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The Actuary The magazine of the Institute & Faculty of Actuaries

Mind the GAAP!

UK insurers use a variety of methods to report
on long-term insurance business. Embed-
ded values, together with realistic and statutory valuations, are the most common. In order for an insurer to become listed in the US, accounts are required to be prepared in accordance with the US accounting standards these can give significantly different results compared with the UK reporting bases. Despite this, and the International Accounting Standards Committee’s (IASC) efforts to harmonise insurance accounting globally, many new US listings are still being sought.

The listing regulator
The Securities and Exchange Committee (SEC) regulates the US listing process. In order to obtain a listing on the New York Stock Exchange, a company must demonstrate to the SEC that its accounts have been prepared in accordance with the US financial accounting standards (FAS) that constitute the US generally accepted accounting standards (GAAP). The SEC requires significant detail on the approach used to prepare the accounts, including assumption derivation and actuarial calculation methods.

Product classification
The initial step requires the office to determine how each product fits with the US range of recognised contract types. This is important, as the product classification affects the method of accounting for the products and requires justification to the SEC. The two main insurance accounting standards are FAS60 and FAS97:
– FAS60 Accounting and reporting by insurance enterprises.
– FAS97 Accounting and reporting by insurance enterprises for certain long-duration contracts and for realised gains and losses from the sale of investments.
These almost exclusively cover the product range of a typical UK life company. Table 1 illustrates the likely classification for the most common products.
The method used to calculate reserves, all subsequent related numbers, and the accounting treatment depend upon the product classification.

Most UK conventional contracts are classified as FAS60. The reserves are calculated using a net premium reserving approach. This is similar to the UK approach, with two distinct changes:
– US method uses ‘best estimate’ assumptions at the time of writing the business, with a sufficient provision for adverse deviation. The assumptions include allowances for lapses. Once the reserving assumptions have been set for a particular cohort of business, they are ‘locked in’ for all future valuations.
– The net premium is calculated at inception to be a constant proportion of the office premium receivable. The proportion is calculated on the ‘locked-in’ assumptions, to ensure that the value of net premiums is sufficient to cover the cost of benefits and expenses throughout the expected life of the policy.
This reserving approach provides stability and predictability of the reserve movements from year to year for FAS60 contracts. ‘Locking in’ assumptions introduces a risk of insufficient reserves being held in the future. To counter this, each year the office will perform a test for the adequacy of the reserves to meet the future expenses and benefits, allowing for current best estimate assumptions, and repay any intangible actuarial assets. The test is carried out at a fairly high level to provide further stability.

FAS97 contracts
For these contracts a unit reserve is held. This is the same as in the UK, with the exception of certain accounting differences in treatment of unrealised capital gains tax. Conventional with-profits deferred annuity contracts may be classified as FAS 97, depending upon the precise terms of the contract. This requires a unit account to be calculated, the method for which is not obvious.
For both FAS60 and FAS97 contracts a deferred income reserve may be held in addition to the above reserves, as described below.

Asset classification debt and equity securities
The second significant decision required by the insurer is how to account for its assets. US GAAP accounting standards allow investments in debt and equity securities to be classified in three different categories:
– Trading purchased with intent to sell in the short term. Trading securities are carried at fair value, and changes in fair value are reported in current period earnings.
– Held-to-maturity used for debt securities that the company has the ability and intent to hold to maturity.
– Available-for-sale used for assets classed as neither trading nor held-to-maturity. These are also carried at fair value, however, changes in fair value (unrealised gains and losses) are excluded from the income statement and are reported in equity and disclosed in the statement of other comprehensive income.

Profit emergence
One of the results of the US accounting regulations is a stable emergence of profits over the life of the policy after being put on the books. Generally, the two main features that prevent smooth cash profits under insurance contracts are initial acquisition expenses and non-uniform charging structures/premium income. The US accounting standards create intangible assets (deferred acquisition costs) and liabilities (deferred income reserves) to counteract these distortions. This is sometimes referred to as a ‘deferral and matching’ accounting style.

Deferred acquisition cost (DAC)
Under US GAAP, at acquisition the company will defer all expenses that ‘vary with and are primarily related to the acquisition of new and renewal insurance contracts’. The definition is generally stricter than the UK accounting definition used in the modified statutory solvency basis, resulting in a lower level of deferral in any one particular year (although this does depend on the variability of expenses related to new business). The opposite is true for the amortisation the US approach is to run off over the policy life, which is generally significantly longer than the UK run-off period. Figure 1 above right shows a typical profile of DAC amortisation for a single block of 25-year policies.

Deferred income reserve (DIR)
The DIR assists in producing smooth profit emergence over the life of a contract. An example where a DIR would be required is under unit-linked contracts with non-uniform charging structures (reduced initial allocation periods or bonus units after a pre-specified term).
The DIR works by the insurer making provisions for an additional reserve (the deferred income reserve) to offset the excess profits that would otherwise emerge because of the non-uniform charging structure. This extra reserve is released (amortised) over the life of the contract. The effect is to smooth the emergence of reported profit.

With-profits business
The US does not have the equivalent of with-profits policies that are common in the UK. Under US GAAP, the fund for future appropriations (FFA calculated for with-profits accounting in the UK) is removed and a liability in respect of undistributed earnings created. This represents an accumulation of the policyholder share of the cumulative undistributed earnings of the with-profits business measured on a US GAAP basis. Further significant complications can arise where a company also has an alternative internal structure (for example a demutualised company, or where agreement exists for shareholder access to an orphan estate).

Achieving a US listing for a UK insurance company requires a significant amount of effort (a two-year programme is typical from commencement to listing). The process can be further complicated where the company has a history of acquisitions, mergers, or demutualisation.
The US accounting standards are designed to provide a much smoother emergence of profits over life of business rather than up front, as is typical using embedded value techniques. This reflects the US belief that profit is earned over the life of a policy (treating the policy as a service contract), whereas the UK standards (implicitly) assume that the majority of work (and so profit) is earned in issuing the policy.
In practice there can be distortions from year to year when the US standards are applied to a UK insurance company. While these can normally be managed to produce more stable results, overall the US can give a less smooth profit emergence than UK embedded value measures. The extent of this depends upon several factors, including the type of business the insurer writes.
These differences inevitably give rise to questions such as ‘why are there differences?’ and ‘which one is right?’. The answers are difficult to communicate, particularly for companies also preparing accounts for countries using alternative accounting bases (for example Australian margin on services and Canadian GAAP). The International Accounting Standards Board is currently working to produce one set of principles for an international accounting standard for insurance. The significant challenges that this presents are well worth overcoming to move towards a common global basis for life assurance accounting.