BILL ANALYSIS Ó SB 696 Page 1 SENATE THIRD READING SB 696 (Roth) As Amended August 28, 2015 2/3 vote SENATE VOTE: 38-1 ------------------------------------------------------------------ |Committee |Votes|Ayes |Noes | | | | | | | | | | | | | | | | |----------------+-----+----------------------+--------------------| |Insurance |13-0 |Daly, Beth Gaines, | | | | | | | | | | | | | | |Travis Allen, | | | | |Calderon, Cooley, | | | | |Cooper, Dababneh, | | | | |Frazier, Gatto, | | | | |Gonzalez, Grove, | | | | |Mayes, Rodriguez | | | | | | | |----------------+-----+----------------------+--------------------| |Judiciary |10-0 |Mark Stone, Weber, | | | | |Wagner, Alejo, Chau, | | | | |Chiu, Gallagher, | | | | |Cristina Garcia, | | | | |Maienschein, Thurmond | | | | | | | SB 696 Page 2 |----------------+-----+----------------------+--------------------| |Appropriations |17-0 |Gomez, Bigelow, | | | | |Bloom, Bonta, | | | | |Calderon, Chang, | | | | |Nazarian, Eggman, | | | | |Gallagher, Eduardo | | | | |Garcia, Holden, | | | | |Jones, Quirk, Rendon, | | | | |Wagner, Weber, Wood | | | | | | | | | | | | ------------------------------------------------------------------ SUMMARY: Permits life insurers to use a new methodology, known as principle based reserving (PBR), for determining the amount of reserves required for some types of life insurance policies. Specifically, this bill: 1)Provides that PBR takes effect on January 1 of the year following the first July 1 after PBR is adopted by at least 42 of the 55 jurisdictions within the National Association of Insurance Commissioners (NAIC) representing 75% of the premiums for life, health, and accident insurance policies collected in all 55 jurisdictions. 2)Requires the Insurance Commissioner (commissioner) to certify that the resources necessary to fully implement the oversight functions required by this bill are in place before PBR can take effect. 3)Provides that PBR only applies to policies issued on or after its effective date. 4)Provides that PBR only applies to nonforfeiture benefits on SB 696 Page 3 policies issued on or after its effective date. 5)Requires all life insurers to annually submit an actuarial analysis of the company's reserves based on the Valuation Manual (VM) adopted by the NAIC. 6)Provides that future changes to the VM shall become effective on January 1 of the year following its adoption by NAIC and the issuance of an order adopting the changes by the commissioner. 7)Permits the commissioner to conduct an independent actuarial analysis of a life insurance company's reserves if the company fails to submit one or if the commissioner finds the submitted analysis to be unacceptable. 8)Permits the commissioner to adopt regulations establishing a process to discipline actuaries and insurers for misconduct related to the insurer's actuarial opinion supporting the insurer's reserving under PBR. 9)Provides that documents and information provided to the commissioner as part of the actuarial analysis are confidential and not subject to disclosure under the California Public Records Act, subpoena, or discovery and are not admissible in any private civil action. 10)Permits the commissioner to share documents and information related to the actuarial analysis with other regulators, the American Academy of Actuaries, and the NAIC if the recipient agrees to maintain confidentiality. SB 696 Page 4 11)Provides that if the VM does not address a specific product or does so in a manner in conflict with California law, the insurer must comply with the minimum reserve requirements established by the Insurance Code or by a regulations and bulletins issued by the commissioner. 12)Permits the commissioner to conduct an actuarial examination, at the insurer's expense, of a life insurer's reserves, reserve assumptions, and reserve methodology. 13)Permits the commissioner to require a life insurer to change any reserve assumption or methodology that, in the commissioner's opinion, is necessary to comply with California law or the VM. The life insurer is required to subsequently adjust reserves as required by the commissioner. 14)Permits a life insurer using PBR to consider the particular experience of its insureds, if that experience is substantiated by credible statistical evidence, when determining the level of reserves it is required to maintain. 15)Requires a life insurer to develop governance and oversight processes for the actuarial function under PBR and provide an annual certification of those processes to the commissioner and the directors of the life insurer. 16)Requires a life insurer to share mortality, morbidity, policy holder behavior, or expense experience data with the commissioner as specified in the VM. 17)Defines the PBR related information that is confidential. SB 696 Page 5 18)Establishes the Office of Principle Based Reserving and permits the commissioner to select one subject matter expert, exempt from the civil service, to lead the implementation of PBR and permits the commissioner to set the salary for that position without approval of the Department of Human Resources. 