Reserving revolution: the new principles-based approach to reserving will significantly affect nearly every aspect of the life insurance industry.

Key Points

* The conversion to a principles-based approach to reserving will create a lot more work for many who work in the life insurance industry, including actuaries, regulators and rating analysts.

* The industry's need to create more competitive products was a major force in causing change.

* Given competitive pressures, better technology and product development, the change was inevitable.

* Less competitive companies that lack resources and scale may choose to exit the business, resulting in merger-and-acquisition activity.

Ready or not, radical changes are under way for the life insurance industry in the United States. The changes will be embodied in the way insurers calculate and manage their reserves and capital, but the effects will be far reaching. Consumers likely will see better and more affordable products, while workloads will increase for rating analysts, actuaries, regulators and software modelers.

Driving the historic change in the industry is a switch from formulaic reserving rules to a more flexible, principles-based approach. Most in the industry say this switch has been inevitable, given the realities of competitive pressures facing companies and better information technologies available to them. For the past few years, in fact, insurers and regulators have been involved in a kind of cat-and-mouse game in which companies introduced complex product designs that tested reserving regulations, and regulators responded by trying to clarify the gray areas with additional regulations.

It got to the point that no regulation could anticipate every design, and regulators decided "enough was enough," said Larry Bruning, chief actuary at the Kansas Insurance Department. That was the genesis that led to the National Association of Insurance Commissioners asking the American Academy of Actuaries to help prepare a new reserving approach based on principles rather than formulas, he said.

A principles-based approach would be used to calculate statutory reserves and capital requirements by capturing "all of the identifiable, quantifiable and material financial risks, benefits and guarantees associated with the contracts, including the 'tail risk' and the funding of the risks," according to a posting on the academy's Web site, actuary.org. Insurers would use risk analysis and risk-management techniques, including stochastic modeling. The approach permits the use of relevant company experience to the degree it is credible. Assumptions must be prudent and appropriately conservative.

There is a high likelihood that for most companies, reserves will go down from their current levels, according to George Hansen, managing senior financial analyst and actuary at A.M. Best Co. Andrew Edelsberg, assistant vice president in the Life and Health Division of A.M. Best Co., said capital requirements also may decline for many companies.

Lower reserves and capital requirements would allow insurers to develop more competitive products, a process that already has begun with new product designs and lower prices in recent years, for example, on term and universal life insurance. "What we're seeing now is the natural evolution of this," said Scott Harrison, executive director of the Affordable Life Insurance Alliance. "What we're seeing with principles-based reserving is consumer-driven in the sense that the companies that are writing these products are responding to consumer demand.... That means that companies don't have the luxury of a valuation system that produces reserve requirements that are grossly inconsistent with the economic reserve. The goal is a system that allows companies to calculate the right level of reserves." Harrison said the principles-based approach is "in response to consumer demand for better, more innovative, more affordable products from the life insurance industry."

So what should the various players in the life insurance industry expect to deal with as a result of the adoption of a principles-based approach? Projected outcomes for life insurance executives, rating analysts and regulators are discussed below.

Life Insurance Executives

Short term, think more about the capital side than the reserve side.

Under the current regulatory proposals, only new business would be subject to the new reserving requirements. And reserving regulations would have to be adopted state by state, usually a multi-year process. Capital requirements, however, are technically part of annual statement instructions. As such, they are effective immediately in all jurisdictions and for all products and issues, said Laura Hay, a partner at KPMG and national leader of life and health actuarial services. The NAIC Life and Health Actuarial Task Force is trying to have risk-based capital included in the annual statement instructions to become effective in 2008, she said.

Another reason Hay said insurers should think first about the capital side is that a lot of the rating agencies and regulators focus heavily on statutory risk-based capital, "so the capital aspect is arguably one of the more important components, anyway."

Capital requirements for certain products may be increased.

If a company writes a lot of universal life with secondary guarantees, variable life or level-premium term business that can he renewed after the term, risk-based capital could rise. That is because those products have greater tail risk, Hay said. But that may not always be the case. Hansen and Edelsherg pointed out that higher capital levels did not materialize for variable annuities, which are subject to market risk. Life products are more subject to interest rate risk. The conditional tail expectation is an average of worst-case results, "but in the life insurance business, I don't think there will he such an extreme tail," Hansen said. Interest rate risk can lead to susceptibility to other factors, such as lapsation rates, he added.

Don't overlook the chance operational costs could rise.

Computer run time will rise, something the writers of variable annuities already experienced after new reserving rules went into effect in 2005, said Hay. The principles-based approach also will add to governance costs in that extra peer review will be required, modeling time will increase because of stochastic analysis, and there could be more rules about internal controls. All of these "could compromise your ability to close your statutory books," she said.

