January 2012

Reserving for Universal Life Policies with Secondary Guarantees and the Evolution of AG 38

• Introduction

Universal life policies with secondary guarantees (ULSG) have been around for more than 10 years and comprise a significant part of a growing segment of the life insurance market. A key profit driver and an important component in many life insurers’ product portfolios, ULSG policies have been popular among those seeking affordable, guaranteed long-term life insurance. In a competitive market landscape and demanding economic environment ULSG policies’ product design has been constantly evolving to meet insurers’ core market and regulatory changes. Since the introduction of secondary guarantees, universal life contracts have attracted close scrutiny from insurance regulators in order to ensure the adequacy of statutory reserves for such products. Every step in product design complexity has been met with a corresponding regulatory measure to eliminate the possibility of any potential misalignment of guarantees and reserves.

The latest development is the currently unfolding discussion over the correct or intended regulatory interpretation of Actuarial Guidance XXXVIII—The Application of the Valuation of Life Insurance Policies Model Regulation (AG 38) for the calculation of reserves for later designed ULSG policies. The dialog is occurring because regulators noticed insurers were using different interpretations of AG 38 to calculate reserves. Regulators are addressing the differing interpretations going forward to assure policyholders are protected, reserves are adequate and insurers are consistently interpreting regulatory guidance. The purpose of this article is to explain how ULSG policies work and to explore the public policy issues surrounding ULSG reserves.

• ULSG Product Design

Universal life products offer permanent life insurance that will commonly run until the death of the insured or to maturity (usually when the insured reaches 95 years of age). A premium is paid for the insurance and a part of it is invested in a cash value element. The policy allows for premium flexibility and it will remain in force as long as premiums are paid or are funded from the cash value. Should premium payments cease and the cash value is extinguished, the policy automatically lapses.

To add to the appeal of universal life policies, insurers added secondary guarantees that would ensure the policy would not lapse even if the cash value dropped to zero or negative, if certain minimum premium payments equal to or greater than the cumulative premium requirement are made for a stipulated period. Due to the generally low premiums needed to satisfy the secondary guarantee, these policies could generate very modest cash surrender values or none at all. Generally, stipulated premium secondary guarantee policies allow limited funding flexibility although some offer a catch-up provision to make up the cumulative premium.

The addition of shadow fund accounts produced a more complex secondary guarantee design. In this design, there is no specific premium stated but instead the secondary guarantee remains in effect and, hence, the policy remains in force as long as the shadow fund is greater than or equal to zero, even if the policy account value is zero or negative. The shadow fund account works just like a policy cash account with interest credited and expenses and other charges debited. The shadow account though, only exists to keep the guarantee in effect as long as a positive balance is maintained. The cash in the shadow account is not available to the policyholder.

The latest step in ULSG product evolution involves a multi-fund shadow account design with multiple sets of shadow fund charges. The multiple sets of cost of insurance charges, credited interest rates and policy loads that apply to the shadow fund account are different from the cost of insurance charges, credited interest rates and policy loads that apply to the policy account value. Because the insurer can set the shadow account charges, shadow account credited interest rates and shadow account policy loads to any chosen level when the product is designed, the insurer can effectively control the desired level of the shadow account. Often, the shadow fund account has much lower levels of cost of insurance charges than the cost of insurance charges that apply to the policy account value.

• The “Regulation XXX” Background and AG 38 Progress

When secondary guarantees for universal life products were first introduced, reserves were calculated according to the NAIC Universal Life Insurance Model Regulation (#585), which did not differentiate reserves for the existence of the secondary guarantees. As a result, statutory reserves for these policies did not account for the new product design.

In 2000, the NAIC Valuation of Life Insurance Policies Model Regulation (#830) — commonly referred to as Regulation XXX — was introduced to account for the secondary guarantees present in universal life contracts. Regulation XXX clarified how minimum gross premiums must be calculated. The regulation states that “the minimum premium for any policy year is the premium that, when paid into a policy with a zero account value at the beginning of the policy year, produces a zero account value at the end of the policy year. The minimum premium calculation shall use the policy cost factors (including mortality charges, loads and expense charges) and the interest crediting rate, which are all guaranteed at issue.”

While some contracts used specified-premium secondary guarantees captured by Regulation XXX, which treated them similarly to guaranteed level term contracts, others opted for the shadow fund account design in order to compensate for the increased XXX reserve requirements. As a response to these new complex product designs, AG 38 (also referred to as AXXX) was presented in 2003 to clarify reserve requirements for all universal life products that employ secondary guarantees, with or without shadow account funds. AXXX indicated that the minimum gross premiums are supposed to be the lowest schedule of premiums a policyholder could pay to satisfy the secondary guarantee.

Although AXXX was intended to track the extent to which secondary guarantees were prefunded (contracts that need less future premium to satisfy a secondary guarantee require larger reserves than those that need more future premium), the existence of certain ambiguities used by sophisticated shadow fund designs necessitated a further revision of AG 38 in 2005. Still, despite this revision, there was lack of uniformity in implementation by insurers. Regulators recognized that a number of companies, based on an alternative interpretation of AG 38, designed contracts that may have resulted in an imbalance of guarantees and reserves.

The prospect of contracts with inadequate reserves for ULSG policies led some regulators to bring the issue to the NAIC’s Life Actuarial (A) Task Force (LATF), which put forth a statement on AG 38 in September 2011 to caution about the possibility of some insurers holding “reserves [that] do not properly reflect the full benefits of the secondary guarantee as required by the law, regulation and guideline.”

• What’s at the Core of the Debate?

