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Karen Rudolph: Hello, and welcome to Critical Point brought to you by Milliman. I’m Karen Rudolph, a principal and consulting actuary at Milliman, and I’ll be your host today. In this episode of Critical Point, we're going to be digging into the details of statutory valuation for life insurers. In particular, this episode will give listeners an inside-the-company look at the life insurance examination process, especially when it comes to regulatory reviews around the principle-based reserve valuation. Joining me today are Sarah Theis, qualified actuary for WoodmenLife, and Catherine Murphy, qualified actuary with John Hancock. Both of today’s panelists have been kind enough to spend this time with me so that we can share some firsthand experiences around the regulatory review of PBR valuations within their respective companies. But first a bit about each.

Sarah has 20 years of experience in the insurance industry, ranging from group long-term disability for the first five years, and individual life insurance for the past 15 years. Sarah’s expertise has always been in valuation where her responsibilities include cash flow testing, monthly reserve reporting, and principle-based valuations. She has served in the appointed actuary role for WoodmenLife for five years, and is Woodmen’s qualified actuary.

Catherine has worked in the insurance industry for over 25 years. She has held positions in finance, pricing, ALM, transformation, experience analysis, and valuation. She serves as the deputy appointed actuary, with key responsibilities for principle-based reserves and cash flow testing.

While our panelists have a vast depth of knowledge around life insurance valuation topics, some of our listeners might need a quick intro to principle-based reserves, or PBR. So what is this PBR method, you may ask? It’s a new method of determining U.S. statutory reserves that better quantifies product risks. For new issues, it replaces the old formulaic approach where not only the calculation method, but also the assumptions used, were described or prescribed under a one-size-fits-all approach. Those assumptions were locked in from issue. As a result, the assumptions at any given valuation date in the future do not necessarily align with the current realities of the insurance policy or the economic environment.

PBR replaces this with an approach that considers a range of future economic scenarios, and relies more on company-specific assumptions that can change over time as company experience emerges. Some of these assumptions are subject to regulatory guardrails to keep outlier experience in check. In understanding the complexities of this shift from formulaic to principle-based, the key is knowing that an actuarial projection model is required to generate future liability and asset cash flows, using the company’s specific experience such as mortality, persistency, premium payment behavior, and investment policies among other things. All of these inputs are fundamental to developing the reported reserve output. It turns a bright spotlight on a company’s experience study process, and its governance and modeling frameworks.

So this is a woefully brief but hopefully helpful description to let our listeners not so familiar with PBR concepts in on what we're going to be talking about today. I suppose the one takeaway before we begin our conversation is that PBR is a very calculation-intense, assumption-intense framework and, as a result, actuarial staff can be initially overwhelmed getting the process started. I expect we will hear a bit more about that from our two guests today.

So that’s a background on PBR, but it’s also important to know that it is the qualified actuary that the company looks to to perform all of these aspects of the PBR valuation. To level-set our listeners then, can each of you describe the lines of business you've been assigned to serve as qualified actuary? Catherine, let’s start with you.

Catherine Murphy: Thank you very much, Karen. I am accountable for life insurance, annuities, and long-term care. So I have a very broad spectrum.

Karen Rudolph: And is your staff equally distributed among those different lines of business?

Catherine Murphy: Mostly, yes.

Karen Rudolph: OK. Sarah, how about you?

Sarah Theis: For WoodmenLife, I am the qualified actuary for our life business, and I can just briefly go over what life products that includes. We have a whole life product, both a simplified issue and a fully underwritten, and we have just your traditional term insurance, and we also have two universal life with secondary guarantee products that we sell right now that I’m responsible for. One is our index universal life, and the other is more of a protection-type product with a secondary guarantee.

Karen Rudolph: So you have all three reserving components in your portfolio there?

Sarah Theis: Yes, we do. We calculate the net premium reserve, the deterministic reserve, and the stochastic reserve on different products.

Karen Rudolph: Catherine, is that true for you too?

Catherine Murphy: Yes, it is. At John Hancock we also calculate on the life side the three components whenever it’s applicable.

