Life Insurance
New Rules

• Mary Pat Campbell
• August 2020
• 

ONE OF MANY: The U.S. Securities and Exchange Commission is one of the entities, including the Department of Labor and the National Association of Insurance Commissioners, that impose regulations on the life/annuity industry.

Key Points

• The Situation: Life and annuity insurers are facing some new regulations that will impact their business for years to come.
• What’s Coming: The introduction of Current Expected Credit Losses, the implementation of new approaches to accounting for life/annuity liabilities and increased requirements surrounding the sale of life and annuity products.
• The Good News: While these approaches are often more complex than those they replaced, they are not necessarily a negative effect, and some may relieve other pressures on insurers

While COVID-19 has grabbed the world's attention, life/annuity insurers are preparing for a major disruptor of their own: a series of new regulatory and accounting standard changes. These new rules may provide significant challenges for the life/annuity industry in general and for some insurers specifically over the next several years.

Three changes are of note: the introduction of Current Expected Credit Losses (CECL), the implementation of new approaches to accounting for life/annuity liabilities, and increased requirements surrounding the sale of life and annuity products. These changes may have significant and long-term fallout, affecting product design, distribution business models, and even asset/liability management. The likely impact is increased complexity, and unfortunately will likely be more taxing on insurers with more modest resources.

Market Conduct: Best Interest, Fiduciary Duty or Suitability?

One of the least settled of these changes involves regulations on the sale of annuities and life insurance products. Part of the issue is competing regulators: the Department of Labor (DOL), the Securities and Exchange Commission (SEC), the National Association of Insurance Commissioners (NAIC), and individual state regulators. These groups often have overlapping jurisdiction surrounding products, leading to overlapping requirements for insurers and distributors. While regulators have customer protection as a goal, they have different perspectives on how best to achieve it.

Figure 1 illustrates the regulatory impact. When the SEC attempted to assert its power by regulating the sales of indexed annuities in 2008, product sales in 2009 and 2010 fell notably. The Grassley Amendment in 2011, undoing SEC oversight, led to a rebound in sales. When the DOL's fiduciary duty rule was implemented in 2016, annuity sales decreased the following two years. The rule was struck down in federal court March 2018, and the recovery in annuity sales can be seen in 2018's full-year sales.

After its fiduciary rule was struck down, the DOL said it would revise its proposal by a then-announced deadline of September 2019. However, September 2019 saw the appointment of a new Secretary of Labor, not a revised fiduciary rule.

Other regulatory bodies have been active, however. The SEC issued a final rule, Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg BI) in June 2019, with an effective date of June 30, 2020. At the beginning of June 2020, the DOL sent its new fiduciary rule to the Office of Management and Budget for review, intending to align with the SEC's efforts. The NAIC created the Annuity Suitability (A) Working Group in 2017 to update the Suitability in Annuity Transactions Model Regulation (#275) to provide more uniformity between the states. The Working Group made its recommendations in 2019 and in February, the NAIC membership approved the revision. It is up to individual states to adopt the model regulation.

While the DOL, SEC and NAIC were seeking nationwide standards, individual states developed their own laws and regulations. The regulation that could have the greatest impact is New York's Regulation 187, which set a best-interest standard for both annuity and life insurance sales. The annuity portion of the regulation went into effect in August 2019, which led to multiple companies suspending sales in the state. Jackson National suspended the sale of fee-based annuities in New York, and Penn Mutual suspended all annuity applications. However, insurers re-entered the market after the NY Department of Financial Services provided some clarification on requirements. The annuity portion of the regulation is already showing teeth. In April 2020, three insurers agreed to pay more than $2 million in restitution and penalties to New York State for annuity replacement transactions that violate the state's Regulation 187.

All these cases have featured lawsuits, either by carriers or competing regulatory bodies. In the case of SEC's Reg BI, a coalition of attorneys general from seven states plus the District of Columbia challenged the regulation in federal court. Insurance carriers unsuccessfully sued New York with respect to Reg 187.

In all these cases, regulations have increased requirements for distributors and call into question certain sales practices, such as bonuses for reaching sales targets and even traditional commissions. New York's Reg 187 adds on several more educational requirements for producers, paperwork for compliance, and post-issue requirements that never existed before. For example, if an insurance agent is involved in the conversion of a term life insurance policy into a permanent life insurance policy, that is considered a transaction and requires full documentation under the highest level of sales requirements. The life insurance portion of New York's Reg 187 went into effect on Feb. 1, and the effects are yet to be fully felt, especially as COVID-19 has slowed down life insurance sales. However, the increased compliance requirements likely will depress sales of both annuities and life insurance in New York.

Accounting for Credit Risk: CECL

The Current Expected Credit Losses (CECL) measurement was developed by the Financial Accounting Standards Board (FASB) in reaction to the tardy way banks recorded credit losses during the run-up to the credit crisis of 2008. (The new standard was arguably tardy itself in its decade-long development.) The Accounting Standards Update (ASU) including CECL was announced in 2016 and went into effect for large SEC reporting companies for calendar-year reporting starting this year. Implementation for smaller reporting companies and other entities have been delayed until 2023.

