Evolution of RBC System in the USA Lou Felice

Presentation Agenda Overview of Current RBC System Milestones and Developments Since the Launch of the RBC System Key Areas and Challenges of Current Reforms Differences between RBC and Solvency II in Terms of Capital Requirements RBC in Context of Group-wide Supervision

Overview of current rbc system

Current U.S. RBC – Framework / Structure RBC Is Part of Regulatory Safety Net Licensing in Each State Restrictions on and Regulatory Approval of Key Risk Transactions Statutory Accounting and Reporting, CPA Audit and Actuarial Opinion RBC, Other Intervention Tools and Financial Analysis Corporate Governance and ERM (ORSA) Risk-Focused Financial Examinations Note hazardous condition model reg as a point of intervention based on analysis / exams. Accred Standard

US Solvency Framework Primary goal is to ensure financial health of insurers for purposes of protecting policyholders Work with companies to remedy areas of concern More severe interventions if company continues to deteriorate e.g. regulators will run off or liquidate the insurer if necessary to ensure protection of existing policyholders Provide a consistently applied set of standards Additional goals include availability and affordability of insurance, stable and competitive markets

Current RBC Formula Regulatory Purpose / Use Rules Based, Formulaic / Factor Driven Some company results adjust factors for Life Some modeling used for interest rate and market risk Industry Averages used for some risks Reflects Unique Risks Inherent in Operating an Insurance Company (Compared to Banks, etc.) Reflects Risk profile of Company Type (Life v. P&C) and Specific Company (e.g. Investment Strategy and Insurance Lines of Business) Not All Risks Are Accounted for; Material Risks by Industry Provides Regulatory Authority for Timely Action

Overview of NAIC RBC Formulas Formula vs. Full Modeling Approach Signaling Mechanism between Regulators and Insurers to Identify Poorly Capitalized Companies (Different Levels) Unlike Banking RBC that also Has: “Well Capitalized” “Adequately Capitalized” GENERIC FORMULA: Balance Complexity Against More Accurate Measures of Risk Thus, Not All Risks Are Accounted For For Example, Miscellaneous Receivables Small Amount of $ for Industry So, No Complex Formula Component to Address However, One Company May Have Significant $ The Generic Formula Will Not “FIT” Ideally for ALL For Example, Bail Bond Companies Pay out 80% + Commissions in First Year Causes Large U/W Expense Ratio Some States Allow Netting against Premiums Earned MODELING APPROACH: Allows for More Accurate Measure of Risk for Specific Insurer More Complicated to Create and Maintain Life RBC Formula Uses More Than Any Other Formula Considerations for Moving Toward This Approach As More Complex Information Is Part of Industry Out of Concerns Regarding Not Capturing Risks STANDARDS TO PROVIDE REGULATOR CONTROL OVER RISKS: Different Risk Tolerances for Companies as with Individuals Allows Some Control Over How Much Risk Is Held by Insurer

NAIC RBC System Four formulas: Life, Fraternal (copy of Life), P & C, and Health NAIC Risk-Based Capital for Insurers Model Act serves as a guide RBC law adopted in each state makes the system operational and consistently applied RBC Law incorporates the formulas by reference so Law need not be changed when formula changes NAIC produces the RBC formulas but the content is maintained and modified by State regulators

Overview of Formula Construction Generic Component Information Asset Risk – Affiliated Investment Risk Asset Risk – Default Risk / Market Risk Asset Risk – Credit / Other Underwriting/Insurance Risk Other Types of Risk (Varies by Formula) Business Risk (Life & Health) Interest Rate Risk (Life)

Overview of Formula Construction (Cont.) Asset Risk – Investments Bonds = Default on Principal and/or Interest Preferred Stock = Default and Past Dividends Common Stock = Decrease in Fair Value Mortgages = Default on Principal and/or Interest Real Estate = Decrease in Fair Value Schedule BA Assets = Risk Similar to Underlying Characteristics SCHEDULE BA ASSETS: Limited Liability Corporation Investments Limited Partnership Investments, etc. Investments that Do Not Meet the SSAP Definition of Bonds, Preferred Stock, Common Stock, Mortgage Loans or Real Estate Yet Classify Many Schedule BA Assets According to How They “Behave” Underlying Characteristics of: Bonds, Preferred Stocks, etc. Issue Before Invested Assets Working Group to Consider SVO Ratings for BA

