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2005 Milliman All Rights Reserved

L I F E

Research
Report
AICPA SOP 03-1
Accounting and Reporting by Insurance Enterprises for
Certain Nontraditional Long-Duration Contracts and for
Separate Accounts

A Survey of Practices and Procedures


by Novian E. Junus, FSA, MAAA
Craig W. Reynolds, FSA, MAAA

Because the articles and commentary prepared by the professionals of our firm are often general in nature,
we recommend that our readers seek the advice of an actuary or attorney before taking action.
AICPA SOP 03-1
Accounting and Reporting by Insurance Enterprises for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts

A Survey of Practices and Procedures

PAGE

EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

SUMMARY OF KEY PROVISIONS OF THE SOP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Separate Account Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Valuation of GAAP Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Classification of a Contract as a FAS 97 Universal-Life (UL)-Type Contract . . . . . . . . . . . . . . . . . . . 4

Additional Reserve Requirement for UL-Type Contracts that Contain Death


or Other Insurance Benefit Features. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Additional Reserves for Contracts that Provide Annuitization Benefits . . . . . . . . . . . . . . . . . . . . . . 4

Accounting of Sales Inducements to Contract Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Additional Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

SUMMARY OF SURVEY RESPONSES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Companies Surveyed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Summary Responses to Scope Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Summary Responses to General Technical Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Technical Questions Related to UL-Type Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Technical Questions Related to Fixed Premium/Benefit Annuities and Settlement Options . . . . . . . . . . . 8

Technical Questions Related to Sales Inducements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

APPENDIX A SURVEY RESPONSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

MILLIMAN RESEARCH REPORT


EXECUTIVE SUMMARY
In July 2003, the American Institute of Certified Public Accountants (AICPA) released Statement of Position
(SOP) 03-1. The SOP provides rules for the establishment of additional generally accepted accounting principles
(GAAP) reserves, as well as a deferred acquisition cost (DAC) adjustment for certain life insurance contacts that
have back-end losses, persistency bonuses, or other features that might make the policy account value a poor
proxy for future liabilities.

In many cases, the SOP is open to interpretation. An AICPA Technical Practice Aid (TPA) released in September
2003 clarified some of the uncertainties. In addition, the American Academy of Actuaries (AAA) released a practice
note that provides some guidance. Unfortunately, significant ambiguities and variations in interpretation remain.

In response to this uncertainty, Milliman commissioned a survey of company practice with respect to this SOP.
The survey clearly demonstrates an evolving consistency in most areas of compliance, but some inconsistency
remains. The results of our survey and the summarization thereof follow.

March 2005 MILLIMAN RESEARCH REPORT 1


INTRODUCTION
AICPA SOP 03-1 provides guidance on accounting and reporting by insurance enterprises for certain nontradi-
tional long-duration contracts and for separate accounts. It was approved and released July 7, 2003, and is effec-
tive for financial statements for fiscal years beginning after December 15, 2003. Shortly following the completion
of our survey in late September 2004, the AICPA released a Technical Practice Aid (TPA) titled TPAs 6300.05
6300.08 Q&As Related to the Implementation of SOP 03-1, Accounting and Reporting by Insurance Enterprises
for Certain Nontraditional Long-Duration Contracts, and for Separate Accounts that addressed some, but not all
of the issues relating to this SOP. Where appropriate, we have provided comments that address this TPA as well.

March 2005 MILLIMAN RESEARCH REPORT 2


SUMMARY OF KEY PROVISIONS OF THE SOP
The SOP provides guidance in the following areas:

Eligibility for separate account presentation and treatment of gains and losses on transfers of assets from the
general account to a separate account.

Determination of account value to be used as the GAAP liability subject to FASB Statement No. 97 (FAS 97).

Classification of a contract as a FAS 97 Universal-Life (UL) type contract.

Additional reserve requirement for UL-type contracts that contain death or other insurance benefit features.

Additional reserve requirement for contracts that provide annuitization benefits.

Accounting for sales inducements to contract holders.

Additional disclosures.

Separate Account Presentation


The SOP specifies that only separate accounts that meet certain criteria detailed in Paragraph 11 of the SOP are
to be valued at fair value. A summary of the criteria is outlined below:

a. The separate account is legally recognized.

b. The separate account assets are legally insulated from the general account liabilities of the insurance enterprise.

c. The insurer is required to invest the contract holders funds as directed by the contract holder or in accor-
dance with specific investment objectives.

d. All net investment performance must be passed through to the individual contract holder.

