Good day, ladies and gentlemen, and welcome to the Willis Towers Watson New Accounting Standards conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Ms. [Aida Sukas] Director of Investor Relations. Please go ahead.
Thank you. Good morning, everyone. Welcome to the Willis Towers Watson new revenue and pension accounting standards call. We will refer to the new revenue standard as ASC 606. On the call today are Michael Burwell, our Chief Financial Officer, and Elizabeth Weir, our Director of SEC Reporting and Technical Accounting. Today's call is being recorded and will be available for replay via telephone through tomorrow by dialing 404-537-3406, conference ID 2195898. The replay will also be available for the next three months on our website. This call may include forward-looking statements in reference to non-GAAP measures. Please read these statements regarding the forward-looking statements and non-GAAP measures, which are included in today's presentation, which is posted on our website at wtwco.com.
As you can see in the slide presentation, today we'll be discussing the impact of ASC 606 to Willis Towers Watson as a whole and by segment, which will be demonstrated through some illustrative examples. Finally, we'll address the impact of the new pension accounting standard. After our prepared remarks, we'll open the conference call for a short question and answer session. Given today's call is scheduled for 30 minutes, we will ask everyone to limit their questions to one question with one follow-up. Now I'll turn the call over to Michael Burwell.
Thank you, Aida. Good morning, everyone, and thanks for joining us today. Turning to the executive summary, slide four. As noted in this slide, the Willis Towers Watson adopted ASC 606 on January 1st, 2018. However, we expect there will be seasonal shifts in our quarterly results due to changes impacting how both revenue and expense will be recognized going forward with the adoption of ASC 606. We understand that trying to decipher the impact of the new revenue and expense standards will make analyzing comparative results more difficult. In order to facilitate such comparisons and to measure our performance in meeting the merger objectives, we'll be disclosing our 2018 financial results using two methodologies.
One, we use the ASC 606 standard. The second, we'll continue to use the 2017 U.S. GAAP standard. We hope providing this dual side-by-side reporting will facilitate an easier comparison of our results under the new ASC 606 standard and the previous standard. It's our goal to provide a clear line of sight to the progress we're making against our 2018 merger objectives by providing our 2018 non-GAAP information under both methodologies as well. We'll also discuss changes to pension accounting. As you'll see in more detail a bit later in this call, the pension accounting changes will have no impact to the overall company results. The recording of the pension-related expenses will change within the P&L, and so will a couple of our metrics. We know that cash flow is an important metric for our investors.
We anticipate the impact of ASC 606 standard on free cash flow to be immaterial. Now let's turn to slide five in the deck. To review the changes to the Benefits Delivery and Administration or the BDA segment. This segment will experience the most change as a result of the ASC 606. The recognition of revenue for the individual marketplace, formerly the retiree exchange, will no longer be recognized evenly over a 12-month period following the effective date of the policy. For the new ASC 606 standard, the revenue will predominantly be recognized as of the date of the policy is sold, which is typically in the fourth quarter of the preceding policy year. The individual marketplace represents approximately 50% of the BDA segment revenues. As illustrated on this slide, there'll be quite a change in the seasonality of the revenue stream.
There's one additional note of significance regarding the revenue impact of ASC 606 on the individual marketplace. Under the 2017 GAAP standard, revenues associated with 2017 effective date policies, which have continued to be ratably recognized into 2018. Under the new standard, most of those revenues will be recorded directly to retained earnings as of January 1st, 2018. The financials produced using the 2017 U.S. GAAP standard will continue to reflect these revenues ratably in the profit and loss statements for 2018. This will likely be one of the most meaningful differences between the two reporting methodologies. The impact of ASC 606 on overall segment margin is more complicated to estimate. The revenue models are very different from each line of business, and a shift in new business mix on any given year may change the margin profile.
