U.S. GAAP - Chapter 3 - EXPENSES AND CAPITALIZATION

Background

Statements of Financial Concepts (SFAC)
- SFAC5 - Recognition & Measurement in Financial Statements
  - Guidance for expenses and losses in intended to recognize
    - consumption of benefit - expenses recognized when economic benefit is consumed
    - Loss or Lack of Benefit - losses recognized if it becomes evident taht prev recognized future benefits have been reduced
- SFAC6 - Elements of Financial Statements
  - Expenses - outflows incurred in producing or other activities central to ongong operations
  - expenses represent actual or expected cash outflows that have or will occur as a result of ongoing central operations
- implications - cost not an expense until it is recongnized in co's fin statement
  - example - DAC
  - amortization of the cost, not the original cost that becomes the expense
Statements of Financial Accountnig Standards (SFAS)
- SFAS60 - covers all contract except those reclassified by other standards
- SFAS97 - covers most life and annuity products w/ account values
  - UL/VUL/most fixed def annuities and VA in teh accum stage
  - SFAS60 w/ prems payable < coverage period
- SFAS91 - investment contracts defined in SFAS97
  - in general DAC for GICS, Funding Agreements & DAs w/ minimal SC
- SFAS120 - Par Trad
Terminology
- DAC - amt of capitalized expenses remaining in balance sheet at any reporting date
  - aka Unamortized Aquisition Costs (UAC), Def Pol Acq Cost (DPAC), Unamort Expense Asset (UEA) and expense reserves

Categorization Stipulated by SFAS 60

P26 - maint expenses s/b part of benefit reserve (suggested)
- some co's segregate main exp and report separate reserve
P27 - general expenes not related to acq s/b expensed as incurred
P28 - acq costs ~ acq of new & renewal ins contracts
1994 audits P 8.38 - separate deferral for expenses w/ substantial future utility and recoverable from future revenues => future utility expenses
6 expense categories - mutually exclusive
- Expense Category Asset or Liab Affected
- 1 Deferrable Acq DAC
- 2 Non Def Acq None
- 3 Direct Maint Benefit Reserve
- 4 Investment Expenses DAC & Benefit Reserve
- 5 Future Utility Expense Unique Asset
- 6 Overhead None
- Deferrable Acq Costs - expenses considered to vary w/ and primarily relate to acq of new business
- NonDeferrable Acq Costs - expenses associated w/ NB funtion that dont relate to or vary w/ securing of new policies.
  - ex. new ratebooks, product dev costs (Vx factors, etc)
  - costs in period incurred
- Direct Maintenance Costs - costs associated w/ maintaining records relating to ins contracts & processing of premium collections & commissions
- Investment Expenses - expenses properly chargable against inv income
  - included transaction costs that cannot be capitalized into cost of asset being purchased
- Future Utility Expenses
  - costs of start-up activities, including organization costs s/b expenses as incurred (AICPA SOP 98-5)
  - certain computer hardware and software may qualify for capitalization (AICPA SOP 98-1)
- Overhead - aka indirect cost - balancing item

Expense Categorization Under Other Pronouncements

SFAS91 - Investment Contracts
- tightens rules on loans (compared to SFAS60)
SFAS97 - same expense categories as SFAS60
- % of premium expenses (commis & prem tax) must be separated between deferrable acq and direct maint
- P23-24 - excludes from deferrable category acq costs that tend to be level or recurring => maint expenses instead
Practice Bulletin 8 (AICPA)
- P25 identifies contract admin charges to be included in calc of EGPs as those from P23-24 of SFAS97 (ex ult renewal comm adn recurring prem tax)
SOP 95-1 (AICPA) & SFAS 120
- guidance for mutual co's Par policies
- similar guidance as SFAS97

