Session 57, Profits Followed by Losses Methods and Policies. Moderator: Thomas Q. Chamberlain, ASA, MAAA. Presenter: Charles K. Chacosky, FSA, MAAA

Transcription

1 Session 57, Profits Followed by Losses Methods and Policies Moderator: Thomas Q. Chamberlain, ASA, MAAA Presenter: Charles K. Chacosky, FSA, MAAA Thomas Q. Chamberlain, ASA, MAAA

2 SOA Val Act Session 57 GAAP Accounting for FAS 60 Profits Followed By Losses Charles K. Chacosky, FSA, MAAA August 30, 2016

3 Presenter Charles K. Chacosky, Director with PricewaterhouseCoopers, Philadelphia I am Fellow of the Society of Actuaries and a Member of the Academy of Actuaries. Member, Profits Followed By Losses Subgroup, Financial Reporting Committee, Risk Management and Financial Reporting Council, American Academy of Actuaries Coauthor of the June 2015, American Academy of Actuaries Practice Note, GAAP Accounting for Profits Followed by Losses in Long-Duration Contracts. PwC 2

4 SOA valuation actuary symposium disclaimer Presentations are intended for educational purposes only and do not replace independent professional judgment. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of the Society of Actuaries, its co-sponsors or its committees. PwC 3

5 We will discuss the following topics The FAS 60 profits-followed-by-losses (PFBL) and how that differs from the SOP 03-1 form of PFBL Updates on PFBL since the release of the Practice Note When and how the test is typically completed and interpreting the results of the model output; The methods used to calculate the additional PFBL liability by going through examples and addressing key considerations. PwC 4

6 Introduction The AAA PFBL practice note The practice note is not: - A promulgation of the Actuarial Standards Board; - An actuarial standard of practice; - Binding upon any actuary; - A definitive statement as to what constitutes appropriate practice or generally accepted practice; or - An official or comprehensive interpretation of any accounting guidance. Future accounting, regulatory and legislative activity could change information presented in the practice note. PwC 5

7 Background FAS 60 PFBL is a form of a premium deficiency ASC , Premium Deficiency and Loss Recognition, defines situations under which a premium deficiency may be recognized. ASC describes how such deficiencies should be reflected in the insurance entity s GAAP financial statements In its paragraph 25-9, ASC addresses the premium deficiency situation for long duration contracts under which the liability on a particular line of business may not be deficient in the aggregate, but circumstances may be such that profits would be recognized in early years and losses in later years The original PFBL guidance was FAS 60 paragraph 37 and as such, it has been in effect since at least PwC 6

8 Polling Question #1 My company or client routinely tests for a ASC Profits Followed By Losses Premium Deficiency? A. Yes B. No C. Don t Know D. Not a GAAP Filer and/or Does Not Apply 65% 15% 10% 10% A. B. C. D. 7

9 Polling Question #2 In the past, my company or client has established an additional liability to cover a ASC Profits Followed By Losses Premium Deficiency? A. Yes B. No C. Don t Know D. Not a GAAP Filer and/or Does Not Apply 45% 30% 13% 13% A. B. C. D. 8

10 Background SOP 03-1 PFBL is a form of a unearned revenue liability ASC , Revenue Recognition, defines situations under which a liability for unearned revenue shall be recognized. In its paragraph 25-8, ASC says: If the amounts assessed against the contract holder each period for the insurance benefit feature of an insurance contract are assessed in a manner that is expected to result in profits in earlier years and losses in subsequent years from the insurance benefit function, a liability for unearned revenue shall be recognized in addition to the account balance. The original PFBL unearned revenue guidance was in SOP 03-1 and as such, it went into effect upon adoption (circa 2004). PwC 9

11 Polling Question #3 My company or client has established additional liabilities to cover a SOP 03-1 Profits Followed By Losses? A. Yes B. No C. Don t Know D. Not a GAAP Filer and/or Does Not Apply 56% 21% 14% 9% A. B. C. D. 10

