Principles-based Principles-based Reserves and RBCReserves and RBC

Iowa Actuaries Club Iowa Actuaries Club February 28, 2006February 28, 2006

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

Objectives of this SessionObjectives of this Session

1. Define “Principles-based” 1. Define “Principles-based”

2. Discuss Academy’s Principles-based initiative (PBA)2. Discuss Academy’s Principles-based initiative (PBA)

3. Provide Summary and Update of PBA to Life 3. Provide Summary and Update of PBA to Life ProductsProducts

4. Briefly Summarize ACLI’s “Interim Solution”4. Briefly Summarize ACLI’s “Interim Solution”

5. Briefly Describe work underway to develop new 5. Briefly Describe work underway to develop new mortality tables. mortality tables.

Definition of Principles-basedDefinition of Principles-based

1. Captures all of the material financial risks, 1. Captures all of the material financial risks, benefits, and guarantees associated with the benefits, and guarantees associated with the contracts, including the ‘tail risk’ and the funding contracts, including the ‘tail risk’ and the funding of the risks.of the risks.

2. Utilizes risk analysis and risk management 2. Utilizes risk analysis and risk management techniques to quantify the risks. This may include techniques to quantify the risks. This may include stochastic models or other means of analysis that stochastic models or other means of analysis that properly reflect the risks of the underlying properly reflect the risks of the underlying contracts.contracts.

Definition of Principles-basedDefinition of Principles-based

3. Incorporates assumptions and methods that are 3. Incorporates assumptions and methods that are consistent with, but not necessarily identical to, consistent with, but not necessarily identical to, those utilized within the company’s overall risk those utilized within the company’s overall risk assessment process.assessment process.

4. Permits the use of company experience to establish 4. Permits the use of company experience to establish assumptions for risks over which the company has assumptions for risks over which the company has some degree of control or influence. some degree of control or influence.

5. Provides for the use of assumptions set on a prudent 5. Provides for the use of assumptions set on a prudent best estimate basis that contain an appropriate level best estimate basis that contain an appropriate level of conservatism when viewed in the aggregate.of conservatism when viewed in the aggregate.

In contrast, a “rules-based” approach:In contrast, a “rules-based” approach:

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

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

Definition of Principles-basedDefinition of Principles-based

1. Is consistent with the global trend toward 1. Is consistent with the global trend toward Enterprise Risk Management Enterprise Risk Management

2. Relies more on actuarial judgment2. Relies more on actuarial judgment

3. Requires more sophisticated tools3. Requires more sophisticated tools

4. Requires that a stronger regulatory governance 4. Requires that a stronger regulatory governance process be in place, including independent review process be in place, including independent review

Observations of moving to a Observations of moving to a Principles-based approach (PBA)Principles-based approach (PBA)

Why Do We Need PBR?Why Do We Need PBR?

1. Current valuation system is broken – we have Current valuation system is broken – we have been using band-aids as new products come outbeen using band-aids as new products come out

2. Reserves are too high for some products – too 2. Reserves are too high for some products – too low on otherslow on others

3. Capital requirements and reserves need to take 3. Capital requirements and reserves need to take into account actual risks of products and into account actual risks of products and company company

EvolutionEvolution

Asset Adequacy TestingAsset Adequacy Testing

Equity Indexed Annuity RegulationEquity Indexed Annuity Regulation

C-3 Phase IC-3 Phase I

C-3 Phase IIC-3 Phase II

Academy’s Principles-based InitiativeAcademy’s Principles-based Initiative

Governance Issues and Overall direction:Governance Issues and Overall direction:

SVL II Work Group SVL II Work Group

Reserve work groupsReserve work groups::

Variable Annuities: VACARVMVariable Annuities: VACARVM

Life Products: LRWGLife Products: LRWG

Other Annuities: ARWGOther Annuities: ARWG

Coming soon: LTCComing soon: LTC

RBC work groups: RBC work groups:

Fixed Annuities: C3 Phase IFixed Annuities: C3 Phase I

Variable Annuities: C3 Phase IIVariable Annuities: C3 Phase II

Life Products: C3 Phase IIILife Products: C3 Phase III

Educational OpportunitiesEducational Opportunities

1. 1. Webcasts:Webcasts: Academy has committed to a one Academy has committed to a one hour webcast after each quarterly NAIC hour webcast after each quarterly NAIC meeting. Format: presentations, ask questions.meeting. Format: presentations, ask questions.