But from a risk-management side, an advantage is that acquiring all of this additional information helps support a broader enterprise-risk-management approach, Hay added.

Expect chief financial officers to be more involved.

"It is our view that there's a new role to play for the CFO," Hay said. They will have to understand new requirements and will likely have to become more involved and influential, she said. The result will be "a more holistic picture of the company that takes into account all the views of the various constituencies," said Hay.

An insurer might earn a quantifiable diversification credit.

Insurers are in their infancy in their ability to use diversification credits. "That's when you model out all the different pieces of your business, and the fact that you've got correlated risks should in theory lower your total economic capital," Hay said. "This modeling is a step in the right direction in helping you to get to a quantifiable diversification credit." Modeling is part of broader enterprise risk management, she added.

There can be both positive and negative correlations. A negative correlation, for example, would be if a multi-line insurer insures a building and has group life policies on people working in the building, said Edelsberg.

An insurer will have greater latitude to make prudent assumptions and assign risk margins to them.

Under new guidelines, companies will be expected to set prudent assumptions and regularly re-evaluate them. In the past, they were locked in by regulators' standards on mortality and interest rates, and there was no consideration of company experience. Also, companies will be expected to choose risk margins for the assumptions. These margins can have a significant impact on the emergence of reserves and the risk-based capital, Hay said.

In this work and in running the scenarios that help evaluate it, actuaries have a big role to play. A qualified actuary must ensure the scenarios are supportable and that the valuation and pricing assumptions are compatible, according to Hay.

Smaller insurers will feel pressured by the principles-based approach.

In a lot of cases, smaller companies don't have the resources to do stochastic modeling. "Some don't even have actuarial departments," said Edelsberg. "They actually outsource it to consultants." Lack of resources and scale is why many small companies aren't even in the variable annuity business. It requires significant mitigation techniques such as hedging, along with high-end product design and asset allocation, he said. With life products getting more complex, such as with secondary guarantees on universal life, smaller companies will have to decide whether they will be able to "compete against the big guys that have the financial resources, that can price this product, that can do all this testing and verify their assumptions because these are not plain-vanilla products," Edelsberg said.

Mergers and acquisitions could increase.

If companies conclude they can't compete, they might sell their businesses. "Some variable annuity blocks of business came up for sale in the past couple of years when people realized that unless they were big time in the business, staying in was not worth the cost," said Hay. She also said that lower reserves will help U.S. companies compete globally because "they will be on a more level playing field."

Rating Analysts

Since the new system will create capital requirements that are company-specific rather than formulaic, the job of rating analysts will become more challenging.

The formulaic approach makes it easier to compare companies in the rating process, said Hansen. But now companies will be using their own assumptions and own experience in developing C-3 Phase III results," and so it will be a challenge to compare companies as well as year-by-year results of companies," said Hansen. C-3 Phase III refers to life insurance capital requirements, while C-3 Phase II refers to variable annuity capital requirements, which are already in effect.

"We'll have to figure out a way to incorporate this as well, just as we've incorporated C-3 Phase II," said Edelsberg.

Analysts will be forced to ask for more information from the companies.

"It may get down to the level of asking to look over actuarial opinions or memorandums put together to support the company's results, and being in a position in which they can explain year-to-year changes on behalf of the company," said Hansen. Analysts will want to assess actuaries' comfort levels, he said. If capital rose or fell sharply, analysts will want to know whether it was due to a change in investment philosophy, a reallocation of assets along a certain line or some other factor. And if modeling issues were involved, analysts would want to know whether assumption changes drove those results, he said.

Like companies and regulators, rating agencies may need to hire more professionals.

Actuaries will definitely be in greater demand, said Edelsberg. That is particularly true for their role in providing another level of review not currently in the system, he said. There will also be a demand for modelers. "We somehow have to utilize risk-modeling expertise," Edelsberg said. "Our capital model has to keep up with the companies' capital models."

Insurers already manage more on the basis of GAAP (generally accepted accounting principles) than they do on the basis of statutory accounting.

The principles-based approach narrows the gap between GAAP and star, said Edelsberg. "Stat is so conservative and focused on solvency that a lot of companies we follow, especially the larger, publicly traded ones, don't even manage on that basis," he said. "They just do stat because they have to."

Regulators

The evolution to a principles-based reserving approach has been enabled by competition, advances in risk-measurement theory, greater computer processing power and the emergence of software modeling vendors, according to Bruning. Despite the efficiencies technological improvements bring, Bruning said regulators will probably have to add to their staffs. Other impacts include:

Regulators will have to create an education and training process that shows how to examine a company under the principles-based approach.

