Attachment 17 Hearing Agenda – Ref #2016-03 Statutory ... Conley/Dave Lonchar Delaware Doug Stolte...

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Attachment 17 Hearing Agenda – Ref #2016-03 © 2017 National Association of Insurance Commissioners 1 Statutory Accounting Principles (E) Working Group Hearing Agenda August 6, 2017 ROLL CALL Dale Bruggeman, Chair Ohio Judy Weaver Michigan Jim Armstrong, Vice Chair Iowa Patricia Gosselin New Hampshire Richard Ford Alabama Stephen Wiest New York Kim Hudson California Joe Dimemmo Pennsylvania Kathy Belfi Connecticut Doug Slape / Jamie Walker Texas Holly Conley/Dave Lonchar Delaware Doug Stolte / David Smith Virginia Eric Moser Illinois Tom Houston Wisconsin Stewart Guerin Louisiana REVIEW of COMMENTS on EXPOSED SUBSTANTIVE ITEMS 1. Ref #2016-03 – Special Accounting for Limited Derivatives Ref # Title Attachment # Agreement with Exposed Document? Comment Letter Page Number 2016-03 New SSAP (Julie) Special Accounting for Limited Derivatives Revised Issue Paper Received by ACLI Comments Received ACLI Attachments 17B and 17C Summary: This agenda item is addressing the following charge: Develop and adopt changes to SSAP No. 86—Derivatives, with an effective date of January 1, 2017 or earlier, which allow hedge accounting treatment under SSAP No. 86 for certain limited derivative contracts (e.g. interest rate hedges with counterintuitive effects) that otherwise do not meet hedge effectiveness requirements. In adopting such an allowance, consider if the requirement to meet hedge effectiveness can be replaced by some other information that demonstrates strong risk management is in place over the identified hedges. —Essential On April 8, 2017, the Working Group exposed a revised issue paper, after considering industry comments received from the August 2016 exposure and the additional information requested in January 2017. The revised issue paper continues to identify key areas where input is requested. With the exposure, the Working Group also directed a request to the Variable Annuity Issues (E) Working Group for input on hedging programs initially captured under the proposed special accounting guidance, but that are subsequently terminated or become ineffective. Comments were received from the ACLI, along with a proposed revisions to the exposed issue paper. In order to allow for an easier review, this Hearing agenda has been structured differently to review the comments and proposed revisions by paragraph, with comments included by NAIC staff directly after each section. Recommended Action: Staff recommends that the Working Group consider the comments, direct NAIC staff to make updated revisions for subsequent exposure, and request information from ACLI on pending items. Staff highlights that comments have not yet been received from the Variable Annuities Issues (E) Working Group on the

Transcript of Attachment 17 Hearing Agenda – Ref #2016-03 Statutory ... Conley/Dave Lonchar Delaware Doug Stolte...

Attachment 17 Hearing Agenda – Ref #2016-03

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Statutory Accounting Principles (E) Working Group Hearing Agenda August 6, 2017

ROLL CALL

Dale Bruggeman, Chair Ohio Judy Weaver Michigan Jim Armstrong, Vice Chair Iowa Patricia Gosselin New Hampshire Richard Ford Alabama Stephen Wiest New York Kim Hudson California Joe Dimemmo Pennsylvania Kathy Belfi Connecticut Doug Slape / Jamie Walker Texas Holly Conley/Dave Lonchar Delaware Doug Stolte / David Smith Virginia Eric Moser Illinois Tom Houston Wisconsin Stewart Guerin Louisiana

REVIEW of COMMENTS on EXPOSED SUBSTANTIVE ITEMS

1. Ref #2016-03 – Special Accounting for Limited Derivatives

Ref # Title Attachment # Agreement

with Exposed Document?

Comment Letter Page Number

2016-03 New SSAP

(Julie)

Special Accounting for Limited Derivatives

Revised Issue Paper

Received by ACLI

Comments Received

ACLI Attachments 17B and 17C

Summary: This agenda item is addressing the following charge:

Develop and adopt changes to SSAP No. 86—Derivatives, with an effective date of January 1, 2017 or earlier, which allow hedge accounting treatment under SSAP No. 86 for certain limited derivative contracts (e.g. interest rate hedges with counterintuitive effects) that otherwise do not meet hedge effectiveness requirements. In adopting such an allowance, consider if the requirement to meet hedge effectiveness can be replaced by some other information that demonstrates strong risk management is in place over the identified hedges. —Essential

On April 8, 2017, the Working Group exposed a revised issue paper, after considering industry comments received from the August 2016 exposure and the additional information requested in January 2017. The revised issue paper continues to identify key areas where input is requested. With the exposure, the Working Group also directed a request to the Variable Annuity Issues (E) Working Group for input on hedging programs initially captured under the proposed special accounting guidance, but that are subsequently terminated or become ineffective. Comments were received from the ACLI, along with a proposed revisions to the exposed issue paper. In order to allow for an easier review, this Hearing agenda has been structured differently to review the comments and proposed revisions by paragraph, with comments included by NAIC staff directly after each section. Recommended Action: Staff recommends that the Working Group consider the comments, direct NAIC staff to make updated revisions for subsequent exposure, and request information from ACLI on pending items. Staff highlights that comments have not yet been received from the Variable Annuities Issues (E) Working Group on the

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termination guidance, so this action (and the resulting exposure of the updated issue paper) will provide additional time to receive a response from that Working Group. This hearing agenda has been designed to separately reflect the ACLI comments. The first section details the ACLI comments for which NAIC staff believes will require the most discussion, or for which prior comments from regulators have disagreed with the ACLI request / position. The second section details the ACLI comments or proposed revisions that NAIC staff believes will not be contested. Discussion by the Working Group is welcome on all comments and proposed revisions. To assist with the discussion, NAIC staff provides the following concepts from the Issue Paper:

This project is in accordance with a specific charge of the Financial Condition (E) Committee and the provisions intend to encourage risk-management transactions by insurers for limited, qualifying transactions in order to reduce non-economic volatility and ensure appropriate financial statement presentation with sufficient transparency for regulator review.

The provisions proposed are significantly different from what is currently allowed under SAP, U.S. GAAP and IFRS. The concept of allowing “effective hedge” accounting treatment for macro-hedges is not currently endorsed by any of the noted accounting standards.

The provisions permitting recognition of a “deferred asset” and a “deferred liability” (as those items reflect unrecognized gains or losses) is inconsistent with U.S. GAAP derivative guidance, as well as what constitutes an asset and liability under both SAP and U.S. GAAP.

The provisions to allow the proposed derivative guidance, and unrecognized losses/gains to be shown as assets/liabilities, is being considered as it will allow a comprehensive view of the derivative impact on the balance sheet (as derivatives will be reported at fair value), but the non-economic volatility (based on the mismatch of measurement between derivatives and the designated portion of the AG 43 reserve liability) will not impact the entity’s solvency presentation.

The inclusion of explicit disclosures is necessary to provide clear, transparent information regarding the use and impact of the special accounting provisions within the financial statements for regulator review.

SECTION 1 - REVIEW of COMMENTS REQUIRING DISCUSSION Discussion and direction is requested by the Working Group on the topics within this section. Topics Captured in this Section:

1) Change in Hedging Strategy / Hedging Target 2) Amortization and Ability to Accelerate Amortization 3) Termination Guidance / Expired Derivatives 4) Calculation of Deferred Asset / Deferred Liability 5) Request for Grandfathering

1. Change in Hedging Strategy / Hedging Target – Paragraph 9 Staff Background: Comments on the change in hedge target have previously been received from the ACLI and considered by the Working Group. With the provisions in the proposed guidance (allowing macro, flexible portfolios with dynamic hedges (rebalancing of derivative instruments), previous comments from the Working Group have not supported allowing changes in the hedge target to be considered separately from a change in the hedging strategy. The prior position was that a change in hedge target should be documented as a change

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in hedging strategy. The Working Group disagreed with the industry’s original request to allow for a “monthly” reset of the hedge program, noting that such an element would be too permissive in determining effectiveness, particularly when coupled with provisions that allow flexible portfolios and dynamic hedges. ACLI Comments:

We continue to be concerned that the Issue Paper does not sufficiently accommodate how dynamic hedging strategies actually work in practice. We note that staff did not incorporate our recommendation to differentiate changes in hedge targets and changes in the entity’s hedging strategy. A hedging strategy is the collection of multiple elements, including risks being hedged, objectives, hedging instruments used, and effectiveness measurements. Within a hedging strategy, it may be necessary and appropriate to adjust the hedge target in response to changing market conditions, liability changes and other factors. The nature of these prospective adjustments to the hedge target is documented within and instructed by the hedging strategy. In the context of interest rate hedging, in order to tactically execute a hedging strategy, there must be an amount of interest rate sensitivity identified that translates the hedging technique into an amount of instruments to purchase. The target interest rate sensitivity percentage is merely a numerical manifestation of the overall strategy at a point in time. Even if the hedging strategy is unchanged, the target interest rate sensitivity percentage will evolve with movements in the remaining life of the underlying block, changes in economic conditions, and adjustments to the mix of business.3

ACLI Footnote 3: For example, suppose a company has variable annuity products A, B, and C. All three are initially separate groupings for accounting, valuation, etc. and the company hedge strategy includes hedging a portion of the interest rate sensitivity of variable annuity guarantee benefits. The company initially executes this strategy by defining a hedge target of 90% of interest rate sensitivity of product A, which reflects the company's overall risk appetite, including impacts from other line of business, etc. Later, the company decides to collapse the management of products A and B together for operational efficiencies, because product B is now a very small portion and similar enough to product A that it is no longer worth the effort to manage separately. So now company has two groupings AB and C. Assume that at the time of the consolidation, there is a 90/10 mix of A and B. Assume nothing else has changed in terms of the company's relative risk exposures, other product lines, etc. Now the company changes the tactical definition of the hedge target to be 81% of AB (i.e. A is 90% of AB and the target before the change was to hedge 90% of A -> 90%*90% = 81%). In this instance, the overall strategy hasn't changed, but because of the operational change to product groupings, the definition of the hedge target and coverage percentage had to change accordingly.

We believe that the determination of whether an effective hedging strategy is in place should focus on more than the hedge target. Paragraph 9 (and associated footnote 4) should point to material changes to the company’s hedging strategy. Such changes will normally involve an internal vetting and governance process and are not routine events. Our recommended change in the attached markup will allow dynamic hedging strategies to function as intended while still providing appropriate and timely notification to regulators.

ACLI Proposed Changes – Paragraph 9: 9. As identified in paragraph 4, eligibility for the special accounting provision within this standard is

strictly limited to variable annuity contracts and other contracts involving certain guaranteed benefits similar to those offered with variable annuities that are reserved for in accordance with Actuarial Guideline XLIII, CARVM for Variable Annuities (AG 43). This special accounting provision requires the reporting entity to engage in highly effective fair value hedges that follow a Clearly Defined Hedging Strategy, as defined in AG 43, meeting all required provisions of AG 43 allowing the reporting entity to reduce the amount of the Conditional Tail Expectation (CTE) Amount. In order to qualify as a Clearly Defined Hedging Strategy, the strategy must meet the

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principles outlined in AG 43, be in place (implemented) for at least three months1, and shall at a minimum, identify:

a. Specific risks being hedged2,

b. Hedge objectives,

c. Risks not being hedged,

d. Financial instruments that will be used to hedge the risks,

e. Hedge trading rules, including permitted tolerances from hedging objectives,

f. Metric(s) used for measuring hedging effectiveness,

g. Criteria that will be used to measure effectiveness,

h. Frequency of measuring hedging effectiveness,

i. Conditions under which hedging will not take place, and

j. The individuals responsible for implementing the hedging strategy.

The hedge strategy may be dynamic, static or a combination thereof.

NAIC Staff Comments / Recommendation: The prior comments discussed by the Working Group noted that the ability to frequently change the hedge target seemingly eliminates the possibility of the hedge being ineffective, particularly when coupled with the ability to change the composition of the hedged item (portfolios of variable annuity contracts), and the ability to adjust (rebalance) the hedging instruments. Pursuant to the terms / intent of the guidance, the provision to allow a dynamic hedging approach is to foster adherence to a specific, documented hedging strategy. In reviewing the current comments from the ACLI, NAIC staff requests regulator feedback on whether limited situations should be identified that would permit changes in the “hedge target” to not constitute a “change in hedging strategy.” Instead of identifying limited situations, the Working Group may consider whether the guidance should provide percentage variations in the hedge target that would be permitted without triggering a change in “hedge strategy.” If the Working Group was to agree that provisions could be established allowing for changes in the hedge target, without requiring the company to identify a change in hedge strategy, NAIC staff would recommend limitations as to the frequency of hedge target changes, as well as disclosures that provide explicit information on the changes in the hedge target, and the operational changes or economic conditions that caused the company to adjust the hedge target. NAIC staff would also recommend disclosure that details how the changes in the hedge target impacted the accounting and reporting under the special accounting provisions. To the extent frequency was limited, and disclosure was added, it may collectively provide the domestic regulator enough information that would allow them to assess if they may need to hire an outside specialist to better understand the details and implications of the change in the hedge target.

1 As detailed in AG 43, before a new or revised hedging strategy can be used to reduce the amount of the Conditional Tail Expectation (CTE) otherwise calculated, the hedging strategy should be in place (effectively implemented) for at least three months. As detailed in AG 43, the Company may meet the time requirement by having evaluated the effective implementation of the hedging strategy for at least three months without actually having executed the trades indicated by the hedging strategy (e.g., mock testing or by having effectively implemented the strategy with similar annuity products for at least three months.) 2 The specific risk being hedged shall include a measure of the hedge coverage (e.g., percentage of interest rate sensitivity being hedged) (i.e. rho) is managed within a specific risk tolerance as instructed by the documented hedging strategy..

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After corresponding with NAIC actuaries, it has been noted that the actuarial memorandum does not detail the actual change in a hedge strategy. Rather, the actuarial memorandum simply identifies that there has been a change in hedge strategy. Information on the change may be in the current period documentation on the hedging strategy, but may need to be determined based on a comparison of the current hedging strategy to the prior documentation for the hedging strategy. With this information, staff also suggests additional disclosures to capture changes in the hedging strategy directly in the financial statements.

2. Amortization and Ability to Accelerate Amortization – Paragraph 16 Staff Background: The provisions to amortize unrecognized losses / gains (reported as deferred assets / liabilities) are a critical element of this proposal. As noted, these deferred assets/liabilities do not meet the definition of actual assets/liabilities and the “assets” would generally not satisfy statutory accounting criteria for “admitted assets” as they do not reflect amounts that can be used to satisfy policyholder claims. The impact (amounts) expected to be reported (from review of submitted examples and the disclosed 2017 permitted/prescribed practices) are expected to be material in the financial statements, and would likely significantly influence the review of a company. (The review would be particularly impacted by financial statement users who may not be familiar with the special accounting provisions, especially if that assessment relies on the amount reported for total assets.) The longer the amortization period, the longer the unrecognized loss (reported as an asset) is delayed from recognition. Additionally, as long as the hedge program is effective, losses may continue to be unrecognized (reported as assets) even after the derivative instrument generating the loss has matured, sold or disposed.

ACLI Comments: We have separate comments about the length of the amortization period and the ability of companies to accelerate amortization.

We reiterate our previous comments regarding the appropriate amortization period for deferred assets/liabilities. An amortization period with a length of time up to the Macaulay duration of the guaranteed benefit cash flows based on AG43/VM21 Standard Scenario is the most appropriate methodology. The Macaulay duration provides a weighted average length of time of the guarantee cash flows and appropriately varies by company, block and level of aggregation of business in force. We believe the use of the Macaulay duration appropriately links the amortization to the AG43/VM21 liability and would support the goal of reducing non-economic volatility in the statutory financial statements resulting from accounting mismatches between variable annuity reserves and the related hedges. This approach would also provide a consistent approach for determining the amortization period using a prudent estimate of the lifetime of the liability. Additionally, should the Working Group pursue guidance to address other accounting mismatches (i.e., hedging equity risks) the use of a Macaulay duration becomes even more essential. While we disagree in principle with an arbitrary cap, we believe 20 years is the shortest maximum length that would result in removing most of the non-economic accounting volatility from the statutory financial statements and could accept a 20-year cap. As noted in our previous comment letter, finite amortization periods would be established for each deferred asset or liability balance at the time the deferred asset or liability is established.

Regarding acceleration of amortization, we support the ability of entities to accelerate the amortization of deferrals. The current language, however, could be interpreted to allow entities to accelerate the amortization of select deferred asset/liability cohorts, providing an opportunity to amortize in a manner that is favorable to the financial results of the entity. We believe that acceleration should be available, but it should apply to all cohorts proportionately in order to ensure that amortization is aligned with the overall hedge relationship. Acceleration should be determined for each hedge relationship separately in the event an entity has more than one relationship. In the event of acceleration, the various notifications and disclosures outlined within the

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Issue Paper should provide adequate transparency as to the continued alignment between the recognition of costs and benefits for the hedges and the hedged items. We would welcome the opportunity to work with NAIC staff to develop suitable language to accomplish these goals.

Proposed Guidance: Although the ACLI would request revisions, they did not propose changes to the issue paper. The following is the current issue paper guidance:

16. Deferred assets and deferred liabilities recognized under paragraph 14.b. shall be amortized

using a straight-line method into realized gains or realized losses over a finite amortization period. The amortization timeframe shall equal the Macaulay duration of the guarantee benefit cash flows based on the AG 43 Standard Scenario, but shall not exceed a period of 10 years.

a. Future recognition of deferred assets or liabilities from fair value fluctuations attributed to the hedged risk that are not offset by the reserve liability change do not extend the amortization timeframe for previously recognized deferred assets or deferred liabilities. Reporting entities are required to separately track, with a schedule to show the initial deferred amount and amortization schedule, of the deferred assets and deferred liabilities recognized and outstanding at each reporting date.

b. The amount reported on the financial statement at each reporting date shall reflect the net amount (net as either a deferred asset or deferred liability) for each hedging strategy captured within scope of this guidance.

c. Reporting entities are permitted to amortize a greater portion of the deferred assets and/or deferred liabilities into realized gains or realized losses at any time in advance of the scheduled amortization period.

NAIC Staff Comments / Recommendation: The prior discussion by the Working Group has resulted with the inclusion of the Macaulay Duration in the issue paper as the basis of the amortization period (as recommended by interested parties), but has continued to include a maximum duration. This maximum was previously supported due to the nature of the deferred assets and deferred liabilities (as they represent unrecognized losses and gains). The most recent exposure included a 10-year maximum amortization period. This timeframe was noted as being consistent with provisions provided under some state permitted / prescribed practices. It is noted that a 10-year amortization timeframe is still a significant improvement in addressing the non-economic volatility from fair value mismatches when compared to existing statutory accounting guidance in which fair value fluctuations are recognized immediately. With regards to the amortization timeframe, NAIC staff requests comments from the Working Group on whether they are comfortable extending the amortization period to 20-years, or if the Working Group prefers to retain the 10-year timeframe. As an additional consideration, although NAIC staff does not believe it should directly impact the amortization timeframe, NAIC staff suggests that the Working Group also consider allocation to special surplus an amount equal to the net deferred assets and deferred liabilities recognized under this special accounting guidance. This allocation may highlight the differentiation of these assets/liabilities in the financial statements, and in some states, may reduce the likelihood of dividends being paid as a result of increase in “assets” that actually represent unrecognized losses. This reporting also gives the domestic state complete transparency to the magnitude of these transactions / financial statement impact and assists in determining if a need exists for the state to hire an outside specialist with regard to the hedging strategy. (Staff also highlights that the deferral of losses/gains also impacts the income statement. In the case of unrecognized losses (reported as deferred assets), the reporting entity presents improved earnings / income statement results.) With regards to the accelerated amortization of deferred assets and liabilities, it is NAIC’s staff’s initial reaction that recognition of these items is the most appropriate accounting treatment as they represent unrecognized losses and gains, that in other accounting standards are required to be immediately recognized. NAIC staff does agree, however, that allowing an accelerated recognition of gains (instead of reporting them

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as deferred liabilities), and not requiring the accelerated recognition of a corresponding (equal) amount of deferred liabilities (and continuing to report those items as deferred assets) could result with a reporting entity electing such action to result with favorable financial statements. As such, it is NAIC staff’s recommendation that revisions to require elections for accelerated amortization to occur equally between deferred assets and deferred liabilities so that the election to accelerate amortization has a net impact on the financial statements. In the event that a reporting entity only has deferred assets (or deferred liabilities), a reporting entity would be permitted to accelerate amortization without restrictions, as recognition of the gains and losses is considered to be the most appropriate accounting treatment (rather than reporting these items as deferred liabilities or deferred assets).

3. Paragraphs 17-23 – Termination Guidance / Expired Derivatives Staff Background: The issue pertaining to the treatment of deferred assets and liabilities (unrecognized losses and gains) as a result of a terminated / ineffective program is another critical element in the issue paper. Similar to the past discussions, there is concern for retaining deferred assets and liabilities for an extended period of time after the termination of the program or if the hedge becomes ineffective. (As noted previously, these assets reflect losses– which do not qualify under the asset/liability definition and are not assets that can be used to satisfy policyholder obligations.) A referral was provided to the Variable Annuities Issues (E) Working Group to obtain their thoughts on this issue, and a referral response is still pending. In a review of the Note 1 disclosures for year-end 2016, permitted/prescribed practices provided for the accounting treatment of derivatives for variable annuity hedges was one of the largest (collectively) in terms of financial statement impact. For individual companies, the practices provided for derivatives also seemed to reflect a large percentage of surplus. ACLI Comments: 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 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 No. 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.

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Issue Paper Guidance - Although the ACLI requests revisions, they did not track changes to the issue paper: 17. For outstanding (non-expired) derivative instruments that were removed from a highly effective

hedging strategy (rebalanced), subsequent gains and losses from fair value fluctuations shall not impact the previously recognized deferred assets or deferred liabilities. The deferred assets and deferred liabilities for these derivative instruments shall be “locked” and amortized under the remaining schedule unless the reporting entity elects to terminate or accelerate amortization.

18. For outstanding (non-expired) derivative instruments in a hedging strategy that no longer qualifies within scope of this standard (e.g., AG 43 requirements are not met) or is no longer a highly effective hedge, any non-amortized deferred assets or deferred liabilities shall be immediately recognized as unrealized gains and/or unrealized losses. All future fair value fluctuations for these derivative instruments shall be recognized as unrealized gains or unrealized losses unless the instrument is subsequently designated as part of a highly effective hedging strategy. If the derivative is re-designated as part of a highly effective hedging strategy qualifying under this standard, subsequent fair value fluctuations (after the re-designation) may be accounted for under this special accounting provision.

19. Reporting entities may elect to terminate use of this special accounting provision at any time. In those instances, if the derivative instruments are outstanding, all deferred assets and deferred liabilities shall be immediately eliminated with recognition as unrealized gains and/or unrealized losses. Regardless of whether the hedging strategy is determined to be highly effective, subsequent accounting of the derivatives within the hedging strategy shall follow the fair value accounting approach in SSAP No. 863.

Measurement / Recognition of Realized Gains or Losses of Expired Derivatives

20. With the ability to rebalance the hedging instrument, this guidance allows for individual derivative instruments to expire and/or be removed from the portfolio of the hedging instrument, and not immediately trigger an assessment that the overall hedging strategy is no longer highly effective. Furthermore, special allowances are included to consider the tenure differences between a hedging instrument and AG 43 liability duration. These allowances permit expired4 derivative instruments that were part of a highly effective hedging strategy at the time of expiration to continue amortizing the deferred gains and deferred losses over the previously established amortization timeframe even if the overall hedging strategy is subsequently terminated or subsequently identified as no longer qualifying as a highly effective hedge.

21. Reporting entities with expired derivative instruments that were part of a highly effective hedging strategy at the time of such expiration are not required to terminate the amortization schedule initially established for the deferred assets and deferred liabilities attributed to that derivative instrument.

22. Consistent with the guidance in paragraph 15.c., reporting entities are permitted to amortize a greater portion of the deferred assets and/or deferred liabilities from expired derivatives into realized gains or realized losses at any time in advance of the scheduled amortization period.

23. Consistent with the guidance in paragraph 18, reporting entities may elect to terminate use of this special accounting provision at any time. In those instances involving expired derivatives, all remaining deferred assets and deferred liabilities shall be immediately eliminated with recognition as realized gains and/or realized losses.

3 Macro-hedges and the ability to rebalance hedging instruments are not provisions permitted within “effective” hedges in scope of SSAP No. 86. As such, hedging strategies with these components accounted for under SSAP No. 86 shall follow the fair value accounting approach detailed in that standard. 4 Throughout this standard the use of the word “expire” is intended to capture all instances in which the derivative is no longer outstanding. It includes maturities, terminations, sales, and/or other closing transactions of a derivative.

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NAIC Staff Comments / Recommendation: Given the significant surplus impact the special accounting guidance may provide, NAIC staff strongly cautions against accounting guidance that would continue to allow the recognition of deferred assets (unrecognized losses) in the financial statements with an amortization schedule that matches what is allowed for an open / effective program, once the program has been terminated, or is no longer deemed to be effective. Such a provision would seemingly allow a company to implement a program for a short-time frame, incur significant losses on the derivative instruments, terminate the program, and not fully recognize the incurred losses for 20-years. (The 20-year maximum is the industry’s requested timeframe. The issue paper proposes a 10-year maximum.) Although NAIC staff recognizes that the termination of the program could have a “cliff” impact on industry - as it would require the significant incurred losses from expired derivatives to be recognized – NAIC staff believes that continued amortization, as if the program as still in place and effective is too permissive under the statutory accounting concepts of conservatism and recognition. As a compromise position, to alleviate the full recognition of incurred losses at time of termination / ineffectiveness, NAIC staff would recommend that the deferred assets / liabilities be amortized over their remaining amortization period, not to exceed a shortened amortization timeframe (e.g., 5-years). (If the deferred assets had an amortization period that was less than the shortened timeframe, they would continue under the established period. If the amortization period was greater than the shortened timeframe at the time of termination / ineffective determination, the amortization schedule would be revised to require full amortization of the deferred assets within the shortened timeframe. NAIC staff believes that this proposal reduces the impact that full recognition of incurred losses would generate at the time of termination, and provides regulators with a shorter timeframe (e.g., 5-years) that is manageable in assessing the continued impact of the incurred losses / deferred assets on the company’s financial position. (Although the referral response from the Variable Annuities Issues (E) Working Group is still pending, NAIC staff believes that Working Group is also considering a recommendation to utilize a shortened amortization timeframe.) After considering the referral response, if the Working Group agrees with a shortened amortization timeframe. NAIC staff would recommend that amortization timeframe (e.g., 5-years) be established for deferred assets / liabilities for all programs terminated / determined ineffective regardless if the derivative instrument is still outstanding. However, NAIC staff would agree that if the derivative instrument is still open (not expired), then the reporting entity would have the ability to designate that derivative instrument as part of a new effective hedge that qualifies for the special accounting provision. If the outstanding instrument was designated as part of an new effective hedge qualifying under the guidance, then new deferrals (from losses / gains occurred as part of the new hedge) would commence immediately and be permitted to be amortized under the special accounting provisions. NAIC staff recommends deferring final decisions on this aspect until after the referral response is received. At that time, the Working Group will consider the referral response and NAIC staff will draft proposed revisions per the Working Group’s direction for subsequent review.