2. 2. Academy websiteAcademy website: : www.actuary.org/risk.asp– Gives overview of projectsGives overview of projects– Provides links to documents SeminarsProvides links to documents Seminars

3. SeminarsSeminars

Life Reserve Work GroupLife Reserve Work Group

Overview and Update Overview and Update

LRWG Charge and ScopeLRWG Charge and Scope

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

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

working on RBC requirements for life products)working on RBC requirements for life products)

Scope: Scope: Initially, scope was limited to ULInitially, scope was limited to UL Now, scope is all life productsNow, scope is all life products

Basic FrameworkBasic FrameworkBased on Gross Premium Reserve (GPR)Based on Gross Premium Reserve (GPR)::

Reserve = PV of future benefits and expense Reserve = PV of future benefits and expense (excluding FIT) less PV of future gross premiums(excluding 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, material risks (mortality, interest, expenses,

lapse, premium levels, etc.)lapse, premium levels, etc.) Reserve assumptions will include a margin for Reserve assumptions will include a margin for

adverse deviation (not best estimates)adverse deviation (not best estimates) Discount rates will be pre-taxDiscount rates will be pre-tax

Basic Framework (cont) Basic Framework (cont) Reserve is the greater of:Reserve is the greater of:

1.1. A deterministic, seriatim, single A deterministic, seriatim, single scenario reserve calculationscenario reserve calculation

2. A stochastically derived reserve (if needed) 2. A stochastically derived reserve (if needed) using a prescribed CTE level using a prescribed CTE level

Since the stochastic reserve is done in the Since the stochastic reserve is done in the aggregate, risk offsets between contracts are aggregate, risk offsets between contracts are recognized (but limited).recognized (but limited).

Basic Framework (cont)Basic Framework (cont)Deterministic ReserveDeterministic Reserve: :

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

Is not designed to capture tail riskIs not designed to capture tail risk

Is subject to a cash surrender value floor on a Is subject to a cash surrender value floor on a contract by contract basiscontract by contract basis

Basic Framework (cont)Basic Framework (cont)

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

the “tail risk” of the contract (risks that have high the “tail risk” of the contract (risks that have high impact, but low probability)impact, but low probability)

Will use a CTE (conditional tail expectation) level that Will use a CTE (conditional tail expectation) level that

is set by regulators, such as 65 CTEis set by regulators, such as 65 CTE

Current thinking is that only interest rate movements Current thinking is that only interest rate movements will be modeled stochasticallywill be modeled stochastically

Basic Framework (cont) Basic Framework (cont)

““Prudent Best Estimate” AssumptionsPrudent Best Estimate” Assumptions

Assumptions will be based on “prudent best estimates” Assumptions will be based on “prudent best estimates” that include a provision for adverse deviationthat include a provision for adverse deviation

Definition: Conservative end of actuaries best estimate Definition: Conservative end of actuaries best estimate confidence intervalconfidence interval

Since actuarial judgment is involved, will need to set Since actuarial judgment is involved, will need to set limits and controls on setting assumptionslimits and controls on setting assumptions

Basic Framework (cont) Basic Framework (cont)

Asset Model Needed to Project Cash FlowsAsset Model Needed to Project Cash Flows

Needed for both Deterministic and Stochastic ReserveNeeded for both Deterministic and Stochastic Reserve

Asset Model is used to determine:Asset Model is used to determine: Discount rates for GPRDiscount rates for GPR Earned rates for surrender benefitsEarned rates for surrender benefits

Discount rates for GPR calculation:Discount rates for GPR calculation: Based on projected portfolio rates in each year Based on projected portfolio rates in each year New money treasury rates will be prescribed for New money treasury rates will be prescribed for

Deterministic Reserve; modeled for Stochastic Deterministic Reserve; modeled for Stochastic

Principles-based versus Asset Adequacy AnalysisPrinciples-based versus Asset Adequacy Analysis

Both involve more actuarial judgment than current Both involve more actuarial judgment than current “rules-based” valuation approach “rules-based” valuation approach

Asset adequacy analysis has few limits and Asset adequacy analysis has few limits and controls; actuary has a high degree of controls; actuary has a high degree of discretion in discretion in setting assumptions setting assumptions

In contrast, the Principles-based approach will have In contrast, the Principles-based approach will have controls, caps and limits placed controls, caps and limits placed throughout the throughout the

frameworkframework

Basic Framework (cont)Basic Framework (cont)

ChallengesChallenges

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

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

Criteria to require Stochastic ReserveCriteria to require Stochastic Reserve

Treatment of non-guaranteed elementsTreatment of non-guaranteed elements

Impact on taxes (tax deductibility & 7702 issues) Impact on taxes (tax deductibility & 7702 issues)

Major Issues Under Discussion Major Issues Under Discussion

Discount Rate Discount Rate Including Federal Income Taxes Including Federal Income Taxes

Allowing full aggregationAllowing full aggregation

Gross Premium Valuation vs. PV of greatest Gross Premium Valuation vs. PV of greatest accumulated deficiency (VACARVM approach)accumulated deficiency (VACARVM approach)

Stochastic Reserve exclusion Stochastic Reserve exclusion

Small Company concernsSmall Company concerns

Timeline and DeliverablesTimeline and Deliverables

LHATF exposed the proposal for comment at the LHATF exposed the proposal for comment at the December 1, 2005 LHATF Winter meeting.December 1, 2005 LHATF Winter meeting.

