Got C-3 Phase II? Writers of variable annuities are ably employing this complicated capital reserves regulation, despite lengthy instructions and even longer computer run times.

Key Points

* Life writers selling variable annuities have had a year to put into practice C-3 Phase II, a regulatory requirement that ensures writers of variable annuities will reserve enough capital to meet needs.

* Implementation of this new regulation, effective since December 2005, has been costly and complex, but most VA writers are in compliance.

* Actuaries are excited about this regulation, which not only takes the rules out of stochastic modeling and makes the process principles-based, but brings actuaries to the forefront of risk-based capital negotiations.

Four years ago, when actuary James W. Lamson was part of the design team constructing a new regulation to establish capital reserve requirements for variable annuities writers, he admittedly was a bit apprehensive. After all, it would be the first time VA writers would be performing stochastic modeling en masse, and this regulation--C-3 Phase II--was going to be intense.

All that anxiety washed away during the past 12 months, as Lamson and his colleagues began to solicit and receive feedback about the regulation's implementation and its large-scale success.

Lamson, president of Actuarial Resources Corp. in Overland Park, Kan., and chair of the Annuity Reserve Working Group of the American Academy of Actuaries, earlier this year drafted a follow-up survey for the academy on the initial industrywide launch of C-3 Phase II among life insurers selling variable annuities. Lamson and the academy also participated in developing a practice note for C-3 Phase II, the purpose of which was "to let actuaries know what other practices their peers are doing to satisfy the requirements," he said.

"It's not like stochastic modeling wasn't done before; but it's the first time everyone who was doing it was following the same set of principles and doing it from a regulatory perspective. It was a really good opportunity to learn what people have actually done," Lamson said. "Everything, in my view, worked out lots better than it looked like it could have four years ago, when we were first putting C-3 Phase II requirements together. I was very happy with what was done. I still think there's room for improvement, but people were able to get the job done in a pretty timely manner."

"This was the first attempt, and by golly, I thought it went pretty darn well," he added.

Risk-Based Capital Reserves

C-3 Phase II is part of a larger effort developed by the National Association of Insurance Commissioners to "better reflect interest-rate risk in required capital" with the introduction of "company-specific scenario modeling," according to a September 2005 pre-implementation report from Towers Perrin-Tillinghast. This complex risk-based capital formula for life insurers "in effect, calculates how much capital an insurer must maintain," the report stated.

C-3 Phase II was adopted by the NAIC's Capital Adequacy Task Force in June 2005 and went into effect December 2005.

According to NAIC definitions, roughly 90 companies nationwide must comply with the new requirement. The NAIC noted that 81 companies had reported amounts for C-3 Phase II in June. First-time application of C-3 Phase II has been virtually without incident, the organization stated: "Any new complicated procedure will cause a lot of questions and extra work, especially in the first year until companies get the hang of it. The number of questions was fewer than we expected."

As for Lamson, 70 companies responded to the academy's survey. Actuaries reported the most difficult aspect of compliance with C-3 Phase II was understanding the directions.

"It was disconcerting for those of us who worked on putting that together," Lamson noted. "The American Academy worked for three-to-four years in putting together its recommended approach, and there was just a huge effort by many actuaries and many companies and many regulators. So we all did the best that we could do in putting this together."

He's since come to view actuarial reactions to implementing C-3 Phase II as less of a reflection "that we did a poor job" and more one of actuaries having to deal with a revolutionary new way of functioning. Actuaries already have experience with asset adequacy analysis and other mechanical aspects of using modeling for variable annuities, things that by sheer experience and training they are more prepared to tackle, he said. "The doing part of it they were equipped to handle; the understanding part of it, because it was new and complex, was more of a challenge."

"Understanding should be the hardest part," he added.

The American Council of Life Insurers has received little feedback from its 377 member companies on the implementation of C-3 Phase II, other than that the companies are fully complying with its requirements and are initiating the necessary changes to implement it, according to ACLI Spokesman Whit Cornman.

Mike DeGeorge, vice president and general counsel for NAVA, the National Association for Variable Annuities, echoed that sentiment: "We've not really heard anything from our members since the new requirement took effect at the end of last year. The companies are complying with the new requirement and setting the capital reserve accordingly, and are dealing with it."

"For some companies, the thought last year was the new requirement would result in higher RBC reserves than previously," DeGeorge said. "But for the lack of any input from our members since December, I conclude that whatever those reserves turn out to be, the companies are able to meet them."

