This paper is the first in a series of quarterly papers that Milliman intends on publishing during 2022 and 2023 that focuses on the current status of the emerging principle-based reserving framework for non-variable annuities, commonly referred to as VM-22, and the corresponding Risk-Based Capital (RBC) framework.
After the global financial crisis in 2008, the insurance industry started working on outlining a new holistic statutory reserving framework that would better recognize and reflect the material risks in all types of products. In 2009, the National Association of Insurance Commissioners (NAIC) adopted a revised Standard Valuation Law, which authorized a new Statutory Valuation Manual that outlined the methodology for determining appropriate principle-based reserves (PBR) for life insurance and annuity products. The PBR framework for life insurance products was eventually finalized under VM-20, “Requirements for Principle-Based Reserves for Life Products,” with an effective date of January 1, 2017, to be mandatory for new business sold on January 1, 2020, and later. For variable annuities (VA), the introduction of C-3 Phase II in 2005 for determining capital requirements and Actuarial Guideline XLIII in 2009 for statutory reserves represented first steps toward a principle-based approach, with subsequent industry-level quantitative impact studies and industry feedback resulting in the development of VM-21, “Requirements for Principle-Based Reserves for Variable Annuities,” in the Statutory Valuation Manual, effective for all VA business (both existing and new business) on January 1, 2020.
For certain non-variable annuities (non-VA), an initial principle-based approach for determining capital requirements was put in place in 2000 as part of C-3 Phase I. However, the existing statutory reserve framework for non-VAs is a prescriptive, rules-based paradigm1 with no recognition of assumptions developed from a company’s internal experience. Commensurate with the changes to the statutory framework under VM-20 and VM-21, in recent years the Annuity Reserve and Capital Working Group (ARCWG), a subcommittee of the American Academy of Actuaries’ Life Valuation Committee, has developed and presented to the Life and Annuity Task Force a proposed PBR framework for non-VAs that leverages the existing and approved VM-20 and VM-21 regulations.
This proposed PBR framework, “Requirements for Principle-Based Reserves for Non-Variable Annuities,” often referred to as “VM-22,” will be the subject of an industry field testing initiative that will help inform the final version of the framework that will ultimately be adopted. At this point, given that a) the industry field testing (VM-22 Field Testing) is yet to be carried out,2 b) any subsequent refinements to the proposed framework would need to be publicly exposed and discussed, and c) the NAIC would need to vote on adoption of the final version by the NAIC summer meeting for it to be effective as of the start of the following year, it is almost certain that VM-22 will not be effective on January 1, 2023, as was previously anticipated by the industry. In addition, the principle-based capital requirements for non-VAs, superseding the C-3 Phase I requirements and covering all non-VAs, are expected to be approved only after VM-22 becomes effective.
As of the date of this paper, non-VA products that are in scope of VM-22 include those shown in Figure 1.
FIGURE 1: NON-VA PRODUCTS IN SCOPE OF VM-22
|Account Value Based Annuities||Payout Annuities|
Products that are specifically out of scope of VM-22 include guaranteed investment contracts, stable value contracts, and funding agreements. Registered index-linked annuities (RILAs) are covered by VM-21 and are also specifically excluded from VM-22; however, it is possible that this will be revisited in the future.
Moreover, as of the date of this paper, the NAIC has not decided whether VM-22 will apply retrospectively. It is likely that this decision will be deferred pending the results of the VM-22 Field Testing. If it only applies prospectively, then companies will need to ensure that appropriate governance and operational controls exist around the potentially different models (and perhaps even modeling platforms) for new business issued after the effective date versus existing in-force. If it applies retrospectively, we expect a pickup in merger and acquisition and reinsurance activity, where the latter might involve both unwinding of existing surplus relief treaties and initiation of new reinsurance treaties that are priced under the new framework.
VM-22 is expected to employ a stochastic reserve methodology, similar to that in VM-20 and VM-21, leveraging a pretax CTE 70 calculation for the greatest present value of accumulated asset deficiencies (GPVAD), which reflects all base policy and rider cash flows, assets, hedging, and reinsurance cash flows, using company prudent estimate assumptions. Asset modeling treatment for the general account and the derivation of discount rates for the GPVAD will similarly follow the principles in VM-20 and VM-21, with the prescribed alternate reinvestment strategy being a notable exception. In the proposed VM-22 draft, the alternate reinvestment strategy utilizes a 40% BBB/40% A/15% AA/5% Treasury distribution, and the reserve that is calculated under this distribution is a floor to the reserve that is calculated using the company’s own reinvestment strategy.
The VM-22 proposal specifies exclusion tests that are similar in concept to the stochastic exclusion test under VM-20. Groups of policies that do not have material market or policyholder optionality risks are likely to pass the exclusion test, allowing companies the option (but not the obligation) to continue using the existing rules-based paradigm for such groups. However, any business that is supported by a dynamic based hedging program cannot be excluded from the stochastic reserve requirements.3
For business with underlying risks (including policyholder behavior risks) that do not materially vary with economic conditions and business that is not supported by a future hedging program, VM-22 would provide a “deterministic certification” option to calculate the stochastic reserve requirements using a single deterministic economic scenario. It is envisioned that this option will only apply to a limited number of non-VA product types, such as single premium immediate annuities and similar payout and/or structured settlement annuities that have limited or no embedded asset and liability optionality.