During 2006, LRWG will assist LHATF in finalizing During 2006, LRWG will assist LHATF in finalizing the details of the proposal (and will assist the C3 the details of the proposal (and will assist the C3 Phase III work group to finalize the RBC proposal). Phase III work group to finalize the RBC proposal).

Goal is for LHATF to approve final draft of reserve Goal is for LHATF to approve final draft of reserve proposal at December 2006 LHATF meeting, and proposal at December 2006 LHATF meeting, and sends to A Committee for approvalsends to A Committee for approval

Begin state-by-state adoption in 2007. Begin state-by-state adoption in 2007.

Key Issues Needing Regulatory AttentionKey Issues Needing Regulatory Attention

Development and implementation of an acceptable Development and implementation of an acceptable governance process governance process

Make changes to SVL that enable the Principles-Make changes to SVL that 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

Determine specific limits and controls on reserve Determine specific limits and controls on reserve assumptions and marginsassumptions and margins

Decide if new approach will be applied to inforce Decide if new approach will be applied to inforce contracts, or only applied prospectively. contracts, or only applied prospectively.

Determining Determining Assumption MarginsAssumption Margins

Considerations for setting assumption Considerations for setting assumption margins under a principles-based systemmargins under a principles-based system

1. This is a major issue!1. This is a major issue!

2. Regulators need to determine the balance between prescribed 2. Regulators need to determine the balance between prescribed

standards and actuarial judgment.standards and actuarial judgment.

3. The LRWG believes there are several reasons why different 3. The LRWG believes there are several reasons why different

margins are justified compared to current formulaic approachmargins are justified compared to current formulaic approach

4. The LRWG has developed a tool that provides a quantitative 4. The LRWG has developed a tool that provides a quantitative

comparison of the aggregate impact of all assumption margins comparison of the aggregate impact of all assumption margins

on the reserveon the reserve

Reasons for different assumption margins Reasons for different assumption margins under a Principles-based approach:under a Principles-based approach:

1. 1. Assumptions reflect risk characteristics of each companyAssumptions reflect risk characteristics of each company; no ; no need to establish an “industry-based margin” to cover need to establish an “industry-based margin” to cover uncertainties between companies. uncertainties between companies.

2. 2. Assumptions are not “locked-in” at issueAssumptions are not “locked-in” at issue; less need for a ; less need for a provision for adverse deviation since assumptions can be provision for adverse deviation since assumptions can be revised in the future revised in the future

3. 3. Implicit margins are already built into the methodologyImplicit margins are already built into the methodology

Blending to an industry mortality table if experience not Blending to an industry mortality table if experience not fully crediblefully credible

Removing mortality improvement is a marginRemoving mortality improvement is a margin

Cash value floor is a marginCash value floor is a margin

Possible approach to compare aggregate Possible approach to compare aggregate impact of all assumption marginsimpact of all assumption margins

The LRWG is exploring is the use of a number we are calling “Z” The LRWG is exploring is the use of a number we are calling “Z” to provide for the quantitative comparison of the aggregate impact to provide for the quantitative comparison of the aggregate impact

of all assumption margins. It is defined as followsof all assumption margins. It is defined as follows::

Z = Z = Reserve held - Best estimate liabilityReserve held - Best estimate liability Present value of capital requirementPresent value of capital requirement

““Z” represents the amount by which the pre-tax return on capital Z” represents the amount by which the pre-tax return on capital is expected to exceed the return on invested assets:is expected to exceed the return on invested assets:

ROC = Z + i (pre-tax)ROC = Z + i (pre-tax)

Possible approach to compare aggregate Possible approach to compare aggregate impact of all assumption marginsimpact of all assumption margins

Given this connection with the return on capital, one can Given this connection with the return on capital, one can determine whether the aggregate impact of all margins are determine whether the aggregate impact of all margins are within a reasonable range.within a reasonable range.

For these illustrations, the level of capital was set equal to For these illustrations, the level of capital was set equal to 100% of claims plus 5% of the reserve. 100% of claims plus 5% of the reserve.

““Z” could be used as a disclosure item to compare the Z” could be used as a disclosure item to compare the aggregate impact of all assumption margins. aggregate impact of all assumption margins.

