The Financial Reporter · The Financial Reporter The Newsletter of the Life Insurance Company Financial Reporting Section SVL II: Connecting the Dots by Shirley Shao June 2005 Issue

The Financial ReporterThe Newsletter of the Life Insurance Company Financial Reporting Section

SVL II: Connecting the Dotsby Shirley Shao

June 2005 Issue No. 61

continued on page 3 >>

T here seems to be an exponen-tially increasing number of dotsin my job! AG38, RBC C-3

Phase 2, risk management, Sarbanes-Oxley, SOP 03-01, the Morris Report,IASB and IAIS Solvency, just to namea few buzzwords. What is my worldbecoming, where is it going, and howdo all of these dots connect? Or dothey?

I turned to the American Academy ofActuaries for an answer, and wasintroduced to the SVL II Task Force ofthe Life Risk Solvency Committee,chaired by Dave Sandberg. The proj-

ect began at the request of the NAIC in March2004. The Academy was asked to consider whatenhancements should be made to the currentStandard Valuation Law (SVL). The formulationof the SVL 15 years ago incorporated the thenlatest advances in modeling and risk awareness,resulting in an appointed actuary role and risk-based capital requirements. The NAIC askedwhat has been learned since that would be rele-vant to consider in a new standard valuation law(Standard Valuation Law II).

GoalThe goal of the task force is to develop a set ofanalytics, standards for communication andprinciples for reporting to be reflected in possi-ble enhancements to the valuation and capitalrequirements for life insurance companies in theUnited States.

Framework (from the top down)The task force is approaching this from two per-spectives: top-down and bottom-up (and maybeeverywhere in between, too).

From the top down, the task force would like tobuild a new enterprise risk management (ERM)reporting framework. Under this framework, anenterprise-wide view of all potential risks andrewards are to be explicitly identified and ana-lyzed. It would be a comprehensive and consis-tent ERM structure that applies to all producttypes, including life, annuities, health and rein-surance.

This proposed framework would require a rangeof rigorous and analytic approaches to producethe blend of reserves and capital; it wouldrequire the necessary review, accountability anddisclosure to address the traditional NAIC C1-C4 risks; and it could incorporate broader busi-ness risks, such as the impact of new business orother nonfinancial risk.

The key to this ERM framework is the use of amodeling-based, prospective valuation, whichwill be more principles-based than today’s for-mula-based valuation. This will allow reservesand capital to be determined based on theunderlying risks that pertain to the individualcompany, rather than a disconnected fixed for-mula for all companies. In addition, it enablesthe use of a consistent ERM framework for bothreserves and capital, rather than today’s some-what disconnected reserve and capital require-ments. In addition, it will enable reserves andrisk-based capital to be established consistentlyand be more aligned with how risk is measured

The Financial Reporter

Published by the Life Insurance CompanyFinancial Reporting Section of the Society of Actuaries

475 N. Martingale Road, Suite 600Schaumburg, Illinois 60173p: 847.706.3549f: 847.706.3599 w: www.soa.org

This newsletter is free to section members. A subscription is $15.00. Current-year issues areavailable from the communications department.Back issues of section newsletters have been placed in the SOA library and on the SOA Website (www.soa.org). Photocopies of back issues may be requested for a nominal fee.

2004-2005 Section LeadershipThomas Nace, ChairpersonDarin G. Zimmerman, Vice-ChairpersonKerry A. Krantz, SecretaryRichard H. Browne, TreasurerDaniel J. Kunesh, Council MemberHenry W. Siegel, Council MemberYiji S. Starr, Council MemberHoward L. Rosen, Council MemberBarbara L. Synder, Council Member

Jerry Enoch, Newsletter EditorLafayette Life Insurance Company1905 Teal Road • Lafayette, IN • 47905p: 765.477.3220f: 765.477.3349e: [email protected]

Richard Browne, Associate Editore: [email protected]

Keith Terry, Associate Editore: [email protected]

Joe Adduci, DTP Coordinatore: [email protected]: 847.706.3548

Clay Baznik, Publications Directore: [email protected]

Julie Young, Practice Area Administratore: [email protected]

Facts and opinions contained herein are the soleresponsibility of the persons expressing themand shall not be attributed to the Society ofActuaries, its committees, the Life InsuranceCompany Financial Reporting Section or theemployers of the authors. We will promptly correct errors brought to our attention.

Copyright ©2005 Society of Actuaries.All rights reserved.Printed in the United States of America.

June 2005 Issue No. 61

SVL II: Connecting the DotsWith an increasing number of complex issues facing the profession, there is a risk that respons-es will be adopted that are inconsistent with each other or even incompatible. The NAIC hasasked the Academy to consider what enhancements should be made to the current StandardValuation Law. The Academy has formed the SVL Task Force to examine possibilities for valuation and captial requirements. Learn about this important, ambitious task. Shirley Shao

Chairperson’s CornerThe section’s objectives for 2005.Tom Nace

Editor’s CornerOur next editor has been found! Other comments.Jerry F. Enoch

Status of Reserach Projects Sponsored by the Financial Reporting SectionThe title says it all. Short and sweet.Henry Siegel

Calculation of the Benefit Ratio in SOP 03-1In the last issue we carried an article that compared two approaches for calculating the bene-fit ratio under SOP 03-1. The Academy’s practice note states that both approaches are reason-able interpretations of the SOP. The author provides detail and additional insight into thismatter. Another “must read” for anyone who calculates these benefit ratios.Darrin G. Zimmerman

International Financial Reporting Standards (IFRS) UpdateThis brief update, based on a recent seminar on IFRS, summarizes Phase I, some expecteddirection under Phase II, the planned convergence between U.S. GAAP and IFRS, and resultsfrom a survey.Mark J. Freedman and Maria Torres-Jorda

Alternatives for Funding XXX ReservesA brief article that summarizes a number of methods available for funding reserves requiredunder Triple-X. Other applications of these methods, while not addressed, are possible.David R. Prickitt

Demystifying Life Insurance Securitization: XXX and AXXX Securitization Issuesand ConsiderationsAn examination of one of the methods for funding XXX reserves, which, of course, has broad-er applications and is an increasingly important source of capital for the industry.Steven D. Lash and Rebecca Kao Wang

What’s OutsideArticles of interest to financial reporting actuaries.

What’s Inside

1

8

10

10

11

14

16

18

23

2 Financial Reporter | June 2005

and managed within a company. The frameworkmust also provide enough safety and transparencywithin the modeling-based approach so that boththe regulators and industry can enjoy the benefits ofmore economic- (reality) based reserves and capital.

Since this ERM framework would depend on valua-tion actuaries’ doing the “right” thing, communica-tion will become ever more important to make itwork. Many governance issues around this frame-work will need to be built to ensure transparency andappropriate disclosures to a broad range of stake-holders. These may involve peer review, professionalstandards, management and regulatory oversight,etc.

If successful, this framework will: Ø

Strengthen the regulators’ ability to do their jobs.

Ø

Relieve the current patchwork collection of valuation requirements.

Ø

Align financial reporting with how the compa-ny actually manages its risks and opportunities.

Ø

Provide flexibility for innovative product designs.

Where We Are Now (from the bottom up)In the United States, there are various dots formingthat use model-based reserves (the AG 38, long-termUL solution) or modeled capital (RBC-C3 Phase 2).We have also been doing the model-based cash-flowtesting for more than a decade, but have not used theresults in our books except in rare circumstances. Inthe GAAP world, we see more and more “carve-outs”: FAS 133, SOP 03-01, fair-value disclosure,etc, that use model-based valuation. FAS 97 DACvaluation has also been model-based.

Outside the United States, several countries, such asAustralia, Canada and the United Kingdom, havemoved forward to model-based reserve and/or capi-tal requirements. There are even more examples, ifwe count the disclosure requirements. Given theflexibility of the model-based valuations, severalcountries are building—or have already built—governance processes around model-based valuationsto ensure the integrity of the valuation to the public,regulators and management.

Canada is the leader with its two-year-old requirement for peerreview of the required actuarialopinions for life, P&C and pen-sions covering:Ø

Report of the appointed actuary

Ø

Dynamic capital adequacy testing—a future financial performance report

Ø

Minimum continuing capi-tal and surplus require-ment—Canadian risk-based capital

Ø

Verification that dividend practices comply

Ø

Propriety of expense and investment income allocation between par and non-par business

Before requiring peer review, the regulator felt therewas too wide a range of practices under its model-based valuation, and that some actuaries were “skat-ing too close to the line.”

The peer review in Canada is an external review, usu-ally performed by consulting firms. It is preferablydone on a pre-release basis, which allows collegiality,but it may be submitted post-release. Ultimately, thereviewer would exercise professional judgment indetermining the extent and depth of the review. Theearly indication is that the peer review process isworking effectively.