Karen Rudolph: Great. So we have here experts on all legs of the three-legged stool. That’s great. So in the Valuation Manual there was this transition period that went from 2017 through 2019 where a company was given the opportunity, it wasn't mandatory, to go ahead and adopt life PBR during those years for new issues. So whether your first year was during that transition period, or whether it was sort of the 2020 mandatory year, I expect that there were a lot of pain points if you think back on the first year that you went about calculating, getting your system set up, getting your models prepared, getting your experience studies in line, all your ducks in a row. Can you provide some color on the differences in the valuation routine, either going from all formulaic to sort of now we have this PBR thing to do? Or if you were an early adopter, maybe your first experience in reporting PBR versus where you are today, say 2021 year-end.

Sarah Theis: Yeah, I can go first on that. WoodmenLife, we adopted PBR in 2020. Really, the reason we held off, there were a couple reasons. I think a lot of the PBR was still getting ironed out, and the Valuation Manual was still changing quite a bit, so we held off. We were also just limited with our resources. But during 2020, yes, we did have a lot of pain points during that year. It was a stressful year. Probably one of our biggest challenges was just getting PBR calculated, checked, validated, within the timeframe that we wanted to report it out to management. That first year, we were still unfamiliar with what was going to cause the change in the reserve. Would this assumption change, how much change in reserve would that cause. With margins—just developing margins, we were still working on that to figure out how all that should be done. A lot of it was just figuring out PBR, and having enough validations and checks done that we felt comfortable reporting it.

Catherine Murphy: Good to hear, Sarah. So at John Hancock, I would say that on our front we started implementing PBR with our 2018 products. We gradually selected which product we could do so that we would not have to convert all of the products all at once. So it was just more spreading to make sure that we could handle the work from a resourcing standpoint. The other thing is John Hancock is a company affiliated with a Canadian company, Manulife Financial, and Canadian accounting rules already require us to do principle-based type of reserving. So we have been doing a lot of very similar calculations as what PBR requires. So we had our experience study, we have been discussing margins and so on, so we were a little bit ahead of the curve on a number of things just because of the experience we've had on our Canadian accounting regimen.

Karen Rudolph: Catherine, would you say that your models had a sort of a head start in being PBR-ready at that point?

Catherine Murphy: I would say yes, definitely on the deterministic side. The stochastic is still a little bit of a challenge, just to make sure that all the runs complete in time in a stable environment, and there's no model crashes, and of course analyzing stochastic reserve is a little bit more challenging. The Canadian rules don't require us to do stochastic on the life side, so that was a little new. So that’s where we've been focusing our energy as well.

Karen Rudolph: I suppose one of the pain points, and I think I’ve heard you both mention it in some fashion, is run time on the stochastic reserve side.

Catherine Murphy: Yes.

Karen Rudolph: It’s just not knowing what to expect that first go around, and I expect that practice makes perfect, and maybe you did some preliminary runs so that you would know how much time to leave before reporting deadlines.

All right. Now that we have sort of a platform with respect to the lines of business and the types of reserves that you're calculating, let’s turn our attention to the regulatory review. What we're really focused on here is there is an NAIC department of PBR review, and this effort is led by the California Department of Insurance. For our listeners who are not as familiar, the regulators I think knew at the outset that this paradigm that we're talking about of PBR would be difficult for all states to review with the same degree of rigor, right? So each state insurance department isn’t necessarily staffed on an actuarial side to the same level as states that have maybe more domiciliary companies.

So early on I think the system that was put in place was this specific department of PBR review. It’s led by the California department, as I mentioned, and they conduct on-site reviews or virtual reviews of a company’s PBR valuation. Now that encompasses both California domicile companies and companies that are not domiciled in California. They work with the domiciliary state’s regulator, however, is my understanding. Not that I’ve lived through one of these, but I have seen this thing called the questionnaire that they put out.