To make examinations easier, regulators are considering pooling states' resources to create a team of actuaries dedicated to reviewing companies in a more centralized way. Bruning, who is also vice chair of the NAIC Life and Health Actuarial Task Force, heads a committee that is looking into this idea. The team would be an alternative to each state department using its own actuaries or hiring more. It would also add uniformity to how each company is examined.

As principles-based reserving takes shape, the NAIC is considering fundamentally changing the way it regulates life insurance companies.

Bruning said the organization has formed an executive-level PBR Working Group to seek out ways to make the principles-based environment more effective. Today, insurance laws aren't uniform across all 50 states, required reserving levels vary by state, and actuaries have to file 50 different kinds of certification statements. "So we're saying that maybe we should rethink that legal framework and have a centralized filing location," Bruning said. "We're trying to explore that and address consistency and uniformity issues. That in and of itself presents some legal challenges, since states want authority. But this is such a fundamental change that we said it's time to step back and explore." The working group is charged with overseeing this process and acting as a steering committee on policy issues, Bruning said.

There is some concern that regulators may impose burdensome internal controls on companies.

The more ambitious of two approaches is to use the principles-based reserving project as an opportunity to impose a much more rigorous enterprisewide risk-management protocol or regime on the industry, according to Harrison. "The risk, obviously, is that by imposing unduly burdensome governance requirements on companies, we could in essence create a formula-based system just in a different name," he said. "By definition, there has to be some appropriate level of actuarial discretion. In a principles-based environment, there has to be room for judgment--professional judgment--subject to management oversight and possibly even board review."

But regulators have learned they need to be clear in specifying what they expect from the principles-based process.

Regulators want companies to identify all risks to which they are exposed, and they want stochastic modeling to help identify risk parameters and risk sensitivity, Bruning said. For example, if a product might be especially sensitive to lapse rates, regulators will want to see stochastic runs showing what happens if lapse rates change, even if they double. "If companies are way off, it could affect their solvency," he said. And regulators will want to know how companies will work their way through any extreme scenarios, he added.

The principles-based approach could result in products that aren't possible today.

As an example, Bruning pointed to a life policy that a young couple might buy. It provides the couple, which has little in assets, a significant death benefit. Later in life, it becomes a retirement income funding vehicle. Finally, it funds long-term care. Such a product couldn't be offered today due to different regulations on health, life and retirement-income products, he said. Regulators in the future, however, could remove those constraints and modernize the product-filing part of the regulatory environment, he said.

MORE RESPONSIBILITY: Laura Hay, a partner at KPMG and national leader of life and health actuarial services, explained that under the new guidelines, companies will be expected to set prudent assumptions and choose risk margins for the assumption. These margins can have a significant impact on the emergence of reserves and the risk-based capital, she said.

What the Change Is All About

The way regulators require insurers to calculate reserves for life insurance products has been in effect with only minor changes for more than a century. In mid 2004, the National Association of insurance Commissioners asked the American Academy of Actuaries to help change the methods for determining statutory reserves and risk-based capital from a formulaic to a principles-based approach. Today, much of that work is complete. The new approach is likely to take effect by the end of this year for capital, and the NAIC hopes to adopt a new standard valuation model law by early next year. The model law would incorporate the principles-based approach for statutory reserves, but it would go into effect only as each state adopts the model law in 2008 or later.

Risks Associated With Life Insurance Products

Mortality Risk

* More rating classes

Capital Market Risk

* Variable products

* Equity-indexed products

Policyholder Behavior Risk

* Lower-than-expected lapses in level-premium term products

* Lapse and interest-rats risk in universal life with secondary guarantees

Changes in the Life Insurance Market

* Arbitrage in life settlements

Source: KPMG's Financial Executive's Guide to the Principles-Based Approach to Statutory Reserves and Risk-Based Capital for Life Insurance

Dates of Interest to the Financial Executive

 By Year-End    Principles-based approach is scheduled to apply to:

    2005        Risk-based capital for variable annuities with
                supplemental guarantees whenever issued (phased in)

    2007        Reserves for variable annuities with supplemental
                guarantees issued after 1980

    2008        Reserves for virtually all life insurance issued
                after the effective date of the regulation (the
                effective date depends on the date that all relevant
                laws and regulations are adopted by the states, and
                may be after 2008)

                Risk-based capital for virtually all life insurance
                regardless of issue date

  2008-2010     Reserves and risk-based capital for long-term-care
                insurance and all annuities not already covered
                (issue dates not yet determined; as with life
                insurance, effective dates will depend on when
                states adopt the model regulation)

One More Date

    2010        New provisions in NAIC Model Audit Regulation
                (requirements regarding internal controls over
                statutory financial reporting) take effect.

Source: KPMG