Principle-Based Reserves Doug Van Dam, FSA, MAAA PolySystems, Inc

1. Principle-Based ReservesDoug Van Dam, FSA, MAAAPolySystems, Inc

2. Presentation Outline • PBR – Statutory (40 minutes) • Background • Impact • Key Dates • Calculations • Company Planning • Still in Progress • The other PBR – GAAP (10 minutes) • Q&A

3. Background

4. GOAL of PBR - Statutory “Right-size” reserves based on the risk in the product Some products don’t fit well in the current static valuation methods Reserves will reflect current and anticipated future economic conditions On the other hand, regulators want a conservative minimum reserve ACLI and companies are concerned about impact on tax reserves

5. Three pieces to PBR Revised Standard Valuation Law Revised Standard Non-forfeiture Law Valuation Manual

6. Goals of Valuation Manual Consolidate in one document PBR and non-principle-based valuation requirements Promote uniformity among states Efficient, consistent, and timely updates Phase-in changes Mandate experience reporting Enhance industry compliance

7. Valuation Manual • Introduction • Reserve Requirements • Actuarial Opinion and Report Requirements • Experience Reporting Requirements • Valuation Manual Minimum Standards • VM-01 Definitions for Terms in Requirements VM-01 • VM-02 Minimum Nonforfeiture Mortality and Interest VM-02 • VM-05 NAIC Model Standard Valuation Law VM-05 • VM-20 Requirements for Principle-Based Reserves for Life Products VM-20 • VM-21 Requirements for Principle-Based Reserves for Variable Annuities VM-21 • VM-25 Health Insurance Reserves Minimum Reserve Requirements VM-25 • VM-26 Credit Life and Disability Reserve Requirements VM-26 • VM-30 Actuarial Opinion and Memorandum Requirements VM-30 • VM-31 Reporting and Documentation Requirements for Business Subject to a Principle VM-31 • VM-50 Experience Reporting Requirements VM-50 • VM-51 Experience Reporting Formats VM-51 • VM-Appendix A Requirements VM-A • VM-Appendix C Actuarial Guidelines VM-C • VM-Appendix G Corporate Governance Requirements for Principle-Based Reserves VM-G • VM-Appendix M Mortality Tables

8. Impact and Key Dates

9. Impact on Reserves • Analysis by Towers Watson demonstrated • Term life reserves decreased 38 to 64% • The range for Universal Life with Secondary Guarantees (ULSG), depending on how companies had previously reserved, was from an increase of 63% to a decrease of 44% • Other life reserves, (e.g., whole life) were unchanged • Non-VM 20 not affected

10. Key Dates • AG 38 • NAIC’s Exec. Committee and Plenary voted on 9/12/12 to adopt revisions to AG 38 that will require some companies to calculate and report a modified version of VM 20’s Deterministic Reserve this year-end • Valuation Manual • Adopted by NAIC 12/2/2012 • AZ was first to adopt, 9 other jurisdictions working it into 2013 legislative sessions. Could be effective as early as 1/1/2015, more likely to be 1/1/2016 or later • Requires 42 of 56 jurisdictions and > 75% of direct premium, then starts following January 1 • PBR affects only new business • Transition – PBR not required until three years after effective date • Experience reporting effective with the date of the VM, but who and what are TBD

11. New York • NY is not entirely on board yet with current document. NY issues include: • Actuarial: Seriatim DR for auditing; level of conservatism in mortality, asset credit quality, post level term period profits, prefers focusing efforts on best estimate assumptions rather than margins. • Superintendent: PBR in banking didn’t work; reserves decrease  insolvency increases; unclear prices will decrease; regulators ill equipped; not sure PBR is the answer; at least wants 3 years of parallel testing.

12. Calculations

13. Exclusion Tests for a Block of Business • Determine and group in-scope policies • Calculate Stochastic Exclusion Test (SET) • Fail SET, then calculate all 3 reserve basis (Net Premium, Deterministic, and Stochastic) • Pass SET, then calculate Deterministic Test • Fail Deterministic Test, calculate Deterministic and Net Premium Reserves • Pass Deterministic and Stochastic Test, then calculate only Net Premium Reserves • EXCEPT, adjusted Deterministic Reserves need to be calculated to do Stochastic Exclusion Ratio Test

14. Stochastic Exclusion Ratio Test • Requires calculating adjusted deterministic reserves (no margins) under 16 interest and equity scenarios • If changes to interest and equity rates don’t materially change the deterministic reserve, then the deterministic reserve adequately covers all the risks and you don’t have to calculate the stochastic reserve • Test statistic = Largest Adjusted Deterministic Reserve minus Baseline Adjusted Deterministic Reserve divided by PVBEN • Must be less than 4.5% to pass • Adjusted for reins by subtracting ceded benefits

