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Life Insurance—Reserving, Expenses and Going Concern

March 15th, 2013

Background

Life insurance is heavily regulated. Starting in 2005, I have followed closely and been heavily involved in the attempted formulation of a new approach to computing life insurer liabilities, known as “Principle Based Reserves” (PBR). One portion of these new reserves would be projected expenses for long term contracts sold by insurers. As of a financial reporting date, these expense projections would apply to all current policies on the books that are covered in the PBR scope.

Prescribed methodology for reserves and expenses is provided in a document known as a “Valuation Manual.” In particular, the Manual section known as VM20 covers these issues. Although the Manual is considered quite prescriptive, when regulation is extensive, there is almost always a considerable portion of gray areas.

One gray area involves what level of projected unit expenses should be assumed when current expenses are uncomfortably high and can reasonably be expected to reduce in the future. The VM20 states that all expenses must be allocated to operating lines of business in projections. Also, it states that “expense improvements” are precluded. But it also states that a “going concern” assumption is permitted.

In a summary article, I attempted to show how a small life insurer, with very high current unit costs, might cope with reserving for expenses under the new PBR. Basically, I said that, with proper documentation and a track record that showed some unit expense improvement, insurers could project improvement in unit expenses over time. This would produce lower reserve liabilities than projecting full current unit expenses.

From my draft on this subject, I received some vehement objections. This article describes these objections and my replies to them.

Litany of Objections and Complaints

The first objection was that my proposal above was merely “my opinion” and presumably was therefore unworthy of consideration. One of my answers was pointing out how long I had been actively involved in discussions and evolution of PBR.

Next, I was provided with an apparent textbook discussion of “going concern.” While accurate, it seemed innocuous and referred primarily to a (non insurance) company’s ability to pay its debts. Therefore, supposedly, the concept of “going concern” was irrelevant to the question of unit expense assumptions in PBR reserves.

One response was to ask, why would a statement permitting a going concern assumption be included in VM20 if it was irrelevant to reserve methodology? Also, I remembered a call of an advisory group to regulators that was drafting the expense section of the Manual. After preclusions of expense improvement and required full allocation wording had been included, the “going concern” wording was added. I remembered that it had been included to reassure some advisory group members who were rightfully concerned about the implications for reserve magnitudes of these two expense phrases.

From my actuarial and accounting background, the spirit of “going concern” had always implied a growing company, not growing at a breakneck, out of control speed, but at a controlled, reasonable pace.

Further, my answer was that going concern has a unique aspect for life companies selling long term contracts. Each year’s new business sales do not just replace last year’s sales. They add a new layer of long term contracts to remaining layers from last year’s sales, and the sales of the previous year’s long term contracts remaining in force, etc.

This sequence of layer after layer should often exert a tendency to reduce unit administrative expenses. Without doubt, some insurers are inherently inefficient. Sometimes, the need for a new administrative system, an expanded internal network, new regulatory requirements etc. can raise unit costs and stop this pattern. But if the company is reasonably efficient, and has sales that more than offset terminations of previous layers, its volume should grow. Some additional expense may result from needed personnel to handle new business. But if new sales and increased inforce volume did not allow for reaching lower unit costs (known as “reaching critical mass”), then there would be no incentive to increase or continue sales in the first place (other than for agents to get more commissions).

It’s always possible that the late addition of “going concern” in VM20 was a ploy, intended only to quell concerns on expenses. But I remember when I heard this insertion, my reaction was that, while not perfect, “going concern” did provide some protection to small insurers.

How My Proposal for VM20 Interpretation Would Work

Take two companies, A and B, with A small and B large. A has not achieved critical mass, so its unit administrative expenses are $90 per policy actual and $40 in pricing its life products.

A must calculate reserves under PBR, in accord with VM20. Also, reserves for some of its products are not covered by the Valuation Manual. However, these reserves are validated by a process similar to that described in VM20, known as “Cash Flow Testing” (CFT).

