Pulling Together On PBA

Pulling Together on PBA

Here's the latest information on principle–based approach from those in the know.

Moderated by Mike Boot

This is the first part in a two–part discussion on PBA. Part two of this roundtable will appear in the October/November 2008 issue of The Actuary. Stay tuned!

There are significant changes under way for the life insurance industry in the United States as insurers calculate and manage their reserves and capital due to a move to a principle–based approach (PBA). Recently, a roundtable discussion on the future of PBA took place in the form of a conference call. Mike Boot, FSA, MAAA, FCA, the SOA senior staff fellow, acted as the moderator. The industry–leading participants included: Donna Claire, FSA, MAAA, president of Claire Thinking, Inc.; Hubert Mueller, FSA, CERA, MAAA, a principal with Towers Perrin; Karen Rudolph, FSA, MAAA, a principal with Milliman; and Mary J. Bahna–Nolan, FSA, MAAA, a director with PricewaterhouseCoopers.

BOOT: Welcome and thank you for agreeing to serve on this panel on principle–based approach. Let's get started by asking everyone to share a little background information and why you're interested in participating in this call.

CLAIRE: I'm interested in the subject of getting reserves and capital at the right levels in companies. I work a lot in the regulatory arena. I think it's to both the regulators' and companies' best interest to be able to set their reserves and capital at the proper levels for two main reasons: to make sure we have healthy companies and to be competitive in today's economic environment.

I head the American Academy of Actuaries' Principle–Based Approach Steering Committee which coordinates the American Academy of Actuaries' capital and reserve subgroups, and we've been working very hard. We have about 425 volunteers in various subgroups. I also head the joint SOA/American Academy of Actuaries' Preferred Mortality Project Oversight Group. Getting intercompany experience is going to be very important to PBA. Companies will need to find out where the industry's experience is on a number of assumptions that will be the basis of reserves and capital.

MUELLER: My involvement with principle–based regulation has been in a number of areas for about the last five years. I am a member of the Life Capital Adequacy Subcommittee (LCAS) of the American Academy of Actuaries, which is focused on developing and promoting the principle–based process and working with the regulators directly. I am also a member of the Academy's Annuity Capital Working Group (ACWG), which is developing the models and regulation for principle–based capital for fixed annuities (C–3 Phase IV). I also chaired a PBA seminar last year, and am again involved in the upcoming PBA seminar this September in Washington.

My particular interest in principle–based is similar to Donna's, in that the old regulatory model has shown to be deficient, particularly for products with secondary guarantees. That said, I'm very interested in moving the industry forward to a more up–to–date model of accounting for product risks, and reflecting that in capital and reserve requirements in a more appropriate fashion than we currently have in place. In particular, I'm always looking at some of the learnings from the Solvency II regulation in Europe. Many of my colleagues work in Europe and we have a close working relationship, so I'm trying to learn from the best of both worlds and promote relevant ideas.

RUDOLPH: Part of my practice deals with valuation issues and helping companies understand and implement statutory guidelines. We assist them with asset adequacy analysis and reviewing statutory liabilities as part of due diligence processes. The supporting skill set for my practice has focused on the modeling of life insurance products with projection systems so, in that regard, I'm interested in the PBA initiative.

As PBA began to take shape, I undertook the job of monitoring this initiative for other Milliman consultants in the life discipline. Together with another principal, I co–chair Milliman's PBA committee, the objective of which is to help clients get through the PBA implementation as it comes to fruition. I'm excited about PBA becoming the new norm for life statutory reporting and so I've had the opportunity to participate with some of the modeling tasks and the Academy working groups and just generally listening to what's happening with respect to PBA.

BAHNA–NOLAN: I want to echo what Donna, Hubert and Karen all said with respect to why I'm interested in PBA. Tagging on to what Hubert was saying, I also spend time working with our international colleagues. I think an exciting aspect of PBA is with respect to globalization in that it helps to put U.S. companies on a more even playing field. I came up through the product channels and often found it frustrating that–with the products that were being designed–the reserves really didn't capture the risks that were embedded in the product. I think that PBA will do a lot to help even that playing field between all companies.

