BILL ANALYSIS                                                                                                                                                                                                    Ó



          SENATE COMMITTEE ON INSURANCE
                             Senator Richard Roth, Chair
                                2015 - 2016  Regular 

          Bill No:             SB 696         Hearing Date:    April 22,  
          2015
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          |Author:    |Roth                                                 |
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          |Version:   |April 14, 2015                                       |
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          |Urgency:   |No                     |Fiscal:    |Yes              |
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          |Consultant:|Hugh Slayden                                         |
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                   Subject:  Insurance:  principle-based valuation


           SUMMARY     Replaces the current method of calculating contract reserves  
          for life insurance products with a new method, Principle-Based  
          Reserving (PBR), for some types of life insurance policies  
          issued on or after the effective date, as specified.
          
          
          DIGEST
            
          Existing law


            1.  Sets minimum benefit values when policies are surrendered or  
              lapsed (referred to as "nonforfeiture benefits").


           2.  Requires every life insurer doing business in California to  
              annually submit to the Insurance Commissioner (IC) the opinion  
              of a qualified actuary as to whether the "reserves" (assets set  
              aside to pay future claims) are calculated appropriately, based  
              on assumptions that satisfy contractual provisions, consistent  
              with prior reported amounts, and in compliance with applicable  
              state law. 


           3.  Requires insurers to calculate reserves according to a  
              statutory method, known as the "Net Premium Reserve Method,"  
              using a formula, specified mortality tables approved by the IC,  







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              and method for calculating the applicable interest rates, for  
              the purpose of determining reserves required by law for various  
              types of life insurance contracts.
           

          This bill


            1.  Requires the IC and life insurers to incorporate a new  
              methodology known as Principle-Based Reserving that employs  
              a specified manual of valuation instructions, known as the  
              Valuation Manual (VM), adopted by the National Association  
              of Insurance Commissioners (NAIC) in making determinations  
              relating to reserve requirements and the minimum standard of  
              valuation for policies and contracts, as specified. 


           2.  Requires insurers to calculate reserves using PBR for  
              policies issued after the effective date of the VM.


           3.  Requires an insurer to annually submit to the IC the  
              opinion of a qualified actuary as to whether the reserves  
              are calculated appropriately and that the opinion be  
              governed by the VM and other applicable standards.


           4.  Requires a company to establish reserves subject to PBR  
              that meet specified conditions in the VM, including  
              quantifying the benefits, guarantees, and funding associated  
              with the contracts, and requires the company to develop and  
              file with the IC upon request, a principle-based valuation  
              report. 


           5.  Requires an insurer to submit mortality, morbidity,  
              policyholder behavior, or expense experience, and other data  
              as prescribed in the VM. 


           6.  Grants the IC the authority to adopt tables of select  
              mortality factors and rules for use by issuing a bulletin or  
              through the adoption of regulations, and declares the  
              Legislature's intent that those rules be consistent with the  








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              NAIC's Valuation of Life Insurance Model Regulation 830.


           7.  Provides that the VM goes into effect January 1 the year  
              after it has been adopted by the NAIC by an affirmative vote  
              of at least 42 members, or three-fourths of the members  
              voting, whichever is greater, so long as it was adopted by  
              July 1 of the preceding year.


           8.  Provides that the PBR goes into effect when enacted by  
              states representing greater than 75 percent of the direct  
              premiums written and at least 42 of the 55 jurisdictions  
              (including U.S. states and some territories).


           9.  Establishes a process for amending the VM.


           10. Requires that the VM include minimum valuation standards;  
              establishes criteria for which method applies to particular  
              policies or contracts and specifically which ones are  
              subject to PBR; establishes rules on how to treat  
              assumptions of risk for which the company has little to no  
              control; imposes procedures for corporate governance and  
              oversight of the actuarial functions; and sets standards for  
              products not subject to PBR.  


