AcSEC Presentation DAC on Internal Replacements

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AcSEC PresentationDAC on Internal Replacements

• April 27, 2004

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What Do We Want to Accomplish Today?

• Background on Project
• Update from FASB SOP clearance meeting
• Discuss next steps for the project
• AcSEC to provide guidance on direction

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Exposure Draft Issued March 14, 2003

• 60 Day Comment Period

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ED Scope of Project

• ED defines an internal replacement as
• Modification in product benefits or features that
  occurs by amendment or rider to an existing
  contract or by the exchange of an existing
  contract for a new contract.
• The election of a feature within an existing
  contract may result in a modification that would
  require evaluation under the provisions of this
  SOP.
• The same accounting treatment should apply to a
  given modification no matter how it is made.
• Paragraph 10 specifies certain modifications of
  existing contracts that are not considered
  internal replacements.

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ED Determining Not Substantially Different

• An internal replacement transaction results in a
  contract that is substantially different from the
  replaced contract unless the modification is
  specifically identified as not constituting an
  internal replacement or if all of the following
  conditions exist
• The modification does not result in a change in
  the inherent nature of the contract.
• An additional deposit, premium, or charge
  relating to the original benefit, in excess of
  amounts contemplated in the original contract, is
  not required to effect the transaction.
• There is no net decrease in the balance available
  to the contract holder, when applicable.
• The modification does not result in a change to
  either the amortization method or revenue
  classification of the contract.
• Additional benefits, whether elected as a result
  of provisions of the original contract or
  provisions added subsequently, do not become the
  primary benefits under the contract.

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ED Inherent Nature

• Items to consider in determining the inherent
  nature of a contract include
• The kind and degree of mortality risk, if any
• The kind and degree of morbidity risk, if any
• The nature of the investment return rights and
  provisions, if any, for example, whether under
  the provisions of the contract the investment
  returns are set periodically at the discretion of
  the insurance enterprise, determined by formula,
  or determined based on a pass-through of actual
  investment performance, as well as whether the
  contract provides multiple investment allocation
  alternatives to the contract holder. The nature
  of a contracts investment return rights and
  provisions refers to the contractual provisions
  relative to the determination of the investment
  return and does not reference the specific nature
  or the risk profile of the investment or the
  level of investment return.

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ED Accounting for Internal Replacements that
are Substantially Different

• An internal replacement that is deemed to be
  substantially different from the replaced
  contract should be accounted for as an
  extinguishment of the replaced contract, which
  should be treated as lapsed or surrendered.
• Unamortized deferred acquisition costs, deferred
  revenue liabilities, and deferred sales
  inducement assets from the replaced contract
  associated with an internal replacement
  transaction that is substantially different
  should not be deferred in connection with the
  replacement contract.

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ED Accounting for Internal Replacements that
are Not Substantially Different

• An internal replacement that is determined to be
  not substantially different from the replaced
  contract should be accounted for as a
  continuation of the replaced contract.
• Unamortized deferred acquisition costs, deferred
  revenue liabilities, and deferred sales
  inducement assets associated with the replaced
  contract should continue to be deferred in
  connection with the replacement contract.
• Sales inducements offered in conjunction with an
  IR that is not substantially different should be
  accounted for as if explicitly identified in the
  original contract at inception (SOP 03-1
  interaction).

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ED Retrospective Approach

• Treat the replacement contract as a continuation
  of the original contract
• For FASB 97/120 products
• EGPs/EGMs of the replacement contract are treated
  as a revision of the future EGPs/EGMs of the
  original contract
• requires linking actual and expected performance
  components associated with the replacement
  contract to the historical performance components
  associated with the original contract

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ED Costs Related to Internal Replacements

• Acquisition costs related to internal replacement
  activity should be evaluated for deferral in
  accordance with the provisions of FASB Statements
  No. 60 and No. 97, as appropriate.
• Acquisition costs incurred in connection with an
  internal replacement where the contracts involved
  are determined to be not substantially different,
  are deemed to be costs associated with renewals.

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Summary of Significant Comments - Scope of Project

• Respondents Commented
• Definition of an internal replacement is too
  broad
• Has significant potential to create misleading
  results
• Exercise of features or riders contained in
  original contract should not result in a
  requirement to evaluate under the proposed SOP
• Additions of riders should not result in internal
  replacements
• Requirement to track all contract replacements,
  modifications, and exercises of contract features
  and riders will create significant administrative
  burdens

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Summary of Significant Comments Determination
of Substantially Different

• Respondents Commented
• Proposed criteria are overly complex
• Criteria for determining are neither clear nor
  accurate
• Definition of inherent nature should be primary
  purpose
• Many did not agree with proposed definition of
  inherent nature
• Inappropriate and misleading to write off DAC if
  the internal replacement is expected to preserve
  or improve future margins associated with the
  contract
• Inconsistent with guidance in EITF 96-19

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September 2003AcSEC clears revised
SOPNovember 2003 Revised SOP sent to FASB
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Revised SOP

• Definition of internal replacement includes all
  contract modifications (same as ED)
• Is the modification an exchange of one contract
  for another?
• If yes, has the exchange resulted in a
  substantial change to the contract
• If yes, treat as a contract termination and new
  contract issuance
• If no, treat as a continuation of the contract.
  Retrospective accounting is conceptually correct,
  prospective accounting if not practicable.
• If no, is the contract feature integrated with
  the base contract
• If not integrated, by definition the contract
  feature does not impact the base contract and
  should be accounted for as a separate contract
• If integrated has it resulted in a substantial
  change to the contract?
• If yes, treat as contract termination and new
  contract issuance
• If no, account for retrospectively as the
  continuation of the combined contract.

