Noise in Accounting for Reinsurance of Universal Life
By Steve Malerich
The Financial Reporter, November 2022
In an earlier issue of The Financial Reporter, I took a fresh look at accounting for ceded reinsurance of universal life (UL) under GAAP’s Targeted Improvements to the Accounting for Long-Duration Contracts (LDTI).[1] Recognizing the right of setoff (ASC 210-20-45-2) that is common in reinsurance, that article (“A Fresh Look at Accounting for Reinsurance of Universal Life”) derived an ideal reinsurance recoverable asset or cost of reinsurance liability for each of two approaches to accounting for the insurance element of UL contracts—with and without an additional liability for insurance benefits.
In this article, I examine several techniques that have been used before to account for UL reinsurance and recognize the amount of accounting “noise” inherent in each. Conceptually, noise happens when accounting for the reinsurance is inconsistent with the direct accounting for the underlying contracts and the economic protection provided by the reinsurance.
Before LDTI, amortization of DAC based on gross profits also produced noise in accounting for reinsured benefits. This sometimes had the effect of reducing overall noise and sometimes increasing it. Even the ideals identified in “A Fresh Look …” would have experienced noise from DAC amortization prior to LDTI. With the elimination of gross profits as a DAC amortization base, that effect on overall noise is eliminated.
The formulas presented here, when applied to output from an existing valuation, can indicate the amount of noise that would carry over from an existing approach and its sensitivity to future events. Together, these can help to quickly determine whether a different approach would be better.
Measuring Noise
Under LDTI, the amount of noise depends on the difference between ideal and reported measurements. In this article, accumulated noise is defined to be the excess of the reported reinsurance recoverable asset over the ideal (formula <12> in “A Fresh Look …”). Or, if reinsurance is reported as a cost of reinsurance liability, accumulated noise is the excess of the ideal (formula <13> in “A Fresh Look …”) over the reported liability.
| Notation defined in “A Fresh Look …” |
|
RR – reinsurance recoverable asset corresponding to future reinsured benefits |
Accumulated noise can be precisely measured as the portion of lifetime reinsurance cost that would ideally have been recognized to date minus the portion that has actually been recognized.
This will be visible in all accumulated noise formulas below. Key to understanding the proportions is the historical ratio (the present value of actual past cash flows of type ‘x’ divided by the present value of lifetime ‘x’):
Noise within a reporting period involves a complex interaction among many parts through normal accruals and for remeasurement with cash flow updates. With limited space, this article looks only at variances from and changes in expected benefits, expressed here as ∆(xB), events that are likely to produce the most significant noise.
To simplify understanding, this article uses derivatives of accumulated noise functions to estimate remeasurement noise and ignores the relatively insignificant contribution of secondary (persistency) effects.
“A Fresh Look …” also noted that it might be appropriate to amortize the cost of reinsurance premiums even when an additional liability is not required. In that situation, whether or how to amortize this cost is a matter of judgment. Without an ideal, there can be no accumulated noise from amortizing reinsurance premium. Without any direct remeasurement gain or loss, however, any remeasurement gain or loss from reinsurance (including remeasurement of reinsurance premium amortization) will appear as noise within a reporting period.
Unearned Premium
The unearned premium approach recognizes an asset for only the unearned portion of a current period’s reinsurance premium. By itself, the approach does not include amortization of reinsurance premiums over the life of the business. And, since there is no accrual for future recoveries:
<2> RR = 0
Without Additional Liability
As identified in “A Fresh Look …,” this approach is ideal for reinsurance of contracts that do not require an additional liability.
<3> accumulated Noise = 0
Within any reporting period, there will be no remeasurement noise unless separate amortization of reinsurance premiums includes retrospective remeasurement.
