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3.7 Modifications or exchanges of insurance contracts
Publication date: 30 Sep 2020
us Insurance guide
An insurance entity’s new products may be more attractive than an existing product. As a result, insurance entities may give policyholders the ability to replace their existing policies. Additionally, insurance entities modify certain provisions in existing policies to improve the marketability of their insurance products in a changing and innovative marketplace, or to decrease the operational or administrative burden of accounting and servicing a wide variety of policy types.
Guidance relating to accounting by insurance entities for DAC in connection with modifications or exchanges of insurance contracts applicable to all short-duration and long-duration contracts, including investment contracts, and reinsurance contracts is in ASC 944-30-35-24 through ASC 944-30-35-63. The fundamental concept is that DAC relates to a contractual relationship and not a customer relationship. Modifications of insurance contracts that substantially change the replaced contracts should be considered as new contracts and the related DAC written off. Internal replacements of insurance contracts that do not substantially change the replaced contracts are considered continuations of the replaced contracts and the related DAC is maintained.
In addition to the ASC guidance, the AICPA issued guidance in a question-and-answer format with the AICPA Technical Questions and Answers (TQA) publication, specifically section 6300 – Insurance companies. Figure IG 3-2 provides an index of the relevant TQAs.
Figure IG 3-2
Index of AICPA TQAs addressing modifications and replacements
Index of AICPA TQAs addressing modifications and replacements
TQA #
|
Subject
|
IG Guide Reference
|
6300.27
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Changes in Investment Management Fees and Other Administrative Charges in Applying FASB ASC 944-30
|
|
6300.30
|
Commissions Paid on an Increase in Insurance Coverage or Incremental Deposits in Applying FASB ASC 944-30
|
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3.7.1 Application of the internal replacements accounting model
ASC 944-30-35-24 through ASC 944-30-35-56 identifies a sequence of steps to determine whether an internal replacement results in a substantially changed contract.
Before applying these steps, an insurer must determine if the modification or exchange meets the definition of an internal replacement, as defined in ASC 944.
Definition from ASC 944-30-20
Internal Replacement: A modification in product benefits, features, rights, or coverages that occurs by a contract exchange; by amendment, endorsement, or rider to a contract; or by the election of a benefit, feature, right, or coverage within the contract.
This initial determination highlights that certain actions executed by an insurance entity, such as changing cost of insurance charges, interest crediting rates, or similar provisions within ranges outlined in the contract, without any other changes in benefits or coverages, are generally not modifications to the contract and are not internal replacements.
A flowchart summarizing the accounting model set out in the Internal Replacement Transactions Subsections of this Subtopic follows.
View image
3.7.1.1 Internal replacements
An internal replacement is a modification in product benefits, features, rights, or coverage that occurs by any of the following:
- Legal extinguishment of one contract and issuance of another contract (referred to as a contract exchange)
- Amendment of, endorsement or rider to, an existing contract
- Election of a benefit, feature, right, or coverage within a contract
The definition of an internal replacement is very broad. Modifications of insurance contracts take a variety of legal forms and as such, the substance of the modification, rather than its legal form, dictates the accounting for changes to existing contracts. Therefore, most modifications to insurance contracts may be considered internal replacements and subject to analysis under ASC 944-30-35-24 through ASC 944-30-35-56. Furthermore, while "product feature" is not a defined term, we believe this term includes premiums, fees, or other assessments, and thus changes in premiums, fees, or assessments not within ranges outlined in the original contract, whether increases or decreases, would be considered internal replacements subject to analysis under the internal replacements accounting model.
Question IG 3-11 addresses whether changes considered in the initial contract are modifications.
Question IG 3-11
Are changes to premium rates on a long-duration insurance contract for which the insurer has the contractual right to change premium rates considered modifications as contemplated in ASC 944-30?
Are changes to premium rates on a long-duration insurance contract for which the insurer has the contractual right to change premium rates considered modifications as contemplated in ASC 944-30?
PwC response
It depends. Changes to a group insurance contract's premium or benefits based on the insurer's consideration of the actual experience of an individual contract holder (i.e., an individual employer) or the renegotiation of premiums or benefits with an individual contract holder, even without any explicit underwriting, generally would meet the definition of an internal replacement subject to analysis under ASC 944-30. In situations in which the revised premium rate is determined based on a formula specified in the contract that involves objective inputs not subject to insurer discretion or the change is made for an entire class of contracts, the revision would generally not meet the definition of an internal replacement.
