U.S. life insurers will soon be contending with some major changes to accounting standards for certain of their life and annuity products. The Financial Accounting Standards Board (FASB) last year announced a change to the accounting standards used under U.S. generally accepted accounting principles (GAAP) for certain long-duration insurance contracts associated with life and annuity products. S&P Global Ratings expects these long-duration targeted improvements (LDTI) to have a significant impact on the U.S. life insurance industry--in particular, they could drive many insurers to shift their strategies as a result of increased volatility of reported GAAP capital and earnings.

However, we don't anticipate widespread rating changes on the first day of implementation--currently slated for Jan. 1, 2022, for most public companies. Rather, we believe the shifts in insurers' strategies would happen over the longer term. We also expect the new standards could result in consolidation or even increased privatization of the sector as insurers work to implement and educate their investors and other constituents on the new standards.

Considering how significant these new standards will be for U.S. life insurers, we're addressing some common questions about the specifics of the proposal and how they could affect our ratings.

Frequently Asked Questions

What are the proposed changes to the accounting standards?

The standard--ASU 2018-12--proposes four major changes for long-duration contracts (see table 1).

Table 1

How will these new standards affect companies' reported earnings and capital?

We anticipate greater volatility for both reported earnings and capital, regardless of whether an insurer chooses to take the full retrospective approach or the modified retrospective approach (also known as the pivot approach). The full retrospective approach is difficult to implement largely because of data limitations around policies that were issued many years or even decades ago. So we expect most companies to implement the pivot approach.

Under both approaches, the assumptions and discount rates used in calculating reserves for many products that insure longevity, morbidity, or mortality risks--whole life, term life, long-term care (LTC), disability, and payout annuities--need to be updated annually. This will need to be done using a discount rate based on a low-credit-risk fixed-income instrument yield rate that is also subject to an annual update. Most industry participants translate this to an 'A' corporate bond yield, though FASB has not provided more specific guidance. The updating of risk assumptions will flow through earnings, while discount rate changes will flow through other comprehensive income (AOCI).

We anticipate insurers adopting the pivot approach that have locked-in rate assumptions that are significantly higher than the rate at the time of implementation will experience material drops in equity, particularly if the insurers have very long-duration liabilities. In today's interest rate environment, with historically tight spreads and the 10-year Treasury yield under 2%, we believe many insurers' locked-in rates are likely to be materially higher than the prescribed rate.

Either way, without the "unlocking" methodology insurance companies currently use, which only updates reserves when loss recognition testing demands it, we expect to see greater volatility over shorter periods. However, we also anticipate "cliff-type" reserve events (whereby reserves remain stable for a long period and then increase sharply)--like we've seen in LTC in recent years--to become much rarer.

How will the new standards affect ratings?

In general, we don't change our ratings based on revisions to accounting standards because accounting does not necessarily reflect the true economics of a business. But to the extent increased disclosures reveal deficiencies in a company's financial risk profile, we could change our ratings. (Examples of this include if we were to find certain risks are significantly underhedged relative to peers or greater asset–liability mismatch that was previously masked under "locked-in" assumptions.)

Even with material decreases in equity, particularly for companies adopting the pivot approach, we think it's unlikely we would move ratings on day one. Rather, we could make adjustments for certain items we deem nonmaterial or misrepresentative, as well as gauge expected management responses that may restore equity over our ratings horizon (usually 18 months).

For example, with pivot adopters, we may assess leverage by either adjusting parts of AOCI (which would carry the losses caused by the updated discount rate), or by offsetting the decline in AOCI by including future profitability arising from favorable experience in insured risks that would emerge over the life of the policy, similar to an embedded value approach. We would also take into account planned management actions to reduce leverage.

We also do not expect the implementation of the new standards to affect our view of capital adequacy for most companies because we typically assess capital on a statutory basis, and statutory accounting is unaffected by this change. However, we would likely use our adjusted assessment of equity in our debt-funded double leverage calculations that directly affect our view of statutory capital.

What impact will the proposed changes have on insurers' strategies and reporting methods?

We believe the primary impact of the new standards will be changes to strategy, reporting, or ownership structure as insurers, particularly those that are publicly held, try to educate their investors and constituents. We could see longer-tail lines of business being deemphasized or even sold to avoid the sensitivity to rates, similar to what happened in the U.K. following the implementation of Solvency II.

Many publicly held life insurance companies that have significant market exposures or particularly complex liability profiles already trade at a discount relative to book value. We expect this to continue as investors struggle to reconcile the increased volatility in the business. We could also see some insurers or business lines transferred to private ownership since the cost of capital for a publicly held company may rise significantly if insurers cannot overcome the stigma of volatile reported results.

We also believe certain insurers that are currently opting to report on a GAAP basis, for example some mutual companies, may choose to report only on a statutory basis per their regulatory requirements because of the increased volatility and the onerous operational processes surrounding implementation of ASU 2018-12. Consequently, there could be a greater emphasis on statutory accounting, GAAP cash flow metrics, and non-GAAP measures. Accessibility to hedging and liquidity may be affected since lower GAAP shareholders' equity could lead to the cancelation of International Swaps and Derivatives Assn. agreements and increase the risk of violating covenants with minimum consolidated net worth requirements.

Which lines of business might be most affected?

The product types we expect to be affected are whole life, term life, payout annuities, disability, LTC, and variable or fixed annuities with benefits that are currently reserved under SOP 03-1. (The Statement of Position, or SOP, 03-1 covers accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and separate accounts.) This would typically include variable annuities with guaranteed minimum death benefits, guaranteed minimum income benefits, and, to a limited extent, guaranteed lifetime withdrawal benefits. Also, for fixed indexed annuities, living benefit riders are covered under the standard.

We took a look at insurers' potential exposures to two lines of business that we expect to be affected by the accounting change: variable annuities that are most likely to be currently reserved under SOP 03-1 and LTC (see charts 1-2). We chose these two lines because the public disclosures regarding them tend to be widely available. Consequently, we are able to provide a more comprehensive view of the major writers in the industry. The size of the bubbles and the percentages next to the insurer names represent the relative size of the exposure (either by account value or current GAAP reserves) versus reported GAAP shareholders' equity.

Chart 1

Chart 2

These exposures do not necessarily mean the new standards will have a negative or positive impact on the reported shareholders' equity of the companies in the charts. For all affected business lines, the actual size of the impact to GAAP equity at the time of the transition will depend on the company's chosen adoption method, as well as its current assumptions used for the discount rate in its reserve and experience relative to pricing on the book. For the variable annuity business, some of the future volatility in reserves may be offset by hedging certain economic exposure, such as low interest rates.

Appendix

Table 2

Table 3