ASC 944-40-30-19D(c) provides guidance on the accounting for multiple market risk benefits within a single long-duration contract.

Accounting for market risk benefits within an insurance contract often becomes more complex when there are multiple MRBs. Each potential MRB should be analyzed separately to determine if it meets the scope criteria.

Once a conclusion is reached that multiple MRB features must be separated from the host contract, the value of the compound MRB is based on one unit of account rather than determining separate fair value measurements for each market risk benefit component and adding them together. A separate unit of account method is inconsistent with ASC 944-40-30-19D(c) and may produce an inappropriate valuation result since multiple MRBs within a single insurance contract will likely affect each other’s fair values.

In theory, the requirement to value the components together could yield different results than if each of the components was valued separately. For example, we expect that the volatility of the combined MRBs would be lower than the volatility when valuing the components separately, potentially resulting in a lower risk margin for the combined MRBs. Additionally, the interdependency of certain assumptions emphasizes the requirement to perform a combined valuation. Lapse assumptions for variable annuity products tend to be more dependent on the extent to which the guaranteed minimum living benefits are “in-the-money” than the factors affecting the GMDBs if the GMDB were valued separately.

ASC 944-40-35-8A requires that changes in the fair value of market risk benefits be recognized in net income, except that fair value changes in MRBs (issued or purchased) attributable to a change in the instrument-specific credit risk of the reporting entity are required to be recognized in other comprehensive income. The requirement to report changes attributable to the instrument-specific credit risk in other comprehensive income rather than in earnings is consistent with the accounting for a change in fair value of a liability caused by a change in credit risk when the fair value option is elected under ASC 825, Financial Instruments. The FASB also understands that insurance entities typically exclude the risk of non-performance in the development of their hedging strategies.

Consistent with the liability fair value option guidance in ASC 825, instrument-specific credit risk for MRBs is measured as the portion of the periodic change in fair value that is not due to changes in a base market rate, such as a risk-free interest rate (the “base rate method”). There is no guidance provided in terms of what portion of the spread above risk-free constitutes “instrument-specific.” An alternative method may be used if it is considered to faithfully represent the portion of the total change in fair value resulting from a change in instrument-specific credit risk. Other potential choices may include the portion of the periodic change in fair value that is not due to changes in the risk-free rate plus or minus any combination of the following: (1) industry sector spread, (2) overall individual company credit standing, or (3) individual company credit standing for a specific product. The selected methodology is a policy election and will need to be disclosed, if material, and consistently applied to each financial liability from period to period.

Determining the nonperformance risk relating to the components of an insurance contract containing an MRB that is bifurcated for financial reporting purposes (e.g., a variable annuity with a guaranteed minimum accumulation benefit) requires consideration of the nature of the hybrid instrument's contractual terms and whether payments under each of the contractual components (i.e., the host contract and the market risk benefit) have the same or different credit standings. Essentially, the individual components should be treated as separate liabilities of a single entity that may have different levels of nonperformance risk. For example, in the case of a variable annuity with a GMAB, the variable annuity host liability may be fully collateralized by related separate account assets, while the bifurcated minimum guarantee is not. In such a case, the nonperformance risk of the bifurcated market risk benefit would need to be considered separately based on its specific attributes. Additional data points in determining nonperformance risk may include credit spreads or credit default swaps spreads and should consider the issuing entity credit data when determining the nonperformance risk of regulated subsidiaries.

An insurance or investment contract, such as a variable annuity with a guarantee feature, may provide a guaranteed return on future potential deposits, in addition to existing deposits, for a specified fee that is other than a current market fee.

The guarantee, and the right to make future deposits that will be subject to the guarantee, are attributes of the existing contract. Therefore, such guarantees need to be incorporated into the valuation if a market participant would incorporate these attributes into the price at which it would be willing to execute the transaction.

