A reinsurance section of a new valuation manual that is being developed could make it possible to offer new reinsurance products if comfort can be reached on moving away from rules-based requirements toward a principles-based reserving approach, interviews with National Underwriter show.

But the development of VM-20 is also raising concerns among several key states, including Florida and New York, that there needs to be a comfort level about assumptions that are made and there needs to be an actual risk transfer that takes place, not just an exchange of cash flows.

The Valuation Manual is an actuarial roadmap that will be used to enact principles-based reserving should that model system be adopted by the National Association of Insurance Commissioners, Kansas City, Mo., and enacted by states.

Actuaries at the American Academy of Actuaries, Washington, and many regulators believe that PBR will reduce redundant reserves and that VM-20 could change the way reinsurance is offered.

Currently, some states will not recognize reinsurance credit when all benefits within a policy are not ceded, according to Sheldon Summers, a California regulator who chairs the Academy’s Life Reinsurance Work Group. For instance, at least in some states, the reinsurance of only the secondary guarantee benefit within a universal life policy would be considered to be non- compliant with the risk transfer regulation.

If there is a liberalization of risk transfer rules, then it would be possible for reinsurers to offer more customized treaties, Summers says. He explains that some provisions that currently would not satisfy risk transfer rules would be modeled under PBR and reflected in the reserve calculation, and other provisions that are either difficult to model or which present public policy concerns would, under PBR, be subject to prescribed modeling assumptions. So, for example, if a treaty includes a provision allowing a reinsurer to terminate the treaty because of a rating downgrade on the part of the ceding company, then the ceding company’s reserve calculation would assume the rating downgrade occurs immediately if such an assumption would result in higher reserves.

When asked about the impact of PBR on reinsurance, Summers responded: “On the one hand, I would expect less need for treaties or securitization transactions that offer relief from redundant reserves. But on the other hand, if risk transfer rules are relaxed or eliminated, then the added flexibility will result in an increase in reinsurance treaties.”

The current exposure of PBR would change the risk transfer rules under current law as well as the NAIC’s accounting practices and procedures manual, according to Tom Campbell, vice president and corporate actuary with Hartford Life, Hartford, Conn., and vice president-life insurance issues with the Academy.

The current rules-based requirements are structured so that a direct writer either gets a full reinsurance reserve credit for treaties or no reserve credit, he says.

PBR requires modeling of risks associated with business and measures a company’s risk management practices, Campbell says.

But, he continues, there is currently discomfort among some regulators over how modeling will be done and over whether there will actually be transfer of risk. If specific issues can be identified, the Academy can work on alleviating concerns, he adds. Campbell says that disclosure may be one way to help lessen concern.

The modeling contemplated by PBR would reflect cash flow in which the ceding company pays premium and the reinsurer pays a claim, he explains.

The difference between projected claims and expenses, and the assets and cash flow available to pay claims would be the required reserves, Campbell says.

The new system would allow companies to properly reflect risks and allow for new types of reinsurance that transfer risk, he says. Currently, for instance, a direct writer cannot just reinsure lapse risks in a product because the risk transfer rules do not permit the reinsurance of a single risk since the entire contract must be reinsured. So, unless the entire contract is reinsured, there is no reserve credit given, Campbell adds.

If a PBR approach is used, reinsurers would be able to write new types of reinsurance and companies would be provided new risk transfer tools, he says.

Diane Wallace, a life actuary based in Stamford, Conn., who is participating in VM-20′s development, says that existing rules limit the structure of reinsurance agreements because “more complex reinsurance structures cannot be valued accurately using current reserve formulas based only on required mortality tables and interest.”

Contracts that do not meet structure rules are excluded from reserve calculations, she adds. But, the proposed PBR valuation method is based on a “complex cash flow model, which can easily and accurately model complex reinsurance structures.”

Such a new system, according to Wallace, would allow insurers and reinsurers to design risk management tools to “improve financial strength and stability” and provide regulators with “cash flow models that much more accurately value all reinsurance agreements regardless of structure. And most importantly, these new tools can result in better insurance products for consumers and enhanced confidence in the financial strength of the industry.”

But not all regulators agree. During a recent conference call, Amanda Fenwick, a New York regulator, said it was important that risk transfer rules stay in place to prevent possible manipulation. A New York spokesperson said the state’s actuarial staff at the department would not be available to comment for this article.

But Dan Keating, a Florida regulator and life actuary, says that before any change in reinsurance regulatory requirements is contemplated, it is important that the new approach accurately reflects reinsurance transactions by ensuring that there is actually a risk transfer and not just modeling based on exchanges of cash flows.

While Keating says that existing rules can, at times, hinder innovation and that while it can be a good thing to have new reinsurance options if they make sense, there needs to be actual risk transfer and not just an exchange of cash flows.

While innovation is a good thing, Keating says an incremental approach that measures how principles-based reserving for reinsurance is working may be the best approach. He says his concern is that if too much freedom is permitted when making assumptions and if a company is negatively impacted, then under a worst case scenario, the result could be court cases over what the correct assumptions are.

Additionally, the lack of requirements will create more need for regulators to oversee a company’s assumptions, something that could place a strain on insurance departments, he says. That is why regulators are looking at the possibility of creating a central agency to help monitor company assumptions, Keating continues.

John Bruins, a life actuary with the American Council of Life Insurers, Washington, says that PBR and VM-20 as a part of this new approach would make it possible to offer new reinsurance transactions and would allow for better risk management.

Current drafts of other portions of the Valuation Manual such as VM-30, which outlines requirements for the Actuarial Memorandum, address concern over assumptions because they require documentation of those assumptions, he says.

In a Jan. 30 draft, the description of the actuarial memorandum does provide for documentation of assumptions such as those used for both base and excess lapse rates, the interest crediting rate, default costs, bond call functions and mortgage prepayments.