Session 57, Profits Followed by Losses ‐ Methods and Policies  

 Moderator: 

Thomas Q. Chamberlain, ASA, MAAA  

Presenter: Charles K. Chacosky, FSA, MAAA 

Thomas Q. Chamberlain, ASA, MAAA     

www.pwc.com

SOA Val Act Session 57

GAAP Accounting for FAS 60 Profits Followed By Losses

Charles K. Chacosky, FSA, MAAAAugust 30, 2016

PwC

Presenter

• Charles K. Chacosky, Director withPricewaterhouseCoopers, Philadelphia

• I am Fellow of the Society of Actuaries and a Member of the Academy of Actuaries.

• Member, Profits Followed By Losses Subgroup, Financial Reporting Committee, Risk Management and Financial Reporting Council, American Academy of Actuaries

• Coauthor of the June 2015, American Academy of Actuaries Practice Note, GAAP Accounting for Profits Followed by Losses inLong-Duration Contracts.

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SOA valuation actuary symposium disclaimer

Presentations are intended for educational purposes only and do not replace independent professional judgment. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of the Society of Actuaries, its co-sponsors or its committees.

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We will discuss the following topics

• The FAS 60 profits-followed-by-losses (PFBL) and how that differs from the SOP 03-1 form of PFBL

• Updates on PFBL since the release of the Practice Note

• When and how the test is typically completed and interpreting the results of the model output;

• The methods used to calculate the additional PFBL liability by going through examples and addressing key considerations.

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Introduction – The AAA PFBL practice note

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• The practice note is not:

- A promulgation of the Actuarial Standards Board;

- An actuarial standard of practice;

- Binding upon any actuary;

- A definitive statement as to what constitutes appropriate practice or generally accepted practice; or

- An official or comprehensive interpretation of any accounting guidance.

• Future accounting, regulatory and legislative activity could change information presented in the practice note.

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Background – FAS 60 PFBL is a form of a premium deficiency

ASC 944-60, Premium Deficiency and Loss Recognition, defines situations under which a premium deficiency may be recognized.

• ASC 944-60 describes how such deficiencies should be reflected in the insurance entity’s GAAP financial statements

• In its paragraph 25-9, ASC 944-60 addresses the premium deficiency situation for long duration contracts under which “the liability on a particular line of business may not be deficient in the aggregate, but circumstances may be such that profits would be recognized in early years and losses in later years”

• The original PFBL guidance was FAS 60 paragraph 37 and as such,it has been in effect since at least 1983.

6

My company or client routinely tests for a ASC 944-60 Profits Followed By Losses Premium Deficiency?

7

A. B. C. D.

65%

10%10%15%

A. YesB. NoC. Don’t KnowD. Not a GAAP Filer and/or Does Not

Apply

Polling Question #1

In the past, my company or client has established an additional liability to cover a ASC 944-60 Profits Followed By Losses Premium Deficiency?

8

A. B. C. D.

45%

13%13%

30%

A. Yes

B. No

C. Don’t Know

D. Not a GAAP Filer and/or Does Not Apply

Polling Question #2

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Background – SOP 03-1 PFBL is a form of a unearned revenue liability

ASC 944-605, Revenue Recognition, defines situations under which a liability for unearned revenue shall be recognized.

• In its paragraph 25-8, ASC 944-605 says: “If the amounts assessed against the contract holder each period for the insurance benefit feature of an insurance contract 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, a liability for unearned revenue shall be recognized in addition to the account balance.”

• The original PFBL unearned revenue guidance was in SOP 03-1 and as such, it went into effect upon adoption (circa 2004).

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My company or client has established additional liabilities to cover a SOP 03-1 Profits Followed By Losses?

10

A. B. C. D.

56%

9%14%

21%

A. Yes

B. No

C. Don’t Know

D. Not a GAAP Filer and/or Does Not Apply

Polling Question #3

PwC

Background – FAS 60 PFBL premium deficiency contrasted with the SOP 03-1 form of PFBL

• Premium deficiency testing is typically performed annually (at least) at a high aggregation level (such as line of business). The SOP 03-1 testing for PFBL is typically applied at a more granular UL-type DAC cohort level and is performed when the policy is issued.

• Premium deficiency testing for PFBL includes all the profit elements from the block tested. The SOP 03-1 test for PFBL focuses on just the insurance benefit feature being tested.

• Reportedly, the upcoming FASB Exposure draft on the proposed targeted improvements for long duration contracts accounting will eliminate premium deficiency testing, but retain some SOP 03-1 liabilities (such as ULSG).

