Session 51 TS, Hot Topics in GAAP Reporting. Moderator: Thomas Q. Chamberlain, ASA, MAAA

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1 Session 51 TS, Hot Topics in GAAP Reporting Moderator: Thomas Q. Chamberlain, ASA, MAAA Presenters: Katie Cantor, FSA, MAAA Charles K. Chacosky, FSA, MAAA Thomas Q. Chamberlain, ASA, MAAA

2 Hot Topics in GAAP Reporting: Indexed Products May 5, 2015 Katie Cantor, FSA, MAAA 2014 Oliver Wyman

3 Indexed annuity sales trends $ Billions Source: Wink s Sales & Market Report and LIMRA 2014 Oliver Wyman 1

4 Trends in market players and distribution Foreign subs in retreat Alternative buyers gaining ground Expansion in banks and broker dealers Broader carrier base 2014 Oliver Wyman 2

5 Indexed UL (IUL) sales trends 1,800 1,600 1,400 $ Millions 1,200 1, IUL production has shown significant growth in the last decade Source: Wink s Sales and Market Report and LIMRA 2014 Oliver Wyman 3

6 IUL trends 1 Crediting mechanics Continued innovation on crediting mechanics, but S&P 500 still dominant with 2/3 of sales Newly added gold price index DJIA, NASDAQ, Russell, bond, EuroStoxx 50, Hang Seng, DJ-UBS Commodity Index and others also available Participation rates greater than 100%, even on Annual PTP 2 Protection Resurgence of protection IUL, including lifetime guarantees NLG premiums were highly competitive for a brief time 3 Living 4 COI 5 VUL 6 Statutory benefits charge reductions with indexed crediting and GAAP reserving Long term care or living benefit riders that provide an accelerated benefit have been added to IUL products Wellness Rider Quit smoking incentive In exchange for an irrevocable election of installment payments upon death, COI charges are reduced over the life of the product Illustration shows higher cash value accumulation Some VUL products compete with IUL by offering capped and floored indexed crediting strategies FAS 133 is challenging for IUL Minimum reserves under AG 36 continue to be approximated in pricing and sometimes for valuation as well Source: Wink s Sales and Market Report and Oliver Wyman IUL Financial Reporting and Risk Management survey 2014 Oliver Wyman 4

7 Section 2 US GAAP

8 Components of US GAAP valuation Fixed account FAS 97 Fixed indexed account FAS 133 / 157 No lapse guarantees SOP 03-1 DAC amortization FAS Oliver Wyman 6

9 US GAAP base contract reserve methodology for indexed liabilities Application of FAS 133 is very complicated for IUL products; simplified approaches are often employed Methodology for IUL base contract indexed account US GAAP liabilities FAS 133 Option budget method Stochastic approach Simplified FAS 133 Account value + current option value Swap method FAS 97 Account value only 2014 Oliver Wyman 7

10 FAS 133 liability development Range of practice and robustness of modeling varies Cash flows entering the embedded derivative calculation Advanced Future premium & fund transfers Intermediate Partial withdrawals & policy loan utilization Basic Death benefits & surrender benefits 2014 Oliver Wyman 8

11 Bifurcation of ED excess cash flows Bifurcation is complicated to model and track Approaches to compute excess cash flows often involves multiple runs and separate tracking of results Examples of approaches that can be used include: No future premium is modelled - Track (and bifurcate) new premium separately from historical premium - Pro-rata approach Future premium is modelled - Explicitly calculate attribution of ED excess cash flows to each actual premium - Pro-rata approach 2014 Oliver Wyman 9

12 Basis for discount rate and non performance risk spread Treasury rate Discount rate Treasury rates plus non-performance spread Swap rates Swap rates plus non-performance spread Non-performance risk Corporate bond credit spread Estimate based on credit default swap spread on own debt 2014 Oliver Wyman 10

13 Host calculation Common approaches to the host calculation depend on the method employed FAS 133 Method Host is the present value of guaranteed cash flows at the host accrual rate (attributable to premium paid to date only) Host accrual rate is re stated at each period (unlocked for premium received or actual withdrawals) Host accrual rate is unlocked at the end of each indexed crediting period Simplified FAS 133 Method Common approach is to restate the host accrual rate at the beginning of each indexed crediting term 2014 Oliver Wyman 11

