Principle-based reserving: Potential impacts for the industry and your company The Dbriefs Insurance series

Andrew Mais, Senior Manager, Deloitte Services LP Thomas Chamberlain, Senior Manager, Deloitte Consulting LLP Howard Mills, Managing Director, Deloitte LLP Jeffrey Webb, Senior Manager, Deloitte Tax LLP October 25, 2016

Agenda

• A brief history of principle-based reserving • Principle-based reserves summary • Principle-based reserves and tax reserves • Importance of governance and technology • Future state planning in a principle-based reserves • Conclusions • Q&A

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Polling question #1

What best describes your role within your organization? 1. Actuarial 2. Compliance/Legal 3. Finance 4. Tax 5. Other 6. Don’t know/not applicable

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A brief history of principlebased reserving

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A brief history of principle-based reserving (PBR)

• Long sought by the life insurance industry, the debate at the National Association of Insurance Commissioners (NAIC) over PBR has gone on for nearly a decade. • PBR would allow life insurers to have flexibility and relief from “excessive” or “redundant” reserving requirements, would move away from a formulaic, rigid approach to one better able to accurately reflect the risks of various and complex products in a timely manner under varying economic conditions, and better align economic and statutory reserving requirements. • PBR was moving along steadily for years until then New York Department of Financial Services (NYDFS) Superintendent Lawsky stated in 2013 that New York would not adopt PBR as it posed a risk to life insurer solvency and consumers best interests. California and, for a time Texas, followed New York in voicing objections to PBR. • One concern was that a reduction in required life insurer reserves could have negative effects on consumer protection. Sources: National Association of Insurance Commissioners, “Principle-based reserving,” http://www.naic.org/cipr_topics/principle_based_reserving_pbr.htm, accessed October 24, 2016. Katherine Chiglinsky, “New York Agrees to ‘Principle-Based’ Reserving Rule for Life Insurers,” Insurance Journal, July 7, 2016, http://www.insurancejournal.com/news/east/2016/07/07/419303.htm, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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A brief history of principle-based reserving

• In 2015 California announced that it had decided to, again, support PBR (Texas had previously also gone back to supporting PBR) leaving New York as the last major hold out. One concern would be the creation of a reserving standard for the entire US except for New York. • On July 6, 2016 NYDFS announced that it would implement principle-based reserving for the calculation of life insurance reserves beginning in January 2018. NYDFS appointed an advisory committee of Life Insurance Company CEOs to assist NYDFS in crafting the reserving calculation standards, a wellreceived sign that industry will have input on establishing the appropriate reserving safeguards.

Sources: Thomas Harman, “California Lawmakers Moving Bill to Establish Principle-Based Reserving,” July 10, 2015, Best’s Insurance News & Analysis, http://www3.ambest.com/ambv/bestnews/newscontent.aspx?refnum=184576&URATINGID=2255588&altsrc=23, accessed October 24, 2016. Katherine Chiglinsky, “New York Agrees to ‘Principle-Based’ Reserving Rule for Life Insurers,” Insurance Journal, July 7, 2016, http://www.insurancejournal.com/news/east/2016/07/07/419303.htm, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Polling question #2

VM-20 will be effective as of January 1, 2017. This means the guidance must be adopted by each company no later than: 1. January 1, 2017 2. December 31, 2017 3. September 15, 2017 4. January 1, 2020 5. December 31, 2021 6. Don’t know/Not applicable

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Principle-based reserves guidance summary

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Valuation manual 20: Reserve method of record VM-20 will replace the existing definition of the Commissioner’s reserve valuation method (“CRVM”):

Scope

• VM-20 covers individual life insurance policies (term life, whole life, universal life are a few such products)

Effective

• VM-20 effective on 01/01/2017 and is for new business only (Prospective) • This is different from VA CARVM which was retrospective and applied to prior issues

Exemptions

• There is a 3-year grace period for all companies • Other exemptions exist

Source: National Association of Insurance Commissioners, Valuation Manual 20, August 29, 2016, http://naic.org/documents/committees_a_latf_related_valuation_manual_noapf_160829.pdf, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Principle-based reserves guidance summary Calculation summary Clearly defined hedging strategy (CDHS)? X Perform stochastic exclusion test? (Section 7) Pass stochastic exclusion test (3 options, Section 7)

Yes X No

X X

Calculate stochastic reserve (“SR”, Section 6)

Term life or ULSG product? X Pass deterministic exclusion Test? (no ULSG, Section 8)? Reserve is net premium reserve (NPR)

Calculate deterministic Reserve (DR) (Section 5)? Reserve is max (NPR, DR+DDPA,SR+DDPA*)

*DDPA = Deferred Premium Asset For the decision tree branches to the left, SR+DDPA = 0 since the Stochastic Exclusion test was passed. Source: Deloitte Consulting LLP Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Principle-based reserves guidance summary Assumptions summary Assumptions are specific to the method. PBR includes anticipated company experience as well as prescribed regulatory tables.