Modeling Results:Modeling Results:20-year Level Premium20-year Level Premium

Term ProductTerm Product

Modeling Results:Modeling Results:20-year level premium term product20-year level premium term product

Initial results were presented to LHATF in DecemberInitial results were presented to LHATF in December Overall reserves were lower than current formulaic reservesOverall reserves were lower than current formulaic reserves

However, concerns were expressed about the appropriateness of the However, concerns were expressed about the appropriateness of the high reserve levels in the early durations (higher than current high reserve levels in the early durations (higher than current formulaic) formulaic)

Upon review, the impact was due to high assumption margins that Upon review, the impact was due to high assumption margins that were used: in early years, impact of high margins has large effect on were used: in early years, impact of high margins has large effect on PV of benefits, but not PV of premiums. PV of benefits, but not PV of premiums.

Conclusion: overall margin levels must be carefully considered Conclusion: overall margin levels must be carefully considered under the PBA, especially for mortality (e.g. the loadings used for under the PBA, especially for mortality (e.g. the loadings used for 2001 CSO may be too high.). 2001 CSO may be too high.).

Recap of Results from December LHATFRecap of Results from December LHATFExcerpts from Slide 9, of December term presentationExcerpts from Slide 9, of December term presentation

Numeric Summary – Impact of all margins on deterministic Reserve gross of reinsurance.Numeric Summary – Impact of all margins on deterministic Reserve gross of reinsurance.

Issue Age 45Issue Age 45 Issue Age 65Issue Age 65

PolicyPolicy

DurationDuration

(EOY)(EOY)

Deterministic Deterministic Reserve With Reserve With

MarginsMargins

CurrentCurrent

FormulaiFormulaicc

RatioRatio

Deterministic/Deterministic/

FormulaFormula

Deterministic Deterministic Reserve With Reserve With

MarginsMargins

CurrentCurrent

FormulaicFormulaic

RatioRatio

Deterministic/Deterministic/

FormulaFormula

11 $9,636$9,636 $0$0 N/AN/A $30,965$30,965 $0$0 N/AN/A

22 11,11211,112 4,3654,365 254%254% 41,72241,722 27,87427,874 149%149%

33 12,71612,716 8,6468,646 147%147% 53,23453,234 55,20055,200 96%96%

44 14,27214,272 12,82212,822 111%111% 64,78764,787 81,89581,895 79%79%

55 15,84415,844 16,85016,850 94%94% 76,14976,149 107,823107,823 70%70%

Modeling Results:Modeling Results:20-year level premium term product20-year level premium term product

Decided that multiple scenarios using different assumption Decided that multiple scenarios using different assumption margins needed to be modeledmargins needed to be modeled

Changes Made in Model since December Changes Made in Model since December Policy terminates end of 20Policy terminates end of 20thth year (removed option to renew) year (removed option to renew) Increased the premium levelIncreased the premium level Assumed mortality fully credible (no blending)Assumed mortality fully credible (no blending) Modeled different assumption margins (primarily mortality Modeled different assumption margins (primarily mortality

margins)margins) Formulaic Reserves updated to use 2001 CSOFormulaic Reserves updated to use 2001 CSO

20 Year Term Product Description20 Year Term Product DescriptionPlan of Insurance:Plan of Insurance: 20 Year Level Term20 Year Level Term

Guaranteed PremiumsGuaranteed PremiumsNo Renewal Option after 20 yrs.No Renewal Option after 20 yrs.

Gender/Issue Ages: Gender/Issue Ages: Male, 45 and 65 Male, 45 and 65Risk Class: Risk Class: Best Non Smoker ClassBest Non Smoker Class

Premium InformationPremium Information Age 45Age 45 Age 65Age 65

Annual Rate per $1000Annual Rate per $1000 $1.35$1.35 $11.81$11.81

Policy FeePolicy Fee $65.00$65.00 $65.00$65.00

Total Premium $1,000,000 FaceTotal Premium $1,000,000 Face $1,415.00$1,415.00 $11,875.00$11,875.00

Pre-Tax IRR on Distributable Earnings Pre-Tax IRR on Distributable Earnings (1)(1) 10%10% 10%10%

(1) Reflecting capital of 100% of claims and 5% of reserves. Reserves using PBE assumptions(1) Reflecting capital of 100% of claims and 5% of reserves. Reserves using PBE assumptions

Market Perspective Premium ComparisonMarket Perspective Premium ComparisonIssue Age 45, Best Class – Annual Premiums for $1,000,000 Face AmountIssue Age 45, Best Class – Annual Premiums for $1,000,000 Face Amount

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

An

nu

al P

rem

ium

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

LR

WG 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39

Company

Market Perspective Premium ComparisonMarket Perspective Premium ComparisonIssue Age 65, Best Class – Annual Premiums for $1,000,000 Face AmountIssue Age 65, Best Class – Annual Premiums for $1,000,000 Face Amount