The accounting firms in Canada have not been veryinvolved in the peer review, since the auditor can relyon the work of the actuary. Due to recent focus oncorporate governance resulting from Enron, theMorris review, etc., the regulator is consideringwhether this reliance should be terminated.However, even with increased audit scope, it wouldnot be expanded to include a recalculation of thenumbers. Rather, it focuses on the question of howmuch the auditor should review/state/opine onwhether the methods and assumptions employedwere appropriate and within a range of acceptedactuarial practice. It will probably require peerreview from the auditors for certain actuarial reports,but not for all.

Financial Reporter | June 2005

>> SVL II: Connecting the Dots

Shirley Hwei-ChungShao, FSA, MAAA, isvice president and actu-ary with PrudentialInsurance Company inNewark, N.J. She canbe reached at [email protected].


3


Moving to Europe, the failureof the United Kingdom’sEquitable, an event as signifi-cant in England as the failure ofEnron was in the United States,has prompted official investiga-tion of the actuarial profession.

The Morris Report from the United Kingdom gov-ernment was released in the past March. It conclud-ed that continued self-regulation by the actuarialprofession is unlikely to restore public confidencesince it has been too introspective, not forward-look-ing enough and slow to modernize. The professionalstandards have been weak, ambiguous and perceivedas influenced by commercial interests. There is alsoan absence of proactive monitoring of members’compliance with the actuarial professional standards.

Therefore, it recommended a fundamental restruc-turing of the regulatory framework for the U.K.actuarial profession:Ø

The regulation of the actuarial profession should be subject to independent oversight by the Financial Reporting Council (which also provides oversight to the U.K. accounting profession).

Ø

The FRC should create an Actuarial Standards Board with a majority of actuarial members and representation from the users of actuarial advice, consumers and regulators to set future actuarial technical standards.

Ø

The FRC should also oversee the other activities of the actuarial profession including setting codes of conduct, administering education, monitoring of compliance with professional standards and administering disciplinary procedures.

Ø

The actuaries who have statutory reserve duties have whistle-blowing duties with appropriate legal protections.

Separately, the IASB’s efforts in building globalaccounting requirements came from the cry fortransparent international accounting standards afterthe Asian financial crisis. The IASB has split its proj-ect in two parts. Phase I, a compromise, short-termsolution, is now in place for EU-listed companies.The IASB is now working on Phase II, which is sup-posed to provide a more rigorous solution to controlinsurance accounting once and for all. U.S. insurerswill be affected directly, since the IASB has an agree-ment with FASB to work toward convergence. PhaseII is moving toward requiring more, if not complete,model-based valuation.

While the IASB is busy with new insurance account-ing standards, the International Association ofInsurance Supervisors (IAIS) is looking into a newinternational solvency framework. The pressure ison, after the adoption of Basel II last summer, whichprescribed the capital requirements for banks andaligned them closer to modern risk managementpractices. Basel II provides incentive for firms toadopt more sophisticated approaches in modelingand risk management, and requires additional dis-closure of risk management practices. The IAIS alsohas reached a joint working agreement with theIASB.

Are you seeing dots yet?

Connecting the DotsSo, how can we form a connection between thishigh-level ERM framework at the top and what’salready happening around us at the bottom?

Since completion of a comprehensive ERM frame-work will take many years, the early phases of frame-work development will leverage the work of the keyNAIC/Academy initiatives, serving as “pilots” or“building blocks” to test applications for the broaderERM framework.

Initial Phase (Next 2 years)The SVL II Task Force will focus on implementingbuilding blocks for C-2 (pricing) and C-3 (interestand equity) risks. For pragmatic reasons, the first fewbuilding blocks will be completed at the productlevel. They will include high priority issues of cur-rent concern, such as RBC C-3 Phase 2 and reservesfor variable annuities and UL with secondary guar-antees. These dots can then serve as “pilots” or“building blocks” to test, shape and crystallize futureinitiatives, eventually leading to a comprehensiveERM state.

In the initial phase, the task force may also considerthe valuation of equity-indexed annuities, which canbe built off of the C-3 equity risk and interest riskpilots. Additional work will focus on correlation ofequity and interest risks. The task force may alsoaddress changes to best estimate assumptions overtime for long-term care.

In addition, the task force expects continued modi-fications of the asset default (C-1) and the generalbusiness risk (C-4) components to be done throughthe current RBC committee structures of the AAAand NAIC.

Basel II provides incentive for firmsto adopt more sophisticatedapproaches in modeling and riskmanagement...


The task force serves as a coordinator, the dot connec-tor, for the above initiatives. It works with variousAcademy groups, such as the one developing reservesfor UL with secondary guarantees, to ensure that theyare moving consistent with the strategic direction.

The task force takes on the work related to peerreview itself. A major concern of the ERM frame-work has been that model-based balance sheet entrieswill result in a wide range of practices between com-panies. This would challenge the regulators to deter-mine which practices are unreasonable. It wouldchallenge rating agencies and stock analysts, whorepresent customers, stockholders, bondholders andother members of the public, to evaluate the relativestrength of different companies. It would challengecompany management to know how aggressive orconservative its valuation is. Therefore, establishing arequired, independent regulatory review may be theprimary means used to provide an acceptable, nar-rowed, range of practice.

Given the sweeping impact of this project, the taskforce has devoted time to build communication linksto ensure adequate input and review. The task forceplans to reach out to other Academy committees,SOA sections, NAIC groups, the Casualty ActuarialSociety, various industry groups and rating agencies.It goes beyond the U.S. borders to reach the IAA,CIA and IAIS.

Next Phase (3-5 years)For the next phase, the task force will Ø

Expand the product types to fixed annuities, EIAs (if not completed in the initial phase), VUL with and without guarantees, traditional life (participating and non-participating for term and whole life), LTC, LTD, medical and perhaps product types such as dental and acci-dental death and dismemberment.

Ø

Monitor the remaining C-3 equity/interest and C-2 mortality/morbidity projects, taking into consideration the structure and the lessons learned from the pilots. This would also include putting a plan together to address C-1 and C-4 risks.

Ø

Develop a strategy to address correlations between product types and risk types. The goal is to study the issue and lay a framework. This may include methods that regulators can use to control allowed diversification credits.

Ø

Continue to work with the NAIC to develop oversight tools for the regulators. This includes validation and review procedures, as well as

self-regulating processes, such as peer review, back-testing, corporate gover-nance and reporting standards.

Ø

Coordinate the development of educational materials and training of both practition-ers and overseers.

Ø

Identify and work with the SOA to develop the neces-sary tools and studies to sup-port this initiative, such as: industry experience studies to support smaller compa-nies, industry “averages” for regulator or professional needs and industry studies to analyze relationships of assumptions (e.g. interest rates and contract-holder behavior, interest rates and company behavior).

Ø

Address the interaction of statutory reserves with tax reserves. This could include engaging tax authorities in discussion (this may be done via both this group and other Academy or SOA venues).

Peer ReviewThe task force is currently focused on peer review. Atthe March LHATF meeting, it presented the peerreview processes, practices and results in Canada.

The additional freedom and authority that comeswith model-based valuation will need to be counter-balanced with responsibility and accountability. Thisis particularly important in the Sarbanes-Oxleyworld of needing greater financial statement trans-parency.

Below are some of the questions the task force is cur-rently asking: Ø

Do we need to have a required review? Does it need to be independent? The Academy could recommend what would be useful and effective in a required review by the regulators.

Ø

How do we require a review? Since the first phase is focused on short-term test cases, a regulation may be the only practical alternative. For example, if regulators allow cash flow testing as a part of the AG 38 solution and they conclude that an accompanying review is needed, they may need to prescribe it, rather than waiting for company management or the profession to self-regulate.



5


Ø

What is the scope of therequired review: is it product-specific or is it for the wholecompany? Could the regulatorauthorize or approve an inter-nal review process as sufficient?Is it just for AG 38 products,

for RBC C-3 Phase 2, etc? Can the regulator “waive” the review, and for what reasons?

Ø

Who is the audience of the required review? Is it the appointed actuary, senior management, the Board of Directors, the regulator or the public at large?

Ø

What are the acceptable qualifying criteria to be a “reviewing actuary?” Is there an approval or accreditation process? In Canada, the peer reviewer is selected by the appointed (or prepar-ing) actuary and approved by the Board, with veto power by the regulator. How will this review be coordinated with the audit function to clarify accountability and reliance?

Ø

What is the frequency of the required, independent review? In Canada, it is every three years, but the review is for the entire company, like a triennial examination. What is the timing of review: pre-release or post-release of compa-ny numbers?

Ø

What must be included in the report of the review?

Ø

What is the legal protection for both the review-ing and the opining actuary? Can confidentiali-ty be extended to the review report? This answer is linked to answers to other questions. Since the short-term proposals will likely be imple-mented through regulations only, the only prac-tical options may be to extend the confidential-ity and opining actuary protection to the reviewing actuary.

Ø

Is there is a need to collect key assumptions in a central location (AAA, SOA, ASB, NAIC, etc.)?

