An Update on Where Things Stand on Principles-based Reserves IAC Presentation February 23, 2007 David Neve Co-chair, L

1. An Update on Where Things Stand on Principles-based Reserves IAC Presentation February 23, 2007 David Neve Co-chair, Life Reserves Work Group

2. Topics covered in this session • Definition of Principles-based Approach • Update of the Life Reserves Work Group (LRWG) proposal for life products • Discuss proposed changes to the Standard Valuation Law • Discuss purpose and content of new Valuation Manual • Describe purpose and requirements of PBA Review Actuary • Discuss alternatives to the LRWG proposal

3. Definition of Principles-based A Principles Based System (PBA) of statutory Risk-Based Capital (RBC) and minimum reserve requirements incorporates the following common elements: Captures all of the benefits and guarantees associated with the contracts and their identifiable, quantifiable and material risks, Utilizes risk analysis and risk management techniques to quantify the risks. This may include, to the extent required by an appropriate assessment of the underlying risks, stochastic models or other means of analysis that properly reflect the risks of the underlying contracts. Incorporates all risk and risk factors included in the company’s risk assessment and evaluation processes (which include economic valuations, internal capital allocation models, experience analysis, asset adequacy testing, GAAP valuation and pricing).

4. Definition of Principles-based 4. Permits the use of company experience, based on the availability of relevant company experience and its degree of credibility, to establish assumptions for risks over which the company has some degree of control or influence. Provides for the use of assumptions, set on a prudent estimate basis, that contain an appropriate level of conservatism Reflects risks and risk factors in the calculation of reserves and capital that may be different from one another and may change over time as products and risk measurement techniques evolve, both in a general sense and within the company’s risk management processes.

5. Initial approach for PBA life reserves will be prospective only. May allow retroactive application to inforce (or subset) later. • Drafts of Model Regulation and two Actuarial Guidelines were exposed for comment at December LHATF meeting (are available on Academy website) Overview of Proposed LRWG Approach

6. Overview of Proposed LRWG Approach Reserve is the greater of: A deterministic, seriatim, single scenario reserve calculation 2. A stochastically derived reserve (if needed) using a prescribed CTE level

7. Overview of Proposed LRWG Approach Deterministic Reserve: Based on Gross Premium Valuation (GPV) method. GPV reserve = Present value of future benefits and expenses, less present value of future gross premiums. Is not designed to capture tail risk Is subject to a cash surrender value floor on a contract by contract basis

8. Overview of Proposed LRWG Approach Stochastic Reserve: Multiple scenarios will be used to properly capture the “tail risk” of the contract (risks that have high impact, but low probability) 2. Only interest rates and equity returns are required to be modeled stochastically Will use a CTE (conditional tail expectation) level that is set by regulators, such as 65 CTE Reserve for each scenario will be based on the Greatest Present Value of Accumulated Deficiencies (GPVAD) due to regulatory concerns over interim deficiencies.

9. Overview of Proposed LRWG Approach Prudent Estimate Assumptions Assumptions not stochastically modeled will be based on the actuary’s best estimate of the future “Anticipated Experience” plus a margin that includes a provision for adverse deviation and estimation error. Margins will be determined by the actuary using professional judgment, subject tothe guidelines established by the NAIC and ASOPs.

10. Overview of Proposed LRWG Approach Asset Model Is Needed to Project Cash Flows Expect most companies to use cash flow testing model Asset Model is used to determine: Future liability and asset cash flows Discount rates Accumulated assets for GPVAD calculation for Stochastic Reserve

11. Summary of Recent Changes to Proposed LRWG Approach 1) LRWG proposal has been combined into single document At the request of LHATF, the 3 documents exposed for comment at the December meeting (Model Regulation and 2 Actuarial Guidelines) have been combined into a single document. Uses a “requirements format” that is the common template that will be used for all requirements placed in the Valuation Manual. Thus, this draft of the LRWG proposal is now in a form that is ready to be placed in the designated section of the Valuation Manual. This template following a “requirements format” is not final, but putting the LRWG proposal into this format will provide an example of what the Valuation Manual might look like.

12. Summary of Recent Changes to Proposed LRWG Approach 2) Changes to the Guiding Principles: A drafting note was added to Principle 1 that lists the types of risks that are not required to be included in the reserve calculation (i.e. risks that are of ageneral business nature that are not readily quantifiable, which include risks historically viewed as C4 risks). A new Principle was added (Principle 2) to require that all Risk Factors included in the company’s risk assessment and evaluation processes shall be reflected in the reserve methodology (with exceptions if certain conditions are met). Expanded Principle 5 (which addresses the determination of assumption margins) to include a reference to the aggregate impact of all margins.

