An Update on Where Things Stand on
Principles-based Reserves
IAC Presentation
February 23, 2007
David Neve
Co-chair, Life Reserves Work Group
Topics covered in this session
1.
Definition of Principles-based Approach
2.
Update of the Life Reserves Work Group (LRWG) proposal for life
products
3.
Discuss proposed changes to the Standard Valuation Law
4.
Discuss purpose and content of new Valuation Manual
5.
Describe purpose and requirements of PBA Review Actuary
6.
Discuss alternatives to the LRWG proposal
Definition of Principles-based
A Principles Based System (PBA) of statutory Risk-Based Capital (RBC) and
minimum reserve requirements incorporates the following common elements:
1.
Captures all of the benefits and guarantees associated with the contracts
and their identifiable, quantifiable and material risks,
2.
Utilizes risk analysis and risk management techniques to quantify the
risks. This may include, to the extent required by an appropriate
assessment of the underlying risks, stochastic models or other means of
analysis that properly reflect the risks of the underlying contracts.
3.
Incorporates all risk and risk factors included in the company’s risk
assessment and evaluation processes (which include economic
valuations, internal capital allocation models, experience analysis, asset
adequacy testing, GAAP valuation and pricing).
Definition of Principles-based
4.
Permits the use of company experience, based on the availability of
relevant company experience and its degree of credibility, to establish
assumptions for risks over which the company has some degree of control
or influence.
5.
Provides for the use of assumptions, set on a prudent estimate basis, that
contain an appropriate level of conservatism
6.
Reflects risks and risk factors in the calculation of reserves and
capital that may be different from one another and may change over
time as products and risk measurement techniques evolve, both in a
general sense and within the company’s risk management
processes.
Overview of Proposed LRWG Approach
• Initial approach for PBA life reserves will be
prospective only. May allow retroactive
application to inforce (or subset) later.
• Drafts of Model Regulation and two Actuarial
Guidelines were exposed for comment at
December LHATF meeting (are available on
Academy website)
Overview of Proposed LRWG Approach
Reserve is the greater of:
1. A deterministic, seriatim, single scenario
reserve calculation
2. A stochastically derived reserve (if
needed) using a prescribed CTE level
Overview of Proposed LRWG Approach
Deterministic Reserve:
1.
Based on Gross Premium Valuation (GPV) method.
2.
GPV reserve = Present value of future benefits and
expenses, less present value of future gross premiums.
3.
Is not designed to capture tail risk
4.
Is subject to a cash surrender value floor on a contract
by contract basis
Overview of Proposed LRWG Approach
Stochastic Reserve:
1.
Multiple scenarios will be used to properly capture the “tail risk” of the
contract (risks that have high impact, but low probability)
2.
Only interest rates and equity returns are required to be modeled
stochastically
3.
Will use a CTE (conditional tail expectation) level that is set by
regulators, such as 65 CTE
4.
Reserve for each scenario will be based on the Greatest Present
Value of Accumulated Deficiencies (GPVAD) due to regulatory
concerns over interim deficiencies.
Overview of Proposed LRWG Approach
Prudent Estimate Assumptions
•
Assumptions not stochastically modeled will be based on
the actuary’s best estimate of the future “Anticipated
Experience” plus a margin that includes a provision for
adverse deviation and estimation error.
•
Margins will be determined by the actuary using
professional judgment, subject to the guidelines established
by the NAIC and ASOPs.
Overview of Proposed LRWG Approach
Asset Model Is Needed to Project Cash Flows
•
•
Expect most companies to use cash flow testing model
Asset Model is used to determine:
• Future liability and asset cash flows
• Discount rates
• Accumulated assets for GPVAD calculation for
Stochastic Reserve
Summary of Recent Changes to
Proposed LRWG Approach
1) LRWG proposal has been combined into single document
–
At the request of LHATF, the 3 documents exposed for comment at the
December meeting (Model Regulation and 2 Actuarial Guidelines) have
been combined into a single document.
–
Uses a “requirements format” that is the common template that will be
used for all requirements placed in the Valuation Manual.
–
Thus, this draft of the LRWG proposal is now in a form that is ready to be
placed in the designated section of the Valuation Manual.
–
This template following a “requirements format” is not final, but putting
the LRWG proposal into this format will provide an example of what the
Valuation Manual might look like.
Summary of Recent Changes to
Proposed LRWG Approach
2) Changes to the Guiding Principles:
–
A drafting note was added to Principle 1 that lists the types of risks that
are not required to be included in the reserve calculation (i.e. risks that
are of a general business nature that are not readily quantifiable, which
include risks historically viewed as C4 risks).
–
A new Principle was added (Principle 2) to require that all Risk Factors
included in the company’s risk assessment and evaluation processes
shall be reflected in the reserve methodology (with exceptions if certain
conditions are met).