12 Background FAS 60 PFBL premium deficiency contrasted with the SOP 03-1 form of PFBL Premium deficiency testing is typically performed annually (at least) at a high aggregation level (such as line of business). The SOP 03-1 testing for PFBL is typically applied at a more granular UL-type DAC cohort level and is performed when the policy is issued. Premium deficiency testing for PFBL includes all the profit elements from the block tested. The SOP 03-1 test for PFBL focuses on just the insurance benefit feature being tested. Reportedly, the upcoming FASB Exposure draft on the proposed targeted improvements for long duration contracts accounting will eliminate premium deficiency testing, but retain some SOP 03-1 liabilities (such as ULSG). PwC 11

13 Polling Question #4 How would you describe your company s or client s preparation for the FASB proposed targeted improvements for long duration contracts GAAP accounting? A. Nothing, but glad to hear Premium Deficiency testing could be eliminated 47% B. Don t know, waiting, or does not apply to us C. Just getting started more focused on PBR and/or other things D. Reviewed the proposed targeted improvements 19% 14% 14% E. reviewed + discussed with auditor + gathering historical data 7% A. B. C. D. E. 12

14 Polling Question #5 When my company or client established an additional liability to cover a ASC Profits Followed By Losses Premium Deficiency, it was for: A. LTC products B. Payout Annuity contracts C. UL policies D. Multiple lines E. Don t know which ones 38% 27% 19% 12% 4% A. B. C. D. E. 13

15 What is a FAS 60 PFBL premium deficiency? PFBL occurs when GAAP gains are expected in the near future, but GAAP losses in later accounting period(s) are expected to be reported because (a) is projected to exceed (b): 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; and b) The sum of premiums earned plus investment income earned on assets supporting the related GAAP liability for future policy benefits. However, the present value of those future losses must be less than the present value of the future gains. Otherwise, there is a full premium deficiency which must be addressed. PwC 14

16 What happens if there is newly observed FAS 60 PFBL premium deficiency? , Long-Duration Contracts, specifies that the liability shall be increased by an amount necessary to offset losses that would be recognized in later years. However, the ASC 944 guidance does not indicate the period or pattern over which to recognize (accrue or release) the additional liability for PFBL. There does not appear to be any support in the GAAP literature for a possible write-down of the DAC asset (unamortized acquisition costs) to address PFBL. PwC 15

17 What typically has led to a FAS 60 PFBL? PFBL has occurred with a variety of products depending on pricing, contract provisions, and changes to management new best estimates. It has occurred in long-duration non-participating blocks, including but not limited to: Universal Life without SOP 03-1 liabilities; Payout annuities; and Guaranteed renewable A&H contracts, such as Long-Term Care (LTC). If your long-duration block is not listed above, you may still need to test! PwC 16

18 PFBL examples Background Consider a closed block of life payout annuities issued between 1985 and This year s experience studies indicate lower mortality and the investment manager provides lower reinvestment rates than those in the current GAAP assumptions. For simplicity, we will illustrate: This block forms a Loss Recognition testing (LRT) group All of these annuities were life-contingent at issue A discount rate of zero and The remaining lifetime is 10 years. PwC 17

19 PFBL examples 4Q2016 loss recognition testing Remaining GAAP Profit ($ millions) Pattern Scenarios Projection Scen. A Scen. B Scen. C Scen. D Scen. E Scen. F Year Profit Profit Profit Profit Profit Profit Sum of Sum of Net Total Scenario A is not PFBL since there are no losses B is not PFBL since there are no profits (must address full Loss Recognition) C is not PFBL since losses > profits (must address full Loss Recognition) D is not PFBL since losses < later profits E is PFBL since losses < earlier profits: If do nothing, LR event would occur in 2018 F is PFBL since losses > later profits: If do nothing, LR event would occur in 2019 PwC 18

