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Progress Towards a New Approach to Regulatory Reserving and Required Capital

Progress Towards a New Approach to Regulatory Reserving and Required Capital
by Larry M. Gorski

There's a lot going on in U.S. regulatory reserving and required capital. This article brings you up to date on all the major concerns.

Changes in U.S. regulatory reserve and risk–based capital requirements have the potential to significantly impact the insurance industry and practicing actuaries in this country. New software has to be developed or existing software modified. Products may have to be modified. Additional sources or uses of newly released capital may need to be found. Valuation actuaries may need to learn new skills. The movement towards a principles–based regulatory reserve and risk–based capital may have all of the impacts just mentioned. One principles–based regulatory initiative was adopted and made effective during 2005. Additional initiatives made significant progress. This report identifies and summarizes activity related to principles–based reserve and risk–based capital initiatives during 2005 and possible emerging issues in 2006 and later years.

Sources Scanned
The primary sources of material were the minutes from NAIC Life and Health Actuarial Task Force (LHATF) conference calls and meetings and the material produced by the American Academy of Actuaries and the Society of Actuaries that provide suggested changes as part of their assistance and input to LHATF.

Results of Scanning Process
The development of products such as equity indexed annuities and various types of guarantees for variable annuities made it apparent that the traditional formulaic minimum approach to statutory reserving for life insurance and annuities as well as the valuation actuary requirements was in need of extensive revision. In addition, the inability of statutory mortality standards to keep pace with multi–class preferred and super preferred underwriting structures has created the need for insurers to find ways to deal with the excessive reserves and resulting strain on surplus and cost of capital concerns due to the use of overly conservative mortality tables for this business. In response to these issues, the regulatory community, along with the American Academy of Actuaries and Society of Actuaries, initiated a series of projects. Following is a summary of these projects.

Review of Actions During 2005
Risk–Based Capital for Variable Annuities
The signature event of 2005 was the adoption of new rules for calculating regulatory risk–based capital for variable annuities including associated guarantees. The rules require the calculation of an amount using the procedures and guidance contained in the American Academy of Actuaries (AAA) C-3 Phase 2 Report (June 2005) and an amount based on the Standard Scenario developed by the NAIC. The AAA C-3 Phase 2 amount is based on a principles–based approach while the Standard Scenario amount is a formulaic calculation. The amount of reported RBC is based on the greater of the modeling–based amount and the Standard Scenario amount. The rules are in effect for 12/31/05.

The basis for the component developed by the AAA is a stochastic cash flow model that recognizes the effects of policy aggregation. If the requirements for hedging are satisfied, the effects of hedging can be recognized in the calculation of risk–based capital. Assumptions used in the cash flow model are not prescribed, but based on company experience and actuarial judgment.

The AAA C-3 Phase 2 Report (June 2005) also provides an alternative methodology that may be used to calculate risk–based capital requirements for Guaranteed Minimum Death Benefits. Companies using the Alternative Methodology factors may not reduce the calculated amount for hedging.

The NAIC Capital Adequacy Task Force (CADTF) formed the Results Subgroup to evaluate various aspects of the C-3 Phase 2 project including compliance with the C-3 Phase 2 rules. Surveys designed to gather high–level information concerning insurer compliance with the C-3 Phase 2 rule were sent to insurers late in November. Insurers were also requested to work with the Results Subgroup to do a detailed evaluation of C-3 Phase 2 compliance.

Reserves for Variable Annuities
A companion to the AAA recommendation concerning C-3 Phase 2 RBC is Actuarial Guideline VACARVM. The document provides rules and guidelines to compute reserves for variable annuities including associated guarantees. Like the project previously discussed, there is a principles–based component and a deterministic component of the Standard Scenario. Unlike the RBC C-3 Phase 2 project, AG VACARVM has not been adopted by the NAIC. The latest draft was exposed for comment during the December 2005 NAIC Meeting.

One of the stumbling blocks to adoption has been the requirements included in the Standard Scenario. Opposition to earlier versions of the Standard Scenario exposed for comment focuses on the perceived level of conservatism underlying the Standard Scenario and the complexity of the requirements including the resources needed to perform the required calculations. The draft that was exposed for comments contained revisions to the Standard Scenario.

Reserves for Life Insurance Policies
The primary initiative to develop a principles–based approach to reserving for life insurance policies is being driven by the AAA Life Reserving Work Group (AAA LRWG). The NAIC exposed for comment during the December 2005 NAIC Meeting the current proposal developed by the AAA LRWG. The current proposal includes a Model Regulation that contains the core components (basic modeling methodology) while three actuarial guidelines deal with setting assumption, determining margins for the assumptions and disclosure. The scope of the proposal includes term insurance, universal life insurance and other forms of life insurance.

Preferred Mortality Experience Study
To support the principles–based approach to reserving, the regulators have requested the development of preferred mortality valuation tables suitable for statutory reserving. The project was started in June 2005 with a data call. The Joint AAA–SOA Preferred Mortality Project Oversight Group is overseeing the project. The initial deliverable from this project will likely be interim preferred mortality tables to be used within the current regulatory formulaic valuation framework.

Related Developments
To implement the principles–based approach to reserving, fundamental changes to the Standard Valuation Law will have to be made. Current proposals to amend the Standard Valuation Law include adding language concerning requirements dealing with risk management and governance.

Expected Activity During 2006
It is anticipated that AG VACARVM (reserves for variable annuities) will be adopted by the NAIC in 2006. To complement the proposal dealing with the principles–based reserving for life products, a proposal dealing with a principles–based approach to regulatory RBC for these products is under discussion.

The projects already discussed focused on traditional actuarial functions, i.e., calculating formula reserves, valuation actuary requirements and building cash flow models. Discussions of the principles–based approach have included discussions over the need to develop a regulatory required "peer review" of the actuary's work. Many details need to be resolved before this idea is ready for adoption by the NAIC. For example, will the required review be a "pre–release" review or a "post–release" review. In this case, "pre–release" and "post–release" refer to filing the statutory financial statement using principles–based reserves. Other details include, "Who is the client in a regulatory required peer review assignment?" and "What is the relationship between the regulatory required peer review and current regulatory financial examinations?"

Challenges for the Practicing Actuary
It should be obvious that implementation of a principles–based approach to reserving will cause an increase in the responsibilities of the actuary involved in statutory valuation. Will the actuary be provided the resources (tools and people) to meet the additional requirements? Will the legal liability of the actuary increase? Will the professional responsibilities increase under a principles–based approach? These questions will be discussed in 2006.

The Need to Continue Scanning
The long–term nature of the NAIC LHATF initiatives and the potential for significant issues to be addressed in 2006 indicates that the scanning activity continue in 2006.

Larry M. Gorski is a consulting actuary for Claire Thinking Inc. He can be contacted at actuary@mchsi.com.