For this reason, we will refrain from providing any directional estimates for the BDA segment margin. Now let's turn to human capital and benefits on slide six. There will be a shift in how approximately 10%-15% of segment revenues related to health and benefit brokering will be recorded. Currently, the revenues are recognized in the quarter in which the policies are effective. Under ASC 606, they'll be recognized evenly over the year. This may seem in direct contrast to how the individual policies in the BDA segment will be recognized. The difference relates to the fact that most of the services under the health and benefit contracts continue past the point of securing a policy. For active employees, we continue to provide significant services for their employers over the course of the year.
Expenses associated with retirement actuarial valuations and the implementation of TAS systems for new clients will be capitalized and amortized over the life of a contract. Margins may improve slightly for these projects. Let's move on to slide seven to discuss Investment, Risk and Reinsurance or IRR. As you can see from the example on the slide, we don't anticipate any significant revenue movement within the quarters or on an annual basis. However, approximately 5% of the segment revenues related to pro-rata treaty reinsurance will be accelerated as of the effective date of the policy. We expect that some of the acceleration will be offset by the commissions earned on policies effective during 2017. The commissions associated with pro-rata policies sold in 2017, we recorded directly to retained earnings as of January 1st, 2018, instead of being recorded or being recognized in 2018.
Costs associated with the placement of policies will be recognized at policy inception when revenue is recognized. They were expenses incurred under the 2017 accounting standard. There should be no material impact to margins on an annual basis. Finally, turning to Corporate Risk and Broking, or CRB, on slide eight. ASC 606 will have no significant impact on the revenue recognition for CRB. However, as in the case for most of our expenses related to placement of policies, we record the cost on the effective date of the policy rather than recording the expenses as incurred. There may be some slight timing issues in terms of margin, but this standard should not impact the overall segment margin over the course of the year. As you can see on slide nine, using our 2016 revenue and operating margin quarterly and annual results, the total change appears to be marginal.
I would caution that the 2016 results may vary from 2017 or 2018 results due to the mix of income or the timing of large project overlapping a quarter or a fiscal year, among other factors. Now let's shift gears and change the focus to the new pension accounting standard on slide 10. As of January 1st, 2018, the service cost component of the pension expense will continue to be included in the salaries and benefits line on the profit and loss statement. The service cost is the amount an employee accrues in pension benefits during the year. The other pension-related costs will now be recorded below income from operations and expense/income. This will have no impact to the company-wide results, but will impact income from operations and adjusted income from operations by the amount of the other pension-related costs.
This will have no impact on adjusted EBITDA or adjusted EPS. The new pension cost standard will be applied to the 2017 and 2016 results retrospectively. In summary, we don't expect material changes to the company's annual financial results under the new standard, although there will be some seasonality differences in revenue and cost recognition. In addition, revenues will shift over fiscal years. Some revenues which have been recorded in 2018 will be recorded directly to retained earnings, and other revenues we would have recorded in 2019 will be recorded in 2018. Again, operating margins will experience a seasonal shift. Now, we'll be open the line up for questions. Thanks, everyone. I really appreciate your being on the call with us today, and we'll open up for questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star and then the number one key on your touch tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, to ask a question, please press star and then one now. Our first question comes from Greg Peters from Raymond James. Your line is open.
Perfect. Good morning, everyone. Thank you for the call and for the disclosure, not only on the impact of the accounting changes, but also tax. I wanted to focus for a second on the tax issue. Mike, I was wondering if you could provide some additional color around the tax disclosure, specifically any prospective adjustments that might happen to the deferred tax liability or how the BEAT might impact the consolidated tax position. Could you remind us if there was some specific tax guidance included in the magical $1,010 EPS number that was part of management's incentive comp?
Sure, Greg. Thank you for the question. Let me try to decipher it. First, we thought it was important to share a perspective in terms of the different modeling, obviously, that all companies are doing and what we had done. As a result of the tax reform, we will record a one-time tax benefit in Q4 related to the corporate rate reduction and the impact on our merger-related intangibles overall. Based on that, we did that analysis and modeling based on the guidance we had given is 23%-24% in terms of effective rate for 2017. We had modeled it at 23.5% is the number that we had used, then we had disclosed in the 8-K that it could be -1% or +2% in terms of against that amount. We had in the merger objectives that we would get below 25%.
