GAAP Ch. 4: Traditional Life
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1 GAAP Ch. 4: Traditional Life GAAP Ch. 4: Traditional Life FAS 60 and FAS 97 LP Methodology Source Author: Thomas Herget (2006) Video By: J. Eddie Smith, IV, FSA GAAP Ch. 4: Traditional Life 1 / 76 Key Exam Topics in This Lesson GAAP Accounting for Traditional Life Insurance Product Types That Fall Under FAS 60 FAS 60 Methodology vs. U.S. Stat FAS 60 Reserve Methodology FAS 60 Assumption Guidance and PADs PADs by Assumption FAS 60 Expense Recognition FAS 60 Basics: Benefit and Expense Reserves FAS 60 DAC Concepts FAS 60 GAAP Book Profit FAS 60 Recoverability and Loss Recognition Testing FAS 97 Limited Pay GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 2 / 76
2 Product Types That Fall Under FAS 60 This chapter covers long duration insurance contracts Insurer can t modify benefits or cancel coverage Longer term in nature Short duration contracts relate more to P&C and health Long Duration FAS 60 Products Term life Whole life and endowments Par WL where dividends are NOT based on contribution principle FAS 97 LP requires additional DPL for limited-pay contracts GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 3 / 76 FAS 60 Methodology vs. U.S. Stat Similarities With U.S. Stat Both use a NLP reserve method Assumptions do not change over life of contract Can pre-calculate reserve factors (terminal, mean, mid-terminal, etc.) Key Differences With U.S. Stat GAAP tends to be more earnings-focused, not solvency-focused GAAP audience is shareholders/investors, not regulators FAS 60 assumptions are experience and judgment-based (not prescribed and less conservative) FAS 60 uses explicit assumptions for lapse and expenses FAS 60 allows much larger (and realistic) deferral of acquisition costs GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 4 / 76
3 FAS 60 Reserve Methodology Main goal: Profits will emerge as a level % of GP Will occur if experience = padded assumptions Level profit % = 1 BenPrem% ExpPrem% FAS 60 Reserves 1. Benefit reserve for future DBs and surrender benefits Benefit net premiums = level BenPrem% of GPs 2. Expense reserve for future expenses Expense net premiums = level ExpPrem% of GPs Net GAAP Liability = BenRes + ExpRes Profit% ExpPrem% BenPrem% 100% of Gross Premium Equivalently, Net GAAP Liability = BenRes + MaintExpRes DAC GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 5 / 76 FAS 60 Assumption Guidance and PADs FAS 60 Assumption = Best Estimate + PAD PADs require judgment and should make reserves higher If experience = best estimate, PADs = additional profit All FAS 60 assumptions are locked-in at issue Cannot change unless there is a loss recognition event ASOP 10 gives guidance GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 6 / 76
4 Simple PAD Example 1-Year Term Product with DB = 100,000 Best estimate mortality rate = 0.10 PAD = 0.01 GP = 12,000 Ignore interest and expenses BenPrem% = 0.11(100,000) 12,000 = 91.67%, so Profit% = 8.33% If experience = padded assumption: Profit = 12,000 11,000 = 1,000 = 8.33% of GP If experience = best estimate: Profit = 12,000 10,000 = 2,000 = 8.33% of GP + 1,000 PAD GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 7 / 76 PADs by Assumption 1. Mortality/morbidity rates: typical PAD is 5 10% increase Reflect anti-selection and selective lapsation if applicable 2. Investment earnings rate: PAD is a decrease to the assumed earned rate Could be level or decreasing 3. Lapse rates: PAD depends on type of product Products with low or zero CSV: lower lapses increase the benefit reserve Higher lapses will accelerate DAC amortization, which lowers profits Test the net effect on profits before finalizing 4. Commissions: no PADs required since the commission rate is known exactly 5. Maintenance expenses: Use judgment 6. Taxes: no PADs required on premium taxes Federal income taxes are ignored in the reserve mechanism GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 8 / 76
5 FAS 60 Expense Recognition Expenses are classified as either 1. Deferrable Expenses Vary with and primarily relate to acquisition of insurance contracts Example: FY commission in excess of ultimate renewal Treatment: Capitalize and expense through amortization of DAC asset 2. Non-Deferrable Expenses All other costs Example: maintenance expenses Treatment: reserve for and expense as incurred GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance 9 / 76 GAAP Ch. 4: Traditional Life GAAP Accounting for Traditional Life Insurance FAS 60 Basics: Benefit and Expense Reserves FAS 60 Survivorship Formulas FAS 60 Benefit Reserve Formulas FAS 60 Expense Reserve Formulas Illustrative 5-Year Term Policy Task 1 Determine Survivorship Factors for All Years Task 2 Calculate the Benefit Reserve Task 3 Calculate Expense Reserve FAS 60 Net GAAP Liability FAS 60 DAC Concepts FAS 60 GAAP Book Profit FAS 60 Recoverability and Loss Recognition Testing FAS 97 Limited Pay GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 10 / 76
