developments in deferred acquisition costs (dac) for variable annuities secession 59pd - may 29,...

Developments in

Deferred Acquisition Costs (DAC) for

Variable Annuities

Secession 59PD - May 29, 2003

Developments in

Deferred Acquisition Costs (DAC) for

Variable Annuities

Secession 59PD - May 29, 2003

Bradley Barks, FSA, CPA, MAAACFO and Senior Vice PresidentGlobal Preferred Holdings, Inc.

Bradley Barks, FSA, CPA, MAAACFO and Senior Vice PresidentGlobal Preferred Holdings, Inc.

Presentation SummaryPresentation Summary

I. Recent Results of Public CompaniesII. Comparison of Methods to Address Equity

Market VolatilityIII. Sales Inducements - Long Duration SOPIV. Loss Recognition IssuesV. Internal Replacements SOP

I. Recent Results of Public CompaniesII. Comparison of Methods to Address Equity

Market VolatilityIII. Sales Inducements - Long Duration SOPIV. Loss Recognition IssuesV. Internal Replacements SOP

Recent Results of Public CompaniesRecent Results of Public Companies

Recent Results of Public CompaniesRecent Results of Public Companies

Summary

Methods and Assumptions DAC “Adjustments”

Summary

Methods and Assumptions DAC “Adjustments”

Recent Results of Public CompaniesMethods & Assumptions

Recent Results of Public CompaniesMethods & Assumptions

(in millions unless otherwise stated)

Company (Symbol) Method

Long Term Yield

AssumptionYield

Limitations

Years Yield Adjustments

Made

Underlying Assets

(in billions)Aegon (AEG) (US Business)

Mean Reversion 9%; 9.5% prior to 4Q02

12%; 14.5% prior to 4Q02

5 € 31

Allmerica (AFC) Mean Reversion 8% 12% 5

American International Group (AIG)

Traditional NA NA NA

Hartford Financial Services (HFS)

Traditional: unless "the present value of future gross profits" falls outside a reasonable range.

9% NA NA $64

John Hancock (JHF) Mean Reversion 8%; 9% prior to 4Q02

13%; mid-teens prior to 4Q02

5 $30

Lincoln National (LNC) Mean Reversion 9%; 14% prior to 4Q02

1% and 14.5% 8.6 $34

Met Life (MET) Mean Reversion

Nationwide (NFS) Mean Reversion 8% 0% and 15% 3 $32

Prudential (PRU) Modified Mean Reversion 9% < 15% 4 $15

Source is from 12/31/2002 Form 10K or 20-F and Insurance Industry Analyst Reports

Recent Results of Public CompaniesAdjustments to DAC Balances

Recent Results of Public CompaniesAdjustments to DAC Balances

(in millions unless otherwise stated) Adjustments to DAC for Year ended 12/31/2002

Company (Symbol)

Total Due to Equity Market

Decline

Total for Variable Products

Total for Variable Annuities

Total Reduction in

Income Due to Equity Market

Decline

Total DAC Balance at

12/31/02 (in billions)

2002 DAC Adjustments as

% of Consolidated DAC Balance

Aegon (AEG) (US Business)

€ 450 € 14.089 3.10%

Allmerica (AFC) $629 $698 $1.242 33.63%

American International Group (AIG)Hartford Financial Services (HFS)

$0 $6.689 0.00%

John Hancock (JHF) $64 $49 $36 $3.996 1.58%Lincoln National (LNC) $89 $49 $2.971 2.91%Met Life (MET) $111 $11.727 0.94%

Nationwide (NFS) $347 $328 $3.027 10.29%

Prudential (PRU) $137 $7.031 1.91%

Source is from 12/31/2002 Form 10K or 20-F and Insurance Industry Analyst Reports

Comparison of Methods to Address Equity Market Volatility




Summary

Basis of Long-term Assumptions and Methods How Far Out on the Tail Are We? How Bad Might It Be 5 to 10 Years from Issue? “Ideal Method” – Achieves Best Matching Comparison of Methods to the “Ideal”

