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The Future of Financial Regulation KCAC Seminar Wednesday June 24, 2009

The Future of Financial Regulation KCAC Seminar Wednesday June 24, 2009. Larry J. Bruning FSA, MAAA Chief Actuary Kansas Insurance Department lbruning@ksinsurance.org. Forces Driving Modernization . SMART Act (August 2004) Optional Federal Charter (April 2006)

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The Future of Financial Regulation KCAC Seminar Wednesday June 24, 2009

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  1. The Future of Financial RegulationKCAC SeminarWednesday June 24, 2009 Larry J. Bruning FSA, MAAA Chief Actuary Kansas Insurance Department lbruning@ksinsurance.org

  2. Forces Driving Modernization • SMART Act (August 2004) • Optional Federal Charter (April 2006) • International Initiatives (October 2005) IAIS – International Association of Insurance Supervisors IASB – International Accounting Standards Board IAA – International Actuarial Association KCAC Seminar

  3. State Regulatory Issues • Lack of Uniformity in State Regulation • Producer Licensing Duplication • Product Innovation & Introduction Barriers • Rate Regulation • Market Conduct Duplication • Non-uniform Privacy Regime KCAC Seminar

  4. NAIC Modernization Initiatives • Interstate Compact (IIPRC) • Model Producer Licensing Act • Model Privacy of Consumer Financial & Health Information Regulation • Principles-Based Valuation Project KCAC Seminar

  5. Consumer Impact of Modernization • Improved Solvency Protection Awareness & Transparency • Price Changes in Products • More Products available for Consumer • More Competition among Companies • First Step towards Principles-Based Products KCAC Seminar

  6. History of Valuation • 1858 Massachusetts Legislation • Commissioner to Calculate Reserves on all policies of all Licensed Companies • Actuary Elizur Wright Appointed Commissioner • Wright selected Net Level Premium Reserve Method, Combined Experience Mortality Table (1843 British) and 4% Interest Rate • Controversial Decision of Immense Importance KCAC Seminar

  7. Valuation In 2009 • Commissioner to Calculate or Cause a Valuation to be made of all Policies of all Licensed Companies • Commissioner’s Reserve Valuation Method and 2001 CSO Mortality Table with 4% Interest Rate • 1990’s Asset Adequacy Analysis Required KCAC Seminar

  8. Valuation Summary • Virtually Unchanged for 150 Years • One Size Fits All Companies • Does not address all Insurance Risks • Reserve too Conservative for Some Not Adequate for Others KCAC Seminar

  9. Forces Driving Valuation Change • Increased Complexity in Product Design • Need to address Evolving Risks • Limited Capital Resources • Competition in Consumer Asset Accumulation • Competition in Risk Management • Advances in Risk Measurement Theory • Advances in Actuarial Modeling Software • Advances in Computer Processing Capacity KCAC Seminar

  10. Valuation Framework • Current Valuation Framework A company’s capital and reserve requirement is a function of prescribed regulatory formulas using prescribed industry based risk parameters. • Principles-Based Valuation (PBA) Framework A company’s capital and reserve requirement will be a function of that company’s risk profile and risk management processes. KCAC Seminar

  11. Current Valuation Framework • Prescribed Formulas (CRVM, CARVM) • Prescribed Mortality Tables • Prescribed Interest Rate • Prescribed CSV Floor (Aggregate) • Prescribed Asset Adequacy Testing • Prescriptions found in Standard Valuation Law & Accounting Practices and Procedures Manual KCAC Seminar

  12. Principles-Based Framework • Captures all Material Risks • Utilizes Risk Analysis and Risk Management Techniques • Incorporates Assumptions and Methods Consistent with Company’s Overall Risk Assessment Process • Permits use of Credible Company Experience for Risks over which Company has some degree of control • Right-Sizes Reserves and Capital Based on Underlying Risks • Recognizes the Solvency Objective of Statutory Regulation KCAC Seminar

  13. Key Elements of PBA • Calculation Methodology for Reserves & Capital • Amend the Standard Valuation Law • Collection of Company Experience Data • Financial Statement Blank • Accounting Practices & Procedures • Governance Law & Valuation Manual • Examinations and Legal Framework KCAC Seminar

  14. PBA Calculation Methodology • Risk Identification Process • Economic Scenario Generation Process • Financial Model Building Process • Anticipated Experience Assumption Setting Process • Appropriate Margins’ Determination Process • Risk Measurement Process (CTE Metric) • Sensitivity Testing Process • Documentation Process KCAC Seminar

  15. Amend Standard Valuation Law • Law continues to require Commissioner to cause Valuations, Examinations and Compliance • Law enables Valuation Standards to be established through an NAIC process • Law mandates collection of Company Experience • Law references Valuation Manual • Manual contains details of Valuation Standards • Similar Framework to Risk-Based Capital KCAC Seminar