13. Summary of Recent Changes to Proposed LRWG Approach 3) Scope section has been eliminated Scope will be addressed elsewhere in the Valuation Manual. Prior LRWG draft identified products that were excluded from PBA; the current draft is silent. Leaves open the possibility of alternative PBA approaches, such as “PBA Lite” and phase-in of certain products. 4) Reporting of experience requirement has been dropped (now in SVL) 5) “Best Estimate” and “Prudent Best Estimate” terminology has been changed to “Anticipated Experience” and “Prudent Estimate” respectively.

14. Summary of Recent Changes to Proposed LRWG Approach 6) The requirement to use a prescribed credibility method for blending mortality experience with an Industry Table (e.g., the Canadian Normalization Method) was replaced with a requirement that allows the actuary to select the credibility method, but the credibility method must meet certain conditions. 7) The requirements on modeling derivative instruments and derivative programs, including hedging strategies, was revised and streamlined. 8) The requirements to determine policyholder behavior assumptions were: Streamlined to eliminate duplicative wording that, subject to adoption by the ASB, is anticipated to be in the new PBR ASOP; and Reorganized to add clarity to the requirements

15. Summary of Recent Changes to Proposed LRWG Approach 9) A new element was added in the calculation of the final Reported Reserve called the “Provision for Model Understatement” to reflect the aggregate impact of material approximations, simplifying assumptions or simplified techniques used in the cash flow model. 10) The description of the stochastic modeling exclusion was enhanced and clarified.

16. Outstanding LRWG Technical Issues Determination of assumption margins Individual risk factors, or in the aggregate? What to do when experience data is lacking? Risks to be excluded from reserves (what is the purpose of reserves vs. capital?) Reinsurance issues (e.g. treatment of non-proportional and/or catastrophic coverages). Additional guidance and clarity on modeling derivative programs

17. LRWG Priorities for 2007 • Perform additional product modeling and analysis. • Finalize outstanding technical issues. • Work with LHATF to establish prescribed elements. • CTE level. • interest rate and equity scenarios • net spreads on reinvestment assets • Incorporate modifications resulting from discussions with U.S. Department of Treasury that fit within the actuarial framework being developed. • Review comments received on the exposure draft.

18. Status of LRWG Proposal • The LRWG believes the proposal is close to being “done” from an actuarial perspective – we believe it is close to being ready for final adoption by LHATFafter exposure • Once adopted, we anticipate the new reserve requirements will be placed in the newValuation Manual that is under development. • Needed “tweaks” and refinements after adoption can be implemented via the process to update the Valuation Manual (the process to update the Manual is also under way). • Implementation date and transition rules need to be addressed by the NAIC (outside the scope of the LRWG).

19. Changes to Standard Valuation Law Implementation Objectives • Enable Principles Based Reserves • Promote uniformity in reserve requirements • Provide regulatory balance and oversight • Provide reserve requirements in one place • One exposure process and one adoption • Promote consistent interpretations • Enable more efficient process to implement future changes (similar to process to make RBC changes)

20. Changes to Standard Valuation Law • Proposal adds a new section (section 11) to the current SVL • Detailed PBA reserve requirements are NOT in SVL – will be in the Valuation Manual • Mandatory reporting of company experience has been added. • Annual independent review of PBA requirement has been added • Defines the operative date of the Valuation Manual to be January 1 following the date that both: • The valuation manual is adopted by a ¾ majority of the NAIC; and • The number of states specified in the Valuation Manual has adopted the new SVL (but not less than a majority). 6.Sets forth the conditions for a state to “opt out” of a specific requirement defined in the Valuation Manual if certain conditions are met (much disagreement on this)

21. Changes to Standard Valuation Law Major Challenges to proposed SVL Changes • Will state insurance departments be willing to give up some of their control in order to achieve uniformity? • Will state legislatures be willing to delegate to the NAIC the authority to make future changes to reserve requirements? • Will the industry support the experience reporting and independent review process?

22. New Valuation Manual The Manual will contain reserve requirements for all products • Products issued prior to effective date of the Manual will be subject to current state laws and regulations of each state. • Products issued after the effective date of the Manual will follow the requirements defined in the Manual. • Transition and scope issues will be addressed explicitly in the Manual (i.e. a “traffic light” concept). • The Manual will essentially replace the current structure of Model laws, model regs, and actuarial guidelines (but existing laws, regs and AG will stay in effect).

