PBR and Earnings Volatility
March  2007

As companies transition from formula- to principles-based regulation (PBR), one emerging concern is the potential for greater earnings volatility. The risk of having higher-than-expected claims experience can open a company to a series of cascading effects.

Under PBR, companies will need to annually review their assumptions and update them if they significantly deviate from what is being experienced. Until now, unfavorable claims experience in a given period has been the source of earnings volatility. However, in a principles-based world, if a company has higher than expected claims, it will contend not only with the claims hit to earnings but also with a reserve adjustment reflecting higher claims in all future periods.

We assume at this point that the Internal Revenue Service and Congress will not amend the tax code in light of a transition to PBR. Under the current federal tax code, a company that must adjust its reserves upward on inforce policies will not experience any additional tax benefit from holding higher reserves, as the tax reserve will still be based on the original reserve calculation.

After-GAAP earnings represents the expected earnings at the time of pricing for selected years. The change in reserves represents the financial impact after a ten percent increase in mortality for all future years. A sample of how a ten percent change in mortality assumption can impact a block of 20 year term is shown in the table below.

Mortality Deterioration Can Impact Earnings Through Changes in Reserves (illustration)

DescriptionYear 5Year 10Year 15
After Tax GAAP Earnings60,35541,71427,888
Change in Reserves487 ,016544 ,209433 ,325

The table shows how a 10-percent change in mortality assumptions can impact a block of 20 year term business.  

Additionally, many companies currently calculate their retained capital as a function of reserves. If adverse mortality leads to a reserve adjustment, such companies may also need to increase their capital levels. Even in situations where an insurer uses a non-reserve basis for capital calculation, it is reasonable to expect regulators to look closely at any reserve adjustment. As the official consumer advocate, the regulator’s key interest is to ensure that an insurer retains sufficient capital to remain solvent. They will have little incentive to be generous when companies experience pricing anomalies.

PBR will certainly create more transparency within a company. As a result, companies will have less time to react to unfavorable trends – and may even face new pressures to change assumptions. This has the potential to affect companies much like the DAC unlocking impact of 2002.

This new reality should be a strong incentive for companies to see that products are priced to reflect all the risks and that reserves and capital are allocated to reflect prudent best estimate assumptions. While the meaning of “prudent” is still being worked out, it will need to contain an appropriate level of conservatism, while still reflecting an appropriate return to stakeholders. How much? Some have suggested taking your best estimate and changing it by five percent. The bottom line is that assumptions never materialize exactly as estimated and it is better to err on the side of conservatism.

Financial reporting will be much more intensive in a principles-based environment. The days of “turning the crank” will be gone. The biggest change will be related to keeping the assumptions current. In fact, having a matrix of sensitivities completed in advance of a quarter’s calculation will greatly speed the verification and analysis of results.

Other sound practices that we will be exploring in future issues of The Messenger include better coordination between the pricing and valuation actuaries and careful alignment of underwriting standards and pricing with industry and company experience. We will also review some of the ways to hedge this volatility, examining both the benefits and risks, and how insurers can partner with their reinsurers to manage volatility risk.