4. Appendix A and Paragraph 15 – Calculation of Deferred Asset / Deferred Liability

Staff Background: The guidance in paragraph 15 and Appendix A were developed with information received from Oliver Wyman. NAIC staff does not fully understand the industry’s comments, as the Appendix A illustration clearly identifies that the hedged risk is Rho. Although Rho is the hedged risk, the financial statement impact is driven by fair value fluctuations. This is because it is the difference between fair value of the derivative instrument (reported on the financial statements) and the reported value of the designated AG 43 reserve (which is not a fair value measurement) is what causes the “non-economic” volatility in the financial statements that this project is intended to address.

ACLI Comments: We have separate comments on both the proposed calculation steps and the measurement of gains and losses of outstanding (open) instruments.

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While we believe it would be helpful to have an illustrative example calculation of the deferred asset/liability within the accounting guidance, the calculation in Appendix A appears to be unnecessarily complicated and potentially limiting. It should be possible to streamline and refine the calculation steps listed in paragraph 15.b. We would appreciate the opportunity to work directly with NAIC staff to create a more suitable example. More substantively, we recommend the following changes to the measurement/recognition of gains and losses of outstanding (open) instruments discussed in paragraph 15:

1. The Issue Paper requires the rate coverage proportion or the change in the AG43 liability related to the hedged risk (15.b.i and 15.b.ii) to be measured by changes in fair value due to rates during the reporting period (hedged item divided by full contract). We believe companies may utilize general account assets to mitigate full contract risks, particularly in situations where (a) the variable annuity has a fixed account and minimum guarantees on those fixed accounts, (b) policies are close to annuitized status, and (c) policies are significantly in-the-money (derivatives have paid off and proceeds have invested in fixed income assets to back the higher reserve requirements). The paragraph 15 formula does not consider the impact of the general account assets. As risks covered by general account assets increase, the fair value proportion will decrease. As written, the Issue Paper may incentivize derivative hedging of all variable annuity rate risks and disincentivize traditional asset-liability matching practices with fixed income investments. While the rate risk mitigated with general account assets may be a small portion of the full contract rho today, it may become meaningful and volatile under changing and stress market environments.

2. Additionally, we recommend allowing for the rate coverage proportion to be determined using rho (rate sensitivities) instead of the fair value movements. The full contracts contain sensitivities to both Treasury rates and swap rates, and the key rate durations of the hedge target (typically guarantee riders only) will vary from full contracts (including fixed accounts and base M&E fees). Using rho as the measurement for the proportion of rate coverage will eliminate unnecessary and non-meaningful volatility from the calculation.   

Proposed Guidance: Reflects Minor Revisions Proposed by the ACLI:

15. Fair value fluctuations in the measurement of outstanding (non-expired) derivatives within a highly effective hedging strategy shall be reflected as follows:

b. Fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (designated portion of the AG 43 reserve liability (; e.g., guarantee benefitscash flows) shall be recognized as deferred assets (admitted) and deferred liabilities. The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the designated portion of the AG 43 reserve liabilityhedged item. Reporting entities shall utilize the following calculation for establishing the deferred asset (also illustrated in Appendix A) unless a different method has been approved by the domiciliary state commissioner:

i. Calculate the fair value gain or loss in the hedged item attributable to the hedged risk;

ii. Express the quantity calculated in 14.b.i. as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements.

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iii. Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in 14.b.ii. multiplied by the AG 43 liability change attributable to interest rate.

iv. Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in 14.b.iii.

Appendix A – Calculation of Deferred Asset or Deferred Liability

Under the special accounting provisions within this issue paper, as detailed in paragraph 14.b., fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (AG 43 reserve liability) shall be recognized as deferred assets (admitted) and deferred liabilities.

The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the hedged item.

Unless a different method has been approved by the domiciliary state commissioner, reporting entities shall utilize the following calculation (detailed in paragraph 14) for establishing the deferred asset:

15.b.i Calculate the fair value gain or loss in the hedged item attributable to the hedged risk (Step 1);

15.b.ii Express the fair value gain or loss calculated (Step 1) as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements (Step 2).

15.b.iii Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in Step 2 multiplied by the AG 43 liability change attributable to interest rate (Step 3).

15.b.iv Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in Step 3.

To illustrate the above calculation:

Clearly Defined Hedging Strategy (CDHS) characteristics

Hedged item Rider claims less rider fees Hedged risk 50% of the rho (first-order IR level sensitivity)

Calculation of the deferred asset or liability Note: positive values = increase in liability

Fair value gain (loss) in hedged item attributable to interest rate movement (500) 15.b.i. - Fair value gain (loss) in hedged item attributable to hedged risk (250)

Hence, if the insurer were hedging per the CDHS perfectly, then the insurer should see a 250 fair value loss in the designated IR hedge instruments. To determine how much of that loss should be deferred:

Fair value gain (loss) in full-contract cash flows attributable to IR movement (700) 15.b.ii - Quantity calculated in 15.b.i. as a % of the (700) above 36%

AG 43 liability increase (decrease) from beginning of period to end of period 400 AG 43 liability increase (decrease) attributable to interest rate movements (100) 15.b.iii - AG 43 liability increase (decrease) attributable to the hedged risk (36)

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In this example, even though the AG 43 liability increased by 400 during the reporting period, interest rate movements actually contributed to a 100 decrease. The hedged risk (50% of the interest rate sensitivity of rider cash flows) accounts for 36% of this, or $36 of the liability decrease. As such, $36 of the fair value loss on the interest rate hedge instruments should be reflected immediately and the remainder deferred via a deferred asset equal in amount to 250 – 36 = 214.

15.b.iv – Deferred asset (15.b.i less 15.b.iii) attributable to hedged risk (36) (This is shown as a negative – to be consistent with the decrease in AG 43 liability – but represents a deferred asset. Deferred assets reflect fair value losses.)

NAIC Staff Comments / Recommendation: Pursuant to the background information, NAIC staff needs additional information from the ACLI regarding these comments. As noted, the hedged risk in Appendix A is identified as Rho, and the overall nature of the project is to address the volatility caused by derivative instruments being reported at fair value when the hedged item (the designation portion of the AG 43 reserve) is not reported at fair value. As these elements are the fundamental concepts of the overall issue paper, NAIC staff requests that the ACLI provide their suggested guidance / calculation as soon as possible. 5. Request for grandfathering

Staff Background: As detailed in the issue paper, the concepts within the scope of this project are not permitted within SSAP No. 86, or any accounting standard. Although NAIC staff is aware of prescribed and permitted practices, interpretations that SSAP No. 86 would permit effective hedges for these variable annuity hedges are not in line with existing statutory accounting guidance. ACLI Comments: Several insurers are currently applying accounting treatment similar to the Issue Paper’s proposed treatment, either as a result of a permitted practice or as an interpretation of existing accounting guidance. We believe that it would be beneficial to both regulators and industry to have certainty about the continued appropriateness of these past actions. Therefore, we recommend language such as the following that would allow existing deferral and amortization practices to continue without the necessity of ongoing regulatory approval.

Limited derivative accounting treatment, similar to that described herein, that has previously applied to specified derivative instruments hedging variable annuity guarantees is permitted to continue under approaches approved prior to the effective date of the SSAP supported by this Issue Paper. Where the accounting treatment described in this Issue Paper differs from accounting treatment previously permitted, companies may elect to apply either the previous accounting treatment or to use the treatment outlined in this Issue Paper.

NAIC Staff Comments / Recommendation: NAIC staff does not recommend incorporating guidance within the new SSAP that would codify all prior interpretations and state permitted or prescribed practices. In accordance with the Statutory Statement of Concept of Consistency, NAIC staff would recommend that all reporting entities apply the provisions ultimately adopted in the new SSAP. In the event that a state wanted to allow a reporting entity to continue application of a prior permitted or prescribed practice, such action would continue to be noted as a departure from established statutory accounting principles, and would require disclosure in Note 1. NAIC staff again reiterates the significant financial statement impact of previous practices, and the anticipated financial statement impact that will result from this new SSAP. As such, NAIC staff believes it is critical that any departures from the established guidelines be clearly documented as permitted or prescribed practices in Note 1. NAIC staff believes there would be regulator concerns if reporting entities in other states were applying variations to the allowed guidance without appropriate documentation.

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SECTION 2 - REVIEW of REMAINING ACLI COMMENTS The Working Group is requested to review the ACLI comments and proposed revisions and advise whether there are concerns with the changes or the noted direction recommended by NAIC staff. Topics Captured in this Section:

1) Terms and Concepts 2) Governance Provisions / Actuarial Certifications 3) Notification to State of Change in Hedging Strategy 4) Assessing Hedge Effectiveness 5) Fair Value Fluctuations 6) Realized / Unrealized Gains or Losses 7) Schedule DB / Disclosures 8) Overall Comment – Mismatches in Accounting

1. Paragraph 5: Terms and Concepts

Staff Background: Paragraph 5 was added to provide terms / concepts to apply within the statement. ACLI Comments: We suggest changes to two of the defined terms in paragraph 5.

In 5c, we concur with staff’s clarification that the hedged item may relate to an open or flexible portfolio that allows for changes in obligations (new issuances, surrenders) and fluctuations in balances. However, we are concerned that the current definition of the hedged item is overly narrow and does not appropriately capture the meaning of the term as utilized throughout the remainder of the Issue Paper. For the sake of clarity and consistency, in the attached markup we suggest establishing that the hedged item consists of specified guarantee benefits exposed to interest rate risk. We also suggest minor edits to paragraphs 6 (including footnote), 12, 15a (including footnote), and 15b to establish conceptual distinctions between the hedged item (guarantee benefits exposed to interest rate risk), the underlying contracts, and reported values of AG43/VM21 reserves in statutory financial statements. In the Issue Paper, “hedged item” currently refers to all three of these concepts.

In 5e, we recommend eliminating the definition of “macro-hedge”. The current definition is too limiting, as macro hedging is applicable to more than variable annuities. Furthermore, within the paper, “macro hedging” is used to provide context for the proposed special accounting treatment specific to this Issue Paper. Therefore, a defined term is unnecessary.

ACLI Proposed Changes – Paragraphs 5, 6, 12, 15a and 15b:

6. The following terms reflect concepts specific to this Statement. (This listing only details the key concepts. Specific guidelines are reflected throughout the guidance.)

a. Derivative Instrument: Means an agreement, option, instrument or series or combination thereof: (1) To make or take delivery of, or assume or relinquish, a specified amount of one or more underlying interests, or to make a cash settlement in lieu thereof; or (2) That has a price, performance, value or cash flow based primarily upon the actual or expected price, level, performance, value or cash flow of one or more underlying interests.

b. Dynamic Hedging Approach: A dynamic hedging strategy allows for the portfolio of derivatives comprising the hedging instrument to be rebalanced in accordance with changes to the hedged item in order to adhere to the specified, documented hedging strategy.

c. Hedged item: The hedged item shall consist of reserves reflecting declared guarantee benefits on a pool, or portion thereof, of variable annuity contracts exposed to interest

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rate risk. The hedged item may relate tobe an open or flexible portfolio (e.g., group of variable annuity contracts with different characteristics and liability durations) that allows for addition of newly issued contracts, subtraction of surrenders and fluctuations in balances. The portfolio of variable annuity contracts may consist of as an entire book of business or declared components thereof. The hedged item shall reflect the present value of cash flows of a pool, or portion thereof, of variable annuity contracts exposed to interest rate risk.

d. Hedging Instrument: The hedging instrument shall reflect a specified derivative, or a portfolio of specified derivatives, that hedges the interest rate sensitivity of the designated hedged item. The hedging instrument may reflect a dynamic hedging strategy in which a portfolio of derivatives comprising the hedging instrument is rebalanced in accordance with changes to the hedged item.

e. Macro-Hedge: A macro-hedge refers to the ability to jointly designate a portfolio of variable annuity policies, such as an entire book of business or subsections thereof, as the hedged item.

7. The special accounting provision within this Statement permits reporting entities to utilize a form of “macro-hedging” in which a portfolio of variable annuity policies, which could include the entire book of business or subsections thereof, are jointly designated as the host contracts containing the hedged item, in a fair value hedge5, pursuant to a Clearly Defined Hedging Strategy (throughout this issue paper also referred to as “CDHS” or “hedging strategy”). This is considered a macro-hedge, as the designated hedged item (rate sensitive guarantee benefitsgroup of policies) may be attached to a portfolio of variable annuity contracts with different characteristics and liability durations. Under this special accounting provision, the portfolio of contracts giving rise to the hedged items is not required to be static, but can be revised to remove policies and/or include new policies to allow for continuous risk management (hedging) of the variable annuity guarantee reserves in accordance with the specific risks being hedged and the hedge objectives of the specified, documented hedging strategy. In designating the hedged item, reporting entities are permitted to exclude specific components of the variable annuity contracts, but such exclusions must apply collectively to all policies included within the portfolio. For example, reporting entities may elect to only hedge the interest rate risk of rider cash flows, and if making this election, would define the hedged item as the “fair value of rider claims net of rider fees” for the portfolio of policies designated as giving rise to the hedged item.

12. This standard requires a single measure for assessing whether the hedging strategy is highly effective, and in measuring hedge ineffectiveness. Both at inception, and on an ongoing basis, the hedging relationship must be highly effective in achieving offsetting changes in fair value attributed to the hedged risk during the period that the hedge is designated. In order to meet this requirement, reporting entities electing to use this special accounting provision must calculate the fair value of the hedged item (declared guarantee benefits exposed to interest rate riskAG 43 guarantee reserve) at inception and on an ongoing basis , and compare the cumulative fair value change of the hedged item to the cumulative fair value change of the hedging instruments. This comparison is specific to the designated hedged risks and exposures, therefore, if only a portion of the interest rate risk is hedged or if the designated hedge only include specific components of the variable annuity policies (e.g., riders), for determining hedge effectiveness, the fair value comparisons is limited to those designated items. If an entity’s defined risk management strategy for a particular hedging relationship excludes specific components of the hedging derivative from the assessment of hedge effectiveness, the excluded open components shall be reported at fair value with gains or losses recognized as unrealized gains or losses.

5 As detailed in paragraph 11, these hedges are required to be highly effective in achieving offsetting changes in fair value attributed to the hedged risk between the derivative hedging instruments and the hedged item (present value of declared guarantee benefits exposed to interest rate riskAG 43 liability) during the period that the hedge is designated.

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15. Fair value fluctuations in the measurement of outstanding (non-expired) derivatives within a highly effective hedging strategy shall be reflected as follows:

a. Fair value fluctuations in the hedging instruments attributable to the hedged risk that offset the current period change in the hedged item (designated portion of the AG 43 reserve liability (; e.g., guarantee benefitscash flows)6 shall be recognized as a realized gain or loss.

b. Fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (designated portion of the AG 43 reserve liability (; e.g., guarantee benefitscash flows) shall be recognized as deferred assets (admitted) and deferred liabilities. The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the designated portion of the AG 43 reserve liabilityhedged item. Reporting entities shall utilize the following calculation for establishing the deferred asset (also illustrated in Appendix A) unless a different method has been approved by the domiciliary state commissioner:

i. Calculate the fair value gain or loss in the hedged item attributable to the hedged risk;

ii. Express the quantity calculated in 14.b.i. as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements.

iii. Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in 14.b.ii. multiplied by the AG 43 liability change attributable to interest rate.

iv. Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in 14.b.iii.

c. As detailed in paragraph 12, fair value fluctuations in the hedging instruments that are not attributable to the hedged risk, shall be recognized as unrealized gains or unrealized losses.

NAIC Staff Comments / Recommendation: NAIC staff does not have any initial concerns with ACLI’s proposed revisions pertaining to the terms and concepts.

6 Hedge effectiveness is determined by comparing fair value fluctuations between the hedging instruments and the hedged item. However, in determining recognition in the financial statements, the fair value fluctuation of the hedging instruments is compared to the change in the reported value of the hedged item (designated portion of the AG 43 liability). The designated portion of the AG 43 liability is not reported at fair value in the statutory financial statements, as such, the offset reported as unrealized gains and losses is the portion of the fair value change in hedging instruments offset by the change in the reported value of thehedged item based on the designated portion of the AG 43 reserve calculation. In accordance with the documented hedging strategy, reporting entities shall compare the fair value fluctuations to the change in the designated portion of the reserve liability, after considering recognized derivative returns (including recognized derivative income), when determining the recognition of fair value fluctuations.

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2. Paragraph 8 – Governance Provisions / Actuarial Certifications Staff Background: Paragraph 8 was revised in the last exposure to delete the notification requirements to all states in which a company is licensed on the approval from their domiciliary state to following the special accounting provisions. Revisions were also included to reference the actuarial certifications of AG 43. In speaking with Reggie Mazyck (NAIC Life Actuary), he agreed that revisions to the AG 43 are not necessary as these certifications are captured within AG 43. Although these certifications are detailed in AG 43, the issue paper proposes revisions to capture new general interrogatories where the reporting entity will confirm that they have obtained the necessary certifications. ACLI Comments:

Although the changes made to this paragraph have alleviated our greatest concerns, we do not think the proposed certifications are necessary. Because the proposed certifications are already required in AG43/VM21, we do not believe they need to be duplicated in the accounting guidance. Specifically, section A7.5 requires certifications from both an actuary and a financial officer that are consistent with the certifications in paragraph 8b. We are somewhat confused by NAIC staff’s comments about “needed changes” to AG43 and would appreciate clarification. We are also unclear as to the purpose of the inquiry regarding “the approach to verify certifications.” If the concern is that the certifications should be supported by evidence, Appendix 7 of AG43 outlines requirements for CDHS modeling, multiple types of analysis (including back-testing), setting of E “effectiveness”, certifications, and documentation. From section A 7.5), “The actuary shall document the method(s) and assumptions (including data) used to determine CTE Amount (Adjusted) and CTE Amount (best efforts) and maintain adequate documentation as to the methods, procedures and assumptions used to determine the value of E”. We believe these existing requirements should be sufficiently robust to address regulatory needs.

Proposed Guidance: The ACLI did not propose revisions. The following is currently in the Issue Paper:

8. With the provisions in this standard to allow for flexibility in the hedged item (changes to variable annuity contracts within a portfolio) coupled with a dynamic hedging approach (rebalancing of derivative hedging instruments), there is a greater risk of misrepresentation of successful risk management and achievement of a highly effective hedging relationship. Although this risk cannot be eliminated, the following provisions intend to ensure governance of the program and provide sufficient tools to allow for regulator review:

a. Prior to implementing a hedging program for application within scope of this standard, the reporting entity must obtain explicit approval from the domiciliary state commissioner allowing use of this special accounting provision. The domiciliary state commissioner may subsequently disallow use of this special accounting provision at their discretion. Although this guidance does not restrict the state domiciliary commissioner on when to prohibit future use, disallowance should be considered upon finding that the reporting entity’s documentation, controls, measurement, prior execution of strategy or historical results are not adequate to support future use.

b. Actuarial certifications of AG 43 reserves, consistent with Actuarial Guideline 43 requirements, which explicitly include the following:

i. Certification as to whether the hedging strategy is incorporated within the establishment of AG 43 reserves, and the impact of the hedging strategy within the AG 43 Conditional Tail Expectation Amount.

ii. Certification by a financial officer of the company (CFO, treasurer, CIO, or designated person with authority over the actual trading of assets and derivatives) must certify that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy within AG 43 and that the Clearly Defined Hedging Strategy is the hedging strategy

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being used by the company in its actual day-to-day risk mitigation efforts. This provision does not require reporting entities to use a hedging strategy in determining AG 43 reserves, nor does it require entities to use the special accounting provision within this standard. However, it does require reporting entities that use the special accounting provisions within this standard to certify that the hedging strategy within scope of this standard is a Clearly Defined Hedging Strategy and is reflected in the establishment of AG 43 reserves.

Proposed new General Interrogatories: These would not be in the SSAP, but were included in the issue paper for review. These revisions will be referred to the Blanks (E) Working Group.

26.1 Does the reporting entity have any hedging transactions reported on Schedule DB?

26.2 If yes, has a comprehensive description of the hedging program been made available to the domiciliary state? If no, attach a description with this statement.

26.3 Does the reporting entity utilize derivatives to hedge variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity?

26.4 If so, does the reporting entity utilize:

Special Accounting Provision in SSAP No. XXX

Permitted Accounting Practice

Other Accounting Guidance

26.5 If the reporting entity utilizes the special accounting provision in SSAP No. XXX, the reporting entity shall attest to the following:

Reporting entity has obtained explicit approval from the domiciliary state.

Hedging strategy subject to the special accounting provisions is consistent with the requirements of Actuarial Guideline 43.

Actuarial certification has been obtained which indicates that the hedging strategy is incorporated within the establishment of Actuarial Guideline 43 reserves, and provides the impact of the hedging strategy within the Actuarial Guideline Conditional Tail Expectation Amount.

Financial Officer Certification has been obtained which indicates that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy within Actuarial Guideline 43 and that the Clearly Defined Hedging Strategy is the hedging strategy being used by the company in its actual day-to-day risk mitigation efforts.

NAIC Staff Comments / Recommendation: Although the ACLI does not agree with the including references to the required certifications in the SSAP (since they are in AG 43), NAIC staff recommends retaining the references, along with the proposed general interrogatory elements. NAIC staff agrees that revisions to AG 43 are not necessary. 3. Paragraph 10 – Notification to State of Change in Hedge Strategy

Staff Background: Prior discussion by the Working Group indicated continued support for the notification to the domiciliary state commissioner for changes in hedging strategy. ACLI Comments:

In response to NAIC staff’s inquiry, we would support a requirement to notify the state of change in hedge strategy within a certain period of the change. The aforementioned distinction between the hedging strategy and hedge target is critically important, however.

Proposed Guidance: The ACLI did not propose revisions. The following is currently in the Issue Paper:

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10. While an initially documented hedging strategy may subsequently change, any change in hedging strategy shall be documented, with notification to the domiciliary state commissioner, and include an effective date of the change in strategy. Reporting entities that elect to change a documented hedging strategy prior to the end of the three-month minimum implementation timeframe shall identify the hedging strategy, and all hedging instruments executed under the strategy, as ineffective. The three-month timeframe begins with the stated effective date of the hedging strategy regardless if any hedging instruments have been executed under the hedging strategy. Changes in a documented hedging strategy that occur after the three-month implementation timeframe do not necessitate an ineffective determination as long as hedged items and hedging instruments under the revised/new strategy continue to meet the requirements of a highly effective fair value hedge. Reporting entities are permitted to have more than one hedging strategy implemented, but all implemented strategies must qualify as a component of a Clearly Defined Hedging Strategy pursuant to paragraph 8.

NAIC Staff Comments / Recommendation: Staff highlights that the discussion differentiating between hedge strategy and the hedge target (which is discussed previously in this Hearing agenda) may impact the issue paper and when notification is required. Regardless, it seems that the notification requirement to the state domiciliary regulator detailed in paragraph 10 is not an issue.

4. Paragraphs 11 and 12 – Assessing Hedge Effectiveness

Staff Background: The exposed issue paper included proposed revisions, which were based on prior industry comments, to remove the measurement of ineffectiveness of the hedge, have the fair value comparisons occur between cumulative assessments (rather than current period), and to clarify that if the strategy excludes specific components, then the exposure companies shall be reported at fair value.

ACLI Comments: We support staff’s recommended changes.

NAIC Staff Comments / Recommendation: No further revisions to paragraphs 11-12 are proposed.

5. Paragraphs 15 and 26 – Fair Value Fluctuations

ACLI Comments: We support staff’s changes, but we believe that the language in paragraph 15 footnote 6 and paragraph 26.b. should be modified to encompass full financial statement fair value fluctuations on the hedging instruments (such as intra period realized gains/losses on individual derivative positions within the portfolio of specified derivatives). These fluctuations are assessed against the change in the designated portion of the reserve liability for purposes of determining deferred assets and liabilities.

ACLI Proposed Changes – Paragraph 15 - Footnote 6 & 26b:

15. Fair value fluctuations in the measurement of outstanding (non-expired) derivatives within a highly effective hedging strategy shall be reflected as follows:

a. Fair value fluctuations in the hedging instruments attributable to the hedged risk that offset the current period change in the hedged item (designated portion of the AG 43 reserve liability(; e.g., guarantee benefitscash flows)6 shall be recognized as a realized gain or loss.

Footnote 6: Hedge effectiveness is determined by comparing fair value fluctuations between the hedging instruments and the hedged item. However, in determining recognition in the financial statements, the fair value fluctuation of the hedging instruments is compared to the change in the reported value of the hedged item (designated portion of the AG 43 liability). The designated portion of the AG 43 liability is not reported at fair value in the statutory financial statements, as such, the offset reported as unrealized gains and losses is the portion of the fair value change in hedging instruments offset by the change in the reported value of thehedged item based on the designated portion of the AG 43 reserve calculation. In accordance with the documented hedging strategy, reporting entities shall compare the fair value

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fluctuations to the change in the designated portion of the reserve liability, after considering recognized derivative returns (including recognized derivative income), when determining the recognition of fair value fluctuations.

26. A reporting entity that has any outstanding derivatives accounted for under this special accounting provision, or that has unamortized deferred assets and/or deferred liabilities (representing previously unrecognized qualifying fair value fluctuations) from expired derivatives under the special accounting provision shall disclose the following within the financial statements:

b. Aggregate disclosure of the original cost and fair value of hedging instruments (including all instruments within a portfolio) along with any recognized derivative returns (including recognized derivative income) any investment income recognized during the reporting period. Additionally, disclose the fair value of the hedged item, the change in fair value from the prior reporting period, and the portion of the fair value change attributed to the hedged risk (designated portion of interest rate sensitivity).

NAIC Staff Comments / Recommendation: NAIC staff is fine with the ACLI proposed revisions to Footnote 6 and paragraph 26b. 6. Paragraphs 15 and 21 – Realized / Unrealized Gains or Losses

Staff Background: The exposed issue paper included proposed revisions, which were based on prior industry comments, to incorporate the gains/losses for qualifying derivative instruments to be reported as realized gains and losses (rather than unrealized gains and losses). This change would allow the AG 43 reserve changes and the corresponding derivative changes to both be recognized in earnings. ACLI Comments: In response to NAIC staff’s inquiry, we have not identified any unintended consequences that should be considered when evaluating the reporting of applicable fair value changes within the realized gain/loss financial statement line item.

Proposed Guidance: No Proposed Revisions to Paragraph 21: (The comments from the ACLI were supporting the deletion of the noted text.)

21. Reporting entities with expired derivative instruments that were part of a highly effective hedging strategy at the time of such expiration are not required to terminate the amortization schedule initially established for the deferred assets and deferred liabilities attributed to that derivative instrument. Rather, at the time of expiration, previously recognized unrealized gains and losses for these expired derivatives shall be reclassified as realized gains and realized losses, and the subsequent amortization of deferred assets and deferred liabilities shall be recognized into realized gains and realized losses.

