Monitoring Changes in Capital and Hedge Effectiveness Under Fair Value Accounting Principles

In the early 1970s Richard G. Horn established a methodology for analyzing the earnings of a life insurance company that reflected, at that time, the types of products underwritten and the accounting principles that were in effect. This methodology became to be known as a “sources of earnings analysis.”With the exception of term life insurance, most life insurance and annuity products underwritten today have significant equity risk. Furthermore, fair value accounting principles are replacing historical-based accounting principles. Finally, life insurance companies have sophisticated risk management policies and procedures to manage risk.The purpose of this paper is to extend Horn’s “sources of earnings analysis” to reflect the evolution in product design, accounting standards, and risk management practices. In particular, under fair value accounting principles, the capital account becomes the primary focus of attention. Accordingly, this paper develops a methodology to perform an “analysis of the change in capital” that would replace a traditional “sources of earnings analysis.” In addition, most life insurance companies have hedging programs to manage the embedded equity risks in the types of products they have underwritten. Thus, an important focus of this analysis is to monitor the effectiveness of these hedging programs.