In It for the Long Haul: Updated Accounting Guidance for Long Duration Insurance Contracts
After more than 10 years of research, exposure drafts, and various rounds of deliberations, the FASB has issued ASU 2018-12 Targeted Improvements to the Accounting for Long-Duration Contracts. Acknowledging that there was room for improvement, simplification, and more relevant disclosures, the FASB made three important changes to insurers’ accounting model for life, disability income, long-term care, and annuity products. The main components of the new standard include the re-evaluation of insurance liabilities on a periodic basis rather than locked in assumptions from contract inception date, the addition of the market risk benefits concept, changes to the amortization method of deferred acquisition costs (DAC), and enhanced disclosures for long duration insurance liabilities and DAC.
Policyholder Benefits Liability
- The new standard alters one of the hallmarks of life insurance reserving, under which reserve projections were based on assumptions (e.g., discount rate, mortality, terminations, and expenses) applicable at the time the insurance contracts were made. Barring premium deficiency, these assumptions would continue to be used throughout the life of the contracts. Now insurers will be required to “unlock” those assumptions at least annually and calculate an updated net premium ratio to reflect the actual experience since inception.
- Changes in reserves based on the revised assumptions will be reported as a remeasurement gain or loss, a separate expense line item on the income statement.
- Also included is a change to the discount rate methodology which replaces the insurance company’s expected investment yield approach with the use of observable current market interest rates for upper-medium grade bonds (i.e., A rated fixed income securities). Discount rate assumptions will be updated on a quarterly basis, and changes will be recorded through other comprehensive income (OCI).
Market Risk Benefits
- A new provision under the standard created the market risk benefits category. This guidance addresses the accounting for contract features that protect the policyholders from capital market risk (i.e., equity market or interest rate risk) at the expense of the insurer.
- Market risk benefits will be recorded on the statement of financial position, separately, at fair value. Changes in fair value will be recorded separately on the income statement, and if the changes are instrument-specific they will be recorded separately through OCI.
Deferred Acquisition Costs (DAC)
- The new standard replaces the previous requirement to amortize deferred acquisition costs based on estimated gross profits with a straight-line model. Due to the fact that assumptions are annually “unlocked,” the new guidance eliminates the annual requirement to test for premium deficiency.
The update also requires several new disclosures including liability rollforwards and information about significant inputs, assumptions, and methodologies used in the reserve measurement.
Effective Date and Implementation Details
For public entities, the ASU is effective for fiscal years beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021. For non-public entities, the ASU is effective for fiscal years beginning after December 15, 2021, and interim periods within annual periods beginning after December 15, 2022. Early adoption is permitted for all entities.
While the effective date for these changes are still several years away, life insurers reporting under GAAP need to start implementing changes to their processes, systems, and controls necessary to comply with the new guidance.