LDTI and deals

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

For more details please see these PwC perspectives.

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.

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.