Duncan Briggs and Cheryl Tibbits consider the conservatism in Regulation XXX and the approaches taken to fund the reserve strain

Regulation XXX prescribes the statutory reserving methodology for certain life insurance policies, including term insurance. It was introduced to close perceived loopholes in the prior reserving methodology, where very speculative future profits were used to minimise current reserves. The new regulation became generally effective for business issued in 2000. Since then, we have seen a variety of approaches to funding the excess reserve strain, from increased use of reinsurance to more innovative solutions such as securitisation.

Regulation XXX is a rules-based reserving basis, where a prescribed method and assumptions must be used. While some degree of conservatism is inherent in all prudential reserving bases, the margins embedded in the prescribed Regulation XXX assumptions, in particular for mortality and lapses, are very significant when compared to realistic assumptions for typical term life insurance products.

Significant underwriting is done at policy issue for the majority of term products falling under Regulation XXX. The term market is extremely competitive and companies have introduced risk classes such as "super preferred" to attract the very best risks. Under US valuation mortality standards, sex and smoker distinct mortality can be used, however, no distinction is made between standard and preferred lives. As a result, the already significant conservatism embedded in the mortality assumption for standard lives, is exacerbated for portfolios with a high proportion of preferred lives. The difference between the two mortality bases is significant - valuation mortality might be 200%-300% of expected mortality. In contrast, the prudential margin implicit in certain international reserving bases might only be around 10%.

As with all statutory reserving approaches for life insurance in the US, Regulation XXX reserves are calculated assuming no lapses occur. In practice, many policyholders will lapse their policy, and the company will pay no death claim. On a valuation basis all potential death claims are reserved for, regardless of the likelihood of a prior lapse. This can significantly overstate the total reserve held relative to a reserve using realistic lapse assumptions, or even realistic lapses less a margin.

Calculating conservatism

The conservatism embedded in the prescribed Regulation XXX assumptions can be assessed by calculating an economic reserve, utilising best-estimate assumptions. The difference between the Regulation XXX reserve and the economic reserve is typically characterised as the redundant reserve. Figure 1 illustrates the pattern and level of the redundant reserve for a generic 20-year level term product. In practice, the magnitude of the redundant reserves for a portfolio of term business will vary with a number of different factors, including the mix of plans (eg 10-year versus 20-year level term business) and the proportion of preferred business in the portfolio. Typically, an economic reserve determined on a best-estimate basis will be 80% to 90% less than the statutory reserve. The magnitude of this redundancy, and the long period until the excess reserves can be released, has inspired many companies to explore other sources of capital to fund the excess reserves.

The most straightforward solution is reinsurance, where the direct writers coinsure a very high proportion of the business (and hence statutory reserves) to an offshore reinsurer. Offshore reinsurers are not subject to US regulatory standards, and therefore hold much lower reserves than Regulation XXX. However, for the direct writers to claim full reserve credit, some form of security is required for the difference between the Regulation XXX reserves and those held by the reinsurer. Typically, rolling, one-year letters of credit are used to back that reserve differential, and as a result, there is considerable price uncertainty surrounding the long-term cost of these letters of credit. In addition, as the volume of redundant reserves continues to grow, (both through new business written and the aging of existing in-force portfolios), there may be constraints on the amount of letters of credit available. Finally, the direct writers themselves have an increasing credit exposure to the relatively small number of reinsurers in the market.

Securitisations have emerged as a way of overcoming these constraints, by accessing the capital markets to fund the redundant reserves. In a Regulation XXX securitisation, the redundant portion of the statutory reserve is funded via a capital markets debt issuance. Debt servicing is contingent on the underlying business generating sufficient cash flow. Investors in the securitisation require an adequate level of collateralisation such that the likelihood of cash flows being insufficient to service the debt is small. Securitisation provides a long-term solution to the company's reserve funding requirements.

Regulation XXX securitisations have been completed by several companies, including Genworth and Scottish Re. Currently, the fixed costs associated with a Regulation XXX securitisation are high and have prevented all but the largest scale companies from getting involved. The high cost is partially due to the multiple external parties completing due diligence on the block to be securitised. It is likely that over time these parties will become more comfortable with the risk exposures inherent in a typical Regulation XXX block of business, and as a result the fixed cost associated with the transaction will reduce. As a reinsurer, the securitisations completed by Scottish Re are effectively pooled structures, where the excess reserves of a number of ceding companies are consolidated and securitised. Potentially, the next generation of transactions will also be pooled structures, but where multiple, smaller writers can directly participate in the pool.

Changes in the pipeline

There are a number of different regulatory initiatives underway that, if they come to fruition, could reduce the excess reserves associated with long-duration term business. Most important of these is the move to principles-based reserving methodologies. A principles-based regulatory regime would replace Regulation XXX with a set of principles that outline a methodology for setting prudent assumptions and determining reserves. This methodology would be implemented in a company-specific manner and reflect the actual mix of risks in each company's portfolio.

Each company would set assumptions based on their current experience, with prudential margins appropriate to the degree of uncertainty surrounding that experience. This type of approach has the clear advantage that the nuances of each company's product design and the risks accepted by that company will be recognised, modelled and appropriately reserved for. Given the closer alignment of prudential margins to the actual risks accepted, it is expected that a principles-based approach will reduce the excess reserves under Regulation XXX, perhaps significantly. It is important to note, however, that because this is a new methodology, the regulators may insist on a basis that still includes some sizeable margins for conservatism.

Principles-based methodologies are currently under development, although it is likely to be a number of years before such an approach becomes effective. Another possibility for reserve relief is the adoption of valuation mortality tables that reflect the lower mortality expected for preferred lives. The American Council of Life Insurers has already proposed a split of the current valuation table into preferred and standard versions. The Society of Actuaries has an experience study in progress for preferred mortality, and new valuation tables based on this study will be developed over the next year. The adoption of new valuation mortality tables that include appropriate, but not excessive, prudential margins could be a relatively simple way to reduce the redundant reserves under the current regulations.

With such important changes to reserving methodologies on their way, the current securitisation activity may seem somewhat premature. However, it is probable that any changes would be prospective only, that is, apply only to policies issued after the effective date of the regulatory change. As demonstrated in figure 1, the Regulation XXX reserve strain for current in-force business can be significant and long lasting; therefore, locking in a relatively fixed cost for that funding now is still advantageous. Additionally, the current pricing environment assumes a cost of capital that is consistent with some kind of reinsurance or securitisation solution, therefore it is competitively important for companies to address the cost of financing the Regulation XXX reserve strain now, regardless of any potential future industry developments. Even under a principles-based regulatory environment we believe the conservatism introduced by prudential margins will ensure the securitisation solution remains a viable and attractive option.

- Duncan Briggs and Cheryl Tibbits are actuaries at Towers Perrin.

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