It’s more than an accounting change, but what does it really mean for insurers?
by Chad Runchey & Evan BogardusMr. Runchey is a Principal, Insurance Advisory, and Mr. Bogardus is a Partner, Accounting Change Leader, both with Ernst & Young LLP. Visit ey.com
The insurance industry faces new challenges from new GAAP accounting rule ASU 2018-12 for long-duration contracts. Industry earnings will become more volatile based on changing estimates of future mortality rates and other economic factors. Equity levels may take a hit at transition as well. As the new rule is more than just an accounting change, insurance companies will have to implement changes across functions, including actuarial, finance, financial planning and analysis, investor relations and IT.
Volatile forecasts ahead
New GAAP accounting rules, taking effect for public business entities in 2021, are poised to impact investor perception of the insurance industry’s complexity. The new rules, “Targeted Improvements to the Accounting for Long-Duration Contracts” (FASB ASU 2018-12), apply to all long-duration insurance contracts (e.g., annuity insurance, universal life, whole life, term life and long-term care), but not in equal measures. For traditional products, revisions to long-term assumptions will be reflected in current-year earnings. That means, for example, if an insurer concludes that mortality rates are likely to be higher than previously expected, it will reduce year’s earnings. Under the old rules, current-year earnings would only be updated as a result of loss recognition events, rather than from changes in expectations.
For nontraditional products, certain types of guarantees will be measured at fair value, with changes reflected in current earnings.
For all products, amortization of deferred acquisition costs will change and may be significantly different from today’s amortization patterns.
As a result, insurance industry earnings will become more sensitive to actuarial expectations about changing mortality rates, policyholder behavior and economic conditions. Whatever the future may hold, inherently subjective assumptions will need to be reflected in present-year earnings, which will have significant implications both for insurance enterprise operations and for those that invest in the industry.
Telling the best story to investors
The new FASB accounting rules fundamentally change the main metric — earnings — by which investors value publicly traded insurance companies. Although accounting rules don’t directly change the underlying economics of the business, in this case they will change investor perceptions.
Earnings volatility and complexity was already an issue for the industry, compounded by the dynamics of the changing marketplace and the demand for changes to traditional products. That’s why it’s critical for insurance companies to deliver a reassuring message with enhanced transparency throughout the implementation period, and support that message by delivering high-quality and timely information in subsequent years.
Insurance company CFOs will have the initial responsibility to explain these changes to the investment community. It’s a difficult challenge, considering that investors are much more interested in free cash flow than in subjective-sounding changes to highly complex insurance accounting rules.
During the implementation period, we expect insurers to have lengthy conversations with shareholders to contextualize the increased volatility of earnings. In some cases, an insurer may have to explain large impacts in transition GAAP equity as well.
Looking beyond the transition period, insurers will need to preserve credibility with the investor community by providing accurate year-after-year estimates and increased transparency of key drivers. A cautionary note: if entities frequently change future loss estimates or appear to manipulate them to preserve present-year earnings, they’ll quickly lose credibility with investors.
Not just an accounting change
ASU 2018-12 is an accounting change, but its effects go far beyond the accounting function. New business requirements stemming from the rule change will affect several areas of the insurance enterprise, including:
- IT departments and vendor management teams
Capture at the required level of granularity all relevant and required data from policy administration, billing, cash and claims systems. Store the new data within a data repository accessible to multiple areas of the enterprise. Assess the need for complementary changes to core systems, IT connectivity, rules engines and business intelligence tools. Work with internal IT teams and solution partners to implement the required changes under deadline pressure, even while competing for resources with other transformation initiatives.
Incorporate additional data elements about policyholders, including fine-grained transactional data, into actuarial projection models. Update business processes and governance for actuarial activities, including assumption setting and results analysis.
Revise the process of generating financial statements, with new supplementary statements for increased disclosure and non-GAAP operating earnings metrics for investor clarity.
- Investor Relations
From the CFO down to everyone involved in communications and investor relationships, provide a consistent and clear message to the investment community, backed up by accurate forecasts. Maintain investor confidence with accurate, explainable and timely disclosures.
Apply the new standard while keeping in mind the real business and financial implications of each aspect of the implementation. Make educated decisions about how various accounting treatments may affect the rest of the enterprise.
- Risk Management and Hedging
Because of earnings volatility from unlocking cash flow assumptions related to traditional insurance products and fair valuation of market-risk benefits, management will have to revisit asset and liability matching and hedging strategies to manage volatility.
- Product Design & Pricing
Given the changes, especially in annuity business related to market-risk benefits, insurers will need to evaluate changes needed on product design and pricing of those products.
- Business Srategy
As a result of significant earnings volatility, insurers will need to revisit their optimum product mix and geographies they operate in, and focus on their core products and key geographies. As a result, the capital allocation decisions will be impacted, thus resulting in the selling of none-core businesses and divestitures related to the non-key geographies. Insurers should also keep an eye on these changes in their key product lines and geographies so they can capitalize on these opportunities, either through acquisitions of businesses from other companies or organically investing in other geographies or products.
Getting it right the first time
Insurance companies will need to undertake these changes through a coordinated and strategic effort. In addition to deploying a highly complex accounting change with significant implications to the company’s financial results, the transition involves managing intricate interactions between multiple teams, using new data sources, systems and processes.
Rather than coping with the rule changes separately through each separate department or function, insurance companies should take a strategic approach to ensuring a coordinated response by implementing the complex rule changes, generating new data sources and testing new business processes under tight deadlines and high criticality.
The views expressed herein are those of the authors and do not necessarily represent the views of Ernst & Young LLP or any EY member firms.