Summary

Basis of Long-term Assumptions and Methods How Far Out on the Tail Are We? How Bad Might It Be 5 to 10 Years from Issue? “Ideal Method” – Achieves Best Matching Comparison of Methods to the “Ideal”



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Annualized S&P 500 Return

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S&P 500 Index

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200219921982197219621952



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Hypothetical Fund Value (Starting at 8/1/00)

$0$2,000$4,000$6,000$8,000

$10,000

2000 2002 2004 2006 2008 2010

Worst 5yrs Worst 10yrs S&P 500

4.17% return 2.83% return



Principles of Amortization Methods

Match Revenue and Expense Revenue is EGP Expense is DAC (GMDB, Sales Inducements) Problem: We don’t know what the future EGPs

will be AND they are extremely volatile in the short-term but less volatile in the long-term.

Principles of Amortization Methods

Match Revenue and Expense Revenue is EGP Expense is DAC (GMDB, Sales Inducements) Problem: We don’t know what the future EGPs

will be AND they are extremely volatile in the short-term but less volatile in the long-term.



How to Compare Different Methods?

If we knew what the EGPs would be, we would have a perfect match of Revenue and Expense.

The Ideal Method would be the “Crystal Ball” Method

Comparison Can Be Made Relative to The “Crystal Ball” Method.

How to Compare Different Methods?

If we knew what the EGPs would be, we would have a perfect match of Revenue and Expense.

The Ideal Method would be the “Crystal Ball” Method

Comparison Can Be Made Relative to The “Crystal Ball” Method.



Numerical Comparisons

Assumptions Single Premium $10,000 Avg. Long-term Fund Performance

9% M&E Charges 140 b.p. Expenses 50 b.p. Issue Expenses 7% of Prem. Surrender Charges 7%,6%,5%,4%,3%,2%,1%,0% thereafter Surrender Rates 4% except 15% in year 8


Assumptions Single Premium $10,000 Avg. Long-term Fund Performance

9% M&E Charges 140 b.p. Expenses 50 b.p. Issue Expenses 7% of Prem. Surrender Charges 7%,6%,5%,4%,3%,2%,1%,0% thereafter Surrender Rates 4% except 15% in year 8




Summary of Methods Crystal Ball – Assumes that actual gross profits were known at

issue. Results in perfect matching. Traditional Method – Assumes that expected gross profits are

based on the current fund value projected at the average long-term fund performance rate.

Mean Reversion (modified for simplicity) – Traditional method except that the average long-term fund performance rate is increased or decreased to a cap (14%) or floor (0%) until the FV equals the FV projected at issue. Thereafter, the average long-term fund performance rate is used.

Credibility Method – Assumes that EGPs projected at each valuation date are given 10% weight with the the rest of the weight given to the original EGPs. All EGPs given equal weight after year 10.


Summary of Methods Crystal Ball – Assumes that actual gross profits were known at

issue. Results in perfect matching. Traditional Method – Assumes that expected gross profits are

based on the current fund value projected at the average long-term fund performance rate.

Mean Reversion (modified for simplicity) – Traditional method except that the average long-term fund performance rate is increased or decreased to a cap (14%) or floor (0%) until the FV equals the FV projected at issue. Thereafter, the average long-term fund performance rate is used.

Credibility Method – Assumes that EGPs projected at each valuation date are given 10% weight with the the rest of the weight given to the original EGPs. All EGPs given equal weight after year 10.



Crystal Ball Method Level 9%

$0

$50

$100

$150

$200

$250

1 6 11 16 21 26

Year

Gross Profit Crystal Ball



Crystal Ball Method S&P - 1995-2002

$0

$50

$100

$150

$200

$250

1 6 11 16 21 26

Year

Gross Profit Crystal Ball



Comparison of Methods S&P - 1995-2002

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

1 6 11 16 21 26Year

Crystal Ball Mean Reversion Credibility Traditional




Observations: Crystal Ball – Results in perfect matching. Overall

All methods perform well when market performance is constant. 75% of the 12–month periods had returns greater than 15% or less

than 5%. 85% of 3-month periods were outside of this range. (Using S&P 500 for periods starting at beginning of the month from

1950 thru 2002.) Traditional Method –Results in very poor matching in volatile

markets. Mean Reversion – Effectively dampens poor matching

associated with the Traditional method. Tends to become volatile toward end of amortization period.