Ø

Will there be an option or a requirement to rely on the domestic state?

The task force will coordinate with the Academy’sProfessionalism Committee, which is updating their1997 document on peer review, and with theActuarial Standards Board.

What does it mean to me?This is all very exciting, but challenging! How do I, asa valuation actuary, respond to these changes? And, insome ways, I’m not capable of responding alone. Howcan my profession respond?

Ø

Increasing financial modeling knowledge: In my mind, the requirements for cash-flow test-ing were a revolutionary change for the actuari-al profession. I, along with a generation of valuation actuaries, was brought up to become familiar with modeling. This knowledge provides me with an excellent starting point in the model-based valuation. To take the next step will require more sophisticated modeling to evaluate the more complicated risks, to account for correlations and to determine the appropri-ate principles-based methods for measuring reserves and capital. Of course, for those risks that require stochastic processes, much more sophistication in modeling techniques would be required. I will need to figure out the appropri-ate generators to use, address the limitations of computing power, determine the appropriate cell construction, and look for more robustcomputing platforms.

Ø

Increasing knowledge of customer behavior and risk drivers: The model’s usefulness is limited by how well we can describe and simulate real-life experience. For example, how will customers respond in differing situations to the various guarantees and options that we offer? I can run the stochastic model 100,000 times, but the results are only meaningful if the risk drivers in the model correspond effectively to reality in these scenarios. This effectiveness will need to be tested and validated.

In addition, I will need to be able to build experi-ence studies that monitor various risk drivers morefrequently than that at present, since the prospec-tive valuation in the new world is likely berefreshed or unlocked frequently. It is critical formy colleagues in other firms and me to pool ourexperience efficiently to understand the risks andtheir financial implications.

Ø

Increasing finance and investment knowledge:It is becoming more and more important that our models and valuation be connected with models and valuation used elsewhere in the financial markets. Option theory and hedging strategies will enter my daily life as I continue to debate between the “real world” and “risk- neutral world.”

The model’s usefulness is limitedby how well we can describeand simulate real-life experience.


6

Ø

Increasing responsibilities, counter-balanced by increasing accountability: I will probably feel more empowered, as the new valuation heavily depends on my judgment in assumptions, methods, modeling and results. However, I am also going to be more on the line to withstand peer review for these assumptions and model validation, to make additional disclosures to management and the public, to ensure that adequate controls are in place, to document, document, document and to support regulators and auditors in their review.

Ø

Increasing communication and education to company management and outside audiences: I need to be able to unveil the “black box” to laypersons. As more sophisticated analytical tools and processes are built, I need to be able to ensure that my audience understands the crucial elements of complex models and the resulting conclusions. I need to be able to explain the variances from period to period. The likelihoodof increasing volatility as a result of the new valuation approach will make this communica-tion ever more important.

Some of these developments cantake a very long time to evolve,and I sometimes find it difficultto keep up with current events—never mind about shaping them.Given the revolutionary natureof these developments, however,the profession and I cannotafford to not be at the table,which is why I decided to jointhe SVL II Task Force. I alsodecided to monitor IASB activi-ties much more actively thisyear, as it develops the newexposure draft for insuranceaccounting. It is great that theAcademy, via the SVL II Task Force, is actively tak-ing the leadership in connecting all the dots, mak-ing evolutionary changes while upholding a visionof the end game that will be revolutionary. We, asthe members of the Academy, should all pitch in toeffectively connect the dots!!!


$

7

The latest and most comprehensive guide onthis subject, this must-have text is the work ofexpert authors from accounting, actuarial, banking and legal backgrounds who providereal-life lessons learned and practical, hands-ontechniques that immediately can be applied intoday’s swiftly moving M&A environment.

For more information and to order a copy, visit the SOA Web site athttp://books.soa.org/ma.html.

Delivering all you need for your next deal


Chairperson’s Cornerby Tom Nace

Setting Objectives for the Section

I n my inaugural article last issue, I mentioned thatI would try to keep you informed of the sectioncouncil’s activities as we progress through the year.

This is particularly important this year, since we arein the process of taking on a different role because ofthe SOA strategic plan.

One of the subtle differences in how we will operategoing forward is in the setting of objectives for thesection. While planning the year’s activities did occurin the past, this year the process was more formal-ized. At our section council meeting in February, webrainstormed as to how we could benefit the sectionand what we could realistically accomplish this year.I would like to review with you what we have settledon as our section objectives for the year.

OverviewIn the last issue I mentioned how the section’sresponsibilities were categorized by the formation ofvarious “teams”. Let me refresh your memory as tothe section council teams:

Ø

Membership valueØ

CommunicationsØ

Continuing educationØ

Basic educationØ

ResearchØ

Marketplace relevanceØ

Professional community

In setting our objectives, it was only natural to defineobjectives for each team.

Membership ValueTo improve upon the services provided to our mem-bers, we need to know what you think about thoseservices. What do we do well? What could useimprovement? What should we be doing that wedon’t do now? By addressing these questions we, thesection council, can improve upon the value we pro-vide to our members.

We plan to survey members to learn what you thinkabout the services provided. The survey will beonline, and it has already been drafted. We hope tohave it finalized at our next council meeting and dis-tributed to you by mid-April.

I strongly encourage you all to take the time to par-ticipate in the survey, once you receive notice of itsavailability. We will share the results with you later inthe year.

CommunicationsOur communication plan for 2005 involves someactivities, that have typically been successful, alongwith some newer assignments. In the category of theformer, we have our newsletter, which we will con-tinue to use as one of our main communicationdevices, with our goal of four issues per year.

In addition, we have an objective for 2005 of build-ing communications with the Board of Governors(BoG). In the past, there has been very little in thelines of communication with the BoG. That is aboutto change. In the future, we will maintain a two-waycommunication with the BoG, through the use of aBoG partner who has been assigned to the FinancialReporting Section—Errol Cramer.

The goal of communicating with the BoG is to makesure the Board is aware of the section’s activities,while at the same time the section stays connectedwith the latest strategic direction of the BoG. Thisshould serve to make both the sections and the BoGmore effective in their respective roles.

I have already met with our BoG partner and wehave drafted a communication plan, which we willboth follow.

Finally, in the area of communications, we have set anobjective of improving the section Web site. Our goalis to improve upon the content and the design, as wellas making it more user-friendly. Stay posted for moreon the latest developments in this endeavor.

Continuing EducationProviding continuing education to our members hasalways been one of the cornerstones of the servicesthe council provides for its members. This year willbe no different, as we plan to offer continuing edu-cation through the use of seminars, webcasts andfinancial reporting sessions at the spring and annualmeetings.

The seminars that are in the works at this pointinclude the following topics:Ø

Basic GAAP seminarØ

Advanced GAAP seminarØ

Stochastic modelingØ

Practical guide to cash-flow testingØ

Term insurance (jointly sponsored with the Product Development Section)

This list is preliminary. When we formalize the con-tent and the dates for the seminars, we will notifyyou so that you can make plans to attend.

Chairperson’s Corner

Thomas Nace, FSA,MAAA, is vice presidentwith Polysystems, Incin Cherry Hill, N.J. He can be reached [email protected].

8

In addition to the above seminars, we are planningseveral webcasts throughout the year. Webcasts offermembers a convenient and cost-efficient way ofobtaining continuing education. To date, the web-cast topics cover the following:

Ø

Update on GAAP issuesØ

Sarbanes-Oxley implementation issuesØ

International accounting standards updateØ

SVL 2 Project update

Finally, as usual, we will provide financial reportingrelated sessions at the spring and annual meetings.Information on these will be provided in the prelim-inary (and final) programs distributed by the SOA.

As you can see, you won’t be lacking for opportuni-ties to improve your knowledge base in 2005.

Basic EducationBasic education is one area in which the sectionshave not been involved at all in the past. In 2005, wewill be providing support to the E&E Committee intheir efforts to update the examination syllabus.

In addition, we will be initiating our own review ofthe syllabus for financial reporting topics. Our goalis to make sure we have identified financial reportingtopics that we believe should be on the syllabus.While we will not be directly involved in setting thesyllabus, this objective offers us the opportunity to atleast provide feedback.

By taking a proactive role, we hope to not only estab-lish ourselves as interested parties in the process, butwe also hope to be recognized as a valuable resourcethat can offer improvements to the basic educationsystem.

ResearchLast year we initiated a new research project, cover-ing financial disclosure practices of life insurancecompanies. During 2005, we will be monitoring theprogress of this project to its completion. Results ofthe research will be made available to our members.

In addition, we are currently supporting the updateto the GAAP textbook, whose original publicationwas a tremendous success.

Finally, through our survey, we will be looking to ourmembers to tell us what research projects in thefuture would hold the most interest for you. (Again,I stress the importance of completing the surveyonce it is available.)

Marketplace RelevanceThe goal of marketplace relevance is to team withother actuarial organizations or sections to provide aservice to actuaries who share a common interest.