14 US GAAP targeted areas of improvement wish list Firms would like to see more straightforward accounting requirements for IUL The FASB has announced that they will not pursue convergence with the IASB, but will instead revisit US GAAP with focus on targeted improvements. Some of the most common areas where companies would like to see improvements are Eliminate bifurcation and use a principles based approach to developing the liabilities Provide clarity around treatment of renewal premiums and decrements in developing embedded derivative liabilities and approach to bifurcation in future periods Address hedge accounting rules specific to IUL products Improved disclosure requirements Increased involvement of actuaries in developing new standards Source: Oliver Wyman IUL Financial Reporting & Risk Management Survey 2014 Oliver Wyman 12

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16 Session 51 Hot Topics in GAAP Reporting 2015 SOA Life & Annuity Symposium Charles K. Chacosky May 5, 2015

17 Profits Followed By Losses ( PFBL ) For Life Insurance Companies GAAP Accounting for Profits Followed by Losses in Long-Duration Contracts Exposure Draft released October 2014 Prior History & Scope Definitions Application and Considerations PwC 2

18 Profits Followed By Losses ( PFBL ) Prior History & Scope History U.S. Timeline (Approximately): January 11, 1759, the Presbyterian Synods of New York and Philadelphia founded the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers. The Episcopalian ministers organized a similar fund in In the half century from 1787 to 1837, twenty-six U.S. companies began offering life insurance to the general public, including Pennsylvania Company for Insurances on Lives and Granting Annuities (chartered 1812), the Baltimore Life Insurance Company (1830), the New York Life Insurance and Trust Company (1830), as well as the Girard Life Insurance, Annuity and Trust Company of Pennsylvania (1836). The worldwide Long Depression hits the U.S. (hardest from 1871 to 1874) with 32 U.S. life insurers failing outright, resulting in $35 million of losses for policyholders. The 1918 flu pandemic (January 1918 December 1920) with an estimated 675,000 Americans were among the dead, resulting in another round of PFBL. June 1982, Financial Accounting Standards Board (FASB) issues Statement No. 60, Accounting and Reporting by Insurance Enterprises with PFBL in scope. PwC 3

19 Profits Followed By Losses ( PFBL ) Prior History & Scope Scope ASC 944 Financial Institutions-Insurance, and is defined as relating to long-duration contracts. Long-duration insurance contracts are identified in ASC as including traditional long-duration contracts, universal life-type contracts, certain participating life insurance contracts, guaranteed renewable A&H contracts, and financial guarantee insurance contracts. The PFBL guidance would also apply to limited-pay insurance contracts because they follow the accounting rules for traditional long-duration contracts for establishing reserves. PFBL occurs at any time on various products depending on pricing, contract provisions, and management s revised estimates. As discussed in the history section, general poor economic conditions and poor mortality/morbidity lead to PFBL. Generally, an event that causes losses can cause PFBL, unless your company never had profits! An example where good news causes a PFBL pattern could be a LTC provider which now projects future claims will occur 5 years later than their original locked-in FAS 60 assumptions. Those claims are now projected to occur on the tail of the humpback of the reserves (i.e. FAS 60 would release the Active Life Reserve too soon). PwC 4

20 Profits Followed By Losses ( PFBL ) Definitions For guidance on identifying a long-duration insurance contract, see the Long- Duration Contracts Subsection of Section Long-duration insurance contracts are expected to remain in force for an extended period and must accept significant mortality or morbidity risk under the terms of the contract. Thus, the entity must be required to make payments or forego required premiums contingent on the death or disability (in the case of life insurance and A&H contracts) or the continued survival (in the case of annuity contracts) of a specific individual or group. PFBL does not apply to investment contracts (those that do not incorporate significant insurance risk). A projected loss in a future accounting period would be expected to be reported if (a) exceeds (b), where for that projected future accounting period: (a) The sum of claims incurred plus related settlement expenses, maintenance expenses, amortization expense of unamortized acquisition costs, the change in the related liability for future policy benefits, and policyholder dividends. (b) The sum of premiums earned plus investment income earned on assets supporting the related GAAP liability for future policy benefits. PwC 5

21 Profits Followed By Losses ( PFBL ) Application and Considerations The test for PFBL is typically applied at the ASC level of aggregation which states: Insurance contracts shall be grouped consistent with the entity's manner of acquiring, servicing, and measuring the profitability of its insurance contracts to determine if a premium deficiency exists. Including future new business (yet to be issued) in a current assessment of PFBL has little support in actual practice. The requirements of testing for profits followed by losses are similar to those of testing for premium deficiencies, and the latter testing is performed only on existing business. However, if the terms of an existing contract requires the insurance company to accept and issue future covers at a fixed cost that is projected to generate future losses, then the actuary may be prudent to consider those. If the PFBL test shows future losses, then ASC states that: the liability shall be increased by an amount necessary to offset losses that would be recognized in later years. PwC 6