But before we get into the questionnaire, let’s talk about what did your company’s first California department of PBR review look like? In other words, what year were they fixated on reviewing, was that one of the transition years, or was it 2020? How long after you actually performed your reserve calcs did that review get scheduled, was it on-site or virtual, and how many examiners were on the team? Give us a sense of the complexion of that review. Sarah, do you want to start with that?

Sarah Theis: Sure. Yes. I would love to. Like I said earlier, 2020 was our first year with PBR, and so 2020 was the year that California did a detailed review on our life portion of our PBR. We also have variable annuities, but they were just focusing on our life products. So we submitted our report by April 1, as all companies are required to do, and then from there they sent us the list of questions. So once we received the questions in June, we responded back to them approximately three months from when we received their questions. And then from there they provided us a letter of their findings, suggestions, recommendations on changes that should be made to either our PBR processes, our reports, maybe they found minor mistakes. After we received their letter, we had a 30-minute virtual meeting with two actuaries from California to go over that letter. After having that meeting, they sent that letter with their suggestions to our CEO, and he was required to respond to each of their suggestions within I believe it was the next two months. So that really provided us the opportunity to speak with the CEO, explain what PBR was, and how we were going to tackle each of their issues.

Karen Rudolph: Pretty thorough.

Sarah Theis: Yeah.

Karen Rudolph: Catherine, does that parallel your experiences?

Catherine Murphy: Definitely very similar to our experience. Our first review was in 2018, at which point they gave us their list of questions in July, and we had some time to review the questions, another list of questions that came up later, and then finally their recommendation letter that went to the CEO. So very similar, overall the process is anywhere from five to 11 months depending on which year they do the review.

Once, though, in 2020, we had a little bit more of an in-depth analysis, which means that the intention was California regulators were planning on coming to visit us on-site for three days and go through every component of the report, whether it was product, assumption, margins, governance, controls—basically every piece that we have from a PBR standpoint. So the intent was for them to visit us in our office in Boston and, along with regulators from our domicile state, go through a full exam. But of course the pandemic had different plans, so we ended up doing the three-day review virtually. So every day we’d meet for four or five hours, because of the time differences, so they recognized we could not last until 8:00 PM. on our end, and they didn't want to start at 6:00 AM on their end either. So we had four or five hours of discussions, and in those discussions really we brought in some experts so we could go into a lot more detail. So we had our experience analysis team join in, and they answered all kinds of questions, we had our modelers doing a walkthrough of the models, and so on. So a lot more detailed analysis that happened that one year. I think they do that every five years.

Karen Rudolph: OK. So you’re saying that because you adopted early you did have someone from the California department look over your shoulder, so to speak, on those calculations that you reported for 2018, and that there was a more in-depth for 2020, correct?

Catherine Murphy: Correct.

Karen Rudolph: And was there anything for the 2019 valuation?

Catherine Murphy: Very similar to 2018. So a letter with questions, some time for us to respond, a second letter, more time for us to respond, and finally the conclusion of a 30-minute meeting with the regulators walking through their management letter that went to the CEO.

Karen Rudolph: So we'll get to the CEO in a little bit, but it sounds to me like the regulatory review actuaries are also sort of learning from their own experiences, given that there's a little more rigor put into the 2020 version of the calculations.

Catherine Murphy: That’s correct.

Karen Rudolph: As they're saying it. Yeah.

Catherine Murphy: And as it turns out, because I had just joined the team, it was a fantastic learning experience on my part.

Karen Rudolph: Sink or swim sort of thing.

Catherine Murphy: Absolutely, but it worked out.

Karen Rudolph: So besides the questionnaire, what aspects of the regulatory review strike you as being deep dives into the valuation exercise? So from my point of view, I always wonder if I was an examining regulator and I was going into a company, obviously I’m looking through a lot of data, a lot of spreadsheets, a lot of output. But what aspects can you remember of your review where the regulator was really wanting to see some deep numerical analysis on the reserve calculations? Was that even an aspect of the review?

Catherine Murphy: I believe on our part it was in the detailed review of the 2020 analysis, if I remember correctly, where we had to demonstrate our NPR calculation. They're definitely a lot more familiar with NPRs in the formulaic reserve, so we could walk them through our calculation directly and show them in the model how things were modeled as well.

