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The Financial Reporter

June 2000 – Issue 42 THE FINANCIAL REPORTER NEWSLETTER OF THE LIFE INSURANCE COMPANY FINANCIAL REPORTING SECTION

NUMBER 42 JUNE 2000 Editor’s Notes An Actuarial Analysis of FAS 133 (Part 2) by Thomas Nace by Anson J. Glacy, Jr.

s I write this column, I am deep art 1 of this paper, contained in into what has been commonly the February 2000 edition of known as “March Madness.” For The Financial Reporter, des- some, this evokes the image and P cribed the basic objective and A provisions of the Financial Accounting sound of sneakers squeaking their way across a basketball court as time on the clock runs Standards Board’s new standard on deriv- down. For others, it means putting on a full atives, Statement of Financial Accounting court press, in order that the last interest Standards No. 133, Accounting for scenario might be run and the final touches on Derivative Instruments and Hedging the Actuarial Memorandum might be made, Activities. FAS 133 requires that all deriv- again as the sound of time winding down atives, including those embedded in echoes like a ref’s whistle. non-derivative instruments, be recognized For many, it is like a much-needed time in the balance sheet at fair value. out. Having survived the flurry of activity The Statement dramatically changes called year-end, it is time to take a breath and the way hedging relationships are re-evaluate your game plan for the coming reported and creates earnings and capital Brief Recap of FAS 133 volatility that may be unavoidable. The year. You now realize that all of the projects FAS 133 requires that all derivatives be principles embodied in FAS 133 are that you planned to get done over a 12-month recognized in the balance sheet at fair complex and controversial, particularly period still have to get done, but now you value. The Statement retains a type of as they relate to insurers using deriva- have less than 10 months. hedge accounting that attempts to pre- tives to hedge capital market risks. Part 2 For others yet, somewhat closer to home, it serve the intent of a hedging relationship, of this paper presents a case study of means getting those last articles in hand and but the qualification criteria for this how FAS 133 affects the accounting for reviewed so that putting the next issue of the treatment are complex and potentially perhaps its most interesting application Financial Reporter in the hands of Section onerous. FAS 133 defines derivatives in the life insurance industry: the equity- members on a timely basis becomes a mere based on distinguishing characteristics indexed annuity. Please note that this slam-dunk. rather than by reference to specific types analysis does not constitute accounting There are many instances where “Madness” of instruments and consequently finds is not the name of the game, however. For advice and is not a substitute for a example, March was the month when the comprehensive assessment of how the NAIC Actuarial Life and Health Task Force Statement may affect your organization. (continued on page 11, column 1) (LHATF) meeting was held, as well as the American Academy of Actuaries’ Committee on Life Insurance Financial Reporting In this Issue (COLIFR) meeting. At the March LHATF Editor’s Notes CARVM Reserves for Variable Annuities with meeting, AG-ZZZZ (reserving) was adopted. Guaranteed Living Benefits Also at this meeting, the status of several by Thomas Nace...... 1 An Actuarial Analysis of FAS 133 (Part 2) by James W. Lamson ...... 15 hot projects was discussed. (See Don Maves’ Treasurer’s Report article in this issue on page 4). One of these by Anson J. Glacy, Jr...... 1 by Larry Gorski...... 17 topics was Variable Annuity Guaranteed Life Chair’s Corner by Mike McLaughlin...... 3 The Actuarial Opinion Model Regulation Benefits (VAGLB). As it just so happens, we (AOMR) Takes Center Stage are fortunate to have in this issue an article by Highlights of the March 2000 NAIC Life and Health Actuarial Task Force Meeting by Norman E. Hill...... 18 Jim Lamson discussing this concept and the A Call For Contributors ...... 21 latest developments. by Donald P. Maves...... 4 Financial Section Seminars in 2000...... 5 An Update on International Accounting One of the other topics discussed at the Standards for Insurance Blazing the Path for a Unified Valuation System March meeting was a status on UVS — a by Bruce Moore...... 23 by David K. Sandberg...... 6 Unified Valuation System. Dave Sandberg Record Sessions for Financial Reporting made the status report at the LHATF meeting The “X” Factor — Are You Ready? Special Track on the Web ...... 26 and has also contributed an in-depth article by Larry Gorski...... 14 Own the past ...... 27 Writer’s Haven (continued on page 2, column 1) by Shirley Hwei-Chung Shao...... 28 JUNE 2000 THE FINANCIAL REPORTER PAGE 11