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How would you describe your company’s or client’s preparation for the FASB proposed targeted improvements for long duration contracts GAAP accounting?

12

A. B. C. D. E.

19%

14%

7%

47%

14%

Polling Question #4

A. Nothing, but glad to hear Premium Deficiency testing could be eliminated

B. Don’t know, waiting, or does not apply to usC. Just getting started more focused on PBR

and/or other thingsD. Reviewed the proposed

targeted improvementsE. reviewed + discussed with auditor +

gathering historical data

When my company or client established an additional liability to cover a ASC 944-60 Profits Followed By Losses Premium Deficiency, it was for:

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A. B. C. D. E.

38%

12%

19%

27%

4%

Polling Question #5

A. LTC productsB. Payout Annuity contractsC. UL policiesD. Multiple linesE. Don’t know which ones

PwC

What is a FAS 60 PFBL premium deficiency?

• PFBL occurs when GAAP gains are expected in the near future, but GAAP losses in later accounting period(s) are expected to be reported because (a) is projected to exceed (b):

a) The sum of claims incurred plus related settlement expenses, maintenance expenses, amortization expense of unamortized acquisition costs, the change in the related liability for future policy benefits, and policyholder dividends; and

b) The sum of premiums earned plus investment income earned on assets supporting the related GAAP liability for future policy benefits.

• However, the present value of those future losses must be less than the present value of the future gains. Otherwise, there is a full premium deficiency which must be addressed.

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What happens if there is newly observed FAS 60 PFBL premium deficiency?

• 944-60-25-9, Long-Duration Contracts, specifies that “the liability shall be increased by an amount necessary to offset losses that would be recognized in later years”.

• However, the ASC 944 guidance does not indicate the period or pattern over which to recognize (accrue or release) the additional liability for PFBL.

• There does not appear to be any support in the GAAP literature for a possible write-down of the DAC asset (unamortized acquisition costs) to address PFBL.

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What typically has led to a FAS 60 PFBL?

PFBL has occurred with a variety of products depending on pricing, contract provisions, and changes to management new best estimates. It has occurred in long-duration non-participating blocks, including but not limited to:

• Universal Life without SOP 03-1 liabilities;

• Payout annuities; and

• Guaranteed renewable A&H contracts, such as Long-Term Care (LTC).

If your long-duration block is not listed above, you may still need to test!

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PwC

PFBL examples – Background

Consider a closed block of life payout annuities issued between 1985 and 1990. This year’s experience studies indicate lower mortality and the investment manager provides lower reinvestment rates than those in the current GAAP assumptions. For simplicity, we will illustrate:

• This block forms a Loss Recognition testing (LRT) group

• All of these annuities were life-contingent at issue

• A discount rate of zero and

• The remaining lifetime is 10 years.

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PFBL examples – 4Q2016 loss recognition testing

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| ------------ Remaining GAAP Profit ($ millions) Pattern Scenarios ------------------|Projection Scen. A Scen. B Scen. C Scen. D Scen. E Scen. F

Year Profit Profit Profit Profit Profit Profit2017 10 -2 6 6 5 52018 6 -2 4 4 4 32019 4 -2 2 2 3 22020 2 -2 -2 0 2 02021 2 -2 -2 0 1 -22022 2 -2 -2 -2 0 -42023 2 -2 -2 -4 -1 -42024 2 -2 -2 -2 -2 -22025 2 -2 -2 4 -3 42026 2 -2 -2 6 -3 6

Sum of + 34 0 12 22 15 20Sum of - 0 -20 -14 -8 -9 -12Net Total 34 -20 -2 14 6 8

Scenario A is not PFBL since there are no lossesB is not PFBL since there are no profits (must address full Loss Recognition)C is not PFBL since losses > profits (must address full Loss Recognition)D is not PFBL since losses < later profitsE is PFBL since losses < earlier profits: If do nothing, LR event would occur in 2018F is PFBL since losses > later profits: If do nothing, LR event would occur in 2019

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PFBL examples – The AICPA’s insurance entities expert panel (December 16-17, 2015 meeting)

“The SEC Staff noted that for traditional contracts with locked in assumptions, depending on facts and circumstances, it would not object to a company in a profits followed by losses situation either:

1. Accruing a liability, during the period of gains, to offset the losses using a dynamic method updated over time (when updating calculations if profits followed by losses no longer exists, the liability could be released over time). Registrants should discuss the specifics of each transaction with the SEC Staff, as the Staff may not accept all approaches for accruing the liability over time. OR

2. Accruing an immediate liability to offset the present value of losses that would be recognized in later years (this would be considered a locked calculation not subject to reversal).”

