Co-Chairs, Principle-Based Reserving Implementation (EX) Task Force

To: All NAIC Members

From: Superintendent Joseph Torti III and Commissioner Julie Mix McPeak,

Co-Chairs, Principle-Based Reserving Implementation (EX) Task Force

Date:March 16, 2015

Re: PBR Small Company Exemption

At the Commissioners’ Conference we reported on consideration by the Principle-Based Reserving Implementation (EX) Task Force (Task Force) of a small company exemption for principle-based reserving (PBR).On February 11, the Task Force adopted regulatory criteriafor such an exemption based on company premium writings, risk-based capital (RBC), and other risk characteristics.

The purpose of this memo is to provide further information on the Task Force’s actions and future plans. The following provides background information to help you understand the product line exclusionsalready included in the Valuation Manual, the details of the proposedsmall company exemption, the plans for final adoption of the small company exemption, and, most importantly, our recommendation that your state not legislate a small company exemption in your state’s Standard Valuation Law.

Background

Presently, life insurance reserves are formulaic in nature and are established using a regulatory-prescribed methodology called the Commissioners Reserve Valuation Methodology (CRVM). The reserve is the present value of future benefits minus the present value of future premiums. NAIC models prescribe the valuation interest rate and the one mortality table to use in the calculation. These statutory reserves will often vary significantly from the economic value of the reserves.

The principle-based reserving framework will have three levels of reserve calculations, ranging from an advanced calculation/modeling method for riskier products to a relatively simpler method based on projections of benefits and premium cash flows. Stochastic reserves are calculated using modeling techniques and thousands of scenarios, and apply to product lines such as Universal Life with Secondary Guarantees. Deterministic reserves are similar to stochastic reserves but are limited to one scenario, a much simpler calculation. The net premium reserve (NPR), is effectively a “floor” for the reserves and is cash-flow based. (See Appendix A for detailed descriptions.)

PBR Small Company Exemption

In addition to the product line exclusions (See Appendix A for detailed descriptions), the Task Force adopted anapproach to exemptan entire company. On February 11, the Task Force considered the following PBR small company exemption proposal and adopted the proposal with one modification (as shown below with a strikethrough):

• Companywide Exemption: Unlike the existing product line exclusions, this exemption would apply to the entire company.
• Exempt from Performing PBR Exclusion Tests: Rather than being exempted from the Valuation Manual entirely (and thus not subject to reporting requirements, etc.), the company would be exempted from performing PBR exclusion tests.
• Premium threshold: The company’s ordinary life premiums must be less than $300M for the legal entity and less than $600M for the associated group.
• Risk-Based Capital(RBC) threshold: The company’s RBC must be at least 450%.
• ULSGs: There can be no material Universal Life with secondary guaranty business in force.
• Reserve methodology that applies for exempted companies: PBR’s Net Premium Reserve CRVM
• Location of Small Company Exclusion: The exemption will be included in the Valuation Manual as opposed to being added to the model Standard Valuation Law.

Based on 2013 financial data and other information, we estimate approximately 362 insurance companies, accounting for $9 billion or 4.6% of industry life premiums, could meet the aboveexemption criteria. Some of these companies would also be eligible for exclusion because they are single state companies.

Next Steps at the NAIC

As noted above, the Task Force adopted criteria for the PBR small company exemption on February 11. The NAIC Executive Committee is scheduled to consider adoption of the criteria at the upcoming Spring National Meeting. On March 12 the Life Actuarial (A) Task Forceadoptedan amendment to the NAIC Valuation Manual to incorporate the criteria. Upon adoption by the Life Insurance (A) Committee, the amendment will advance for Plenary consideration by the Summer National Meeting.

Recommendation Regarding States’ Standard Valuation Laws

It is important to note that the 2009 revisions to the Standard Valuation Law, or legislation including substantially similar terms and provisions, must be adopted by 42 jurisdictions representing greater than 75% of direct written premiums in order for the Valuation Manual (including PBR) to become operative. The Task Force is currently considering what to use as the substantially similar terms and provisions to determine the Valuation Manual Operative Date. Inclusion of a small company exemption in a state’s laws that is inconsistent with the Valuation Manual’ssmall company exemption could potentially be an issue in considering whether a state’s laws are substantially similar for purposes of the Valuation Manual Operative Date.

