LDTI Implications and Insights: IDI and LTC
By Rob Winawer, Gregory MacKenzie, Kevin Desmond and Su Su
The Financial Reporter, February 2021
Changes to GAAP accounting guidance for insurers with long-duration liabilities due to Accounting Standards Update (ASU) 2018-12, commonly referred to as Long Duration Targeted Improvements (LDTI), will become effective Jan. 1, 2023, for public companies and Jan. 1, 2025, for non-public companies.
Individual disability insurance (IDI) and long-term care (LTC) business is uniquely impacted by LDTI, requiring companies to treat the active life and disabled life phases of a contract as a single unit of account. Reserves will be calculated based on total premiums and benefits associated with the contract, and individual policies will be grouped into cohorts (e.g., by product type and issue year) for liability calculations. The liability for future policyholder benefits (LFPB) will use a net premium approach with retrospective unlocking of actual premiums and claims and prospective unlocking of assumptions. Assumptions are best estimates and must be reviewed (and potentially updated) on at least an annual basis. Most companies are planning to unlock for actual premiums and claims on the same frequency as in-force updates.
Although possibly more intuitive, treating active and disabled lives as a single unit of account represents a significant departure from current practice. Under the current GAAP accounting framework, separate and distinct reserves are calculated for active and disabled lives, with the components commonly referred to as active life reserves (ALR) and disabled life reserves (DLR). Only DLR assumptions represent best estimates. ALR assumptions reflect provisions for adverse deviation and are locked-in at inception, unless a loss recognition event occurs.
This article highlights key implications and insights as a result of the change to the determination of reserves under LDTI for IDI and LTC products.
Earnings Emergence and Volatility Pre Versus Post-LDTI
The impact of updates to best estimate assumptions on GAAP earnings will likely look very different under LDTI due to the updates to reserve mechanics. Companies will need to be prepared to explain movements in reserves relative to current GAAP accounting practices.
Assumption Unlocking
Under the current GAAP accounting regime, assumption changes for disabled lives directly impact reserves, while assumption changes for active lives have no impact on reserves (since assumptions are locked-in at issue). Locking in assumptions for ALR leads to a disconnect between projected premium and benefit cash flows and the projected reserve release which can result in unintuitive projected net income patterns.
For LDTI, assumption unlocking, while simpler and intuitive in concept, is a departure from current practice.
While frequent unlocking of assumptions might be expected to create additional earnings volatility, LDTI may have the opposite impact in certain cases. Below are some examples that highlight how LDTI may result in either increased or decreased volatility:
- Experience updates: To the extent emerging actual premiums and benefit payments differ from expectations, the income statement impact of these differences will be offset by changes in the LFPB due to unlocking the net premium ratio (NPR).
- Termination rates: Unlocking the NPR will dampen the impact of changes to termination rates unless the premium cap is reached; more (or less) premiums will be reflected in the reserve, offsetting changes in expected benefit cash flows.
- Incidence rates: Changes in expected incidence rates will have reserve implications; previously, with ALR assumptions locked-in at inception, changes in incidence rates would not be reflected in the reserve.
Disaggregation of Reserves for Financial Reporting
A single unit of account view can alleviate some reserve computation complexity.
As noted previously, the current GAAP accounting regime involves separate reserve methodologies depending on whether a policy is currently active or disabled. The ALR and DLR are calculated for individual policies based on their current disability status. Under LDTI, the LFPB will be calculated based on the total premiums and benefits associated with a single cohort of policies. As policies move from active to disabled status, they will remain in the same cohort, combining the active and disabled phases into a single unit of account.
Industry practice has been to report and analyze ALR and DLR separately, a practice companies may wish to continue. Thus, new calculations, processes, and methodologies will likely be required to determine a meaningful split of liabilities associated with the active life and disabled life phases of a contract.
One implication of splitting LFPB into ALR and DLR components is the potential of having a positive LFPB with a negative ALR and positive DLR. For example, if experience over time pushes the NPR toward 100 percent due to unfavorable termination experience, the “DLR portion” of the LFPB will worsen and the “ALR portion” will approach a gross premium reserve. If, as with current practice, premiums are allocated to active life contracts (i.e., the “ALR portion” of the reserve), companies will likely see negative ALRs if active life policies are expected to be profitable (i.e., gross premiums are expected to cover benefits and expenses associated with the policy and produce a profit margin). Negative ALR is unprecedented and valuation actuaries will need to think about the explanation to stakeholders (e.g., this scenario would indicate that disabled lives are more expensive than expected).
Impairments and Premium Deficiencies
Impairment testing under LDTI is performed at a cohort level (rather than a more aggregate line of business level) via capping of the NPR at 100 percent. When the NPR is capped, net premiums are set equal to gross premiums and the LFPB effectively becomes a gross premium reserve. Since many IDI and LTC blocks currently have premium deficiencies, the cohort selection under LDTI could impact earnings to a greater extent than for other products.
Generally, using less granular cohorts will reduce the risk of impairment events, allowing less profitable business to be partially offset by more profitable business in the cohort. While the earnings impact alone provides reason to try to avoid impairment events, impairment events also introduce additional operational complexities due to the LDTI requirement for additional disclosures when net premiums are capped.
