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Mind the GAAP and Non-GAAP

By Robert Winawer, Yiqing Zhang and Joe Kalin

The Financial Reporter, September 2021

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It is hard to overstate the attention placed on GAAP long duration targeted improvements (LDTI) by the life and annuity industry. Companies have dedicated staff to large companywide LDTI implementation projects, and the industry has spent more than US$2 billion on implementation so far.[1] In contrast, almost no time or budget has been allocated to changing non-GAAP operating earnings metrics. Is the lack of time spent on non-GAAP appropriate?

Non-GAAP earnings are at least as important as GAAP because they are as prominently displayed in financial reports as GAAP and more often quoted in CEO commentary. Non-GAAP earnings represent what management believes is the true measure of performance and therefore influences share value. It is often used for internal measurement of line of business performance and often determines incentive compensation. Given the importance of non-GAAP earnings metrics, it is clear that attention to defining and producing these metrics is worth it. Is it time to shift focus over to non-GAAP?

Leading public companies are now in their dry-run testing phase of LDTI implementation and expecting to comment publicly during the first half of 2022. Most other public and private companies are well into their project timelines. The Financial Accounting Standards Board (FASB) guidance is set and methodological interpretation from the American Academy of Actuaries and the American Institute of Certified Public Accountants is supporting efficient industry consensus. It is time for leading companies to focus on non-GAAP earnings, and all companies should earmark significant effort to it in their business plans.

This article gives an overview of the motivations that will shape non-GAAP adjustments, provides insight into some of the major changes that will be made, and shares perspective on actions to promote good reception from investors and other stakeholders.

Motivations Behind Changes to Non-GAAP

The intent of LDTI is to improve the effectiveness, simplicity and timeliness of required GAAP disclosures. Following that overture, many companies are hopeful that LDTI implementation will reduce the number, complexity and magnitude of adjustments to produce their own non-GAAP metrics. Some feel that getting non-GAAP earnings closer to industry standard audited GAAP financial statements will increase confidence in the non-GAAP metrics provided.

Without other impetus, management would modify current adjustments to GAAP disclosures in order to produce the same pre-LDTI non-GAAP results (i.e., only the adjustments from GAAP would adjust and not the end result). Under Regulation G, the Securities and Exchange Commission (SEC) requires public companies that disclose non-GAAP measures to also disclose the most directly comparable GAAP financial measure and reconcile to it.

SEC regulations aside, some companies view LDTI as a fresh-start opportunity to gain conformity within peer groups for non-GAAP measures. Cooperating with companies that have the same lines of business to produce consistent non-GAAP measures will be appreciated by users of the financial metrics. Reducing the work to bridge published results between competitors will attract investment to the industry and benefit everyone.

Some companies will decide to change how they manage their business alongside LDTI adoption. Investments and hedging may change to tighten asset liability management (ALM) that will be more clearly disclosed. Where appropriate, non-guaranteed element rate setting practices may be revisited to address changes to the pattern of earnings recognition. In some cases, reinsurance solutions will be used, and in other cases, lines of business may be divested completely. A company’s non-GAAP philosophy will need to be carefully framed to support any business actions taken.

Leading companies will set a precedent when they make their first high-level public comments on LDTI implications during the first two quarters of next year. Investors will be critical of companies that do not follow through with consistent messaging with non-GAAP measures. Explaining changes to non-GAAP will be important to foster credibility because non-GAAP represents what management views as its core performance and non-GAAP is defined by the company—not the FASB.

Insights Into Changes

Few companies have decided on how non-GAAP measures will change because most are still focusing on LDTI implementation and are looking for emerging approaches from peers. The following are some of the more common adjustments in industry practice today that could come under scope for change due to LDTI.

Traditional and Limited Pay

  • Assumption revisions: Companies are more likely to extend their historical precedent of not removing claim volatility to insurance related assumption unlocking introduced by LDTI because insurance risk is core to the business. Assumption revision impacts are separately quantified under LDTI, which is a helpful disclosure.
  • Liability interest rate updates: All companies have been removing accumulated other comprehensive income (AOCI) that contains unrealized gains on available-for-sale assets. Companies will most likely extend the precedent to AOCI generated by the new LDTI requirement to measure the inception-to-date movement in liability discount rates. Some may take further steps to explain or analyze the AOCI asset/liability mismatch to position the topic pre-emptively.

Universal Life and Deferred Annuity

  • DAC/URL offsets to adjustments and unlocking: Almost all companies have been incorporating DAC/URL offsets to non-GAAP adjustments pre-LDTI when these balances were amortized using estimated gross profits. Post-LDTI these offsets are no longer applicable because DAC/URL will be amortized “straight-line” rather than over estimated gross profits. All else equal, non-GAAP earnings will be larger and more volatile as a result.

Market Risk Benefit (MRB)

  • Own credit risk changes: Almost all companies remove the change in embedded derivatives attributed to change in own credit risk as a non-GAAP adjustment pre-LDTI. Most companies will consistently remove changes in market risk benefits attributed to instrument specific credit risk under LDTI. This adjustment will be relatively easy to make because unlike own credit risk, instrument specific credit risk is part of AOCI.
  • Risks not hedged: Some companies will make non-GAAP adjustments to remove only market-related volatility associated with benefits that they do not hedge. Companies adopting this approach may support the decision by pointing to the long-term nature of insurance that is not fully captured by LDTI.
  • All market risks: Other companies will make adjustments for all market-related volatility and also remove related hedge performance. The approach used will be a function of what a company views as core to their business. As an example, removing all related fees and benefits reduces profit along with volatility.

Non-recurring Items

  • Tax: All companies include tax offsets to pre-tax non-GAAP adjustments, and this practice will continue. Removing tax reform on the horizon will also be done consistently with industry practice taken for the Tax Cuts and Jobs Act.
  • One-time costs: For companies that have historically removed exceptional non-recurring expenses, this will likely continue.
  • Legacy business: Some companies will choose to designate certain blocks as “legacy” or “non-core” and remove their financial performance in non-GAAP measures. This designation often preludes divestiture.

Best Practices That Promote Acceptance

Each company must define and introduce their non-GAAP changes in their own way to tell their own story. There are some best practices that we believe will promote a good reception for any company.

  • Fewer, simpler and smaller adjustments increase transparency and reduce work to interpret and compare to peers.
  • Carefully rationalize non-GAAP changes—both methodologically and quantitatively—over the comparative financial statement period.
  • Focus on the end result as well as the adjustments that are made to derive it.
  • Communicate management actions that support your non-GAAP philosophy.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employer.

Robert Winawer, FSA, MAAA, is a principal at Oliver Wyman. He can be reached at Robert.Winawer@oliverwyman.com.

Yiqing Zhang, FSA, MAAA, is a principal at Oliver Wyman. He can be reached at Yiqing.Zhang@oliverwyman.com.

Joe Kalin is a consultant at Oliver Wyman. He can be reached at Joe.Kalin@oliverwyman.com.

Endnote

1 “LDTI and deals: Transparency, timeliness and transactions? Perspectives on what may motivate buyers and sellers as the LDTI compliance deadline approaches” PWC. Retrieved from https://www.pwc.com/us/en/industries/insurance/library/ldti-and-deals.html