22 Profits Followed By Losses ( PFBL ) Application and Considerations When and how shall the liability shall be increased? Section 9.92 of the AICPA Audit and Accounting Guide for Life and Health Insurance Entities (2014) discusses profits followed by losses situations and states: Adjustments should always be made when losses first become apparent. While the AICPA guide does not provide complete insight on how to increase the liability, this does appear to indicate when to start increasing the liability. Section 9.92 touches on how much saying: In such situations, appropriate adjustments should be made to liabilities to eliminate the recognition of losses in later years. This and general GAAP guidance means that the extra liability cannot be builtup such that its release is projected to result in future profits. Regarding how, some methods practitioners have considered using include: A locked-in increase schedule to build a liability over time to offset future losses or a dynamic increase schedule that changes over time as the projection of future losses change, where either accrues a ratable share of expected profits or premiums. PwC 7

23 Profits Followed By Losses ( PFBL ) Special Considerations No additional liability should be booked when your block has profits followed by losses followed by profits, if the present value of the later period profits exceed the present value of middle period losses. There does not appear to be any support in the GAAP literature for a possible writedown of unamortized acquisition costs to address PFBL. Section 9.93 of the AICPA Audit and Accounting Guide for Life and Health Insurance Entities (2014) states: For participating insurance contracts, the treatment of dividends in loss recognition tests requires special consideration. Generally, the current dividend scale is used to project future dividend benefits. However, if a loss is indicated, the entity should consider whether it has the ability to reduce or eliminate dividends. In such situations, it is reasonable to consider that option in testing for premium deficiencies. PwC 8

24 SOA Life & Annuity Symposium Session 51: US GAAP Developments FASB s Tentative Decisions On Targeted Improvements May 5, 2015

25 FASB s Tentative Decisions on Targeted Improvements Long Duration Products: Targeted Improvements Project Tentative Decision: Assumption Unlocking Tentative Decision: DAC Amortization Tentative Decision: Alternative Discount Rate Tentative Decision: Impact and Disclosure Non-Par Whole Life Earnings Single Premium Immediate Annuity Earnings Some Observations Some Practical Issues 2 Copyright 2014 Deloitte Development LLC. All rights reserved.

26 Long Duration Products: Targeted Improvements Project What are the targeted improvements considered for long duration insurance contracts? The objective of the project is to develop targeted improvements to insurance accounting for long-duration insurance contracts. Those improvements may address recognition, measurement, presentation, and disclosure. For traditional long-duration, limited-payment and participating life contracts (Including long-duration health), FASB has reached a tentative decisions DAC amortization simplification Alternative discount rate methods Unlocking of all assumptions annually Assumption changes would flow through Net Income There would no longer be a Provision for Adverse Deviation (PAD) No requirement for a premium-deficiency test New disclosures 3 Copyright 2014 Deloitte Development LLC. All rights reserved.

27 Tentative Decision: Assumption Unlocking What are the targeted improvements considered for long duration insurance contracts? The Board reached a tentative decision that Insurance entities are required to update all assumptions used in calculating the future policy benefits for traditional long-duration contracts, limited payment contracts, and participating life insurance contracts The update would take place annually during the fourth quarter The impact of the updated assumptions are included in net income There would be no more PAD It is not clear that the assumption unlock also applies to expense reserves and DAC as only future policy benefits are mentioned The update would also apply the updating assumptions for additional liabilities for universal life-type contracts 4 Copyright 2014 Deloitte Development LLC. All rights reserved.

28 Tentative Decision: DAC Amortization What are the targeted improvements considered for long duration insurance contracts? Deferred acquisition costs for certain investment contracts will continue to be amortized using the constant yield method All other long duration contracts will amortize DAC over the expected life of the book of contracts in proportion to the insurance in force. A straight-line method in proportion to the number of contracts outstanding will be used for those contracts where the insurance in force is variable or not determinable The first choice appears consistent with previously identified alternative amortization methods allowed for interest sensitive products, or the balance of insurance in force shall be substituted as the base for computing amortization. 5 Copyright 2014 Deloitte Development LLC. All rights reserved.

29 Tentative Decision: Alternative Discount Rate Discount rate to be used for long duration contracts Alternative discount rate vs. Current discount rate Alternative discount rate a discount rate based on the expected investment yield from a reference portfolio of high-quality, fixed-income investments Current discount rate a discount rate based on the expected investment yield of the portfolio that is backing the business FASB to consider the impact of such a discount rate FASB to clarify the concept high-quality and evaluate disclosure requirements 6 Copyright 2014 Deloitte Development LLC. All rights reserved.

