By Tom Jaros
There is an old adage: “What gets measured, gets managed.” Under generally accepted accounting principles (GAAP) targeted improvements, much more will be measured.
This added clarity will allow internal and external stakeholders to see how reserves interact with other parts of the income statement. Additional measurements and disclosures have the potential to greatly enhance the stakeholder understanding of net income, other comprehensive income (OCI), hedging, and experience studies.
What will this mean to the management of insurance companies? What practices may change as we move forward?
GAAP Targeted Improvements—High Level Overview
- Covered by ASU 2018-12.
- First disclosures required in 2021, with at least a three-year lookback.
- Reserves will be calculated by product group, and by at least issue year.
- Reserve assumptions will be updated on a regular basis, with an elimination of the locked assumption approach.
- The discount rate will be based on an upper-medium-grade (low-credit-risk) fixed-income instrument yield, as opposed to a yield on the underlying assets.
- A concept similar to unrealized gains and losses on reserves will be added to OCI.
- Deferred acquisition cost (DAC) amortization will become much simpler, moving to a straight-line basis.
- Many SOP-03-1 reserves will move to a fair value approach, commonly known as FAS 157.
- Many disclosures related to reserve rollforwards and experience studies will be added to financial statements.
What Are GAAP Targeted Improvements?
Before we get into the nitty-gritty, we need to define what GAAP targeted improvements are. Specifically, we’re talking about targeted improvements to the accounting of long-duration contracts issued by insurance companies.
The Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update (ASU) in August 2018 “to improve financial reporting for insurance companies that issue long-duration contracts such as life insurance and annuities.”[1] According to FASB, “the objective of the ASU is to improve, simplify, and enhance the financial reporting of long-duration contracts, by providing financial statement users with useful information in a timely and transparent manner.”
How close the ASU comes to meeting that goal will be seen after implementation in 2021—but read on for what we can watch for in the run-up to the new standard taking effect.
Net Income Management
GAAP targeted improvements will require the disclosure of reserve rollforwards. It will also require, “Actual experience during the period for mortality, morbidity, and lapses, compared with what was expected for the period.” This places us very close to a source of earnings analysis. Assuming a simplified life product, the before-tax net income could be expressed as follows.
Gross Premiums – Net Premiums
+ Net Investment Income on Equity
+ RsvRel(Mortality) – Death Benefits
+ RsvRel(Lapse) – Surrender Benefits
+ RsvRel(Morbidity) – Morbidity Benefits
+ RsvRel(General Expenses) – General Expenses
+ Investment Income on Reserves – (Discount Rate Applied to Reserves)
– DAC Amortization
+ Adjustments for experience deviations
Where RsvRel = Reserves Released
If reserve assumptions are met, and investment income is aligned to the discount rate, this reduces to:
Gross Premiums – Net Premiums
+ Net Investment Income on Equity
– DAC Amortization
The concept of a net premium will likely become much more important to stakeholders. It becomes the tool for measuring a steady state. Many investors, and hence management, do not like the noise surrounding deviations in mortality, lapse, etc. Under GAAP targeted improvements, all of the noise will be much more visible.
There will be two types of adjustments for experience deviation. The first will come from adjusting the calculations for experience during the last quarter, sometimes referred to as true-ups. The second will come from changing assumptions, sometimes referred to as unlocking.
The disclosures will come close to requiring a source of earnings analysis, but not quite.
- First, there is not a requirement to allocate investment income by product group and issue period, and compare this to the discount rate. Not all companies have tracked investment income by both product group and issue period.
- Second, there is not a requirement to track history on expenses by product group and issue period.
This leads to many questions:
- Will companies want to complete an investment income component in the source of earnings analysis? Methods for allocation of investment income by issue period were established back in the 1980s. If this analysis is done, will this lead to a new way to measure investment teams?