19)Permits the commissioner to assess life insurers for the cost of implementing PBR. The amount assess for each life insurer varies based on the dollar value of life insurance premiums collect by each insurer. 20)Requires that actuaries engaged by the commissioner maintain confidentiality, be free of any conflicts of interest, and disclose potential conflicts of interest. 21)Permits the commissioner to develop regulations regarding the actuaries engaged by the commissioner and provides that the initial regulations may be adopted as emergency regulations. 22)Provides that the actuary providing an opinion under PBR is liable for their negligence or any injury they cause. 23)Makes numerous technical and clarifying changes to the Insurance Code. EXISTING LAW: 1)Requires life insurers to establish reserves for life insurance policies according to statutory formulas that incorporate uniform mortality and interest rate assumptions. SB 696 Page 6 2)Requries those reserves to be funded with high quality assets (generally highly rated government and corporate bonds). 3)Permits life insurers to include reinsurance purchased as part of its funding of reserves. 4)Provides for direct financial regulation of a life insurer by the insurance regulator in the insurer's home state. 5)Permits a life insurer to sell products in another state state if it obtains a certificate of authority from that state. FISCAL EFFECT: According to the Assembly Appropriations Committee, this bill has costs to the California Department of Insurance of $550,000 in Fiscal Year (FY) 2015-16, $1.9 million in FY 2016-17 and $1.4 million in FY 2017-18 and ongoing. First-year costs can be funded in the 2015-16 FY through a 2014-15 appropriation for was $491,000 and 4.0 positions. Projected revenues of $1.2 million annually, based on an assessment schedule included in the bill for a special assessment on insurers to support PBR-related regulatory activities (Insurance Fund). COMMENTS: 1)Purpose. According to the author, life insurance products have evolved far beyond traditional whole life products and involve varying degrees of complexity and risk. An insurance product that poses less risk to the insurer should require lower reserve levels, but the existing formulaic approach does not always take that into account. For some products, existing law requires life insurers to set aside higher SB 696 Page 7 reserves than necessary for some products and too little for others. Applying inappropriate reserving requirements may cause higher premium for some types of products and discourage or eliminate the development of new products. This bill would apply PBR, a dynamic reserving method for new life insurance policies based on a model law adopted by the NAIC. PBR replaces the current approach based on market-wide actuarial data with an individualized approach that more closely reflects the risks of modern life insurance products and the individual experience of the insurer. PBR is intended to more precisely determine the reserving requirements according to the individual characteristics of each product, incorporate data on policyholder behavior (such as policy lapse rates) from an insurer's own experience, and reflect random variables. For example, PBR would allow an insurer to use life expectancy data from its own experience rather than rely on standardized mortality tables. 2)Reserves. When a new life insurance policy is issued, an insurer is required to set aside money as a "reserve" to ensure that sufficient funds are available to pay claims against the policy, and that reserve amount is adjusted periodically throughout the time the policy remains in force. Reserve amounts are dictated by statutory formulas that apply the same mortality and interest rate assumptions to all life insurers. These assumptions are particularly powerful in life insurance because of the "long tail" nature of life insurance policies. Life insurance policies remain in effect for decades and the degree to which these assumptions vary from the actual experience and economic conditions during the life of the policy can have dramatic consequences for the financial condition of a life insurer. Reserves are an expense the life insurer incurs as part of the sale of a life insurance policy, and existing law requires that the reserves be composed of very safe, liquid assets (generally high quality bonds). Because the life insurer has to provide reserves upfront to sell a policy, reserve requirements impact both the profitability of an individual policy and the number/value of policies sold. SB 696 Page 8 3)PBR. PBR is a new methodology developed by the NAIC that allows life insurers to replace the uniform statutory assumptions with assumptions based on the characteristics of their own customers and their own economic forecast when calculating reserve requirements. PBR is embodied in a document known as the "valuation manual" and its current edition limits application of PBR to two types of life insurance policies (term life and universal life policies with secondary guarantees) that are issued after PBR becomes effective. Policies sold prior to PBR being implemented will be