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PFBL examples – Projected accrual and release of PFBL liability from 2016 LRT scenario “E”

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| ---------------- Approach 1 -------------------| | ----------------- Approach 2 -------------------|Projection Scen. E PFBL PFBL Revised Scen. E PFBL PFBL Revised

Year Profit Accrual Liability Profit Profit Accrual Liability Profit12/31/16 9.00 9.00 -9.00

2017 5 3.00 3.00 2.00 5 0.00 9.00 5.002018 4 2.40 5.40 1.60 4 0.00 9.00 4.002019 3 1.80 7.20 1.20 3 0.00 9.00 3.002020 2 1.20 8.40 0.80 2 0.00 9.00 2.002021 1 0.60 9.00 0.40 1 0.00 9.00 1.002022 0 0.00 9.00 0.00 0 0.00 9.00 0.002023 -1 -1.00 8.00 0.00 -1 -1.00 8.00 0.002024 -2 -2.00 6.00 0.00 -2 -2.00 6.00 0.002025 -3 -3.00 3.00 0.00 -3 -3.00 3.00 0.002026 -3 -3.00 0.00 0.00 -3 -3.00 0.00 0.00

Approach Description1 Accrues a ratable share (60%) of expected profits over time to accrue a liability that is just adequate

to offset future losses at such time as the future losses are expected to commence.

2 Accrued $9 million PFBL liability immediately at 12/31/2016 (locked-in) to offset later expected losses.

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PFBL examples – Illustration of a future 2019 LRT scenario “E” (2024 investment yields improved)

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Original 2016 2016 | --------- Approach 1 Not Locked-in ----------- |Projection 2016 Revised PFBL 2019 Profit PFBL PFBL Revised

Year Profit Profit Liability Before PFBL Accrual Liability Profit12/31/16

2017 5 2.00 3.002018 4 1.60 5.402019 3 1.20 7.20 7.20

2020 2 0.80 8.40 2 -1.20 6.00 3.202021 1 0.40 9.00 1 -1.00 5.00 2.002022 0 0.00 9.00 0 -1.00 4.00 1.002023 -1 0.00 8.00 -1 -1.00 3.00 0.002024 -2 0.00 6.00 -1 -1.00 2.00 0.002025 -3 0.00 3.00 -1 -1.00 1.00 0.002026 -3 0.00 0.00 -1 -1.00 0.00 0.00

DescriptionBetween 2016 and 4Q2019. actual = expected. The 4Q2019 LRT revised the future expected yields (favorably).The accrued $7.20 million PFBL liability at 12/31/2019 now appears more than the later expected losses.The excess is released over time. This illustration presumes the proposed targeted improvements for longduration contracts has not become effective as of 12/31/2019.

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PFBL examples – Illustration of a future 2019 LRT scenario “E” (2024 investment yields improved)

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Original 2016 2016 | ---------- Approach 2 Locked-in ----------------|

Projection 2016 Revised PFBL 2019 Profit PFBL PFBL RevisedYear Profit Profit Liability Before PFBL Accrual Liability Profit

12/31/16 9.002017 5 5.00 9.002018 4 4.00 9.002019 3 3.00 9.00 9.002020 2 2.00 9.00 2 0.00 9.00 2.002021 1 1.00 9.00 1 0.00 9.00 1.002022 0 0.00 9.00 0 0.00 9.00 0.002023 -1 0.00 8.00 -1 -1.00 8.00 0.002024 -2 0.00 6.00 -1 -2.00 6.00 1.002025 -3 0.00 3.00 -1 -3.00 3.00 2.002026 -3 0.00 0.00 -1 -3.00 0.00 2.00

DescriptionBetween 2016 and 4Q2019. actual = expected. The 4Q2019 LRT revised the future expected yields (favorably).The accrued $9 million PFBL liability at 12/31/2019 now appears more than the later expected losses. However,due to the lock-in concept, the PFBL liability continues based on the 2016 projection. This illustration presumes the proposed targeted improvements for long duration contracts has not become effective as of 12/31/2019.

.

If my company or client fails their ASC 944-60 Profits Followed By Losses Premium Deficiency later this year, I think we would:

23

A. B. C. D. E.

43%

11%

34%

3%

9%

Polling Question #6

A. Follow our already well established accounting policy by beginning to accrue a liability, during the period of gains, to offset the losses using a dynamic method updated over time (when updating calculations if profits followed by losses no longer exists, the liability could be released over time)

B. Follow our already well established accounting policy by and accrue an immediate liability to offset the present value of losses that would be recognized in later years (this would be considered a locked calculation not subject to reversal)

C. I Don’t KnowD. Flip a coin to pick A/B or loosen the assumptions

such that losses go awayE. Meet and Discuss with our auditors

PwC

Questions?