           11. Requires reserves subject to PBR to incorporate: 


              a.    A level of conservatism that reflects conditions that  
                include unfavorable events that have a reasonable  
                probability of occurring; assumptions, risk analysis  
                methods, and financial models and management techniques  
                consistent with those utilized within the company's  
                overall risk assessment process.


              b.    Assumptions prescribed in the VM, and if not  
                prescribed, assumptions established utilizing the  
                insurers' available experience, to the extent it is  
                relevant and statistically credible, or data established  








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                utilizing other relevant, statistically credible  
                experience  that provide margins for uncertainty including  
                adverse deviation and estimation error.


           12. Requires insurers to establish procedures for corporate  
              governance and oversight of the actuarial valuation function  
              consistent with those described in the VM.


           13. Requires the insurer to develop, and file with the IC upon  
              request, a PBR report that complies with standards  
              prescribed in the valuation manual.


           14. Authorizes the IC to engage a qualified actuary, at the  
              expense of the insurer, to perform an actuarial examination  
              of the insurer and provide an opinion on the appropriateness  
              of any reserve assumption or method used, or to review and  
              provide an insurer's opinion on compliance with reserving  
              requirements.


           15. Authorizes the IC to require an insurer to change any  
              assumption or method necessary to comply with the VM or  
              applicable law, and adjust the reserves as required. Also  
              authorizes the IC to take other disciplinary action as  
              permitted by all other applicable laws.


           16. Exempts specified documents and information, with some  
              exceptions, that are submitted under the PBR process from  
              subpoena, disclosure under the Public Records Act, civil  
              discovery as applied to the IC, and prohibits documents and  
              information from being admitted into evidence in a civil  
              proceeding.


           17. Authorizes the IC to hire and assign department staff,  
              including one exempt position, and retain nondepartmental  
              actuaries and other consultants, to assist in the  
              implementation of PBR.










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           18. Establishes an annual assessment on each participating  
              insurer, effective when the bill (not PBR) goes into effect,  
              that is capped according to the insurer's volume of  
              business, to pay for additional staffing and resources to  
              implement PBR.


           19. Coordinates the assumptions used to determine nonforfeiture  
              benefits with those used to determine reserves under PBR  
              when applicable.


           20. Makes numerous, clarifying, technical, and stylistic  
              changes.


           21. Makes legislative findings regarding the need to protect an  
              insurer's proprietary information and keep information  
              received by IC confidential.


           COMMENTS
            
          1.  Purpose of the bill   SB 696 would allow life insurers to  
              utilize Principle-Based Reserving to calculate the funds set  
              aside to pay future claims.  Stakeholders agree that the  
              current method does not provide reserves that meet the risks  
              for some types of life insurance products.  PBR is intended  
              to "right-size" reserves for those products.

           2.  Background   In order to make sure that life insurers have  
              sufficient funds to pay future claims, they are required by  
              law to set aside sufficient assets, "reserves," to pay  
              anticipated liabilities.  Since only a portion of  
              outstanding policies will pay benefits, it is not necessary  
              to set aside funds to pay the entire benefit, but enough to  
              ensure payment of future claims given the probabilities  
              related to claims, probable investment income on the assets,  
              future premium to be received, reinsurance agreements (where  
              one insurer assumes risks from another insurer) and other  
              factors.  The Standard Valuation Law (SVL) establishes  
              methods required by law to calculate reserves.  Currently,  
              most life insurance products are subject to the method  
              within the SVL known as the Net Premium Reserve Method  








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              (NPRM).  The NPRM applies in a similar manner to all  
              insurers and most products.  SB 696 would add a new method  
              to the Standard Valuation Law, known as Principle-Based  
              Reserving (PBR), that would consider the actual experience  
              of the insurer and incorporates many factors not considered  
              by NPRM.


