Article from: 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.