principles-based reserves and rbc · life practice council webcast january 12, 2006 2 definition of...

Life Practice Council Webcast January 12, 2006 1

Principles-Based Reserves and RBC

Webcast January 12, 2006Sponsored by the American Academy of Actuaries’

Life Practice Council

American Academy of Actuaries

Definition of Principles-based Reserves and RBC

A principles-based approach:

• Uses risk analysis and risk management techniques to quantify Risk

• Captures all of the material risks, benefits and guarantees of the contract/Company

• Permits the use of company-specific experience based on the availability of relevant experience and its degree of credibility

In contrast, a “rules-based” approach:

• Relies on a static formula that may not capture all of the risks of the contract.

• Uses prescribed valuation assumptions that are the same across all companies, regardless of differences in the risk profile of companies.

Definition of Principles-based Reserves and RBC

• Is consistent with the global trend toward Enterprise Risk Management

• Relies more on actuarial judgment

• Requires more sophisticated tools

• Requires that a strong regulatory governance process be in place

Key Observations of moving to a Principles-based approach

Presenters

• Donna Claire, Chair of the Risk Management and Financial Soundness Committee - Also known as the SVL2 Steering Committee

• Dave Neve, Co-Chair of the Life Reserves Work Group

• Tom Campbell, Chair of the Variable Annuities Reserve Work Group

• Larry Gorksi, Chair of the Academy’s Experience Committee and Vice Chair of the Life Capital Adequacy Subcommittee

Quarterly Webcast

• There are a number of initiatives currently being undertaken for the principles-based approach.

• In order to keep everyone informed as to these efforts, we have committed to a one hour webcast after each quarterly NAIC meeting.

• Format: Presentations, can type in questions

Website

• www.actuary.org/risk.asp• Gives overview of projects• Provides links to documents such as the

Life Capital Adequacy Report and the draft of model regulations

Why We Need This

• Current system is broken – we have been using band-aids as new products come out

• Reserves are too high for some products – too low on others

• Capital requirements and reserves need to take into account actual risks of products, company

Evolution

• Asset Adequacy Testing• Equity Indexed Annuity Regulation• C-3 Phase I

• C-3 Phase II• VARWG• LRWG• SVL2

New Principles-based Valuation Standard for Life

Products

David E. NeveCo-chair, Academy Life Reserves Work Group

Objectives of this Session

1. Provide background on LRWG2. Provide an overview of the new proposed

principles-based approach for life products.3. Summarize the key elements of the December

’05 draft that was exposed for comment by LHATF.

4. Review LRWG priorities and timeline for 2006

Background on LRWG

•• Part of the AcademyPart of the Academy’’s Principless Principles--based based initiativeinitiative

•• LRWG was organized in July, 2004LRWG was organized in July, 2004•• Have roughly 70 volunteers, with an active Have roughly 70 volunteers, with an active

core of 25core of 25--30. 30. •• Have formed 10 subgroups (where the real Have formed 10 subgroups (where the real

work gets done!)work gets done!)

LRWG Charge and Scope

• Charge: • Develop a proposal for a new Principles-based

statutory reserve method for life products• Coordinate with C3 Phase III work group (which is

working on RBC requirements for life products)• Scope:

• Initially, scope was limited to UL• Now, scope is all life products

LRWG Guiding Principles

•• Capture all significant risks underlying the productCapture all significant risks underlying the product•• If the company has some degree of control over the risk, If the company has some degree of control over the risk,

assumptions should reflect company experience, if credible.assumptions should reflect company experience, if credible.•• If the company has little or no control over the risk, prescribeIf the company has little or no control over the risk, prescribed d

assumptions will be used. assumptions will be used. •• For risks that are not stochastically modeled, assumptions shoulFor risks that are not stochastically modeled, assumptions should d

be based on be based on ““prudent best estimatesprudent best estimates”” that incorporate appropriate that incorporate appropriate margins for uncertainty. margins for uncertainty.

•• Assumptions will be allowed to change as expectations as to Assumptions will be allowed to change as expectations as to future experience and economic conditions change.future experience and economic conditions change.

Basic Framework ofProposed Approach

Basic Framework

Reserve = PV of future benefits and expenses (ex. FIT) less PV of future gross premiums

•• Reserve assumptions will be determined for all Reserve assumptions will be determined for all material risks (mortality, interest, expenses, lapse, material risks (mortality, interest, expenses, lapse, premium levels, etc.) premium levels, etc.)

•• Reserve assumptions will include a margin for adverse Reserve assumptions will include a margin for adverse deviation (not best estimates) deviation (not best estimates)

•• Discount rates will be preDiscount rates will be pre--taxtax

Basic Framework (cont)

Reported Reserve is the greater of:

1. A deterministic, seriatim, single scenario reserve calculation

2.2. A stochastically derived reserve (if A stochastically derived reserve (if needed) using a prescribed CTE levelneeded) using a prescribed CTE level

Since the Since the StochasticStochastic ReserveReserve is done in is done in the aggregate, risk offsets between the aggregate, risk offsets between contracts are recognized.contracts are recognized.

