statutory accounting principles working...

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Statutory Accounting Principles Working GroupMaintenance Agenda Submission Form

Form A

Issue: Special Accounting Treatment for Limited Derivatives (VAIWG)

Check (applicable entity):P/C Life Health

Modification of existing SSAPNew Issue or SSAP Interpretation

Description of Issue:Based upon recommendation from the Variable Annuities Issues (E) Working Group, the Financial Condition (E) Committee issued the following charge to the Statutory Accounting Principles (E) Working Group:

Develop and adopt changes to SSAP No. 86—Derivatives, with an effective date of January 1, 2017 or earlier, which allow hedge accounting treatment under SSAP No. 86 for certain limited derivative contracts (e.g. interest rate hedges with counterintuitive effects) that otherwise do not meet hedge effectiveness requirements. In adopting such an allowance, consider if the requirement to meet hedge effectiveness can be replaced by some other information that demonstrates strong risk management is in place over the identified hedges. —Essential

This agenda item has been drafted to provide information on an industry proposal received, existing statutory accounting principles and U.S. GAAP, as well as suggest an approach for the Working Group to consider. It should be noted that the FASB is currently working on a project “Accounting for Financial Instruments – Hedge Accounting” with the initial exposure drafted expected in the first quarter of 2016. Pursuant to the SAP Maintenance Process, once issued, the Working Group will review the new FASB standard for statutory accounting purposes. (Tentative decisions to date as a result of this FASB project have been referenced throughout this agenda item as applicable.)

Brief Overview of Industry Derivative Proposal:

1. Allow “effective hedge” accounting treatment for variable annuity contracts that have guarantees that are sensitive to certain interest rate changes. Derivative transaction is intended to offset change in AG43 reserves driven by changes in interest rates.

2. “Hedged Item” would be the present value of cash flows of the variable annuity guarantee exposed to interest rate risk for a pool of variable annuity policies. The pool may reflect the entire book of business, and the proportion of the pool hedged may change as a result of changes in the block of business, interest rate movement, or whether the sensitivity to interest rate risk has expired.

3. “Hedging Instrument” would be a portfolio of interest rate swaps that are periodically rebalanced to the changing risk profile of the variable annuity policies. Rebalancing may include the purchase of additional swaps (or other derivative instruments) or unwinding of previously purchased swaps.

4. Two hedge accounting reserves would be established: (1) Reserve driven by changes in AG 43; and (2) Reserves driven by other changes (realized gains/losses, market values, etc.).

5. Changes in the hedge accounting reserves would be amortized using an effective yield (or amortization rates) over the life of the “hedge program” – also identified as the “duration of the liabilities”.

© 2016 National Association of Insurance Commissioners 1

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Brief Staff Response on Industry Derivative Proposal:

1. The industry proposal would not currently qualify as an effective hedge under U.S. GAAP, or the guidance within SSAP No. 86. Particularly, macro-hedges are specifically prohibited for “effectiveness” within U.S. GAAP, and are not supported with the guidance under SSAP No. 86. Furthermore, there are concerns with the industry proposal, and the potential for significant delay in the recognition of realized losses from derivative transactions.

2. Staff suggests specific, new guidance to SSAP No. 86 to develop parameters and allowances to provide the ability for “special accounting” treatment for derivative transactions that mitigate risk related to guarantees under variable annuity (AG43) policies. This recommendation would be consistent with the initial recommendation from the NAICs consultant titled, NAIC Study of Variable Annuity Reserve and Capital Standards - Quantitative Impact Study:

Facilitate easier access to hedge accounting for qualifying hedge instruments : Clarify and expand the eligibility standards for hedge assets to qualify for hedge accounting treatment under SSAP No. 86 and allow variable annuity writers to carry qualifying hedge instruments on a basis that aligns with the valuation basis of the hedged statutory liabilities, subject to limits or constraints and/or period of amortization.

Existing Authoritative Literature:

SSAP No. 86—Derivatives

56. This statement adopts the framework established by FAS 133, FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133, An amendment of FASB Statement No. 133 (FAS 137) and FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, An amendment of FASB Statement No. 133 (FAS 138), for fair value and cash flow hedges, including its technical guidance to the extent such guidance is consistent with the statutory accounting approach to derivatives utilized in this statement. This statement adopts the provisions of FAS 133 and 138 related to foreign currency hedges. With the exception of guidance specific to foreign currency hedges and amendments specific to refining the hedging of interest rate risk (under FAS 138, the risk of changes in the benchmark interest rate would be a hedged risk), this statement rejects FAS No. 137 and 138 as well as the various related Emerging Issues Task Force interpretations. This statement adopts paragraphs 4 and 25 of FASB Statement No. 149: Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149) regarding the definition of an underlying and guidance for assessing hedge effectiveness. All other paragraphs in FAS 149 are rejected as not applicable for statutory accounting. This statement adopts FSP FAS 133-1 and FIN 45-5: Disclosures about Credit Derivatives and Certain Guarantees, An Amendment of FASB Statement No. 133 and FASB Interpretation No.45 and Clarification of the Effective Date of FASB Statement No. 161 (FSP FAS 133-1 and FIN 45-4) and requires disclosures by sellers of credit derivatives. This statement rejects FSP FIN 39-1, Amendments of FASB Interpretation No. 39, and ASU 2014-03, Derivatives and Hedging – Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps – Simplified Hedge Accounting Approach.

57. This statement adopts revisions to ASC 815-20-25-15 as reflected within ASU 2010-08, Technical Corrections to Various Topics. This statement adopts revisions to ASC 815-10-50-4K as reflected within ASU 2010-11, Derivatives and Hedging (Topic 815), Scope Exception Related to Embedded Credit Derivatives, but rejects all other GAAP revisions from ASU 2010-11 and ASU 2014-16, Derivatives and Hedging, Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share is More Akin to Debt or to Equity . These GAAP revisions are rejected as embedded derivatives are not separated from the host contract and recognized as derivatives under SSAP No. 86. Revisions are also incorporated to SSAP No. 86


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to require disclosures on embedded credit derivatives that expose the holder of a financial instrument to the possibility of being required to make future payments. This disclosure is a modification to the GAAP disclosures specific to statutory accounting as embedded credit derivatives are not separately recognized under statutory accounting. It should be noted that the conclusions reached in this statement are not intended to usurp the rules and regulations put forth by states in their respective investment laws. The contents of this statement are intended to provide accounting guidance on the use of derivatives as allowed by an insurer’s state of domicile. It is not intended to imply that insurers may use derivatives or cash instruments that the insurer’s state of domicile does not allow under the state’s insurance regulatory requirements, e.g., in replication transactions.

