Problems in Life Insurance

I am not an FSA, but I am an actuary.  That said, I am not presently practicing inside a life insurance company, so as I write this, there may be some things that I get wrong.

There are two areas that concern me in life insurance accounting at present.  The first is that there is no good way to estimate the reserves for products that have secondary guarantees.  Yes, many actuaries can create models to try to estimate what the reserves should be.  But when you are dealing with variables that are less than predictable – withdrawal assumptions, investment performance, etc., the results are often less good than desirable.

As a result, there have been reinsurance deals done to eliminate or reduce the formulaic reserves on secondary guarantees.  As a former boss of mine at AIG liked to say, “I drop my deficiency reserves in the Atlantic Ocean.”  In other words, a Bermuda reinsurer with weaker reserving standards would absorb the secondary guarantee risk, even if it was another AIG subsidiary.  The same can be done through securitization and Special Purpose Vehicles.

Two articles on the topic:

  1. Experts Fear Life Insurers Are Courting Reserve Risk
  2. Captive SPVs: Shadow industry or necessary tool for life insurers?

But here is the more recent problem: allowing insurance companies to use their own models for reserving.  If the results of banks using the Basel Standards were bad, this has the potential to be worse.

You want all setting of reserves/accruals in financial companies to be conservative, and not manipulable by the companies, lest solvency be compromised.

When I was active in pricing, reserving, and cash flow modeling, I felt I had some of the best modeling out there, because most actuaries don’t understand complex regression models, and the components of investment return.

But I would never use my models to set the reserves.  That goes too far.

You don’t want to hand over reserving rules to one hired by the company, no matter how ethical he might be.  That way lies disaster.  There are always subtle pressures put on actuaries to be less conservative, because companies face pressure to show good earnings in the short-run.

Think of the mostly European quants, accountants and actuaries using the Basel standards.  Giving them the authority to set their own reserves for credit using internal models led to setting the reserves too low.  You want to have checks and balances.  You don’t want to have players serving as their own umpires.  So what if the statutory standards are too tight?  That just means earnings will be delayed, not eliminated.  Risk margins should be received as earned, and never capitalized.  Besides, the current crisis shows us that we never truly understand the parameters of the distribution.

Now, the rules in question are Statutory rules, affecting solvency, but not earnings, which come from GAAP.  What Statutory affects is the degree of solvency for subsidiaries, and the amount of free cash flow available to the holding company in the short-run.

This gives a lot of flexibility to management teams, and there is a lot more room to be liberal or conservative in terms of overall leverage policy.  In the short run, there could be a self-reinforcing cycle driving up the prices of life insurers as the less conservative buys the more conservative, resets their reserves, and uses the excess cash flow in the short run to acquire more companies.

Now for three quotations from this Wall Street Journal article on the topic:

Critics of the plan say they fear insurers will go overboard in their effort to placate investors who have grumbled for several years about subpar returns, draining the industry of reserves that could be needed in future financial crises. Many publicly traded life insurers are struggling to post the midteens returns on equity that shareholders want. Analysts say it is too soon to calculate how the new method will filter through to returns.

“This a significant and historic vote for the NAIC, moving forward on a substantive change in policy,” said Thomas Sullivan, a partner with PwC’s regulatory advisory business, and a former Connecticut insurance commissioner.

Once insurers can free up capital, “you could see more competitively priced products to consumers and/or improved financial flexibility for insurers,” Mr. Sullivan said.

Others are less optimistic. The move to principles-based reserving “is one of the most important developments in the history of life insurance,” said Joseph Belth, a professor emeritus of insurance at Indiana University and editor of the Insurance Forum. “Future generations of executives, regulators and consumers will have to deal with the financial carnage.”

Benjamin Lawsky, superintendent of the New York Department of Financial Services, had urged fellow regulators to vote no in a letter dispatched last week.

“The insurance industry weathered the financial crisis well precisely because of the careful reserving state regulators have historically required,” Mr. Lawsky said Sunday. “To ignore the lessons of the financial crisis and deregulate the industry, allowing them to keep less in reserves, is unwise.”

Listen to the New York Department of Insurance, which is the giant among pygmies.  They understand insurance regulation, versus most of the others states that don’t, who don’t deserve  a vote.  Listen to Joe Belth, who has fought against all manner of insurance frauds.  He deserves to be listened to as an elder statesman, unlike many others who think loosening up standards will produce some great outcome.

Principles based reserving will be less transparent than current standards.  Think of it this way.  Under the old rules, everyone was using the same algorithm.  You could ask questions about the inputs to it, and whether they were reasonable.  Under the new rules, regulators not only have to ask questions about inputs, but about the algorithms.  I can tell you from my experience, New York and the large states will be challenged trying to regulate that.  The small states?  They can’t even handle the present standards.

Now, it is not a done deal that these standards will come into existence.  Note from this article:

With the adoption of the Valuation Manual and prior approval of revisions to the Standard Valuation Law, the NAIC and Academy can present this as a package to state legislatures for consideration in early 2013. This package must be approved by 42 jurisdictions that represent states in which at least 75 percent of direct premiums are written before PBR takes effect.  

Both New York and California are against this, and they have 18% of the market.  8% more against, and this is dead.  Also, I know from my own forays back in 2000, when I led the effort to modernize Maryland’s life insurance investing code that it is very difficult to convince legislators to adopt new standards that they don’t understand.  I succeeded, and mainly because I was able to explain how excesses would be curbed.  With this legislation, I have no idea how you pitch it, aside from the braindead “More flexibility is good for the life insurance industry,” pitch.

I do not stand behind the American Academy of Actuaries.  I was a member of that for years, but I do not see them as promoting the good of all, but only that of the insurance/benefits industries.

Two more articles:

And to put my money where my mouth is, I am willing to testify against this legislation in state capitols as needed.  Maybe I get the fun of going back to Annapolis, but where else might I go?

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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