24

Chuck ChacoskyDirector – PwC Actuarial Services Life (610) 425-8932 charles.k.chacosky@pwc.com

PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Session 57: Profits Followed by Losses Methods and Policies

Thomas Q Chamberlain, ASA, MAAASenior Manager, Deloitte ConsultingAugust 30, 2016

Agenda

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Profits Followed by Losses

Introduction 3

Preparations 5

Analysis 13

Test Evaluation 17

Definition of Income Example 24

Conclusion 31

Introduction• Profits followed by losses (“PFBL”) often identified as a test of future premium deficiency (ASC 944‐60‐25‐9)

• Not the same as testing for losses generated by a benefit function (SOP03‐1)

• Modeling, assumption, control and accounting elements are considered when developing the PFBL test and any additional liability

• Existing accounting policies may apply• Results may impact multiple areas within a company

27

Introduction

28

• Segment 1: First portion of the cycle where profits occur. Segment 1 is the first occurrence of positive Income before losses occur

• Segment 2: The second portion of a cycle where losses occur. Segment 2 is the first occurrence of negative Income

• Cycle of PFBL: One complete set of an odd Income segment number (profits) and an even Income segment number (losses)

• Cycles can be numbered when recurring

Preparations

29

Preparations• Begin by reviewing the policies, explicit or implicit, that impact loss recognition testing and deferred acquisition costs

• A review of existing policies will help guide the PFBL testing process and limit the potential “reinvention” of existing policies

• New policies may be necessary once the testing is designed and completed, especially if new liability balances are necessary

30

Preparations• Frequency of testing

• Annual testing is the most common when there is no deficiency

• A more robust model may be necessary for PFBL given experience and current interest rates

• Aggregation• Aggregation guidance appears in “ ASC 944” and is referred to as grouping

• The three criteria are 1) manner of acquiring 2) servicing and 3) measuring the profitability of its insurance contracts

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Preparations• Actuarial assumptions for loss recognition

• Loss recognition testing and profits‐followed‐by‐losses testing are on the same best estimate basis

• Actuarial modeling policies• The sophistication of the actuarial model is evaluated based on several aspects (product complexity, cash flow availability and other considerations)

• Definition of Income for the PFBL model and associated consistency with loss recognition testing

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For my company or clients Aggregation Policy is:

33

A. B. C. D.

58%

5%5%

32%

A. Written and well‐established.

B. A series of implicitly‐established groupings.

C. Not well understood or established.

D. Established as needed.

Polling Question #7

Preparations• New policies

• Based on the loss recognition guidance, each company may refine how loss recognition events impact Income (accrue a liability or decrease DAC)

• Is this policy impacted by the treatment of profits‐followed‐by‐losses testing?

• “A premium deficiency shall be recognized by a charge to income and (a) a reduction of unamortized acquisition costs or (b) an increase in the liability for future policy benefits.”[emphasis added]

• Unrealized gains and losses impact on the testing results and on any liability accrual

34

Preparations• New policies (continued)

• Accrual methods• Insurance Entities Expert Panel, December 2015, pre‐approved SEC methods

• The SEC Staff noted that this was for traditional contracts with locked in assumptions

• “Accruing a liability, during the period of gains, to offset the losses using a dynamic method updated over time” or

• “Accruing an immediate liability to offset the present value of losses”

• Treatment of additional liabilities within the definition of Income and existing loss recognition testing

35

Preparations• Assembling Models

• Vendor‐based Valuation or homegrown modeling system output is often collected to form the future cash flows

• Income may be defined and assembled/calculated outside of a vendor based system

• Assumptions external to existing models are introduced• Loss recognition testing and PFBL testing are often combined

• Controls• Extracting and loading data controls benefit from automated‐preventative types of controls

• Validate calculations using alternate calculations and trends• “The SEC Staff explained that internal controls over financial reporting are required to identify contracts in profits followed by losses situations.”

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Analysis

37

Analysis• Carefully consider best estimate assumptions as part of the analysis of cash flows

• ASOP 10 Best‐Estimate Assumptions• Based on “…management’s assessment of emerging experience…”;

• “…established as the ‘most‐likely’, ‘average’ or ‘central’ corresponding to the mode, mean, the median of a probability distribution.” or;

• Actuarial judgment• ASOP 10 also invokes ASOP 23: Data quality which considers the appropriateness, reasonableness and limitations of data used by actuaries

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Analysis• Accounting guidance on contingencies (formerly FAS 5)

• Accrual of Loss Contingency conditions (both must be met)

• “a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

• b. The amount of loss can be reasonably estimated.”

