VARIABLE ANNUITIES ISSUES (E) WORKING GROUP Thursday, July 20, :00 a.m. ET / 10:00 a.m. CT / 9:00 a.m. MT / 8:00 a.m. PT ROLL CALL AGENDA

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1 Date: 7/17/17 Conference Call VARIABLE ANNUITIES ISSUES (E) WORKING GROUP Thursday, July 20, :00 a.m. ET / 10:00 a.m. CT / 9:00 a.m. MT / 8:00 a.m. PT ROLL CALL Iowa, Chair California Connecticut Michigan Minnesota Missouri Nebraska New Jersey New York Ohio AGENDA 1. Adopt May 11 Interim Minutes Jim Armstrong/Mike Yanacheak (IA) Attachment One 2. Quantitative Impact Study (QIS) II Update Jim Armstrong/Mike Yanacheak (IA) Presentation from Oliver Wyman Attachment Two 3. Consider Referral from the SAPWG & Proposed Response Jim Armstrong (IA) Original Referral Attachment Three Draft Proposal from Chair Attachment Four Comment Letter from the ACLI Attachment Five 4. Any other Matters Brought Before the Working Group Jim Armstrong/Mike Yanacheak (IA) 5. Adjournment 2017 National Association of Insurance Commissioners 1

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3 Attachment One Draft: 5/30/17 Variable Annuities Issues (E) Working Group Conference Call May 11, 2017 The Variable Annuities Issues (E) Working Group of the Financial Condition (E) Committee met via conference call May 11, The following Working Group members participated: Mike Yanacheak, Chair (IA); Kim Hudson (CA); Wanchin Chou (CT); Judy Weaver (MI); Fred Andersen and John Robinson (MN); William Leung (MO); Rhonda Ahrens (NE); Felix Schirripa (NJ); William Carmello (NY); and Peter Weber and Dale Bruggeman (OH). 1. Heard a Presentation from Oliver Wyman Kai Talarek (Oliver Wyman) and Aaron Sarfatti (Oliver Wyman) provided the Working Group with an update on the Quantitative Impact Study (QIS) II (Attachment 1), which officially began on Feb. 21. Mr. Talarek stated that he was happy to report that data from cycle I, which is focused on stochastic modeling, had been received, and the project is currently on track with the original proposed plan. He stated they are beginning to work on cycle II of QISII, which will be focused on the standard scenario. He stated once cycle II is completed, they will be in a position to assess the overall impact of the framework, which can be used to help state insurance regulators make adjustments before cycle III is performed and eventually lead to a final recommended proposed framework. Mr. Talarek summarized the other future open conference calls on the status of the QISII work. He indicated that the June conference call would be focused on the outputs of testing cycle I, as well as any regulator guidance, and an update on testing cycle II. Mr. Talarek stated that in mid-july, they will begin discussions on testing cycle III, as well as any regulator guidance and what has been learned from testing cycle I and cycle II. Mr. Talarek provided a summary of each of the four topics that will be focused on during cycle II. The first topic will be revenue sharing, which is currently limited. He stated the goal in cycle II will be to align the proposal with actual company experience. This will look at different variations of existing guidance. One will be to have smaller prescribed reductions in revenue sharing based upon the robustness of the fee streams and reduction of the total fund fees that coincides. Mr. Talarek stated the second topic will be behavioral assumptions. He stated they would look to make modifications to the 2016 proposed framework based upon actual company experience to ensure that the resulting prescriptions are conservative but rooted in actual company data. He stated that part of the proposed framework is only to become binding where appropriate and that there will be a need to develop governance that helps to achieve this objective. Mr. Talarek stated the third topic will be the diversification benefit. He described how the current calculation imposes a seriatim calculation to deny any diversification benefit. He stated there are some real benefits that accrue to the books, and they have a framework that allows such to be used, but at the same time limits the benefits. He noted that the cycle II is attempting to find the correct limit. Mr. Talarek stated the forth item is a study of equity calibration criteria. Mr. Sarfatti noted that based upon numerous inputs, calibration criteria linked to interest rates do not need to be tested, as data is not sufficient to demonstrate direct historical relationships between equity and interest rates. He noted, however, that cycle II will test criteria with a lower mean return and/or higher volatility. Mr. Sarfatti noted that with respect to the purpose of standard scenario, the guidance they are using suggests that anything that is determined by company-defined modeling choices is to be governed. The purpose is not to add stringency to the capital markets scenarios. Mr. Sarfatti noted that for behavioral assumptions, the basic question is what assumptions should be tested and whether the company experience can influence such assumptions through a hybrid governance model. With respect to the hybrid governance model, the idea is to see if there is a way to blend the company data to be used similar to how it can be blended under principles-based reserving (PBR). This governance model is currently in the process of development where Oliver Wyman and the industry are working together in a joint collaboration effort. Chanho Lee (NAIC) asked what the credibility weighting would consist of and its basis. Mr. Sarfatti responded they are studying some alternatives that could be used as a basis for the ideas to be included in the hybrid governance model. However, he noted there may be some areas where a different approach is necessary given the lack of industry data National Association of Insurance Commissioners 1

