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Pricing In A Principle-Based Environment
- 1. Pricing in a Principle-Based Environment PD 67 2010 SOA Annual Meeting October 19, 2010 Michael Frings , FSA, MAAA, CFA Partner Frings Consulting Solutions
- 2. Overview of Principle-Based Approaches 2 SOA PD 67: Pricing in a Principle-Based Environment Michael Frings , FSA, MAAA, CFA Partner, Frings Consulting Solutions
- 3. Learning Outcomes 3 Describe Current & Upcoming PBA methods for … US Statutory US GAAP IFRS Solvency II What are the Product Development ... Changes in Process, Market and Product Timelines for Adoption Lessons Learned SOA PD 67: Pricing in a Principle-Based Environment
- 4. Pricing Definition of PBA “Don’t we already price insurance products using PBA? That is, my pricing assumptions use my best estimates.” That is true Most often, regulators mandate the assumptions for calculating actuarial liabilities and required capital In this session, we broadly define PBA as the application of, generally, best estimates when setting actuarial liabilities and required capital Note: the terms ‘liabilities’ and ‘reserves’ are used interchangeably in this session 4 SOA PD 67: Pricing in a Principle-Based Environment
- 5. Times They Are A Changin’…Slowly Financial Panic of 2008 has accelerated change Planned changes to financial system Putting US GAAP & IFRS on a more market-value basis Convergence between US GAAP & IFRS Revision to NAIC RBC calculations EU Basel III New changes to financial & insurance systems Dodd-Frank Act of 2010 Heath Care Reform Act of 2010 More effort being placed on principle-based approaches 5 SOA PD 67: Pricing in a Principle-Based Environment
- 6. Objectives of PBAAug 2009, AAA Intro to PBA Presentation* “Place greater emphasis on reflecting risks that materialize in ‘tail’ scenarios, where low probability events can have a large impact Reflect underlying economics in statutory financials, providing more information and greater insight to readers of financial statements Link statutory requirements to company risk management practices Allows optimal product price by “right-sizing” the level of reserves Eliminate the practice of designing products “around” the regulations Facilitate simpler products, satisfying consumer demands with straightforward designs Enhances risk-focused examinations” 6 *August 2009, AAA Introduction to PBA Presentation, p. 19 SOA PD 67: Pricing in a Principle-Based Environment
- 7. US Statutory Current PBA Methods PBA methods usually capped or floored Actuarial Liabilities Claims Reserves Active Life Reserves Most health products, excluding disability income (NAIC APPM A-010) Variable annuities (AG 43, NAIC APPM Appx. C) ‘X-factors’ for life insurance deficiency reserves (NAIC APPM A-830) Required Capital C3-Phase I (SPDAs & SPWL) C3-Phase II (Variable Annuities) 7 SOA PD 67: Pricing in a Principle-Based Environment
- 8. US Statutory Upcoming & Proposed (and when) Reserves Principles-Based Reserving (PBR) for new life insurance Products (2014?) Currently, impact of VM-20 being ‘field tested’ by a consulting firm PBR for LTC (no date) Capital C3 Phase III for Life Insurance (Delayed for PBR) C3 Phase III for Annuities (Deferred until after C3P3 for Life) 8 SOA PD 67: Pricing in a Principle-Based Environment
- 9. US GAAPCurrent PBA Methods The users of GAAP financials are investors not regulators Insurance regulators have their own accounting regime So, most GAAP methods are principle-based Biggest change has been to numbering system in July 2009 9 SOA PD 67: Pricing in a Principle-Based Environment
- 10. US GAAPUpcoming & Proposed Changes EITF 09-G – Limits allowable deferred acquisition costs Effective, fiscal periods after Dec. 15, 2011 Recent poll on limits on capitalization of future acq costs 43% polled indicated a 20-50% reduction 36% polled indicated a 10-20% reduction Substantial change in GAAP profit patterns for new products in 2012 and beyond Companies can elect to apply retroactively changing future profit patterns of in force blocks 10 SOA PD 67: Pricing in a Principle-Based Environment
- 11. US GAAPUpcoming & Proposed Changes FASB Discussion Paper, Preliminary Views on Insurance Contracts (Sept 17, 2010) Part of joint IASB/FASB accounting convergence effort Re-write of insurance accounting measurement and income statement and balance sheet Calculation of long-duration insurance liabilities to use probability weighted cash flows Unbundling retained Effective, 2015 (?) and later 11 SOA PD 67: Pricing in a Principle-Based Environment