Assumption

Net Premium

Deterministic

Stochastic

Discount rate

Prescribed max

ALM net asset earned rate (NAER)

105% X 1-Year US Treasury rate @ beginning of the projection year

Policyholder Experience

None\Prescribed

Blended

Blended(1)

Expense

Prescribed

As Stochastic

Anticipated Exp(2)

Economic

None

Prescribed

Prescribed

Margins

None(3)

Some prescribed

Judgment

(1) Blended is a combination of company experience and prescribed assumptions (2) Stochastic expense assumption includes inflation but this is excluded from the deterministic reserves (3) Margins are already included in prescribed tables, no additional margins are necessary for Net Premium reserves Source: Deloitte Consulting LLP Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Principle-based reserves guidance summary Small company exclusion

There is an opportunity for smaller companies to qualify for companywide exemption. This means all of the products are exempt from PBR. • Detailed in the reserve requirements section, subpart D: −The company must file a statement of exemption with the commissioner in the state of domicile along with the NAIC Q2 current year filing. −The statement of exemption must address premium and capital positions, asserting; −Prior year premiums (exhibit I, part 1 of the prior year’s annual statement) is: −Less than $300 M for ordinary life; or −Less that $600 M for the group of life insurers combined ordinary life. −Targeted adjusted capital (“TAC”) is greater than or equal to 450% for the risk based capital (“RBC”) authorized capital level (“ACL”) in the Q2 current year RBC report. Source: National Association of Insurance Commissioners, Valuation Manual 20, August 29, 2016, http://naic.org/documents/committees_a_latf_related_valuation_manual_noapf_160829.pdf, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Principle-based reserves guidance summary Small company exclusion

There is an opportunity for smaller companies to qualify for companywide exemption. This means all of the products are exempt from PBR. • Detailed in the reserve requirements section, subpart D: −The appointed actuary provided an unqualified opinion on reserves (prior year). −The statement of exemption must also confirm risks associated with the on-going and recently issued Universal Life with Secondary Guarantee (“ULSG”) business meets criteria such that; ◦ ULSG policies issued or assumed by the company with an issue date after the operative date of the valuation manual meet the definition of a nonmaterial guarantee ULSG product.

Source: National Association of Insurance Commissioners, Valuation Manual 20, August 29, 2016, http://naic.org/documents/committees_a_latf_related_valuation_manual_noapf_160829.pdf, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Principle-based reserves guidance summary Other exclusions • The VM-20 guidance developed for Life PBR excludes certain product types, reserve types and products issued before the operative date. • In addition to exclusions driven by scope, there are also tests to determine if a group of policies can be excluded from some of the more modeling intensive calculations. −Stochastic Exclusion Test (“SET”): There are three ways to pass the SET ◦ Pass the Stochastic Exclusion Ratio Test ◦ Pass the Stochastic Exclusion Demonstration Test ◦ Qualified Actuary certification that the group is not subject to material interest rate risk or asset return volatility −Deterministic Exclusion Test (“DET”) ◦ Term Life: Sum of all future Valuation Net Premiums < sum of corresponding anticipated gross premiums ◦ Universal Life: Non-material secondary guarantee and must meet the Stochastic Exclusion requirements Source: National Association of Insurance Commissioners, Valuation Manual 20, August 29, 2016, http://naic.org/documents/committees_a_latf_related_valuation_manual_noapf_160829.pdf, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Principle-based reserves guidance summary Products most impacted by the changes • Term life products, universal life contracts with secondary guarantees, and variable universal life contracts will be most impacted by PBR. • Term Life −Decreased reserve levels on a NPR basis but potential aggregate reserve levels using the DR levels (influenced by the company’s own experience) −A steep drop in reserves compounded in many studies the new 2017 CSO mortality tables also beginning in 2017 • Universal Life with Secondary Guarantees and Variable Universal Life Contracts −Volatility on interest rates and equity markets will have a larger influence statutory reserve levels −Certain product sales may halt or revert to designs with less generous (nonmaterial) secondary guarantees • Next Generation of products −As the methods and assumptions become more understood, the product designs will begin to evolve Source: National Association of Insurance Commissioners, Valuation Manual 20, August 29, 2016, http://naic.org/documents/committees_a_latf_related_valuation_manual_noapf_160829.pdf, accessed October 24, 2016. Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Polling question #3

Tax reserves for PBR are subject to IRS guidance and the Internal Revenue Code (IRC). Based on the current guidance, PBR tax reserves are: 1. Well defined with little or no additional guidance needed 2. Based on all three calculation, NPR, DR and SR 3. In need of clarification and guidance 4. Based on two of the three calculation, NPR and DR 5. Unknown and undefined 6. Don’t know/Not applicable