  16. Collection of Company Experience • Mandatory for Principles-Based Valuation (Statute) • Mortality, Morbidity, Lapses, Expenses, Premium Payment Patterns, Other Benefit Utilization Rates • Provides Credible Data When No Credible Company Experience Exists (Industry Experience Studies) • Provides Regulatory Benchmarks to Evaluate Company Assumptions • NAIC Needs to Determine Statistical Agent & Funding KCAC Seminar

  17. Financial Statement Blank • Due & Deferred Premium Asset • Advance Premiums • Reserves Not Classified by Reserve Basis • Change in Reserve Basis • Changes to Income Statement • Consider Additional Disclosures such as Margins KCAC Seminar

  18. Accounting Practices & Procedures • Classification of Product Types • Accounting for Reinsurance • Deficiency Reserves • Unearned Premium Reserves • Analysis of Increase in Reserves KCAC Seminar

  19. Governance Law & VM • Role of Company Board & Management • Risk Management Oversight & Process Controls • Role of Independent Auditor • ASB – ASOP on Principles-Based Valuations • Consistent with NAIC Risk-Focused Financial Surveillance Framework KCAC Seminar

  20. Examinations & Legal Framework • Principles and Objectives • Maintain Company Solvency • Capital & Reserves reflect underlying Risks • Robust Risk Measurement Methodology • Methodology must be Auditable and Examinable • Provides Consistency and Uniformity across States and Companies • Provides Effective Resource Utilization KCAC Seminar

  21. PBA Examinations • Examination is Primarily Prospective • What Could Happen in the Future • Results unique to specific risk profile of Company • Examination of Processes (subjective) • Reserve or Capital is in aggregate • Consistent with Risk Focused Financial Surveillance KCAC Seminar

  22. 2008 Examiners Handbook An examination system should: • Use examination resources as effectively and efficiently as possible • Focus first on those insurers most likely to be the subject of significant actual or potential problems • Use a risk analysis methodology to focus on the combined impact of the environment in which the company operates, the company’s financial and operating results, and the extent and effectiveness of the company’s internal controls KCAC Seminar

  23. Current Legal Framework • Standard Valuation Law • Statute, Regulations, Actuarial Guidelines • Risk-Based Capital • Statute: References NAIC RBC Instructions • Regulations • Financial Statement Filing • Statute: References NAIC Accounting Practices and Procedures Manual & NAIC Blanks • Regulations • Examination of Financial Condition • Statute: References NAIC Examiners Handbook • Regulations: Annual Examination by Independent CPA KCAC Seminar

  24. Legal Framework Options • Filing, Certification and Examination • Every State company does business • State of Domicile of Company • Centralized Review Concept KCAC Seminar

  25. Centralized Review Concept • Centralized Review Activities • Establish Exam and Schedules • Assign Examination Team or Teams • Review Team Examination Reports • Recommend Enforcement or Compliance Actions • Recommend Changes to RBC Instructions/Valuation Manual to NAIC committee process • Establish Examination Standards for Valuation KCAC Seminar

  26. Centralized Review Concept • Benefits of Centralized Review • Provides Consistency and Uniformity States/Companies • Effective Use of Existing State Resources • Support States that lack sufficient resources • Provides Centralized Database to collect financial information • Lower Expenses of Filing and Certification • Gives Regulators an Industry View • Provides for Uniform Enforcement Actions KCAC Seminar

  27. NAIC Committee Structure KCAC Seminar

  28. PBA Project Time-Line • Standard Valuation Law Amendments and Valuation Manual – June 2009 LHATF Adopted Amended SVL • VM Scope – Life Insurance (Term, UL Secondary Guarantees) • State Adoptions – 2011-2012 • Effective Date of PBA & VM – 2012 KCAC Seminar

  29. Valuation Manual Structure • VM-0 (Table of Contents, Introduction, Overview) • VM-1 (Definition of Terms) • VM-2 (Types of Contracts, Riders, Supplemental Benefits, Substandard Risks) • VM-3 (Contracts subject to PBR) • VM-20 (Reserve Requirements for Life Products) • VM-21 (Reserve Requirements for Variable Annuities) • VM-22 (Reserve Requirements for Non-Variable Annuities) • VM-25 (Reserve Requirements for Health Insurance) • VM-26 (Reserve Requirements for Credit Life and Disability) • VM-30 (Requirements of Actuarial Opinion and Memorandum) • VM-31 (Requirements for Reporting and Documentation) • VM-40 (Requirements for Independent Actuarial Review Opinion) Deleted • VM-50 (Requirements of Experience Reporting) • VM-51 (Experience Reporting Data Formats) KCAC Seminar