58. This statement adopts revisions to ASC 815-20 as reflected within ASU 2013-10, Derivatives and Hedging, Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a benchmark interest rate for Hedge Accounting Purposes. These revisions define a benchmark interest rate, clarify what can be used in the U.S. for a benchmark interest rate, and eliminate the prior restriction on using different benchmark rates for similar hedges.

Staff Note: Over time, numerous questions have been received regarding the “adoption of the framework” of FAS 133, FAS 137 and FAS 138, and then the explicit rejection of FAS 137 and FAS 138 except for guidance related to foreign currency hedges and the assessment of hedge effectiveness. As detailed, the accounting and reporting guidance for derivatives, particularly with regards to the four cornerstones identify by FASB, is distinctly different between SSAP No. 86 and FAS 133/ASC 815.

Overview of SAP Accounting – SSAP No. 86

1. Derivative instruments used in hedging transactions that meet the criteria of a highly-effective hedge are considered “effective” and are permitted to be valued and reported in a manner consistent with the hedged asset or liability (referred to as hedge accounting). (P. 16)

2. Derivative instruments used in hedging transactions that do not meet, or no longer meet the criteria of a highly-effective hedge, or that meets the required criteria by the entity has chosen not to apply hedge accounting, shall be accounted for at fair value, with changes in fair value recorded as unrealized gains or unrealized losses (referred to as fair value accounting). (P. 16)

3. Contracts that do not in their entirety meet the definition of a derivative instrument may contain “embedded” derivatives. Under SAP, embedded derivative instruments are not separated from the host contract and accounted for separately as a derivative instrument. (P. 13)

4. Entities are permitted to designate instruments to hedge changes in fair value, variations in cash flows or foreign currency exposure. Although these hedging categories are consistent with U.S. GAAP, U.S. GAAP has more restrictions than SAP for when designations may occur, and U.S. GAAP identifies specific instruments ineligible for designation as hedging instruments. (P. 19)

5. For hedging changes in fair value, SAP allows this type of hedge regardless of whether the hedged asset or liability is recorded at fair value. (P. 19) (Under U.S. GAAP, to designate a derivative as a fair value hedge, the hedged item must have a risk in which changes in its fair value could affect earnings. As such under U.S. GAAP, items held at amortized cost are only permitted to be hedged against changes in fair value attributed to credit risk, foreign exchange risk, or both. Under U.S. GAAP items held at amortized cost are not permitted to be hedged against the overall change in fair value or to changes in fair value as a result of interest rate risk. As these instruments are held at amortized cost, changes in the fair value caused by interest rates are not reflected in earnings.)

6. For contracts that qualify for hedge accounting, the change in the carrying value or cash flow of the derivative is to be recorded consistently with how changes in the carrying value or cash flow of the hedged item is recorded. Upon termination of a derivative that qualifies for hedge accounting, the gain or


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loss shall adjust the basis of the hedged item and be recognized in income in a manner that is consistent with the hedged item. (Exhibit B) (Staff Note: Pursuant to Exhibit B of SSAP No. 86, with exercise of the option, the book value of the derivative increases the cost basis of the hedged item.)

Overview of U.S. GAAP Accounting – U.S. GAAP guidance is based on four cornerstones (815-10-10-1):

1. Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported on the financial statements.

In making this decision, the FASB noted that derivatives are assets or liabilities because they represent rights or obligations and that recognizing those assets and liabilities will make financial statements more complete and more informative. The FASB noted that prior to FAS 133, many derivatives were off-balance-sheet, because, unlike conventional financial instruments (such as stocks, bonds and loans), derivatives often reflect at their inception only a mutual exchange of promises with little or no transfer of tangible consideration. FAS 133, BOC – 219.

2. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.

In making this decision, the FASB identified that fair value is the only relevant measurement attribute for derivatives. They noted that amortized cost is not a relevant measure for derivatives because the historical cost of a derivative often is zero, yet a derivative can be settled or sold at any time for an amount equivalent to its fair value. The reasoning for “held to maturity” instruments being held at amortized cost, was noted as not suitable for derivatives. FAS 133, BOC - Paragraph 223.

3. Only items that are assets or liabilities should be reported in the financial statements.

In making this decision, the FASB identified that derivatives are assets and liabilities, but the gains and losses that result in changes in the fair value of derivatives are not separate assets or liabilities because they have none of the essential characteristics of assets or liabilities. The FASB identified that the act of designating a derivative as a hedging instrument does not convert a subsequent loss or gain into an asset or a liability. A loss is not an asset because no future economic benefit is associated with it. The loss cannot be exchanged for cash, a financial asset, or a nonfinancial asset used to produce something of value, or used to settle liabilities. Similarly, a gain is not a liability because no obligation exists to sacrifice assets in the future. FAS 133, BOC – 229.

4. Special accounting for items designated as being hedged should be provided only for qualifying items. One aspect of qualification should be an assessment of the expectation of effective offsetting changes in fair value or cash flows during the term of the hedge for the risk being hedged.

In making this decision, the FASB noted that a primary purpose of hedge accounting is to link items or transactions whose changes in fair values or cash flows are expected to offset each other. The FASB decided that one of the criteria for qualification for hedge accounting should focus on the extent to which offsetting changes in fair values or cash flows on the derivative and the hedged item or transaction during the term of the hedge are expected and ultimately achieved. FAS 133, BOC – 230.

Key Elements of U.S. GAAP Guidance: (Only relevant excerpts are included.)

1. An entity shall recognize all of its derivative instruments in its statement of financial position as either assets or liabilities depending on the rights and obligations under the contracts. (815-10-25-1)


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2. All derivative instruments shall be measured initially at fair value. (815-10-30-1)

3. All derivative instruments shall be measured subsequently at fair value. (815-10-35-1)

4. Forward contracts and purchased options within the scope of “Certain Contracts on Debt and Equity Securities” shall, at inception, be designated as held to maturity, available for sale, or trading in a manner consistent with the accounting prescribed for that category of securities. Such forward and option contracts are not eligible to be hedging instruments. (815-10-25-17)

5. Unless offsetting guidance is met (210-20-45-1), fair value of derivative instruments in a loss position shall not be offset against the fair value of derivative instruments in a gain position. (815-10-45-4)

6. An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument if, and only if, the following criteria are met:

a) The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.

b) The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP with changes in fair value reported in earnings as they occur.

c) A separate instrument with the same terms as the embedded derivative would be a derivative instrument. (815-15-25-1)

7. Concurrent designation and documentation of a hedge is critical; without it, an entity could retroactively identify a hedged item, a hedged transaction, or a method of measuring effectiveness to achieve a desired accounting result. To qualify for hedge accounting, there shall be, at inception of the hedge, be formal documentation of specific elements. (815-20-25-3)

8. An asset or liability is eligible for designation as a hedged item in a fair value hedge if all of the following additional criteria are met. (Only including key excerpts) (815-20-25-12)

c) The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings.

d) If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities) that is classified as held to maturity in accordance with Topic 320, the designated risk being hedged is the risk of changes in its fair value attributable to credit risk, foreign exchange risk or both.