Overview of Formula Construction (Cont.) Asset Risk – Receivables (Credit Risk) Risk of Non-Recovery of Receivable Amounts Asset Risk – Other Investment Concentration Risk = Additional Risk of High Concentrations in Single Exposures

Overview of Formula Construction (Cont.) Underwriting/Insurance Risk Reserve Risk = Obligations from Past Business Are Understated (Underestimated Reserves) Premium Sufficiency Risk = Premiums Are Inadequate to Cover Claims and Expenses for Policies Written (Under-Priced)

Overview of Formula Construction (Cont.) Other Types of Risk (Varies by Formula) Business Risk (Life and Health) = Primarily Litigation and Guaranty Fund Risk Life Formula Adds a Risk Charge for Separate Account Reserves P&C and Health Formulas Add Growth Risk Interest Rate Risk/Market Risk (Life) = Risk of Losses Due to Changes or Mismatch in Interest Rate Levels (See Presentation Section on C-3 Interest Rate Risk) Risk of market fluctuation in asset values vs. liability cash flows Market risk – risk of market fluctuation in asset value (mostly on stocks) - valuation difference for debt instruments (e.g. Life uses Amortized cost through lower quality designations w/ AVR) , while P&C and Health go to MV below quality designation 2) INTEREST RATE RISK (LIFE): Related to Guaranteed Products (Favorable to Policyholder) Asset and Liability Matching for Life Insurance Products Discussed More in Differences Section

Overview of Formula Construction (Cont.) Detail in the Formulas was Developed to Focus on the Areas of Most Material Risk for Each Formula Life – Asset Risks P&C – Underwriting Risks (Pricing and Reserving) Rely on robust data to maintain and update industry experience

Life Industry Distribution of Risk Components Life RBC Components: C-0 Asset Risk - Affiliates 15% C-1cs Asset Risk - Common Stock 16% C-1o Asset Risk - All Other 33% C-2 Insurance Risk 18% C-3a Interest Rate & Market Risk 10% C-3b Health Credit Risk 0% C-3c Market Risk 2% C-4a Business Risk 5% C-4b Business Risk Admin. Expenses 1%

P/C Industry Distribution of Risk Components Property/Casualty RBC Components: R0 – Asset Risk Affiliated Insurance 15% Company Assets R1 – Asset Risk Fixed Income Investments 2% R2 – Asset Risk Equity Investments 25% R3 – Credit Risk 5% R4 – U/W Risk Reserve 34% R5 – U/W Net Premiums Written 19%

Overview of Formula Construction (Cont.) Health RBC Components: H0 = Asset Risk – Affiliated Company Investments 11% H1 = Asset Risk – Other Invested Assets 15% H2 = Insurance/Underwriting Risk 60% H3 = Credit Risk 4% H4 = Business Risk 10%

How Does the Formula Work? Data Sources and Calculation Financial Amounts: Automated Data Pulls from the Statutory Annual Statement Manual Data Entry from Company Records Multiplied by Risk Factors Equals Risk Charges Covariance Calculation Groups Correlated Risk Charges into Same Component Recognizing Independence vs. Correlation of the Risks Note accounting basis (winding up / more conservative vs. economic balance sheet ) when discussing pulls from “statutory annual statement”. Note that covariance when more risk are correlated tends to favor the main risk types and give little weight to others.

Overview of Formula Construction (Cont.) Covariance Calculation (Continued): Square Root of Sum of Component Amounts Squared = Adjustment to Reflect the Remote Likelihood of Losses from Multiple Formula Components Occurring Simultaneously (Uncorrelated) Combination of Risks < Sum of Each Component Risk

Overview of Formula Construction (Cont.) Covariance Calculation: Life RBC Property/Casualty RBC Health RBC (C1o+C3a)2+(C1cs+C3c)2+(C2)2+(C3b)2+(C4b)2 C0+ C4a+ R0 + (R1)2+(R2)2+(R3)2+(R4)2+(R5)2 H0 + (H1)2+(H2)2+(H3)2+(H4)2

How Does the Formula Work? The Ratio and Action Levels The RBC formula calculates Total Adjusted Capital (Capital and Surplus from the Statutory Balance Sheet Adjusted for Certain Items) The RBC formula also calculates a minimum capital level (Authorized Control Level RBC) The other Action and Control Levels are calculated from the ACL RBC: Company Action Level = 200% of ACL Regulatory Action Level = 150% of ACL Authorized Control Level (ACL) = 100% ACL Mandatory Control Level = 70% of ACL

