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AICPA SOP 03-1
Accounting and Reporting by Insurance Enterprises for
Certain Nontraditional Long-Duration Contracts and for
Separate Accounts
Because the articles and commentary prepared by the professionals of our firm are often general in nature,
we recommend that our readers seek the advice of an actuary or attorney before taking action.
AICPA SOP 03-1
Accounting and Reporting by Insurance Enterprises for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts
PAGE
EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Additional Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Companies Surveyed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
In many cases, the SOP is open to interpretation. An AICPA Technical Practice Aid (TPA) released in September
2003 clarified some of the uncertainties. In addition, the American Academy of Actuaries (AAA) released a practice
note that provides some guidance. Unfortunately, significant ambiguities and variations in interpretation remain.
In response to this uncertainty, Milliman commissioned a survey of company practice with respect to this SOP.
The survey clearly demonstrates an evolving consistency in most areas of compliance, but some inconsistency
remains. The results of our survey and the summarization thereof follow.
Eligibility for separate account presentation and treatment of gains and losses on transfers of assets from the
general account to a separate account.
Determination of account value to be used as the GAAP liability subject to FASB Statement No. 97 (FAS 97).
Additional reserve requirement for UL-type contracts that contain death or other insurance benefit features.
Additional disclosures.
b. The separate account assets are legally insulated from the general account liabilities of the insurance enterprise.
c. The insurer is required to invest the contract holders funds as directed by the contract holder or in accor-
dance with specific investment objectives.
d. All net investment performance must be passed through to the individual contract holder.
Other separate accounts shall be treated as general accounts. Transfer of assets from the general account to the sep-
arate account are to be made at fair value for separate accounts that meet the SOP criteria and resulting gains and
losses are recognized immediately into earnings. Additional guidance is provided for the accounting treatment of
the insurers proportionate interest in certain separate accounts.
Additional Reserve Requirement for UL-Type Contracts that Contain Death or Other Insurance
Benefit Features
Additional reserves may be required for UL-type contracts if the amounts assessed against contract holders for the
insurance benefit are assessed in a manner that is expected to result in profits followed by losses. A liability is to be
set up that recognizes the portion of the assessments that compensates for the benefits to be provided in future
periods. The calculation of the liability starts out with the determination of the benefit ratio that is to be calculat-
ed under a full range of scenarios that considers the volatility inherent in the assumptions. This benefit ratio is
to be periodically evaluated based on emerging experience compared to earlier assumptions. The liability is then
calculated as the current benefit ratio multiplied by the cumulative assessments, less cumulative excess benefits,
and plus credited interest. The assumptions used to determine the liability should be consistent with assumptions
used in estimating gross profits for purposes of amortizing capitalized acquisition costs.
Additional Disclosures
There are three additional areas of disclosure as it relates to this SOP: separate account information, accounting of
sales inducements, and assumptions with regards to calculation of additional reserves.
Companies Surveyed
Twelve companies responded to the survey. Table 1 provides information on company size for the 12 companies
that responded to the survey.
TA B L E 1
2. As expected, the products most affected by the SOP are UL, VA, and fixed deferred annuities. The product fea-
tures that gave rise to SOP 03-1 reserves are secondary guarantees and cost of insurance (COI) structures for
UL/VUL products and GMDB and GMIB for VA products. COI structures include level COIs, reverse select
and ultimate (S&U) COIs, and other structures that result in profits followed by losses.
3. Other, non-reserve effects on company operations are primarily related to disclosures and reclassification of
items such as dollar cost averaging (DCA) accounts, deferral of bonus interest, seed money, and general
account treatment of separate account group annuity and market value adjusted annuities.
4. Most strikingly, a few companies changed their policy forms to specifically identify bonus interest. One com-
pany took the additional step of setting up new accounts (or funds) in its products for bonus interest on fixed
annuities and bonus deposits in variable annuities.