In light of this, our objectives for 2005 encompassour partnering with other sections in a variety of dif-ferent initiatives.

We will be teaming with the Product DevelopmentSection, as I mentioned earlier, to provide a seminardealing with term insurance. The seminar willencompass both product design and financial report-ing topics.

In addition, we will be partnering with theManagement and Personal Development Section toprovide a session at the Annual Meeting dealing witheffective presentations for financial managers. Thissession is an initial attempt at offering education inthe area of personal skills as opposed to technicalskills for the financial reporting actuary.

We have also joined forces with several other sections(Product Development and Reinsurance) to addressthe issue of improving our respective Web sites.

Finally, in a social endeavor, we will team with theInvestment Section in offering a joint reception atthe Annual Meeting.

While sections have done some collaboration withother sections in the past, you can see that in 2005we will take a large step forward in this area.Providing different but synergistic perspectives canonly improve the benefit provided to members.

Professional CommunityProfessional community consists of reaming withother non-actuarial organizations to provide a serviceto actuaries, in which both organizations might ben-efit. We have postponed setting any objectives forthis area until 2006.

ConclusionSo there you have it. We certainly have a full slate ofactivities for 2005, all aimed at making us betterinformed, better-trained actuaries.

I wanted to take the time to address our 2005 objec-tives for a couple of reasons. One, I think it is impor-tant that you are aware of all that is available to youas financial reporting actuaries. Second, I think it isimportant that you have an understanding and anappreciation for all that the section council does.Keeping the members in the loop as to the activitiesof the council is one of my personal goals this year.

While we are attempting to do a lot in 2005, if thereare things that you believe we should be addressingthat aren’t on our to-do list, please let me know. Iwould be very interested in your feedback.


$

9


Next Editor Found! Other Thoughtsby Jerry F. Enoch

I am very pleased that we have found the next edi-tor of The Financial Reporter. Rick Browne, fromKPMG in Chicago, has agreed to succeed me as

editor. Rick has been serving as an associate editorand has agreed to be the next editor, in addition toserving on the section council. When Rick asks forhelp, I hope he gets it!

Rick has already begun taking a more active role inthe editing process, and I expect him to be well pre-pared and chomping at the bit to take over when thetime comes. Rick’s increased involvement hasalready begun to make it easier for me.

I continue to appreciate the authors who write forus. Not only do they provide important informationto the section membership, but, after having written

their articles, they work diligently and cheerfullywith the editors to make the articles easier to readand more useful to the readers. I hope that each ofyou will write a short e-mail of thanks to one of ourauthors. The authors’ e-mail addresses always appearbelow their pictures in their articles.

By the time you receive this issue, there will be little,if any, time before the deadline for submitting arti-cles for the September issue (June 6). I encourageyou to consider writing an article for the newsletter.In our busy profession, there is much about which towrite. The deadline for submitting articles for thefollowing issue is expected to be September 5.

- Jerry

Editor’s Corner

Jerry F. Enoch, FSA,MAAA, is vice presidentand actuary withLafayette Life InsuranceCompany in Lafayette,Ind. He can be reachedat [email protected].

$

Status of Research Projects Sponsored by the Financial Reporting Sectionby Henry Siegel

Financial Statement Disclosure Practices ofLife Insurance CompaniesThis project describes the types of company financialstatement disclosure techniques utilized by U.S. andCanadian life insurers, the extent to which thesemethods are standardized within the industry, therelative value these practices bring to examiners offinancial statements, and the metrics and measures acompany uses to quantify its risks and assess compa-ny performance.

Researcher: Ernst & Young

Status: Project is proceeding slightly behind sched-ule. Final report due during the 3rd quarter of 2005.

Risk-Based Capital CovarianceThis project is an investigation into the covarianceand correlation among various insurance and non-insurance risks generally and particularly in the tail(defined as two standard deviations from the mean).

Status: Project has stalled. Discussions are underwayto decide whether and how to proceed.

Contact Henry Siegel at [email protected] if you wantadditional information on either of these projects. $

10

T he March 2005 issue of The Financial Reportercontained an article by Jay Vadiveloo, Ph.D.,FSA, and Richard Bass, Ph.D. The article

described two methods for calculating the benefitratio described in AICPA Standard of Practice(SOP) 03-1. Method 1 calculates the benefit ratio asthe quotient of the expectation of A and the expec-tation of B (where A is benefits and B is assess-ments). Method 2 calculates the benefit ratio as theexpectation of the quotient of A and B. The authorsalso offer their opinion that, since A and B are neg-atively correlated, Method 2 (which is proven toproduce a larger result) is the “correct” method. Bycharacterizing Method 2 as the “correct” interpreta-tion, one might infer that the authors are of theopinion that Method 1 is incorrect.

On March 8, the American Academy of Actuaries’Life Financial Reporting Committee (LFRC) met inChicago for its quarterly meeting. The authors’ arti-cle caused a very spirited discussion among the atten-dees, for one of the items discussed during the meet-ing was the LFRC’s Practice Note on SOP 03-1. Thisnote is presented in a FAQ (frequently asked ques-tions) format. Question 26 addresses this issue anddeclares that both methods are being employed byactuaries implementing SOP 03-1. The practice notestates that both methods constitute reasonable inter-pretations of the SOP and that other reasonableinterpretations may exist.

The LFRC discussed two main reasons why Method1 (the ratio of the expectations) is a reasonable inter-pretation of this standard. They are:

1. Letter of the Law. The relevant part of SOP 03-1paragraph 26 states:

The amount of the additional liability should bedetermined based on the ratio (benefit ratio) of (a)the present value of total expected excess paymentsover the life of the contract, divided by (b) the pres-ent value of total expected assessments over the life ofthe contract... The insurance enterprise should cal-culate the present value of total expected excess pay-ments and total assessments and investment mar-gins, as applicable, based on expected experience.Expected experience should be based on a range ofscenarios rather than a single set of best estimateassumptions.

The standard does not explicitly describe the expec-tation of random variables, but the language comesvery close in form to saying that the benefit ratio iscalculated as the expectation of A divided by theexpectation of B. The standard does not describe theexpectation of a ratio. One can reasonably hold theopinion that the expectation of the ratio is a moretheoretically correct approach; however, that conclu-sion would be based on an intimate understandingof the economic characteristics of certain products,not on a strict reading of this standard.

2. Internal Consistency. Often accounting stan-dards need to find a practical solution to a theoreti-cal problem. The calculation of the SOP paragraph26 liability takes the following form:

Historical B * (Expected A ÷ Expected B) –Historical A

This general form for liability development has thedesirable qualities that it produces a zero value atinception, it produces a zero value when all liabilitieshave been extinguished, and along the way ExpectedB and Historical B will trend toward one another,just as Expected A and Historical A will also. Thisform works irrespective of how A and B are defined(it is a highly practical approach). However, thisrequires Historical B and Expected B to be definedon a consistent basis. If the benefit ratio were to bedefined as the expectation of the ratio, the formulabecomes:

Historical B * (Expected [A ÷ B]) – Historical A

It is true that, as the liabilities retire, the variabilityof the future will diminish, forcing the final result tozero; but there is no guarantee that this will occur ina smooth or explainable fashion, since the develop-ment of the benefit ratio is less consistent with thedevelopment of historical cash flows than underMethod 1. It is also true that the increased variabil-ity of Method 2 can be mitigated by using a corri-dor-type approach in unlocking, or perhaps by othermeans, as discussed below; nonetheless, Method 1retains an internal consistency advantage overMethod 2.

Calculation of the Benefit Ratio in SOP 03-1by Darin G. Zimmerman

Financial Reporter | June 2005 11


Darin G. Zimmerman,FSA, MAAA, is manag-ing actuary with AEGONUSA, Inc. in CedarRapids, Iowa. He can be reached at [email protected].

As persuasive as these arguments may be, the LFRCdoes not take the position that these arguments cat-egorically prove Method 1 is the only reasonableinterpretation of the standard. We believe it is rea-sonable to hold the opinion that Method 2 is a moretheoretically correct approach (since it implicitly rec-ognizes that A and B are negatively correlated), andthus one could reasonably argue that Method 2 ismore in line with the spirit of the SOP.

Likewise, employing a benefit ratio that is the expec-tation of the ratio of A and B will produce the essen-tial characteristics of a liability formula (start andend at zero), and it is quite possible that the interme-diate results will be explainable, depending on theparticular facts and circumstances of the productbeing valued. As such, we believe Method 2 is also areasonable interpretation of SOP 03-1, and is prop-erly characterized as an “acceptable practice” in ourpractice note on the subject. The actuary shouldconsider these—and possibly other reasonable inter-pretations—in the context of other aspects of thecompany’s SOP liability calculation.

