Derivatives Implementation Group

Statement 133 Implementation Issue No. B29

QUESTIONS

The following questions address certain Statement 133 accounting implications related to the issuer and the holder of equity-indexed annuity (EIA) products.

1. From the holder's perspective, what is the accounting for an EIA product?
2. What is the accounting for the option components of an EIA product that specifies:
   1. A point-to-point design? Does the equity-indexed return feature that specifies a point-to-point design meet the definition of a derivative and require separate accounting under paragraph 12 of Statement 133?

   2. b. A periodic ratchet design?

This question comprises a series of related questions dealing with the accounting for options embedded in EIA products whose terms specify a periodic ratchet design (discussed in the background section below as an option to lock in the yearly investment results or a floor return). In most product designs, the notional amount, participation rate, cap rate, and strike price of the forward-starting options are not known until the subsequent policy anniversary dates are reached. Therefore, do those forward-starting options meet the definition of a derivative instrument in Statement 133? If the forward-starting options are derivatives and require valuation at the policy inception and throughout the life of the contract, what amounts should be used for the unknown factors impacting the options' fair values? If the forward-starting options are not subject to Statement 133, should only the first individual, currently operable option be valued?

BACKGROUND

An EIA is a deferred fixed annuity contract with a guaranteed minimum interest rate plus a contingent return based on some internal or external equity index, such as the S&P 500. The guaranteed contract value is generally designed to meet certain regulatory requirements such that the contract holder receives no less than 90 percent of the initial deposit, compounded annually at 3 percent, which establishes a floor value for the contract.

EIAs typically have minimal mortality risk and are therefore classified as investment contracts under FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. EIAs often do not have specified maturity dates; therefore, the contracts remain in the deferral (accumulation) phase until the customer either surrenders the contract or elects annuitization.¹

Customers typically can surrender the contract at any point in time, at which time they receive their account value, as specified in the contract, less any applicable surrender charges. The account value is defined in the policy as generally the greater of the policyholder's initial investment plus the equity-indexed return or a guaranteed floor amount (calculated as the policyholder's initial investment plus a specified annual percentage return).

There are two basic designs for EIA products:

• The periodic ratchet design, where in the annual version, the customer receives the greater of the appreciation in the equity index during a series of one-year periods (ending on each policy anniversary date) or the guaranteed minimum fixed rate of return over that period.

• The point-to-point design, where the customer receives the greater of the appreciation in the equity index during a specified period (for example, five or seven years, starting on the policy issue date) or the guaranteed minimum fixed rate of return over that period.

For many products of either design, the contract holder receives only a portion of the appreciation in the S&P 500 (or other index, as applicable) during the specified period (a "participation rate") and/or has an upper limit on the amount of appreciation that will be credited during any period (a "cap rate"). For the annual ratchet design, the prospective participation and cap rates for each one-year period are often at the discretion of the issuer, and may be reset on future policy anniversary dates, subject to contractual guarantees. Flexibility on the part of the issuer to establish new cap and participation rates, coupled with uncertainty around the customer's account value (which establishes the notional amount of the option) and strike price (which is determined by the level of the index on subsequent anniversary dates) make several of the terms of the forward-starting options unknown at the annuity contract's inception. However, those flexible terms can be viewed as a bundle of options.

Paragraph 185 of Statement 133 discusses generic equity-indexed notes, and paragraph 200, as amended, discusses equity-indexed annuities, noting that "…if the product were an equity-index-based interest annuity (rather than a traditional variable annuity), the investment component would contain an embedded derivative (the equity-index-based derivative) that meets all the requirements of paragraph 12 of this Statement for separate accounting…."

RESPONSE

Question 1

Industry practice has evolved to require that the holder record its investment based upon EITF Issue No. 96-12, "Recognition of Interest Income and Balance Sheet Classification of Structured Notes." This guidance does not result in a fair value presentation of the asset. As a result, the scope exception in Statement 133 for contracts carried at fair value with changes in value recorded in earnings does not apply. Therefore, holders of equity-indexed annuities that are preparing financial statements must separate the equity-indexed return portion of the contract, apply Statement 133, and follow the guidance in Question 2.

Question 2(a)

From an insurer’s perspective, the option component of an EIA product that specifies a point-to-point design meets the definition of a derivative and requires separate accounting under paragraph 12 of Statement 133 unless a fair value election is made pursuant to Statement 155. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Statement 155 does not apply to hybrid financial instruments that are described in paragraph 8 of FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, which include insurance contracts as discussed in FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, and Statement 97, other than financial guarantees and investment contracts. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) This guidance also applies to the policyholder because it does not qualify for a scope exclusion as stated above.

Question (2b)

For the periodic ratchet design product, the insurer has committed to issue a series of options on the index over the duration of the contract. All of those forward-starting options meet the Statement 133 definition of a derivative and require separate accounting under paragraph 12 of Statement 133 from the perspective of the insurer unless a fair value election is made pursuant to Statement 155. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Statement 155 does not apply to hybrid financial instruments that are described in paragraph 8 of FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, which include insurance contracts as discussed in Statements 60 and 97, other than financial guarantees and investment contracts. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) Statement 133 Implementation Issue No. B15, “Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument,” requires that the embedded feature with multiple components must be separately accounted for as one compound embedded derivative. In valuing those options, there are three main components to be considered:

1. Future S&P 500 index values will need to be estimated to determine both the future notional amounts at each ratchet date and the future strike prices of the future forward starting options.

2. Future annual cap and participation rates, which are often at the discretion of the contract issuer, subject to contractually specified minimums and maximums, will need to be estimated.

3. Non-economic factors related to policyholder-driven developments such as policy surrenders or mortality.

Given the three components, the forward starting options should be valued using the expected future terms (that is, index values and cap and participation rates), but in no event should the value be less than the minimum amounts contractually agreed upon in the contract. Expected terms represent management's estimates of cap and participation rates, rather than contractually guaranteed amounts. This guidance is supported by an analogy to the general guidance in Statement 133 Implementation Issue No. A6, "Notional Amount of Commodity Contracts." The estimated value reflects the notion that the contract provides for a level of equity-indexed return that can be estimated even when considering the issuer's options to adjust the policyholder's participation and cap rates. In subsequent periods when the terms of the forward-starting options become known, the actual terms should be substituted for the expected terms for purposes of valuation.

This guidance also applies to the policyholder (provided it prepares GAAP-based financial statements) since the contracts do not qualify for a scope exception.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.

Pages in this Section: