For a universal life contract, the recognized liability would typically be its account balance and if applicable, embedded derivatives and death or other benefits. After the effective date of ASU 2018-12, (MRBs may also exist. There is diversity in practice on how to establish acquisition “liabilities measured in accordance with the acquirer’s accounting policies for insurance contracts it issues” when there are policyholder liabilities in addition to the account balance. There is similar diversity in the allocation of fair value to other policyholder benefits liabilities (pre-Accounting Standard Codification SOP 03-1) and embedded derivatives.

Example IG 12-1 illustrates different allocations of fair value of an acquired non-traditional universal life contract between its various components in an acquisition.

EXAMPLE IG 12-1
Allocating fair value to different features of an acquired block of variable annuity contracts in a business combination

Insurance Company acquires a block of variable annuity contracts as part of the acquisition of a business assuming the acquisition is after the effective date of ASU 2018-12. The contracts have a guaranteed minimum accumulation benefit (GMAB) feature measured at fair value under MRB guidance. The seller’s total liability is $150,000 and is comprised of the following:

How should Insurance Company recognize the opening liability balances in acquisition accounting (per ASC 944-805-30-1)?

One alternative is to recognize an opening account balance liability for $100,000 and opening MRB liability of $50,000 and an insurance contract intangible asset (VOBA) of $40,000. By carrying over the acquiree’s fair value MRB balance, this method preserves the seller’s original attribution of policyholder fees in identifying the MRB terms in the subsequent measurement of the GMAB MRB liability. The acquirer would need to consider if the own credit risk of the MRB has changed as a result of the transaction. No amount is presented in accumulated other comprehensive income for own credit at acquisition date; however, the own credit component will need to be determined for purposes of measuring the change in own credit in subsequent periods that will be presented in other comprehensive income. This alternative also recognizes that the acquired GMAB feature is of more value than at inception when the guaranteed amount is for an amount higher than those being offered in the market at the acquisition date.

Another alternative is to consider insurance contracts acquired in a business combination as new contracts for measurement and accounting purposes (per ASC 944-805-25-1) and apply practice used in the initial writing of a variable annuity with a GMAB. At inception (and thus at acquisition) the GMAB is defined as the fair value of cash outflows under the feature less an equal amount of future fees that will be collected from the policyholder over the life of the contract. This results in an initial fair value of the GMAB equal to zero. If there are not enough fees projected to be collected, an additional liability would be accrued. This method would result in recognizing an opening account balance liability for $100,000, opening MRB liability of $0, and a VOBA liability of $10,000, assuming insufficient future fees. The VOBA liability may be characterized as a beginning GMAB value or separately amortized over the life of the contract.

There is diversity in practice as to whether the recognition of the fair value of an insurance contract in the two components noted in IG 12.1.4 is applicable to contracts that are classified as investment contracts rather than insurance contracts, such as a deferred annuity in the accumulation phase. For traditional fixed deferred annuities without embedded derivatives or MRBs, one component would be its account balance, with the remaining difference between that balance and its fair value recognized as an intangible asset (or other liability) in accordance with ASC 944 for insurance contracts. The intangible asset (or other liability) typically represents the difference between current market rates and contractual crediting rates of the instrument. Alternatively, the entire fair value is recognized as a liability, in accordance with financial instrument accounting.

Prior to codification of insurance business combination guidance into ASC 805, US GAAP addressed the accounting for the intangible asset recognized upon acquisition as representing the “present value of future profits” (PVFP) embedded in acquired insurance contracts. That guidance was applicable to life insurance contracts or “other long-duration contracts” covered by insurance accounting guidance. In practice, PVFP was often established for all long-duration contracts, including investment contracts. We do not believe the process of codification of insurance business combination guidance was meant to change this practice of establishing PVFP for investment contracts. In addition, there are other areas where the guidance for insurance contracts is followed for investment contracts as well, including the accounting for deferred acquisition costs. Entities should make a policy election and apply that policy consistently. If PVFP is presented as an asset for investment contracts, it would generally not be subject to a premium deficiency test or separate asset recoverability test, given that the investment contract’s PVFP is essentially a form of debt discount or premium associated with the investment contract liability.

