GAAP Ch 6: Universal Life Insurance (SFAS 97)
Source: GAAP, Chapter 6
Applicability
• UL, investment contracts, limited-payment long-duration contracts
(Chapter 4)
Definition
• Universal life-type contracts are long-duration contracts, providing either
death or annuity benefits, with terms that are not fixed and guaranteed
• Universal life-type contracts include any of the following:
o Contract charges are not fixed and guaranteed
o Interest credited is not fixed and guaranteed
o Premiums may be varied by the PH without the consent of the
insurer
• Significance of Mortality and/or Morbidity Risks
o Contracts should be classified at inception as either insurance or
investment contracts, depending on the significance of mortality
and/or morbidity risk
o Test for determining the significance (SOP 03-1): compare the
PV(Excess Payments to be made for all of the contract’s insurance
benefit features) to the PV(all amounts to be assessed against the
PH)
Excess payments = benefit payments > PH account balance
Use multiple scenarios that consider the volatility of
assumptions
Most UL contracts include significant mortality risk
If there is insignificant mortality/morbidity risk
• If revenues from other than investment are significant
SFAS 97
• If revenues from other than investment are insignificant
SFAS 91
Presentation of Results
• “Retrospective deposit method” bases the benefit reserve on AV
• Balance Sheet Presentation is similar to SFAS 60 balance sheet
o Benefit reserve and any other reserves on Liability side
©2010 The Infinite Actuary
GAAP Ch 6
Page 1
o DAC is asset
• Income Statement presentation for UL is quite different from that for SFAS
60 products
o Premiums are not reported as revenue
o Benefits to PH are only reported that are in excess to the account
balance
o Revenue includes all charges collected: COI charges, surrender
charges, policy fees.
If revenue is collected to compensate the insurer for services
to be provided in a later year, a URL is set up, and the
amortization of URL is included in revenue.
o Expense items include benefit claims in excess of account balances,
cost of contract administration, interest credited to PH account
balances, and amortization of DAC. Does not include increase in
reserve.
SFAS 60
SFAS 97
Revenues
Premiums 1000
UL fee income
Net Investment Income 175
Earned deferred revenue
Total Revenues
1,175
Benefits and other Deductions
Death Benefits 90
Surrender Benefits 120
Interest credited to PH account balances
Increase in Reserve 760
Bonus Interest charge
DAC Amortization 40
Commission 20
Other operating costs and expenses 80
Total Benefits & Deductions
1,110
Pre-Tax Earnings
65
Income Taxes
23
Net Earnings
42
©2010 The Infinite Actuary
GAAP Ch 6
300
175
30
505
85
0
200
0
15
40
20
80
440
65
23
42
Page 2
Benefit Reserves
• Benefit Reservet = Account Balancet
o Account Balance = Deposits (net of withdrawals) + Amounts credited
according to the contract – Fees and charges assessed + Additional
interest (such as a persistency bonus)
• Other reserves may need to be set up: URL, Premium Deficiency Reserves,
SOP 03-1 reserve
• Assumptions: best estimate without PADs, not locked in
Capitalization and Amortization of Acquisition Expenses (DAC)
• “Revenue” = Estimated Gross Profits (EGP)
• EGP = Mortality Margin + Interest Margin + Expense Margin + Surrender
Charge + Other (calculated for each time period)
o Mortality Margin = COI charges – DB in excess of AV
o Interest Margin = interest earned – interest credited
Amounts “expected to be earned from the investment of PH
balances” – interest credited to PH account balances
o Expense Margin = contract administration charges – contract
administration costs
Contract administration costs = maintenance expenses and
non-deferred acquisition expenses
o Surrender Charges = AV - CSV for the policies terminated each year
CSV = cash surrender value (what the PH actually received)
AV = account balance (what was in the PH account)
o Other = assessments and costs due to riders or reinsurance
• Expense Capitalization
o Definition of expenses to be capitalized is similar to SFAS 60
o Acquisition costs that vary in a constant relationship to premiums or
insurance in force, are recurring in nature, or tend to be incurred in a
level amount from period to period are charged to expense in the
period incurred and are not deferred
©2010 The Infinite Actuary
GAAP Ch 6
Page 3
• DACt = kt x PVt(EGP) – PVt(DAE)
o =
(
)
()
Use actual experience up to time t and estimates thereafter. If
actual experience differs from expected, the values of kt will
change over time.