Other separate accounts shall be treated as general accounts. Transfer of assets from the general account to the sep-
arate account are to be made at fair value for separate accounts that meet the SOP criteria and resulting gains and
losses are recognized immediately into earnings. Additional guidance is provided for the accounting treatment of
the insurers proportionate interest in certain separate accounts.

Valuation of GAAP Liabilities


The account valueand benefit that accrues to the contract holderis the accrued account balance based on the
accretion method. The accrued account balance, as stated in the SOP, equals:

a. deposit(s) net of withdrawals;


b. plus amounts credited pursuant to the contract;
c. less fees and charges assessed;
d. plus additional interest (for example, persistency bonus); and
e. other adjustments (per other relevant paragraphs in the SOP to the extent not already included in b. above).

March 2005 MILLIMAN RESEARCH REPORT 3


This GAAP liability will also include additional interest and accrual of benefits not yet credited, and any adjust-
ments related to total return type products (in which the return is based on a contractually referenced pool of
assets or index). Additionallyfor products with multiple account valuesthe liability is determined to be the
highest account value available as cash.

Classification of a Contract as a FAS 97 Universal-Life (UL)-Type Contract


The determination, made at inception, is based on significance of mortality and morbidity risk at contract incep-
tion and whether fees assessed or insurance benefits are fixed and guaranteed. The significance of mortality and
morbidity risk is based on the comparison of the present value of excess benefit payments with the present value
of all amounts expected to be assessed against the contract holder. In performing the analysis, the SOP indicates
the need to perform the calculations under various scenarios of assumptions, rather than using a single best-esti-
mate assumption. Contracts where the amount of insurance benefit varies significantly in response to the capital
markets volatility are presumed to have significant insurance risk, unless rebutted, e.g., guaranteed minimum
death benefit (GMDB) in a variable annuity contract.

Additional Reserve Requirement for UL-Type Contracts that Contain Death or Other Insurance
Benefit Features
Additional reserves may be required for UL-type contracts if the amounts assessed against contract holders for the
insurance benefit are assessed in a manner that is expected to result in profits followed by losses. A liability is to be
set up that recognizes the portion of the assessments that compensates for the benefits to be provided in future
periods. The calculation of the liability starts out with the determination of the benefit ratio that is to be calculat-
ed under a full range of scenarios that considers the volatility inherent in the assumptions. This benefit ratio is
to be periodically evaluated based on emerging experience compared to earlier assumptions. The liability is then
calculated as the current benefit ratio multiplied by the cumulative assessments, less cumulative excess benefits,
and plus credited interest. The assumptions used to determine the liability should be consistent with assumptions
used in estimating gross profits for purposes of amortizing capitalized acquisition costs.

Additional Reserves for Contracts that Provide Annuitization Benefits


Additional reserves may also be required for contracts that provide additional benefits in excess of the account
value that are payable only upon annuitization, e.g., two-tier annuities, annuity minimum purchase guarantees,
and guaranteed minimum income benefit (GMIB). If it is determined that the contract is not accounted for
under the provisions of FAS 133, then additional liabilities are necessary if the present value of annuity payments
at the expected annuitization date is greater than the expected account value at that date.

Accounting of Sales Inducements to Contract Holders


Sales inducements are to be recognized as part of the liability without adjustments for anticipated lapses or decre-
ments. An asset should also be set up for sales inducements that meet the criteria in the SOP and amortized in
the same manner as for deferred acquisition costs.

Additional Disclosures
There are three additional areas of disclosure as it relates to this SOP: separate account information, accounting of
sales inducements, and assumptions with regards to calculation of additional reserves.

March 2005 MILLIMAN RESEARCH REPORT 4


SUMMARY OF SURVEY RESPONSES
Overall, we found that companies are coping with the implementation of the SOP and developing assumptions
and methodologies they felt to be appropriate according to their understanding of the SOP. Application of the
SOP to variable annuity (VA) products seems to be less problematic for companies than it is for UL secondary
guarantees. Since experience is rather limited, most policyholder behavior assumptions have been developed based
on judgment. The SOPs impact on the companies operations is seemingly limited to the determination of addi-
tional reserves and not to pricing and hedging practices.