15. Alternative SET Demonstrate that the stochastic reserve is less than the max of Deterministic and Net Premium Reserves Show that main risks which would cause the Stochastic Reserve to “win” have been removed Use your cash flow testing model to show asset adequacy A qualitative risk assessment concludes that the group of policies does not have material interest rate risk or asset return volatility Demonstrations must be within 12 months prior to valuation date

16. The Deterministic Reserve Exclusion Test Pass if the sum of guaranteed gross premiums is greater than the sum of valuation net premiums Universal life with secondary guarantees must calculate the Deterministic Reserve

17. The Net Premium Reserve • Formulaic • Seriatim • CSV floor for each contract • Prescribed assumptions • Net premiums now include an expense and lapse component • New seriatim CRVM-like calcs for Term and ULSG • Defaults back to CRVM for other products

18. PBR Assumptions and Margins • Prescribed Assumptions – Deterministic assumptions used for risks where companies have little control over the outcome (e.g., bond defaults) • Stochastically Modeled Assumptions – Used for risks that are more properly modeled through a stochastic process, i.e., interest rates and equity returns. • Prudent Estimate Assumptions – Used where companies have influence on the outcome of the risk factor • Equals the actuary’s best estimate of the future (anticipated experience) plus a margin for adverse deviation and estimation error • Margins reflect the degree of uncertainty in the anticipated experience assumption and provide an element of conservatism. • They must be reviewed periodically and updated as appropriate.

19. The Deterministic Reserve • Gross Premium Valuation • Expenses exclude FIT and fraternal benefits in lieu of FIT • Net of reinsurance • Discount rate equals net investment earnings divided by invested assets • Investment income + capital G/L – default costs – investment expenses • Use of compression is currently being debated

20. The Stochastic Reserve CTE 70 of greatest present value of accumulated deficiencies, captures tail risk. Calculated in the aggregate, allowing for risk offsets (although still floored at NPR and DR). Requires ALM model. Actuary is supposed to set up additional amount to capture material risk not captured elsewhere. Compression allowed.

21. Company Planning

22. PBR Requires More Governance • Flexibility in assumptions, methods, and models means new obligations to appropriately govern the process (VM-G). • Board must review summary results and process documentation and determine what additional actions, if any, are needed to rely on company’s PBR processes. • PBR assumptions, methods and models must be consistent with other company risk processes. • Must certify effectiveness of internal controls with respect to PBR valuations. • Management provides information to the board, reviews results, adopts necessary internal controls, ensures adequate and competent resources, and functioning PBR processes. • Qualified actuary reviews/approves assumptions, methods and models, oversees calculation, and provides summary report to management and board. • Appointed actuary provides annual statement of actuarial opinion on adequacy of all reserves, PBR and formulaic.

23. Resources • Resources: • VM 20 document (and related amendments, letters, etc.) • Draft ASOP, Standards for Principle-Based Reserves for Life Products • AAA Practice Note • SOA Practitioner’s Guide • Webinars, seminars, conferences • SOA Research Study: “A Survey of Actuarial Modeling Controls in the Context of a Model-Based Valuation Framework” • Even with the right expertise, expect difficulties during implementation.

24. Setting Assumptions and Margins • Importance of experience studies. • Your experience studies, not regulatory prescription, will be the basis of key valuation assumptions. • Evaluate the state of your experience studies (frequency, quality, documentation). • Affects assumptions as well as margins. • VM 20 mortality is particularly difficult. • High amount of prescription. • Prescribed method has been revised. • ULSG lapses. • Relatively little guidance on margins. • Each non-prescribed assumption requires its own margin; correlation offsets allowed. • Still some contention on exactly how to handle. • Start with a simple approach since rules/guidance may change and industry practice is still evolving.

25. Dealing with Volatility in Results • How do you become comfortable results are correct? • With PBR comes volatility (if not holding NPR). • Can’t materially reduce volatility. • Valuation actuaries often focus on producing results that pass a quick reasonableness check. • Will need to be spend much more time understanding results and being able to quantify and explain changes. • But can use tools to help manage and communicate volatility. • Sensitivity analysis. • Attribution analysis – requires good assumption set management and version control. • Leverage hardware and automation – reduces runtime and leaves more time for analysis.

26. Documenting and Reporting External VM 20 documentation requirements are substantial and still not well understood. Internal documentation is just as important as external. Document process and report on results. Automate via production reports. Will likely need new reports for VM 20, but leverage existing reports where possible. Good version control is key.

27. Still in progress

28. NAIC Groups • Life Actuarial Task Force (reports to Life Insurance and Annuities (A) committee). • Aggregate Margin subgroup – e.g., 85th percentile on interest, mortality, withdrawals and expenses may correspond to significantly higher percentile when combined. • Experience Reporting (VM 51) subgroup. • VM PBR Process & Coordination subgroup (considering changes to annual statement blanks). • PBR Implementation Task Force (reports to Executive (EX) committee). • Develop, maintain, and oversee Implementation Plan. • Draft plan available on NAIC website (more detail to come). • Conducted March 2013 survey of state regulators (40/56 replied) – conclusion is that PBR may not cause as much strain on state insurance department resources as some have thought. • State vs. centralized audit/review. • Create legislative educational package to assist states in adoption efforts (AAA also creating its own companion package). • Solutions for captives and SPV within PBR.

