FASB Cash Flow Hedges Hedging Voluntary Increases in Interest Credited on an Insurance Contract Liability

FASB: Cash Flow Hedges: Hedging Voluntary Increases in Interest Credited on an Insurance Contract Liability

Derivatives Implementation Group

Statement 133 Implementation Issue No. G4

Title: Cash Flow Hedges: Hedging Voluntary Increases in Interest Credited on an Insurance Contract Liability
Paragraph references:
21(a)(2)(c), 29(b), 463
Date cleared by Board: July 28, 1999
(Revised September 25, 2000)

QUESTION

Can an insurance company (the issuer) qualify to apply cash flow hedge accounting under Statement 133 if it is hedging the possibility that it may need to voluntarily increase the interest rate used to credit interest on certain contract liabilities?

BACKGROUND

Some insurance contracts (for example, certain whole life policies, universal life policies, repetitive premium variable annuities, and single premium deferred annuities) contain an option allowing the policyholder to put (surrender) the contract to the issuer at contract value. Those contracts, which are not carried at fair value by the issuer, bear interest at a fixed rate.

The issuer is exposed to the risk that an increase in market interest rates will cause the policyholder to exercise its put. Accordingly, the issuer may voluntarily increase the contractual rate on the contract to forestall the policyholder's exercising its put. As a result, the issuer wants to hedge the risk of an increase in future interest cash flows due to an increase in interest rates associated with either of the following two circumstances: (1) the issuer's voluntary increase in the contractual interest rate on existing fixed-rate contracts or (2) the policyholder's exercise of its put option and the insurance company's issuance of new higher fixed-rate contracts to new policyholders. To hedge the risk of having to pay higher interest rates in the future, the issuer chooses to purchase an option on interest rates.

RESPONSE

Yes. Statement 133 would permit an insurance company to qualify for cash flow hedge accounting if it is hedging the possibility that it may need to voluntarily increase the interest rate used to credit interest on certain contract liabilities. Under the Statement's cash flow hedging model, the hedged forecasted transactions would be the future interest credited on its then existing contracts. The hedged forecasted transactions for each interest crediting date could include both the future interest credited on older contracts whose contractual rate has been voluntarily increased and the future interest credited on new contracts with the current higher interest rate issued to new policyholders (which will have replaced older contracts that have been surrendered). In defining the forecasted transactions, the insurance company must ensure that the hedged interest relates to a volume of contracts whose existence at the future interest crediting dates is probable.

In designating the hedged risk, the insurance company must decide whether it is hedging the total variability in those future interest payments or just the variability in the future interest attributable to changes in the designated benchmark interest rate. Although the occurrence of the forecasted transactions (that is, the crediting of interest) must be probable, the cash flow hedging model does not require that it be probable that any variability in the hedged transaction will actually occur-that is, in a cash flow hedge, the variability in future cash flows must be a possibility, but not necessarily a probability. However, the hedging derivative must be highly effective at achieving offsetting cash flows attributable to the hedged risk whenever that variability in future interest does occur.

An insurance company may find it difficult to identify a derivative that will qualify for cash flow hedge accounting, which requires that the hedging relationship be expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk. Because the decision to adjust the interest rate to match the change in interest rates is at the discretion of the insurance company, it may be difficult to conclude that the changes in the hedged interest payments attributable to the hedged risk will be sufficiently correlated with changes in the cash flows of the hedging derivative.

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.