9. Gains and losses on fair value hedges shall be accounted for as follows: (815-25-35-1)

a) The gain or loss on the hedging instrument shall be recognized currently in earnings.

b) The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedging item and be recognized currently in earnings.

If the fair value is fully effective, the gain or loss on the hedging instrument, adjusted for the component (if any) of that gain or loss that is excluded from the assessment of effectiveness under the defined risk management strategy for that particularly hedging relationship, is attributable to the hedged risk. Any difference that would arise would be the effect of hedge ineffectiveness, which consequently is recognized currently in earnings. (815-25-35-2) (One of the tentative decisions under the proposed FASB guidance is that changes in fair value in designated hedging instruments will no longer be split in the income statement between effective and ineffective portions. If considered effective, the entire change in


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the fair value would be presented in the same income statement line where the earnings effective of the hedged item is presented.)

Overview of IFRS Accounting – The International Accounting Standards Board (IASB) is currently working on a project “Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro Hedging”. In April 2014, the IFRS released a Discussion Paper as a first step in developing an accounting model for dynamic risk management.

The objectives of the IFRS project is to simplify and improve the usefulness of financial statements by developing accounting requirements for hedging within the context of open portfolios that are more closely aligned with a company’s risk management activities. The IFRS identified, as a primary driver for initiating the project, the problems associated with applying hedge accounting, which is a fundamentally static concept (linking hedged instruments to hedged items) to dynamic risk management of open portfolios. As such, the IFRS decided to consider a new model for dynamic risk management of open portfolios.

The IASB is currently considering comments received on the exposed Discussion Paper, however, in reviewing project updates, it is anticipated that the IASB will re-issue a revised Discussion Paper for comment before even considering an exposure draft. (This is partly due to the original Discussion Paper focusing on interest rate risk management at banks, and commenters requested additional focus on the management of interest rate risk and other risks within non-bank entities.) As such, there is no expected timeframe for completion of this project at the IASB. This project is considered to be in the early stages, and it is anticipated to take a significant time before a standard is issued. In reviewing comments received by the IASB, some commenters included reference to insurance contracts, identifying that the need for a portfolio accounting model is needed to avoid accounting mismatches. These commenters supported the inclusion of hedged risks within insurance contracts being included in the IASB’s dynamic risk management project.

Industry / Consultant Proposal with NAIC Staff Discussion Items

Overview: Effective hedges for interest rate exposures of variable annuity guaranteed cash flows.

Rationale : Variable annuity products provide guaranteed living and death benefits that are sensitive to interest rate changes. Inconsistencies exist between the accounting treatment of the variable annuity guarantee reserves and the related “non-effective” hedging derivatives for statutory accounting purposes.

Discussion: Use of an amortized cost measurement method for the hedging derivatives would reduce the inconsistency in comparison to a fair value measurement method. However, inconsistencies will continue to exist even with an effective hedge strategy. The guaranteed benefits are determined based on an actuarial calculation, and changes do not mirror a standard amortized cost or fair value measurement method.

Hedged Item : Present value of cash flows of the variable annuity guarantee exposed to interest rate risk for a defined pool of variable annuity policies. (A certain proportion of the defined pool of policies may be the designated hedged item, and this proportion may change in response to the risk profile of the pool.)

Discussion: Pursuant to SSAP No. 86, paragraph 19b, an entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that are attributable to a particular risk. That exposure may be associated with an existing recognized asset or liability, such as all certain future interest payments on variable-rate debt, or a forecasted transaction. Although SSAP No. 86 references portfolios of hedged items for fair value hedges (and “portfolios” are not explicitly included in SSAP No. 86 for cash flow hedges), a generic reference to “portfolios of hedged items” is included in Exhibit C of SSAP No. 86 and was noted by industry as the guidance supporting “portfolios” of hedged items for all hedges. With regards to hedges of forecasted transactions in a cash flow hedge, the U.S.


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GAAP and SSAP No. 86 guidance indicate that the hedged item must be a specifically identified as a single transaction or a group of individual transactions.

Both SAP and U.S. GAAP permit portfolios of similar assets or similar liabilities to be a hedged item for fair value hedges. Under U.S. GAAP, with a fair value hedge structured as a portfolio, the aggregated items must share the risk exposure for which they were being hedged, and the change in fair value for each individual item must be expected to respond in a proportionate manner as to the fair value of the aggregate portfolio.

With regards to cash flow hedges, particularly forecasted transactions, the FASB identified that it would sometimes be impractical and not cost effective to identify each individual transaction that is being hedged. As such, the Board permits aggregation of individual forecasted transactions for hedging purposes in some circumstances. Similar to a hedge of a particular transaction, the entity must identify the hedged transactions with sufficient specificity that it is possible to determine which transactions are hedged transactions when they occur.

Hedging Instrument: Portfolio of interest rate swaps that are periodically rebalanced to the changing risk profile of the variable annuity policies. (The derivative portfolio is periodically rebalanced using the same method as the original purchase, taking into consideration the swaps already owned. The purchase of swaps or unwinding of swaps previously purchased may be performed due, but not limited to:

a) Change in interest rate level or level of convexityb) Change in the amount of inforce contractsc) Change in the average size of the account value d) Age of the policies inforce (those closer to the guarantee have less risk)

Discussion: The definition of a “derivative instrument” is different between GAAP and SAP. However, both GAAP and SAP appear to include language that allows for more than one derivative instrument to be combined and jointly designated as a hedging instrument. It does not appear that a hedging “instrument” can continue as a hedge (even if more than one item has been jointly designed) if there are changes to the instrument under current GAAP or SAP.

SSAP No. 86, paragraph 4 – The definition of a derivative instrument identifies an agreement, option, instrument, “or a series or combination thereof”. Under U.S. GAAP, guidance is explicitly included identifying that “two or more derivatives, or proportions thereof, may also be viewed in combination and jointly designated as the hedging instrument.”

Hedging Criteria : Designated hedge will qualify for hedge accounting by fulfilling the criteria for both a cash flow hedge and documenting hedge effectiveness at inception and on an ongoing-basis. Documentation will include “monthly hedge percentage determination” to identify the portion of the variable annuity block sensitive to interest rate risk for which hedge accounting will be applied, as well as quarterly prospective and retrospective hedge effectiveness assessments.

Discussion: Criteria requirements are currently detailed within SSAP No. 86 for cash flow hedges and with documenting hedge effectiveness. Due to the “changing” nature of both the hedged item and the hedging instruments, it is anticipated that further detail will be established for these specific hedges to clarify the assessment that should occur on an ongoing basis.

