September 14, 1999

The New Derivatives and Hedge Accounting FrameworkFAS 133

September 14, 1999

SFAS 133 Overviewand Implications for

Insurance Companies

Cathy EngelbertPartner, Deloitte & Touche Capital Markets Group

Casualty Loss Reserve Seminar


Overview Agenda Background Information Steps to Hedge Accounting Categories of Hedges What is a Derivative? The Road to Implementation


Statutory v. U.S. GAAP Framework

STATUTORY U.S. GAAP

•Adequacy of Surplus

•Claims paying

•Going Concern•Relevance and reliability

•Comparability and consistency


WHY THE CHANGE? Quantity and variety of derivatives

are increasing

Accounting conventions and standards are outdated, incomplete and inconsistent

Effects of derivatives are not transparent in the financial statements


FAS 133 Chronology

1986 — Financial Instruments Project

1992 — Special Report on Hedging

1996 — Original Exposure Draft Issued

1997 — Revised Exposure Draft

1998 — June, Final Standard

1999 — June, Deferral of Effective Date

Now — Derivatives Implementation Group


Derivative Implementation Group (“DIG”)

Meets every other month Members

– Big five accounting firms (5 representatives)– Local firm (1 representative)– Industry (4 representatives)– SEC/FDIC observers– FASB Board

Next meeting - October 1999 Embedded issues for insurance co.’s


FAS 133 Overview

Effective — Fiscal Years beginning after June 15, 2000

No grandfathering

All derivatives on balance sheet at Fair Value

Early application permitted


FASB’s Cornerstones

Derivatives create Assets and Liabilities

Fair Value — only relevant measure for derivatives

Provide Hedge Accounting but limit appropriately


The Hedger’s Dilemma

Exposure 30 30

Derivative (30) (30)

P&L (30) 30 0

Period Period 1 2 Total


Exposure 30 30


P&L (30) 30 0

Hedge Basics — Objectives



Exposure 30 30


P&L (30) 30 0





Exposure 30 30


P&L (30) 30 0


Fair Value Hedge

Cash Flow Hedge


Exposure 30 30


P&L (2)

Hedge Basics — Ineffectiveness



Steps to Hedge Accounting

Formulate policy

Identify exposureIdentify exposure

Design strategy

Document

Execute

Monitor

Today’s Focus


CashFlowCashFlow

FXFXFairValueFair

Value

Exposure Identification

Exposure?


Fair Value Hedges

FairValueFair

Value

Exposure?

Mark to fair value throughearnings both the derivative and the hedged itemattributable to the risk being hedged


Fair Value Hedges

Exposure to changes in Fair Value

Affects earnings

Sources of exposure:– Recorded asset - fixed price/rate– Recorded liability - fixed rate– Firm commitment (fixed

quantity/fixed price)


Fair Value Hedges

Examples:– Fixed rate debt– Fixed rate AFS security or loan– Inventory– Fixed price, fixed quantity

commodity purchase commitment


Case 1: Fair Value Hedges

Assumptions:

Underlying is a $1,000 fixed rate loan (asset)

Interest rate risk managed with derivative

Interest rates decline


Beginning Balance Sheet

Loan 1,000

Retained Earnings 1,000

Asset Liability


Income Statement

Loan 100

Derivative (102)

Impact (2)

P & L


Ending Balance Sheet

Loan 1,100

Derivative 102

Retained Earnings 998

Asset Liability



Exposure 100 100


P&L (2)


Fair Value Hedge


Risk Components of Financial Asset e.g. Debt instruments

3

100

Default/Credit Risk

Interest Rates103

Total Change in Fair Value of the Loan was $103, but only marked $100 because only hedging Interest Rate risk


Interest Rate Risk Breakdown

102

(2)

Risk Free Interest Rates

Sector Spread

100

Change in Fair Value

of LoanDue to Changes in:


Exposure Identification

CashFlowCashFlow

Exposure?