Deterministic Reserve:

• Uses a single set of assumptions that is aligned with economic reality, yet still provides an appropriate level of conservatism

• Is not designed to capture tail risk• Is subject to a cash surrender value floor on a

contract by contract basis

Stochastic Reserve: • Multiple scenarios will be defined to properly capture

the “tail risk” of the contract• Will use a CTE (conditional tail expectation) level that

is set by regulators, such as 65 CTE• Current thinking is that only interest rate movements

and equity returns will be modeled stochastically • May not be necessary if actuary can demonstrate that

the Deterministic Reserve adequately captures all risks

Challenges

•• Establishing assumption margins (on each Establishing assumption margins (on each assumption and in the aggregate)assumption and in the aggregate)

•• Difficulty of projecting future premium levels Difficulty of projecting future premium levels for UL for UL

•• Volatility due to updating valuation Volatility due to updating valuation assumptionsassumptions

•• Criteria to require Stochastic ReserveCriteria to require Stochastic Reserve•• Impact on taxes (tax deductibility & 7702 Impact on taxes (tax deductibility & 7702

issues) issues)

Key Elements of December ’05 Draft Exposed by LHATF

Form of Proposal Exposed for Comment by LHATF

• Model Regulation plus 3 Actuarial Guidelines• Model Reg outlines basic methodologies and

principles• Three Actuarial Guidelines provide more

details: 1. AG PBR – guidance on setting assumptions2. AG DIS – guidance on disclosure requirements3. AG MAR – guidance on margin requirements

• Presumes changes to SVL have been made, and governance process has been established.

Key Elements of Current Proposal

1. Mortality assumption:• Based on a blend of company experience and

industry experience• Credibility method for blending company

experience with industry experience is prescribed• Margin for uncertainty is then added to this

blended table (TBD by regulators).• Must use an NAIC approved valuation table that

best “maps” to this blended mortality curve. • Presumes a large number (10+) of approved

tables are available

2. Policyholder Behavior Assumptions:• Includes such things as lapses, withdrawals, premium

patterns and benefit utilization. • Will involve actuarial judgment -- guidelines and limits will be

determined by the regulators and/or ASOPs• Premium pattern for non-specified premium products is to be

based on actuary’s prudent best estimate, but impact of four sensitivity tests are required:– Minimum premium scenario – Non-payment of premium– Single premium– Level premiums

3. Method to determine Earned Rates and Discount Rates• Path of Earned Rates determined separately for

each Asset Segment • Earned Rates based on projected net investment

earnings, using returns from actual starting assets and modeled reinvestment assets

• Method to determine new money rates is prescribed • Earnings rates reflect appropriate provision for

default costs (TBD) and investment expenses• Discount rates are set equal to Earned Rates

Key Elements ofCurrent Proposal

4. For Stochastic Reserve, actuary can use a prescribed interest rate and equity return generator, or a company’s own generator if prescribed calibration standards are met

5. Full aggregation of policies is allowed for Stochastic Reserve

• But magnitude of risk offsets limited by Deterministic Reserve• Disclosure of the magnitude of the impact of aggregation is

required6. An Actuarial Memorandum is required which provides

documentation of all assumptions, methods, and results of sensitivity tests.

7. Treatment of Non-guaranteed elements• Can change over time to reflect changing conditions (as in real world)• Can reflect differences between valuation assumptions and the

assumptions underlying the current scale8. Other items:

• Treatment of Reinsurance• Aspects related to Separate Accounts• Treatment of revenue sharing in cash flow model• Modeling of hedges • Method to allocate Stochastic Reserve to individual policies• Stochastic Reserve exclusion • Quantification of aggregate margin from all assumptions

LRWG 2006 Prioritiesand Timeline

Key Future Developments

1. May need new ASOP for setting assumptions • LRWG will work with ASB to develop possible new ASOP(s)• Much of what is now in AG PBR may end up in new ASOP(s)

2. Specific assumption margins need to be developed:• LHATF will need to decide how margins will be established. • AG MAR gives a possible approach to define margin requirements • New ASOP could be used to provide guidance in setting margins • Could use a combination of prescribed requirements (defined in

AG MAR) and actuarial judgment (guidance provided by an ASOP)

• Pros and cons of alternative approaches will be provided in early 2006

Key Issues Needing Regulatory Attention

•• Establishing assumption marginsEstablishing assumption margins•• Changing the SVL to enable the PrinciplesChanging the SVL to enable the Principles--

based approach to be implemented by Model based approach to be implemented by Model Regulation and/or Actuarial Guidelines Regulation and/or Actuarial Guidelines

•• Developing and implementing an acceptable Developing and implementing an acceptable governance processgovernance process

•• Determining if new approach will be applied to Determining if new approach will be applied to inforceinforce contracts, or only applied prospectivelycontracts, or only applied prospectively. .