Overview of Formula Construction (Cont.) Total Adjusted Capital (TAC): Capital & Surplus from Liabilities Page Adjustments AVR (Life and Life Subs) Dividends (Life & Life Subs) Hedging Credit (Life) Non-US Insurance Subsidiaries (Life) Non-tabular Discount (P/C & P/C Subs) Tabular Discount (P/C & P/C Subs) Credit for Capital Notes (Subject to a Limit) = Official TAC

Overview of Formula Construction (Cont.) Total Adjusted Capital (Continued): Tax Sensitivity Total Adjusted Capital Total Adjusted Capital + Additional Adjustments DTA, DTL Subsidiary DTA, DTL = FYI TAC Additional Sensitivity Tests Remove Surplus Notes Additional Charge for Off-Balance Sheet Items NOTE: Ability to Change Factor from 1.000 to a Portion, to 0.000 If Regulators Take Issue with DTAs Impacting Results of RBC, Could Adjust This Item and Make Sensitivity TAC the “Official” TAC

Overview of Formula Construction (Cont.) Action/Control Levels: Authorized Control Level RBC (ACL RBC) = 50% of Calculation after Covariance Company Action Level = 200% of ACL RBC Regulatory Action Level = 150% of ACL RBC Authorized Control Level RBC Mandatory Control Level = 70% of ACL RBC First 2 Levels Are ACTION Levels Last 2 Levels Are CONTROL Levels ACL RBC = 50% OF COVARIANCE CALCULATION: Regulators Selected the Percentage That Generated the Expected Results as Specific Companies Falling into Specific Event Levels Current Work Item Is to Review This 50% Calculation and Assess if It Needs to Be Changed. WE WILL COVER THE SPECIFICS OF THESE LEVELS IN THE UPCOMING SECTION TITLED “OVERVIEW OF RBC MODEL LAWS”!

Overview of Formula Construction (Cont.) Comparison of Total Adjusted Capital (TAC) to Action Levels: “Official” TAC, NOT (Tax) Sensitivity TAC Level of Action Indicators None Company Action Level Regulatory Action Level Authorized Control Level Mandatory Control Level RBC Ratio = TAC/ACL RBC Note, RBC Ratio Does Not Appear in RBC Formula

Overview of RBC Model Laws Section 3 - Company Action Level Event: TAC >= Regulatory Action Level RBC but TAC < Company Action Level RBC OR Trend Test Triggered = Insurer Submits RBC Plan to Commissioner Circle back to trend tests for P&C and Health here and relation to CAL regulator authority in the Law to request an “RBC Plan” for all types of carriers. You may want to mention that Hazardous Condition model picks up where RBC Law leaves off. OR An Unchallenged Adjusted RBC Report Meets 1 of the Above Criteria A Rejected Challenge to an Adjusted RBC Report & Report Meets 1 of the Above Criteria INSURER SUBMITS RBC PLAN TO COMMISSIONER: RBC Plan & RBC Report – Don’t Get Confused! RBC Report = the RBC Filing Completed by Insurer, Stored on NAIC FDR RBC Plan = a Consequence of the RBC Report’s Results

Overview of RBC Model Laws (Cont.) RBC Plan: Identify Conditions Proposed Corrective Actions Current + 4 Year Financial Projections Key Assumptions for Projections Quality of & Problems with Insurer’s Business Submitted within 45 Days of Company Action Level Event Commissioner Response to RBC Plan (60 Days): Plan to be Implemented, or Unsatisfactory (Revised RBC Plan or Reg. A.L. Event) RBC PLAN: Identify Conditions That Contribute to Company Action Level Event Proposed Corrective Actions That the Insurer Intends to Take Current + 4 Year Financial Projections Future Projections Using Corrective Actions Key Assumptions for Projections Also Identify the Projections’ Sensitivity to the Assumptions Quality of & Problems with Insurer’s Business Including but not limited to: Assets Anticipated Business Growth & Association Surplus Strain Extraordinary Exposure to Risk Mix of Business Use of Reinsurance, if Any Submitted within 45 Days of Company Action Level Event To Commissioner of State of Domicile Possible to Other State Commissioners (if Notified in Writing of Request) COMMISSIONER RESPONSE TO RBC PLAN (60 DAYS): Commissioner Responds with Either Option within 60 Days from Receipt of Plan If Unsatisfactory Plan, Commissioner’s Response Must Present the Reasons