5. The SOP had little to no impact on companies pricing and the SOP is not, by itself, motivating new product
designs. Only one company changed its product design so that SOP 03-1 will not affect the product. Another
updated its pricing guidelines so that new products will not have a stream of mortality profits followed by losses.
7. In terms of the effect on hedging practices the SOP had virtually no effect on the companies practices. One
company indicated that it now hedges the change in SOP reserve. The SOP introduces a market-sensitive
reserve for GMDBs and GMIBs. The use of equity market hedging is widespread in the VA industry. Some
companies are now calibrating their hedging programs to match the market sensitivity of the SOP reserve.
For VA writers whose primary hedge target is a fair-value or statutory measure, the sensitivity of the SOP
reserve is compared to these alternative measures.
Scenarios
For VA, the number of scenarios range from 100 10,000 stochastically generated scenarios. For UL, they
ranged from 1 63, either a deterministic set or a representative set of stochastically generated scenarios. For
VUL, the number of scenarios ranged from 1 100, either a deterministic set or a representative set of stochasti-
cally generated scenarios.
If the scenarios are a deterministic set, they are generally either chosen by consensus, a best estimate scenario, or
one that is used for the financial plan. All surveyed companies used equal weights for this deterministic set of sce-
narios. If scenarios are stochastically generated, the stochastic scenario parameters used in the scenario generation
model are usually determined directly or indirectly from historical data.
Eight companies surveyed generate scenarios stochastically and the descriptions that respondents gave to their sce-
nario generation methods follow.
Mean reverting, risk premium, independent log normal, real world scenarios.
Risk premium, mean reverting, interest rate/equity return correlated log normal scenarios.
RSLN for equity return scenarios and Cox-Ingersoll-Ross for interest rate scenarios with correlation between
interest rates and equity returns.
Only half of the companies surveyed indicated that they use a method to smooth equity returns for amortizing
DAC on variable products. Two of the companies that do so indirectly reflect the mean reversions in projecting
excess payments and assessments to determine benefit ratios. The other companies determine the SOP 03-1
reserves independently of DAC and hence, the smoothed equity returns are not reflected in the SOP 03-1
reserve calculations.
Approximately half of the companies surveyed developed dynamic lapse and benefit election rate assumptions.
Only two companies have dynamic premium assumptions, which partly reflects the fact that many of the compa-
nies are only modeling products that are single premium, or that can be approximated as single premium.
Most companies indicate that they haveas at least one of their criteriaused judgment in developing these poli-
cyholder behavior assumptions. The other common criteria are experience analysis, economic/behavioral theory,
and sensitivity analysis.
Level of Aggregation
For the most part, the aggregation level for SOP 03-1 reserves is the same as that for DAC. The rest of the com-
panies surveyed, except for one, had a finer level of aggregation for DAC purposes. The AICPA TPA has since
confirmed that the level of aggregation should be no less fine than the level of the DAC aggregation.
Benefit Ratio Evaluation, Purchase GAAP (PGAAP), and Products With No Explicit Charge
Most companies plan to recalculate the benefit ratio on a quarterly basis, with one company intending to recalcu-
late the benefit ratio monthly. A few will perform annual recalculations.
Purchase GAAP was essentially a non-issue for most companies. The two companies that had to consider PGAAP
effects indicated that they determined the benefit ratio from the purchase date and not at the contract inception
(issue) date.
Most companies did not have to determine the implicit charge for products with no explicit charge related to the
associated insurance benefit. These were either small plans aggregated into other plans or the product did not fail
the profits followed by losses test for newer products. The one company that had to determine an implicit charge
for its older business used interest margins.
Only two companies performed some form of iteration to deal with the interdependence of URRs and estimated
gross products (EGPs), and SOP 03-1 reserves.
3) Excluding DAC and reserve effects, what other effects has SOP 03-1 had on your operations (e.g., accounting
for separate account seed money, disclosures, etc.)?
