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I.R.C. §446: LB&I Directive Related to Hedging of Variable Annuity Guaranteed Minimum Benefits by Insurance Companies

LB&I Control No: LB&I-04-0514-0050
July 17, 2014

MEMORANDUM FOR ALL LARGE BUSINESS AND INTERNATIONAL DIVISION EMPLOYEES
FROM: Heather C. Maloy /s/ Heather C. Maloy
Commissioner, Large Business and International Division
SUBJECT: I.R.C. §446: LB&I Directive for Hedging of Variable Annuity Guaranteed Minimum Benefits (GMxB) by Insurance Companies

This Directive provides that LB&I examiners should not challenge the eligibility of an insurance company’s guaranteed minimum benefit (“GMxB”) Hedges (defined below) to qualify as hedging transactions under Treas. Reg. § 1.1221-2(b).  In addition, this Directive provides that LB&I examiners should not challenge an insurance company’s (A) mark-to-market (“MTM”) values of Eligible GMxB Hedges (defined below) if they conform to the MTM values reported in the company’s Annual Statement (defined below); and (B) should not challenge the method of accounting described in this Directive for income, deductions, gains, and losses relating to Eligible GMxB Hedges for Variable Annuity (“VA”) contracts issued before December 31, 2009.

This Directive is intended to provide an efficient and uniform method of accounting for certain GMxB Hedge income, deductions, gains and losses, which would allow LB&I and taxpayers to more efficiently manage their audit resources.

This Directive applies only to the portion of the aggregate net Eligible GMxB Hedge gain or loss related to the VA contracts issued before December 31, 2009.  Eligible GMxB Hedge gain or loss related to the VA contracts issued on or after December 31, 2009 should be accounted for using a method consistent with the matching requirements in Treas. Reg. § 1.446-4(e)(1).  Additionally, if an insurance company does not meet the requirements of this Directive, regular audit procedures will apply to GMxB Hedges for all of the company’s VA contracts.

This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.

Background:

Insurance companies are required by state law to file Annual Statements using the accounting principles set out in the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual, Statement of Statutory Accounting Principles (SSAP), or equivalent accounting standards mandated by insurance regulators.

Several Actuarial Guidelines (AGs) adopted by the NAIC provide standards for the valuation of reserves for VA contracts involving GMxB.  Insurance companies follow these AGs for the purposes of tax reserve calculations.  AG 34 values reserves for guaranteed minimum death benefits (see Definitions, below).  AG 39 values reserves for guaranteed living benefits (see Definitions, below). 

Variable annuities have features of both life insurance and investment products.  VA contracts generally are regulated by the State insurance regulators and the Securities and Exchange Commission.  The sale of VA contracts is overseen by the Financial Industry Regulatory Authority.  Current VA contracts often provide one or more GMxB.  For example, a single contract may provide a Guaranteed Minimum Death Benefit and Guaranteed Minimum Living Benefit.

A VA contract with GMxB subjects insurance companies to the risk of incurring liabilities that exceed the value of segregated account assets for the contract. Insurance companies typically hedge the risks associated with GMxB obligations.

Definitions:

“Actuarial Guideline (AG)” means an interpretation published by the NAIC of a statute dealing with an actuarial topic.  In the case of AGs dealing with reserve methods, the statute is the Standard Valuation Law (SVL).  For example, AG 33, AG 34, AG 39, and AG 43 provide guidance regarding the application of the Commissioner’s Annuity Reserve Valuation Method under the SVL to various kinds of annuities.

“Annual Statement” means the form that is approved by the NAIC, which is filed by an insurance company for the year with the insurance departments of States, Territories, and the District of Columbia.  If the insurance company is not required to file the NAIC annual statement, “Annual Statement” means a pro forma annual statement filed with the company's federal income tax return under Treas. Reg. § 1.6012-2(c)(5) or a certified independently-audited financial statement that is required to be provided to a government agency other than the IRS.

“GMxB Hedge” means a hedging transaction described under Treas. Reg. § 1.1221-2(b) that is entered into by an insurance company for the purpose of managing the aggregate risks associated with GMxB under VA contracts (or counteracting such hedging transactions).

“Eligible GMxB Hedge” means a GMxB hedge that satisfies the identification and recordkeeping requirements under Treas. Reg. § 1.1221-2(f).

“Guaranteed Minimum Benefit (GMxB)” is a provision in a VA contract which guarantees a minimum payout.  There are several types of guaranteed minimum benefits.  A Guaranteed Minimum Death Benefit (“GMDB”) provides a minimum guaranteed amount in the event of the policyholder’s death, such as a guaranteed return of premiums paid for the VA contract.  A Guaranteed Minimum Accumulation Benefit (GMAB) provides the policyholder with a guaranteed minimum account value on a specified date, regardless of the performance of the investment allocations chosen by the policyholder.  A Guaranteed Minimum Income Benefit (GMIB) or a Guaranteed Minimum Withdrawal Benefit (GMWB) provides the policyholder with guaranteed payout amounts at future dates, even if the account value could not otherwise support the benefit.  GMAB, GMIB, and GMWB are sometimes collectively referred to as Guaranteed Minimum Living Benefits (GMLB).