4 Attachment One Mr. Sarfatti noted that with respect to revenue sharing, this topic has not received much focus but that next steps include the industry collection of historical experience of revenue sharing with a focus on periods of stress. Additionally, he said that this will be supplemented with other information and that cycle II will test both industry and Oliver Wyman formulations of revenue-sharing restrictions. Mr. Robinson asked if it was in scope to suggest that policyholder behavior be revised every three years. Mr. Sarfatti responded that this was something they suggested last August in their proposal, and they have seen no reason to amend this recommendation. Having no further business, the Variable Annuities Issues (E) Working Group adjourned. W:\National Meetings\2017\Spring\Cmte\E\VAIWG\ VAIWGmin.docx 2017 National Association of Insurance Commissioners 2

5 Attachment Two NAIC VA ISSUES WORKING GROUP QIS II PUBLIC CALL #3 JULY 20, 2017 Oliver Wyman

6 Attachment Two CONFIDENTIALITY Our clients industries are extremely competitive, and the maintenance of confidentiality with respect to our clients plans and data is critical. Oliver Wyman rigorously applies internal confidentiality practices to protect the confidentiality of all client information. Similarly, our industry is very competitive. We view our approaches and insights as proprietary and therefore look to our clients to protect our interests in our proposals, presentations, methodologies and analytical techniques. Under no circumstances should this material be shared with any third party without the prior written consent of Oliver Wyman. Oliver Wyman

7 Agenda Attachment Two Recap timeline for QIS II and update on progress Outline conclusions from Cycle 1 testing on CTE-related recommendations Summarize focus areas for Testing Cycle 3 Oliver Wyman 2

8 Attachment Two Cycle 2 submissions are delayed by approximately two weeks, though we still anticipate concluding Cycle 3 testing by mid-september of this year QIS II timeline February 21, 2017 Final specifications for Test Cycle 1 released; QIS II begins March 31, 2017 Discussions for Test Cycle 2 specifications begin June 9, 2017 Discussions for Test Cycle 3 specifications begin September 15, 2017 Submission deadline for Test Cycle 3 results; Test Cycle 3 ends Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. March 3, 2017 Deadline for feedback on templates and WG participation indication April 28, 2017 Submission deadline for Test Cycle 1 results; Test Cycle 1 ends July 21, 2017 Submission deadline for Test Cycle 2 results; Test Cycle 2 ends Discussions with NAIC, regulators, and industry on QIS II conclusions and recommended framework revisions to be implemented Originally planned to be July 7, 2017; participants have experienced delays in submission, driven by implementation time for new Standard Scenario behavioral assumptions recommended in 2016 Oliver Wyman 3

9 Attachment Two Cycle 1 results were presented to QIS participants on June 29 and addressed most of Oliver Wyman s CTE-related recommendations from 2016 Changes tested Current framework Tested framework Remove Working Reserve and allow simplified reflection of hedging Remove requirement to run off currently-held hedge assets to maturity Allow higher credit for liability projections with modeled CDHS Align RBC and AG 43; calculate C3 as difference between a tail CTE and reserves Harmonize stochastic scenarios and general account modeling Statement value of hedge assets need to be projected in liability projection Deficiency triggered in each scenario when asset statement value dips below Working Reserve Unrealized hedge losses may trigger deficiency Currently-held hedge assets need to be run off without allowance for rebalancing E factor limited to 70% for all companies, and to 30% if not reflecting hedging explicitly C3 charge is calculated as arithmetic difference between: TAR, calculated under C3 Phase II Reserve, calculated under AG 43 Calibration criteria set for US diversified equity fund returns, but not for other risk factors Working Reserve is removed Reserve calculated to ensure adequacy of assets to meet all realized cash outflows at CTE 70 level Statement value of hedge assets do not need to be projected only settlement cash flows Currently-held hedge assets may be liquidated in the first projection period though not required; if liquidated, rest of projection is unhedged 100% E factor allowed, as hedge ineffectiveness is often already reflected in CDHS modeling Impact of two separate E factors were presented C3 = 65% of [X] multiplied by difference between: CTE High under revised AG 43 CTE 70, also under revised AG 43 Impact of several different combinations of CTE High and [X] scalars were tested Standardized, generated via the Academy ESG; volatility-control funds use company own modeling General account modeling aligned to VM-20 Oliver Wyman 4

