Revenue Recognition. approach might apply to life insurance. A presentation for the IAA Accounting Committee s by Jim Milholland May 27, 2009.

Transcription

1 Revenue Recognition How the transaction price approach might apply to life insurance A presentation for the IAA Accounting Committee s by Jim Milholland May 27, Agenda Introduction Example; 5 year term insurance Obligations and unit of account Consideration Assets, liabilities and revenue Balance sheet and P&L Additional points for development Why year-to-year doesn t work Future topics 2 1

2 Introduction Discussion paper issued on 19 December 2008 Asset and liability approach means that revenue recognition is now about liability measurement for obligations assumed in ordinary business transactions ti and how these run off Rights and obligations arise from contracts with customers. Can be net contract asset or net contract liability. Revenue arises when contract assets increase or contract liabilities decrease Performance obligation not satisfied until resources transfer to customer Goods when enforceable rights or access to goods transfer to customer Services when a service or access to a service is provided Revenue reflects delivery not activity 3 Transaction price approach Initial Measurement Measure performance obligations at contract price Assumes contract price only for goods/services yet to be provided Allocate portion of contract price to each performance obligation on basis of standalone sales price Measurement includes any amounts in pricing that are to recover direct/indirect costs of obtaining a contract Like UPR with no DAC [but only if delivery is at incurral, not payment] Subsequent Measurement Measure remaining performance obligations as a proportion of the amount of contract price allocated at inception Initial measure locked in updated only if performance obligation onerous (Liability Adequacy Test) 4 2

3 Example 5 year level premium term insurance The example reflects only premiums and death benefits. No profit is made. Other factors (e.g., cancellation rights, discounting, margins) will be added later. Premiums are at the beginning of the year and deaths are at the end of the year. Amounts are not realistic but the relative patterns of premiums and benefits are characteristic of life insurance. Year Ttl Total Premiums Benefits Revenue Recognition According to the Discussion Paper (para 2.35): For a contract with a customer, revenue is recognised when a contract asset increases or when a contract liability decreases Extract from Discussion Paper (para 2.32): 6 3

4 Contract accounting In the DP, revenue recognition relates to contracts, not portfolios At inception, the expected obligation cash flows for a single contract are small Revenue recognition can take place at the contract level if one attributes a ratable share of expected benefits to each contract With this rationale,,performance takes place for all contracts when benefits inure to some contracts. Alternatively, performance takes place as the obligation to provide protection is satisfied. 7 Alternative approaches Future premiums as rights The first approach values the performance over five years Future premiums are rights Obligation to accept future premiums The second approach looks at the obligations for benefits that have been purchased and the obligation to accept future premiums without re-pricing or re-underwriting 8 4

5 Future premiums as rights The approach in this presentation is to measure the total contractual obligation at 550 at the contracts inception. Customers are buying a 5 year product on Day 1. The performance obligation at inception is the total obligation plus a margin* to calibrate the obligation to the consideration The decrease in the net performance obligation does not reflect premium payments *nil in this example 9 Consideration/Rights The total amount of the consideration to be received from customers is 550 At inception 110 is received in cash Remaining future payments are the insurers rights under the contract 10 5

6 Net performance obligation The amount of 550 is a naïve measure of the future benefits. The transaction ti price model is not impacted by the choice of measurement attribute on Day 1 because it calibrates the liability to the contract price. However the measurement attribute may affect the allocation of the consideration and will be important for remeasurement. 11 Net Contract Position In this example, the future benefits comprise the obligation The insurer has rights to future premiums The net contract position is the future benefits less future premiums 12 6

7 Revenue = decrease in performance obligations Year Inception Obligations 550 * Rights Net contract position Revenue * * *The initial obligation is calibrated to the value of the consideration, hence there is no revenue at inception **Revenue is recognised as the obligation decreases only. No impact of the rights decreasing as decrease in rights does not give rise to revenue 13 Profit and Loss Year Revenue Benefits P&L

8 Balance sheet Assets are the cumulative cash flows The liability is the net contract t position; namely, the remaining performance obligation less the future premiums The assumption throughout is that the measurement of liabilities is consistent with the basis for measuring rights and obligations underlying revenue recognition. 15 Cumulative cash flows End of year Total Premiums received Benefits paid Net cash flow Cumulative cash flow 16 8

9 Balance sheet Policy Inception duration Assets Liabilities Obligations Rights Net position Equity Recognition of rights The first alternative presumes that the value of future premiums is recognizable. Arguments in support of recognition are based on: the definition of an asset and the criteria for recognition: An asset is a present economic resource to which the entity has a right or other access that others do not have There is recognition when (a) it is probable that any future economic benefit associated with the item will flow to the entity; and (b) the item has a cost or value that can be measured with reliability the whole contract; i.e., if the unit of account is the contract, then once the determination is made that the contract is recognized, then the accounting must consider all expected cash flows 18 9