subject to existing reserve requirements as long as those policies are in force. NAIC commissioned a study of a prior version of the VM that found term life insurance reserves would decrease significantly across the board and that reserve requirements for universal life policies with secondary guarantees (ULSG) would vary from insurer to insurer. This variance was attributed to the disparity among insurers in how they have implemented existing rules for establishing reserves for this type of policy. PBR doesn't become effective until at least 42 states (representing at least 75% of premiums collected) adopt it. At last report, 33 states have adopted PBR, but because New York has rejected PBR it is virtually impossible for PBR to become effective unless California adopts it (New York has refused to adopt PBR in favor of a modification of the current statutory formula that results in reserves that are lower than current rules require but are above those that would be required under PBR). Effectively, the choice to make PBR the national standard is California's to make. 4)Excessive Reserves. The principal argument made in favor of PBR is that it "right-sizes" reserves, and by doing so, it SB 696 Page 9 will lower the cost of insurance. Those lower costs can manifest themselves in a number of ways. Lower reserve requirements allow insurers to write more policies with the same amount of capital. They also make new policies cheaper to write which can manifest as either lower prices or increased profit for the insurer, or both. Determining the "right" level of reserves is a vexing problem. Because life insurance policies are in force for decades, the "right" level of reserves is highly dependent on how the economy performs over that time period and whether the predicted life expectancy is borne out by actual experience. The existing statutory formula for reserves responds to the inherent uncertainty in these predictions by establishing conservative assumptions about interest rates and mortality and applies them across the board. This system provides relative certainty for the insurer regarding what the reserve requirements for any policy will be over the life of the policy, and imposes costs and benefits to individual insurers based on how their particular book of business matches the assumptions. PBR replaces those conservative, across the board assumptions with assumptions based on each insurer's particular mix of policyholders and economic forecast. As actual loss experience and economic performance deviates from the insurer's initial set of assumptions over the life of an individual policy, the insurer will have to adjust its reserves accordingly. Given the inherent difficulty of making accurate long term economic forecasts, reserve requirements will most certainly change over time. Insurers and their regulators believe the more individualized, iterative method of reserving embodied in PBR a better match for life insurance products with variable premium options (like ULSG). An NAIC study found that the impact of PBR on ULSG products was highly varied depending on how individual insurers have applied existing rules for establishing reserves. Some insurers would see reserve requirements fall, and some insurers would see reserve requirements rise. SB 696 Page 10 Insurers and regulators also support the application of PBR to term life insurance which is perhaps the most straightforward, plain-vanilla life insurance product available. The same NAIC study found that reserve requirements for term life policies would decline across the board (by large percentages) under PBR. This result is offered as evidence by both insurers and regulators that existing reserve requirements are excessive. 5)Captives. One approach used by insurers to respond to their belief that existing reserve requirements are excessive has been an increased use of questionable "captive" reinsurance arrangements. Insurers often chose to purchase reinsurance to spread some or all of the risk attached to its policies to another insurer. Insurers can use reinsurance agreements to satisfy reserve requirements. This is a well-accepted practice and it can protect both insurers and policyholders. Many entities offering reinsurance are licensed and regulated as insurance companies, and as licensed reinsurers they are required to provide high quality assets to secure the reinsurance that they sell. Some insurers choose to use another entity within the parent holding company (known as a "captive") as a reinsurer. Captives are used in various lines of insurance and are accepted, as a general matter, as legitimate reinsurance by insurance regulators. However life insurers greatly increased their use of captive reinsurance transactions in recent years. Many of these reinsurance transactions have been characterized as "shadow insurance" where the life insurer purchases reinsurance from captive reinsurer located in a jurisdiction with lower capital requirements (commonly in offshore havens). According to a study published by Federal Reserve Bank of Minneapolis, SB 696 Page 11 In contrast to traditional reinsurance with