Principles Based Valuation – Should Small Companies Be Steamed by This Steam Roller?

The Principles Based Valuation (PBV), has received a lot of support from the industry. Instead of using prescribed methods, assumptions and tables to calculate statutory reserves, they will be calculated based on actuarial judgement in accordance with best practice standards. Before reserves are officially released, it is crucial that such reserves be peer reviewed by another professional actuary.

Numerous actuaries have spent hours developing the framework to create a viable valuation structure. The American Council of Life Insurers (our primary trade association) has supported the approach since late 2005. One regulator has called the Principles Based Valuation Support a “steamroller.” Small insurers and other stakeholders should now voice concerns about the whole Principles Based Valuation proposal. While strict opposition might not be necessary, it is important to ask key questions.


These reservations include:

1. Do Principles Based Valuation is needed? It would, supposedly, reduce redundancies in the current statutory reserve requirements. There are four industry groups that seem to be most concerned about alleged redundant statutory reserves levels: Universal life writers, who are required to hold deficiency reserve funds; term writers who are highly competitive in terms of their minimum guarantees (and may not have any reserves at all or not have half of the cost of insurance after account value runs out); term insurance writers who have created policies to reduce the reserve requirements of Regulation XXXX; variable life and annuity authors who believe the standard New York Insurance Department scenario to provide minimum general account guarantee coverage is not enough. There could be other product insurers. There are a lot of large companies. However, small insurers could also be part this group. But, does this industry group represent the majority of insurance companies or is it just a subset?

2. Principles Based Valuation would lead to lower statutory reserves even without the above sections and bring their current levels closer to those under generally accepted accounting principles. This would be desirable from a solvency perspective.

3. Small companies worry about the “level playing fields.” Larger companies that are able and willing to pay for an actuarial peer-review could have smaller statutory reserves under Principles Based Valuation. This could give them an unfair competitive advantage.

4. For federal income tax purposes, statutory reserves created under Principles Based Valuation must be maintained qualified. In the hope of protecting tax-qualified status, proposals have proposed a cash value floor to be a minimum reserve. This floor would not apply for term life or medical insurance reserves. The Treasury has implied at times that they won’t allow reserves that don’t correspond to the table in National Association of Insurance Commissioners regulations.

5. Recently, the New York Insurance Department proposed a model law to implement Principles Based Valuation. It may be meritorious in some aspects. It seems that it would require adequate reserves to keep Principles Based Valuation liabilities less conservative than under generally accepted accounting principle (if not at the same level as current statutory levels). The model law also describes Principles Based Valuation, but does not distinguish between stochastic and formulaic calculations.

6. New York’s proposal could have at least one objection. They propose that minimum reserve scenarios be tested (gross premium), and that the minimum test reserves be subject to a Treasury rate, regardless of company’s investment rate of return. New York previously required that the minimum or best estimate reserve be increased to 7.5% for official testing. This seems to be sufficient conservative. It seems absurd to require a Treasury interest rate if a company earns more than that (even in a low interest environment).

7. Some regulators are concerned that small companies would have unacceptablely low reserves if they were left to their own devices under Principles Based Valuation. This could help answer their concern if peer-review actuaries are considered agents of regulators and their responsibilities are clearly defined.

8. Proponents of Principles Based Valuation refer to the recent bankruptcy in the United Kingdom of Equitable Life. They claim this is evidence of the need for Principles Based Valuation to be implemented in the United States so that actuaries can use their professional judgment when setting sound reserves.

This argument seems weak. In Britain, and in other countries, actuaries have been setting reserve under a similar principle to Principles Based Valuation for many years. Peer reviews and adequate peer review standards might have been lacking. Britain appears to be abandoning Principles Based Valuation. This is because it requires actuaries to submit to strict oversight by a government Board. The entire actuarial profession was thrown into disrepute by the de facto Principles Based Valuation.

9. Although it has not been explicitly stated, Principles Based Valuation is a way to raise the status and credibility of actuaries. This would be at a time when the profession is concerned about its image and its standing in risk management. There are also concerns over potential inroads by other professions to actuarial prerogatives.

