By Ross Zilber
As a valuation actuary, I rarely come across an actual consumer. My work is mostly with the data, and my immediate customers are usually others who work in financial reporting. But it is good to stop and think that everything I do is for the ultimate benefit of consumers. I remember my first ASA professionalism course where I was taught the first Precept of the Code of Professional Conduct, that as an actuary my profession’s code includes responsibilities to the public.
I understand this in my work as protecting the public against insolvency of an insurance company. The images most often I was given are that of unscrupulous actuary who uses aggressive, unrealistic reserve assumptions. However, in over 20 years as an actuary, I believe I have seen more harm done by overly conservative actuaries—those who cause consumers to be priced out of insurance products.
The data clearly points to a narrative: The middle class needs insurance, and it is significantly underinsured in the U.S. LIMRA data shows that 90% of households believe that the family’s primary wage earner needs to own life insurance, 35% would feel adverse financial impacts within one month if the primary wage earner died, and yet only 59% own any life insurance. Of those with life insurance, 20% believe they don’t have enough. The most common barrier to buying life insurance is price, according to 63% of responders.
Another challenge compounding this issue is the “liquid expectations,” as coined by Accenture. The phenomenon of the “liquid expectation” is based on consumer experiences with services like Amazon and Uber, where the experience is personal yet very simple. Products that involve multi-tiered shadow accounts to meet a simple life insurance need are not meeting these expectations. Complexity of products can be more harmful to consumers than price; millennials likely wouldn’t give a chance to our products even if we improve pricing but do not address complexity.
As an actuary I have seen insurance products in Canada and in five Asian countries, but nowhere have I seen the complexity of U.S. products. Consumers with a simple lifetime protection need would have a choice between two products—either complex Universal Life with Secondary Guarantees (ULSG) with multi-tiered shadow accounts or high premium participating policy. ULSG was designed as a response to regulation. These products have various sets of interrelated charges, none of them mean anything in terms of actual product risks, and are used only as reserve levers. Participating products are expecting policyholders to pay higher premiums with the expectation of future dividends. Even if those dividends are realized, these premiums are a high percentage of disposable income and unrealistic for people in the middle class.
How did we get here? Why can’t we offer simple lifetime protection to the middle class—the group that needs insurance the most?
This story starts way back in the 19th century. Insurance business was regulated by states in a disorganized way. On February 3, 1866, the Legislature of the Commonwealth of Virginia passed a statute important for the history of the insurance business that prohibited nondomestic companies from doing business in the state. These state barriers created a challenge to the growth of large insurance companies interested in the interstate commerce. The response from the industry was to license a lawyer, Samuel Paul, by a coalition of New York companies, to sell business in Virginia. Paul applied for a license and had all the required paperwork, except for deposit of bonds with the treasury of the state. He proceeded to sell a fire insurance policy in Virginia.
The setup worked perfectly. The Commonwealth of Virginia fined him $50 (about $1,050 in 2019 dollars). Paul’s law firm took this $50 fine all the way to the Supreme Court. The issue was not the $50 fine, but the scope of state’s regulatory authority.
The insurance companies and state regulators had some successes in this legal battle. This skirmish resulted in state commissioners coming together in forming the National Association of Insurance Commissioners (NAIC) in 1871. The mission of NAIC then was to coordinate regulation of multiple insures.
The NAIC had a difficult task of creating uniform financial reporting standards 150 years ago. Computational tools of that time were primitive. What some call the first computer, the Analytical Engine, was still being developed by the British mathematician Charles Babbage. Simple computational tools and tables could only handle deterministic models. These tools required consistency of projection probabilities and discounting. That means reserves could only include mortality and no other decrements like lapses, and no other cash flows like reinsurance, expenses, or investment income.
This methodology matured into CRVM (Commissioners Reserve Valuation Method) in 1941. The methodology used commutation functions—pre-multiplied factors—because the tools of the day couldn’t do complex arithmetic. These are no longer on the educational societies’ syllabi, but you can still see these dinosaurs in valuation today.