Karen Rudolph: And Catherine, was that for a term product do you remember, or ULSG or both?

Catherine Murphy: I’m not 100% sure. I think it was a term product.

Karen Rudolph: Sarah, does that—

Sarah Theis: That was very similar. They had asked us to provide audits from our valuation software of the net premium reserve, and that was both on our term certificates and our ULSG product.

Karen Rudolph: So my understanding is also that the National Association of Insurance Commissioners (NAIC) has their own system that they either run sort of a sample product through to calibrate a company’s calculations on given policies. Do you recall any requests for using your own system to determine an NPR, say on a prototype cell?

Catherine Murphy: I don't recall that at all.

Karen Rudolph: Nothing like that?

Catherine Murphy: No.

Sarah Theis: I don't either.

Karen Rudolph: I know that the VM-31 requirements indicate that the actuary has to report a lot of detail around the deterministic reserve. In other words, show us all the cash flows that go into the deterministic reserve, show us the discount rate, show us the calculation where you bring everything back to the valuation date. I assume that that’s something the regulators looked at closely as well?

Catherine Murphy: Yes.

Sarah Theis: Yep. Us too.

Karen Rudolph: All right. Let’s talk about any surprises in the regulatory review, and that data request list. So the questionnaire that we've been talking about that was the result of the California department’s initial sort of go-over of all of your data and your reporting, they issue this questionnaire to the qualified actuary. I’ve seen some of those for clients that we've helped sort of struggle through the responses and such, and I’m wondering can you describe how lengthy yours was when you first saw it, and were there any surprises? In particular what I recall is that the questionnaire often branched out into sort of unexpected areas of governance or modeling systems and platforms, and just questions around things that you might not have expected to have to answer. Catherine, do you recall anything like that?

Catherine Murphy: I don't recall exactly. Well, in 2018 I was not part of the team, so I don't have any such recollection, but looking at the history of the detail of the questions has been quite surprising to me because the first year they asked us over 90 questions on life products, and that’s very lengthy. Some of the questions are fairly simple, “did you mean this?” or “did you mean that?” and other questions could be “would be more effective if your report included this type of description?” But other questions sometimes were really justification on why you think your assumption makes sense, and we would go back and justify, we felt comfortable with our overall PBR report and PBR reserve. I don't think at any point in time that our PBR reserve was in question, the level of the reserve. It was mostly how do we improve the overall documentation, and I think that the California regulators have really the best interests of the industry setting the standard in how much documentation would be beneficial.

Karen Rudolph: Sarah?

Sarah Theis: For 2020, we received just around 75 questions, and like Catherine said, yes, some of them are easy to answer, “did you mean this,” like she said. But I think almost half of our questions involved our governance and controls. We knew we weren't quite there yet, so I think some of their intention with the governance and controls questions was to show us how we do need to improve, what can we do, which was a lot of their recommendations in the letter as well.

Karen Rudolph: I’m wondering now how your chief executive officer-level managers received the questionnaire and/or the letter that they got from the regulator. So just to square away the reason for the question, C-suite managers don't typically get letters from regulators, and so here’s a first-time occurrence, and they're probably not as familiar with what’s going on in the actuarial valuation world as you as the qualified actuary are. So maybe you can recount what you did to educate your senior leaders about this regulatory review, and some of the feedback that you got. Catherine?

Catherine Murphy: So thank you, Karen. When the CEO received the letter, we wanted to make sure that we put some context into all of this. So we're lucky that we have a good relationship with our CEO, and we could pick up the phone and give them a little bit of background. So we explained to them that this was just normal process for principle-based reserving, principle-based reserving being a new type of reserving methodology. So we were able to explain to them what was happening, why we were going through this exam with California, and what the outcome was. The big thing was we wanted to make sure that we assured them that the recommendations that California made, whether it made sense to us or not, whether we agreed or not. Then we also assured them that our reserves level was right, and we had some areas to improve mostly on the documentations front, and maybe tidying up a little bit on the governance.

