Principle-based Reserving Comes to Roost for Life Insurance Companies

Effective January 1, 2017 the long-awaited Principle-Based Reserving rules, or PBR, became a reality. PBR had its birth in 2009 with the National Association of Insurance Commissioners (NAIC) adoption of the Standard Valuation Law (SVL), which subsequently developed the Valuation Manual.  PBR presents a revised approach to calculating life insurance reserves, moving from the current formulaic reserve calculation to a method that more closely reflects the risks associated with the wider variety of products currently available.

So, what is PBR? And, what are some of its pros and concerns?  The current process for developing policy reserves employs an established program of formulas prescribed by state laws and regulations.  PBR calls for companies to hold the higher of (a) the reserve using prescribed factors, and (b) the reserve which considers a wide range of future economic conditions and is computed using justified company experience factors, such as mortality, policyholder behavior, and expenses.

The Pros:

PBR alleviates the need for frequent updating for new product designs as is required under the statutory formulaic concept. Moreover, current formulas do not continually reflect the risks or the true cost of the liability or obligations of the insurer.  This leads to some products potentially incurring overly conservative reserves calculations, or in some cases, inadequate reserves.  PBR adjusts reserves in conjunction with changing economic conditions, and also as insurers accumulate credible individual experience.  The PBR goal is to maintain strong solvency oversight by regulators and continue to make sure companies maintain their obligations to policyholders.

The Concerns:

Two key states, New York and California initially expressed concerns regarding the NAIC accelerated pace to get PBR in place. They pointed to the real-world example of a similar reserve process that was responsible for intensifying the 2008 financial crisis.  Prior to that crisis, banks operated under a similar system also called principle-based reserving.  Though the insurance and bank business models differ, the appeal for lower reserving that PBR allows, may ultimately create the same moral dilemma for the insurance industry.  Companies, particularly public entities, are under constant scrutiny from stockholders and analysts to produce improving results and capital ratios on a consistent basis. Further, the effects of under-reserving may not materialize for a number of years following the reserving decision.  Finally, both states argued that regulators are not equipped to implement and oversee the PBR program.

The PBR Small Company Exemption:

Considering PBR’s implementation and timing complexities, the NAIC has established an exemption process based upon company premium writing, risk-based capital and certain other risk characteristics. The premium threshold is less than $300 million of ordinary life premiums per company or $600 million for the associated group.  A company’s RBC ratio must also be at least 450%.

Finally, companies cannot be exempt if they carry material in force Universal Life with secondary guarantees (ULSGs).

Who’s Next? PBR represents the next generation of reserving standards. Though it has been firmly focused on the life insurance industry, the NAIC has left the doors wide open for future consideration of a PBR system for non-life product lines.