© 2017 National Association of Insurance Commissioners 1

Date: 7/17/17

Conference Call

VARIABLE ANNUITIES ISSUES (E) WORKING GROUP Thursday, July 20, 2017

11:00 a.m. ET / 10:00 a.m. CT / 9:00 a.m. MT / 8:00 a.m. PT

ROLL CALL

Iowa, Chair Missouri California Nebraska Connecticut New Jersey Michigan New York Minnesota Ohio

AGENDA

1. Adopt May 11 Interim Minutes—Jim Armstrong/Mike Yanacheak (IA) Attachment One 2. Quantitative Impact Study (QIS) II Update— Jim Armstrong/Mike Yanacheak (IA)

• Presentation from Oliver Wyman Attachment Two 3. Consider Referral from the SAPWG & Proposed Response— Jim Armstrong (IA)

• Original Referral Attachment Three • Draft Proposal from Chair Attachment Four • Comment Letter from the ACLI Attachment Five

4. Any other Matters Brought Before the Working Group— Jim Armstrong/Mike Yanacheak (IA)

5. Adjournment

© 2017 National Association of Insurance Commissioners 1

Draft: 5/30/17

Variable Annuities Issues (E) Working Group Conference Call May 11, 2017

The Variable Annuities Issues (E) Working Group of the Financial Condition (E) Committee met via conference call May 11, 2017. The following Working Group members participated: Mike Yanacheak, Chair (IA); Kim Hudson (CA); Wanchin Chou (CT); Judy Weaver (MI); Fred Andersen and John Robinson (MN); William Leung (MO); Rhonda Ahrens (NE); Felix Schirripa (NJ); William Carmello (NY); and Peter Weber and Dale Bruggeman (OH).

1. Heard a Presentation from Oliver Wyman

Kai Talarek (Oliver Wyman) and Aaron Sarfatti (Oliver Wyman) provided the Working Group with an update on the Quantitative Impact Study (QIS) II (Attachment 1), which officially began on Feb. 21. Mr. Talarek stated that he was happy to report that data from cycle I, which is focused on stochastic modeling, had been received, and the project is currently on track with the original proposed plan. He stated they are beginning to work on cycle II of QISII, which will be focused on the standard scenario. He stated once cycle II is completed, they will be in a position to assess the overall impact of the framework, which can be used to help state insurance regulators make adjustments before cycle III is performed and eventually lead to a final recommended proposed framework.

Mr. Talarek summarized the other future open conference calls on the status of the QISII work. He indicated that the June conference call would be focused on the outputs of testing cycle I, as well as any regulator guidance, and an update on testing cycle II. Mr. Talarek stated that in mid-July, they will begin discussions on testing cycle III, as well as any regulator guidance and what has been learned from testing cycle I and cycle II.

Mr. Talarek provided a summary of each of the four topics that will be focused on during cycle II. The first topic will be revenue sharing, which is currently limited. He stated the goal in cycle II will be to align the proposal with actual company experience. This will look at different variations of existing guidance. One will be to have smaller prescribed reductions in revenue sharing based upon the robustness of the fee streams and reduction of the total fund fees that coincides.

Mr. Talarek stated the second topic will be behavioral assumptions. He stated they would look to make modifications to the 2016 proposed framework based upon actual company experience to ensure that the resulting prescriptions are conservative but rooted in actual company data. He stated that part of the proposed framework is only to become binding where appropriate and that there will be a need to develop governance that helps to achieve this objective.

Mr. Talarek stated the third topic will be the diversification benefit. He described how the current calculation imposes a seriatim calculation to deny any diversification benefit. He stated there are some real benefits that accrue to the books, and they have a framework that allows such to be used, but at the same time limits the benefits. He noted that the cycle II is attempting to find the correct limit.

Mr. Talarek stated the forth item is a study of equity calibration criteria. Mr. Sarfatti noted that based upon numerous inputs, calibration criteria linked to interest rates do not need to be tested, as data is not sufficient to demonstrate direct historical relationships between equity and interest rates. He noted, however, that cycle II will test criteria with a lower mean return and/or higher volatility.

Mr. Sarfatti noted that with respect to the purpose of standard scenario, the guidance they are using suggests that anything that is determined by company-defined modeling choices is to be governed. The purpose is not to add stringency to the capital markets scenarios.

