Insurance companies that issue long-duration contracts (LDTI) can expect volatility, increased data and disclosure requirements, and the potential for a new market for reinsurers thanks to recent accounting changes, according to Milliman’s William Hines and Francois Dauphin. In the latest episode of Critical Point, Milliman’s life insurance actuaries discuss key takeaways from the Financial Accounting Standards Board (FASB) Targeted Improvements to the Accounting for Long-Duration Contracts (LDTI), which will require significant risk management and has a go-live date of January 2021.
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Rebecca Driskill: Hello and welcome to Critical Point, brought to you by Milliman. I'm Rebecca Driskill, and I'll be your host today. In today's episode of Critical Point, we're going to be talking about life insurance, specifically the way the updated FASB Accounting Standard could have a profound effect on insurers’ long-term financials. William Hines and François Dauphin are part of a team of Milliman Consultants working on what the U.S. GAAP Targeted Improvements might mean for insurers and the industry as a whole. There are a number of high-level takeaways that we're going to discuss on today's episode, so let's get right into it. William? François? Good morning.
William Hines: Good morning.
François Dauphin: Good morning.
Rebecca Driskill: First, just to give listeners a sense of the big picture, how important is the new U.S. GAAP standard for insurers? William, how often do we see this kind of change?
William Hines:This kind of change happens very infrequently. Large-scale changes to the GAAP financial reporting occur probably once every 20 years.
Rebecca Driskill: And what is prompting these changes?
William Hines: Well, I think the goal of the changes is to provide better information to the users of financial statements. And think of the users as capital providers to insurance companies, policy holders, possibly agents, people who are looking for solid companies. But the users are looking for more current information about the estimate liabilities on the balance sheet, more up-to-date and frequent updates of what current views of the liabilities are. And FASB is trying to meet those types of requests through the changes in LDTI.
Rebecca Driskill: We're talking about life insurance. Can you just tell me a little bit about what kinds of products will these changes affect most?
William Hines: Yeah, the products that will be affected are a couple of different ones. Traditional insurance contracts will be affected significantly. These are typically fixed benefit, fixed premium type products like whole life insurance, term insurance, disability income insurance, long-term care insurance. But also contracts like variable contracts and other fixed indexed annuities that have both death and living benefit guarantees. They'll be impacted quite significantly as well.
François Dauphin: And I would say across the board, all products are going to be impacted as well with the disclosure requirements introduced by the Targeted Improvements.
William Hines: As well as the changes to deferred acquisition costs and the amortization of that will affect all products as well.
Rebecca Driskill: So William, these are-- it's an accounting standard. Why are actuaries involved?
William Hines: Milliman and actuaries are involved in U.S. GAAP because the changes from the Targeted Improvements primarily impact the quantitative or the calculations of the reserve liabilities that companies put on their balance sheet. And actuaries are just heavily involved in that activity of those calculations and are best poised to help companies make those changes.
Rebecca Driskill:I want to break it down into a number of takeaways, starting with the most immediate impact. François, what's the first thing that executives of insurance companies need to know about how the standard can affect business?
François Dauphin: Well, I think the requirements for traditional products, which is to use unlocked assumptions and discount rates, is going to create significant volatility in the level of income as well as equity. And that is going to be very important to understand what is driving that volatility.
Rebecca Driskill: So this volatility, what does that mean for CFOs or for insurers? How is it changing the way business is managed?
François Dauphin: Well, it makes it harder to forecast accurately what's going to happen. There's been traditionally an expectation that your income emergence or your reserve runoff for traditional business is smooth, and that most of the volatility is going to be centered around your guaranteed minimum benefits on variable annuities. So now there's going to be increased focus to explain that volatility for traditional products going forward.
Rebecca Driskill: I mean, what is the benefit? Why make that change?
William Hines: For traditional products, the assumptions that go into the reserve calculations have been locked and never change once a contract is issued unless that reserve becomes deficient. And at that point in time, you would reset the reserves based on current assumptions. But there is no signal within the financial statements that experience is getting worse until the point your reserve is insufficient. And so users of the financial statements and the stakeholders of FASB decided that this was something that really needed to change and that there needed to be more information, a more current view of where current experience was relative to the reserves, and as a result, FASB decided that they would unlock all assumptions for traditional products and make them all current views.
Rebecca Driskill:Okay, so we've talked about volatility with traditional contracts. Are we going to see volatility in any of the other products offered by life insurers?
William Hines: Yes, we will. In particular, there's a new category of benefits that's been developed in the Targeted Improvements called Market Risk Benefits, which are effectively death and living benefits on any annuities that transfer significant market risk to the insurers or possibly living benefits on life insurance contracts. Today there are two different measurement models used for those types of benefits depending on the underlying character of the benefit. And FASB has decided to move them to a single consolidated measurement basis, which will be fair value. And the use of fair value for all of those types of benefits will significantly increase the level of volatility in the reserves that are being calculated.
Rebecca Driskill: And so what are the ramifications of that?
François Dauphin: Well, for insurers I think there's going to be an incentive now to hedge the risk fully for those contracts as a way to mitigate or reduce that volatility. But as we know, hedging is expensive, so we can see-- under that approach, profitability will be reduced. So maybe an alternative way, one which is yet to be explored is, if there's reinsurers out there who use a different accounting regimes to report on, might want to take on that risk and it might be cheaper for companies to do that.