–
Expanded Principle 5 (which addresses the determination of assumption
margins) to include a reference to the aggregate impact of all margins.
Summary of Recent Changes to
Proposed LRWG Approach
3) Scope section has been eliminated
–
Scope will be addressed elsewhere in the Valuation Manual.
–
Prior LRWG draft identified products that were excluded from PBA; the
current draft is silent.
–
Leaves open the possibility of alternative PBA approaches, such as “PBA
Lite” and phase-in of certain products.
4)
Reporting of experience requirement has been dropped (now in SVL)
5)
“Best Estimate” and “Prudent Best Estimate” terminology has been
changed to “Anticipated Experience” and “Prudent Estimate”
respectively.
Summary of Recent Changes to
Proposed LRWG Approach
6)
The requirement to use a prescribed credibility method for blending
mortality experience with an Industry Table (e.g., the Canadian
Normalization Method) was replaced with a requirement that allows
the actuary to select the credibility method, but the credibility method
must meet certain conditions.
7)
The requirements on modeling derivative instruments and derivative
programs, including hedging strategies, was revised and streamlined.
8)
The requirements to determine policyholder behavior assumptions
were:
•
•
Streamlined to eliminate duplicative wording that, subject to adoption
by the ASB, is anticipated to be in the new PBR ASOP; and
Reorganized to add clarity to the requirements
Summary of Recent Changes to
Proposed LRWG Approach
9)
A new element was added in the calculation of the final Reported
Reserve called the “Provision for Model Understatement” to reflect
the aggregate impact of material approximations, simplifying
assumptions or simplified techniques used in the cash flow model.
10) The description of the stochastic modeling exclusion was enhanced
and clarified.
Outstanding LRWG Technical Issues
1)
Determination of assumption margins
•
Individual risk factors, or in the aggregate?
•
What to do when experience data is lacking?
2)
Risks to be excluded from reserves (what is the purpose of reserves
vs. capital?)
3)
Reinsurance issues (e.g. treatment of non-proportional and/or
catastrophic coverages).
4)
Additional guidance and clarity on modeling derivative programs
LRWG Priorities for 2007
1. Perform additional product modeling and analysis.
2. Finalize outstanding technical issues.
3. Work with LHATF to establish prescribed elements.
•
CTE level.
•
interest rate and equity scenarios
•
net spreads on reinvestment assets
4. Incorporate modifications resulting from discussions with U.S.
Department of Treasury that fit within the actuarial framework
being developed.
5. Review comments received on the exposure draft.
Status of LRWG Proposal

The LRWG believes the proposal is close to being “done” from
an actuarial perspective – we believe it is close to being ready
for final adoption by LHATF after exposure

Once adopted, we anticipate the new reserve requirements will
be placed in the new Valuation Manual that is under
development.

Needed “tweaks” and refinements after adoption can be
implemented via the process to update the Valuation Manual
(the process to update the Manual is also under way).

Implementation date and transition rules need to be addressed
by the NAIC (outside the scope of the LRWG).
Changes to Standard Valuation Law
Implementation Objectives
1.
Enable Principles Based Reserves
2.
Promote uniformity in reserve requirements
3.
Provide regulatory balance and oversight
4.
Provide reserve requirements in one place
5.
One exposure process and one adoption
6.
Promote consistent interpretations
7.
Enable more efficient process to implement future
changes (similar to process to make RBC changes)
Changes to Standard Valuation Law
1.
Proposal adds a new section (section 11) to the current SVL
2.
Detailed PBA reserve requirements are NOT in SVL – will be in
the Valuation Manual
3.
Mandatory reporting of company experience has been added.
4.
Annual independent review of PBA requirement has been
added
5.
Defines the operative date of the Valuation Manual to be
January 1 following the date that both:
•
•
6.
The valuation manual is adopted by a ¾ majority of the NAIC; and
The number of states specified in the Valuation Manual has adopted
the new SVL (but not less than a majority).
Sets forth the conditions for a state to “opt out” of a specific
requirement defined in the Valuation Manual if certain conditions
are met (much disagreement on this)
Changes to Standard Valuation Law
Major Challenges to proposed SVL Changes
1.
Will state insurance departments be willing to give up
some of their control in order to achieve uniformity?
2.
Will state legislatures be willing to delegate to the
NAIC the authority to make future changes to reserve
requirements?
3.
Will the industry support the experience reporting
and independent review process?
New Valuation Manual
The Manual will contain reserve requirements for all
products
•
Products issued prior to effective date of the Manual will
be subject to current state laws and regulations of each
state.
•
Products issued after the effective date of the Manual
will follow the requirements defined in the Manual.
•
Transition and scope issues will be addressed explicitly
in the Manual (i.e. a “traffic light” concept).
