The American Academy of Actuaries Introduction to PBA: An Overview of a Principle-Based Approach to Reserves and Capital in the U.S. for Life and Annuity Products August 2010 Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 IInnttrroodduuccttiioonn ttoo PPBBAA History of Reserves and Capital (U.S.) (cid:132) The Case For Change (cid:132) The Solution – A Principle-Based Approach (PBA) (cid:132) PBA Development and Implementation (cid:132) Appendix (cid:132) Appendix I – Reserve Methodology (cid:132) Appendix II – Capital Methodology (cid:132) Appendix III – U.S. vs. International (cid:132) Appendix IV – Valuation Manual Detail (cid:132) Appendix V – Governance (cid:132) Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 2 IInnttrroodduuccttiioonn ttoo PPBBAA History of Reserves and Capital (U.S.) (cid:132) The Case For Change (cid:132) The Solution – A Principle-Based Approach (PBA) (cid:132) PBA Development and Implementation (cid:132) Appendix (cid:132) Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 3 HHiissttoorryy ooff RReesseerrvveess aanndd CCaappiittaall ((UU..SS..)) RReesseerrvvee VVaalluuaattiioonn –– HHiissttoorriiccaall 1858 Massachusetts Legislation (cid:132) Commissioner to calculate reserves on all policies of all (cid:132) licensed companies Actuary Elizur Wright was appointed commissioner (cid:132) Wright selected Net Level Premium Reserve Method and (cid:132) Combined Experience (1843 British) Mortality Table and 4% Interest Rate Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 4 HHiissttoorryy ooff RReesseerrvveess aanndd CCaappiittaall ((UU..SS..)) RReesseerrvvee VVaalluuaattiioonn –– HHiissttoorriiccaall Very little change in valuation process for last 150 years (cid:132) Minimum reserve is based on a formula with prescribed (cid:132) mortality and interest IRS tax deductible reserves have been engineered with the (cid:132) same formulaic approach No actuarial judgment allowed in determining the minimum (cid:132) In 1990s, Asset Adequacy Analysis added to test the (cid:132) adequacy of the formulaic reserve in light of the supporting assets Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 5 HHiissttoorryy ooff RReesseerrvveess aanndd CCaappiittaall ((UU..SS..)) RReesseerrvvee VVaalluuaattiioonn –– CCuurrrreenntt Governed by the Standard Valuation Law, with supporting regulations and (cid:132) Actuarial Guidelines Generally, minimum reserve standards have been established to be (cid:132) sufficient to cover future claims 75%-85% of the time Subject to an Actuarial Opinion signed by a qualified actuary (cid:132) Opinion supported by Asset Adequacy Analysis, which is a principle-based (cid:132) analysis of the reserves in light of the assets Asset Adequacy Analysis is calculated in the aggregate and defines a floor (cid:132) (i.e., only impacts reserve if a deficiency is discovered) Valuation is currently formula-based for most products (cid:132) Model-based for Variable Annuities (AG VACARVM) (cid:132) The first step away from the traditional formulaic approach to (cid:132) calculating reserves Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 6 HHiissttoorryy ooff RReesseerrvveess aanndd CCaappiittaall ((UU..SS..)) RRiisskk--BBaasseedd CCaappiittaall ((RRBBCC)) –– HHiissttoorriiccaall Originally, states only specified minimum surplus requirements (cid:132) to start a company Later added solvency ratios (IRIS) to monitor companies on an (cid:132) ongoing basis Companies and rating agencies began developing risk-based (cid:132) capital (RBC) measures The NAIC developed a standardized RBC regime to supplement (cid:132) the IRIS ratios and identify weakly capitalized companies Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 7 HHiissttoorryy ooff RReesseerrvveess aanndd CCaappiittaall ((UU..SS..)) RRiisskk--BBaasseedd CCaappiittaall ((RRBBCC)) –– HHiissttoorriiccaall NAIC RBC regime primarily formula-driven, derived from data in published (cid:132) statutory statements Calculation delineates four categories of risk (C1-C4): (cid:132) Asset default and subsidiary risk (C1) (cid:132) Pricing inadequacy risk (C2) (cid:132) Interest rate mismatch and equity risk (C3) (cid:132) General business risk (C4) (cid:132) Covariance among risk categories is reflected in determination of total (cid:132) capital requirements Calculation emphasizes solvency and the identification of weakly capitalized (cid:132) companies Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 8 HHiissttoorryy ooff RReesseerrvveess aanndd CCaappiittaall ((UU..SS..)) RRiisskk--BBaasseedd CCaappiittaall ((RRBBCC)) –– CCuurrrreenntt RBC statute references NAIC RBC Instructions for specific methodology and (cid:132) factors, promoting uniformity across states Generally, minimum capital requirements are expected to be sufficient to (cid:132) protect insurer solvency 95% of the time RBC Ratio of actual to required capital determines regulatory action (cid:132) Formula-based for C-1, C-2 and C-4 (cid:132) Model-based for C-3 for VAs and certain fixed annuities (cid:132) C-3 Phase I – addressed interest rate risk on certain fixed annuities (cid:132) C-3 Phase II – addressed interest rate and equity risk for VAs (cid:132) The first steps away from a traditional formulaic approach to calculating (cid:132) RBC Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 9 IInnttrroodduuccttiioonn ttoo PPBBAA History of Reserves and Capital (U.S.) (cid:132) The Case For Change (cid:132) The Solution – A Principle-Based Approach (PBA) (cid:132) PBA Development and Implementation (cid:132) Appendix (cid:132) Copyright ©2010 by the American Academy of Actuaries An Overview of a Principle-Based Approach to Reserves & Capital August 2010 10