Session 30, Latest GAAP Developments/Hot Topics in GAAP Reporting Moderator: Thomas Q. Chamberlain, ASA, MAAA Presenter: Thomas Q Chamberlain, ASA, MAAA Robert G. Frasca, FSA, MAAA Hoi Yan Kwan, FSA, MAAA Leonard J. Reback, FSA, MAAA
Latest GAAP Developments/ Hot Topics in GAAP Reporting Robert Frasca, FSA, MAAA August 29, 2016
Disclaimer The material contained herein is for discussion purposes only. The material is intended to be used to illustrate points raised in a verbal presentation and should not be used outside of that context or on a standalone basis. Nothing contained within this material, or within the accompanying verbal presentation, should be interpreted as constituting accounting advice. Page 2
US GAAP developments Financial instruments classification and measurement ASU 2016-01, Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities Elimination of available-for-sale classification for equity securities Measurement alternative for equity investments Financial liabilities measured under fair value option change in own credit reported in other comprehensive income Impairment of securities ASU 2016-13, Financial Instruments Credit Losses on Financial Instruments Goodwill impairment (exposure draft) Long-duration contracts Page 3
Targeted improvements to US GAAP Insurance contract developments June 2013 FASB and IASB issue exposure drafts FASB re-deliberates plan in February 2014 and decides to focus on targeted improvements Out of scope Contracts written by non-insurance entities IASB continues deliberations; will not issue final standard before the end of 2015 Short-duration disclosures Final standard released May 2015 Long-duration measurement Deliberations began August 2014 Expected ED in H2 2016 Page 4
Targeted improvements to US GAAP Current proposals for long-duration contracts Periodic assumption update Assumption update methods for traditional long-duration contracts, limited-payment contracts, and participating contracts Premium deficiency and loss recognition Discount rate Accounting for participating life insurance contracts Amortization of deferred acquisition costs Market risk benefits Disclosures Transition Page 5
Liability for policyholder benefits Traditional and limited pay contracts Update cash flow assumptions: No provision for adverse deviation Annual updates, at the same time each year Revise the net premium ratio using actual historical experience and updated future cash flow assumptions Retrospectively adjusted as a cumulative catch-up in net income Net/gross premium ratio capped at 100%; premium deficiency test eliminated Page 6
Liability for policyholder benefits Traditional and limited pay contracts Change the discount rate: Based on a high-quality fixed-income instrument yield Recognize the effect of changes in discount rates in other comprehensive income (OCI) Net/gross premium ratio unchanged for discount rate changes Page 7
Transition Long duration contracts Transition method applied at the beginning of the earliest period presented Cash flow assumptions: Retrospective approach for each level at which reserves are calculated Use actual historical information or, if not possible, use objective information to estimate at the appropriate level If impracticable to apply a retrospective approach, apply guidance to in-force contracts on the basis of their existing carrying amounts at the transition date and updated future assumptions Discount rate: Cumulative-effect adjustment of changes in discount rates between contract inception and transition date recorded in OCI. Page 8
Deferred acquisition costs Amortization Multiple DAC amortization methods would be replaced by one primary method based on the respective amount of insurance in force Alternative method would be available if amount of insurance in force is variable and cannot be reliably predicted or readily determined: a straight-line method in proportion to the number of contracts outstanding Would not apply to certain investment contracts currently using an effective interest method No accrual of interest on the DAC balance Existing carrying amounts carried over on the date of transition, adjusted for the removal of any related amounts in accumulated OCI Page 9
10-year level term - baseline 14,000.00 Reserve projections 12,000.00 10,000.00 8,000.00 6,000.00 4,000.00 2,000.00-0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Proposed US GAAP Page 10
10-year level term baseline 30,000 DAC projections 25,000 20,000 15,000 10,000 5,000-0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Proposed US GAAP Page 11
10-year level term - baseline 5,000 Pre-tax income 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500-1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Proposed US GAAP Page 12
10% mortality deterioration no prospective recognition 14,000 Reserve projections 12,000 10,000 8,000 6,000 4,000 2,000-0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Semi-retrospective Full retrospective Page 13
10% mortality deterioration no prospective recognition 30,000 DAC projections 25,000 20,000 15,000 10,000 5,000-0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Semi-retrospective Full retrospective Page 14
10% mortality deterioration no prospective recognition 4,500 Pre-tax income 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500-1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Semi-retrospective Full retrospective Page 15
10% mortality deterioration prospective recognition in year 4 14,000 Reserve projections 12,000 10,000 8,000 6,000 4,000 2,000-0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Semi-retrospective Full retrospective Page 16
