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Reserving clash: the life industry is divided over reserve requirements for certain UL policies with secondary guarantees.

Key Points

* A UL policy with a secondary guarantee is a UL policy with a "no-lapse" guarantee.

* The debate over reserving for these policies stems from various interpretations of the NAIC's Actuarial Guideline 38.

* Some observers say the split is generally between stock and mutual companies.

* In December 2004, the NAIC directed a task force to begin working on approaches to setting reserves based on "asset-adequacy" modeling.


Storm clouds have gathered. A controversy has grown among companies in the life insurance industry and state regulators over the appropriate level of reserves for some universal life products with secondary guarantees, an increasingly fast growing and popular consumer product design. The hubbub stems from various interpretations of the National Association of Insurance Commissioners' Actuarial Guideline XXXVIII.

Some companies argue that guarantees and product features that might be valuable to policyholders probably would not be offered if stringent requirements were adhered to, said Robert Frasca, senior manager with Ernst & Young in Boston. On the other hand, other companies argue "that some of these guarantees that companies are offering really are quite risky and they should have to set up additional resettles for them," he said.

The key is how regulators will come down on proposals currently being debated on reserving requirements. "If you go from one state to the next, you can get an entirely different opinion," Frasca said. "It will be interesting ... because it will wind up giving some insight as to whether the future of regulation is more formula-based or whether it's more principles-based."

Mark Konen, executive vice president of life and annuity manufacturing for Jefferson Pilot Financial Corp., said the split on proposed changes to AG 38 is between the companies that manufacture the UL product with secondary guarantees and the companies that don't manufacture it.

"It's something akin to two cats using the same litter box--the end result can be a little messy, and generally one cat has to give," Nebraska Insurance Commissioner Tim Wagner said in a speech to the NAIC's Life and Annuities Committee, or "A" Committee, in December.

AG 38, was passed in 2002 by the NAIC to provide guidance regarding Regulation Triple-X, which addressed reserve requirements for life insurance policies with non-level premiums or benefits, according to the American Council of Life Insurers, the industry trade group. AG 38 is the model rule that offers a complex mathematical formula for calculating reserves. The ACLI is neutral on AG 38, but continues to monitor the issue, said Jack Dolan, a spokesman for the group, in January.

'No-Lapse' Guarantee

A UL policy with a secondary guarantee is a UL policy with a "no-lapse" guarantee, according to the ACLI. If certain conditions are met, such as the payment of a certain premium, the policy will not lapse. The UL no-lapse designs effectively guarantee that a policy will stay in force for a predetermined period of time, even if the policy account falls below zero--which typically triggers a lapse of a policy.

These products meet "a very real consumer need," said Jefferson Pilot's Konen.

"If you think of what consumers have experienced over the last few years, be it an insurance product or another financial product, they've seen stock market returns erode and interest rates decline," Konen said. "So we have a consumer that has a psyche of looking for guarantees ... looking for certainty that isn't in a lot of financial instruments."

There are two methods of producing a guarantee of non-lapse of a universal life insurance contract, according to the ACLI.

The first method, called the stipulated premium method, guarantees that a contract will stay in force as long its some minimum premium amount is paid every premium period. The second method, called the shadow account method, guarantees that a contract will stay in force as long as the shadow account balance remains positive, where the shadow account is calculated using interest credits and/or mortality and expense charges that are more favorable than those guaranteed in the policy. Premiums can be any amount, or even skipped, as long as the shadow account remains positive.

These products carry their share of risks, including interest rate and lapse risks, said Dave Sandberg, vice chair of the American Academy of Actuaries' life practice council and chair of its solvency and risk management committee. With either method, a design is at risk if interest rates are lower than assumed or needed in the pricing; that is, the company will invest the premiums and assume some earned rate on its assets backing the policy, he said. And at the same time, policyholders realize they have a valuable guarantee and so lapse less often than assumed in the pricing, so they can take advantage of the guarantee.

"Many companies do price these risks responsibly, and maybe even all of them do, but the uncertainty as to which designs may have very risky guarantees embedded in these fairly complex designs is real," Sandberg said.

Konen said that Jefferson Pilot is "quite satisfied" that the company meets AG 38 requirements "and we go beyond that and make sure that from a scenario-testing, risk-analysis standpoint, that our reserves are adequate."

Looking for Principles

While AG 38 states that actuaries should follow the principles of the guideline for new products and product innovations, the principles to be used are not specifically stated in the guideline, according to Sandberg.

One principle that would be consistent with the Standard Valuation Law concept is to use the present value of future benefits less the present value of future premiums within the requirements stated in the Standard Valuation Law. This would then require the same reserves for a fully paid-up UL policy with a secondary guarantee as required for traditional term product Triple-X reserves, he said.

Another contrasting approach for fulfilling the AG 38 requirement to follow the principles is that reserves should make adequate provision for risk, but not be overly conservative, Sandberg said. Because the current reserve requirements of the Standard Valuation Law focus on rule-based product definitions and not risk-based product definitions, using different combinations of mortality, interest rate and expense load guarantees to satisfy the rule-based product definitions, while still evaluating the underlying risks, would allow lower reserves than the present value based approach, he said.

New York Proposal

One key proposal to change the reserve requirements under AG 38 for certain UL products with secondary guarantees was offered in 2004 by New York State Insurance Department actuary, William Carmello. His proposal is backed by, among others, Northwestern Mutual, New York Life and American International Group Inc.

Certain companies "were able to design their product in a way to produce very low reserves and the fix that we proposed was to get to the level of reserves that was originally intended, both by regulation XXX and Actuarial Guideline 38," Carmello said, explaining that some companies found a "loophole," which he said allows them to under-reserve.