Fast-forward to the late 1980s. People have calculators on their watches, but CRVM is still based on the outdated methodology—commutation functions. Statutory valuation of insurance products still does not recognize lapses, reinsurance, expenses, or investment strategy. This environment gave birth to the U.S. version of Term products—premiums are held level for the duration of level term period but then increase sharply. Because consumers are expected to lapse their policy at the end of the level term period, they did not care how high those post-level-term premiums got. However, actuarial valuation still did not include lapses (or antiselection), and present value of those higher premiums post-level-term was reducing actuarial reserves.
The industry took full advantage of the prescriptive but flawed valuation regime. During this time the market saw introduction of UL products with unusual cash values, another variant on the same formulaic flaw. By the mid-’90s the industry was in the middle of “Term wars.” Term insurance is a commodity product, sold in a spreadsheet way, where only the top, most competitive companies would be shown to a potential consumer. It is not uncommon in my experience for the most competitive companies to have premiums literally within single dollars for a million-dollar policy. All a company needed to do to impart a competitive position was to dial down reserves by increasing post-level-term premiums, which no one expected to pay or collect anyway. The flaws of formulaic, archaic CRVM methodology were obvious—and regulators had to get involved.
Regulators in 2000 came out with Regulation XXX, which defines segmented reserves. The intention was good: to eliminate leverage from premiums that are not expected to be paid. However, this formulaic regulation patch ended up causing more harm than good. The primary flaws of the regulation were that it was very conservative and formulaic. The conservatism of this regulation led to creation of the industry of reserve financing; more on it later. The formulaic problem led to companies designing products focused on the regulation, not on consumer need.
I want to ask the reader to stop and contemplate on this point—for the remainder of this article (and the past 19 years) consumer need was a focus of neither the regulators nor industry.
What came next were shadow account products. These products have phantom charges—“shadow accounts”—that were used for no other reason but to produce the lowest XXX reserves. The complexity of UL products took another level; in addition to current and guaranteed charges, there was another set of charges that was not illustrated. These shadow accounts were not accessible for cash, but determined if the policy stayed in force. The design of these shadow accounts allowed companies to dial down reserves by setting a structure of the charges in the shadow account that was not related to the pattern of premiums consumers expected to pay. This concluded the first round of the regulator-vs.-industry bout. I would give this “shadow account” round to the industry.
In the second round, regulators evened the score with Regulation AXXX, which attempted to address shadow account products with yet another formula. Around that time, I worked for a large UL writer with primary reporting basis of International Financial Reporting Standards (IFRS). I remember looking at projected AXXX reserves that were multiple of the IFRS reserves for a UL product. Reserves were perceived to be approaching unreasonable percentage of face amount. There were no reasonable assumptions to mortality or interest that would warrant AXXX level of reserves.
The industry found significant flaws in the eight-step formulaic AXXX calculation. In one of the steps there was a calculation of the Net Single Premium (NSP), which was in the denominator. AXXX reserves decreased as NSP increased. The challenge was on how to increase NSP—that is, decrease reserves—without changing policyholder premiums. The solution was to create two sets of premium charges in the shadow account: one applied up to a certain threshold, which was set high enough to avoid application to actual premiums paid by the policyholders, and another set of very high charges created to reduce NSP.
This flaw in the formula allowed companies to dial down reserves (usually close to IFRS) without changing product premiums. Regulators came back with more prescription in the alphabet soup of regulations Actuarial Guideline XXXVIII (AG 38) A, B, C, D, and E.
Reserve financing is a key weapon in the next round. These structures gained prominence in the earlier 2000s. Their genesis dates to the use of letters of credit (LOCs). LOCs have been used by international automakers for years: If GM sends a fleet of cars overseas to a dealer in a foreign country, the dealer would take out an LOC from the local bank, which has a relationship with a U.S. bank of GM, in effect guaranteeing creditworthiness of the dealer. The LOC is not meant to be drawn; it is very similar to a credit card. I don’t know whose idea it was first to use LOCs in the insurance industry, but by the mid-2000s most insurance companies financed large portion of reserves with LOCs. (It got to a point where the insurance industry started dominating large automakers, drawing concerns of LOC capacity.)