One other reasonable interpretation might includecombining Method 2 with a corridor approach tounlocking the benefit ratio. The authors specificallymention greater earnings volatility as one of thedrawbacks of Method 2. Tempering that volatilitywith a corridor approach to unlocking might be apractical way to implement a calculation that has thebenefit of explicitly recognizing the negative correla-tion between the benefits and assessments withoutproducing excessively volatile results that do notaccurately portray the underlying economic realitiesof the business.

The following numerical example is presented in aneffort to help the reader better comprehend what ismeant by internal consistency.

Consider a variable annuity with a return of premiumguaranteed minimum death benefit (GMDB) featurethat has an assumed mortality rate of 2 percent andtotal policy charges of 2 percent of account value. Themodel’s projection period is one year and there areonly two scenarios tested, as shown in Table 1.


>> Calculation of the Benefit Ratio in SOP 03-1

Account Balance Death Total Scenario Beginning Ending Benefits Charges BRUp 100 120 0 2.40 0%

Down 100 80 .40 1.60 25%

Combined 200 200 .40 4.00 10%

12

BR Death Hypothetical Scenario x Charges Benefits Difference SOP LiabilityUp .24 0 .24 .24

Down .16 .40 (.24) 0

Combined .40 .40 0 N/A

Table 1Hypothetical Annuity GMDB Cash Flows

Table 2SOP 03-1 Liability Calculation Using Method 1

The benefit ratio would be 10 percent underMethod 1 and 12.5 percent under Method 2. Theliability in Paragraph 26 of the SOP is calculated asBR*charges, and is reduced by benefits paid in excessof the account balance, but is never less than zero.Using Method 1, the Benefit Ratio of 10 percentwould yield the results contained in Table 2.

Using Method 2, the SOP Paragraph 26 Liability iscalculated using a benefit ratio of 12.5 percent. Theresults of these caluclation can be found in Table 3.

This example demonstrates that the expectation ofthe Method 2 Benefit Ratio multiplied by assess-ments is greater than the expectation of benefits.Method 1 is similar to an unbiased estimator sincethose two quantities are equal. If the actuarybelieves the SOP liability should be both an

unbiased estimator andshould explicitly recognizethe negative correlationbetween benefits and assess-ments (as Method 2 does),one could adjust the liabilitycalculation by multiplying theMethod 2 Benefit Ratio by aconstant multiplier in orderto remove the initial bias contained in Method 2.

Finally, I’d like to thank the authors for their article.In my circle of professional acquaintances it has pre-cipitated a discussion that I feel is much needed, andI know I have a much better understanding of theissues involved as a result of having read theirthoughts on the subject.

...one could adjust the liability calculation ... in order to removethe initial bias contained in Method 2.


BR Death Hypothetical Scenario x Charges Benefits Difference SOP LiabilityUp .30 0 .30 .30

Down .20 .40 (.20) 0

Combined .50 .40 .10 N/A

$

Table 3SOP 03-1 Liability Calculation Using Method 2


T his article is based on a seminar about interna-tional financial reporting standards (IFRS)sponsored by the Society of Actuaries and

Ernst & Young LLP on November 30 and December1, 2004. Attendees came from the United States,Canada, the United Kingdom, France, Italy,Singapore and Trinidad.

The seminar began with an update on the currentstate of the International Accounting StandardsBoard’s (IASB’s) insurance project, presented byIASB board member, Tricia O’Malley. Europeanlisted companies are required to comply with IFRSfor their 2005 consolidated financial statements.The IASB originally envisioned a full fair valueframework for insurance liabilities. However, giventhe lack of time and fierce opposition to a fair valuestandard, a two-phased approach was finally adopt-ed for insurance contracts. Phase I, effective in2005, requires companies to implement severalcomponents of the IFRS framework that do notinvolve significant conversion efforts and will notlikely be reversed during Phase II.

Phase I and Phase II IFRS RequirementsInsurance companies must value their assets basedon IAS 39, the standard that applies to financialassets and liabilities. IAS 39 requirements for invest-ed assets, derivatives and embedded derivatives aresimilar to those defined in SFAS 115 and SFAS 133

for U.S. GAAP. Companies are required to classifyeach product as either an investment or an insurancecontract. Products, such as guaranteed investmentcontracts, which contain only financial, lapse orexpense risk, would be classified as investment con-tracts. Term insurance, U.S.-type universal life prod-ucts and variable contracts with guaranteed mini-mum death-benefit features would meet the defini-tion of insurance contracts. Investment contractsmust be accounted for under IAS 39, which givescompanies the option to use either a fair value oramortized cost valuation technique. Some invest-ment contracts (e.g., U.K. unit-linked products)have service contract features which must beaccounted for under IAS 18. Until Phase II is ineffect, insurers must account for insurance contractsunder IFRS 4, which is principally based on thecompany’s existing accounting policies.

A summary of the key standards that apply to insur-ance companies is shown in Exhibit 1 below.

Once the IASB issues a standard, it must beendorsed by the European Commission before itbecomes effective in the European Union (EU).Intense political activity surrounded the endorse-ment and application of IFRS. The EU adoptedIFRS 4 in its entirety, but IAS 39 was approved onlyafter carving out several items. The European

International Financial ReportingStandards Updateby Mark J. Freedman and Maria Torres-Jorda

14

Phase Assets

Phase I IAS 39 forInvested Assets

LiabilitiesInvestment Insurance

IAS 39 and some IFRS 4Aspects in IAS 18

Phase II IAS 39 for Invested Assets

IAS 39 and some Phase II StandardAspects in IAS 18 (not yet defined)

Exhibit 1Key Standards for Insurers


Central Bank and various EU banking and securitiesregulators expressed concerns that the fair valueoption might be used inappropriately when appliedto financial assets or financial liabilities whose fairvalue is not verifiable. IAS 39’s allowance of report-ing all financial assets and liabilities at fair value wasrestricted by the EU, so that European companies donot have the choice of reporting their investmentcontracts at fair value, unless the liability cash flowsare contractually linked to the performance of assetsthat are measured at market value. The IASB is con-tinuing discussions with the European Commission,and the full fair value option may be amended toreflect the concerns of the European Central Bankand regulators.

When the challenges and efforts related to the 2005transition appear to be over, it becomes time to startthinking about the Phase II requirements. The IASBre-started Phase II deliberations in July 2004, with a“clean sheet” approach. As Tricia O’Malley stated,the Board is not considering any specific model atthis point, but any potential standard has to be con-sistent with the overall IFRS framework and objec-tives. The key goal of the IFRS framework is to pro-duce financial information that is useful to makeeconomic decisions. This means that the informa-tion should be readily understandable, relevant, reli-able and comparable. The IASB considers thatembedded value frameworks have several positiveattributes, but Tricia highlighted that the inclusionof future investment returns in the valuation of theliabilities is their major pitfall. Though unclear whatthe final outcome is going to be, she mentioned thatthe Phase II model may likely be based on a prospec-tive discounted cash flow approach.

The development of the Phase II standard has nowbecome one of the several “modified joint projects”undertaken by the IASB and FASB. “Modified joint”implies that one Board is responsible for bringing theproject to a point where a Preliminary ViewsDocument can be released. The other board wouldthen issue an Invitation to Comment, incorporatingthe Preliminary Views Document. After this stage,the project becomes “joint,” and both boards areexpected to issue the same or similar exposure draftsand final guidance. International convergence is nowa key component of FASB’s strategy, which is highlyencouraged and supported by the Securities andExchange Commission. Steve Belcher, a FASB repre-sentative, stated that despite challenges and obstaclesto overcome during the process, both boards arecommitted to convergence in an effort to improvefinancial reporting.

The SurveyDuring the seminar, a survey was conducted amongthe audience to capture their reactions toward theissues discussed in this article. Interestingly, themajority of the attendees believes that the IASB willultimately adopt a fair value model for insurance inPhase II and that the IASB and FASB standards willconverge sometime between 2009 and 2013.Additional details about the survey results can befound in Exhibit 2.

Exhibit 2Survey Results - Key HighlightsThe survey was conducted among 35 senior insuranceexecutives who attended the “International FinancialReporting Standards for Insurers” seminar held onNovember 30 and December 1, 2004 in New YorkCity.

• 38 percent personally prefer a fair value frame-work for Phase II. A close second was U.S. GAAP, in its current state.

• 66 percent believe that the IASB will ultimately adopt a fair value model for Phase II.

• 69 percent think that the IASB and FASB will ultimately converge sometime between 2009 and 2013. Only 3 percent believe that conver-gence will never occur.

• 50 percent of those currently involved in an IFRS conversion project for insurance state that dealing with standards that are still a moving target was the most major challenge faced. System changes came in second at 20 percent.

• Of those respondents employed by companies that are required to comply with IFRS by 2005, approximately 70 percent are planning to (1) closely monitor Phase II developments, (2) try to influence the direction of the standards, and (3) pilot test different proposals. Of those employed by other companies, most are plan-ning to assign a few people to monitor develop-ments, but on a more passive basis until the joint IASB/FASB Phase II exposure draft is issued.

