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Insurance entities issue various types of insurance and investment contracts, and reinsurance contracts, with embedded derivatives. These include certain equity indexed life and annuity contracts and reinsurance contracts with returns based on referenced investment portfolios.
The derivative accounting guidance in ASC 815-10-15-13 provides a scope exception from derivative accounting for certain insurance contracts and market risk benefits. Contract features need to be assessed to determine if the scope exemption applies or if accounting as an embedded derivative is required. ASC 815-15-55-66 through ASC 815-15-55-69 notes that the equity-indexed return portion of the contract will generally be required to be separated from the host and accounted for as a derivative. See IG 2.4 for additional considerations surrounding long-duration insurance contract classification. Refer to IG 9.9 for additional details on reinsurance contracts that contain embedded derivatives.
Features that meet the definition of an embedded derivative are required to be accounted for at fair value. Unlike market risk benefits, the entire change in fair value of the embedded derivative is recognized through income. Consideration should be given to the measurement of the embedded derivatives and related guidance, including the issues identified in IG 5.7.1 through IG 5.7.3.

5.7.1 Insurance contracts with embedded derivatives

ASC 820 requires that a fair value measurement reflect the price the transferor would pay to transfer the liability in an orderly transaction between market participants at the measurement date, even if there is no active market in which to transfer insurance and investment contract liabilities and the embedded derivatives in such contracts, and even if transfer is not permitted under the terms of the contract. Therefore, an entity valuing a contract or embedded derivative component of a contract in the absence of an observable market would need to determine the hypothetical market in which the transfer would occur.
Some insurance entities have suggested that reinsurance is the exit market for insurance contracts, investment contracts, and embedded derivative components of such contracts. While the typical indemnity reinsurance transaction may be a viable way to economically transfer the risks related to these contracts, the ceding entity is still primarily obligated to the insured parties, and, thus, indemnity reinsurance is not equivalent to a complete transfer of the obligation as contemplated in ASC 820. While actual or hypothetical reinsurance transactions may offer data points and inputs into the fair value measurement, they would not necessarily be representative of an exit price. Accordingly, if reinsurance transactions (either actual or hypothetical) are used as inputs, how those inputs might differ from an actual transfer would need to be considered, including reinsurance contract terms, such as termination provisions, loss limits, potential premium adjustment provisions, remaining services provided by the cedant (such as policy administration and claims handling), and compliance (primary obligor risks, such as market conduct and reputational risks).
As an alternative to reinsurance, another direct insurance entity may provide a hypothetical market, possibly viewed in the context of a business acquisition. Such an approach would require consideration of what type of acquirer is involved in the business acquisition. That is, whether the buyer would be a strategic buyer or a financial buyer, the size of the buyer and size of the portfolio that would be purchased, the efficiencies in administrative systems of a typical market participant, and other factors.
Because of their unique features and lack of an established active market for transfers of the obligations, determining the fair value of many, if not all insurance and investment contracts or embedded derivative components of such instruments will require significant unobservable inputs. As a result, the fair value measurements are likely to be Level 3 measurements for fair value hierarchy disclosure purposes. Such unobservable inputs will reflect the insurance entity's assumptions about the assumptions market participants would use in pricing the specific portfolio, using the best information available, which might include the entity's own data. The insurance entity's own data should be adjusted if information indicating that market participants would use different assumptions is reasonably available without undue cost and effort. However, in many cases, there may be no reason to believe that the insurance entity's own assumptions are not consistent with those of a typical market participant.

5.7.2 Nonperformance risk – embedded derivatives

ASC 820 requires that the fair value of a liability reflect the nonperformance risk (including credit risk) relating to that liability. In the debt market, changes in either an entity's specific credit rating or general credit spreads will typically have a direct and immediate impact on the fair value of the instrument. However, for certain insurance and investment contracts, premium pricing can be relatively insensitive to changes in ratings that relate to an insurer's claim paying ability or overall financial strength (at least within the upper levels of credit). For example, for retail products, consumers often do not distinguish a difference in claim paying ability above some level that is deemed acceptable. The commercial insurance and reinsurance markets may be somewhat more sensitive to credit rating changes.
The existence of state or other governmental guaranty funds and collateralization may also serve to reduce the significance of nonperformance risk in these measurements. As discussed in FV 8.1.1, credit risk may differ among liabilities of the same entity for a number of reasons. In addition to the items highlighted within that section, insurance contract liabilities may have other features that may be considered when measuring fair value. For example, variable annuity, variable life, and certain pension contracts may be collateralized by insurance entity separate account assets. Funds in a separate account are not commingled with other assets of the insurance entity for investment purposes. In the US, certain separate account assets are legally insulated from the general account liabilities of an insurance entity, such that the separate account contract holder is not subject to an insurer’s default risk to the extent of assets held in the separate account. While separate account liabilities are generally collateralized by the related separate account assets, the extent of the legal insulation provided by the separate account arrangement may vary from jurisdiction to jurisdiction
Another unique aspect of insurance entity operations is state guaranty funds, which help to pay claims of insolvent insurance entities. State laws specify the lines of insurance covered by these funds and the dollar limits payable. Although ASC 820-10-35-18A states that guarantees of liabilities should not be considered by the issuing entity in determining the fair value of the liability, ASC 825-10-25-13b exempts government guarantees from this exclusion.
In order to consider collateralization, a third-party, or a governmental guarantee in valuing a liability, such a feature must be an attribute of the instrument and inseparable from it. For example, with regard to state guaranty funds, it may be appropriate to consider their impact in the assessment of nonperformance risk if the guarantee would apply to the contract in the event the liability were transferred (i.e., if the guaranty fund remains obligated to provide its guarantee on the contract liability). This fact should be verified with appropriate legal or regulatory experts, as laws may vary by state and by type of insurance contract. Other restrictions may also exist, such as limitations on the amount of coverage provided by the guaranty fund for specific types of contracts.
See IG 5.6.3 and IG 5.6.4 for additional considerations around nonperformance risk.

5.7.3 Identification of risk margins for significant assumptions

ASC 820 requires that inputs to valuation techniques include the assumptions that market participants would use in pricing the asset and liability, including assumptions about risk. This includes the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. However, ASC 820 does not require that a separate risk margin be explicitly estimated for each input into a fair value estimate.
For fair value measurements that use a present value technique, ASC 820-10-55 provides guidance on how assumptions about risk can be factored into the present value calculation, describing three different methods that adjust the cash flows for risk. One method, the discount rate adjustment technique, uses a single set of cash flows (contractual, promised, or most likely) and a risk-adjusted discount rate to capture all the risk and uncertainty of that single set of cash flows. However, this method assumes that the release of all risks is purely time based, which will not always be the case. The other two methods are variations of the expected cash flow technique. The first uses risk-adjusted expected cash flows discounted using a risk-free rate, so that the entire risk premium is captured in the cash flows. The second uses expected cash flows and a risk-adjusted discount rate (but different from the risk-adjusted rate used in the discount rate adjustment technique). This method thereby captures the risk and uncertainty through use of both expected cash flows and the discount rate. In addition, market participants might apply industry-based risk assumptions, such as risk-neutral or policyholder behavior assumptions with risk margins. If specific risk measurement methodologies are used for certain types of policies or contracts by market participants, they should be considered in the measurement of fair value under ASC 820.
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