Mr. Sarfatti noted that for behavioral assumptions, the basic question is what assumptions should be tested and whether the company experience can influence such assumptions through a hybrid governance model. With respect to the hybrid governance model, the idea is to see if there is a way to blend the company data to be used similar to how it can be blended under principles-based reserving (PBR). This governance model is currently in the process of development where Oliver Wyman and the industry are working together in a joint collaboration effort. Chanho Lee (NAIC) asked what the credibility weighting would consist of and its basis. Mr. Sarfatti responded they are studying some alternatives that could be used as a basis for the ideas to be included in the hybrid governance model. However, he noted there may be some areas where a different approach is necessary given the lack of industry data.

Attachment One

© 2017 National Association of Insurance Commissioners 2

Mr. Sarfatti noted that with respect to revenue sharing, this topic has not received much focus but that next steps include the industry collection of historical experience of revenue sharing with a focus on periods of stress. Additionally, he said that this will be supplemented with other information and that cycle II will test both industry and Oliver Wyman formulations of revenue-sharing restrictions. Mr. Robinson asked if it was in scope to suggest that policyholder behavior be revised every three years. Mr. Sarfatti responded that this was something they suggested last August in their proposal, and they have seen no reason to amend this recommendation. Having no further business, the Variable Annuities Issues (E) Working Group adjourned. W:\National Meetings\2017\Spring\Cmte\E\VAIWG\3-14-17VAIWGmin.docx

Attachment One

© Oliver Wyman

JULY 20, 2017

NAIC VA ISSUES WORKING GROUP QIS II – PUBLIC CALL #3

Attachment Two

CONFIDENTIALITY Our clients’ industries are extremely competitive, and the maintenance of confidentiality with respect to our clients’ plans and data is critical. Oliver Wyman rigorously applies internal confidentiality practices to protect the confidentiality of all client information.

Similarly, our industry is very competitive. We view our approaches and insights as proprietary and therefore look to our clients to protect our interests in our proposals, presentations, methodologies and analytical techniques. Under no circumstances should this material be shared with any third party without the prior written consent of Oliver Wyman.

© Oliver Wyman

Attachment Two

2 © Oliver Wyman

• Recap timeline for QIS II and update on progress

• Outline conclusions from Cycle 1 testing on CTE-related recommendations

• Summarize focus areas for Testing Cycle 3

Agenda Attachment Two

3 © Oliver Wyman

Cycle 2 submissions are delayed by approximately two weeks, though we still anticipate concluding Cycle 3 testing by mid-September of this year

Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.

QIS II timeline

February 21, 2017 Final specifications for Test Cycle 1 released; QIS II begins

March 3, 2017 Deadline for feedback on templates and WG participation indication

March 31, 2017 Discussions for Test Cycle 2 specifications begin

April 28, 2017 Submission deadline for Test Cycle 1 results; Test Cycle 1 ends

June 9, 2017 Discussions for Test Cycle 3 specifications begin

July 21, 2017 Submission deadline for Test Cycle 2 results; Test Cycle 2 ends

September 15, 2017 Submission deadline for Test Cycle 3 results; Test Cycle 3 ends

Discussions with NAIC, regulators, and industry on QIS II conclusions and recommended framework revisions to be implemented

Originally planned to be July 7, 2017; participants have experienced delays in submission, driven by implementation time for new

Standard Scenario behavioral assumptions recommended in 2016

Attachment Two

4 © Oliver Wyman

Cycle 1 results were presented to QIS participants on June 29 and addressed most of Oliver Wyman’s CTE-related recommendations from 2016

Changes tested Current framework Tested framework

Remove Working Reserve and allow simplified reflection of hedging

• Statement value of hedge assets need to beprojected in liability projection

• Deficiency triggered in each scenario when assetstatement value dips below “Working Reserve”

• Unrealized hedge losses may trigger deficiency

• Working Reserve is removed

• Reserve calculated to ensure adequacy of assetsto meet all realized cash outflows at CTE 70 level

• Statement value of hedge assets do not need to be projected – only settlement cash flows

Remove requirement to run off currently-held hedge assets to maturity

• Currently-held hedge assets need to be run offwithout allowance for rebalancing

• Currently-held hedge assets may be liquidated inthe first projection period – though not required; ifliquidated, rest of projection is unhedged

Allow higher credit for liability projections with modeled CDHS

• “E factor” limited to 70% for all companies, and to30% if not reflecting hedging explicitly

• 100% “E factor” allowed, as hedge ineffectivenessis often already reflected in CDHS modeling

• Impact of two separate “E factors” were presented

Align RBC and AG 43; calculate C3 as difference between a tail CTE and reserves

• C3 charge is calculated as arithmetic differencebetween:– TAR, calculated under C3 Phase II– Reserve, calculated under AG 43

• C3 = 65% of [X] multiplied by difference between:– “CTE High” under revised AG 43– CTE 70, also under revised AG 43

• Impact of several different combinations of “CTEHigh” and [X] scalars were tested