1. Will provide a list of pros and cons of various alternatives in early 2006

2. Possible alternatives:– Prospective only– Entire Inforce– Prospective only, plus AG38 products issued

after 7/1/05– Prospective only, plus all XXX products issued

after the effective date of XXX

Prospective Only versus Inforce

1. Work with LHATF to finalize methodology2. Work with LHATF to develop methods and/or

requirements to establish assumption margins3. Work with ASB to develop possible new ASOP(s) 4. Coordinate efforts with C-3 Phase III work group 5. Complete modeling of all major products6. Education and communication efforts

– Periodic webcasts to provide updates on proposal– LRWG Seminar (midyear)– Write a new Practice Note for life product reserves

LRWG 2006 Priorities

RecommendedTimeline and Deliverables

•• During 2006, LRWG assists LHATF in During 2006, LRWG assists LHATF in finalizing the details of the proposal finalizing the details of the proposal

•• During 2006, the LRWG assists the C3 Phase During 2006, the LRWG assists the C3 Phase III work group to finalize the RBC proposal. III work group to finalize the RBC proposal.

•• LHATF approves final draft of reserve LHATF approves final draft of reserve proposal at December 2006 LHATF meeting, proposal at December 2006 LHATF meeting, and sends to A Committee for approvaland sends to A Committee for approval

•• Begin stateBegin state--byby--state adoption in 2007. state adoption in 2007.

New Principles-based Valuation Standard for

Variable Annuities

Tom CampbellChair, Academy Variable Annuity Reserves

Work Group

Reserves for VA ProductsAG VACARVM

• LHATF has exposed 12/1/2005 version― www.naic.org/documents/committees_models0504_agvacr6.pdf

– Applies to contracts issued after 1980– Won’t be effective until at least 12/31/2006

• Key Changes from 4/29/2005 Exposure– Academy VARWG changes as of

8/10/2005– ACLI proposal for Standard ScenarioAcademy Work Group reports: www.actuary.org/life/phase2.asp

Changes Recommended by the Academy VARWG

• Consistency with RBC C-3 Phase II– Clarification on Principle 2– Reference to Academy C-3 Phase II report– Working Reserve for variable pay-outs– Use of Revenue Sharing in Alt Method– Clarification under Modeling of Hedges– Certification on Prudent Best Estimate

Exposed Revisions to the Standard Scenario

• Original Standard Scenario reserve– Proposed by LHATF/CADTF subgroup– Floor for modeled-based reserve– Seriatim Calculation– Concern with principles-based reserve– Tax basis?

• Original SS Expanded by NYSID– Two separate seriatim calculations– Additional seriatim AG 33 as a floor– Exposed in the 4/29/2005 version of AG

• Concerns raised– SS level vs. CTE level– Seriatim nature of SS– Mortality and other assumptions

• ACLI Proposal– Included in 12/1/2005 exposure– Intended to be temporary until peer review and

governance requirements are put into place– Form of proposal is a mark-up of the 4/29/2005

version of the SS• Expected to produce reserve closer to CTE reserve• Simplify calculation

• Modifications to the SS in the ACLI Proposal:– CSV floor applied at total contract reserve level rather

than at component level– Eliminate two of the three seriatim calculations– Change discount rate to SVL valuation rate– Allow use of explicit charges for guaranteed benefits– Simplify ITM-ness calculation– 70% of 1994 MGDB Table mortality (down from 80%)– Revise lapse and utilization assumptions– Approved hedge criteria in line with those allowed in

CTE calculation

Reserves for VA ProductsAG VACARVM

• Next Steps– Numerical examples for the Standard

Scenario– Consensus on form of Standard Scenario– Comments on 12/1/2005 exposure– Update effective date

• Could be as early as 12/31/2006

• Adoption in 2006?

Update to AG 39Reserves for VAGLBs

• Actuarial Guideline XXXIV– Adopted in 2002 as an interim approach– Placeholder until a new reserve basis based on

RBC C-3 Phase II is established– Three-year sunset (1/1/2006)

• December NAIC meeting– LHATF extended the sunset date to 1/1/2008

• Report of final changes:– www.naic.org/documents/committees_models_ag39-2.pdf

New Principles-Based Valuation Standard for Life Capital Adequacy;

Preferred Mortality Tables

Larry GorskiVice Chair, Academy Life Capital Adequacy

Subcommittee, Chair Experience Studies Subcommittee

Update on RBC C-3 Phase 2

• Instructions incorporating the AAA LCAS Recommendations, NAIC Standard Methodology and Smoothing/Transition Rules adopted by the NAIC with a 12/31/05 effective date

