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Insurance Solutions Group

Insurance Solutions
The Fair Value Option (“FVO”): To Mark or Not to
Mark - That is the Question

March 29, 2007 FAS 159, the Fair Value Option (“FVO”), provides companies with the one time option to
make an irrevocable, instrument by instrument election to mark financial assets and liabilities
Martin P. Klein (including insurance and reinsurance contracts) to market. With early adoption only
212-526-8357 available for the first 120 days of the fiscal year or until first quarter 2007 financial
mklein@lehman.com statements have been issued, companies have limited time to determine if they want to make
this election and furthermore which securities to apply the election to.
Craig Sabal
212-526-9886 This document serves to assist insurance companies in understanding this new option and
csabal@lehman.com assist them in determining the what, which and when of implementation.

Amy Cooper Topics explored include:


212-526-4126
amycoope@lehman.com • Historical Background

• Overview of Fair Value Option

• Implementation considerations

• Variable annuity case study

This material has been prepared by the Insurance Solutions Group and is not a product of Lehman Brothers Research Department. It is for information
purposes only. Neither Lehman Brothers Inc., nor its employees, provide tax or legal advice. Please consult with your accountant, tax adviser and/or attorney
advice concerning your particular circumstances.
Lehman Brothers Insurance Solutions Group

Historical Background

For insurance companies, the strategic decision to manage the capital market risks associated
with insurance blocks, particularly annuities, can be extremely difficult as economic and
accounting incentives often are not directly aligned. Under the FAS 133 framework, the vast
majority of insurance liabilities are not marked-to-market whereas their derivative hedging
counterparts are. It becomes necessary for insurers to weigh the benefits of risk management
versus the potential for increased income statement volatility if hedge accounting is not
achieved.

The FASB, realizing this, had a variety of objectives when issuing the fair value option:

1. Mitigate problems caused by the inconsistency of having certain assets reported at fair
value with related liabilities held at amortized cost, thereby creating earnings volatility.

2. Enable companies to achieve an offset accounting effect for changes in fair values without
having to apply more complex hedge accounting provisions under FAS 133.

3. Move closer to a mark-to-market accounting system and achieves further convergence


with IASB 39 “Financial Instruments: Recognition and Measurement”, which allows for the
mark to market of financial instruments.

Overview of the Fair Value Option

The fair value option is generally available for recognized financial assets and liabilities,
including insurance and reinsurance contracts. Generally, an entity may decide whether to
elect FVO for each eligible item either upon adoption of FAS 159 or on the date the
company recognizes the eligible item.

When deciding whether or not to implement the fair value option and which assets or
liabilities to select, it is important to note that the election is on an instrument by instrument
basis, which means that the fair value option may be elected for a single item without
electing it for other similar items. Additionally, under the election all risks are marked to
market and the election is irrevocable. This represents a divergence from FAS 133, where
certain items/risks of an instrument can be segregated and marked to market (to be further
discussed).

FVO is effective as of the beginning of the first fiscal year that begins after November 15,
2007. Early adoption is possible for the first 120 days of 2007 if the company has not issued
first quarter financial statements. Otherwise the standard adoption is as of year end.
Companies have a one time chance to adopt for existing financial assets and liabilities.
Companies therefore need to thoroughly evaluate existing instruments to determine which
they wish to elect the FVO.

When adopting, a cumulative effect adjustment is made to retained earnings to adjust


balances to fair value, which means the income statement is not impacted at the time of
implementation.

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Implementation Considerations

1. Hedging Opportunities and Considerations

In many situations companies may have had difficulties achieving hedge accounting
under FAS 133, especially for items such as variable annuity hedging and portfolio
hedging. By electing to mark these securities to market this lengthy process of obtaining
hedge accounting can be avoided.

For insurance and reinsurance contracts that were historically not-marked-to-market, this
provides added accounting incentive for companies to hedge their rate and equity
exposures. A major consideration of the fair value option, however, is it requires
marking the entire contract to market and not just select risks. This differs from FAS
133, which allows for risk splitting and marking to market changes attributed to specific
risks e.g. rates, credit or FX. This could increase income statement volatility under FVO
if a company is not properly hedging the full risk exposure of an asset or liability. (See
the Appendix for a Variable Annuity Case Study.)

Companies must assess the tradeoff of the quantitative work required to obtain hedge
accounting under FAS 133 and the impact of any “ineffectiveness” hedge verses the
simplicity of applying the fair value option and the possibility of increased income
statement volatility from marking all risks.

2. Increased International Convergence

For large international companies, electing the fair value option should reconcile certain
differences in reporting between IAS 39 and U.S. GAAP requirements. This should also
reduce the amount of financial statement reconciliations required.

3. Fair Value Measurement (“FVM”)

Companies that adopt the fair value option must also adopt the fair value measurement
requirements. The primary motivation for this requirement is to facilitate comparisons
between companies that may or may not elect the fair value options for similar
instruments.

FVM mandates that one of three main valuation techniques must be consistently applied:
market, income or cost basis using observable market inputs as much as possible. These
valuations also take into consideration a company’s credit standing.