Harmonize stochastic scenarios and general account modeling

• Calibration criteria set for US diversified equityfund returns, but not for other risk factors

• Standardized, generated via the Academy ESG;volatility-control funds use company own modeling

• General account modeling aligned to VM-20

Attachment Two

5 © Oliver Wyman

• Oliver Wyman’s 2016 recommendations sought to address four of the five motivations for captive use– Mitigate non-economic volatility in statutory capital ratios– Align market risk profiles of funding requirements and insurer target hedge program– Mitigate funding requirement in downturn scenarios, net of the hedging strategy– Increase DTA admissibility – though this was not explicitly tested in QIS II

• Cycle 1 results indicate that recommendations appear effective in reducing motivations for captive use– Reduces non-economic volatility in statutory capital ratios for most companies– Reduces total balance sheet volatility for companies with economically-focused hedge programs– Mitigates capital buffer needed to manage multiples of the unstable C3 charge, particularly in stress

• Recommendations also align with the set of previously agreed-upon framework enhancement objectives– Ensures funding requirement robustness: improves risk-sensitivity and overall “signal value” of RBC ratio

by removing non-economic volatility and dis-incentivizing voluntary reserves– Promotes comparability: uses harmonized scenarios and aligns with VM-20 in general account modeling

• Choice of “CTE High” and scalar for calculating C3 affects total funding requirements, but not effectivenessof revision on reducing total balance sheet volatility and non-economic statutory capital ratio volatility

• Accordingly, we do not anticipating revising these CTE-related recommendations that were tested, thoughwe will continue to refine specific parameters therein – e.g., the “CTE High” and scalar for calculating C3

Results from Cycle 1 affirmed the effectiveness of most of Oliver Wyman’s 2016 recommendations on the CTE calculation

Attachment Two

6 © Oliver Wyman

The CTE-related recommendations from 2016 materially reduce four of the five cited motivations for captive usage

Motivation Effectiveness of 2016 Oliver Wyman CTE-related recommendations

1 Mitigate non-economic volatility in statutory capital ratios

• More stable C3 charge calculation materially reduces the volatility in thedenominator of statutory capital ratios – and thus the ratio itself

2 Align market risk profiles of the funding requirements and the insurer target hedge program

• Revised framework retains “book value” liability valuation properties ofcurrent framework for unhedged exposures

• Allowance for 100% “E factor” allows fair-value based full hedging to turnstatutory reserve into effectively a fair value reserve, thereby fully aligningasset and liability market sensitivities in most IR conditions

• In high IR conditions, however, hedge accounting is needed to align asset-liability sensitivities fully as reserves are bound by the CSV floor

3 Mitigate funding requirement in downturn scenarios (net of the hedging strategy)

• Greater C3 stability reduces need to hold excess capital buffer to fundmultiples of an unstable C3 charge that has the potential to balloon – orotherwise change in unintuitive manners – in market stress

4 Consolidate exposures from across legal entities

• Not addressed by Oliver Wyman’s recommendations

5 DTA admissibility • Not tested in QIS II, but expected to be fully effective – if implemented –given the direct nature of this motivation for using captives

H

M

H

L

?

H High effectiveness M Medium effectiveness L Low effectiveness

Attachment Two

7 © Oliver Wyman

The CTE-related recommendations from 2016 also adhere to most of the framework enhancement objectives previously discussed

Enhancement objectives Effectiveness of 2016 Oliver Wyman CTE-related recommendations

Framework requirements

Ensure robustness of funding requirements

• Improves risk sensitivity and signal value of the RBC ratio by disallowing voluntary reserves to offset C3 charge dollar-for-dollar

Promote sound risk management

• Reduces total balance sheet volatility – both in surplus and required capital – for companies with extensive, fair value-focused hedge programs

• However, under 2016YE market conditions, hedging still increases industry-aggregate reserve and TAR levels as hedging is materially costlier than CTE 70 under current equity calibration criteria

Promote comparability • Revised framework uses harmonized scenarios for separate account returns and aligns more closely with VM-20 in general account modeling

Design choices

Preserve current statutory construct where feasible

• Current AG 43 statutory construct largely retained; proposed changes in revised framework apply only to select elements of the overall projection

• C3 change deviates materially from C3 Phase II, but uses AG 43 chassis

Minimize implementation complexity

• As revised framework retains much of the AG 43 calculation construct, implementation complexity should be modest – though TBD based on more detailed company feedback

H High effectiveness M Medium effectiveness L Low effectiveness

M

M

H

H

?

