The accounting method utilized by these companies works similarly to their operating model—certain assumptions are made about a product, such as the expected mortality and expenses associated with a term life policy, and then the product is priced accordingly and sold to customers. Under current GAAP rules, when revenues and expenses as well as assets and associated liabilities are recorded, those initial assumptions typically remain constant (i.e., “locked in”) throughout the life of the product. The assumptions are subject to annual review, but they are changed for accounting purposes only when a substantial premium deficiency arises. Going forward, this will no longer be the case. Due to the recent adoption of Accounting Standards Update (ASU) 2018-12, Targeted Improvements to the Accounting for Long-Duration Contracts, actuarial assumptions will be regularly “unlocked” and updated over time, resulting in what are expected to be sizeable impacts on both income statements and balance sheets.
To understand the significance of the upcoming accounting changes, it is helpful to understand the rules that have long been in place. Statement of Financial Accounting Standards (SFAS) 60, Accounting and Reporting by Insurance Enterprises, issued in 1982 and currently encapsulated in Accounting Standards Codification (ASC) Topic 944, “Financial Services—Insurance,” recognizes profit over the life of an insurance contract based on actual experience as the contract is released from risk, and distinguishes between short- and long-duration contracts. Short-duration contracts typically include, but are not limited to, most property, casualty, and liability coverage contracts; health insurance contracts; disability insurance contracts; and nonguaranteed renewable term life insurance contracts. Specifically, short-duration contracts have premiums that reset regularly and essentially include all contracts that are not considered long-duration. In May 2015, FASB issued ASU 2015-09, Disclosures about Short-Duration Contracts, which was effective for public entities in reporting years beginning after December 15, 2015. While ASU 2015-09 did amend several sections of ASC 944, those amendments related primarily to disclosures and did not substantively impact the valuation of or accounting for short-duration contracts.
There are two types of long-duration contracts: investment contracts that do not expose insurance companies to the risks associated with policyholder mortality or morbidity, and insurance contracts that do. Investment contracts are accounted for similarly to interest-bearing or other financial instruments. This article does not consider short-duration or investment contracts; because ASU 2018-12 only affects the valuation of and accounting for long-duration contracts, this article focuses only on those insurance contracts, such as whole life or multiyear-level premium term insurance.
Under the current standard, long-duration insurance contracts can be aggregated based on issuance date, attained age, or similar premiums. Cash flow assumptions are set at the inception of the aggregated policies, then locked in (i.e., the assumptions are never changed). These locked assumptions provide the basis for calculating the net premium ratio, a pivotal tool for accruing expenses and liabilities. The net premium ratio is calculated as the net premium (i.e., the amount needed to pay benefits and maintenance expenses) divided by the gross premium (i.e., the amount the customer pays). The resulting net premium ratio is used to estimate benefit expense over the life of the insurance contract and to accrue the liability for future policy benefits (i.e., claims).
Under the current rules, assets resulting from long-duration contracts consist primarily of deferred acquisition costs (DAC), which are directly related to premium revenue and vary with production. In other words, a greater number of initiated insurance policies will lead to higher DAC. Liabilities include claims incurred but not yet reported (IBNR) and a liability for future policyholder benefits (reserve). The reserve is calculated as the net present value of future claims and related expenses less the net present value of future net premiums. The discount rate used is the company’s expected investment yield. Revenue, intuitively, consists primarily of premium revenue, which is recognized when due from customers. The determination of expenses, however, is more involved. Actual claim costs are added to the amortization of DAC, as well as to the change in the IBNR and the reserve. The value of the two liabilities requires significant judgment and estimation and includes provisions for adverse deviation (PAD). PADs are essentially additional buffers for insurance companies whenever claim obligations, mortality rates, or policy lapses are higher than expected.
ASC 944-60-35-5 currently requires an annual premium deficiency test to determine a company’s ability to cover future losses. For long-duration contracts, this test entails comparing the present value of expected future gross premiums to the present value of expected future claims and expenses using current best estimate assumptions. The present value of future claims and expenses, less the present value of future gross premiums, represents a best estimate of the reserve liability. If this amount exceeds the current reserve, net of any unamortized DAC, there is a premium deficiency equal to the excess. In the absence of a deficiency, no adjustments are required, and the original assumptions continue to be used. In the event of a deficiency, a loss equal to the deficiency is immediately recognized by a charge to amortization expense and a reduction in the unamortized DAC balance. If the unamortized DAC balance is not large enough to absorb the entire loss, an increase to the reserve is recorded. The updated assumptions will continue to be used in future periods unless future premium deficiency tests indicate that further unlocking is required.
