Pulling Together on PBA Part Two
Pulling Together On PBA Part Two
The latest information on principle-based approach from those in the know.
Moderated by Mike Boot
This article is the second part of a panel discussion on the status of principle-based approach (PBA). Mike Boot of the Society of Actuaries moderated the conversation. The panel members included: Donna Claire, Claire Thinking Inc.; Hubert Mueller, Towers Perrin; Mary Bahna–Nolan, PricewaterhouseCoopers; and Karen Rudolph, Milliman. The first part of the discussion appeared in the August–September issue of The Actuary and covered what impact the principle–based approach will have on companies and on actuaries as well as international experience with PBA. You can find the first article at Pbapart1.
BOOT: I know that PBA will impact company experience studies. The way that industry experience tables have been constructed by the Society of Actuaries will also be modified. Mary and Donna, I know you were very involved with the new preferred mortality and valuation basic mortality table work that the American Academy of Actuaries and the Society of Actuaries sponsored. Describe how that table was impacted and how that will impact other experience studies.
CLAIRE: I will give a quick overview, and Mary, who was involved with many details of the project, will follow up. As Karen previously commented, one of the things with the new system is you have got to make a lot more assumptions. Right now there are many companies that, for example, aren't quite sure if they start a preferred mortality class, what type of experience they can expect. The industry, specifically the SOA and the Academy, are trying to help the companies with this process. This preferred mortality project was specifically aimed at PBA to spell out that if you have certain underwriting standards, then what type of mortality you can expect and, therefore, what type of reserves would come out of that process. I'll let Mary explain exactly what the process is.
BAHNA–NOLAN: Thanks, Donna. Developing the new mortality tables was a big effort. It was the first time for developing industry preferred mortality tables and the industry as a whole did not have credible preferred mortality experience. We first had to start with properly defining preferred, and the various levels of preferred. We need to consider how the companies are going to use this table and with respect to the choosing of the table, how a company knows which table to choose. As Donna mentioned, if a company doesn't have a lot of experience of their own, but they have guidelines they use that are competitive with other guidelines in the market, how do they know which table to use? How can we make it so it's a fair system, and not disadvantage companies that may not be as large or may be newer in the preferred market arena. There are a lot of considerations such as these that had to go into the development of the table. The number of tables that we ultimately developed cover the broad range of risks that we see in the industry. The first time you do something there are always a lot of things you learn from it, and we did. To develop the 2008 VBT took a lot of experts in a lot of different areas from underwriting to mortality to modeling to graduation to be able to come up with the many tables. As the industry gets more and more preferred experience and as companies know they will need to do a better job of tracking their mortality experience specifically with respect to the various risk classes, the tables and the table development will only get easier and better over time.
CLAIRE: To follow up on the second part of that question, Mary explained the extensive work that went into the mortality studies. There are a number of other areas where we anticipate similar work will be done. Right now, the SOA in connection with LIMRA is doing a lapse rate study. Again when you're setting reserves, you want to make sure that the tables are as accurate as possible. For example, are the lapses different for the products that Hubert previously mentioned–universal life with secondary guarantees, which are guaranteeing lifetime coverage if you pay a certain level of premiums? We want to know whether the lapses differ from those of a traditional universal life product.
To give another example, there is also information needed on variable annuities. You want answers to various questions if you provide guarantees of various types. If it's a mortality guarantee, what is the expected level of mortality? If it is an annuity benefit, what is the election rate? There are a lot more studies that will be needed at the Society of Actuaries and the Academy to support the work of the actuary in this endeavor.
BAHNA–NOLAN: This means there's going to be a lot more data that companies are going to have to capture within their systems, and so that's another aspect of PBA that I don't believe a lot of companies are necessarily thinking about, which is what level of data do we need to be capturing versus what we have today.
BOOT: Clearly there's going to be involved a greater need for actuaries and modeling resources and that could increase some expenses, so companies will demand to see more benefits. What benefits would companies see after the move to PBA?