Attachment Two

8 © Oliver Wyman

We are currently in the midst of Testing Cycle 2, which evaluates five topics Testing Cycle 2 began in mid-May and will conclude in late July

Topic Purpose

1 Standard Scenario market paths

• Evaluate range of Standard Scenario market paths – i.e., drop and recovery rates – that would produce reserves close to CTE 70 level under same behavioral assumptions

2 Standard Scenario behavior assumptions

• Verify and identify revisions to August 2016 prescriptions using participant experience data

• Test impact of Standard Scenario behavioral assumptions in conjunction with other proposed Standard Scenario changes

3 Standard Scenario Diversification Benefit Adjustment

• Assess, at the model point level, prevalence of Standard Scenario amounts that: – Differ significantly from the results using companies’ Prudent Estimate assumptions – Cannot be justified by experience or regulatory principles

4 Reflection of revenue sharing

• Evaluate impact of alternative reflection of revenue sharing on CTE and Standard Scenario

• Alternative reflections of revenue sharing tested include: – Smaller prescribed reductions to non-guaranteed revenue sharing – Reduction in total fund fees coincident with reduction in revenue sharing

5 Equity calibration criteria

• Test impact of alternative equity calibration criteria that are invariant to starting market conditions but different from current criteria

Attachment Two

9 © Oliver Wyman

We expect Cycle 3 to require fewer calculations than prior cycles and test only parametric changes to Cycle 1 and Cycle 2 specifications

Test from prior Cycle Parametric changes tested in Cycle 3

Revised CTE calculation, with alternative revenue sharing reflection

• Current AG 43 equity calibration criteria – with standardized scenarios provided by OW

• Alternative equity calibration criteria – with standardized scenarios provided by OW

• Current AG 43 revenue sharing reflection methodology

• Parametric changes to alternative revenue sharing reflection methodology tested in Cycle 2

Revised Standard Scenario calculation, with company behavior assumptions

• Small number of deterministic market paths tested – with scenarios provided by OW – withselect parametric changes, if necessary, to those tested in Cycle 2

• Continue testing the three different methods for hedge reflection as in Cycle 2– One-year reflection of CDHS, to be evaluated on a standalone basis– Full CDHS (similar to “best-efforts” CTE) and no CDHS (similar to “adjusted” CTE), to be

evaluated using the same “E factor” as revised CTE

Revised Standard Scenario calculation, with prescribed behavior assumptions

Attachment Two

QUALIFICATIONS, ASSUMPTIONS AND LIMITING

CONDITIONS

This report is for the exclusive use of the Oliver Wyman client named herein. This report is not intended for general circulation or publication, nor is it to be reproduced, quoted or distributed for any purpose without the prior written permission of Oliver Wyman. There are no third party beneficiaries with respect to this report, and Oliver Wyman does not accept any liability to any third party.

Information furnished by others, upon which all or portions of this report are based, is believed to be reliable but has not been independently verified, unless otherwise expressly indicated. Public information and industry and statistical data are from sources we deem to be reliable; however, we make no representation as to the accuracy or completeness of such information. The findings contained in this report may contain predictions based on current data and historical trends. Any such predictions are subject to inherent risks and uncertainties. Oliver Wyman accepts no responsibility for actual results or future events.

The opinions expressed in this report are valid only for the purpose stated herein and as of the date of this report. No obligation is assumed to revise this report to reflect changes, events or conditions, which occur subsequent to the date hereof.

All decisions in connection with the implementation or use of advice or recommendations contained in this report are the sole responsibility of the client. This report does not represent investment advice nor does it provide an opinion regarding the fairness of any transaction to any and all parties.

Attachment Two

To: Jim Armstrong, Chair of the Variable Annuities Issues (E) Working Group

From: Dale Bruggeman, Chair of the Statutory Accounting Principles (E) Working Group

Re: Special Accounting for Limited Derivatives – Accounting Guidance for Terminated Hedges

Date: April 19, 2017

The purpose of this memo is to request input from the Variable Annuities Issues (E) Working Group on the future

benefit of effective hedges offsetting a variable annuity guarantee reserve, if any, once the effective hedging

program has been discontinued or becomes ineffective.

Pursuant to their 2017 charge, the Statutory Accounting Principles (E) Working Group is considering special

accounting guidance for limited derivative contracts that hedge interest rate risk for certain variable annuity

reserves. This guidance currently proposes to allow reporting entities to offset fair value fluctuations from

hedging instruments as follows:

Fair value fluctuations of the hedging instrument, as part of a highly-effective, qualifying hedge, that

directly offsets the current-period change in the hedged item (variable annuity reserve) will be recognized

concurrently with the reserve change, allowing for an immediate offsetting impact in the financials.

