Updating Life Insurance Reserve Formulas
By Heather Morton | Vol . 24, No. 28 / July 2016
Did You Know?
- Every state requires insurers to set aside enough funds, or reserves, to pay a reasonable number of claims on the insurance policies they have sold.
- Forty-two states representing 75 percent of U.S. life insurance premiums combined had to enact legislation for principle-based reserving to become operational.
- Principle-based reserving will be operational in January 2017 because the threshold has been met.
Every state requires insurers to set aside enough funds, or reserves, to pay a reasonable number of claims on the insurance policies they have sold. Having enough reserves on hand not only ensures that life insurers will remain solvent through the years, but also that policyholders will receive what they have paid for. Currently, the system used to calculate the reserves required for life insurance products—using insurance industry-based parameters, mortality tables and prescribed interest rates—has raised concerns among many life insurers, actuaries and insurance regulators. This system has seen very little change for decades, until now. The pre-set, formulaic “one-size-fits-all” approach to regulation has caused critics to question how well they can adapt to recent innovations in, and the increasing complexity of, today’s life insurance products.
Proponents of modernizing the current statutory formulas point out that they do not accurately reflect the risks of a particular product or the true cost of the insurers’ liability and obligations, leading some reserve requirements to be too high, while others may be too low. If the reserve requirements are too high, consumers are at risk of paying higher-than-necessary premiums. If they’re too low, insurance companies could become insolvent, leaving consumers high and dry. Many believe that for specific products, such as term life, the formula based system has resulted in redundant reserves and that the cost of those reserves are being passed along to consumers.
In response to these concerns, the National Association of Insurance Commissioners first began the difficult process of modernizing the reserve requirement nearly a decade ago. After several years of development and discussion, the association in 2009 adopted a new method to calculate life insurance policy reserves based on certain principles rather than on a pre-set formula. The association finished an updated Valuation Manual at the end of 2012. Because the revisions require amendments to state standard valuation and standard non-forfeiture laws for life insurance policies, the insurance commissioners, along with life insurers and actuaries, began encouraging state legislators to revise life insurance laws to incorporate the new principle-based method.
Principle-based reserving considers more factors when determining the amount needed to be held in the reserve. It will replace the pre-set formulas with a new tiered, comparison approach that requires life insurers to make two different computations and use the one that yields the higher amount. The first calculation, based on the traditional formula, uses standard mortality tables and interest rates set in statutes and regulations. The second figure considers future economic conditions and uses individualized figures based on the company’s experience with factors such as mortality, policyholder behavior and previous expenses in the computations.
Principle-based reserves supporters say the current formula approach forces frequent changes to state laws and regulations just to try to keep up with all the new life insurance products introduced. Since principle-based reserving has been under development for almost a decade, it has been subject to actuarial modeling, testing and refinement. They point out that principle based reserving currently is used by property and casualty and health insurance companies here in the United States, as well as in international insurance markets. Using the principle-based reserving approach gives state regulators access to more tools to monitor insurance companies’ reserve levels and tailor reserve requirements to match each company’s unique risks.
Critics express concern that the new method could weaken reserve and capital standards for insurance companies in a similar way to what happened to the banking sector before the recent financial crisis. Others voice concern over a lack of expertise among state regulators to accurately verify the adequacy of the new reserve amounts required, and that states will not have the ability to participate in the review and analysis of individual reserving models.
To become effective nationwide, the revisions had to be enacted by at least 42 states where residents generate a least 75 percent of the total life insurance premiums paid in the country. That threshold was met in 2016.
In fact, since the National Association of Insurance Commissioners voted to adopt the Valuation Manual in 2012, 45 state legislatures have enacted laws to authorize principle-based reserving. Arizona, Indiana, Louisiana, Maine, New Hampshire, Rhode Island and Tennessee were the first states to enact legislation in 2013. Then, in 2014, Connecticut, Florida, Hawaii, Iowa, Michigan, Mississippi, Nebraska, New Jersey, New Mexico, Ohio, Oklahoma, Virginia and West Virginia enacted legislation. Arkansas, California, Colorado, Delaware, Georgia, Illinois, Kansas, Kentucky, Maryland, Missouri, Montana, Nevada, North Carolina, North Dakota, Oregon, South Dakota, Texas, Vermont and Wisconsin followed in 2015. This year, Alabama, Idaho, Minnesota, South Carolina, Utah and Washington have all enacted legislation to implement principle-based reserving. The current 45 states represent 79.51 of the total U.S. life insurance premiums.
Legislation still is pending in Massachusetts, New York and Pennsylvania.