I have been involved with PBA for several years. I am a member of the Life Reserve Working Group, which is the Academy's grass roots group responsible for developing the initial states for principle–based reserves. I am also a member of the joint SOA and Academy preferred mortality group and chaired the team that developed the 2008 Valuation Basic Table.

BOOT: We clearly have an expert panel today. One of the things that I would like to get out of this conversation is to learn about the impact of the PBA on the insurance industry and more

specifically on actuaries. Donna, in a nutshell, what is the principle–based approach and where does it stand with regard to impacting capital and reserves?


CLAIRE: The principle–based approach is exactly what it sounds like. We're relying on certain principles as opposed to what we have currently in the United States–mainly a formula–based approach. The principle–based approach captures all risks of benefits associated with a contract. It quantifies the risk, uses the company's experience to determine what their risk profile is and then sets up the proper level of reserves and capital. There is some conservatism in PBA for unknown volatility, but at a level that would be correct for both the company and for the regulators focusing on the company's solvency.

BOOT: I know that other parts of the world have already made the change away from a static formula approach. What has been their experience?

MUELLER: What we have seen is that in Europe, Solvency II is well under way. Solvency II is the framework for risk–based capital which is very similar to the U.S. framework of using principles to look at the underlying risks of products in determining capital and reserves. One of the differences that we've seen in Europe is that Solvency II tends to be mainly focused on risk–based capital and less so on reserves. Only in a few of the 27 European Union (EU) member countries are reserves currently under discussion; the focus is mainly on risk–based capital, which also traditionally was formula–based in Europe, just like in the United States.

One of the key differences as to how the Europeans have gone about it is that they really have taken more of a top– down approach, where at the regulatory level–led by a few of the larger member countries and then more or less ratified by the others–they've set out the principles for how this would have to happen. The regulation applies to life, health and property & casualty insurance, but a lot of the implementation is left to the local markets. In response to that, the European CFO Forum–a group of very large European–based multinationals–has come up with guidance principles that they developed and that they subsequently disseminated to the other insurance companies in those 27 markets.

There is also the International Accounting Standards Board (IASB), the Committee of European Assurers (CEA) and the International Actuarial Association (IAA), which have become active with Solvency II. Quantitative impact summaries are being completed by companies across the EU about the impact of Solvency II, and how that would work for them. In a nutshell, I would say the approach in Europe has been much more top–down; whereas in North America, we have taken more of a bottom–up approach where we're looking at each product group separately. We're looking at variable annuities separately; we're looking at fixed annuities separately and life products separately; and for each of these product segments, we're looking at developing new regulation for capital and reserves. In total, we have six tracks, whereas Europe has taken more of a top down approach, really just pursuing one general track.

BAHNA–NOLAN: Hubert did a good job explaining what has been going on in Europe. From a practical implementation standpoint, it has taken European companies a few years to really get this working and get it right, specifically in areas like International Financial Reporting Standards (IFRS) and with Solvency II. There have been challenges with respect to modeling, such as making sure there's enough modeling expertise, as well as just computing power to do some of the modeling that's involved There are also challenges with regard to setting risk margins and in determining an appropriate level of risk margin for an individual assumption as well as in total. I think there have been many challenges that companies are still working through.

BOOT: It does sound like there is much we can learn from what's already occurred. Hubert, I know Towers Perrin is conducting a regular survey among life insurance CFOs, so we are really interested in what that survey is telling you about their feelings regarding the move to PBA. How did they feel it would change the insurance industry?

