Practice Note on Anticipated Common Practices Relating to AICPA Statement of Position 03-1

44 Pages·2005·0.12 MB·English

Practice Note on Anticipated Common Practices Relating to AICPA Statement of Position 03-1:
Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration
Contracts and for Separate Accounts

April 2005

The American Academy of Actuaries (Academy) is the public policy organization for actuaries
practicing in all specialties within the United States. A major purpose of the Academy is to act as the
public information organization for the profession. The Academy is non-partisan and assists the public
policy process through the presentation of clear and objective actuarial analysis. The Academy regularly
prepares testimony for Congress, provides information to federal elected officials, comments on draft
federal regulations, and works closely with state officials on issues related to insurance. The Academy
also develops and upholds actuarial standards of conduct, qualification and practice and the Code of
Professional Conduct for all actuaries practicing in the United States.

This practice note has not been promulgated by the Actuarial Standards Board nor by any other
authoritative body of the American Academy of Actuaries. The information in this practice note is not
binding on any actuary and is not a definitive statement as to what constitutes generally accepted
practice in this area.

The Academy welcomes your comments and suggestions for additional questions to be addressed by this
practice note. Please address all communications to Amanda Yanek, Life Policy Analyst at
([email protected]).

The members of the work group that are responsible for this practice note are as follows:

Errol Cramer, FSA, MAAA Kevin Palmer, FSA, MAAA
William Hines, FSA, MAAA David Rockwell, FSA, MAAA
Ken LaSorella, FSA, MAAA Carol Salomone, FSA, MAAA
Patricia Matson, FSA, MAAA Roger Smith, FSA, MAAA
John Morris, FSA, MAAA Michelle Smith, FSA, MAAA
1100 Seventeenth Street NW Seventh Floor Washington, DC 20036 Telephone [phone] Facsimile 202 872 1948 www.actuary.org
Introduction

This is an update to the original practice note dated March 2004. The original practice
note was prepared by a work group organized by the Life Financial Reporting Committee
of the American Academy of Actuaries. The work group was charged with developing a
description of some of the anticipated common practices that might be considered by
actuaries in the United States with implementation of Statement of Position (SOP) 03-1,
effective generally starting 2004. The practice note has been updated by the Life
Financial Reporting Committee for subsequent accounting guidance that has been
released and for additional issues that have arisen from company experience with
implementation of the SOP. Events occurring subsequent to the date of publication of this
Practice Note may make the practices described herein irrelevant or inappropriate.

The practices presented here represent views of actuaries in industry, consulting and
public accounting firms involved in implementation of the SOP. The purpose of the
practice note is to assist actuaries with application of the SOP. It should be recognized
that the information contained in the practice note provides guidance, but is not a
definitive statement as to what constitutes generally accepted practice in this area.
Actuaries should consider the facts and circumstances specific to their situation,
including the views of their independent auditors, when practicing in this area.

This practice note has been divided into six sections:

Section A: General GAAP requirements for life and annuity contracts
Section B: GAAP reserves for minimum death benefit and other insurance guarantees
Section C: GAAP reserves for minimum annuitization guarantees
Section D: GAAP reserves and assets for sales inducements
Section E: Reinsurance and hedging
Section F: Transitional rules for implementation of Statement of Position 03-1

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Section A: General GAAP Requirements for Life and Annuity Contracts

Q1. What accounting guidance is discussed in this Practice Note, and how does that
guidance relate to existing GAAP requirements?

A1. The accounting guidance discussed in this note is that contained in AICPA Statement
of Position (SOP) 03-1 (July, 2003), FASB Staff Position (FSP) No. FAS 97-1 (June,
2004) and AICPA Technical Practice Aids (TPA) 6300.05 – 6300.10 (September, 2004).

The SOP provides guidance related to valuation, accounting and reporting for
nontraditional products. This includes, for example, guidance as to how liabilities are to
be measured for variable annuity death benefit guarantees, two-tier annuities and
guaranteed annuitization benefits and guidance as to how to account for bonus interest
and other sales inducements. The FSP and TPA augment the SOP by addressing specific
issues that surfaced as companies adopt the guidance in the SOP.
SAS 69 gives the hierarchy of various financial pronouncements. In that hierarchy, an
SOP is considered category (b), ranking below category (a) guidance like FAS 60 and
FAS 97. The TPA are considered category (d) and, while not addressed specifically by
SAS 69, some believe it is appropriate to categorize the FSP as category (c) GAAP.

