For years, analysts and investors have complained that life and retirement financials aren’t timely or transparent enough. They’ll soon have the clarity they’ve been asking for. In less than two years, many insurers will start to adhere to Long Duration Targeted Improvements (LDTI), a modified accounting standard which the FASB updated to address their main concerns.
LDTI is a sweeping change to the way companies value their obligations: how risky they are, what benefits they may need to pay, how often they need to change their assumptions, and more. The clock is ticking, and there’s a limited window of opportunity to prepare for the new accounting standard. Insurers will need to understand the strategic implications, to recognize the processes that will need to change, and then to decide how to respond.
Here’s one effect to the new standard: it may encourage a new round of insurance deals. This will shift the landscape of winners and losers, and it will create strategic opportunities to reposition blocks/portfolios/businesses through M&A.
The accounting revisions are welcome to many, but there’s no denying that compliance with LDTI could be costly and complicated. (We now estimate that LDTI compliance cost for the industry will top $2 billion.) There have been growing calls for insurers to exit non-core businesses. For some insurers, LDTI will be a catalyst to spin off operations that are no longer central to their strategy. For others, it may provide an opening to move into or consolidate a leading position in certain lines of business.
Here are some opportunities for industry buyers and sellers as the LDTI compliance deadline approaches.
How LDTI changes financial reporting
Nobody ever said that the rules for insurance accounting were easy. When we prepared our Insurance Contracts Guide to help CFOs understand the current standards and guidance for recording insurance contracts, we needed more than 300 pages to address the details. But these are the kind of details that matter: get them wrong, and you could mislead investors and regulators, or worse.
LDTI raises the ante. In 2018, the Financial Accounting Standards Board (FASB) issued its LDTI update to Generally Accepted Accounting Principles (GAAP) through ASU 2018-12 — another 193 pages, if you’re counting. Since then, FASB delayed the implementation date of the new standard until 1/1/2022 for large SEC filers and 1/1/2024 for all others. The new standard represents a material change to the way many insurers and reinsurers report on their business, and it’s laying bare some fundamental weaknesses in some issuers’ operating models.
Some stakeholders are already making their own estimates on how industry players may be affected. They recognize that this is big: it will make earnings more volatile, and it could significantly change balance sheets and income statements. It will also change the way deferred acquisition costs (DAC) are amortized for most long-duration contracts. Many industry insiders welcome the change: it will make for fairer performance comparisons across entities and will give a more realistic perspective on risk. But for some insurers who will struggle with the cost of compliance or may have already been thinking about divesting non-core blocks, or for would-be buyers who want to broaden their industry exposure, these changes may represent a tipping point.
| Some key changes** | Current GAAP | GAAP under LTDI |
|---|---|---|
| Updated assumptions | Assumptions are “locked-in” throughout the life of a traditional life insurance policy and only unlocked when there is a loss recognition event. |
You’ll need to review/update the assumptions you use to calculate actuarial reserves at least once a year (at the same time), and update the discount rate assumption at each reporting date. If evidence suggests cash flow assumptions should be revised, you’ll have to update the actuarial reserve assumptions more frequently. |
| Standard discount rates | Insurers can use “expected investment yield” discount rates, and many choose rates above Single A yields. | All insurance companies will use the same discount rate assumption: upper-medium grade, fixed-income instrument yield (Single “A”.) |
| Fair market value (FMV) benefits | Some guaranteed benefits are valued under an insurance accrual model rather than FMV. |
You’ll report policyholder market risk benefits, such as guaranteed minimum death benefits, at fair value. If there are FMV changes (from other than the insurer’s credit risk), you’ll report them on the income statement. |
| Amortizing deferred acquisition costs (DAC) | DAC is amortized either in proportion to premium recognized or based on the expected future profitability of the underlying product. | You’ll use simpler methodologies for these calculations, reporting amortization on a straight-line basis over the expected life of the contract. |
| Financial statements | (Existing presentation, disclosures) | You’ll present additional information, with disclosures that show disaggregated roll-forwards of future policyholder benefits, policyholder account balances, market risk benefits, separate accounts, and DAC. |
**The examples presented here are representative only, for general guidance. We encourage you to review the FASB standard and consult professional advisors for how the new standard might apply specifically to you.
When the changes were first proposed, many carriers discovered that they didn’t actually have effective ways to determine the full impact of the change given the substantial differences to current reporting. This was a catalyst that led them to lean into some long-needed finance modernization projects, deploying new actuarial software, and creating new data warehouses to support the required calculations. Now, as the implications of the change are becoming clearer, some insurers could emerge as stronger competitors, and others are starting to recognize that some operations no longer make sense as part of their portfolio.
