Exam Problem 2019 Spring #9 part c.)

Turley36Turley36
in Odomirok.8-9-IS

If the question would have stated that the derivative would have not been highly effective, would the mark-to-market valuation accounting method of the bond apply here, and the correct answer would have been to use the market value of the bond? (In turn decreasing the value of the bond portfolio.) Or would the fact that the portfolio was a NAIC Class 2 Bond mean that I would have still needed to take the amortized cost of the bonds in the portfolio? (Causing the surplus to remain unchanged.)

Thanks

Comments

  • grahamgraham
    edited June 2021

    First, here's a direct answer to your questions. Then further down is a more detailed explanation:

    • Even if the derivative is not highly effective, the bond valuation doesn't change. It's the derivative that gets valued differently. The derivative would be marked-to-market (i.e. valued at "fair value") but the bond would still be valued at amortized cost.
    • Since the bond is still valued at amortized cost, changes in the fair value of the bond would not cause a change in surplus. But if the derivative is valued at "fair value" then changes in the derivative's value would cause a change in surplus.

    And here's how I thought through all of this:

    If the hedge is highly effective then hedge accounting may be used. Hedge accounting records the bond and the derivative as a single item. Without hedge accounting, the bond and the derivative would appear as separate items in financial statements and it could appear there is large volatility even if the bond and derivative offset each other (which is the whole point of a derivative, provided it's effective.)

    So, its advantageous for an insurer to use hedge accounting because it makes the financial statements simpler and doesn't shown unnecessary volatility. Maybe nobody cares if the bond value goes down significantly if the corresponding derivative goes up by a roughly equal amount. If this is indeed what's happening then it isn't a problem.

    A problem may arise however if an insurer is trying to hide volatility in its assets by pairing it with a derivative (or something it claims is functioning like a derivative.) There have to safeguards against an insurer using hedge accounting where it isn't warranted. That's where the concept of "highly effective" comes in. If a derivative is highly effective then hedge accounting can be used. Otherwise hedge accounting cannot be used and the bond has to have its own line in financial statements so users can explicitly see any fluctuations in its value.

    That's a long way of saying that if the derivative is not highly effective then it's essentially no longer connected to the bond in the way a derivative is intended to be. Since the connection is broken, the derivative would then be valued at "fair value" unlike the underlying bond. Changes in fair value of the derivative flow into unrealized gains/losses and directly into surplus (bypassing the income statement.) The NAIC Class 2 bonds would not affect surplus because they are valued at amortized cost and changes in the fair value of assets valued at amortized cost do not affect surplus.

  • Turley36Turley36

    Thank you so much Graham! This clears up everything.

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