When an entity chooses to recognize the entire fair value of the investment contract as a net liability (i.e., with no PVFP established) at the business combination date, the fair value may be less than the investment contract “account balance” that is payable on demand. If the subsequent accounting for the investment contract is amortized cost (i.e., the fair value option is not elected), the difference between the acquisition date fair value and the account balance is amortized to earnings in a systematic and rational manner. This approach is consistent with the subsequent accounting for liabilities arising from contingencies and with the accounting for the insurance contract intangible asset (or liability) discussed in IG 12.3.4.

Example IG 12-2 illustrates different allocations of fair value of an acquired non-traditional fixed indexed annuity contract between its various components in an acquisition prior to the adoption of ASU 2018-12. In order to illustrate the differences, Example IG 12-3 illustrates the allocation after adoption of ASU 2018-12.

EXAMPLE IG 12-2
Allocating fair value to different features of an acquired fixed indexed annuity contract in a business combination – Acquisition accounting prior to the adoption of ASU 2018-12

Insurance Company acquires a block of fixed indexed annuity contracts as part of the acquisition of a business. The contracts have an equity participation crediting feature as well as a guaranteed minimum withdrawal benefit (GMWB).

How is the fair value allocated in acquisition accounting to opening liability balances (per ASC 944-805-30-1 (a)) by Insurance Company before adoption of ASU 2018-12?

At the acquisition date, the seller’s balances are as follows:

The fair value of the acquired insurance contracts would be divided into two components as described in IG 12.1.4: the opening insurance liability balances and the insurance contract intangible asset (or liability). The opening liability balances may differ from the seller’s liability balances. There is no prescribed approach for determining these amounts. One approach applied in practice is to allocate the fair value of the contract of $107,000 as follows:

The $3,000 additional liability would be established in the acquirer’s balance sheet consistent with its existing accounting policies for similar liabilities. The $115,000 equity indexed account balance would be separated into its components for accounting purposes. The equity return feature is an equity option embedded within the annuity contract (the hybrid debt instrument). In accordance with ASC 815-15-30-2, the embedded derivative would be recognized at its fair value of $22,000. The host contract would be recognized at $93,000 (the difference between the basis of the hybrid instrument of $115,000 and the $22,000 fair value of the embedded derivative feature). The acquirer would need to consider if the own credit risk of the embedded derivative has changed as a result of the transaction.

EXAMPLE IG 12-3
Allocating fair value to different features of an acquired fixed indexed annuity contract in a business combination – Acquisition accounting after adoption of ASU 2018-12

Insurance Company acquires a block of fixed indexed annuity contracts as part of the acquisition of a business. The contracts have an equity participation crediting feature as well as a guaranteed minimum withdrawal benefit (GMWB).

How is the fair value allocated in acquisition accounting to opening liability balances (per ASC 944-805-30-1 (a)) by Insurance Company after adoption of ASU 2018-12

At the acquisition date, the seller’s balances are as follows:

The fair value of the acquired insurance contracts would be divided into two components as described in IG 12.1.4: the opening insurance liability balances and the insurance contract intangible asset (or liability). The opening liability balances may differ from the seller’s liability. There is no prescribed approach for determining these amounts. One approach is to allocate the fair value of the contract of $107,000 as follows:

This example approach combines the policyholder account balance ($115,000) and the MRB fair value ($4,000) to estimate the opening insurance liability balances. Another approach determines the fair value of each of the components of the instrument: the embedded derivative, the MRB, and the host debt instrument (with the host debt instrument valued as the present value of the guaranteed amount using crediting rates offered on similar debt instruments). A third approach solves for the opening liability balances by valuing the present value of future GAAP profits and adding that amount to the allocated fair value of $107,000.

The $119,000 investment in the contract would then be separated into its components for accounting purposes. The equity return feature is an equity option (embedded derivative) and the GMWB is an MRB embedded within the annuity contract. In accordance with ASC 815-15-30-2 and ASC 944-40-30-19D, the embedded derivative and embedded MRB would be recognized at their fair values of $22,000 and $4,000, respectively. The host contract would be valued at $93,000 (the difference between the basis of the hybrid instrument of $119,000 and the $22,000 fair value of the embedded features). The acquirer would need to consider if the own credit risk of the MRB has changed as a result of the transaction.

