By Cyril Tuohy
States considering the implementation of principle-based reserving (PBR) should exercise “substantial caution,” as few regulators are likely to have the technical expertise to be able to evaluate the internal capital models used by insurers, the Federal Insurance Office (FIO) said.
The latest statements about PBR shows the FIO has deep reservations regarding PBR, which some state regulators oppose and others support.
“States should move forward with substantial caution to implement PBR,” the FIO report said. “State regulators require significant additional technical expertise or resources to properly evaluate the rigor and quality of idiosyncratic reserve models that vary among firms within a heterogeneous insurance industry.”
PBR allows insurance companies to set aside reserves for future claims in accordance with their internal capital models.
State regulators have been considering whether to move toward PBR measures for more than 10 years as a way to improve the formula-based system prescribed by the Model Standard Valuation Law (SVL) and developed by the National Association of Insurance Commissioners.
Critics of the formula-based system maintain that it is too rigid, static and conservative. They also say it does not take into account particularities of specific insurance carriers regarding their risk exposures and hedging strategies, even when insurance companies are reviewed annually by states to ensure carriers can pay claims.
Life insurers that set aside too much in reserve because they followed standardized formulas are prone to the inefficient allocation of capital. Money that could otherwise be used for acquisitions or to launch new products sits idle, the critics contend.
The report by the FIO, a unit of the U.S. Treasury Dept., also noted how difficult it is to adopt consistent reserving requirements across 56 jurisdictions.
State regulators had different interpretations of the guidelines for the Valuation of Life Insurance Policies Model Regulation, which establishes reserve requirements for life insurance products with secondary guarantees, the report found.
Setting adequate reserve levels matter since reserves allow insurance carriers to pay claims. An insurance company without enough in reserve faces insolvency. That almost happened to AIG, the largest insurance company in the world.
In 2008, when tens of millions of homeowners couldn’t continue paying their mortgages, lenders invoked the insurance policies bought to cover debt obligations. AIG couldn’t fulfill its promises and required a bailout from the U.S. government.
The AIG debacle was the classic example of an insurance company that couldn’t pay its claims because it hadn’t set aside enough in reserve. It was short of reserves because a “rogue” division never had to answer to state regulators responsible for ensuring reserves were adequate.
For PBR to work, regulators are going to have to figure out the “black box” used by carriers to justify a given reserve level, but the FIO report casts doubt on whether that is feasible as it would require new platoons of actuarial and examination experts.
“To obtain necessary expertise, states likely would have to contract with consulting actuaries and other professionals, many of whom may have clients in the life insurance industry and, thus, state regulators will need to sort through and manage potential conflicts of interest,” the report said.
Moves toward PBR suffered a major blow earlier this year when New York state regulators announced they were backing out of discussions around a modified version of PBR as it “represents an unwise move away from reserve requirements,” according to New York Superintendent of Financial Services Benjamin M. Lawsky.
Reserve requirements established by formulas and “diligently policed by insurance regulators,” are more effective than PBR, Lawsky said in a September letter to the nation’s insurance commissioners. In it, he also compared PBR to “outsourcing the setting of reserves to companies themselves.”
In its final recommendation regarding PBR, the FIO recommended that states “move forward cautiously” with PBR implementation only on two conditions. The first is if states can establish “consistent, binding guidelines” to determine if an insurer complies with accounting and solvency requirements, and the second is only if states can hire “supervisory resources” to monitor and review carriers that subscribe to PBR when setting reserves.
The 65-page FIO report, submitted to Congress last week, was required under Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act called for a study on how best to modernize and streamline insurance regulation.
Nearly 150 written comments were submitted to the Treasury Department, which began collecting testimony for the report in 2011.
Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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