Hedge Effectiveness: Derivative instruments used in hedging transactions that meet the criteria of a highly effective hedge shall be considered an effective hedge and are permitted to be valued and reported in a manner consistent with the hedged item. Derivative effectiveness will not be bifurcated.

Discussion: Key items to discuss with this proposal:


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A. Measurement of Effective Hedge: Under SSAP No. 86, derivative instruments meeting the criteria of a highly effective hedge are permitted to be valued and reported in a manner consistent with the hedged item. As the AG43 liability is not an “amortized cost” measurement, it is anticipated that the guidance will be clarified to allow the hedging instruments to be reflected at amortized cost. Similar to existing guidance within SSAP No. 86, reporting entities may choose not to apply this “special accounting” and account for the derivatives at fair value.

B. Bifurcating Effectiveness: Although SAP guidance prohibits the bifurcation of hedge effectiveness of a derivative instrument, the intent of that guidance was for situations in which the entire instrument was being designated as the hedging instrument. As GAAP allows for a portion of a derivative to be designated as the hedging instrument, GAAP only allows recognition of the portion that is actually “effective” in the same manner as the hedge items. (Under GAAP, this only pertains to income statement recognition, and is specifically noted as an exact offset to the hedged item. As such, a hedge that meets the criteria to be “effective” may have both effective and ineffective accounting implications if not 100% effective.) For SAP, it is anticipated that guidance prohibiting the bifurcation of hedging effectiveness will continue. However, guidance should likely clarify that a portion of a derivative instrument is not permitted to be designated as the hedging instrument, and that the entire derivative instrument must be designated and assessed for hedging effectiveness.

Hedge Accounting : Changes in the derivative instrument will be recognized in the financial statements to the extent that the derivative changes offset changes in the AG43 reserve due to interest rate movement. Any other changes in the present value of cash flows of the hedging instrument, or in the fair value of the hedging instrument, are excluded from realized or unrealized gains and losses, unless the hedge becomes ineffective. Should the hedging relationship become ineffective, hedge accounting shall be discontinued and the derivatives will be measured and reported at fair value. The unrealized gains or losses booked under the hedge accounting will be amortized over the duration of the liabilities.

Discussion: One of the key differences between GAAP and SAP is the measurement method of derivative instruments and how fluctuations in the derivative impact the hedged item. Under GAAP, all derivatives are reported at fair value, and all changes in fair value are recognized in the financial statements – regardless if it is an effective or ineffective hedge.

Under GAAP, the changes in an effective hedge are recognized consistently with the hedged item. So, fluctuations of the hedged item recognized in other comprehensive income are offset by corresponding fluctuations of the hedging instrument. If the hedge is ineffective, or if the offset does not match completely, additional fluctuations of the hedging instrument are recognized directly to net income. (In either case, all fluctuations of the hedged item and the hedging instrument are reflected in the financial statement.)

Under current SAP guidance, the accounting focus has been on the balance sheet value of the derivative and the hedging instrument. As such, under SAP, an effective hedge is permitted to be recorded “consistently with the hedged item” (e.g., amortized cost), and hedges that do not qualify for hedge effectiveness are recorded at fair value. With this guidance, under an effective hedge, in theory, the gains/losses of the hedged item would be offset by the gains/losses of the hedging instrument – but this is an “off-balance sheet item” as these gains/losses are not reported or shown within the statutory financial statements.

The amortization of the gains/losses under the hedge over the course of the liabilities is a key element that would need to be considered for statutory accounting. Under current SAP, any


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gain or loss on the hedge transaction will adjust the basis of the hedged item at the time of sale, maturity, expiration or other closing transaction of the derivative. (Further discussion of this element is detailed below with regards to hedge termination.)

Hedge Termination : If a portion of the hedging instrument (derivative) is sold (or otherwise removed from the portfolio of hedging instruments (maturity, expiration, etc.), and the portfolio of hedging instruments remains an effective hedge, the gain/loss from the portion of the hedging instrument will be added to the hedge adjustment.

Discussion: The provisions to allow a portion of the hedging instruments portfolio to “terminate” (and to add other hedging instruments to the portfolio) and continue to classify the hedge as “effective” without recognizing the termination of the effective hedge (and requiring “fair value” accounting ) is a concept very different from existing SAP guidance and GAAP.

With this proposal, both the portfolio of hedging instruments (derivatives) and the hedged item (AG 43 liabilities) can change over time – either with adding/removing hedging instruments and adding/removing liabilities from the portfolio of hedged items. With the proposed concept to amortize gains/losses over the “duration of the liabilities” it seems possible that the amortization of gains/losses could be perpetually adjusted – as the liabilities (for new hedged items) would extend into the future. This would seemingly delay (indefinitely) the recognition of gains/losses within the financial statements. Consideration should occur on the appropriate timeframe for recognition – particularly in situations in which the hedging instrument that generated the gain/loss is no longer part of the hedging instrument portfolio.

Hedge Reporting : The following indicates the industry proposed reporting assuming that the derivatives currently exist and are not considered effective hedges:

Balance Sheet Current fair value of derivative will be removed from the carrying value of the derivative (DB) and

combined with the hedged item. This will be completed operationally by including the opening fair value amount as a separate adjusted to “aggregate write-in for liabilities”. This entry will zero out the derivative asset and liability amounts related to the hedging instrument and move the opening the fair value to the aggregate write-in line, offsetting the hedged item on the balance sheet. The change in fair value previously recorded as a change unrealized gains and losses within surplus will be locked in at the date of the change and reflected in surplus.

Swap income will be accrued and recorded when earned through Miscellaneous Income (Hedge accounting adjustment) in order to combine the derivative cash flows with the hedged item.

Swap Agreements where the transactions are exchange traded are “settled daily” through the exchange of variation margin in the form of cash. Company accounting policy is to record the cash as part of a variation margin settlement through a derivative asset / liability line and change in unrealized gain / loss. After implementation, variation margin received for swaps would be offset to the cash received (paid) with a payable (receivable) to (from) the exchange. This will be reflected in either an aggregate write-in for liabilities or an aggregate write-in for invested assets depending on the position. Variation margin received / paid on different swap agreements will be reported gross.

With hedge accounting, changes in the fair value of the hedging instrument will be recorded as hedged adjustments to the extent they offset changes in AG43 due to interest rates. These adjustments will be recorded consistently with the hedged item. (These could be positive or negative adjustments.)


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If a portion of the hedging instrument is sold and a capital gain or loss realized, and the portfolio of hedging instruments remains an effective hedge, the gain or loss will be added to the hedge accounting adjustment.

Opening fair value of the hedging instrument, periodic hedge adjustments and any realized gain or loss will be amortized through a single amortization over the life of the hedge program by recording an adjustment to other income. Per accounting policy, this adjusted is amortized using an effective yield over the life of the hedge program as approximated by revenue. (Revenue was determined to be an appropriate measure since when revenue on an individual contract is no longer collected, the benefit payment is known and is no longer sensitive to interest rates.) The amortization will be recorded monthly and re-calculated quarterly based on the end of quarter swap book value, adjusted for new hedge accounting adjustments. Amortization can be either positive or negative, depending on interest rate movements.