Issue Tracking:

Any cases having this issue should use UIL 446.33-01 Hedging Transactions – Variable Annuity Contracts

Examination Guidance:

LB&I examiners should not challenge the method of accounting for Eligible GMxB Hedges described below in A. section of this Directive.  This Directive applies only to the Eligible GMxB Hedges related to the VA contracts issued before December 31, 2009.  Eligible GMxB Hedges related to the VA contracts issued on or after December 31, 2009 should be accounted for using a method consistent with the matching requirements in Treas. Reg. § 1.446-4(e)(1).

A. In General

The following is required:

  1. The identification of GMxB obligations as “ordinary obligations” under Treas. Reg. § 1.1221-2(c)(2) and the eligibility of GMxB Hedges to qualify as hedging transactions under Treas. Reg. § 1.1221-2(b),

  2. MTM values of Eligible GMxB Hedges if they conform to MTM values reported in the company’s Annual Statement, including all accompanying notes, schedules, and exhibits;

  3. Any reasonable method consistently used by an insurance company to allocate Eligible GMxB Hedge income, deductions, gains, and losses between VA contracts issued before December 31, 2009, and VA contracts issued on or after December 31, 2009;  and

  4. A method of accounting for recognition of the portion of Eligible GMxB Hedge income, deductions, gains, and losses allocable to VA contracts issued before December 31, 2009, that includes the following steps.

Step 1.  MTM Valuation of Eligible GMxB Hedges:

  1. Hedge income, deduction, gain, or loss is determined for all Eligible GMxB Hedges using a MTM method.  For this purpose, the MTM Eligible GMxB Hedge income, deduction, gain, or loss includes all realized gains and losses and non-marked items of income and deduction including periodic swap receipts and payments.

  2. All Eligible GMxB Hedge income, deductions, gains and losses for the year are aggregated and netted.

  3. All costs of Eligible GMxB Hedges are capitalized (included in basis or amount realized, as appropriate).

Step 2.  Determine Aggregate Net Hedge Gain or Loss on all Eligible GMxB Hedges for the Taxable Year

Aggregate net hedge income, deduction, gain or loss is determined by adding:

  1. The amount of income, deduction, gain or loss realized during the taxable year with regard to any Eligible GMxB Hedge;

  2. The amount of MTM gain or loss on each Eligible GMxB Hedge outstanding at the close of the taxable year determined by using MTM values of Eligible GMxB Hedges that conform to MTM values reported in the company’s Annual Statement, including all accompanying notes, schedules, and exhibits; and,

  3. All periodic swap amounts that accrue with regard to any Eligible GMxB Hedge during the taxable year.

Step 3.  Allocate Aggregate Net Hedge Gain or Loss Between—

  1. VA contracts issued before December 31, 2009, and

  2. VA contracts issued on or after December 31 2009.

Only the portion of the aggregate net hedge gain or loss allocable to VA contracts issued before December 31, 2009, is taken into account in Step 4 below.  Hedge gain or loss allocable to VA contracts issued on or after December 31, 2009, should be accounted for using a method consistent with the matching requirements in Treas. Reg. § 1.446-4(e)(1).

Step 4.  Accounting for the Portion of Aggregate Net Hedge Gain or Loss Allocable to VA Contracts Issued Before December 31, 2009.   

(a)  Net Hedge Gain:

  1. Net hedge gain for the year first offsets and reduces unrecognized net hedge losses carried forward from preceding years on a first-in-first-out (FIFO) basis.

  2. Net hedge gain for the year (after reduction for any offset against unrecognized net hedge losses from preceding years per step 4(a)1) above), is added to any unrecognized net hedge gains carried forward from preceding years.  The sum of these net hedge gains is recognized to the extent of the net tax deduction for the year relating to the VA contracts issued before December 31, 2009. The net tax deduction is the amount of the GMxB accrued during the year plus (or minus) the increase (or decrease) in tax reserves for the GMxB for the year, but not less than zero. Even if the company only partially hedges its GMxB, the full increase in tax reserves and accrued benefits for all GMxB under VA contracts issued before December 31, 2009, are taken into account.

  3. The remaining portion of the net hedge gain, if any, is not recognized and is carried forward and taken into account in the succeeding year (except for purposes of applying item 4(a)4) below).

  4. Any hedge gain not taken into account within the five years following the year in which incurred is recognized no slower than ratably over the succeeding five years, i.e., one-fifth of the excess in each year.

(b)  Net Hedge Loss:

  1. Net hedge loss for the year first offsets and reduces unrecognized net hedge gains carried forward from preceding years on a FIFO basis.