10 Attachment Two Results from Cycle 1 affirmed the effectiveness of most of Oliver Wyman s 2016 recommendations on the CTE calculation Oliver Wyman s 2016 recommendations sought to address four of the five motivations for captive use Mitigate non-economic volatility in statutory capital ratios Align market risk profiles of funding requirements and insurer target hedge program Mitigate funding requirement in downturn scenarios, net of the hedging strategy Increase DTA admissibility though this was not explicitly tested in QIS II Cycle 1 results indicate that recommendations appear effective in reducing motivations for captive use Reduces non-economic volatility in statutory capital ratios for most companies Reduces total balance sheet volatility for companies with economically-focused hedge programs Mitigates capital buffer needed to manage multiples of the unstable C3 charge, particularly in stress Recommendations also align with the set of previously agreed-upon framework enhancement objectives Ensures funding requirement robustness: improves risk-sensitivity and overall signal value of RBC ratio by removing non-economic volatility and dis-incentivizing voluntary reserves Promotes comparability: uses harmonized scenarios and aligns with VM-20 in general account modeling Choice of CTE High and scalar for calculating C3 affects total funding requirements, but not effectiveness of revision on reducing total balance sheet volatility and non-economic statutory capital ratio volatility Accordingly, we do not anticipating revising these CTE-related recommendations that were tested, though we will continue to refine specific parameters therein e.g., the CTE High and scalar for calculating C3 Oliver Wyman 5

11 Attachment Two The CTE-related recommendations from 2016 materially reduce four of the five cited motivations for captive usage Motivation Mitigate non-economic volatility in statutory capital ratios Align market risk profiles of the funding requirements and the insurer target hedge program Mitigate funding requirement in downturn scenarios (net of the hedging strategy) Consolidate exposures from across legal entities Effectiveness of 2016 Oliver Wyman CTE-related recommendations H M H L More stable C3 charge calculation materially reduces the volatility in the denominator of statutory capital ratios and thus the ratio itself Revised framework retains book value liability valuation properties of current framework for unhedged exposures Allowance for 100% E factor allows fair-value based full hedging to turn statutory reserve into effectively a fair value reserve, thereby fully aligning asset and liability market sensitivities in most IR conditions In high IR conditions, however, hedge accounting is needed to align assetliability sensitivities fully as reserves are bound by the CSV floor Greater C3 stability reduces need to hold excess capital buffer to fund multiples of an unstable C3 charge that has the potential to balloon or otherwise change in unintuitive manners in market stress Not addressed by Oliver Wyman s recommendations DTA admissibility Not tested in QIS II, but expected to be fully effective if implemented? given the direct nature of this motivation for using captives H High effectiveness M Medium effectiveness L Low effectiveness Oliver Wyman 6

12 The CTE-related recommendations from 2016 also adhere to most of the framework enhancement objectives previously discussed Attachment Two Enhancement objectives Effectiveness of 2016 Oliver Wyman CTE-related recommendations Framework requirements Ensure robustness of funding requirements M Improves risk sensitivity and signal value of the RBC ratio by disallowing voluntary reserves to offset C3 charge dollar-for-dollar Promote sound risk management M Reduces total balance sheet volatility both in surplus and required capital for companies with extensive, fair value-focused hedge programs However, under 2016YE market conditions, hedging still increases industryaggregate reserve and TAR levels as hedging is materially costlier than CTE 70 under current equity calibration criteria Promote comparability Revised framework uses harmonized scenarios for separate account returns H and aligns more closely with VM-20 in general account modeling Design choices Preserve current statutory construct where feasible H Current AG 43 statutory construct largely retained; proposed changes in revised framework apply only to select elements of the overall projection C3 change deviates materially from C3 Phase II, but uses AG 43 chassis Minimize implementation complexity? As revised framework retains much of the AG 43 calculation construct, implementation complexity should be modest though TBD based on more detailed company feedback H High effectiveness M Medium effectiveness L Low effectiveness Oliver Wyman 7