Key takeaway
Some insurers could decide that they don’t want the burden of complying with the new accounting standards for long duration insurance contracts, especially if these businesses are already underperforming or not core to an insurer’s current strategy. This could spur a new round of deal-making between carriers that want to exit and buyers that see this as a strategic opportunity. For example, if you’re not required to report results on a GAAP basis, or if you’re privately held and less concerned about short-term volatility, may have more appetite for business blocks affected by LDTI.
Is your product set affected?
This one is easy: if you work for a company that writes life insurance or annuity contracts, the answer is probably “yes.” But it gets complicated quickly. As historical GAAP results are revised, changes to opening GAAP equity figures will vary by product group. And even if your models are spot on, the precise effect on equity may not be knowable yet because it’s dependent on changes in market interest rates between now and the date that you adopt the new standard. Here’s a quick look at the effects by product line:
- Traditional Non-participating (non-dividend-paying) Life Products
- Life Contingent Limited-Pay Contracts
- Long-Term Care (LTC)
- Participating Whole Life
- Universal Life Products
- Deferred Annuities
Traditional Non-participating (non-dividend-paying) Life Products
Opening GAAP equity may be computed differently due to a variety of issues, from balance sheet optimization to data and system constraints. Some carriers could see equity drop because premium deficiency reserves will be calculated differently. Similarly, the new standard requires companies to calculate reserves using current interest rates, which could be far lower than their historical values. Over the lifetime of traditional products, we expect greater earnings volatility and lower equity volatility, but these may play out differently in the short term.
Life Contingent Limited-Pay Contracts
For these products, the transition will likely decrease equity due to the changes in discount rates and loss recognition, as noted above. LDTI removes provisions for adverse deviations, and this could accelerate profits—but this could be offset by updated assumptions. Then, there are issues with DAC and deferred profit liability. The bottom line: for payout annuity products, changes to equity, profit emergence, and relative volatility will all be highly dependent on a company’s individual circumstances.
Long-Term Care (LTC)
For some time now, there has been a significant bid-ask spread that has held back both would-be buyers and sellers. But, when the transition occurs, changes in the required discount rate and loss recognition events are likely to increase liabilities for many insurers. We could also see more earnings volatility as companies change the way they develop prospective assumptions.
Participating Whole Life
LDTI eliminates shadow DAC adjustments, and this could lead to higher equity as of the transition date. But the impact on profits could vary significantly by carrier, depending on how they estimate gross margins. In general, we expect to see lower volatility for both earnings and equity for this product group going forward.
Universal Life Products
While many universal life insurers will see an increase to equity once the LDTI transition is complete, the effect on profit could vary significantly by carrier. Since DAC and unearned revenue liability is amortized on a constant level basis under the new standard, profitability may depend on subtleties of product design. For insurers with large historical losses, this could add significant expense in future years as they change the way they amortize DAC.
Deferred Annuities
Insurers offering this product category could be affected differently, depending on whether they offer Guaranteed Minimum Benefits (GMxBs). In general, carriers offering GMxBs will need to move to a fair value approach to estimating liabilities; which could increase the liabilities from the current amortized cost method and will increase equity volatility.
Key takeaway
The new standard could have a large effect on equity and profitability, from Day One and over the long haul. But what will the effect be? It will depend on product mix, accounting policy, control procedures, and even system capabilities. Insurers will want to pay close attention to the drivers of change that affect their own financial statements. Some may want to start to think about how they’ll manage compliance, and others may actually decide that they’d be better off by sidestepping the transition through strategic divestitures.
How LDTI may change insurance performance measures
As we noted in the previous section, every company could be affected differently, depending on product mix—and this is only the start of the story. In general, the historical standard allowed companies to “lock in” certain assumptions for long periods unless there were obvious premium deficiencies. Under the LDTI standard, results may be far more variable, and there will clearly be some winners and losers.