PV always calculated from issue
o Assumptions are best estimates without PADs
Interest rate used is credited rate
o Retrospective: DACt = (DACt-1 + DAEt) x (1 + i) – kt x EGPt
Can only use if no change in kt or any assumption
o The amount of DAC at any time depends upon the relationship
between future EGPs after that point and EGPs up to that point
The following (Table 6-6 in GAAP book) is a simplified example.
Credited rate is assumed to be 0%.
• At PY 3, EGP(3) = 50 (instead of the expected 100), but
future expectations for EGP remain at 100
Original Expectation
PY
1
2
3
4
5
PV@0%
k-factor
EGP
100
100
100
100
100
500
40%
©2010 The Infinite Actuary
DAE
200
200
DAC
160
120
80
40
0
Actual to PY 3; Future
expectations unchanged
EGP
DAE
DAC
100
200
156
100
111
50
89
100
44
100
0
450
200
44%
GAAP Ch 6
Actual Reported
Results
EGP
DAE DAC
Page 4
• Examples of Benefit Reserve, EGP, and DAC for a Universal Life Policy
o Tables 6-7 through 6-13 are a good example of the workings of a UL
contract and the calculation of EGP, DAC, and the Benefit Reserve.
o Here is a simplified example. Suppose you have a UL policy,
$100,000 face amount. In the table below are data for the first 3
years of the policy (all values are expected values). In addition, we
are given that PV0(EGP) = 4,250 and all of the DAE are in the table.
Calculate the EGP, DAC, and the Benefit Reserve for the first 3 years.
The credited rate is 5%.
PY
COI
collected
1
2
3
223
202
195
PY
1
2
3
DB in
excess
of AV
78
93
105
EGP
©2010 The Infinite Actuary
Interest
assumed
Interest
Credited
168
296
404
115
203
278
Loads
& Pol
Fees
42
37
33
DAC
GAAP Ch 6
Maint
Exp
Surr
Charges
DAE
AV
95
85
76
252
360
263
2443
178
0
1847
3406
4756
Benefit Res
Page 5
Profit = Revenue – Expenses
Revenue = Policy charges collected + Investment Income
Policy charges collected = COIs + Loads & Policy Fees +
Surrender Charges
Expenses = Death Benefits in Excess of Account Balance +
Commissions + Other Expenses + Interest Credited - Change in DAC
Other expenses = acquisition and maintenance expenses
Income Statement
Revenue
COI Collected
Loads &Fees
Surr Charges
Investment Income
TOTAL Revenue
Expenses
DB in excess of AV
Interest Credited
Acq Exp
Maint Exp
Change in DAC
TOTAL Expenses
PROFIT
©2010 The Infinite Actuary
PY1
PY2
PY3
223
42
252
168
685
202
37
360
296
895
195
33
263
404
895
78
115
2443
95
93
203
178
85
105
278
0
76
GAAP Ch 6
Page 6
• Selection of Assumptions and Unlocking
o At each time period, assumptions used are best estimate, without
PADs.
o True-up for Actual Experience/Retrospective Unlocking
Retrospective unlocking = replacing EGPs with actual historic
gross profits, without changing future assumptions
o Assumptions and Prospective Unlocking
Prospective unlocking = replacing existing assumptions with
new assumptions going forward
o Example continues: Suppose that in year 2, there is an unexpected
$2000 increase in interest earned
For retrospective unlocking, we will assume that the
assumptions for years 3 and later do not change
For prospective unlocking, we will assume that the interest
earned in years 3 and beyond are decreased by 50%
Retrospective Unlocking
PY
1
2
3
©2010 The Infinite Actuary
Investment
earnings
168
2296
404
EGP
DAC
Change from
Original DAC
397
2514
436
GAAP Ch 6
Page 7
Prospective Unlocking
PY
1
2
3
Investment
Earnings
168
2296
202
EGP
DAC
Change from
Original DAC
397
2514
234
Summary of Effects of Unlocking
DAC duration 1
Impact of Retrospective Unlocking
Impact of annual events
Impact of Prospective Unlocking
DAC duration 2
(original projection)
(retro(1) – original(1))
(retro(2) – retro(1))
(pro(2) – retro(2))
Deferral of Unearned Revenue—Unearned Revenue Liability (URL)
• Compensation to the insurance company for services to be provided in the
future are not earned in the period assessed. You report these as unearned
revenue and then you set up an Unearned Revenue Reserve. Also called a
Deferred Revenue Liability.