Overview of RBC Model Laws (Cont.) Section 4 - Regulatory Action Level Event: TAC >= Authorized Control Level RBC but TAC < Regulatory Action Level RBC = RBC Plan (within 45 days) to Commissioner AND Commissioner Examination or Analysis AND Commissioner’s Order for Corrective Actions AND Experts to Review RBC Plan at Insurer’s Expense OR Unchallenged Adjusted RBC Report Meets the above Criteria Rejected Challenge to Adjusted RBC Report & Report Meets the above Criteria Failure to File RBC Report by Filing Date (Usually March 1) Unless Commissioner Has Advance Notice & Cured within 10 Days Notification That RBC Plan/Revised RBC Plan = Unsatisfactory to Commissioner AND Commissioner JUDGES It to Be a Regulatory Action Level Event (Unchallenged) Insurer Challenges Commissioner’s JUDGMENT But Is Rejected Commissioner Notifies of Failure to Adhere to RBC Plan/Revised RBC Plan Substantial Adverse Effect on Eliminating Company Action Level Event (Unchallenged) Insurer Challenges Failure to Adhere & Substantial Adverse Effect Judgment But Is Rejected COMMISSIONER ANALYSIS: of Assets, Liabilities & Operations EXPERTS MAY BE RETAINED BY COMMISSIONER!

Overview of RBC Model Laws (Cont.) Section 5 - Authorized Control Level Event: TAC >= Mandatory Control Level RBC but TAC < Authorized Control Level RBC = RBC Plan (within 45 days) to Commissioner AND Commissioner Examination or Analysis AND Commissioner’s Order for Corrective Actions AND Experts to Review RBC Plan at Insurer’s Expense OR Place Company under “Regulatory Control” OR Unchallenged Adjusted RBC Report Meets the Above Criteria Rejected Challenge to Adjusted RBC Report & Report Meets the above Criteria Failure of Insurer to Respond to Corrective Order to the Satisfaction of the Commissioner (Unchallenged) Challenged But Rejected PLACE COMPANY UNDER “REGULATORY CONTROL”: If in the Best Interests of: Policyholders Creditors Public

Overview of RBC Model Laws (Cont.) Section 6 - Mandatory Control Level Event: TAC < Mandatory Control Level RBC = Place Company under “Regulatory Control” Section 7 – Hearings (Insurer’s Right to Challenge) Adjusted RBC Report Unsatisfactory RBC Plan or Revised RBC Plan that Resulted in a Regulatory Action Level Event Notice of Failure to Adhere to RBC (or Revised) Plan with Substantial Effect on Company Action Level Event Corrective Order from Commissioner SECTION 6 – MANDATORY CONTROL LEVEL EVENT: OR Challenged Adjusted RBC Report Meeting the above Criteria Rejected Challenge to Adjusted RBC Report & Report Meets the above Criteria Place Company Under “Regulatory Control”: If P/C Company Is in Run Off, Allow to Continue to Run Off

Milestones and developments since launch of RBC system

Milestones and Development Formula Implementation 1993 = Life RBC Formula 1994 = P/C RBC Formula 1998 = Health RBC Formula Sensitivity Tests Expanded over Time C-3, Phase II Project for Life RBC Incorporated stochastic modeling into the Risk Charge for Annuities Trend Tests LIFE Over the years, expanded into more detailed asset classifications for more tailored risk charges; and increased # of asset components

Milestones and Development Sensitivity Tests Expanded over Time Increases RBC risk charges for affiliated investments, restricted assets, contingent liabilities and guarantees, and long-term leases Added tax sensitivity adjustment to TAC Back out Deferred Tax Assets (DTAs) Add back Deferred Tax Liabilities (DTLs) Same adjustments for subsidiary amounts

Milestones and Development Trend Tests Life RBC TAC > 200% ACL and < 300% ACL; AND Trending downward for prior 2 years (e.g., 1st prior year 270% and 3rd prior year 230%) P/C RBC Combined Ratio > 120% Health RBC Combined Ratio > 105% May be room for scenario (stress tests)