After recognizing the fair value fluctuations that directly offset the reserve change, any remaining fair

value fluctuations of the hedging instrument would be recognized as a deferred asset or deferred liability.

(Unrecognized fair value losses would be reported as deferred assets, and unrecognized fair value gains

would be reported as deferred liabilities.) These deferred assets and deferred liabilities will be amortized

using a straight-line method into realized losses and gains. Although the maximum amortization period is

still being debated, the current proposal for the amortization timeframe is to equal the Macaulay duration

of the guarantee benefit cash flows based on the AG 43 Standard Scenario, with a maximum allowable

timeframe. This approach intends to match the future expected benefits from the effective hedge to the

reserve liability as best as possible and remove non-economic accounting volatility from the financials.

The issue currently being debated is whether deferred assets (unrecognized losses) and deferred liabilities

(unrecognized gains) reflected under the special accounting provision should continue to be permitted to be

recognized on the balance sheet, and amortized into gains/losses, when the overall derivative hedging program

has been terminated or no longer qualifies under the guidance (e.g., the program becomes ineffective). To be

clear, under the proposed guidance, individual hedging instruments of a qualifying effective hedge could be

terminated without impacting the amortization of deferred assets and deferred liabilities. The inquiry in this

referral is addressing the broader question of termination / non-qualification of the overall hedging strategy.

As a simple example:

From January 2019 through December 2021, the reporting entity engaged in derivative activity to hedge

guarantee reserve liabilities in accordance with the established special accounting provisions. In

aggregate, this activity resulted in $300 million in losses from the fair value fluctuations of the hedging

instruments. Of this $300 million, $120 million was recognized as direct offsets to current-period reserve

liability changes, and $180 million was recognized as deferred assets. Based on the Macaulay duration

calculation, the deferred assets were scheduled for amortization into realized losses over a 10-year

timeframe when initially recognized. (See the charts below for information on the recognition /

amortization of the deferred assets.)

Attachment Three

2

Recognition of Deferred Asset

Amortization Schedule of

Deferred Assets

(10-Year Amortization - Only

limited years shown.)

Reporting

Period

Derivative

FV Losses

Recognized

Loss**

Deferred

Asset

2020 2021 2022 2023 2024

2019 (142) 52 90 9 9 9 9 9

2020 (100) 40 60 - 6 6 6 6

2021 (58) 28 30 - - 3 3 3

Total 300 120 180 9 15 18 18 18

** The loss recognized is the portion of the fair value fluctuations that directly offsets current period

changes in the hedged item. After recognizing the fair value fluctuations that directly offset the

reserve change, any remaining fair value fluctuations are recognized as a deferred asset.

Deferred Asset at Time of Hedge Termination / Ineffectiveness

Original

Deferred Asset

Recognized

Amortization

Recognized

Through 2021

Deferred Asset at

time of Termination /

Ineffectiveness

2019 90 18 72

2020 60 6 54

2021 30 - 30

Total 180 24 156

In December 2021, the reporting entity elected to terminate the hedge accounting program. At that time, a

total of $156 million was recognized as deferred assets under the special accounting provisions. As

illustrated in the charts, this $156 million represented the unrecognized losses from fair value fluctuations

of derivative instruments remaining after prior period amortization.

With the termination of the overall hedge accounting program, the issue to be addressed is whether it is

appropriate to conclude that the $156 million of unrecognized losses (recognized as deferred assets under

the special accounting provisions when the program was effective) will provide offsetting benefits for

future reserve liability changes, even though the hedge program has been terminated and will not be in

place when those future reserve liability changes occur.

As additional detail, the concept of deferred assets and deferred liabilities is not supported under existing statutory

accounting concepts, or U.S. GAAP, and is being considered only within the confines of this special accounting

provision. With unrecognized losses reported as deferred assets, the provision will improve the statutory financial

statements of a reporting entity by increasing assets and deferring recognition of the loss (increasing current-

period net income). These accounting entries result with an overall increase to surplus, and allow for the

presentation and admittance of assets not available for policyholder claims. Although these provisions are outside

of the standard statutory accounting concepts, the Working Group is considering these changes in order to

encourage risk mitigation efforts for guaranteed benefits of variable annuity reserves, and provide a

comprehensive view of derivatives and the impact of effective hedging strategies in the financial statements. With

the guidance being proposed, derivative instruments would be reported at fair value, but the non-economic

volatility (change in fair value for an effective hedge) will not impact the reporting entity’s solvency presentation.

