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Modernizing The Insurance Financial Process

Modernizing The Insurance Financial Process

Will a principles–based approach simplify reporting regulations and make them more flexible?

I sat down this last Thanksgiving to record and reflect on those things for which I was thankful. One of the major items on my top 10 list is a strong sense of gratitude to be involved with a profession working to modernize an important aspect of insurance financial reporting in the United States. I am referring to statutory reporting and the Principle–Based Initiative that the Academy, the industry and the regulators have been so diligently working on. From my vantage point, what do I see occurring in the United States?

Larry Bruning, chief actuary for the state of Kansas and Al Gross, Virginia Insurance Commissioner have been pointing out that our net premium reserve formula–the basis of our current standard valuation law–was established more than 150 years ago by Elizur Wright, an early actuary and commissioner for the state of Massachusetts. They contend that while this conceptual framework is a testament to the power of logical and forward thinking by an actuary, it may also be time to tap into some logical and forward thinking by today's actuaries to update the ideas and strengthen that conceptual framework. There are a complex array of products and associated risks that have developed over the last 20 years that require an improvement to the old paradigm in order to modernize insurance regulation.

Recommended Shift in Focus
It seems to me that perhaps a key change needed is a shift from focusing on formulas and programming to a new emerging focus that centers on the management of processes. These processes then become the foundation for interpretation, recommendations and a review/dialogue that extends to a much larger circle of interested parties, including senior management, the Board and regulators. This shifting of focus will help us realign our work and time, thus, adding value to our profession through our unique professional advantages. This uniqueness centers on our ability to identify, measure and manage risk for public and private needs through common professional standards, training and continued professional development.

Over the years, our profession–both nationally and internationally–has increasingly focused on the utilization of what some countries call an actuarial control cycle (and which is now included in one of the modules recently added to the new SOA syllabus). In the United States, we have more traditionally referred to this as feedback loops, and generalists might label this as a learning environment or cycle.

The statutory reserve requirements and review processes in the current law do not create a learning environment. The financial reporting and review requirements need to allow that type of environment to emerge. The current recommended changes in the draft model law exposed by the NAIC in October of 2006 include:

  1. A centralized NAIC process to update reserve requirements uniformly via a Valuation Manual similar to the process that occurs for RBC via the instructions to the annual statement.

    In contrast to a top–down approach that would mandate a new valuation framework for the entire company across all lines of business, the manual allows a bottom–up approach to be used by the NAIC to manage the inclusion of principles–based product and risk reporting on an incremental basis. The current life reserve proposal includes sections that address C3 risk requirements while also providing guidance on the margins to be used for C2 risk. Fixed annuity and long–term care reserve proposals are also being developed, and, when completed and approved by regulators, can be included in the valuation manual requirements.

  2. Governance is included in the law to strengthen the overall solvency standard (due to increased discretion in setting reserves based on long–term assumptions):
    • Required independent review.
      • The traditional audit function is still needed to verify controls and the appropriate entry of financial transactions into the balance sheet/income statement. The required independent review is for items where judgment has been used. It verifies that both the methodology and the documentation of the basis for the estimate of the margins and assumptions have met a verifiable standard. It is also essentially a pre–release review, though the actual sign–off will likely be shortly after the financials are finalized.
      • One of the opportunities this provides for is that disputes about such items as assumptions will have a third party involvement. Important issues can be identified promptly so that discussion can occur at a professional level such as through a dispute board, focused research or a group to recommend practical solutions.
      • This allows states with limited expertise to know that there has been a professional process used and relied on, just as occurs in the audit function.
    • Required submission of company experience to a central data source.
      • This allows certifying actuaries, regulators and reviewers to have a better context for setting and reviewing assumptions.
      • This process is expected to be overseen by a combined group of regulators, professional groups (SOA and AAA) and industry as has occurred with the Joint Mortality project. The intent is to ensure that there is a purpose to data submission and usage that is cost effective and organized to add value to the risk management process.
  3. While not included in this new law, the NAIC is also exploring how to further modernize its own examination and review process. If done prior to the new model law being passed, this allows both the NAIC and industry time to implement any structural support that might be needed prior to implementation.

New Model Timing
The adoption of this new model Standard Valuation Law by the NAIC could well occur in the first half of 2007. This would then allow legislatures to consider and adopt it in 2008 and 2009. If that is the case, the model would be effective for 2009 or 2010 issues for life insurance and any other products adopted by then that are included in the NAIC valuation manual.

This also allows time to work out some of the other implications for the principles–based approach. For example, John White, director of the Securities and Exchange Commission's division of corporation finance, on November 10, 2006, discussed the question of how the SEC staff could review and enforce principles–based rules. While they are the personal comments by the SEC regulator, they reflect his awareness that a principles–based approach is intended to simplify regulation and make it more flexible, as well. "We need to be principles–based in our side of it," he stated, while mentioning that his division staff received training in November focusing on "this very topic."

The other area where further insight will be gained is how this supports Enterprise Risk Management. The SOA is building its messaging around the theme of "Risk is Opportunity." A principles–based approach is an important opportunity for a financial reporting process that is based on risk to be supported by two professional organizations (the Academy and the SOA). These two entities are increasingly able to support and strengthen a risk reporting framework, and I, for one, would be grateful to see this topic covered in a future issue of The Actuary.

Dave Sandberg, FSA, MAAA, is vice president and corporate actuary at Allianz Life Insurance Company of North America in Minneapolis as well as the vice president for the American Academy of Actuaries Life Practice Council. He can be reached at