10% mortality deterioration prospective recognition in year 4 30,000 DAC projections 25,000 20,000 15,000 10,000 5,000-0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Semi-retrospective Full retrospective Page 17
10% mortality deterioration prospective recognition in year 4 4,500 Pre-tax income 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500-1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Current US GAAP Semi-retrospective Full retrospective Page 18
Targeted improvements to US GAAP Practical implications Implementing processes and internal controls around the assumption unlocking process Evaluating how to set the discount rate including the collection of required data Implementing new process and controls for the DAC amortization method Implementing processes and internal controls to produce new required disclosures and disaggregation levels Explaining results and volatility, including baseline historical data Next steps: formal comment period Page 19
www.pwc.com Latest GAAP Development/Hot topics in GAAP reporting Indexed products Daphne (Hoi Yan) Kwan, FSA, MAAA August 29, 2016
Agenda Indexed Products Overview GAAP Hot Topics Indexed Products Flexible Premiums Policyholder Behavior Assumptions Risk Margins GLWB Riders Other GAAP Valuation Considerations PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 2
GAAP hot topics related to indexed products Overview Sales for both indexed universal life and indexed annuities have increased significantly in the last decade Number of market participants has increased Crediting mechanics are becoming more complex Flexible premium is allowed for indexed products Valuation Challenge Guaranteed lifetime income benefit is becoming more and more common for both indexed life and annuities Other riders such as long term care or nursing home benefits are also available No-lapse guarantees and guaranteed death benefit complicate valuation PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 3
GAAP hot topics related to indexed products Flexible premium Challenges Indexed products are valued under FAS 133/157 with the contract bifurcated at issue into host and embedded derivative with no gains or losses. Premium deposit Each premium deposit is bifurcated, resulting in multiple embedded derivatives for a contract? Bifurcate each premium deposit or group premium payments together? Future premiums Include future premiums in the projection or not? If not, reserve runs off quickly If yes, how to assume premium allocation to the account options? PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 4
GAAP hot topics related to indexed products Policyholder behavior assumptions Policyholder behavior assumptions are still mostly limited to surrenders. More advanced assumptions are not fully used by companies either because there is not enough experience or they are difficult to model: Partial withdrawal utilization Dynamic lapse, especially when there are GLWB riders GLWB rider utilization rates Transfer between different indexed accounts and fixed accounts Future premiums PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 5
GAAP hot topics related to indexed products Risk margins Paragraph B2d of FAS 157 notes that the fair value measurement, using present value approach should capture the price for bearing the uncertainty inherent in the cash flows (risk premium) How to apply risk premium/margins? How much risk premium/margins? Application of risk margins gets more complicated with GLWB riders in place PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 6
GAAP hot topics related to indexed products GLWB rider GAAP valuation methodology GLWB rider design is getting more and more complicated. Which accounting guidance is applicable for these riders? SOP 03-1 FAS 133/157 More common However GLWB riders were simpler in design Less volatile Accounting mismatch Proposed changes to market risk benefits may result in a future switch of accounting method Less common Challenges in applying the methodology More volatile Better match with hedging instruments No changes in methodology and modeling if the new proposed changes are adopted PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 7
GAAP hot topics related to indexed products Other GAAP valuation considerations Other indexed product GAAP valuation considerations include Host accrual rate locked in or Dynamic? - Locked in how to reflect true up - Dynamic is the accrual rate recalculated at issue or at valuation date? Whether to include GLWB rider fees and cashflows in the base contract reserve calculation or DAC EGP projection? Scenarios option budget or stochastic scenarios - Option budget does that capture policyholder behavior? - Stochastic scenarios how many scenarios? Run time issue? Option Budget - Different option budget for different crediting strategies? - How often to update/unlock the assumptions? PwC Latest GAAP Development/Hot topics in GAAP reporting Indexed products 8
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GAAP Hot Topics FASB Targeted Improvements II Leonard Reback, FSA, MAAA August 29, 2016
Agenda Participating Contracts Market Risk Benefits SOP 03-1 Disclosures 2
Participating Contracts 3
Participating Contracts Under current US GAAP, participating contracts that meet certain criteria (i.e., FAS 120) are accounted for very differently than other traditional contracts (i.e., FAS 60) Under the proposed targeted improvements, par contracts will be accounted for consistently with other traditional and limited payment contracts 4
Participating Contracts Net premium valuation Updated cash flow assumptions Generally updated annually Net premium ratio retrospectively unlocked subject to 100% cap Current discount rate Based on high-quality fixed-income market rates Updated each reporting period Change in discount rate reported in other comprehensive income (OCI) Possible deferred profit liability (DPL) if limited payments DAC amortized in proportion to inforce without interest accretion 5