3.7.2 Modifications from contract holder elections within original contract
In accordance with ASC 944-30-35-26, modifications resulting from the election by the contract holder of a feature or coverage that was within the original contract are not internal replacements if all of the following conditions are met:
- The election is made in accordance with terms fixed or specified within narrow ranges in the original contract.
- The election of the benefit, feature, right, or coverage is not subject to any underwriting.
- The insurance entity cannot decline to provide the coverage or adjust the pricing of the benefit, feature, right, or coverage.
- The benefit, feature, right, or coverage had been accounted for since the inception of the contract.
ASC 944-30-35-26 does not explicitly define what a "narrow" range is as used in the first criterion. However, the terms must be specific enough that the contract holder is able to evaluate whether to elect the feature in current and future market conditions and the range should be narrow enough to provide a meaningful guarantee to the contract holder. Contractual provisions that allow the contract holder to add future coverages at then-current rates, subject to stated minimums and maximums, generally are not specific enough to meet the first criterion. An important factor in addressing this criterion is whether the range has commercial substance to the contract holder's decision to invest in the original contract. If inclusion of the option and the option price range made an economic difference to the contract holder as compared to a contract that instead provides for election of the option at the then-current market rate, this would indicate a narrow range.
With respect to the second criterion, in certain situations, an insurer may perform limited procedures for the election of a specific benefit included in the original contract. To the extent the procedures are limited and do not involve insurer discretion or judgment to accept the risk or price the election, the procedures would typically not be considered underwriting.
The rationale for the last criterion is that if the provision in question was truly part of the original contract, the entity should have accounted for the feature since the contract’s inception and therefore election of the feature is not a new contract (i.e., the option to elect the feature was accounted for as a derivative under ASC 815, market risk benefit, or as an additional liability in accordance with the applicable guidance in ASC 944). If a contract feature should have been accounted for under ASC 815 or ASC 944, and the entity has either been accounting for it since contract inception or has made a determination at the inception of the contract (and since) that the provision was/is immaterial, the election of the feature would not be an internal replacement.
ASC 944-30-35-28 treats the accumulation phase of a deferred annuity contract as separate and distinct from the annuitization phase, even if annuitization is in accordance with terms fixed in the original contract. Therefore, the existence of an annuitization option in a deferred annuity will not change the requirement to amortize DAC over the accumulation (deferral) phase of an annuity contract.
3.7.3 Modifications – partial withdrawals, surrenders, coverage reductions
In accordance with ASC 944-30-35-29, partial withdrawals, surrenders, or reductions in coverage allowed by the original contract or required by state law or regulation are not internal replacements as long as there are no re-underwriting or other modifications to the contract that would require evaluation under ASC 944-30-35-37.
Question IG 3-12 addresses whether certain modifications required by state law are internal replacements.
Question IG 3-12
In the event that policyholders fail to make premium payments in accordance with a previously purchased whole-life policy, all states have enacted non-forfeiture laws that require insurers to modify coverage on existing policies rather than allowing the contract to terminate. These modifications include reducing the face amount of the existing policy to a level that has been fully funded by previous premium payments (known as reduced-paid-up insurance) or conversion of a whole life policy to extended term insurance. Are these modifications considered internal replacements?
In the event that policyholders fail to make premium payments in accordance with a previously purchased whole-life policy, all states have enacted non-forfeiture laws that require insurers to modify coverage on existing policies rather than allowing the contract to terminate. These modifications include reducing the face amount of the existing policy to a level that has been fully funded by previous premium payments (known as reduced-paid-up insurance) or conversion of a whole life policy to extended term insurance. Are these modifications considered internal replacements?
PwC response
No. These changes would meet the provisions of ASC 944-30-35-29 and, therefore, would not be internal replacements.