20 PFBL examples The AICPA s insurance entities expert panel (December 16-17, 2015 meeting) The SEC Staff noted that for traditional contracts with locked in assumptions, depending on facts and circumstances, it would not object to a company in a profits followed by losses situation either: 1. Accruing a liability, during the period of gains, to offset the losses using a dynamic method updated over time (when updating calculations if profits followed by losses no longer exists, the liability could be released over time). Registrants should discuss the specifics of each transaction with the SEC Staff, as the Staff may not accept all approaches for accruing the liability over time. OR 2. Accruing an immediate liability to offset the present value of losses that would be recognized in later years (this would be considered a locked calculation not subject to reversal). PwC 19

21 PFBL examples Projected accrual and release of PFBL liability from 2016 LRT scenario E Approach Approach Projection Scen. E PFBL PFBL Revised Scen. E PFBL PFBL Revised Year Profit Accrual Liability Profit Profit Accrual Liability Profit 12/31/ Approach Description 1 Accrues a ratable share (60%) of expected profits over time to accrue a liability that is just adequate to offset future losses at such time as the future losses are expected to commence. 2 Accrued $9 million PFBL liability immediately at 12/31/2016 (locked-in) to offset later expected losses. PwC 20

22 PFBL examples Illustration of a future 2019 LRT scenario E (2024 investment yields improved) Original Approach 1 Not Locked-in Projection 2016 Revised PFBL 2019 Profit PFBL PFBL Revised Year Profit Profit Liability Before PFBL Accrual Liability Profit 12/31/ Description Between 2016 and 4Q2019. actual = expected. The 4Q2019 LRT revised the future expected yields (favorably). The accrued $7.20 million PFBL liability at 12/31/2019 now appears more than the later expected losses. The excess is released over time. This illustration presumes the proposed targeted improvements for long duration contracts has not become effective as of 12/31/2019. PwC. 21

23 PFBL examples Illustration of a future 2019 LRT scenario E (2024 investment yields improved) Original Approach 2 Locked-in Projection 2016 Revised PFBL 2019 Profit PFBL PFBL Revised Year Profit Profit Liability Before PFBL Accrual Liability Profit 12/31/ Description Between 2016 and 4Q2019. actual = expected. The 4Q2019 LRT revised the future expected yields (favorably). The accrued $9 million PFBL liability at 12/31/2019 now appears more than the later expected losses. However, due to the lock-in concept, the PFBL liability continues based on the 2016 projection. This illustration presumes the proposed targeted improvements for long duration contracts has not become effective as of 12/31/2019. PwC. 22

24 Polling Question #6 If my company or client fails their ASC Profits Followed By Losses Premium Deficiency later this year, I think we would: A. Follow our already well established accounting policy by beginning to accrue a liability, during the period of gains, to offset the losses using a dynamic method updated over time (when updating calculations if profits followed by losses no longer exists, the liability could be released over time) B. Follow our already well established accounting policy by and accrue an immediate liability to offset the present value of losses that would be recognized in later years (this would be considered a locked calculation not subject to reversal) C. I Don t Know D. Flip a coin to pick A/B or loosen the assumptions such that losses go away E. Meet and Discuss with our auditors 43% 34% 11% 9% 3% A. B. C. D. E. 23

25 Questions? Chuck Chacosky Director PwC Actuarial Services Life (610) PwC PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. 24

26 Session 57: Profits Followed by Losses Methods and Policies Thomas Q Chamberlain, ASA, MAAA Senior Manager, Deloitte Consulting August 30, 2016

27 Agenda Profits Followed by Losses Introduction 3 Preparations 5 Analysis 13 Test Evaluation 17 Definition of Income Example 24 Conclusion 31 26

28 Introduction Profits followed by losses ( PFBL ) often identified as a test of future premium deficiency (ASC ) Not the same as testing for losses generated by a benefit function (SOP03 1) Modeling, assumption, control and accounting elements are considered when developing the PFBL test and any additional liability Existing accounting policies may apply Results may impact multiple areas within a company 27

29 Introduction Segment 1: First portion of the cycle where profits occur. Segment 1 is the first occurrence of positive Income before losses occur Segment 2: The second portion of a cycle where losses occur. Segment 2 is the first occurrence of negative Income Cycle of PFBL: One complete set of an odd Income segment number (profits) and an even Income segment number (losses) Cycles can be numbered when recurring 28

30 Preparations 29

31 Preparations Begin by reviewing the policies, explicit or implicit, that impact loss recognition testing and deferred acquisition costs A review of existing policies will help guide the PFBL testing process and limit the potential reinvention of existing policies New policies may be necessary once the testing is designed and completed, especially if new liability balances are necessary 30

32 Preparations Frequency of testing Annual testing is the most common when there is no deficiency A more robust model may be necessary for PFBL given experience and current interest rates Aggregation Aggregation guidance appears in ASC 944 and is referred to as grouping The three criteria are 1) manner of acquiring 2) servicing and 3) measuring the profitability of its insurance contracts 31

33 Preparations Actuarial assumptions for loss recognition Loss recognition testing and profits followed bylosses testing are on the same best estimate basis Actuarial modeling policies The sophistication of the actuarial model is evaluated based on several aspects (product complexity, cash flow availability and other considerations) Definition of Income for the PFBL model and associated consistency with loss recognition testing 32

34 Polling Question #7 For my company or clients Aggregation Policy is: A. Written and wellestablished. 58% B. A series of implicitlyestablished groupings. C. Not well understood or 32% established. D. Established as needed. 5% 5% A. B. C. D. 33

35 Preparations New policies Based on the loss recognition guidance, each company may refine how loss recognition events impact Income (accrue a liability or decrease DAC) Is this policy impacted by the treatment of profitsfollowed by losses testing? A premium deficiency shall be recognized by a charge to income and (a) a reduction of unamortized acquisition costs or (b) an increase in the liability for future policy benefits. [emphasis added] Unrealized gains and losses impact on the testing results and on any liability accrual 34

36 Preparations New policies (continued) Accrual methods Insurance Entities Expert Panel, December 2015, pre approved SEC methods The SEC Staff noted that this was for traditional contracts with locked in assumptions Accruing a liability, during the period of gains, to offset the losses using a dynamic method updated over time or Accruing an immediate liability to offset the present value of losses Treatment of additional liabilities within the definition of Income and existing loss recognition testing 35

37 Preparations Assembling Models Vendor based Valuation or homegrown modeling system output is often collected to form the future cash flows Income may be defined and assembled/calculated outside of a vendor based system Assumptions external to existing models are introduced Loss recognition testing and PFBL testing are often combined Controls Extracting and loading data controls benefit from automatedpreventative types of controls Validate calculations using alternate calculations and trends The SEC Staff explained that internal controls over financial reporting are required to identify contracts in profits followed by losses situations. 36

38 Analysis 37

39 Analysis Carefully consider best estimate assumptions as part of the analysis of cash flows ASOP 10 Best Estimate Assumptions Based on management s assessment of emerging experience ; established as the most likely, average or central corresponding to the mode, mean, the median of a probability distribution. or; Actuarial judgment ASOP 10 also invokes ASOP 23: Data quality which considers the appropriateness, reasonableness and limitations of data used by actuaries 38

40 Analysis Accounting guidance on contingencies (formerly FAS 5) Accrual of Loss Contingency conditions (both must be met) a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. b. The amount of loss can be reasonably estimated. 39

41 Analysis Complexity of Model Future projected losses cause Substantially deterioration of policyholder behavior Investment income Other Materiality of results Rigor of monitoring and analysis Subsequent events and frequency 40