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Principle-based tax reserves

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Principle-based tax reserves Existing tax reserve guidance and implications

The existing tax reserve guidance for Life PBR is limited to some dated guidance before the adoption of variable annuity PBR (VA CARVM) and VA CARVM related guidance. Tax reserve guidance consists of: • Notice 2008-18 and Notice 2010-29 −Notice 20018-18 discusses general PBR tenets ◦ “…inappropriate for a change in statutory accounting under 807(d) to effect wholesale change …in the qualification of contracts as ‘life insurance contracts’ under 7702.” ◦ “Treasury Department and IRS does not anticipate …tax principles should not be necessary to override statutory accounting” ◦ Tax reserves are based on the NAIC method at the date of issue as specified by 807(d)(3)(A)(i) and (B)(i)

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Principle-based tax reserves Existing tax reserve guidance and implications

Tax reserve guidance consists of: • Notice 2008-18 and Notice 2010-29 (continued) −Notice 20018-18 discusses “Life PBR” tenants ◦ Life PBR reserves should be prospective (limits the discussion relative to 807(f) to newly issued contracts) ◦ Life PBR tax deductible reserves should be determined seriatim (contract-bycontract) ◦ Based upon expected value rather than a worst case tail of a distribution ◦ Based on standard, industry-wide interest rate and mortality factors versus company experience ◦ The VM-20 guidance allows for a 3-year grace period. Existing tax guidance does not support this (yet)

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Principle-based tax reserves Existing tax reserve guidance and implications

• Notice 2010-29 targets specific VA CARVM elements for tax purposes. While Life PBR is not covered and we are to make “no inference…on Life PBR” from this guidance, there may be some areas that will replicate in future. −Consistent with the allowable VA CARVM delay in implementation, it would be reasonable to look to future IRS guidance related to the VM-20, 3-year grace period. −Clarification around the allowable deductible tax reserve will be necessary. Based on the tenets provided, the current NRP appears to be the only qualified balance (DR and SR do not meet tenets). −This guidance is not clear regarding the applicable statutory cap. Future guidance may be consistently silent on the impact of DR and SR. Certain statutory accounting\tax reserve policies may be required to determine the appropriate final statutory cap.

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Polling question #4

Technology, governance and controls are as important to managing risk as a clearly defined hedging strategy. In preparation for PBR, companies should: 1. Create a plan to implement PBR that incorporates customers and suppliers 2. Assign all of the responsibility for PBR system conversions to IT 3. Buy new Actuarial Valuation systems 4. Take advantage of exclusion options as long as possible 5. Convert all of the current inforce business before January 1, 2017 6. Don’t know/Not applicable

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Importance of governance and technology

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Importance of technology Technology, models and governance

Technology already plays a large role in generating life insurance reserves. The new process will create additional steps in the processing and system updates. • Assessing PBR readiness is a good time to evaluate the critical components of the actuarial software(s) that will be part of the calculations −Prevents unintentional mismatched between system functionality (oversimplification, improper granularity, and other items) −Aligns purposes, starting points, and functionality (methods and assumptions) • System run times for the SR and DR may be barriers to a timely close −The increased number of calculations, new calculations and multiple interest/equity scenarios (benefits, asset returns, investment performance) • The comparison of aggregated results (NPR, DR, SR) external from existing systems may require additional external programing. This may also require processing redesign. • Existing technological support may become a valuation system (data warehouse for comparison of aggregate results, performance of exclusion tests, etc.) Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Importance of technology Technology, models and governance With multiple reserve calculations system consistency and alignment is critical to the accuracy of reporting. • System governance over functionality, upgrades and changes will require additional discipline −Change management requirements, process and documentation will require enhancements −Validation procedures and comparative projections across multiple systems may be required (Valuation versus Modeling) −Assumption functionality support (dynamic assumptions, company experience, prescribed assumptions, etc.) • Assumption governance will promote consistency and transparency around assumption setting −Dynamic and standard policyholder assumptions can share improved consistency −Explaining the impact of economic assumption changes will require new levels of analysis Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Importance of technology Data management/data governance Processing data across multiple actuarial systems introduces multiple data formats as both inputs and outputs. Data warehouses or data marts and data definitions can improve data controls as well as migration across procedures. Input • Administrative systems −Defined data collection procedures −General input item definitions (centralized) and specific system input formats −Historical administrative system data to develop assumptions −Investment systems and assumptions Output • Valuation systems −Results across multiple scenarios and systems defined −Aligning results across systems (with multiple formats and outputs) −Designing/mapping to reporting formats and analytical formats Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Importance of technology Controls

