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7.3 Loss recognition (premium deficiency) – long-duration contracts
Publication date: 30 Nov 2021 (updated 31 Mar 2023)
us Insurance guide
Long-duration contracts are principally life and annuity contracts, and the applicability of the premium deficiency test is dependent on the classification of the contract, as defined in ASC 944.
The premium deficiency test (detailed in ASC 944-60-15-5) is only required for universal life contracts and participating contracts. No testing is required for traditional and limited pay contracts. However, testing is required for the present value of future profit (PVFP) associated with all acquired blocks of long-duration contracts regardless of their contract classification.
7.3.1 Loss recognition (premium deficiency) – traditional and limited-pay
As cash flow assumptions are required to be updated regularly and the net premium ratio is capped at 100% (i.e., net premiums cannot exceed gross premiums), a premium deficiency test under ASC 944-60 is not required for nonparticipating traditional and limited-payment insurance contracts. Expected benefits and claim-related costs in excess of premiums are expensed immediately. As the liability assumptions are updated at least annually, if conditions improve whereby the contracts are no longer expected to have net premiums in excess of gross premiums, the improvement would be captured in the remeasurement process and reflected in earnings in the period of improvement. Unamortized deferred acquisition cost (DAC) is not part of the net premium ratio and is not subject to a separate premium deficiency or recoverability test, consistent with analogizing DAC to debt issuance costs. However, unamortized PVFP from past business combinations needs to be separately tested for recoverability even if associated with traditional and limited-payment contracts.
7.3.2 Loss recognition (premium deficiency) – universal life and participating
A premium deficiency test is required for contracts other than traditional and limited-payment contracts, such as universal life and participating insurance contracts. ASC 944 provides guidance for the initial and subsequent measurement. Refer to figure IG 5-4 for considerations regarding shadow adjustments.
7.3.2.1 Initial measurement of loss recognition
The guidance for determining the existence of a premium deficiency for universal life and participating contracts is covered in ASC 944-60-25-7 through ASC 944-60-25-8, ASC 944-60-30-1, and ASC 944-60-30-2.
Original policy benefit assumptions for certain long-duration contracts ordinarily continue to be used during the periods in which the liability for future policy benefits is accrued under Subtopic 944-40. However, actual experience with respect to investment yields, mortality, morbidity, terminations, or expenses may indicate that existing contract liabilities, together with the present value of future gross premiums, will not be sufficient to do both of the following:
- Cover the present value of future benefits to be paid to or on behalf of policyholders and settlement costs relating to a block of long-duration contracts
- Recover unamortized present value of future profits.
The premium deficiency shall be recognized by a charge to income and either of the following:
- A reduction of unamortized present value of future profits
- An increase in the liability for future policy benefits
If the conditions in paragraph 944-60-25-7 exist, an entity shall determine the liability for future policy benefits using revised assumptions as the remainder of the present value of future payments for benefits and related settlement costs (determined using revised assumptions based on actual and anticipated experience) minus the present value of future gross premiums (also determined using revised assumptions based on actual and anticipated experience).
A premium deficiency shall then be determined as the liability measured in paragraph 944-60-30-1 minus the liability for future policy benefits at the valuation date, reduced by the unamortized present value of future profits.
For universal life-type contracts, we believe the premium deficiency analysis includes both the “liability for future policy benefits” described in ASC 944-40-30-16, unamortized deferred sales inducement assets, and any additional accrued liabilities for death, other insurance, and annuitization benefits. That is, the amount subject to premium deficiency testing should include the sum of the following components:
- the accrued policyholder account balance (ASC 944-40-25-14),
- additional liabilities for death or other insurance benefits (as described in ASC 944-40-25-27A) and annuitization benefits (as described in ASC 944-40-25-26 and ASC 944-40-25-27),
- unamortized deferred sales inducement assets
- amounts assessed against policyholders for services to be performed in the future (e.g., unearned revenue),
- amounts previously assessed against policyholders that are refundable on contract termination, and,
- any amounts previously recorded for premium deficiencies.
The premium sufficiency/deficiency calculation is usually performed when current and anticipated experience varies significantly from the original assumptions. One indication that current and anticipated experience may be varying from original assumptions is when the insurance company significantly changes assumptions used for new business from those used in the prior period.
The significant assumptions are:
- investment yields
- mortality and morbidity rates
- terminations
- expenses
To determine if a premium deficiency exists, the present value of expected cash outflows or “future benefits and settlement costs” and the present value of expected cash inflows or “future gross premiums” relating to the contract are considered.
- Cash outflows include all the benefits (e.g., death benefits and surrenders) and related settlement costs that accrue to the benefit of the policyholder. Expected assessments, including charges for administration, mortality, and expense that are expected to be deducted from the account balance that is ultimately paid to the policyholder, are projected.
- Cash inflows include gross premiums expected to be paid by the policyholder. For universal life contracts, “gross premiums” refers to expected deposits to be paid by the policyholder.
Unamortized DAC is not a component in the analysis; however, the unamortized present value of future profits from past business combinations is included. Maintenance costs are specifically excluded as a cash outflow in the present value of future payments for benefits and related costs.
No loss is reported currently if it results in creating future income.
Question IG 7-1 addresses the appropriate discount rate to be used in determining the present value of expected cash outflows and inflows in the premium deficiency test for universal life type contracts.
Question IG 7-1
What discount rate should be used in the loss recognition test relating to universal life type contracts?
What discount rate should be used in the loss recognition test relating to universal life type contracts?
