Deferred Acquisition Cost: Exploring the Most Simplified Approach
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Deferred acquisition cost: Exploring the most simplified approach Background insurance models and similarly amortized balances, such as sales inducement assets In August 2018, the Financial Accounting Contents (SIA), unearned revenue reserves (URR), Standards Board (FASB) issued Accounting Deferred acquisition cost amortization and potential changes based on company Standards Update 2018-12 (ASU 2018-12), method explored ..................................2 elections across purchase GAAP VOBA amending the accounting model under US Alternative to a proportional balances and reinsurance accounting GAAP for certain long-duration insurance adjustment ..............................................6 cost-of-reinsurance balances. contracts and making major changes Actual deferred acquisition cost across multiple historical GAAP earnings amortization examples ........................7 emergence patterns. This is especially Conclusion ..............................................8 true when considering the amortization of deferred acquisition costs (DAC) across all Deferred acquisition cost: Exploring the most simplified approach Deferred acquisition cost amortization method explored For the purposes of this point of view, the reference to DAC will be is allowed if it is consistent with benefit reserve grouping, and assumed to apply to all balances electing or required to use the ASU approximates an individual-contract straight-line basis. Finally, the 2018-12 DAC amortization method. Unifying the basis of amortization DAC asset cannot exist on a balance that has been extinguished due across multiple insurance accounting paradigms creates a single to excess and unexpected terminations (944-30-35-3B) and where methodology and reduces the complexity of the calculation. The new there is no more impairment test. These new requirements are as guidance is in 944-30-35-3A through 3C. The wording allows for a few simple as can be…or are they? interpretations that are largely based on current industry practices, If we begin to break down the language and the intent (as any good but tend to generate some difficult methodology questions. This accountant, analyst, or actuary will do), we note that the “expected article explores the most simplified approach by promoting a set of term” is not defined. What does the expected term mean? Is it the challenging observations to avoid when developing one’s own DAC same as the expected lifetime? Is this a constant number at every amortization policy. point in the future, or does it get recalculated? These questions are There are four key elements to consider when changing from for the single policy. Then the grouping questions begin. If I group my today’s DAC amortization methods to the LDTI DAC amortization contracts, how do I adjust the DAC balance to make sure my cohort method: deferrals, amortization basis (also known as revenue approximates the individual straight-line basis? How do I address, or gross profits), interest, and timing. The simplification of DAC and make the necessary adjustments for, excess or unexpected amortization includes the removal of future expected deferable terminations? Do the two methods (single-contract and grouped) expenses in the determination of amortization rate. The impact of need to be equal, or simply approximately close? Or is it simply future deferrable expenses is explicitly prohibited (944-30-30-2) until the same method applied to either data grouping that is required? the expense is realized. Today’s methods include revenue as the Finally, the unspoken question that some companies do not even amortization base, which creates additional complications hidden consider: timing. Under current US GAAP guidance, traditional within the development of gross profits or margins when the DAC product DAC is amortized at the beginning of the period, and is for interest-sensitive or participating business. DAC under LDTI interest-sensitive product DAC is amortized at the end of the period has eliminated the complexities of a revenue-based amortization. In (see table 3). When does the LDTI DAC amortization timing take fact, it is forbidden to match the expense amortization with revenue place: the beginning or the end of the period? How does this affect or profit (944-30-35-3C). This change to the amortization basis my amortized, unlocking, or true-up amounts? Let’s try to answer disconnects the amortization of DAC from the matching principle some of these questions by aligning the DAC amortization method (revenue and expense alignment). As for the additional key elements, with the straight-line depreciation method. interest on the unamortized DAC balance has also been removed Since the straight-line method is explicitly identified in the guidance, (944-30-35-3C). It appears that housecleaning of complexities has it may be helpful to revisit the definition of “straight-line basis.” We been successfully