Let me begin by admitting that I am primarily a product development actuary, not a reserve actuary. That fact alone may convince some readers that I am biased in my thinking, but I’d like to think that I can see multiple sides of this issue.
What is the issue? – Principles-Based Reserves, or PBR.
Recent regulatory and legislative developments have now anchored an effective date of January 1, 2017 as the date when the clock starts ticking for the transition to PBR. By January 1, 2020, all new life products must be reserved for using PBR techniques. In the interim, insurers can migrate to PBR on a policy form by policy form basis. Is this a good development or a bad development?
You will likely get as many answers to that question as there are noses on faces. Here’s mine – the perception that PBR was needed developed fifteen years or more ago as new product designs and features emerged which were not explicitly anticipated in formulaic statutory reserve rules. Insurers developed varying approaches to this conundrum, some using more, some using less aggressive approaches to fill the reserve void. This was clearly a reality that needed to be addressed. Well-meaning actuaries and regulators set about to create a more flexible, more prudent reserve approach that would “right-size” reserves. The emergence of powerful technology tools would support the increasing sophistication needed in calculations.
So, where did we end up? Well, let us first acknowledge that we haven’t totally ended up anywhere, because major parts of the VM-20 mechanics for PBR are still in flux, even as we stare the effective date in the face. Further, the definition of tax reserves under this regime is still undefined. But the framework is there, and to put it mildly, the framework is unwieldy.
Without diving into the detailed mechanics of PBR, insurers will need to consider three defined layers of possible reserve impact, with rigorous rules around the development of assumptions for all key variables. Assumptions should be based upon credible experience with an allowance for conservatism, with the degree of conservatism increased as the amount of actual historical experience declines. Further, these assumptions must be re-visited regularly, to ensure that reserves are adequate “on the fly”. For reinsured business, the reinsurer is responsible for its own PBR methodology, so the concept of mirror reserving is now out the window. In some cases, insurers will be expected to perform stochastic on stochastic analysis, challenging the speed and sophistication of internal financial models. And this entire protocol will be subject to audit by state auditors, outside auditors, and tax auditors – a monumental task, indeed. Valuation Actuary reports could end up being thousands of pages long.
What will the arrival of PBR mean for new life insurance product development? Let’s answer that question by first conceding that the deployment of people resources within an insurer to assist in PBR implementation will likely drain some resources away from product development, slowing the pace of new product introductions, at least for a while.
Some other likely implications:
- Except for term life insurance, the impact of PBR on reserves will likely be to maintain or raise them. Accordingly, term life prices are likely to fall, but prices of most other products will probably rise, especially in this low interest rate climate.
- Insurers will hesitate before developing innovative new designs, especially if the lack of credible historical experience on such a design requires padding reserves with substantial conservatism.
- The greater likelihood of changes to inforce reserves on policies due to environmental changes and emerging experience will make it more common for insurers to change non-guaranteed elements on inforce business. This could be both favorable and unfavorable to consumers.
A higher interest rate environment would generally help mitigate the impact of life PBR reserves, but as of now, the implications for consumers, agents, and carriers are less than favorable – fewer products, more expensive products, and less stable inforce policy parameters.