PwC response
ASC 944-60-25-7 requires that a reporting entity assess universal life-type contracts for premium deficiency, 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. As a result of the lack of a prescribed rate, a discount rate such as investment yield or the account balance crediting rate may be appropriate. We believe the discount rate used should be consistent with the underlying economics and other relevant assumptions. If investment yield is used as the discount rate, it must be disclosed in accordance with ASC 944-60-50-2. Refer to Figure IG 5-5 for considerations related to shadow adjustments.
Question IG 7-2 addresses how market risk benefits associated with universal life insurance contracts are considered in the premium deficiency analysis.
Question IG 7-2
Are market risk benefits a component of the universal life insurance premium deficiency analysis?
Are market risk benefits a component of the universal life insurance premium deficiency analysis?
PwC response
No. The universal life liability for future policy benefits excludes market risk benefits because market risk benefits are measured at fair value and therefore do not meet the “liability for future policy benefits” glossary definition of “an accrued obligation to policyholders that relates to insured events, such as death or disability.” That is, premium deficiency guidance applies to balances measured under an accrual model, but not under a fair value model. Entities should ensure that the fees attributed to the market risk benefits in the fair value model are excluded from the cash inflows for the universal life liability for policy benefits premium deficiency test.
7.3.2.2 Subsequent measurement of loss recognition
If a premium deficiency liability is recognized, future changes in the liability are based on the revised assumptions. The liability for future policy benefits should be estimated periodically based on revised assumptions using actual and anticipated experience and compared with the current liability for future policy benefits (reduced by the unamortized present value of future profits) in accordance with ASC 944-60-35-5 to determine if any additional premium deficiency exist. We believe the assumptions should be unlocked even for favorable development that would lead to a reversal of previously recognized amounts.
7.3.3 Profits followed by losses for universal life and participating contracts
ASC 944-60-25-9 requires that an additional liability be recorded in situations when there are profits followed by losses for universal life and participating contracts.
In some instances, the liability on a particular line of business may not be deficient in the aggregate, but circumstances may be such that profits would be recognized in early years and losses in later years. In those situations, the liability shall be increased by an amount necessary to offset losses that would be recognized in later years.
There is no detailed guidance indicating how that liability should be measured or over what period it should be recognized. An example of a profits followed by losses situation for universal life is a contract priced such that cost of insurance (COI) assessments in later attained ages were not expected to fully cover expected mortality costs but expectations of other assessments and investment spread earnings in addition to the COI were expected to cover these costs such that the contracts were expected to be profitable in all future years. However, subsequent experience relating to mortality in later years or the level of future deposits and investment returns cause the company to now expect losses in later years even though currently all years combined do not demonstrate a premium deficiency.
In these situations, we believe there are at least two alternative approaches for accruing the additional liability:
- Accrue a liability over the profitable periods in a systematic and rational manner such that the additional liability is fully established by the date that the losses are expected to emerge, or
- Immediately recognize the full liability.
With respect to the systematic and rational manner in which to accrue the liability, different methods may be used. The key principle is, at the point in time when losses are expected to emerge, the liability should be fully established. The accrual is essentially meant to zero out the future loss periods without creating profits or losses in the later years.
We expect entities to apply a consistent accounting policy for profits followed by losses and describe the specific calculation method selected.
Question IG 7-3 addresses whether to include reinsurance benefits in the premium deficiency test.
Question IG 7-3
Can a company include reinsurance benefits and the cost of reinsurance in its premium deficiency test?
Can a company include reinsurance benefits and the cost of reinsurance in its premium deficiency test?
PwC response
Yes, if that is the company’s accounting policy. There is no explicit guidance in ASC 944 on how to consider reinsurance costs and recoveries in the premium deficiency test in ASC 944-60-25-7 and likewise there is no guidance on what should be included in “profits” or “losses” for purposes of the “profits followed by losses” test in ASC 944-60-25-9. One option is to treat reinsurance as a component of the net profits or losses of the group, similar to other related revenues and expenses that are not part of the contract with the policyholder, such as investment yields and claim settlement expenses paid. The consideration of reinsurance in the premium deficiency calculation is akin to the inclusion of investment yields, as the purchased reinsurance has effectively replaced investments in supporting the payment of claims. Alternatively, reinsurance could be considered a separate financial instrument and not included in direct policy cash flows.
7.3.4 Recoverability test for present value of future profits
The fair value of insurance contracts acquired in a business combination is divided into two basic components: (1) assets and liabilities measured in accordance with the acquirer’s accounting policies for insurance and reinsurance contracts that it issues or holds and (2) the insurance contract intangible asset (or liability) representing the residual. In many cases this will represent the future GAAP profits to be realized from the acquired insurance contracts and is called “present value of future profits” (PVFP) or value of business acquired (VOBA).
To the extent that PVFP relating to all types of insurance (including traditional and limited payment) and reinsurance contracts acquired represents an asset under ASC 944-30-35-63 and ASC 944-805-35-3, it is subject to a recoverability test in accordance with ASC 944-60. For further consideration, see IG 12.3.4.
7.3.5 Loss recognition (premium deficiency) – investment contracts
For normal interest-bearing obligations, there is no premium deficiency test. If a company expects to incur a negative interest spread (i.e., expected investment earnings are less than contractual liability crediting rates), the loss from that spread is recognized as realized over the life of the obligation. It would not be appropriate to write down the DAC balance on these types of contracts to estimated net realizable value as neither ASC 944 nor ASC 310 subjects these balances to impairment testing. Similarly, if a PVFP asset exists for investment contracts, it would generally not be subject to a premium deficiency test or separate asset recoverability test given that PVFP is essentially a form of debt discount or premium associated with the investment contract liability.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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