Key areas and challenges of current reforms

Challenges and Current Reforms Incorporating Catastrophe Risk Charge Considering Calibration of Formulas Assessing Asset Risk Charges Assessing Underwriting charges (P&C) How to Incorporate Operational Risk Role of Scenario Testing (Stress Testing) Can mention role of rating agencies v. regulator if not too far off topic. Cat risk related to U/W charges

Differences between rbc and solvency ii capital requirements LF: A strong lead-in on the relative roles of capital and other regulatory tools in U.S v. sol II would be helpful. Would also consider adding some of the “similarities” between the systems. Maybe like the dialogue paper (i.e. similarities and differences next to each other) Or just note similarities when discussing the slides on differences.

Differences between RBC and Solvency II Accounting Differences SII market consistent balance sheet gives a going concern view of solvency position US statutory balance sheet gives more of a winding up basis Capital Requirement Calculation Differences SII uses independent MCR and SCR calculations for an insurer RBC uses a single formula for a specific insurer to generate 4 action/control levels

Differences between RBC and Solvency II (cont.) Capital Requirement Calculation Differences (cont.) RBC uses separate formulas by industry type – life (& fraternal), property/casualty, health SII SCR is a single formula with sub-components utilized based upon insurer type

Differences between RBC and Solvency II (cont.) Capital Requirement Calculation Differences (cont.) RBC is not based on an overarching calibration target; only specific calibration at individual risks level SII SCR is calibrated to an overall value at risk with a confidence level of 99.5% RBC covers a specified list of material risks at the industry level SII SCR takes into account all quantifiable risks, while the MCR is a linear formula based on a set of risk factors applied to individual company liabilities

Differences between RBC and Solvency II (cont.) Use of Internal Models Life RBC allows some risk factors to be modified by insurer/industry experience; partial models are currently limited to life/ annuity products with guarantees subject to interest rate/market fluctuation risks Models are not approved, but regulators set prescribed statistical parameters and time horizons and may apply a standard model that acts as a floor on capital SII MCR requires a standardized approach, but insurers can choose between the standard approach or the use of an internal model for either specific risk modules or for all its risks for SCR

Differences between RBC and Solvency II (cont.) Use of the Capital Requirement RBC has some influence on insurers’ risk management (e.g. Reserves reduced for reinsurance, but not for collateral); addressed mainly through other supervisory tools SII is designed to provide incentives for risk management Capital add on may be required by regulator, but it is not part of the RBC capital amount SII capital add on increases SCR

Differences between RBC and Solvency II (cont.) Use of the Capital Requirement in the U.S. Other oversight tools are used with RBC Many prioritization and analysis tools focus on specific activities within the insurer; these are addressed to prevent a future capital problem Hazardous Financial Condition Regulation in addition to RBC Specific Legal Action For example, a company with 1000% RBC ratio could still trigger a Hazardous Financial Condition trigger by having a large drop in surplus

Differences between RBC and Solvency II (cont.) Own Risk & Solvency Assessment (ORSA) US – exemption for insurers under $500 million in premiums (commissioner can still require) SII – required of all insurers and groups US – legal requirement tied to analysis and regulatory oversight with more discretion left to the company to determine/justify risk assumption and mitigation methods SII – more prescriptive legal requirement linking risk and capital management (including how the risk profile deviates from SCR assumptions)

Rbc in context of group-wide supervision

RBC and Group-Wide Supervision RBC assesses risk charges on each legal entity insurer for ownership of parent, subsidiaries and affiliates; but it does not establish specific capital requirements for non-insurance entities RBC aggregation does not recognize diversification benefits, but those benefits tend to disappear when groups are stressed US system focuses on understanding the risks outside of the insurance entities and how they may impact the insurers Holding Company Model Act.

RBC and Group-Wide Supervision US does not support a consolidated approach to a group capital calculation How do you construct a reasonably accurate group capital requirement that works for the many different group structures, types of businesses included, differing legal system requirements, etc.? Where does the group capital reside and how is the priority of distribution established in a liquidation when it resides at the holding company (and issues of fungibility)?