Line of Business and Category Analysis

studies must be done to allocate expense to 6 categories
- LOB allocation - first, group expenses by LOB, then to appropriate accounting model
- Category determination - costs assigned to appropriate category
  - Then some converted to "unit" basis to make calcs easier
Categorization
- example in book illustrates allocations
- total expenses should tie to statement
Percentage of premium expense allocation
- prem taxes usually removed from study since they can be directly assigned @ policy level
- prem tax and commissions usually stated as % prem in reserve formulas
Allocations of Salary & Other Expenses
- salaries important allocation b/c other expenses (such as EE benefits) can use same allocation
- utilities & rent can be allocated by # EE/ # pol inforce/% prem income
Distinction between Direct Maintenance and Overhead Expenses
- requires judgment
- non-level direct maint expenses (claims settlement exp & limited pay policies after prem period) affect benefit reserve
- level % of revenue expenses do not affect benefit reserve (prem collection expenses)
- entire direct maint cost s/b included in developing benefits reserves
- SFAS97/120 policies - level maint expenses can affect either benefit reserves or DAC
  - General Practice - include entire direct maint costs in generating GAAP A & L
Investment Expenses
- if investments allocate to products w/in LOB, easy to directly assign expenses
- usually expressed as a reduction of investment income
- Inv Income and Expenses generally expressed as % of underlying assets
- % is what is generally used in formulas for benefit reserve & GAAP
Selection of Units of Measurements & Unitization of Expenses
- Types of Per Unit Measures - per policy, per current face amt, per unit issued, % prem
- use judgement in determing most appropriate unit of measurement
- p. 43 - table w/ common choices
- investment expenses - % of underlying assets - bps
  - investmetn expenses/(avg cash and invested asset balances)
- can use muliple units for an expense ex. $150/policy + $2/unit
- u/w cost on a per app basis (not per policy issued) - needs to be converted to per policy
- DI claims adjustment expenses - per $claims paid
- if converting to GAAP, need to develop expense assumptions for earlier years
Other Issues
- some deferrable expense occur prior to policy issue (u/w costs) - could be in separate reporting period
- record as prepaid expense, then wehn policy issued, release and capitalize expense
- backdating - soem cos restate prior period, other include in current cohort
- related party service agreements typically transparent
- expense reimbursements tied to production of business usually deferrable
  - tied to avg # pols inforce - ????
- w/r to large non-recurring expenses, little guidance, but actuary s/b soncsitent between years
- carve out development expenses from overhead to minimize earning distortions
  - this distortions would accelerate earnings
- little experience when starting a new LOB - usually expensed too high and refined as necessary
- re S/A products - expenses associated w/ product should follow the product

Determination of Deferrability of Acquisition Costs

All expenses capitalized are subject to recoverability testing
Commissions
- short duration contracts - entire comm is capitalized
- long duration - excess of first year over ultimate level is deferrable
  - excess of renewal over ultimate is deferrable in renewal years
  - ultimate level - direct maint expense
- question on excess for flex prem F97 products - "facts and circumstances" of each case govern
- beware of commission advancing and chargebacks
- agent financing costs often capitalized
  - if loans - accounted as receivables adn not a DAC element
- commission trailers - usually considered maint
- commission vesting schedule - declining over times - creates higher initial DAC
Expenses Similar to Commissions
- volume bonuses, sales contests, etc - if based on purely new production ,then deferrable
  - capitalized as incurred
- persistency bonus - grey area, but normally considered deferrable, at least in part
  - facts and circumstances should determine
- commission overrides - if % of premium, treated same as commission
  - salary-plus-bonus basis - allocation less clear
  - agency recruitment and training not deferrable
  - sales lead creation and sales illustrations are deferrable
- agency expense allowances & expense reimbursments - if vary w/ production, deferrable
Home Office Expenses
- some mktg and sales expenses deferrable, some not. Are if closely related to selling
- most u/w expenses are deferrable - includes support staff to a degree
- most policy issue expenses are deferrable
- some HO services in support of policy issue (sales illustrations) usually deferrable

Timing of Deferrability

actuary should ensure that expense in reserve formula correlate to actual in financial statement
True-Up
- amount capitalized shoudl equal DAC incurred in financial statement
- SFAS60 P31 - estimated costs can be usded if difference not significant
- Two general techniques
  - direct input of actual quantified dollars
  - conversion and expression of actual dollar values to units for entry into actuarial reserve formulas
- reserve factors normally used for F60 and limited pay F97
  - assumptions locked at issue, basic benefits and guar values don't change w/ time
- F97 & F120 products - easier to use direct input dollars
- SFAS60 P31 i) and II) not significantly different
  - i) implied capitalization derived from reserve formulas
  - ii) actual def acq costs incurred
- approaches used to demonstarte this equality
  - re-enter deferrable cost assumptions preiodically from recently performed studies
  - apply modification factors to certain policies based on issue date (pp 50-52 for details)
Commission Timing
- must be consistent w/ recognition of commissions as a cost in the income statement
- if due premium, commission would have been payable - liab established for cost of collecting unpaid prem and asset for due prem
- if mid-terminal, unearned prem is established. Associated commission is re-established as an asset (aka equity in the unearned prem) and is part of total DAC
- for worksheet approaches, amount is input directly from general ledger
  - will include some prior period commissions, but assumed to be nota significant concern
Anticipation of Future Deferrable Expenses
- future deferrable expenses must be anticipated and estimated in the DAC calc from the issue date forward (ex - heaped renewal commissions)