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

$11,000

$12,000

$13,000

$14,000

$15,000

$16,000

$17,000

$18,000

An

nu

al P

rem

ium

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

LR

WG 16 17 18 19 20 21 22 23 24 25 26

Company

Five Margin Levels Five Margin Levels

Level 1: Deterministic interest scenario, 2001 CSO mortality margins, Level 1: Deterministic interest scenario, 2001 CSO mortality margins, 30% lower lapse rates30% lower lapse rates

Level 2: Same as level 1, but mortality margin of 9.375 deaths per 1000 Level 2: Same as level 1, but mortality margin of 9.375 deaths per 1000 divided by edivided by e

xx

Level 3: Same as level 1, but mortality margin of 3.5 deaths per 1000 Level 3: Same as level 1, but mortality margin of 3.5 deaths per 1000 divided by edivided by e

xx

Level 4: Deterministic interest scenario, mortality margin of 3.2%, no Level 4: Deterministic interest scenario, mortality margin of 3.2%, no other marginsother margins

Level 5: Deterministic interest scenario, mortality margins of 2.1%, 10% Level 5: Deterministic interest scenario, mortality margins of 2.1%, 10% lower lapse rateslower lapse rates

Best Estimate reserve (no margins) is also shownBest Estimate reserve (no margins) is also shown

ObservationsObservations Level 4 and Level 5 margins give a near zero reserve at Level 4 and Level 5 margins give a near zero reserve at

time 0, which is close to a “no gain or loss at issue” time 0, which is close to a “no gain or loss at issue” scenarioscenario

The reserve at the end of the first year always decreases The reserve at the end of the first year always decreases from time 0, due to acquisition expensesfrom time 0, due to acquisition expenses

But the reserve is not “forced” to be zero at the end of the But the reserve is not “forced” to be zero at the end of the first year, since there is no FPT adjustment as under the first year, since there is no FPT adjustment as under the current formulaic current formulaic

Cash value floor would come into play (reserve is Cash value floor would come into play (reserve is negative) in early durations for Level 3, 4 and 5. negative) in early durations for Level 3, 4 and 5.

Deterministic reserve is about the same as the stochastic Deterministic reserve is about the same as the stochastic reserve.reserve.

Observations (cont.)Observations (cont.)

Current formulaic reserves start with small “Z”, but then Current formulaic reserves start with small “Z”, but then “Z” gets very large, due to impact of mortality margin on “Z” gets very large, due to impact of mortality margin on PV of benefits and net premiums.PV of benefits and net premiums.

Level 4 and Level 5 margins produce a “Z” value close to Level 4 and Level 5 margins produce a “Z” value close to 4%, consistent with a 10% IRR assumption (that is, 4% 4%, consistent with a 10% IRR assumption (that is, 4% over investment return) over investment return)

Levels 1, 2 and 3 margins have significantly higher “Z” Levels 1, 2 and 3 margins have significantly higher “Z” values (in excess of 20%). values (in excess of 20%).

20 Year Term Examples:20 Year Term Examples:Deterministic Terminal Reserves at Different Margin LevelsDeterministic Terminal Reserves at Different Margin Levels Male, 45, Best Class, $1,000,000, Annual Premium of $1,415.00.Male, 45, Best Class, $1,000,000, Annual Premium of $1,415.00.

PolicyPolicy CurrentCurrent Principles-based with MarginsPrinciples-based with Margins PBA BestPBA Best

Year-EndYear-End FormulaicFormulaic Level 1Level 1 Level 2Level 2 Level 3Level 3 Level 4Level 4 Level 5Level 5 EstimateEstimate

At IssueAt Issue $ 0 $ 0 $ 6,931$ 6,931 $3,309 $3,309 $1,249 $1,249 $3 $3 $2 $2 $(362)$(362)

11 $ 0 $ 0 4,785 4,785 947 947 (1,143)(1,143) (2,448)(2,448) (2,436)(2,436) (2,834)(2,834)

22 3,386 3,386 5,956 5,956 1,888 1,888 (239)(239) (1,618)(1,618) (1,588)(1,588) (2,026)(2,026)

33 6,673 6,673 7,081 7,081 2,813 2,813 667 667 (760)(760) (717)(717) (1,184)(1,184)

44 9,859 9,859 8,214 8,214 3,752 3,752 1,591 1,591 130 130 181 181 (309)(309)

55 12,892 12,892 9,328 9,328 4,699 4,699 2,536 2,536 1,063 1,063 1,118 1,118 611 611

…… …… …… …… …… …… …… ……

1010 24,14524,145 13,58313,583 8,5548,554 6,5546,554 5,2635,263 5,2925,292 4,7914,791

1515 23,686 23,686 13,156 13,156 9,068 9,068 7,653 7,653 6,956 6,956 6,905 6,905 6,567 6,567

Discount Rate MarginDiscount Rate Margin DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic NoneNone

Mortality MarginMortality Margin 2001 CSO2001 CSO 0.009375/ex0.009375/ex 0.0035/ex0.0035/ex 3.2%3.2% 2.1%2.1% NoneNone

Lapse Rate MarginLapse Rate Margin 30%30% 30%30% 30%30% NoneNone 10%10% NoneNone

20 Year Term Examples:20 Year Term Examples:Deterministic Terminal Reserves at Different Margin LevelsDeterministic Terminal Reserves at Different Margin Levels Male, 45, Best Class, $1,000,000, Annual Premium of $1,415.00.Male, 45, Best Class, $1,000,000, Annual Premium of $1,415.00.

-5,000

0

5,000

10,000

15,000

20,000

25,000

30,000

At

Issu

e 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Formulaic Level 1 Level 2 Level 3 Level 4 Level 5

20 Year Term Examples:20 Year Term Examples:Comparison of Z Levels and Deterministic Reserve MarginsComparison of Z Levels and Deterministic Reserve Margins Male, 45, Best Class, $1,000,000, Annual Premium of $1,415.00.Male, 45, Best Class, $1,000,000, Annual Premium of $1,415.00.

PolicyPolicy CurrentCurrent Principles-based with MarginsPrinciples-based with Margins PBA BestPBA Best

Z ValuesZ Values FormulaicFormulaic Level 1Level 1 Level 2Level 2 Level 3Level 3 Level 4Level 4 Level 5Level 5 EstimateEstimate

At IssueAt Issue 4.5% 4.5% 90.7%90.7% 45.7%45.7% 20.0%20.0% 4.5%4.5% 4.5%4.5% 0.0%0.0%

At 10 YearsAt 10 Years 228.4%228.4% 103.7%103.7% 44.4%44.4% 20.8%20.8% 5.6%5.6% 5.9%5.9% 0.0%0.0%

Discount Rate MarginDiscount Rate Margin DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic NoneNone

Mortality MarginMortality Margin 2001 CSO2001 CSO 0.009375/ex0.009375/ex 0.0035/ex0.0035/ex 3.2%3.2% 2.1%2.1% NoneNone

Lapse Rate MarginLapse Rate Margin 30%30% 30%30% 30%30% NoneNone 10%10% NoneNone

20 Year Term Examples:20 Year Term Examples:Deterministic Terminal Reserves at Different Margin LevelsDeterministic Terminal Reserves at Different Margin Levels Male, 65, Best Class, $1,000,000, Annual Premium of $11,875.00.Male, 65, Best Class, $1,000,000, Annual Premium of $11,875.00.

PolicyPolicy CurrentCurrent Principles-based with MarginsPrinciples-based with Margins PBA BestPBA Best

Year-EndYear-End FormulaicFormulaic Level 1Level 1 Level 2Level 2 Level 3Level 3 Level 4Level 4 Level 5Level 5 EstimateEstimate

At IssueAt Issue $0$0 25,916 25,916 7,717 7,717 3,849 3,849 (73)(73) 346 346 (3,966)(3,966)

11 $0 $0 18,732 18,732 (438)(438) (4,422)(4,422) (8,631)(8,631) (8,144)(8,144) (12,734)(12,734)

22 22,483 22,483 29,126 29,126 8,862 8,862 4,741 4,741 187 187 758 758 (4,129)(4,129)

33 44,193 44,193 39,322 39,322 18,067 18,067 13,833 13,833 9,082 9,082 9,694 9,694 4,614 4,614

44 65,059 65,059 49,208 49,208 27,094 27,094 22,777 22,777 17,942 17,942 18,562 18,562 13,382 13,382

55 85,058 85,058 59,255 59,255 36,375 36,375 31,993 31,993 27,192 27,192 27,784 27,784 22,566 22,566

…… …… …… …… …… …… …… ……

1010 171,494 171,494 104,894 104,894 79,045 79,045 74,521 74,521 71,648 71,648 71,526 71,526 66,854 66,854

1515 187,852 187,852 112,903 112,903 89,834 89,834 86,121 86,121 85,876 85,876 85,127 85,127 81,877 81,877

Discount Rate MarginDiscount Rate Margin DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic NoneNone

Mortality MarginMortality Margin 2001 CSO2001 CSO 0.009375/ex0.009375/ex 0.0035/ex0.0035/ex 3.2%3.2% 2.1%2.1% NoneNone

Lapse Rate MarginLapse Rate Margin 30%30% 30%30% 30%30% NoneNone 10%10% NoneNone

20 Year Term Examples:20 Year Term Examples:Deterministic Terminal Reserves at Different Margin LevelsDeterministic Terminal Reserves at Different Margin Levels Male, 65, Best Class, $1,000,000, Annual Premium of $1,415.00.Male, 65, Best Class, $1,000,000, Annual Premium of $1,415.00.