RBC and Group-Wide Supervision US does support a legal entity based approach to assessing group capital which includes and understanding and assessment of group-wide risks that may adversely impact the legal entities as a result of group-wide activities occurring outside of the legal entities but within the broader group Perhaps use simple but effective ratios and scenario (stress) tests to perform group capital assessments US system will use ORSA Summary Reports to see the group’s material risks (including in stressed environment) and how the capital objective is structured to account for those risks (including in stressed environment) On scenario (stress) tests can note that the results can be compared to either a group wide capital requirement (Sol II) or an aggregated entity based requirement (U.S. RBC)

Questions???

ASSAL – November 2012 Lou Felice Reserves - P/C - Life ASSAL – November 2012 Lou Felice

Property and Casualty Reserves

SSAP No. 55—Unpaid Claims, Losses and Loss Adjustments Expenses Claims, losses, and loss/claim adjustment expenses shall be recognized as expense when a covered or insured event occurs. A covered or insured event: Occurrence The occurrence of an incident which gives rise to a claim or the incurring of costs. Claims Made Reporting to the entity of the incident that gives rise to a claim.

Insurance Data Organization Accident Date The date on which the loss occurred. Report Date The date on which the loss is first reported to the insurer. Recorded Date The date on which the loss is first entered into the statistical records of the insurer.

Who Sets the Reserves? Case Reserves: Claims Representatives IBNR/Bulk: Actuaries & Company Management SSAP 55: “Management’s Best Estimate” By line of business and in Aggregate Reserve will NOT be accurate with certainty. All reasonable outcomes to be considered – not all possible outcomes If all points within a range are probable (RARE), record the midpoint.

Management’s Best Estimate "Management's best estimate" is the value of the ultimate settlement amount, undiscounted except for some small amounts of fixed and reasonably determinable claim values that can be discounted. It can be viewed that margin exists equal to the difference in the best estimate reserve and a discounted reserve, but there is not to be conservatism in the estimate. Financial reporting in Schedule P via loss development triangles provides a means to test for implicit margins/conservatism in a company's reserves, showing development in accident year incurred values.

What Costs are Considered? Generally, the amount necessary to settle unpaid claims… SSAP 55: Reported losses Incurred but not reported claims (IBNR) Can include “Development on Known Claims” Loss adjustment expenses Defense and Cost Containment (DCC) Adjusting and Other (AO)

Loss Adjustment Expenses (LAE) DCC Defense, Litigation, Medical Cost Containment Cost of Experts …(potentially testify in court) In DEFENSE of Claim: Private investigators, appraisers Attorney Fees – (Duty to Defend) AO: All other LAE Claim Adjusters In Determination of Coverage: Attorney Fees – (Litigation in determining coverage)

How Are Reserves Estimated? SSAP 55 Loss Reserve Projections by line of business Not Just for Company in TOTAL…it’s by line Results of More than One Method Should be Considered

Loss Development = Change in Loss Over Time How Are Reserves Estimated? Loss Development Analysis: Triangle Loss Development = Change in Loss Over Time Accident Year Cumulative Paid Losses at Age Estimated Ultimate 12 24 36 48 2002 100 200 300 Predict $300 each year 2003 2004 2005

How Are Reserves Estimated? Are They Right? Compare: Indicated Reserve: Actuarial Estimate Carried Reserve: Amount on the Books Are They Adequate or Inadequate? Same as…Are They Redundant or Deficient? RBC Reserve Factors designed to pick up some inadequacy in reserves.

Salvage and Subrogation Salvage: Car value when it’s totaled. Subrogation: Paid claim but reimbursed by at-fault person. Received: Adjust Paid Losses for amounts received. Anticipated: If choose to anticipate recoverables, then estimate & deduct from the liability for unpaid claims or losses. (Required to maintain data & perform actuarial tests to support reasonableness.)

Discounting Time Value of Money No discounting, unless authorized See SSAP 54 and 65 Fixed and reasonably determinable payments (Issue Paper No. 65) Example: Workers compensation Tabular indemnity reserves Long-term disability claims

Catastrophe Loss Reserves Are Catastrophe Reserves Catastrophe Loss Reserves Are established only AFTER a catastrophe has occurred Any reserves for the “Potential for a CAT” are Special Surplus Funds Hail Collecting data on Cat Reserve development specifically starting year-end 2012. Earthquake Tornado Wind

Actuarial Opinion In the Statement of Actuarial Opinion, the Appointed Actuary must address the risk of material adverse deviation. This gives the regulators better knowledge of the possibility for unfavorable reserve development impacting the solvency of a company. What does (or could) impact the management best estimate is the actuary's best estimate and/or range of estimates in the Actuarial Opinion Summary. Significant difference between the actuary's and the management's estimates leads to regulator/management discussion, so management is often significantly influenced by the actuary's best estimate.