Credibility Method – Good matching over entire amortization period.


Observations: Crystal Ball – Results in perfect matching. Overall

All methods perform well when market performance is constant. 75% of the 12–month periods had returns greater than 15% or less

than 5%. 85% of 3-month periods were outside of this range. (Using S&P 500 for periods starting at beginning of the month from

1950 thru 2002.) Traditional Method –Results in very poor matching in volatile

markets. Mean Reversion – Effectively dampens poor matching

associated with the Traditional method. Tends to become volatile toward end of amortization period.

Credibility Method – Good matching over entire amortization period.



Comparison of Methods Alternate between 5% and 15%

$0

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$40

$60

$80

$100

$120

1 6 11 16 21 26Year




Comparison of Methods Level 7%

$0

$10

$20

$30

$40

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$60

$70

$80

$90

$100

1 6 11 16 21 26Year


Sales Inducements to Contract Holders - Non-traditional Long-duration

Statement of Position (NTLD SOP)

Sales Inducements to Contract Holders - Non-traditional Long-duration

Statement of Position (NTLD SOP)

Sales Inducements - NTLD SOPSales Inducements - NTLD SOP

Summary Definition of Sales Inducements Accounting Treatment Disclosures Effective Date and Transition

Summary Definition of Sales Inducements Accounting Treatment Disclosures Effective Date and Transition


Definition Insurer must demonstrate that amounts are

Incremental to amounts credited on similar contracts without sales inducements, AND

Higher than the contract’s expected ongoing crediting rates for periods beyond the inducement, as applicable, AND

Must be part of the original contract Examples: Day-one bonus, persistency bonus,

enhanced credited rate Applies to UL and Investment Contracts

(Deferred Annuities)

Definition Insurer must demonstrate that amounts are

Incremental to amounts credited on similar contracts without sales inducements, AND

Higher than the contract’s expected ongoing crediting rates for periods beyond the inducement, as applicable, AND

Must be part of the original contract Examples: Day-one bonus, persistency bonus,

enhanced credited rate Applies to UL and Investment Contracts

(Deferred Annuities)


Accounting Treatment Recognized as part of the liability for policy

benefits Cannot reflect surrenders in determining

amounts to defer or amounts included in Liability for Policy Benefits

Deferred and amortized New item: “Deferred Sales Inducements” Amortization same methodology and assumptions as

DAC Amortization is included as a component of benefit

expense Surrender assumption is included in

amortization.

Accounting Treatment Recognized as part of the liability for policy

benefits Cannot reflect surrenders in determining

amounts to defer or amounts included in Liability for Policy Benefits

Deferred and amortized New item: “Deferred Sales Inducements” Amortization same methodology and assumptions as

DAC Amortization is included as a component of benefit

expense Surrender assumption is included in

amortization.


Disclosure Requirements

Nature of costs capitalized and amortization method

Amounts capitalized and amortized Unamortized balances

Disclosure Requirements

Nature of costs capitalized and amortization method

Amounts capitalized and amortized Unamortized balances


Transition Rules and Effective Date

Effective for fiscal years beginning after December 15, 2003

Initial costs deferred prior to adoption are not adjusted

Unamortized balances amortized according to SOP at initial application

Cannot retroactively capitalize sales inducements not previously deferred

Prospective No cumulative effects Must Adopt Retroactive to Beginning of a Fiscal

Year

Transition Rules and Effective Date

Effective for fiscal years beginning after December 15, 2003

Initial costs deferred prior to adoption are not adjusted

Unamortized balances amortized according to SOP at initial application

Cannot retroactively capitalize sales inducements not previously deferred

Prospective No cumulative effects Must Adopt Retroactive to Beginning of a Fiscal