Obviously, we had achieved that in terms of that calculation. Without specifically going through each of the provisions, whether it's the BEAT provisions, et cetera, we'll be prepared to talk about that in our fourth quarter call to go through more of those provisions. Obviously, we're looking at each of those individual components of the tax reform bill and going through those calculations. This is our best estimate in terms of where we stand today. Thank you for the question, Greg, and hopefully that helps.
Yeah, it does. Just my one follow-up question. I think a day or two ago, there was an announced sale of Loan Protector Services. Is there any meaningful impact to your financials from that after the sale is completed?
No. No, there will not be.
All right, great. Thanks for your answers.
Oh, no problem. Thanks for the questions.
Thank you. Our next question comes from Jay Gelb from Barclays. Your line is open.
Thank you. I just had a question regarding the two ways of reporting earnings in 2018. I can't recall another time where this would happen in the industry. Which basis do you think we should focus on? I think everyone currently has it based on the 2017 U.S. GAAP, but the new standard is obviously going to be the ongoing numbers.
Yeah. It's a good question. Thanks for the question, Jay. The new standard will be the new standard, and it's really going through that adoption period of time. Obviously, we think GAAP continues to evolve, and GAAP tends to be how people are reporting. I would think that new GAAP is really where people are going to focus going forward. We just thought, just to be clear, that there wasn't something happening that you weren't able to track it, being now to be able to look at it in both perspectives. From an investor standpoint, we want to be able to provide you with both. Candidly, I think new GAAP is really where the world is evolving to, and I think that's really where you should tend to focus on going forward, quite candidly, from my perspective.
I don't know, Liz, who's here with me, anything you would add to that, Liz?
I think that this is a great opportunity for you to see the differences between the two bases and to get comfortable with how the shifts in the quarters will change. This is going to become our new normal, though. If you're trying to compare to 2017, it's best to look at the 2017 GAAP results or on that basis. If you're trying to think forward on modeling, you really want to focus on the new results.
Right. In focusing on the new results, my hope is Willis Towers Watson will be able to provide pro forma results going back at least 2017 and 2016 so we can form a baseline. Otherwise, it's going to be impossible to have quarterly estimates.
The dual reporting requirement is actually one that is a requirement of the standard adoption itself, and there were two choices that every company had. Either they're doing it this way or not providing comparables and just completely recasting 2016 and 2017. We do not have any intentions of providing pro forma results for 2016 and 2017. Again, we hope that through providing 2018 under both methodologies, you will be able to get what you need from that information.
We wouldn't know what 2017 was, if we're trying to think about forward estimates for the quarters, how would we do that?
I think, Jay, you'd have to take a look at what we're producing for 2018 quarter by quarter and start to model that going forward into 2019 and beyond.
All right. I'll follow up with you. Thanks.
Sure. Great.
Yeah. Thanks. Thanks for the question, Jay.
Thank you. Our next question comes from Elyse Greenspan from Wells Fargo. Your line is open.
Hi, good morning. My first question actually relates to the pension accounting changes. In the slide deck, you guys mentioned that there's no change related to the pension changes, no changes on your earnings. If I go to slide 10, it does seem like your earnings benefited by $87 million, and if you would apply the changes retrospectively for the first nine months of 2017. Is there actually a pension benefit to your earnings? Am I missing something here?
Why don't I let Liz answer that question? Liz?
No, when you look at net income, there's no change whatsoever. This is just a movement within different lines within our profit and loss statements to move from what was an operating income. Parts of it will come down to be in non-operating or other expense income. At the end of the day, that's why it does not impact our adjusted EBITDA or adjusted EPS, because those numbers start after all of those results are included.
