A.M. Best Special Report: Development of 'Principles-Based' Reserves Shifting Into High Gear.

OLDWICK, N.J. -- In a recently issued special report, A.M. Best Co. observes that the insurance industry has aggressively stepped up efforts to develop principles-based reserves for life insurance products and fixed annuities. There are currently 20 committees of the American Academy of Actuaries devoted to this project. A.M. Best believes it is quite possible that principles-based reserve methods may be in place for life insurance products by 2009.

New product designs have led to significant growth in sales of universal life products with secondary guarantees and sales of variable products with guaranteed living benefits. The complexities of these products have rendered formulaic reserves more prone to exploitation and less reliable in reflecting actual product risks. This has spawned some industry concerns over the adequacy of the statutory reserves for such products calculated under the current guidelines.

A prime example of product exploitation was the development of universal life products with product features disguising certain guarantees by the use of shadow accounts. Formulaic reserves were subject to varying interpretations when these features were developed, leading to inconsistent applications of existing reserve guidelines. In a similar fashion, formulaic reserves did not accurately reflect risks associated with current living benefits being offered on variable annuities.

At its 2006 Fall National Meeting, the National Association of Insurance Commissioners (NAIC) adopted an interim solution that will impact reserves required under the Valuation of Life Insurance Policies Model Regulation, also known as Regulation XXX. This interim solution applies to business issued on or after January 1, 2007, and will provide some relief from the reserve redundancies that result from the current regulation in that companies can use preferred class mortality from the 2001 CSO mortality tables when calculating reserves. A.M. Best believes that until principles-based reserves are fully implemented, reserve redundancies will continue to drive companies to seek alternative reserve funding solutions for aggressively-priced term business.

Also at the Fall National Meeting, the NAIC adopted revisions to Actuarial Guideline 38, frequently referred to as Regulation AXXX. One of the most significant revisions is the use of a 7% load to the net single premium used in the reserve calculation. The amended guideline also allows for the use of a modest lapse rate assumption (2%) for the first five years, followed by 1% to attained age 90 for contracts issued on or after January 1, 2007. A.M. Best expects that while the revisions provide some reserve relief, companies will continue to pursue either reinsurance or securitization transactions in order to move the perceived "excess" reserves off of their statutory statements.

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A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.