              Net Premium Reserve Method (NPRM).  The current formula  
              reflects an almost 150-year-old method originally designed  
              for whole life insurance policies.  Whole life policies have  
              no termination date and are intended to remain in effect  
              until the death of the insured and payment of the death  
              benefit.  The Net Premium Reserve Method (NPRM) is  
              prescribed by law utilizing an inflexible formula and  
              operates on standardized assumptions, such as life  
              expectancies established by mortality tables and anticipated  
              investment income determined by interest rates established  
              in statute.  Any factual input is based on data collected  
              across the life insurance industry and may not reflect the  
              actual experience of the insurer.  The NPRM does not account  
              for random fluctuations.  NPRM has worked well for  
              traditional life products intended to be held for the  
              insured's entire life and have relatively simple terms. 


              However, life insurers offer a variety of life insurance  
              products that involve a variety of complexity and different  
              risks.  For example, term life insurance policies expire  
              after a specified period and appeal to consumers who are  
              more likely to give up the policy as they get older; they  
              also cost less for the same death benefit because they pose  
              less risk of loss to the insurer.  Insurers argue that the  
              NPRM does not adequately account for specific liabilities of  
              different products resulting in excessive reserving for some  
              and under-reserving for others.

              NPRM may limit insurer's options for designing more complex  
              products.  Additionally, the potential for over-reserving  
              caused by the NPRM encourages some insurers to engage in  
              creative accounting practices that take advantage of  
              weaknesses in the interstate insurance regulatory system.   
              The NAIC white paper, titled Captives and Special Purpose  
              Vehicles, describes how some life insurers use captive  








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              reinsurers domiciled in other states or countries to avoid  
              "perceived reserving redundancies."  This technique is a  
              form of creative accounting permitting an insurer to set  
              aside fewer reserves by shifting some risk to a wholly-owned  
              subsidiary subject to weaker regulatory standards.  The  
              white paper suggests that PBR will make the use of a  
              captive, which is an additional operating expenses, less  
              attractive for policies issued once PBR is implemented.


              Principle-Based Reserving.  Under PBR, the insurer proposes  
              a valuation method based on its experience with that product  
              and other factors specific to the product and insurer.  PBR  
              requires insurers to submit to regulators detailed modelling  
              and analysis specific to that product; the insurer proposes  
              its own reserve requirements for evaluation by the  
              regulator.  Unlike the current NPRM, PBR incorporates  
              "stochastic" modeling for many types of policies that  
              incorporates random variations observed in historical data.   
              To develop this model, insurers must run a large number of  
              simulations (in contrast to NPRM that involves plugging in  
              standard assumptions into a formula).  PBR allows the  
              insurer to use its own data on mortality and policyholder  
              behavior if it can prove that the data is credible.


              The PBR method is structured according to a detailed manual,  
              called the Valuation Manual (VM).  The VM contains the  
              details, rules and standards that the insurer must follow.   
              The VM incorporates a review and updating process to ensure  
              ongoing evaluation of the effectiveness of the PBR  
              methodology.


              Once the modeling is complete, insurers would be required to  
              hold the higher of (1) a baseline reserve similar to the  
              current NPRM that applies to a product or type of product  
              prescribed by the VM or (2) the reserve calculated according  
              to insurer's model.  


              By incorporating variables that NPRM misses, PBR is supposed  
              to provide greater flexibility to design less conventional  
              products.  According to the NAIC, PBR is a critical element  








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              to paving the way for new multi-benefit products that can be  
              more flexible and valuable to consumers, including life  
              insurance policies that can convert to annuities upon  
              retirement, products that could cover an entire family for  
              life insurance, or that could provide life insurance  
              protection for one person while simultaneously providing  
              retirement income to a parent or to pay for home or nursing  
              home care.