ConclusionIn general, the main takeaway for those employed bya European company needing to comply with IFRSwas a sense of relief, because the Phase II standardwas being delayed. On the other hand, manyemployed by U.S. companies were quite surprisedthat U.S. GAAP and IFRS standards are moving soquickly toward convergence. All seemed to thinkthat the developments over the next few years shouldbe quite interesting.

Maria Mercedes Torres-Jorda is an actuarialadvisor at Ernst & YoungLLP in New York, N.Y.She can be reached [email protected].

Mark J. Freedman, FSA,MAAA, is a senior actu-arial advisor at Ernst &Young LLP inPhiladelphia, Penn. Hecan be reached [email protected].

$


Alternatives for Funding XXXReservesby David R. Prickitt

F ive years ago, the life insur-ance industry thought it waschanging forever: XXX was

coming...level premium terminsurance was going away. Theproduct that had been so popularin the last few years was facing ahuge regulation change. The pre-mium increase necessary to sup-port the new reserves would beenormous.

The popular press advocatedbuying level premium term now,before the large premium increas-es from the new regulation.Direct companies marketed their

products in a “fire sale” environment. The clockstruck midnight on January 1, 2000; the industryheld its breath and waited. What would happen?From the consumers’ point of view, very little hap-pened.

The anticipated premium jump, as the regulationtook effect, was small and short-lived. In fact, premi-ums are now at or below their pre-XXX levels. Whathappened? Where did all the reserves go?

Companies have used a variety of tools to maintaintheir premiums and comply with the new regula-tions. Of course, no single solution works for everycompany. Some of these alternatives have been usedfor the last five years (old school) while others arejust now gaining traction in the marketplace (newschool). They differ in complexity, duration and set-up cost. Some of them allow the direct writer to keepthe emerging profits, while others do not.

BackgroundUnder XXX, companies have to establish reservesduring the first half of a premium guarantee periodthat could be multiples of the annual premiums. Thecompanies can then release these reserves in the laterpart of the premium guarantee period. This createsthe classic humpback reserve pattern.

GAAP reserves are set on “realistic assumptions”with a provision for adverse deviation. The reserves

increase in the early part of the term and decreaselater. However, the humpback is much smaller andflatter than on a statutory basis. This creates a largedifference in the amount and development of levelpremium term insurance reserves that increases overtime and decreases as the term period ends.

Old SchoolSelf FinanceSome companies have chosen to retain the reserveson the books of the direct writing company. Theincrease in reserves required by XXX is offset by adecrease in surplus. In this method, the direct writerenjoys the economic benefit of its product. Thismethod is simple to implement and no external par-ties share in the profits. Offsetting these benefits,companies must decide to invest company surplus oraccept lower profit levels on these products to main-tain competitive premiums.

Traditional CoinsuranceOther companies have reinsured large percentages oftheir business to traditional reinsurers. In fact, a 90-percent cession is not uncommon. The reservestransfer to the balance sheet of the reinsurer. Thedirect writer receives a commission at issue but givesup the share of the profits from the product afterissue. This alternative is easy to implement and sometraditional reinsurers have made this a large part oftheir business.

Affiliate Reinsurance Backed with Short-term Letters of CreditSome larger companies have reinsured their businessto an offshore, unrated affiliate. The reinsurer isestablished in a jurisdiction where the GAAP reserveis sufficient for the valuation standard. In thesearrangements, the direct writer usually sets up liabil-ities equal to the GAAP reserve. The offshore entityprovides reserve collateral for the difference betweenthe statutory and the GAAP reserve. Since the rein-surer is unauthorized, the collateral must be in theform of either assets in trust or letters of credit.Usually the reinsurer buys a short-term letter ofcredit written by an acceptable unaffiliated bank.Reinsurance regulators have strict requirements onthese letters of credit. There can be no conditions for

16


the ceding company to draw on the instrument(clean), it cannot be terminated before the expirydate (irrevocable) and will be renewed unless thebank provides sufficient written notice (evergreen).Banks are currently offering five-year instruments inthe market that meet these requirements.

In order to be acceptable to regulators and auditors,this needs to be an “arm’s length” transaction. Thecost of the reinsurance must be reasonable based onhow the risks are divided between the two parties.Therefore, economic benefits from the business areshared between the direct writer and the offshoreaffiliate.

This structure works well and can be set up quickly.Currently, short-term letters of credit are inexpen-sive, but they are static and do not increase. Theneed, however, continues to increase each year as thereserve increases in the early part of the humpback.Therefore, a company must secure more capacitythan it currently needs. This could be expensive aswell as inefficient. Alternatively, the company cango into the market each year to meet the currentneed; yet that strategy may expose the company to apricing risk.

Additionally, there is a fundamental mismatchbetween liabilities with durations of up to 30 yearsbeing backed by short-term instruments. Investorsand rating agencies are concerned that this structurecould be vulnerable to price increases in letter ofcredit costs.

New SchoolSecuritizationSecuritization is considered to be the most compre-hensive solution to the extra reserves resulting fromXXX. The structures developed to date are quitecomplex and the transactions set up have been timeconsuming and expensive. Therefore, these transac-tions make the most economic sense if they are largeand cover long duration business.

Under this structure, the direct writer places thereserves in a captive reinsurer. The captive reinsurersells bonds. The proceeds from the bonds are used topurchase assets to back the reserves. The bonds arerepaid over time with free cash flows from the poli-cies, investment income from the assets and therelease in reserves as the level premium term ends.

This structure can last throughout the term of thebusiness and the ongoing cost is very reasonable. Italso insulates the company from any risk from letterof credit cost increases.

Frequently, a financial guarantoris used to maintain a very highcredit rating on the bonds byguaranteeing the payments tothe bondholders. This gives thefinancial guarantor control ofthe economics of the transac-tion. Because the financial guar-antor needs to be sure that the cash flows from thebusiness are sufficient for the obligations it has guar-anteed, the guarantor may require that the profitsremain in the captive as protection to the bondhold-ers. Over time, if permitted by the structure, thesegains could be returned to the direct writing compa-ny as a dividend.

Long Duration Letters of CreditLong duration letters of credit are a new tool to thismarketplace. These instruments are used in the samestructures as the short-term letters of credit men-tioned above. However, they have a typical durationof 15 years. The details on these products tend to beincomplete; however, it appears that the initialsource of these long duration letters of credit was theEuropean Banks. In addition, several domestic bankshave begun offering them to their best customers.They provide the same flexibility for an offshoreaffiliate as the short-term letter, but of course thecosts are higher and they are scarce. They are alsostatic and can have the same inefficiencies and risksas the short-term letters discussed above.

Nontraditional ReinsuranceSome non-traditional reinsurance structures havebeen developed to help companies deal with theextra reserves required by XXX. Both conventionalreinsurers and some new providers, such as banks,offer them.

These transactions involve an offshore reinsurer pro-viding collateral based on letters of credit or assets intrust for the difference between statutory and GAAPreserves. These transactions meet the statutoryrequirements for risk transfer and allow the directwriting company to take reserve credit. They canalso be written to match the duration of the liabili-ties. For some companies, this could be 20 or 30years.

Frequently, these transactions include an experiencerefund feature that returns the profits of the businessto the direct writing company. The ceding companyonly pays for the reserve relief related to the differ-ence between the statutory and GAAP reserve.

Securitization is considered to bethe most comprehensive solutionto the extra reserves resultingfrom XXX.

continued on bottom of page 23 >>

17

David R. Prickitt, FSA,MAAA, is vice presidentand senior actuary atWachovia BankInsurance Group inCharlotte, N.C. He canbe reached at [email protected].


L ife insurance securitizationshave become a burgeoningarea receiving a significant

amount of recent attention. Anumber of recent deals address-ing the various capital needs ofthe life insurance industry havebeen funded. Although life insur-ance securitization is not yet asprolific as other types of asset-based securitizations, such asmortgages and loans, significantmomentum is building. One spe-cific need facing the life insuranceindustry and receiving particularfocus is the funding of the“hump-backed” reserves associat-ed with Regulations XXX and

AXXX. With the belief that statutory reserves underthese regulations are overly conservative and the factthat traditional methods of reserve funding arebecoming increasingly difficult and costly, securitiza-tion has been used as a vehicle to alleviate the capitalstrain caused by these statutory requirements. Themagnitude of the capital need has been estimated bysome to be in the $100 to $150 billion range in thecoming decade, depending upon the level of productsales. Securitization could provide this much-neededcapital for the industry and potentially become amore cost effective form of long-term financing.This article describes the basic building blocks usedin XXX and AXXX securitizations, as well as some ofthe issues and considerations of which the partiesinvolved need to be mindful when considering secu-ritization as a funding option.