Recoverability Testing and Loss Recognition

Authority and Definitions
- SFAS60 P32-37 - establish a liability or decrease DAC to provide for probable future losses in a LOB reducing the chance of a loss emerging in the future
- Recoverability - whether a DACable expense is deferrable from exonomic perspective
  - PVGP >= PV (Benefits + Direct Maint Costs + DAC Expenses)
    - if not, remove or reduce PADs and retest
- Loss Recognition - testing fro probable loss on entire LOB
  - prospective recoverability testing on entire LOB of existing business
  - best-estimate assumptions
- Level of Aggregation for Testing
  - consistency - once groupings defined, classifications maintained
  - recoverability - accounting period cohort
  - loss recognition - entire LOB inforce
  - guidance for groupings - SFAS60 P32
    - manner of acquiring - major sales type (direct vs agency)
    - manner of servicing
    - manner of measurement of profitability - F60 vs F97
Gross Premium Valuation Test and teh Order of Adjustments to the Balance Sheet
- compares gross prem valn w/ GAAP net liabilities
  - if GAAP net liab < Gross Prem Valn, probable loss - prem def = difference
  - Gross Prem Reserve (ASOP22) actuarial value future CF disbursements - future CF receipts
    - best est assumptions
- pre-tax
- if a premium deficiency from recoverability resting, order of adjustments
  - F60 - sufficient margins for deviation removed until def eliminated
    - no PADs for 97/120 so this step skipped
  - reclassify expense from def to non-def until deficiency eliminated
  - premium def reserve established such that net gaap liab = gross prem reserve
- if premium def from loss recognition testing, order of adjustments
  - eliminate PADs until deficiency eliminated (F60, no PADs for F97/120)
  - reduce DAC asset until deficiency eliminated
  - prem def reserve established
- once F60 loss recognition occurs, revised assumptions locked in place, unless future loss recognition
  - can't adjust for future improvments
- 20-30 years is usual lifetime of policies modeled (as approx to keep spreadsheets managable)
Exclusion of Interest on Surplus from the Testing
- aka interest on prior profits - should we count it for testing?
- GPV (gross prem reserve) = net GAAP liab - PV future GAAP book profits
  - formulas do not include Int on Surplus
- Int for GPV traditionally level, but can be graded if that is Actuary's best estimate
- exclusion of int can result in some unexpected GAAP losses in preiods of declining int rates
  - due to int related gains on asset sales (not a SAP problem because of IMR)

Relation fo GAAP Expense Assumptions to Pricing Expense Assumptions

start w/ same baseline expense assumptions
potential different classifications across line for pricing, GAAP will have more aggregation
variation in allocation of costs between base/rider/supp benefits
expense assumptions can vary by dur for non-level prem (and some other) palns

Special Expense Issues

Internal Replacements
- DAC asset is NOT carried over from old contract to new contract (SFAS97 P26)
Reinsurance
- SFAS60 P39 - coins allowance apply a negative to DAC to obtain net capitalized position (converse for assuming party)
- timing may differ between direct and reinsured block
Purchase Acctg
- VOBA (Value of Business Acquired) - asset established at purchase
  - might be reduced in anticipation of paying future commissions (1st yr & heaped renewal)
- these commissions s/b reflected in DAC (even though pre-purchase business) & not in VOBA
Discontinued Operations
- APB30 - segregate infrequent transactoins from typical results
- if difficult to allocate expenses to the segment being disposed, transaction should NOT be classified as a disposal trx
- if a loss recognition, GPV @ measurement date indicates loss for block, provide for future losses
- expense assumptions may change due to segregation of assets assigned to a block
- fully allocate expenses to block, including severance etc
- need a way to deal w/ expenses in fun-off mode when block becomes very small

Worksheet Approaches to DAC Calc

works best w/ non-commission acq expenses
if comm included, need to estimate future (heaped renewal) commissions
Static Worksheets
- initial DAC established
- expected inforce schedule created using mortality and lapse rates
- terminal duration selected and amortized to zero
- example p. 65
- drawbacks
  - remaining DAC may be behind/ahead depending on actual persistency
  - no convenient byproduct that extablishes recoverability or facilitates loss recognition
Dynamic Worksheets
- resolve ahead/behind drawback of static worksheets
- takes static results and adjusts by ration of actual/expected cumulative persistency
- F97/120 worksheet (vs F60) would use EGP ro EGM instead of GP as amort basis

Copyright © 2004 Steve Welander.
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