13 Attachment Two We are currently in the midst of Testing Cycle 2, which evaluates five topics Testing Cycle 2 began in mid-may and will conclude in late July Topic Standard Scenario market paths Standard Scenario behavior assumptions Standard Scenario Diversification Benefit Adjustment Reflection of revenue sharing Equity calibration criteria Purpose Evaluate range of Standard Scenario market paths i.e., drop and recovery rates that would produce reserves close to CTE 70 level under same behavioral assumptions Verify and identify revisions to August 2016 prescriptions using participant experience data Test impact of Standard Scenario behavioral assumptions in conjunction with other proposed Standard Scenario changes Assess, at the model point level, prevalence of Standard Scenario amounts that: Differ significantly from the results using companies Prudent Estimate assumptions Cannot be justified by experience or regulatory principles Evaluate impact of alternative reflection of revenue sharing on CTE and Standard Scenario Alternative reflections of revenue sharing tested include: Smaller prescribed reductions to non-guaranteed revenue sharing Reduction in total fund fees coincident with reduction in revenue sharing Test impact of alternative equity calibration criteria that are invariant to starting market conditions but different from current criteria Oliver Wyman 8

14 We expect Cycle 3 to require fewer calculations than prior cycles and test only parametric changes to Cycle 1 and Cycle 2 specifications Attachment Two Test from prior Cycle Parametric changes tested in Cycle 3 Revised CTE calculation, with alternative revenue sharing reflection Revised Standard Scenario calculation, with company behavior assumptions Revised Standard Scenario calculation, with prescribed behavior assumptions Current AG 43 equity calibration criteria with standardized scenarios provided by OW Alternative equity calibration criteria with standardized scenarios provided by OW Current AG 43 revenue sharing reflection methodology Parametric changes to alternative revenue sharing reflection methodology tested in Cycle 2 Small number of deterministic market paths tested with scenarios provided by OW with select parametric changes, if necessary, to those tested in Cycle 2 Continue testing the three different methods for hedge reflection as in Cycle 2 One-year reflection of CDHS, to be evaluated on a standalone basis Full CDHS (similar to best-efforts CTE) and no CDHS (similar to adjusted CTE), to be evaluated using the same E factor as revised CTE Oliver Wyman 9

15 Attachment Two QUALIFICATIONS, ASSUMPTIONS AND LIMITING CONDITIONS This report is for the exclusive use of the Oliver Wyman client named herein. This report is not intended for general circulation or publication, nor is it to be reproduced, quoted or distributed for any purpose without the prior written permission of Oliver Wyman. There are no third party beneficiaries with respect to this report, and Oliver Wyman does not accept any liability to any third party. Information furnished by others, upon which all or portions of this report are based, is believed to be reliable but has not been independently verified, unless otherwise expressly indicated. Public information and industry and statistical data are from sources we deem to be reliable; however, we make no representation as to the accuracy or completeness of such information. The findings contained in this report may contain predictions based on current data and historical trends. Any such predictions are subject to inherent risks and uncertainties. Oliver Wyman accepts no responsibility for actual results or future events. The opinions expressed in this report are valid only for the purpose stated herein and as of the date of this report. No obligation is assumed to revise this report to reflect changes, events or conditions, which occur subsequent to the date hereof. All decisions in connection with the implementation or use of advice or recommendations contained in this report are the sole responsibility of the client. This report does not represent investment advice nor does it provide an opinion regarding the fairness of any transaction to any and all parties.