unaffiliated (i.e., third-party) reinsurers, these transactions do not transfer risk because the liabilities stay within the holding company?We find that liabilities ceded to shadow reinsurers grew rapidly from $11 billion in 2002 to $364 billion in 2012. This activity now exceeds total unaffiliated reinsurance in the life insurance industry, which was $270 billion in 2012. Life insurers using shadow insurance tend to be larger and capture 48 percent of the market share for both life insurance and annuities. These companies ceded 25 cents of every dollar insured to shadow reinsurers in 2012, up significantly from 2 cents in 2002. In addition to the question of whether such captive transactions provide any real risk transfer, some regulators have been concerned with the adequacy of assets backing up these reinsurance transactions. The New York Department of Financial Services (New York) reviewed "shadow insurance" transactions by New York life insurers and found that a number of captive reinsurers were allowed to use "hollow assets" such as a letters of credit or a promise that the holding company will pay any claims on the reinsurance (referred to as a "naked parental guarantee") as reserves. New York also found that these transactions had the perverse effect of boosting the "risk-based capital" scores (a regulatory measure of a life insurer's financial well-being). Many have attributed the increase in shadow insurance to a series of rules imposed by the NAIC for ULSG policy reserves beginning in 2000. These rules significantly increased the amount of reserves required for ULSG policies. There is a diversity of opinion among regulators and insurers regarding both the implementation of these rules and whether the rules require insurers to keep excessive reserves. The New York State Department of Financial Services has been among the most SB 696 Page 12 critical of these captive transactions characterizing them as "financial alchemy." However, the Iowa Insurance Commissioner has characterized these captive transactions a rational response to excessive reserving requirements. Wherever the merits of the argument lie between these two perspectives, the NAIC has adopted, as part of its work on PBR, an interim requirement for captive reinsurers to provide sufficient, high quality assets to secure their reinsurance commitments. The NAIC is in the process of developing changes to the model law governing the credit granted for reinsurance to make these requirements permanent. California, like the other states, will need to enact the new model law when it is adopted by the NAIC to maintain its accreditation status with the NAIC. Solving the problems presented by troublesome captive reinsurance transactions is one of the principal arguments offered in support of PBR. PBR will do this by reducing reserve requirements and eliminating the disparity between existing statutory accounting and GAAP accounting that generates a tax advantage for insurers using captives. Many regulators are convinced that the "shadow insurance" problem will be solved by the combination of new NAIC rules on captives and PBR. 6)Regulatory Capacity. Under existing law, the primary burden of overseeing the financial health of life insurers lies with the insurer's home state regulator. However, there has not been a major life insurer domiciled in California since Pacific Life shifted to Nebraska in 2005. PBR provides the commissioner with extensive responsibility and authority to oversee the financial health of life insurers domiciled in other states but licensed to sell insurance in California. Among these insurers are three life insurer's that have been designated as "too big to fail" by the United States Treasury Department. The Department of Insurance will have to add significant new resources to assume the regulatory responsibilities in this bill. SB 696 Page 13 In addition to new responsibilities over life insurers not domiciled in California, the PBR system establishes a completely new paradigm in that standard formulaic reserves calculations are being replaced with company-specific, dynamic actuarial modelling. The sophistication of the actuarial analysis this new system places on life insurers places a comparable burden on regulators - they will have to do things at a level of sophistication not previously required. In order to match the actuarial resources that the life insurers will be required to use to develop their company-by-company reserving models, the commissioner will have to retain actuarial talent of equal quality. This reality is recognized by all of the stakeholders, and this bill has two key provisions that address this issue: 1) there is an industry assessment intended to fund the DOI's capacity to attract adequate actuarial resources, and 2) there is a "trigger" that requires the commissioner to certify that adequate resources are in place before the key provisions of this bill become operative. These elements are a critical set of conditions necessary for the new PBR paradigm to go into effect. Analysis Prepared by: Paul Riches / INS. / (916) 319-2086 FN: 0001717 SB 696 Page 14