Q2. What role do actuaries play in interpreting the provisions of the SOP?

A2. Actuaries are qualified to provide guidance in interpreting the SOP. However, the
final interpretation will result from the accounting profession’s rule setting process.

Q3. What are the key items of interest to actuaries covered by SOP 03-1?

A3. Following are the items that are usually of interest to actuaries covered by the SOP:

1. Paragraph 11 of the SOP sets out four conditions for recording a separate account
arrangement at fair value, including the requirement that all investment performance,
net of contract fees, be passed through to the contract holder. If the four conditions
are not all met, the separate account assets and liabilities are accounted for as general
account assets and liabilities.

2. Under FAS97, the base benefit liability is the contract holder account balance. There
are situations where a contract has multiple account balances defined; the SOP
clarifies that the account balance to be reported as a liability in the company’s
financial statements is that which is essentially available in cash. For example,
paragraph D5 of the SOP requires that the lower cash value tier versus the
annuitization tier apply for a two-tier product. The SOP, in paragraphs 20 through
23, further clarifies that the base liability is the account balance prior to any surrender
charges or market value adjustments. Finally, it requires that accrued but not yet
credited benefits be included in the liability.
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3. Guidance is given in determining the significance of mortality and morbidity risk to
be used in the classification of a contract as an investment contract or a universal life-
type contract as defined in FAS 97. The determination is made at contract inception
(exceptions apply at initial implementation of the SOP and for the reinsuring
company upon initial reinsurance of inforce contracts). The general criteria are based
on the present value of benefits in excess of the account value as compared to the
present value of amounts assessed against the contract. Contracts where the amount
of insurance varies significantly in response to the capital markets are presumed,
unless rebutted, to have significant insurance risk. There is a rebuttable presumption
that a contract has significant mortality risk where the additional insurance benefit
would vary significantly in response to capital markets volatility.

4. Liabilities in addition to the account balance might be required for certain insurance
benefit features for universal life-type contracts as defined in FAS 97. Specific
examples given are minimum guaranteed death benefits (MGDB) on variable
products and no-lapse guarantees on universal life-type contracts. A methodology is
prescribed for calculating these liabilities.

5. Liabilities in addition to the account balance might be required for annuitization
options typically offered under life insurance and deferred annuity contracts. Specific
examples given are guaranteed minimum income benefits (GMIB) on variable
products and the higher account balance available upon annuitization for two-tier
annuities. A methodology is prescribed for calculating these liabilities.
6. Sales inducements are defined. The SOP requires a liability to be accrued over the
period in which the contract remains in force for the contract holder to qualify for the
inducement or at the crediting date, if earlier. Examples given are a bonus at issue
(an additional liability is not necessary if the bonus is actually credited to the account
balance), a persistency bonus, and an enhanced crediting rate (“bonus interest”) over
an initial contract period. Additionally, certain sales inducements qualify for deferral
as an asset in the same way as, but separate from, deferred acquisition costs (DAC).
Deferred sales inducement costs are to be amortized over estimated gross profits
(EGPs) over the life of the contract. Sales inducements that were not capitalized
previously are not capitalized at transition.

Q4. What other items are covered by SOP 03-1?

A4. Following are some additional items covered by the SOP:

1. GAAP separate account treatment applies only to contract holder funds of variable
products that meet four specific criteria (accounts are legally recognized, the assets
are legally insulated from general account liabilities, contract holder directs
investment strategy and all investment performance, net of contract fees and
assessments, must go to the contract holder). An insurer might have an ownership
interest in the separate account (“seed money”); the insurer may record its ownership
as a mutual fund-type investment provided it has less than 20% of the total separate
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account, otherwise it must apply a look-through to the underlying assets (i.e., use
general account treatment). Rules are defined for recording gains/losses on transfers
of assets between the general account and separate account. Finally, certain variable-
like accounts where the insurer owns the assets (total return contracts) are required by
the SOP to record liabilities at fair value whether or not the assets are at fair value.

2. A variety of disclosures are now required with the financials covering separate
accounts, insurance guarantees, annuitization guarantees, and sales inducements.
Required disclosures include methodology descriptions and net amount at risk (NAR)
exposures.

Q5. Are benefits valued under FAS 133 within the scope of the SOP?

A5. Benefits valued under FAS 133 appear to be outside the scope of the SOP.
Paragraph 7 of the SOP states, ”Embedded derivatives contained in nontraditional
contracts should be accounted for in accordance with FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities, and its related guidance.”
The SOP clarifies in several places, for example, paragraphs 21 and 31, that it does not
apply to contract features falling under FAS 133.

However, contracts containing embedded derivatives might have other benefit features
that are outside the scope of FAS 133 and it appears these features would then fall under
the SOP. Also, FAS 133 allowed companies a choice to exempt contracts that were
inforce prior to its adoption, and it would appear these grandfathered contracts then fall
under the SOP.

Q6. What topics from the SOP are further addressed by the FSP or the TPA?

A6. The FSP addresses the issue of whether the SOP changes the prior FAS97
requirements for establishment of an unearned revenue liability (URL). With adoption of
the SOP, some believed that it was no longer appropriate to establish certain URLs, e.g.
for UL cost of insurance charges that are disproportionate to the death benefit provided.
The FSP states in paragraph 8 “This requirement of SOP 03-1 does not amend Statement
97 and does not limit the requirement of Statement 97 to recognize a liability for
unearned revenue only to those situations where profits are expected to be followed by
losses.”

The TPA address six topics specific to the SOP:

6300.05. Definition of an Insurance Benefit Feature
6300.06 Definition of an Assessment
6300.07 Level of Aggregation of Additional Liabilities Determined under SOP 03-1
6300.08 Losses Followed by Losses
6300.09 Reinsurance
6300.10 Accounting for Contracts that Provide Annuitization Benefits
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Questions 6300.05 - .09 give guidance on the application of paragraph 26 of the SOP and
question 6300.10 gives guidance on the application of paragraphs 31-35 of the SOP.

Section B: GAAP Liabilities for Contracts with Death or Other Insurance Benefit
Features

Q7. What are the circumstances under which the SOP might require liabilities in
addition to account balances for insurance benefits?

A7. Additional liabilities for insurance benefits might be required by the SOP when all
of the following apply:

1. A contract contains a mortality or morbidity contingent benefit feature providing for
payment of an amount in excess of the account balance;

2. The contract is classified as a FAS 97 universal life-type contract with fees and
benefits that are not fixed and guaranteed; and

3. It is expected that periodic charges assessed for insurance benefits will result in
profits in early years and losses in subsequent years (i.e., there is an element of front-
ending of charges relative to benefits incurred).

The SOP requires a determination to be made as to whether the insurance risk in a
contract meets the test of being significant. If not, the SOP requires the contract to be
classified as an investment contract with no additional liabilities held for the insurance
benefits (insurance benefits, if any, thereby deemed by the SOP to be non-significant).
This determination is usually made at inception of the contract and would not usually be
subsequently reconsidered (exceptions apply at initial implementation of the SOP, and for
the reinsuring company upon initial reinsurance of inforce contracts).

Q8. What are examples of benefit features that might require additional insurance
liabilities?

A8. The SOP specifically mentions the following:

1. Minimum guaranteed death benefits (MGDB) provided under variable annuity
contracts (paragraph 3);

2. No-lapse guarantees that keep universal life (UL) and variable universal life (VUL)
contracts in force when the account balance is zero and any minimum stipulated
premiums are insufficient to cover the cost of insurance plus all other contract
charges (paragraph 3);

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3. Long-term care or similar insurance benefits provided during the accumulation phase
of a deferred annuity (paragraph D21);

4. Earnings protection benefits on deferred annuities that pay a death benefit in excess
of account balance to cover taxes on contract earnings (paragraph D22); and

5. MGDB or other insurance benefits provided with mutual fund or other noninsurance
contracts (paragraph 30).

The above are examples only; any benefit paid in excess of the account balance and
based on mortality or morbidity contingency would generally be considered. In fact,
TPA 6300.05 is specific that the base mortality or morbidity benefit feature should be
considered. These insurance benefit features would usually be considered both by the
insurer providing the benefit directly and by a reinsurer assuming all or a portion of
the risk.

Q9. What would generally be considered in deciding to classify a deferred annuity
as an insurance contract versus an investment contract?

