NAIC RBC ratio under C-3 Phase II (which includes a slow phase-in).” Fitch added that it believes PRISM “more appropriately measures the embedded guarantees of these products, while giving credit for reinsurance and hedging activities.”

A significant portion of this capital sits with mutual insurers, Meyer said. This finding reflects that stock companies often dividend up to their parent, which in turn uses those funds for such purposes as paying shareholder dividends and servicing debt, he said.

The capital level was helped by a benign credit environment and strong equity market performance, Meyer continued.

Companies that scored the best on PRISM were both diversified and wrote whole life business. Universal life was the most capital intensive because of interest rate risk, followed by term insurance and then whole life, Meyer said.

The report said that fixed immediate annuities, including structured settlements, generate more required capital than fixed deferred annuities because of the greater interest-rate risk associated with longer payout patterns, which give rise to greater reinvestment and mortality risk.

Julie Burke, a Fitch managing director North America Life & Non-life operations in Chicago, said diversification was a common thread captured by PRISM for both the life and property-casualty markets.

In the life insurance market, diversification refers primarily to underlying risk factors such as mortality and morbidity rather than just product diversification, she explained.

The creation of a new principles-based system also continued among life actuaries participating in a regulatory project that is being developed with the help of the American Academy of Actuaries, Washington.

The latest phase of the project, C3 Phase III, evaluates interest rate and market risks. The academy’s life capital work group is recommending that the rules apply to all life insurance products in force. It is also recommending that stochastic scenarios could be created from an academy-supplied generator or from a proprietary generator.

Asset projections would reflect a company’s reinvestment and disinvestment policies, according to an Academy presentation. The latest component of the principles-based project would have a year- end 2008 effective date.

As part of that project, the Academy’s annuity capital work group is trying to implement PBA to quantify C3 for annuity products, including equity-indexed products.