Mark to fair value through other comprehensive income ONLY the derivative (effective portion)


Cash Flow Hedge

Exposure to changes in cash flows

Affects earnings

Sources of exposure:– Recorded asset - floating rate– Recorded liability - floating rate– Forecasted transaction


Cash Flow Hedges

Examples:– Floating rate debt– Floating rate AFS security or loan– Forecasted commodity purchase/sale– Forecasted bond purchase or loan sale– Planned debt issuance– Repricing of short-term liability– Forecasted foreign currency purchases and

sales (including intercompany)


Case 2: Cash Flow Hedges

Assumptions:

Exposure is repricing of $1,000 liability

Interest rate risk managed with derivative

Interest rates decrease - derivative decreases in value by 102


Beginning Balance Sheet

Cash 1,000

Liability 1,000

Asset Liability


Cash Flow Hedges

Earnings (2)

OCI (100)

Comprehensive Earnings(102)

Amounts accumulated in OCI are reclassified to earnings when interest expense is accrued


Cash Flow Hedges - Ending B/S

Cash 1,000

Liability 1,000

Derivative 102

Equity Component (100)

Retained Earnings (2)

AssetLiability



Exposure 100 100


P&L (2)


(100)

Cash Flow Hedge


“Non-Qualifying” Exposures

Portfolio of dissimilar items Held To Maturity debt securities(interest

rate) Future intercompany transactions

– Forecasted (except FX) Items already at fair value through earnings Equity method/consolidated investees Minority interests Firm commitment to acquire/sell business Your own equity


What’s a Derivative

All exchange traded derivatives

Many, many OTC contractsCommon Uncommon

Options (caps/floors) •Certain Supply Contracts Forwards • Embeddeds (i.e., convertible bonds) Swaps •Certain embedded puts & calls

•Certain insurance contracts


What’s a Derivative

Financial instrument or contract

– Underlying

– Notional amount or payment provision

No (or smaller) investment at inception Requires or permits net settlement or

de facto net settlement


Embedded Derivatives

Implicit/explicit terms

Clearly and closely related Host contract + embedded derivative = hybrid

contract Interest rate embeddeds in debt hosts: leverage test Embeddeds in insurance liabilities


Hybrid Instruments

Insurance

Host Contract

Embedded DerivativesDebt

F/X Option

Interest Rate Index

Leverage Features

Commodity Index

Equity Index

Lease

Equity

Foreign ExchangeSupply


Interest Rates in a Debt Host - Example

Insurance Company invests $10 million in bonds with an 8% coupon. The bonds matures in five years. If LIBOR increases by 500 basis points within any one year, the bonds mature and the Ins. Co receives $8.0 million.

Embedded derivative IS NOT clearly and closely related


Interest Rates in a Debt Host - Example

Insurance Company invests $10 million in Company A’s debt with a coupon of 7% and a term of 10 years. Company A’s market rate for 10-year debt is 8.25%. Embedded in the debt is an interest rate adjustment that resets the interest rate to 18% if 3-month LIBOR increases to 9% or greater during the first three years of the debt.



Calls and Puts in a Debt Host - Example

Insurance Co. invests $800,000 in 10-year bonds with a par value of $1 million. The bonds have a coupon of 8%. The bonds are putable by the insurance co. if 3-month LIBOR rates change 150 basis points.



Calls and Puts in a Debt Host - Example

Insurance Co. invests $950,000 in 10-year bonds with a par value of $1 million. The bonds are putable by the insurance co. if the S&P declines 20%.



Equity-indexed Payments in a Debt Host - Example

Insurance Co. invests in 10-year notes. The notes have no stated coupon. Interest is to be paid based on changes in the stock price of Company Y.



Excluded from FAS 133:•Traditional property / casualty insurance

contracts (explicitly excluded)•Disaster / catastrophe bonds, whose principal

repayment is solely dependent on the occurrence of losses for which the insurer/issuer is at risk. (based on claim payments incurred by insurer due to specified disaster)

•Non-exchange traded contracts based on physical variables and not expressed in dollars

Property / Casualty Contracts


Subject to FAS 133:•Property / casualty insurance contract with embedded

derivative (e.g., FX contract)•Disaster / catastrophe bonds, whose principal

repayment is solely dependent on a specified industry loss (based on industry loss index expressed in dollars)

•Publicly traded options with payment triggered by catastrophe industry loss index expressed in dollars

•Exchange-traded contracts based on physical variables

•Nonexchange-traded contracts based on damage expressed in dollars




Property/casualty insurance contract with embedded derivative– Traditional coverage such as worker’s

compensation, property, general liability coverage

– Combined with foreign currency options– Foreign exchange risk element is not

insurance– Embedded derivative subject to FAS 133


Insurance Company writes policies that expose it to loss should a level 4 hurricane strike the coast of Florida.