Summary of Operations Net investment income will no longer contain income for interest rate swap cash flows in the hedging

relationship and change in net unrealized capital gains (losses) will no longer contain changes in fair value. Changes for both of these items will be recorded through the hedge accounting adjustment liability write-in.

Upon implementation of hedge accounting, an adjustment line will be created in order to account for the hedging instrument with the hedged item. As such, the offset to changes in hedge accounting adjustment line will be recorded in the Summary of Operations line, Aggregate write-ins for miscellaneous income. This write-in is recorded in the same Summary of Operations caption as the hedged item.

Statement of Cash Flows Swap cash flows will be recorded through miscellaneous income rather than net investment income.

Schedule DB Schedule DB will no longer include book values for these derivative instruments, instead all derivative

positions that are part of the portfolio representing the hedging instrument will be reported on Schedule DB with a zero book value and unrealized gain/loss amount, but will report a fair value.


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Initial Staff Proposal for Discussion

Overview: Special Accounting Treatment for Interest Rate Exposures of Variable Annuity Guarantees.

1. Rationale : Variable annuity products provide guaranteed living and death benefits that are sensitive to interest rate changes. Inconsistencies exist between the accounting treatment of the variable annuity guarantee reserves and the related “non-effective” hedging derivatives for statutory accounting purposes.

Staff Recommendation: Although the industry’s proposed accounting / reporting for derivatives is significantly different from U.S. GAAP, and seems to be beyond the original intent of SSAP No. 86, staff is supportive of pursuing revisions to explicitly address derivative transactions hedging AG43 guarantee reserve calculations. This support is consistent with the intent to encourage risk-management transactions by insurers, and identification that the existing derivative accounting guidance may hinder insurers from engaging in these transactions. Staff proposes that guidance be separate and distinct from existing “effectiveness” guidance within SSAP No. 86 and included within a separate section / different SSAP with specific accounting and reporting guidance.

2. Hedged Item : Present value of cash flows of a defined pool of variable annuity policies with similar guarantee durations, for which the guarantee is exposed to interest rate risk. (The exposure to interest rate risk is a key factor of this proposal. Staff recognizes that this is not the only aspect that causes volatility for AG 43 related reserves, but it is the specific example provided in the assigned charge.)

Staff Recommendation: The current SSAP No. 86 concept of a “portfolio” as a hedged item was intended to be consistent with U.S. GAAP and limited to fair value hedges. For the specific hedging guidance related to AG43 reserves, staff suggests inclusion of guidance allowing a portfolio of designated variable annuity policies subject to interest rate risk. The portfolio shall include policies with similar guarantee durations at the date the entity designates the pool as a hedged item. (For example, the designated hedged item may be a portfolio of variable annuity contracts with different characteristics and liability durations, but all policies within the pool have a similar guarantee duration.) Upon establishment of a designated pool of variable annuity contracts, no additional variable annuity policies would be permitted to be added to the pool, but the pool of policies may be reduced as policies originally included within the designated pool terminate, expire, or otherwise no longer become sensitive to interest rate risk. The actuarial determined expected life of the policies within the pool could be used as the amortization period for the recognition of gains or losses under the effective hedge, or a lesser timeframe could be utilized based on an established, documented approach by the reporting entity. Companies are permitted to hedge more than one pool of variable annuity contracts.

This proposed guidance would be a form of “macro-hedging” as the hedged item could reflect a portfolio of “dissimilar” items. (Macro-hedging is prohibited from meeting “hedge effectiveness” under U.S. GAAP.) Although all items within the pool would be related to variable annuity contracts, as the contracts could have different terms and components, the portfolio would not be considered “similar” under U.S. GAAP.

This proposed guidance is different from the industry proposal. Per the industry proposal, the entire block of variable annuity business subject to interest rate risk could be the hedged item, with changes overtime as contracts are added / removed from the pool. The industry proposal also permits designation of a “portion” of the pool as the hedged item, with changes permitted to this “portion” as determined by the company. Staff is concerned that this approach is too permissive and would be difficult for regulators to actively review and assess for hedge effectiveness. Additionally, it seems that with the changes permitted (for both the hedged item and hedging instruments), hedge effectiveness could be “controlled” simply by adjusting the items involved in the hedge. Additionally, with the industry proposal, the amortization of gains/losses would occur over the duration of the “liabilities” (as the hedged item). With an ever-changing AG43 portfolio, and different / new “liability” durations, it seems that the amortization period could continuously be adjusted and


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extended, resulting with gains/losses being amortized over periods beyond the duration of policies originally hedged.

3. Hedging Instrument: A specified derivative, or a portfolio of specified derivatives, designated to hedge the interest rate sensitivity of a designated pool of variable annuity policies.

Staff Recommendation: For the specific hedging guidance related to AG43 reserves, staff suggests inclusion of guidance allowing a specified derivative, or a portfolio of specified derivatives to hedge the interest rate sensitivity of a designated pool of variable annuity policies. (As identified in the discussion for the hedged item, that pool shall include policies with similar guarantee durations.)

This proposed guidance is different from the industry proposal. As noted in the industry proposal, derivatives identified as hedging the risk would be permitted to be “rebalanced” frequently. This rebalancing could include the purchase of additional swaps or the unwinding of previously purchased swaps, without the change in the derivatives being considered an expiration, sale or termination of the hedging transaction. (This industry proposal would seem to allow significant changes to the derivative instruments – perhaps a complete replacement – and not require recognition of gains and losses.)

It is staff’s assessment that with a designated pool of variable annuity policies with similar guarantee durations (as detailed in the discussion for the hedged item), it is appropriate to have a designated derivative (or portfolio of derivatives jointly designated) as hedging the risk from the designated pool. This approach would still allow companies to effectively manage risks related to AG43 guarantees, but still follow the principles of SSAP No. 86 and U.S. GAAP with regards to review and assessment of hedge effectiveness.

Hedging Criteria: Designated hedge will qualify for hedge accounting by fulfilling the criteria for a cash flow hedge and documenting hedge effectiveness at inception and on an ongoing-basis. Documentation will require quarterly prospective and retrospective hedge effectiveness assessments. In addition to meeting the “effective hedge” documentation requirements, the derivative must also qualify under the requirements detailed in AG43 for a “clearly defined hedging strategy.” To the extent that these AG 43 requirements are modified based upon recommendations from the NAICs consultant, or otherwise, NAIC staff would propose that similar changes be made to these ”special accounting” requirements, and that regulators of the Statutory Accounting Principles (E) Working Group be given an opportunity to determine if such modifications provide the needed comfort to demonstrate strong risk management is in place to allow this “special accounting treatment.” If the hedging strategy does not meet the criteria to adjust the Conditional Tail Expectation Amount under AG43, then the ability to utilize the “special accounting treatment” being proposed for AG43 policies would not be permitted.