6 FAS 60 Survivorship Formulas Surv t = Surv t 1 ( 1 q d x+t 1)( 1 q w x+t 1 ) = alive and in-force EOY t PremPaid t = Surv t 1 GP t paid BOY t MortExp t = Surv t 1 q d x+t 1 DB t SurrExp t = Surv t 1 (1 q d x+t 1 ) qw x+t 1 CSV t Exp t = DAE t + MaintExp t = all expenses incurred BOY DAE t = Surv t 1 DeferrableExpenses t MaintExp t = Surv t 1 MaintExpenseCost t i = GAAP investment rate assumption (could also vary with t) GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 11 / 76 FAS 60 Benefit Reserve Formulas Prospective: Retrospective: BenRes t = PVFB t BenPrem% PVGP t BenPrem% = PVFB 0 PVGP ( 0 PVFB t = DB q x+t 1 v Surv ) t+1 q x+t v Surv t PVGP t = GP ä x+t BenRes t = (BenRes t 1 Surv t 1 + BenPrem% PremPaid t ) (1 + i) SurrExp t MortExp t (1 + i) 0.5 Surv t GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 12 / 76
7 FAS 60 Expense Reserve Formulas Prospective Expense Reserve (expenses occur BOY) ExpRes t = PVFE t ExpPrem% PVGP t ExpPrem% = PVFE 0 PVGP 0 Retrospective Expense Formula ExpRes t = ( ExpRest 1 Surv t 1 Exp t + ExpPrem% PremPaid t ) (1 + i) Surv t GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 13 / 76 Illustrative 5-Year Term Policy TIA Life sells the following 5-year term policy targeting FSA students concerned with studying themselves to death on the path from ASA to FSA Face amount = 100,000 Gross annual premium = 220 GAAP investment assumption (with PAD) = 6.85% all years No surrender benefits Other FAS 60 Assumptions (PADs Included): PY 1000q d x+t 1 q w x+t 1 PP Exp PU Exp Comm %Prem Exp % % 2.00% % % 2.00% % % 2.00% % % 2.00% % % 2.00% GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 14 / 76
8 Task 1 Determine Survivorship Factors for All Years Determine survivorship factors for all years. GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 15 / 76 Pause Video No peeking! GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 16 / 76
9 Task 1 Solution: Survivorship Factors Surv t = Surv t 1 ( 1 q d )( ) x+t 1 1 q w x+t 1 Surv 0 = Surv 1 = ( )(1 0.18) = Surv 2 = ( )(1 0.12) = Surv 3 = ( )(1 0.10) = Surv 4 = ( )(1 0.09) = Surv 5 = ( )(1 0.08) = Yours may differ slightly due to rounding GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 17 / 76 Survivorship Refresher Remember that Surv t = probability of being in force t years from t = 0 Surv t = t p x = didn t die and didn t lapse from x to x + t And the probability of being in-force k years from any time t is: Surv t+k Surv t Example: we re at t = 2 and want the probability of being in force at t = 4: Surv 4 = Surv = Always anchor at the date you re starting from GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 18 / 76
10 Task 2 Calculate the Benefit Reserve Determine the benefit reserve for at least the first 3 years. The solution will show all 5 years. GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 19 / 76 Pause Video No peeking! GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 20 / 76
11 Task 2 Solution: BenRes Formulas need for the benefit reserve: Retrospective: BenRes t = PVFB t BenPrem% PVGP t BenPrem% = PVFB 0 PVGP ( 0 PVFB t = DB q x+t 1 v Surv ) t+1 q x+t v Surv t PVGP t = GP ä x+t BenRes t = (BenRes t 1 Surv t 1 + BenPrem% PremPaid t ) (1 + i) SurrExp t MortExp t (1 + i) 0.5 Surv t GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 21 / 76 Task 2 Solution: BenRes First, we need PVFB and PVGP at time 0 so we can calculate the BenPrem% ( PVFB 0 = ) = Tip: You can also do EOY discounting work with A x, then adjust 0.5 years PVFB 0 = DB A x (1 + i) 0.5 = = GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 22 / 76
12 Task 2 Solution: BenRes And now PVGP at time 0: PVGP 0 = GP ä x:5 ( PVGP 0 = 220 = Now we can get the BenPrem%: = ) GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 23 / 76 Task 2 Solution: BenRes At issue: BenRes 0 = PVFB 0 BenPrem% PVGP 0 = = 0 (as always) From here, it s easiest to develop the BenRes retrospectively: BenRes 1 = ( ( )(1.0685) ) = BenRes 2 = ( ( )(1.0685) ) = etc. GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 24 / 76
13 FAS 60 Benefit Reserve Summary Alternative ways to get BenRes 2 : PY Surv PremPaid PVGP MortExp PVFB BenRes BenRes 2 = (562.61) = [ ] 33.26( ) (180.29) (1.0685) 62.28(1.0685) 0.5 = = GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 25 / 76 Task 3 Calculate Expense Reserve Determine the total expense reserve for at least the first 3 years. The solution will show all 5 years. Focus on the single ExpRes approach first. GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 26 / 76
14 Pause Video No peeking! GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 27 / 76 Task 3 Solution: Expense Reserve Returning to slide 14 to gather expense assumptions: PY PP PU Comm %Prem Total Exp Surv = Exp = = = = = GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 28 / 76
15 Task 3 Solution: Expense Reserve Just like the BenRes approach, except expenses occur BOY PVFE 0 = = ExpPrem% = = ExpRes 0 = (743.83) = 0 (as always) ( (220) )(1.0685) ExpRes 1 = = ( ( ) (180.29) 29.01)(1.0685) ExpRes 2 = = etc. GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 29 / 76 FAS 60 Net GAAP Liability Net GAAP PY BenRes ExpRes Liability GAAP Ch. 4: Traditional Life FAS 60 Basics: Benefit and Expense Reserves 30 / 76
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