10 Obligation to accept future premiums By making an initial payment of 110 (in the example), the policyholder can purchase insurance by paying 110 in each future period rather than paying what would be required at an older age for the remaining term The performance obligation can be separated into the current year s benefits and the obligation to accept future premiums 19 Measuring the obligation The performance obligation is priced as the shortfall in consideration resulting from committing to accept the level premium in the future Years remaining Premiums remaining Beneifts remaining Shortfall

11 Revenue using loyalty obligation Year Rollforward of obligations BOY addition to.current year obligation addition to loyalty obligation total addition = consideration total BOY obligation Revenue=decrease for the year = obligation satisfied EOY obligation The revenue is the same as before 21 Commentary The resulting net liability is the familiar (present) value of future benefits less the (present) value of future premiums The performance obligation has the same measure whether future premiums are rights or the obligation is to accept future premiums as they relate to the same cash flows The key is hat the obligations must be be considered over the term of the contract 5 years in this example 22 11

12 Additional points for development The boundary problem can be addressed since the term of the obligation is clear Guaranteed insurability is reflected in obligations there is no need to treat it like a financial option To properly reflect all the features of the contract, it is necessary to look over the term of the contract, not just over the period for which coverage has already been purchased The approach is the same for life as for non-life or short- duration insurance as well The approach works regardless of the measurement attribute The approach is likely to be seen as consistent with other industries. 23 Why year-to-year doesn t work Consider the contract as a series of one-year contracts Each year the policyholder purchases One year s term insurance at standard rates for underwritten lives, and The right to continue to purchase one year s insurance coverage at standard rates (the guarantee) The following slides illustrate how each year s prices would be calculated lated and how the consideration (the premium) would be allocated to the two components Also illustrated is how the P&L emerges 24 12

13 Development of year-to-year example slide sequence Expected deaths this is the mortality table underlying the calculations Rational premiums this show the calculation of the total cost year-to-year using the presumption of an efficient market, consistent with the pricing of guarantees A comparison of death benefits, rational premiums, the cost of the guarantee, and the scheduled premium 25 Expected Deaths a select and ultimate table Age Total x x x x x The first row is expected death benefits for a group of PHs insured at age x for 5 yrs The second row is for a same sized group of PHs insured at x+1 for 4 yrs. The lower benefits for x+1 in the first year as compared to the second year of the first row reflects underwriting. The final row is for one year of insurance for a same-sized group aged x

14 Calculating the Rational Premiums Term insurance for n years ending at x+4 Term period Total Term insurance for one year at age x+4 is for the expected deaths for an underwritten group Term insurance for tow years at x+3 must charge the same in the second year as for one year term insurance or else the healthy lives would go to a competitor. The insurer can not charge the expected death benefits of 135. In order to charge enough, it must charge 110 in the first year, spreading the cost of the higher deaths over the PH group. Every PH pays a little more in order to know that he is guaranteed insurability for the second year. Hence the cost of the guarantee is Pushing this logic back gets the resulting table 27 Why year to year doesn t work Year Total Death benefits Select mortality Cost of guarantee Rational Premium Level premium Margin in level premium Considering only one year s obligation requires calibrating to that year s consideration, resulting in positive and negative margins. As a rule, if consideration does not follow the pattern of performance, looking at the two period by period results in distortions. Accounting periods and contract payment periods are not deciding factors. Reflecting the term of the contract (i.e., 5 years) can not be avoided

15 P&L If year-to-year with cost of guarantee P&L Total Revenue Deaths Guarantee Total Benefits Profit The annual consideration has been allocated to the select deaths to for the year and to the cost of guarantee. The revenue is the allocated amounts for the select deaths and the run out of the guarantee as extra deaths occur. Profits and loss are spurious, created by the fact that the initial obligation for each period is calibrated to the consideration for that period, whereas the annual consideration is a level premium for the ratable amount of benefits for the entire term of the contract. 29 Possible alternative The contract is for 5 years and the performance is the select mortality plus the price of the guarantee. The initial performance obligation is 550, as before, but revenue follows the pattern of the rational premium in slide 26. Year Total Revenue

16 Unbundling Unbundling can be accomplished by identifying i the consideration for insurance and service in the contract Some contracts unbundle naturally; e.g., universal life insurance For others, the consideration must be imputed 31 Unbundling example Five year endowment policy Year Premium 1,000 1,000 1,000 1,000 1,000 Policy value 950 1,875 2,770 3,630 4,450 Imputed consideration 32 16

17 Treatment of components Once identified, the insurance and service component tfollows the treatment t tfor a recurring premium product The deposit component, follows FAS 39, either amortized costs or fair value 33 Future topics Reflecting realistic withdrawal rates Discounting and margins Acquisition costs Universal life example to reflect deposit and other components Participating whole life to address deposit and other components that are not explicit in the contract What constitutes delivery standing ready, incurral, payment, something else, some combination of these? Experience deviations Re-measurement 34 17