- Will companies want to increase disclosures on general expenses? Expenses are sometimes glossed over in reserve calculations, yet management of expenses is one the most commonly utilized tools of CFOs.
- Under GAAP targeted improvements, reserves will be tracked by issue year, with the option to track by issue quarter. To what extent will companies want to use the “quarter option” to allow better analysis of pricing efforts, which may vary frequently?
- Will analysis of blocks by issue period lead to greater use of reinsurance? The profitability of old blocks will become more apparent, which may lead to unloading old blocks in order to meet future profit targets.
Other Comprehensive Income Management
OCI has often been overlooked in the past. One of the key components of OCI has been unrealized capital gains and losses on assets. Unfortunately, for many products, there has not been an offset for the impact of current interest rates on reserves. This has led to great volatility in OCI—one of the reasons for OCI to be ignored by some. Under GAAP targeted improvements, this changes. OCI will become a much better indicator of the level of asset liability management (ALM).
GAAP targeted improvements will place the reserve changes due to interest rate changes in OCI. This will be akin to unrealized gains and losses on reserves, an offset to unrealized gains and losses on assets. As such, ALM may lead to reduced volatility of OCI.
There are some caveats. Much ALM work in the past has been completed on a risk-neutral basis. The OCI reserve impact will be based on changes to upper-medium-grade fixed-income instrument yields, a real-world measure. Will the GAAP targeted improvements lead to more real-world ALM analysis?
One final note. I will never forget a chief investment officer (CIO) who did not trust ALM reports. These reports would state that surplus would change by $X million for a 1-basis-point change in interest rates. He stated that interest rates had changed by much more than 1 basis point several times, and he had never seen the financial impact. Perhaps this CIO will fall in love with the new OCI. Changes in GAAP equity will be very visible when ALM is indicated differently under these changes..
Hedging
Hedging of benefits making use of SOP-03-1—e.g., guaranteed minimum death benefits—has been difficult. Changes in SOP-03-1 reserves has not been well aligned with existing hedging instruments. These instruments have always been better aligned with Financial Accounting Standard (FAS) 157.
Under GAAP targeted improvements, many products with SOP-03-1 reserves will now make use of FAS 157. For those deciding to hedge such benefits, volatility on financial statements will be significantly reduced.
Experience Studies Management
Experience studies have been a key item in deciding when to unlock assumptions for reserve calculations. For most companies, investors have not been privy to this information. This all changes under GAAP targeted improvements, when experience studies for mortality, morbidity, and lapses will be disclosed. Some of the experience studies may be new to internal managers. Internal managers may want the ability to drill down. Looking at the aggregate trends will also be important.
The disclosed experience studies will undoubtedly create both questions and the desire for additional disclosure. ASU 2018-12 states that an insurer will want to make disclosures such that “useful information is not obscured by the inclusion of a large amount of insignificant detail.” Determining the right amount of detail may be difficult. Published experience studies will be at a fairly high aggregate level. This leads to more questions:
- What will happen when there is an assumption unlocking without any warning coming from published experience studies? Will companies provide more information?
- What happens when investors see an aggregate trend, yet no action is taken? The lack of action may be due to analysis at a more granular level, where deviations do not appear material. Will actuaries determine different methods when large block assumptions appear material but experience is not material for smaller blocks?
Actuaries may become much better at explaining how things not included in the experience studies may impact the setting of assumptions. Changes in competitive environment and new government regulations can be important factors that will not show up in experience. Product features not yet reflected in experience can also be important determinants. The selection of assumptions will become much more public.
Conclusion
GAAP targeted improvements will provide a much greater level of information to all stakeholders. The interaction of reserves with other parts of the income statement will provide new levels of understanding. This may lead to significant changes in management practices. It may also lead to the next set of targeted improvements.
TOM JAROS, MAAA, FSA, is currently operating in Houston.
Endnote
[1] “Accounting Standards Update 2018–12”; FASB in Focus, Financial Accounting Standards Board.
