Assessing Your Readiness for the 2001 CSO

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Assessing Your Readiness for the 2001 CSO

• Chris DesRochers
• Phil Ferrari
• Abe Gootzeit
• Brian King

September 2002
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Presentation Outline

• 2001 CSO Overview
• Product Implications of the 2001 CSO
• Tax Implications of the 2001 CSO
• Assessing Your Readiness
• Questions and Answers

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What We Would Like You to Take Away from Today

• Appreciate that the 2001 CSO conversion is a
  significant business problem for the U.S. life
  insurance industry.
• Understand at a high level the technical and
  product design effects of the 2001 CSO.
• Think about your companys strategy and business
  processes to address the 2001 CSO.
• Assess your readiness.

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The 2001 CSO Table

• The 2001 CSO Table is a collection of tables
• Nonsmoker-smoker and composite.
• Ultimate and select ultimate.
• Male-female and gender blended.
• Age-nearest and age-last birthday.
• No ETI Table.
• Age 120 maturity.
• All of the tables will be published by the
  Academy 2001 CSO working group.

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Development of 2001 CSO

• 1990-1995 Basic Table was developed by the SOAs
  Individual Experience Studies Committee (SOA
  Committee).
• The 1990-1995 Basic Table is based on mortality
  experience over the years 1990-1995.
• Additional data from other sources was used to
  supplement the data at young and old ages.
• The mortality was projected to the year 2001using
  recent mortality improvement trends.
• The 1990-1995 Basic Table was graduated to
  provide the smoothness necessary for a valuation
  table.
• Margins were added by AAA Committee.
• Adequacy is an issue.

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Source AAA Report, June 2002
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Source AAA Report, June 2002
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Source AAA Report, June 2002
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NAIC Model Regulation

• Unlike the 1980 CSO, implementation is by NAIC
  Model Regulation, not statute.
• Faster adoptions?
• State variations?
• Recognition Of The 2001 CSO Mortality Table For
  Use In Determining Minimum Reserve Liabilities
  And Nonforfeiture Benefits Model Regulation
  (07/26/02)
• Plan-by-plan implementation allowed.
• Asset adequacy analysis requirement.
• Not adopted.
• Deficiency reserves on same table.
• Mortality reporting.
• Gender-blending method.

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Overall Effects of 2001 CSO

• The 2001 CSO will affect product structure,
  competitiveness and profitability.
• State-law impacts
• Reserves and nonforfeiture values.
• COI and surrender charges.
• Federal law impacts
• Tax reserves under IRC 807.
• Definitional limits under IRC 7702 7702A.
• Effects vary by product, gender, age and class.

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Implementation Timeline

• 2001 CSO may be used for products on January 1 of
  the year following adoption of the Model
  regulation.
• 2001 CSO must be used for all products issued
  after January 1, 2008.
• NAIC is on schedule to adopt the 2001 CSO Model
  regulation in December 2002.
• AAA Working Group to produce all tables by
  December 2002.
• Initial products January 1, 2004.
• 2001 CSO will be prevailing for federal tax
  purposes when adopted by 26 states.
• No reasonable mortality transition rules.
• IRS not currently focused on the issue.

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Effects by Product Type

• Traditional products will be affected more
  directly than non-traditional products because of
  must changes in product structure.
• Non-traditional products will probably have
  changes to load structures as certain sources of
  profit are hampered.

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Development of Product Strategy
2001 CSO Effects
Portfolio Conversion Plan
Product Structure
Competitiveness
Profitability
Whole Life
Universal Life
Variable Universal Life
Specialty Products
Term
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Term Insurance

• Valuation mortality and basic reserves reduced.
• Reserves at 85 of 80CSO levels for older ages
• 75 of 80CSO levels for younger ages
• Effect on deficiency reserves mixed.
• NS NP decrease, more likely GPNP, deficiencies
  decrease
• SM NP increase, deficiency increase especially
  females
• Increased profit, if gross premiums held
  constant.
• Higher issue ages and longer level term periods
  under triviality test.