Par Contracts Issues These decisions seem to raise some issues particular to par contracts: Discount rate independent from dividend credited rate Locked-in interest accretion rate inconsistent with the fact that par contract credited rates can change over time Accounting treatment of change in dividend credited rate differs from that of change in discount rate 6
Discount Rate / Dividend Credited Rate Mismatch For non-participating contracts the credited rate is fixed at contract inception No dependence on investment returns So a liability discount rate divorced from the investment return rate can be justified For FAS 120 par contracts, the dividend credited rate will depend on investment returns If the discount rate is below the dividend credited rate, can generate loss at inception of profitable contracts If asset yields and liability discount rates change by different amounts, can generate volatility in OCI, even if the asset and liability yields are consistent 7
Par Example 5 year single premium contract with no mortality risk Single premium of $1000 Premium accumulates with interest at 2%; balance paid out at maturity Annual dividend payment equal to investment yield less 2% cash value rate So interest spread always equals zero Since no other source of profit or loss, net income and OCI should also always be zero Assume initial asset yields are 5% Some reinvestment of asset cash flows annually 8
Base Case 1100 1080 1060 1040 1020 1000 980 960 940 920 900 Asset Fair Value Liability Value 1 2 3 4 5 If the liability discount rate equals the asset rate, and rates stay constant, liability values always equal asset values, and income is zero in all years 9
If the liability discount rate happened to equal 4% at inception: 1150 1100 1050 1000 950 Asset Fair Value Liability Value 900 1 2 3 4 5 If the liability discount rate is below the asset rate, the initial liability value exceeds the initial asset value, creating a loss at issue 10
If the liability discount rate happened to equal 4% at inception: 20 10 0-10 -20-30 -40-50 Net Income 1 2 3 4 5 Assuming everything else occurs as expected, the result is an initial loss, followed by offsetting gains in subsequent years, even though economically there should be no income in any year. Net Income 11
Possible Fixes for Discount Rate / Dividend Credited Rate Mismatch Discounting par contract liabilities (perhaps subject to certain criteria) using market returns on the investment backing the liabilities Criteria may require a degree of linkage between investment returns and dividends, such as under the contribution principle Calculating the par liability projecting cash flows based on a hypothetical dividend scale based on the liability discount rate Would be complex to implement Would still leave volatility in OCI since liability discount rate would not move identically to asset rates 12
Locked-in Interest Accretion Rate For non-participating contracts, a locked-in interest accretion rate to calculate net income is consistent with the locked-in credited rate For par contracts, if interest rates decrease we would expect dividend credited rate and projected cash flows to also decrease Calculating net income by discounting these reduced cash flows at a fixed rate would generate an immediate gain, even if spreads remained unchanged And if interest rates increase we would expect dividend credited rate and projected cash flows to also increase A locked-in interest accretion rate would generate an immediate loss, even if spreads remained unchanged 13
If the liability discount rate happened to equal 5% at inception, but rates rise to 8% at end of year 1: 1150 1100 1050 1000 950 Asset book value Liabilities @ locked in rate 900 1 2 3 4 5 Liability at the end of year 1 rises, because increasing projected dividends are discounted at the initial 5% rate. This does not reflect the economics. 14
If the liability discount rate happened to equal 5% at inception, but rates rise to 8% at end of year 1: 40 20 Net Income 0-20 -40 1 2 3 4 5 Net Income -60 The liability increase at the end of year 1 causes a net loss in year 1. This is offset in OCI and reverses in subsequent years. If interest rates drop, we would get a similar gain in that year. 15
Possible Fixes to Locked-in Interest Accretion Rate Calculate net income for participating contracts based on a set of interest accretion rates that are consistent with the pattern of projected dividend credited rates Keeps the discounting consistent with the interest sensitive cash flows May be complex to determine the set of rates Consistent with AAA comment letter and IFRS permitted approach Calculate net income by locking in both the interest accretion rate and the dividend scale credited rates This means that changes in both discount rates and credited rates would be reported in OCI May be complex to maintain as dividend scales change over time Do not require OCI for par contracts Would increase net income volatility due to market rate changes Scope out par contracts from targeted improvements 16
Mismatch between Credited Rate / Discount Rate Changes When discount rate change, the impact is reported in OCI, without impacting the net premium ratio or net income When dividend credited rates change, projected cash flows change, the impact is reported in net income after retrospectively unlocking the net premium ratio Even if the net economic impact of these interrelated items is neutral, the disparate accounting treatments will create noise in net income and on the balance sheet 17