As of the date of this paper, the stochastic real-world scenarios currently used under PBR, excluding C-3 Phase I, are generated using the American Academy of Actuaries’ Interest Rate Generator (AIRG) with parameters that are consistent with prescribed regulatory requirements. For the C-3 Phase I calculation, a separate C-3 Phase I Interest Rate Generator developed by the American Academy of Actuaries is used. However, in late 2020 the NAIC engaged Conning, Inc., to develop a new economic scenario generator (ESG) for all PBR applications. Conning is in the process of developing the new generator, which is anticipated to address known deficiencies that exist in the current suite of generators. The industry field testing for this new generator is expected to occur between June and September 2022 and will precede the VM-22 Field Testing. Once adopted, the new ESG will be used for all PBR statutory reporting in the United States, including VM-22.
Aggregation and calculation granularity
Under VM-20, aggregation of policies is allowed within similar product types while VM-21 allows aggregation across all policies under the purview of VM-21, including both VAs and RILAs. VM-22 may allow aggregation across policies if the business and risks associated with those policies are managed together and/or are part of the same integrated risk management program and strategy.4 To the extent that this is not the case, aggregation would not be permitted. As an example, it might be logical for companies to group policies that are part of the same hedging, risk management, or asset management program. The same level of aggregation would apply to both the stochastic projection and the exclusion test. Consistent with other statutory valuation and testing exercises, aggregation is to be limited to policies within the same legal entity—that is, aggregation across policies from different legal entities will not be allowed.
Additional Standard Projection Amount
Under VM-21, companies are required to calculate an Additional Standard Projection Amount (ASPA) that could potentially be an add-on to the company stochastic reserve. The Standard Projection calculation that underlies this amount is similar to the company stochastic projection with the exception that prescribed assumptions need to be used instead of the company’s own prudent estimate assumptions. The ASPA essentially comes into consideration if the company prudent estimate assumptions may be considered outliers compared to the prescribed assumptions.
For VM-22, a similar Standard Projection is expected to be employed, although as of the date of this paper it is not clear whether or not the corresponding ASPA will be a binding part of the overall reserve calculation or simply a disclosure item. Moreover, the ARCWG is still in the process of developing prescribed assumptions for mortality, policyholder behavior, and expenses for each of the non-VA products that are in scope of VM-22.
VM-22 suggests that the modeling of hedge assets in support of riders and guarantees, whether classified as a Clearly Defined Hedging Strategy or not, will follow the requirements similar to those provided in VM-21. There is the additional stipulation that a hedge-breakage expense for hedges backing indexed-related interest credits should be included in the calculations to reflect any potential basis risk and hedge transaction timing mismatch (against reality). This hedge-breakage expense can be modeled either as an expense or as a reduction to hedge payoffs.
Many conceptual topics within VM-22 continue to be debated by the NAIC as it seeks feedback from the ARCWG, the American Council of Life Insurers, regulators, individual companies, and other interested parties.
An immediate next step that is expected to have a major influence on the proposed VM-22 framework, its potential consequences, and the adoption date is the industry field test related to the new NAIC ESG that is slated for this summer. This field test will apply to all existing PBR and capital requirements. The results of the ESG field test will be studied and the learnings applied to the construction of the VM-22 Field Testing, which we expect to occur in 2023.
C-3 capital requirements will also change for non-VAs. Today, for fixed-indexed annuities, such requirements follow a factor-based method where the factors have been set by state regulators, have not been updated in decades, and do not vary from company to company. For fixed deferred and income annuities, while stochastic testing may be used, as mentioned above, C-3 capital requirements are based on an outdated economic scenario generator. We expect that the new capital requirements for all non-VAs in scope of VM-22 will be conceptually similar to those in VM-21; that is, based on the deep tail of the loss distribution, e.g., between the CTE 70 (reflecting the reserve level) and CTE 98 (reflecting the total asset requirement) metrics. In developing a consistent and fair capital methodology for all non-VAs, additional complications arise if companies opt out of PBR on the exclusion test grounds and if the scope of VM-22 applicability is limited to new business only.
The VM-22 framework is still a proposed draft, subject to change depending on the outcomes of the VM-22 Field Testing, industry feedback, and input from the ARCWG and the NAIC. Accordingly, the reader should be mindful that certain provisions may change between now and actual implementation.
It is not clear whether the reserves and capital requirements for non-VA business will generally increase, decrease, or stay at their current levels, so it would be advisable for companies to participate in both the NAIC ESG and VM-22 Field Testing so they can study the potential outcomes and proactively ideate corresponding management actions.
As companies participate in these field tests, here are a few questions to consider:
- Does your total asset requirement level increase, decrease, or stay about the same? If an increase, what management actions could you take?
- How sensitive is your business to changes in mortality and policyholder behavior (such as lapsation and withdrawal utilization)?
- What impact, if any, do the proposed aggregation rules have on the way you might manage your business going forward?
- How does analyzing stochastic risk metrics under PBR instead of a prescriptive rules-based framework better inform you about your business?
- Are you able to forecast (the new) reserve and capital requirements using your current modeling platform?
2The timing of this field testing is yet to be confirmed but will be subsequent to the separate industry field testing for the new NAIC economic scenario generator that is currently being developed by Conning, Inc., which is expected to occur between June and September 2022.