- 12. IFRSInternational Financial Reporting Standards Currently, IFRS insurance accounting is country specific—so not really a single standards IFRS exposure draft (July 31, 2010) develops unified, principles based approach Many areas of agreement with US GAAP insurance accounting discussion paper: definitions, measurement of income, calculation of long duration liabilities, use of margins Some major disagreements: Calculation of margins, presentation of other comprehensive income, short v. long duration liabilities 12 SOA PD 67: Pricing in a Principle-Based Environment
- 13. Solvency II What: European Union risk-based capital for insurance companies Applies to pricing for insurance companies outside of the US When: Evolved out of Solvency I; BASEL I, II, III Balance sheet approach instead of product based approach (as US RBC is) Notable impact on discussions taking place the US and the NAIC Solvency Modernization Initiative (EX) Task Force 13 SOA PD 67: Pricing in a Principle-Based Environment
- 14. Impact of PBAonUS Statutory Capital 14 SOA PD 67: Pricing in a Principle-Based Environment
- 15. US Statutory Capital (RBC)Description US Statutory Capital established by NAIC through Risk-Based Capital Overview and Instructions Fraternal, Health, Life & P/C versions Updated every year Principle-based approach in the C3-Interest Rate component Remaining factors are static…for now 15 SOA PD 67: Pricing in a Principle-Based Environment
- 16. Development of Life C3 Component Life C3 Phase I (2000) SPDAs, SPWL, etc. AAA generated scenarios Results in a higher (not lower) RBC requirement Life C3 Phase II (2005) Variable annuities AAA generated scenarios Life C3 Phase III (Delayed?) All life insurance products (AAA) or selected products (ACLI) Uses principles from C3P2 Likely to see an impact study done before adopted by NAIC 16 SOA PD 67: Pricing in a Principle-Based Environment
- 17. Impact on Pricing Process Complex RBC calculations Transparency of rating agency models Increased complexity of insurance contract options to the policy holder Increased complexity of accounting standards Uncertainty on when changes to the above become effective 17 SOA PD 67: Pricing in a Principle-Based Environment
- 18. Impact on Pricing Process Typically, pricing methods use approximations for complicated RBC calculations % premium, % reserves, % claims, etc. Accurately calculating Life RBC C-3 requires complicated modeling of future liability and asset cash flows at each point (mthly, qtrly, annly) in the process Advantages to developing a simplified ‘formula’ 18 SOA PD 67: Pricing in a Principle-Based Environment
- 19. Pitfalls of Simplified RBC Calcs Aren’t accurate…How accurate do they need to be GAAP ROE = NI/E C3P3 may be small/immaterial component of GAAP equity Include co-variance vs. assume stand-alone Don’t worry capital requirements will change! An evolving, reactive process Not only NAIC RBC but rating agency requirements change Best approach: Understand sensitivity to capital changes and keep up-to-date with changes 19 SOA PD 67: Pricing in a Principle-Based Environment
- 20. Recently Published C3P3 Resultsfrom Chou & Wickland* Sample Universal Life Product Lower C3 component, material after surrender charge period 20 * Transitioning to RBC C3 Phase III, Financial Reporter, March 2010, Iss. 80, pp. 6-11 SOA PD 67: Pricing in a Principle-Based Environment
- 21. Recently Published C3P3 Resultsfrom Chou & Wickland* Sample Term Life Product No C3 component 21 SOA PD 67: Pricing in a Principle-Based Environment * Transitioning to RBC C3 Phase III, Financial Reporter, March 2010, Iss. 80, pp. 6-11
- 22. Observations Understanding materiality of C3P3 component on life products ULSG with large A-XXX reserves and Term Life might generate no C3P3 capital Decreased tax efficiency of life products PBR might generate lower stat & tax reserves and RBC relatively unchanged 22 SOA PD 67: Pricing in a Principle-Based Environment