Possible Fixes Exempt changes in cash flows resulting from dividend credited rate changes from impacting the net premium ratio This is essentially consistent with the IFRS approach If a set of interest accretion rates is used to determine net income, the revised rates could be used to retrospectively unlock the net premium ratio This would mean that both the discount rate change and the credited rate change would impact the net premium ratio 18
Demutualization Closed Blocks Demutualization closed blocks would be subject to the same valuation requirements as other participating contracts They will also still be subject to a policyholder dividend obligation (PDO) liability if earnings above glidepath Questions have been raised as to whether it would be worth all the work to apply the proposed guidance to closed blocks At least one potential benefit is that if interest rates rise, liability decrease will be better matched to asset fair value increases, since PDO cannot be negative 19
Demutualization Closed Blocks Some alternatives have been raised by industry: Fair value option for closed blocks Set liability value equal to the asset value Possibly include an additional liability per SOP 03-1 or fair value if future losses are anticipated due to guarantees being in-themoney 20
Market Risk Benefits 21
Market Risk Benefits Two criteria: 1. The contract holder has the ability to direct funds to one or more separate account investment alternatives, and investment performance, net of contract fees and assessments, is passed through to the contract holder. 2. The insurance entity provides a benefit protecting the contract holder from adverse capital market performance, exposing the insurance entity to other than nominal capital market risk 22
Market Risk Benefits So basically, capital market performance guarantees on variable (and similar) contracts Include VA GMDB, GMIB, GMAB, GMWB, lifetime withdrawal benefits VUL no lapse guarantees Possibly some guarantees on some equity indexed products, depending on structure Some market risk benefits are currently accounted for under SOP 03-1, others are embedded derivatives at fair value 23
Market Risk Benefits Under the proposed accounting, all market risk benefits would be treated consistently: Fair value reported on the balance sheet Most of the change in fair value reported in net income Change in fair value resulting from changes in own credit standing reported in OCI 24
Market Risk Benefits Implications Likely more volatility from market risk benefits currently reported under SOP 03-1 Better match with hedging instruments SOP 03-1 does not match with fair value of most hedging instruments Even market risk benefits currently classified as embedded derivatives would report changes in own credit in OCI Less need for bifurcation decisions within market risk benefits More consistency in accounting treatment among market risk benefits But possible inconsistency between, say, a GMDB on a VA and a GMDB on an EIA 25
Market Risk Benefits Transition The Board decided that at the transition date, an insurance entity should measure market risk benefits at fair value in accordance with the guidance. No explicit guidance on how to determine the attributed fee for inforce benefits Retrospective calculation to inception may be difficult and expensive, and require hindsight Retrospective calculation could lead to substantial change to balance sheet at transition date Calibrating to existing SOP 03-1 reserve would avoid these problems, but would auditors permit that? Once the transition balance is determined, the cumulative effect of own credit changes since inception would be recorded in AOCI, the remainder of the balance in retained earnings 26
SOP 03-1 and Disclosure 27
SOP 03-1 A few changes anticipated for SOP 03-1 Discount rate would be unlocked each reporting period (I think) Benefit ratio subject to a 100% cap Under a retrospective calculation this would reduce the liability, but I expect there to be an additional liability or prospective calculation requirement to address this Determination would be made each reporting period if there are projected future losses requiring an SOP 03-1 reserve Currently this assessment is only made at contract inception This would replace loss recognition/pfbl testing for UL 28
Disclosures Lots of additional disclosures, including: Disaggregated tabular rollforwards will be required for most liabilities and DAC assets Reconciliations of the rollforwards to the balance sheet Information about risk management Disclosures about inputs, judgments and assumptions, including the impact of these judgments Ranges and weighted averages of assumptions, as well as comparison to actual experience 29
Disclosures Information about certain adverse developments: Net premium ratio would exceed the 100% cap Establishment of an SOP 03-1 liability for an inforce contract Undiscounted projected future net premiums and benefits (for traditional contracts and SOP 03-1 benefits) Information on account balances by ranges of interest rate guarantees, including the difference between the current credited rate and the guarantee Information about market risk benefit balances that are in-the-money versus out-of-the-money 30
Disclosures Although there are many proposed additional disclosures, requiring a lot of additional work, many of these may be useful to investors A possible exception is the weighted average of assumptions This may be particularly challenging to do Think of GMDB mortality, averaged over many projected years/ages over many projected scenarios for each contract or cell Result may be misleading in some cases, especially if compared to other companies with different underwriting, product mix, customer base, etc. 31