Principles-Based Reserving
October  2006

If presentations at industry conferences are a barometer, the migration from formulas-based to principles-based reserving is a highly anticipated event. To be sure, we are witnessing in PBR the greatest change in our business since at least the adoption of Regulation Triple X. But, like many of these presentations, sometimes we may focus too much on the benefits without giving the potential risks their due consideration.

PBR 101
PBR seeks to move our current reserve calculations from a static, one-size-fits-all formula basis to a system whereby the required reserves more closely reflect each life insurer’s unique business characteristics. How a company manages its business – including investments, underwriting, product characteristics and guarantees and portfolio distribution – will all be incorporated on an enterprisewide basis to determine how much in reserves a company should hold.

A much anticipated result of this transition will be to see reserve redundancies for certain products decline to more reasonable levels. If this does occur, the ability to expense the redundancies for tax purposes will also be affected.

Capital will also see changes. We have already been exposed to risk-based capital formulas, so discussion on the effects to levels of retained capital have seemingly been light. However, whereas reserve levels for certain products might get a beneficial clip, capital may need to increase. Unfortunately for our industry, financing capital increases is a much more expensive proposition than current redundant reserve financing options.

The details are still missing on each of these issues. So the bigger question may not be “How will reserve and capital levels move?” but rather “To what magnitude will reserve and capital levels move?” If other nations that already use some form of principles-based assessments can be reliable examples, prospects are good that the decline in reserve holdings will be offset to an unknown degree by the lost tax benefits and increased required capital.

The National Association of Insurance Commissioners (NAIC) appears to be on a fast track to get the guidelines for PBR published by yea​​r end. The hope then is to have the requisite number of states adopt the rules by year end 2007 with nationwide incorporation and phase-in occurring in 2008.

We feel that such a timeline is ambitious at best. If the adoption of Regulation Triple X is any bellwether of actual timing (remember that a similarly ambitious timeline was proposed for Triple X as well), we believe that any action taken on implementing PBR by 2010 should be celebrated.

For this reason, we are concerned that companies, in their anticipation of the PBR migration, may already be incorporating assumptions of what will result from the switch into their current pricing. Companies that are actively pursuing this can expect pushback from their reinsurers for affordable coverage.

We are excited about the prospects for PBR from both business and risk management perspectives. By reflecting how a company runs its business, PBR will reward those firms that maintain strict underwriting guidelines, reliable data and conservative pricing assumptions.

On the other hand, companies whose underwriting, for example, demonstrates generous use of exceptions and table shaving will be forced to have their reserve holdings reflect the greater risk inherent in their business. In either case, reserves and capital retention will be more appropriate to the nature of an insurer’s business.