30 Tentative Decision: Impact and Disclosures What are the targeted improvements considered for long duration insurance contracts? The impact to income for these changes will flow through net income Since assumptions will be updated annually, there is no longer a need to test for premium deficiency Disclosures related to the assumption update must include weighted-average discount rates used to measure the liability for future policy benefits by time bands Information related to the methods and inputs used to measure the future policy benefits, including assumptions (discount rates, mortality, morbidity, termination or lapse and expense assumptions) Reconciliation of opening and closing future policy benefits with separate disclosures for changes in the liability for new contracts, benefit payments, changes in assumptions and derecognition of contracts 7 Copyright 2014 Deloitte Development LLC. All rights reserved.

31 Insurance contracts Modeling key assumptions Deloitte model Single policy projections of Net Income to isolate impacts Plain-vanilla products Non-Par Whole Life (NPWL) Product details Non-Par Whole Life Level benefit and annual premium in all years PAD equal to 50 bps on discount rate and 5% on mortality Guaranteed cash values Unlocking methodologies Retrospective: Reserve is recalculated at time of unlocking as if assumption change were known at issue. Prior assumptions are updated for actual experience. Prospective: Reserve k-factor applicable to future EGPs only is recalculated with consideration of pre-unlocking reserve 8 Copyright 2014 Deloitte Development LLC. All rights reserved.

32 Insurance contracts Modeling key assumptions Scenarios Actual experience is same as original assumptions Actual mortality is 105% of expected starting in policy year 6 Actual mortality is 105% of expected starting in policy year 6 and discount rate increased by 25 bps starting in policy year 11 Actual mortality is 140% of expected starting in policy year 5 Accounting paradigms Current guidance with PAD Current guidance with no PAD Unlocking per the FASB s Tentative Decisions and no PAD 9 Copyright 2014 Deloitte Development LLC. All rights reserved.

33 Insurance contracts Modeling results NPWL Assuming experience is as expected Net Income Removing PAD accelerates earnings Note: FAS60 no PAD and Unlocked are the same FAS60 with PAD FAS60 no PAD Unlocked 10 Copyright 2014 Deloitte Development LLC. All rights reserved.

34 Insurance contracts Modeling results 250 NPWL 5% adverse mortality Net Income Adverse mortality (does not lead to Loss Recognition) Discount rate increased Unlocked and Unlocked with discount change are the same in years FAS60 with PAD Unlocked FAS60 no PAD Unlocked (with discount change) 11 Copyright 2014 Deloitte Development LLC. All rights reserved.

35 Insurance contracts Modeling results NPWL 5% adverse mortality Net Income Prospective unlocking tends to have less of an impact at time of unlocking than Retrospective Retrospective Prospective 12 Copyright 2014 Deloitte Development LLC. All rights reserved.

36 Insurance contracts Modeling results NPWL 40% adverse mortality Net Income FAS60 with PAD is cushioned since PADs are being released Note: FAS60 no PAD and Unlocked are the same FAS60 with PAD FAS60 no PAD Unlocked 13 Copyright 2014 Deloitte Development LLC. All rights reserved.

37 Insurance contracts Some Observations Tentative Decisions likely to increase volatility in Net Income and a removal of PADs accelerates earnings Clarifications needed on how to apply the new principles How would a block of policies differ from the single policy example? Potential for multiple assumption changes with some offsets (i.e., some favorable assumption changes and some unfavorable changes) Discount rate change would impact all business and typically in same direction Unlocking method to use Retrospective: Reserve is recalculated at time of unlocking as if assumption change were known at issue Prospective: Reserve k-factor applicable to future EGPs only is recalculated with consideration of pre-unlocking reserve Will unlock of assumptions also apply to DAC and expense reserves? If premium deficiency testing is eliminated, is it still necessary to check for profits followed by losses? 14 Copyright 2014 Deloitte Development LLC. All rights reserved.

38 Insurance contracts Some Practical Issues Less reliance on 1Q, 2Q & 3Q statements Users may resort to other means to anticipate what 4Q unlocking will look like Will need to develop new processes and new internal controls Company s processes will differ between 4Q and other quarters There will be significant work related to system changes to perform calculations Includes admin system feeds, actuarial system changes, G/L changes, etc. Will be particularly challenging for factor-based reserve systems There may be increased volatility in 4Q earnings from saving up assumption changes since Jan. 1 Use of reserve shortcuts sometimes used in the industry (e.g., grade from GAAP to statutory reserve in later years) may disappear FAS 115 calculations would need to be performed more frequently or not at all depending on the discount rate changes PAD removal inconsistent with dividends based on contribution principle 15 Copyright 2014 Deloitte Development LLC. All rights reserved.

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