In PBR reserves and CFT, the company could have several outcomes:

Best case, use $40 in reserve projections and hope that its big glob of unallocated expenses (from the excess of $90 over $40) doesn’t draw regulatory attention.

Worst case, include $90 per policy in these calculations, for all projection years, without relief. This would result in relatively high reserves, higher than Bs. Also, if included in CFTs, its non PBR statutory reserves might require strengthening. The company might even need more capital, due to these additional reserves.

Intermediate case, in calculations, grade from $90 to $40 and assume that, from reasonable projected volumes of new business, hold reasonable PBR reserves.

B’s actual unit expenses are assumed about equal to $40 pricing. B is probably selling new business, but all the falloff of numerous past layers of sales offsets much or all of its new business. In fact, B may need to consider the impact of inflation as to whether to raise its $40 each projection year. Ignoring inflation, a $40 level unit expense assumption means that B holds somewhat lower expense reserve liabilities than A. But the difference would be a lot less than if A assumed a level $90 per policy.

A’s approach with grading seems defensible under certain circumstances. Its track record should show reasonable efficiency and, hopefully, some progress already in reducing unit costs through additions of new business layers.

Further Considerations

One other objection I received was a suggestion to say nothing in my article about expense grading and insert a need for regulatory guidance. Well, doing nothing or going hat in hand to regulators to seek permission of company management often invites the worst possible response. I believe that most reputable life executives and actuaries would not react this way to the many gray regulatory areas. Instead, they would take a reasonable, well documented position that best serves their company’s interests.

For company A, some might elect to go with a $40 unit expense assumption and leave a big glob of unallocated expense. From my studies, the regulatory trend among states would be to challenge this approach. Instead, some would choose my suggested graded approach of assuming $90 down to $40.

This second position may be challenged by regulators, but documentation of the company’s track record should help. Companies can always demand hearings, if necessary, or if the issue is sufficiently urgent to the company’s capital or even solvency, resort to litigation.

This type of issue, assumed unit expenses for PBR reserves, is unique to life insurance. But its controversial nature and need for thoughtful responses to objections are often found in general business matters.

Norman E. Hill

Norman E. Hill, FSA, MAAA, Member AICPA
NoraLyn
Books By Hills

Author, “Winner and Final Chairman”
Member: IFWTWA and SPJ

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Mentoring– Good Advice, Good Role Models, and Good Contexts

March 6th, 2013

Everyone, in my opinion, needs some form of mentoring, whether professional or personal.  In my professional career, I have often received some mixture of all the above, good advice, role models, and contexts. For me, one key was that some of the good advice did not come from what you would call “good people.” In other words, some of the advice did not come from good role models. Further, some of the “good” role models were good in only a limited sense, less so in others.

The key is identifying good context. Most people conduct their lives with mixed premises, some good, some bad. This is mainly because no one is omniscient or infallible. In proper circumstances, the advice given and what it represents can be entirely valid. But it is up to the recipient to analyze the situation thoroughly, see how the advice or example is proper and beneficial, while not overlooking when these would be less proper and beneficial. In other words, these two sources can be useful to our professional careers, as long as we never lose sight of their limitations.

I have received mentoring from several individuals with these limitations in their character or attitudes. Before describing positives, let me provide some negatives, which illustrate the prevalence of mixed premises:

  • A man who, bursting with seeming energy, always ran up escalators—However, when he achieved an initial goal (whether in business or with his wives), he became bored with the result, and would want to sell out, before his boredom produced unfavorable results (for him, which often left others holding the proverbial bag); also, when he negotiated deal, instead of being satisfied with a win-win situation, he felt compelled to brag (legitimately or not) how he had outwitted the other party.
  • A very intelligent, creative lawyer-consultant—Privately, he often expressed contempt for the very clients and businessmen who were paying our fees.
  • A consultant on making presentations who stressed the importance of a high energy level—I heard her say this as I was making my own test presentation; she was urging me to achieve this, saying I wasn’t doing so currently; BUT she came in front of the group, waved her hand in front of me and even massaged my chest; at least for me, this was the worst way imaginable to spur me to better performance. In fact, it worsened my presentation and I believe it’s an unacceptable way of teaching and leading.
  • A writer who conveyed the importance of time management—He gave several ridiculous examples of such management. The worst one was his pointing favorably to a political demagogue who frantically shifted from one sophistic trick to another.
  • A colleague of mine who cautioned on relying on cold notes to support actions or reports—He was an alcoholic with many incredibly petty and contrary traits.
  • Some bosses may have worse traits than these–In today’s job market, while you may hope to move away from them, to other companies or departments, this might not be possible overnight; the best course of action is to adopt any favorable characteristics of theirs, but also to plan a move elsewhere as soon as possible. In any event, identify their undesirable characteristics or actions and don’t adopt the latter as your own.

On the positive side, some examples of good advice I have received, both from the above characters and others, include:

  • There is no substitute for hard work—This almost sounds like a plug for motherhood. Skills employed in, say, short-lived mathematical or computer manipulations may bring short term gratification. But they are less likely to lead to long term goal fulfillment than diligent, hard work (sometimes called “plugging away”) in carrying out completely all tasks at hand.
  • Know when the breaks are coming your way—A casual interpretation of this would be to rely on chance occurrences and lady luck; my interpretation as a positive approach is to see when initial success results from a particular course of action AND associated projections of future success from the same course of action now seem reasonably likely.
  • You don’t have to tell people everything you know—This is aimed at communications with peers, more senior organization members, or clients. It’s essential that a professional be able to communicate effectively. Often, this requires an air of self-confidence without arrogance and projections of knowledge on the subject that don’t pose some kind of threat to the recipient. HOWEVER, communication of knowledge should generally be delimited to the immediate subject at hand. Otherwise, the communicator runs the risk of skipping over the immediate subject, of boring, snowing, or antagonizing his audience, and leaving the impression that he is quite pedantic.
  • Maintain a high energy level—In speaking, whether formally, in meetings, or even on the phone, demonstrating a certain degree of energy and intensity, make that of interest in the topic, is very helpful.
  • Avoid being mesmerized by what you read or hear—This should be turned into a positive approach, one of reading and listening critically, to avoid being deceived by mistakes and miscalculations of others that may directly affect you adversely. Examples include:
    • One senior executive indirectly expressed it this way—he had heard a lot of ideas and presentations, some very questionable; when he concluded some were ludicrous, he could say confidently that the presenters were the ludicrous ones, not him; in other words, from accumulated experience, he could judge which ideas were sound, which were not, and be confident with his conclusions.
    • In a most prestigious business review, I read an article, praising the organization I was then with, as a classic example of a successful corporate reorganization and turnaround: I was amazed, since I knew that dysfunctional elements of the reorganization, not far beneath the surface, would most likely cause it to fail; I was accurate, although the unraveling occurred sooner than I anticipated; the point is, outside readers, with critical analysis, should have seen many weak aspects of the reorganization.
    • Be a good manager of time—Professionals dealing with technical or otherwise demanding

assignments need to remember that time available to complete projects is finite; timetables for projects and project phases should almost always be set out in advance; just as important, since new circumstances can arise, timetables should constantly be monitored and updated.

  • Follow the approaches and styles of successful people, including peers, and adopt those that seem helpful to you AND with which you are comfortable—This is certainly not a call for slavish conformity, but for observing others who seem successful and adopting their approaches to the extent they may improve your own performance.
  • There is little value in cold notes—In other words, from a conversation, presentation, etc., record notes from it promptly, before using them for other actions or reports. Key points can easily slip away and damage your later performance.

Having good role models can often aid in one’s own success.  Hopefully, the person(s) to whom a professional reports can serve as a role model.  Unfortunately, this is not always the case. Also, bosses of professionals may be from different fields themselves. Examples often occur in consulting or accounting firms.