First, reserve calculations are tied to actuarial expertise. Actuaries also design the current reserve standards and formulaic reserves. As experience evolves, Society of Actuaries members from both industry and departments have created new reserve tables. For more complicated products, Actuaries have created guidelines and reserve standards.

This means that actuaries were always involved in all aspects of statutory reserve development, including peer review and actuarial judgement, long before the new proposal was made.

10. Principles Based Valuation has one major concern: some actuaries believe that stochastic processing techniques should always be used in reserve calculations. They argue that stochastic is superior to formulaic methods, and that actuaries should be required to explain why they don’t use the stochastic method.

According to the dictionary, stochastic is “a process that involves a randomly determined sequence observation. Each of these observations is taken as a sample from one element of a probability distribution.” Here, the key words are “probability distribution.” This distribution is predetermined and assumed. Although it may be based upon statistical experience and professionally compiled data, it is still an assumption.

Stochastic calculations are said to be able to capture outlying risks inherent within many coverages, i.e. Very low probabilities but can be very dangerous if they are actually realized. These low probabilities are merely assumptions in an overall distribution.

Alternative calculations are required for almost all formulaic reserve scenarios. To capture all possible outcomes, it is more likely that there will be a large number of alternative reserves. This could lead to higher reserves. There are many benefits options. The more policyholder behavior that can affect results, the greater number of possible scenarios that should be considered. This requires sound actuarial judgement. This does not appear to show the superiority or the efficacy of the stochastic approach.

11. The Conditional Tail Expectation is a key component of the current stochastic approach. This is the use of reserves that are based on an arithmetic average number of worst-case scenario. The “65CTE” calculation uses the average of 35 worst-case scenarios. An “80CTE”, on the other hand, uses the average of 20 worst-case scenarios. This means that “80CTE”, which is a combination of the worst-case scenarios and better results, would have lower reserves than “65CTE.”

These worst-case scenarios, however, are assumptions in the probability distribution. If they were not weighted with a probability, many adverse scenarios would result in the company’s insolvency. If they were so weighted, it would make sense to use them. Actually, true worst-case scenarios involve:

a. All policyholders die.

b. All policyholders with health insurance who enter nursing homes for stays of 20+ years.

c. Variable coverage: The stock market plummeting to zero, all policyholders moving to the general account, and then dying.

These scenarios are not used by anyone, as they can lead to the collapse of society.

12. Principles Based Valuation advocates have suggested that small businesses could be granted exemptions from stochastic processing regulations. As stated, there is not enough evidence to support the inherent superiority this approach. Then stochastic could be viewed as an alternative to the formulaic option.

13. There is concern that these advocates could include requirements for stochastic processing in Actuarial Standards of Practice.

14. Some actuaries have said that the stochastic processing approach is not for them. This means that actuaries who don’t adopt the stochastic processing approach uniformly will be replaced by statisticians and non-actuaries qualified to calculate reserves. This argument can be answered by saying that there are certain activities that should not be done. This means that stochastic processing will be used extensively to calculate or test reserves for certain products. To make it a uniform standard, however, it will need to be subjected to more rigorous testing and critiques than it has been used so far.

Summary of Issues

The Principles Based Valuation proposals have potential pitfalls and pluses for small companies. There are many pluses:

1. A company that writes certain products, which generate large deficiency reserve or other types above, may have lower statutory reserves.

2. Possibility to enter certain product lines that were previously restricted by reserve requirements.

Minuses can be:

1. Peer review can result in expensive expenses.

2. Stochastic processing can lead to costly expenses in terms of software and machine time.

There are many options for small companies:

1. All parties oppose principles-based valuation

2. Lobby for Principles Based Valuation legislation and regulations that are general and do not require or favor either the stochastic or formulaic approach.

3. It is important to insist that both stochastic and formulaic approaches are available.

4. Actuaries working for small insurers need to be vigilant and resist any attempt by Actuarial Standards of Practice to force them into using stochastic approaches.

5. For peer review and margins that are appropriate to the insurer’s risk profile, lobby for Principles Based Value requirements. Principles Based Valuation should be available to small businesses with simple portfolios of investments and products.