With Additional Liability
For contracts that require an additional liability, lifetime reinsurance cost would ideally be recognized in income in proportion to assessments. By recognizing 100 percent of net cost as paid:[2]
<4> accumulated Noise = [AV(cP - cB) + PV(cP - cB)] × h(dA) - AV(cP - cB)
Any deviation from expected reinsured benefits will produce noise in the current reporting period due to the absence of appropriate remeasurement.
<5> remeasurement Noise ≈ ∆(cB) × [1 - h(dA)]
The ‘1’ inside the brackets indicates the portion of the variance actually recognized in income. The historical ratio represents the portion needed to align with direct remeasurement.
For an assumption change, nothing is recognized in current income and the ‘1’ is removed from formula <5>. The historical ratio remains because that is the proportion of present value change that is needed to align with direct remeasurement.
Net Cost
Using the net cost approach:
<6> RR =(pR - cR)×PV(dA) - PV(cP - cB)
Without an Additional Liability
Without an additional liability, accumulated noise is the excess of recognized recoverable over actual recoveries.
<7> accumulated Noise = [AV(cB) + PV(cB)] × h(dA) - AV(cB)
For a ceded benefit variance:
<8> remeasurement Noise ≈ ∆(cB) × [h(dA) - 1]
For a change in future ceded benefits, remove “–1” from this formula.
With an Additional Liability
“A Fresh Look …” identified net cost as ideal when the underlying reinsured contracts require an additional liability. There is no noise in the ideal.
<9> accumulated Noise = 0
<10> remeasurement Noise = 0
Standalone
Using the standalone approach:
Alone, this approach does not amortize the cost of reinsurance premium.
Without an Additional Liability
As with net cost, accumulated noise from standalone is the excess of recognized recoverable over actual recoveries.
<12> accumulated Noise = [AV(cB) + PV(cB)] × h(cP) - AV(cB)
For a ceded benefit variance:
<13> remeasurement Noise ≈ ∆(cB) × [h(cP) - 1]
For a change in future benefits, remove “–1”.
With an Additional Liability
Lifetime reinsurance cost would ideally have been recognized in proportion to historical assessments. Since the standalone approach recognizes it in proportion to reinsurance premium:
<14> accumulated Noise = [AV(cP - cB) + PV(cP - cB)] × [h(dA) - h(cP)]
In this situation, the amount of noise depends on how closely ceding premiums align proportionally with assessments of the underlying cohort.
For a deviation from or a change in expected reinsured benefits:
<15> remeasurement Noise ≈ -∆(cB) × [h(dA) - h(cP)]
Gross Profit
Using the gross profit approach, the net cost of reinsurance is amortized on gross profits (gP). Though LDTI removes the concept of gross profit from insurance accounting standards, a company that has amortized reinsurance on gross profit may continue to do so. Though calculated as a liability, RC may be negative, an asset.
<16> RC = PV(cP - cB) - nR × PV(gP)
Where nR is the amortization rate:
Without an Additional Liability
Again, accumulated noise is the excess of recognized recoverable over actual recoveries.
<18> accumulated Noise = [AV(cB) + PV(cB)] × h(gP) - AV(cB)
For a ceded benefit variance:
<19> remeasurement Noise ≈ ∆(cB) × (nR - 1) × [1 - h(gP)]
Within the second factor, nR represents the effect of the variance as a component of gross profit and “–1” represents its effect on recoveries. For a change in future benefits, remove “1” from the last factor.
With amortization based on gross profits, even a variance or change in retained benefits will affect remeasurement of reinsurance. To estimate the resulting noise, substitute rB for cB and remove “–1” from the middle factor, keeping “1” in the last factor for a variance but removing it for a change in projected benefits.
With an Additional Liability
Once again, lifetime reinsurance cost would ideally have been recognized in proportion to historical assessments. Since it has been recognized in proportion to gross profit:
<20> accumulated Noise = [AV(cP - cB) + PV(cP - cB)] × [h(dA) - h(gP)]
Here, the amount of noise depends on how closely gross profits align proportionally with assessments.