  30. PBA Project Organization • In 2007 LHATF Organized Drafting Subgroups • LHATF – Amendments to SVL (Chair – Larry Bruning, KS) • PBR Life Subgroup (Chair – Pete Weber, OH) VM-20 • PBR Reporting Subgroup (Chair – Katie Campbell, AK) VM-30, VM-31 • PBR Reinsurance Subgroup (Chair – Sheldon Summers, CA) • PBR Health Subgroup (Chair – Julia Philips, MN) VM-25, VM-26, VM-30 • PBR Experience Reporting Subgroup (Chair – Fred Anderson, NY) VM-50, VM-51 • PBR Process & Coordination Subgroup (Chair – Mike Boerner, TX) VM-0, VM-1, VM-2, VM-3 KCAC Seminar

  31. NAIC Milestones • NAIC Adopts C-3 Phase II PBA Risk Based Capital for VA’s Effective 2005 • NAIC Adopts AG 43 PBA Reserves for VA’s Effective 2009 • NAIC Stress Testing of Insurance Industry (Events of 4 Qtr 2008) • Formation of Solvency Modernization Initiative (EX) TF • Formation of Capital & Surplus Relief (EX) Working Group KCAC Seminar

  32. LRBC Results Subgroup • Texas - Chair • Connecticut • Minnesota • District of Columbia • New York • Kansas KCAC Seminar

  33. LRBC Results Subgroup • 12 Companies Selected • Review 2007 & 2008 RBC Filings • Review 2007 and 2008 Actuarial Memorandums • Report on Quality of Modeling, Analysis and Documentation • Report on Effectiveness of Standard Scenario • Recommend Changes for 2010 RBC Instructions KCAC Seminar

  34. KCAC Seminar

  35. History of Equity Markets KCAC Seminar

  36. NAIC Stress Testing • Events of 4 Qtr 2008 raised questions on Insurance Industry’s ability to remain solvent • NAIC formed a special working group to stress test the insurance industry to evaluate possible areas of concern • Industry broken down into sectors: P/C, Health, Life and Separate Account • NAIC staff developed a projection model for RBC • NAIC also looked at Guarantee Fund Capacity KCAC Seminar

  37. Analysis of TAC Components KCAC Seminar

  38. Analysis of TAC Components KCAC Seminar

  39. Projected RBC RatiosC&S = 60%, AVR = 50% & C-3c = 120% Of 2008 Ratios With Permitted Practices Ratios Without Permitted Practices

  40. Guarantee Fund Capacity • $ 8.8 Billion ($4.7 B Life & $4.1 B Health) Initial • $ 16 – 18 Billion over 2 Years • $ 20 – 25 Billion over 3 Years • 2 or 3 Large Company Insolvencies • Insolvency Strategy – Deliver on Long Term Contract Guarantees vs. Liquidity Cash Out • Modeling Tool Available KCAC Seminar

  41. Variance of the CTE Metric • North American Actuarial Journal Volume 9, Number 2 April 2005 “Variance of the CTE Estimator” by B. John Manistre and Geoffrey H. Hancock • Develops a formula for the Variance of the CTE metric • Presents many real life examples of sampling error • Presents an example of Variance Reduction KCAC Seminar

  42. Variance of the CTE Metric KCAC Seminar

  43. Variance of the CTE Metric KCAC Seminar

  44. Variance of the CTE Metric • 1st term of variance formula dominates if probability distribution is “heavy tailed” • 2nd term of variance formula gains importance if probability distribution is “light tailed” • Sample size is a critical consideration in “heavy tailed” distributions • When n < 1,000 and the risk profile is “fatter tailed” than the normal distribution, sampling error can be so large it renders any tail measures of questionable value KCAC Seminar

  45. Variance of the CTE Metric KCAC Seminar

  46. Variance of the CTE Metric KCAC Seminar

  47. Variance of the CTE Metric KCAC Seminar

  48. Variance of the CTE Metric KCAC Seminar

  49. Variance of the CTE Metric • Sample size is critical in estimating CTE for “heavy tailed” distributions • Computer run time is important in completing the analysis • Estimating CTE can be improved upon by reducing sampling error using variance reduction techniques • Variance reduction techniques reduce computer run time allowing for more in depth sensitivity testing KCAC Seminar

  50. Variance of the CTE Metric • Construct a “control portfolio”. This is a small but representative portfolio of assets and liabilities that represents the actual in force block. • Value the “control portfolio” over a large number of scenarios such as 50,000 • Set maximum number of scenarios over which you are willing to run the actual in force block such as 1,000 • Select 1,000 scenarios out of the tail of the 50,000 such that the 1,000 represents the tail of the 50,000 KCAC Seminar

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