23. New Valuation Manual The Manual will also include: • Definition of Principles-based reserves • The process to update the Manual • Requirements for PBA Review Opinion • PBA reserve disclosure and reporting requirements • PBA experience reporting requirements • Coordination with APPM (Accounting Practices and Procedures Manual)

24. Possible Timeline • March/September 2007: Possible NAIC adoption of SVL changes • Early 2007: Academy prepares initial draft of Valuation Manual • September 2007. Academy prepares substantive completion of Valuation Manual • March/June 2008: NAIC adoption of Valuation Manual • January 1, 2009 or 2010: Effective date of Valuation Manual for adopting states.

25. PBA Review Opinion Purpose of the PBA Review Opinion: Provide Company management, the Company’s board of directors, insurance regulators, and the Company’s auditors with a confidential, independent review of the subjective elements of a principles-based valuation. It purpose is NOT to opine on the accuracy of the reserve calculation (audit does that), or on the adequacy of the reserves (AOMR Opinion does that). The Valuation Manual prescribes: • The specific requirements for a review opinion of a valuation performed under a principles-based approach (PBA) per the Standard Valuation Law and applicable regulations; and • Requirements applicable to the appointment of the PBA Review Actuary.

26. PBA Review Opinion Designation of PBA Review Actuary • Is selected by the Company • Must met prescribed qualifications (same as qualifications for Appointed Actuary). • Must be independent from the company (not employed by the company, not have a material financial interest in the company, etc.) • Commissioner can reject the company’s selection (then company has to select another one) • PBA Review Actuary can be an employed of the company’s audit firm.

27. PBA Review Opinion General Requirements • The Company shall file within thirty (30) days following the filing of an Annual Statement, a single PBA Review Opinion that covers all PBA valuations in the Company • The PBA Review Actuary shall support the PBA Review Opinion by a PBA Review Report, which shall be kept confidential and available upon request of the Commissioner. • The PBA Review Actuary will immediately notify the domiciliary Commissioner, with a copy to the Company, if, during the course of the analysis and review done in order to prepare the PBA Review Opinion, the PBA Review Actuary identifies a material issue with a valuation performed under a principles-based approach that cannot be satisfactorily resolved with the Company before the filing date of the Annual Statement.

28. PBA Review Opinion The PBA Review opinion shall state: • All quantifiable material risks are considered; • The methods used are appropriate; • The models used are reasonable for the purpose; • The assumptions used are supportable; • The margins in the reserves are supportable; and • The requirements of a PBA reserve valuation as defined by [insert applicable sections] of the Valuation Manual and applicable Actuarial Standards of Practice have been satisfied.

29. Alternatives to current LRWG Proposal • Subgroup under Mike Boerner’s Valuation Law and Manual Team was was formed to address concerns raised by small companies. • Discussion was held with LHATF on 2/9 via conference call on possible alternatives to the “full blown” LRWG approach. • Major areas of concern with LRWG approach: • The process to justify the use of stochastic modeling is perceived to be too complex. The resources required for this process will put a strain on many companies where it may not be needed given their product mix. • The cost of an extensive and independent PBA review. • The experience reporting required for a myriad of assumptions, including mortality, lapse and policyholder behavior may be unnecessary (or at least not necessary annually) for companies that do not have material experience. • The cost of the PBA approach can put smaller companies at a disadvantage, leading to an unlevel playing field.

30. Alternatives to current LRWG Proposal Three possible alternative approaches under discussion: 1) Phase in the LRWG requirements • LRWG requirements would initially only apply to more complex products (e.g. Variable, UL with long term secondary guarantees), with other products being added later. • Would allow actuaries and regulators to gain experience and a comfort level with the new PBA process based on a limited set of products before rolling it out to all products.

31. Alternatives to current LRWG Proposal • Add simplifying elements to the current LRWG approach to address the concerns above. For example: • Define a simplified approach to satisfy the stochastic modeling exclusion requirements. • Define a simplified approach to setting Prudent Best Estimate assumptions. • Define a simplified approach for determining the discount rates.

32. Alternatives to current LRWG Proposal 3) Develop a new “PBA Lite” approach that is outside the LRWG framework, but still meets PBA principles. For example: • The actuary would classify the reserve approach needed for all products as either • Current formulaic approach (net premium reserves), • Deterministic gross premium reserves, or • The LRWG approach. • This classification would be fixed and would require justification based on scenario testing and risk profiles present in the products.