Companies need to quickly get a handle on the effects of this transition so they can prepare analysts and investors for these changes. For some insurers, profit measures will shift, and this could also change the key performance indicators (KPIs) they use to run their business and drive external market perceptions.
| Key metric | Potential changes under LDTI |
|---|---|
| US GAAP net income | GAAP net income is a driver for comparisons across the industry, and this value will shift depending on a carrier’s product mix. We expect more net income volatility overall, but even two companies with comparable product offerings could be affected differently. As we move toward greater standardization, this could highlight different companies’ hedging practices. |
| Comprehensive income | This measure typically hasn’t been relevant to users, because traditional insurance liability balances didn’t record the equivalent of “mark to market” adjustments for their future policy benefit assumptions. LDTI will introduce a similar adjustment. Some insurers with particularly effective asset-liability matching may use this chance to differentiate themselves with investors. |
| Non-GAAP measures | Most public life insurance companies already present adjusted operating earnings or an equivalent non-GAAP measure in their financial statements. Carriers may use these metrics to add additional color when they feel that GAAP doesn’t tell the full story. In theory, LDTI could reduce the need for these adjustments, though we don’t expect them to go away. Under new rules, the market and regulators could pay closer attention to what variances are highlighted. |
| Cash and statutory KPIs | LDTI shouldn’t affect metrics such as cash flow, free cash flow, dividend paying ability, and statutory results unless companies make changes to the economic features of underlying contracts or related hedging programs. Because they’re likely to stay unchanged, analysts could pay closer attention to these measures as vital performance indicators. |
Key takeaway
The LDTI standard could fundamentally change the way many companies present their story to the markets. The greater transparency will make it easier for analysts and investors to compare performance. This could put greater pressure on companies with underperforming blocks or without effective hedging strategies in place. Carriers may want to prepare for how they will communicate their numbers under LDTI—but companies may also decide that they’d be better off by simplifying the story that they have to tell.
LDTI and insurance deals – Motive and opportunity
Is it realistic to think that an accounting change could lead to a spate of divestitures? We’d argue that such a shift may already be underway. Here are several factors that could encourage insurance dealmakers in 2020:
- LDTI will be expensive to implement
- Reinsurance transactions could be complicated
- If you combine businesses, you’ll need to choose an amortization approach
- LDTI could change the ways insurers view variable annuities (VA) and LTC coverage
- Some companies will find business lines affected by LDTI more appealing
- Case study: Variable annuities (VAs)
LDTI will be expensive to implement
The new standard requires firms to have a much greater handle on financial reporting, with an emphasis on real-time information. Many companies have put LDTI at the center of finance modernization projects that cross accounting, actuarial, and IT departments. In a recent survey of 26 companies, respondents told us that they plan to spend about $700 million on LDTI compliance, and we estimate that costs across the industry could top $2 billion. At the same time, resources may be hard to find; 77% of those we surveyed said their actuarial resources aren’t sufficient to implement the standard. Some companies may decide to opt out by selling non-core assets that would minimize their LDTI exposure.
Reinsurance transactions could be complicated
If you’re considering a large reinsurance transaction before LDTI goes into effect, make sure you’re prepared. Even if you’re ceding an entire block of business, you’ll still have reporting requirements under LDTI. In some cases, LDTI may lead to results that aren’t intuitive, such as ongoing earnings impact on a net basis after entering into a reinsurance agreement. There are many subtleties here, and there are still active discussions with FASB and the industry on how to interpret the guidelines. There are also operational considerations: companies may need to consider where future servicing and valuation of the reinsured business will be performed. And, reinsurance counterparties could have very different accounting interpretations and reporting requirements from that of cedents. Proceed with caution.
If you combine businesses, you’ll need to choose an amortization approach
As we’ve noted, LDTI simplifies the way you’ll amortize DAC, but other intangible assets and liabilities that you acquire in a business combination may not follow the same rules. There may be operational advantages to aligning your amortization methodologies—but highly acquisitive companies may benefit from retaining their existing approach to amortizing these balances. You’ll want to model and analyze your options.
LDTI could change the ways insurers view variable annuities (VA) and LTC coverage
There have been a handful of recent, notable annuity block deals, and though LDTI hasn’t been their catalyst, that could change. Similarly, there have been a few prominent pension risk transfer (PRT) transactions recently, and LDTI potentially could increase activity in this area. After years of low interest rates, there has been a gap between the way sellers and buyers might view these businesses. Many insurers may have been content to quietly run off these legacy blocks with locked-in actuarial assumptions. Facing the prospect of LDTI, as companies are required to update GAAP balance sheets and reserves, the valuation gap could be closing.
Some companies will find business lines affected by LDTI more appealing
Of the large companies subject to the 1/1/2022 deadline, 25% plan to release quantitative financial results to analysts as early 2Q2020. If you’re already well down the road to a successful LDTI implementation, you may find it easier to take on new business from peers that may be lagging. We also note that private equity (PE) fundraising is at an all-time high, and PE firms are sitting on $800 billion in ‘dry powder’ looking for a home. If you’re open to expanding your insurance presence, you may find sellers who are now more willing to talk.