Karen Rudolph: Thanks, Catherine. Sarah?

Sarah Theis: Yeah. This letter was something new that the CEO had received, I don't know if they had ever received a letter like this before, but we were lucky because our CFO is an actuary, and he actually sat in on the 30-minute meeting with the two actuaries from California, so that was nice. I know he briefly provided an update to our CEO, so when I met with him and explained it to him, walked through the suggestions, how we were going to tackle each of them, it was easier, he was already familiar with it. I let him know too that, yeah, this is an annual letter we will be receiving, it’s not unique to our company but PBR is important, it stresses the importance in a company of how important PBR really is.

Karen Rudolph: Yes, and I can agree that from what I’ve seen on the reviews it is a lot more focused on documentation of the rationale of the qualified actuary’s decisions with respect to assumptions and margins and such, and not necessarily, of course they always have an eye on solvency, of course that’s their job, but it’s not framed as a challenge to the qualified actuary or to the company but rather let’s work together and figure out what your thought process is in principle-based reserve valuation.

So another challenge I think that you might agree with is just keeping up with the developments around principle-based reserves because this is, as the regulators say, a living document, the Valuation Manual, and they're working right now, as I said earlier, on non-variable annuity requirements, and this will go on for some time. So one of the other key developments is the testing of a new economic scenario generator. So let’s just talk briefly about how you keep up with what’s going on sort of in the queue, and let’s use the economic scenario generator as an example. There have been some life actuarial task force calls around the generator, most recently one to sort of announce the kickoff of a field test. I don't know if your companies are participating but there were some acknowledgments that reserves, if you’re calculating a stochastic or deterministic reserve, chances are good that it will increase because of the emphasis on the new generator towards a low-for-long type characteristic. So, Sarah, how do you keep up with developments?

Sarah Theis: The primary way I keep up is just through emails. I read about each of the APFs that are being reviewed or have been accepted. I also participate in the calls that discuss the different APFs. Just looking over the redlined version of the Valuation Manual, I know that’s an annual change, but that’s another way that I like to keep up. As far as participating in the field test, WoodmenLife is a smaller to midsize company, so we don't have the resources to participate in a lot of those, but I do go look at the results to see how this will impact WoodmenLife and our PBR reserves.

Catherine Murphy: On our front, yes, we do try to keep up as much we can, there's so many changes, some very, very large changes that are brewing at the moment. Within John Hancock we do have some resources who are dedicated to making sure that there is awareness of all the changes that are coming up, and in addition to that, several of us have been tasked to follow a specific issue and then report back. I also personally listen to the majority of the life actuarial task force calls on Thursday afternoon, there are a number of calls as well with the ACLI to hear what other industry leaders are thinking about the various issues, of course reading the redlines, all the amendment proposal form. When I joined this team, I did not appreciate how much of the work would be on staying ahead of all the changes, staying on top of all the changes that are coming up on the regulatory front, I had not appreciated that, but it’s fun.

Karen Rudolph: Yeah, it makes you the subject matter expert within your company on PBR.

Catherine Murphy: Yes.

Karen Rudolph: Yeah, because you know what’s brewing, as you say.

Catherine Murphy: Exactly.

Karen Rudolph: And there are some big changes brewing. So, one other topic I wanted to touch on today is now, you know, you have broad responsibilities, PBR is one of them, but cash flow testing I believe is also in your wheelhouse as far as responsibilities in your company. During the examination process for PBR, my sense was that the examiners—it was not unusual for them to sort of call for the cash flow testing documentation, the AOM. Were they interested in seeing consistencies between cash flow testing and PBR, and maybe where inconsistencies developed, finding out why those were inconsistent, with respect to assumptions or methods?

Catherine Murphy: On our side we just talked about the PBR report with California, so the cash flow testing report would be on the purview of our domicile regulators, and that’s where we could get some questions if applicable, but there's very little overlap. Sometimes we will share that some assumptions are the same as cash flow testing, or sometimes they're different because PBR requires something different, but they were not explicitly reviewing both at the same time.