3.7.4 Integrated and nonintegrated contract features
Internal replacements that do not meet the criteria established in ASC 944-30-35-26 through ASC 944-30-35-28 or ASC 944-30-35-29 require further analysis. The next step in the analysis is to determine whether the internal replacement is a nonintegrated contract feature. If the internal replacement meets the definition of a nonintegrated feature, as defined in ASC 944-30-35-30 and ASC 944-30-35-31, it is not considered a substantial change in the original (base) contract, and no further analysis is required. The nonintegrated feature would be accounted for similar to a separately issued contract. If the contract feature being modified is integrated, the transaction should be analyzed under ASC 944-30-35-37 to determine if the original contract is substantially changed. Figure IG 3-3 summarizes the definitions of integrated and nonintegrated features for short-duration and long-duration contracts.
Figure IG 3-3
Definitions of integrated and nonintegrated features for short-duration and long-duration contracts
Definitions of integrated and nonintegrated features for short-duration and long-duration contracts
Contract type |
Integrated |
Nonintegrated |
Long-duration (ASC 944-30-35-30) |
Contract features for which the benefits can only be determined in conjunction with the account value or other contract holder balances related to the base contract |
Contract features for which the determination of benefits provided by the feature is not related to or dependent on the account value or other contract holder balances of the base contract |
Short-duration (ASC 944-30-35-31) |
Contract features for which there is explicit or implicit reunderwriting or repricing of existing components of the base contract |
Contract features that provide coverage that is underwritten and priced only for that incremental insurance coverage and do not result in the explicit or implicit reunderwriting or repricing of other components of the contract |
Underwriting and pricing for nonintegrated features are typically executed separate from other components of the contract and theoretically could be purchased separately as an insurance contract, similar to a rider. In contrast, an integrated contract feature is one in which benefits provided by the feature can be determined only in conjunction with the account value or other balance relating to the base contract. However, the fact that the premiums to fund the additional or modified benefits are paid from the base contract’s value is not by itself an indication that the benefit feature is integrated.
In limited circumstances, it may not be clear if a contract feature is integrated or non-integrated, such as changes to the premium payment period of a life insurance contract from 10 years to 5 years, when the death benefit remains unchanged and the option was not part of the original contract provisions. As noted in TQA 6300.25, a contract feature is presumed to be integrated unless it clearly meets the definition of a non-integrated contract feature.
An example of an integrated contract feature for a short-duration contract is the addition of, or change to, an experience refund provision in a worker's compensation insurance contract.
Examples of integrated contract features for long-duration contracts include guaranteed minimum death benefits (GMDBs), guaranteed minimum income benefits (GMIBs), guaranteed minimum accumulation benefits (GMABs) and guaranteed minimum withdrawal benefits (GMWBs), as well as no lapse guarantees and secondary guarantees. These are integrated contract features because, in all cases, the benefit provided can only be determined in conjunction with the account value of the annuity contract.
Examples of nonintegrated contract features for short-duration contracts include a newly acquired automobile added to an existing personal automobile contract and a personal articles floater added to a homeowner's contract.
Examples of nonintegrated contract features for long-duration contracts may include a long-term care rider added to an annuity or disability contract, a term life rider added to an annuity contract, and an accidental death benefit feature added to a traditional life contract.
Waiver of premium benefits added to a traditional life contract is considered a nonintegrated modification. When added to a universal life type contract, waiver of premium could be integrated or nonintegrated, depending on the design of the benefits. A universal life waiver benefit that pays a fixed target premium would be considered nonintegrated but a similar benefit that pays cost of insurance (COI) charges would be considered integrated because the account balance is a factor in the determination of the COI charge.
Question IG 3-13 discusses whether paid-up addition features are internal replacements.
Question IG 3-13
Do paid-up addition features (benefit allowing policyholders to use dividends to purchase additional increments of insurance) offered under certain participating life insurance meet the definition of an internal replacement? If so, are these features considered integrated or nonintegrated features?
Do paid-up addition features (benefit allowing policyholders to use dividends to purchase additional increments of insurance) offered under certain participating life insurance meet the definition of an internal replacement? If so, are these features considered integrated or nonintegrated features?
PwC response
Paid-up addition features may in certain instances meet the conditions relating to contract holder elections as described in ASC 944-30-35-26 and as such would not be considered internal replacements. See IG 3.7.2 for additional information on the contract holder election criteria. However, in other instances, such paid-up additions may be considered internal replacements, but would generally meet the criteria to be considered a nonintegrated feature.
