#20 | AG38 Q&A

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Marketing groups, carriers and even regulators are mail-bombing producers with pieces related to AG 38 and its implications. Some, like Crump’s, are definitely worth reading. Others, like the NAIC’s “Producer’s Guide to AG38,” are trashcan fillers. The NAIC’s piece spends 264 of its 1,154 words talking about things other than AG38, only 70 of those 264 words actually talk about AG38 in particular and 2 of those 70 words are “triple whammy,” which speaks volumes about what the NAIC thinks about producers. The problem with almost every piece that I’ve seen so far is that only half of the issue is addressed. Companies are quick to say how the changes to AG 38 will force them to hold higher reserves. They’re not so quick to say what they were doing before that invited the scrutiny and what the impact of their previous actions might be on producers and their clients. In the spirit of addressing the other half of the story, I put together my own little blurb on AG 38.

Is AG 38 a new regulation?
No. AG 38 was put in place in 2003.

What are the mechanics of AG 38?
AG 38 is a nine step formula that essentially measures the degree to which the policy guarantee has been overfunded and applies an additional reserve requirement to the economic reserve based on the level of overfunding. In shadow account designs, the shadow account value is equal to the level of overfunding. The shadow account value is then divided by the single premium necessary to fund the guarantee assuming that the shadow account value starts the year at zero. This ratio is then multiplied by the statutory net single premium. At its core, AG 38 merely applies additional reserves for policies with guarantees that funded to remain in-force.

Has AG 38 been changed before?
Yes. Section 8A specifies the original formula. Section 8B was added in 2006 to squelch abuses in calculating the single premium necessary to fund the guarantee. Carriers were apparently creating pricing mechanisms that would force the single premium to be artificially high and force, by extension, a lower ratio and a consequently lower reserve. Section 8C was added later to allow and specify the use of lapse rates in statutory reserving. Sections 8D and 8E are the revisions taking place in 2013.

What were carriers doing that caused regulators to revise AG 38 again?
To make a very long story short, carriers were applying a very liberal reading to the language in AG 38 regarding the “minimum gross premium” required to calculate the degree of overfunding in the shadow account. Some carriers built a separate shadow account charge structure that could only be triggered if the shadow account value hits zero, which is the qualifier for calculating minimum gross premium in AG 38. The primary shadow account charges determined the actual premium paid, but the alternative charges determined the degree to which the premiums overfunded the policy based on the new set of minimum gross premiums. The implications are huge – a policy with $1 in the shadow account at the end of every year has a vastly different cost structure than a policy with $0. The reasoning was almost exclusively based on a reading of the regulation that followed its letter but obviously not its spirit. The effect of using an alternative shadow account structure was a much, much lower reserve than would otherwise be required.

What are the arguments on both sides? 
The regulators have argued that insurance carriers have essentially exploited a loophole by creating dramatically higher policy charge structures that policyholders will not actually experience. Carriers have argued that they have every intent of charging higher costs if a policyholder actually triggers the increased cost curve. In essence, both are correct. The regulators correctly argue that policyholders pay premiums in excess of the absolute minimum premium and that, therefore, the minimum premium set forth by the alternative charge structure is a fabrication designed solely to reduce reserves. The carriers correctly argue that they would really charge based on the alternative charge structure if a client does fund a policy so that the end of the year shadow account value is zero. But, to be sure, no one is debating the fact that carriers actively sought to shirk higher reserves associated with AG 38 by employing alternative charge structures.

Can policyholders inadvertently trigger the alternative cost curve?
Yes. Without making immediate adjustments, policyholders who do not fund the contracts to the precise specifications in the illustration will jump to the alternative curve at some point. Some products have more of a margin of error than others. In the worst case, a single missed premium could trigger the alternative curves. In the best case, a missed premium might delay the trigger until beyond Age 90 or 100. But in the latter situation, a lapse pending policy with a shadow account value of zero could require a premium in excess of half of the face amount. It’s important to note that most contracts specify that the alternative curve is only charged for one year and then jumps back to the primary curve. It’s also important to note that some contracts specify different triggers (like John Hancock) and others have more complex mechanism for calculating alternative cost curves (Pacific Life). The almost universal result of triggering the alternative cost curve is a very, very large premium requirement relative to the originally estimated cost.