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Source AAA Report, June 2002
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Term Premium
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Term Insurance - Strategy

• 2001 CSO produces lower statutory reserves.
• Reduced surplus strain in early years.
• Higher profitability/earlier breakeven year.
• Premiums can be reduced.
• Simple rate-filing.
• More competitive product.
• Maintain or increase market share.
• Higher issue ages for level term products.

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Permanent Life Insurance

• Statutory and tax reserves reduced.
• Generally 8-15.
• Premiums reduced.
• Dividends reduced.
• PUA premiums reduced amounts increased.
• Cash values reduced.
• 12-16 for both plans, younger ages.
• 3-9 for both plans, older ages.

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Source AAA Report, June 2002
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Whole Life Equivalent Premium
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Whole Life Cash Values
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Permanent Life Insurance - Strategy

• Opportunity to increase profits.
• Competitive effects of reducing cash values.
• Or, lower premiums to get back to the same level
  of profitability.
• 10 to 15 reductions possible.
• Participating life
• Adjustments for dividend strategy.
• Additional insurance and lower cash values from
  paid up additions.

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Flexible, Nontraditional Products

• Most notable effect is product load structure.
• Reduction in COI rates.
• Reduction in first-year maximum surrender charge.
• Product changes needed to maintain profits.
• IRR profit margins reduced if no changes made.
• Accumulation Products Funding limits under
  7702/7702A reduced.
• Death Benefit Products No-lapse premiums may be
  reduced, for some plans.
• Extended maturity provisions may be eliminated,
  or altered.

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UL Surrender Charges
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UL Mortality Margins
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Flexible, Nontraditional Products - Strategy

• Some product designs will need to be changed.
• Product loads will need to be restructured to
  maintain profits.
• Increased mortality and expense risk charges.
• Increased front-end load.
• Increased or additional per unit expense charge.
• Variations in loading structure will affect
  competitive positioning.
• Product competitiveness (or profitability) will
  generally decrease under 01CSO.

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Secondary Guarantee Provisions

• No-lapse guarantee to age 100.
• Level premium provisions.
• XXX reserves will be lower.
• Improved profits.
• Shadow account value products.
• XXX reserves (ART type) will be lower.
• Wait for AXXX?
• Impacts of table on financial reinsurance
  arrangements.

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Systems Implications

• The 2001 CSO tables have unique features that may
  not be supported by current systems.
• Extension of table to age 120.
• 25 year select and ultimate.
• Storage limitations.
• Older legacy systems may not support endowment
  beyond age 100.
• IT Support is becoming a scarce resource.

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Federal Income Tax Issues

• Tax reserves.
• Section 807 defines tax reserves for life
  insurance to be the greater of
• the net surrender value of the contract, or
• federally prescribed reserves.
• The 2001 CSO will be the new prevailing table
  under section 807.
• Definition of life insurance.
• Reasonable mortality under section 7702 and
  7702A limitations.

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Prevailing Commissioners Standard Table

• The Prevailing Commissioners Standard Table is
  the required mortality table for computing
  federally prescribed tax reserves.
• The most recent commissioners standard tables.
• Prescribed by the NAIC.
• Permitted to be used for valuing reserves for
  that contract.
• Under the insurance laws of at least 26 states.
• When the contract was issued.
• The IRS will likely issue guidance on when the
  new tables are required to be used.

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Prevailing Table Implementation

• Companies can elect to use the 2001 CSO Table
  once it becomes the prevailing table.
• Section 807(d)(5)(B) Transition Rule
• If there is a change in the prevailing table
  during the calendar year, companies may elect to
  use the prior table to value reserves for
  contracts issued during that year through the end
  of the following three calendar years.

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Reasonable Mortality Requirements

• Section 7702 and 7702A limitations are based on
  reasonable mortality charges.
• Reasonable mortality charges cannot exceed
  mortality charges specified in the prevailing
  tables.
• Unless provided for by regulation to date no
  regulations have been issued.
• Proposed regulations never finalized.
• Reasonable mortality applies to the calculation
  of guideline premiums, net single premiums and
  7-pay premiums.
• The overall effect of the 2001 CSO is to increase
  the death benefit relative to the cash value.