As noted within AG43, meeting the requirements of that standard does not supersede any statutes, laws, or regulations of any state or jurisdiction related to the use of derivative instruments for hedging purposes and should not be used in determining whether a company is permitted to use such investments in any state or jurisdiction. As such, there may be derivative transactions that meet the derivative requirements of AG43 and not qualify for effective hedge accounting under SSAP No. 86 or this “special accounting treatment”.

Staff Recommendation: Staff suggests that the effective hedge guidance from SSAP No. 86 for cash flow hedges be utilized for “special accounting treatment”. This guidance requires inception and ongoing assessment of effectiveness whenever financial statements are reported, at least every three months. These assessments should be consistent with the originally documented risk management strategy for the particular hedging relationship. The term “highly effective” will continue to describe a cash flow hedging relationship where the change in cash flows or present value of cash flows of the derivative hedging instrument is within 80-125 percent of the opposite change in cash flows or present value of the cash flows of the hedged item attributable to the hedged risk. The current guidance also specifies the formal documentation of the components of the hedging relationship, assessment of the effectiveness (prospectively and retrospectively) at


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least quarterly, approval of the company to engage in these transactions, and description of the entity’s methodology to very compliance with domiciliary state limitations. Staff also suggests that the language in FASB Codification for assessing effectiveness be reviewed and considered for inclusion in the SSAP guidance. (Several aspects are already included in Exhibit A of SSAP No. 86, but would be easier to follow within the actual guidance.)

Although the proposed suggestion is generally consistent with the industry proposal, the industry proposal includes elements to assess hedge effectiveness based on the proposal of an ever-changing hedged item (variable annuity block of business) with an ever-changing hedging instrument (rebalancing portfolio of derivatives). The staff suggested proposal, although allowing derivative transactions to manage the risk of the guarantee provided under the variable annuity contracts, would not permit the changing dynamics to the hedged item or the hedging instrument as detailed in the industry proposal.

As this derivative guidance is specific to AG43 policies, staff is suggesting that the documentation requirements for effective hedge accounting include both the effective hedge detail from SSAP No. 86, and the requirements detailed in AG43. If the hedging strategy does not meet the criteria to adjust the Conditional Tail Expectation Amount under AG43, then the determination of allowance under this “special accounting treatment” would not be permitted. As noted within AG43, meeting the requirements of that standard does not supersede any statutes, laws, or regulations of any state or jurisdiction related to the use of derivative instruments for hedging purposes and should not be used in determining whether a company is permitted to use such investments in any state or jurisdiction. As such, there may be derivative transactions that meet the requirements of AG43 and would not qualify for effective hedge accounting or this “special accounting treatment”.

Pursuant to AG43, in order to qualify as a Clearly Defined Hedging Strategy, the strategy must meet the principles outlined in the Background Section of the Guideline (particularly Principle 5) and shall, at a minimum, identify:

a) The specific risks being hedged,b) The hedge objectives,c) The risks not being hedged, d) The financial instruments that will be used to hedge the risks, e) The hedge trading rules including the permitted tolerances from hedging objectives,f) The metric(s) for measuring hedging effectiveness,g) The criteria that will be used to measure effectiveness,h) The frequency of measuring hedging effectiveness,i) The conditions under which hedging will not take place, and j) The person or persons responsible for implementing the hedging strategy.

As detailed in AG43, Appendix 7 – Modeling of Hedges, the approximate costs and benefits of the hedging instruments shall be included in the calculation of the Conditional Tail Expectation Amount. Before either a new or revised hedging strategy can be used to reduce the amount of the Conditional Tail Expectation Amount otherwise calculated, the hedging strategy should be in place (effectively implemented by the company) for at least three months. Additionally, an actuary must provide certification as to whether the Clearly Defined Hedging Strategy is fully incorporated into the stochastic cash flow model and any supplementary analysis of the impact of the hedging strategy on the Conditional Tail Expectation Amount. Lastly, a financial officer of the company (CFO, treasurer, or CIO, or a designated person with authority over the actual trading of assets and derivatives) must certify that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy and that the Clearly Defined Hedging Strategy is the hedging strategy being used by the company in its actual day to day risk mitigation efforts. (Staff Note – Only high-level concepts from AG43, Appendix 7 are provided above.)


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4. Hedge Effectiveness: Derivative instruments used in hedging transactions that meet the criteria of a highly effective hedge shall be considered qualified for the “special accounting treatment” and permitted to be valued and reported at amortized cost. This provision will not be bifurcated within an investment.

Staff Recommendation: For the specific hedging guidance related to AG43 reserves, staff suggests retaining the general accounting concepts included within SSAP No. 86 if the hedge is effective. Specific consideration is needed for the treatment of gains/losses upon the termination of a hedge under this special accounting provision. Under current SSAP, “effective hedge” accounting does not continue once a hedge is “ineffective” and if sold, or otherwise terminated, the gains/losses on the hedge item is realized and is used to adjust the basis of the hedged item. As noted in the industry proposal, if the hedging instrument is sold, or otherwise removed from the portfolio of hedging instruments, it appears that there would be continuation of an effective hedge assessment, and continued deferral of the “realized” gain or loss from the sale of the derivative instrument as if it that instrument was still serving as an effective hedge.

Pursuant to guidance in SSAP No. 86, the staff suggestion would include the following concepts:

Derivative instruments used in hedging transactions within the scope of this item that meet the criteria of a highly effective hedge shall be considered as qualifying for the “special accounting treatment” and are permitted to be valued and reported at amortized cost. (Although the AG43 liability is not an “amortized cost” measurement, using amortized cost for the assets would assist in mitigating the volatility mismatch from reporting the derivative assets at fair value.)

Derivative instruments used in hedging transactions that do not meet or no longer meet the criteria of an effective hedge prior to the stated hedging timeframe, or that meet the required criteria but the entity has chosen not to apply hedge accounting, shall be accounted for at fair value and the changes in the fair value shall be recorded as unrealized gains or unrealized losses.