A9. Paragraph 24 of the SOP states, ”If the mortality and morbidity risk associated with
insurance benefit features offered in a contract is deemed to be nominal, that is, a risk of
insignificant amount or remote probability, the contract should be classified as an
investment contract; otherwise, it should be considered an insurance contract.” So, if a
deferred annuity provides for the possibility that death or morbidity benefits will be paid
in excess of the account balance, the actuary would usually assess the significance of the
insurance risk. (Determination of materiality regarding what is “significant” is outside
the scope of this Practice Note. However, paragraph 24 of the SOP does provide some
guidance with references to terms such as ”nominal” ”insignificant” and ”remote.”) If it
is determined that the amount of benefits expected to be paid for the contract is
insignificant or there is only a remote probability that benefits in excess of the account
balance will be paid, the contract is classified as an investment contract, otherwise, the
contract is classified as an insurance contract.

Paragraph 24 of the SOP provides a rebuttable presumption that insurance risk is
significant if insurance benefits ”would vary significantly in response to capital markets
volatility.” Thus, for example, variable annuities with MGDB would usually be
classified as universal life-type insurance contracts unless the actuary has a persuasive
case to rebut the presumption that the insurance risk is significant.

According to paragraph 25 of the SOP, in determining whether the insurance risk is
significant, the actuary generally projects expected insurance benefits and contract
revenues under a “full range of scenarios, that considers the volatility inherent in the
assumptions, rather than making a best estimate using one set of assumptions.”
Insurance benefits include amounts paid in excess of the account balance and related
claim administration costs. Contract revenues include amounts assessed against the
contract holder, including investment margins, surrender charges and policy fees. The
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present value of expected benefits is compared to the present value of expected
assessments (revenues) across the range of scenarios tested.

For example, if benefits in excess of account balance are projected in virtually all
scenarios but the present value of these benefits is almost always relatively small
compared to the present value of assessments, the actuary might conclude the insurance
risk is insignificant and classify the contract as an investment contract. On the other
hand, if the present value of these benefits is relatively large in even a few scenarios, the
actuary might conclude the insurance risk is significant and classify the contract as an
insurance contract.

Q10. If the insurance risk is significant, does the SOP always require that insurance
liabilities be held in addition to the account balance?

A10. Paragraph 26 of the SOP states that an additional insurance liability should be
established ”if the amounts assessed against the contract holder each period for the
insurance benefit feature are assessed in a manner that is expected to result in profits in
earlier years and losses in subsequent years from the insurance benefit function.” Some
actuaries interpret this to mean additional insurance liabilities would usually be
considered only if insurance charges are expected to be more than insurance benefits in
early years and less than insurance benefits in later years. This is termed the ”profits
followed by losses” test.

The FSP and TPA 6300.06 and 6300.08 provide additional guidance on how to apply
paragraph 26 of the SOP. Several specific situations are discussed in the remainder of
this section.

Q11. Does the actuary usually consider a range of scenarios to determine whether
to expect profits followed by losses from the insurance benefit feature?

A11. As discussed in Q10 above, paragraph 26 of the SOP requires an assessment as to
whether profits followed by losses is expected. Paragraph 26 goes on to say, “expected
experience should be based on a range of scenarios rather than a single set of best
estimate assumptions.” As discussed in Q9 above, a full range of scenarios is also
usually considered in determining whether the insurance risk is significant.

In this light, some actuaries believe it is likewise appropriate to consider a range of
scenarios to determine whether to expect profits followed by losses from the insurance
benefit feature. Other actuaries, however, may believe it is appropriate in some or all
situations to look at a single deterministic scenario based on the best estimate
assumptions used in DAC amortization.

Q12. Does the SOP require the test for “profits followed by losses” and the liability
calculation to be performed for each benefit feature on a standalone basis, or may
one aggregate at the entire contract level or some other level?

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A12. Paragraph 26 of the SOP states “the insurance benefit feature” is to be tested for
profits followed by losses from “the insurance benefit function.” TPA 6300.05,
Definition of an Insurance Benefit Feature, states “The test should be applied separately
to the base mortality and morbidity feature and, in addition, separately to each other
individual mortality or morbidity feature.” TPA 6300.05 also provides guidance on what
constitutes a mortality or morbidity feature separate from the base feature.

Neither the SOP nor the TPA specifically addresses whether the liability calculation must
be performed for each insurance benefit function. Some actuaries therefore believe
insurance benefit features may be combined for purposes of calculating the additional
liability. Others believe that since the test for profits followed by losses is performed for
each insurance benefit function, it is preferable for the liability to be calculated for each
insurance benefit function.