Companies Surveyed
Twelve companies responded to the survey. Table 1 provides information on company size for the 12 companies
that responded to the survey.

TA B L E 1

NUMBER OF SURVEYED COMPANIES


Size in US$ Billion
Under $25 $25 - $49.99 $50 - $99.99 Over $100
General Account Assets 4 2 4 2
Separate Account Assets 5 3 3 1
Total Assets Under Management 8 2 1 1

Summary Responses to Scope Questions


1. In this section, we posed questions to determine if the SOP had implications beyond the products and fea-
tures specifically mentioned in the SOP and also if pricing or hedging practices were affected by the SOP.
Overall, we did not find many surprises with how the SOP affected companies operations. Although, it was
interesting to note that a few companies took the extra step of changing their pricing guidelines or adding
policyholder disclosures in their policy forms, to name a few.

2. As expected, the products most affected by the SOP are UL, VA, and fixed deferred annuities. The product fea-
tures that gave rise to SOP 03-1 reserves are secondary guarantees and cost of insurance (COI) structures for
UL/VUL products and GMDB and GMIB for VA products. COI structures include level COIs, reverse select
and ultimate (S&U) COIs, and other structures that result in profits followed by losses.

3. Other, non-reserve effects on company operations are primarily related to disclosures and reclassification of
items such as dollar cost averaging (DCA) accounts, deferral of bonus interest, seed money, and general
account treatment of separate account group annuity and market value adjusted annuities.

4. Most strikingly, a few companies changed their policy forms to specifically identify bonus interest. One com-
pany took the additional step of setting up new accounts (or funds) in its products for bonus interest on fixed
annuities and bonus deposits in variable annuities.

5. The SOP had little to no impact on companies pricing and the SOP is not, by itself, motivating new product
designs. Only one company changed its product design so that SOP 03-1 will not affect the product. Another
updated its pricing guidelines so that new products will not have a stream of mortality profits followed by losses.

March 2005 MILLIMAN RESEARCH REPORT 5


6. The SOP has not caused any of the surveyed companies to pull products from the market and none intro-
duced new products or changed product features solely because of SOP 03-1.

7. In terms of the effect on hedging practices the SOP had virtually no effect on the companies practices. One
company indicated that it now hedges the change in SOP reserve. The SOP introduces a market-sensitive
reserve for GMDBs and GMIBs. The use of equity market hedging is widespread in the VA industry. Some
companies are now calibrating their hedging programs to match the market sensitivity of the SOP reserve.
For VA writers whose primary hedge target is a fair-value or statutory measure, the sensitivity of the SOP
reserve is compared to these alternative measures.

Summary Responses to General Technical Questions


In summary, responses to the general technical questions vary considerably between companies and the type of
product. Only one company developed policyholder behavior scenarios, though policyholder behavior was gener-
ally projected to vary with the economic environment. Policyholder behavior assumptions, as expected, are prima-
rily derived using judgment since there is little experience. In general, companies tended to use more scenarios for
VA products and all companies use the mean of the scenario results in computing the benefit ratio.

Scenarios
For VA, the number of scenarios range from 100 10,000 stochastically generated scenarios. For UL, they
ranged from 1 63, either a deterministic set or a representative set of stochastically generated scenarios. For
VUL, the number of scenarios ranged from 1 100, either a deterministic set or a representative set of stochasti-
cally generated scenarios.

If the scenarios are a deterministic set, they are generally either chosen by consensus, a best estimate scenario, or
one that is used for the financial plan. All surveyed companies used equal weights for this deterministic set of sce-
narios. If scenarios are stochastically generated, the stochastic scenario parameters used in the scenario generation
model are usually determined directly or indirectly from historical data.

Eight companies surveyed generate scenarios stochastically and the descriptions that respondents gave to their sce-
nario generation methods follow.

Internal random scenario generation based on sampling historical equity returns.

Mean reverting, risk premium, independent log normal, real world scenarios.

Internal random scenario generation with mean reversion.

Regime Switching Log Normal (RSLN)-C3 RBC Phase II set of scenarios.

Arbitrage free, lognormal distribution, and mildly mean reverting scenarios.

Risk premium, mean reverting, interest rate/equity return correlated log normal scenarios.