• Guidance provided in:– LR024 (Life RBC Instructions)– AAA Practice Note– NAIC CADTF Q&A document

Life Practice NoteC3 Phase II RBC and VACARVM Reserves

• Available on Academy website• http://www.actuary.org/pdf/practnotes/life_va05.pdf

• Topics:Details on products covered Acceptable practiceComparison of RBC and Reserve Types of models / granularityDetails on starting assets Details on scenariosDetails on modeling assumptions Details on Alt. MethodologyDetails on Standard Scenario Treatment of reinsuranceTreatment of hedging Consistency of Phase I and IICertification & documentation Peer reviewGlossary of additional terms

NAIC CADTF Q&A Document

• Officially adopted RBC Instructions (LR024) in need of clarification and correction.

• Issues identified through questions submitted to the NAIC prior to the December NAIC meeting

• Special session at the December NAIC meeting devoted to discussing questions

NAIC CADTF Q&A Document

• Team representing the regulators, the insurance industry and the AAA reviewed questions and developed responses

• Most questions dealt with Standard Scenario and the Smoothing/Transition Rules

• Q&A document can be found on the NAIC webpage ---http://www.naic.org/committees_e_capad_lrbc_c3_market.htm

Enhanced RBC C-3 Phase 2 Pre-packaged scenarios

• The new tool integrates the C-3 Phase 1 Interest Rate Generator into the production of money market, US Treasury and corporate bond fund pre-packaged scenarios.

• Parameters used in the interest rate generator have not been updated.

• New tool allows the user to use yield curves as of the run date to produce money market, US Treasury and corporate bond fund pre-packaged scenarios.

• Some control over the type and format of the output. • Can’t be used until adopted by the LCAS.• Consult AAA webpage for information concerning status

Other Related Activities

• NAIC CADTF Results Subgroup– Purpose -- “evaluate the overall effectiveness of

the C3P2 methodology” by conducting an in-depth analysis”

– Industry Survey (High Level questions)– In-depth analysis of the modeling assumptions,

processes and results for a sample of insurers– More information can be found at

http://www.naic.org/documents/committees_e_capad_winter05_materials.pdf

Preferred Mortality Project

• Reasons for project– An essential element of a principles-based

reserving system– Output from project may be useful as

valuation tables under the traditional, rule-based reserving

– Produce experience tables of greater utility to company actuaries

Project Oversight

• AAA-SOA Preferred Mortality Project Oversight Group (“POG”).

• The POG oversees the teams responsible for completing assigned tasks and project funding.

• POG members represent different stakeholders– SOA (2)– AAA (2)– Regulators (2)– Insurance Industry (ACLI, NALC, ALIA)

• Project tasks assigned to 6 teams.

POG Teams

• Data Validation• Underwriting Criteria • Experience Analysis• Valuation Basic Tables• Implementation• Valuation Tables

POG Teams

• Team members were selected to ensure overlap between adjacent tasks.

• Team members were selected to ensure continuity with the development of the 2001 CSO Tables.

• Team members were selected to ensure coordination with AAA Principles-based Reserve project.

Key to Project Success

• Communication, Communication, Communication– The POG meets via conference call on a

weekly basis.– The Team leaders meet via conference call

on bi-weekly basis.– Dialogue with AAA LRWG

Deliverables

• Valuation Basic Tables and Valuation Tables submitted to the NAIC – March 2007

• Infrastructure for future preferred mortality tables

Challenges

• Develop the number of valuation basic tables (without margins) and valuation tables (with margins) expected by the AAA LRWG– Lack of data for later policy duration in the select

period– Tables for a sufficient number of underwriting

classes– Persistence of the relationship between underwriting

class mortality

Status

• All 6 teams are operational• Data Validation Team

– 46 out of an expected 50 submissions received– 41 submissions reviewed at File Validation Level– Next step is Data Validation

• Underwriting Criteria (“UC”)– UC will be requested in the near future– UC scoring algorithm defined

Status

• Experience Analysis Team– Developing framework for analyzing experience

after being mapped to UC score intervals • Valuation Basic Tables Team

– Identifying information and data needed to extend number of experience tables to number of tables desired by the AAA Life Reserves Work Group.

Status

• Implementation Team– Task is to develop recommended regulation or

actuarial guideline that sanctions the use of the tables and provides rules for the use of the tables.

– Work has started.• Valuation Team

– Last team formed. Researching margins in the 2001 CSO Tables.

QUESTIONS?

Life Practice CouncilAmerican Academy of Actuaries

1100 17th Street NW 7th Floor

Washington, DC 20036202-223-8196

www.actuary.org

Principles-Based Reserves and RBC

Webcast January 12, 2006Sponsored by the American Academy of Actuaries’

Life Practice Council

American Academy of Actuaries

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