While the NAIC has heard comments that the implementation was both costly and time-consuming, the organization also received feedback that C-3 Phase II is "a necessary step in the right direction."

Lamson believes the large variable annuity writers already were doing the types of things required by C-3 Phase II in their businesses, while the small-to-medium-size writers weren't able to follow suit because of lesser technology, time and manpower. The NAIC did note that larger companies were often "doing something akin to C-3 Phase II" already, and that it could be a barrier to entry for small companies.

A Do-or-Die Situation

Companies that do not comply with C-3 Phase II requirements will no longer be able to sell variable annuities.

"There were two options companies had: If you did not have guaranteed life benefits you could follow an 'Alternative Methodology' laid out in the instructions," said Vice President and Actuary Tim Gaule of Security Benefit Life Insurance Co. Gaule moderated the Valuation Actuary Symposium of the Society of Actuaries on Sept. 18.

Hartford Life has been prepared for the C-3 Phase II initiation for some time, the company said. "For years, the Hartford has been looking closely at the types of risks C-3 Phase II is designed to address," said Vice President and Corporate Actuary Tom Campbell. "As such, the concepts C-3 Phase II introduced have long been incorporated into our variable annuity risk and pricing models."

Most companies, including Security Benefit, used the stochastic modeling approach. "If you have life benefits like we did, you could," Gaule said. The alternative methodology was a factor-based approach. He has not heard of any smaller companies giving up VA products to avoid the new regulations.

The stochastic modeling approach uses projected revenues and expenses in a model using a number of scenarios, the minimum of which would be 1,000; capital results would be based on the worst 10% of those, Gaule said. Companies likely will run C-3 Phase II once per quarter. For most companies, C-3 Phase II implementation involved about 1,000 scenarios, but companies could run up to 10,000 scenarios. "The challenge there is, you're running a large number of scenarios and you're talking about very long computer run times," Gaule said.

"I suspect companies are going to have to hire additional people" especially as the VA community moves into the other phases, Gaule said. "There's going to be an increased demand for talent. It's going to take manpower to get this done."

Security Benefit did not require additional manpower to run its models, but it did have to buy additional computers, Gaule said. The company also used distributive processing, which allowed it to use several computers at the same time.

"We can set up the run on one computer and have that run farm out to several," Gaule explained. Security Benefit's run time for C-3 Phase II was four days, using nine computers. "I'm really fortunate; I have a really good modeling team here," he said.

Other companies experienced similar run times. Aegon, which also presented at the Sept. 18 Valuation Actuary Symposium, noted the company used 65 computers and 192 hours of computing time--four days' worth--to complete the C-3 Phase II model installation, Gaule said.

"With Aegon, the person had a larger block than we did. Your run times depend also on the amount of modeling cells you have," Gaule explained. "The ideal model is probably a Seriatim model (in which each policy has its own cell). If you did that, your run times would probably be too long. But companies tend to group similar types of risk into the same cells, on a policy-by-policy model. To avoid long run times, you list policies with similar risk together."

According to Lamson's Sept. 18 presentation at the symposium, about two-thirds of the companies ran their stochastic scenarios in 24 hours or less. Some companies spent a week or two doing the actual processing, he said.

"There was quite a bit of variability in the number of hours consumed," Lamson said. "But to have two-thirds of insurers running their projections in 24 hours or less I thought was pretty encouraging. So the industry really geared up on this."

"Some companies are applying a great deal of technology; some are using 500 computers," Lamson said.

"They're very involved in hedging programs to hedge the risk of those guarantees, and those companies are typically running on a nightly cycle. They're rebalancing their hedge portfolios on a daily basis."

C-3 Phase II was a "big overhaul" for the companies involved, Lamson added. "It's a significant change in the way actuaries go about their business for financial statement work. There's a lot more emphasis on software, computers and model-building expertise. The modeling art has become absolutely forefront and center to this whole process."

A Principles-Based Approach

In the past there was a lot of "mechanical," almost "mindless," application because everything was done according to rules, Lamson said. But C-3 Phase II is a principles-based approach, not a rules-based approach, which is the "heart and soul" of the entire process.

"In a rules-based environment there's little room for reflection of reality if necessary, and a great deal of reliance on conservatism; any time that there's a set of rules, people can find ways to kind of get around those rules. That's the problem with an RBA [rules-based approach]," Lamson said. "A principles-based approach says: 'Here are the guiding principles, now go out and do the right thing,' and determine, in this case, an amount of capital that's appropriate given your company's particular circumstance."