CLAIRE: Much of what has already been mentioned by Hubert, Karen and Mary. In effect, the major advantage is the companies will concentrate on understanding what risks they are assuming–what options they're giving to the customer, how to mitigate those risks, understanding under what circumstances the company is at risk. The major advantage to the company is they will be able to make intelligent decisions as to what risks they want to take, as opposed to the current system where it's a rule–based system and some companies are just trying to figure out how to get the lowest possible statutory reserves. They'll understand that the principle is to set up reserves for the risks that they're taking. Yes some companies are going to have lots of bells and whistles on their products. If they're not mitigating the risk, they will set up additional reserves. Other companies may choose to go to the capital markets to figure out which bells and whistles are going to cost them a lot of money and which ones are really needed. The advantage to the regulators will be that they will be able to see the risks the companies are choosing. There will be, in effect, a scorecard as the actuary does his/her work to figure out how the company is doing and whether it will need extra reserves and/or capital in the future. I will admit I also gave a PBA presentation before FASB and they did ask if there are enough actuaries to be able to do the job that we envision. My counter argument is the actuaries will become a much more effective risk manager which will serve the company a lot better. The job of the actuary, I think, is going to be a lot more exciting in the future and it will be a job that will be valued by the company.
RUDOLPH: I agree with what Donna has said. The PBA initiative involves quite a bit of change for our profession and with any change comes resistance. A change to the processes that we currently use is going to be painful in the beginning, but I think there will be a lot of benefits in the long run and ultimately we'll be glad that we went through this change. We've convinced ourselves, I think, and rightfully so, that reserves and capital requirements under PBA will coincide now with the risk parameter of the products and the risk parameters of the company. I think it will be beneficial to no longer have to deal with new model regulations or interpretations of those regulations through actuarial guidelines. Another benefit might be that companies will become more practiced and consistent at monitoring their experience in order to report such experience to their statistical agent. Other benefits that aren't readily apparent and that might take a while to realize fully are the well defined feedback loops that are necessary for practical implementation of a PBA environment within a company. Experience studies on mortality are the obvious example, but lapse and other policy holder behavior elements will require a consistent feedback loop so that the actuary receives the data from the department that monitors the experience and then communicates how that experience impacts the statutory financials to the board of directors. The use of a central statistical agent will allow companies to benchmark their own experience against industry data. I think in the end, a side benefit will be that the companies will have a better sense of where they are in relation to their industry competitors. Participation in the data collection process is critical for the success of PBA. Another benefit will be that the board of directors must become more actively engaged and obligated to understand not only the assumptions used, but the whole PBA process and its implications for the company. As a result, the actuary will become more skilled in communicating variances from one reporting period to the next.
BOOT: I know this is still evolving. How do actuaries stay abreast of the developments in this area and what are the major hurdles to be on the look out for down the road?
CLAIRE: First, the Academy Web site has a PBA section: Actuary.org/risk.asp. Also the Academy sponsors a quarterly webcast to keep people abreast as to what's happening–mostly on the regulatory front. At this point, it's up to the regulators to come up with the laws/regulations to support PBA. In addition, as Hubert mentioned, there are periodic seminars. There are obviously a lot of things published by both the SOA and the Academy on this subject. It is very important that everybody gets involved sooner rather than later. The industry groups such as the ACLI are now taking a much more active role. It is very important for every company to figure out exactly what PBA means to them. We try to give them the opportunity in articles, in seminars, in webcasts, etc., to try to stay up on the subject.
MUELLER: I concur with what Donna said. I would add that, besides attending industry events like webcasts and seminars to stay abreast of developments, we would also encourage companies to start doing some calculations of what these new requirements would look like in their current and planned products, and start to incorporate those requirements as they price or re–price existing products, because clearly these requirements are coming. We are expecting that VA CARVM will be implemented this year. Hopefully the annuity and life capital models will be implemented next year and the reserve models will be rolled out starting in 2010. It is definitely not too early to investigate what the new requirements would look like for your existing products, and any planned or future products.
