AcSEC Presentation DAC on Internal Replacements

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AcSEC PresentationDAC on Internal Replacements

• December 11, 2001

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What is the Issue?

• When one contract is replaced by another
  contract, what happens to existing unamortized
  deferred acquisition costs?

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Why is this an issue today?

• Rapid introduction of new products and product
  features
• Convergence of products resulting from business
  combinations
• Marketed as replacements for existing contracts,
  especially near end of surrender period
• Highly competitive environment
• Demographic changes

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What Do We Want to Accomplish Today?

• Broad overview of current long-duration insurance
  products
• Overview of DAC and amortization process
• Task Force tentative views

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Long-Duration Insurance Products
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Annuity Products

• Deferred
• Fixed
• Variable
• Equity Indexed
• Immediate
• Fixed
• Variable

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Life Products

• Low Premium Products
• Term
• High Premium Products
• Whole Life
• Universal Life
• Variable and Variable Universal Life
• Single Premium Life

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Accounting Classifications

• Investment contract - contract where the
  probability that life contingent or insurance
  event payments will be made is remote or present
  value of such payments is insignificant
• Insurance contract - contract where the
  probability that life contingent or insurance
  event payments will be made is other than remote
  or present value of such payments is not
  insignificant

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DAC Overview
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Four Basic Expense Categories

• Deferrable acquisition
• Nondeferrable acquisition
• Maintenance
• Overhead

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Implications of Expense Categories

• Deferrable acquisition - amortized through
  income unamortized balance shown as asset on
  balance sheet
• Non-deferrable acquisition, overhead and
  maintenance - expensed as incurred

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Definition of Deferrable Acquisition Costs

• FAS 60 Guidance
• . . . costs that vary with and are primarily
  related to the acquisition of new and renewal
  insurance contracts. Commissions and other costs
  (for example, salaries of certain employees
  involved in the underwriting and policy issue
  functions, and medical and inspection fees) that
  are primarily related to insurance contracts
  issued or renewed during the period in which the
  costs are incurred shall be considered
  acquisition costs.

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Deferrable Acquisition Costs

• Deferred costs are subject to
• Recoverability testing at time of policy issue
• Loss recognition testing at end of each
  accounting period

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Amortizing DAC
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DAC Amortization - FAS 60 Long-Duration Products

• Amortized relative to premiums
• Factor-based approach
• Assumptions locked-in at issue for both DAC and
  reserves
• Assumptions include provision for adverse
  deviation

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DAC Amortization - FAS 97 Methodology

• Amortized in proportion to EGPs
• Assumptions are best estimate and unlocked each
  reporting period
• Change in estimates result in retrospective
  adjustment of DAC
• Discount rate used to compute the present value
  of EGPs is either
• Crediting rate in effect at inception of
  contracts
• Latest revised crediting rate applied to
  remaining benefit period

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How to Understand FAS 97 DAC Movement

• DAC prior period
• New deferrals
• - Amortization (/- impact of unlocking)
• Interest on DAC balance
• /- Shadow adjustments (OCI)
• DAC current period

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FAS 97 Unlocking Process - Each Reporting Period

• EGPs are replaced by actual gross profits
• Future gross profits must be revised when future
  expectations change
• DAC recalculated from issue change in balance
  impacts net income

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FAS 120 DAC

• Similar to FAS 97 however, uses EGMs rather than
  EGPs
• EGMs include
• Premiums
• Investment income
• Benefit claims
• Administration costs
• Change in reserves
• Annual policyholder dividends
• Other assessments and credits

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Current Accounting Guidance Initial Task Force
Views
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DAC On Internal Replacements

• FAS 97 provided guidance on internal replacements
  of traditional life contracts by universal
  life-type contracts
• PB 8 clarified that FAS 97 applied only to
  replacement of traditional by universal life-type
• Accounting for other internal replacements should
  be based on the circumstances of the transactions
• Diversity in practice for all other internal
  replacements

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Related Guidance

• EITF 96-19 defines when modifications of a debt
  instrument result in a substantially different
  instrument
• Although insurance contracts may contain features
  not common to debt instruments, both are
  long-term obligations
• Thus analogy to EITF 96-19 is considered
  appropriate

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EITF 96-19

• If not substantially different the new debt is
  treated as a continuation of the original debt
• If substantially different the original debt is
  treated as an extinguishment
• Determination of substantially different is based
  on a quantitative test
• gt10 change in present value of cash flows

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What is Substantially Different?

• Due to features not commonly found in debt
  instruments, Task Force is proposing to use
  layers of analysis to determine if substantially
  different
• DOA internal replacements that are always
  considered substantially different
• Qualitative Screens series of questions to
  determine if not substantially different or if
  additional analysis is required
• Quantitative Analysis determine significance of
  the change, is it within a 10 corridor

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DOA - Internal Replacements

• FAS 60 traditional life insurance contract that
  has been replaced by a FAS 97 universal life-type
  contract (FAS 97 guidance)
• Changes in the type of benefit
• Changes in the type of mortality risk
• Changes in the type of morbidity risk
• Long-duration contract to short-duration contract
  and vice versa

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Qualitative Screens

• If internal replacement meets all six criteria,
  then considered not substantially different and
  no quantitative analysis needed
• If negative response to any of the criteria,
  quantitative analysis is required to determine
  the significance of the change in the new
  contract or amendment

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Qualitative Criteria

• Transaction did not result in any reunderwriting
• Substantially the same type of benefits are being
  provided in the replacement contract
• The amount of benefits, mortality and expense
  charges, and surrender charges and period remain
  unchanged
• No parties were compensated, in any manner, in
  the transaction
• No additional deposit required by the contract
  holder
• No change, positive or negative, in the contract
  holders account value due to the transaction

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Quantitative Analysis

• If quantitative analysis required to determine if
  internal replacements are substantially
  different, compare the present value of
  contracts
• future adjusted premium revenue for FAS 60
  contracts
• future adjusted estimated gross profits for FAS
  97 contracts
• future adjusted estimated gross margins for FAS
  120 contracts

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Task Force Tentative Views

• If not substantially different
• Carry over existing unamortized deferred
  acquisition costs
• Capitalize new deferrable acquisition costs
• (FAS 60)
• Amortize aggregate deferred acquisition costs
  prospectively

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Task Force Tentative Views

• If substantially different
• Apply accounting models for termination and new
  contract issuance

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Next Steps

• January 2002 AcSEC Meeting
• Review Task Force tentative issues conclusions
• Definition of a replacement
• Detail of qualitative quantitative tests
• Application example
• AcSEC tentative approval of Task Force approach