- 23. Keeping Up with Changes ACLI Through member email alerts and/or becoming an ‘interested party’ on relevant ACLI committees Big 4 Accounting Firms Each publishes topic specific updates on topics relating to the NAIC, FASB, IASB, SEC, etc. American Academy of Actuaries Committees and task force publish information on important actuarial topics NAIC Publishes updates and notes from committees, task forces, and working groups. Especially useful are update from NAIC quarterly meetings Your In-House Valuation Actuary Check in with her/him periodically 23 SOA PD 67: Pricing in a Principle-Based Environment
- 24. Questions 24 SOA PD 67: Pricing in a Principle-Based Environment
- 25. Appendices 25 SOA PD 67: Pricing in a Principle-Based Environment
- 26. References NAIC. (2010). Accounting Practices and Procedures Manual. NAIC. (2010). Risk-Based Capital Overview and Instructions. July 2009 NAIC RBC Description http://www.naic.org/documents/committees_e_capad_RBCoverview.pdf Aug/Sep 2009 AAA Introduction to PBA http://www.actuary.org/pdf/life/pba101_sept09.pdf 26 SOA PD 67: Pricing in a Principle-Based Environment
Editor's Notes
- Not all products use mandated assumptions to set actuarial liabilities. For example, most health products like long-term care, medical supplement, and critical illness policies use company morbidity experience when pricing and setting active life reserves. Company experience is generally used to establish claims or disabled lives reserves. Actuaries also have some leeway when seeing policy holder lapse assumptions for health products. Industry experience tables either do not exist or there is too much variation between companies to make those tables credible enough for setting those actuarial liabilities. Of course, when using company assumptions, either under existing laws and regulations or upcoming ones, expect regulators to scrutinize assumptions much more carefully. And that is the trend we see applied to upcoming PBA methods.
- Static capital and reserve regimes are often seen as inflexible at the upper and lower limits of capital. That said, it is difficult to come up with one formula or approach that will result in the right capital and reserve requirements as the ‘right’ amount is only know after the liability is extinguished.
- At the summer NAIC meeting, the Life and Health Actuarial Task Force (known as LHATF) did not finalize the Valuation Manual which is the companion to the changes in the Standard Valuation Law for Life Insurance. Instead the latest version of the Valuation Manual (VM-20) was released for comments and field testing to gain an understanding of the Industry effect and to identify any sections of that need to be refined. The field testing is to be completed by the end of 2010 and will likely result in a delay of 1 year to the introduction of the Valuation Manual. It is interesting to note that for Variable Annuities it was reported at the summer meeting that AG43 needs to be refined for hedging as those companies that hedge get a higher total asset requirement and others find that the standard scenario floor is often higher than the stochastic reserve.LHATF Regulatory Testing Subgroup promoting impact testing of VM-20, also known as "Field Testing" and a report from the actuarial consulting firm Oliver Wyman on their evaluation of RBC C-3 Phase 2 and AG 43 methodologies. The Field Testing initiative will be coordinated by an actuarial consulting firm and will identify companies to participate in determining the implementation impact of VM-20. All companies with at least $100 million of new annualized premium last year will be strongly encouraged to participate in the testing. The objective of the testing is to develop an understanding of the industry effect and identify any sections of the guidance or requirements that may need refinement. The testing is to be completed by year-end 2010 in order to keep the PBR project moving forward, and could delay the introduction of the valuation manual up to one year. LHATF clarified their 2011 charge related to the review of AG 43 to include consideration of modifications that may be needed pending the completion of the Oliver Wyman study.PBR for LTC is focused on developing a credible LTC morbidity table along with development of a claims model that factors in lapses, mortality and claims costs) to simulate how claims on a block of LTC would emerge over time.
- ASC 944 Financial Services Insurance
- Rating agency requirements can change, too, making the ability to accurately project ROEs in serious doubt. Indeed caveats are warranted here.