As U.S. life insurers prepare for the long-duration targeted improvements (LDTI) under the Financial Accounting Standards Board’s Accounting Standards Update 2018-12 that will apply to U.S. generally accepted accounting principles (GAAP) reporting for most Securities and Exchange Commission (SEC) filers from Q1 2023, one of the issues that we are seeing clients come up against is the need to demonstrate the observability of the discounting yield curve for long-term liabilities.
Essentially, what the change in the GAAP discount rate approach means is that life insurers reporting under U.S. GAAP will no longer be able to apply a locked in, and often in practice quite discretionary, discount rate to their traditional policy benefit liabilities. Instead, their financial reporting will have to demonstrate the use of a currently observable, upper-medium grade market rate.
Or, as the standard reads:
“The liability for future policy benefits shall be discounted using an upper-medium grade (low credit risk) fixed income instrument yield. An insurance entity shall consider reliable information in estimating the upper-medium grade (low credit-risk) fixed income instrument that reflects the duration characteristics of the liability for future policy benefits (see paragraph 944-40-55-13E). An insurance entity shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs in determining the discount rate assumption.”
Why does this matter right now? Well, for one reason, we’re starting to hear reports of auditors quizzing companies about what they propose to do to “minimize the use of unobservable inputs,” particularly beyond the typical 30-year horizon of most published yield curves. And that’s where the pension experience comes in.
Pension plans, like life insurers, must be positioned to pay the benefits promised to a participant (policyholder) many years down the road. And they have for some time had to report how they’re gearing up to do so by valuing their funding levels based on high credit quality, observable, instruments. Accordingly, our retirement team maintains a methodology called RATE:Link that develops term structures of interest rates from high credit quality (AA-rated) corporate bond data over a wide range of maturities, and which has been scrutinized and accepted by all the major audit firms.
We’ve applied the principles of RATE:Link to the upper-medium grade (A-rated), observable LDTI requirement for insurers. To date, the applicability and results have been very promising, not only in meeting the reporting requirements but also, potentially, providing a solid basis for companies to be confident in the yield curve beyond most published horizons.
As attention around this issue builds, will you be ready with an answer to the foreseeable question from your auditors: “How are you setting the points on your yield curve that aren’t observable?”