Examples of role models in my own career include:

  • A CPA in a public accounting firm—He was reasonably skilled in applied mathematics, and excellent in communicating complicated concepts to clients; these skills extended to presentations or conversations. He almost always remained calm when unexpected or adverse outcomes occurred and could usually deal with them.
  • A lawyer in a consulting firm—He too was reasonably skilled in applied mathematics, and excellent in communicating complicated concepts to clients; these skills were very obvious in presentations and above all in written communications.
  • An executive who consistently ran up escalators–He was very energetic, and this tendency of his impressed on me skills such as managing scarce time and maintaining a high energy level.
  • This may represent a combination of advice and role model and needs to be expressed positively—I call it the aviary principle–when I was in college, an actuary who was recruiting told this story—when he was younger, he wanted to be an ornithologist, but confused the terms “aviary” with “actuary;” afterwards,  as an actuary, when he dealt with actuaries, he met many rare and queer birds; revamping this positively, actuaries or any professionals  should always strive to be a professional, one who understands the implications of his appearance and his conclusions, and can communicate them intelligibly to others.

I can’t stress enough the importance of context in these areas. Some advice is great in some situations, but if interpreted differently, not so good in others. Some role models have limitations in their skills, attitudes, or character. Some people just operate with mixed premises, some good, some bad. Even if the bad outweighs the good, they may have characteristics that are desirable for you, and even worth living up to.

In summary, in our careers, we can receive much good advice and observe numerous role models to some degree. But, above all, we must keep the context of our receipt and observations in mind, so they provide lasting benefits to us. When striving to operate as a professional, not a “back office geek”, even if working in a back office, this approach should enhance one’s own career and profession.

Norman E. Hill

Norman E. Hill, FSA, MAAA, Member AICPA
NoraLyn
Books By Hills

Author, “Winner and Final Chairman”
Member: IFWTWA and SPJ

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Disclosure, Not Destruction–Mark to Market Accounting

July 5th, 2009

Recent Development of Mark to Market Accounting

Several years ago, I noted a press release about the appointment of a new Chief Accountant at the SEC. He was a retired partner from an accounting firm where I had also been a partner. At first, I thought this was a positive development. A top-flight accountant should ensure sensible accounting policies at the top GAAP regulatory agency. The first quote I saw from the new Accountant dissuaded me from this view. “I’m just a little old country boy who likes market values,” came out of his mouth. I wasn’t sure just what he meant. In the past, whenever I heard the phrase, “…Little ole’country boy,” I automatically reached for my wallet. I, along with all publicly traded companies, soon found out exactly what he meant. He rigorously imposed the mark to market rule for invested assets such as bonds and mortgages. This approach had an immediate impact on balance sheets of banks, insurance companies, and other financial institutions. Until now, life insurance companies especially stated publicly that they sold long term contracts.

Therefore, on balance sheets, they had always carried the above types of invested assets at amortized value. The exceptions for insurers had been for: 1. The above assets deemed to suffer from permanent impairment. 2. Separate accounts tied to variable annuities and similar products, where matching assets had mostly been common stocks and where other types had also been carried at market values. The Chief Accountant touted the market value approach with a near-fanaticism. One exception was allowed, for an insurer that committed to having both the intent and ability to carry the above assets to maturity. However, if a company traded or disposed of such assets prematurely, there were significant penalties. These penalties seemed to spook the national audit firms. Whether it was deference to one of their own as the SEC’s Chief Accountant, or actual fear of him, they seemed to recommend strongly against even thinking about the exemption to keep amortized cost. In the meantime, statutory accounting for insurance companies continued to stress amortized cost. Of six investment grade categories for the above assets, the lowest one was for those with permanent or very significant impairments. The latter would be carried at market value, but the great majority of such assets continued with amortized cost on balance sheets. Until recently, there was little controversy as to HOW to compute market values. Prevailing trades were often available with published market values. If not, the present value of cash flows, using a prevailing discount rate, could be used, since this, at least implicitly, was the basis for traded values. One corruption of this approach was uncovered in the Enron bankruptcy. For exotic energy futures, no published market values were available. The pattern of future cash flows was basically unknown. Apparently, the company made up its own cash flow patterns and “market values” each quarter, using blatantly obvious balancing item approaches, rather than any objective attempts at cash flow estimation.