completed, with many of the most confusing can start by explaining this through our understanding of straight- elements removed. line depreciation. This is essentially the manner in which the value of On the most basic level, the new amortization amount is very clearly an asset is run off over the useful lifetime to the ultimate value. Here identified as a cost that is charged to expense on a seriatim (single- is a simple, classic example of straight-line depreciation. contract) straight-line basis over the expected term of the contract. The guidance goes on to explain that the grouping of contracts 2 Deferred acquisition cost: Exploring the most simplified approach Table 1. Straight-line depreciation table example description straight line purchased value 800 estimated useful lifetime 5 4 3 2 1 0 amortization amount 160 item\time => 0 1 2 3 4 5 beginning balance 800 640 480 320 160 0 amortization 160 160 160 160 160 ending balance 640 480 320 160 0 Table 1 establishes the amount to amortize at initial purchase as for some and shortened for other assets. Since the objective of 800. The purchase has a five-year estimated useful lifetime to reach this approach is to simplify or improve the DAC amortization, it has the ultimate value (zero). This is of interest because it clearly shows been proposed that this combined duration is acceptable. As long a constant-level basis (and no interest) using a pivot approach. as the remaining amount is amortized consistently across the future The constant-level basis occurs when the timing of depreciation lifetime, and the balance associated with policies that drop from is measured at the beginning of the year. Our DAC straight-line the cohort is removed from the ending unamortized balance, this amortization method takes away the following from this example: is sufficient to meet the requirements of the guidance. The same method is applied both at a cohort level and at a seriatim level, and • The expected term is the useful lifetime, which is defined by the the amount is always decreasing (save for new deferrals). final runoff amount (zero in this example). For our purposes, the final run-off amount can be a zero unamortized DAC balance or a This useful lifetime can be projected to zero lives or to a certain sufficiently small population of contracts in a cohort as defined by threshold. It is important to include in the actuarial projections the accounting policy. The policy would include considerations for used to determine the useful lifetime the appropriate phases of shock lapse rates, maturity dates, separation of product life cycles, the contract. For example, the lifetime of a deferred annuity does and extinguishment of the underlying account value. not include the payout phase of the contract. Table 2 uses the cumulative useful lifetime (sum of the estimated useful lifetime is • The constant rate of amortization is recalculated at every point in the sum of the row immediately above within the table) and applies time. This is consistent with a pivot method that also introduces the straight-line approach using this sum as the denominator. This new deferrals (as the new deferrals have a shorter useful lifetime). is done to expand the example and address true-up of inforce data The straight-line depreciation method is usually used on each and assumption unlocking. individual asset separately. If, however, we group assets together that have different useful lifetimes, a combined duration would result. Based on this combination, the useful lifetime is extended 3 Deferred acquisition cost: Exploring the most simplified approach Table 2. Straight-line depreciation table sum of useful lifetime example description straight line purchased value 800 time 0 1 2 3 4 5 estimated useful lifetime 5 4 3 2 1 0 estimated useful lifetime 15 10 6 3 1 0 amortization amount 53 53 53 53 53 item\time => 0 1 2 3 4 5 beginning balance 800 533 320 160 53 0 amortization 267 213 160 107 53 ending balance 533 320 160 53 0 In our simple example in table 2, if the useful lifetime were to So far, we have addressed the useful lifetime of a contract used in increase by half a year after year one, but the ultimate value were the DAC amortization period and the method (whether a single life to stay the same, the impact of this change would stretch the or grouped cohort), but we have not addressed timing. Timing under amortization period into the future, and the current value would the LDTI DAC amortization method would appear moot, given the be unaffected. The current unamortized balance stays the same, lack of interest. A consideration of the previous straight-line example but the future amortization amount is lower due to an increased does not support that hasty conclusion. Table 3 details the current denominator. This reduction in amortization allows the ultimate simple US GAAP DAC annual amortization formulas (no unlock or value to be realized half a year later. Here, the total amount true-up included) that show the timing of amortization (before or amortized is still 800.