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17 Attachment Three To: Jim Armstrong, Chair of the Variable Annuities Issues (E) Working Group From: Dale Bruggeman, Chair of the Statutory Accounting Principles (E) Working Group Re: Special Accounting for Limited Derivatives Accounting Guidance for Terminated Hedges Date: April 19, 2017 The purpose of this memo is to request input from the Variable Annuities Issues (E) Working Group on the future benefit of effective hedges offsetting a variable annuity guarantee reserve, if any, once the effective hedging program has been discontinued or becomes ineffective. Pursuant to their 2017 charge, the Statutory Accounting Principles (E) Working Group is considering special accounting guidance for limited derivative contracts that hedge interest rate risk for certain variable annuity reserves. This guidance currently proposes to allow reporting entities to offset fair value fluctuations from hedging instruments as follows: Fair value fluctuations of the hedging instrument, as part of a highly-effective, qualifying hedge, that directly offsets the current-period change in the hedged item (variable annuity reserve) will be recognized concurrently with the reserve change, allowing for an immediate offsetting impact in the financials. After recognizing the fair value fluctuations that directly offset the reserve change, any remaining fair value fluctuations of the hedging instrument would be recognized as a deferred asset or deferred liability. (Unrecognized fair value losses would be reported as deferred assets, and unrecognized fair value gains would be reported as deferred liabilities.) These deferred assets and deferred liabilities will be amortized using a straight-line method into realized losses and gains. Although the maximum amortization period is still being debated, the current proposal for the amortization timeframe is to equal the Macaulay duration of the guarantee benefit cash flows based on the AG 43 Standard Scenario, with a maximum allowable timeframe. This approach intends to match the future expected benefits from the effective hedge to the reserve liability as best as possible and remove non-economic accounting volatility from the financials. The issue currently being debated is whether deferred assets (unrecognized losses) and deferred liabilities (unrecognized gains) reflected under the special accounting provision should continue to be permitted to be recognized on the balance sheet, and amortized into gains/losses, when the overall derivative hedging program has been terminated or no longer qualifies under the guidance (e.g., the program becomes ineffective). To be clear, under the proposed guidance, individual hedging instruments of a qualifying effective hedge could be terminated without impacting the amortization of deferred assets and deferred liabilities. The inquiry in this referral is addressing the broader question of termination / non-qualification of the overall hedging strategy. As a simple example: From January 2019 through December 2021, the reporting entity engaged in derivative activity to hedge guarantee reserve liabilities in accordance with the established special accounting provisions. In aggregate, this activity resulted in $300 million in losses from the fair value fluctuations of the hedging instruments. Of this $300 million, $120 million was recognized as direct offsets to current-period reserve liability changes, and $180 million was recognized as deferred assets. Based on the Macaulay duration calculation, the deferred assets were scheduled for amortization into realized losses over a 10-year timeframe when initially recognized. (See the charts below for information on the recognition / amortization of the deferred assets.)

18 Attachment Three Reporting Period Recognition of Deferred Asset Amortization Schedule of Deferred Assets (10-Year Amortization - Only limited years shown.) Derivative FV Losses Recognized Loss** Deferred Asset 2019 (142) (100) (58) Total ** The loss recognized is the portion of the fair value fluctuations that directly offsets current period changes in the hedged item. After recognizing the fair value fluctuations that directly offset the reserve change, any remaining fair value fluctuations are recognized as a deferred asset. Deferred Asset at Time of Hedge Termination / Ineffectiveness Original Deferred Asset Recognized Amortization Recognized Through 2021 Deferred Asset at time of Termination / Ineffectiveness Total In December 2021, the reporting entity elected to terminate the hedge accounting program. At that time, a total of $156 million was recognized as deferred assets under the special accounting provisions. As illustrated in the charts, this $156 million represented the unrecognized losses from fair value fluctuations of derivative instruments remaining after prior period amortization. With the termination of the overall hedge accounting program, the issue to be addressed is whether it is appropriate to conclude that the $156 million of unrecognized losses (recognized as deferred assets under the special accounting provisions when the program was effective) will provide offsetting benefits for future reserve liability changes, even though the hedge program has been terminated and will not be in place when those future reserve liability changes occur. As additional detail, the concept of deferred assets and deferred liabilities is not supported under existing statutory accounting concepts, or U.S. GAAP, and is being considered only within the confines of this special accounting provision. With unrecognized losses reported as deferred assets, the provision will improve the statutory financial statements of a reporting entity by increasing assets and deferring recognition of the loss (increasing currentperiod net income). These accounting entries result with an overall increase to surplus, and allow for the presentation and admittance of assets not available for policyholder claims. Although these provisions are outside of the standard statutory accounting concepts, the Working Group is considering these changes in order to encourage risk mitigation efforts for guaranteed benefits of variable annuity reserves, and provide a comprehensive view of derivatives and the impact of effective hedging strategies in the financial statements. With the guidance being proposed, derivative instruments would be reported at fair value, but the non-economic volatility (change in fair value for an effective hedge) will not impact the reporting entity s solvency presentation. The original guidance proposed by NAIC staff suggested immediate recognition of the deferred assets and deferred liabilities when the overall hedging strategy has been terminated, or no longer qualifies under the special accounting provisions. Comments received from the American Council of Life Insurers (ACLI) opposed this guidance, and included the following statement: We believe the risk of variability in the fair value of the AG 43 liability remains after the termination of a fair value hedge and as such, amounts deferred as part of the relationship will remain deferred and be amortized into income over the period the hedged item affects income. This termination guidance is 2