Life Insurance Reserves

Life Insurance Policy Reserves Excess of the present value of future benefits over the present value of future net premiums Based on an interest rate – minimum determined annually (largely set by regulation) Based on a mortality table – changed every 10 – 15 years Cash value floor Zero Lapses in calculation Life reserves in the United States are conservative and are based on conservative mortality tables, lapse exclusion and separation of expenses (net premium). Expenses as incurred and treated separately as earned / incurred) However prescribed interest rates are higher than current market interest rates. An overview of Life reserves would be PV of future benefits Less PV of net premium Some life insurance policies build cash value and it is always the minimum reserve.

Life Insurance Reserves Determination of future benefits Face amount Indexed (Cost of Living) Universal / Variable Life When looking at the future benefits You look at face amount of the policy and the other promises made to the insured for benefits. Some less common life policies have benefits that change with the cost of living such as funeral polices. On Universal / Variable Life policies you look at the other promises so current fund values plus guaranteed interest rate credited plus guaranteed cost of insurance less assumed gross premium (cash inflows). The net premium is not the full premium paid for the policy, but part of the premium that represents the main life insurance risks, interest and mortality. Usually this is a level percentage of the guaranteed gross premium

Life Insurance Reserves Net premiums Based on the interest and mortality of the reserve Level percentage of the guaranteed gross premiums Other patterns Net level premium reserves (NLP) Commissioners Reserve Valuation Method (CRVM) CRVM graded to NLP May limit period of insurance In the US the pattern of net premium can vary. It can be 1 Based on the interest and mortality of the reserve 2. Level percentage of the guaranteed gross premiums or 3. Other patterns Net level premium reserves (NLP) Commissioners Reserve Valuation Method (CRVM) this method modifies the first year net premium and has the reserve lower the first year as just a mortality amount then they increase the net premium % in subsequent years this is because of the high first year commission costs. CRVM graded to NLP This is a blended rate that uses CRVM in the first years and grades to a net level premium method.

Life Insurance Reserves Deficiency Reserves Present value of the excess of net premiums over guaranteed gross premiums 1976 – Difference between actual reserve and minimum reserve based on maximum interest rate and specified mortality table 1990’s – Allowed to modify specified mortality with actuarial certification Any line of business can have to set up deficiency reserves if future premiums and income are not enough to cover future benefits. Usually when you see a premium deficiency reserves it is an indication of either underpricing or higher than expected losses. However in life insurance because of the conservative interest and mortality requirements, some companies also have to set these up. In this case this is reflective of the difference between an economic reserve and the statutory required reserve

Deferred Annuity Reserves The greatest present value of all possible future guaranteed benefits streams over future considerations. (CARVM) – discount at interest only. Surrenders Partial Withdrawals Annuitizations Death Benefits CARVM Commissioners Annuity Reserve Valuation Method When calculating reserves for deferred annuities we use the CARVM discounted for interest only You have to consider other cash flow variables also such as Surrenders (taking CV out) Partial Withdrawals Annuitizations Death Benefits

Contract Reserves Similar to Life Claims Reserves Similar to P&C Heath Reserves Contract Reserves Similar to Life Claims Reserves Similar to P&C In general , us health claim reserves are much like PC reserves. In setting Health reserves like for Property and Casualty you have to look at historical claims patterns and actuarial scenarios. Above are some examples of the primary variables that are reviewed. Medical insurance Analyze historical claim payment patterns Categorize claims by period incurred and by period paid Follow up studies Contract reserve are in general the bulk reserve for future expected losses. And they include an amount for morbidity that is required by regulation. NOTE that longevity is impacting LTC and Disab reserves opposite than life reserves Disability / Long-Term Care Present value of amount due in the future Morbidity table may be specified in a regulation I wanted to mention that the Policy reserve is both the unearned premium reserve and the contract reserve. The contract reserve includes money form the level premium which is set aside to pay higher costs in the future. (Example on a whole life policy with a level term you set aside payments when they are younger to cover higher costs when the insured is older.)