If the internal replacement meets the definition of a nonintegrated feature, it is not considered a substantial change in the base contract, and no further analysis is required. The nonintegrated contract feature or coverage would thus be accounted for in a manner similar to a separately issued contract. Furthermore, as nonintegrated contract features, benefits, or coverages are more akin to separate contracts, any future modifications to such features are evaluated on a stand-alone basis (i.e., apart from the existing base contract).
3.7.5 Determination if substantially changed contract
If the internal replacement involves integrated contract features or coverages, an insurance entity is required to determine whether the contract has changed substantially because of the modification. A modified contract that is substantially unchanged from the replaced contract should be accounted for as a continuation of the replaced contract, whereas a contract modification that substantially changes the replaced contract should be accounted for as an extinguishment of the replaced contract and the issuance of a new contract in accordance with ASC 944-30-35-36.
An internal replacement involves contracts that are substantially unchanged only if all of the conditions noted in ASC 944-30-35-37 are met.
An internal replacement (other than those described in paragraphs 944-30-35-26 through 35-29) is determined to involve contracts that are substantially unchanged only if all the following conditions exist:
- The insured event, risk, or period of coverage of the contract has not changed, as noted by no significant changes in the kind and degree of mortality risk, morbidity risk, or other insurance risk, if any.
- The nature of the investment return rights (for example, whether amounts are determined by formulas specified by the contract, pass through of actual performance of referenced investments, or at the discretion of the insurer), if any, between the insurance entity and the contract holder has not changed.
- No additional deposit, premium, or charge relating to the original benefit or coverage, in excess of amounts specified or allowed in the original contract, is required to effect the transaction; or if there is a reduction in the original benefit or coverage, the deposit, premiums, or charges are reduced by an amount at least equal to the corresponding reduction in benefits or coverage.
- Other than distributions to the contract holder or contract designee or charges related to newly purchased or elected benefits or coverages, there is no net reduction in the contract holder’s account value or, for contracts not having an explicit or implicit account value, the cash surrender value, if any.
- There is no change in the participation or dividend features of the contract, if any.
- There is no change to the amortization method or revenue classification of the contract.
If any of the conditions are not met, an internal replacement is determined to involve a replacement contract that is substantially changed from the replaced contract.
Example 2 (see paragraph 944-30-55-33) illustrates the application of this guidance.
If any of these conditions are not met, an internal replacement is considered a replacement contract that is substantially changed from the replaced contract. The analysis is performed using the terms of the contract immediately before and after the modification.
Question IG 3-14 addresses whether reinstated contracts are substantially unchanged.
Question IG 3-14
An insurance entity reinstated a lapsed contract for which it no longer had an obligation to pay claims. Does the reinstated contract meet the conditions of a substantially unchanged contract?
An insurance entity reinstated a lapsed contract for which it no longer had an obligation to pay claims. Does the reinstated contract meet the conditions of a substantially unchanged contract?
PwC response
If an insurer decides to reinstate a lapsed contract for which it no longer had an obligation to pay claims, the lapsed contract would have been extinguished and the reinstated contract would be considered a newly issued contract for accounting purposes at the date the reinstatement occurs. The reinstated contract would not meet the conditions of a substantially unchanged contract as the lapsed contract has already been terminated.3.7.5.1 Changes in insured event, risk, or period of coverage
The evaluation of whether there are significant changes in insurance risk or period of coverage is done prospectively as events occurring prior to the internal replacement are irrelevant to the replacement transaction. Therefore, when assessing the significance of a change in insurance risk or the period of coverage, the remaining period of coverage of the replaced contract is compared to the remaining period of coverage provided by the replacement contract. The prospective comparison is consistent with the guidance for debt modifications in ASC 470-50-40.
Judgment must be used to determine whether there are significant changes in the "degree" of mortality, morbidity, or other insurance risk, considering the specific facts and circumstances of the modification. The focus should be on the substance of the changed risks of the contract between the insurance entity and the contract holder. The guidance in ASC 944-30-35-37(a) does not prescribe a specific approach for analyzing the significance of the change in insurance risk. However, the implementation guidance of Example 2 in ASC 944-30-55-33 through ASC 944-30-55-76 provides several example approaches that could be applied when assessing the change in the degree of insurance risk for various products and features.
Examples of factors to consider in determining whether there has been a significant change in insurance risk because of an internal replacement include:
- Changes in the actuarially estimated costs of benefit features (e.g., death benefits, claim costs)
- Changes in the relationship between the expected cost of the benefit and the charges for the benefit, as described in ASC 944-30-55-39 with regard to a universal life contract.