19 Attachment Three consistent with the concept in GAAP and statutory accounting and aligns with the spirit of the accounting guidance which forever links the hedged item to the hedging instrument prior to the termination event. Although NAIC staff has noted disagreement with the ACLI s interpretation of the U.S. GAAP and SAP guidance, the key issue is whether the deferred assets (unrecognized losses) from previous fair value fluctuations of derivative instruments recognized when the overall hedge strategy was in place and effective should be perceived to offset future reserve changes even when the overall hedging strategy has been terminated or is ineffective. NAIC staff recognizes that these unrecognized losses (deferred assets) are likely going to be significant, therefore understands industry concern with immediate recognition in the financial statements. However, if the special accounting provisions were not established / followed, the statutory accounting provisions in SSAP No. 86 Derivatives, would require recognition of the hedging instruments at fair value, with changes in fair value recognized as unrealized gains or losses. The Statutory Accounting Principles (E) Working Group is interested in the Variable Annuities Issues (E) Working Group s position on whether fair value fluctuations from effective hedges should be perceived to offset future guarantee reserve changes even when the hedging program has been terminated or does not qualify under the guidance. The Statutory Accounting Principles (E) Working Group is also interested in possible compromising proposals, perhaps allowing continued amortization of deferred assets and deferred liabilities for a shortened timeframe after the hedge program is terminated or becomes ineffective. (For example, if the fair value fluctuations may be perceived to offset future reserve changes for a limited number of years, accelerated amortization could be permitted for an additional 3-5 years after termination, but not be permitted for the duration allowed for ongoing effective derivative programs.) The Statutory Accounting Principles (E) Working Group appreciates the review of the Variable Annuities Issues (E) Working Group on this particular issue, and invites additional comments on all aspects of the proposed special accounting guidance. An updated issue paper was exposed during the 2017 Spring National Meeting, with comments due May 19, This issue paper has been provided as an accompaniment to this referral, and is also available via the following web page: Thank you for providing input on this issue. Please contact SAPWG staff, Julie Gann, if you have any questions. Cc: Julie Gann/Robin Marcotte/ Fatima Sediqzad/Jake Stultz/Dan Daveline 3

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21 -- Attachment Four MEMORANDUM TO: Variable Annuities Issues (E) Working Group FROM: Jim Armstrong, Chair, Variable Annuities Issues (E) Working Group DATE: June 13, 2017 RE: Letter from SAPWG Regarding Hedges Discontinued or Ineffective As you may recall, in the fall of 2015, the Financial Condition (E) Committee adopted a report from the Variable Annuities Issues (E) Working Group which represented a framework for changing the statutory framework for variable annuities as proposed by the Working Group. The framework for changes contemplated, among other things, how the current framework creates non-economic volatility and that changes should be made to the statutory framework to promote strong risk management. One of the proposals in the framework for changes was to modify statutory accounting for its treatment of interest rate hedges. On April 19, I received a letter from the chair of the Statutory Accounting Principles (E) Working Group, along with the proposed issue paper that has been drafted to address this specific proposal related to statutory accounting. In summary, the proposed issue paper provides special accounting treatment for interest rate hedges of variable annuity guarantees that would reduce non-economic volatility in the financial statements, and in turn, promote strong risk management. It does this by requiring the hedge, if proven to meet all of the criteria within the proposed issue paper, to be marked to market but offset by a deferred asset or liability. More specifically, fair value fluctuations in the hedge that do not offset the current period change in the hedged item (the variable annuity reserve liability) shall be recognized as a deferred asset or a deferred liability, and amortized into unrealized gains or losses over the lessor of the Macaulay duration of the guarantee benefit cash flows or ten years. As noted, the issue paper requires certain criteria to be met in order to receive such accounting, including among other things, a requirement to prove the hedges are effective. To the extent the criteria are no longer met for the overall hedging strategy, the issue paper requires any non-amortized deferred assets or deferred liabilities to be immediately recognized. The letter from the Statutory Accounting Principles (E) Working Group requests input from the Variable Annuities Issue (E) Working Group on the future benefit of hedges once the effective hedging program has been discontinued or becomes ineffective. To answer the question, I think we all would agree that hedges, just like insurance, provide value to the holder over the entire life of the hedge, not just the point in time when the insured is indemnified. And just like insurance, it s important that they hedge remain in place after a claim is made, for its uncertain when the protection may be needed. From that standpoint, the response is that the hedges provide benefits and the statutory framework should not discourage their use in managing the ongoing risk. Having said that, it s important to note that the purpose of the question seems to be driven by the overall concern that a regulator would have as the result of an unrecognized loss on an ineffective overall hedging strategy. Such is the case during a market uptick, when the customer base of the insurer can become disinterested with the