NAIC Staff Comments / Recommendation: NAIC staff highlights that this reporting approach will be out of line with the fundamental realized / unrealized division that exists under statutory accounting. However, NAIC staff agrees that this reporting process will result with a consistent reporting line for the AG 43 reserve changes, and the offsetting derivative fair value changes. As previously noted, this can be accomplished through an instruction change for the Exhibit of Capital Gains and Losses. (For derivative instruments that qualify, the gain/loss amounts would be captured in column 2 instead of column 4.) The last exposure requested information on unintended consequence of this change, and nothing has been identified. NAIC staff still suggests a disclosure to capture the aggregate amount of “realized” gains and losses for open derivative instruments so that what would have been considered “unrealized” is known for comparison purposes. Otherwise, unless there are regulator concerns with this reporting change, NAIC staff does not believe further discussion is necessary.

7. Paragraph 26 – Schedule DB / Disclosures Staff Background: The exposed issue paper identified the prior ACLI comments that Schedule DB be leveraged as much as possible and requested the use of subtotals to capture derivative information. In response, staff noted support for leveraging Schedule DB, but noted that subtotals on existing schedules may

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not be sufficient to provide needed information. This prior exposure requested industry to provide an illustrated Schedule DB to detail the revisions they would proposed to capture these derivative structures.

ACLI Comments: NAIC staff has requested input on whether a separate DB schedule would be beneficial to capture information for transactions within this special accounting provision. We do not believe a separate DB schedule is necessary. It should be possible to leverage existing schedules to capture the required information, with some footnote enhancements. We would be willing to work with staff to create a workable construct.

NAIC Staff Comments / Recommendation: Similar to the prior exposure, NAIC staff requests that the ACLI provide suggested changes to Schedule DB. NAIC staff highlights that the reporting of the information, and the presentation of information in the financial statements to ensure transparency regarding the special accounting provisions are critical elements that need to be addressed before the proposed SSAP can be considered for adoption. 8. Overall Comment

Final ACLI Comment: Beyond this Issue Paper, we encourage the Working Group to proactively address similar accounting mismatches that emerge from the application of existing statutory accounting practices to a company’s risk mitigation efforts, specifically hedging other risk exposures present in variable annuity guarantees, for example, equity risks. It is important, however, not to delay this Issue Paper addressing the immediate accounting need to reduce accounting mismatches arising from interest rate risk mitigation activities. We acknowledge the concurrent workstreams and analysis being performed by the Variable Annuity Issues Working Group around Actuarial Guideline 43 (AG43) creates an evolving accounting and capital management landscape and can be challenging in the accounting standard setting process.

NAIC Staff Comments / Recommendation: Upon completion of this project, NAIC staff would encourage the ACLI and industry to present the Working Group with other accounting mismatches that need to be addressed. Topics for consideration by the Working Group are always available to be submitted under the Form A submission process.

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Exposure Draft

Issue Paper 15X— Special Accounting Treatment for Limited Derivatives

Hearing Date: Interim Call or 2017 Summer NM Location: Interim Call or 2017 Summer NM

Deadline for Written Notice of Intent to Speak:

May 19, 2017

Deadline for Receipt of Written Comments:

May 19, 2017

Notice of Public Hearing and Request for Written Comments

Basis for hearings. The Statutory Accounting Principles Working Group (SAPWG) will hold a public hearing to obtain information from and views of interested individuals and organizations about the standards proposed in this Exposure Draft. The SAPWG will conduct the hearing in accordance with the National Association of Insurance Commissioners (NAIC) policy statement on open meetings. An individual or organization desiring to speak must notify the NAIC in writing by May 19, 2017. Speakers will be notified as to the date, location, and other details of the hearings. Oral presentation requirements. The intended speaker must submit a position paper, a detailed outline of a proposed presentation or comment letter addressing the standards proposed in the Exposure Draft by May 19, 2017. Individuals or organizations whose submission is not received by that date will only be granted permission to present at the discretion of the SAPWG chair. All submissions should be addressed to the NAIC staff at the address listed below. Format of the hearings. Speakers will be allotted up to 10 minutes for their presentations to be followed by a period for answering questions from the SAPWG. Speakers should use their allotted time to provide information in addition to their already submitted written comments as those comments will have been read and analyzed by the SAPWG. Those submissions will be included in the public record and will be available at the hearings for inspection. Copies. Exposure Drafts can be obtained on the Internet at the NAIC Home Page (http://www.naic.org). The documents can be downloaded using Microsoft Word. Written comments. Participation at a public hearing is not a prerequisite to submitting written comments on this Exposure Draft. Written comments are given the same consideration as public hearing testimony. The Statutory Accounting Principles Statement of Concepts was adopted by the Accounting Practices & Procedures (EX4) Task Force on September 20, 1994, in order to provide a foundation for the evaluation of alternative accounting treatments. All issues considered by the SAPWG will be evaluated in conjunction with the objectives of statutory reporting and the concepts set forth in the Statutory Accounting Principles Statement of Concepts. Whenever possible, establish a relationship between your comments and the principles defining statutory accounting. The exposure period is not meant to measure support for, or opposition to, a particular accounting treatment but rather to accumulate an analysis of the issues from other perspectives and persuasive comments supporting them. Therefore, form letters and objections without valid support for their conclusions are not helpful in the deliberations of the working group. Comments should not simply register your agreement or disagreement without a detailed explanation, a description of the impact of the proposed guidelines, or possible alternative recommendations for accomplishing the regulatory objective. Any individual or organization may send written comments addressed to the Working Group to the attention of Julie Gann at [email protected], Robin Marcotte at [email protected], Fatima Sediqzad at [email protected] and Jake Stultz at [email protected] no later than May 19, 2017. Electronic submission is preferred. Julie Gann is the NAIC Staff that is the project lead for this topic. National Association of Insurance Commissioners 1100 Walnut Street, Suite 1500, Kansas City, MO 64106-2197 (816) 842-3600

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Special Accounting Treatment for Limited Derivatives

Issue Paper Revisions and Related Discussion Points

Issue Paper – April 8, 2017

1. Paragraph 1 – Inclusion of updated charge.

2. Paragraph 5 – Inclusion of terms / concepts for use within the Statement.

3. Paragraph 7 – Inclusion of explicit direction that reporting entities shall bifurcate risks, with the

provisions of the special accounting treatment shall apply to fair value changes due to interest rate risk. This guidance identifies that the fair value fluctuations not attributed to the hedged risk shall be recognized as unrealized gains or losses.

4. Paragraph 8a – Deletion of notification requirement to states in which a company is licensed. The ACLI commented that this notification requirement is unnecessary, and would place an undue burden with little benefit to regulators. They have identified that approval by the domiciliary state, along with disclosures and/or general interrogatories can accomplish the enhanced level of regulatory review. Inquiry – Input is requested regarding this deletion, and whether the actuarial memo and proposed financial statement general interrogatories / disclosures are sufficient.

5. Paragraph 8b & 8c – Revisions to reference the actuarial certifications of AG 43 requirements. The

ACLI commented that the actuarial and financial officer certification should be implemented through the actuarial certification of AG 43, along with an addition to the Supplemental exhibits and Schedule Interrogatories asking if the certification has been filed and have suggested disclosure requirements. Staff suggests that reference to these items be retained within the guidance. Also, as revisions would likely be needed to AG 43, suggests a referral to the appropriate group to incorporate needed changes and to ensure the AG 43 certification requirements is in place prior to the effective date of the guidance. Inquiry – Input is requested regarding the approach to verify certifications.

6. Paragraph 10 – The ACLI commented that the notification upon any change in hedging strategy places undue administrative burden on reporting entities and state regulators. They have noted that documentation of hedging strategy in the actuarial memorandum (required in AG 43) and in the footnotes to the financial statements is sufficient to mitigate risk and provide governance and oversight of the program. From preliminary information received, communicating a change in hedging strategy is not considered an undue burden, and this information would be beneficial for regulator review. As such, no change has been proposed to reflect this ACLI comment.

7. Paragraph 10 – The ACLI has commented that a change in the hedge target shall not constitute a change in strategy as the entity’s hedge strategy is to mitigate interest rate risk and sensitivity to a tolerable level. The ACLI has commented that entity tolerances can change as a result of the market environment or guarantee positions, and management must be able to react to changing economics without risk of losing hedge accounting. Staff has not incorporated changes to reflect these comments. As previously noted, staff is cautious of an approach that would allow changes in the hedge target without documentation of a change in hedging strategy. This comment was considered when drafting the issue paper, and the proposal for a “monthly reset” of the hedging strategy was noted as overly permissive if coupled with provisions that allow a flexible portfolio of contracts and a dynamic hedge (where hedging instruments can be rebalanced to match changes in the underlying). Staff also highlights that the issue paper already proposes to allow a designated portion of the cash flows to be the hedged item. This is more permissive than U.S. GAAP, as the GAAP guidance

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requires all contractual cash flows of the entire hedge to be used in calculating the change in the hedged item’s fair value attributed to the hedged risk. The concept to require a 3-month timeframe for the hedging strategy, with notation of the specific risk being hedged (which the issue paper identifies as the percentage of interest rate sensitivity) is consistent with the concepts for a “Clearly Defined Hedging Strategy” (CDHS) under AG 43. To qualify as a CDHS, the strategy must be in place for 3 months, with identification of various elements. (AG 43 does not specifically identify the percentage of interest rate, but it is specific with regards to the specific risks being hedged, hedged objectives, risks not being hedged, etc.) Inquiry – Additional input is requested, particularly if regulators have a different view.

8. Paragraph 11 – Deletion of requirement to document ineffective portion of the hedge. The ACLI

commented against this disclosure, citing that the information would be incomplete and likely misleading. With the draft “targeted improvement” revisions for hedging instruments being considered under U.S. GAAP, FASB is currently proposing to delete this disclosure requirement. Information about hedge effectiveness will still be captured.

9. Paragraph 11 – New footnote incorporates suggested ACLI revisions to clarify that the retrospective

assessment shall be based on the hedge target that was in effect during the retrospective periods.

10. Paragraph 12 – Revisions to incorporate suggested ACLI revisions to remove reference to FAS 133 and to indicate that the fair value comparison shall occur on the cumulative change, rather than the current-period change.

11. Paragraph 12 – Revisions to explicitly incorporate language that the excluded components of the

hedging derivative shall be reported at fair value with the gains and losses recognized as unrealized. This is consistent with the ACLI comments to incorporate language on this issue.

12. Paragraphs 15 & 21 – The ACLI has provided comments noting a statutory disconnect in how

derivative gains/losses are recognized in comparison to the AG 43 reserve change. These comments identify that the change in liability will be recognized in net income, and the fair value changes will be recognized (or amortized) to unrealized gains or losses (outside of net income). The ACLI is correct that this disconnect does not occur under U.S. GAAP, as offsetting fair value changes in hedged items and hedging instruments are concurrently recognized in earnings. Staff agrees that it would be best for offsetting impacts for hedged items and hedging instruments to be reflected in the same reporting line. Although it is inconsistent with current statutory accounting provisions, staff is recommending revisions to clarify that fair value changes in highly effective derivatives to be recognized (or amortized) to realized gains and losses. This would also address the tracking concerns noted by interested parties for when highly effective derivative instruments expire (as the recognition would continue to realized gains and losses). Staff is recommending use of unrealized gains and losses for excluded components / risks and for derivative instruments that are not highly effective. Inquiry – In reviewing the statutory financials, staff believes this can be accomplished through an instruction change for the Exhibit of Capital Gains and Losses. (For derivative instruments that qualify, the gain/loss amounts would be captured in column 2 of this exhibit instead of column 4.) Staff requests input on whether this reporting change would have any unintended consequences that should be considered. Staff suggests that a disclosure be added to capture the aggregate amount of “realized” gains and losses for “open” derivative instruments so that information is known for comparison assessments.

13. Paragraph 16 – The ACLI has suggested that the amortization timeframe for deferred assets and

liabilities be based on the Macaulay duration of the guarantee benefit cash flows based on the AG 43 Standard Scenario, not to exceed 20-years. The ACLI identified 20-years as the shortest maximum

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length that would result in removing most of the non-economic accounting volatility from the statutory financial statements. The ACLI comments also supported the determination of the amortization period for each deferred asset or liability at the time the deferred asset/liability is established. Staff is aware that a 10-year amortization has been used by at least one company through a permitted practice. This company identified that the Macaulay duration for their block would have exceeded 20+ years, and a simplified 10-year timeframe was utilized to ensure transparency. Inquiry – The current issue paper incorporates a maximum 10-year timeframe for simplification and transparency. Staff is conducting additional research on prescribed and permitted practices to identify if there are consistent timeframes that have been approved by the states.

14. Paragraph 18 – Although no revisions have been proposed to this paragraph, the ACLI has provided

comments opposing the requirements to discontinue amortization (and recognized gains/losses) when a non-expired derivative instrument no longer qualifies within the standard, or if it is no longer an effective hedge. The ACLI has cited U.S. GAAP guidance as support for allowing the amortization timeframe to continue for deferred assets/liabilities in these scenarios. Although U.S. GAAP allows recognition of ineffective hedges to occur prospectively, this is because the impacts of the fair value hedge were reflected as a change in fair value / earnings when they occurred. As the hedged item is reported at fair value, the change in fair value is used to adjust the hedged item. Staff also highlights that existing SSAP No. 86 for forecasted transaction requires deferred gains or losses to be recognized immediately in unrealized gains or losses if the forecasted transaction is no longer probable. Regulator Inquiry – Staff understands that the immediate recognition of gains and losses for ineffective / hedges that no longer qualify may have an undesirable impact on the statutory financial statements. However, there are concerns for amortizing an unrealized loss (as a deferred asset) for years after the derivative program was identified as ineffective. Staff will be conducting further research on this issue, and inquiring with the Variable Annuity Issues (E) Working Group regarding the impact of these prior effective hedges on the remaining / future AG43 liabilities.

Excerpts from U.S. GAAP – 815-251-35-1 and 815-25-35-2:

Gains and losses on a qualifying fair value hedge shall be accounted for as follows:

a. The gain or loss on the hedging instrument shall be recognized currently in earnings.

b. The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.

If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for the component, if any, of that gain or loss that is excluded from the assessment of effectiveness under the entity’s defined risk management strategy for that particular hedging relationship (as discussed in paragraphs 815-20-25-81 through 25-83), would exactly offset the loss or gain on the hedged item attributable to the hedged risk. Any difference that does arise would be the effect of hedge ineffectiveness, which consequently is recognized currently in earnings.

SSAP No. 86, paragraph 24b (excerpt):

If a forecasted transaction is determined to no longer be probable per the standards above, hedge accounting shall cease immediately and any deferred gains or losses on the derivative must be recognized in unrealized gains or losses. If an entity demonstrates a pattern of determining that hedged forecasted transactions probably will not occur, such action would call into question both the entity's ability to accurately predict forecasted transactions and the propriety of using hedge accounting in the future for similar

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forecasted transactions. Accordingly, hedge accounting for transactions forecasted by that entity will no longer be permitted.

15. Paragraph 26 – The ACLI commented that the individual tracking for these derivative transactions would be extremely burdensome given the volume of individual derivative contracts, and will not add value to the regulatory process. Although they agreed that an audit trail should be provided, they have recommended that documentation of deferred assets and liabilities and amortization be reflected in aggregate by reporting period. Revisions have been proposed to capture aggregate disclosures. Additionally, revisions have been proposed to separately capture information on the fair value change of excluded components recognized as unrealized gains and losses.

16. Proposed General Interrogatories - The ACLI suggested disclosures to identify whether a reporting entity uses the special accounting provisions and whether the provisions are consistent with AG 43. Rather than including in a disclosure, staff has proposed the inclusion of new GI to capture this information and for the reporting entity to attest to certain components of the program.

17. Schedule DB – The ACLI has suggested that Schedule DB be leveraged as much as possible for

disclosures on derivatives that receive hedge accounting treatment for variable annuities, and have requested for the NAIC to add new subtotals to capture derivatives instruments subject to this issue paper. Although staff is supportive of leveraging Schedule DB, staff is uncertain that the inclusion of subtotals will likely be sufficient, particularly if different types of derivative instruments are used (e.g., futures), as information on the instruments could be divided across different DB schedules, and with the enhanced information that will be requested. Inquiry – Input is requested regarding the form/structure of desired disclosures – including whether a separate DB schedule would be beneficial to capture the information for the transactions captured within this special accounting provision. Industry representatives are requested to provide an illustrated Schedule DB, with the revisions they would propose to capture these derivative structures.

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Statutory Issue Paper No. XX

Special Accounting Treatment for Limited Derivatives

STATUS Exposure Draft – April 8, 2017 Type of Issue: Common Area SUMMARY OF ISSUE

1. Current statutory accounting guidance for derivatives qualifying for hedging effectiveness is in SSAP No. 86—Derivatives. Based upon a recommendation from the Variable Annuities Issues (E) Working Group, the Financial Condition (E) Committee issued the following 2016 2017 charge to the Statutory Accounting Principles (E) Working Group:

Develop specific statutory accounting guidance for certain limited derivative contracts hedging variable annuity guarantees, subject to fluctuations as a result of interest rate sensitivity, reserved for in accordance with Actuarial Guideline XLIII—CARVM for Variable Annuities (AG 43). This guidance shall place an emphasis on reducing non-economic surplus volatility for these specific hedges in situations where strong risk-management is in place, with safeguards to ensure appropriate financial statement presentation and disclosures, sufficient transparency, and regulatory oversight. This charge shall be a high priority, with the earliest effective date feasible that allows for adequate development of guidance and related reporting schedules. Develop and adopt changes to SSAP No. 86—Derivatives, with an effective date of January 1, 2017 or earlier, which allow hedge accounting treatment under SSAP No. 86 for certain limited derivative contracts (e.g. interest rate hedges with counterintuitive effects) that otherwise do not meet hedge effectiveness requirements. In adopting such an allowance, consider if the requirement to meet hedge effectiveness can be replaced by some other information that demonstrates strong risk management is in place over the identified hedges. —Essential

2. Pursuant to the direction from the Financial Condition (E) Committee, this issue paper has been drafted to detail substantive statutory accounting revisions to allow special accounting treatment for limited derivatives hedging variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity. The provisions within this issue paper are proposed to be separate and distinct from the guidance in SSAP No. 86, as the items subject to the scope of this guidance, and the provisions within, would not qualify for hedge effectiveness under SSAP No. 86. Allowances provided within this issue paper are only permitted if all of the components of the issue paper are met, and shall not be inferred as an acceptable statutory accounting approach for derivative transactions that do not meet the stated qualifications or that are not specifically addressed within this guidance.

3. The guidance within this issue paper is anticipated to be included as a new SSAP applicable to the limited derivative situations addressed within. Upon adoption of the issue paper, the Working Group will conclude on the location of this guidance within statutory accounting.

SUMMARY CONCLUSION

4. This statement establishes statutory accounting principles to address certain, limited derivative transactions hedging variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity. Eligibility for the special accounting provision within this standard is strictly limited to variable annuity contracts and other contracts involving certain guaranteed benefits similar to those

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offered with variable annuities that are reserved for in accordance with Actuarial Guideline XLIII, CARVM for Variable Annuities (AG 43). The statutory accounting guidance within this statement is considered a special accounting provision, only permitted if all the components in the standard are met, and shall not be inferred as an acceptable statutory accounting approach for situations that do not meet the stated qualifications or that are not specifically addressed within this guidance.

Terms / Concepts (for purposes of this Statement)

5. The following terms reflect concepts specific to this Statement. (This listing only details the key concepts. Specific guidelines are reflected throughout the guidance.)

a. Derivative Instrument: Means an agreement, option, instrument or series or combination thereof: (1) To make or take delivery of, or assume or relinquish, a specified amount of one or more underlying interests, or to make a cash settlement in lieu thereof; or (2) That has a price, performance, value or cash flow based primarily upon the actual or expected price, level, performance, value or cash flow of one or more underlying interests.

b. Dynamic Hedging Approach: A dynamic hedging strategy allows for the portfolio of derivatives comprising the hedging instrument to be rebalanced in accordance with changes to the hedged item in order to adhere to the specified, documented hedging strategy.

c. Hedged item: The hedged item may be an open or flexible portfolio (e.g., group of variable annuity contracts with different characteristics and liability durations) that allows for addition of newly issued contracts, subtraction of surrenders and fluctuations in balances. The hedged item shall reflect the present value of cash flows of a pool, or portion thereof, of variable annuity contracts exposed to interest rate risk.

d. Hedging Instrument: The hedging instrument shall reflect a specified derivative, or a portfolio of specified derivatives, that hedges the interest rate sensitivity of the designated hedged item. The hedging instrument may reflect a dynamic hedging strategy in which a portfolio of derivatives comprising the hedging instrument is rebalanced in accordance with changes to the hedged item.

e. Macro-Hedge: A macro-hedge refers to the ability to jointly designate a portfolio of variable annuity policies, such as an entire book of business or subsections thereof, as the hedged item.

Special Accounting Provision

4.6. The is special accounting provision within this Statement permits reporting entities to utilize a form of “macro-hedging” in which a portfolio of variable annuity policies, which could include the entire book of business or subsections thereof, are jointly designated as the hedged item, in a fair value hedge1, pursuant to a Clearly Defined Hedging Strategy (throughout this issue paper also referred to as “CDHS” or “hedging strategy”). This is considered a macro-hedge, as the designated hedged item (group of policies) may be a portfolio of variable annuity contracts with different characteristics and liability durations. Under this special accounting provision, the portfolio of hedged items is not required to be static, but can be revised to remove policies and/or include new policies to allow for continuous risk

1 As detailed in paragraph 11, these hedges are required to be highly effective in achieving offsetting changes in fair value attributed to the hedged risk between the derivative hedging instruments and the hedged item (AG 43 liability) during the period that the hedge is designated.

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management (hedging) of the variable annuity guarantee reserves in accordance with the specific risks being hedged and the hedge objectives of the specified, documented hedging strategy. In designating the hedged item, reporting entities are permitted to exclude specific components of the variable annuity contracts, but such exclusions must apply collectively to all policies included within the portfolio. For example, reporting entities may elect to only hedge the interest rate risk of rider cash flows, and if making this election, would define the hedged item as the “fair value of rider claims net of rider fees” for the portfolio of policies designated as the hedged item.

5.7. This special accounting provision permits reporting entities to utilize a specified derivative, or a portfolio of specified derivatives, as the hedging instrument within a fair value hedge to hedge the interest rate sensitively, or a specific percentage2 of the interest rate sensitivity, of the designated hedged item. The hedging instrument may reflect a dynamic hedging strategy in which a portfolio of derivatives comprising the hedging instrument is rebalanced in accordance with changes to the hedged item in order to adhere to the specified, documented hedging strategy. Although the hedging instruments must address interest rate risk, this guidance does not preclude use of derivative instruments that may offset risks other than interest rate risk from being designated as the hedging instruments. For derivative instruments that are affected by multiple risk factors, including interest rate risk, reporting entities shall apply this special accounting treatment to the change in fair value due to interest rate risk. Reporting entities shall bifurcate the change in fair value due to the various risk factors (e.g., fair value volatility due to interest rates (rho), and other risk factors, such as equity level (delta) or volatility (vega). Pursuant to paragraph 12 and 15, fair value fluctuations not attributed to the hedged risk, including fair value changes from excluded open components, shall be recognized as unrealized gains or losses.

6.8. With the provisions in this standard to allow for flexibility in the hedged item (changes to variable annuity contracts within a portfolio) coupled with a dynamic hedging approach (rebalancing of derivative hedging instruments), there is a greater risk of misrepresentation of successful risk management and achievement of a highly effective hedging relationship. Although this risk cannot be eliminated, the following provisions intend to ensure governance of the program and provide sufficient tools to allow for regulator review:

a. Prior to implementing a hedging program for application within scope of this standard, the reporting entity must obtain explicit approval from the domiciliary state commissioner allowing use of this special accounting provision. Upon approval from the domiciliary state to use the special accounting provision, the reporting entity must notify all states in which they are licensed of the approval to use this special accounting provision. The domiciliary state commissioner may subsequently disallow use of this special accounting provision at their discretion. Although this guidance does not restrict the state domiciliary commissioner on when to prohibit future use, disallowance should be considered upon finding that the reporting entity’s documentation, controls, measurement, prior execution of strategy or historical results are not adequate to support future use.

b. Actuarial certifications of AG 43 reserves, consistent with Actuarial Guideline 43 requirements, which explicitly include the following:

i. Certification An external, qualified actuary, approved by the domiciliary state commissioner, must provide certification as to whether the hedging strategy is incorporated within the establishment of AG 43 reserves, and the impact of the hedging strategy within the AG 43 Conditional Tail Expectation Amount.

2 In identifying the hedged risk, reporting entities must identify whether they are hedging the full, or a portion of (e.g., 40%), the interest rate sensitivity.

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ii. Certification by Aa financial officer of the company (CFO, treasurer, CIO, or designated person with authority over the actual trading of assets and derivatives) must certify that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy within AG 43 and that the Clearly Defined Hedging Strategy is the hedging strategy being used by the company in its actual day-to-day risk mitigation efforts. This provision does not require reporting entities to use a hedging strategy in determining AG 43 reserves, nor does it require entities to use the special accounting provision within this standard. However, it does require reporting entities that use the special accounting provisions within this standard to certify that the hedging strategy within scope of this standard is a Clearly Defined Hedging Strategy and is reflected in the establishment of AG 43 reserves.

7.9. As identified in paragraph 4, eligibility for the special accounting provision within this standard is strictly limited to variable annuity contracts and other contracts involving certain guaranteed benefits similar to those offered with variable annuities that are reserved for in accordance with Actuarial Guideline XLIII, CARVM for Variable Annuities (AG 43). This special accounting provision requires the reporting entity to engage in highly effective fair value hedges that follow a Clearly Defined Hedging Strategy, as defined in AG 43, meeting all required provisions of AG 43 allowing the reporting entity to reduce the amount of the Conditional Tail Expectation (CTE) Amount. In order to qualify as a Clearly Defined Hedging Strategy, the strategy must meet the principles outlined in AG 43, be in place (implemented) for at least three months3, and shall at a minimum, identify:

a. Specific risks being hedged4,

b. Hedge objectives,

c. Risks not being hedged,

d. Financial instruments that will be used to hedge the risks,

e. Hedge trading rules, including permitted tolerances from hedging objectives,

f. Metric(s) used for measuring hedging effectiveness,

g. Criteria that will be used to measure effectiveness,

h. Frequency of measuring hedging effectiveness,

i. Conditions under which hedging will not take place, and

j. The individuals responsible for implementing the hedging strategy.

8.10. While an initially documented hedging strategy may subsequently change, any change in hedging strategy shall be documented, with notification to the domiciliary state commissioner, and include an

3 As detailed in AG 43, before a new or revised hedging strategy can be used to reduce the amount of the Conditional Tail Expectation (CTE) otherwise calculated, the hedging strategy should be in place (effectively implemented) for at least three months. As detailed in AG 43, the Company may meet the time requirement by having evaluated the effective implementation of the hedging strategy for at least three months without actually having executed the trades indicated by the hedging strategy (e.g., mock testing or by having effectively implemented the strategy with similar annuity products for at least three months.) 4 The specific risk being hedged shall include a measure of the hedge coverage (e.g., percentage of interest rate sensitivity being hedged).