Journey to the New Standard
A joint project between FASB and the IASB to write a converged standard for the insurance industry was initiated in 2006 and resulted in an exposure draft being issued in 2013. After receiving feedback from interested stakeholders, FASB took the unusual step of pulling back its exposure draft in order to redeliberate, and the joint project was terminated shortly thereafter. The IASB opted to continue with the original, broader scope and issued International Financial Reporting Standard (IFRS 17), Insurance Contracts, in May 2017, with an effective date of January 2021 (tentatively deferred to January 2022). FASB, however, chose to narrow its scope considerably. With respect to short-duration contracts, FASB aimed to improve required disclosures by issuing ASU 2015-09, Disclosures about Short-Duration Contracts.
With respect to long-duration contracts, FASB chose to focus on improving the overall accounting model. In September 2016, it issued an exposure draft and received comments through December 2016. Based on information presented on its website, FASB received more than 450 comment letters between 2006 and 2016 concerning the accounting for long-duration contracts from users, preparers, auditors, industry groups, and others. One major criticism was that the traditional accounting model utilized original assumptions to measure current liabilities, even though long-duration contracts may be in force for many years. Because the use of potentially out-of-date assumptions resulted in less decision-useful information, respondents broadly supported unlocking and updating the liability measurement assumptions.
Most of the concerns raised during the 2016 comment period centered on four topics. First, preparers were concerned with the costs associated with application on a full retrospective basis, as well as with the catch-up provision. FASB agreed to allow adoption on a modified retrospective basis (i.e., as of the earliest year presented on the face of the financial statements) and for cash flow assumptions to be unlocked and updated annually, opposed to quarterly, as originally proposed. Second, preparers and industry groups noted that applicable cash flow assumptions largely include mortality (i.e., death claims), morbidity (i.e., health claims), and lapse rate assumptions, none of which are highly volatile. Recommendations included changing the initially proposed requirement from “update” assumptions at least annually to “review” assumptions at least annually, and FASB agreed to make this change.
Third, preparers expressed concern about the proposed rate for discounting cash flows. In the initial draft, FASB indicated that a current high-quality fixed income instrument yield be used, regardless of the return that an insurance entity expects to earn on its investment portfolio. Preparers noted that the suggested rate would not reflect the characteristics of the insurance liability and suggested that a lower-quality yield would be more appropriate. FASB compromised, and the final standard requires that future cash flows be discounted using a current upper-medium grade (i.e., low-credit-risk) fixed income instrument yield, which is generally interpreted as a Grade A interest yield over a comparable time period. (For example, to calculate present values associated with the cash flows of an insurance contract with a 7–12 year duration, the yield from a high-quality 10-year bond would be used.) Fourth, preparers and auditors indicated disagreement with the proposed method for amortizing deferred acquisition costs. FASB had initially indicated that DAC should be amortized in proportion to the amount of insurance in force, which resulted in concerns that the term “insurance in force” is too narrow. Thus, FASB decided that DAC should be amortized on a constant basis to derive a level amortization amount over the expected life of the insurance contract.
The New Standard
After completing its deliberations, FASB issued ASU 2018-12, Targeted Improvements to the Accounting for Long-Duration Contracts. Exhibit 1 lists its key provisions as indicated in FASB’s August 2018 news release. The standard was originally issued effective for fiscal years beginning after December 15, 2020, but in November 2019, FASB decided to postpone the effective date by one year. The newly adopted standard includes several changes, but two are expected to have the largest impact on both the internal efforts required by insurance companies and the resulting financial reporting: the review (and updating or unlocking, as appropriate) of actuarial assumptions at least annually, and the change from using an unobservable internal measure as the discount rate to using an upper-medium grade fixed income instrument yield. Unlike the unlocking of cash flow assumptions, which must be performed at least annually, the discount rate assumption must be updated at each financial reporting date. Both of these changes are expected to significantly affect the reserve reported on the balance sheet, but the impact will be reflected on different financial statements. Changes to the reserve resulting from updates to cash flow assumptions will be recognized as a current period expense and included in net income; changes to the reserve resulting from updates to the discount rate will be recognized through other comprehensive income.
Key Attributes of ASU 2018-12
- Requires updated assumptions for liability measurement. Assumptions used to measure the liability for traditional insurance contracts, which are typically determined at contract inception, will now be reviewed—and, if there is a change, updated—at least annually, with the effect recorded in net income.
- Standardizes the liability discount rate. The liability discount rate will be a standardized, market-observable discount rate (upper-medium grade fixed-income instrument yield), with the effect of rate changes recorded in other comprehensive income.
- Provides greater consistency in measurement of market risk benefits. The two previous measurement models have been reduced to one measurement model (fair value), resulting in greater uniformity across similar market-based benefits and better alignment with the fair value measurement of derivatives used to hedge capital market risk.
- Simplifies amortization of deferred acquisition costs. Previous earnings-based amortization methods have been replaced with a more level amortization basis.
- Requires enhanced disclosures. These include roll forwards and information about significant assumptions and the effects of changes in those assumptions.