Cox-Ingersoll-Ross interest rate scenario generation model.

Log normal equity return scenario generator.

RSLN for equity return scenarios and Cox-Ingersoll-Ross for interest rate scenarios with correlation between
interest rates and equity returns.

March 2005 MILLIMAN RESEARCH REPORT 6


Computation of Benefit Ratios and SOP Liabilities
All of the companies surveyed computed the benefit ratio using the mean of the stochastic results (as opposed to a
contingent tail expectation (CTE) measure), and they discount the average of the projected results using the DAC
interest rate to discount across scenarios (as opposed to discounting using path dependent rates).

Only half of the companies surveyed indicated that they use a method to smooth equity returns for amortizing
DAC on variable products. Two of the companies that do so indirectly reflect the mean reversions in projecting
excess payments and assessments to determine benefit ratios. The other companies determine the SOP 03-1
reserves independently of DAC and hence, the smoothed equity returns are not reflected in the SOP 03-1
reserve calculations.

Policyholder Behavior Assumptions


Only one company developed additional policyholder behavior scenarios. Another company performed sensitivity
testing of assumptions but only to determine an appropriate range of scenarios to use in testing. However, policy-
holder behavior was generally projected to vary with the economic scenario.

Approximately half of the companies surveyed developed dynamic lapse and benefit election rate assumptions.
Only two companies have dynamic premium assumptions, which partly reflects the fact that many of the compa-
nies are only modeling products that are single premium, or that can be approximated as single premium.
Most companies indicate that they haveas at least one of their criteriaused judgment in developing these poli-
cyholder behavior assumptions. The other common criteria are experience analysis, economic/behavioral theory,
and sensitivity analysis.

Projection of Estimated Gross Profits (EGP)


All of the companies surveyed reduce the future EGP for the value of (assessments x benefit ratio) but only seven
adjust for investment income on SOP reserves. Only two of the companies project EGP using multiple scenarios.

Level of Aggregation
For the most part, the aggregation level for SOP 03-1 reserves is the same as that for DAC. The rest of the com-
panies surveyed, except for one, had a finer level of aggregation for DAC purposes. The AICPA TPA has since
confirmed that the level of aggregation should be no less fine than the level of the DAC aggregation.

Benefit Ratio Evaluation, Purchase GAAP (PGAAP), and Products With No Explicit Charge
Most companies plan to recalculate the benefit ratio on a quarterly basis, with one company intending to recalcu-
late the benefit ratio monthly. A few will perform annual recalculations.

Purchase GAAP was essentially a non-issue for most companies. The two companies that had to consider PGAAP
effects indicated that they determined the benefit ratio from the purchase date and not at the contract inception
(issue) date.

Most companies did not have to determine the implicit charge for products with no explicit charge related to the
associated insurance benefit. These were either small plans aggregated into other plans or the product did not fail
the profits followed by losses test for newer products. The one company that had to determine an implicit charge
for its older business used interest margins.

March 2005 MILLIMAN RESEARCH REPORT 7


Technical Questions Related to UL-Type Plans
UL plans seem to be more problematic to implement than VA plans. This may be due to the fact that there is
considerably more literature and guidance with regard to the valuation and pricing of the minimum guarantees in
VA (i.e., Canadian Segregated Funds, C3 RBC Phase II, etc.)

Definition of Assessment and Benefits for No-Lapse Guarantee UL Plan


There were a variety of responses for the amount of assessment after the account value goes negative for a no-lapse
guarantee UL plan. Only eight companies responded, and four defined assessments as zero, three as stipulated pre-
mium, and one as COIs plus expense loads. Six of the eight companies responded that the benefit in such a sit-
uation is the death benefit paid, one is still undecided, and one did not respond to this part of the question.

SOP Liabilities for Reverse S&U COI Plans


Only one company indicated that it has set up SOP 03-1 reserves for plans with reverse S&U COIs. Another did
so for a level COI plan. The company that set up SOP 03-1 reserves for the reverse S&U COI plans also had an
unearned revenue reserve (URR) and still has a URR in addition to the SOP 03-1 reserves.