• URLt = ktURL x PVt(EGP) – PVt(unearned revenue)
o =
( )
()
Use actual experience up to time t and estimates thereafter
PV always calculated from issue
• Unearned Revenue examples
o Front-end loads: charges that are much higher in first few years than
ongoing charges
o COI charges that do not follow a normal mortality pattern
©2010 The Infinite Actuary
GAAP Ch 6
Page 8
• Example based on p. 187 in GAAP book: The COI charges per $1000 NAR
are based on the following pattern:
Duration 1
COI
2.28
2
2.40
3
2.64
4
2.76
5
3.00
6
3.24
7
3.78
8
3.84
Suppose the company decides to charge 3.00 per 1000 for years 1 –
5. The excess mortality charges would be established as deferred
revenue and amortized over life of contract. Credited rate = 5.5%.
PY
DB
AV
1
2
3
4
5
6
7
20
PV
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
2101
4310
6623
9059
11614
14296
17115
69072
©2010 The Infinite Actuary
Ins
Inforce
100,000
87,925
79,025
71,800
65,950
61,200
57,400
34,125
Excess
COI
EGP
URL
396
514
436
375
342
321
311
530
4768.8
GAAP Ch 6
Page 9
Treatment of Bonuses and Other Special Benefits (SOP 03-1)
• Bonuses (also called sales inducements) are similar to deferred acquisition
expenses (like commissions) except that they are paid to the PH, and not to
the agent. Because they are paid to the PH, they cannot be part of DAC.
Recoverability and Loss Recognition
• Same principles as under SFAS 60
• Loss recognition is usually performed on a block of business
• The discount rate used in recoverability testing and loss recognition should
be the best estimate of the earned rate, not the crediting rate
• DAC is recoverable if k-factor is less than or equal to 100%, using the
earned rate (not the credited rate)
• Once a recoverability problem has occurred, or a loss has been recognized,
it is appropriate to use the earned rate to amortize any remaining DAC
Profits Followed by Losses (SOP 03-1)
• Profits/losses = Assessments – Excess payments
• SOP 03-1 reserves are set up if the amounts assessed against the contract
holder each period for the insurance are assessed in a manner that is
expected to result in profits in earlier years and subsequent losses.
• Definition of an assessment: If there is an explicit fee for a benefit, then
you would use that fee
o If the pricing is done on an integrated basis and the COI charges are
insufficient to cover the death benefit, then use COI + appropriate
investment or other margins
• It is presumed that a no-lapse guarantee on a UL contract will result in
profits followed by losses.
• Table 6-18 contains 2 examples of Profits Followed by Losses test for the
same UL product. In both cases, the excess payments are the death
benefits in excess of the AV. In the first case, the assessment used in the
test is only the COI charges. In this case, there are profits, but in year 7+,
there are losses. In this case, an additional SOP 03-1 reserve would be set
up. In the bottom part of the table, the test is performed using both COI +
Interest Margins as the assessment in the test. In this case, no losses occur,
and no additional reserve is needed.