An Actuarial Analysis of FAS 133 (Part 2) continued from page 1 derivatives embedded in non-derivative cash flows or other exchanges linked to of the retrospective deposit method for financial contracts. the performance of an equity index are universal life-type contracts, whereby the The Statement excludes traditional considered under FAS 133 to comprise account balance accruing to the benefit of insurance contracts that compensate the two components: (1) a traditional debt the policyholder is defined as the policy policyholder as a result of an identifiable instrument and (2) a series of forward liability. Therefore, if an EIA policy’s insurable event or of an adverse change in options on the index. As such, the equity- carrying amount under FAS 133 is less the value of a specific asset or liability for indexed annuity is treated as a traditional than its corresponding FAS 97 carrying which the policyholder is at risk. deferred annuity combined with a series amount, an adjustment would be required. However, the FASB believes that some of forward-starting equity-indexed em- A minimum interest guarantee in an insurance contracts may contain deriva- bedded derivatives. Since the economic equity-indexed annuity is considered to be tive-like features, and these contracts characteristics of the embedded deriv- an embedded derivative that is clearly and receive specialized accounting treatment. atives are not clearly and closely related closely related to the economic character- FAS 133 is effective for fiscal years to the economic characteristics of the host istics of the host policy and thus does not beginning after June 15, 2000, but compa- policy, they must be separated by bifur- require bifurcation. Similarly, the market- nies may early-adopt as of the beginning cation from the host policy and marked- value adjustment, which may be found in of any fiscal quarter. Most insurers will to-market through income. As a result, some equity-indexed annuities, represents delay adopting FAS 133 until January 1, FAS 133 will introduce earnings volatility an embedded derivative that is also 2001, when adoption is required. for the EIA writer to the extent that it is clearly and closely related to movements unable to “hedge” these exposures with in interest rates and not subject to bifurca- The Equity-Indexed other assets that are also marked-to- tion. Finally, the S&P 500-indexed em- Annuity market through income. bedded derivative contained in equity- Emerging within the past five years, the At inception of the policy, the carrying indexed annuities cannot be treated as a equity-indexed annuity (EIA) is a variant amount of the host policy would be deter- hedged item since (i) all derivatives must of a traditional deferred annuity and links mined by independently calculating the be recorded in the balance sheet at fair a portion of credited interest to some fair value of the embedded derivative and value and (ii) paragraph 405 of FAS 133 external index (typically the Standard and then assigning the remainder of the EIA prohibits hedge accounting if the hedged Poor’s 500 stock price index). The EIA deposit to the host. (This treatment is item is measured at fair value. thus replaces interest credits determined consistent with the fundamental GAAP Conceivably, these embedded deriva- largely at the discretion of the insurance principle that gains and losses emerge tives, once separated from the host policies, company with those defined through over time.) The host policy would then be could be designated as hedging instruments formula based on movements in the S&P accreted from its inception value to its in other company hedging relationships. 500. A wide variety of product designs guaranteed liquidation value at a constant are found in the EIA world, depending on interest rate. The guaranteed liquidation Valuation of the value would be a contractual surrender, the specific crediting formula employed. Embedded Derivative For example, a point-to-point design death or annuitization value available at For actuaries, the S&P 500-based embed- bases credited interest on the change in the policy maturity or other expiry date. ded derivative contained in equity- the S&P 500 over two discrete points in This approach is consistent with FASB indexed annuities poses a new and chal- time, say five years apart. In this case, staff guidance contained in FAS 133 lenging valuation exercise. FAS 133 excess interest over and above that Implementation Issue B6, Embedded requires that this derivative be measured contractually guaranteed might be defined Derivative: Allocating the Basis of a at fair value, which paragraph 3 describes as some participation rate (like 75%) Hybrid Investment to the Host Contract as “the only relevant measure for deriva- multiplied by the five-year percentage and the Embedded Derivative. tive instruments.” Fair value is defined change in the S&P 500, but no less than For financial reporting purposes, the as the amount at which willing and zero. In contrast, an annual reset design hybrid instrument (the host policy and the unencumbered counterparties could trans- bases excess interest on yearly changes in embedded derivative) would be reported act an instrument. Active markets with the S&P 500. as a single item. Some observers believe that the total policy remains subject to the quoted prices give the best evidence of fair value and should be used as the basis FAS 133 Treatment of requirements of FAS 97, Accounting and Reporting by Insurance Enterprises for for measurement. In their absence, esti- Equity-Indexed Annuities Certain Long-Duration Contracts and for mates of fair value should consider prices According to FAS 133 paragraphs 10c, Realized Gains and Losses from the Sale for similar instruments and results of 12, 61h and 185, instruments containing of Investments. FAS 97 calls for the use valuation techniques (like option-pricing (continued on page 12, column 1) PAGE 12 THE FINANCIAL REPORTER JUNE 2000