- Changes in the benefit ratio (i.e., comparing the change in the relationship between future projected guarantee benefits and total assessments under the contract).
- Changes in the net amount at risk before and after the modification
Entities should develop accounting policies for assessing the significance of a change in insurance risk in an internal replacement and consistently apply those policies for similar types of internal replacements. Certain approaches may be more appropriate than others depending on the type of internal replacement. When selecting an assessment approach, consideration should be given to the substance of the change between the insurer and the contract holder.
When assessing the replacement of a return-of-premium GMDB with a ratchet-type GMDB, the implementation guidance in ASC 944-30-55-65 concludes that although the actual mortality event is the same, the risk has changed because of the combined effects of mortality and investment events. In arriving at this conclusion, the change was analyzed using the gross expected mortality costs as an indicator of a significant change in the degree of mortality risk. ASC 944-30-55-66 has an example of a change in MRB benefits that is not a substantial change as the mortality costs remain similar.
Question IG 3-15 addresses how to consider re-underwriting under ASC 944-30-35-37(a).
Question IG 3-15
Would the re-underwriting of a contract in and of itself indicate a change in the kind or degree of insurance, thereby precluding an insurance entity from meeting criterion in ASC 944-30-35-37(a)?
Would the re-underwriting of a contract in and of itself indicate a change in the kind or degree of insurance, thereby precluding an insurance entity from meeting criterion in ASC 944-30-35-37(a)?
PwC response
It depends. The re-underwriting of an entire contract would be considered an indicator of a substantial change in the insurance risk rather than an absolute requirement. Situations in which more limited procedures are performed, especially those that involve only a specific risk or component of a contract and do not involve insurer judgment or discretion with respect to acceptance or rejection of the insured or discretion as to price, do not appear to meet the definition of re-underwriting. An example of a more limited procedure would be one in which limited procedures are performed to validate an insured’s statement that they are currently a non-smoker. This would generally not be considered re-underwriting. Facts and circumstances should be carefully reviewed to determine whether there has been a re-underwriting as part of the analysis in ASC 944-30-25-37(a). However, it is also important to note that the lack of underwriting is not, by itself, sufficient to conclude that the change is not substantial.
3.7.5.2 Changes in the nature of investment return rights
The guidance in ASC 944-30-35-37(b) is principles based and, as such, requires qualitative considerations to assess changes in the nature of investment returns. We believe that entities should use their best judgment when developing an approach for making this assessment, and consistently apply the approach for similar types of internal replacements.
In many cases, the evaluation of the nature of investment return rights is straightforward. The guidance is clear that changing the investment crediting rate from one type of return to another (e.g., from a pass through return to a formulaic return or to a return based on the discretion of the insurance entity) represents a change in the nature of the investment return rights. Therefore, replacing a fixed or general account product with a variable product will result in a substantially changed contract. In addition, adding an investment return floor, such as a GMIB, GMAB, or GMWB, to a variable annuity without any existing minimum guarantees, or capping of the return such that actual returns are not passed along to the contract holder, would result in a substantially changed contract.
Another example of a change in the nature of investment return rights would be a change in contract holder liquidity rights. For example, a variable annuity product may have different types of guarantees: a GMIB (payable in installments over a specified annuitization period; a GMAB (payable at the end of a specified period); or a GMWB (payable during the accumulation phase of the contract). Because each of these features provides for different timing of cash flow accessibility to the contract holder, the change in contract holder liquidity rights is a change in the nature of the investment rights.
In other cases, the determination as to whether a change to investment return rights constitutes a change in its nature will be less straightforward. These include situations when a component of an investment return formula has changed, such as a change in the strike price formula or strike price amount of an investment return floor. Changing the strike price of a guarantee in a variable annuity with a GMAB ratchet that is currently out of the money (i.e., the guarantee is below the current variable annuity account balance) to a next generation of the GMAB ratchet, with the guaranteed floor reset at the modification date to the current account balance (i.e., at the money) is one example. This example, and other situations requiring analysis of changes in the nature of investment return rights, require careful consideration of the facts and circumstances in order to determine if the revision fundamentally changes the nature of the investment return rights. Changes to formulaic inputs may be of such a degree that they change the fundamental nature of the investment return rights.
