New Rules Could Prevent Annuity Derivatives Blight

State insurance regulators are moving ahead with a project that could help keep variable annuities on the shelves — by keeping decreases in the theoretical value of derivatives contracts from making their financial statements look like a blighted soybean leaf.

Publicly traded insurers, especially, fear that "non-economic" changes in derivative contract values could make their earnings look terrible, and force them to narrow, or eliminate, their variable annuity product offerings.

Life insurers use derivatives contracts, or contracts with other financial services companies, to back up variable annuity benefits guarantee promises.

Through many of the contracts, the other companies, or counterparties, have promised to pay cash to the insurers if interest rates fall below a specified level, or rise above a specified level. The derivatives contract promises help a life insurer make sure it can, for example, provide a minimum crediting rate of at least 1% on a customer's variable annuity account value.

The derivatives contracts, and insurance regulators' proposed "Statement of Statutory Accounting Principles" (SSAPs) are complicated, but the impact of a lack of change is clear: Increasing interest rates could cause big drops in the fair value of the derivatives contracts, and make variable annuity issuers' earnings look as ugly as sin.

Some accountants and regulators contend that reflecting the current value of all assets and liabilities in financial statements immediately gives everyone the best picture of how a company is doing.

From the perspective of life insurers, reflecting all of the fair value changes in financial statements immediately would be unfair, because the derivatives contracts would be working exactly as intended: helping variable annuity issuers support minimum crediting rate promises.

The fair value, or theoretical value, of the derivatives would be falling simply because interest rates were moving around, not because anyone had spent paid any cash to anyone, or because the insurer might try to sell its derivatives contracts to someone else.

What Regulators Are Doing

Members of the Statutory Accounting Principles Working Group, part of the National Association of Insurance Commissioners (NAIC), worked on SSAP No. 108, "Derivatives Hedging Variable Annuity Guarantees" last week in San Francisco, at the NAIC's fall national meeting.

The SSAP would apply only to derivatives contracts used to hedge interest rate risk in variable annuity contracts, and only if the insurer could show that the hedge was "highly effective" at helping it cope with changes in interest rates.

If an insurer could show that it had a highly effective hedging strategy, it could include a small part of the derivatives value change in its results now, and defer including the rest.

In an example shown in an appendix, for example, the insurer might have a $250 million fair value loss in a hedged item attributable to hedged risk. In that example, the insurer ends up having to reflect $36 million in fair value loss immediately and deferring $214 million.

SSAP No. 108 drafters have pointed out that many life insurers have already received permission from their home state regulators to use similar procedures, through "permitted practices," or exemptions from the usual rules.

Some state insurance regulators dislike the idea of letting life insurers defer hedging related liabilities or assets.

One version of the draft on the working group's website includes a provision that would let a variable annuity issuer's own home state regulator ask to see what would happen to the issuer's risk-based capital ratio, or indicator of financial health, if it had recognized all derivatives-related gains and losses immediately.

The working group ended up approving the draft SSAP, with an effective date of Jan. 1, 2020. Insurers could adopt the SSAP as early as Jan. 1, 2019.

The American Council of Life Insurers (ACLI) has been asking the NAIC to let the SSAP take effect as quickly as possible.

Early adoption will help reduce "potential negative consequences as interest rates are expected to rise throughout 2018," Mike Monahan, senior director, accounting policy, at the ACLI, told the NAIC in a comment letter in May.