Case study: Variable annuities (VAs)
VAs were an important part of the financial planning landscape throughout the end of the last century. But the financial crisis, and the unprecedented low interest rates that followed, led to a fundamental mismatch between what investors had paid for and what insurers could profitably provide. Many prominent issuers stopped writing new VA business and put some or all of their existing VA business in runoff. Now, there’s a growing uncertainty about how these blocks will perform. With LDTI looming, many companies may decide that it no longer makes sense to maintain the fixed costs associated with regulatory compliance, training, licensing, and operations for a shrinking product set, especially as keeping this capital-intensive business in runoff status could make earnings far more volatile.
Key takeaway
The timing may now be right for a realignment of buyers and sellers for certain legacy books of insurance business. Some sellers are now recognizing that the cost of inaction could be greater than a prospective write-down—especially when would-be dealmakers have so much capital at their disposal.
- Some considerations for would-be sellers
- Some considerations for would-be buyers
Some considerations for would-be sellers
Run the numbers. How will the new standard affect your company, with and without the specified block(s)? Calculate important KPIs under LDTI using working assumptions. You can then pinpoint where the biggest shifts will be, look at possible levers for managing impacts that don’t reflect underlying performance (e.g. removal of potential “mismatches” caused by the accounting approach in LDTI), and begin to estimate the effort to manage through the turmoil of the next few years. You’ll want to start this process as quickly as possible in light of wider business strategies. The impending deadline could mean there will soon be a much greater supply of run-off blocks on the market.
Assume “no deal.” Develop a pro forma plan for retooling the business in its current form under LDTI rules. What systemic changes will you need to be able to report under the new procedures, given a much greater emphasis on timely comparisons? How will you need to change your KPI suite to adapt to the new standards? Which metrics will help you manage your business across all lines? How will you educate analysts, investors, and your board about what any perceived hits to equity or profitability ‘really’ mean? Quantify this effort so you can assess the opportunity cost to investing in those areas that are a closer fit with your company’s strategy and purpose.
Some considerations for would-be buyers
Understand the structure. There are a variety of ways to structure this type of transaction. You’ll want to determine how to complete the acquisition efficiently in a way that optimizes the accounting, capital and tax considerations for both parties, such as optimal harvesting of net operating losses from existing hedge programs.
Check the models. One of the biggest issues for firms facing LDTI transitions is the inability to get accurate, timely information about risk exposure. How can you evaluate the data quality and financial model integrity underpinning the proposed transaction?
Optimize the balance sheet. You may be able find more cost-effective ways to hedge a given book of business or find other ways to provide funding stability. You may also find ways to increase deal value by examining the provisions in policyholder contracts. Done properly, the due diligence process can help you understand what levers you can control while still making good on your obligations to policyholders and meeting product compliance standards.
Assess the regulatory impact. Many of the products subject to the new LDTI standard have complex regulatory profiles. Be sure you understand how a proposed transaction will change your company’s regulatory exposure in different jurisdictions. Will you need to supplement your existing filings, licensing, registrations, etc.?
Calculate the costs. Cost arbitrage will be at the root of many buy/sell decisions: knowing what costs sellers will need to incur on implementation, relative to what you might need to spend as a buyer.
Review the role of reinsurance. The operational complexities of reinsurance deals will be very different in the future. Make sure you understand your LDTI implementation requirements fully and put appropriate servicing agreements in place for ongoing reporting before moving ahead with large reinsurance deals.
The road ahead
Even after several years of discussion about LDTI, it’s surprising how little many industry observers know about the coming changes. Yes, this an opportunity to transform some core technology systems, from actuarial valuation software to financial ledgers. Yes, this is a chance to rethink data infrastructure and systems, because LDTI will require companies to update accounting processes in some fundamental ways.
However, given the fundamental impacts to business performance and longer-term strategies, we think it’s also a proverbial burning platform.
LDTI is an excellent opportunity for insurers to step back and reconsider their core strengths and business strategies. We believe that a number of companies will take advantage of the change to refine their portfolio mix and step away from those activities that no longer make business sense. Others will use this chance to increase their presence in businesses in which they can excel.
Which side are you on?
Learn more about how PwC can help you prepare for the operational, business, regulatory and market demands of LDTI, as well as drive profitable growth through deals.
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