Although these requirements are relatively easy for any items that have an active
secondary market, fair value measurement may be difficult for financial instruments that
are not traded in the liquid markets. This is especially true for insurance contracts that
have no secondary market and for which it may be difficult to assign a value to the
underlying actuarial risks.

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4. Reporting and Disclosure Requirements

Both fair value measurement and the fair value option have lengthy reporting and
disclosure requirements. Securities in which the fair value option is elected are to be
separated from those that are recorded at amortized cost. Additionally, in order to
facilitate comparisons between companies that elect and those that do not, there are
extensive disclosure requirements. Examples of this include management’s reason for
choosing to fair value selected items and an explanation of how the election has
impacted earnings.

We observe that while the FVO in certain circumstances should better align financial
reporting with underlying economics, it will further deteriorate the comparability of
financial statements across the industry. Indeed, even for a particular company
comparability with past results may be reduced, and inconsistent treatment for similar
financial positions may also result.

.
Variable Annuity Case Study

To illustrate the implications of FAS 159, we assume a generic variable annuity (VA) policy
with an embedded return of premium guaranteed minimum death benefit rider (GMDB
ROP). Historically, GMDB ROPs have not been marked to market under FAS 133, and
derivative hedging solutions used by insurers for these guarantees have not qualified for
hedge accounting. This has dissuaded certain insurers from hedging the economic risks
inherent in these policies due to the likelihood of GAAP reported earnings volatility.

FAS 159 allows for electing to fair value the GMDB ROP rider, which initially seems to
benefit insurers. A closer look reveals that if the company elects to mark the rider to market
it must also do so for the entire variable annuity policy, including the M&E fee. As
discussed earlier, an insurer can not split a contract in electing fair value. This raises an issue
for variable annuity writers as the M&E fee could have earnings volatility if held at fair value
and not hedged, which could be greater than an unhedged GMDB ROP.

Figure 1 illustrates the change in fair value recognized through earnings of a $1 billion
GMDB ROP block of business when exposed to an immediate equity market shift under
three scenarios:

Scenario 1 – GMDB ROP hedge with no offset: A variable annuity writer hedges the
economic value of the GMDB ROP by purchasing put options, but does not achieve hedge
accounting and does not elect fair value on the policy. The hedge value fluctuations directly
impact earnings.

Scenario 2 – GMDB ROP hedge, elect fair value: A variable annuity writer hedges the
economic value of the GMDB ROP by purchasing put options, and elects to fair value the
policy. Here the guarantee offset, but the M&E fees fluctuations directly impact earnings.

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Lehman Brothers Insurance Solutions Group

Scenario 3 – GMDB ROP and M&E fee hedge, elect fair value: A variable annuity writer
hedges the economic value of the GMDB ROP by purchasing put options, elects to fair value
the policy, and hedges the M&E fee stream by selling futures.

Figure 1. GMDB ROP Scenarios (in $mm)

140

120
Fair Value Changes ($ mm)
Earnings Impact from

100

80

60

40

20

0
-30% -20% -10% 0% 10% 20% 30%
S&P Market Movements

GMDB ROP Hedge with no offset

GMDB ROP hedge, elect fair value

GMDB ROP and M&E fee hedge, elect fair value

Source: Lehman Brothers1

Reviewing the three scenarios reveals that in order to hedge a GMDB ROP and minimize the
earnings volatility, an election to fair value a GMDB ROP needs to be made and the M&E
fees hedged as well. Many insurers have not historically hedged these fees, relying on them
to provide exposure to the equity markets. Hedging the M&E fee stream and essentially
locking in the future expected fees would take away that long exposure. Therefore, the
election to fair value must be carefully considered in conjunction with the risks and reward
the company is looking to retain.

1
Assumptions:
 Variable annuity policies with a GMDB ROP benefit only
 Initial account value is $1bn
 Variable annuity fees total 1.25% (1.05% M&E fees + 0.20% GMDB ROP fees)
 Underlying funds are fully invested in funds that track the S&P 500
 GMDB ROP hedged through purchasing S&P ATM put options with approximate total notional of $145mm
 M&E fees hedged through selling 1-year S&P futures. Approximately 2900 futures contracts sold.
 Impact from changes in SOP03-1 reserves not included

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This material has been prepared by the Insurance Solutions Groups and is not a product of Lehman Brothers Research Department. It
is for informational purposes only. Lehman Brothers makes no representation that the information contained in this document is
accurate or complete. Opinions expressed herein are subject to change without notice. Clients are advised to make an independent
review regarding the economic benefits and risks of purchasing or selling financial instruments and reach their own conclusions
regarding the legal, tax, accounting and other aspects of any transaction in the financial instrument in relation to their particular
circumstances. Lehman Brothers enters into transactions on an arm's length basis and does not act as advisor or fiduciary to its
counter parties except where a law, rule or written agreement expressly provides otherwise.

No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. ©2007 Lehman
Brothers Inc. All rights reserved. Member of SIPC.

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