For contracts with guaranteed minimum annuitization or withdrawal benefits accounted for at fair value as MRBs, ASC 944-40-35-8B provides guidance on the accounting at the date of annuitization or extinguishment of the account balance. That date marks the end of one accounting contract (the deferred annuity contract with an MRB recognized at fair value) and the beginning of a new contract (the payout annuity). This is because the payout phase is viewed as a separate contract and is not combined with the accumulation phase, as noted in ASC 944-30-35-3. At the date of annuitization or account balance extinguishment (for withdrawal benefits), the MRB would be derecognized, and any amount in AOCI relating to changes in instrument-specific credit risk would be reversed through OCI. The derecognized MRB amount, along with the derecognized contract holder account balance (if any), would be the “in substance” single pay premium used to derive the deferred profit liability recognized at inception of the payout annuity when the “in substance” premium exceeds the liability for future policy benefits. The payout annuity is a new contract for accounting purposes, the liability for which is subject to limited payment accounting, as described in IG 5.3.

Example IG 5-7 and Example IG 5-8 illustrate the accounting upon the election of the annuitization option for a GMIB feature and upon the extinguishment of the account balance (i.e., when the account balance goes to zero) for a GMWB feature accounted for as an MRB, in accordance with ASC 944-40-35-8B.

EXAMPLE IG 5-7
Accounting upon the election of the annuitization option for a GMIB feature accounted for as an MRB, resulting in a deferred profit liability

Insurance Company issues a deferred annuity contract with a GMIB feature that is accounted for as an MRB. At the annuitization date, the contract holder account balance ($50) plus the MRB fair value ($49) is equal to $99, and a cumulative decrease in the MRB’s instrument-specific credit risk since the inception of the contract of $1 has resulted in an existing credit balance in AOCI. Upon annuitization, the liability for future policy benefits for the payout annuity is $90 (measured in accordance with the initial recognition guidance for limited payment contracts in ASC 944-40-30-7).

What is the accounting upon the election of the annuitization option for a GMIB feature accounted for as an MRB?

In accordance with ASC 944-40-35-8B, Insurance Company would record the following journal entry to derecognize the unrealized instrument-specific credit risk through OCI. Insurance Company would not record a gain or loss in net income because there is no settlement of an obligation for an amount less than the contractual obligation amount (i.e., no realization of Insurance Company’s previously estimated nonperformance).

Insurance Company would record the following journal entry to reflect the annuitization using the derecognized contract holder account balance and the MRB liability as the “in substance” premium for the payout annuity.

In this entry, a deferred profit liability is recognized at the inception of the payout annuity because the “in substance” premium exceeds the liability for future policy benefits. There is diversity in practice as to whether premium revenue and claims expense are separately recognized in the statement of operations in the period of annuitization or, since the transaction is not a new sale, the amounts are netted. This result would be the same for a GMWB where the account value is extinguished, except there is no debit to contract holder account balance as it has been reduced to zero.

EXAMPLE IG 5-8
Accounting upon the election of the annuitization option for a GMIB feature accounted for as an MRB, resulting in a loss

Insurance Company issues a deferred annuity contract with a GMIB feature that is accounted for as an MRB. At the date of extinguishment of the account balance, the contract holder account balance is $50, the MRB fair value is $34, and a cumulative decrease in the MRB’s instrument-specific credit risk since the inception of the contract of $1 has resulted in an existing credit balance in AOCI. Upon extinguishment, the liability for future policy benefits for the payout annuity is $90 (measured in accordance with the initial recognition guidance for limited payment contracts in ASC 944-40-30-7).

What is the accounting upon the election of the annuitization option for a GMIB feature accounted for as an MRB?

In accordance with ASC 944-40-35-8B, Insurance Company would record the following journal entry to derecognize the unrealized instrument-specific credit risk through OCI. Insurance Company would not record a gain or loss in net income because there is no settlement of an obligation for an amount less than the contractual obligation amount (i.e., no realization of Insurance Company’s previously estimated nonperformance).

Insurance Company would record the following journal entry to reflect the extinguishment using the derecognized MRB liability as the “in substance” premium for the payout annuity.