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effective date of the change in strategy. Reporting entities that elect to change a documented hedging strategy prior to the end of the three-month minimum implementation timeframe shall identify the hedging strategy, and all hedging instruments executed under the strategy, as ineffective. The three-month timeframe begins with the stated effective date of the hedging strategy regardless if any hedging instruments have been executed under the hedging strategy. Changes in a documented hedging strategy that occur after the three-month implementation timeframe do not necessitate an ineffective determination as long as hedged items and hedging instruments under the revised/new strategy continue to meet the requirements of a highly effective fair value hedge. Reporting entities are permitted to have more than one hedging strategy implemented, but all implemented strategies must qualify as a component of a Clearly Defined Hedging Strategy pursuant to paragraph 8.

Assessing Hedge Effectiveness

9.11. The provisions within this standard require the entity to use a specific method, as detailed in paragraph 11, to assess hedge effectiveness at inception and on an ongoing basis. At a minimum, hedge effectiveness assessment is required whenever financial statements are reported, at least every three months. Documentation requires prospective and retrospective5 hedge effectiveness assessments, with on-going assessment consistent with the originally documented risk management strategy. In addition to assessing whether the hedge is highly effective, the quarterly documentation shall include a measure of the ineffective part of hedge. This standard does not require separate financial statement recognition of the effective and ineffective components of the hedging strategy; however, disclosure of these components is required.

10.12. This standard requires a single measure for assessing whether the hedging strategy is highly effective, and in measuring hedge ineffectiveness. Both at inception, and on an ongoing basis, the hedging relationship must be highly effective in achieving offsetting changes in fair value attributed to the hedged risk during the period that the hedge is designated. In order to meet this requirement, reporting entities electing to use this special accounting provision must calculate the fair value of the hedged item (AG 43 guarantee reserve) at inception and on an ongoing basis in a similar fashion as FAS 133, and compare the cumulative current period fair value change of the hedged item to the cumulative current period fair value change of the hedging instruments. This comparison is specific to the designated hedged risks and exposures, therefore, if only a portion of the interest rate risk is hedged or if the designated hedge only include specific components of the variable annuity policies (e.g., riders), for determining hedge effectiveness, the fair value comparisons is limited to those designated items. If an entity’s defined risk management strategy for a particular hedging relationship excludes specific components of the hedging derivative from the assessment of hedge effectiveness, the excluded open components shall be reported at fair value with gains or losses recognized as unrealized gains or losses.

11.13. The term highly effective describes a fair value hedging relationship where the change in fair value of the derivative instrument is within 80 to 125 percent of the opposite change in fair value of the hedged item attributed to the hedged risk. It shall also apply when an R-squared of .80 or higher is achieved when using a regression analysis technique.

Measurement / Recognition of Unrealized Gains and Losses of Outstanding (Open) Instruments

12.14. All designated hedging instruments (all derivatives, including those reflected in portfolios) shall be reported in the financial statements at fair value.

5 For situations in which there has been a change in hedging strategy pursuant to paragraph 10, when conducting retrospective hedge effectiveness assessments, reporting entities shall assess effectiveness based on the hedge target that was actually in effect during the retrospective time periods.

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13.15. Fair value fluctuations in the measurement of outstanding (non-expired) derivatives within a highly effective hedging strategy shall be reflected as follows:

a. Fair value fluctuations in the hedging instruments attributable to the hedged risk that offset the current period change in the hedged item (designated portion of the AG 43 reserve liability; e.g., guarantee cash flows)6 shall be recognized as a realized gain or loss.

b. , and fair value fluctuations in the hedging instruments that are not attributable to the hedged risk, shall be recognized as unrealized gains or unrealized losses.

c.b. Fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (designated portion of the AG 43 reserve liability; e.g., guarantee cash flows) shall be recognized as deferred assets (admitted) and deferred liabilities. The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the hedged item. Reporting entities shall utilize the following calculation for establishing the deferred asset (also illustrated in Appendix A) unless a different method has been approved by the domiciliary state commissioner:

i. Calculate the fair value gain or loss in the hedged item attributable to the hedged risk;

ii. Express the quantity calculated in 14.b.i. as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements.

iii. Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in 14.b.ii. multiplied by the AG 43 liability change attributable to interest rate.

iv. Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in 14.b.iii.

c. As detailed in paragraph 12, fair value fluctuations in the hedging instruments that are not attributable to the hedged risk, shall be recognized as unrealized gains or unrealized losses.

16. Deferred assets and deferred liabilities recognized under paragraph 14.b. shall be amortized using a straight-line method into unrealized gains or unrealized losses over a finite amortization period. The amortization timeframe shall equal the Macaulay duration of the guarantee benefit cash flows based on

6 Hedge effectiveness is determined by comparing fair value fluctuations between the hedging instruments and the hedged item. However, in determining recognition in the financial statements, the fair value fluctuation of the hedging instruments is compared to the change in the reported value of the hedged item (designated AG 43 liability). The designated portion of the AG 43 liability is not reported at fair value in the statutory financial statements, as such, the offset reported as unrealized gains and losses is the portion of the fair value change in hedging instruments offset by the change in the hedged item based on the AG 43 reserve calculation. In accordance with the documented hedging strategy, reporting entities shall compare the fair value fluctuations to the change in the designated portion of the reserve liability, after considering recognized derivative income, when determining the recognition of fair value fluctuations.

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the AG 43 Standard Scenario, but shall not exceed a period of 10 years. shall not exceed five (5) years unless there is explicit documentation demonstrating that a longer period is more closely linked to the expected liability duration of the hedged item. In situations in which a longer period is substantiated, and approved by the domiciliary state commissioner, the amortization timeframe is not permitted to exceed ten (10) years.

d.a. Future recognition of deferred assets or liabilities from fair value fluctuations attributed to the hedged risk that are not offset by the reserve liability change do not extend the amortization timeframe for previously recognized deferred assets or deferred liabilities. Reporting entities are required to separately track, with a schedule to show the initial deferred amount and amortization schedule, of the deferred assets and deferred liabilities recognized and outstanding at each reporting date.

e.b. The amount reported on the financial statement at each reporting date shall reflect the net amount (net as either a deferred asset or deferred liability) for each hedging strategy captured within scope of this guidance.

f.c. Reporting entities are permitted to amortize a greater portion of the deferred assets and/or deferred liabilities into unrealized gains or unrealized losses at any time in advance of the scheduled amortization period.

14.17. For outstanding (non-expired) derivative instruments that were removed from a highly effective hedging strategy (rebalanced), subsequent gains and losses from fair value fluctuations shall not impact the previously recognized deferred assets or deferred liabilities. The deferred assets and deferred liabilities for these derivative instruments shall be “locked” and amortized under the remaining schedule unless the reporting entity elects to terminate or accelerate amortization.

15.18. For outstanding (non-expired) derivative instruments in a hedging strategy that no longer qualifies within scope of this standard (e.g., AG 43 requirements are not met) or is no longer a highly effective hedge, any non-amortized deferred assets or deferred liabilities shall be immediately recognized as unrealized gains and/or unrealized losses. All future fair value fluctuations for these derivative instruments shall be recognized as unrealized gains or unrealized losses unless the instrument is subsequently designated as part of a highly effective hedging strategy. If the derivative is re-designated as part of a highly effective hedging strategy qualifying under this standard, subsequent fair value fluctuations (after the re-designation) may be accounted for under this special accounting provision.

16.19. Reporting entities may elect to terminate use of this special accounting provision at any time. In those instances, if the derivative instruments are outstanding, all deferred assets and deferred liabilities shall be immediately eliminated with recognition as unrealized gains and/or unrealized losses. Regardless of whether the hedging strategy is determined to be highly effective, subsequent accounting of the derivatives within the hedging strategy shall follow the fair value accounting approach in SSAP No. 867.

Measurement / Recognition of Realized Gains or Losses of Expired Derivatives

17.20. With the ability to rebalance the hedging instrument, this guidance allows for individual derivative instruments to expire and/or be removed from the portfolio of the hedging instrument, and not immediately trigger an assessment that the overall hedging strategy is no longer highly effective. Furthermore, special allowances are included to consider the tenure differences between a hedging

7 Macro-hedges and the ability to rebalance hedging instruments are not provisions permitted within “effective” hedges in scope of SSAP No. 86. As such, hedging strategies with these components accounted for under SSAP No. 86 shall follow the fair value accounting approach detailed in that standard.

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instrument and AG 43 liability duration. These allowances permit expired8 derivative instruments that were part of a highly effective hedging strategy at the time of expiration to continue amortizing the deferred gains and deferred losses over the previously established amortization timeframe even if the overall hedging strategy is subsequently terminated or subsequently identified as no longer qualifying as a highly effective hedge.

21. Reporting entities with expired derivative instruments that were part of a highly effective hedging strategy at the time of such expiration are not required to terminate the amortization schedule initially established for the deferred assets and deferred liabilities attributed to that derivative instrument. Rather, at the time of expiration, previously recognized unrealized gains and losses for these expired derivatives shall be reclassified as realized gains and realized losses, and the subsequent amortization of deferred assets and deferred liabilities shall be recognized into realized gains and realized losses.

18.22. Consistent with the guidance in paragraph 15.c., reporting entities are permitted to amortize a greater portion of the deferred assets and/or deferred liabilities from expired derivatives into realized gains or realized losses at any time in advance of the scheduled amortization period.

19.23. Consistent with the guidance in paragraph 18, reporting entities may elect to terminate use of this special accounting provision at any time. In those instances involving expired derivatives, all remaining deferred assets and deferred liabilities shall be immediately eliminated with recognition as realized gains and/or realized losses.

Derivative Income

20.24. Derivative income (e.g., swap cash flows) shall be recognized as investment income when earned received.

21.25. Pursuant to the documented hedging strategy as a fair value hedge, derivative income shall be considered as part of the overall hedging strategy and included in the assessments on whether the strategy is highly effective.

Disclosures

22.26. A reporting entity that has any outstanding derivatives accounted for under this special accounting provision, or that has unamortized deferred assets and/or deferred liabilities (representing previously unrecognized qualifying fair value fluctuations) from expired derivatives under the special accounting provision shall disclose the following within the financial statements:

a. Discussion of hedged item (portfolio of variable annuity policies), including information on the guarantees sensitive to interest rate risk, along with information on the designated hedging instruments being used to hedge the risk. Discussion of the hedging instruments shall identify whether a hedging instrument is a single instrument or portfolio, as well as information on the hedging strategy, and assessing hedging effectiveness and compliance with the “Clearly Defined Hedging Strategy” of AG 43. Identification shall occur on whether the hedged item is intended to be fully hedged under the hedging strategy, or if the strategy is only focused on a portion of the liability characteristics or a portion of the interest rate sensitivity. Hedging strategies shall be identified as highly effective or ineffective. For highly effective strategies that are not 100% effective, information on the ineffective components shall be disclosed. (For example, iIf the strategy for a particular hedging relationship excludes a specific component of the gain or loss, or related cash

8 Throughout this standard the use of the word “expire” is intended to capture all instances in which the derivative is no longer outstanding. It includes maturities, terminations, sales, and/or other closing transactions of a derivative.

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flows, from the assessment of hedge effectiveness, details on the excluded components shall be disclosed.)

b. Aggregate Ddisclosure of the original cost and fair value of all hedging instruments (including all instruments within a portfolio) along with any investment income recognized during the reporting period. Additionally, disclose the fair value of the hedged item, the change in fair value from the prior reporting period, and the portion of the fair value change attributed to the hedged risk (designated portion of interest rate sensitivity).

c. Schedule showing the aggregate fair value change from the prior reporting period for the designated components for all hedging instruments, with identification of the fair value change the portion reflected in unrealized gains, unrealized losses, deferred assets, and deferred liabilities (outstanding derivatives), and the portion reflected in realized gains and realized losses (expired derivatives). This schedule shall also show the current period amortization, including any expedited amortization elected by the reporting entity, and the future scheduled amortization of the deferred assets and deferred liabilities. This schedule shall also identify the fair value of the excluded components of the hedging instruments, and the fair value change reflected in unrealized gain and unrealized loss.

d. Identification of any 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.

e. 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.

Proposed new General Interrogatories: These would not be in the SSAP, but are included here for review. These revisions will be referred to the Blanks (E) Working Group.

26.1 Does the reporting entity have any hedging transactions reported on Schedule DB?

26.2 If yes, has a comprehensive description of the hedging program been made available to the domiciliary state? If no, attach a description with this statement.

26.3 Does the reporting entity utilize derivatives to hedge variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity?

26.4 If so, does the reporting entity utilize:

Special Accounting Provision in SSAP No. XXX

Permitted Accounting Practice

Other Accounting Guidance

26.5 If the reporting entity utilizes the special accounting provision in SSAP No. XXX, the reporting entity shall attest to the following:

Reporting entity has obtained explicit approval from the domiciliary state.

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Hedging strategy subject to the special accounting provisions is consistent with the requirements of Actuarial Guideline 43.

Actuarial certification has been obtained which indicates that the hedging strategy is incorporated within the establishment of Actuarial Guideline 43 reserves, and provides the impact of the hedging strategy within the Actuarial Guideline Conditional Tail Expectation Amount.

Financial Officer Certification has been obtained which indicates that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy within Actuarial Guideline 43 and that the Clearly Defined Hedging Strategy is the hedging strategy being used by the company in its actual day-to-day risk mitigation efforts.

Appendix A – Calculation of Deferred Asset or Deferred Liability

Under the special accounting provisions within this issue paper, as detailed in paragraph 14.b., fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (AG 43 reserve liability) shall be recognized as deferred assets (admitted) and deferred liabilities.

The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the hedged item.

Unless a different method has been approved by the domiciliary state commissioner, reporting entities shall utilize the following calculation (detailed in paragraph 14) for establishing the deferred asset:

14.b.i Calculate the fair value gain or loss in the hedged item attributable to the hedged risk (Step 1);

14.b.ii Express the fair value gain or loss calculated (Step 1) as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements (Step 2).

14.b.iii Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in Step 2 multiplied by the AG 43 liability change attributable to interest rate (Step 3).

14.b.iv Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in Step 3.

To illustrate the above calculation:

Clearly Defined Hedging Strategy (CDHS) characteristics

Hedged item Rider claims less rider fees Hedged risk 50% of the rho (first-order IR level sensitivity)

Calculation of the deferred asset or liability Note: positive values = increase in liability

Fair value gain (loss) in hedged item attributable to interest rate movement (500)

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14.b.i. - Fair value gain (loss) in hedged item attributable to hedged risk (250) Hence, if the insurer were hedging per the CDHS perfectly, then the insurer should see a 250 fair value loss in the designated IR hedge instruments. To determine how much of that loss should be deferred:

Fair value gain (loss) in full-contract cash flows attributable to IR movement (700) 14.b.ii - Quantity calculated in 14.b.i. as a % of the (700) above 36%

AG 43 liability increase (decrease) from beginning of period to end of period 400 AG 43 liability increase (decrease) attributable to interest rate movements (100) 14.b.iii - AG 43 liability increase (decrease) attributable to the hedged risk (36)

In this example, even though the AG 43 liability increased by 400 during the reporting period, interest rate movements actually contributed to a 100 decrease. The hedged risk (50% of the interest rate sensitivity of rider cash flows) accounts for 36% of this, or $36 of the liability decrease. As such, $36 of the fair value loss on the interest rate hedge instruments should be reflected immediately and the remainder deferred via a deferred asset equal in amount to 250 – 36 = 214.

14.b.iv – Deferred asset (14.b.i less 14.b.iii) attributable to hedged risk (36) (This is shown as a negative – to be consistent with the decrease in AG 43 liability – but represents a deferred asset. Deferred assets reflect fair value losses.)

Effective Date and Transition

23.27. After adoption of this issue paper, the NAIC will release a Statement of Statutory Accounting Principle (SSAP) for comment. Users of the Accounting Practices and Procedures Manual should note that issue papers are not represented in the Statutory Hierarchy (See Section IV of the Preamble) and therefore the conclusions reached in this issue paper should not be applied until the corresponding SSAP has been adopted by the Plenary of the NAIC. It is expected that the SSAP will be effective for _______.

DISCUSSION - PENDING UPDATE FROM APRIL 3, 2017 REVISIONS:

(Staff will update the discussion section after the April 3 SSAP revisions are exposed and discussed by the Working Group.) 24.28. The provisions within this issue paper are significantly different from what is currently allowed under SAP, U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The concept of allowing “effective hedge” accounting treatment for macro-hedges is currently not endorsed by any of the noted accounting standards. Provisions within this issue paper have been drafted with the intent to encourage risk-management transactions by insurers for limited, qualifying transactions in order to reduce non-economic surplus volatility and ensure appropriate financial statement presentation with sufficient transparency for regulator review.

Application of SSAP No. 86 Guidance

25.29. The concepts within scope of this issue paper, particularly the allowance for macro-hedges and dynamic (rebalancing) hedging instruments are not permitted within SSAP No. 86. Although limited comments have been received indicating that macro-hedge transactions using a dynamic (rebalancing) approach for variable annuity guarantees could occur under the current concepts of SSAP No. 86, the Statutory Accounting Principles (E) Working Group does not agree with this interpretation. The Working Group agrees that separate guidance is needed to address these limited derivative situations to comply with the Financial Condition (E) Committee charge.

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26.30. Hedge effectiveness determinations under SSAP No. 86 requires use of derivative instruments in hedging transactions that meet the criteria in SSAP No. 86, paragraphs 17 through 19. The application of the guidance in these paragraphs, as well as existing hedge effectiveness guidance under U.S. GAAP and IFRS, is contrary to the concept of a dynamic hedging as the existing guidance is designed primarily for static exposures in which it is necessary to identify a specific hedged item and hedging instrument, and designate them as linked in an individual hedging relationship.

27.31. Existing SSAP No. 86 guidance for fair value hedges does allow for similar assets or similar liabilities to be aggregated and hedged as a portfolio. With the fair value hedge portfolio guidance, a particular risk exposure is still required to be designated, and the portfolio of similar assets or similar liabilities must share the risk exposure for which they are designated as being hedged. As detailed within paragraph SSAP No. 86, paragraph 20.e, the change in fair value attributed to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributed to the hedged risk. This guidance is adopted explicitly from U.S. GAAP. The FASB has specifically indicated that the “proportional” requirement was to be interpreted strictly, but did not require the term to reflect “identical” items. To illustrate, under a FASB example, percentage decreases within a range of 9 to 11 percent could be considered proportionate if that interest rate change reduced the fair value of the portfolio by 10 percent.

28.32. SSAP No. 86 does not include guidance permitting cash flow hedges involving portfolios. SSAP No. 86 guidance is explicit that the hedging relationship shall be highly effective in achieving offsetting cash flows attributable to a particular risk during the term of the hedge. The guidance identifies that this exposure may be associated with an existing recognized asset or liability, or as a forecasted transaction9.

29.33. With regards to forecasted transactions, SSAP No. 86 guidance allows single transactions and groups of individual transactions to be the hedged transaction. If the hedged transaction is a group of individual transactions, the transactions must share in the same risk exposure for which they are designated as being hedged. The guidance for forecasted transactions does allow more than one risk to be hedged (for example, the risk of changes in cash flows can be related to purchase/sales price, interest rate risk, foreign currency change risk, or default risk), however, the occurrence of the forecasted transaction (e.g., purchase/sale, cash inflow/outflow) must be probable. (SSAP No. 86 identifies that the term probable requires a significantly greater likelihood of occurrence than the phrase more likely than not.) Once a forecasted transaction is no longer probable, hedge accounting is to immediately cease and any deferred gains or losses are to be recognized immediately. Once a pattern occurs of forecasted transactions not being probable, the entity’s ability to accurately predict forecasted transactions is questioned and the entity is no longer permitted to use hedge accounting in the future for similar forecasted transactions.

30.34. Furthermore, existing guidance in SSAP No. 86 is drafted to reflect derivative transactions hedging invested assets. Although the scope of SSAP No. 86 does not limit the guidance, the specific provisions within the standard do not provide guidance for hedging liabilities. As noted within the draft guidance, the new SSAP will be specific to derivative transactions hedging the AG 43 liability.

31.35. The guidance reflected in the March 2016 original agenda item as the “Initial Staff Proposal for Discussion” (subsequently referred to as the “original agenda item”) proposed use of a “closed” portfolio concept. As detailed within the guidance in this issue paper, the requirement of a closed portfolio has been revised to allow use of a flexible portfolio as the hedged item, providing the ability to continuously

9 A forecasted transaction is a transaction expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event - when it occurs - will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices. For transactions detailed within this issue paper, the hedged items are recognized liabilities (AG 43 reserves); therefore the guidance for derivative forecasted transactions does not appear applicable for derivatives within scope of this issue paper.

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adjust the hedged item to remove policies and/or include new policies to effectively manage risk. Use of an open portfolio further differentiates the hedging programs allowed within this issue paper from what is permitted as effective hedges under SSAP No. 86, U.S. GAAP and IFRS. This issue paper reflects the conclusion that the accounting provisions within are separate and distinct from the provisions within SSAP No. 86 and should not be inferred to any derivative transaction that does not explicitly qualify within the scope of this issue paper.

Hedge Strategy

32.36. The guidance within this issue paper requires reporting entities to engage in highly effective fair value hedges that follow a Clearly Defined Hedging Strategy (CDHS or “hedging strategy”) as defined in AG 43. The documentation required under a CDHS includes:

a. The specific risks being hedged,

b. The hedge objectives,

c. The risks not being hedged,

d. The financial instruments that will be used to hedge the risks,

e. The hedge trading rules, including the permitted tolerances from hedging objectives,

f. The metric(s) for measuring effectiveness,

g. The criteria that will be used to measure effectiveness,

h. The frequency of measuring hedging effectiveness,

i. The condition under which hedging will not take place, and

j. The person or persons responsible for implementing the hedging strategy.

33.37. While the hedging strategy may change over time, this issue paper requires each hedging strategy to be implemented for a minimum of three months. The provisions in AG 43 also require the hedging strategy to be effectively implemented for at least three months. As detailed in AG 43, reporting entities can meet the time requirement by having evaluated the effective implementation of the hedging strategy for at least three months without actually having executed any trades indicated by the hedging strategy (e.g., mock testing or by having effectively implemented the strategy with similar annuity products for at least three months). For purposes of this issue paper, the three month time-frame is the required timeframe before a change can occur in the documented hedging strategy without an inherent determination that the hedging strategies, and the derivatives within, were ineffective.

34.38. Any change in the hedging strategy shall be clearly documented and include an effective date of the change in strategy. Determination of whether the hedging instruments were highly effective shall be made in accordance with the hedging strategy in place at the time of assessment.

35.39. Comments received identified that most companies identify a target rate sensitivity and purchase interest rate derivatives that will hedge exposure to this target. These comments noted that the target can change with changes in risk appetite and suggested a monthly reset to reflect changes in risk appetite. These comments indicated that regardless of changes in the risk appetite that may occur throughout each month, the hedging strategy would be locked at the beginning of each month. Per these comments, the monthly reset of the overall hedging strategy would not trigger ineffectiveness as long as subsequent cash

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flows were considered effective under the updated hedging strategy. These comments suggested that reporting entities should be required to specify the operational practices in setting or determining hedging strategies to allow for these changes.

36.40. For the special accounting provisions being discussed in this agenda item, provisions have not been established to allow for a monthly reset of hedging strategies. Instead, hedging strategies are required to be implemented for at least three months. As detailed within the issue paper, reporting entities are allowed to engage in a dynamic hedging strategy in which the hedging instruments may be rebalanced to accommodate changes in the hedged item (which reflects a flexible portfolio of variable annuity contracts) to adhere to a specified, documented derivative strategy. With these provisions, it seems unnecessary, and overly permissive, to incorporate provisions that allow monthly revisions to the hedging strategy. A three-month implementation timeframe still allows for timely revisions throughout a year if a company’s risk appetite was to change and is consistent with AG 43 provisions. In situations in which the hedging strategy must be revised to reflect a revised risk appetite before the three-month implementation timeframe is over, the hedge should be terminated, and deemed ineffective, with subsequent establishment of a new hedging strategy to reflect the updated risk appetite and parameters for assessing hedge effectiveness.

Hedge Designation - Fair Value Hedge Addressing Variability Attributed to Interest Rate Risk

37.41. The guidance within this issue paper limits the hedge designation to a fair value hedge that addresses variable annuity guarantees sensitive to interest rate risk. Although variable annuity guarantees can be sensitive to other market factors, the guidance in this issue paper is only limited to interest rate risk. This issue paper acknowledges that the initial interest rate risk limitation was a scoping consideration (and not a result from a review of other risk factors) and should not preclude subsequent consideration, if supported by the Working Group, of other risks. Unless, and until, subsequent consideration of other risks are considered for inclusion within this guidance, hedges addressing other risks would be subject to the guidance in SSAP No. 86.

38.42. The requirement for a fair value hedge is specific within the proposed guidance and requires assessment on whether the derivative instrument hedges changes in the fair value of hedged item (AG 43 liability or specific portion thereof) attributable to interest rate risk. In determining effectiveness, the hedging relationship shall be highly effective in offsetting changes in the fair value attributable to the hedge risk during the period in which the hedge is designated. The term highly effective describes a fair value hedging relationship where the change in fair value of the derivative hedging instrument is within 80 to 125 percent of the opposite change in the fair value of the hedged item attributable to the hedged risk. It shall also apply when an R-squared of 0.80 or higher is achieved when using a regression analysis technique.

39.43. The use of a fair value hedge detailed within this issue paper is intended to allow for hedging relationships that consider all contractual cash flows in calculating the change in fair value, or if in accordance with the documented risk management hedging strategy, a designated portion of the contractual cash flows from the hedged item. This is inconsistent with existing guidance in SSAP No. 86 (as well as derivative guidance under U.S. GAAP) in which all contractual cash flows of the entire hedged item must be used in calculating the change in the hedged item’s fair value attributed to changes in the benchmark interest rate. However, as noted by comments received, designating a portion of the cash flows as the hedged item is crucial; otherwise effectiveness may be compromised as fair value changes in cash flows from designated instruments may be more or less than the fair value changes in cash flows from the hedged item. Revisions in the designated portion of cash flows intended to be hedged in accordance with the documented risk management hedging strategy would be considered a change in hedging strategy and subject to the guidance in this issue paper for those situations. (Staff Note: Both SSAP No. 86 and U.S. GAAP allow designation of a specific portion of an asset or liability to be the

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hedged item. However, once designated, all contractual cash flows related to that specified portion must be considered in calculating the change in the hedged item’s fair value attributed to changes in the benchmark interest rate being hedged to determine hedge effectiveness. Pursuant to the provisions within this issue paper, From information received, it is staff’s understanding that in addition to the designated portion of a specified liability, specific contractual cash flows of that explicit portion are also permitted to be designated. also need to be designated. However, staff requests clarification on this aspect.)

40.44. Under SSAP No. 86 and U.S. GAAP, hedge designations are required to be static and are not permitted to be revised over the hedge term. With the provisions in this issue paper, changes are not permitted unless, and until, the reporting entity documents a new hedging strategy. Unless there is a change in hedging strategy, subsequent assessments of effectiveness shall be consistent with the originally documented risk management strategy, and the designated portion of cash flows, for the hedged item. Fair value gains or losses on the derivative instrument that do not offset the change in the fair value of the hedged item attributable to the hedged risk, as detailed within the hedging strategy, are considered ineffective elements of the hedge, and depending on the degree of ineffectiveness could trigger assessment that the entire hedge is ineffective.