Question IG 3-16 addresses whether changes in investment management fees are a substantial change.
Question IG 3-16
Are changes to investment management fees and other administrative charges considered under paragraph ASC 944-30-35-37 when determining whether a contract is substantially unchanged?
Are changes to investment management fees and other administrative charges considered under paragraph ASC 944-30-35-37 when determining whether a contract is substantially unchanged?
PwC response
Changes to investment management fees and other administrative charges in accordance with terms and within ranges specified in the original contract, without any other change in benefits or coverages, are not considered modifications. For changes in administrative fees not meeting those criteria (e.g., a change from a flat fee plus percentage of assets to a pure percentage of assets fee), the change should be evaluated under ASC 944-30-35-37(b) in conjunction with investment return rights. ASC 944-30-35-37(a) and ASC 944-30-35-37(c) are not applicable to changes in administrative fees, but instead were meant to apply to changes in insurance risk or charges relating to insurance risk.
3.7.5.3 Changes in deposits, premiums or other charges
The purpose of the criterion in ASC 944-30-35-37(c) is to prevent a change in the deposits, premiums, or other charges relating to the original coverage, which would be indicative that the economics of the replaced contract have changed. A change in the deposit, premium, or other charges are not prohibited as long as the change relates to the new change in the benefit or coverage and is not in excess of the amount that is commensurate with the change in benefit provided.
3.7.5.4 Change to policyholder account value or cash surrender value
Under the criterion in ASC 944-30-25-27(d), there can be no net reduction in the contract holder’s account value or no reduction in the cash surrender value for contracts not having an explicit or implicit account value, other than distributions to the contract holder or contract designee or charges related to newly purchased or elected benefits or coverage.
If there is a net reduction in account value or similar feature, this would be equivalent to a surrender charge and thus indicative of a change in the substance of the original contract. For a universal life-type, limited payment, or investment contract that has an explicit account balance, changing the surrender charge amount or surrender charge period would not be considered a modification until surrender occurs. This is consistent with the concept inherent in ASC 944-30-35-24 that a change is not a change until elected by the contract holder.
3.7.5.5 Change in the participation or dividend features
In accordance with ASC 944-30-35-37(e), changing the participation or dividend features of a contract would be considered a substantial change. Changing dividend scales, by themselves, is not considered a violation of this provision. However, the addition of a dividend feature to an individual life contract, or the addition of an experience refund provision to a group contract, are examples of changes in the participation or dividend feature that would cause the modification to fail this provision and thus be considered a substantial change.
3.7.5.6 Change to the amortization method or revenue classification
If the contract modification causes the accounting model to change, for example, from a contract accounted for as a traditional life-insurance contract to a contract accounted as a universal life-type contract, the modification would result in a substantially changed contract under ASC 944-30-35-37(f).
3.7.6 Accounting for a substantially unchanged contract
When an internal replacement results in a replacement contract that is substantially unchanged from the replaced contract, any unamortized deferred acquisition costs (DAC), unearned revenue liabilities, and deferred sales inducement assets associated with the replaced contract should continue to be deferred and amortized or earned in connection with the replacement contract (i.e., the internal replacement should be accounted for as a continuation of the replaced contract). Other balances associated with the replaced contract, such as any liability for GMDBs or GMIBs, should continue to be recognized as if the replacement contract is a continuation of the replaced contract. Attributed fees for MRBs would remain unchanged if the MRB is unchanged. However, if an MRB feature was changed but determined not to be a substantial change (as in the example in ASC 944-30-55-66), there may be an incremental insignificant change to the attributed fee. For example, if the fair value of the new incremental MRB costs was equal to fifteen basis points of account balance, then fifteen basis points might be added to the existing attributed fee going forward.
Additionally, if the replaced contract was acquired in a business combination, any present value of future profits (PVFP) or value of business acquired (VOBA) established in accordance with ASC 944-805-25-3 would be accounted for in a similar manner. See IG 12 for accounting considerations related to contracts acquired in conjunction with a business combination.
