FAS 97: Accounting for Long-Duration Insurance Contracts

Statement of Financial Accounting Standards No. 97 (FAS 97) was a historical accounting rule from the Financial Accounting Standards Board (FASB). Issued in December 1987, it established specific accounting and reporting rules for certain long-duration insurance contracts and updated how insurers reported realized investment gains and losses.

FAS 97 was developed in response to new life insurance products that offered more flexibility than traditional policies. The previous primary standard, FAS 60, did not address the unique features of these products, creating a need for more specific guidance.

Scope and Applicability of FAS 97

FAS 97 applied to three specific classes of long-duration contracts. The accounting for other products not covered by this standard remained under the guidance of FAS 60. This segregated the accounting for newer, flexible insurance products from traditional ones.

The first category was universal life-type contracts, defined by their flexible nature. Policyholders can vary premium payments and the death benefit may be adjusted. A characteristic is the separation of the insurance and investment components, with the policyholder’s account balance being a central feature.

A second category included limited-payment contracts. These policies subject the insurer to mortality or morbidity risk for a period that extends beyond when premiums are collected. A common example is a “20-pay life” policy, where premiums are paid over 20 years, but coverage continues for life. The terms of these contracts are fixed and guaranteed.

The final group consisted of investment contracts. These contracts do not expose the insurance company to significant risks from policyholder mortality or morbidity. Their primary function is investment accumulation rather than insurance protection, such as certain types of annuities.

Accounting for Universal Life-Type Contracts

The accounting for universal life-type contracts under FAS 97 used the retrospective deposit method. This established the liability for policy benefits at an amount equal to the policyholder’s account balance.

Under this standard, premium receipts were not recorded as revenue. Instead, revenue was recognized from fees the insurer assessed against the policyholder’s account, such as mortality charges, administration fees, and surrender charges.

A feature of FAS 97 was its treatment of Deferred Acquisition Costs (DAC). These costs, such as agent commissions and underwriting expenses, were capitalized as an asset on the balance sheet and then amortized over time.

The amortization of DAC was linked to policy profitability. DAC was amortized as a constant percentage of the present value of estimated gross profits (EGPs) from a book of contracts. EGPs were composed of future margins from mortality charges, investment returns, administration fees, and surrender charges. This required insurers to regularly evaluate profit estimates and adjust amortization if expectations changed.

Accounting for Limited-Payment and Investment Contracts

Limited-Payment Contracts

For limited-payment contracts, premium payments were recognized as revenue when due from the policyholder. A liability for future policy benefits was established to cover the contract’s obligations. A feature of this accounting was that any profit was recognized over the entire period that benefits were provided, not just during the premium-paying years. This prevented the front-loading of profits and matched income recognition with the coverage period.

Investment Contracts

Investment contracts, which lack significant mortality or morbidity risk, were accounted for like other interest-bearing financial instruments. Payments received from contract holders were recorded as a liability, not revenue. This liability would then accrue interest over time, and revenue for the insurer was derived from fees for asset management or other services.

Treatment of Realized Gains and Losses

A change introduced by FAS 97 was the required presentation of realized investment gains and losses on the income statement. The standard mandated that these gains and losses be reported as a component of other income on a pretax basis. This was a departure from FAS 60, which required these items to be reported separately, below operating income and net of taxes.

The rationale for this change was that investment management is an integral part of an insurance company’s operations, not a separate activity. Including realized gains and losses within the main body of the income statement provided a more comprehensive picture of an insurer’s performance.

This requirement applied to all investments and precluded deferring realized gains and losses to future periods. It also aligned the accounting more closely with how other financial institutions reported investment results.

Transition to Long-Duration Targeted Improvements (LDTI)

The accounting landscape for long-duration insurance contracts has changed, with FAS 97 being largely superseded by a new standard. In August 2018, the FASB issued Accounting Standards Update 2018-12, known as Long-Duration Targeted Improvements (LDTI), which alters the accounting for these contracts.

A prominent change under LDTI is the method for amortizing Deferred Acquisition Costs (DAC). The FAS 97 model of amortizing DAC based on estimated gross profits has been replaced. Under LDTI, DAC is now amortized on a straight-line basis over the expected term of the contracts. This change simplifies the amortization process and removes the volatility associated with updating profit estimates.

Another change is the requirement for insurers to review and update the assumptions used to measure the liability for future policy benefits at least annually. Under the previous rules, these assumptions were ‘locked-in’ at the time of policy issuance unless a premium deficiency occurred. With LDTI, the effects of changes in these assumptions are now reflected in net income. Understanding the historical context of FAS 97 remains useful for analyzing financial statements from prior periods.