A number of insurers created new ULSG products that appear to have been designed with an alternative interpretation of AG 38. According to this interpretation, the usage of shadow accounts, along with multiple sets of charges applied to these accounts, allows a calculation of minimum premiums that could result in comparatively lower reserves.

The reserve method for all ULSG policies begins with the calculation of the present value of future benefits less the present value of future valuation premiums. According to Regulation XXX, the minimum reserves during the secondary guarantee period are the greater of the basic reserves for the secondary guarantee plus the deficiency reserve, if any, for the secondary guarantees and the minimum reserves required by other rules or regulations governing universal life plans.

Regulation XXX, Section 7A(2) states: “…the minimum reserve shall be the greatest of the respective minimum reserves at that valuation date of each unexpired secondary guarantee, ignoring all other secondary guarantees. Secondary guarantees that are unilaterally changed by the insurer after issue shall be considered to have been made at issue. Reserves described in Subsections B and C below shall be recalculated from issue to reflect these changes.”

Regulation XXX, Section 7A(4) also states: “For purposes of this section, the minimum premium for any policy year is the premium that, when paid into a policy with a zero account value at the beginning of the policy year, produces a zero account value at the end of the policy year. The minimum premium calculation shall use the policy cost factors (including mortality charges, loads and expense charges) and the interest crediting rate, which are all guaranteed at issue.”

The current debate revolves around a ULSG product design issued by several companies that employs two separate schedules of guaranteed charges that apply to the shadow fund account. The first schedule of guaranteed charges is low and applies as long as the shadow account value is greater than zero. The second set of guaranteed charges is much higher and applies when the shadow account value goes to zero or negative. The second set of guaranteed charges are the guaranteed charges that take a zero shadow account value at the beginning of the policy year to a zero shadow account value at the end of the policy year. When the company is calculating the reserves on the secondary guarantee, they are using the second (higher) set of guaranteed charges, which lowers the reserve and, in some cases, lowers the reserve significantly over what the reserve would be if the first (lower) schedule of guaranteed charges were used in the reserve calculation.

Regulators intended to account for these complexities when they developed AG 38 to clarify how reserves for ULSG policies subject to Regulation XXX are to be determined, defining the minimum gross premiums as those that will keep the secondary guarantee in effect. As noted above, the lower charges are guaranteed and they will keep the secondary guarantee in effect. If the shadow account value were going to go exactly to zero, the policyholder could deposit as little as a cent more than the low guaranteed set of charges to keep the shadow account value positive so the higher guaranteed set of charges never come into play. Therefore, the consensus position of the LATF was that this lower set of guaranteed charges should be considered the minimum gross premiums that keep the secondary guarantee in effect.

Others contend the latest LATF statement on AG 38 attempts to define the term “minimum gross premiums” by introducing novel terms — such as the “lowest schedule of premiums” — that are not found in AG 38. Some life insurers instead, employ the definition of “minimum premiums” as the year-by-year premiums that satisfy the zero-to-zero description found in Section 7A(4) of Model Regulation XXX. The companies’ contention is centered on the fact that the purpose of AG 38, as an interpretive guidance to Regulation XXX, is to only interpret and not change.

According to Section 7A(2) of Model Regulation XXX, if a policy contains more than one secondary guarantee, the minimum reserve shall be the greatest of the respective minimum reserves at that valuation date of each unexpired secondary guarantee, ignoring all other secondary guarantees. Hence, if the lower guaranteed set of charges produces a higher reserve than the higher guaranteed set of charges, Section 7A(2) requires the higher reserve must be held.

The phrase “more than one secondary guarantee” as found in the LATF statement, some would argue, is inconsistent with its original use in Regulation XXX, which referred to more than one secondary guarantee “period.” Because Regulation XXX talks of secondary guarantee periods, and not guaranteed sets of charges and/or credits, these commenters maintain that the reference of the LATF statement to “more than one secondary guarantees” is confusing and inappropriate.

• NAIC Efforts towards Resolution

During the NAIC 2011 Fall National Meeting, the Executive (EX) Committee received the amended statement on AG 38 from the Life Insurance and Annuities (A) Committee as it was adopted by the LATF. The Executive (EX) Committee believed that, due to the interpretive differences on this issue and  considering the sensitivities on all sides, it was sensible to forward the statement to the newly  established Joint Working Group (of the Life Insurance and Annuities (A) Committee and Financial Condition (E) Committee) for further study instead of adopting it at that point.

The Joint Working Group is tasked with determining whether it is prudent and necessary to develop interim guidelines and/or tools to be utilized by regulators in evaluating reserves for ULSG policies. The interim nature of the guidelines and/or tools is due to the fact the future implementation of a principle-based reserving (PBR) system will render them inapplicable.

In January 2012, the Joint Working Group issued a draft framework for how to evaluate policies issued before a specified date (in-force business), as well as policies issued on and after a specified date (prospective business). As drafted, the first are to be treated as closed blocks of in-force business that would be evaluated by actuaries on a stand-alone basis to determine reserve adequacy. The second would be reserved using a formulaic approach consistent with the LATF’s interpretation of AG 38 (as modified or clarified to address any questions regarding its requirements). Lastly, policies issued after the effective date of PBR would be reserved using PBR methodology.

The Joint Working Group noted that, before fully implementing the Framework, a number of key decisions still need to be made. These decisions will be made in an open process with input from regulators and interested parties. At the time this article was written, the Joint Working Group had released its draft framework for public comment and established a Jan. 30, 2012, deadline to receive comments. In a public news release, Texas Insurance Commissioner Eleanor Kitzman, chair of the Joint Working Group said, “This framework, in addition to the process in general, reflects the states’ commitment to develop a uniform interpretation regarding existing reserving requirements for ULSG and term UL products, while also considering how reserves for these products should be set in the future.”.

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