Q13. My company issues a UL contract with reverse select and ultimate COI
charges. Although the margin of COI charges over expected death benefits
decreases over time, it is always positive. We currently defer a portion of COI
charges as unearned revenue under the unearned revenue liability (URL)
requirements of FAS 97. Does the SOP require us to do anything different?

A13. In addressing this issue, the actuary may wish to consider sections of the FSP
discussed below.

As the SOP limits establishment of an additional insurance liability to only those
situations of profits followed by losses, a question had arisen as to whether the same
requirement applied regarding establishment of a URL under FAS97, i.e., no URL unless
profits were followed by losses. The FSP poses the question in paragraph 6 by stating,
“Some have read paragraph 26 as limiting the situations in which recognizing unearned
revenue is appropriate – that is, only in the situation in which profits are followed by
future losses would the recognition of unearned revenue be appropriate.” The FSP
addresses this question in paragraph 8 by stating “SOP 03-1 does not amend Statement
97 and does not limit the requirement of Statement 97 to recognize a liability for
unearned revenue only to those situations where profits are expected to be followed by
losses.”

However, the company may wish to consider whether it is appropriate to hold a URL in
view of guidance from the FSP which states in paragraph 11“It is improper to record a
liability for unearned revenue if the purpose is an attempt to inappropriately level the
contract’s gross profit over the life of the contract or the accrual would serve to produce
a level gross profit from the mortality benefit over the life of the contract.” Therefore,
one might conclude that it would be preferable the company to continue its practice of
holding a URL for reverse select and ultimate COIs (regardless of whether or not profits
are followed by expected losses), provided the company has determined that a portion of
the upfront COIs are designed to provide for later death coverage and deferral does not
serve merely to levelize the COI profit margin.
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Q14. My company issues a UL contract with level COIs. COIs are less than
expected death benefit expenses at the later durations. Under the unearned revenue
liability (URL) requirements of FAS 97, we currently defer a portion of early year
COI charges. Does the SOP require us to do anything different for inforce or new
contracts?

A14. This differs from the situation in Q13 as the expectation is that the insurance
benefit feature will produce profits followed by losses. In addressing this situation,
actuaries may wish to consider the sections of the FSP discussed below.

Some actuaries point to paragraph 12 of the FSP which states, “Paragraph 26 of SOP 03-
1 specifies how to determine the amount of the accrual for the insurance benefit feature
when profits are expected to be followed by losses.” They interpret this to mean that for
benefit features where profits followed by losses are expected, the requirement is for an
additional insurance liability (per paragraph 26 of the SOP), in lieu of the URL.

Other actuaries believe the requirement of paragraph 26 of the SOP is in addition to,
rather than in place of, the URL. They believe the SOP can not change the URL
requirement of FAS 97, for example, as stated in paragraph 8 of the FSP “This
requirement of SOP 03-1 does not amend and does not limit the requirement of Statement
97 to recognize a liability for unearned revenue only to those situations where profits are
expected to be followed by losses.” They further note that it is possible to have both a
URL and an additional insurance liability, as stated in paragraph 14 of the FSP, “If a
reporting enterprise has accrued unearned revenue liabilities in accordance with
paragraphs 17(b) and 20 of Statement 97, those amounts should be considered in
determining the necessary insurance benefit liability under paragraph 26 of SOP 03-1.
Accordingly, for purposes of paragraph 26, an increase during a period in an unearned
revenue liability is excluded from the amounts assessed against the contractholder’s
account balance for that period and a decrease in an unearned revenue liability during a
period is included with the assessments for that period.”

In situations where the company does hold a URL, paragraph 14 of the FSP states that the
URL "should be considered in determining the necessary insurance benefit liability. . ."
Many actuaries interpret this to mean that it is still necessary to perform the profits
followed by losses test and, if needed, determine an additional insurance liability per the
SOP Additionally, some actuaries believe both the test and calculation of additional
reserves are done based on assessments net of changes in URL. A question may arise as
to which components of the change in URL should be included in the profits followed by
losses test (i.e., the entire amount versus just the amount associated with the insurance
benefit feature). This issue is discussed in Q18.

Q15. Certain of our UL riders have level rider premiums, and we have been
holding FAS 60 reserves for these riders. Does this change under the SOP?

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