BackgroundIntroduced in 2000, Regulation XXX significantlyincreased the U.S. statutory reserve requirements forterm life insurance writers. In some cases, thesestatutory reserves have risen to over eight to 10 timesthat of an “economic” type reserve, such as a FAS 60reserve under U.S. GAAP. The XXX reserve typical-ly demonstrates a hump-backed pattern, increasing

rapidly in early years until it peaks around the mid-point of the level term period. Although the use ofthe 2001 CSO mortality table may lower the reserve,it does not eliminate the large gap between the statu-tory reserve and the economic reserve. This differ-ence is even more acute for preferred underwritingclasses, where the valuation mortality table deviatesmost from that expected in pricing.

The high XXX reserves cause considerable capitalstrain for insurers. Many companies deal with this byceding the business to offshore reinsurers where localstatutory reserving requirements are less onerous,such as permitting the use of U.S. GAAP. In orderfor an insurer to take reserve credit on their U.S.statutory statement, the amount of the credit takenneeds to be funded, the most popular form offinancing being the use of a LOC.

Two particular issues have arisen in relation to thistraditional solution. The first relates to the usage ofLOCs. Industry observers are forecasting a rapidincrease in the cost of LOCs (possibly as much as 10times!), as the demand increases along with the risein XXX reserves. There is also the potential risk ofLOC shortages, as banks reach internal credit con-centration limits. Additionally, with the passage ofBASEL II, a new capital adequacy framework forbanking organizations, the reserve requirements forbanks issuing LOCs have increased substantially.Furthermore, the LOC solutions used are typicallyannually renewable, making them a short-term solu-tion to a long-term liability. Rating agencies haveexpressed their discomfort in the use of short termLOC to back reserve credits for longer-term policies.

The second issue arising with the traditional reinsur-ance solution is the consolidation of the reinsurancemarket. As there are fewer reinsurance companieswilling to assume XXX-related risks, pricing hasstrengthened. This reduction in reinsurance capacity,

Demystifying Life InsuranceSecuritization: XXX and AXXXSecuritization Issues andConsiderationsby Steven D. Lash and Rebecca Kao Wang

18

along with the related higher cost, has caused someceding insurers to have higher than acceptable con-centrations of risk.

Universal life (UL) policies with secondary guaran-tees are subject to Regulation AXXX (also known asActuarial Guideline 38). Reserves under AXXXdemonstrate a similar “hump-backed” pattern asXXX with longer tails since universal life typicallyhas a longer average policy life than term life prod-ucts. The reinsurance market for the AXXX reserveis very limited and most insurers currently retain therisk. As UL with secondary guarantee productsevolve and grow, the burden of increased capitalneeds will emerge for the industry. The emergencyadoption of an amendment to New York Regulation147 in December 2004 resulted in higher reservesfor some New York-licensed companies writing cer-tain forms of UL with secondary guarantees. In addi-tion, the ongoing discussion by NAIC’s Life andHealth Actuarial Task Force (LHATF) adds an extralayer of complexity and uncertainty to the AXXXreserve debate.

In order to address the looming capital need associ-ated with XXX and AXXX reserves, many haveturned to alternate capital-funding solutions, amongwhich securitization has been considered the moreelegant solution and has increasingly been gainingpopularity.

The Securitization SolutionSecuritization is the process of repackaging certainassets or cash flows for sale in the capital markets asdebt securities that pay periodic coupons as well asthe eventual repayment of principal. Investors buy-ing these securities will assume the risks inherent inthe underlying cash flow. In order to provideinvestors with a choice of investments with respect totheir risk appetite, these debt securities are typicallydivided into “tranches,” where each tranche mayhave different coupon payments, payment terms andrisk level.

Exhibit 1 is a simple hypothetical securitizationexample where the original cash flow is divided intothree tranches and sold at par. The investors for thedifferent tranches will be rewarded according to thelevel of risk assumed. The investors owning tranchesA and B will be paid first, with the equity investorsreceiving the remaining cash flow. If there is anunexpected drop in cash flow, such as due to adversemortality experience, the equity investors will bearthe risk first. As the cash-flow performance worsens,losses may eventually need to be borne by the othertranches. The rating agencies calculate the rating of

each tranche based on scenarioanalyses such that the seniormost tranche is affected onlyupon the most extreme negativeperformance experience. Con-versely, if there is an unexpectedincrease in cash flow, the equityinvestors will enjoy the addi-tional income while investorsfor tranches A and B receivesteady coupon payments. As theequity investors assume thehighest volatility, they are compensated with thehighest return, compared to investors in tranches Aand B.

A common type of securitization in the asset worldis a mortgage-backed security (MBS), where the cashflows from a pool of mortgages are sold as debt.Insurance securitizations follow a very similarprocess, except that the cash flows are derived fromliabilities instead of assets, and the risks are related toinsurance risks such as mortality and lapsationinstead of prepayment.

Exhibit 2 on page 20 is an example of how an XXXor AXXX securitization structure might be struc-tured. This sample is purely hypothetical and is notintended to depict any existing deal, but containscommon building blocks found in some of thesetransactions. For the forthcoming discussion, we willsuppose a block of term insurance reserves underXXX is being securitized. Similar concepts wouldapply to UL reserves under AXXX as well.

The original company is either a direct writer or areinsurer looking to finance its mounting XXXreserve. The company typically would set up a cap-tive reinsurer and cede off its block of term policiesunder a coinsurance treaty. Many companies chooseto set up captives either offshore or in states thatoffer favorable regulatory accounting treatment,such as allowing the use of GAAP reserves for thecaptive’s regulatory reporting.

There are many variations to the structure in Exhibit2. A holding company may be set up as the parent tothe captive reinsurer. Many prefer this type of hold-ing company structure, since the original companydoes not directly own the captive reinsurer, and it isless likely that the original company will need toreflect the captive reinsurer on its statutory financialstatement.


Securitization is the process ofrepackaging certain assets orcash flows for sale in the capitalmarkets as debt securities thatpay periodic coupons as well as the eventual repayment ofprincipal.

19


Rebecca Kao Wang,FSA, MAAA, is a senioractuarial advisor at Ernst& Young, LLP in NewYork, N.Y. She can bereached at [email protected].

Steven D. Lash, FSA,MAAA, is a senior actuar-ial advisor at Ernst &Young, LLP in New York,N.Y. He can be reachedat [email protected].


>> Demystifying Life Insurance Securitization ...

20

Exhibit 1: A Simple Securitization Example

Exhibit 2: A Sample Securitization Structure

OriginalCompany(Insurer orReinsurer)

Financial Guarantor(Optional)

CaptiveReinsurer

CoinsurancePremium

InvestmentIncome

Return forInvestors

Return forInvestors

Proceeds fromSale of Notes


Fee forGuarantee

FinancialGuarantee


Claims

Notes IssuingCompany (SPV)

Investors

Reg. 114Trust

Pricing Base Case

Unexpected Drop in Cash Flow by $5 each year

Unexpected Increase in Cash Flow by $5 each year

1 2 3 4 5Liability Cash Flow 30 30 30 30 330



Tranche A 9% 100 9 9 9 9 109

Tranche A 9% 100 9 9 9 9 109

Tranche A 9% 100 9 9 9 9 109

Tranche B 10% 100 10 10 10 10 110

Tranche B 10% 100 10 10 10 10 110

Tranche B 10% 100 10 10 10 10 110

Equity 11 11 11 11 111

Equity 6 6 6 6 106

Equity 16 16 16 16 116

Par = $100 = Tranche NPV, Tranche Discount Rate = Coupon Rate

Coupon Rate NPV

Coupon Rate NPV

Coupon Rate NPV

In order for the original company to obtain the need-ed statutory reserve credit, an important considerationis to ensure that proper risk transfer has occurred.Statement of Statutory Accounting Principles (SSAP)No. 61 and Appendix A-791 of the NAIC’sAccounting Practices and Procedures Manual must befollowed. For example, for a term policy, mortalityand lapse risks must be transferred, whereas a univer-sal life policy requires the transfer of mortality, lapse,asset credit quality, reinvestment and disintermedia-tion risks. A reinsurance treaty that transfers only thesecondary guarantee risk may not pass the definitionof risk transfer. Failing to qualify for risk transfer in areinsurance arrangement could result in the loss offavorable insurance accounting treatment for the orig-inal company.

Special Purpose Vehicles (SPVs, and also known asSpecial Purpose Entities, or SPEs) are often used insecuritization. An SPV is set up to serve a specificpurpose, such as raising capital and servicinginvestors in a securitization. It performs little or noother activities. The investors have claims to assetsonly in the SPV and have no recourse to the origi-nal company. Similarly, the creditors of the originalcompany have no claims to any assets in the SPV. The equity holder of the SPV is often the original

company, an affiliate or an investment bank, andcontrols the SPV’s activities, including the issuingof debt or equity securities, as well as selling notes tothe investors. In GAAP accounting, SPVs are subjectto complex accounting requirements. For example inthe United States, if an SPV is determined to be aVariable Interest Entity (VIE), as defined inFinancial Accounting Standards BoardInterpretation No. 46 (FIN 46), which containscomplex guidance regarding SPV consolidation, FIN46 would apply. Otherwise, different accountingrequirements, such as Accounting Research Bulletin51 (ARB 51), Statement of Financial AccountingStandards No. 94 (FAS 94), and AccountingPrinciple Board Opinion No. 18 (APB 18) may beapplicable. Under International Financial ReportingStandards (IFRS), separate requirements apply, suchas Standing Interpretations Committee (SIC) 12. Adiscussion on SPV accounting requirements isbeyond the scope of this article. Qualified account-ants, tax and legal professionals should always beconsulted in any transaction.