-50,000

0

50,000

100,000

150,000

200,000

250,000

At

Issu

e 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Formulaic Level 1 Level 2 Level 3 Level 4 Level 5

20 Year Term Examples:20 Year Term Examples:Comparison of Z Levels and Deterministic Reserve MarginsComparison of Z Levels and Deterministic Reserve Margins Male, 65, Best Class, $1,000,000, Annual Premium of $11,875.00.Male, 65, Best Class, $1,000,000, Annual Premium of $11,875.00.

PolicyPolicy CurrentCurrent Principles-based with MarginsPrinciples-based with Margins PBA BestPBA Best

Z ValuesZ Values FormulaicFormulaic Level 1Level 1 Level 2Level 2 Level 3Level 3 Level 4Level 4 Level 5Level 5 EstimateEstimate

At IssueAt Issue 4.5% 4.5% 34.1%34.1% 13.3%13.3% 8.9%8.9% 4.5%4.5% 4.9%4.9% 0.0%0.0%

At 10 YearsAt 10 Years 113.0%113.0% 41.1%41.1% 13.2%13.2% 8.3%8.3% 5.2%5.2% 5.0%5.0% 0.0%0.0%

Discount Rate MarginDiscount Rate Margin DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic DeterministicDeterministic NoneNone

Mortality MarginMortality Margin 2001 CSO2001 CSO 0.009375/ex0.009375/ex 0.0035/ex0.0035/ex 3.2%3.2% 2.1%2.1% NoneNone

Lapse Rate MarginLapse Rate Margin 30%30% 30%30% 30%30% NoneNone 10%10% NoneNone

20 Year Term Examples:20 Year Term Examples:Model Office Reserve Levels – Aged 20 YearsModel Office Reserve Levels – Aged 20 Years

Current Formulaic Reserve:Current Formulaic Reserve: $121,301$121,301

Comparative Deterministic ReservesComparative Deterministic Reserves– Level 2:Level 2: $ 50,564 (42% of Formulaic) $ 50,564 (42% of Formulaic) – Level 4:Level 4: $ 41,095 (34% of Formulaic)$ 41,095 (34% of Formulaic)

Stochastic reserves not materially differentStochastic reserves not materially different

CConsiderations for onsiderations for Application of Application of

Principles-based Reserving Principles-based Reserving to In force Contractsto In force Contracts

Arguments For the Application of PBRArguments For the Application of PBRto All In force Contractsto All In force Contracts

1.1. Measures the risks of a company more appropriately than Measures the risks of a company more appropriately than current formulaic reservescurrent formulaic reserves• Provides a consistent methodology for all business.Provides a consistent methodology for all business.• Consistent with international actuarial and accounting Consistent with international actuarial and accounting

directionsdirections• Constitutes a more rigorous approach for all blocks of Constitutes a more rigorous approach for all blocks of

businessbusiness• Provides better information for regulatorsProvides better information for regulators

2.2. Reduces those reserves that are redundant under current Reduces those reserves that are redundant under current regulation and strengthens those reserves that are inadequate regulation and strengthens those reserves that are inadequate under current regulation, and will tend to lessen dependence under current regulation, and will tend to lessen dependence on complex reinsurance and financing solutionson complex reinsurance and financing solutions

3.3. Consistent with Enterprise Risk Management in that:Consistent with Enterprise Risk Management in that:• Incorporates risk of the entire block of business Incorporates risk of the entire block of business • The reserve will allow some offset of covariant risks The reserve will allow some offset of covariant risks • Reserves are set using the same or similar models to Reserves are set using the same or similar models to

those that should be used to manage the business.those that should be used to manage the business.

4. Allows the entire asset portfolio to be reflected in the 4. Allows the entire asset portfolio to be reflected in the reserve calculation, reducing the subjectivity involved in reserve calculation, reducing the subjectivity involved in allocating assets between PBR and non-PBR liabilitiesallocating assets between PBR and non-PBR liabilities

5.5. Mitigates the change in the pattern of margins under PBR as Mitigates the change in the pattern of margins under PBR as compared to the current formulaic approachcompared to the current formulaic approach

6.6. Potentially reduces Potentially reduces on-goingon-going costs by not requiring costs by not requiring companies to maintain multiple reserve approaches  companies to maintain multiple reserve approaches  

Arguments For the Application of PBRArguments For the Application of PBRto All In force Contractsto All In force Contracts

Arguments Against the Application of PBR Arguments Against the Application of PBR to All In force Contractsto All In force Contracts

1.1. Potential for large reserve discontinuity if inforce block is Potential for large reserve discontinuity if inforce block is large relative to new business large relative to new business 

2.2. May have significant tax implicationsMay have significant tax implications• Retroactive changes in reserve method are not permitted Retroactive changes in reserve method are not permitted

for tax purposesfor tax purposes• Reserves increase will not increase tax-deductible Reserves increase will not increase tax-deductible

reserve, but reserve decreases will likely decrease tax-reserve, but reserve decreases will likely decrease tax-deductible reservedeductible reserve

3.3. Does not allow for as long a “learning period” with respect Does not allow for as long a “learning period” with respect to the overall application, systems, and peer review before to the overall application, systems, and peer review before the approach is applied to a large block of businessthe approach is applied to a large block of business

Arguments Against the Application of PBR Arguments Against the Application of PBR to All In force Contractsto All In force Contracts

4.4. System implications and training may System implications and training may initiallyinitially lead to large lead to large implementation costs.implementation costs.

