Hedge Accounting

Derivatives and Hedging : FASB Topic 815

Derivatives and Hedging (FASB Topic 815)

Hedge Accounting is a great way of reducing income volatility. It is codified in FAS 133 and ASC 815.

When derivatives are used to hedge certain type of risks (such as future liabilities linked to equity markets or interest rates), and the accounting and reporting is done in a proper way (as prescribed by GAAP), then the fluctuations in the value of derivatives (hedges) or the value of ‘hedgeable’ risks can be removed from the balance sheet.

This is clearly a phenomenal benefit, but how many hoops an organization has to jump in order to avail of it? Implementation of Special Hedge Accounting is not straightforward, and many parties and processes are involved.

At Annuity Risk, we see that benefits outweigh costs for entities of all sizes and the nature of business (not just insurers). We help with the following:

Feasibility Analysis: What risks to hedge, and how?
Derivative Hedging Strategy: What derivatives to use, and how?
Hedge Effectiveness Reporting
Special Hedge Accounting
Audit Support

Background

GAAP requires all entities under its purview to recognize derivatives at fair value on their balance sheets. Not only are actual derivatives (options, swaps, futures, etc.) in scope, but also are embedded derivatives within contracts such as floating rate loans, convertible debt, indexed annuities, and variable annuities. Hedge Accounting has the following requirements.

At the inception of the Hedge Accounting:

Declare the intent and purpose of the hedge.
Specify the period of hedge’s utility.
Specify frequency of evaluation.
Specify the scope of the hedge, describing in detail what risks are being hedged.
Describe in detail the evaluation criteria of hedge’s effectiveness and measurement frequency.
Evaluation criteria should have firm criteria for passing or fail hedge effectiveness.
Get approval from external auditor on the evaluation criteria, pass/fail criteria and frequency of measurement.

After inception of Hedge Accounting:

Once the hedging begins or the Hedge Accounting program is implemented, evaluate hedge effectiveness at frequent intervals (minimum quarterly).
At every reset of hedging relationship, revaluate hedge effectiveness.

Conclusion

Typically, the ratio of the change in value of the hedge to the change in the value of the embedded derivative becomes the basis of evaluation criteria for a derivative’s (hedge’s) effectiveness in hedging its target risks. FAS 157 has further guidance on the reasonability of calculation methodologies.

P&L from derivatives which fail the test of hedge effectiveness need to be reported under net income (other comprehensive income).

At Annuity Risk, our view is that Hedge Accounting allows insurers and asset managers to maximize their savings from hedging. Prudence in hedge accounting, together with expertise in hedging and derivative trading, can dramatically lower the period-over-period variability in net income.

Email: info@annuityrisk.com
Phone: +1 646-535-4245

7659 Mall Road #1004, Florence, KY 41042