In a typical transaction, an affiliate company outside of the U.S. (e.g., Barbados), would assume redundant non-formulaic reserves through variety of reinsurance options (e.g., coinsurance or co/mod-co arrangement). The assuming company, which was likely outside of U.S., would attain an LOC for the redundant reserve. Those LOCs would be an asset on their balance sheet to allow reserve credit for the cedant. In effect, it is like using available credit on a credit card as an asset. These structures matured to more sophisticated vehicles, and later used cheaper-than-LOC funding and more efficient cost structures.
I will give this LOC round to the industry to edge ahead 2-1.
Regulator response was Actuarial Guideline XLVIII (AG 48). The guideline required primary level of security (i.e., no LOCs) in the size of economic reserve on the reinsurer’s balance sheet for the ceding company to get reserve credit. As a high-level solution, this is the first regulation that made sense to me; regulators established guardrails with companies needing to have real assets supporting economic reserves. The catch is that the economic reserve was defined by Valuation Manual-20: Principle-Based Reserves (PBR).
PBR was in the making for decades and grew out of recognition that a formulaic approach based on a 150-year-old work-around of arithmetic just does not work in the modern age. However, like any change, it was hard to let go of the formulaic part.
At first, there was introduction of Net Premium Reserve (NPR), which was supposed to be reserve floor but came to dominate reserves for several products. Initially, Deterministic and Stochastic Reserves (DR/SR) were intended to be principle-based. I remember attending an actuarial meeting where these reserves were described as similar to cash flow testing work and Canadian IFRS. DR/SR were intended to be best estimate assumptions with reasonable margins. Then came in “guardrails”; these are the prescriptive elements. These end up dominating PBR reserves, and as the saying goes in the industry, the “P” in PBR stands not for “Principle” but for “Prescribed.”
This final PBR round goes to the regulator for a draw of 2-2, but a total loss for consumers.
The products in the U.S. still under-serve middle class. Midpoint of middle class for the U.S., based on Pew’s definition, is income of about $80,000 annually. This household would need about $560,000 in protection, based on the rule of seven times income. For a 40-year-old Standard Male this is about $9,000 a year in premium, or 12% of disposable income. This rules out participating policies for the middle class. Non-participating policies have lower premium but have complex designs which prevent many middle-class buyers from buying insurance. PBR initially gave a glimmer of hope, but with its current framework, it is very similar to the pre-PBR, formulaic approach. Prescription came to dominate so much of PBR reserves that many companies started to finance them, just like in the pre-PBR times of AXXX.
Middle-class consumers are not the only group that suffers from overly prescriptive regulation. For example, recent discussion about reserve credit for reinsurance under PBR would disproportionally impact products sold to women. The life insurance market has underserved women and not offered competitive coverage, especially in the protection space. Many families depend on income from two working parents, and there is a lot of information in the financial planning space about the protection needs of stay-at-home moms, single mothers, caregivers, and many similar groups. Due to a lack of focus on these market segments in the past, direct writers lack credible experience for these low mortality cells to set rates competitively, and to develop new purchase processes to attract these customers. Prohibitive regulatory “guardrails” on reinsurance credit under PBR would further drive the gender coverage gap.
At the end, I think this is all about change management. I used to have a large collection of cassette tapes. At one point car manufacturers stopped making car stereos that could play cassettes, the cost of CD players got more affordable, and one day cassettes ended up in the trash. Does the reader remember floppy discs? I am sure those would still work—if you could find a computer to use them. I would not recommend forcing floppies into the laptop USB drive. Yet, we still insist on forcing commutation functions into the principle-based reserves. The prescribed formulaic reserves are cassettes and floppy discs of the actuarial past.
There are a growing number of regulators who are supportive of change and reject archaic irrelevant formulaic regime. I am optimistic that the “wind of change,” as in the famous Scorpions’ song, is already here. The truly principles-based approach would change the focus of the regulator and the industry back to where it should be—the consumer.
ROSS ZILBER, MAAA, FSA, is a vice president and deputy appointed actuary at John Hancock.
 2018 Insurance Barometer Study, LIMRA, by James Scanlon, Maggie Leyes, and Karen Terry
 “Why Life Insurance is growing more complex”, by Bob Sollmann, Principle Director, Insurance Practice, Accenture website, 2018