3.7.6.1 Substantially unchanged short-duration contracts
As required by ASC 944-30-35-52, for short-duration contracts, the replacement contract is viewed as a prospective revision to the replaced contract. The unamortized DAC is unchanged at the time of the replacement with the future recognition of unearned premium and amortization of DAC adjusted accordingly on a prospective basis based on the revised terms. In accordance with ASC 944-30-35-54, when the modification is a reduction in benefits with a directly proportionate reduction in premiums, the modification should result in an immediate proportionate reduction in unamortized DAC rather than a prospective revision.
3.7.6.2 Substantially unchanged long-duration contracts
For long-duration contracts, other than certain investment contracts noted in IG 3.5.3, the replacement contract that is substantially unchanged is viewed as a prospective revision to the replaced contract in accordance with ASC 944-30-35-46. The unamortized DAC is unchanged at the time of the replacement with the future amortization adjusted on a prospective basis for any change in the expected life of the replacement contract. In accordance with ASC 944-30-35-50 and ASC 944-30-35-51, any related liability for future policy benefits or market risk benefits is required to be updated as described in ASC 944-40-35 and other balances that are determined based on activity over the life of the contract, such as an additional liability for death or other insurance benefits, is calculated considering the term of the replacement contract and activity during the term of the replaced contract.
3.7.6.3 Substantially unchanged investment contracts
ASC 944-30-25-48 requires that for certain investment contracts accounted for as interest-bearing or other financial instruments for which DAC is amortized using the interest method under ASC 310-20, the replacement contract represents revisions to the cash flows of the replaced contract. As such, the unamortized DAC and deferred sales inducement assets are adjusted accordingly. See IG 3.5.3 for information about investments contracts accounted for as interest-bearing or other financial instruments.
3.7.6.4 Costs – substantially unchanged internal replacements
Costs incurred on internal replacements that result in a substantially unchanged contract should be accounted for as policy maintenance costs and expensed as incurred (i.e., the costs should not be deferred) in accordance with ASC 944-30-35-55.
ASC 944-30-35-56 requires any portion of renewal commissions paid on the replacement contract that meet the criteria for deferral in accordance with ASC 944-30 continue to be deferrable if they do not exceed the amount of deferrable renewal commissions on the replaced contract. See IG 3.4 for further guidance on the criteria for deferral of acquisition costs. The guidance is intended to prevent the deferral of additional costs incurred related to substantially unchanged contract modifications that do not result in additional insurance coverage or incremental deposits. For example, if a contract were exchanged for a new generation of the contract, and the agent was paid a commission on the rollover of the existing account balance, the commission would not be deferrable. Additionally, to the extent a commission is paid at a rate in excess of the rate provided at the replaced contract’s inception, the excess commission would not be deferrable. The guidance does not prevent the deferral of commissions paid on premiums attributable to an increase in insurance coverage or incremental deposits not previously provided for in the contract.
3.7.6.5 Sales inducements – substantially unchanged internal replacements
ASC 944-30-35-57 through ASC 944-30-55-60 indicates that if a surrender charge assessed on the replaced contract is offset by an immediate sales inducement on the replacement contract, insurance entities should offset the immediate sales inducement against the surrender charge to determine whether there has been a net reduction in the contract holder’s account in accordance with ASC 944-30-35-37(d). The sales inducement liability will be recorded as part of the liability for policy benefits over the period in which the contract must remain in force to qualify for the inducement or at the crediting date, if earlier. The criteria in ASC 944-30-25-6 through ASC 944-30-25-7 for recognition of a related sales inducement asset cannot be satisfied in these circumstances because the sales inducement was not specifically identified in the original contract. See IG 3.6 for the criteria for deferring sale inducement assets.
Example IG 3-10 illustrates the accounting for a sales inducement offered with an internal replacement of an investment contract.
EXAMPLE IG 3-10
Sales inducement offered with an internal replacement of an investment contract
Sales inducement offered with an internal replacement of an investment contract
Insurance Company offers a sales inducement in conjunction with the conversion of an investment contract to a universal life contract. The account balance of the replaced contract immediately prior to the internal replacement was $10,000. Upon termination of the replaced contract, a surrender charge of $500 was applied and a $500 sale inducement bonus was offered in conjunction with the new internal replacement contract.
How would Insurance Company apply the guidance in ASC 944-30-35-57 and what would be the resulting accounting?