Other SOP 03-1 non-reserve effects on company operations are primarily related to disclosures and reclas-
sification of items such as DCA, bonus interest deferral, seed money, and separate accounts for group con-
tracts and market value adjusted annuities. A few companies indicated that they also changed the policy
forms to specifically identify bonus interest. One company also set up new accounts (or funds) in its
products for bonus interest on fixed annuities and bonus deposit in variable annuities.
4) How has product design/pricing been affected by SOP 03-1? Have you pulled any products from the market,
introduced new products, or changed product features because of SOP 03-1?
Overall, most companies responded that the SOP had no impact on their pricing or product design. Only
one company that we surveyed changed its product design so that the product will not be affected by
SOP 03-1. One other updated its pricing guideline so that new products will not have mortality profits
followed by losses. In general, SOP 03-1 is not by itself motivating new product designs.
Companies surveyed have not pulled any products from the market. Nor have they needed to introduce
new products or changed product features solely because of SOP 03-1.
All except for one of the companies surveyed indicated that SOP 03-1 had no impact on their hedging
practices. One company indicated that it now hedges the change in SOP reserve.
The responses to the number of scenarios used to determine the benefit ratio vary by product. For VA,
they ranged from 100 10,000 stochastically generated scenarios. For UL, the number of scenarios was
much fewer-they ranged from 1 63either a deterministic set or a representative set of stochastically
generated scenarios. For VUL, the number of scenarios ranged from 1 100. As with UL, companies
used either a deterministic scenario or a representative set of stochastically generated scenarios.
2) If the scenarios are not stochastically generated, how are these scenarios chosen? Do you weight the scenarios,
and if so, how?
If the scenarios are not stochastically generated, they are generally chosen by consensus, as a best esti-
mate scenario or one that is used for the financial plan. All surveyed companies used equal weights for
these scenarios.
3) If the scenarios are stochastically generated, what scenario generation method/model have you used?
For the eight companies that generate scenarios stochastically, a variety of approaches are in use.
Following are the descriptions that respondents gave to their scenario generation methods:
Mean reverting, risk premium, independent log normal, real world scenarios.
Risk premium, mean reverting, interest rate/equity return correlated log normal scenarios.
RSLN for equity return scenarios and Cox-Ingersoll-Ross for interest rate scenarios with correlation
between interest rates and equity returns.
Companies indicate that the parameters are usually determined-directly or indirectly-from historical
data. One company specifically mentioned that the scenarios are generated in its investment area, cali-
brated to American Academy of Actuaries (AAA) C3 RBC Phase II proposal and are the same scenarios
used for pricing and other applications. Another used the prepackaged AAA C3 RBC Phase II scenar-
ios and one company set the mean of the stochastic scenarios to be consistent with the long-term
return assumption in its DAC calculations.
b) Is the benefit ratio determined using the mean of the stochastic results? If not, what measure is used?
All surveyed companies computed the benefit ratio using the mean of the stochastic results.
4) When discounting across scenarios, do you discount the average of the projected results or compute the average of
the present values, where each present value is calculated at a path-dependent interest rate? Or do you use the
DAC interest rate?
All the companies responded that they discount the average of the projected results using the DAC interest
rate to discount across scenarios.
5) Do you do any sort of mean reversion or other methods to smooth equity returns for amortizing DAC on vari-
able products? How, if at all, are such smoothed equity returns reflected in SOP 03-1 reserve determination?
Only half of the companies surveyed indicated that they use a method to smooth equity returns for amor-
tizing DAC on variable products. Two of the companies that do so indirectly reflect the mean reversions
in projecting excess payments and assessments to determine benefit ratios. The rest of the companies
responded that the SOP 03-1 reserves are set independently of DAC and that the smoothed equity
returns are not reflected in the SOP 03-1 reserve calculations.
6) Do you include policyholder behavior scenarios, in addition to interest rate or equity return scenarios?
Only one company developed additional policyholder behavior scenarios. Another company performed
sensitivity testing of assumptions but only to determine appropriate range of scenarios to use in testing.
However, policyholder behavior was generally projected to vary with the economic scenario.