The C-3 Phase II regulation establishes uniform requirements "that are pretty much state-of-the-art across the board, so all insurers, small and large, can benefit from this analysis," Lamson said. It also gives actuaries "more individual power in making models, and more freedom."

"This is the biggest change in the way actuaries go about their business in the 33 years that I've been in the business," said Lamson, who has been an actuary since 1973. "It's very exciting, at least for those of us who embrace it. It's like any change that happens: There are people who yearn for the old days, the old ways you used to do things, and there are others who are eager to explore the brave new world of principles-based work."

In the past, models and actuarial work were much more simplistic because of less computer power and less software availability than there is today, Lamson said. And so, "to a very large degree," the implementation of C-3 Phase II represents new technology.

It involves much more freedom for the actuary, "but what comes with that is tremendous responsibility," Lamson continued. "When the actuary has bad news for the CEO, he can't hide behind the rules. Instead he's got to be able to stand up and say, 'I did the right thing, this is what we got,' and then be able to defend that."

"It's an opportunity for the actuary to stand up and be counted, to be relied upon. It's a huge deal," Lamson said. "It's hard for me to overstate how big this is."

There's a little concern about giving actuaries too much freedom, Gaule noted: "They might use assumptions too freely and establish too low of capital. That's the concern that necessitated the standard scenario." The standard scenario serves as a floor to the results and is dictated by the regulation, he added.

Getting used to C-3 Phase II really was step one.

"This last year, what companies did was get the model set up. I think the challenge will be in refining the model and what we think are the appropriate assumptions," Gaule said. "We're still all waiting for feedback from the regulators."

According to the NAIC, the C-3 Phase II Results Subgroup of the Capital Adequacy Task Force is currently in the process of reviewing the results of five individual life companies to provide a cross-section of the filings submitted. Some individual states also have been reviewing the results from their domiciled companies as well. NAIC's Life and Health Actuarial Task Force is planning to conduct surveys of large annuity writers, using the C-3 Phase II information, for determining how to best establish reserves for variable annuities with living benefit guarantees.

The NAIC noted that the American Academy of Actuaries is already working on C-3 Phase III: "And regulators have expressed a desire to move at a slow, measured pace and be careful to make sure the changes are the right changes, or at least as right as possible."

What's C-3 Phase II?

C-3 Phase II is a regulation for writers of variable annuities to ensure they reserve enough capital to meet needs. It's a broad-scale venture into a principles-based modeling approach, rather than the usual formula-based approach. The regulation was adopted by the Capital Adequacy Task Force of the National Association of Insurance Commissioners in June 2005 and went into effect December 2005.

According to the NAIC, companies that must comply with 0-3 Phase II requirements include those life writers selling:

* All variable annuities, except for modified guaranteed annuities;

* Group annuities containing guarantees similar in nature to variable annuity guaranteed living benefits or guaranteed minimum death benefits;

* All other products that contain guarantees similar in nature to VAGLBs or GMDBs.

Efforts and Results

The American Academy of Actuaries conducted a follow-up survey on the initial industrywide launch of C-3 Phase II among life insurers selling variable annuities. Seventy companies, representing nearly 100% of the VA industry, responded, according to the academy. Two questions and their responses were as follows:

What aspects of compliance with the C-3 Phase II requirements were most difficult in terms of the amount of work required? (Check all that apply and/or indicate any item not listed.)

                                                  Number of Respondents

Interpreting LR023 instructions                                      53

Interpreting American Academy of Actuaries June 2005 Report          44

Understanding and complying with the Standard Scenario
requirements                                                         41

Obtaining sufficient computer resources                              35

Determination of assumptions                                         30

Creating documentation                                               21

Creation of the model population                                     12

Reflecting a clearly defined hedging strategy in modeling             9

Creating equity and/or interest rate scenarios                        9

Source: American Academy of Actuaries

Note: Table made from bar graph.

Can you estimate the change that C-3
Phase II had in the overall risk-based-capital
requirement for the variable annuity
line of business at your company? (Forty-three
companies replied to this question.)

Saw an increased
in risk-based
capital

Saw a decrease

Saw no change

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Security Benefit Life Insurance Co.

A.M. Best Company # 07025

Distribution: Independent sales reps using regional wholesalers

Aegon USA Inc.

A.M. Best Company # 69707

Distribution: Career agents, financial planners, banks, brokers, independent consultants

Hartford Life Group

A.M. Best Company # 70116

Distribution: Brokers/dealers and banks

For ratings and other financial strength information about these companies, visit www.ambest.com