There will be several layers of controls that can be introduced into the PBR process. Governance over models and data was already mentioned. Processing Design • Create a plan for implementation with managements consensus • Make design decisions deliberately (order of processing, product features, timing of analysis) −Not just processing but analytics, reporting and model implementation/ validation controls across areas • Incorporate improvements, upgrades and/or automation −Automation can help reduce manual controls and standardize dashboards • Customers and suppliers should work together (Pricing, Planning, Financial Reporting or other areas) −This will assist with pooling resources, assigning tasks and aligning tasks −Include General IT Controls, processing controls and analytics Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Polling question #5

Understanding that VM-20 will likely fundamentally change the structure statutory and tax reserve reporting and ultimately product design. My company has been preparing for VM-20 by (select the one that best applies): 1. Preparing models across multiple actuarial functions to keep internal structures operating 2. Planning the next generation of products designs and associated investment strategies 3. Evaluating the need for new infrastructure systems and data storage and reporting 4. Assessing how products fit into exclusion options 5. Planning on how to spend the 3-year grace period 6. Don’t know/Not applicable

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Future state planning for principle-based reserves

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Future state planning for principle-based reserves Operations: Valuation and financial reporting An understanding of the processing steps is the beginning of the proper level of understanding. Once understood, the reserve process requires a blending with the existing in-house steps to identify missing information or engines before new products are designed. • There are many new forms of data prescribed and developed that are necessary. The timing of data collection must align with the availability of regulatory data and assumption development. • The time to completion using multiple calculation engines will need to be analyzed to determine if processing can run concurrently or consecutively to meet deadlines after model preparation is complete. • Increase rigor over assumption setting will require time and documentation. • Reporting and analysis requirements may require more sensitivity runs, stress testing analysis and more robust explanations due to the complexity of processing. This combines run time concerns with data alignment and processing controls as key operational steps. • Decide if areas other than Valuation to complete the appropriate Exclusion tests? Modeling? Pricing? Reporting? Copyright © 2016 Deloitte Development LLC. All rights reserved.

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Future state planning for principle-based reserves Operations: Pricing and product design

Despite the possible exclusions, companies that do not adopt VM-20 run the risk of being left behind. Pricing and product design should figure deep in the analysis of profitability drivers available to insurers. • Pricing area product designs will require innovation, updates and analysis. This is an opportunity for key actuarial disciplines to share resources, align profitability dashboards and work together. • Decide on what pricing strategy will be appropriate going forward, innovative design, fast follower or a blend. • Product filing areas and administrative system updates may also be required based on the product designs elected and VM-20 product reserve submission descriptions • Review the regulatory horizon before making any final decisions. Consider IFRS, IASB, RBC and even US GAAP changes (FASB TI) on the horizon. There may be more enterprise-wide opportunity for efficiency than originally anticipated (instead of a new system, an existing system, etc.)

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Conclusions

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Conclusions Potential impact to industry and company Based on the information provided today, we know VM-20 will take effect 1-12017. Additionally, current industry thinking relative to VM-20 is: •

Prepare for a period of some uncertainty as regulators ramp up their capacity to properly implement PBR, including through the development of the experience reporting framework and the expansion of NAIC staff to provide assistance to individual states. Regulators might be cautious in the beginning, aware of the potential charge that they have hurt consumers by reducing reserves.

•

A vast majority of the industry intends to take advantage of the 3 year grace period.

•

Due to the 3-year grace period and the fact that VM-20 is prospective only, the industry sense of urgency around VM-20 has been muted save for companies impacted by early adoption related issues (AXXX 8E and AG 48).

•

It is unclear what the next generation of products will include but older product chassis may be reinstated or repriced with new mortality while the design phase evolves.

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Conclusions Potential impact to industry and company Based on the information provided today, we know VM-20 will take effect 1-12017. Additionally, current industry thinking relative to VM-20 is: •

Tax reserve questions have yet to be addressed and may be a source of income strain. The current NPR as a tax deductible reserve has been shown to be lower than current reserve levels in most studies.

•

There may be an ancillary impact on financial reinsurance treaty activity, not only because of VM-20 but also due to recent Rector Report changes (AG 48).

•

Smaller companies may avoid the cost of PBR by using the appropriate exclusion guidance.

•

The older CRVM reserve calculations must still be supported based on the issue year.

•

Sustained low interest rate environment will continue to inflate the value of the DR and SR, when applicable.

•

Cash flow testing results will continue to get more complicated as the formulaic reserve levels no longer determine the starting balances.

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Question and answer

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Join us November 29 at 2 p.m. ET as our Financial Services series presents: The insurance tax environment: What could 2017 bring?

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Contact information

Andrew Mais

Howard Mills

Senior Manager Deloitte Services LP [email protected]

Managing Director Deloitte LLP [email protected]

Jeffrey Webb

Thomas Chamberlain

Senior Manager Deloitte Tax LLP [email protected]

Senior Manager Deloitte Consulting LLP [email protected]

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This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation.

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