An Actuarial Analysis of FAS 133 (Part 2) continued from page 11 models) consistent with the objective of • Value under option-pricing theory der- different method of crediting interest.) measuring fair value. ives only from how and when financial Certainly, the company’s liability to the While little valuation guidance exists instruments turn into cash. So, in valu- EIA policyholder extends beyond the in GAAP, of most relevance for an ing the EIA embedded derivative, the interest credits to be made at the end of equity-indexed embedded derivative may policy is followed through to its ulti- the current policy year. Proper valuation be FAS 123, Accounting for Stock-Based mate liquidation via surrender, death of the EIA embedded derivative recog- Compensation. FAS 123 states that “the or annuitization. This means that nizes the intertemporal nature of the fair value of a stock option (or its equiv- accounting-inspired accruals (like liability. Intertemporal effects reflect how alent) … shall be estimated using an credited interest) will not play a role in capital market events, the insurance option-pricing model (for example, the the valuation. company’s subsequent credited rate Black-Scholes or a binomial model) that response to them, and the policyholder’s takes into account … the exercise price • The valuation actuary will need to iden- resulting lapse/no-lapse decision can and expected life of the option, the tify the portion of the liquidation value change the size and timing of a policy’s current price of the underlying stock and attributable to changes in the S&P 500 ultimate liquidation value. Recall that its expected volatility, expected divi- by removing amounts related to the option-pricing theory derives value only dends on the stock, and the risk-free guaranteed liquidation value from it. from how and when financial instruments interest rate for the expected term of the turn into cash. Thus, proper valuation option.” Further, the FASB believes “it Only this residual piece enters into the recognizes the multi-term character of the should be possible to reasonably esti- value of the embedded derivative. embedded derivative and its ultimate mate the fair value of most stock options “payoff’’ in the form of surrender, death and other equity instruments” and finds • The two principal options in the in- or annuitization benefits. that only in “unusual circumstances” will dexed annuity (the company’s limited the terms of a stock option or other right to reset certain crediting features Representative Accounting equity instrument make it impossible to and the policyholder’s right to “put” the Depiction reasonably estimate the instrument’s fair contract back to the company for cash) The above discussion demonstrates that the value. (Appendix B of FAS 123 illus- should be reflected through appropriate application of FAS 133 to equity-indexed trates techniques for estimating the fair behavioral assumptions. Since policy- annuities is a complex undertaking. values of options with complicated holder behavior regarding equity- Besides the proper identification of the features that may have relevance in the indexed policies is not yet well defined, embedded derivative and its valuation at EIA world.) Finally, in estimating the this valuation assumption will demand fair value, issues of coordination and expected life of a stock option, FAS 123 considerable attention from the actuary. consistency with prior FASB statements looks to “expectations … about employ- (like FAS 97 and 123, but not limited to ees’ exercise behavior.” • A Monte Carlo approach to the them) come into play. Using a hypothetical In applying option-pricing concepts valuation, wherein movements in the product design of a five-year point-to-point to the embedded derivative in an equity- S&P 500 occur in a randomized liability with no deaths, premature surren- indexed annuity, valuation actuaries fashion, is most intuitive and straight ders or renewals, Table 1 displays a spreadsheet will need to observe the following forward, although other methods are (http://www.soa.org/sections/finrep.html) considerations: possible. The valuation apparatus em- developed to clarify the mechanics of ployed by the actuary may need to mod- EIA bifurcation. Note that the depiction • In option-pricing, one is not generally el correlated changes in interest rates if sidesteps some of the difficult valuation free to select the capital market assump- these are thought to play