22 Attachment Four variable annuity product. Under these circumstances the liability cash flows are mostly fees that were going to materialize on the balance sheet under the original policyholder behavior assumptions and with above expectation lapse no longer will do so to the extent previously expected. The deferral of the loss recognition was meant to make the loss recognition coincide with the fee revenue recognition. If policies lapse, so too will the future profits. However, 100% recognition of any derivatives that are currently in a loss position would be inconsistent with the remaining reduced cash flows that do materialize. This lapse effect could also materialize in idiosyncratic insurer distress scenarios even though such scenarios are relatively unlikely as they would have to occur under very favorable capital markets conditions for there to be a deferred hedge loss asset. I would propose the Working Group consider an approach that recognizes both sides of this issue. One that recognizes sound risk management and the value that hedges provide throughout their ownership, but balanced with the concern of any unrecognized losses associated with an overall hedging strategy that is no longer effective. I propose a response to the referral that suggests the identified deferred liabilities be recognized over the lessor of the remaining scheduled amortization or 5 years. This should be coupled with material public disclosures as suggested below to clearly identify the situation so the regulator can consider the information in their ongoing monitoring of the insurer s financial condition. Proposed Disclosures The draft issue paper, exposed during the 2017 Spring National Meeting, includes the following two disclosures pertaining to ineffective or terminated hedges: a. Identification of outstanding hedging instruments previously captured within scope of this standard and subsequently identified as part of an ineffective hedging strategy. Disclosure shall identify the eliminated deferred assets and deferred liabilities, and the recognition of unrealized gains and unrealized losses resulting from the ineffective hedging strategy. b. Identification of any election by the reporting entity to terminate use of the special accounting provisions, the resulting elimination of deferred assets and deferred liabilities, and the impact to unrealized gains and unrealized losses and/or realized gains and realized losses. With the suggestion to allow amortization of deferred assets and deferred liabilities over the remaining scheduled amortization, not to exceed five years, it is recommended that the disclosures be revised to encompass the following: a. For hedging strategies identified as ineffective previously captured within scope of this standard, information on the determination of ineffectiveness, including variations from prior assessments resulting in the change from an effective to ineffective hedge. This disclosure shall also include: i. Identification of outstanding hedging instruments previously captured within scope of this standard and subsequently identified as part of an ineffective hedging strategy. This disclosure shall identify the date in which the domiciliary state was notified that the hedging strategy had been identified by the reporting entity as ineffective. ii. iii. Deferred assets and deferred liabilities previously recognized under the effective hedging strategy with a schedule that shows the amortization that would have occurred if the program had remained highly effective, as well as a schedule that details the amortization that will occur as the program has become ineffective (maximum five-year timeframe). Disclosure on whether the reporting entity is electing to expedite amortization (in advance of the remaining scheduled amortization or the maximum five-year timeframe) and how this election will impact the scheduled amortization. b. For situations in which the reporting entity has elected to terminate the hedging strategy and/or discontinue the special accounting provisions permitted within this SSAP, the reporting entity 2

23 Attachment Four shall disclose the key elements in the reporting s entity decision to terminate, identifying changes in the reporting entity s objectives or perspectives from initial application. This disclosure shall also include: i. Identification of outstanding hedging instruments previously captured within scope of this standard and the accounting impact as a result of the termination / discontinuation. (Derivative transactions not captured within the special accounting provision would be subject to the accounting and reporting guidance within SSAP No. 86.) This disclosure shall identify the date in which the domiciliary state was notified that the hedging strategy or the election to use the special accounting provision in this SSAP had been terminated. ii. iii. Deferred assets and deferred liabilities previously recognized under the hedging strategy and/or program, with a schedule that shows the amortization that would have occurred if the strategy and/or program had remained highly effective, as well as a schedule that details the amortization that will occur with the termination of the strategy and/or program (maximum five-year timeframe). Disclosure on whether the reporting entity is electing to expedite amortization (in advance of the remaining scheduled amortization or the maximum five year timeframe) and how this election will impact the scheduled amortization. 3