It's just geography, Elyse.
It's just geography. Your year-to-date adjusted earnings would not have changed for slide 10.
Right.
Right.
Then another question to follow up on the tax side of things. You guys laid out that your tax rate could go down 1% to up 2%. Could you just walk us through, I guess, the different reasons? What would cause such a wide range, and what do we need to think about to whether you guys end up benefiting or are modestly negatively impacted by the tax reform?
Just factually, as we stated in the 8-K that was filed this morning, that we've modeled it based on our 2017 results. 2018, we will talk about on our fourth quarter call, Elyse. Obviously, there's continued to be refinements, communications that continue to happen on the tax bill itself. We continue to monitor it, that's based on all the information we've had to date. That's the best guess that we have in terms of the -1% or +2%, without going through all the details, and we'll be glad to do that on our fourth quarter call and take you through all those details. We thought it would be important to at least give you that level of guidance based on analysis that we've done to date, which was the reason we filed the 8-K today.
Just one last question. I'm sorry. The 10-10 earnings target for 2018, I know Greg had asked this earlier, that's based on a 25% tax rate, which was included in the merger?
That's right. We had estimated that we would get below 25%, and that's what we included in there. Yes.
Okay. Thank you very much.
No problem. Thanks, Elyse, for the question.
Thank you. Our next question comes from Joshua Shanker from Deutsche Bank. Your line is open.
Yeah, thank you. Just one more Loan Protector question. Which segment is Loan Protector in? I guess we'll see revenues there through January of this year?
Yes. Josh, Loan Protector is in the IRR segment. Yes, I think the press release said that it was going to close at the end of January.
Yeah
We would see revenues for one month.
Yeah. Is there any seasonality in that business?
Nothing to speak about.
Yeah.
Okay. Thank you. Everything else answered. Thanks.
Thank you.
Thank you.
Thank you. Our next question comes from Ryan Tunis from Credit Suisse. Your line is open.
Hey, thanks. I guess just one more on the 10-10. None of this, just to be clear, none of this changes the goalposts with the discussion around 10-10, correct? We're not going to see a different number at 18?
Yeah, right now, that's what our current thinking is. Obviously, we continue to monitor anything that's related to tax, and we've made our best estimates based on looking at 2017. We continue to monitor what's happening in the marketplace, what interpretations, what laws are written. I mean, any interpretations or the laws written, but any interpretations that are actually coming out there, Ryan. Look, that's our best estimate and where we stand today, but never say never in terms of what's actually happening real time in the marketplace. I just give you that cautionary language.
Okay. The one other one was, it doesn't sound just really, I think you said a marginal impact on free cash. The $1 billion and three of free cash flow for 2018 mentioned on the 3Q call, that's still a good number to use?
Yeah. We'll obviously update any further guidance in our fourth quarter call. Right now that's the current view.
All right. Thanks so much, guys.
No problem.
Thank you. Our next question comes from Mark Marcon from Baird. Your line is open.
First of all, thanks for doing this call. It's very useful. With regards to just the tax rate, just to be 100% clear as it relates to the 10-10, the assumption was 25%, or was it 23.5% in terms of the 2018 tax rate? Can you just walk us through, and I know everything is occurring real time, but a couple of the elements that could potentially move the tax rate up to, say, the 25.5% range? What exactly would drive that?
The first question back on the modeling itself. We had said back that we believe we would get below 25% in terms of the effective tax rate, which we put out there as the merger objectives. What guidance we'd given is 23%-24%, and we had modeled it off the midpoint of that at 23.5%, just in terms of the numbers themselves. We had not given further 2018 guidance, which we'll do in detail in our fourth quarter call, Mark. Look, there's a lot of different variables in the law that relates to it. We are continuing to be in dialogue with various advisors, various analysis that's in place, et cetera. At this stage, there's just a lot of variables that continue to go through it. It's obviously our best estimate. I'd love to give you, Mark, chapter and verse of what that is.