The original guidance proposed by NAIC staff suggested immediate recognition of the deferred assets and

deferred liabilities when the overall hedging strategy has been terminated, or no longer qualifies under the special

accounting provisions. Comments received from the American Council of Life Insurers (ACLI) opposed this

guidance, and included the following statement:

We believe the risk of variability in the fair value of the AG 43 liability remains after the termination of a fair value hedge and as such, amounts deferred as part of the relationship will remain deferred and be amortized into income over the period the hedged item affects income. This termination guidance is

Attachment Three

3

consistent with the concept in GAAP and statutory accounting and aligns with the spirit of the accounting guidance which forever links the hedged item to the hedging instrument prior to the termination event.

Although NAIC staff has noted disagreement with the ACLI’s interpretation of the U.S. GAAP and SAP

guidance, the key issue is whether the deferred assets (unrecognized losses) from previous fair value fluctuations

of derivative instruments – recognized when the overall hedge strategy was in place and effective – should be

perceived to offset future reserve changes even when the overall hedging strategy has been terminated or is

ineffective. NAIC staff recognizes that these unrecognized losses (deferred assets) are likely going to be

significant, therefore understands industry concern with immediate recognition in the financial statements.

However, if the special accounting provisions were not established / followed, the statutory accounting provisions

in SSAP No. 86—Derivatives, would require recognition of the hedging instruments at fair value, with changes in

fair value recognized as unrealized gains or losses.

The Statutory Accounting Principles (E) Working Group is interested in the Variable Annuities Issues (E)

Working Group’s position on whether fair value fluctuations from effective hedges should be perceived to offset

future guarantee reserve changes even when the hedging program has been terminated or does not qualify under

the guidance. The Statutory Accounting Principles (E) Working Group is also interested in possible

compromising proposals, perhaps allowing continued amortization of deferred assets and deferred liabilities for a

shortened timeframe after the hedge program is terminated or becomes ineffective. (For example, if the fair value

fluctuations may be perceived to offset future reserve changes for a limited number of years, accelerated

amortization could be permitted for an additional 3-5 years after termination, but not be permitted for the duration

allowed for ongoing effective derivative programs.)

The Statutory Accounting Principles (E) Working Group appreciates the review of the Variable Annuities Issues

(E) Working Group on this particular issue, and invites additional comments on all aspects of the proposed special

accounting guidance. An updated issue paper was exposed during the 2017 Spring National Meeting, with

comments due May 19, 2017. This issue paper has been provided as an accompaniment to this referral, and is also

available via the following web page: http://www.naic.org/cmte_e_app_sapwg.htm

Thank you for providing input on this issue. Please contact SAPWG staff, Julie Gann, if you have any questions.

Cc: Julie Gann/Robin Marcotte/ Fatima Sediqzad/Jake Stultz/Dan Daveline

Attachment Three

--

MEMORANDUM

TO: Variable Annuities Issues (E) Working Group

FROM: Jim Armstrong, Chair, Variable Annuities Issues (E) Working Group

DATE: June 13, 2017

RE: Letter from SAPWG Regarding Hedges Discontinued or Ineffective

As you may recall, in the fall of 2015, the Financial Condition (E) Committee adopted a report from the Variable

Annuities Issues (E) Working Group which represented a framework for changing the statutory framework for

variable annuities as proposed by the Working Group. The framework for changes contemplated, among other

things, how the current framework creates non-economic volatility and that changes should be made to the

statutory framework to promote strong risk management.

One of the proposals in the framework for changes was to modify statutory accounting for its treatment of interest

rate hedges. On April 19, I received a letter from the chair of the Statutory Accounting Principles (E) Working

Group, along with the proposed issue paper that has been drafted to address this specific proposal related to

statutory accounting. In summary, the proposed issue paper provides special accounting treatment for interest rate

hedges of variable annuity guarantees that would reduce non-economic volatility in the financial statements, and

in turn, promote strong risk management. It does this by requiring the hedge, if proven to meet all of the criteria

within the proposed issue paper, to be marked to market but offset by a deferred asset or liability. More

specifically, fair value fluctuations in the hedge that do not offset the current period change in the hedged item

(the variable annuity reserve liability) shall be recognized as a deferred asset or a deferred liability, and amortized

into unrealized gains or losses over the lessor of the Macaulay duration of the guarantee benefit cash flows or ten

years.

As noted, the issue paper requires certain criteria to be met in order to receive such accounting, including among

other things, a requirement to prove the hedges are effective. To the extent the criteria are no longer met for the

overall hedging strategy, the issue paper requires any non-amortized deferred assets or deferred liabilities to be

immediately recognized.