Entities shall not bifurcate the effectiveness of derivatives. A derivative instrument is either classified as an effective hedge or an ineffective hedge. Entities must account for the derivative using fair value accounting if it is deemed to be ineffective or becomes ineffective. Entities may redesignate a derivative in a hedging relationship even though the derivative was used in a previous hedging relationship that proved to be ineffective. An entity shall prospectively discontinue hedge accounting for an existing hedge if any one of the following occurs:

o Any criterion for hedge effectiveness is no longer met;

o The derivative expires or is sold, terminated, or exercised prior to the stated end date of the hedging transaction (the effect is recorded as realized gains or losses or, for effective hedges of firm commitments or forecasted transactions, in a manner that is consistent with the hedged transaction);

Note: For this special accounting period, the stated end date of the hedge will likely end before the amortization period / variable annuity guarantee interest-rate risk ends. This is because the impact to the AG43 reserves has a less immediate impact as a result of the changes in interest rates. It is anticipated that the proposed special accounting will allow for the hedging instrument to terminate at a specified timeframe, with the amortization of the gains/losses extending beyond that timeframe to correspond with the change in AG43 reserve. If the hedging instrument was terminated, became ineffective, etc., prior to the stated timeframe, then the hedge would not qualify for the special accounting treatment and the gains or losses would be immediately recognized.

o The entity removes the designation of the hedge; or

o The derivative is deemed to be impaired


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5. Hedge Accounting : Changes in the derivative instrument will be recognized in the financial statements to the extent that the derivative changes offset changes in the AG43 reserve due to interest rate movement. Any other changes in the present value of cash flows of the hedging instrument, or in the fair value of the hedging instrument, are amortized per the determined timeframe. Should the hedging relationship become ineffective, hedge accounting shall be discontinued and the derivatives will be measured and reported at fair value.

Staff Recommendation: For the specific hedging guidance related AG43 reserves, staff suggests retaining the general accounting concepts included within SSAP No. 86 for effective hedges. However, as detailed within the “reporting” guidance, staff proposes that the existing concept to allow reporting of the derivatives to be “combined with the hedged item” be eliminated from statutory accounting. (Staff plans to suggest this change for all derivatives, but this agenda item is focused on the AG43 derivatives, so is only being considered for this component at this time.)

The effective hedge accounting guidance currently in SSAP No. 86 provides for the following:

Derivatives in an effective hedge are valued and reported in a manner consistent with the hedged asset or liability. Since the AG43 reserves are not actually held at an amortized cost, as an amortized cost measurement is more representative of the measurement of AG43, that method will be the designated measurement method unless the company elects to use fair value.

Derivatives that do not meet the effective hedge requirements (including documentation requirements) shall be valued at fair value, with changes in the fair value recorded as unrealized gains or losses. Entities would be permitted to elect this measurement method even if the hedge qualifies as an effective hedge.

Derivatives cannot be bifurcated for effectiveness. A derivative instrument is either effective or ineffective. If identified as ineffective, or if becomes ineffective (or meets other noted criteria), it shall follow the fair value accounting method.

For derivatives held at amortized cost, the fair value fluctuations will not be reported in the measurement value of the derivative. Fair value (and the unrealized gains/losses) will be included in Schedule DB. The cost (if any) of the derivative shall be amortized over the actuarially determined expected average life for the portfolio of AG43 policies identified as the hedged item (or pursuant to the reporting entity’s documented timeframe).

Derivative cash flows received and accruals of income/expense will be recognized in the income statement in a specified manner. Although the guidance in SSAP No. 86 indicates “consistent with the hedged item” – the references in SSAP No. 86 assume that the hedge is to an investment, so the cash flows from the hedged instrument and the hedging item are often offset within “investment income”. With this proposal, it is anticipated that the cash flows received will be recorded as a write-in to “Miscellaneous Income”.

6. Hedge Termination : Pursuant to staff’s suggestion for the hedged item and the hedging instrument, if the hedging instrument (or portfolio of similar instruments jointly designated) is sold (or otherwise removed from the hedging instrument - maturity, expiration, etc.), prior to the stated hedge end date, the transaction will cease to be an effective hedge.

Staff Recommendation: Consistent with the guidance for “hedge effectiveness,” derivative instruments used in hedging transactions that do not meet or no longer meet the criteria of an effective hedge prior to the stated end date of the hedge, or that meet the required criteria but the entity has chosen not to apply hedge accounting, shall be accounted for at fair value and the changes in the fair value shall be recorded as unrealized gains or unrealized losses.


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This is inconsistent with the industry proposal, as their proposal would have allowed movement in/out of a designated hedged instrument (portfolio of swaps) without terminating hedge effectiveness. Although a new hedge can be designated, by perpetually indicating an “effective” hedge even when there are changes to the hedging instrument, any losses that should be recognized (such as if the derivative instrument was sold) would seem to be delayed from recognition. (As noted in the Statutory Statement of Concepts, accounting treatments which tend to defer expense recognition do not generally represent acceptable SAP treatment.)

7. Hedge Reporting : Detailed reporting requirements for these derivatives are proposed.

Balance Sheet

All effective hedge derivatives within scope of this section will be required to be reported separately. (These derivatives will not be permitted to be combined with the hedged item.) As such, all derivatives will be captured within the “derivative asset” or “derivative liability” line within the balance sheet. Accordingly, the liability for the guarantee for the variable annuity policies will not be directly adjusted for the cost of the derivative instrument. (As noted below in the discussion for Schedule DB, staff proposes that a new section in Schedule DB to separately detail these derivative transactions. If desired, the Working Group may want to consider whether separate reporting would be beneficial directly on the balance sheet.)

The effective hedge derivative instruments (e.g., swaps) shall be initially reported at cost, and amortized over the stated amortization timeframe.

o If the swap was acquired without a cost, it shall be initially reported as zero.

o If the swap was previously reported at fair value, the fair value at the time of the effective hedge designation shall be reported as cost. Any previous unrealized gain/loss from prior fair value fluctuations shall immediately be recognized as a realized gain/loss through net income.

The fair value, and any unrealized gains or losses from changes in fair value, of the effective hedging derivative instruments (e.g., swaps) will be reported on Schedule DB. With hedge effectiveness accounting, changes in the fair value of the hedging instrument will be identified as a “hedge accounting adjustment” and will be amortized in a constant effective yield method over the over the life of the hedged item or the reporting entity’s stated amortization timeframe. This amortization will be recorded through other income.

Swap income will be accrued and recorded when earned and included as a “hedge accounting adjustment”. This adjustment (which also includes fair value changes in the hedging instrument) will be amortized under a constant effective yield method over the life of the hedged item, or the reporting entity’s stated amortization timeframe. (This amortization will be recorded through Misc. other income.

Swap Agreements where the transactions are exchange traded are “settled daily” through the exchange of variation margin in the form of cash. The cash, as part of a variation margin settlement, will be recorded gross through a derivative asset / liability line and change in unrealized gain / loss. Although the cash is “received” daily, the variation margin is subject to continued adjustment as the derivative contract continues. As such, this inflow/outflow is not considered a realized gain/loss until the exchange traded derivative contract is terminated, expired, matured, or otherwise closed.