RUDOLPH: I would add to that by saying that it's also not too early to ask your valuation systems vendor what is in the works for PBA implementation. Vendors must stay abreast of these developments as well. The National Association of Insurance Commissioners (NAIC) subgroups' conference calls are open to the public. A list of these calls can be found on the NAIC Web site. All of these measures are ways to keep your finger on the pulse of the PBA developments.
BAHNA–NOLAN: The other three stole all my suggestions as far as ways to keep abreast of what is going on with respect to the development. The one other thing I would throw out there is to just get involved. We always need volunteers to help. There's still a lot of work that needs to be done and there's no better way to understand what's going on and to learn what really needs to be done than to be working on and helping to shape it. I will also throw out that it's never too early to start the communications with senior management and to try to give them an understanding of what PBA means from a systems capabilities and staffing perspective, and how PBA may elongate the time it takes to develop a product and get it to market. Senior management needs to have an understanding of the full impact of what PBA may mean.
BOOT: Thank you. I'm going to ask one final question, asking you to look in your crystal ball on this issue. I know there are changes to U.S. GAAP with an emphasis on fair value. The International Financial Reporting Standards are also gaining a lot of momentum. It could be an alternative for some companies. Do you ever see a world where all these accounting changes and approaches converge together?
CLAIRE: I think the PBA system that we're setting in place in the United States can accommodate that. The methodology and exactly how you report some things may be different in the future, but the basic concept that you're going to recognize and quantify the risk is the same in all the systems. I think eventually there can be convergence. Twenty years down the road the way we're modeling will be changed, because the advantage of this system is that it is stimulating actuarial theory, modeling and quantification techniques. I think we'll see major advantages to the actuarial profession because we're going to a system that is trying to measure the risks and the reserves and capital will be a part of everybody's risk management system.
MUELLER: The other thing we're seeing is the conversion within the International Accounting Standards. There is a very good chance that by the middle of this year, FASB will decide to join IFRS Phase II, which will eventually move the United States in line with about 150 other countries around the world in implementing fair value accounting standards for insurance liabilities by 2012. If that were to occur, that would certainly help to propel the whole issue of principle–based requirements to the forefront. Not only would fair value requirements apply to insurance accounting in general and would change some of the ways that liabilities are being accounted for today, but the principle–based requirements for capital and reserves would eventually help accelerate this development by providing a better recognition of the cost of embedded options included in insurance products. This has been recognized to be one of the major hurdles in implementing a fair value accounting system in the United States. Another action item is that companies will need to learn to deal with the ensuing reserve volatility, by improving their risk management capabilities, including the effectiveness of their hedging programs.
RUDOLPH: After listening to Hubert's answer, one wonders how the industry can all of a sudden jump into that paradigm. But I think what we've done is a step in that direction by having the standard valuation law, which points to the valuation manual. Partitioning the technical requirements into a document separate from the law allows U.S. statutory regulation to be flexible in regard to reshaping our U.S. practices to get those requirements or guidelines in line with IFRS and fair value accounting when the time is right.
BAHNA–NOLAN: Piggybacking on what Karen was saying, I think that there will be a time when we are all on the same standard. I do think that is awhile away. We need to walk before we can run, and U.S. companies are behind our international brethren with respect to reserving and capital and the way we're approaching it, so I think this is a great first step for us to get there. With globalization, I think that in time it will be required that we all be on the same standard. I think it will be very difficult to compete if we aren't all moving at least in the same direction.
BOOT: I want to thank you all for being part of the discussion on principle–based approach. You've really helped our readers see the future through this discussion and it sure seems like there's going to be a lot of important developments to continue to watch in this area.
Mike Boot, FSA, MAAA, FCA, can be reached at email@example.com; Donna Claire, FSA, MAAA, at CLAIRETHINKING@cs.com; Hubert Mueller, FSA, MAAA, CERA, at firstname.lastname@example.org; Karen Rudolph, FSA, MAAA, at email@example.com; and Mary Bahna–Nolan, FSA, MAAA, at firstname.lastname@example.org.