Reserve calculations for life insurance have been unchanged for almost 150 years. Currently, insurers use a formula-based static approach to calculate reserves for products. However, insurance products have increasingly grown in complexity which led to a need for a new reserve method. The NAIC adoption of the Standard Valuation Law (SVL) in 2009 introduced a new method for calculating life insurance policy reserves. This new method, referred to as Principle-Based Reserving, or PBR, replaces the current formulaic approach to determining policy reserves with an approach that more closely reflects the risks of the highly complex products. The improved calculation is expected to “right-size reserves,” reducing reserves that are too high for some products and increasing reserves that are too low for other products.
The NAIC adoption of the Valuation Manual referenced in the 2009 version of the SVL marked a major milestone in the move from formulaic rules to PBR. The Valuation Manual begins the process of revising reserving requirements to be more dynamic to meet the needs for today’s variety of products and helps to mitigate the need for insurers to modify products in ways that avoid the formulaic regulatory requirements. The Valuation Manual was adopted by a supermajority of NAIC members in December 2012, paving the way for states to begin adopting revisions to the SVL in their legislative sessions. Once at least 42 states (a supermajority) representing 75% of total U.S. premium adopt the revisions to the SVL, PBR will be implemented over approximately three years and only for new business.
What is PBR?
- Insurers set aside funds, or reserves, to pay insurance claims when due. Currently, formulas and assumptions are used to determine these reserves, as prescribed by state laws and regulations.
- Companies will hold the higher of a) the reserve using prescribed factors and b) the reserve which considers a wide range of future economic conditions and is computed using justified company experience factors, such as mortality, policyholder behavior, and expenses.
- The Valuation Manual is established by the Standard Valuation Law and would be used to detail the reserve calculation requirements.
- The new Standard Valuation Law and Valuation Manual are built to encompass requirements for all life and health insurers and the business they write. Initially, reserving methods only change for life insurance. However, over time, PBR is expected to be developed for additional product lines.
Why is PBR needed?
- The formulaic approach prescribed by current state laws and regulations needs to be frequently updated as new product designs are introduced. PBR alleviates this need to a great degree.
- State laws would establish principles upon which reserves are to be based rather than specific formulas, with more detail and constraints included in the Valuation Manual.
- Current formulas do not always accurately reflect the risks or the true cost of the liability or obligations of the insurer. For some products this leads to excessive conservatism in reserve calculations and for others it results in inadequate reserves.
- The current system locks in certain assumptions, resulting in reserves that do not change as economic conditions change or as insurers accumulate actual experience. The new system adjusts reserves as economic conditions change and as insurers accumulate credible experience.
The NAIC Principle-Based Reserving Implementation (EX) Task Force serves as the coordinating body with all NAIC technical groups involved with projects related to the PBR initiative for life and health policies and also to assess the solvency implications of life insurer-owned captive insurers and alternative mechanisms.