Keith Parker explores the complexities of Regulation XXX and assesses the industry's response to the hotly debated piece of legislation.

Regulation XXX in the US has been the subject of debate, worry and confusion, possibility, excitement and a myriad of other emotions since it was first proposed. These responses reached a crescendo just before the official implementation of this much-contested regulation on 1 January 2000. Its implementation was as auspicious as the date it was to become effective. However, the world of post-XXX looks very different from that which the doomsday prophets predicted. The industry's response to Regulation XXX, suggests that solutions seem to be available to meet the specific needs of most cedants.

Regulation XXX was implemented by the National Association of Insurance Commissioners (NAIC) and has now been adopted by all states within the US through codification. The regulation is called the NAIC Valuation of Life Insurance Policies Model Regulation (Regulation XXX). Generally speaking, this regulation altered the rules concerning the minimum standard for the valuation of plans of life insurance with non-level premiums or benefits and/or plans with secondary guarantees. At the outset it immediately became apparent that this meant the inclusion of term policies and universal life policies with secondary guarantees. Simply speaking, the revised regulation requires insurers to hold substantially increased reserves for these types of policies.

For term business reserves are concentrated around the middle of the underlying term period and thus the reserve curve under Regulation XXX looks somewhat humpback in shape. At this stage we are only two years into the growth in reserves with the most significant impact still to come. People holding extreme views wondered whether the US term market would be decimated and/or altered forever. A general `fire sale' took place during the latter part of 1999; consumers were urged to `buy now' before prices rocketed, however, panic did not take hold. In fact the US term market is as robust as ever. Why? The answer can be found by exploring the post-XXX world and looking at what industry participants are doing to manage XXX reserves.

Work in progress
It has to be said that Regulation XXX is a complicated piece of legislation and is a `work in progress'. Someone once said: "Necessity is the mother of invention." It is clear that the industry's broad response to the challenges posed by Regulation XXX has been to adopt solutions to immediate needs which may or may not have long-term implications. The continued availability of pre-XXX products - to which the legislation applies - at marginally increased prices is testament to the success of this approach. It could be fair to say that industry participants overreacted. Of course, reserving methodologies are a matter of professional opinion. Is any one piece of legislation any more `right' than another? Consumerism is a powerful phenomenon in the US and the insolvency of a life insurer is simply unacceptable. It could be argued that Regulation XXX, is overly cautious; having said that, erring on the side of caution in this type of environment is a natural response. What can be said, however, is that at the very least, the introduction of Regulation XXX was to ensure that adequate reserves exist for the guarantees provided by a policy.

Market reactions
Only two and a half years have elapsed since the formal introduction of Regulation XXX - not a very long time in the world of 30-year term products but nonetheless adequate enough to gauge its early impact.

Much of the feedback regarding the impact of Regulation XXX and the industry's response has been shared at conventions, conferences and forums, and in industry papers. The Regulation XXX Survey Subcommittee of the Society of Actuaries' Life Insurance Mortality and Underwriting Survey Committee conducted a formal survey in June 2001 in the US. The responses are particularly instructive.

A modicum of caution must be exercised in the interpretation of these responses owing to the fact that Regulation XXX had only been formally introduced for 18 months at the time the survey was conducted. It must also be recognised that only 49 insurance companies and four reinsurers responded. Is this representative enough to draw adequate conclusions? Perhaps: perhaps not. However, at present it is the most comprehensive information available on the subject. Of the 49 life companies, 34 (69%) considered, but did not necessarily implement, reinsurance as a solution. In terms of responses, changing product design and rates on existing products appear in second and third place, respectively. These two responses were popular and individually only marginally less than the use of reinsurance response. Surprisingly, 29% of total respondents indicated that they had taken no action whatsoever. Perhaps aside from those respondents who indicated no action had been taken, the results are consistent with intuition.

If these responses were to be considered in reverse order, taking no action in the light of Regulation XXX seems like a very brave thing to do. Considering the responses on an individual basis, however, makes more sense. Some companies had shorter length premium guarantees, some had large amounts of surplus and others wanted to gain a competitive advantage. An immediate question that springs to mind relates to the sustainability of the actions taken, or should I say, not taken.

The next two responses, namely changing rates and/or product design, encompass a large variety of individual actions taken. The two most popular design changes include shortening the length of the guarantee period and raising the level of the gross premiums. Others lowered the maximum issue age or the number of underwriting classes offered.

The use of X-factors was also explored in great detail. X-factors are used in the computation of reserves under Regulation XXX. I will not go into any detail regarding X-factors other than to say that the approaches taken in determining X-factors seem to be particularly diverse and provide a great tool in mitigating the impact of Regulation XXX.

Offshore versus onshore
The last of the responses that I will deal with relate to the use of reinsurance as a possible solution to Regulation XXX. Of the life companies that considered reinsurance, most of them (85%) considered an onshore reinsurer. However, using an onshore reinsurer may simply be moving the risk to the reinsurer without actually solving the problem, a factor that might be reflected in the price offered. Of course, a number of the US reinsurers are actually subsidiaries of foreign-owned companies. This is relevant as two of the four reinsurers that responded indicated that they went to an offshore affiliate for advice. One stated that it placed business with an offshore affiliate. In addition, a significant percentage of the life companies indicated that they placed business with an offshore reinsurer, subsidiary or affiliate. `Offshore' has increasingly become the buzzword in the industry. But offshore reinsurance isn't necessarily the solution unless the reinsurer can provide the letter of credit at a low cost. This requires both capacity and a good credit rating. Before the meaning of offshore can be explored, the role of how reinsurance helps a life company subject to Regulation XXX should be considered.

When a life company reinsures its term business it may offset its reserves on the ceded portion provided the reinsurer is licensed in the US or provides security. In return, the reinsurer provides the life company with reserve credit for the portion reinsured. An offshore reinsurer has three options available to provide reserve credit to the ceding company: it can place equivalent reserve assets in a US trust; it can provide the ceding company with a letter of credit (in effect a guarantee) for the equivalent reserve assets; or it can provide a combination of the two.

The reinsurer will most likely be able to reserve on a much lower basis than that prescribed under Regulation XXX, but this will depend on the reinsurer and regulation applicable in its offshore domicile. What effectively takes place is a form of reserve or regulatory arbitrage. This is nothing new and is widely used in both the life and non-life industries. It is, however, new to Regulation XXX. In addition, the choice of an appropriate offshore domicile can assist with tax efficiencies. Furthermore, some of the offshore domiciles are becoming attractive because they are not subject to US Federal Excise Tax.

One downside to the life companies using reinsurance, whether onshore or offshore, is that they give up potential mortality improvement gains and other related experience. Recently, some offshore reinsurers examined this and have subsequently developed ways to assist with capital relief whilst allowing the ceding companies to retain the risks that they believe they understand, and hence believe to be profitable.

It's difficult to draw a conclusion as to which of the responses is most appropriate; no single solution meets every cedant's needs. However, it is the sustainability of a response or set of responses that is most important. As mentioned before, the reserves under Regulation XXX follow a humpback shape. Regulation XXX is thus at present still in its infancy and some life companies might be adopting a very short-term view to a long-term problem.

These firms may be able to run today but they certainly won't be able to hide. In my opinion a combination of responses, given above, is most appropriate. I appreciate too that every company's internal dynamics differ from the next; this is important. However, it does appear that the use of reinsurance is one of the most sustainable of responses and hence one that should be seriously considered.

By Keith Parker

Keith Parker is vice president of sales and marketing, Canada LifeInternational Re. He can be contacted at keith.parker@canadalife.ie