Under ASC 944-805-35-1, any insurance or reinsurance contract intangible asset (or liability) is required to be subsequently measured “on a basis consistent with the related insurance or reinsurance liability.” No specific methods are prescribed, although in practice, prior to ASU 2018-12, the related DAC amortization method applicable to the contract (and related assumptions) was often used by analogy under the view that these amounts are fixed intangible assets or liabilities to be amortized. Entities that view acquired contract intangible assets and liabilities as similar to DAC continue to align amortization with their DAC amortization policy and thus use the simplified DAC amortization method prescribed by ASU 2018-02.

Others may view contract intangible assets and liabilities acquired in a business combination as different from DAC, given that such balances represent the residual measurement of future cash flows (i.e., the fair value of future contractual cash flows of purchased contracts less the GAAP liability established using ASC 944 principles). In many cases, the fair value of the contracts established in acquisition accounting is estimated using a discounted cash flow approach (i.e., discounting future premiums, benefits, fees, and expenses, which represent net profits), implying that the accretion of interest and amortization of the residual measurement based on estimated gross profits, premiums, or other methods may continue to be appropriate for the related acquired present value of future profits (PVFP) asset or liability. Acquired contracts are considered newly purchased contracts. As a result, amortization of the insurance contract intangible asset is based on premiums or expected gross profit (or expected gross margins) from the acquisition date forward and not from the original policyholder contract inception date. For amortization methods that incorporate investment yields, see Figure IG 5-4 for shadow adjustment considerations. 

The PVFP balances are contract cash flows and therefore should be included in premium deficiency tests for all types of long-duration models, including traditional insurance, limited-payment, universal life, and participating insurance contracts. See IG 7.3. That is, the guidance in ASC 944-60-25-7 regarding premium deficiency testing has a specific requirement to include the present value of future profits in the analysis. For traditional and limited-payment contracts, only the PVFP asset balance is subject to the premium deficiency test because the liability is subject to a separate loss recognition test (the ratio of benefits to premiums cannot exceed 100%) as described in IG 5.2.1.

Since PVFP represents an intangible asset, we believe it would not be appropriate to reverse any previous write downs of PVFP amounts for subsequent favorable development.

The requirements in ASC 944-60-25-3 and ASC 944-60-25-7 relating to PVFP recoverability testing have not changed with regard to either the level of aggregation at which the testing is performed or the interest assumptions used in estimating the present value of future cash flows. The guidance specifies that insurance contracts should be grouped consistent with the entity's manner of acquiring, servicing, and measuring the profitability of its insurance contracts. The guidance refers to “investment yields” as one of the assumptions that may be used in assessing the recoverability of PVFP.

Question IG 12-2 discusses the level of aggregation to be utilized for the PVFP recoverability test for nonparticipating traditional and limited-payment contracts. Question IG 12-3 discusses the discount rate to be utilized for the PVFP recoverability test for nonparticipating traditional and limited-payment contracts.

It depends. The recoverability test for PVFP is required to be performed at the level at which an entity acquires, services, and measures profitability in accordance with ASC 944-60-25-3, which was not amended by ASU 2018-12. However, insurance entities should consider whether the application of this guidance may change the level at which profitability is measured for nonparticipating traditional and limited-payment contracts that are measured at the cohort level. If an entity believes that measuring profitability at the cohort level is a key/predominant indicator in the PVFP recoverability test, switching to a cohort grouping level may be appropriate.

ASC 944-60-25-7 requires that a reporting entity assess PVFP for recoverability, but it does not prescribe a particular discount rate to be used in the assessment. It does mention “investment yields, along with mortality, morbidity, terminations, or expenses” as relevant assumptions in performing a loss recognition test, implying that investment yield may be an appropriate discount rate. However, some believe that the upper-medium grade fixed-income instrument yield is appropriate for the recoverability assessment, given that this is the discount rate used in measuring the liability for future policy benefits to which the PVFP relates. Others believe it may be appropriate to use the risk-adjusted rate used to estimate the fair value of the liability from which the PVFP was calculated (as described in IG 12.1.4) in the recoverability assessment. As a result of the lack of a prescribed rate, rates such as investment yield, the liability for future policy benefits upper-medium grade fixed-income instrument yield, or a risk-adjusted rate may all be considered as appropriate choices depending on the particular facts and circumstances of the purchased block and the entity. If investment yields are used, refer to Figure IG 5-4 for considerations related to shadow adjustments.