MUELLER: The survey that we are doing among North American life insurance CFOs is actually conducted three times a year. One of the surveys in 2006, and another in 2007, was focused on the implementation of a principle–based framework. An interesting finding was that CFOs were overwhelmingly in favor of the concept of a principle–based framework: more than 80 percent said that they would be somewhat or strongly in favor of such a framework. However, when we asked them what they thought about the implementation process, more than 60 percent of CFOs were either neutral or skeptical as to how the process was being implemented. We attribute this to perhaps a lack of general knowledge about the process among the CFOs. The response could have also been related to timing as there probably was not enough involvement of the industry in the process at large. While Donna was saying earlier that more than 400 actuaries are involved, even today we still have a feeling that there are quite a few companies that have been on the sidelines.

While more education on the part of the industry is needed, more active participation by the companies is required. We still see quite a few companies saying, "We know something is happening, but we're not really getting our people too much involved in the process until the dust has settled and we see what is actually coming in the regulations." This is clearly going to be an issue for them. As the current rules are being developed, they already have implications for various products, and companies would be well served to take those into account in pricing or re–pricing their products. The CFOs that we have polled also did say that they strongly believe that the new principle–based regulations would dramatically change the competitive landscape for life insurers in a variety of ways, including there would be a greater need to develop hedging programs; new ways to manipulate the system would be possible; and there may be some added flexibility in setting up the regulatory framework. That was a significant concern for the CFOs, which they thought might lead to a lack of comparability across companies in their results.

To date, there has not been enough interest and participation in the process, but probably not enough knowledge on the CFO's part to get actively involved, yet they did believe that the new principle–based regulations would significantly impact their companies' existing risk management frameworks in a number of areas.

BOOT: It does seem like a larger workload will fall to actuaries. Besides working more hours on the same reserving and capital tasks, how will the move to PBA impact actuaries who are working in the financial reporting and valuation roles?

BAHNA–NOLAN: I think there are a couple implications for actuaries. One, actuaries are going to–not that they aren't already–be turned into true risk managers. They're going to have to really understand all facets of the business and the impact of the various assumptions experience and objectives of the company. There's going to have to be much better communication between the financial actuaries and the product development actuaries with respect to the products being developed and any of the risks embedded within the contract.

In addition, I think overall communication is going to have to improve for most actuaries. PBA certainly does lend itself to more volatility with respect to the level of reserves than what we've had under a static reserve approach. Being able to manage that volatility, explain the volatility and communicate why it's happening is going to be very important as we go forward.

RUDOLPH: Cash flow forecasting is not a new concept for our profession, but, having said that, valuation actuaries in their roles of fulfilling the statutory valuation requirements are more accustomed to prescribed assumptions. With the advent of PBA and the new normal, the assumptions that they must use in statutory accounting are going to have to be built using judgment. The actuary must be able to support these assumptions and also the margins they assign to these assumptions.

I agree wholeheartedly with Mary's comments that there must be increased communications between valuation actuaries in their assumption–setting roles and other actuaries and non–actuaries in other areas of the company. For example, with respect to the mortality assumption, I think valuation practitioners will become more comfortable with their knowledge base of the underwriting practices of the company in order to use some of the tools that have been developed for that purpose. For example, the underwriting criteria scoring system and credibility metrics that will be used for mortality assumption setting are tools being developed to assist the actuary through the PBA implementation process. Valuation actuaries are going to need an increased understanding of their own company's models. This extends all the way through to the intricacies of modeling dynamic hedging programs.

Actuaries will need the skills necessary to explain to the board of directors changes in the reserve and capital levels of the company. Then, last but not least, documentation is going to be key to this process and will therefore become a greater part of the valuation actuary's daily routine.

BOOT: I'm glad you mentioned that actuaries will be risk managers. Prior to joining the Society of Actuaries, I worked 25 years in the industry primarily in product development roles. I often viewed the statutory reserves just as a number in the blue blank. It clearly seems like that will change. I must ask, what is the impact going to be to someone who is not working in the financial reporting area? For example, if someone is working in a product development role, what impact will PBA have?