The letter from the Statutory Accounting Principles (E) Working Group requests input from the Variable

Annuities Issue (E) Working Group on the future benefit of hedges once the effective hedging program has been

discontinued or becomes ineffective. To answer the question, I think we all would agree that hedges, just like

insurance, provide value to the holder over the entire life of the hedge, not just the point in time when the insured

is indemnified. And just like insurance, it’s important that they hedge remain in place after a claim is made, for its

uncertain when the protection may be needed. From that standpoint, the response is that the hedges provide

benefits and the statutory framework should not discourage their use in managing the ongoing risk.

Having said that, it’s important to note that the purpose of the question seems to be driven by the overall concern

that a regulator would have as the result of an unrecognized loss on an ineffective overall hedging strategy. Such

is the case during a market uptick, when the customer base of the insurer can become disinterested with the

Attachment Four

2

variable annuity product. Under these circumstances the liability cash flows are mostly fees that were going to

materialize on the balance sheet under the original policyholder behavior assumptions and with above expectation

lapse no longer will do so to the extent previously expected. The deferral of the loss recognition was meant to

make the loss recognition coincide with the fee revenue recognition. If policies lapse, so too will the future

profits. However, 100% recognition of any derivatives that are currently in a loss position would be inconsistent

with the remaining reduced cash flows that do materialize. This lapse effect could also materialize in

idiosyncratic insurer distress scenarios even though such scenarios are relatively unlikely as they would have to

occur under very favorable capital markets conditions for there to be a deferred hedge loss asset.

I would propose the Working Group consider an approach that recognizes both sides of this issue. One that

recognizes sound risk management and the value that hedges provide throughout their ownership, but balanced

with the concern of any unrecognized losses associated with an overall hedging strategy that is no longer

effective. I propose a response to the referral that suggests the identified deferred liabilities be recognized over the

lessor of the remaining scheduled amortization or 5 years. This should be coupled with material public disclosures

as suggested below to clearly identify the situation so the regulator can consider the information in their ongoing

monitoring of the insurer’s financial condition.

Proposed Disclosures

The draft issue paper, exposed during the 2017 Spring National Meeting, includes the following two disclosures

pertaining to ineffective or terminated hedges:

a. Identification of outstanding hedging instruments previously captured within scope of this

standard and subsequently identified as part of an ineffective hedging strategy. Disclosure shall

identify the eliminated deferred assets and deferred liabilities, and the recognition of unrealized

gains and unrealized losses resulting from the ineffective hedging strategy.

b. Identification of any election by the reporting entity to terminate use of the special accounting

provisions, the resulting elimination of deferred assets and deferred liabilities, and the impact to

unrealized gains and unrealized losses and/or realized gains and realized losses.

With the suggestion to allow amortization of deferred assets and deferred liabilities over the remaining scheduled

amortization, not to exceed five years, it is recommended that the disclosures be revised to encompass the

following:

a. For hedging strategies identified as ineffective previously captured within scope of this standard,

information on the determination of ineffectiveness, including variations from prior assessments

resulting in the change from an effective to ineffective hedge. This disclosure shall also include:

i. Identification of outstanding hedging instruments previously captured within scope of

this standard and subsequently identified as part of an ineffective hedging strategy. This

disclosure shall identify the date in which the domiciliary state was notified that the

hedging strategy had been identified by the reporting entity as ineffective.

ii. Deferred assets and deferred liabilities previously recognized under the effective hedging

strategy with a schedule that shows the amortization that would have occurred if the

program had remained highly effective, as well as a schedule that details the amortization

that will occur as the program has become ineffective (maximum five-year timeframe).

iii. Disclosure on whether the reporting entity is electing to expedite amortization (in

advance of the remaining scheduled amortization or the maximum five-year timeframe)

and how this election will impact the scheduled amortization.

b. For situations in which the reporting entity has elected to terminate the hedging strategy and/or

discontinue the special accounting provisions permitted within this SSAP, the reporting entity

Attachment Four

3

shall disclose the key elements in the reporting’s entity’ decision to terminate, identifying

changes in the reporting entity’s objectives or perspectives from initial application. This

disclosure shall also include:

i. Identification of outstanding hedging instruments previously captured within scope of

this standard and the accounting impact as a result of the termination / discontinuation.

(Derivative transactions not captured within the special accounting provision would be

subject to the accounting and reporting guidance within SSAP No. 86.) This disclosure

shall identify the date in which the domiciliary state was notified that the hedging

strategy or the election to use the special accounting provision in this SSAP had been

terminated.

ii. Deferred assets and deferred liabilities previously recognized under the hedging strategy

and/or program, with a schedule that shows the amortization that would have occurred if

the strategy and/or program had remained highly effective, as well as a schedule that

details the amortization that will occur with the termination of the strategy and/or

program (maximum five-year timeframe).

iii. Disclosure on whether the reporting entity is electing to expedite amortization (in

advance of the remaining scheduled amortization or the maximum five year timeframe)

and how this election will impact the scheduled amortization.