In addition, the Financial Regulation Standards and Accreditation (F) Committee is currently considering revising the accreditation standards based upon the current language of the Standard Valuation Law, which does not include a small company exemption. For these reasons, we are encouraging states to not add a small company exemption into your Standard Valuation Law, but rather rely on the collective decisions included in the Valuation Manual to provide uniformity on this important issue.

If you have any questions, please give us a call. Or you can contact NAIC staff:

Dan Schelp, NAIC Managing Counsel, , 816-783-8027

Larry Bruning, NAIC Life Actuary, , 816-783-8231

Reggie Mazyck, LATF Staff, NAIC Life Actuary, , 202-471-3991

Kris DeFrain, PBRI TF Staff, NAIC Director of Research and Actuarial, , 816-783-8229

APPENDIX A[1]

Explanation of Reserve Methodology and PBR Product Line Exemptions

PBR RESERVE TYPES (in order from advanced to simpler):

Stochastic Reserve -- Stochastic reserving involves modeling of assets and benefits over time, utilizing assumptions of mortality, policyholder behavior (i.e. lapses, policy loans), and company expenses. The company can utilize the industrywide assumptions or prove credibility of its own data to use more specific company mortality or policyholder behavior. Modeling involves using 1000 randomly-generated interest rate scenarios over 30+ years and averaging of the 300 worst modeled reserve results (CTE 70 methodology) to determine the deficiency to book as the reserve. The stochastic reserving methodology is similar to that used for AG43, except interest rate returns are utilized rather than the S&P 500 returns. A company’s product line of UL policies with secondary guarantees cannot be exempt from stochastic reporting if that product line’s volume is significant.

Deterministic Reserve–A deterministic reserve is a reserve amount calculated under a single defined economic scenario and a single set of assumptions. It is equal to the present value of benefits and expenses less the present value of premiums. Discount rates used are investment returns under a prescribed economic scenario. One caveat is that if the ULSG product line for a company is deemed not to be significant and is excluded from the stochastic reserve, then those ULSG products cannot test out of deterministic reserving.

Net Premium Reserve -- The net premium reserve (NPR) is the amount by which future benefits exceed future net premiums.The NPR is very similar to CRVM except NPR includes more different assumptions (for interest and mortality)and includes lapse assumptions and expenses. Expenses are based on a prescribed formula.

PBR PRODUCT LINE EXCLUSION TESTS

Stochastic Exclusion Tests

To be excluded from stochastic modeling for a particular product line, a company has two choices of main methods, both having some options to simplify the methodology should a company choose.

The first main method is a Stochastic Exclusion Ratio Test. An original calculation was supplemented with an optional short-cut for ease of calculation. The original calculation is to determine the percentage of a change in deterministic reserves from a baseline scenario to the worst-case of 15 scenarios, all divided by the present value of benefits under the baseline scenario. A ratio less than 6.0% passes the test. The short-cut version is the same except the deterministic reserve calculations can be replaced by gross premium reserves developed from the cash flows from the company’s Asset Adequacy Analysis models. This main advantage of the “short-cut” is that companies can use the Asset Adequacy Analysis model that they are already required to use for the current Asset Adequacy Analysis Test.

The second method for exclusion from stochastic modeling is to perform a Stochastic Exclusion Demonstration Test in the PBR Actuarial Report once every three years. The demonstration must provide “reasonable assurance” that a stochastic reserve would not be greater than the higher of the deterministic reserve and the NPR. At the option of the company, the stochastic reserve can be the full-blown stochastic reserve calculation, a stochastic reserve calculation on a representative sample of policies, or a reserve using a sufficient number of adverse deterministic scenarios. Effectively, the qualified actuary would attest that the product line is not subject to material interest rate risk.

Deterministic Exclusion Test

If a product line is exempt from stochastic modeling, the product line would be tested for exclusion from deterministic reserving. The Deterministic Exclusion Test is a comparison of the net premiums (as required by regulators) to the gross premiums (charged per the insurance contract). If the net premiums are less than the gross premiums, the policy line is excluded from calculating the deterministic reserve.

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[1] Deterministic Reserve and Net Premium Reserve explanations are revised from the original letter to add clarity.