Carmello's main concern is solvency. He said that if companies' reserves are too low, they won't have enough money to pay claims. But he also is concerned with having "a level playing field."

Bill Koenig, senior vice president and chief actuary of Northwestern Mutual, said that his company's interest is in having reserve standards that apply fairly across the board.

"The problem we see is that the current AG 38 was drafted in such a way that it's possible that companies could hold reserves as low as 45%, maybe, of what the reserve would be in an otherwise similar product that didn't make use of some of the curiosities in AG 38," Koenig said. "It's our feeling that similar guarantees should carry similar reserves."

With different interpretations of Actuarial Guideline 38, it's unclear what reserves companies are holding--an unhealthy situation for the industry or consumers, Koenig said.

Nebraska Commissioner Wagner said the debate centers on lapse. Stock insurers that are reserving this business, under the current language of AG 38, are using a lapse assumption, he said. "You assume that so much of the business will lapse over time, then you can reduce the reserve by the amount of that lapse."

Mutual companies, however, do not want a lapse assumption under AG 38, Wagner said. "If they offer these products, which they have every right to do, they don't have the lapses that a stock company has, and, as a result, it would cost them more to finance those risks than the stock companies, because a higher reserve would be necessary."

Because mutuals work on the basis of dividends, they have lower lapse rates, according to Wagner. Mutuals "would have to post some really large reserves, because the lapse assumptions would be different."

Wagner, as well as North Dakota Insurance Commissioner Jim Poolman, said the split is generally between stock and mutual companies. Others say, however, that may be too broad a generalization to make.

Sandberg elaborated on lapse and interest rate risks. "What if interest rates drop significantly in the future and stay dropped? How will people lapse in that environment?" he asked. For example, a company may have assumed a 5% to 10% lapse rate, but now, they may only get 1% to 2%, he said.

Certain UL products can "mimic" more traditional products, such its term life insurance, Sandberg noted.

Scott Harrison, a Washington, D.C.-based attorney who represents a coalition of 15 insurance companies, mostly stock companies, said an uneven playing field is not the issue.

Companies "are free to sell this product; they have chosen not to," Harrison said. "Instead of selling this product, they have instead attempted to force my [clients] to post higher reserves and increase the cost of this product to consumers."

A New Model

At the NAICs Winter National Meeting in New Orleans in December 2004, the "A" Committee directed the NAIC's Life and Health Actuarial Task Force to begin working on approaches to setting reserves based on "asset-adequacy" modeling--an approach that uses mortality, interest rate and lapse assumptions, rather than the traditional "formulaic" approach, the approach that Carmello, the N.Y. insurance department actuary, generally supports.

The formulaic approach is based on long-standing actuarial tools such as mortality tables, which some say forces companies to hold excessive reserves.

The current formula-based approach developed years ago is "antiquated," and for many products, requires reserves that are grossly in excess of what's required under an adequacy test, leading to higher prices for consumers, said Harrison.

Going to an asset-adequacy approach moves in the direction of a principles-based method, Jefferson Pilot's Konen noted.

In a January research note, Credit Suisse First Boston equity analysts Tom Gallagher and Kevin M. Feder, apparently referring to Carmello's proposal, wrote that a proposal to increase required statutory reserves for certain UL insurance contracts under AG 38 "appears to have hit a roadblock, a potential positive for life insurers with sizable UL businesses," such as Jefferson Pilot, Lincoln National and MetLife.

The equity analysts also wrote, "It appears as though the more draconian scenario will not go through. Furthermore, we would guess that Greg Serio (who we understand was a proponent of the harsh version of AG 38) stepping down as the New York insurance commissioner also makes it less likely that the current version will not go through."

The "A" Committee directed the task force to develop a solution to the AG 38 issue using the asset-adequacy approach by the June 2005 NAIC meeting, the ACLI said. While it did not instruct the task force to stop its work on the formulaic proposal, as of January, it was unclear whether the task force will do so.

New York Regulation

Meanwhile, the New York insurance department in mid-January issued a regulation that requires those that sell universal life insurance in the state to set aside adequate reserves "in keeping with the spirit" of AG 38, which establishes the national standard for the industry. The department adopted the amendment to Regulation 147, which sets forth New York's life insurance reserve rules.

Commissioner Poolman said that the "A" Committee gave direction to the task torte "to work on a long term fix" for the issue. All interviewed said they support a long-term solution.

"While we are supportive of the Carmello approach, we are certainly interested in working with other ACLI companies to try to come to some resolution that would be agreeable to all of the ACLI members," said Northwestern Mutual's Koenig.

Learn More

Northwestern Mutual Life Insurance Co.

A.M. Best Company # 06845

Distribution: Exclusive sales force

Jefferson Pilot Financial Corp.

A.M. Best Company # 06928 (Jefferson Pilot Life Insurance Co.)

Distribution: Independent agents; captive agents

For ratings and other financial strength information about these companies, visit

Going Up

Universal life was up 12% in the third quarter and 20% for 2004, accounting for 37% of 2004 annualized premium, according to Limra International's third-quarter report on individual life insurance sales in the United States. Limra did not have hard numbers on UL with secondary guarantees, "but we have seen evidence to indicate that a significant portion of new UL premium stems from such products," said Howard S. Drescher, a Limra spokesman.
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Title Annotation:Life; universal life
Comment:Reserving clash: the life industry is divided over reserve requirements for certain UL policies with secondary guarantees.(Life)(universal life )
Author:Lysiak, Fran Matso
Publication:Best's Review
Geographic Code:1USA
Date:Mar 1, 2005
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