  2. Net hedge loss for the year (after reduction for any offset against unrecognized net hedge gains from preceding years per step 4(b)1) above) is added to any unrecognized net hedge losses carried forward from preceding years.  The sum of these net hedge losses, up to the increase for the taxable year in aggregate tax reserves for GMxB under VA contracts issued before December 31, 2009, is not recognized and is carried forward and taken into account in the succeeding year (except for purposes of applying item 4(b)4) below).

  3. The remaining portion of the net hedge loss, if any, is recognized and is currently deductible.

  4. Any hedge loss not taken into account within the five years following the year in which incurred is deducted no slower than ratably over the succeeding five years, i.e., one-fifth in each year.

B. Implementation

If insurance companies under examination want to apply the provisions of this Directive, LB&I examiners will make the change in method of accounting.  This change will be made whether the existing method of accounting is permissible or impermissible, and whether the issue is under exam or not.  The change will be made under the principles and requirements of Rev. Proc. 2002-18, 2002-1 C.B. 678 generally for the earliest open year under examination, except that, 1) if the parties agree (and notwithstanding section 5 of Rev. Proc. 2002-18), the year of change may be a taxable year other than the earliest open taxable year under examination, and 2) a positive § 481(a) adjustment shall be taken into account over four taxable years under the rules of section 7 of Rev. Proc. 97-27, 1997-1 C.B. 680, as modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696.

Insurance companies not under examination may apply the provisions of this Directive by filing a Form 3115, Application for Change in Accounting Method, under Rev. Proc. 97-27.

C.  Consistency Requirement

For this to apply, an insurance company must:

  • In determining hedge gains and losses on Eligible GMxB Hedges, use the MTM values for all Eligible GMxB Hedges conforming to MTM values for the same hedges reported in the company’s Annual Statement, including all accompanying notes, schedules, and exhibits.

  • Report net Eligible GMxB Hedge gains and losses for all VA contracts issued before December 31, 2009, consistent with the Examination Guidance.

D.  Certification Statement

To be eligible for this Directive, an insurance company must sign and complete the attached LB&I Directive on Hedging of Variable Annuity Guaranteed Minimum Benefits Certification Statement (“Certification Statement”).  An insurance company must complete all sections of the Certification Statement, have the statement signed by an authorized individual, and provide the statement to the LB&I examiner within 30 days of a request for the statement.  A separate Certification Statement may be requested for each taxable year under audit.  For a consolidated Federal income tax return, a separate Certification Statement may be requested for each insurance company.  An LB&I examiner will consider any insurance company not in compliance with these requirements ineligible for this Directive and subject to regular audit procedures.

The Certification Statement must be signed by an individual who is authorized to execute the insurance company’s Federal income tax return for the taxable year under audit, and must certify, under penalty of perjury that, for the taxable year under audit, the taxpayer used the method of accounting set forth in this Directive to recognize Eligible GMxB Hedge income, deductions, gains, and losses for VA contracts issued before December 31, 2009 for Federal income tax purposes.

Insurance companies should retain the underlying accounting documentation that would permit the LB&I examiner to verify the taxpayer’s compliance with the requirements of this Directive.  If an insurance company fails to properly and timely submit the requested documentation, then the Industry Director or his/her delegate may determine that this Directive does not apply to the insurance company.

E.  Contact

Questions concerning this Directive should be directed to the Insurance & Financial Instruments Issue Practice Groups.

I.R.C. § 446: IIR Related to Hedging of Variable Annuity Guaranteed Minimum Benefits by Insurance Companies

Certification Statement

Taxpayer Name:    __________________________________________________

Taxpayer EIN:    ____________________________________________________

Tax Year:    ________________________________________________________
  
Relevant Period of the Annual Statement: __________________________________________________

Annual Statement Information:

  1. Mark-to-market value of all Eligible GMxB Hedges reported as of December 31:______________________________________________

  2. Mark-to-market value of all Eligible GMxB Hedges related to variable annuity contracts issued:

    1. Before December 31, 2009_________________________________

    2. On or after December 31, 2009 _____________________________

  3. Total net mark-to-market amounts reported for the taxable year for:

    1. Eligible GMxB Hedge Gains: _______________________________

    2. Eligible GMxB Hedge Losses: ______________________________

Certification
By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

I certify, under penalty of perjury, that for the tax year to which this certification statement applies, the taxpayer used the method of accounting set forth in the Examination Guidance of this Directive to recognize Eligible GMxB Hedge income, deductions, gains, and losses for VA contracts issued before December 31, 2009 for Federal income tax purposes.

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.

 

Signature: _________________________________________________________

Date: _____________________________________________________________

Title: _____________________________________________________________

For corporations, the certification must be signed by an individual authorized under I.R.C. section 6062.

Page Last Reviewed or Updated: 12-Jul-2016