1. Aggregate margins in the context of level premium term life insurance Results of a study sponsored by the Kansas Insurance Department Slides prepared by Steve Strommen FSA, CERA, MAAA Blufftop LLC March 2015 1

2. Margins are for protection The amount needed to fund future benefits is uncertain Policyholders need security that all benefits will be paid Therefore, insurers must hold assets greater than than the average expected cost. – Part of the excess is a reserve margin – Part of the excess is required capital and surplus Margins help establish a balance between financial efficiency for insurers and security for policyholders Reserve margins can provide the basis for transferring a profitable block of business from a seller to a buyer - the transfer value includes margins 2

3. Motivation for an aggregate margin Sum of individual margins may not strike proper balance between security and competitiveness – Each individual margin tends to be conservative – “Stacking” of conservative individual margins may be excessive – Correlation among individual risks may not be adjusted for – Implicit margins make the measurement of conservatism in margins more difficult and the adjustment for correlation among risks almost impossible Advantages of an aggregate margin – Separation of the total aggregate margin means starting from a true central estimate without implicit margins – Non-correlation of risks is easily reflected – Degree of conservatism can be measured and established consistently among different product types based on risk 3

4. Layers of margin in term reserves 4

5. Starting from the central estimate (bottom line on previous chart) – RSM adds an explicit aggregate margin based on one of two methods: cost of capital or percentile method – VM-20 adds additional implicit margins: Future mortality improvement cannot be reflected Required blending to standard tables – Net premium reserve adds additional margins: No reflection of expense provision in future gross premiums Initial expense allowance smaller than actual expenses No reflection of lapses Mandated use of standard mortality tables 5

6. Two concepts for the aggregate margin Cost of capital (a.k.a. transfer value) – Margin is the present value of the year by year cost of capital – Cost of capital rate is based on the extra annual return on capital for putting it at risk of loss. This is the market price for the service of bearing risk. When margin = cost of capital, the expected future release of margin is sufficient reward for market participants to commit required capital. The total reserve equals the transfer value. This provides policyholder protection without reliance on Guarantee funds. Confidence level (percentile) – Margin makes the reserve likely to be sufficient in X% of scenarios – Consistent with basing the margin on a particular level of CTE 6

7. Over the life of a long-term contract, the cost of capital margin: – Starts higher than the percentile method – Amortizes more regularly as the business ages – Ends lower than the percentile method For the modeled term insurance business: 7

8. Different margins, similar reserves 8

9. Calculating an aggregate margin Could be done using full stochastic modeling of all assumptions Alternately, could be built up from margins on individual assumptions – Assumption margins could be specified, or their effect in dollars could be quantified with sensitivity tests – If margin for each assumption is quantified in dollars (like C-1, C-2, C-3 risks), then non-correlation can be reflected much like in the Life RBC square root formula. 9

10. Calculating an aggregate margin Cost of capital method – Amount for each risk driver based on representative scenario at 99.9% level – Aggregate these amounts* to get initial capital requirement – Project cap. req. in proportion to PV remaining cash flows – Margin is present value of X% of each year’s capital Percentile method – Amount for each risk driver based on representative scenario at chosen percentile level (e.g. 84%) – Aggregate these amounts* to get the margin 10 * Use a square root formula like that used to aggregate risks for RBC

11. RSM risk drivers are much like margins on individual assumptions 11

12. Advantages of RSM risk driver approach to calculating margins The key risk drivers are identified, together with the central estimate assumptions and the distribution around the central estimate in a theoretically sound manner Adapts to the risk profile of the block of business being values as measured through the process of scenario generation and modeling Non-correlation of risks easily reflected using a square-root formula as in RBC All of the margin is explicit, not implicit The aggregate margins using either the cost of capital method or the percentile method can be used in the calculation of the statutory reserve 12

13. Advantages of the cost of capital approach cited by the Aggregate Margin Task Force Clarifies the respective roles of reserves and capital. Because the need for capital is reflected, the rationale is directed at complete protection of the policyholder, not just X% likelihood, providing the economic basis for transfer to a buyer in the event the seller has financial difficulty Consistent with market pricing methods. Other frameworks use it (Solvency II, IFRS) so it fosters worldwide consistency. Accepted capital measures already exist and could be used as a basis for the cost of capital. 13

14. Lessons learned studying term Current statutory reserves for term life insurance have large implicit or hidden margins – This is true for both net premium reserves and VM-20 modeled reserves Mortality improvement is the largest implicit margin in current statutory reserves and the largest reserve redundancy above an adequate reserve The cost of capital approach and the confidence interval (percentile) approach differ in the pattern of margins over time, with the cost of capital margin starting higher and ending lower. For a seasoned block of business with different issue years, the two methods may produce comparable margins. RSM approximates full stochastic modeling reasonably well on this product type. 14