Definition of Excess Benefits


Only three companies responded to the question of how excess benefits are defined in calculating SOP 03-1
reserves. One of them indicated that death benefits paid, less any reserve released, is the excess benefit that is
defined in calculating SOP 03-1 reserves. The second company indicated that the death benefit paid when the no
lapse guarantee is in effect is the excess benefit. The third company indicated that the trailing loss (the amount of
the losses that are derived from the profits followed by losses test) is the excess benefit.

Reflecting Change in URR in Assessments


Five of the companies responded that they had reflected the change in URR in the calculation of assessments for
the profits followed by losses test. Three companies responded that they did not reflect the change and the rest did
not comment.

Only two companies performed some form of iteration to deal with the interdependence of URRs and estimated
gross products (EGPs), and SOP 03-1 reserves.

Technical Questions Related to Fixed Premium/Benefit Annuities and Settlement Options


This did not seem to affect most of the companies that we surveyed. Only one company considered a range of
annuitization election rates. One company considered a range but found that it did not have any impact and two
companies used a single best estimate.

Technical Questions Related to Sales Inducements


Late-duration persistency bonuses were not an issue with most of the companies. All of the four companies that
responded essentially indicated no change from previous practice.

March 2005 MILLIMAN RESEARCH REPORT 8


APPENDIX A SURVEY RESPONSES
Scope Questions TA B L E 2
1) What products are affected at
your company? PRODUCT NUMBER OF POSITIVE RESPONSES
UL 9
The products most affected by the VUL 4
SOP are UL, VA, and fixed deferred VL 1
annuity. This is possibly biased due Fixed Deferred Annuities 6
to the sample of companies in our VA 10
survey but also reflective of the Fixed Premium/Benefit Annuities 0
intent of the SOP. Settlement Options 4

2) What product features gave rise to


SOP 03-1 reserves?
TA B L E 3

As expected, the product features


PRODUCT PRODUCT FEATURES
that gave rise to SOP 03-1 reserves
are secondary guarantees and COI UL Secondary Guarantees and COI Structures
structures for UL/VUL products VUL COI Structures and Secondary Guarantees (GMDB)
and GMDB and GMIB for VA VL Secondary Guarantees
Fixed Deferred Annuities 2 Tier Products
products. COI structures include
VA GMDB, GMIB, and EEB (Earnings Enhancement Benefits)
level COIs, reverse S&U COIs, and
Settlement Options Mortality and Minimum Interest Rate Guarantees
other structures that result in profits
SPL Minimum Interest Rate Guarantees
followed by losses.

3) Excluding DAC and reserve effects, what other effects has SOP 03-1 had on your operations (e.g., accounting
for separate account seed money, disclosures, etc.)?

Other SOP 03-1 non-reserve effects on company operations are primarily related to disclosures and reclas-
sification of items such as DCA, bonus interest deferral, seed money, and separate accounts for group con-
tracts and market value adjusted annuities. A few companies indicated that they also changed the policy
forms to specifically identify bonus interest. One company also set up new accounts (or funds) in its
products for bonus interest on fixed annuities and bonus deposit in variable annuities.

4) How has product design/pricing been affected by SOP 03-1? Have you pulled any products from the market,
introduced new products, or changed product features because of SOP 03-1?

Overall, most companies responded that the SOP had no impact on their pricing or product design. Only
one company that we surveyed changed its product design so that the product will not be affected by
SOP 03-1. One other updated its pricing guideline so that new products will not have mortality profits
followed by losses. In general, SOP 03-1 is not by itself motivating new product designs.

Companies surveyed have not pulled any products from the market. Nor have they needed to introduce
new products or changed product features solely because of SOP 03-1.

March 2005 MILLIMAN RESEARCH REPORT 9


5) How, if at all, has SOP 03-1 affected your hedging practices?

All except for one of the companies surveyed indicated that SOP 03-1 had no impact on their hedging
practices. One company indicated that it now hedges the change in SOP reserve.

General Technical Questions


1) How many scenarios are you using to determine the benefit ratio for the SOP 03-1 reserves?

The responses to the number of scenarios used to determine the benefit ratio vary by product. For VA,
they ranged from 100 10,000 stochastically generated scenarios. For UL, the number of scenarios was
much fewer-they ranged from 1 63either a deterministic set or a representative set of stochastically
generated scenarios. For VUL, the number of scenarios ranged from 1 100. As with UL, companies
used either a deterministic scenario or a representative set of stochastically generated scenarios.

