After more than a decade, the FASB published a new standard in August 2018 which provides for Targeted Improvements to the Accounting for Long-Duration Contracts. The new standard is only applicable for insurers and reinsurers. Despite the name "targeted improvements", the new standard has very significant impacts to the accounting for long duration contracts. There are four major changes in the new standard, which include: (1) the calculation of the liability of future policy benefits, (2) a simplified amortization method for deferred acquisition costs, (3) recording market risk benefits at fair value, and (4) enhanced disclosures. Watch our video for a quick walk through of each of these changes.
Hi! I'm Tom Barbieri, a partner in PwC's national office.
And I'm Kara Wilson, a senior manager in PwC's national office.
After more than a decade, the FASB published a new standard in August 2018. The new standard provides for Targeted Improvements to the Accounting for Long-Duration Contracts. It is only applicable to insurers and reinsurers and despite the name "targeted improvements", the new standard has some very significant impacts to the accounting for long duration contracts.
There are four major changes in the new standard. The first is a change to the calculation of the liability of future policy benefits. The second is a simplified amortization method for deferred acquisition costs. The third is a requirement to record all market risk benefits at fair value, and the last is enhanced disclosures.
Tom, can you walk us through the first change?
Sure, Kara. The first change, as you noted, is related to the calculation of the liability for future policy benefits. The new guidance will require companies to at least annually update their cash flow assumptions used in the calculation of the liability.
It also specifies the interest rate used to discount the liability. When a company updates its assumptions, it will have to "remeasure" the liability back to the inception as if it used these assumptions all along. This change will apply to whole life, term, long term care and payout annuities. However, universal life contracts, and participating contracts will not be impacted.
This is a big change for life insurers as the current accounting for "FAS 60" products is to record a consistent margin over the life of the contract which is calculated and "locked in" at inception. Users did not like the method of "setting it and forgetting it", since insurers were not updating margins to reflect their best estimates each period.
I should also mention that the FASB removed the concept of including a provision for adverse deviation, or "PAD," because a provision wasn’t needed since assumptions will be periodically updated to reflect a company’s "best estimate."
Tom, I would imagine that this could lead to more volatility in the financial statements?
Yeah, this was definitely a concern for many preparers, however, ultimately the board believed that this accounting provides better information to users.
Having said that, given the potential for this volatility, the standard requires separate disclosure of this remeasurement in the income statement, so the remeasurement amount is visible to the users of the financial statements.
That's helpful. The other update to the calculation of the liability for future policy benefits that I heard you mention is that the new standard requires the discount rate used to be a single A bond rate. Under the current guidance, the rate was based on an individual insurer's investment yield. Seems like a big change.
Yeah, that is correct. Users did not like that two companies with the same risk could have different liabilities based on their investment strategy. So, now the FASB has required that all companies use a comparable rate which translates to a single "A" corporate bond rate. The rate must also be updated at each reporting period end with the change in the accounting recorded within Other Comprehensive Income, or OCI.
Thanks, Tom. The second change in the new standard is that both users and preparers desired was to simplify the method for amortization of deferred acquisition cost, or DAC, to all long duration contracts.
Users and preparers believed that the current methods which are based on revenue or estimated gross profits were just too complex. What did the FASB do to address the amortization of DAC?
Well, the FASB has introduced a simplified method, that is, under the new guidance DAC must be amortized over the expected term of the individual contract. This method divorces the amortization pattern of DAC from both revenues and profits.
The new standard allows contracts to be grouped consistent with the groupings used for the liability for future policy benefits, provided that it approximates what the amortization would have been on an individual basis. Further, DAC no longer needs to be tested for impairment, nor does it accrete any interest.
Finally, experience adjustments are required to be recognized immediately in the income statement. So, if a contract lapses, DAC associated with that contract will be written off.
Tom, it seems like while they simplified things, it will still require companies to update their current actuarial models for DAC.
Yeah, that's correct.
Thanks, Tom. The next change in the standard relates to features that the FASB refers to as "market risk benefits, or MRBs." What are these benefits, Tom, and why did the FASB create this approach?
Well, often times, variable or fixed annuity contracts include features to protect the policyholder from a capital market risk. This includes various types of guaranteed minimum benefits often referred to as "GMXBs." The goal with this change is to eliminate the diversity in practice that exists when accounting for these contract features.
Market risk benefits are required to be remeasured at fair value with the changes in fair value recorded in the income statement. Except for the part of the change that relates to changes in the credit risk of the insurer, which will be recorded through OCI.
The standard also requires separate presentation of MRBs both on the balance sheet and in the income statement. The hardest part of this change is evaluating which features are going to be included within its scope.
I would imagine that this change will also introduce volatility into the income statement.
Yeah, absolutely, however many companies hedge these risks with derivatives or other financial instruments, so there may be an opportunity to get a natural offset in the income statement.
That's a good point. The last change in the standard relates to enhanced disclosure requirements which may be challenging as preparers will need to make changes to data, systems, and processes to support the new disclosures. What are some of those new disclosures?
Well, the new standard requires disaggregated rollforwards for all of the key long duration balances. It also requires additional quantitative and qualitative information about significant inputs and assumptions used to determine those balances.
These enhanced disclosures will increase transparency, which may lead to more questions from investors and analysts around judgments and changes. Companies will need to consider the potential questions and be prepared to have additional communications.
Well, Tom, given that there is a lot to do to implement the new guidance, what is the effective date of the standard?
The updates are effective as of January 1, 2021 for public companies. And earlier adoption is permitted. Private companies have an additional year.
For public companies this effectively means that when they issue their 2021 financial statements, they will need to adopt the provisions as of 1/1/19. The FASB has provided favorable transition guidance for some of the targeted changes which means they could be adopted on a modified retrospective basis.
Well, companies have a lot of work ahead of them to get ready for the new guidance. But the good news is there are many resources available to help.