Principle-based reserves methodology has become a reality
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Principle-based reserves standards become effective in Jan. 2017. Life insurance companies have work to do to prepare for implementation.
With the recent adoption by the National Association of Insurance Commissioners of a recommendation that the state threshold has been met for principle-based reserves (PBR) standards to become effective Jan. 1, 2017, certain companies that issue life insurance have a significant amount of work to do to prepare for implementation.
It’s important for companies to clearly understand PBR requirements, as well as potential benefits and challenges associated with implementation.
Reserves are generally calculated as the present value of future benefits less the present value of future premiums, using prescribed, conservative and “locked-in” assumptions for mortality and interest and an expense allowance. While this approach, in most cases, produces a conservative reserve for traditional products in times of financial stability, there are several concerns with this approach, including:
- Lapses are ignored, and they can have a relatively dramatic impact on reserve adequacy for some products
- As the market environment changes, the locked-in assumptions become outdated
- The risks, and associated reserve needs, for more complex products are not well captured in a “single scenario” and simplistic reserve approach
- Mortality improvement has exceeded expectations, resulting in outdated mortality assumptions
- The actual investment portfolio and investment decisions of the company are not taken into account in reserving
Due to the limitations in the traditional standards, there has been a progression in the approach for setting reserves, with each step relying more heavily on principle-based methods.
Reserves under PBR still involve an evaluation of future benefits and future premiums; however, that may be where similarities to the current reserving process end.
The projections of future benefits and premiums consider all cash flows material to the business, including premiums and other revenue collected from the insured, investment income, policyholder benefit payments (including surrender benefits net of surrender charges) and expenses. The calculation involves using some prescribed assumptions and some assumptions that are based on company experience and actuarial judgment.
The calculation also provides for margins for uncertainty. In order to include investment income in the projections, both assets and liabilities are projected. Rather than using a single economic scenario, a range of economic scenarios are considered, and the resulting reserve is based on the average of the results of the worst 30 percent of the scenarios.
There is a simplifying “exclusion test,” as well as a small company exemption that allow certain business and certain companies to use a more simplified approach. Small companies may file for an exemption prior to July 1 of each year if certain criteria are met.
In addition to the small company exemption, companies can demonstrate that they should be excluded from the stochastic reserve, or both the stochastic and deterministic, by performing certain tests.
Stay active in monitoring the guidance
Changes to the Standard Valuation Manual will continue to be evaluate. Therefore, companies will need specific resources charged with not only monitoring the guidance to ensure that valuation processes are in compliance, but also to assess the effects of potential changes on pricing and risk management.