At least 10 insurers are participating in a pilot programme on principles-based reserving, as the regulation edges closer to a 2017 launch
The size of reserves is in all places a bone of contention to insurers and regulators.
Disagreements run deep in the US, where the overly prudent formulaic approach prescribed to calculate the amount of capital insurers hold against future claims dates back to the time of the Civil War, in the mid-19th century.
The level of required reserves for some life and universal life policies is so much higher than what actuaries deem sensible that, to the despair of regulators, more and more insurers have been using affiliated captives – branded shadow insurers – to finance the redundant part of the reserves.
Discussions and technical work on how to fix the system have been going on for more than a decade, but accelerated in the aftermath of the financial crisis and today are close to bearing fruit. A new method to calculate reserves, the so-called principles-based reserving (PBR), could come into force as early as 1 January 2017, and is expected to usher in a period of rapid transformation of insurers' risk management and product design strategies.
"[The pilot project] should help insurers to iron out issues in the back-end, in particular it will help them with the actual filling out of the [reporting] templates."
With a go-live date in sight, both regulators and insurers are stepping up preparation efforts. "There is relatively little time to prepare for this regulation, and a new phase of work must begin now," says Kim Steiner, senior consultant at Willis Towers Watson, in Connecticut.
The objective of PBR is to 'right size' the amount of required reserves through tailored calculations. The one-size-fits-all formulas and assumptions currently in use are blind to economic fluctuations and fail to capture the real risks in most innovative products.
In contrast, PBR will allow insurers to rely on their own experience – for instance, regarding the behaviour of policyholders in products that allow flexibility to pay premiums and withdraw savings – as well as to account for economic conditions, such as changes in interest rates.
"Like Solvency II in Europe, PBR will offer flexibility while requiring the necessary safeguards," says Howard Mills, global insurance regulatory leader at constancy Deloitte.
Three states to go
The legislative text that introduces PBR is the revised Standard Valuation Law, adopted in 2009 by the National Association of Insurance Commissioners (NAIC). Being a model law, it will become a national standard after 42 states with a combined life insurance premium of at least 75% of the nationwide total bring valuation manuals in line with it.
State adoption was slow at first, and the process came under threat after New York came out against it. But at the end of 2015, 39 states representing 71% of aggregate premiums, had already enacted legislation.
While the figures are unchanged since then, nine states are expected to consider legislation this year. Industry representatives have expressed confidence that the threshold will be crossed before the end of June, which is necessary for PBR to come into force in January 2017. If not, the expectation is that this will happen in 2018. An update on the status of ratifications is expected during the spring meeting of the NAIC, on 3 to 6 April, in New Orleans.
Pilot programme
The demise of captives?
An indirect effect of the introduction of PBR is the reduced attractiveness of captives. Yet experts are reluctant to pronounce their death. "I would be surprised if the captive market would simply go away. PBR still has some margins above the economic reserves, therefore there might still be enough redundancy to make captives relevant for insurers," says Kim Steiner, senior consultant, Americas Life Practice at Willis Towers Watson, in Connecticut.
In the meantime, preparatory work is under way. At present, all eyes are set on the pilot programme launched by the NAIC in February. At least 10 unnamed companies are participating in the exercise, in which they were given the chance to choose which products to test, and whether to do so on single or multiple years.
There have been several impact studies on PBR that gauged the change in the amount of reserves and highlighted areas of the regulations that are hard to interpret. The pilot project is the final step in this direction. Willis Towers Watson's Steiner says the focus will be on practical elements of implementation plans, such as the reporting and control mechanisms in place. "This should help insurers to iron out issues in the back-end, in particular it will help them with the actual filling out of the [reporting] templates."
Training programmes, involving the board for instance, will also be discussed to a great extent, Mills predicts, noting that PBR will require some investment from firms in this particular area.
If past experience is anything to go by, not only will the NAIC provide its feedback to the participants, but it will also share its conclusions with the rest of the industry, to promote best practices.
Uneven relief
Impact studies have shown that the introduction of PBR will bring the aggregate level of insurers' reserves down, but this reduction will not materialise across the board.
Insurers will take material relief on term life portfolios. Universal life products with secondary guarantees (ULSG) are also poised to benefit from the regulatory overhaul, but the results in this case point to significant variations.
The reduction can have implications for product design, but more importantly on pricing and competition. In this respect, it is worth distinguishing between large players, which already do financing transactions to take reserve relief, from other market players, who lack the scale to do so.
"PBR will make mid-sized players more competitive, because they will effectively see their reserve requirements come down. The impact on large players might be nil if they already finance away their redundant reserves," Steiner says.
Phasing-in
Despite the focus on the 1 January date, the shift to PBR won't happen overnight. Legacy business is effectively excluded from the new regime, which means that firms will be made to calculate reserves under two different systems for a long time.
In addition, there is a three-year phase-in period during which insurers can bring in the new approach to reserve calculation. The decision on when to take the leap will depend on the level of preparation of firms.
A survey by the Society of Actuaries conducted in 2014 found that few insurers considered themselves fully prepared, singling out training and systems as priority areas. While the situation has evolved since then, there are still major gaps in preparation, Steiner explains.
"On one end of the spectrum, there are firms that have already built in the functionalities, have set their assumptions and are checking how their products look like under PBR. The question for them is whether to apply it from day 1," she says.
"On the other end of the spectrum, there are firms that only now are starting to look at the regulations and consider the work they need to do."
Coping with holdouts
While the NAIC is hoping to achieve universal adoption, there is a risk that some states hold out. The most prominent case is New York, originally a backer of PBR, which in 2014 introduced an alternative formulaic approach that allows for a reduction of life reserves, but without giving insurers discretion over the calculations.
It remains to be seen whether the state can come round, but as things stand insurers would be forced to split their business. "If New York becomes a holdout, insurers will have to have a New York subsidiary, to which they apply the old formulaic approach to calculate their reserves," according to Howard Mills, global insurance regulatory leader at consultancy Deloitte.
However, this may not always represent a huge burden, as New York is already a special case regarding many regulations and most insurers that write business there already do it through a subsidiary.