Derivatives Implementation Group

Statement 133 Implementation Issue No. B7

QUESTION

If the insurer, rather than the policyholder, actually owns the investments supporting a variable annuity product, does the conclusion that the investment component of a traditional variable annuity contracts (described in the second and third bullet points of paragraph 200) does not contain embedded derivatives remain valid?

BACKGROUND

Paragraph 200 of Statement 133, contained in Section 2 of Appendix B, Examples Illustrating Application of the Clearly-and-Closely-Related Criterion to Derivative Instruments Embedded in Hybrid Instruments, provides examples of variable annuity product structures. The second bullet point of paragraph 200, related to an investment component states, in part:

     The policyholder directs certain premium investments in the investment account that includes equities, bonds, or both, which are held in separate accounts that are distinct from the insurer's general account assets. This component is not considered a derivative because of the unique attributes of traditional variable annuity contracts issued by insurance companies. Furthermore, any embedded derivatives within those investments should not be separated from the host contract by the insurer because the separate account assets are already marked-to-market under Statement 60.

In addition, the third bullet point of paragraph 200 related to an investment account surrender right at market value states:

     Because this right is exercised only at the fund market value (without the insurer's floor guarantee) and relates to a traditional variable annuity contract issued by an insurance company, this right is not within the scope of this Statement.

In concluding that certain traditional variable annuity product structures, as defined in FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, and as contemplated in FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, do not contain embedded derivatives, the second and third bullet points of paragraph 200 do not refer to ownership of the assets specifically resting with either the policyholder or the insurer. While the policyholder is entitled to direct the investment of premiums into various approved funds, the insurance company actually owns the investments. That is noted by the National Association of Insurance Commissioners' Statement of Statutory Accounting Principles No. 56, Separate Accounts, which states that "assets held in separate accounts are owned by the insurer."

A traditional variable annuity product structure, as that term is used in this issue, includes the following attributes:

• The policyholder's payments, after deduction of specified sales and administrative charges, are used to purchase units of a separate investment account (a "separate account").

• The policyholder directs the allocation of the account value among various investment options (typically various mutual funds). The policyholder bears the investment risk (that is, the account value is based entirely on the performance of the directed investments).

• The units may be surrendered for their current value in cash, although there is often a small surrender charge, or the units may be applied to purchase annuity income.

• The insurer guarantees mortality and maximum expense charges, and amounts are deducted periodically from the separate account to cover these charges.

• Deferred annuity contracts typically provide a death benefit during the accumulation period under which the policyholder may receive the greater of the sum of premiums paid or the value of total units to the credit of the account at time of the policyholder's death.

RESPONSE

Yes. The guidance in the second and third bullet points of paragraph 200 that a traditional variable annuity contract contains no embedded derivatives that warrant separate accounting under Statement 133 remains valid even though the insurer, rather than the policyholder, actually owns the assets. The following indicators provide the basis for concluding that a traditional variable annuity contract is not a hybrid instrument to be accounted for under paragraph 12:

• The variable annuity contract is established, approved, and regulated under special rules applicable to variable annuities (such as state insurance laws, securities laws, and tax laws).

• The assets underlying the contract are insulated from the general account liabilities of the insurance company (the policyholder is not subject to insurer default risk to the extent of the assets held in the separate account).

• The policyholder's premium is invested in contract-approved separate accounts at the policyholder's direction.

• The insurer must invest in the assets on which the account values are based.

• The policyholder may redirect its investment among the contract-approved investment options.

• The account values are based entirely on the performance of those directed investments.

• All investment returns are passed through to the policyholder (including dividends, interest, and gains/losses).

• The policyholder may redeem its interests at any time; however, it may be subject to surrender charges.

• The policyholder has voting rights in certain separate account structures.

In addition, although the liability to policyholders is not specifically required to be remeasured at fair value with changes reported in earnings under existing GAAP, current accounting practice for traditional variable annuity contracts is to record a liability equal to the summary total of the market value of the assets held in the separate account for the policyholders.

The guidance in Statement 133 Implementation Issue B8, "Embedded Derivatives: Identification of the Host Contract in a Nontraditional Variable Annuity Contract," is based on the above guidance for traditional variable annuity contracts. However, in determining the accounting for other seemingly similar structures, it would be inappropriate to analogize to the above guidance due to the unique attributes of traditional variable annuity contracts and the fact that the above guidance can be viewed as an exception for traditional variable annuity contracts issued by insurance companies.

The minimum death benefit component during the accumulation period is not an embedded derivative that warrants separate accounting under Statement 133, as discussed in paragraph 200.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.

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