Redefined Mark to Market and Economic Turmoil Recent so-called economic turmoil really stems from accounting distortions. For many securities, recent trades have disappeared. Many securities, even though still performing, became temporarily illiquid. However, instead of relying on the present value of cash flows, a new interpretation of “market value,” namely, liquidation or fire sale value, has been uniformly followed. Apparently, this has been an SEC interpretation of market value. The result has been that temporarily illiquid securities of banks and some other financial institutions were immediately subjected to drastic balance sheet writedowns. These carried over, of course, to retained earnings. Banks, brokerage houses, investment banks, and even insurance giants like AIG teetered on the edge of bankruptcy. Ratings were also impacted very negatively, due to these severe reductions in retained earnings and other measures of financial soundness. Mergers, government-enforced mergers, or government loans (“bailouts”) have become the order of the day. In the words of Holman Jenkins, from a recent Wall Street Journal article, “Mark to Mayhem,” “Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on a accounting writedown.” With forced asset writedowns triggering much lower retained capital, this is exactly what has happened. Two other articles that also point the finger at bad accounting for the recent crisis are “Mark to Nonsense,” by Steve Forbes in the 9 15 08 Forbes and “How to Save the Financial System” by William Isaac, in a recent Wall Street Journal issue. Some have said that investors, rating agencies and others deserve to know the current status of asset portfolios. In other words, they deserve to know what current “fire sale” values of securities are. One approach would be to disclose such values, together with management statements that these values are only temporary (assuming no permanent impairment) and do not reflect any intentions or need on their part to sell currently. On September 30, 2008, the SEC’s current Chief Accountant issued Statement 2008-234. I
t stated that, in determining market value, the use of discounted cash flows was acceptable, even in the absence of recent trades. This extraordinary statement could be construed as a regulatory admission that its previous pronouncements in this area were dead wrong. In any event, it could have an extremely favorable effect on balance sheet and retained earnings values. Third quarter GAAP financials could show drastic improvements in results, due to revised market values, and institutions teetering on the brink of insolvency before could now how a restoration to health. The sad aspect of this could well be that such institutions were never teetering in the first place, but were victimized by bad accounting.

Current Developments A few days ago, Wells Fargo Bank put in a bid for Wachovia assets that was much higher than Citigroup’s. The latter bid came before the abovementioned SEC announcement, restoring historical methods for determining market value. It could be very interesting to see if there is a link between the new Wells Fargo bid and a likely very significant, positive accounting change. Momentum for a government bailout of financial institutions started before the 9-30 SEC announcement. Most unfortunately, after one failure, a revised Bill was passed by the House on 10 3 08 (after Senate passage on 10 1 08). The total cost of the Bill is stated as a staggering $700 billion. Possibly, $350 billion of this is earmarked to Secretary Poulson for his purchases of “troubled” assets (at prices he apparently sets). IF market values rocket upward, after more reasonable accounting prevails, perhaps Poulson won’t find many attractively priced assets. Those with permanent impairments would be covered by this Bill, to be sure. However, the likely government strings that would go with any purchase may make such transactions unattractive. One can always hope!

Summary The current “economic crisis,” to be sure, includes an increase in permanently impaired assets. Mortgage defaults and other non-performing assets are noticeably higher than in recent years. However, the great bulk of the crisis is really due to bad accounting. In other words, it is an artificially induced crisis from regulatory impositions of fire sale interpretations of “market value,” instead of the more rational one of present value of future cash flows. Financial institutions should be able to use the latter market values for balance sheet presentation of performing assets. Due to misuse of market value and recently prevailing fire sale values, these should also be disclosed in financial statements. Hopefully, rather than any “bailout,” this approach to market values can restore investor confidence and ensure that our economy can ride out this scary setback.

Norman E. Hill, FSA, MAAA, CPA
“Winner and Final Chairman”

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