B.3 LFM 840 - Derivatives and Hedging

Question 1

ASC 815 definition & principles of derivatives

Answer 1

Definition of derivative: a financial instrument with all the following:

1. Contract contains an underlying variable(ex: security price, interest rate) and a notional amount (ex: fixed # of shares)
2. contract requires no initial net investment
3. Contract permits net settlements by a means outside the contract (ex: futures), or delivery of an asset

Principles:

• Derivatives can be an asset or liability and should be reported as a financial instrument
• reported at FV

Question 2

ASC 815: Hedgeable Risks

Answer 2

Hedgeable risks for financial insutrument-related exposures:

• market price risk
• IR risk
• Forex risk
• credit risk

hedgeable risks for non-financial instrument related exposures:

• FV hedges: only market price risk is hedgeable
• CF and FX hedge: certain components of forecasted transactions may also be hedgeable

Question 3

3 types of hedges under ASC 815

Answer 3

1. Fair Value hedge
   - hedges exposure to changes in FV of assets/liab
   - allows companies to alleviate risk related to changing prices where a company is bound to a fixed price
   ex: pay floating/receive fixed IR swaps
2. CF hedges
   - protects exposure to variability in expected CFs
   - eliminates variable CFs
3. Net investment in foreign operations to protect risk of FX changes

Question 4

ASC 815: Hedge accounting Criteria

Answer 4

1. Formal documentation at inception
2. hedge relationship is expected to be highly effective in offsetting FV or CF changes
3. hedged items present an exposure to change in FV or CF that could affect reported earnings
4. Hedge item is not related to:
   - asset/liab already accounted for at FV through earnings
   - investments accounted for by the equity method
   - consolidated subsidiaries
   - future business combos
   - entity-issuedequity instruments

Question 5

ASC 815: Accounting Treatment of Derivatives

Answer 5

• derivative is always carried at FV on the balance sheet
• if derivative doesnt qualify as hedging instrument, changes in FV go through current earnings

if it does qualify:
– FV hedge: g/l on a derivative instrument as well as the offsetting g/l on the hedged item is recognized currently in earnings
– CF hedge: effective portion of the g/l on derivative instrument is reported as a component of OCI and reclassified into earnings in the same period
during which the hedged forecasted transaction affects earnings
– Net investment in forex: g/l on hedging instrument is reported in OCI as part of the cumulative translation adjustment to the extent it is effective

Question 6

Disclosures required by ASC 815

Answer 6

disclosures required, financial statement footnotes:
– Derivatives’ underlying risk exposures (credit, interest, etc.)
– Accounting designation (FV, CF, or NI hedge)
- Levels of activity

Tabular disclosures required for both balance sheet and income statement:
– Location and FV of derivatives
– Separate disclosures for each affected line item
– Present on gross basis separated by contract type

• Counterparty credit risk
• Amounts recognized in income when firm commitments no longer qualify as FV hedges

Question 7

Disclosures required by ASC 815

Answer 7

disclosures required, financial statement footnotes:
– Derivatives’ underlying risk exposures (credit, interest, etc.)
– Accounting designation (FV, CF, or NI hedge)
- Levels of activity

Tabular disclosures required for both balance sheet and income statement:
– Location and FV of derivatives
– Separate disclosures for each affected line item
– Present on gross basis separated by contract type

• Counterparty credit risk
• Amounts recognized in income when firm commitments no longer qualify as FV hedges

Documentation requirements include:
– Identification of the derivative
– Related hedged item/transaction
– Nature of the risk being hedged
– How effectiveness will be assessed (retrospectively and prospectively)

Question 8

ASC 815: Criteria for bifurcating embedded derivatives

Answer 8

Hybrid instrument - an instrument consisting of a host contract and embedded derivatives

• embedded derivative (ED) a derivative in another derivative
• ASC 815 requires ED be bifurcated and accounted separately form the host
• ED must be bifurcated when all 3 criteria are met:
  1. ED’s economic characteristics are not closely related to the hosts
  2. Hybrid instruments FV changes are not required to be reported in immediate earnings under another standard
  3. a ‘freestanding’ derivative with the same terms as ED would be a derivative under ASC 815

Question 9

ASC 815: Impact of ASC 2017-12

Answer 9

pg 92. doesnt seem to be important…

Question 10

Hedging strategies

Answer 10

• hedging can reduce earnings volatility and make it easier for the investment community to predict financial performance
• symmetrical hedge strat: locks in returns
• asymmetrical hedge strat: protect against losses similar to insurance
• Derivatives can also be used to speculate

Question 11

ASC 815 Relevance to insurers

Answer 11

equity index annuities
- Derivative = long call on the equity index
– Appreciation in AV from the equity-indexed feature is the embedded derivative requiring bifurcation and recording at FV

IUL
- ASC 815 considers the host contract debt-like
– The DB does not exclude the contract from ASC 815 because the policyholder can
surrender to obtain equity-linked returns
– ED = appreciation in AV resulting from the equity-index feature
– If the DB is also indexed, that feature should not be bifurcated since it’s only payable
at death

considerations when valuing ED

• part rates
• caps on indexed performance
• ph propensity to surrender
• NF value owed on surrender
• Counterparty risk
• risk margin required for embedded derivatives