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25 Attachment Five Mike Monahan Senior Director, Accounting Policy July 13, 2017 Mr. Jim Armstrong, Chairman Variable Annuities Issues Working Group National Association of Insurance Commissioners 1100 Walnut Street, Suite 1500 Kansas City, MO Re: Letter from SAPWG Regarding Hedges Discontinued or Ineffective Dear Mr. Armstrong: The American Council of Life Insurers (ACLI) 1 is pleased to respond to the June 13, 2017 letter (the letter ) to the SAPWG regarding the treatment of deferred gains or losses on hedges previously designated under exposure , Special Accounting Treatment for Limited Derivatives (the Issue Paper ) that subsequently become dedesignated or ineffective in a future time period. We appreciate the desire to arrive at a compromise position that recognizes both sides of the issue expressed in the letter. The letter states that hedges provide value to the holder over the entire life of the hedge, and that it is important that hedges remain in place after a claim is made because it is uncertain when protection may be needed. We agree with these statements and believe they support our original position outlined below, that immediate recognition of previously deferred amounts when the hedge strategy was effective is inappropriate 2, and maintaining the previously established amortization schedule when hedge accounting is discontinued is consistent with current statutory accounting guidance in SSAP 86. Previous ACLI comments on Paragraphs of the Issue Paper: We continue to be concerned about the cliff effect that could result under staff s proposed accounting for hedging strategies that no longer qualify under the scope of the standard. In some circumstances, marking hedges to market may create a significant non-economic impact on the insurer s reported solvency, producing an overly positive or negative picture of the insurer s financial health. We recommend that hedge gains and losses deferred in accordance with this standard continue to be 1 The American Council of Life Insurers (ACLI) is a Washington, D.C.-based trade association with approximately 290 member companies operating in the United States and abroad. ACLI advocates in state, federal, and international forums for public policy that supports the industry marketplace and the 75 million American families that rely on life insurers products for financial and retirement security. ACLI members offer life insurance, annuities, retirement plans, long-term care and disability income insurance, and reinsurance, representing 94 percent of industry assets, 93 percent of life insurance premiums, and 97 percent of annuity considerations in the United States. Learn more at 2 Immediate acceleration of previously deferred amounts can be appropriate only if it is revealed that past effectiveness testing was flawed and the designated hedging strategy was not effective when those amounts were initially deferred; however, this situation is expected to be a relatively rare occurrence. American Council of Life Insurers 101 Constitution Avenue, NW, Washington, DC (202) t (866) f mikemonahan@acli.com

26 Attachment Five 2 amortized under established timeframes. The cause of disqualification (i.e., voluntary or involuntary), or the status of a derivative position (i.e., open or expired) should not impact the continued amortization of prior deferrals. We believe SSAP 86, paragraph 18, supports our conclusion that immediate write off of basis adjustments to the hedged item (deferred assets or liabilities in this case) is not required upon termination, and that these amounts can continue to be amortized according to the original schedule. We propose the following language in place of paragraphs (not shown in the markup): For any outstanding derivative instruments in a hedging strategy that no longer qualifies within the scope of the standard, gains and losses previously deferred in accordance with this standard shall continue to be amortized in accordance with the previously established amortization schedule. After considering prior deferrals made in accordance with this standard, future fair value fluctuations for outstanding derivative instruments shall be recognized prospectively as unrealized gains or unrealized losses. If the derivative instruments are subsequently designated as part of a highly effective hedging strategy qualifying under this standard, new deferrals would commence prospectively. Gains and losses deferred in accordance with this standard pertaining to expired derivative instruments that are part of a highly effective hedging strategy at the time of expiration shall continue amortizing over the previously established timeframe. Reporting entities may elect to terminate use of this special accounting provision at any time. In those instances, deferred assets/liabilities shall continue to be deferred and amortized in accordance with the previously established amortization schedule. *** ACLI welcomes discussion on our viewpoints as expressed above. Please do not hesitate to contact us should you also have any questions. Thank you. Sincerely, Mike Monahan Senior Director, Accounting Policy cc: Dan Daveline, Director, NAIC Financial Regulatory Services