Year

Loss Recognition IssuesLoss Recognition Issues

Loss Recognition IssuesLoss Recognition Issues

Summary

Impact of GMDB Cost Sales Inducements Effect: Loss Recognition is permanent

vs. DAC unlocking can be recaptured

Summary

Impact of GMDB Cost Sales Inducements Effect: Loss Recognition is permanent

vs. DAC unlocking can be recaptured

Proposed SOP: Deferred Acquisition Costs On Internal Replacements

Proposed SOP: Deferred Acquisition Costs On Internal Replacements

DAC on Internal ReplacementsDAC on Internal Replacements

Summary

Background Supporting Literature Definition of Internal Replacement Accounting Treatment Effective Date and Transition

Summary

Background Supporting Literature Definition of Internal Replacement Accounting Treatment Effective Date and Transition


Background Proposed Statement of Position released 3/14/03 Comments Due 5/14/03 Applies to DAC, Unearned Revenue Liability and Sales

Inducements Note: Sales Inducements incurred because of a

modification (i.e., were not contemplated in the original contract) can be deferred if the new contract is “Not Substantially Different.” (Contrary to NTLD - SOP)

FINAL STATEMENT MAY CHANGE

Background Proposed Statement of Position released 3/14/03 Comments Due 5/14/03 Applies to DAC, Unearned Revenue Liability and Sales

Inducements Note: Sales Inducements incurred because of a

modification (i.e., were not contemplated in the original contract) can be deferred if the new contract is “Not Substantially Different.” (Contrary to NTLD - SOP)

FINAL STATEMENT MAY CHANGE


Supporting Literature SFAS 60, Par. 28 SFAS 97, Par. 26,70-72 AICPA Practice Bulletin #8 (11/90) SFAS 91-Accounting for Non-refundable Fees and Costs

Associated with Originating and Acquiring Loans and Indirect Costs of Leases

SFAS 120 – Accounting and Reporting by Mutual Life Insurance Enterprises and for Certain Participating Contracts

SFAS 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities

EITF # 96-19 – Guidance on Extinguishment of Debt Instruments

Supporting Literature SFAS 60, Par. 28 SFAS 97, Par. 26,70-72 AICPA Practice Bulletin #8 (11/90) SFAS 91-Accounting for Non-refundable Fees and Costs

Associated with Originating and Acquiring Loans and Indirect Costs of Leases

SFAS 120 – Accounting and Reporting by Mutual Life Insurance Enterprises and for Certain Participating Contracts

SFAS 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities

EITF # 96-19 – Guidance on Extinguishment of Debt Instruments


Definition of Internal Replacement: Modification of the Contract “Substantially Different” “Inherent Nature” Changed

Definition of Internal Replacement: Modification of the Contract “Substantially Different” “Inherent Nature” Changed

DAC on Internal ReplacementsSchematic of Statement Of Position

DAC on Internal ReplacementsSchematic of Statement Of Position

Is the Is the Modification an Modification an

Internal Internal Replacement?Replacement?

NoNo

YeYess

Is at least one of the Is at least one of the criteria of criteria of

“substantially “substantially different” (Par. 11) different” (Par. 11)

met? Also use met? Also use examples in Par. 13-18.examples in Par. 13-18.

““Not Not Substantially Substantially

Different” Different” Accounting Accounting TreatmentTreatment

YeYess

NoNo

““Substantially Different” Substantially Different” Accounting TreatmentAccounting Treatment

Is there a Is there a Modification to Modification to the Contract?the Contract?

