Principle Based Reserve Pricing

1
An Update on Where Things Stand on
Principles-based Reserves IAC Presentation
February 23, 2007 David Neve Co-chair, Life
Reserves Work Group
2
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

3
Definition of Principles-based

• A Principles Based System (PBA) of statutory
  Risk-Based Capital (RBC) and
• minimum reserve requirements incorporates the
  following common elements
• Captures all of the benefits and guarantees
  associated with the contracts and their
  identifiable, quantifiable and material risks,
• 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.
• Incorporates all risk and risk factors included
  in the companys risk assessment and evaluation
  processes (which include economic valuations,
  internal capital allocation models, experience
  analysis, asset adequacy testing, GAAP valuation
  and pricing).

4
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.
• Provides for the use of assumptions, set on a
  prudent estimate basis, that contain an
  appropriate level of conservatism
• 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
  companys risk management processes.

5

• 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)

6
Overview of Proposed LRWG Approach

• Reserve is the greater of
• A deterministic, seriatim, single scenario
  reserve calculation
• 2. A stochastically derived reserve (if needed)
  using a prescribed CTE level

7
Overview of Proposed LRWG Approach

• Deterministic Reserve
• Based on Gross Premium Valuation (GPV) method.
• GPV reserve Present value of future benefits
  and expenses, less present value of future gross
  premiums.
• Is not designed to capture tail risk
• Is subject to a cash surrender value floor on a
  contract by contract basis

8
Overview of Proposed LRWG Approach

• Stochastic Reserve
• 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
• Will use a CTE (conditional tail expectation)
  level that is set by regulators, such as 65 CTE
• Reserve for each scenario will be based on the
  Greatest Present Value of Accumulated
  Deficiencies (GPVAD) due to regulatory concerns
  over interim deficiencies.

9
Overview of Proposed LRWG Approach

• Prudent Estimate Assumptions
• Assumptions not stochastically modeled will be
  based on the actuarys 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.

10
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

11
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.

12
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
  companys 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.

13
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.

14
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

15
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.

16
Outstanding LRWG Technical Issues

• Determination of assumption margins
• Individual risk factors, or in the aggregate?
• What to do when experience data is lacking?
• Risks to be excluded from reserves (what is the
  purpose of reserves vs. capital?)
• Reinsurance issues (e.g. treatment of
  non-proportional and/or catastrophic coverages).
• Additional guidance and clarity on modeling
  derivative programs

17
LRWG Priorities for 2007

• Perform additional product modeling and analysis.
• Finalize outstanding technical issues.
• Work with LHATF to establish prescribed elements.
• CTE level.
• interest rate and equity scenarios
• net spreads on reinvestment assets
• Incorporate modifications resulting from
  discussions with U.S. Department of Treasury that
  fit within the actuarial framework being
  developed.
• Review comments received on the exposure draft.

18
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).

19
Changes to Standard Valuation Law

• Implementation Objectives
• Enable Principles Based Reserves
• Promote uniformity in reserve requirements
• Provide regulatory balance and oversight
• Provide reserve requirements in one place
• One exposure process and one adoption
• Promote consistent interpretations
• Enable more efficient process to implement future
  changes (similar to process to make RBC changes)

20
Changes to Standard Valuation Law

• Proposal adds a new section (section 11) to the
  current SVL
• Detailed PBA reserve requirements are NOT in SVL
  will be in the Valuation Manual
• Mandatory reporting of company experience has
  been added.
• Annual independent review of PBA requirement has
  been added
• Defines the operative date of the Valuation
  Manual to be January 1 following the date that
  both
• 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).
• 6. 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)

21
Changes to Standard Valuation Law

• Major Challenges to proposed SVL Changes
• Will state insurance departments be willing to
  give up some of their control in order to achieve
  uniformity?
• Will state legislatures be willing to delegate to
  the NAIC the authority to make future changes to
  reserve requirements?
• Will the industry support the experience
  reporting and independent review process?

22
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).

23
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)

24
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.

25
PBA Review Opinion

• Purpose of the PBA Review Opinion
• Provide Company management, the Companys board
  of directors, insurance regulators, and the
  Companys 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
• 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
• Requirements applicable to the appointment of the
  PBA Review Actuary.

26
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 companys selection
  (then company has to select another one)
• PBA Review Actuary can be an employed of the
  companys audit firm.

27
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.

28
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.

29
Alternatives to current LRWG Proposal

• Subgroup under Mike Boerners Valuation Law and
  Manual Team was was formed to address concerns
  raised by small companies.
• Discussion was held with LHATF on 2/9 via
  conference call on possible alternatives to the
  full blown LRWG approach.
• 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.

30
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.

31
Alternatives to current LRWG Proposal

• 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.

32
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
• Current formulaic approach (net premium
  reserves),
• Deterministic gross premium reserves, or
• The LRWG approach.
• This classification would be fixed and would
  require justification based on scenario testing
  and risk profiles present in the products.