Approximately half of the companies surveyed developed dynamic lapse and benefit election rate assump-
tions. Table 4 shows which policyholder behavior assumptions companies have developed as a dynamic
function (which depends on the
value of the benefit or the economic TA B L E 4
The responses are varied with nine companies indicating that they have-as at least one of their criteria-
used judgment in developing these assumptions. Three companies have developed their assumptions from
a combination of experience analysis, judgment, economic/behavioral theory, and sensitivity analysis. One
has developed theirs solely from experience analysis and another solely from economic/behavioral theory.
Two other companies developed theirs primarily based on judgment and another two companies from a
combination of experience analysis and judgment. Lastly, one company developed its policyholder behav-
ior assumptions from a combination of judgment and sensitivity analysis.
8) How are estimated gross profits (EGPs) calculations adjusted as a result of SOP 03-1?
a) Only two of the companies surveyed indicated that the EGPs are developed using multiple scenarios.
b) All of the companies surveyed indicated that they reduce the future EGPs for the value of (assessments)
x (Benefit Ratio).
c) Seven companies surveyed adjust for interest earned on the SOP 03-1 reserve.
9) What level of aggregation have you used in determining SOP 03-1 reserves, i.e., at what granularity (cohorts)
are these calculations performed? How does this compare to the level of DAC granularity/aggregation?
Table 5 shows the level of aggregation used in determining SOP 03-1 reservesnote that this may be different
than the level used to test for profits
followed by losses (or to test for the TA B L E 5
Nine companies indicated that they plan to recalculate the benefit ratio on a quarterly basis. One compa-
ny indicated that they will recalculate the benefit ratio monthly and the rest will perform annual recalcu-
lations. One company elaborated further, by indicating that the recalculations will be performed quarterly
for variable annuities and annually for VUL and UL.
Purchase GAAP was a non-issue for ten of the companies. The two companies that had to consider pur-
chase GAAP effects indicated that they determined the benefit ratio from the purchase date and not at the
contract inception (issue) date.
Only six companies indicated that they have products (such as zero-explicit-mortality-charge SPWL) with
no explicit charge related to the associated insurance benefit. Four of them indicated that these were small
plans and were either aggregated into other plans or ignored. One company indicated that the product did
not fail the profits followed by losses test for newer products but used interest margins for older products.
Another company indicated that it tested the product and it did not fail the profits followed by losses test-
presumably tested in aggregate-and hence did not calculate an implicit charge.
For the eight companies that responded to this question, assessments are defined as zero (four), stipulat-
ed premium (three), or COIs and expense loads (one) after the account value goes negative, for no-lapse
guarantee UL plans.
Six of the eight companies responded that the benefit in such a situation is the death benefit paid, one
is still undecided, and one did not respond to this part of the question.
2) Are SOP 03-1 reserves being set up for reverse S&U COIs?
Only one company indicated that it has set up SOP 03-1 reserves for plans with reverse S&U COIs. One
other did so for a level COI plan.
a) Did you previously hold an unearned revenue reserve (URR) for these and do you still hold the URR?
The company that set up SOP 03-1 reserves for the reverse S&U COI plans also had an URR and still
has a URR in addition to the SOP 03-1 reserves.
Only three companies responded to this question. One of them indicated that death benefits paid, less
any reserve released, is the excess benefit that is defined in calculating SOP 03-1 reserves. The second
company indicated that the death benefit paid when the no lapse guarantee is in effect is the excess
benefit. The third company indicated that the trailing loss (the amount of the losses that are derived
from the profits followed by losses test) is the excess benefit.
3) Do you reflect change in URR in your calculation of assessments for the profits followed by losses test?
Five of the companies responded that they had reflected the change in URR in the calculation of assess-
ments for the profits followed by losses test. Three companies responded that they did not reflect the
change and the rest did not comment.
Only two companies performed some form of iteration to deal with the interdependence of URRs and
EGPs and SOP 03-1 reserves.
Late-duration persistency bonuses were not an issue with most of the companies. All of the four compa-
nies that responded essentially indicated no change from previous practice.