Per risk management policy, IC enters into a contract with Reinsurance Co. The contract provides for payment of actual losses incurred by WBIC of up to $50 million in excess of a $100 million retention, provided that industry hurricane losses exceed $10 billion (a.k.a. an industry loss warranty). The premium paid by IC to Reins Co. is $500,000.

Hurricane strikes Florida. Industry losses are $12 billion and IC incurs $150 million in claims.

Does this transaction represent a property-casualty contract excluded from the scope of FAS 133?

– Yes (only reimbursed for insured losses)



Insurance Co. enters into a contract that provides for a payment of $150 million in the event that industry hurricane losses exceed $10 billion. The payment is not contingent upon the level of losses incurred by IC. The premium paid by IC for this contract is $520,000.

A hurricane strikes Florida. Industry losses are $12 billion and IC incurs $120 million in claims.

Does this transaction represent a property-casualty contract excluded from the scope of FAS No. 133?

No (the payment is based on changes in a variable rather than the occurrence of insured losses)



Exemptions - Climatic or Geological Variables - Examples

A hotel operator in a resort beach community enters into a contract with a counterparty that requires $1.0 million to be paid to the hotel operator if there is a hurricane during June, July or August.

Contract is not a derivative because payment is based on a climatic variable (i.e., if the hurricane occurs)


Exemptions - Climatic or Geological Variables - Examples

A hotel operator in a resort beach community enters into a contract with a counterparty that requires $1.0 million to be paid to the hotel operator if hurricane damage exceeds $1.0 billion during June, July or August.

Contract is a derivative because payment is based on a dollar amount of damage


Weather Derivatives

Contracts indexed to climatic or geological variables (rather than currency units) – E.g., linked to inches of rainfall or snowfall,

degree days•Excluded from FAS 133, para. 10e.•No guidance provided in FAS 133 for such

excluded derivatives - EITF is addressing in 99-2


Life Insurance and Annuities Excluded from FAS 133:

• Traditional whole-life contracts (FAS 60)• Traditional participating contracts (FAS 120/SOP 95-1)• Traditional universal-life contracts (FAS 97)• “Vanilla” variable annuity (FAS 60 & FAS 97))• “Vanilla” variable life (FAS 60 and FAS 97)• Market value adjusted annuity (FAS 97)

Subject to FAS 133:• Deferred variable annuity with a minimum guaranteed

investment return (min accum benefits or floor)• Equity-indexed deferred annuity• Equity- linked cash surrender value

DIG• Variable annuity with payment alternatives


KEY BENEFITS

Comprehensive guidance Increased transparency Account for actual economic

hedge (ineffectiveness) Flexibility in FX hedging of

forecasted transactions Matching of hedge results

maintained for forecasted transaction hedges


KEY CHALLENGES

Complexity of interpretations Volatility Complexity of implementation

(processes, systems, training, etc.) Strict similar asset / liability designation

requirements (limits portfolio hedging) Embedded derivatives Written Options Interpretation of definition


KEY CHALLENGES - Continued

Effectiveness Testing - at least quarterly Ineffectiveness recognized through the

income statement•Credit spread•Changes in time value on options

Combined interest rate and currency swaps

No special hedge accounting for fx denominated assets and liabilities

Documentation and Designation Specificity


The Road to Implementing SFAS 133

Determine Tax Impact, Transition Adjustments and Evaluate Disclosures

Assess Valuation Capabilities

Perform Hedge Effectiveness

Assess Processes / Technology and Implement Changes

Categorize Inventory and Exposures

Compile Inventory of Derivatives and Related Exposures

Review and AssessRisk Management Policies

Form an Implementation Team


[email protected]

Documents

September 14, 1999