As a result of the annual required unlocking of cash flow assumptions and the quarterly updates to the discount rate applied, PADs will no longer be required, nor will a premium deficiency test have to be conducted. Removing PADs is expected to cause increased reported DAC assets and decreased reserve liabilities early in the life of a product, although these results will reverse over the product’s life. PAD removal is also expected to have a large impact on the timing of benefit and expense recognition, and thus the recognition of income. Total income over the life of the product will be equal under the prior and impending accounting standards (all other things being equal), but the timing of recognition will be much different, with higher income levels reported early and lower income levels reported later under the new standard. The following numerical example illustrates how this single accounting change can affect the balance sheets and income statements of insurance companies.
This example assumes that there is no difference between actual and expected mortality or lapses, as well as no changes to discount rates. The primary difference between the old standard and the new standard reflected in the figures is the removal of the PADs in the projections for the new guidance. This single difference, though, will cause an overall increase in projected face amounts in force throughout the 35-year term because projected mortality and policy lapse rate assumptions are lower without the PAD buffer (Exhibit 2). The increased amount is more visibly evident for the initial 10-year life of the product with the largest difference, $5.01 million (11% of total in force), appearing at year 4. After year 10, the face amounts in force under the two accounting standards become more similar due to the convergence of projections with reality as time passes. In addition, regular step-downs in the face amounts in force take place at years 10, 15, 20, 25, and 30, as policyholders reach the end of their level premium period. These drops, sometimes referred to as “shock lapses,” are normally experienced by insurance companies on this type of product and refer to large policy lapses associated with higher assessed premiums after the level premium period (i.e., customers opt out of renewing, causing noticeable decreases in the remaining face amount in force).
The effects of a higher face amount in force flow through to both the balance sheet and the income statement. With respect to the balance sheet, the higher face amount in force directly causes an initial increase in DAC (i.e., an asset calculated as a percentage of face in force). In addition, due to decreased assumed mortality rates associated with the removal of the PAD, projected claim costs will decrease. Lower projected claim costs will result in decreased projected required reserves (i.e., a liability); therefore, early in the life of the product, the new standard will cause insurance companies to report higher assets and lower liabilities.
DAC will initially be higher under the upcoming standard due to the increased face amount in force; however, it will also be amortized on a straight-line basis, typically as a function of the face amount in force over the life of the product, which accelerates the amortization after year 1. This results in higher initial DAC balances, but lower reported DAC assets for the majority of the 35-year term used in this example.
The removal of the PAD requirement will have two competing effects on liabilities. The reserve liability will decrease due to lower projected mortality rates (i.e., the PAD buffer will not be required), but that reduced liability will be moderated somewhat by an increased reserve requirement associated with the higher assumed face amount in force. Overall, under the upcoming standard, the projected reserve liability will be consistently lower throughout the illustrated 35-year product life (Exhibit 3).
The largest annual difference ($66,459), which appears in year 15, represents a 21% reduction compared to the old standard. At maturity, DAC will be fully amortized and the reserve completely utilized, and accordingly, asset and liability balances under both standards will ultimately be reduced to zero.
With respect to the income statement, pretax accounting income is calculated as total revenue minus benefits minus expenses. Total revenue, consisting of gross premiums and investment income, is assumed to be equal under both standards. Benefits consist of both death benefits and changes in the reserve liability. Death benefits are equal under the current and upcoming standards; however, as discussed previously, the increase to the reserve will be lower overall under the new standard. Exhibit 4 illustrates how total benefit expense will be recognized under both standards. Total benefit expense will initially be $13,270 (17%) less under the new standard. Because increases to the liability account early in the life of the product will be lower under the new standard, subsequent decreases later in the product’s life will also be less. Total benefit expense is approximately equal under the two standards in year 16, but thereafter the upcoming standard will result in a higher annual total benefit expense. The largest differences, $8,501 and $8,847, are seen at the 20- and 30-year shock periods, respectively.
Other than benefit expense, the only difference in expenses under the two standards is the amortization of DAC. With the new standard, DAC amortization will be on a straight-line basis, typically as a function of face amount in force, which in this example increases during the first year and runs off thereafter. As discussed previously, by the end of the first year, DAC will be higher under the new standard due to increased projected face amount in force, resulting in more deferral of acquisition costs and lower amortization in the first year of the product life. This will directly lead to an increased amount of DAC amortization over the remaining life of the product, specifically $2,791. In addition, DAC will amortize faster in the early years after year 1 under the new standard due to differences in the amortization method. Exhibit 5 illustrates how amortization is recognized under the two accounting standards; year 5 amortization will be $3,447 (38%) higher under the new standard. The accelerated amortization under the new standard reverses as compared to the old standard at the 20-year mark, when the largest proportional shock lapse occurs.
