U.S. GAAP - Chapter 7 - DEFERRED ANNUITIES

Overview

characteristics of current DAs
- premium pattern - SPDA & FPDA
- load structure - FEL, BEL (SC) or combo. BEL most common
- surrender Value - typically prems rec'd + credited int - prior partial w/d - SC
  - typically has 10-15% free partial w/d provision
- int guarantee structure - guaranteed for a year or less subject to floor.
  - based on co experience and competitive considerations
  - sometimes guaranteed longer (SPDA products)
- taxable nature - tax-qual or nontax-qual.
  - tax-qual deposits deductible on taxes
  - both - int not taxed until w/d
  - all w/d taxed to extent not previously taxed
features
- db = max(fund value, prems paid)
- bailout - SC waived if actual rate credited falls below a set limit
- MVA annuities - normally SPDAs
  - if early surr, SC and MVA
  - adjustment normally defined in contract
- bonus annuities - either extra $ added to fund value or bonus int rate - typically 1st year only
- two-tiered annuities - one int rate for accum to annuitizaton, one rate for accum to surrender

Accounting Model Classification

older annuities fall under f60 - issued before F97, prems fixed by contract, int guarantees and benefits bundled (similar to trad life)
- prems considered revenue
- reserves calced vial NLP
- DAC amortized w/r to premium revenue
most modern DAs dont qualify for F60 for 2 reasons
- product features unbundled - excess int, expense charges & SC explicitly defined by contract
- prems not fixed - can be varied w/o insurer consent (w/in contract limits)
to classify properly, need to know
- accum and payout phase - single contract or two contracts
- if contract contains significant mort guarantees
- significant sources of revenue other than investment of contractholder funds
"significant" mort risk - generally disregard the presence of guaranteed purchase options in DA contracts as significant mort risk
usually defined as an Investment Contract
AICPA Practice Bulletin 8 reinforces thinking - most DAs either F97 or F91

Benefit Reserves

F97 for Investment Contracts
- generally use UL guidance for defining reserves and DAC asset
- liab for policy benfit = account value
  - + amounts assessed for future services (fees, FELs)(URL)
  - + previously assessed amounts refundable at termination [seldom applicable to DAs]
  - + any probably loss (prem def)[n/a to inv contracts]
- URL accrues in direct proportoin to gross profits
- accrual s/b made for int bonuses (& accrual s/b part of gross profit calc)
F91
- DAs w/ little or no SC & no add'l DB other than account value
- policy liab = account value using retrospective deposit method
- if no explict acct value, prospective method using best-estimate assumptions w/o PADs
DAC and FEL considerations
- Practice Bulletin 8 - DA F97 DAC s/b treated as an asset like UL
  - not explicitly stated, but same method used for F91
- Commissions and CREs are primary acq costs, but anything else that qualifies under F60 s/b OK
- FEL in excess of ongoing service loads s/b deferred as Unearned Revenue
- DAC amortizes and URL accrues w/r to EGP for F97, int method for F91
DAC Amortizatoin under F97
- uses saem revenue defintion as F97 UL
- use gross profits as revenue for amortizing DAC and accruing URL
- Definition of Gross Profits
  - F97 P23 includes the following EGP items
    - amounts expected to be assessed for mortality less benefit claims in excess of PO balances
    - amounts expected to be assessed for contract admin less costs incurred for contract admin
    - amounts expected to be earned from investment of PO balances less int credited to PO balances (int margin)
    - amounts expected to be assessed against PO balances upon contract termination (SC)
    - other expected assessements and credits
  - best estimates over life of contract w/o PADs
  - for DAs, admin, int and SC are most significant items (particularly int margin)
  - mort margin usually trivial unless rider w/ significant mort charges included
  - other includes things like contingent bonus accruals
  - Excluded items: DAC, deferred excess FEL, FIT
  - Included : recurring acq expenses, ultimate level of commissions, PT
  - Overhead is excluded
  - Int Margin is to include realized g/l
  - AICPA Practice Bulletin 8 - Expected G/L s/b included since projected future income should include expected total yield from these investments
  - int margins should include impact of policy loans if applicable
- DAC Amortization Process
  - F97 DAC - amortized in proportion to EGP revenue each accounting period over the period that such revenue is recognized (often capped at x years)
  - many co's use worksheet approach
  - some co's use valn systems that calc DAC at contract level
  - amort process can be expressed using eithe retrospective or prospective approach
  - k(0) = pv(DAC)(0) / PV(EGP)
  - assumptions not locked - replace EGP w/ actual each acctg period (true-up)
    - update best estimate assumptions if warranted
    - k(t) updated each accting period
      - recalc is as of original issue date
      - adjustments to balance made to current and future balances - don't restate past financials
  - if k(0) > 1 at issue, recoverability problem may exist
    - k(0) recalced using estimated earned rate (instead of credited rate)
      - confirms earnings will be available if needed and maintain consistency w/ loss recognition concepts
    - if still > 1, reduce DAC until k(0) = 1
      - reduction charged against earnings in current acctg period
  - F60 procedures for handling recoverability problmes
  - if PV(EGP)(0) < 0, no DAC is established
    - no additional reserve req'd to make up deficiency
  - possible for GAAP loss in all future years for F97 DAs
  - adhere to general guidance in F60
  - if significant profits expected in one or more periods
    - PV(EGR, Gross Costs, or balance of Ins inforce) s/b substituted as base
  - int rate for k(t) is either
    - rate in effect at contract inception
    - actual prior credited rates and latest revised rate for future periods
  - int rate choice must be used consistently for all future years for cohort
EGP & DAC formulas
- assumptions
  - EGP derived from investment and expense margins and SC
  - all commission expressed as % of prem
- Definitions
  - t - contract or calendar year
  - n - # years to end of revenue period
  - GP(t) - expected GP collected in year t
  - m - # prem payments per year
  - C(t) - deferrable commision rate in year t
  - i(t) - credited int rate for year t
  - I_E(t)/AI_E(t) - expected/actual earned rate
  - I_C(t)/AI_C(t) - expected/actual credited rate
  - E_A(t)/AE_A(t) - expected/actual admin costs
  - E_C(t)/AE_C(t) - expected/actual admin contract charges
  - SC_E(t)/SC_A(t) - excpected/actual SC
  - EGP(t) - EOY value of EGP(revenue) in year t
  - AGP(t) - EOY value of AGP in year t
  - DAE(0) - non commission deferrable expenses @ issue
  - CAP(t) - BOY cap acq costs
    - = DAE(0) + C(1)*GP(1)*(1+i(1))^{-(m-1)/2m} in year 1
    - = C(t)*GP(t)*(1+i(t))^{-(m-1)/2m} in renewal years
  - DAC(t) - DAC asset at end of policy year t
  - DAC_CY(t) - DAC asset at EOY t
  - k(t) - amort factor for AGP/EGP in year t
- Formulas
  - EGP(t) = (I_E(t) - I_C(t)) + (E_C(t) - E_A(t)) + SC_E(t)
  - k(0) = sum(CAP(s)/prod(1+i(p))) / sum(EGP(s)/prod(1+i(r))) for s=1 to n; p=0 to s-1; r=1 to s
    - assume CAP(s) - BOY value and EGP(s) - EOY value
  - k(t) = sum(CAP(s)/prod(1+i(p))) / [sum(AGP(v)/prod(1+i(v))) + sum(EGP(w)/prod(1+i(w)))] for s=1 to n; p=0 to s-1; v = 1 to t; w=t+1 to n
  - Retrospective formula for DAC (end of contact year)
    - DAC(t) = (DAC(t-1) + CAP(t))*(1+i(t)) - k(t)*AGP(t)
  - Prospective
    - DAC(t) = k(t)*PV(future EGP revenues) - PV(future deferrable costs)
  - Calendar year apporx
    - DAC_CY(t) = 0.5*(DAC(t-1) + DAC(t))
  - if amort schedule developed from first principles, validatoin of model data w/actual inforce data s/b done
    - validate account value, commissions, policy count, & premium at a minimum

DAC Amortization under SFAS91

Practice Bulletin 8 - recognize acq and int costs as expenses @ constant rate applied to net policy liab
interest method
generally defined as diff between policy liab and notional account value, calced @ solved for BE rate
BE rate - rate where policy liab @ issue = notialnal account value + PV(est DAC) <- @ assumed credited rate
after issue, notional acct valued calced using original BE rate and remaining DAC is diff between notional acct value and policy liab @ valn
Int method generally used when policy liab calced under prospective method
if contract has explicit account value, retrospective method used in practice & handled more like F97 product, including using EGPs
F91 Inv Contracts not subject or recoverability analysis or loss recognition testing
in practice, amt of DAC allowed @ issue is limited if BE rate exceeds co's best estimate of investment rate
if DAC is eliminated and best est rate is still < BE rate
- NO add'l reserve req'd & losses each year earned rate < BE rate

Accrual of Unearned Revenue Liability (URL)

FEL in excess of level renewal service loads are deferred
F97 P20 FEL - amt assessed that represnt compensation to insurance enterprise for services to be provided in future periods
FEL genearlly associated w/ DAs subject to F97 investment contract acctg model
recognition of deferrable FEL reseults in establishment of URL
excess loads deferred each acct period as incurred and realased into earning in proportion to AGP realized each period (similar to DAC capitalization adn amortizatoin)
release rate factor developed similar to k factor
- k(0) = PV future URL / PV future EGP sicounted as assumed credited rate