Companies will also need to consider how to allocate existing premium deficiency reserves (PDR), currently determined at the block (i.e., product line or more aggregate) level, to the LDTI cohorts. Possible allocation bases include the ALR, the DLR, the combined ALR and DLR, the original or current daily benefit amount, or premiums. The selected allocation methodology could have a significant impact on earnings. For example, if the combined ALR and DLR is used for allocation and the DLR is significantly larger than the ALR, the majority of the PDR would be allocated to cohorts with more disabled policies. Considering the relatively short duration of disabled policies compared to active policies, the liability associated with the PDR could be released much faster using this allocation basis.
Transition Considerations
Modified Retrospective Versus Full Retrospective
The most impactful transition decision from both a financial and operational perspective is whether a full retrospective or modified retrospective method will be used for LDTI transition. The full retrospective approach involves recalculating reserves using LDTI methodologies starting from cohort inception, while a modified retrospective approach involves pivoting off current GAAP reserves.
Because this decision must be made entity-wide, a consistent approach must be employed across all product lines. The full retrospective method requires the use of actual historical premiums and claims (i.e., estimates are not allowed) back to inception when recalculating the net GAAP liability. Unless there is a recent purchase GAAP event, the full retrospective method likely requires increased time and effort as well as a significant amount of historical data. Given the additional work required to obtain historical data for the full retrospective method, companies are generally electing a modified retrospective approach.
Note though that companies using the fully retrospective approach have an opportunity to either reduce or strengthen reserves at transition (depending on pre-LDTI assumptions vs. post-LDTI best estimate assumptions) with the reserve change impact reflected in retained earnings.
Modified Retrospective Discount Rates
Under a modified retrospective approach, for business issued prior to LDTI transition, the locked-in discount rate (i.e., the rate used for reserve changes that flow through the income statement) is based on the interest rate in effect immediately before LDTI transition. Two common approaches for cohorts containing varying discount rates pre-LDTI transition are (1) to calculate a single weighted average rate at the cohort level for ALR and DLR combined, or (2) to maintain separate discount rates based on the rate in effect for ALR and DLR.
A combined discount rate for active and disabled policies under LDTI could be significantly different from discount rates immediately before applying LDTI, depending on the issue year and claim incurral year. Thus, the pattern of emerging earnings could differ significantly pre- and post-LDTI. Assuming the discount rate associated with disabled lives is lower than for active lives due to the current low-interest rate environment, maintaining separate discount rates has the potential to improve short-term earnings.
From an operational perspective, maintaining a single discount rate post-transition may be preferable due to the additional process complexity from maintaining separate rates.
Impact of Using Single Unit of Account on Other Balances
The single unit of account view impacts other components of the net GAAP liability in addition to the LFPB.
Deferred Profit Liability
Multiple views emerged (in ASC subtopic 944-605) regarding whether or not the single unit of account brings IDI and LTC contracts under the umbrella of limited payment contracts requiring a deferred profit liability (DPL). One potential view is that “the period over which benefits are provided” extends beyond the premium payment period, thereby bringing the contracts within the definition of limited-payment contracts and “requiring deferral and amortization of the profit margin.” An alternative perspective is that premiums foregone due to disability are best viewed as a waiver of premium benefit and not an ending of the premium paying period; thus, a DPL is not required.
If a company does take the position that a DPL is required for its business, earnings will emerge slower since an initial liability will be set up representing the present value of expected deferred profits. The liability would then be amortized into earnings over the life of the contract.
Deferred Acquisition Cost Asset
The single unit of account view (i.e., combining active and disabled lives) will lengthen the deferred acquisition cost asset (DAC) amortization period beyond the period over which policyholders are paying premiums to the point where the last disability claim is paid. From an earnings perspective, this will have the opposite impact as the DPL. The DAC will amortize over an extended period which will further defer costs and increase initial profits.
Conclusion
The use of a single unit of account with retrospective cash flow updates and prospective assumption unlocking may impose a significant impact on profit emergence when compared to the pre-LDTI profit pattern. Certain methodology decisions, such as cohort setting, allocating existing PDR, and determining locked-in discount rates at transition will influence how earnings will emerge under LDTI.
Companies with material IDI and LTC business should carefully review past and expected experience and perform adequate sensitivity testing in order to make well-informed methodology decisions. The actuarial and accounting teams will need to balance financial and operational considerations in making each of the decisions, and the team performing analysis should be proactive in informing management of potential earnings implications.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.
Rob Winawer, FSA, MAAA, is a principal at Oliver Wyman. He can be reached at robert.winawer@oliverwyman.com.
Gregory MacKenzie, ASA, MAAA, is a senior consultant at Oliver Wyman. He can be reached at gregory.mackenzie@oliverwyman.com.
Kevin Desmond, FSA, MAAA, is a senior consultant at Oliver Wyman. He can be reached at kevin.desmond@oliverwyman.com.
Su Su, FSA, MAAA, is a consultant at Oliver Wyman. She can be reached at su.su@oliverwyman.com.