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Change in Tax Limitations
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Issues Particular to the 2001 CSO

• Which 2001 CSO table should be viewed as
  reasonable?
• When should you use the 2001 CSO?
• How do the calculation rules of section 7702
  apply?
• Other Tax Law Issues
• Substandard Mortality and the 2001 CSO.
• Loss of grand-fathering for pre-existing
  contracts.
• The industry may get guidance on these issues as
  a result of the 2001 CSO.

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Which 2001 CSO Table is Reasonable?

• Remember, the 2001 CSO is a collection of tables.
• IRS Issued Guidance for 1980 CSO Tables.
• Notice 88-128 provided limited safe harbors.
• Proposed Reg. 1.7702-1 provided additional safe
  harbors.
• Prop. Reg. 1.7702-1 was never finalized.
• IRS will likely issue guidance.
• Hopeful that Prop. Reg. 1.7702-1 will serve as
  precedent.

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When is the 2001 CSO Reasonable?

• Does Section 7702 require the use of the 2001 CSO
  Table once it becomes the prevailing table?
• Does the section 807 three-year transitional
  period apply?
• IRS may issue guidance on this issue.
• Alternatives may include
• Section 807 transition rule.
• Adopt state-by-state treatment.
• Apply transition rules provided for in the Model
  Reg.
• Others?

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Calculations to age 100 and beyond?

• Many UL and VUL products have a maturity
  extension rider beyond age 100.
• The 2001 CSO table extends to age 120.
• IRC 7702 deems a maturity date between ages 95
  and 100.
• Calculation rules of section 7702(e)(1)
• How should 7702 /7702A limits be calculated for
  contracts that mature beyond age 100?
• Calculations beyond age 100 for DBO 2 contracts.
• GLPs can be as much as 50 to 75 higher.
• The prudent choice might be to wait for guidance
  before designing a product with a maturity age
  beyond 100.
• Will there be a change in the tax laws?

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Aons Recommended Approach
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2001 CSO Product Readiness Assessment
Portfolio Conversion Plan
Product Readiness Assessment
Portfolio Rationalization Strategy
Product Strategy Review
New Product Strategy
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Portfolio Conversion Plan
How to build a 2001 CSO-compliant product
portfolio that properly prioritizes conversion
and new development
What products should be converted when?

• Strategy for on-going
• product development?

Simple rate-filing basis versus major structural
changes

• Wait and see?

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2001 CSO Product Assessment -Activities
Determine Scope of Review
1980 CSO Baseline Benchmarking
Single Product
Competitive Benchmarking
Product Line
Portfolio
2001 CSO Product Analysis
Prepare Client Data Request
Strategies Analysis
Report Generation
Data Review And Model Office Set-up
Presentation of Results and Follow-up Analysis
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Goals for Process Improvement Readiness
Assessment

• Establish four plans to guide process improvement
• Projects to improve the process
• Better project management
• Process management to institutionalize change
• Leadership support to ensure success
• Create the internal capability to continually
  improve the process (option)

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A 2001 CSO Readiness Assessment The Process Team
The deliverable is four plans
How to make project management effective and
efficient
How to improve the NPD process
How to incorporate process management into NPD
to guide and sustain gains
What leadership support is needed to govern the
transition and an accelerated PD process
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2001 CSO Process Assessment
2001 CSO Process Readiness Assessment
Plan to prioritize portfolio conversion
Process Management
Project Management
Plan for process improvement
Leadership Support
Product/portfolio support
Resource allocation decisions
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Summary

• The 2001 CSO is coming.
• NAIC approvals.
• State adoptions.
• IRS Treasury action.
• Ignoring it is not an option.
• It is a business problem.
• Product issues and opportunities.
• Product development process tune-up.