Analysis
The account balance of the investment contract prior to surrender charges is $10,000 and a $500 surrender charge is imposed. The resulting $9,500 credited to the replacement contract account value (prior to consideration of the sales inducement) would result in a substantial change to the contract. However, since an immediate bonus of $500 was credited to the replacement contract, there would be no net reduction to the balance available to the contract holder and the internal replacement would result in a contract that is substantially unchanged provided the other conditions of ASC 944-30-25-37 are satisfied. Additionally, there would be no net impact on earnings as the $500 surrender charge would be directly offset by the $500 immediate sales inducement bonus that is expensed as incurred.
3.7.7 Contract assessments
ASC 944-30-35-61 indicates that front-end fees assessed in connection with an internal replacement of a long-duration contract are evaluated for deferral in accordance with ASC 944-605.
3.7.8 Substantially changed contract (extinguishment of replaced contract)
ASC 944-30-40-1 through ASC 944-30-40-4 requires a replacement contract that is substantially changed from the replaced contract to be accounted for as an extinguishment. Under the guidance, any balances associated with the original replaced contract are derecognized. These balances may include unamortized DAC, PVFP, unearned revenue liabilities, deferred sales inducement assets, liability for future policy benefits, or market risk benefits. The replacement contract is accounted for as if it were a newly issued contract. As such, acquisition costs related to the replacement contract should be evaluated for deferral in accordance with the provisions of ASC 944-30. See IG 3.4 for further guidance on the criteria for deferral of acquisition costs.
ASC 944-30-40-1 through ASC 944-30-40-4 does not provide explicit guidance on the amount of non-cash consideration used to calculate the gain or loss on extinguishment of the replaced contract and the initial premium for the newly issued contract when an internal replacement results in a substantially changed contract.
One way practice has viewed this non-cash transaction is that the consideration for the extinguishment and the premium for the replacement contract would be the same amount adjusted for any cash exchanged, such as additional premiums or deposits paid by the policyholder for the replacement contract. The non-cash consideration could be the sum of the account balance carried over to the replacement contract from the replaced contract and the fair value of any off-market terms, including benefits, guarantees, premiums, or deposits. Off-market terms are those that are different from terms offered to a new contract holder for the same or similar contract.
An example of an off-market feature on a variable annuity replacement contract would be a GMDB, GMIB, GMAB, or GMWB that has a starting floor guarantee amount above the new account balance (i.e., in the money) but has related policy fees comparable to the fees for a similar guarantee that has a starting floor guarantee equal to the new account balance (i.e., at the money).
Example IG 3-11 illustrates the considerations when determining whether the lapse and reinstatement of a long-duration life insurance contract results in a contract extinguishment
EXAMPLE IG 3-11
Determining whether the lapse and reinstatement of a long-duration life insurance contract results in a contract extinguishment
Determining whether the lapse and reinstatement of a long-duration life insurance contract results in a contract extinguishment
Insurance Company issued a long-duration life insurance contract that lapsed due to nonpayment of premium. As a result, Insurance Company has no obligation to pay claims during the lapse period. Under the terms of the contract, the policyholder can reinstate the contract within a specified period from the lapse date with no ability of Insurance Company to re-underwrite this risk. In the period between lapse and reinstatement, if the insured dies, there is no death benefit paid. Should the lapse and reinstatement be treated as a contract extinguishment?
Analysis
An extinguishment occurs when an insurance enterprise has no further obligation to pay claims due to the lapse of a contract. However, in the fact pattern above, the policyholder has the unilateral right to reinstate the contract without any underwriting or other qualifying criteria. Therefore, although Insurance Company has no obligation to pay a death benefit claim during the period between lapse and reinstatement, its obligation to the policyholder has not been totally extinguished. Insurance Company may have future death benefit exposure under the current contract if the policyholder decides to reinstate the policy by paying a premium, and thus the contract would not be considered extinguished. In addition, the lapse in coverage would not be considered a contract modification because it was part of the original contract provisions that such a lapse could occur without necessarily terminating the contract. Therefore, neither a contract extinguishment nor a modification has occurred.
In other fact patterns, a policyholder may not have the unilateral right to reinstate the contract (either through the contract terms or a past practice that makes it legally enforceable), or the insurer may have an administrative practice of reinstating lapsed contracts at its discretion while retaining the right to deny reinstatement. In such cases, a lapsed contract would result in an extinguishment for accounting purposes.
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