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