Did every carrier use this methodology?
Yes, for the most part. The exceptions are few. Aviva, Nationwide and Lincoln Benefit Life (SUL only) are the only ones I’ve seen. Also, policies written before 2006 tend to not use the alternative cost curve.

What are the new updates in Sections 8D and 8E?
Section 8D only deals with reserving for in-force policies. Section 8E clarifies the parts of the original calculation that were being abused and specifies three safe harbor methodologies for calculating minimum gross premiums. The net result is that carriers can’t use multiple charge structures to receive a reserve benefit. Section 8E also specifies that the crediting rate on the shadow account can’t exceed a certain cap based on market rates. For policies that don’t conform to the safe harbor methodologies, Section 8E outlines adjustments to the calculation that restricts the ability for carriers to use premium payment assumptions to change reserves and specifies a minimum reserve floor. In the final tally, Section 8E forces carriers to reserve for NLG policies based on the letter and spirit of AG 38. That means higher reserves across the board, but only because the loophole is now closed.

Do higher reserves associated with the adoption of Section 8E mean higher Guaranteed UL prices?
Yes, holding all else constant. But all else isn’t held constant. Most carriers are actively pushing those reserves off to third parties – traditional reinsurers, authorized affiliated reinsurers, unauthorized affiliated reinsurers (captives) and foreign reinsurers. These entities can follow separate reserving regimes that are less stringent than AG 38. However, the use of non-traditional reinsurers to achieve reserving arbitrage is coming under intense scrutiny as their prevalence and scale increase. Some life insurers are sending more than half of their reinsured business to captives specifically designed for reserving relief (according to Schedule S in the statutory filings). If these arrangements are treated as if on the carrier’s own balance sheet, GUL prices would almost certainly go up and the product type may even cease to exist. Carriers without the ability or willingness to engage in captive reinsurance transactions will likely be the first to raise prices or exit the market.

What about Principles Based Reserving (PBR)?
Life insurance carriers contest that formulaic reserves like AG 38 create unnecessary burdens that are far in excess of what is economically justifiable. PBR theoretically creates a means for carriers to reserve for products based on intrinsic economic risk. But how exactly PBR should be structured is less clear and some of its second order effects, like sensitivity to the macroeconomic environment and arbitrary assumptions, could cause problems down the road. The NAIC took a big step towards PBR in approving the use of Valuation Manual 20 for determining the reserves for in-force policies (subject to minimum reserve requirements). Carriers are generally expecting PBR to be in effect for new business by 2015. Whether or not that actually happens is another story. PBR has been on the docket for years. But some companies are basically building inherently short term reserve solutions through financing arrangements on the assumption that PBR will be in effect down the road. If that doesn’t happen, those companies might be left holding the bag.

What should I tell my clients about AG 38?
Talking to clients about AG 38 is tricky. On the one hand, Section 8E could dramatically impact the pricing and availability of GUL products. On the other hand, the effects of Section 8E are contingent on the availability of financing arrangements to manage the full AG 38 reserving requirements. Telling clients that Section 8E creates a firesale situation before the end of the year is probably an exaggeration. The current crop of products also employs the alternative charge structures that heap administration risk onto the client and the producer. Discussing AG 38 also introduces the idea that the carriers were previously reserving inadequately and that they are consequently undercapitalized. This isn’t necessarily true, depending on the definition of undercapitalization, but it’s certainly not a pleasant issue to discuss with a policyholder. My opinion is that discussing AG 38 as a means to promote action creates a host of new complications that might lead to inaction. What is worth discussing about AG 38, however, is the impact of the contingent cost curve on in-force policies. Every policyholder should know that missing premiums, paying late and even paying early can have dramatic effects on policy performance.

As a final note, I believe AG 38 highlights the incredible complexity of GUL products that most of us didn’t appreciate until recently. What I’ve concluded after diving into shadow account structures is that GUL products aren’t riskless. They only masquerade as simple, transparent and predictable financial instruments. In reality, they are anything but and we ought to treat them accordingly.

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