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5.10 “Shadow” accounting
Publication date: 31 May 2024
us Insurance guide
Most insurance entities classify many of their debt security investments as available for sale (AFS). AFS investment accounting recognizes unrealized gains and losses relating to the securities’ remeasurement each period to fair value in OCI. ASC 320-10-S99-2 requires that the carrying amount of certain assets and liabilities be adjusted to the amount that would have been reported if the unrealized holding gains and losses from AFS securities had been realized (often referred to as a “shadow” OCI adjustment). Accounts that could require a shadow adjustment include noncontrolling interests, certain policyholder liabilities, and intangible assets arising from insurance contracts acquired in business combinations that are amortized using the gross-profits method. Shadow adjustments are recognized with a corresponding credit or charge reported directly to other comprehensive income. The accounting prescribed should not affect reported net income.
ASU 2018-12 de-linked invested assets from the valuation of traditional insurance and limited payment contract liabilities and divorced the amortization of certain assets and liabilities from the expected profit emergence pattern. The FASB and SEC have not updated the guidance in ASC 320-10-S99-2 for the provisions of ASU 2018-12. ASC 320-10-S99-2 still cites potential shadow adjustments for deferred acquisition costs and premium deficiency for traditional and limited-payment contracts to the extent that a premium deficiency would have resulted had unrealized holding gains and losses on assets supporting the liabilities been realized. Upon the adoption of ASU 2018-12, these are not instances that would generate a shadow adjustment.
In situations when the contractual liability or asset has already been adjusted through income for the fair value of the related asset (e.g., due to the requirements of derivative accounting or accounting for long-duration contracts), shadow adjustments are not appropriate. While only required for registrants, most insurers follow ASC 320-10-S99-2 in practice.
Figure IG 5-4 summarizes the insurance balances that may require shadow adjustments.
Figure IG 5-4
Insurance balances that may require shadow adjustments
Insurance balances that may require shadow adjustments
Balance | Contracts impacted | Shadow adjustment required | Explanation |
|---|---|---|---|
Premium deficiency loss recognition testing
| All contracts other than nonparticipating traditional and limited-payment contracts
| Depends
| A premium deficiency test is required for contracts other than nonparticipating traditional and limited-payment contracts, as described in IG 7.3. To determine if a premium deficiency exists, the expected cash outflows and expected cash inflows relating to the contract should be considered. The significant assumptions outlined in ASC 944-60-25-7 include investment yields. If entities use their updated “book” investment yields to determine any income statement premium deficiency charge, an additional shadow calculation is then performed using current market yields. The impact on the liability of using current market rates rather than updated book investment yields to discount the cash flows in performing the premium deficiency test will result in a corresponding shadow adjustment in OCI.
|
Recoverability test of PVFP
| Nonparticipating traditional and limited-payment contracts
| Depends
| The net premium ratio used to calculate the liability for future policy benefits for traditional and limited-payment contracts is required to be updated at least annually and is capped at 100%, which represents the premium deficiency test on the liability. However, as noted in IG 7.3, ASC 944-60-25-7 also requires a separate recoverability test of the unamortized PVFP balance and identifies “investment yields” as one of the assumptions that may be used in assessing the recoverability of PVFP. If book investment yields relating to AFS securities are used in performing the PVFP recoverability test for traditional and limited payment contracts, a shadow PVFP recoverability test would also need to be performed using current market yields in place of the book yields.
|
Additional liability for annuitization, death or other insurance benefits
| Universal life-type contracts
| Generally yes
| ASC 944-40-30-26 and ASC 944-40-30-20 require the additional liability for annuitization, death, or other insurance benefits to be calculated based on a benefit ratio that is calculated as the present value of total expected excess payments divided by the present value of total expected assessments over the life of the contract (as noted in IG 5.8). Total assessments in the benefit ratio include the explicit fees charged to the policyholder for the feature as well as other administrative charges. In addition, for contracts in which the assets are reported in the general account, investment margins are included as part of total expected assessments in accordance with ASC 944-40-30-22. For general account contracts that include investment margins relating to AFS securities as part of total assessments, the hypothetical realization of any unrealized gains and losses on these investments would be included in the shadow assessments calculation for the liability, with a corresponding shadow adjustment in OCI.
|
Amortization of PVFP
| Long-duration insurance contracts
| Depends
| ASC 944-805 requires any insurance or reinsurance contract intangible asset (or additional liability) to be amortized “on a basis consistent with the related insurance or reinsurance liability,” but does not prescribe specific methods.
In some cases, an insurer may choose to amortize PVFP based on profit emergence, and that profit emergence may include consideration of book investment yields on AFS securities. Entities that amortize based on estimated gross profits or other methods that incorporate book investment yields on AFS securities would need to record shadow adjustments in OCI using current market yields in place of the book yields.
Other insurers might analogize the balances to DAC as fixed intangible assets or liabilities to be amortized. In these instances, the PVFP is amortized on a straight-line basis consistent with the related DAC amortization method and there would be no shadow PVFP amortization.
|
Amortization of cost of reinsurance
| Long-duration insurance contracts
| Depends
| ASC 944-605-35-14 requires that the cost of reinsurance be amortized over the remaining life of the underlying reinsured contracts if the reinsurance contract is long-duration) or over the contract period of the reinsurance (if the reinsurance contract is short-duration). However, ASC 944 is silent as to the pattern of amortization. In some cases, an insurer may choose to amortize the cost of reinsurance based on profit emergence, and that profit emergence may include consideration of book investment yields on AFS securities. Entities that amortize based on estimated gross profits or other methods that incorporate book investment yields on AFS securities would need to record shadow adjustments in OCI using current market yields in place of the book yields.
Other insurers might analogize the balances to DAC as fixed intangible assets or liabilities to be amortized. In these instances, the cost of reinsurance would be amortized on a straight-line basis consistent with the related DAC amortization method and there would be no shadow cost of reinsurance amortization.
|
Policy dividend obligation (PDO)
| Closed block participating contracts
| Yes
| Mutual life insurance entities can convert to stock life insurance entities through a process of demutualization. Upon demutualization, there are assets that are designated to the closed block to preserve reasonable policyholder dividend expectations. These assets cannot subsequently benefit the shareholders of the life insurance entity. The demutualization alone does not constitute an accounting event that would change the historical carrying value of the assets and liabilities attributed in the closed block. However, at the date of demutualization, the assets contributed to the closed block are based upon what is determined to be sufficient expected future earnings to cover the liabilities and policyholder dividend expectations of the closed block (glide path). To the extent that subsequent earnings of the closed block income exceed the glide path, a policyholder dividend obligation is established, as those earnings are not income of the stock life insurance entity but instead are owed to the closed block policyholders. To the extent those excess earnings are due to unrealized gains and losses on AFS securities, a corresponding shadow adjustment should be recognized to OCI.
|
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