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Revised SOP - Integrated

• A contract feature is considered integrated with
  the contract if the benefit provided can only be
  determined in conjunction with the base contract.
• Examples of integrated contract features
• MGDBs, GMABs, GMIBs, premium waiver
• Examples of non integrated contract features
• LTC rider to annuity contract or disability
  contract
• Term life rider to annuity contract

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Revised SOP Determining Substantial Changes

• An internal replacement (contract exchange or
  other contract modification) is determined to
  involve contracts that are substantially
  unchanged only if all of the following conditions
  exist
• The insured event of the contract has not
  changed, as noted by no significant changes in
  the kind and degree of mortality risk, morbidity
  risk, or other insurance risk, if any (Inherent
  nature in ED).
• The investment reward rights, if any, have not
  shifted between the insurance enterprise and the
  contract holder (Inherent nature in ED).
• No additional deposit, premium, or charge
  relating to the original benefit, in excess of
  amounts contemplated in the original contract, is
  required to effect the transaction (Same as ED)
• Other than distributions to the contract holder
  or contract designee, there is no net reduction
  in the contract holders account value or, for
  contracts not having an explicit or implicit
  account value, the cash surrender value, if any
  (Reworded from ED)
• There is no change in the participation or
  dividend features of the contract, if any
  (Included as an example in the ED)
• There is no change to the amortization method or
  revenue classification of the contract (Same as
  ED).
• ED also contained notion of whether additional
  benefits become the primary benefit under the
  contract

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Revised SOP - Accounting for Internal
Replacements that are Substantially Unchanged

• Treat the replacement as a continuation of the
  original contract
• For FASB 97/120 products
• Retrospective Approach, or
• If it is not reasonably practicable to do
  retrospective, should determine the balance of
  unamortized deferred acquisition costs related to
  the replaced contract to carry forward to the
  replacement contract and utilize estimated gross
  profits or margins only of the replacement
  contract to determine future amortization (New
  from ED).

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Summary Significant Changes from ED to Revised
SOP

• Reordering of criteria for determining if
  substantial changes (inherent nature incorporated
  into criteria, not change in overall concept).
• Revised SOP divided test between contract
  exchanges, and integrated or nonintegrated
  benefit features.
• Accounting for contracts that are substantially
  unchanged
• FAS 97/120 retrospective or if not practicable
  determine balance to defer and use prospective
  EGPs/EGMs.

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FASB SOP Clearance Meeting

• FASB did not clear the document
• FASB recommended AcSEC and Task Force reconsider
  conclusions
• Determining substantial changes investment
  reward rights
• Costs related to internal replacements
• Sales inducements offered with an internal
  replacement

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Next Steps After FASB SOP Clearance Meeting
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Option 1- Revise the current SOP based on FASB
recommendations

• Change in the nature of the investment return
  rights between the insurance enterprise and the
  contract holder would result in a substantially
  changed contract
• (would include cap and floor, paragraph 13b)
• Costs incurred with an internal replacement that
  results in a substantially unchanged contract
  should be expensed
• (paragraphs 22 23) (Significant change in
  practice)
• Sales inducements offered with an internal
  replacement that results in a substantially
  unchanged contract should not be accounted for as
  if the sales inducement was explicitly identified
  in the original contract at inception
  (interaction with SOP 03-1)
• (paragraph 19)

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Option 1- Revise the current SOP based on FASB
recommendations

• Task Force recommends
• Not including a quantitative analysis of cash
  flows
• All scenarios tested fell within 10 corridor
• Virtually all realistic replacement scenarios are
  likely to fall within 10 corridor
• Minority task force view - SOP should contain a
  quantitative analysis, similar to EITF 96-19
• Additionally Task Force recommends
• Revise definition of internal replacement
• A modification that results from the election of
  a feature or a right in accordance with terms
  fixed or specified within reasonably narrow
  ranges in the original contract is not considered
  an internal replacement, unless the modification
  results in a change to the DAC amortization
  method or revenue classification of the contract.
  
• Exercising a priced, existing option that was
  included within reasonably narrow ranges
  specified in the original contract.
• Not new negotiation or offer/acceptance between
  enterprise and contract holder.

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Option 2 Disclosure Only

• Disclosure of internal replacement policy and
  methodology
• Pros
• Provides insight into company treatment of
  internal replacements that facilitates
  comparability of results
• SOP does not meaningfully improve comparability
• Cost beneficial vs. implementing current SOP
• SOP too complicated
• Application will be inconsistent
• Cons
• Does not eliminate potential diversity
• Risk that current accounting could be second
  guessed
• Another standard setter provides guidance
• Current draft SOP could evolve into current
  practice or defacto GAAP

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Option 3 - Revise definition of an internal
replacement

• Definition of internal replacement only includes
  contract exchanges
• Other contract modifications not included in
  scope
• Pros
• Better aligned with industry expectations/interpre
  tations of what constitutes an internal
  replacement
• Captures significant majority of what drove the
  issue of diversity
• Cons
• Narrow definition previously rejected

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Option 4 Simplify Concept

• Revise definition of internal replacement
• A modification that results from the election of
  a feature or a right in accordance with terms
  fixed or specified within reasonably narrow
  ranges in the original contract is not considered
  an internal replacement, unless the modification
  results in a change to the DAC amortization
  method or revenue classification of the contract.
• Nontrivial modifications to economic terms
  contract extinguishment
• Pros
• Simple concept and easy to interpret
• Cons
• Extreme outcome
• Captures more activity than Task Force intended,
  including items not believed to be appropriate
  for consideration under this proposed SOP.
• Implementation requires meticulous tracking of
  modifications

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Next Steps

• June 2004 AcSEC Meeting
• Discuss revised SOP with AcSEC
• Discuss analysis of changes from ED