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September 14, 1999

SFAS 133 Overview and Implications for Insurance Companies Cathy Engelbert Partner, Deloitte & Touche Capital Markets Group. September 14, 1999. Casualty Loss Reserve Seminar. Overview Agenda. Background Information Steps to Hedge Accounting Categories of Hedges What is a Derivative?

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September 14, 1999

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  1. SFAS 133 Overviewand Implications for Insurance CompaniesCathy EngelbertPartner, Deloitte & Touche Capital Markets Group September 14, 1999 Casualty Loss Reserve Seminar

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

  3. Statutory v. U.S. GAAP Framework U.S. GAAP STATUTORY • Going Concern • Relevance and reliability • Comparability and consistency • Adequacy of • Surplus • Claims paying

  4. WHY THE CHANGE? • Quantity and variety of derivatives are increasing • Accounting conventions and standards are outdated, incomplete and inconsistent • Effects of derivatives arenot transparent in the financial statements

  5. 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

  6. 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

  7. FAS 133 Overview • Effective — Fiscal Years beginning after June 15, 2000 • No grandfathering • All derivatives on balance sheet at Fair Value • Early application permitted

  8. FASB’s Cornerstones • Derivatives create Assets and Liabilities • Fair Value — only relevant measure for derivatives • Provide Hedge Accounting but limit appropriately

  9. The Hedger’s Dilemma Period Period 1 2 Total Exposure 30 30 Derivative (30) (30) P&L (30) 30 0

  10. Hedge Basics — Objectives Period Period 1 2 Total Exposure 30 30 Derivative (30) (30) P&L (30) 30 0

  11. Hedge Basics — Objectives Period Period 1 2 Total Exposure 30 30 Derivative (30) (30) P&L (30) 30 0

  12. Hedge Basics — Objectives Fair Value Hedge Period Period 1 2 Total Exposure 30 30 Derivative (30) (30) P&L (30) 30 0 Cash Flow Hedge

  13. Hedge Basics — Ineffectiveness Period Period 1 2 Total Exposure 30 30 Derivative (32) (32) P&L (2)

  14. Steps to Hedge Accounting • Formulate policy • Identify exposure • Design strategy • Document • Execute • Monitor Today’s Focus

  15. Exposure Identification Exposure? FX Fair Value Cash Flow

  16. Fair Value Hedges Exposure? Fair Value Mark to fair value through earnings both the derivative and the hedged item attributable to the risk being hedged

  17. 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)

  18. Fair Value Hedges • Examples: • Fixed rate debt • Fixed rate AFS security or loan • Inventory • Fixed price, fixed quantity commodity purchase commitment

  19. Case 1: Fair Value Hedges Assumptions: • Underlying is a $1,000 fixed rate loan (asset) • Interest rate risk managed with derivative • Interest rates decline

  20. Beginning Balance Sheet Asset Liability Loan 1,000 Retained Earnings 1,000

  21. Income Statement P & L Loan 100 Derivative (102) Impact (2)

  22. Ending Balance Sheet Asset Liability Loan 1,100 Derivative 102 Retained Earnings 998

  23. Hedge Basics — Objectives Fair Value Hedge Period Period 1 2 Total Exposure 100 100 Derivative (102) (102) P&L (2)

  24. Risk Components of Financial Asset e.g. Debt instruments 3 Default/Credit Risk 100 103 Interest Rates Total Change in Fair Value of the Loan was $103, but only marked $100 because only hedging Interest Rate risk

  25. Interest Rate Risk Breakdown Change in Fair Value of Loan Due to Changes in: 102 Risk Free Interest Rates 100 (2) Sector Spread

  26. Exposure Identification Exposure? Cash Flow Mark to fair value through other comprehensive income ONLY the derivative (effective portion)

  27. Cash Flow Hedge • Exposure to changes in cash flows • Affects earnings • Sources of exposure: • Recorded asset - floating rate • Recorded liability - floating rate • Forecasted transaction

  28. 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)

  29. 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

  30. Beginning Balance Sheet Asset Liability Cash 1,000 Liability 1,000

  31. Cash Flow Hedges Earnings (2) OCI (100) Comprehensive Earnings (102) • Amounts accumulated in OCI are reclassified to earnings when interest expense is accrued

  32. Cash Flow Hedges - Ending B/S Asset Liability Cash 1,000 Liability 1,000 Derivative 102 Equity Component (100) Retained Earnings (2)

  33. Hedge Basics — Objectives Period Period 1 2 Total Exposure 100 100 Derivative (102) (102) P&L (2) (100) Cash Flow Hedge

  34. “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

  35. What’s a Derivative • All exchange traded derivatives • Many, many OTC contracts CommonUncommon • Options (caps/floors) •Certain Supply Contracts • Forwards • Embeddeds (i.e., convertible bonds) • Swaps •Certain embedded puts & calls •Certain insurance contracts

  36. 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

  37. 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

  38. Hybrid Instruments Host Contract Debt Embedded Derivatives Equity • F/X Option • Interest Rate Index • Leverage Features • Commodity Index • Equity Index Lease Insurance Supply Foreign Exchange

  39. 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

  40. 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. • Embedded derivative IS NOT clearly and closely related

  41. 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. • Embedded derivative IS NOT clearly and closely related

  42. 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%. • Embedded derivative IS NOT clearly and closely related

  43. 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. • Embedded derivative IS NOT clearly and closely related

  44. Property / Casualty Contracts • 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

  45. 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 indollars

  46. Property / Casualty Contracts • 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

  47. Property / Casualty Contracts • 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)

  48. Property / Casualty Contracts • 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)

  49. 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)

  50. 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

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