Sarah Theis: Yep. That was similar to us. They weren't reviewing the cash flow testing in their questions, they had asked a couple questions as to how PBR does compare to cash flow testing. One example was, do we develop assumptions for cash flow testing and PBR using the same methods, are the base assumptions consistent? But they didn't ask for any details or our AOM or anything, so it was primarily geared towards the PBR only.

Karen Rudolph: OK. And this topic that I’m going to bring up kind of points back to the keeping up with PBR developments idea. The Academy of Actuaries periodically hosts continuing education seminars around PBR. I think we call it the PBR Bootcamp, maybe you have attended one of those in the past. The most recent PBR Bootcamp webinar was virtual, and the panelists were primarily from the California office of PBR review, and during that webinar the concept of independent reviews was emphasized, and I kind of picked up on that, but did either of your companies obtain any type of independent review? Now, whether that was a review of the documentation, a review of assumptions, or review of the model itself, can you speak to whether that was performed by a third party or maybe internal to your company where you would have a similarly qualified actuary not directly involved in the valuation who was doing that review? Catherine, do you have any comments on that?

Catherine Murphy: Sure. I would say that the first time that we wrote our PBR report we had an external party reviewing it to make sure that we were following all the expectations and what VM-31 was requiring. So that was the starting point. Subsequent to that, most of our reports are being done by several individual contributors, and then we have two or three other actuaries who review to make sure that the whole story hangs together, that we are consistent in messaging, and that we are disclosing the right information. With respect to other reviewers, if we do change any of our assumptions, we generally reach out to other actuaries outside of the organization to do some form of a peer review, but it’s not necessarily just PBR-related, it’s overall.

Sarah Theis: I had also attended that PBR Bootcamp and, yeah, that’s what I got out of it too is they were really stressing the focus on reviewers, a peer review. Because PBR is still immaterial for WoodmenLife, we haven't had an external review of our models or PBR report or anything yet, as California recommended. We will probably have that done as PBR becomes more material for Woodmen. For our models, we had a pricing actuary at WoodmenLife conduct a peer review on our models to make sure everything that should line up with the pricing models did line up on the pricing models. So that’s where we are today.

Karen Rudolph: Good. And, yeah, the benefits of an independent review I think are beneficial for the company, for the comfort of the regulator. You know, I’ve often wondered if the independent review is performed, and the regulator asks for it, what are they looking for, but I think that answer is TBD. So as Sarah says, as the valuation gets more material over time then independent reviews will probably become more prevalent. Do you have any closing thoughts around your company’s to-do list for improving your PBR valuation as a result of these California reviews?

Sarah Theis: I can answer that first. As California pointed out, I noted before our governance and controls, that was the big item we need to focus on. We knew, working on PBR throughout 2020 and 2021, that wasn't our primary focus, we knew we weren't there, but just California pushing us, made us set up a plan for this. It really will help in the long run, it’ll add confidence to our models and just make everyone understand them a little better. So that’s going to be our major to-do list for the next year, or three years down the road too.

Catherine Murphy: Yes. On our side I think some of the recommendations that California made we've implemented already, and they have not been necessarily very much time-consuming. But we're the closest to the models, to the documentation. So we're probably the most critical of the work that we do. We always have opportunities to make things better. Probably the biggest challenge that we have over the next year or so is making sure that the stochastic results get run without crashes and give us results that we can truly understand.

Karen Rudolph: We've come to the end of our time, and I want to thank Sarah and Catherine for joining us today.

Catherine Murphy: Thank you very much, Karen, and thank you very much Sarah as well.

Sarah Theis: Yeah, thank you Karen, and thank you Catherine. I enjoyed this podcast.

Karen Rudolph: Your insights will be helpful to our listeners in better understanding the experiences of companies with respect to the PBR regulatory review process. You've been listening to Critical Point presented by Milliman. If you enjoyed this episode, rate us five stars on Apple Podcasts or share this episode with your colleagues. Until next time.