If the hedging instrument is sold, terminated or expired, or if the hedging instrument otherwise becomes an ineffective hedge, prior to the stated end date of the hedge the amortization of any hedging adjustments will cease, and the derivative instrument shall be reported at fair value, with realized or unrealized gains


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or losses. (If the derivative is sold before the stated end date, the impact would be realized. If the derivative is ineffective, but still owned, the fair value fluctuations would be unrealized.)

Summary of Operations Net investment income will no longer contain income for interest rate swap cash flows in the hedging

relationship and change in net unrealized capital gains (losses) will no longer contain changes in fair value. Changes for both of these items will be recorded through the hedge accounting adjustment.

New reporting requirements will be established in order to account for the hedging instrument, and documentation of the amortization adjustments.

Statement of Cash Flows Swap cash flows will be recorded through miscellaneous income.

Schedule DB Schedule DB will detail all components regarding these derivative transactions – including book value,

fair value, unrealized gains/losses, income, and the combined hedge accounting adjustment. It is suggested that a separate DB schedule specific for these variable annuity transactions be developed.

Activity to Date (issues previously addressed by SAPWG, Emerging Accounting Issues WG, SEC, FASB, other State Departments of Insurance or other NAIC groups): The Variable Accounting Issues (E) Working Group recommended a charge that the Statutory Accounting Principles (E) Working Group consider “hedge” accounting treatment to offset the change from the AG 43 reserve.

Information or issues (included in Description of Issue) not previously contemplated by the SAPWG: None

Recommendation:Expose the proposed agenda item with a request for comment. Comments are requested on the various components of the “staff proposal” as well as other elements that should be considered in providing “special accounting provisions” for these specific derivative contracts. Staff recognizes that a particular industry proposal was provided and reviewed, and therefore is looking to receive information on other approaches that are being utilized or considered by the variable annuity providers.

Staff Review Completed by: Julie Gann – January 2016

Status:On April 3, 2016, the Statutory Accounting Principles (E) Working Group moved this agenda item to the active listing, categorized as substantive, and exposed the agenda item with a request for comment on the various components of the staff proposal, as detailed above, as well as other elements that should be considered in providing “special accounting provisions” for certain derivative contracts related to variable annuities that do not meet hedge effectiveness requirements.

On August 26, 2016, the Statutory Accounting Principles (E) Working Group exposed an issue paper proposing special accounting treatment for certain limited derivatives related to variable annuity products for a 90-day exposure period, ending Nov. 28, 2016, to correspond with an exposure on a related topic at the Variable Annuities Issues (E) Working Group. The issue paper incorporates several concepts that are different from the “initial staff proposal for discussion” detailed in this agenda item and exposed on April 3, 2016. Key concepts in the issue paper include:

Location of Guidance: One concept that is proposed to be retained from the original exposure is that the special accounting provisions be separate and distinct from SSAP No. 86—Derivatives. The issue paper specifically indicates that the special accounting guidance is permitted only if all of the components of the issue paper are met, and the guidance shall not be inferred as an acceptable statutory accounting approach


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for derivative transactions that do not meet the stated qualifications or that are not specifically addressed within this guidance. (As a related item, during the 2016 Summer National Meeting, the Accounting Practices and Procedures (E) Task Force requested that the Financial Condition (E) Committee change the charge to remove both the Jan. 1, 2017 effective date and reference to SSAP No. 86.)

Macro-Hedging: Portfolio of Variable Annuity Policies designated as hedged item. Portfolio is not required to be static, but can be revised to remove / add policies for continuous risk management.

Dynamic Hedging Instrument: Hedging instruments permitted to be rebalanced in accordance with changes in the hedged item.

Governance: Oversight provisions assist with regulator review (e.g., explicit approvals / certifications).

Actuarial Guideline 43 - CARVM For Variable Annuities (AG 43): Requires compliance with provisions of AG 43, including Clearly Defined Hedging Strategy.

Hedge Type: Hedges must qualify as “fair value hedges” using a prescribed method to determine effectiveness in which the fair values of the hedged item (AG 43 reserve) and the hedging instruments are used to determine effectiveness.

Measurement: Derivatives are reported at fair value, but allows recognition of “deferred assets and deferred liabilities” to neutralize the volatility impact from fair value fluctuations. These deferred items are amortized into gains/losses over a finite amortization period, with provisions to allow companies to better match the amortization with the expected liability duration from the hedged item.

Expiration of Derivatives: With rebalancing concept, guidance allows “expired” derivatives to continue amortization – if part of an highly effective hedging strategy – at the time of expiration, recognizing tenure differences between the hedged item and hedging instruments.

Disclosures: Intended to result with a new schedule DB that specifically addresses the hedging strategies and related derivatives captured within the issue paper. Also anticipates a schedule for all hedging instruments with detailed information to provide clear, transparent information on the use and impact of this special accounting provision.

As detailed in the issue paper, there are several questions throughout the discussion section. These questions are intended to highlight key discussion points and/or potential concerns with the proposed guidance. With the issue paper exposure, responses to these questions from both regulators and interested parties are requested.

On December 10, 2016, the Statutory Accounting Principles (E) Working Group directed staff to review and consider comments received, to ensure adequate assessments of changes and Working Group member discussion on proposed statutory accounting guidance. Staff shall continue to work with key stakeholders to consider revisions to the proposal, with the potential for an interim exposure and/or conference call to allow for continued progress on the development of statutory accounting provisions.

On January 24, 2017, the Statutory Accounting Principles (E) Working Group requested additional information from industry on the following elements:

Expected / benchmark amortization timeframes based on the industry’s proposed use of the Macaulay Duration approach.

As comments received generally opposed the proposed approval and certification requirements, noting that what was proposed would be overly burdensome, industry suggestions are recommended on different


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or modified governance procedures. (It is an initial opinion that the special accounting provisions should require an enhanced level of regulatory review.)

Comments received noted that the proposed special accounting provision will typically encompass only a portion of derivatives in a Clearly Defined Hedging Strategy. Although staff does not disagree with these comments, staff would like additional information from industry on how hedging instruments, which may offset risks other than interest rate risk, will be accounted for if a component of the hedging instrument is captured within the issue paper guidance.

Comments received opposed the proposed guidance for when outstanding (non-expired) derivative instruments no longer qualify for the special accounting provisions, or when the hedge is not highly effective. Staff is interested in receiving proposals from industry on “termination” guidance, particularly addressing how deferred assets (unrealized losses from prior fair value fluctuations) should be impacted. The industry comments noted that the original proposed guidance was inconsistent with GAAP “termination” guidance, however, staff highlights that the special accounting proposal is not in-line with GAAP guidance, therefore statutory-specific “termination” provisions are likely necessary. (For example, under GAAP, gains and losses resulting from changes in the fair value of derivatives are not separate assets or liabilities because they have none of the essential characteristics of assets or liabilities. As such, under GAAP, there would no recognition of a “deferred asset” as proposed in the issue paper.)

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