As insurers embark on an annual exercise of demonstrating their asset adequacy, companies with interest-sensitive life and annuity liabilities will utilize the cash flow testing (CFT) methodology, defined as the “projection and comparison of the timing and amount of cash flows under one or more scenarios in order to evaluate cash flow risks.”1
As the interest rates have significantly increased over year-end 2021, insurers testing a variety of scenarios may find that certain scenarios, such as those reflecting the increasing yield curve, would result in the need for an additional reserve, in part because of punitive dynamic lapse formulas, whether those assumed by the insurer (because there has been no recent interest rate environment in which to calibrate legacy formulas) or required by regulation, which could in turn result in selling certain assets at a loss.
What follows is not an exhaustive list, and each company will have its own circumstances, but it is useful to review certain management actions that may be considered in asset adequacy,2 and highlight modeling considerations that might help reduce the need for additional reserves.
Management actions and modeling considerations
- Reinvestments and disinvestments: Assumptions in the CFT models for disinvestment and reinvestment are often simplistic and do not get revisited often, which may result in a disconnect with the actual company actions. As an example, disinvestment strategies often rely on selling bonds while specifying the priority as to which bonds are to be sold first and keeping more complex securities intact. Investment department goals, however, may be significantly different and not appropriately reflected in the CFT modeling. It would be useful to review actual practices to determine whether modeling modifications are needed that better reflect in modeling the current company practices.
- Alternative assets: Some actuaries, when performing asset adequacy analysis, deliberately gravitate toward easier-to-model assets, which tend to be bonds. Alternative assets, some of which may not be interest-sensitive, are among the harder-to-model assets, and many companies these days have alternative assets supporting their reserves. Sometimes selling such assets, even at a loss, may be more beneficial than selling bonds when the interest rates are high. It is important to keep in mind that the recently promulgated Actuarial Guideline LIII – Application of the Valuation Manual for Testing the Adequacy of Life Insurance Reserves, may limit a company’s ability to fully benefit from the inclusion of alternative assets.
- Countercyclical investments: Companies may engage in entering swaption positions. For example, when the interest rates are low, they can cheaply buy swaptions to receive money in high interest rate scenarios. Similarly, when the interest rates are high, they can buy floors to protect from the guarantees kicking in. Entering into such derivatives transactions could allow companies to reflect them in the CFT modeling and avoid massive losses.
- Duration swaps: Many companies have derivatives programs and could utilize swaps to improve their asset-liability management profiles and rely on cash flow to improve earnings and sometime liquidity (e.g., pay-fixed, receive-floating). Certain floating bonds can also be used for this purpose.
- Short-term borrowing and Federal Home Loan Banks: Reliance on company-practiced securities lending and borrowing, to the extent allowed in asset adequacy, should be reflected. Even if costly and limited, short-term liquidity may be included in asset adequacy to the extent it reflects actual company practice.
- Increase in sales and commissions: This is often done to ensure liquidity. While new business cannot be directly included in asset adequacy, internal replacements may potentially be allowed if there is a high probability of their occurring. If a tactic includes an increase in the commissions to the agent to move from product A to product B and keep money in the company, then it would in effect accomplish a similar thing.
- Crediting higher rates: This tactic can prevent mass lapsation, both in reality and as determined by certain regulations, because there will be little incentive for policyholders to look elsewhere. If this is something that the company management contemplates and practices, the company actuary should consider reflecting it in the CFT modeling.
- Use market value adjusted (MVA) features: In general, MVAs are put in place to prevent significant lapse behavior. In addition, if a product design allows for adding such a feature in flight for policies originally without the MVAs, it might provide another level of protection.
- Own risk and solvency assessment (ORSA) review: Most companies are subject to the ORSA requirements in one or more jurisdictions. Certain company actions in the run-on-the-bank scenario, or a similar but milder scenario, could be described in the ORSA, to the extent actionable, and should be reviewed if it helps with the CFT modeling. Sometimes asset adequacy and ORSA work are done in different departments, so this could be a time to harmonize company actions if that is the case.
In addition to ASOP 22 mentioned earlier, practitioners are advised to review various additional ASOPs to help determine applicability of each consideration; in particular, ASOP 7, Analysis of Life, Health, or Property/Casualty Insurer Cash Flows, ASOP 23, Data Quality; ASOP 41, Actuarial Communications; and ASOP 56, Modeling.
The rising interest rate environment we experience at the moment is something of a novelty to many actuaries. Concerns about spread compression in low rate environments for interest-sensitive life and annuity products are replaced by concerns about disintermediation risk and selling certain assets at depressed prices, potentially necessitating additional asset adequacy reserves.
The existing CFT techniques may not always be up to date—companies may be simplistic in asset modeling or assumptions could be disconnected from tactics employed by investment departments. Other considerations, called upon specifically to stave off additional lapses, may not be reflected.
To help actuaries think through the CFT implications, we offer a list of considerations, potentially challenging the existing CFT modeling approach by recognizing management actions, which may reduce the need for additional reserves.
If you are interested in the CFT considerations related to the 2022 Special Considerations Letter provided by New York State Department of Financial Services, you may find helpful an article written by Bill Sayre: "2022 NYDFS Special Considerations letter: Changes to reserve requirements".
For further information, feel free to contact me at [email protected] or (646) 473-3320.
1 Sec. 2.5 of Actuarial Standard of Practice (ASOP) 22, Statements of Actuarial Opinion Based on Asset Adequacy Analysis for Life Insurance, Annuity, or Health Insurance Reserves and Other Liabilities.