a role in induc- issues discussed above (e.g., policyholder tions to be used. Wise Nobel prize ing policyholder or insurer behavior. psychology, multi-term valuation) by winners have demonstrated through modeling a single index term only. Also arbitrage arguments how a “law of one Character of the note that important considerations like price” prevails. Governing valuation Embedded Derivative DAC, Federal Income Taxes and general assumptions (e.g., volatility) for S&P In accepting an EIA deposit, an insurance expenses are ignored for purposes of 500-based instruments are observable in company agrees to make equity-indexed illustration. the marketplace. Further, invoking interest credits throughout the life of the The spreadsheet depicts the emergence what’s known as “risk-neutral” capital policy. (To complicate the valuation exer- of earnings over the five-year period in market assumptions has been found to cise further, some companies also permit response to a saw-tooth-like pattern of greatly simplify the valuation exercise. policyholders to “transfer” at specific S&P 500 performance. In addition to times in the policy’s life by electing a bifurcating the liability into its host policy JUNE 2000 THE FINANCIAL REPORTER PAGE 13 and embedded derivative compo- Table 1 nents, the spreadsheet funds the liability with a combination of a zero-coupon bond and an S&P 500 Illustration of GAAP Accounting: 5-Year Point-to-Point Liability call option, both timed to mature in year five. Together, the bond and the Deposit 10,000 Participation Rate 75% call option fully defease the EIA Zero-Coupon Bond Rate 7.00% liability regardless of where the S&P 500 winds up. Since the call Capital Markets 0 1 2 3 4 5 option and the embedded derivative Index Growth -10% 20% -10% 20% 20% mirror each other and the zero- Index Level 1,500 1,350 1,620 1,458 1,750 2,104 coupon bond and the host policy are Implied Volatility 22.0% 22.0% 22.0% 22.0% 22.0% 22.0% both accreted at a constant interest Risk-Free Rate 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% Dividend Rate 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% rate, accounting symmetry is attained and smooth earnings emer- Calculation of Black-Scholes Option Values 0 1 2 3 4 5 gence can be expected. Minimum Guarantee (SNFL) 10,433 However, the aforementioned Guaranteed Growth in Policy Value 4.33% FAS 97 floor disrupts accounting Liability Option Strike 1,587 symmetry in year one, when an equity market downdraft depresses Time to Expiry 543210 d1 0.6145 0.2847 0.6190 0.1890 0.7702 the fair values of both the call d2 0.1226 -0.1553 0.2380 -0.1221 0.5502 option and the embedded derivative Black-Scholes Price 384.39 238.94 354.97 182.34 287.40 517.11 by an equal amount. But since the Balance Sheet 0 1 2 3 4 5 total value of the hybrid instrument (the host policy together with the Market Value of Option 1,922 1,195 1,775 912 1,437 2,586 embedded derivative) is not permit- Zero-Coupon Bond (HTM) 8,078 8,644 9,249 9,896 10,589 11,330 ted to pierce the FAS 97 floor, the Total Assets 10,000 9,838 11,023 10,808 12,026 13,915 spreadsheet depicts the loss result- Market Value of Embedded Dx 1,922 1,195 1,775 912 1,437 2,586 ing from the artificially elevated FAS 133 Host 8,078 8,502 8,949 9,418 9,913 10,433 liability level. (See the explanatory FAS 97 Floor 10,000 10,085 10,171 10,258 10,345 10,433 Total Liabilities 10,000 10,085 10,723 10,330 11,350 13,019 calculations at the bottom of Table 1 on the Web site). This year-one Equity - (247) 300 478 676 896 loss will then lead to higher future- period earnings, as the flooring Pre-Tax Income (247) 547 178 198 221 adjustment subsequently reverses. This asymmetry may be further exacer- annuity. In this context, the important Anson J. Glacy, Jr., ASA, is senior bated to the extent that the purchased valuation considerations discussed above consulting actuary at Ernst & Young, S&P 500 call option fails to match the will be key to ensuring a reasonable LLP, in Hartford, CT. He can be reached characteristics of the embedded deriva- pattern of EIA earnings emergence. at [email protected]. tive contained in the equity-indexed

Chairperson’s Corner continued from page 1 bigger, and it’s urgent. We can’t stay a needs of business and society as opportu- The next Chairperson’s Corner will small, exclusive profession. The exclusiv- nities to provide valuable services. Once talk about how your participation can ity of our profession does not keep salaries again, the need is there. Now that the "Big make a difference and how you can get high. All it does is restrict the scope and Tent" concept and the activities of the involved. volume of work performed by actuaries. SOA’s Strategic Planning Committee are Once again, a challenge and opportu- familiar to most of our members, our Mike McLaughlin, ASA, is a partner nity is presenting itself. On past occasions perspective is broader. Once again our with Ernst and Young LLP in Chicago, our profession has been too small, too profession is being challenged. This time IL. parochial, or perhaps both, to see the around, I think we’re ready.