I'll be prepared to do that on our Q4 call, to give you more of those details. At this stage, I'm just not prepared to give you further dialogue or further detail on that.
Mike, I really appreciate that. Just to be clear on the 10-10, is it based on 23.5, or should we anticipate a change if, for example, the tax rate ends up being 25%?
Yeah, we're in discussions at an enterprise level, Mark, overall, obviously with our board and all those types of processes. Right now, I'm not prepared to give you any further guidance to it. We are clearly looking at all aspects of it. I don't want to just give you a wishy-washy answer, I'm just being clear with you. That's our best estimate of where we are right now. We'll continue to update that in terms of the fourth quarter, we'll give you all that detail in terms of guidance, where we are, et cetera. Unfortunately, I can't give you much more at this stage.
Okay. The only reason for mentioning it is I was anticipating 23.5, that was what my 10-10 was based on. If it moved up to 25, to me it seems like that 10-10 could change a little bit.
Yeah.
Would have room to change.
Right. Yeah, I don't know the details with your model, but in terms of when we originally set out the 10-10 goal, what we had set out, if you'd recall, is the 25% tax rate as part of that calculation. I understand your models may be different than what we're working with, but that was our original stance when we put these merger objectives in place in 2016.
That's great.
That was actually part of the S-4.
Terrific. Thank you.
No problem. Thanks for the question, Mark.
Thank you. Our next question comes from Paul Newsome from Sandler O'Neill. Your line is open.
Good morning. Thanks very much for the call. It's great. Very helpful. I was curious as to whether or not under the new accounting standards, there could be situations, or more situations where revenue gets shifted between quarters. Let me give you an example. For example, sometimes reinsurance renewals get all completed in December, even though they're January 1st effective, and sometimes it gets pushed back into January, when the actual contracts get signed. Does that have an impact on the timing of revenue and profit recognition? That sort of example.
Yeah, maybe I'll turn it to Liz, Paul, but the answer to that's yes. Liz, why don't you take him through it?
Yeah. The answer is yes, that timing does impact the timing of recognition, but it's actually not completely a change of ASC 606 because for the majority of our broking revenue, we already recognized our revenue on policy inception date. That's not a change from the old standards to now.
Okay. That was my only question that was left. Appreciate it.
No problem. Thanks for the question, Paul.
Thank you. This will be our last question from Kai Pan from Morgan Stanley. Your line is open.
Thank you, and good morning. Mike, you mentioned earlier that there will be a one-time tax benefit in the fourth quarter. Could you clarify that and how big that could be?
Yeah. Based on our position, we are in a net tax liability position, obviously with the rate change, just on its surface, without anything else included in there, moving from 35% to 21%, you're reducing that liability, which obviously would have a benefit to be in place. At this stage, we're not prepared to give you an amount, but we will do that on our fourth quarter call, to give you that detailed amount. Just knowing, I guess at this stage, we thought it would be helpful to know that it is indeed a benefit from our perspective, and we'll look forward to reporting the order of magnitude of that as part of our fourth quarter call.
Okay, thanks. My follow-up is on your long-term tax rates. You talk about tax rates could marginally change from 2017, if you look at longer term, will that be your long-term tax rate, or are you rethinking your tax strategy under the new law? Because your tax rate now is much lower than some of the peers, going forward, if you keep the same tax rate, you could be higher than some of your peers.
Yeah. I think it's a great question, Kai. We're not prepared at this time to give you exactly what we believe it to be on a long-term basis, just rest assured that we will continue to analyze and look at this situation to make sure that we're in the most effective tax rate for the company going forward. There are more to come, I guess, is what I would leave you with.
Thank you so much.
No problem.
Thank you. That does conclude our question and answer session for today's conference. I would now like to turn the conference back over to Michael Burwell for any closing remarks.
I'd just like to thank everybody for participation as well as the questions today. Thank you very much. We'll look forward to reporting our fourth quarter results. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a wonderful day.