FASB Embedded Derivatives Identification of the Host Contract in a Nontraditional Variable Annuity Contract

FASB: Embedded Derivatives: Identification of the Host Contract in a Nontraditional Variable Annuity Contract

Derivatives Implementation Group

Statement 133 Implementation Issue No. B8

Title: Embedded Derivatives: Identification of the Host Contract in a Nontraditional Variable Annuity Contract
Paragraph references: 12, 16, 61(e), 200
Date cleared by Board: July 28, 1999
Affected by: FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities
(Revised September 25, 2000)

QUESTION

How does one determine the host contract in a nontraditional variable annuity contract (a hybrid instrument)?

BACKGROUND

While traditional variable annuity contracts represent the majority of contracts sold today by life insurance and other enterprises, those enterprises have also developed a wide range of variable annuity contracts with nontraditional features. Nontraditional features of traditional variable annuity contracts result in a sharing of investment risk between the issuer and the holder. Nontraditional variable annuity contracts provide for some sort of minimum guarantee of the account value at a specified date. This minimum guarantee may be guaranteed through a minimum accumulation benefit or a guaranteed account value floor. For example, the floor guarantee might be that, at a specified anniversary date, the contract holder will be credited with the greater of (1) the account value, as determined by the separate account assets, or (2) all deposits that are made, plus three percent interest compounded annually.

While these nontraditional variable annuity contracts have distinguishing features, they possess a common characteristic: the investment risk associated with the assets backing the contract is shared by the issuer and the policyholder. That is, in contrast to traditional variable annuity contracts, the investment risk is, by virtue of the nontraditional product features, allocated between the two parties and not borne entirely by only one of the parties (the holder in the case of a traditional variable annuity contract).

Paragraphs 12 and 16 of Statement 133 require that, in certain circumstances, an embedded derivative is to be accounted for separately from the host contract as a derivative instrument. An example illustrating the application of paragraph 12 to insurance contracts is provided in paragraph 200 of Statement 133. Paragraph 200, second bullet point entitled "Investment Component," states in part:

     The policyholder directs certain premium investments in the investment account that includes equities, bonds, or both, which are held in separate accounts that are distinct from the insurer's general account assets. This component is not considered a derivative because of the unique attributes of traditional variable annuity contracts issued by insurance companies.

RESPONSE

The FASB staff guidance presented in Statement 133 Implementation Issue B7 indicates that a traditional variable annuity (as described in that Issue) contains no embedded derivatives that warrant separate accounting under Statement 133 even though the insurer, rather than the policyholder, actually owns the assets.

The host contract in a nontraditional variable annuity contract would be considered the traditional variable annuity that, as described in Issue B7, does not contain an embedded derivative that warrants separate accounting. Nontraditional features (such as a guaranteed investment return through a minimum accumulation benefits or a guaranteed account value floor) would be considered embedded derivatives subject to the requirements of Statement 133. Paragraph 12 of Statement 133, states, in part, that:

     Contracts that do not in their entirety meet the definition of a derivative instrument such as … insurance policies… may contain "embedded" derivative instruments-implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument. The effect of embedding a derivative instrument in another type of contract ("the host contract") is that some or all of the cash flows or other exchanges that otherwise would be required by the host contract, whether unconditional or contingent upon the occurrence of a specified event, will be modified based on one or more underlyings. [Emphasis added; reference omitted.]

The economic characteristics and risks of the investment guarantee and those of the traditional variable annuity contract would typically be considered to be not clearly and closely related.

In determining the accounting for other seemingly similar structures, it would be inappropriate to analogize to the above guidance due to the unique attributes of nontraditional variable annuity contracts and the fact that the above guidance, which is based on Issue B7, can be viewed as an exception for nontraditional variable annuity contracts issued by insurance companies.

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.