41.45. Despite comments initially received supporting use of a cash flow hedge approach, the general nature of the hedging strategies employed for these variable annuity contracts are more representative of a fair value hedge. However, as the hedged item (AG 43 reserve) is not reported at fair value, these hedging strategies do not qualify for a fair value hedge. Based on information received, reporting entities already calculate the fair value for the AG 43 reserve and use the fair value changes in the hedged item and hedging instruments to determine hedge effectiveness. Rather than pursue the cash flow hedge designation, this issue paper has been prepared to follow the method that is intuitively applied, although the standard requirements to qualify for a fair value hedge are not met. (With the hedged item recognized at an amount other than fair value (AG 43 reserve calculation), the gains or losses attributed to changes in the fair value do not adjust the AG 43 liability and are not recognized currently in earnings.)

Hedged Item - Flexible Portfolio or Closed Portfolio

42.46. The guidance within this issue paper proposes use of a flexible portfolio as the hedged item, reflecting the possibility to include variable annuity contracts with different characteristics and different liability durations (macro-hedge). The designated portfolio would not be required to be static in a closed portfolio, but could be revised to remove policies and/or include new policies to allow for continuous risk management of the variable annuity guarantee reserves.

43.47. The use of a flexible portfolio, rather than a closed portfolio, reflects consideration of industry comments regarding the current aggregate approach for risk-management strategies. Furthermore, consideration was given to comments indicating that requiring use of a closed portfolio would be operationally burdensome in accordance with documentation requirements and assessments of hedge effectiveness. Key elements noted by industry include:

a. Open or flexible portfolio is imperative as the liability changes on a daily basis with changes to inforce business and capital market factors. Requiring the redesignation of a hedge relationship due to any change in the hedged item is operationally burdensome as new hedge documentation and assessments of effectiveness would be required frequently.

b. Portfolio approach based on guarantee duration (detailed in the original agenda item) could result in an exorbitant amount of hedge relationships that become difficult to maintain. Sensitivity and risk profile can vary from policy to policy and within a policy by performance of the separate account underlying it. Combining policies by duration at inception of the hedge relationship is arbitrary.

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c. Multiple portfolio approach is challenging as most risk management strategies hedge at an aggregate level to capture the diversification inherent in the business. Additionally, a closed portfolio approach would require segmentation of the AG 43 calculation. As AG 43 was designed to be an aggregate projection of liabilities and assets of all variable annuity policies in force, the AG 43 calculation includes inherent diversification. The sum of a segmented AG 43 does not necessarily equal the calculation at an aggregate level and could result in entities holding greater reserves than necessary by a material amount.

44.48. The IASB also has a project to consider a new accounting model for dynamic risk management. This project was driven from difficulties associated with applying existing hedge accounting requirements to a dynamically managed portfolio with continuous frequent changes in the risk positions that are hedged. Within this IASB project, the IASB identifies that under current hedge accounting guidelines, open portfolios are in effect forced into closed portfolios for hedge accounting purposes, and this practice makes it difficult to reflect dynamic risk management in the financial statements.

45.49. Moving towards a flexible portfolio is intended to better reflect the key features of dynamic risk management. As detailed in the IASB discussion paper and the related April 2014 IFRS in Focus (Deloitte)10, when derivatives are used to hedge risks which are not measured on the same basis (i.e., hedged item and hedging instruments both measured and reported at fair value with fair value fluctuations recognized as unrealized gains or losses), volatility arises, despite the risk management objective of reducing economic volatility. Hedge accounting helps to reduce this volatility; however, hedge accounting is not well suited to the hedging of dynamic portfolios. Hedge accounting requires the specific designation of hedged items and hedging instruments and requires specific mechanics and effectiveness testing to be performed. Such requirements are better suited to individual hedges or hedges of static groups of items (closed portfolios) rather than hedges of portfolios that are constantly changing with new exposures added and old exposures removed (open or dynamic portfolios) and where the portfolio of hedging derivatives is also frequently changing.

46.50. Consistent with issues identified by the IASB, the use of closed portfolios, following the general hedge accounting model, gives rise to various issues, including:

a. Treating open portfolios as a series of closed portfolio hedges inevitably leads to profit or loss volatility from hedge ineffectiveness that is inconsistent with the economic position and reflective of the dynamic risk management applied.

b. As the portfolio of hedged items and hedging instruments change, hedge accounting leads to frequent de-designations and re-designations which give rise to operational difficulties regarding tracking and amortization of hedge adjustments.

47.51. In the original agenda item, use of a closed portfolio was suggested as an ever-changing portfolio of variable annuity contracts would be difficult for regulators to actively review and assess for hedge effectiveness compliance. Additionally, there was concern that allowing for a variable portfolio, particularly if coupled with a flexible hedging instrument, could allow for companies to “control” the hedge effectiveness by adjusting both the hedged item and the hedging instruments. Although these concerns still exist, provisions within the issue paper have been included to incorporate a higher degree of review and approval for these derivative transactions. Particularly, provisions have been incorporated to require explicit approval from the domiciliary state prior to implementing a hedging program within scope of this guidance, and the guidance requires certifications from both an external actuary and a financial officer of the company on the use and impact of the hedging strategy on AG 43 reserves.

10 Deloitte: IFRS in Focus - IASB Issues Macro Hedging Discussion Paper, April 2014

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48.52. In reviewing the comments from industry, as well as the discussion elements supporting the IASB project, requiring the closed portfolio approach detailed in the original agenda item may not be successful in encouraging further risk-management transactions by insurers. The operational burden in applying the concepts of closed portfolios would likely limit the general application of the special accounting provisions being considered, further perpetuating concerns that existing accounting guidance may hinder insurers from engaging in appropriate risk-management activities.

Hedging Instrument - Dynamic Hedging Strategy (Rebalancing)

49.53. The provisions within this issue paper permits reporting entities to utilize a specified derivative, or a portfolio of specified derivatives, as the hedging instrument. The portfolio of derivatives is allowed to be rebalanced in accordance with changes in the hedged item to adhere to a specified derivative strategy. The ability to rebalance derivatives designated as the hedging instrument is different from the guidance proposed in the original agenda item, but is supported from comments identifying that dynamic hedging is a prevalent industry practice and widely accepted as an appropriate risk management technique. Commenters noted that a dynamic hedging strategy rebalances derivative portfolios to result in targeted market sensitivity and is not a result of a flawed hedge. Irrespective of one open or multiple closed hedged items, a dynamic instrument is fundamental in applying adequate risk management measures for variable annuities as the sensitivity changes over time and life of the policies. Comments indicated that designating one static pool at inception could result in significant hedge accounting and economic ineffectiveness, and highlight that the instruments used to hedge a liability with a changing risk profile must be flexible.

50.54. Although comments received indicated that the guidance in SSAP No. 86 supports the concept of dynamic hedging (rebalancing of hedging instruments), staff does not believe that interpretation is consistent with the intent of SSAP No. 86, nor is that interpretation consistent with derivative guidance under U.S. GAAP or IFRS. Pursuant to U.S. GAAP derivative guidance, separate financial instruments shall not be combined, and evaluated as a unit, unless two more derivative instruments in combination are jointly designated as the hedging instrument. As previously noted, guidance in SSAP No. 86, as well as U.S. GAAP and IFRS, are designed primarily for static exposures in which it is necessary to identify a specific hedged item and hedging instrument (including a unit of combined instruments), and designate them as linked in an individual hedging relationship.

Hedging Criteria – Assessment of Effectiveness

51.55. Although the provisions within this issue paper incorporate new concepts for what is allowed as the hedged item and the hedging instrument, as well as incorporates a specific approach to determine hedge effectiveness, the concept of whether a fair value hedge is effective – and whether the hedging relationship achieves offsetting changes in fair value – is consistent with concepts established in SSAP No. 86 (as well as U.S. GAAP and IFRS) for assessing effectiveness. Key provisions include:

a. Use of a specified method that will be used to assess hedge effectiveness at inception and on an ongoing basis, requiring hedge effectiveness assessment whenever financial statements are reported, with a minimum requirement of every three months. As detailed in the issue paper, in order to determine hedge effectiveness reporting entities must calculate the fair value of the hedged item (portion of AG 43 reserve liability) at inception and on an ongoing basis in a similar fashion as FAS 133, and compare the current period fair value change of the hedged item to the current period fair value change of the hedging instruments. This comparison is specific to the designated hedged risks and exposures, therefore, if only a portion of the interest rate risk is hedged or if the designated hedge only include specific components of the variable annuity policies (e.g.,

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riders), for determining hedge effectiveness, the fair value comparisons is limited to those designated items.

b. Documentation is required for both prospective and retrospective effectiveness assessment, with ongoing assessment consistent with the documented risk management strategy in effect at the time of assessment. (Changes from the original hedging strategy are permitted in accordance with this issue paper.)

c. A highly effective hedging relationship is one where the change in fair value , is within 80 to 125 percent of the opposite change in fair value of the hedged item attributed to the hedged risk. A highly effective hedge also exists when an R-squared of .80 or higher is achieved when using a regression analysis.

52.56. Unlike the guidance in SSAP No. 86 (as well as U.S. GAAP), the guidance within this issue paper does not allow reporting entities to determine how they will assess hedge effectiveness. Rather, this issue paper specifies a particular approach for assessing whether the hedging strategy is highly effective, and in measuring hedge effectiveness. The hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributed to the hedged risk between the hedged item and the hedging instrument during the period that the hedge is designated. With the dynamic / rebalancing approach detailed within this issue paper, an individual hedging instrument is considered to be part of the effective hedge if the entire portfolio of hedging instruments achieves offsetting changes in fair value during the period in accordance with the hedging strategy. Rebalancing individual hedging instruments within a portfolio does not result with an ineffective assessment as long as the entire hedging instrument (portfolio) continues to meet the hedge effectiveness requirements under the documented hedging strategy.

53.57. As a continued GAAP to SAP difference, the requirements in this issue paper do not require reporting entities to separately report in the financial statements the ineffective portion of a highly-effective hedging transaction. For U.S. GAAP filers, in all instances, the actual measurement of cash flow hedge ineffectiveness is to be recognized in earnings each reporting period. The recognition of ineffectiveness is based on whether exact offset of cash flows is not achieved. As a change from SSAP No. 86, this issue paper does require measurement and disclosure of any ineffective part of the hedge.

Measurement of Open / Outstanding Derivative Instruments Hedging Criteria

54.58. This issue paper requires all derivative hedging instruments to be reported at fair value. Derivative instruments combined in a portfolio are also required to be separately reported at fair value. Although this is a measurement change from derivatives in effective hedges under SSAP No. 86, the fair value measurement approach is consistent with U.S. GAAP and IFRS. The FASB has identified that fair value is the only relevant measurement attribute for derivatives. Furthermore, the FASB specifically identified that amortized cost is not a relevant measurement because the historical cost of a derivative is often zero, yet a derivative can be settled or sold at any time for an amount equivalent to its fair value. The FASB reasoning supporting “held to maturity” instruments being held at amortized cost was noted as not suitable for derivatives.

55.59. The requirement to use fair value under this special accounting provision is a change from SSAP No. 86 for derivatives that qualify as effective hedges. This change is appropriate under this accounting guidance for the following reasons:

a. Fair value fluctuations in hedging instruments attributable to the hedged risk that offset the changes in the AG 43 liability shall be recognized as unrealized gains and losses. These offsets result in a neutral financial statement impact, with the financial statements

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reflecting the impact of the effective hedge. This offset is only possible under a fair value measurement method in which fair value fluctuations are reflected in the financial statements. Under an amortized cost measurement method, fair value fluctuations are not recognized in the financial statements. (Although AG 43 reserve changes impact income, it is appropriate to keep the fair value fluctuations from hedging instruments in unrealized gains and losses as “below the line” changes impacting surplus and not net income. As fair value fluctuations can reverse, under current statutory accounting provisions, these changes are not reported as net income adjustments, particularly if net income increases can impact dividends.)

b. Provisions are established to allow for the recognition of a “deferred asset” or “deferred liability” for the portion of the fair value fluctuations attributed to the hedged risk that do not immediately offset the changes in the AG 43 liability. The recognition of these balance sheet items negates the surplus volatility from the non-offsetting fair value fluctuations.

c. Use of fair value will result with consistent measurement methods for derivatives between SAP and U.S. GAAP. Additionally, the reporting of fair value and the development of the deferred assets and deferred liabilities will clearly present derivative positions under this special accounting provision. This is particularly important for instances in which gains and losses from expired derivatives are not immediately reflected in the financial statements, but are scheduled for amortization.

56.60. The provisions within this issue paper permitting recognition of a “deferred asset” and a “deferred liability” to reflect the non-offsetting portion of unrealized losses and unrealized gains as a result of fair value fluctuations attributed to the hedged risk is inconsistent with U.S. GAAP derivative guidance, as well as the general definitions for what constitutes an asset or liability under both SAP and U.S. GAAP. Gains and losses resulting from changes in the fair value of derivatives are not separate assets or liabilities because they have none of the essential characteristics of assets or liabilities. As noted by the FASB, the act of designating a derivative as a hedging instrument does not convert a subsequent loss or gain into an asset of a liability. A loss is not an asset because there is no future benefit associated with it. The loss cannot be exchanged for cash, a financial asset, or a nonfinancial asset used to produce something of value, or used to settle liabilities. Similarly, a gain is not a liability because no obligation exists to sacrifice assets in the future.

57.61. The reporting of derivative gains and losses from effective hedges as assets or liabilities is not new under statutory accounting. Currently, in SSAP No. 86, upon the sale, maturity, or other closing transaction of a derivative, which is an effective hedge, any gain or loss on the transaction will adjust the basis (or proceeds) of the hedged item(s) individually or in the aggregate. This “adjustment to the basis of the hedged item” reflects the recognition of derivative losses or gains as assets or liabilities. Although these provisions exist in SSAP No. 86, the impact is not easily identifiable in the assets or liabilities reported on the financial statements. With the exception of impairment assessments for the hedged item (pursuant to the SSAP in which the hedged item falls), increases in an asset basis of a hedged item as a result of derivative losses are not restricted, nor are they explicitly nonadmitted.

58.62. SSAP No. 86 also provides an alternative treatment, whereas if the item being hedged is subject to IMR, the gain or loss on the terminated hedging derivative may be realized and subject to IMR. This alternative approach also reflects the recognition of a balance sheet impact (increase or decrease in liabilities) for realized gains and losses that do not meet the definition of assets or liabilities. For IMR items, losses recognized from derivative instruments reduce the IMR liability, whereas gains from derivative instruments increase the IMR liability. With the provisions established for IMR, safeguards are in place to prevent recognition of a contra-liability (or asset) for realized losses that exceed realized gains.

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IP No. 15X Issue Paper

© 2017 National Association of Insurance Commissioners 15X-20

If realized losses exceed the IMR liability, resulting with a negative liability balance, the IMR liability is required to be shown as zero. A negative liability for IMR is not permitted to be reflected in the financial statements.

59.63. Although staff does not generally support the recognition of balance sheet items that do not meet the definitions of assets or liabilities, this process is proposed in this issue paper for the following reasons:

a. The process to recognize the fair value of derivative instruments, coupled with the recognition of “deferred assets” and “deferred liabilities” (reflecting non-offsetting unrealized / realized gains and losses attributed to the hedged risk), provides a comprehensive view of the derivative impact in the balance sheet. With this approach, the derivative is reported at fair value, but the non-economic volatility from market fluctuations does not impact the entity’s solvency presentation.

i. For example, a derivative acquired at zero cost currently in a liability position from fair value fluctuations will be reported as a derivative liability in the financial statements. The unrealized loss from fair value fluctuations attributed to the hedged risk which were not recognized as they did not offset AG 43 reserve changes will be shown as a deferred asset. This deferred asset would be admitted, although it does not meet the definition of an asset, or the concept of an admitted asset under SSAP No. 4, as it does not reflect a probable future benefit or something that would be available for policyholder benefits. However, by reporting both the derivative liability and the deferred asset, non-economic volatility in the financial statements is mitigated, while improving presentation as the derivative obligation (derivative liability) will be presented in the financial statements. In addition, under the narrow scope of this issue paper, it’s important to consider accounting that captures what is relevant and a faithful representation of the business model of variable annuity life insurers, who as indicated elsewhere within this issue paper, utilize dynamic hedging as a risk management technique that if determined to be highly effective under the requirements of this statement, reduces risk, and helps the industry as a whole to better serve the marketplace. Under current guidance, using an amortized cost approach, the derivative would be reported at zero, and not be adjusted for fair value fluctuations, therefore the liability position of the derivative would not be shown in the financial statements.

b. The process to recognize the fair value of derivative instruments is consistent with the U.S. GAAP guidance for reporting derivatives, therefore eliminating the GAAP or SAP difference on the reporting of these investments.

c. The recognition of “deferred assets” and “deferred liabilities” and the separate amortization of these balances, outside of IMR, prevents the application of this special accounting provision from diluting or impacting the recognition of IMR. Pursuant to SSAP No. 7, IMR defers recognition of realized capital gains and losses resulting from changes in the general level of interest rates. As the recognition of deferred assets and deferred liabilities proposed within this issue paper initially reflects unrealized gains or losses, (and then realized gains and losses once the derivative instrument expired), using a separate amortization process of these items, and not commingling these items with IMR, retains the original intent of IMR.

60.64. The guidance in this issue paper is focused on the accounting guidance for the derivative instruments that hedge an AG 43 liability, not the impact that a Clearly Defined Hedging Strategy, under

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© 2017 National Association of Insurance Commissioners 15X-21

the provisions of AG 43, can have on the recognized AG 43 liability. One question that arose during the development of this issue paper was whether there was any double counting of the impact of the hedge that would be recorded under this proposed issue paper and what would be recorded as part of the AG 43 liability. It was determined this was not an issue as the amount of credit given to a hedge (the asset to the company under this proposed accounting) under AG 43 is significantly muted by the mechanics and in fact many times actually works to the detriment of the company in AG 43 but is not considered to be material.

Amortization of Deferred Assets and Deferred Liabilities

61.65. This issue paper proposes that deferred assets and deferred liabilities from non-expired derivative contracts be amortized into unrealized gains and losses over period of five years, unless the reporting entity can provide explicit documentation demonstrating that a longer period is more closely linked to the expected liability duration of the hedged item. Although it would be preferred for the amortization period to be linked directly to the AG 43 liability, it is not anticipated that a consistent approach could be determined across reporting entities. Although one commenter suggested a 25-year timeframe, as the amortization can reflect the delayed recognition of unrealized (and realized losses), this timeframe was identified as too long. In working with other industry representatives, a timeframe of 5-years was suggested to NAIC staff. Under the fair value accounting approach in SSAP No. 86, the derivative fair value fluctuations are recognized as they occur, so these commenters noted that a 5-year amortization timeframe would be a significant improvement to the current guidance. For companies that are able to adequately demonstrate a linkage to the expected AG 43 liability, these companies are permitted to extend the amortization, but not to exceed ten years. It is also noted that unrealized gains and losses recognized on a quarterly basis are required to be separately scheduled for amortization over the allowed timeframe. By limiting the amortization timeframe, the scheduling process is anticipated to be manageable, allowing for more effective regulator review.

62.66. This issue paper also allows for reporting entities to accelerate amortization or terminate use of the special accounting provision at any time. With this provision, all deferred assets and deferred liabilities recognized related to outstanding derivative instruments would be immediately eliminated and recognized as unrealized gains and losses. This accounting would be consistent with the fair value accounting method prescribed in SSAP No. 86 if it had been followed. If terminated, subsequently, all derivatives within the documented hedging strategy would be required to follow the fair value accounting under SSAP No. 86.

Measurement / Recognition of Realized Gains and Losses

63.67. With the ability to rebalance derivative hedging instruments, this issue paper allows for individual derivative instruments to be removed from the portfolio, and/or expire, and not immediately result with an ineffective hedging assessment. Comments received indicate that this approach is consistent with guidance under SSAP No. 86, as gains and losses are either allowed to be an adjustment to the hedged item, or are realized and included in IMR. However, the guidance in this issue paper allows for derivatives to be removed from the hedging strategy and not be identified as an ineffective hedge. This concept is not supported by the existing guidance within SSAP No. 86.

64.68. The provisions within this issue paper is only intended to encompass situations in which the overall hedging strategy is highly effective at the time that the derivative is either removed from the portfolio of hedging instruments or expires. If the hedging strategy is highly effective at that time, then regardless of future determination of effectiveness, the deferred assets or deferred liabilities recognized for the derivative instrument will continue to be amortized under the remaining amortization scheduled established when the hedge was deemed highly effective.

Attachment 17A Ref #2016-03

IP No. 15X Issue Paper

© 2017 National Association of Insurance Commissioners 15X-22

65.69. Once a derivative has expired, the deferred asset and deferred liability will no longer be amortized into unrealized gains and losses, but will be amortized into realized gains or losses.

66.70. For derivatives that have not expired, but were removed from the portfolio of hedging instruments, subsequent gains and losses from fair value fluctuations shall not impact the previously recognized deferred assets or deferred liabilities, but rather be recognized directly as unrealized gains and losses. With this approach, the unrealized gains or losses, reflected as deferred assets or liabilities, will be “locked in” once the derivative is removed from the portfolio of hedging instruments.

Derivative Income

67.71. This issue paper requires that all derivative income received for all derivative instruments within scope of this guidance shall be reported as investment income.

68.72. U.S. GAAP derivative guidance is focused on income statement matching. As such, under U.S. GAAP, the “effective” portion of gains and losses on a derivative instrument is reported consistently between the hedging instrument and hedged item resulting with an exact offset to gains and losses attributed to the hedged risk. , The “ineffective” portion directly effects earnings because there is no offsetting adjustment for the ineffective aspect of the gain or loss. As the focus for statutory accounting is less on income statement matching, and more on the balance sheet impact of the hedged item and the derivative hedging instruments (reducing non-economic volatility), provisions to defer recognition of income received is not considered appropriate for statutory accounting.

69.73. The provisions to recognize income received is also consistent with the SSAP No. 86 guidance in situations in which the derivative is not combined with the hedged item. Pursuant to current guidance, periodic cash flows and accruals of income/expense are to be reported in a manner consistent with the hedged item, usually as net investment income or another appropriate caption within operating income. (Staff notes that tThe SSAP No. 86 is drafted with an assumption that the hedged item is an asset, there is no guidance in SSAP No. 86 that reflects consideration of designating a liability as a hedged item.)

70.74. The cash flow guidance in SSAP No. 86 is different for situations in which the derivative is combined with the hedged item. Under that guidance, the income reported for the derivative on Schedule DB is zero, and the cash flows are to be reported with the hedged item instead of with the derivative. There are concerns with regards to this existing guidance (both in SSAP No. 86, as well as this issue paper), as income from derivative instruments would not be identifiable within the financial statements or Schedule DB. Staff is under the impression that this allowance is not often elected under SSAP No. 86, however, with the need for clear reporting under this special accounting provision, this approach is not presented as an option within this issue paper.

71.75. Comments received supported continuation of the concepts in SSAP No. 86, in which changes in the carrying value or cash flow of the derivative shall be recognized in the same period and in the same category of income or surplus as the amortization or fair value changes of the hedged item; e.g., net gain from operations, realized capital gains and losses on investments, unrealized capital gains and losses on investments, or unrealized foreign exchange capital gain or loss. The comments received also identify that as cash flows from swaps are included in the calculation of the hedged item (e.g., projected within AG 43), swap income will be accrued and recorded when it is earned consistently with the hedge item. This issue paper does not reflect these comments. Rather, consideration of income shall be recognized as received, and be included as a factor in determining the recognition of fair value fluctuations in the derivative instruments (e.g., the degree of offset between the AG 43 liability and the fair value fluctuations impacting the recognition of deferred assets and deferred liabilities). It is anticipated that this approach will not result in material differences in the financial statements, but will allow for proper recognition of income when received.

Attachment 17A Ref #2016-03

Special Accounting Treatment for Limited Derivatives IP No. 15X

© 2017 National Association of Insurance Commissioners 15X-23

Disclosures

72.76. The disclosure requirements in this issue paper are intended to result in a new schedule DB that specifically address the hedging strategies and related derivatives within this issue paper. The disclosure requirements also envision a schedule for all hedging instruments, with detailed information regarding the cost, fair value, unrealized gains and losses, deferred assets and deferred liabilities, and the amortization schedule. The intent of the proposed disclosures is to provide clear, transparent information regarding the use and impact of this special accounting provision within the financial statements.

RELEVANT STATUTORY ACCOUNTING AND GAAP GUIDANCE

Statutory Accounting

(Staff Note – Excerpts of GAAP and SAP Guidance are planned for inclusion in the final version. These elements have been excluded from the preliminary draft to save space.) G:\DATA\Stat Acctg\3. National Meetings\A. National Meeting Materials\2017\Summer\Hearing - VA\17a - 16-03 - IP VA - ED 4-8-17 - Fair Value Hedge.docx

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statutory financial statements. In the Issue Paper, “hedged item” currently refers to all three of these concepts.

In 5e, we recommend eliminating the definition of “macro-hedge”. The current definition is too limiting, as macro hedging is applicable to more than variable annuities. Furthermore, within the paper, “macro hedging” is used to provide context for the proposed special accounting treatment specific to this Issue Paper. Therefore, a defined term is unnecessary.

B. Paragraph 8

Although the changes made to this paragraph have alleviated our greatest concerns, we do not think the proposed certifications are necessary. Because the proposed certifications are already required in AG43/VM21, we do not believe they need to be duplicated in the accounting guidance. Specifically, section A7.5 requires certifications from both an actuary and a financial officer that are consistent with the certifications in paragraph 8b. We are somewhat confused by NAIC staff’s comments about “needed changes” to AG43 and would appreciate clarification. We are also unclear as to the purpose of the inquiry regarding “the approach to verify certifications.” If the concern is that the certifications should be supported by evidence, Appendix 7 of AG43 outlines requirements for CDHS modeling, multiple types of analysis (including back-testing), setting of E “effectiveness”, certifications, and documentation. From section A 7.5), “The actuary shall document the method(s) and assumptions (including data) used to determine CTE Amount (Adjusted) and CTE Amount (best efforts) and maintain adequate documentation as to the methods, procedures and assumptions used to determine the value of E”. We believe these existing requirements should be sufficiently robust to address regulatory needs.

C. Paragraph 9

We continue to be concerned that the Issue Paper does not sufficiently accommodate how dynamic hedging strategies actually work in practice. We note that staff did not incorporate our recommendation to differentiate changes in hedge targets and changes in the entity’s hedging strategy. A hedging strategy is the collection of multiple elements, including risks being hedged, objectives, hedging instruments used, and effectiveness measurements. Within a hedging strategy, it may be necessary and appropriate to adjust the hedge target in response to changing market conditions, liability changes and other factors. The nature of these prospective adjustments to the hedge target is documented within and instructed by the hedging strategy. In the context of interest rate hedging, in order to tactically execute a hedging strategy, there must be an amount of interest rate sensitivity identified that translates the hedging technique into an amount of instruments to purchase. The target interest rate sensitivity percentage is merely a numerical manifestation of the overall strategy at a point in time. Even if the hedging strategy is unchanged, the target interest rate sensitivity percentage will evolve with movements in the remaining life of the underlying block, changes in economic conditions, and adjustments to the mix of business.2

2 For example, suppose a company has variable annuity products A, B, and C. All three are initially separate groupings for accounting, valuation, etc. and the company hedge strategy includes hedging a portion of the interest rate sensitivity of variable annuity guarantee benefits. The company initially executes this strategy by defining a hedge target of 90% of interest rate sensitivity of product A, which reflects the company's overall risk appetite, including impacts from other line of business, etc. Later, the company decides to collapse the management of

3 Attachment 17B

We believe that the determination of whether an effective hedging strategy is in place should focus on more than the hedge target. Paragraph 9 (and associated footnote 4) should point to material changes to the company’s hedging strategy. Such changes will normally involve an internal vetting and governance process and are not routine events. Our recommended change in the attached markup will allow dynamic hedging strategies to function as intended while still providing appropriate and timely notification to regulators.