Rebecca Driskill: So then there's the potential here for this to almost create a new market for reinsurers. Is that accurate?
François Dauphin: I think so, absolutely. And it would depend on their view of the risk, and whether they're willing to take it on, their appetite.
Rebecca Driskill: What kind of market, what sort of---
William Hines: Well, there's always been a reinsurance market for these types of products, but the cost for reinsuring has been pretty prohibitive because companies have been able to re-- to not fully hedge and retain some of the risk to maintain some of the profitability. With the change to Market Risk Benefits, moving to fair value, there'll be less and less ability of the direct writers to be able to manage this business profitably. So there will be more opportunities I think for reinsurers, especially ones that are not subject to U.S. GAAP, to be able to come into the market and come up with customized solutions.
Rebecca Driskill: So takeaway number one is really all about increased volatility. Takeaway number two really has to do with data and disclosures and how the updated standard could really change the amount of data that needs to be collected. Is that correct?
William Hines: That is correct. The requirements for additional disclosures, both in numerical terms, quantitative disclosures as well as qualitative disclosures, has increased significantly with these targeted changes and will affect all lines of business.
Even the amount of information that's going to be required and the level of granularity at which it is going to be-- need to be disclosed is going to pose a lot of challenge for companies because their systems will need to be adjusted significantly to deal with these types of calculations during the financial close process and being able to go through an audit and have all the appropriate governance in place.
Rebecca Driskill:So is the bottom line here don't underestimate that?
William Hines: That's exactly it. Don't underestimate the amount of additional work that's required for disclosures well beyond just doing the normal calculations.
François Dauphin:Yeah, so it goes way beyond actuarial calculations. It impacts various areas of the companies.
Rebecca Driskill: And what kind of challenges does that introduce for CFO's, actuaries, executives that need to now, I guess, collect the data, right?
William Hines: Yeah, I mean, there's several different types of challenges here, one of which is actually sourcing the information from new places. You know, the actual cash flows have never been fed into the reserve systems, historically. Validating those cash flows are appropriate for those calculations, putting the controls in place to make sure that the data is appropriately brought through. And then on the other side, sort of the output side of the reserve calculations and all of the disclosures, capturing that data in some type of environment, an IT environment where that is also controlled, but can be easily brought into the financials is going to pose a significant challenge.
Rebecca Driskill: What are some of the ways insurers are responding to these challenges?
William Hines: We've seen a lot of companies implement some very interesting tools to help them through this process, whether it's an outsourcing software type situation or customizing something internally. But basically working through a lot of automation of processes. Not just calculations themselves but the processes to collect and disseminate data. And to build repositories of financial data, a financial warehouse that companies can use to better manage their business on a go forward basis as well as explain how that impact will be borne out in the GAAP financials.
Rebecca Driskill: You know, we talk a lot about insurtech and looking at these-- at changes from a holistic perspective. Are these accounting standards, is it compliance, is it a more holistic insurtech revamping? What's your guys' take on this?
William Hines: Certainly there are companies that are thinking about this from more of a compliance view, "What's the minimum I can do to become compliant with LDTI and get through the audit appropriately?" But there certainly are a lot of companies that are seeing the requirements here as being fairly significant around other processes other than just the reserve calculations, the movement of data, the governance processes, the disclosures that are required, the volume of information, and thinking more holistically about it, and trying to revamp all of their processes.
François Dauphin: What we're seeing right now is a modernizing effort being undertaken, or for those insurers who haven't done so previously, this is being used as an excuse to really move-- you know, update their platforms. So LDTI becomes part of a broader modernization effort. And what we're seeing with the challenge for these companies who are taking the more holistic approach is time, really, because the standard becomes effective January 1st, 2021, for public reporting entities. And these solutions take time and resources to implement. And so right now we're seeing companies also balance, "What can I do as a temporary solution until I reach the end state of where I want to be?"
Rebecca Driskill: So amidst this uncertainty or all of these changes, how important is the audit process? Is that something that should be happening a few months from now? Is that something that should be happening now?
François Dauphin: Oh, I think it needs to be happening now. And I-- for companies that haven't been engaged with their auditor regularly, you know, creating or opening this channel of communication is going to be very important. The requirements of LDTI cannot use estimates of actual historical experience, but does materiality play a role in this?
Rebecca Driskill: The goal here is to have hopefully have a healthier system overall. Is that accurate?
William Hines: Yeah, I think that's right. I think what it's going to take a while to get used to because what-- if you continue to measure the balance sheet on a current basis, you will have more frequent updates to the numbers, you'll have more volatility in income, and more information being provided through the disclosures, particularly, that will create hopefully a better understanding of the risk profile of insurance companies and how income might emerge over time.
François Dauphin: Not just for users of financial information outside the company, but even like for the C-suite at companies to be able to understand and explain those results I think this is going to be helpful.
Rebecca Driskill: Well, William, François, thank you for joining me. You've been listening to Critical Point, presented by Milliman. To listen to other episodes of our podcast, visit us at milliman.com, or you can find us on iTunes, Google Play, Spotify, or Stitcher. See you next time.