By Russ Banham
A new accounting standard issued by the Financial Accounting Standards Board (FASB) should make it easier for investors to compare companies that sell long-duration life and health products and annuities with market guarantees. However, companies will need to expend a great deal of effort to comply with the standard.
FASB’s Accounting Standards Update No. 2018-12 is driven by the accounting standard-setting body’s objective to improve the existing recognition, measurement and disclosure requirements for life insurance and annuity contracts that remain in force for an extended time. The standard takes effect in 2021 for public business entities operating on a fiscal year basis, and in 2022 for other entities (early adoption is permitted).
Let’s look first at these changes as they relate to life insurance, a product involving a promise of payment that may not occur for several decades. The assumptions used by insurers to measure the liabilities for their policyholders’ future benefits extend decades into the future. Under current accounting rules, the assumptions are locked at contract inception and held constant over the term of the contract. If the contract was sold in 1980, the assumptions at the time—the discount rate and estimates of longevity, for example—would generally remain appropriate 30 years later. This approach takes a long view of the obligation and avoids changes in the short term.
FASB’s updated rules will require insurers to revisit their assumptions for these types of life contracts annually, or earlier if they believe significant changes have occurred. Any changes in the liability resulting from these new assumptions will be recognized immediately; however, FASB has made an important distinction: Changes in the discount rate won’t be recognized in earnings while changes related to other assumptions will be.
That’s good news for both investors and companies as it provides a current view of the liability without introducing unnecessary noise into earnings. “Many investors felt the current accounting model was not very transparent, making it difficult for them to understand what was on the books, while companies were worried about earnings volatility caused by movements in interest rates,” explained Edward Chanda, national sector leader for insurance at audit firm KPMG LLP in the United States.
With regard to annuities with market guarantees under current accounting practices, some types of guarantees previously were accounted for as insurance and others at fair value. However, under the new accounting standard, any such guarantee that is responsive to market changes will be accounted for at fair value. While this will make it easier to compare companies, earnings volatility resulting from changes in fair value associated with these long-term contracts could make it more difficult for companies to explain their earnings to investors.
Clearer Vistas Ahead
Concerns about the current accounting had prompted FASB’s joint efforts with the International Accounting Standards Board to update the accounting standard nearly a decade ago. The two groups eventually parted company, with FASB focused on more targeted reforms to long-duration contracts.
There are several benefits of the new standard. FASB stated that it will improve the timeliness of reporting changes in an insurer’s liability for future policy benefits and provide guidance regarding the rate used to discount future cash flows. It also will improve and enhance the consistency of the accounting for certain market-based options or guarantees associated with deposit (or account balance) contracts. Other benefits include simplifying the amortization of deferred acquisition costs and improving the effectiveness of the required disclosures.
By and large, these changes will make it easier for investors and other stakeholders to compare different insurers on more of an apples-to-apples basis. “The changes are a step in the right direction for investors in terms of providing more consistency between companies and greater transparency about the assumptions,” said Laura Gray, principal and leader of KPMG’s actuarial practice.
The onus is on insurers to provide this transparency. The new standard requires significant changes in insurer accounting processes, since economic events could change the assumptions almost every year. Even more worrisome is the hard work required to ensure their data, systems and processes are compliant within a relatively tight timeframe. “It will require significant investments in people and resources that may be in short supply,” said Gray.
Insurers are bracing for the changes. “While everyone acknowledges there are challenges with the current ‘locked’ approach, there’s always an element of trepidation when it comes to change,” said Chanda. “Companies have been telling their story one way for a long time and now they have to tell it other ways, separating the signals from the noise.”
In planning their transition, companies should form steering committees and working groups to wrestle with the tougher aspects of the new standard, Gray said. “A lot of judgment will be needed to determine future results,” she explained. “But, as people get used to the ‘new normal,’ these judgments around assumption-setting will become better understood.”
Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.