• Table 6-19 is an example of Profits Followed by Loss test for a UL product
with a Secondary Guarantee. (NLG = no-lapse guarantee). In this case, they
©2010 The Infinite Actuary
GAAP Ch 6
Page 10
split the assessments and the excess Death Benefits into base policy and
NLG, and then test them separately. This example is given below:
Example of UL with NLG, Profits/Losses Test
Assumptions:
• Expected assumptions in chart are based on a range of scenarios
• No explicit charge for NLG
• COI charges are intended to cover the base mortality benefit and the NLG
PY
Total
DB
1
2
3
4
5
6
7
8
9
10
689
763
832
896
955
1020
1093
1164
1233
1300
Base
Excess
DB
671
742
785
809
812
809
822
814
805
777
NLG
Excess
DB
0
0
0
10
32
59
70
94
111
138
COIs
Interest
Margin
738
816
864
901
928
955
982
999
1008
1006
125
242
354
466
577
695
821
951
1085
1227
Other
Assessments
985
954
925
896
869
850
841
831
822
812
Total
Assessments
1848
2012
2143
2263
2374
2500
2644
2781
2914
3045
Calculations:
• Base excess DB = DB in excess of AV released on death
• NLG Excess DB = DB paid to PH whose AV is negative
• Interest margin is due to the spread of 50bps
• Other assessments come from policy fees
• Total assessments = COI + Interest Margin + Other Assessments
To do a Profit/Loss test, we look at Assessments – Excess Benefits. At this point,
we have Excess DB for the Base and Excess NLG DB. We need to split the
assessments into a portion for the base and a portion for the NLG.
Portion of assessments allocated for NLG = PV(NLG benefits)/PV(COI)
o Rest are allocated to the base
PV0(NLG Excess DB) = 288, and PV0(COI) = 6284. NLG% = 288/6284 = 4.6%.
©2010 The Infinite Actuary
GAAP Ch 6
Page 11
PY
1
2
3
4
5
6
7
8
9
10
Base
Assessments
704
778
824
860
886
911
937
953
961
960
NLG
Assessments
34
37
40
41
43
44
45
46
46
46
Base
Profit/Loss
33
37
39
51
74
102
114
139
156
183
NLG
Profit/Loss
34
37
40
31
11
-15
-25
-48
-65
-92
• Conclusions: Since the Base Profit is always positive, there is no need for an
SOP liability for the base. However, since the NLG has a Profit followed by
losses, we would need an additional SOP liability for the NLG.
Establishment of Liabilities under SOP 03-1
• For insurance contracts that exhibit a pattern of profits followed by losses,
need SOP 03-1 reserve
• Benefit ratio = PV0(Excess Benefits)/PV0(Assessments)
o Calculated used multiple scenarios
• SOP Liab(t) = benefit ratio x cumulative assessments – cumulative excess
payments + accreted interest
• SOP Liab(t) = SOP Liab(t-1) x (1 + i) + [Benefit Ratio x Assessments – Excess
Payments] x (1 + i).5
©2010 The Infinite Actuary
GAAP Ch 6
Page 12
Example: a simplified UL contract. Expected Credited Rate = 8.0%.
PY
1
2
3
4
5
Excess
DB
671
742
813
862
865
COI
Profits/
Losses
1687
1530
1162
729
612
Total
Assessments
2979
2938
2577
2531
2575
SOP
Reserve
Calculations:
• Excess DB, COI, and Total Assessments are given
• Impact on DAC
o Once you have your SOP 03-1 reserve, you subtract the change in
SOP reserve from the EGPs. Then you use your new EGPs to get new
k-factors for amortizing DAC.
Example (continued). We are assuming that the DAE = 5000, all at issue.
PY
1
2
3
4
5
EGP
2126
1996
1764
1670
1710
DAC
©2010 The Infinite Actuary
Change in SOP Liab
GAAP Ch 6
Revised EGP
Revised DAC
Page 13
Note: The effect of SOP on EGP is that it takes some of the estimated gross
profits from the earlier years and moves them to the later years, where
they are “needed” to cover later losses.
Same example using other definition of SOP 03-1 reserve:
PY
1
2
3
4
5
Excess
DB
671
742
813
862
865
Total
Assessments
Cum
Excess DB
Ratio x Cum
Assess
Accreted SOP
Interest Reserve
2979
2938
2577
2531
2575
©2010 The Infinite Actuary
GAAP Ch 6
Page 14