•
The Manual will essentially replace the current structure
of Model laws, model regs, and actuarial guidelines (but
existing laws, regs and AG will stay in effect).
New Valuation Manual
The Manual will also include:
•
Definition of Principles-based reserves
•
The process to update the Manual
•
Requirements for PBA Review Opinion
•
PBA reserve disclosure and reporting requirements
•
PBA experience reporting requirements
•
Coordination with APPM (Accounting Practices and
Procedures Manual)
Possible Timeline
• March/September 2007: Possible NAIC adoption of
SVL changes
• Early 2007: Academy prepares initial draft of Valuation
Manual
• September 2007. Academy prepares substantive
completion of Valuation Manual
• March/June 2008: NAIC adoption of Valuation Manual
• January 1, 2009 or 2010: Effective date of Valuation
Manual for adopting states.
PBA Review Opinion
Purpose of the PBA Review Opinion:
Provide Company management, the Company’s board of directors, insurance
regulators, and the Company’s auditors with a confidential, independent review
of the subjective elements of a principles-based valuation.
It purpose is NOT to opine on the accuracy of the reserve calculation (audit
does that), or on the adequacy of the reserves (AOMR Opinion does that).
The Valuation Manual prescribes:
1.
The specific requirements for a review opinion of a valuation
performed under a principles-based approach (PBA) per the
Standard Valuation Law and applicable regulations; and
2.
Requirements applicable to the appointment of the PBA Review
Actuary.
PBA Review Opinion
Designation of PBA Review Actuary
–
Is selected by the Company
–
Must met prescribed qualifications (same as qualifications
for Appointed Actuary).
–
Must be independent from the company (not employed by
the company, not have a material financial interest in the
company, etc.)
–
Commissioner can reject the company’s selection (then
company has to select another one)
–
PBA Review Actuary can be an employed of the company’s
audit firm.
PBA Review Opinion
General Requirements
•
The Company shall file within thirty (30) days following the filing of an
Annual Statement, a single PBA Review Opinion that covers all PBA
valuations in the Company
•
The PBA Review Actuary shall support the PBA Review Opinion by a
PBA Review Report, which shall be kept confidential and available
upon request of the Commissioner.
•
The PBA Review Actuary will immediately notify the domiciliary
Commissioner, with a copy to the Company, if, during the course of the
analysis and review done in order to prepare the PBA Review Opinion,
the PBA Review Actuary identifies a material issue with a valuation
performed under a principles-based approach that cannot be
satisfactorily resolved with the Company before the filing date of the
Annual Statement.
PBA Review Opinion
The PBA Review opinion shall state:
•
•
•
•
•
•
All quantifiable material risks are considered;
The methods used are appropriate;
The models used are reasonable for the purpose;
The assumptions used are supportable;
The margins in the reserves are supportable; and
The requirements of a PBA reserve valuation as defined
by [insert applicable sections] of the Valuation Manual
and applicable Actuarial Standards of Practice have been
satisfied.
Alternatives to current LRWG Proposal
1.
Subgroup under Mike Boerner’s Valuation Law and Manual Team was
was formed to address concerns raised by small companies.
2.
Discussion was held with LHATF on 2/9 via conference call on possible
alternatives to the “full blown” LRWG approach.
3.
Major areas of concern with LRWG approach:
–
–
–
–
The process to justify the use of stochastic modeling is perceived to be too
complex. The resources required for this process will put a strain on many
companies where it may not be needed given their product mix.
The cost of an extensive and independent PBA review.
The experience reporting required for a myriad of assumptions, including
mortality, lapse and policyholder behavior may be unnecessary (or at least
not necessary annually) for companies that do not have material experience.
The cost of the PBA approach can put smaller companies at a disadvantage,
leading to an unlevel playing field.
Alternatives to current LRWG Proposal
Three possible alternative approaches under discussion:
1) Phase in the LRWG requirements
– LRWG requirements would initially only apply to more
complex products (e.g. Variable, UL with long term secondary
guarantees), with other products being added later.
– Would allow actuaries and regulators to gain experience and
a comfort level with the new PBA process based on a limited
set of products before rolling it out to all products.
Alternatives to current LRWG Proposal
2) Add simplifying elements to the current LRWG
approach to address the concerns above.
For example:
– Define a simplified approach to satisfy the stochastic
modeling exclusion requirements.
– Define a simplified approach to setting Prudent Best Estimate
assumptions.
– Define a simplified approach for determining the discount
rates.
Alternatives to current LRWG Proposal
3) Develop a new “PBA Lite” approach that is outside the
LRWG framework, but still meets PBA principles.
For example:
–
The actuary would classify the reserve approach needed for all
products as either
1. Current formulaic approach (net premium reserves),
2. Deterministic gross premium reserves, or
3. The LRWG approach.
–
This classification would be fixed and would require justification
based on scenario testing and risk profiles present in the products.