Economy


Gross Premium Valuation and the new standards for life insurance reserves




Suit The C-Suite
Ronald Allan E. De Leon and Catherine R. Laigo

Posted on May 04, 2015


In August 2013, President Benigno S. C. Aquino III signed into law Republic Act No. 10607, otherwise known as “The Amended Insurance Code,” which revised the 1978 Insurance Code and brought it up to date with the current business environment. The Amended Code introduced a number of significant changes, one of which is the change in the valuation of the life insurance companies’ policy liabilities, which under Section 216, should be prescribed by the Commissioner of the Insurance Commission (IC) in accordance with internationally accepted actuarial standards. On Oct. 30, 2014, the IC issued Circular Letter No. 2014-42-A, “Valuation for Life Insurance Policy Reserves,” pursuant to which life insurance companies and mutual benefit associations will be changing the basis of valuation of their life insurance reserves from Net Premium Valuation (NPV) to Gross Premium Valuation (GPV).

THE REQUIREMENTS
Life insurance policy reserves or benefit reserves are the estimated liabilities recorded by the insurer for the future cash outflows required to meet insurance and other promised benefits under the insurance contract. Previously, life insurance companies used the NPV in valuing its life insurance policy reserves. While NPV is not an incorrect approach in calculating reserves, a majority of countries are currently using, or shifting towards, the GPV approach because it is a market-consistent approach and represents the best estimate of the insurance company’s liabilities. By changing the requirement of the valuation approach, the Philippines is aligning itself with global standards.

Other than the valuation approach, inputs such as discount rates, decrements (e.g., mortality, morbidity, etc.) and other assumptions are revised. Under the old requirement, insurance companies were only required to consider discount rates and mortality rates in their inputs. In the new circular, other assumptions are considered, namely morbidity, lapse and/or persistency, expenses, non-guaranteed benefits, and margin for adverse deviation (MfAD).

One of the changes that will cause a substantial impact would be the new requirement for the discount rate. Currently, discount rates are capped at 6%. However under this new circular, current market rates will be used to discount future cash flows. Using discount rates prevailing at market could cause a significant increase in the liability given that we are facing a low interest rate regime. Further, the movement of the liability will be more unpredictable considering the volatile movement of interest rates.

Another significant change is the addition of the MfAD in the new circular. MfAD is an additional margin above the best estimate. As such, this would cause an overall increase in the computed reserves when applied to the above assumptions (i.e., decrements, expense and discount rate).

IMPLICATIONS
With this regulatory change, insurance companies will now have to deal with financial results that are more volatile and susceptible to changes in estimate and assumptions, as well as changes in the economic environment. While the clear and significant impact is on the general increase in the reserve liabilities for accounting and reporting purposes, insurance companies should also consider the implications to their capital management, asset and liability management (ALM), and product design and pricing. The volatility in reserve liabilities could affect risk-based capital (RBC) ratios and drive changes in capital planning, especially against the backdrop of increasing net worth requirements until 2022. ALM practices will have to be revisited as insurance companies seek to balance their investment management strategies and the objective of reducing volatility in their financial statements. Products will now be designed and priced to reflect the ‘risks’ they introduce, which could lead to certain products being altered or even withdrawn.

The new valuation approach also changes the tax basis for reserving liabilities, and companies should factor this into their implementation plans.

Insurance companies will have to strengthen their data management and capabilities, as historical experience is crucial in the valuation process and in the formation of future expectations. Companies will also have to invest in systems that would allow them to run the required calculations. This may not be an issue for some companies, but for those who will be affected, a decision has to be made on whether to acquire systems or pursue interim solutions based on an evaluation of business requirements, cost efficiency, and strategic direction.

Shifting to the new valuation standards would also require skilled personnel with expertise in actuarial, accounting, systems, and risk analysis, among other things. Training programs, knowledge sharing and capacity building would be fundamental to a successful implementation.

Beyond being simply a regulatory change, it is clear that shifting to this new valuation methodology will be a complex and involved process that will have a significant business impact. However, insurance companies should welcome this change as a challenge and an opportunity to revisit their current business operations.

Because of this new circular, insurance companies will need to assess the financial, operational and strategic impact to the company, which are not only concerns of the actuaries, but also of different units in a company. Implementing this change will bring about collaborative efforts from Finance, Risk, Actuarial, and IT units with Senior Management heavily monitoring the implementation challenges brought about by these changes.

Lastly, for companies to surpass this new challenge, there needs to be greater cooperation from all stakeholders, including the IC, insurance companies and industry associations.

Ronald Allan E. De Leon is a Senior Director and Catherine R. Laigo a Director at SGV & Co.