Reserving regulations

David Merkel blasts away at principles-based reserving:

You don’t want to hand over reserving rules to one hired by the company, no matter how ethical he might be.  That way lies disaster.  There are always subtle pressures put on actuaries to be less conservative, because companies face pressure to show good earnings in the short-run.

Think of the mostly European quants, accountants and actuaries using the Basel standards.  Giving them the authority to set their own reserves for credit using internal models led to setting the reserves too low.  You want to have checks and balances.  You don’t want to have players serving as their own umpires.  So what if the statutory standards are too tight?  That just means earnings will be delayed, not eliminated.  Risk margins should be received as earned, and never capitalized.  Besides, the current crisis shows us that we never truly understand the parameters of the distribution.

He’s reacting to this (sub. reg.) Wall Street Journal piece:

State regulators Sunday approved new rules for how U.S. life insurers set reserves for future claims, a decision that may ultimately free up billions of dollars for acquisitions, stock buybacks, dividend increases and other uses designed to boost the industry’s flagging returns.

I’ll put my potential conflict of interest up front – I do work occasionally with state insurance departments.

This idea has been kicking around the NAIC for a few years. Insurance commissioners are working trying to move away from prescriptive regulation – setting down a bunch of rules and making sure companies follow them. They are trying to move toward principles-based regulation – setting a goal for companies to strive toward.

The distinction has eluded me at time, in part because the words prescriptive and principles sound alike. But also, I’m a casualty actuary, and we have always had a principles-based approach to reserve-setting. P/C companies create their own models, then share them with regulators.

Now, property casualty contracts are probably easier to model than life contracts. Most p/c contracts expire without an obligation (no claim to pay). I’ve never worked on the life side, but I gather virtually all life contracts involve a payment at the end, and estimating the percentage that lapse is itself an important calculation that rises or falls with the economy. Add to that the interest rate and mortality assumptions embedded in the contract, and I can see David’s concern.

He may be a bit too concerned, though. The impairment rate on p/c companies is about 1%, and most insolvencies are so tiny they barely make the trade press. And regulators aren’t the only ones who will review reserving models. So will external auditors and ratings agencies. And they review them more frequently than regulators do and, often, with greater rigor.

 

About 1% of P/C companies become impaired in a year.

 

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