CECL's purpose is to create an allowance for expected credit losses, especially for assets not held at fair value. Assets held at amortized cost, such as commercial mortgages, would be subject to a more complicated method of accounting for the embedded credit risk.

Prior to CECL's introduction, credit losses weren't accounted for under GAAP until a credit event occurred. The problem: Many banks knew they were carrying poor credit risks in the form of residential mortgages, but as long as they didn't recognize a credit event, the banks didn't have to write down the assets.

With the new accounting standard, entities must reflect an asset's expected credit loss throughout its lifetime, updating that expectation during each accounting period. Again, assets that have a fair value reflected in market prices, where the market is deep and liquid, likely do not require many such adjustments.

However, commercial mortgages originated by life insurers—a significant portion of many life/annuity company portfolios (Figure 2)—and similarly illiquid assets may require more complex accounting. While the standard mentions potential approaches to measuring the expected credit loss, there is no one method prescribed and, more importantly, no safe harbor for insurers.

Applying the CECL Approach More Broadly?

Initial measurements of CECL may have minimal impact in a benign economic environment, but a more volatile environment would likely lead to expectations of higher credit losses and may require more frequent updates and more balance-sheet volatility. Credit-loss models may require additional sophistication.

We do note that the new regulations are not all downside. For example, in the prior approach to credit losses, companies could not recognize credit improvement after an asset write-down. CECLs can move both up and down, reflecting improving market conditions. In addition, insurers could benefit from earlier identification of assets at risk and possibly avoid a sudden recognition of credit loss on an asset.

CECL is a change in GAAP, not statutory, accounting, but some are advocating its approach more broadly. In general, statutory accounting is more conservative than GAAP due to its focus on solvency and policyholder protection. The more conservative CECL practice has sparked the interest of insurance regulators, who generally favor the most conservative practices for the NAIC. However, the current NAIC statutory approach is far simpler than CECL, and many small insurers already challenged to improve investment yield would find themselves disadvantaged further in compliance costs.

The life insurance industry has pushed back on implementing CECL in a statutory setting, arguing that asset valuation reserve (AVR) and risk-based capital (RBC) provide for capturing and regulating credit risk exposures in insurer portfolios. However, property/casualty insurers do not have an equivalent reserve as AVR, so the NAIC may yet be tempted to follow in FASB's footsteps.

Long-Duration Contracts

The final change of note is FASB's Long-Duration Contracts Targeted Improvements project, which culminated in an ASU issued in August 2018. Again, the difference between the goals of statutory and financial accounting is highlighted in the change. Life insurance products have long suffered in the investment community, partly due to the opacity in measuring life insurance performance. Aspects of the prior approach—locking in valuation assumptions at policy issue, complicated approaches to amortizing deferred acquisition costs, and infrequent testing of deviation from valuation assumptions—made it difficult to evaluate if GAAP measurements were capturing the behavior of the business.

The new ASU includes:

• A requirement to unlock liability valuation assumptions at least once a year. Before, valuation assumptions were often locked in at policy issue and never updated.
• A standardized valuation rate based on current market-observable interest rates and yields. Before, valuation rates were locked in at inception for many life products and differed company to company. The effect of changing rates will be recorded in other comprehensive income.
• Fair value measurement of embedded financial guarantees, to be more closely linked to derivative-measurement approaches.
• Simplified amortization of deferred acquisition costs.
• A requirement for additional disclosures, such as roll-forwards, significant valuation assumptions, and the effect of changes in those assumptions.

There is hope that tying liability values to current market conditions, as well as requiring additional detailed disclosures, may help investors better interpret life insurance business performance. However, there is concern that the additional detail can be difficult to fully and clearly implement.

In response to industry concerns about implementation, FASB announced in 2019 that the effective date for this ASU was pushed back. The new ASU will be effective for calendar-year large public insurers in January 2022, with an effective date of January 2024 for smaller life insurers and other entities subject to the rule. There will be a one-time adjustment reported when the new standard goes into effect, with an option to develop the effect retrospectively.

Regulatory Respite?

Life/annuity insurers have been buffeted by several headwinds from 2019 into 2020: three consecutive interest rate drops by the U.S. Federal Reserve from July to October 2019, impacts from the coronavirus pandemic, and another two interest rate cuts by the Fed in March 2020.

With equity markets in a roil and the interest rates at record lows, regulations developed during a fairly stable environment may be even more difficult to implement. Many regulations and laws grew out of the prior financial crisis in 2008 and 2009. Given the dilatory nature of regulatory development, we find ourselves in the middle of great volatility again, though the nature of the crisis differs this time.

In all these approaches, the focus on protecting consumers, providing good information to investors, and supporting an insurance industry that can survive and even thrive should be front of mind for regulators. However, regulators have been more focused on helping insurers ease into these more complex compliance regimes rather than removing them.

The good news is that while these approaches are often more complex than those they replaced, they do not necessarily have a negative effect, and some may relieve other pressures on insurers. In addition, as these regulations come into effect, regulators have shown a willingness to work with the life/annuity industry to help the industry survive and even thrive under these requirements.

Contributor Mary Pat Campbell, FSA, MAAA, is a vice president in Conning’s Insurance Research unit. She can be reached at marypat.campbell@conning.com.