FASB Embedded Derivatives Application of Statement 97 and Statement 133 to Equity-Indexed Annuity Contracts

FASB: Embedded Derivatives: Application of Statement 97 and Statement 133 to Equity-Indexed Annuity Contracts

Derivatives Implementation Group

Statement 133 Implementation Issue No. B30

Title: Embedded Derivatives: Application of Statement 97 and Statement 133 to Equity-Indexed Annuity Contracts
Paragraph references: 10, 12, 16, 17, 18, 200
Date cleared by Board: March 14, 2001
Date latest revision posted to website: June 16, 2006
Affected by: FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised June 16, 2006)

QUESTIONS

From the insurer's perspective, how does 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, affect Statement 133 requirements when an embedded derivative in an equity-indexed annuity (EIA) contract is required to be separated and accounted for as a derivative?

With respect to EIA contracts that have embedded derivatives, how should an issuer apply the guidance in paragraph 16 of Statement 133 that requires that the host contract be accounted for based on generally accepted accounting principles (GAAP) applicable to instruments of that type? Is the host contract a debt instrument that is subject to financial instrument accounting, and, if so, at what rate and to what maturity date would the debt host be accreted?

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 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 Statement 97. Paragraph 15 of Statement 97 states that "amounts received as payments for such contracts shall not be reported as revenues. Payments received by the insurance enterprise shall be reported as liabilities and accounted for in a manner consistent with the accounting for interest-bearing or other financial instruments."1

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1Practice has developed referring to the insurance company's accounting for its investment contract liabilities as being "Statement 97 accounting," including references to the "Statement 97 account value" and the retrospective deposit method. Those practice-developed references are used in this Issue for convenience.

EIA contracts 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.2 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).

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2This refers to the policyholder receiving periodic payments under various payment options, including their remaining life or for a term-certain period.

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 during the specified period (a "participation rate") and/or has an upper limit on the amount of appreciation that they will be credited during any period (a "cap rate"). For the annual ratchet design, the 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 implied option-strike price (which is determined by the level of the index on subsequent anniversary dates) would require the issuer to make several assumptions in valuing the forward-starting options at the annuity contract's inception and throughout the term of the contract.

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.” (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.)

To illustrate the host contract and embedded derivative valuation issues, consider the following EIA point-to-point design example, which includes a minimum account value stated as a return on the principal amount of the annuity:

Initial premium

$100,000

Participation rate

100% participation in the equity returns, credited at the end of the contract term

Contract term

3 years

Minimum account value at the end of the contract term

$103,030 ($100,000 compounded annually at the minimum accumulation rate of 1% per year)

Implied option strike price

Current S&P 500 × 1.0303

Embedded option valuation

Monte Carlo-Option model calculated value at $20,000 at inception

At inception, the insurer has received $100,000, recorded as follows:

Cash

100,000

     Embedded derivative

 

20,000

     Host zero-coupon debt obligation

 

80,000

In the above journal entry, Statement 133 Implementation Issue No. B6, "Allocating the Basis of a Hybrid Instrument to the Host Contract and the Embedded Derivative," is followed: the embedded derivative is recorded at fair value, and the carrying value assigned to the host contract is the difference between the proceeds received from the issuance of the hybrid instrument and the fair value of the embedded derivative. Paragraph 16 states that "if an embedded derivative instrument is separated from its host contract, the host contract shall be accounted for based on GAAP applicable to instruments of that type that do not contain embedded derivative instruments." Accordingly, in this example, the host contract would be accreted annually to the minimum account value at the end of the contract ($103,030) using an effective yield method (in this example, the implicit interest rate underlying the host is 8.8 percent).

Consider the following scenarios at the end of year 1.

Scenario 1 — S&P index increases 15%. The components are valued as follows:

 

Embedded derivative

$28,968

 

(Assumed)

 

Accreted value of host contract


87,032

 

($80,000 × 1.088)

 

Value of hybrid instrument

$116,000
_________

 

 

Statement 97 value (in absence of Statement 133):


$115,000

 

($100,000 at 15% return)

Note that because of the market's implicit valuation of future volatility in the S&P index, as reflected in the fair value of the embedded derivative, the combined value of the embedded derivative and the host contract is greater than that which would be calculated for the contract as a whole under Statement 97. The proper accounting in Scenario 1 is to record a total liability of $116,000, the Statement 133 hybrid contract value.

Scenario 2 — S&P Index has declined. The components are valued as follows:

 

Embedded derivative

$ 7,968

 

 

Accreted value of host contract

87,032

 

 

Value of hybrid instrument

$95,000
________

 

Statement 97 value (in absence of Statement 133):


$101,000

($100,000 at 1% return)

In Scenario 2, how should the insurer interpret the requirements of Statement 97 and Statement 133? The above components already reflect the application of paragraph 12 (the derivative is measured at fair value) and paragraph 16 (the host contract is accreted like a debt instrument). However, prior to adoption of Statement 133, the accreted minimum liability to be reported under Statement 97 would have been $101,000. Should a loss of $6,000 be recorded to bring the total liability balance up to the $101,000 Statement 97 value?

RESPONSE

From the issuer's (insurer's) perspective, an EIA liability comprises a fixed annuity host and an embedded written equity option. The embedded equity option should be accounted for under the provisions of Statement 133. The fixed annuity component should be accounted for under the provisions of Statement 97 that require debt instrument accounting. In this example, the host contract is a discounted debt instrument that should be accreted using the effective yield method to its minimum account value at the projected maturity or termination date.

Upon receipt of consideration for an EIA contract, the issuing company should allocate a portion of the consideration to the embedded written option, as described in Implementation Issue B6, using the "with and without" method (that is, the fair value of the option is assigned to the embedded derivative). The remainder of the consideration should be assigned to a fixed annuity host contract. Both credited interest and changes in the fair value of the embedded equity option would be recognized in earnings. Accordingly, in this example, the host contract would be accreted annually to the minimum account value at the end of the contract ($103,030) using an effective yield method (in this example, the implicit interest rate underlying the host is 8.8 percent).

As a result, in Scenario 2 above, the EIA liability would be recorded at $95,000 at the end of year 1. A separate calculation of a Statement 97 account value is no longer required because the derivative is carried at fair value in accordance with Statement 133 and the host contract is recorded following the GAAP accounting guidance for a Statement 97 investment contract. Therefore, the insurer should ignore any minimum liability that exceeds the sum of the embedded derivative separately accounted for and the host debt instrument that is accounted for applying the debt model.

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.