2) If the scenarios are not stochastically generated, how are these scenarios chosen? Do you weight the scenarios,
and if so, how?

If the scenarios are not stochastically generated, they are generally chosen by consensus, as a best esti-
mate scenario or one that is used for the financial plan. All surveyed companies used equal weights for
these scenarios.

3) If the scenarios are stochastically generated, what scenario generation method/model have you used?

For the eight companies that generate scenarios stochastically, a variety of approaches are in use.
Following are the descriptions that respondents gave to their scenario generation methods:

Internal random scenario generation based on sampling historical equity returns.

Mean reverting, risk premium, independent log normal, real world scenarios.

Internal random scenario generation with mean reversion.

Regime switching log normal (RSLN)-C3 RBC Phase II set of scenarios.

Arbitrage free, lognormal distribution, and mildly mean reverting scenarios.

Risk premium, mean reverting, interest rate/equity return correlated log normal scenarios.

Cox-Ingersoll-Ross interest rate scenario generation model.

Log normal equity return scenario generator.

RSLN for equity return scenarios and Cox-Ingersoll-Ross for interest rate scenarios with correlation
between interest rates and equity returns.

March 2005 MILLIMAN RESEARCH REPORT 10


a) How are the parameters determined in setting the long-term equity return, fund/interest rate/equity correla-
tions, and volatility?

Companies indicate that the parameters are usually determined-directly or indirectly-from historical
data. One company specifically mentioned that the scenarios are generated in its investment area, cali-
brated to American Academy of Actuaries (AAA) C3 RBC Phase II proposal and are the same scenarios
used for pricing and other applications. Another used the prepackaged AAA C3 RBC Phase II scenar-
ios and one company set the mean of the stochastic scenarios to be consistent with the long-term
return assumption in its DAC calculations.

b) Is the benefit ratio determined using the mean of the stochastic results? If not, what measure is used?

All surveyed companies computed the benefit ratio using the mean of the stochastic results.

4) When discounting across scenarios, do you discount the average of the projected results or compute the average of
the present values, where each present value is calculated at a path-dependent interest rate? Or do you use the
DAC interest rate?

All the companies responded that they discount the average of the projected results using the DAC interest
rate to discount across scenarios.

5) Do you do any sort of mean reversion or other methods to smooth equity returns for amortizing DAC on vari-
able products? How, if at all, are such smoothed equity returns reflected in SOP 03-1 reserve determination?

Only half of the companies surveyed indicated that they use a method to smooth equity returns for amor-
tizing DAC on variable products. Two of the companies that do so indirectly reflect the mean reversions
in projecting excess payments and assessments to determine benefit ratios. The rest of the companies
responded that the SOP 03-1 reserves are set independently of DAC and that the smoothed equity
returns are not reflected in the SOP 03-1 reserve calculations.

6) Do you include policyholder behavior scenarios, in addition to interest rate or equity return scenarios?

Only one company developed additional policyholder behavior scenarios. Another company performed
sensitivity testing of assumptions but only to determine appropriate range of scenarios to use in testing.
However, policyholder behavior was generally projected to vary with the economic scenario.

Approximately half of the companies surveyed developed dynamic lapse and benefit election rate assump-
tions. Table 4 shows which policyholder behavior assumptions companies have developed as a dynamic
function (which depends on the
value of the benefit or the economic TA B L E 4

scenario). Note that only two com-


P O L I C Y H O L D E R B E H AV I O R A S S U M P T I O N POSITIVE RESPONSES
panies have dynamic premium
assumptions, which partly reflects Lapse/surrender rates and persistency 7
the fact that many of the companies Premium/deposit activity 2
are only modeling products that are Partial withdrawals 2
single premium, or that can be Benefit election rates 5
Any other possible anti-selective behavior 1 - mortality
approximated as single premium.

March 2005 MILLIMAN RESEARCH REPORT 11


7) How have the policyholder behavior assumptions been developed?

The responses are varied with nine companies indicating that they have-as at least one of their criteria-
used judgment in developing these assumptions. Three companies have developed their assumptions from
a combination of experience analysis, judgment, economic/behavioral theory, and sensitivity analysis. One
has developed theirs solely from experience analysis and another solely from economic/behavioral theory.
Two other companies developed theirs primarily based on judgment and another two companies from a
combination of experience analysis and judgment. Lastly, one company developed its policyholder behav-
ior assumptions from a combination of judgment and sensitivity analysis.