Once the securitization cash flows are repackagedinto different tranches, notes will be sold to theinvestors. The proceeds from the sale of the notes



Exhibit 3: Financial Guarantee Example

Unexpected Drop in Cash Flow by $25 each yearTranches A and B Guaranteed by Financial Guarantor


Tranche A - 9% 100 9 9 9 9 109Wrapped

Financial Guarantee 4 4 4 4 0

Tranche B 10% 68 0 0 0 0 110

Equity 0 0 0 0 86

Coupon NPV


will then be passed from theSPV back to the captive rein-surer to be placed in aRegulation 114 trust. Thecash flows used in a securitiza-tion are derived typically fromcaptive reinsurers’ profits andthe Regulation 114 trustinvestment income. Regul-ation 114 of the OfficialCompilation of Codes, Rulesand Regulations (11 NYCRR4) of the New York StateInsurance Department speci-fies rules on the use of a trust

account to fund reserve credits under a reinsurancearrangement. For example, only certain types ofinvestments are allowed in the trust, and equityinvestments are not permitted. The trust is typicallyset up at a bank, which acts as the trustee, while thebeneficiary of the trust is the original company, withthe grantor being the captive reinsurer.

The recent XXX deals completed were “wrapped” bythird party financial guarantors (also known asmonoline guarantors) to assist in the sale of the notesby boosting the credit rating of the notes. Thesecompanies typically guarantee, or “wra,p” the dealsby guaranteeing the investors payment of interestand principal in certain tranches. In our prior exam-ple, tranche A could be “wrapped” so that if the lia-bility cash flows do not support the payment of theprincipal and interest, the financial guarantor wouldbe responsible to provide the remainder, as shown inExhibit 3. In this example, tranche B and the equityinvestors will receive no periodic payments and lim-ited principal payments.

By having some of the notes wrapped, higher pro-ceeds can be raised and the wrapped notes willreceive a high credit rating. The SPV pays the finan-cial guarantor a premium to compensate for the risksthe guarantor assumes. The actuarial risks thesemonoline companies are guaranteeing require signif-icant analyses to be performed.

Many constituents are involved in the structuring ofa life insurance securitization deal. Actuaries areneeded to construct actuarial models in order toproject liability cash flows to be securitized and per-form sensitivity testing to analyze the risks of beingunable to pay down the various tranches of the debt.Furthermore, actuaries need to carefully evaluate thefinancial impacts on various accounting bases, such

as statutory, economic and GAAP. ConsolidatedGAAP impacts would be more involved and compli-cated because of the potential FIN 46 issues. GAAPearnings emergence patterns need to be carefullystudied as well. Financial guarantors may performdue diligence on the actuarial projections to properly understand the insurance risks they areassuming, such as mortality and lapsation.Accountants are closely involved, especially in deal-ing with the complex rules for the SPVs and theaccounting ramifications. Investment bankers areneeded to help structure and market the deal.Lawyers are needed to review the legality of thestructure. Rating agencies are intimately involvedthroughout the process to provide proper ratings forthe resulting securities. Finally, the regulators areinvolved for the final approvals. In a recent transac-tion, there were 17 different professional firmsinvolved in some capacity! The sheer number of par-ties involved is an indication of the complexity ofthese securitization deals.

The New Frontier Life insurance securitizations are complex transac-tions, given the nature of the business involved. Inthe near term, these transactions will continue to betime consuming and costly due to the intricate mod-eling and analyses required. Moreover, as new play-ers and non-insurance investors try to get throughthe initial learning curve, additional time and costmay be required. A company needs to be preparedfor the scrutiny of its business and practices by actu-aries, accountants, lawyers, investment bankers, rat-ing agencies, regulators and financial guarantors.The development of sound actuarial models,assumptions and experience studies is crucial.Processes and controls must be top notch in this newfrontier in life insurance company capital manage-ment. The fact that a number of transactions hasbeen completed to date is a good indication of thecapital markets’ growing acceptance of the inherentinsurance risks involved.

XXX and AXXX securitizations are two of the manyforms of securitizations in the United States allowingthe life insurance industry to tap into the vast capi-tal market for funding. Many European companieshave used securitization to allow for more efficientuse of capital, such as embedded value securitiza-tions. The current activities in the United Statescould catapult securitization to be a leading capitalsolution for the life insurance industry.

>> Demystifying Life Insurance Securitization ...

A company doing a securitization needs to be prepared for the scrutiny of itsbusiness and practices by actuaries, accountants, lawyers,investment bankers, rating agencies, regulators and financial guarantors.

22

$


This is a listing of some articles published elsewhere that may interest financialreporting actuaries. If you would like to recommend an article for inclusion inthis list in a future issue, please e-mail the editor.

“Asset Adequacy for the Long-Term Care Product: A Case Study” is a brief case study ofthe initial asset adequacy testing of a small, multi-line insurer with long-term care insur-ance. Short and easy to read. By Amy Pahl. Long-Term Care News. December 2004.

“AXXX Regulation: An Interview with Bradley M. Smith of Milliman, Inc.” is a well-paced, easy to read interview that addresses a number of issues about this current hotbutton. There are related articles in the same newsletter. 2-1/2 pages. By John O. Nigh.Reinsurance News. August 2004.

“The Universal Life Work Group” is an excellent companion piece to our cover article,“SVL II: Connecting the Dots.” It places the work group in context by listing the vari-ous AAA work groups that are addressing different aspects of principles-based reservesand capital requirements, including the SVL II Work Group. It succinctly describes“rules-based approach” and “principles-based approach,” and it explains when a stochas-tic approach is appropriate. After identifying the challenges the work group faces, itdescribes the eight subgroups that are doing the work. Four pages. By David E. Neve.Product Matters! March 2005.

“The End of a Tumultuous Year” provides a summary of events of a regulatory natureduring 2004, including VA reserves and RBC, Actuarial Guideline 38, reinsurancereserve credits on YRT reinsurance, etc. Three pages. By Larry M. Gorski. ProductMatters! March 2005.

What’s Outside

These transactions are more difficult to set up thantraditional reinsurance arrangements because theycan expose the reinsurer to substantial risk if thetransactions are not properly structured. The rein-surer has gains only up to the fees with all the addi-tional profits returned to the direct writer. If thebusiness has adverse experience, the losses can besubstantial. Therefore, the reinsurer seeks a higherlevel of safety to ensure that there should be signifi-cant excess cash flows to cover the fees and provide arecapture incentive for the direct writer. This solu-tion has the same mismatch risk as affiliate reinsur-ance backed with a long duration letter of credit.

However, there is an offsetting advantage. This solu-tion does not impact the direct writer’s letter of cred-it capacity.

ConclusionIn the last five years, the industry has been very cre-ative in finding alternatives to the higher reserverequirements of XXX without penalizing the con-sumer with higher premiums. These solutions willbecome longer term, easier and more cost-effectiveover time. In addition, future generations of solu-tions can be expected as consumer demand contin-ues and statutory reserves grow. $

Alternatives for Funding XXX Reserves

Your ideas and contributions are the most important component of this newsletter. All

articles will include a byline to give you full credit for your effort. For those of you

interested in working further depth on The Financial Reporter, several associate editors

are needed. For more information, please call Jerry Enoch, editor at (765) 477-3220 or

Rick Browne at (312) 665-8511.

The Financial Reporter is published quarterly as follows:

Publication Date Submission DeadlineSeptember 2005 June 6, 2005

Preferred FormatPlease e-mail your articles as MS Word documents (.doc) to the newsletter editor.

Headlines are typed upper and lower case. Please use a 12-point Times New Roman font

for the body text. Carriage returns are put in only at the end of paragraphs. The right-

hand margin is not justified. Author photos are accepted in .jpg format (300 dpi) with

dimensions of at least 2” x 2” to accompany their articles.

If you must submit articles in another manner, please contact Joe Adduci, (847)

706-3548, at the Society of Actuaries for help.

Please send articles via e-mail or in hard copy to:

Jerry Enoch, FSA

Lafayette Life Insurance Company

1905 Teal Road

Lafayette, IN 47905

Phone: (765) 477-3220 | Fax: (765) 477-3349

E-mail: [email protected]

Thank you for your help.

Articles Needed for The Financial Reporter

Documents

The Financial Reporter · The Financial Reporter The Newsletter of the Life Insurance Company Financial Reporting Section SVL II: Connecting the Dots by Shirley Shao June 2005 Issue