Variable Annuities and SFAS 157

Posted at on November 7, 2009

Wouldn’t it be interesting to know an insurance company’s own estimate of the risk that it will not keep its promises?

With new! improved! GAAP accounting, you can.

Statement of Financial Accounting Standards (SFAS) 157: Fair Value Measurements was issued by the Financial Accounting Standards Board in 2006, and it became effective in 2008. It provides guidance on how to estimate the fair value of assets and liabilities that are subject to fair value accounting. This includes equity-indexed annuities and variable annuity guaranteed living benefits, such as guaranteed minimum withdrawal benefits.

One element of the fair valuation of variable annuity living benefits is the insurer’s own credit risk. An increase in credit risk is reflected in an increase in the discount rate that is used to value the insurer’s liabilities, leading to a lower valuation. A decrease in credit risk is reflected in a decrease in the discount rate that is used to value the insurer’s liabilities, leading to a higher valuation. (For an excellent discussion of methodological issues, see Rony Sleiman and Tricia Matson, “SFAS 157 Adoption Impacts,” The Financial Reporter, December 2008.)

“Losses from derivatives that do not qualify for hedge accounting were $1.3 billion. This is primarily attributable to a $895 million pre-tax loss driven by an improvement in MetLife’s own credit spread and its impact on the valuation of certain insurance liabilities. MetLife’s average credit spread decreased by 315 basis points over the quarter. This reverses derivative gains in previous quarters that occurred when our credit spread widened.”

And here’s an excerpt from MetLife, Inc.’s Form 10-Q for the Quarterly Period Ended September 30, 2009 (p. 144):

“As it relates to unhedged risks associated with variable annuity embedded derivatives, there was a year over year increase in losses, from gains in the prior year period to losses in the current year. The losses associated with unhedged risks were driven by the narrowing of MetLife’s credit spread in the current period.”

Variable annuity prospectuses invariably contain a cursory warning that guarantees are an obligation of the insurer and subject to the insurer’s claims-paying ability. However, they provide no disclosure of the changes in discount rates that each insurer uses to account for its promises. The accounting picture is choppy seas; the marketing picture is a calm port in the storm.

Insurers promise peace of mind, so you might wonder why the accounting system does not require insurers to record the cost of providing it. If the risk of default increases, why don’t insurers have to record the cost of hedging that risk to restore complete confidence?

Instead, SFAS 157 reminds me of the story about the man who killed his parents and then pleaded for mercy because he was an orphan. An insurer can mess up its financial position and then record a gain from the resulting decrease in the fair value of its liabilities.

Does this make sense to you?


10-3-11 update

The bizarre creation of accounting gains from impaired creditworthiness has caught the attention of European bank regulators who are developing the Basel III framework for capital requirements. An article in the August 2011 issue of Risk, a U.K. trade publication, provided this summary:

“Many banks adjust the value of trades to reflect the possibility of their own default, with the counter-intuitive effect that a rise in their credit spread appears as a profit. Basel refuses to recognize this in bank capital rules, but there is a split on the issue in the industry — and among regulators themselves.”