42 Test Evaluation 41

43 Test Evaluation 42

44 Test Evaluation Example 1: Potential Interpretations (to be supported by facts and circumstances) Interpretation 1 There is a PFBL event An additional liability must be accrued over the profits Interpretation 2 There is a PFBL event An additional liability equal to the present value of losses is established Interpretation 3 There is a PFBL event No accrual is established as the amount is immaterial and remote (or not probable) given the future duration and existing interest rate environment Future monitoring for deterioration or improvement is necessary 43

45 Test Evaluation Example 1: Potential Interpretations (to be supported by facts and circumstances) Further considerations Assets supporting this product portfolio are reported as available for sale Does the accrual method and/or PFBL test require a shadow element? PFBL Test and Additional PFBL Liability How are multiple cycles of PFBLs considered or incorporated? How are odd segments considered or incorporated? 44

46 Polling Question #8 For my company or clients, when interpreting the results of the PFBL test, we: A. Consider only the Income when determining the impact B. Rely heavily on judgment and estimation C. Evaluate the robustness of the model, the likelihood of results, established policies and the materiality of future losses 67% 30% 3% A. B. C. 45

47 Test Evaluation Impacted areas Pricing area awareness Allows this area to modify product designs to prevent future PFBL events (Integrated Pricing) Investments area awareness Allows this area to modify investment strategies as necessary to prevent future PFBL events Financial Reporting area awareness Besides accounting policy decisions, ledger preparation and disclosures may require updates Tax Department awareness Consider tax impacts in conjunction with Pricing, Investments and Valuation areas 46

48 Polling Question #9 For my company or clients PFBL has impacted the following areas: 60% A. Pricing B. Accounting (Financial Reporting) 33% C. Investments D. None of the above E. All of the above 0% 0% 7% A. B. C. D. E. 47

49 Definition of Income Example 48

50 Definition of Income Example 6 Year GIC Example Initial Premium = 1,000,000 Interest Paid = 6.00% Final Maturity Value = 1,418,519 Portfolio Earned Rate Used Excel Solver to determine year 1 rate All future rate decreasing by 50 bps Objective: Create a product that has break even earnings at issue Create a pattern of profits followed by losses Not intended to follow strict FASB guidance on DAC amortization 49

51 Definition of Income Example Present value of profits = 0 (off by rounding in Excel) Earnings contains a pattern of profits followed by losses The earnings is driven entirely by the spread 50 No actuarial decrements in the projections Present values calculated using the earned rate

52 Definition of Income Example Present value of profits = Commissions paid Maintain breakeven status, change portfolio earned rate to generate profits Amortize deferred acquisition costs over income (not premium, allow negative balances) 51

53 Definition of Income Example FAS 60 Income Presentation Break even at present value using portfolio earned rate Present value using crediting rate used for DAC amortization 52

54 Definition of Income Example FAS 97 Income Presentation Slightly different DAC presentation, amortization and offsetting opportunity cost for the different between investment portfolio and crediting rate on DAC The Income using the FAS 97 presentation equals the Income on a FAS 60 basis Note that the Income is identical. 53

55 Polling Question #10 For my company or clients, PFBL testing is performed: A. On all FAS 60 business B. On Certain FAS 60 business perceived to be at risk C. On FAS 60 and in scope FAS 97 business D. On FAS 60 business and perceived at risk, in scope FAS 97 business E. Not at all 36% 27% 15% 12% 9% A. B. C. D. E. 54

56 Conclusion 55

57 Conclusion As with loss recognition, PFBL models can be as sophisticated as desired Policies Define Income up front with interdepartmental consensus Develop new policies and methods together with the Finance area Controls Apply change management controls to the new model (model access, new assumption implementation, data requirements, methodology or documentation of model changes) 56

58 Conclusion Communication Include external auditors to solidify consensus on intended interpretations, new policies and results Communicate results clearly to interested and impacted areas (Product, Investments, Tax, Finance, others) Document new policies and methods 57

59 Questions 58