NoNo

YeYess


Modifications not considered an Internal Replacement Both Contemplated in the Original Contract AND

Does Not Change the Inherent Nature of the Contract

Examples in the SOP (Safe Harbors): Changes in Rates or Charges within Ranges Outlined in

Original Contract without Changes in Benefits Changes in Allocations among investment alternatives

(100% allocation is all right) Addition of Investment Alternative (only if Contract

already has multiple alternatives) Election of an Inflation Adjustment Benefit Purchasing Paid-Up Additions

Modifications not considered an Internal Replacement Both Contemplated in the Original Contract AND

Does Not Change the Inherent Nature of the Contract

Examples in the SOP (Safe Harbors): Changes in Rates or Charges within Ranges Outlined in

Original Contract without Changes in Benefits Changes in Allocations among investment alternatives

(100% allocation is all right) Addition of Investment Alternative (only if Contract

already has multiple alternatives) Election of an Inflation Adjustment Benefit Purchasing Paid-Up Additions


“Not Substantially Different” (must meet all conditions)

No additional deposit, premium or charge is required above amounts contemplated in the contract

No net decrease in Policy Balances No change from SFAS 60 to SFAS 97 or to

SFAS91 or visa versa New Benefit does not become Primary Benefit Modification does not change “Inherent Nature”

of Contract (more subjective)

“Not Substantially Different” (must meet all conditions)

No additional deposit, premium or charge is required above amounts contemplated in the contract

No net decrease in Policy Balances No change from SFAS 60 to SFAS 97 or to

SFAS91 or visa versa New Benefit does not become Primary Benefit Modification does not change “Inherent Nature”

of Contract (more subjective)


“Inherent Nature” of Contract Consider any change including rider, amendment,

exchange of contract or “election of a feature within an existing contract”

Most significant Factors Kind and Degree of Mortality or Morbidity Risk Rights and Provisions for Determining Investment

Return

Legal Form of Change does not matter “Election of Existing Feature” may be Problematic

“Inherent Nature” of Contract Consider any change including rider, amendment,

exchange of contract or “election of a feature within an existing contract”

Most significant Factors Kind and Degree of Mortality or Morbidity Risk Rights and Provisions for Determining Investment

Return

Legal Form of Change does not matter “Election of Existing Feature” may be Problematic


“Inherent Nature” – Safe Harbors (examples) Additional Investment Alternatives (same as

above) Addition of MVA provision (change only effects

surrender charge) Addition of LTC Rider to Disability Contract (No

Change in Primary Benefit) Addition of Enhancement of GMIB, GMAB or

Annuitization Guarantee (Only Affects Benefits After Termination)

“Inherent Nature” – Safe Harbors (examples) Additional Investment Alternatives (same as

above) Addition of MVA provision (change only effects

surrender charge) Addition of LTC Rider to Disability Contract (No

Change in Primary Benefit) Addition of Enhancement of GMIB, GMAB or

Annuitization Guarantee (Only Affects Benefits After Termination)


“Inherent Nature” – Failures (examples) Replace Term Life with Whole Life (adding

Significant Component) Add GMDB to Contract with Insignificant Death

Benefit or Visa Versa Replace Disability Contract with LTC Contract

(Changes nature of Morbidity Risk) Replace UL with Life Contingent Payout Annuity Change from Discretionary to Formulaic

Investment Crediting Methodology Replacement of Variable Contract with Fixed

Contract or Visa Versa

“Inherent Nature” – Failures (examples) Replace Term Life with Whole Life (adding

Significant Component) Add GMDB to Contract with Insignificant Death

Benefit or Visa Versa Replace Disability Contract with LTC Contract

(Changes nature of Morbidity Risk) Replace UL with Life Contingent Payout Annuity Change from Discretionary to Formulaic

Investment Crediting Methodology Replacement of Variable Contract with Fixed

Contract or Visa Versa


Transition

Effective Date: For Replacements in Fiscal Years beginning on or after December 15, 2003

Prospectively applied Prior balances should not be adjusted prior to

year of adoption Must Adopt Retroactive to Beginning of a Fiscal

Year

Transition

Effective Date: For Replacements in Fiscal Years beginning on or after December 15, 2003

Prospectively applied Prior balances should not be adjusted prior to

year of adoption Must Adopt Retroactive to Beginning of a Fiscal

Year

developments in deferred acquisition costs (dac) for variable annuities secession 59pd - may 29,...

Documents

ideal slide

equity market volatility

different methods

crystal ball method

ideal method

market performance

credibility method

crystal ball results