D. Paragraph 10

In response to NAIC staff’s inquiry, we would support a requirement to notify the state of change in hedge strategy within a certain period of the change. The aforementioned distinction between the hedging strategy and hedge target is critically important, however.

E. Paragraphs 11 and 12

We support staff’s recommended changes. F. Paragraphs 15 and 26

We support staff’s changes, but we believe that the language in paragraph 15 footnote 6 and paragraph 26.b. should be modified to encompass full financial statement fair value fluctuations on the hedging instruments (such as intra period realized gains/losses on individual derivative positions within the portfolio of specified derivatives). These fluctuations are assessed against the change in the designated portion of the reserve liability for purposes of determining deferred assets and liabilities.

G. Paragraphs 15 and 21

In response to NAIC staff’s inquiry, we have not identified any unintended consequences that should be considered when evaluating the reporting of applicable fair value changes within the realized gain/loss financial statement line item.

H. Paragraph 16

We have separate comments about the length of the amortization period and the ability of companies to accelerate amortization.

products A and B together for operational efficiencies, because product B is now a very small portion and similar enough to product A that it is no longer worth the effort to manage separately. So now company has two groupings AB and C. Assume that at the time of the consolidation, there is a 90/10 mix of A and B. Assume nothing else has changed in terms of the company's relative risk exposures, other product lines, etc. Now the company changes the tactical definition of the hedge target to be 81% of AB (i.e. A is 90% of AB and the target before the change was to hedge 90% of A -> 90%*90% = 81%). In this instance, the overall strategy hasn't changed, but because of the operational change to product groupings, the definition of the hedge target and coverage percentage had to change accordingly.

4 Attachment 17B

We reiterate our previous comments regarding the appropriate amortization period for deferred assets/liabilities. An amortization period with a length of time up to the Macaulay duration of the guaranteed benefit cash flows based on AG43/VM21 Standard Scenario is the most appropriate methodology. The Macaulay duration provides a weighted average length of time of the guarantee cash flows and appropriately varies by company, block and level of aggregation of business in force. We believe the use of the Macaulay duration appropriately links the amortization to the AG43/VM21 liability and would support the goal of reducing non-economic volatility in the statutory financial statements resulting from accounting mismatches between variable annuity reserves and the related hedges. This approach would also provide a consistent approach for determining the amortization period using a prudent estimate of the lifetime of the liability. Additionally, should the Working Group pursue guidance to address other accounting mismatches (i.e., hedging equity risks) the use of a Macaulay duration becomes even more essential. While we disagree in principle with an arbitrary cap, we believe 20 years is the shortest maximum length that would result in removing most of the non-economic accounting volatility from the statutory financial statements and could accept a 20-year cap. As noted in our previous comment letter, finite amortization periods would be established for each deferred asset or liability balance at the time the deferred asset or liability is established.

Regarding acceleration of amortization, we support the ability of entities to accelerate the amortization of deferrals. The current language, however, could be interpreted to allow entities to accelerate the amortization of select deferred asset/liability cohorts, providing an opportunity to amortize in a manner that is favorable to the financial results of the entity. We believe that acceleration should be available, but it should apply to all cohorts proportionately in order to ensure that amortization is aligned with the overall hedge relationship. Acceleration should be determined for each hedge relationship separately in the event an entity has more than one relationship. In the event of acceleration, the various notifications and disclosures outlined within the Issue Paper should provide adequate transparency as to the continued alignment between the recognition of costs and benefits for the hedges and the hedged items. We would welcome the opportunity to work with NAIC staff to develop suitable language to accomplish these goals.

I. Paragraphs 17-23

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 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 No. 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

5 Attachment 17B

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.

J. Paragraph 26

NAIC staff has requested input on whether a separate DB schedule would be beneficial to capture information for transactions within this special accounting provision. We do not believe a separate DB schedule is necessary. It should be possible to leverage existing schedules to capture the required information, with some footnote enhancements. We would be willing to work with staff to create a workable construct.

K. Appendix A and Paragraph 15

We have separate comments on both the proposed calculation steps and the measurement of gains and losses of outstanding (open) instruments.

While we believe it would be helpful to have an illustrative example calculation of the deferred asset/liability within the accounting guidance, the calculation in Appendix A appears to be unnecessarily complicated and potentially limiting. It should be possible to streamline and refine the calculation steps listed in paragraph 15.b. We would appreciate the opportunity to work directly with NAIC staff to create a more suitable example. More substantively, we recommend the following changes to the measurement/recognition of gains and losses of outstanding (open) instruments discussed in paragraph 15:

1. The Issue Paper requires the rate coverage proportion or the change in the AG43 liability related to the hedged risk (15.b.i and 15.b.ii) to be measured by changes in fair value due to rates during the reporting period (hedged item divided by full contract). We believe companies may utilize general account assets to mitigate full contract risks, particularly in situations where (a) the variable annuity has a fixed account and minimum guarantees on those fixed accounts, (b) policies are close to annuitized status, and (c) policies are significantly in-the-money (derivatives have paid off and proceeds have invested in fixed income assets to back the higher reserve requirements). The paragraph 15 formula does not consider the impact of the general account assets. As risks covered by general account assets increase, the fair value proportion will decrease. As written, the Issue Paper may incentivize derivative hedging of all variable annuity rate risks and disincentivize traditional asset-liability matching practices with fixed income investments. While the rate risk

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Attachment 17C – ACLI Comments Ref #2016-03

Special Accounting Treatment for Limited Derivatives IP No. 15X

© 2017 National Association of Insurance Commissioners XX-1

Includes Mark-Up of ACLI Comments

Special Accounting Treatment for Limited Derivatives

Issue Paper Revisions and Related Discussion Points

Issue Paper – April 8, 2017

1. Paragraph 1 – Inclusion of updated charge.

2. Paragraph 5 – Inclusion of terms / concepts for use within the Statement.

3. Paragraph 7 – Inclusion of explicit direction that reporting entities shall bifurcate risks, with the

provisions of the special accounting treatment shall apply to fair value changes due to interest rate risk. This guidance identifies that the fair value fluctuations not attributed to the hedged risk shall be recognized as unrealized gains or losses.

4. Paragraph 8a – Deletion of notification requirement to states in which a company is licensed. The ACLI commented that this notification requirement is unnecessary, and would place an undue burden with little benefit to regulators. They have identified that approval by the domiciliary state, along with disclosures and/or general interrogatories can accomplish the enhanced level of regulatory review. Inquiry – Input is requested regarding this deletion, and whether the actuarial memo and proposed financial statement general interrogatories / disclosures are sufficient.

5. Paragraph 8b & 8c – Revisions to reference the actuarial certifications of AG 43 requirements. The

ACLI commented that the actuarial and financial officer certification should be implemented through the actuarial certification of AG 43, along with an addition to the Supplemental exhibits and Schedule Interrogatories asking if the certification has been filed and have suggested disclosure requirements. Staff suggests that reference to these items be retained within the guidance. Also, as revisions would likely be needed to AG 43, suggests a referral to the appropriate group to incorporate needed changes and to ensure the AG 43 certification requirements is in place prior to the effective date of the guidance. Inquiry – Input is requested regarding the approach to verify certifications.

6. Paragraph 10 – The ACLI commented that the notification upon any change in hedging strategy places undue administrative burden on reporting entities and state regulators. They have noted that documentation of hedging strategy in the actuarial memorandum (required in AG 43) and in the footnotes to the financial statements is sufficient to mitigate risk and provide governance and oversight of the program. From preliminary information received, communicating a change in hedging strategy is not considered an undue burden, and this information would be beneficial for regulator review. As such, no change has been proposed to reflect this ACLI comment.

7. Paragraph 10 – The ACLI has commented that a change in the hedge target shall not constitute a change in strategy as the entity’s hedge strategy is to mitigate interest rate risk and sensitivity to a tolerable level. The ACLI has commented that entity tolerances can change as a result of the market environment or guarantee positions, and management must be able to react to changing economics without risk of losing hedge accounting. Staff has not incorporated changes to reflect these comments. As previously noted, staff is cautious of an approach that would allow changes in the hedge target without documentation of a change in hedging strategy. This comment was considered when drafting the issue paper, and the proposal for a “monthly reset” of the hedging strategy was noted as overly permissive if coupled with provisions that allow a flexible portfolio of contracts and a dynamic hedge (where hedging instruments can be rebalanced to match changes in the underlying).

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IP No. 15X Issue Paper

© 2017 National Association of Insurance Commissioners 15X-2

Staff also highlights that the issue paper already proposes to allow a designated portion of the cash flows to be the hedged item. This is more permissive than U.S. GAAP, as the GAAP guidance requires all contractual cash flows of the entire hedge to be used in calculating the change in the hedged item’s fair value attributed to the hedged risk. The concept to require a 3-month timeframe for the hedging strategy, with notation of the specific risk being hedged (which the issue paper identifies as the percentage of interest rate sensitivity) is consistent with the concepts for a “Clearly Defined Hedging Strategy” (CDHS) under AG 43. To qualify as a CDHS, the strategy must be in place for 3 months, with identification of various elements. (AG 43 does not specifically identify the percentage of interest rate, but it is specific with regards to the specific risks being hedged, hedged objectives, risks not being hedged, etc.) Inquiry – Additional input is requested, particularly if regulators have a different view.

8. Paragraph 11 – Deletion of requirement to document ineffective portion of the hedge. The ACLI

commented against this disclosure, citing that the information would be incomplete and likely misleading. With the draft “targeted improvement” revisions for hedging instruments being considered under U.S. GAAP, FASB is currently proposing to delete this disclosure requirement. Information about hedge effectiveness will still be captured.

9. Paragraph 11 – New footnote incorporates suggested ACLI revisions to clarify that the retrospective

assessment shall be based on the hedge target that was in effect during the retrospective periods.

10. Paragraph 12 – Revisions to incorporate suggested ACLI revisions to remove reference to FAS 133 and to indicate that the fair value comparison shall occur on the cumulative change, rather than the current-period change.

11. Paragraph 12 – Revisions to explicitly incorporate language that the excluded components of the

hedging derivative shall be reported at fair value with the gains and losses recognized as unrealized. This is consistent with the ACLI comments to incorporate language on this issue.

12. Paragraphs 15 & 21 – The ACLI has provided comments noting a statutory disconnect in how

derivative gains/losses are recognized in comparison to the AG 43 reserve change. These comments identify that the change in liability will be recognized in net income, and the fair value changes will be recognized (or amortized) to unrealized gains or losses (outside of net income). The ACLI is correct that this disconnect does not occur under U.S. GAAP, as offsetting fair value changes in hedged items and hedging instruments are concurrently recognized in earnings. Staff agrees that it would be best for offsetting impacts for hedged items and hedging instruments to be reflected in the same reporting line. Although it is inconsistent with current statutory accounting provisions, staff is recommending revisions to clarify that fair value changes in highly effective derivatives to be recognized (or amortized) to realized gains and losses. This would also address the tracking concerns noted by interested parties for when highly effective derivative instruments expire (as the recognition would continue to realized gains and losses). Staff is recommending use of unrealized gains and losses for excluded components / risks and for derivative instruments that are not highly effective. Inquiry – In reviewing the statutory financials, staff believes this can be accomplished through an instruction change for the Exhibit of Capital Gains and Losses. (For derivative instruments that qualify, the gain/loss amounts would be captured in column 2 of this exhibit instead of column 4.) Staff requests input on whether this reporting change would have any unintended consequences that should be considered. Staff suggests that a disclosure be added to capture the aggregate amount of “realized” gains and losses for “open” derivative instruments so that information is known for comparison assessments.

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13. Paragraph 16 – The ACLI has suggested that the amortization timeframe for deferred assets and liabilities be based on the Macaulay duration of the guarantee benefit cash flows based on the AG 43 Standard Scenario, not to exceed 20-years. The ACLI identified 20-years as the shortest maximum length that would result in removing most of the non-economic accounting volatility from the statutory financial statements. The ACLI comments also supported the determination of the amortization period for each deferred asset or liability at the time the deferred asset/liability is established. Staff is aware that a 10-year amortization has been used by at least one company through a permitted practice. This company identified that the Macaulay duration for their block would have exceeded 20+ years, and a simplified 10-year timeframe was utilized to ensure transparency. Inquiry – The current issue paper incorporates a maximum 10-year timeframe for simplification and transparency. Staff is conducting additional research on prescribed and permitted practices to identify if there are consistent timeframes that have been approved by the states.

14. Paragraph 18 – Although no revisions have been proposed to this paragraph, the ACLI has provided

comments opposing the requirements to discontinue amortization (and recognized gains/losses) when a non-expired derivative instrument no longer qualifies within the standard, or if it is no longer an effective hedge. The ACLI has cited U.S. GAAP guidance as support for allowing the amortization timeframe to continue for deferred assets/liabilities in these scenarios. Although U.S. GAAP allows recognition of ineffective hedges to occur prospectively, this is because the impacts of the fair value hedge were reflected as a change in fair value / earnings when they occurred. As the hedged item is reported at fair value, the change in fair value is used to adjust the hedged item. Staff also highlights that existing SSAP No. 86 for forecasted transaction requires deferred gains or losses to be recognized immediately in unrealized gains or losses if the forecasted transaction is no longer probable. Regulator Inquiry – Staff understands that the immediate recognition of gains and losses for ineffective / hedges that no longer qualify may have an undesirable impact on the statutory financial statements. However, there are concerns for amortizing an unrealized loss (as a deferred asset) for years after the derivative program was identified as ineffective. Staff will be conducting further research on this issue, and inquiring with the Variable Annuity Issues (E) Working Group regarding the impact of these prior effective hedges on the remaining / future AG43 liabilities.

Excerpts from U.S. GAAP – 815-251-35-1 and 815-25-35-2:

Gains and losses on a qualifying fair value hedge shall be accounted for as follows:

a. The gain or loss on the hedging instrument shall be recognized currently in earnings.

b. The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.

If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for the component, if any, of that gain or loss that is excluded from the assessment of effectiveness under the entity’s defined risk management strategy for that particular hedging relationship (as discussed in paragraphs 815-20-25-81 through 25-83), would exactly offset the loss or gain on the hedged item attributable to the hedged risk. Any difference that does arise would be the effect of hedge ineffectiveness, which consequently is recognized currently in earnings.

SSAP No. 86, paragraph 24b (excerpt):

If a forecasted transaction is determined to no longer be probable per the standards above, hedge accounting shall cease immediately and any deferred gains or losses on the derivative must be recognized in unrealized gains or losses. If an entity demonstrates

Attachment 17C – ACLI Comments Ref #2016-03

IP No. 15X Issue Paper

© 2017 National Association of Insurance Commissioners 15X-4

a pattern of determining that hedged forecasted transactions probably will not occur, such action would call into question both the entity's ability to accurately predict forecasted transactions and the propriety of using hedge accounting in the future for similar forecasted transactions. Accordingly, hedge accounting for transactions forecasted by that entity will no longer be permitted.

15. Paragraph 26 – The ACLI commented that the individual tracking for these derivative transactions would be extremely burdensome given the volume of individual derivative contracts, and will not add value to the regulatory process. Although they agreed that an audit trail should be provided, they have recommended that documentation of deferred assets and liabilities and amortization be reflected in aggregate by reporting period. Revisions have been proposed to capture aggregate disclosures. Additionally, revisions have been proposed to separately capture information on the fair value change of excluded components recognized as unrealized gains and losses.

16. Proposed General Interrogatories - The ACLI suggested disclosures to identify whether a reporting entity uses the special accounting provisions and whether the provisions are consistent with AG 43. Rather than including in a disclosure, staff has proposed the inclusion of new GI to capture this information and for the reporting entity to attest to certain components of the program.

17. Schedule DB – The ACLI has suggested that Schedule DB be leveraged as much as possible for

disclosures on derivatives that receive hedge accounting treatment for variable annuities, and have requested for the NAIC to add new subtotals to capture derivatives instruments subject to this issue paper. Although staff is supportive of leveraging Schedule DB, staff is uncertain that the inclusion of subtotals will likely be sufficient, particularly if different types of derivative instruments are used (e.g., futures), as information on the instruments could be divided across different DB schedules, and with the enhanced information that will be requested. Inquiry – Input is requested regarding the form/structure of desired disclosures – including whether a separate DB schedule would be beneficial to capture the information for the transactions captured within this special accounting provision. Industry representatives are requested to provide an illustrated Schedule DB, with the revisions they would propose to capture these derivative structures.

Attachment 17C – ACLI Comments Ref #2016-03

Special Accounting Treatment for Limited Derivatives IP No. 15X

© 2017 National Association of Insurance Commissioners XX-1

Statutory Issue Paper No. XX

Special Accounting Treatment for Limited Derivatives

STATUS Exposure Draft – April 8, 2017 Type of Issue: Common Area SUMMARY OF ISSUE

1. Current statutory accounting guidance for derivatives qualifying for hedging effectiveness is in SSAP No. 86—Derivatives. Based upon a recommendation from the Variable Annuities Issues (E) Working Group, the Financial Condition (E) Committee issued the following 2016 2017 charge to the Statutory Accounting Principles (E) Working Group:

Develop specific statutory accounting guidance for certain limited derivative contracts hedging variable annuity guarantees, subject to fluctuations as a result of interest rate sensitivity, reserved for in accordance with Actuarial Guideline XLIII—CARVM for Variable Annuities (AG 43). This guidance shall place an emphasis on reducing non-economic surplus volatility for these specific hedges in situations where strong risk-management is in place, with safeguards to ensure appropriate financial statement presentation and disclosures, sufficient transparency, and regulatory oversight. This charge shall be a high priority, with the earliest effective date feasible that allows for adequate development of guidance and related reporting schedules. Develop and adopt changes to SSAP No. 86—Derivatives, with an effective date of January 1, 2017 or earlier, which allow hedge accounting treatment under SSAP No. 86 for certain limited derivative contracts (e.g. interest rate hedges with counterintuitive effects) that otherwise do not meet hedge effectiveness requirements. In adopting such an allowance, consider if the requirement to meet hedge effectiveness can be replaced by some other information that demonstrates strong risk management is in place over the identified hedges. —Essential

2. Pursuant to the direction from the Financial Condition (E) Committee, this issue paper has been drafted to detail substantive statutory accounting revisions to allow special accounting treatment for limited derivatives hedging variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity. The provisions within this issue paper are proposed to be separate and distinct from the guidance in SSAP No. 86, as the items subject to the scope of this guidance, and the provisions within, would not qualify for hedge effectiveness under SSAP No. 86. Allowances provided within this issue paper are only permitted if all of the components of the issue paper are met, and shall not be inferred as an acceptable statutory accounting approach for derivative transactions that do not meet the stated qualifications or that are not specifically addressed within this guidance.

3. The guidance within this issue paper is anticipated to be included as a new SSAP applicable to the limited derivative situations addressed within. Upon adoption of the issue paper, the Working Group will conclude on the location of this guidance within statutory accounting.

SUMMARY CONCLUSION

4. This statement establishes statutory accounting principles to address certain, limited derivative transactions hedging variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity. Eligibility for the special accounting provision within this standard is strictly limited to variable annuity contracts and other contracts involving certain guaranteed benefits similar to those

Attachment 17C – ACLI Comments Ref #2016-03

IP No. 15X Issue Paper

© 2017 National Association of Insurance Commissioners 15X-2

offered with variable annuities that are reserved for in accordance with Actuarial Guideline XLIII, CARVM for Variable Annuities (AG 43). The statutory accounting guidance within this statement is considered a special accounting provision, only permitted if all the components in the standard are met, and shall not be inferred as an acceptable statutory accounting approach for situations that do not meet the stated qualifications or that are not specifically addressed within this guidance.

Terms / Concepts (for purposes of this Statement)

5. The following terms reflect concepts specific to this Statement. (This listing only details the key concepts. Specific guidelines are reflected throughout the guidance.)

a. Derivative Instrument: Means an agreement, option, instrument or series or combination thereof: (1) To make or take delivery of, or assume or relinquish, a specified amount of one or more underlying interests, or to make a cash settlement in lieu thereof; or (2) That has a price, performance, value or cash flow based primarily upon the actual or expected price, level, performance, value or cash flow of one or more underlying interests.

b. Dynamic Hedging Approach: A dynamic hedging strategy allows for the portfolio of derivatives comprising the hedging instrument to be rebalanced in accordance with changes to the hedged item in order to adhere to the specified, documented hedging strategy.

Hedged item: The hedged item shall consist of reserves reflecting declared guarantee benefits on a pool, or portion thereof, of variable annuity contracts exposed to interest rate risk. The hedged item may relate tobe an open or flexible portfolio (e.g., group of variable annuity contracts with different characteristics and liability durations) that allows for addition of newly issued contracts, subtraction of surrenders and fluctuations in balances. The portfolio of variable annuity contracts may consist of as an entire book of business or declared components thereof. The hedged item shall reflect the present value of cash flows of a pool, or portion thereof, of variable annuity contracts exposed to interest rate risk.

c. Hedging Instrument: The hedging instrument shall reflect a specified derivative, or a portfolio of specified derivatives, that hedges the interest rate sensitivity of the designated hedged item. The hedging instrument may reflect a dynamic hedging strategy in which a portfolio of derivatives comprising the hedging instrument is rebalanced in accordance with changes to the hedged item.

Macro-Hedge: A macro-hedge refers to the ability to jointly designate a portfolio of variable annuity policies, such as an entire book of business or subsections thereof, as the hedged item.

Special Accounting Provision

4.6. The is special accounting provision within this Statement permits reporting entities to utilize a form of “macro-hedging” in which a portfolio of variable annuity policies, which could include the entire book of business or subsections thereof, are jointly designated as the host contracts containing the hedged item, in a fair value hedge1, pursuant to a Clearly Defined Hedging Strategy (throughout this issue paper

1 As detailed in paragraph 11, these hedges are required to be highly effective in achieving offsetting changes in fair value attributed to the hedged risk between the derivative hedging instruments and the hedged item (present value of declared guarantee benefits exposed to interest rate riskAG 43 liability) during the period that the hedge is designated.

Attachment 17C – ACLI Comments Ref #2016-03

Special Accounting Treatment for Limited Derivatives IP No. 15X

© 2017 National Association of Insurance Commissioners 15X-3

also referred to as “CDHS” or “hedging strategy”). This is considered a macro-hedge, as the designated hedged item (rate sensitive guarantee benefitsgroup of policies) may be attached to a portfolio of variable annuity contracts with different characteristics and liability durations. Under this special accounting provision, the portfolio of contracts giving rise to the hedged items is not required to be static, but can be revised to remove policies and/or include new policies to allow for continuous risk management (hedging) of the variable annuity guarantee reserves in accordance with the specific risks being hedged and the hedge objectives of the specified, documented hedging strategy. In designating the hedged item, reporting entities are permitted to exclude specific components of the variable annuity contracts, but such exclusions must apply collectively to all policies included within the portfolio. For example, reporting entities may elect to only hedge the interest rate risk of rider cash flows, and if making this election, would define the hedged item as the “fair value of rider claims net of rider fees” for the portfolio of policies designated as giving rise to the hedged item.

5.7. This special accounting provision permits reporting entities to utilize a specified derivative, or a portfolio of specified derivatives, as the hedging instrument within a fair value hedge to hedge the interest rate sensitively, or a specific percentage2 of the interest rate sensitivity, of the designated hedged item. The hedging instrument may reflect a dynamic hedging strategy in which a portfolio of derivatives comprising the hedging instrument is rebalanced in accordance with changes to the hedged item in order to adhere to the specified, documented hedging strategy. Although the hedging instruments must address interest rate risk, this guidance does not preclude use of derivative instruments that may offset risks other than interest rate risk from being designated as the hedging instruments. For derivative instruments that are affected by multiple risk factors, including interest rate risk, reporting entities shall apply this special accounting treatment to the change in fair value due to interest rate risk. Reporting entities shall bifurcate the change in fair value due to the various risk factors (e.g., fair value volatility due to interest rates (rho), and other risk factors, such as equity level (delta) or volatility (vega). Pursuant to paragraph 12 and 15, fair value fluctuations not attributed to the hedged risk, including fair value changes from excluded open components, shall be recognized as unrealized gains or losses.

6.8. With the provisions in this standard to allow for flexibility in the hedged item (changes to variable annuity contracts within a portfolio) coupled with a dynamic hedging approach (rebalancing of derivative hedging instruments), there is a greater risk of misrepresentation of successful risk management and achievement of a highly effective hedging relationship. Although this risk cannot be eliminated, the following provisions intend to ensure governance of the program and provide sufficient tools to allow for regulator review:

a. Prior to implementing a hedging program for application within scope of this standard, the reporting entity must obtain explicit approval from the domiciliary state commissioner allowing use of this special accounting provision. Upon approval from the domiciliary state to use the special accounting provision, the reporting entity must notify all states in which they are licensed of the approval to use this special accounting provision. The domiciliary state commissioner may subsequently disallow use of this special accounting provision at their discretion. Although this guidance does not restrict the state domiciliary commissioner on when to prohibit future use, disallowance should be considered upon finding that the reporting entity’s documentation, controls, measurement, prior execution of strategy or historical results are not adequate to support future use.

b. Actuarial certifications of AG 43 reserves, consistent with Actuarial Guideline 43 requirements, which explicitly include the following:

2 In identifying the hedged risk, reporting entities must identify whether they are hedging the full, or a portion of (e.g., 40%), the interest rate sensitivity.

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IP No. 15X Issue Paper

© 2017 National Association of Insurance Commissioners 15X-4

i. Certification An external, qualified actuary, approved by the domiciliary state commissioner, must provide certification as to whether the hedging strategy is incorporated within the establishment of AG 43 reserves, and the impact of the hedging strategy within the AG 43 Conditional Tail Expectation Amount.

ii. Certification by Aa financial officer of the company (CFO, treasurer, CIO, or designated person with authority over the actual trading of assets and derivatives) must certify that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy within AG 43 and that the Clearly Defined Hedging Strategy is the hedging strategy being used by the company in its actual day-to-day risk mitigation efforts. This provision does not require reporting entities to use a hedging strategy in determining AG 43 reserves, nor does it require entities to use the special accounting provision within this standard. However, it does require reporting entities that use the special accounting provisions within this standard to certify that the hedging strategy within scope of this standard is a Clearly Defined Hedging Strategy and is reflected in the establishment of AG 43 reserves.