Attachment Four

American Council of Life Insurers

101 Constitution Avenue, NW, Washington, DC 20001-2133

(202) 624-2324 t (866) 953-4097 f mikemonahan@acli.com

www.acli.com

Mike Monahan Senior Director, Accounting Policy

July 13, 2017

Mr. Jim Armstrong, Chairman

Variable Annuities Issues Working Group

National Association of Insurance Commissioners

1100 Walnut Street, Suite 1500

Kansas City, MO 64106-2197

Re: Letter from SAPWG Regarding Hedges Discontinued or Ineffective

Dear Mr. Armstrong:

The American Council of Life Insurers (ACLI)1 is pleased to respond to the June 13, 2017 letter (the “letter”)

to the SAPWG regarding the treatment of deferred gains or losses on hedges previously designated under

exposure 2016-03, Special Accounting Treatment for Limited Derivatives (the “Issue Paper”) that

subsequently become dedesignated or ineffective in a future time period. We appreciate the desire to

arrive at a compromise position that recognizes both sides of the issue expressed in the letter. The letter

states that hedges provide value to the holder over the entire life of the hedge, and that it is important

that hedges remain in place after a claim is made because it is uncertain when protection may be needed.

We agree with these statements and believe they support our original position outlined below, that

immediate recognition of previously deferred amounts when the hedge strategy was effective is

inappropriate2, and maintaining the previously established amortization schedule when hedge accounting

is discontinued is consistent with current statutory accounting guidance in SSAP 86.

Previous ACLI comments on Paragraphs 17-23 of the Issue Paper:

We continue to be concerned about the cliff effect that could result under staff’s proposed accounting

for hedging strategies that no longer qualify under the scope of the standard. In some circumstances,

marking hedges to market may create a significant non-economic impact on the insurer’s reported

solvency, producing an overly positive or negative picture of the insurer’s financial health. We

recommend that hedge gains and losses deferred in accordance with this standard continue to be

1 The American Council of Life Insurers (ACLI) is a Washington, D.C.-based trade association with approximately

290 member companies operating in the United States and abroad. ACLI advocates in state, federal, and

international forums for public policy that supports the industry marketplace and the 75 million American families

that rely on life insurers’ products for financial and retirement security. ACLI members offer life insurance,

annuities, retirement plans, long-term care and disability income insurance, and reinsurance, representing 94

percent of industry assets, 93 percent of life insurance premiums, and 97 percent of annuity considerations in the

United States. Learn more at www.acli.com.

2 Immediate acceleration of previously deferred amounts can be appropriate only if it is revealed that past

effectiveness testing was flawed and the designated hedging strategy was not effective when those amounts were

initially deferred; however, this situation is expected to be a relatively rare occurrence.

Attachment Five

2

amortized under established timeframes. The cause of disqualification (i.e., voluntary or involuntary),

or the status of a derivative position (i.e., open or expired) should not impact the continued

amortization of prior deferrals. We believe SSAP 86, paragraph 18, supports our conclusion that

immediate write off of basis adjustments to the hedged item (deferred assets or liabilities in this case)

is not required upon termination, and that these amounts can continue to be amortized according to

the original schedule.

We propose the following language in place of paragraphs 17-23 (not shown in the markup):

For any outstanding derivative instruments in a hedging strategy that no longer qualifies

within the scope of the standard, gains and losses previously deferred in accordance with

this standard shall continue to be amortized in accordance with the previously established

amortization schedule. After considering prior deferrals made in accordance with this

standard, future fair value fluctuations for outstanding derivative instruments shall be

recognized prospectively as unrealized gains or unrealized losses. If the derivative

instruments are subsequently designated as part of a highly effective hedging strategy

qualifying under this standard, new deferrals would commence prospectively.

Gains and losses deferred in accordance with this standard pertaining to expired

derivative instruments that are part of a highly effective hedging strategy at the time of

expiration shall continue amortizing over the previously established timeframe.

Reporting entities may elect to terminate use of this special accounting provision at any

time. In those instances, deferred assets/liabilities shall continue to be deferred and

amortized in accordance with the previously established amortization schedule.

***

ACLI welcomes discussion on our viewpoints as expressed above. Please do not hesitate to contact us

should you also have any questions. Thank you.

Sincerely,

Mike Monahan

Senior Director, Accounting Policy

cc: Dan Daveline, Director, NAIC Financial Regulatory Services

Attachment Five