8) How are estimated gross profits (EGPs) calculations adjusted as a result of SOP 03-1?

a) Only two of the companies surveyed indicated that the EGPs are developed using multiple scenarios.

b) All of the companies surveyed indicated that they reduce the future EGPs for the value of (assessments)
x (Benefit Ratio).

c) Seven companies surveyed adjust for interest earned on the SOP 03-1 reserve.

9) What level of aggregation have you used in determining SOP 03-1 reserves, i.e., at what granularity (cohorts)
are these calculations performed? How does this compare to the level of DAC granularity/aggregation?

Table 5 shows the level of aggregation used in determining SOP 03-1 reservesnote that this may be different
than the level used to test for profits
followed by losses (or to test for the TA B L E 5

need to set up SOP 03-1 reserves).


LEVEL OF AGGREGATION NUMBER OF COMPANIES
For the most part (eight companies), Major product type (aggregated across all issue years) 4
the aggregation level for SOP 03-1 Presence of rider 1
reserves is the same as that for DAC. Issue year and major product type 4
The rest of the companies surveyed, Reinsured blocks and major product type 1
except for one, had a finer level of Death benefit risk class 1
Issue year, major product type and issue company 1
aggregation for DAC purposes.

10) How often do you expect to recalculate your benefit ratios?

Nine companies indicated that they plan to recalculate the benefit ratio on a quarterly basis. One compa-
ny indicated that they will recalculate the benefit ratio monthly and the rest will perform annual recalcu-
lations. One company elaborated further, by indicating that the recalculations will be performed quarterly
for variable annuities and annually for VUL and UL.

11) What unique issues or approaches apply for purchase GAAP?

Purchase GAAP was a non-issue for ten of the companies. The two companies that had to consider pur-
chase GAAP effects indicated that they determined the benefit ratio from the purchase date and not at the
contract inception (issue) date.

March 2005 MILLIMAN RESEARCH REPORT 12


12) Do you have any productssuch as zero-explicit-mortality-charge single premium whole life (SPWL)with no
explicit charge related to the associated insurance benefit? If so, how do you calculate the implicit charge?

Only six companies indicated that they have products (such as zero-explicit-mortality-charge SPWL) with
no explicit charge related to the associated insurance benefit. Four of them indicated that these were small
plans and were either aggregated into other plans or ignored. One company indicated that the product did
not fail the profits followed by losses test for newer products but used interest margins for older products.
Another company indicated that it tested the product and it did not fail the profits followed by losses test-
presumably tested in aggregate-and hence did not calculate an implicit charge.

Technical Questions Related to UL Plans


1) How are assessments defined for no-lapse guarantee UL plans after the account value goes negative? What is
the benefit in such a situation? Is it the waived fees/charges or the death benefit paid?

For the eight companies that responded to this question, assessments are defined as zero (four), stipulat-
ed premium (three), or COIs and expense loads (one) after the account value goes negative, for no-lapse
guarantee UL plans.

Six of the eight companies responded that the benefit in such a situation is the death benefit paid, one
is still undecided, and one did not respond to this part of the question.

2) Are SOP 03-1 reserves being set up for reverse S&U COIs?

Only one company indicated that it has set up SOP 03-1 reserves for plans with reverse S&U COIs. One
other did so for a level COI plan.

a) Did you previously hold an unearned revenue reserve (URR) for these and do you still hold the URR?

The company that set up SOP 03-1 reserves for the reverse S&U COI plans also had an URR and still
has a URR in addition to the SOP 03-1 reserves.

b) How are excess benefits defined in calculating SOP 03-1 reserves?

Only three companies responded to this question. One of them indicated that death benefits paid, less
any reserve released, is the excess benefit that is defined in calculating SOP 03-1 reserves. The second
company indicated that the death benefit paid when the no lapse guarantee is in effect is the excess
benefit. The third company indicated that the trailing loss (the amount of the losses that are derived
from the profits followed by losses test) is the excess benefit.

3) Do you reflect change in URR in your calculation of assessments for the profits followed by losses test?

Five of the companies responded that they had reflected the change in URR in the calculation of assess-
ments for the profits followed by losses test. Three companies responded that they did not reflect the
change and the rest did not comment.

March 2005 MILLIMAN RESEARCH REPORT 13


4) Do you perform any sort of iteration to deal with the interdependence of URRs and EGPs and SOP 03-1 reserves?

Only two companies performed some form of iteration to deal with the interdependence of URRs and
EGPs and SOP 03-1 reserves.

Technical Questions Related to Fixed Premium/Benefit Annuities and Settlement Options


1) Do you consider a range of annuitization election rates?

Only one company considered a range of annuitization election rates.

Technical Questions Related to Sales Inducements


1) How, if at all, do you adjust for persistency in calculating your sales inducement liability for late-duration per-
sistency bonuses?

Late-duration persistency bonuses were not an issue with most of the companies. All of the four compa-
nies that responded essentially indicated no change from previous practice.

March 2005 MILLIMAN RESEARCH REPORT 14


Milliman Offices
Albany (518) 869-8378 Indianapolis (317) 639-1000 Norwalk (203) 855-2200 San Diego (858) 558-8400
4 Corporate Plaza, Suite 410 Bank One Center/Circle Evaluation Associates La Jolla Centre II
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Albany, NY 12203-5401 Suite 601 Suite 700 Suite 900
Fax: (518) 869-8379 Indianapolis, IN 46204-5128 Norwalk, CT 06854-1958 San Diego, CA 92121-3042
Fax: (317) 639-1001 Fax: (203) 855-2357 Fax: (858) 597-0111
Atlanta (404) 237-7060
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Suite 2500 Two Venture Plaza 1120 South 101st Street 650 California Street
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Mailing Address: Fax: (913) 649-8131 Fax: (610) 687-4236 So Paulo, SP
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Columbus (614) 481-0200 Fax: (503) 227-7956 Tampa, FL 33607
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Suite 200B Av. Revolucin No. 639, Piso 1 Princeton, NJ (609) 452-6400
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Fax: (614) 485-9538 03800 Mxico, D. F. Suite 3500 New Otani Garden, Court 23F
Mxico Princeton, NJ 08540 4-1 Kioicho
Dallas (214) 891-7300 (Cas./Life) Fax: 011-52-55-5615-8177 ex. 305 Fax: (609) 452-6411 Chiyoda-ku
(214) 863-5500 (Pension) Tokyo, Japan 102-8578
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Suite 1000 Via Monte di Piet 21 One Financial Plaza
Dallas, TX 75231-5030 20121 Milan Suite 550 Washington, D.C. (703) 917-0143
Fax: (214) 891-7310 (Cas./Life) Italy 501 North Broadway 8000 Towers Crescent Drive
(214) 863-5501 (Pension) Fax: 011-39-02-8633-7400 St. Louis, MO 63102 Suite 1000
Fax: (314) 231-0249 Vienna, VA 22182-2700
Denver (303) 299-9400 Milwaukee (262) 784-2250 Fax: (703) 827-9266
1099 Eighteenth Street 15800 Bluemound Road Salt Lake City (801) 924-1390
Suite 3100 Suite 400 515 East 100 South
Denver, CO 80202-1931 Brookfield, WI 53005-6069 Suite 600
Fax: (303) 299-9018 Fax: (262) 784-4116 (Health/Admin.) Salt Lake City, UT 84102
(262) 784-6388 (Cas./Life) Fax: (801) 924-1395
Greensboro, NC (336) 856-6001 (262) 784-7287 (Pension)
1500 Pinecroft Road
Suite 123 Minneapolis (952) 897-5300
Greensboro, NC 27407 8500 Normandale Lake Blvd.
Fax: (336) 856-8398 Suite 1850
Minneapolis, MN 55437-3830
Hartford (860) 687-2110 Fax: (952) 897-5301
80 Lamberton Road
Windsor, CT 06095-2126 Munich 011-44-89-5908-2395 Milliman Global
Fax: (860) 687-2111 Maximilianstrasse 35a Member Firm Locations
80539 Mnchen
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Fax: 011-852-2147-9879
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Suite 4330 Fax: (646) 473-3199 (Life/Health) Channel Islands Japan United Kingdom
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Fax: (713) 658-9656 (646) 473-3399 (Pension)
Denmark Mxico

MILLIMAN RESEARCH REPORT


March 2005 MILLIMAN RESEARCH REPORT 16