For a deviation from or a change in expected reinsured benefits:
<21> remeasurement Noise ≈ ∆(cB) × (nR - 1) × [h(dA) - h(gP)]
To estimate noise from a variance or change in retained benefits, substitute rB for cB and remove “–1” from the middle factor.
Adjusted Gross Profit
Having experienced significant noise amortizing reinsurance on gross profit, some companies modified the gross profit approach, removing deviations from expected ceding premiums and benefits (∆P and ∆B) from an adjusted cost (aC) and applying them to adjusted profit (aP), producing an adjusted amortization rate (aR).
<22> aC = (cP - ∆P) - (cB - ∆B)
<23> aP = gP- ∆P + ∆B
Since expected deviations from expected reinsurance premiums and benefits are always zero, there is no adjustment to projected cost or gross profit. This, together with the adjusted history, changes formula <16>’s cost of reinsurance liability into:
<25> RC = PV(cP - cB) - aR × PV(gP)
Without an Additional Liability
Again, accumulated noise is the excess of recognized recoverable over actual recoveries, but adjustments for unexpected recoveries produce an additional term in the measurement of accumulated noise.
<26> accumulated Noise = [AV(cB) + PV(cB)] x h(aP) - AV(cB) - AV(∆B) x [h(aP) - 1]
Other than secondary effects on persistency, a variance from expected reinsured benefits does not produce noise. For a change in expected benefits:
<27> remeasurement Noise ≈ ∆(cB) × (aR - 1) × [-h(aP)]
For a variance or change in retained benefits, substitute rB for cB and remove “–1” from the middle factor. For a retained benefits variance, add “1” to the last factor.
With an Additional Liability
Here, too, unexpected reinsurance cash flows are recognized differently, producing an additional term in accumulated noise.
<28> accumulated Noise = [AV(cP - cB) + PV(cP - cB)] x [h(dA - h(aP)] - AV(∆P - ∆B) x [1 - h(aP)]
For a change in expected reinsured benefits:
<29> remeasurement Noise ≈ ∆(cB) × (aR - 1) × [h(dA) - h(aP)]
For a deviation from expected reinsured benefits, substitute “1” for “h(aP)” in the last factor. For a variance or change in retained benefits, substitute rB for cB and remove “–1” from the middle factor.
Hybrid Measurements
As noted in “A Fresh Look …,” some companies define excess benefits to be amounts payable only after the policyholder account value is exhausted. Benefits payable prior to exhaustion are recognized as incurred. Ideal accounting for reinsurance would align with this hybrid accounting approach.
Measuring noise is then a combination of differences between the hybrid ideal and whatever technique is used to account for reinsurance.
Eliminating Noise
Though LDTI requires little or no change to accounting for UL reinsurance, changes to DAC and URL amortization alter the effectiveness of recognizing the economic cost and protection of reinsurance. The dynamics described here can help to determine whether a change in technique would be appropriate.
Since a change is not required, however, any change must be recognized as a preferrable change in accounting principle (ASC 250-10-45-1 and 45-2(b)) or as a revision of estimate (ASC 250-10-45-17) from the adoption of an improved model.
For a change in principle, the outstanding balance must be retrospectively remeasured with an adjustment to retained earnings as of the earliest period presented (ASC 250-10-45-5) unless it would be impracticable to do so (ASC 250-10-45-6 and 45-7).
The immediate effect of a change in estimate must be recognized in net income (ASC 250-10-45-17) for the period of change.
Ideally, an improvement to reinsurance accounting would be made concurrent with the event (LDTI) that changed its effectiveness. As an ASC topic 250 change, however, there is no inherent tie to LDTI. An improvement could wait for a later date.
Statements of fact and opinions expressed herein are those of the author and are not necessarily those of the Society of Actuaries, the newsletter editors, or the author’s employer.
Steve Malerich, FSA, MAAA, is a director at PwC. He can be reached at steven.malerich@pwc.com.