RUDOLPH: Clearly, products being priced under PBA reserves must reflect those reserves and of course any capital required. I think actuaries in the pricing division must be more comfortable with their understanding of a lot of the assumptions that they're setting, right down to the grass roots level. For example, when we go and set a mortality assumption for a new product being priced, pricing actuaries need to be able to call on their underwriters for support in setting the mortality assumption, get their input, get their expertise and then blend that together with the actuarial knowledge behind the similar block or the experience studies that they have available to date. They need to be able to call on their accounting colleagues for expense analysis similar to products that are priced with prescriptive assumptions. Now we are also faced with establishing a margin on that assumption. The investments must be modeled.

As you know, PBA is a complete cash flow forecasting, including the asset side. So any exposure or risk related to the economic environment needs to be accurately captured by the pricing actuary. They have to become comfortable with the stochastic approach where that kind of an approach is necessary for pricing. I think that, going forward, pricing actuaries will be less inclined to work independently from the valuation process. They'll need to have open dialogue with their valuation counterparts in order to price for all the benefits and options in a way that is consistent with the method the valuation actuary will use to handle the same items.

MUELLER: We are also expecting to see a flurry of product development activities in the marketplace. In fact, we have already seen some leading–edge life companies capitalize on the ideas within the principle–based framework by using their knowledge of the new regulations in the way they are introducing new product features that focus on mitigation of risk. In other words, they are already looking forward at how the regulation will impact their capital and reserves, and are coming out with products and product features that have mitigated tail risks, such that they can reduce their capital and potentially also reserve requirements. Overall we would say that the implications of PBA on the product design and pricing of products–particularly those products with material tail risk–will be significant. It will require that companies assess, measure and determine the risks associated with products that have tail risk.

The implementation of PBA will also require more sophisticated stochastic modeling and risk management capabilities, and we are already seeing some companies leap ahead, using more efficient modeling techniques. Those companies that are currently still mainly pricing with a deterministic model will need to educate their pricing staff on using stochastic approaches. As Karen said, I agree that substantially more discussion with the valuation actuaries will be needed. From a company perspective, I think it means that companies will likely need to increase their modeling capabilities overall and probably also the size of the actuarial staff, because more work will be needed to calculate capital and reserves going forward.

There has been some interesting initial intelligence that is coming out of the PBA work that we have done. We're finding that when you incorporate hedging into the pricing process, first you need to think about the use of appropriate risk–free scenarios and make assumptions about market volatility. From an actuarial perspective, this forces you to work much closer with the capital market folks. Secondly, when companies have done that, they've actually found that while the level of capital might be reduced when you incorporate hedging, in fact, the level of reserves might increase because you're only getting hedging credit in a few of the scenarios, but you're paying for the cost of hedging over a much larger number of scenarios. Companies may be surprised to find that in a reserve calculation where the number of scenarios included in the results is much larger–(CTE 65 vs. CTE 90 for total asset requirement)–your reserve requirements might actually go up when you incorporate hedging.

BOOT: Thank you all for your keen insight on this very important topic. We will have to wait for next month's discussion to cover more ground on the impacts of PBA.

Mike Boot can be reached at mboot@soa.org; Donna Claire at CLAIRETHINKING@cs.com; Hubert Mueller at hubert.mueller@towersperrin.com; Karen Rudolph at karen.rudolph@milliman.com; and Mary Bahna–Nolan at mary.j.bahna-nolan@us.pwc.com.

Be on the lookout for the October/November 2008 issue of The Actuary for the second part of this discussion on PBA!

Learn More About PBA!

To learn more details about principle–based approach (PBA), you are encouraged to attend an in–depth, one–day seminar on September 24 in Washington, D.C., titled, "Advanced Seminar on Principle–Based Approach (PBA) for Reserves and Capital." This seminar is jointly sponsored by the Society of Actuaries and the American Academy of Actuaries.

In addition, 10 sessions at the 2008 Valuation Actuary Symposium on September 25–26 in Washington, D.C. are designed to focus on detailed impacts on specific product types. Visit SOA.org for more details on these educational conferences.