7.9. As identified in paragraph 4, eligibility for the special accounting provision within this standard is strictly limited to variable annuity contracts and other contracts involving certain guaranteed benefits similar to those offered with variable annuities that are reserved for in accordance with Actuarial Guideline XLIII, CARVM for Variable Annuities (AG 43). This special accounting provision requires the reporting entity to engage in highly effective fair value hedges that follow a Clearly Defined Hedging Strategy, as defined in AG 43, meeting all required provisions of AG 43 allowing the reporting entity to reduce the amount of the Conditional Tail Expectation (CTE) Amount. In order to qualify as a Clearly Defined Hedging Strategy, the strategy must meet the principles outlined in AG 43, be in place (implemented) for at least three months3, and shall at a minimum, identify:

a. Specific risks being hedged4,

b. Hedge objectives,

c. Risks not being hedged,

d. Financial instruments that will be used to hedge the risks,

e. Hedge trading rules, including permitted tolerances from hedging objectives,

f. Metric(s) used for measuring hedging effectiveness,

g. Criteria that will be used to measure effectiveness,

h. Frequency of measuring hedging effectiveness,

i. Conditions under which hedging will not take place, and

3 As detailed in AG 43, before a new or revised hedging strategy can be used to reduce the amount of the Conditional Tail Expectation (CTE) otherwise calculated, the hedging strategy should be in place (effectively implemented) for at least three months. As detailed in AG 43, the Company may meet the time requirement by having evaluated the effective implementation of the hedging strategy for at least three months without actually having executed the trades indicated by the hedging strategy (e.g., mock testing or by having effectively implemented the strategy with similar annuity products for at least three months.) 4 The specific risk being hedged shall include a measure of the hedge coverage (e.g., percentage of interest rate sensitivity being hedged) (i.e. rho) is managed within a specific risk tolerance as instructed by the documented hedging strategy..

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j. The individuals responsible for implementing the hedging strategy.

The hedge strategy may be dynamic, static or a combination thereof.

8.10. While an initially documented hedging strategy may subsequently change, any change in hedging strategy shall be documented, with notification to the domiciliary state commissioner, and include an effective date of the change in strategy. Reporting entities that elect to change a documented hedging strategy prior to the end of the three-month minimum implementation timeframe shall identify the hedging strategy, and all hedging instruments executed under the strategy, as ineffective. The three-month timeframe begins with the stated effective date of the hedging strategy regardless if any hedging instruments have been executed under the hedging strategy. Changes in a documented hedging strategy that occur after the three-month implementation timeframe do not necessitate an ineffective determination as long as hedged items and hedging instruments under the revised/new strategy continue to meet the requirements of a highly effective fair value hedge. Reporting entities are permitted to have more than one hedging strategy implemented, but all implemented strategies must qualify as a component of a Clearly Defined Hedging Strategy pursuant to paragraph 8.

Assessing Hedge Effectiveness

9.11. The provisions within this standard require the entity to use a specific method, as detailed in paragraph 11, to assess hedge effectiveness at inception and on an ongoing basis. At a minimum, hedge effectiveness assessment is required whenever financial statements are reported, at least every three months. Documentation requires prospective and retrospective5 hedge effectiveness assessments, with on-going assessment consistent with the originally documented risk management strategy. In addition to assessing whether the hedge is highly effective, the quarterly documentation shall include a measure of the ineffective part of hedge. This standard does not require separate financial statement recognition of the effective and ineffective components of the hedging strategy; however, disclosure of these components is required.

10.12. This standard requires a single measure for assessing whether the hedging strategy is highly effective, and in measuring hedge ineffectiveness. Both at inception, and on an ongoing basis, the hedging relationship must be highly effective in achieving offsetting changes in fair value attributed to the hedged risk during the period that the hedge is designated. In order to meet this requirement, reporting entities electing to use this special accounting provision must calculate the fair value of the hedged item (declared guarantee benefits exposed to interest rate riskAG 43 guarantee reserve) at inception and on an ongoing basis in a similar fashion as FAS 133, and compare the cumulative current period fair value change of the hedged item to the cumulative current period fair value change of the hedging instruments. This comparison is specific to the designated hedged risks and exposures, therefore, if only a portion of the interest rate risk is hedged or if the designated hedge only include specific components of the variable annuity policies (e.g., riders), for determining hedge effectiveness, the fair value comparisons is limited to those designated items. If an entity’s defined risk management strategy for a particular hedging relationship excludes specific components of the hedging derivative from the assessment of hedge effectiveness, the excluded open components shall be reported at fair value with gains or losses recognized as unrealized gains or losses.

11.13. The term highly effective describes a fair value hedging relationship where the change in fair value of the derivative instrument is within 80 to 125 percent of the opposite change in fair value of the

5 For situations in which there has been a change in hedging strategy pursuant to paragraph 10, when conducting retrospective hedge effectiveness assessments, reporting entities shall assess effectiveness based on the hedge target that was actually in effect during the retrospective time periods.

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hedged item attributed to the hedged risk. It shall also apply when an R-squared of .80 or higher is achieved when using a regression analysis technique.

Measurement / Recognition of Unrealized Gains and Losses of Outstanding (Open) Instruments

12.14. All designated hedging instruments (all derivatives, including those reflected in portfolios) shall be reported in the financial statements at fair value.

13.15. Fair value fluctuations in the measurement of outstanding (non-expired) derivatives within a highly effective hedging strategy shall be reflected as follows:

a. Fair value fluctuations in the hedging instruments attributable to the hedged risk that offset the current period change in the hedged item (designated portion of the AG 43 reserve liability(; e.g., guarantee benefitscash flows)6 shall be recognized as a realized gain or loss.

b. , and fair value fluctuations in the hedging instruments that are not attributable to the hedged risk, shall be recognized as unrealized gains or unrealized losses.

c.b. Fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (designated portion of the AG 43 reserve liability (; e.g., guarantee benefitscash flows) shall be recognized as deferred assets (admitted) and deferred liabilities. The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the designated portion of the AG 43 reserve liabilityhedged item. Reporting entities shall utilize the following calculation for establishing the deferred asset (also illustrated in Appendix A) unless a different method has been approved by the domiciliary state commissioner:

i. Calculate the fair value gain or loss in the hedged item attributable to the hedged risk;

ii. Express the quantity calculated in 14.b.i. as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements.

iii. Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in 14.b.ii. multiplied by the AG 43 liability change attributable to interest rate.

iv. Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk

6 Hedge effectiveness is determined by comparing fair value fluctuations between the hedging instruments and the hedged item. However, in determining recognition in the financial statements, the fair value fluctuation of the hedging instruments is compared to the change in the reported value of the hedged item (designated portion of the AG 43 liability). The designated portion of the AG 43 liability is not reported at fair value in the statutory financial statements, as such, the offset reported as unrealized gains and losses is the portion of the fair value change in hedging instruments offset by the change in the reported value of thehedged item based on the designated portion of the AG 43 reserve calculation. In accordance with the documented hedging strategy, reporting entities shall compare the fair value fluctuations to the change in the designated portion of the reserve liability, after considering recognized derivative returns (including recognized derivative income), when determining the recognition of fair value fluctuations.

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less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in 14.b.iii.

c. As detailed in paragraph 12, fair value fluctuations in the hedging instruments that are not attributable to the hedged risk, shall be recognized as unrealized gains or unrealized losses.

16. Deferred assets and deferred liabilities recognized under paragraph 14.b. shall be amortized using a straight-line method into unrealized gains or unrealized losses over a finite amortization period. The amortization timeframe shall equal the Macaulay duration of the guarantee benefit cash flows based on the AG 43 Standard Scenario, but shall not exceed a period of 10 years. shall not exceed five (5) years unless there is explicit documentation demonstrating that a longer period is more closely linked to the expected liability duration of the hedged item. In situations in which a longer period is substantiated, and approved by the domiciliary state commissioner, the amortization timeframe is not permitted to exceed ten (10) years.

d.a. Future recognition of deferred assets or liabilities from fair value fluctuations attributed to the hedged risk that are not offset by the reserve liability change do not extend the amortization timeframe for previously recognized deferred assets or deferred liabilities. Reporting entities are required to separately track, with a schedule to show the initial deferred amount and amortization schedule, of the deferred assets and deferred liabilities recognized and outstanding at each reporting date.

e.b. The amount reported on the financial statement at each reporting date shall reflect the net amount (net as either a deferred asset or deferred liability) for each hedging strategy captured within scope of this guidance.

f.c. Reporting entities are permitted to amortize a greater portion of the deferred assets and/or deferred liabilities into unrealized gains or unrealized losses at any time in advance of the scheduled amortization period.

14.17. For outstanding (non-expired) derivative instruments that were removed from a highly effective hedging strategy (rebalanced), subsequent gains and losses from fair value fluctuations shall not impact the previously recognized deferred assets or deferred liabilities. The deferred assets and deferred liabilities for these derivative instruments shall be “locked” and amortized under the remaining schedule unless the reporting entity elects to terminate or accelerate amortization.

15.18. For outstanding (non-expired) derivative instruments in a hedging strategy that no longer qualifies within scope of this standard (e.g., AG 43 requirements are not met) or is no longer a highly effective hedge, any non-amortized deferred assets or deferred liabilities shall be immediately recognized as unrealized gains and/or unrealized losses. All future fair value fluctuations for these derivative instruments shall be recognized as unrealized gains or unrealized losses unless the instrument is subsequently designated as part of a highly effective hedging strategy. If the derivative is re-designated as part of a highly effective hedging strategy qualifying under this standard, subsequent fair value fluctuations (after the re-designation) may be accounted for under this special accounting provision.

16.19. Reporting entities may elect to terminate use of this special accounting provision at any time. In those instances, if the derivative instruments are outstanding, all deferred assets and deferred liabilities shall be immediately eliminated with recognition as unrealized gains and/or unrealized losses. Regardless

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of whether the hedging strategy is determined to be highly effective, subsequent accounting of the derivatives within the hedging strategy shall follow the fair value accounting approach in SSAP No. 867.

Measurement / Recognition of Realized Gains or Losses of Expired Derivatives

17.20. With the ability to rebalance the hedging instrument, this guidance allows for individual derivative instruments to expire and/or be removed from the portfolio of the hedging instrument, and not immediately trigger an assessment that the overall hedging strategy is no longer highly effective. Furthermore, special allowances are included to consider the tenure differences between a hedging instrument and AG 43 liability duration. These allowances permit expired8 derivative instruments that were part of a highly effective hedging strategy at the time of expiration to continue amortizing the deferred gains and deferred losses over the previously established amortization timeframe even if the overall hedging strategy is subsequently terminated or subsequently identified as no longer qualifying as a highly effective hedge.

21. Reporting entities with expired derivative instruments that were part of a highly effective hedging strategy at the time of such expiration are not required to terminate the amortization schedule initially established for the deferred assets and deferred liabilities attributed to that derivative instrument. Rather, at the time of expiration, previously recognized unrealized gains and losses for these expired derivatives shall be reclassified as realized gains and realized losses, and the subsequent amortization of deferred assets and deferred liabilities shall be recognized into realized gains and realized losses.

18.22. Consistent with the guidance in paragraph 15.c., reporting entities are permitted to amortize a greater portion of the deferred assets and/or deferred liabilities from expired derivatives into realized gains or realized losses at any time in advance of the scheduled amortization period.

19.23. Consistent with the guidance in paragraph 18, reporting entities may elect to terminate use of this special accounting provision at any time. In those instances involving expired derivatives, all remaining deferred assets and deferred liabilities shall be immediately eliminated with recognition as realized gains and/or realized losses.

Derivative Income

20.24. Derivative income (e.g., swap cash flows) shall be recognized as investment income when earned received.

21.25. Pursuant to the documented hedging strategy as a fair value hedge, derivative income shall be considered as part of the overall hedging strategy and included in the assessments on whether the strategy is highly effective.

Disclosures

22.26. A reporting entity that has any outstanding derivatives accounted for under this special accounting provision, or that has unamortized deferred assets and/or deferred liabilities (representing previously unrecognized qualifying fair value fluctuations) from expired derivatives under the special accounting provision shall disclose the following within the financial statements:

7 Macro-hedges and the ability to rebalance hedging instruments are not provisions permitted within “effective” hedges in scope of SSAP No. 86. As such, hedging strategies with these components accounted for under SSAP No. 86 shall follow the fair value accounting approach detailed in that standard. 8 Throughout this standard the use of the word “expire” is intended to capture all instances in which the derivative is no longer outstanding. It includes maturities, terminations, sales, and/or other closing transactions of a derivative.

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a. Discussion of hedged item (portfolio of variable annuity policies), including information on the guarantees sensitive to interest rate risk, along with information on the designated hedging instruments being used to hedge the risk. Discussion of the hedging instruments shall identify whether a hedging instrument is a single instrument or portfolio, as well as information on the hedging strategy, and assessing hedging effectiveness and compliance with the “Clearly Defined Hedging Strategy” of AG 43. Identification shall occur on whether the hedged item is intended to be fully hedged under the hedging strategy, or if the strategy is only focused on a portion of the liability characteristics or a portion of the interest rate sensitivity. Hedging strategies shall be identified as highly effective or ineffective. For highly effective strategies that are not 100% effective, information on the ineffective components shall be disclosed. (For example, iIf the strategy for a particular hedging relationship excludes a specific component of the gain or loss, or related cash flows, from the assessment of hedge effectiveness, details on the excluded components shall be disclosed.)

b. Aggregate Ddisclosure of the original cost and fair value of all hedging instruments (including all instruments within a portfolio) along with any recognized derivative returns (including recognized derivative income) any investment income recognized during the reporting period. Additionally, disclose the fair value of the hedged item, the change in fair value from the prior reporting period, and the portion of the fair value change attributed to the hedged risk (designated portion of interest rate sensitivity).

c. Schedule showing the aggregate fair value change from the prior reporting period for the designated components for all hedging instruments, with identification of the fair value change the portion reflected in unrealized gains, unrealized losses, deferred assets, and deferred liabilities (outstanding derivatives), and the portion reflected in realized gains and realized losses (expired derivatives). This schedule shall also show the current period amortization, including any expedited amortization elected by the reporting entity, and the future scheduled amortization of the deferred assets and deferred liabilities. This schedule shall also identify the fair value of the excluded components of the hedging instruments, and the fair value change reflected in unrealized gain and unrealized loss.

d. Identification of any 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.

e. 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.

Proposed new General Interrogatories: These would not be in the SSAP, but are included here for review. These revisions will be referred to the Blanks (E) Working Group.

26.1 Does the reporting entity have any hedging transactions reported on Schedule DB?

26.2 If yes, has a comprehensive description of the hedging program been made available to the domiciliary state? If no, attach a description with this statement.

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26.3 Does the reporting entity utilize derivatives to hedge variable annuity guarantees subject to fluctuations as a result of interest rate sensitivity?

26.4 If so, does the reporting entity utilize:

Special Accounting Provision in SSAP No. XXX

Permitted Accounting Practice

Other Accounting Guidance

26.5 If the reporting entity utilizes the special accounting provision in SSAP No. XXX, the reporting entity shall attest to the following:

Reporting entity has obtained explicit approval from the domiciliary state.

Hedging strategy subject to the special accounting provisions is consistent with the requirements of Actuarial Guideline 43.

Actuarial certification has been obtained which indicates that the hedging strategy is incorporated within the establishment of Actuarial Guideline 43 reserves, and provides the impact of the hedging strategy within the Actuarial Guideline Conditional Tail Expectation Amount.

Financial Officer Certification has been obtained which indicates that the hedging strategy meets the definition of a Clearly Defined Hedging Strategy within Actuarial Guideline 43 and that the Clearly Defined Hedging Strategy is the hedging strategy being used by the company in its actual day-to-day risk mitigation efforts.

Appendix A – Calculation of Deferred Asset or Deferred Liability

Under the special accounting provisions within this issue paper, as detailed in paragraph 14.b., fair value fluctuations in the hedging instruments attributable to the hedged risk that do not offset the current period change in the hedged item (AG 43 reserve liability) shall be recognized as deferred assets (admitted) and deferred liabilities.

The ability to recognize a deferred asset and deferred liability is limited to only the portion of the fair value fluctuation in the hedging instruments that is attributed to the hedged risk and does not immediately offset changes in the hedged item.

Unless a different method has been approved by the domiciliary state commissioner, reporting entities shall utilize the following calculation (detailed in paragraph 14) for establishing the deferred asset:

14.b.i Calculate the fair value gain or loss in the hedged item attributable to the hedged risk (Step 1);

14.b.ii Express the fair value gain or loss calculated (Step 1) as a percentage of the change in the full-contract fair value (i.e., with all product cash flows) attributed to interest rate movements (Step 2).

14.b.iii Calculate the AG 43 liability change attributed to the hedged risk as the quantity calculated in Step 2 multiplied by the AG 43 liability change attributable to interest rate (Step 3).

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14.b.iv Establish the deferred asset or deferred liability in the amount of the fair value loss or (gain) of the designated hedging instruments attributed to the hedged risk less the AG 43 liability decrease or (increase) attributed to the hedged risk as calculated in Step 3.

To illustrate the above calculation:

Clearly Defined Hedging Strategy (CDHS) characteristics

Hedged item Rider claims less rider fees Hedged risk 50% of the rho (first-order IR level sensitivity)

Calculation of the deferred asset or liability Note: positive values = increase in liability

Fair value gain (loss) in hedged item attributable to interest rate movement (500) 14.b.i. - Fair value gain (loss) in hedged item attributable to hedged risk (250)

Hence, if the insurer were hedging per the CDHS perfectly, then the insurer should see a 250 fair value loss in the designated IR hedge instruments. To determine how much of that loss should be deferred:

Fair value gain (loss) in full-contract cash flows attributable to IR movement (700) 14.b.ii - Quantity calculated in 14.b.i. as a % of the (700) above 36%

AG 43 liability increase (decrease) from beginning of period to end of period 400 AG 43 liability increase (decrease) attributable to interest rate movements (100) 14.b.iii - AG 43 liability increase (decrease) attributable to the hedged risk (36)

In this example, even though the AG 43 liability increased by 400 during the reporting period, interest rate movements actually contributed to a 100 decrease. The hedged risk (50% of the interest rate sensitivity of rider cash flows) accounts for 36% of this, or $36 of the liability decrease. As such, $36 of the fair value loss on the interest rate hedge instruments should be reflected immediately and the remainder deferred via a deferred asset equal in amount to 250 – 36 = 214.

14.b.iv – Deferred asset (14.b.i less 14.b.iii) attributable to hedged risk (36) (This is shown as a negative – to be consistent with the decrease in AG 43 liability – but represents a deferred asset. Deferred assets reflect fair value losses.)

Effective Date and Transition

23.27. After adoption of this issue paper, the NAIC will release a Statement of Statutory Accounting Principle (SSAP) for comment. Users of the Accounting Practices and Procedures Manual should note that issue papers are not represented in the Statutory Hierarchy (See Section IV of the Preamble) and therefore the conclusions reached in this issue paper should not be applied until the corresponding SSAP has been adopted by the Plenary of the NAIC. It is expected that the SSAP will be effective for _______.

DISCUSSION - PENDING UPDATE FROM APRIL 3, 2017 REVISIONS:

(Staff will update the discussion section after the April 3 SSAP revisions are exposed and discussed by the Working Group.) 24.28. The provisions within this issue paper are significantly different from what is currently allowed under SAP, U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The concept of allowing “effective hedge” accounting treatment for macro-

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hedges is currently not endorsed by any of the noted accounting standards. Provisions within this issue paper have been drafted with the intent to encourage risk-management transactions by insurers for limited, qualifying transactions in order to reduce non-economic surplus volatility and ensure appropriate financial statement presentation with sufficient transparency for regulator review.

Application of SSAP No. 86 Guidance

25.29. The concepts within scope of this issue paper, particularly the allowance for macro-hedges and dynamic (rebalancing) hedging instruments are not permitted within SSAP No. 86. Although limited comments have been received indicating that macro-hedge transactions using a dynamic (rebalancing) approach for variable annuity guarantees could occur under the current concepts of SSAP No. 86, the Statutory Accounting Principles (E) Working Group does not agree with this interpretation. The Working Group agrees that separate guidance is needed to address these limited derivative situations to comply with the Financial Condition (E) Committee charge.

26.30. Hedge effectiveness determinations under SSAP No. 86 requires use of derivative instruments in hedging transactions that meet the criteria in SSAP No. 86, paragraphs 17 through 19. The application of the guidance in these paragraphs, as well as existing hedge effectiveness guidance under U.S. GAAP and IFRS, is contrary to the concept of a dynamic hedging as the existing guidance is designed primarily for static exposures in which it is necessary to identify a specific hedged item and hedging instrument, and designate them as linked in an individual hedging relationship.

27.31. Existing SSAP No. 86 guidance for fair value hedges does allow for similar assets or similar liabilities to be aggregated and hedged as a portfolio. With the fair value hedge portfolio guidance, a particular risk exposure is still required to be designated, and the portfolio of similar assets or similar liabilities must share the risk exposure for which they are designated as being hedged. As detailed within paragraph SSAP No. 86, paragraph 20.e, the change in fair value attributed to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributed to the hedged risk. This guidance is adopted explicitly from U.S. GAAP. The FASB has specifically indicated that the “proportional” requirement was to be interpreted strictly, but did not require the term to reflect “identical” items. To illustrate, under a FASB example, percentage decreases within a range of 9 to 11 percent could be considered proportionate if that interest rate change reduced the fair value of the portfolio by 10 percent.

28.32. SSAP No. 86 does not include guidance permitting cash flow hedges involving portfolios. SSAP No. 86 guidance is explicit that the hedging relationship shall be highly effective in achieving offsetting cash flows attributable to a particular risk during the term of the hedge. The guidance identifies that this exposure may be associated with an existing recognized asset or liability, or as a forecasted transaction9.

29.33. With regards to forecasted transactions, SSAP No. 86 guidance allows single transactions and groups of individual transactions to be the hedged transaction. If the hedged transaction is a group of individual transactions, the transactions must share in the same risk exposure for which they are designated as being hedged. The guidance for forecasted transactions does allow more than one risk to be hedged (for example, the risk of changes in cash flows can be related to purchase/sales price, interest rate risk, foreign currency change risk, or default risk), however, the occurrence of the forecasted transaction (e.g., purchase/sale, cash inflow/outflow) must be probable. (SSAP No. 86 identifies that the term probable requires a significantly greater likelihood of occurrence than the phrase more likely than not.)

9 A forecasted transaction is a transaction expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event - when it occurs - will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices. For transactions detailed within this issue paper, the hedged items are recognized liabilities (AG 43 reserves); therefore the guidance for derivative forecasted transactions does not appear applicable for derivatives within scope of this issue paper.

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Once a forecasted transaction is no longer probable, hedge accounting is to immediately cease and any deferred gains or losses are to be recognized immediately. Once a pattern occurs of forecasted transactions not being probable, the entity’s ability to accurately predict forecasted transactions is questioned and the entity is no longer permitted to use hedge accounting in the future for similar forecasted transactions.

30.34. Furthermore, existing guidance in SSAP No. 86 is drafted to reflect derivative transactions hedging invested assets. Although the scope of SSAP No. 86 does not limit the guidance, the specific provisions within the standard do not provide guidance for hedging liabilities. As noted within the draft guidance, the new SSAP will be specific to derivative transactions hedging the AG 43 liability.

31.35. The guidance reflected in the March 2016 original agenda item as the “Initial Staff Proposal for Discussion” (subsequently referred to as the “original agenda item”) proposed use of a “closed” portfolio concept. As detailed within the guidance in this issue paper, the requirement of a closed portfolio has been revised to allow use of a flexible portfolio as the hedged item, providing the ability to continuously adjust the hedged item to remove policies and/or include new policies to effectively manage risk. Use of an open portfolio further differentiates the hedging programs allowed within this issue paper from what is permitted as effective hedges under SSAP No. 86, U.S. GAAP and IFRS. This issue paper reflects the conclusion that the accounting provisions within are separate and distinct from the provisions within SSAP No. 86 and should not be inferred to any derivative transaction that does not explicitly qualify within the scope of this issue paper.

Hedge Strategy

32.36. The guidance within this issue paper requires reporting entities to engage in highly effective fair value hedges that follow a Clearly Defined Hedging Strategy (CDHS or “hedging strategy”) as defined in AG 43. The documentation required under a CDHS includes:

a. The specific risks being hedged,

b. The hedge objectives,

c. The risks not being hedged,

d. The financial instruments that will be used to hedge the risks,

e. The hedge trading rules, including the permitted tolerances from hedging objectives,

f. The metric(s) for measuring effectiveness,

g. The criteria that will be used to measure effectiveness,

h. The frequency of measuring hedging effectiveness,

i. The condition under which hedging will not take place, and

j. The person or persons responsible for implementing the hedging strategy.

33.37. While the hedging strategy may change over time, this issue paper requires each hedging strategy to be implemented for a minimum of three months. The provisions in AG 43 also require the hedging strategy to be effectively implemented for at least three months. As detailed in AG 43, reporting entities can meet the time requirement by having evaluated the effective implementation of the hedging strategy for at least three months without actually having executed any trades indicated by the hedging strategy

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(e.g., mock testing or by having effectively implemented the strategy with similar annuity products for at least three months). For purposes of this issue paper, the three month time-frame is the required timeframe before a change can occur in the documented hedging strategy without an inherent determination that the hedging strategies, and the derivatives within, were ineffective.

34.38. Any change in the hedging strategy shall be clearly documented and include an effective date of the change in strategy. Determination of whether the hedging instruments were highly effective shall be made in accordance with the hedging strategy in place at the time of assessment.

35.39. Comments received identified that most companies identify a target rate sensitivity and purchase interest rate derivatives that will hedge exposure to this target. These comments noted that the target can change with changes in risk appetite and suggested a monthly reset to reflect changes in risk appetite. These comments indicated that regardless of changes in the risk appetite that may occur throughout each month, the hedging strategy would be locked at the beginning of each month. Per these comments, the monthly reset of the overall hedging strategy would not trigger ineffectiveness as long as subsequent cash flows were considered effective under the updated hedging strategy. These comments suggested that reporting entities should be required to specify the operational practices in setting or determining hedging strategies to allow for these changes.

36.40. For the special accounting provisions being discussed in this agenda item, provisions have not been established to allow for a monthly reset of hedging strategies. Instead, hedging strategies are required to be implemented for at least three months. As detailed within the issue paper, reporting entities are allowed to engage in a dynamic hedging strategy in which the hedging instruments may be rebalanced to accommodate changes in the hedged item (which reflects a flexible portfolio of variable annuity contracts) to adhere to a specified, documented derivative strategy. With these provisions, it seems unnecessary, and overly permissive, to incorporate provisions that allow monthly revisions to the hedging strategy. A three-month implementation timeframe still allows for timely revisions throughout a year if a company’s risk appetite was to change and is consistent with AG 43 provisions. In situations in which the hedging strategy must be revised to reflect a revised risk appetite before the three-month implementation timeframe is over, the hedge should be terminated, and deemed ineffective, with subsequent establishment of a new hedging strategy to reflect the updated risk appetite and parameters for assessing hedge effectiveness.

Hedge Designation - Fair Value Hedge Addressing Variability Attributed to Interest Rate Risk

37.41. The guidance within this issue paper limits the hedge designation to a fair value hedge that addresses variable annuity guarantees sensitive to interest rate risk. Although variable annuity guarantees can be sensitive to other market factors, the guidance in this issue paper is only limited to interest rate risk. This issue paper acknowledges that the initial interest rate risk limitation was a scoping consideration (and not a result from a review of other risk factors) and should not preclude subsequent consideration, if supported by the Working Group, of other risks. Unless, and until, subsequent consideration of other risks are considered for inclusion within this guidance, hedges addressing other risks would be subject to the guidance in SSAP No. 86.