39

Analysis• Complexity of Model

• Future projected losses cause• Substantially deterioration of policyholder behavior• Investment income• Other

• Materiality of results• Rigor of monitoring and analysis• Subsequent events and frequency

40

Test Evaluation

41

Test Evaluation

42

Test Evaluation• Example 1: Potential Interpretations (to be supported by facts and circumstances)

• Interpretation 1• There is a PFBL event• An additional liability must be accrued over the profits

• Interpretation 2• There is a PFBL event• An additional liability equal to the present value of losses is established

• Interpretation 3• There is a PFBL event• No accrual is established as the amount is immaterial and remote (or not probable) given the future duration and existing interest rate environment

• Future monitoring for deterioration or improvement is necessary

43

Test Evaluation• Example 1: Potential Interpretations (to be supported by facts and circumstances)

• Further considerations• Assets supporting this product portfolio are reported as available for sale

• Does the accrual method and/or PFBL test require a “shadow” element?

• PFBL Test and Additional PFBL Liability• How are multiple cycles of PFBLs considered or incorporated? 

• How are odd segments considered or incorporated?

44

For my company or clients, when interpreting the results of the PFBL test, we:

45

A. B. C.

30%

67%

3%

Polling Question #8

A. Consider only the Income when determining the impact

B. Rely heavily on judgment and estimation

C. Evaluate the robustness of the model, the likelihood of results, established policies and the materiality of future losses

Test Evaluation• Impacted areas 

• Pricing area awareness• Allows this area to modify product designs to prevent future PFBL events (Integrated Pricing)

• Investments area awareness• Allows this area to modify investment strategies as necessary to prevent future PFBL events

• Financial Reporting area awareness• Besides accounting policy decisions, ledger preparation and disclosures may require updates

• Tax Department awareness• Consider tax impacts in conjunction with Pricing, Investments and Valuation areas

46

For my company or clients PFBL has impacted the following areas:

47

A. B. C. D. E.

0%

60%

33%

7%

0%

Polling Question #9

A. PricingB. Accounting (Financial 

Reporting)C. InvestmentsD. None of the aboveE. All of the above

Definition of Income Example

48

Definition of Income Example• 6‐Year GIC Example

• Initial Premium = 1,000,000• Interest Paid = 6.00%• Final Maturity Value = 1,418,519• Portfolio Earned Rate

• Used Excel Solver to determine year 1 rate• All future rate decreasing by 50 bps

• Objective: • Create a product that has break‐even earnings at issue• Create a pattern of profits followed by losses• Not intended to follow strict FASB guidance on DAC amortization

49

Definition of Income Example

50

Present value of profits = 0 (off by rounding in Excel)• Earnings contains a pattern of profits 

followed by losses• The earnings is driven entirely by the spread

• No actuarial decrements in the projections• Present values calculated using the earned 

rate

Definition of Income Example

51

Present value of profits = Commissions paid• Maintain breakeven status, change portfolio earned rate to generate profits• Amortize deferred acquisition costs over income (not premium, allow negative balances)

Definition of Income Example

52

FAS 60 Income Presentation• Break‐even at present value using portfolio earned rate• Present value using crediting rate used for DAC amortization

Definition of Income Example

53

FAS 97 Income Presentation• Slightly different DAC presentation, amortization and offsetting opportunity cost for the 

different between investment portfolio and crediting rate on DAC• The Income using the FAS 97 presentation equals the Income on a FAS 60 basis• Note that the Income is identical.

For my company or clients, PFBL testing is performed:

54

A. B. C. D. E.

15%12%

9%

27%

36%

Polling Question #10

A. On all FAS 60 businessB. On Certain FAS 60 business 

perceived to be at‐riskC. On FAS 60 and in‐scope FAS 

97 businessD. On FAS 60 business and 

perceived at‐risk, in‐scope FAS 97 business

E. Not at all

Conclusion

55

Conclusion• As with loss recognition, PFBL models can be as sophisticated as desired

• Policies• Define Income up front with interdepartmental consensus

• Develop new policies and methods together with the Finance area

• Controls• Apply change management controls to the new model (model access, new assumption implementation, data requirements, methodology or documentation of model changes)

56

Conclusion• Communication

• Include external auditors to solidify consensus on intended interpretations, new policies and results

• Communicate results clearly to interested and impacted areas (Product, Investments, Tax, Finance, others)

• Document new policies and methods

57

Questions

58