Question

1. Explain how a regulator uses legal reserve requirements to influence the premium rates an insurer charges?

Answer 1

In addition to capital requirements, insurers are subject to other regulations with respect to their financial structure and operations. A principal requirement is the reserves that insurers are mandated to set aside for future benefit payments and potential losses on investments. Historically, life insurers were required to maintain mandatory reserves for potential losses on stocks and bonds based on regulatory valuations and credit ratings; i.e., the mandatory securities valuation reserve (MSVR). No mandatory cushion for losses existed for other major investments, which became a problem when the economy soured. These requirements were significantly enhanced with the adoption of asset valuation reserve (AVR) and interest maintenance reserve (IMR) requirements, which became effective in 1993 for the 1992 reporting year. The AVR extended and refined reserve requirements for all major asset classes, including real estate and mortgage loans. The IMR requires insurers to amortize interest-related gains and losses over the remaining life of the disposed asset. Insurers are required to file special schedules detailing the calculations of these reserves.

Insurers also are required to maintain adequate reserves for their liabilities for future claims and benefit payments. The rules for life insurers’ reserves tend to be more prescriptive based on standard actuarial procedures and assumptions. Increasing insurer and regulatory attention to asset-liability matching has encouraged actuaries to employ more dynamic methods in setting reserves and managing various financial risks (Swiss Re, 2000). The NAIC’s adoption and revision of the “Triple X” actuarial guidelines for valuing life insurance policy reserves was a significant development.

With the exception of statutory formulas for workers’ compensation reserves, the requirements governing property-liability insurers are less prescriptive. The primary challenge for property-liability insurers is to determine reserves for claims that have been incurred but not yet paid. The factors affecting property-liability insurers’ obligations for future claims payments tend to vary and are more subjective (than for life insurers), particularly for long-tail lines where claims obligations can extend many years beyond the termination of policy. The increased danger of large catastrophes from natural disasters and acts of terrorism also has required insurers to use sophisticated modeling techniques to manage the risk of low-frequency, high-severity loss events, which may include setting aside additional capital. Regulators must evaluate the financial statements and actuarial opinions filed by property-liability insurers to assess whether insurers are establishing adequate reserves.3 If regulators believe an insurer is shorting its reserves, they may require the insurer to increase its reserves or take other action. Although specific laws or regulations governing property-casualty insurer reserves were not proposed, their regulatory oversight has been enhanced through the use of actuarial opinions and RBC penalties for reserve deficiencies.