29. NAIC Groups (Cont) • Financial Analysis Working Group (reports to Financial Condition (E) committee) • Goals is to create level playing field across states by doing independent review and issue report to non-domestic states (hired two actuarial consulting firms to assist with 8D and 8E review). • Emerging Accounting Issues Working Group (reports to Accounting Practices and Procedures Task Force of the Financial Condition (E) committee). • Responds to questions of application, interpretation and clarification that are generally narrow in scope. • Answered 20+ questions on 8D, 10+ on 8E (many questions on AOM).

30. AAA and ACLI • Life Reserves Work Group recently submitted amendment forms: • Clarification to the approach in VM 20 to model policy loan cash flows in the deterministic reserve and stochastic reserve calculations (simplification). • Alternate approach to calculate the deterministic reserve called the Direct Iteration Method (easier way to calculated starting assets). • Modification to the treatment of the IMR in the deterministic reserve (simplification). • PBR Strategy Subgroup – Working on companion brief to NAIC’s legislative brief for state legislators. • PBR Impact Task Force – Working on an appropriate response to the question received from many legislators regarding the expected dollar impact of PBR on total industry reserves. • PBR Practice Note Work Group. • ACLI Issues: • Net premium reserves; • Aggregate margins; • Mortality assumptions; • (Re)investment assumptions; • Starting assets and low interest rate environment.

31. The Other PBR – New GAAP

32. FASB/IASB Insurance Project Objectives • Reduce diversity of accounting practices that currently exist for insurance contracts • Align insurance accounting with other business sectors, where possible • Increase users’ understanding of insurance financial statements • Help investors make decisions • IASB has worked on an insurance standard for 14 years

33. Estimated Timeline • New IFRS ED for Insurance Contracts June 2013 • This will be an Exposure Draft but they are only asking for comments on five areas: • Presentation of premium • Unlocking residual margin • Changes in discount rate go through OCI • Transition requirements • Participating contract mirroring • FASB Exposure Draft for Insurance Contracts expected July 2013 • Final standards adopted in 2014; effective in 2018

34. Big Bang All of your in force Every company Will rely on well controlled valuation process that can assist in explaining period to period movement Depending on the business it may or may not include stochastic projections

35. Overview of Exposure Draft Principles-based approach with additional guidance Reflects the economics of insurance contracts Based on insurance contracts, not insurance companies

36. Goals of Exposure Draft • A measurement model that focuses on the drivers of profitability and uses current estimates of cash flows • Presentation of information about insurance contracts that reflects the changes in those drivers • Consistent accounting for embedded options and guarantees in insurance contracts • Consistency with market inputs, such as interest rates • A coherent framework for dealing with complex and future insurance contracts

37. Building Blocks • Current estimate of future cash flows • Time value of money • IFRS - Risk adjustment • IFRS - Residual margin • FASB – Single Margin

38. Current Estimate of Future Cash Flows • Current, use all relevant information • Unbiased • Explicit • Probability weighted • Expected value (mean), not “best estimate” • Number of scenarios depend on product • Exclude non-performance risk for insurer but may include non-performance risk for ceded reinsurance

39. Time Value of Money • Consistent with current observable market prices • Exclude factors not present in the insurance liability • Independent of assets held unless obligation is a direct function of a set of assets • Do not consider non-performance risk of insurer • Guidance in ED is risk free plus adjustment for illiquidity (bottom up) • IASB and FASB will now allow top down • Any discounting would be a change for P&C

40. IASB – Risk Adjustment • Compensation the insurer requires for bearing the uncertainty inherent in cash flows that arise as the insurer fulfills the insurance contract • Designed to take into account that insurers/investors have a preference for an expected cash flow of 10 with a standard deviation of 1 versus an expected cash flow of 10 with an standard deviation of 12 • Re-measured at each period • Not a PAD

41. IASB – Residual Margin Residual Margin is the plug so that there is no profit at issue Residual Margin is re-measured for changes in future assumptions. Current year experience flows through income statement

42. FASB – Single Margin Similar to IASB Residual Margin – it is the plug so that there is no profit at issue. The FASB is not in favor of running experience changes through the margin.

43. Transition • Measure the present value of fulfillment cash flows using current estimates • Derecognize current DAC balances • Determine the single or residual margin: • Through retrospective application of new principles to all prior periods where it is practical to do so • For earlier periods where the retrospective application is not practical, estimate the margin • Determine the discount rate for a minimum of 3 years • Use difference from a reference rate for prior periods if necessary

44. Questions?