To better reflect the combined income statement effect of the new accounting standard, Exhibit 6 reflects how projected pretax accounting income will differ before and after implementation. Although total income is the same under both during the 35-year product life, recognized profits under the new guidance are higher earlier in the product life. At year 1, the $19,721 total increase in pretax accounting income under the new standard comprises a $13,270 reduction in required reserve increase (due to the elimination of the PADs), a $4,175 reduction in DAC amortization (due to the change in amortization method), and a $2,276 increase in deferred acquisition costs (due to a higher face amount in force).
During the first 15 years, the existing guidance requires a higher reserve to be maintained due to the mandated PADs, which causes an increase in reported benefit expenses and thus reduced profits. In later years, the release of that higher reserve under the current standard reduces benefits, resulting in increased profits that are particularly noticeable at the 20- and 30-year shock periods. Because there is no PAD buffer under ASU 2018-12, the reserve releases are smaller than under the current standard, resulting in lower income in the later years of the product’s life. Again, total pretax accounting income over the life of any cohort of contracts will be equal under the two standards, but it will be recognized earlier under the new approach.
The impact to the income statement of any insurance company will depend on its mix of business by contract year. It should be noted that entities with a higher concentration of new or recently issued long-duration contracts will be more profoundly affected by the implementation of ASU 2018-12 than companies with a larger proportion of short-duration or more seasoned long-duration contracts in force. In addition, there could be a significant difference in the earnings impact reported by an entity depending on the contract year in which the new standard is implemented.
Under the modified retrospective transition approach indicated in the new standard, the differences in the reserve and DAC will be reflected in retained earnings in the year of adoption. To illustrate the impact of this approach, assume that a company with the block of business depicted in this example transitions to the new standard at year 15, at the peak of the net reserve difference shown in Exhibit 3. This company would report both lower benefit reserves and a lower DAC balance at transition. Specifically, the transition adjustment to retained earnings would, in this illustrative example, be over $66,000, pretax. As a result, assuming everything else is equal, the company’s pretax accounting income reported post-transition over the remaining reporting periods for this block of business would be $66,000 lower than the pretax result expected under the current standard. This transition effect is smaller both before and after the net reserves reach their peak. The pretax accounting income pattern will follow the pattern shown in Exhibit 6 from the transition year forward.
Life insurance companies with a relatively high proportion of long-duration contracts will likely be most affected by ASU 2018-12. SEC Staff Accounting Bulletin (SAB) 74, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period, requires disclosures of the expected impact of recently issued accounting standards on financial statements. Because the ASU’s effective date is still well in the future, however, companies are not yet providing detailed information. A review of the 2018 financial statements of the largest 25 insurance companies, as ranked by AM Best based on total assets, suggests that companies are still assessing the impact of ASU 2018-12. Eight companies disclosed that they are still evaluating the standard and expect a material impact, while 14 disclosed that they are still evaluating but gave no indication of the expected impact. Three companies did not mention ASU 2018-12.
Exhibit 7 includes 2018 10-K disclosures of AM Best’s top five companies, beginning with the largest entity. Much more detailed disclosure is anticipated in future filings, which might include information on the proportional mix of business between short- and long-duration contracts.
Excerpted Disclosure Comments Regarding Financial Statement Impact
“The options for method of adoption and the impacts of such methods are under assessment. The magnitude of such adjustments is currently being assessed.” (Prudential)
“We are evaluating the effect this standard will have on our Consolidated Financial Statements.” (Berkshire Hathaway)
“The Company has started its implementation efforts and is currently evaluating the impact of the new guidance. Given the nature and extent of the required changes to a significant portion of the Company’s operations, the adoption of this standard is expected to have a material impact on its consolidated financial statements.” (MetLife)
“The adoption of this standard is expected to have a significant impact on our consolidated financial condition, results of operations, cash flows and required disclosures, as well as systems, processes and controls.” (American International Group)
“We are currently evaluating the impact of adopting this ASU on our consolidated financial condition and results of operations.” (Lincoln National)
While the requirement to remove the PADs under ASU 2018-12 will considerably change the emergence of earnings by insurance companies, there are several other aspects of the standard that could also have a significant direct effect on earnings, namely the quarterly updating of discount rates and the annual unlocking of cash flow assumptions; these warrant further analysis. Furthermore, there are many potential implementation concerns that users or preparers will need to consider, such as the gathering of large amounts of prior-year data and decisions concerning how to best aggregate contracts going forward. In addition to obtaining the necessary information (i.e., prior data, interest rates, actual cash flows), companies will likely need to undertake significant reprogramming efforts and potentially update existing computer systems.
The authors thank Steve Malerich, Fellow of the Society of Actuaries, for providing projected cash flows, reserve requirements, and DAC for a notional $60,000,000 face value of policies in force, 5- to 35-year level term product.