U.S. Solvency Modernization Initiative Principle-Based Reserving © 2009 The National Association of Insurance Commissioners All Rights Reserved

Principles-Based Valuation Project Why is it needed? Good public policy Requires understanding of the real economic condition of the company. Improves the price of products to consumers Eliminate flaws in current methodology Eliminates need to constantly develop new rules Focused on “what could happen” instead of “what happened” International More consistent with international reserving initiatives and accounting if the NAIC moves in that direction. Allows U.S. to compete in the global insurance market GENERALLY WILL RESULT IN LESS CONSERVATIVE RESERVES © 2009 The National Association of Insurance Commissioners All Rights Reserved

SVL PBR Requirements Include: Quantification of benefits, guarantees, and funding at a level of conservatism for unfavorable events that have a reasonable probability of occurring. Quantification of significant tail risk. Assumptions, risk analysis, financial models, and management techniques consistent with company’s overall risk assessment process. Provide margins for uncertainty such that the greater the uncertainty the larger the margin. Prescribed formulaic component may be included.

Life PBR Requirements in VM Found in VM-20 Life PBR Scope: Variable and Non-Variable Individual Life Contracts Issued on and after the Operative Date of the Valuation Manual Option Provided to Use Three Year Transition Period. Excludes Preneed and Credit Life Products. VM-20 PBR is the greatest of three reserves*: Net Premium Reserve (NPR) – prescribed formulaic Deterministic Reserve (DR) – single economic scenario Stochastic Reserve (SR) – multiple economic scenarios * Exemption criteria apply depending on product. Product may be exempted from SR or both DR & SR. Deterministic = Standard Scenario Taxes always big implication factor

Net Premium Reserve (NPR) A non-PBR prospective calculation Intended to be a floor for the PBR reserve May ultimately be the basis for the tax reserve NPR is developed for Term NPR revisions for Universal Life with secondary guarantees currently in discussion. NPR is not developed yet for other products and would default to current reserve requirements until developed. ACLI will work to develop NPR for other products.

Deterministic Reserve (DR) A PBR reserve calculation which models cash flows over a single economic scenario. Cash flows include projected benefits, expenses, premiums and related amounts. Assume you have blocks of business which can be modeled together ( i.e. – only one “model segment”) The Deterministic Reserve is the present value of the projected benefits, expenses, and related amounts less the present value of the projected premiums and related amounts.

Stochastic Reserve (SR) A PBR reserve which models cash flows using stochastically generated economic scenarios. Assume you have blocks of business which can be modeled together (i.e. – only one “model segment”) For each economic scenario starting assets (& reinvestment assets) are projected and increased/reduced at each future year by the projected the cash flows to find any future deficits. The largest present value of a future deficit is added to starting assets to produce a reserve for that economic scenario. Calculate the average of the largest 30% of the economic scenario reserves (referred to as the 70th percentile Conditional Tail Expectation or CTE 70). SR = CTE 70 + any additional amount for material risk not reflected.

PBR – Transition & Exclusions Transition period from VM operative date Provides up to 3 years to apply VM-20 PBR Must continue to apply VM-20 once elected Current requirements apply during use of 3 year transition. Products not subject to VM-20 continue with current requirements. Includes Preneed life and Credit life insurance. Products subject to VM-20 can be excluded from the rigor of PBR requirements via exclusion tests. Stochastic & Deterministic exclusion tests. NEW BUSINESS ONLY

Stochastic Reserve Exclusion Tests Products can be excluded from stochastic reserves if: Certification provided by qualified actuary of no material interest rate risk or asset return volatility risk; or Does not apply to certain products such as universal life with secondary guarantees. Stochastic exclusion ratio test is passed; or Demonstration provided that reserves will not increase under stochastic requirements.

Deterministic Reserve Exclusion Test Products can be excluded from the deterministic reserve requirements if the sum of net valuation premiums are less than the sum of the corresponding guaranteed gross premiums. This exclusion test cannot be used for: Products which are required to calculate the stochastic reserve. Universal life products with a secondary guarantee.

Exemption - Doing Business Only in One State The SVL provides an option the Commissioner may consider during legislative adoption to exempt specified products of a domestic company that does business only in that state from the requirements of the Valuation Manual. Any products exempted will apply current reserve requirements in addition to any requirements established by the commissioner by regulation.

Questions? © 2009 The National Association of Insurance Commissioners All Rights Reserved