38.42. The requirement for a fair value hedge is specific within the proposed guidance and requires assessment on whether the derivative instrument hedges changes in the fair value of hedged item (AG 43 liability or specific portion thereof) attributable to interest rate risk. In determining effectiveness, the hedging relationship shall be highly effective in offsetting changes in the fair value attributable to the hedge risk during the period in which the hedge is designated. The term highly effective describes a fair value hedging relationship where the change in fair value of the derivative hedging instrument is within 80 to 125 percent of the opposite change in the fair value of the hedged item attributable to the hedged

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risk. It shall also apply when an R-squared of 0.80 or higher is achieved when using a regression analysis technique.

39.43. The use of a fair value hedge detailed within this issue paper is intended to allow for hedging relationships that consider all contractual cash flows in calculating the change in fair value, or if in accordance with the documented risk management hedging strategy, a designated portion of the contractual cash flows from the hedged item. This is inconsistent with existing guidance in SSAP No. 86 (as well as derivative guidance under U.S. GAAP) in which all contractual cash flows of the entire hedged item must be used in calculating the change in the hedged item’s fair value attributed to changes in the benchmark interest rate. However, as noted by comments received, designating a portion of the cash flows as the hedged item is crucial; otherwise effectiveness may be compromised as fair value changes in cash flows from designated instruments may be more or less than the fair value changes in cash flows from the hedged item. Revisions in the designated portion of cash flows intended to be hedged in accordance with the documented risk management hedging strategy would be considered a change in hedging strategy and subject to the guidance in this issue paper for those situations. (Staff Note: Both SSAP No. 86 and U.S. GAAP allow designation of a specific portion of an asset or liability to be the hedged item. However, once designated, all contractual cash flows related to that specified portion must be considered in calculating the change in the hedged item’s fair value attributed to changes in the benchmark interest rate being hedged to determine hedge effectiveness. Pursuant to the provisions within this issue paper, From information received, it is staff’s understanding that in addition to the designated portion of a specified liability, specific contractual cash flows of that explicit portion are also permitted to be designated. also need to be designated. However, staff requests clarification on this aspect.)

40.44. Under SSAP No. 86 and U.S. GAAP, hedge designations are required to be static and are not permitted to be revised over the hedge term. With the provisions in this issue paper, changes are not permitted unless, and until, the reporting entity documents a new hedging strategy. Unless there is a change in hedging strategy, subsequent assessments of effectiveness shall be consistent with the originally documented risk management strategy, and the designated portion of cash flows, for the hedged item. Fair value gains or losses on the derivative instrument that do not offset the change in the fair value of the hedged item attributable to the hedged risk, as detailed within the hedging strategy, are considered ineffective elements of the hedge, and depending on the degree of ineffectiveness could trigger assessment that the entire hedge is ineffective.

41.45. Despite comments initially received supporting use of a cash flow hedge approach, the general nature of the hedging strategies employed for these variable annuity contracts are more representative of a fair value hedge. However, as the hedged item (AG 43 reserve) is not reported at fair value, these hedging strategies do not qualify for a fair value hedge. Based on information received, reporting entities already calculate the fair value for the AG 43 reserve and use the fair value changes in the hedged item and hedging instruments to determine hedge effectiveness. Rather than pursue the cash flow hedge designation, this issue paper has been prepared to follow the method that is intuitively applied, although the standard requirements to qualify for a fair value hedge are not met. (With the hedged item recognized at an amount other than fair value (AG 43 reserve calculation), the gains or losses attributed to changes in the fair value do not adjust the AG 43 liability and are not recognized currently in earnings.)

Hedged Item - Flexible Portfolio or Closed Portfolio

42.46. The guidance within this issue paper proposes use of a flexible portfolio as the hedged item, reflecting the possibility to include variable annuity contracts with different characteristics and different liability durations (macro-hedge). The designated portfolio would not be required to be static in a closed portfolio, but could be revised to remove policies and/or include new policies to allow for continuous risk management of the variable annuity guarantee reserves.

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43.47. The use of a flexible portfolio, rather than a closed portfolio, reflects consideration of industry comments regarding the current aggregate approach for risk-management strategies. Furthermore, consideration was given to comments indicating that requiring use of a closed portfolio would be operationally burdensome in accordance with documentation requirements and assessments of hedge effectiveness. Key elements noted by industry include:

a. Open or flexible portfolio is imperative as the liability changes on a daily basis with changes to inforce business and capital market factors. Requiring the redesignation of a hedge relationship due to any change in the hedged item is operationally burdensome as new hedge documentation and assessments of effectiveness would be required frequently.

b. Portfolio approach based on guarantee duration (detailed in the original agenda item) could result in an exorbitant amount of hedge relationships that become difficult to maintain. Sensitivity and risk profile can vary from policy to policy and within a policy by performance of the separate account underlying it. Combining policies by duration at inception of the hedge relationship is arbitrary.

c. Multiple portfolio approach is challenging as most risk management strategies hedge at an aggregate level to capture the diversification inherent in the business. Additionally, a closed portfolio approach would require segmentation of the AG 43 calculation. As AG 43 was designed to be an aggregate projection of liabilities and assets of all variable annuity policies in force, the AG 43 calculation includes inherent diversification. The sum of a segmented AG 43 does not necessarily equal the calculation at an aggregate level and could result in entities holding greater reserves than necessary by a material amount.

44.48. The IASB also has a project to consider a new accounting model for dynamic risk management. This project was driven from difficulties associated with applying existing hedge accounting requirements to a dynamically managed portfolio with continuous frequent changes in the risk positions that are hedged. Within this IASB project, the IASB identifies that under current hedge accounting guidelines, open portfolios are in effect forced into closed portfolios for hedge accounting purposes, and this practice makes it difficult to reflect dynamic risk management in the financial statements.

45.49. Moving towards a flexible portfolio is intended to better reflect the key features of dynamic risk management. As detailed in the IASB discussion paper and the related April 2014 IFRS in Focus (Deloitte)10, when derivatives are used to hedge risks which are not measured on the same basis (i.e., hedged item and hedging instruments both measured and reported at fair value with fair value fluctuations recognized as unrealized gains or losses), volatility arises, despite the risk management objective of reducing economic volatility. Hedge accounting helps to reduce this volatility; however, hedge accounting is not well suited to the hedging of dynamic portfolios. Hedge accounting requires the specific designation of hedged items and hedging instruments and requires specific mechanics and effectiveness testing to be performed. Such requirements are better suited to individual hedges or hedges of static groups of items (closed portfolios) rather than hedges of portfolios that are constantly changing with new exposures added and old exposures removed (open or dynamic portfolios) and where the portfolio of hedging derivatives is also frequently changing.

46.50. Consistent with issues identified by the IASB, the use of closed portfolios, following the general hedge accounting model, gives rise to various issues, including:

10 Deloitte: IFRS in Focus - IASB Issues Macro Hedging Discussion Paper, April 2014

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a. Treating open portfolios as a series of closed portfolio hedges inevitably leads to profit or loss volatility from hedge ineffectiveness that is inconsistent with the economic position and reflective of the dynamic risk management applied.

b. As the portfolio of hedged items and hedging instruments change, hedge accounting leads to frequent de-designations and re-designations which give rise to operational difficulties regarding tracking and amortization of hedge adjustments.

47.51. In the original agenda item, use of a closed portfolio was suggested as an ever-changing portfolio of variable annuity contracts would be difficult for regulators to actively review and assess for hedge effectiveness compliance. Additionally, there was concern that allowing for a variable portfolio, particularly if coupled with a flexible hedging instrument, could allow for companies to “control” the hedge effectiveness by adjusting both the hedged item and the hedging instruments. Although these concerns still exist, provisions within the issue paper have been included to incorporate a higher degree of review and approval for these derivative transactions. Particularly, provisions have been incorporated to require explicit approval from the domiciliary state prior to implementing a hedging program within scope of this guidance, and the guidance requires certifications from both an external actuary and a financial officer of the company on the use and impact of the hedging strategy on AG 43 reserves.

48.52. In reviewing the comments from industry, as well as the discussion elements supporting the IASB project, requiring the closed portfolio approach detailed in the original agenda item may not be successful in encouraging further risk-management transactions by insurers. The operational burden in applying the concepts of closed portfolios would likely limit the general application of the special accounting provisions being considered, further perpetuating concerns that existing accounting guidance may hinder insurers from engaging in appropriate risk-management activities.

Hedging Instrument - Dynamic Hedging Strategy (Rebalancing)

49.53. The provisions within this issue paper permits reporting entities to utilize a specified derivative, or a portfolio of specified derivatives, as the hedging instrument. The portfolio of derivatives is allowed to be rebalanced in accordance with changes in the hedged item to adhere to a specified derivative strategy. The ability to rebalance derivatives designated as the hedging instrument is different from the guidance proposed in the original agenda item, but is supported from comments identifying that dynamic hedging is a prevalent industry practice and widely accepted as an appropriate risk management technique. Commenters noted that a dynamic hedging strategy rebalances derivative portfolios to result in targeted market sensitivity and is not a result of a flawed hedge. Irrespective of one open or multiple closed hedged items, a dynamic instrument is fundamental in applying adequate risk management measures for variable annuities as the sensitivity changes over time and life of the policies. Comments indicated that designating one static pool at inception could result in significant hedge accounting and economic ineffectiveness, and highlight that the instruments used to hedge a liability with a changing risk profile must be flexible.

50.54. Although comments received indicated that the guidance in SSAP No. 86 supports the concept of dynamic hedging (rebalancing of hedging instruments), staff does not believe that interpretation is consistent with the intent of SSAP No. 86, nor is that interpretation consistent with derivative guidance under U.S. GAAP or IFRS. Pursuant to U.S. GAAP derivative guidance, separate financial instruments shall not be combined, and evaluated as a unit, unless two more derivative instruments in combination are jointly designated as the hedging instrument. As previously noted, guidance in SSAP No. 86, as well as U.S. GAAP and IFRS, are designed primarily for static exposures in which it is necessary to identify a specific hedged item and hedging instrument (including a unit of combined instruments), and designate them as linked in an individual hedging relationship.

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Hedging Criteria – Assessment of Effectiveness

51.55. Although the provisions within this issue paper incorporate new concepts for what is allowed as the hedged item and the hedging instrument, as well as incorporates a specific approach to determine hedge effectiveness, the concept of whether a fair value hedge is effective – and whether the hedging relationship achieves offsetting changes in fair value – is consistent with concepts established in SSAP No. 86 (as well as U.S. GAAP and IFRS) for assessing effectiveness. Key provisions include:

a. Use of a specified method that will be used to assess hedge effectiveness at inception and on an ongoing basis, requiring hedge effectiveness assessment whenever financial statements are reported, with a minimum requirement of every three months. As detailed in the issue paper, in order to determine hedge effectiveness reporting entities must calculate the fair value of the hedged item (portion of AG 43 reserve liability) at inception and on an ongoing basis in a similar fashion as FAS 133, and compare the current period fair value change of the hedged item to the current period fair value change of the hedging instruments. This comparison is specific to the designated hedged risks and exposures, therefore, if only a portion of the interest rate risk is hedged or if the designated hedge only include specific components of the variable annuity policies (e.g., riders), for determining hedge effectiveness, the fair value comparisons is limited to those designated items.

b. Documentation is required for both prospective and retrospective effectiveness assessment, with ongoing assessment consistent with the documented risk management strategy in effect at the time of assessment. (Changes from the original hedging strategy are permitted in accordance with this issue paper.)

c. A highly effective hedging relationship is one where the change in fair value , is within 80 to 125 percent of the opposite change in fair value of the hedged item attributed to the hedged risk. A highly effective hedge also exists when an R-squared of .80 or higher is achieved when using a regression analysis.

52.56. Unlike the guidance in SSAP No. 86 (as well as U.S. GAAP), the guidance within this issue paper does not allow reporting entities to determine how they will assess hedge effectiveness. Rather, this issue paper specifies a particular approach for assessing whether the hedging strategy is highly effective, and in measuring hedge effectiveness. The hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributed to the hedged risk between the hedged item and the hedging instrument during the period that the hedge is designated. With the dynamic / rebalancing approach detailed within this issue paper, an individual hedging instrument is considered to be part of the effective hedge if the entire portfolio of hedging instruments achieves offsetting changes in fair value during the period in accordance with the hedging strategy. Rebalancing individual hedging instruments within a portfolio does not result with an ineffective assessment as long as the entire hedging instrument (portfolio) continues to meet the hedge effectiveness requirements under the documented hedging strategy.

53.57. As a continued GAAP to SAP difference, the requirements in this issue paper do not require reporting entities to separately report in the financial statements the ineffective portion of a highly-effective hedging transaction. For U.S. GAAP filers, in all instances, the actual measurement of cash flow hedge ineffectiveness is to be recognized in earnings each reporting period. The recognition of ineffectiveness is based on whether exact offset of cash flows is not achieved. As a change from SSAP No. 86, this issue paper does require measurement and disclosure of any ineffective part of the hedge.

Measurement of Open / Outstanding Derivative Instruments Hedging Criteria

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54.58. This issue paper requires all derivative hedging instruments to be reported at fair value. Derivative instruments combined in a portfolio are also required to be separately reported at fair value. Although this is a measurement change from derivatives in effective hedges under SSAP No. 86, the fair value measurement approach is consistent with U.S. GAAP and IFRS. The FASB has identified that fair value is the only relevant measurement attribute for derivatives. Furthermore, the FASB specifically identified that amortized cost is not a relevant measurement because the historical cost of a derivative is often zero, yet a derivative can be settled or sold at any time for an amount equivalent to its fair value. The FASB reasoning supporting “held to maturity” instruments being held at amortized cost was noted as not suitable for derivatives.

55.59. The requirement to use fair value under this special accounting provision is a change from SSAP No. 86 for derivatives that qualify as effective hedges. This change is appropriate under this accounting guidance for the following reasons:

a. Fair value fluctuations in hedging instruments attributable to the hedged risk that offset the changes in the AG 43 liability shall be recognized as unrealized gains and losses. These offsets result in a neutral financial statement impact, with the financial statements reflecting the impact of the effective hedge. This offset is only possible under a fair value measurement method in which fair value fluctuations are reflected in the financial statements. Under an amortized cost measurement method, fair value fluctuations are not recognized in the financial statements. (Although AG 43 reserve changes impact income, it is appropriate to keep the fair value fluctuations from hedging instruments in unrealized gains and losses as “below the line” changes impacting surplus and not net income. As fair value fluctuations can reverse, under current statutory accounting provisions, these changes are not reported as net income adjustments, particularly if net income increases can impact dividends.)

b. Provisions are established to allow for the recognition of a “deferred asset” or “deferred liability” for the portion of the fair value fluctuations attributed to the hedged risk that do not immediately offset the changes in the AG 43 liability. The recognition of these balance sheet items negates the surplus volatility from the non-offsetting fair value fluctuations.

c. Use of fair value will result with consistent measurement methods for derivatives between SAP and U.S. GAAP. Additionally, the reporting of fair value and the development of the deferred assets and deferred liabilities will clearly present derivative positions under this special accounting provision. This is particularly important for instances in which gains and losses from expired derivatives are not immediately reflected in the financial statements, but are scheduled for amortization.

56.60. The provisions within this issue paper permitting recognition of a “deferred asset” and a “deferred liability” to reflect the non-offsetting portion of unrealized losses and unrealized gains as a result of fair value fluctuations attributed to the hedged risk is inconsistent with U.S. GAAP derivative guidance, as well as the general definitions for what constitutes an asset or liability under both SAP and U.S. GAAP. Gains and losses resulting from changes in the fair value of derivatives are not separate assets or liabilities because they have none of the essential characteristics of assets or liabilities. As noted by the FASB, the act of designating a derivative as a hedging instrument does not convert a subsequent loss or gain into an asset of a liability. A loss is not an asset because there is no future benefit associated with it. The loss cannot be exchanged for cash, a financial asset, or a nonfinancial asset used to produce something of value, or used to settle liabilities. Similarly, a gain is not a liability because no obligation exists to sacrifice assets in the future.

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IP No. 15X Issue Paper

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57.61. The reporting of derivative gains and losses from effective hedges as assets or liabilities is not new under statutory accounting. Currently, in SSAP No. 86, upon the sale, maturity, or other closing transaction of a derivative, which is an effective hedge, any gain or loss on the transaction will adjust the basis (or proceeds) of the hedged item(s) individually or in the aggregate. This “adjustment to the basis of the hedged item” reflects the recognition of derivative losses or gains as assets or liabilities. Although these provisions exist in SSAP No. 86, the impact is not easily identifiable in the assets or liabilities reported on the financial statements. With the exception of impairment assessments for the hedged item (pursuant to the SSAP in which the hedged item falls), increases in an asset basis of a hedged item as a result of derivative losses are not restricted, nor are they explicitly nonadmitted.

58.62. SSAP No. 86 also provides an alternative treatment, whereas if the item being hedged is subject to IMR, the gain or loss on the terminated hedging derivative may be realized and subject to IMR. This alternative approach also reflects the recognition of a balance sheet impact (increase or decrease in liabilities) for realized gains and losses that do not meet the definition of assets or liabilities. For IMR items, losses recognized from derivative instruments reduce the IMR liability, whereas gains from derivative instruments increase the IMR liability. With the provisions established for IMR, safeguards are in place to prevent recognition of a contra-liability (or asset) for realized losses that exceed realized gains. If realized losses exceed the IMR liability, resulting with a negative liability balance, the IMR liability is required to be shown as zero. A negative liability for IMR is not permitted to be reflected in the financial statements.

59.63. Although staff does not generally support the recognition of balance sheet items that do not meet the definitions of assets or liabilities, this process is proposed in this issue paper for the following reasons:

a. The process to recognize the fair value of derivative instruments, coupled with the recognition of “deferred assets” and “deferred liabilities” (reflecting non-offsetting unrealized / realized gains and losses attributed to the hedged risk), provides a comprehensive view of the derivative impact in the balance sheet. With this approach, the derivative is reported at fair value, but the non-economic volatility from market fluctuations does not impact the entity’s solvency presentation.

i. For example, a derivative acquired at zero cost currently in a liability position from fair value fluctuations will be reported as a derivative liability in the financial statements. The unrealized loss from fair value fluctuations attributed to the hedged risk which were not recognized as they did not offset AG 43 reserve changes will be shown as a deferred asset. This deferred asset would be admitted, although it does not meet the definition of an asset, or the concept of an admitted asset under SSAP No. 4, as it does not reflect a probable future benefit or something that would be available for policyholder benefits. However, by reporting both the derivative liability and the deferred asset, non-economic volatility in the financial statements is mitigated, while improving presentation as the derivative obligation (derivative liability) will be presented in the financial statements. In addition, under the narrow scope of this issue paper, it’s important to consider accounting that captures what is relevant and a faithful representation of the business model of variable annuity life insurers, who as indicated elsewhere within this issue paper, utilize dynamic hedging as a risk management technique that if determined to be highly effective under the requirements of this statement, reduces risk, and helps the industry as a whole to better serve the marketplace. Under current guidance, using an amortized cost approach, the derivative would be reported at zero, and not be adjusted for fair value fluctuations, therefore the liability position of the derivative would not be shown in the financial statements.

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b. The process to recognize the fair value of derivative instruments is consistent with the U.S. GAAP guidance for reporting derivatives, therefore eliminating the GAAP or SAP difference on the reporting of these investments.

c. The recognition of “deferred assets” and “deferred liabilities” and the separate amortization of these balances, outside of IMR, prevents the application of this special accounting provision from diluting or impacting the recognition of IMR. Pursuant to SSAP No. 7, IMR defers recognition of realized capital gains and losses resulting from changes in the general level of interest rates. As the recognition of deferred assets and deferred liabilities proposed within this issue paper initially reflects unrealized gains or losses, (and then realized gains and losses once the derivative instrument expired), using a separate amortization process of these items, and not commingling these items with IMR, retains the original intent of IMR.

60.64. The guidance in this issue paper is focused on the accounting guidance for the derivative instruments that hedge an AG 43 liability, not the impact that a Clearly Defined Hedging Strategy, under the provisions of AG 43, can have on the recognized AG 43 liability. One question that arose during the development of this issue paper was whether there was any double counting of the impact of the hedge that would be recorded under this proposed issue paper and what would be recorded as part of the AG 43 liability. It was determined this was not an issue as the amount of credit given to a hedge (the asset to the company under this proposed accounting) under AG 43 is significantly muted by the mechanics and in fact many times actually works to the detriment of the company in AG 43 but is not considered to be material.

Amortization of Deferred Assets and Deferred Liabilities

61.65. This issue paper proposes that deferred assets and deferred liabilities from non-expired derivative contracts be amortized into unrealized gains and losses over period of five years, unless the reporting entity can provide explicit documentation demonstrating that a longer period is more closely linked to the expected liability duration of the hedged item. Although it would be preferred for the amortization period to be linked directly to the AG 43 liability, it is not anticipated that a consistent approach could be determined across reporting entities. Although one commenter suggested a 25-year timeframe, as the amortization can reflect the delayed recognition of unrealized (and realized losses), this timeframe was identified as too long. In working with other industry representatives, a timeframe of 5-years was suggested to NAIC staff. Under the fair value accounting approach in SSAP No. 86, the derivative fair value fluctuations are recognized as they occur, so these commenters noted that a 5-year amortization timeframe would be a significant improvement to the current guidance. For companies that are able to adequately demonstrate a linkage to the expected AG 43 liability, these companies are permitted to extend the amortization, but not to exceed ten years. It is also noted that unrealized gains and losses recognized on a quarterly basis are required to be separately scheduled for amortization over the allowed timeframe. By limiting the amortization timeframe, the scheduling process is anticipated to be manageable, allowing for more effective regulator review.

62.66. This issue paper also allows for reporting entities to accelerate amortization or terminate use of the special accounting provision at any time. With this provision, all deferred assets and deferred liabilities recognized related to outstanding derivative instruments would be immediately eliminated and recognized as unrealized gains and losses. This accounting would be consistent with the fair value accounting method prescribed in SSAP No. 86 if it had been followed. If terminated, subsequently, all derivatives within the documented hedging strategy would be required to follow the fair value accounting under SSAP No. 86.

Measurement / Recognition of Realized Gains and Losses

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IP No. 15X Issue Paper

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63.67. With the ability to rebalance derivative hedging instruments, this issue paper allows for individual derivative instruments to be removed from the portfolio, and/or expire, and not immediately result with an ineffective hedging assessment. Comments received indicate that this approach is consistent with guidance under SSAP No. 86, as gains and losses are either allowed to be an adjustment to the hedged item, or are realized and included in IMR. However, the guidance in this issue paper allows for derivatives to be removed from the hedging strategy and not be identified as an ineffective hedge. This concept is not supported by the existing guidance within SSAP No. 86.

64.68. The provisions within this issue paper is only intended to encompass situations in which the overall hedging strategy is highly effective at the time that the derivative is either removed from the portfolio of hedging instruments or expires. If the hedging strategy is highly effective at that time, then regardless of future determination of effectiveness, the deferred assets or deferred liabilities recognized for the derivative instrument will continue to be amortized under the remaining amortization scheduled established when the hedge was deemed highly effective.

65.69. Once a derivative has expired, the deferred asset and deferred liability will no longer be amortized into unrealized gains and losses, but will be amortized into realized gains or losses.

66.70. For derivatives that have not expired, but were removed from the portfolio of hedging instruments, subsequent gains and losses from fair value fluctuations shall not impact the previously recognized deferred assets or deferred liabilities, but rather be recognized directly as unrealized gains and losses. With this approach, the unrealized gains or losses, reflected as deferred assets or liabilities, will be “locked in” once the derivative is removed from the portfolio of hedging instruments.

Derivative Income

67.71. This issue paper requires that all derivative income received for all derivative instruments within scope of this guidance shall be reported as investment income.

68.72. U.S. GAAP derivative guidance is focused on income statement matching. As such, under U.S. GAAP, the “effective” portion of gains and losses on a derivative instrument is reported consistently between the hedging instrument and hedged item resulting with an exact offset to gains and losses attributed to the hedged risk. , The “ineffective” portion directly effects earnings because there is no offsetting adjustment for the ineffective aspect of the gain or loss. As the focus for statutory accounting is less on income statement matching, and more on the balance sheet impact of the hedged item and the derivative hedging instruments (reducing non-economic volatility), provisions to defer recognition of income received is not considered appropriate for statutory accounting.

69.73. The provisions to recognize income received is also consistent with the SSAP No. 86 guidance in situations in which the derivative is not combined with the hedged item. Pursuant to current guidance, periodic cash flows and accruals of income/expense are to be reported in a manner consistent with the hedged item, usually as net investment income or another appropriate caption within operating income. (Staff notes that tThe SSAP No. 86 is drafted with an assumption that the hedged item is an asset, there is no guidance in SSAP No. 86 that reflects consideration of designating a liability as a hedged item.)

70.74. The cash flow guidance in SSAP No. 86 is different for situations in which the derivative is combined with the hedged item. Under that guidance, the income reported for the derivative on Schedule DB is zero, and the cash flows are to be reported with the hedged item instead of with the derivative. There are concerns with regards to this existing guidance (both in SSAP No. 86, as well as this issue paper), as income from derivative instruments would not be identifiable within the financial statements or Schedule DB. Staff is under the impression that this allowance is not often elected under SSAP No. 86,

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however, with the need for clear reporting under this special accounting provision, this approach is not presented as an option within this issue paper.

71.75. Comments received supported continuation of the concepts in SSAP No. 86, in which changes in the carrying value or cash flow of the derivative shall be recognized in the same period and in the same category of income or surplus as the amortization or fair value changes of the hedged item; e.g., net gain from operations, realized capital gains and losses on investments, unrealized capital gains and losses on investments, or unrealized foreign exchange capital gain or loss. The comments received also identify that as cash flows from swaps are included in the calculation of the hedged item (e.g., projected within AG 43), swap income will be accrued and recorded when it is earned consistently with the hedge item. This issue paper does not reflect these comments. Rather, consideration of income shall be recognized as received, and be included as a factor in determining the recognition of fair value fluctuations in the derivative instruments (e.g., the degree of offset between the AG 43 liability and the fair value fluctuations impacting the recognition of deferred assets and deferred liabilities). It is anticipated that this approach will not result in material differences in the financial statements, but will allow for proper recognition of income when received.

Disclosures

72.76. The disclosure requirements in this issue paper are intended to result in a new schedule DB that specifically address the hedging strategies and related derivatives within this issue paper. The disclosure requirements also envision a schedule for all hedging instruments, with detailed information regarding the cost, fair value, unrealized gains and losses, deferred assets and deferred liabilities, and the amortization schedule. The intent of the proposed disclosures is to provide clear, transparent information regarding the use and impact of this special accounting provision within the financial statements.

RELEVANT STATUTORY ACCOUNTING AND GAAP GUIDANCE

Statutory Accounting

(Staff Note – Excerpts of GAAP and SAP Guidance are planned for inclusion in the final version. These elements have been excluded from the preliminary draft to save space.) G:\DATA\Stat Acctg\3. National Meetings\A. National Meeting Materials\2017\Summer\Hearing - VA\17c - sapwg_exposure_16_03_ip156v6_1mrkup.docx

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