5.5. Most, but not all, past changes in reserve methodology have Most, but not all, past changes in reserve methodology have not been applied to inforce business.not been applied to inforce business.

6.6. Some blocks may be very small or the reserves may already Some blocks may be very small or the reserves may already be equal to the Cash Surrender Value, creating a lot of be equal to the Cash Surrender Value, creating a lot of additional work for little or no value. additional work for little or no value.

Application of PBR to Subset of Inforce Application of PBR to Subset of Inforce

• Three recent dates with significant changes to formulaic Three recent dates with significant changes to formulaic reserves: reserves:

1.1. January 1, 2000 – Reg “XXX”January 1, 2000 – Reg “XXX”

2.2. January 1, 2003 – AG38, section 8January 1, 2003 – AG38, section 8

3.3. July 1, 2005 – revised AG38, section 8July 1, 2005 – revised AG38, section 8

• Inforce contracts subject to these reserve standards are possible Inforce contracts subject to these reserve standards are possible subsets that could be subject to application of PBRsubsets that could be subject to application of PBR

• Some of the arguments against application to inforce Some of the arguments against application to inforce contracts are mitigatedcontracts are mitigated

• But many of the problems described above dealing with But many of the problems described above dealing with the application to inforce contracts still existthe application to inforce contracts still exist

Phased-in Application of PBR Phased-in Application of PBR

• Another option is to phase-in the application to inforce Another option is to phase-in the application to inforce contracts over time (or phase-in the effect over time). contracts over time (or phase-in the effect over time).

• For example, initially PBR would be prospective only, and For example, initially PBR would be prospective only, and then all or a portion of inforce contracts would be phased on then all or a portion of inforce contracts would be phased on over X years. over X years.

• Some of the arguments against application to inforce Some of the arguments against application to inforce contracts are mitigatedcontracts are mitigated

• But many of the problems described above dealing with But many of the problems described above dealing with the application to inforce contracts still existthe application to inforce contracts still exist

ACLI Interim ProposalACLI Interim Proposal

• ACLI has a strong commitment to see PBR ACLI has a strong commitment to see PBR implementedimplemented

• Concern: it will take several years to get thereConcern: it will take several years to get there

• Need an “interim solution” by 4/1/07Need an “interim solution” by 4/1/07

• Interim solution elements:Interim solution elements:

• Split 2001 CSO table into preferred and residual Split 2001 CSO table into preferred and residual tablestables

• Allow use of lapse assumptions for UL SGAllow use of lapse assumptions for UL SG

• Allow non-premium paying UL SG contracts to Allow non-premium paying UL SG contracts to use the surrender charge offset use the surrender charge offset

Preferred Mortality ProjectPreferred Mortality Project

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

reserving systemreserving system– Output from project may be useful as valuation Output from project may be useful as valuation

tables under the traditional, rule-based tables under the traditional, rule-based reserving reserving

– Produce experience tables of greater utility to Produce experience tables of greater utility to company actuaries company actuaries

Project OversightProject Oversight

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

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

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

Project tasks assigned to 6 teams. Project tasks assigned to 6 teams.

POG TeamsPOG Teams

Data ValidationData ValidationUnderwriting Criteria Underwriting Criteria Experience AnalysisExperience AnalysisValuation Basic TablesValuation Basic TablesImplementationImplementationValuation Tables Valuation Tables

DeliverablesDeliverables

Valuation Basic Tables and Valuation Valuation Basic Tables and Valuation Tables submitted to the NAIC – March Tables submitted to the NAIC – March 20072007

Infrastructure for future preferred mortality Infrastructure for future preferred mortality tablestables

ChallengesChallenges

Develop the number of valuation basic tables Develop the number of valuation basic tables (without margins) and valuation tables (with (without margins) and valuation tables (with margins) expected by the AAA LRWGmargins) expected by the AAA LRWG– Lack of data for later policy duration in the select periodLack of data for later policy duration in the select period– Tables for a sufficient number of underwriting classesTables for a sufficient number of underwriting classes– Persistence of the relationship between underwriting Persistence of the relationship between underwriting

class mortalityclass mortality