              The IC must review these figures, models, data, and  
              assumptions for approval.  The individualistic PBR approach  
              is much more labor intensive for the regulator. This bill  
              provides for an assessment (capped according to the  
              insurer's volume of business) on each participating insurer  
              to offset CDI's costs related to the workload resulting from  
              the transition to PBR.  The assessment begins immediately,  
              even though full implementation of PBR will not occur for  
              several years, in order to give CDI the resources to build  
              the staff and infrastructure needed to conduct thorough  
              examinations.  SB 696 also empowers the IC to hire  
              independent actuaries for additional analysis (at the  
              insurer's expense), requires insurers to change assumptions  
              or methods not consistent with the VM or the Standard  
              Valuation Law, and establishes specific valuation  
              requirements when needed.  


              Two studies examined the potential impacts of PBR on variety  
              of products and both suggest similar results.  Both studies  
              are based on a prior version of the VM; according to the  
              Association of California Life and Health Insurance  
              Companies, while some additional edits have been made to  
              refine and clarify the requirements, it is doubtful those  
              changes had a material impact on the testing conclusions.   
              The studies, Presentation and Analysis of Results of VM - 20  
              Impact Study on Principle - Based Reserves for Life  
              Insurance Products (March 15, 2012) sponsored by the NAIC  
              and VM-20 Impact Study Compendium (February 2012) sponsored  
              by the American Council of Life Insurers, generally indicate  
              that PBR would lower reserves for term life insurance, have  
              mixed results for universal life insurance with secondary  
              guarantees (ULSG), and would not affect many other types of  
              products.  (ULSG are sophisticated policies that provide the  








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              policyholder flexibility to adjust premium amount and  
              frequency, as well as the death benefit, but also contain a  
              lapse protection feature.)  According to the NAIC's Impact  
              Study, PBR would result in an initial decrease of total life  
              insurance reserves of less than 5% because it would only  
              apply to new business, but that reduction would grow as more  
              policies become subject to the new reserving method.


              States would not implement PBR until at least 42 of the 55  
              jurisdictions of the U.S. (including Guam, U.S. Virgin  
              Islands, etc.) representing 75% of total U.S. premium adopt  
              the NAIC model.  According to Pacific Life Insurance  
              Company, 25 states have already adopted the model act. Once  
              PBR reaches the threshold, the changes will be implemented  
              over approximately three years and only for new business.   
              New York will not implement PBR, but it has significantly  
              lowered reserve requirements on some policies.  Because of  
              its market share, California's participation is essential  
              for implementation of PBR nationally.


              PBR would require insurers to provide the IC with very  
              sensitive and confidential information not required under  
              the NPRM.  With some exceptions, documents and information  
              submitted under the PBR process would not be subject to  
              subpoena, disclosure under the Public Records Act, the civil  
              discovery process, and could not be admitted into evidence  
              in a civil proceeding.  However, these protections only  
              apply to materials obtained by the IC and would not affect  
              the ability of a litigant to obtain information or documents  
              through other means.  The bill has been double-referred to  
              the Committee on Judiciary that will further consider these  
              provisions.


              PBR significantly increases the expense to calculate  
              reserves for insurers and CDI.  Smaller insurers might not  
              have the up-front resources to implement PBR as effectively  
              as larger insurer potentially providing larger insurers a  
              market advantage.  The NAIC is currently considering  
              exemptions for smaller companies to be incorporated into the  
              VM, but recommends against incorporating exemptions into  
              statute.








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           3.  Support   The Association of California Life and Health  
              Insurance Companies and the American Council of Life  
              Insurers state that PBR would provide a uniform approach to  
              reserve calculations that more realistically reflects the  
              risks, variables, and changes in consumer behavior that  
              affect the value of cash reserve calculations.  This in turn  
              leads to more flexible product designs, greater consumer  
              choice, and could improve pricing.

           4.  Opposition   None received.
           

          POSITIONS
            
          Support
           
          Association of California Life & Health Insurance Companies  
          (co-sponsor)
          California Department of Insurance (co-sponsor)
          American Council of Life Insurers
          Pacific Life Insurance Company
          United Services Automobile Association (USAA)
           
          Oppose
               
          None received.

                                      -- END --