D.2 Accounting for business combinations

Question 1

FAS 141 and FAS 142

Answer 1

• FAS 141 requires the use of purchase method and prohibits “pooling of interest” accounting
• FAS 141 states transactions are initiated at the earlier of:
  1. when the major terms of the business combination are announced to shareholders
  2. or; when shareholders are notified in writing of an exchange offer
• the acquiring enterprise must be defined, but can require significant judgement
• Goodwill = Cost of acquired entity - FV of net assets acquired
• net asset = Tangibles + intangibles - goodwill - liabilities
• VOBA is a major type of non-goodwill intangible asset
• acquisition date = when assets are received, liabilities transferred, or equity interest is issued
• DAC is replaced by VOBA
• VOBA = an amortizable intangible asset
• Restate PH reserves on a FV basis
• recalc DTAs and DTLs based on temporary timing differences

FAS 142 requires an impairment approach to goodwill
- requires 2-step FV approach for goodwill impairment testing at least annually
- under previous GAAP rules, goodwill was amortized
- acquired assets and liabilities must be assigned to one or more RUs
-

Question 2

Primary involvement of actuaries in business combinations

Answer 2

• Actuaries determine the initial FV of VOBA and other intangible assets
• determine post-acquisition DAC
• restate PH liabilities at FV
• Goodwill impairment testing
• expense recoverability analysis and loss recognition testing
• preparing GAAP financial projections that include acquisition accounting values for planning and budgeting purposes

Question 3

FAS 141 key calculations at acquisition date

Answer 3

• acquisition accounting = FV
• PH reserves at purchase date - recalculate at FV using current best estimates
• PH reserves after purchase date - lock in and continue using best estimates + PADs for FAS 60 business
• DAC asset at purchase date - Zero out existing DAC at purchase date, this gets replaced by VOBA
• VOBA - based on AAV; PV of profits inherent in acquired inforce
• Discount rate for VOBA amortization - GAAP earned rate for FAS 60, or credited rate for FAS 97
• Goodwill = Cost of acquired entity - FV of net assets acquired including intangibles
• Deferred Taxes - Calculate DTAs and DTLs based on timing differences between acquisition accounting and tax accounting

Question 4

factors that impact sale price of insurer

Answer 4

• confidence level of assumptions for both buyer and seller
• desired risk rate of return (hurdle)
• urgency
• tax consequences unique to the transaction that impact FV
• economies of scale created
• special opportunities for buyer and seller

Question 5

Calculate VOBA using AAV

Answer 5

VOBA = embedded value of the inforce business

AT VOBA = PF AT stat inc - PV CoC - Stat Rsv + GAAP Ben Rsv + DTL’

• use the same discount rate as DAC
• unlock VOBA same as DAC for FAS 97
• VOBA is subject to the same recoverability and loss recognition testing as DAC under FAS 60 and 97

Question 6

How to identify intangible assets and determine their value (other than VOBA)

Answer 6

1. VOBA = PV of profits in acquired inforce business
2. Distribution systems likely to generate new and renewal business
   = PV profits expected to be written by agents/distributors
3. Service contracts/outsourcing costs
   - measured and amortized straight-line over remaining contract period
4. third party service agreements
   IIA = PV expected fee revenue - expected expenses
5. trade names and trademarks
   - difficult to quantify
6. customer relationships/marketing info
   reflect level of renewal or NB expected from relationships
7. reinsurance contracts
8. state licences
   - infinite useful life
9. state approved insurance products

Question 7

how to calculate goodwill

Answer 7

• negative goodwill implies the buyer paid less than FV of the net assets acquired
• neg goodwill should be recognized immediately in earnings as extraordinary gain
• assets with reliable FV should not be reduced by negative goodwill

Question 8

how to allocate values to reporting units

Answer 8

• goodwill should be allocated to the RU level on the acquisition date
• when an RU’s allocated purchase price > allocated net assets the RU’s excess purchase price = RU goodwill

-basically the catch all after comparing the allocated purchase price to the allocated net assets

Question 9

amortization rules for intangible assets

Answer 9

• FAS 142 defines useful life - period where asset is expected to contribute to future CFs
• amortize if the future life is determinable
• VOBA and most non-goodwill intangible assets fall in this category
• VOBA amortized like DAC
• if indefinite useful life, do not amortize

Question 10

how to carry out impairment testing for goodwill

Answer 10

• intangible assets need to be impairment tested at least annually (FAS 142)
• amortizable assets (VOBA) - evaluate and reflect any change in useful life prospectively
• an asset is impaired when carrying value > undiscounted CF
• if an asset is impaired, write carrying value down to the FV and record as a loss
• once an impairment occurs, it is permanent and cannot be reversed

1. determine the FV of each RU
2. compare the FV of each RU with its carrying value
3. Determine the implied FV of goodwill for the RU
4. impairment reduction = carrying value of goodwill - implied FV of goodwill
5. revised carrying value of goodwill = implied FV of goodwill