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Lawsky: NAIC's new reserving system will lead to shortfall

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Updates with Lincoln National statement–

New York Department of Financial Services (DFS) Superintendent Ben Lawsky says that the life insurance industry continues to be under-reserved and that the compromise constructed by state regulators for a new reserving method has failed, possibly imperiling policyholders and even the system of state-based regulation.

The issue is underpinned by one of the most important discussions happening in insurance regulation today, five years after the financial crisis and more than two decades after the collapse of huge life insurers in New York, like Executive Life of New York (ELNY), and elsewhere that left policyholders with, at the end of the road, broken annuity promises: capital.

Is there enough of it to keep policyholders safe now and well into the future? Is there enough to keep the industry safe and keep it from causing a financial crisis? 

Lawsky’s signature strong language, calling the nearly decade-long reimagining of actuarial guidelines a “recipe for disaster” came in a letter this week to fellow state insurance regulators. In it, Lawsky warned them of the new actuarial system they are seeking to adopt, called principles based reserving (PBR). It is used now by life insurers in a modified form under an agreement devised by the states for Actuarial Guideline 38 (AG 38) for certain in-force universal life products with secondary guarantees (USLG).

Companies will be asked by New York to increase their reserves by billions overall, and these companies include AIG, The Principle Financial Group, Lincoln National Group and others, a source confirmed, including Genworth Financial.

New York will no longer implement the state regulatory body- approved fix that addresses the USLG products’ reserves, Lawsky said, dropping out of the formerly-agreed upon solution and sending insurers skittering to meet with their actuaries.

Genworth, one of the companies issuing the policies, has previously told regulators that rules-based reserve approaches like the AG38 guidance, as it is called, do not work well for products like universal life with secondary guarantees. Genworth had said in discussions that PBR be much more effective in establishing reserve levels that are appropriate in view of the insurance risk assumed.

Companies say that any impact of potential increased reserves for affected companies would be subject to a phase-in period over a number of years.

Lincoln National, Radnor, Pa., said in a statement Friday afternoon that the impact of any of the DFS’s proposed changes would be limited to its New York subsidiary, Lincoln Life & Annuity Company of New York, which has an estimated 585 percent risk-based capital (RBC) ratio. The company said that its capital plan overall is not expected to be impacted and it would go ahead with share repurchases in the fourth quarter.

Regardless, Lincoln Life has a strong capital base to absorb a significant reserve increase in New York, and has discontinued sale of USLG policies in New York earlier in the year, the company stated. 

Not all agree. In fact, the life industry, state insurance regulators, the actuarial body that worked on PBR and even the Federal Insurance Office (FIO) to some degree support or are expected to support PBR as applied with oversight, resources and caution, according to sources. FIO will be issuing its modernization report “soon,” (really!) and is expected to touch on the cornerstone of state regulatory reserving modernization, the PBR, without rejecting it, but supporting its prudent use, if states continue to monitor its application. 

PBR is described as a more modern, flexible actuarial reserving set of principles, different from the formulaic method of the past, one that takes into account creative new life insurance products.

The PBR application to AG 38 (commonly known as AXXX) arose two years ago when some life companies reported to New York state actuaries that other companies were exploiting loopholes in AG 38 to lower their reserves for universal life products with secondary guarantees (USLG). The state actuaries were already familiar with Triple X ploys to lower their reserves on term life in previous years.

A compromise worked out through a commissioner-level group at the National Association of Insurance Commissioners (NAIC), which seized the issue from a group of state actuaries, applied a modified version of PBR to AG 38, with a different model for in-force business and for future business.

Lawsky said the compromise, based on preliminary results, reveals that companies have only increased their reserves by less than $1 billion, a drop in the bucket compared to the $20 billion the industry was under-reserved by, and the $10 billion projected, according to Lawsky.

“To now glide unquestioningly along the path to PBR, in the face of empirical evidence with regard to AG 38 showing that companies will take every advantage of it to reduce their reserves as much as possible, leaves insurance regulators vulnerable to the charge that we are too willing to sacrifice solvency and consumer protection in our regulation of the insurance industry,” Lawsky told his fellow insurance commissioners. 

He urged states to reconsider their course on PBR, fearing it can be manipulated to the detriment of the U.S. insurance solvency regime. 

PBR is supposed to address the practice of reinsuring Triple X and/or A-XXX’s (hefty reserves for universal life products with secondary guarantees to affiliated captives or special purpose vehicles), but Lawsky has said that not only will the AG 38 PBR fix not hold water, but that companies will continue their practice of what he called “shadow insurance” to offload what they feel are excess reserves, away from the eyes of the  domiciliary state regulator. The NAIC is trying to make the process more transparent, and possibly considering adoption of guidelines in a captives white paper as part of state accreditation. 

The AG 38 principle as applied to future policies starting in 2014 will be stricter than those for in-force policies. Some companies have adjusted their reserves, their public filing statements show, but it is not enough for New York regulators.  PBR implementation is contingent upon the operating manual, or the NAIC-approved “Valuation Manual,” becoming operative six to 18 months after 42 states with at least 75 percent of subject premium have adopted the revised law, meaning that if New York, Texas and California all hold out, PBR will be blocked.  

This is not the first time that Lawsky and the DFS has warned about PBR.

Lawsky launched a warning in a Nov. 26 letter near the eve of the NAIC national meeting where the state-based organization is gathering to adopt the pivotal Valuation Manual .  

Lawsky said they all should be able to say with a straight face that PBR is the right move, or there could be major solvency issues in the future.

California Insurance Commissioner Dave Jones continues worry about resource issues for PBR, which the NAIC has tried to address with a sort of board of NAIC actuarial staff and possibly outside consultants to oversees appropriate PBR application. 

The response from the life insurance industry and a state regulator who often speaks on these and other national and international issues was swift. 

“It is both inaccurate and disappointing that New York Financial Services Superintendent Benjamin Lawsky would suggest in a September 11 letter to fellow insurance commissioners that planned changes to life insurer solvency regulation would put at risk policyholders and taxpayers,” The American Council of Life Insurers (ACLI) said. 

“The life insurance industry is financially strong, perhaps stronger than it has ever been,” the ACLI added.

“But what should be most troubling to regulators and consumers is that the Superintendent’s letter reflects a complete failure to recognize life insurers’ unwavering support for strong solvency regulation and consumer protection. If a life insurer fails, competing life insurers must pay the tab for the insolvency. It is in the interest of the entire industry and its policyholders that companies are well capitalized,” the ACLI said. 

“I admire Superintendent Lawsky and consider him one of my closest colleagues at the National Association of Insurance Commissioners, however, we simply differ on this important policy issue,” stated Connecticut Insurance Commissioner Tom Leonardi.

“Principle-based reserving does not assume that regulators will blindly follow the company model and, if they do, they are not doing their job…..We can demand that the company change unreasonable assumptions, re-compute reserves based on the revised assumptions and require increases in reserves if necessary,” Leonardi stated.

“Even the Society of Actuaries agrees that the current system does not account for the highly complex products that have been devised over the past decade and that current reserves are probably too high or in some cases too low, so staying with the old system does not address this problem,” he added.

A spokesperson for FIO and the Treasury-housed Financial Stability Oversight Council (FSOC), which oversees insurers’ impact on financial stability nationally, had no comment. 

“We have been using principal-based reserving in the property-casualty business without incident for quite some time and most developed countries have been using it for life and annuity as well,” Leonardi stated.