Selection of Assumptions

need to select appropriate assumptions at issue and periodically thereafter as necessary
best estimates w/o pads
often pricing assumptions w/ PADs removed
historic prem patterns s/b reviewd since PO can vary FPDA prem payments
exonomic trends can alos affect payment history
assumed earned and credited rates - two of most important assumptoins for DAs
- take into account
  - investment strategy
  - asset type and quality
  - asset duration
  - liquidity
  - disintermediation risk
- provisions for default cost - by quality rating
int crediting strategy can change over tiem
- strongly influenced by competition and desired spread
- new LOB probably very competitive
- runoff block probably large spread to maximize profits
reflect prem taxes
gross of FIT (no tax assumption)

Loss Recognition Tests

adverse experinece over a period of time reduces AGP and can cause future assumption changes
- these can lead to doubts as to remaining DAC recoverability
Practice Bulletin 8 - if portion of DAC balance is probably not recoverable, it should be written off
necessary to conduct preiodic tests of recoverability
if k(t) ? 1, may not be adequate future revenues to amortize remaining DAC
- need to reduce DAC balance until k(t) <= 1
F97 investment contracts never need a def reserve
cannot reinstate written off DAC if experience improves

Examples pp 186 - 190
Presentation of Results

income statement considerably different from US Stat and F60
s/b reported in form similar to F97 UL
F97 revenue
- investment income
- COIs
- SC
- expense charges
- released URL
DA expenses
- benefit claims in excess of acct value
- admin expenses
- int credited
- amort of DAC
- accrual of special liab (ex. accrued liab for contingent bonus features)
primary differences - prems, surr benefits, resv incr, credited int

Acconting for Special Features

MVA Annuities
- product description
  - allows companies to guar a competitive crediting rate in exchange for additinal surrender penalty
  - MVA designed to cover g/l when surrenders occur @ times when int rates are higher/lower than when contract was issued
  - change in intended discourange disintermediation and to recover the realized g/l on those surrenders that do take place
- accounting issues
  - when and how MVA adjustments and realized g/l s/b included in EGP calc
    - what discount rate s/b used when int rates change
  - at contract issue - most co' do not anticipate future MVA adj or realized g/l
    - credited rate set equal to guar rate and earned rate = (for guar period) earned rate on assets underlying assets @ issue
  - when int rates change, need to decide if need to adjust rates going forward (recalc EGP)
  - which int rate to use to recalc VP EGP in DAC amortization factor calc
    - crediting rate in effect @ inception OR
    - latest revised rate applied to remaining benefit period
- example pp 194-195
Bonus Annuities
- Product Description
  - two bonus designs
    - immediate fund enhancement of % of first yr prem (or single prem)
    - additional int enhancement in one or more years early in contract
  - both usually accomplished by reducing commissions
  - usually increases early persistency
  - bonus may or may not be immediately vested
- Accounting Issues
  - some argue that bonus is a mktg related cost adn s/b a sales expense like commmission
    - therefore s/b deferrable
  - some co's designate the benefit as contingent and not guaranteed to occur and accrue liab over a period of years, commonly in relation to EGP
  - AICPA had not yet rendered an opinion on this yet
- Example 196-197
Two-Tiered ANnuities
- Product Description
  - two tiers
    - one w/ lower rate for surrenders (liquid fund)
    - one w/ higher rate for annuitization (income fund)
  - usually between 100-300 bps difference between rates
  - liquid fund typically FEL (5-10%)
    - some use SC (BEL) 5-10 yrs grading to 0
    - int usually near guar rate until end of SC period (or approx 10 years if FEL)
      - then usually same as income fund
  - income fund typically enhanced by 5-10% 1st year prem bonus
- Accounting Issues
  - fairly controversial for GAAP methodology
  - typically considerred investment contracts (despite annuitization encouragment)
  - two basic approaches - based on liquid fund and based on income fund
    - some use a blended 3rd approach
  - liquid fund reserve - liquid fund + accrual of add'l lib for diff between liquid and income funds
    - URL for FEL established and released in proprtion to AGP
    - add'l liab generally accrues ~ liquid fund or EGP
  - income fund reserve = income fune (including any enhancements)
  - DAC amortized in relation to EGP, defined by approach selected
  - EGP for income fund approach -
    - = excess inv income on assets supporting income fund
    - + diff between two funds on surrender
    - + expense load margins
  - income fund bonuses - some co's capitalize tihs amt liek DAC and mortize w/r EGP
    - some calc amt in same manner, but report it as a contra-liability instead of deferred asset
  - some believe liquid fund approach yields a more reasonable GAAP earning pattern
    - income fund leads toward over-reserving
    - liquid fund approach doesn't have capitalized bounus issues
- example p 199-202

Copyright © 2004 Steve Welander.
Permission is granted to copy, distribute and/or modify this document under the terms of the GNU Free Documentation License, Version 1.2 or any later version published by the Free Software Foundation; with no Invariant Sections, no Front-Cover Texts, and no Back-Cover Texts. A copy of the license is included in the section entitled 'GNU Free Documentation License'.