Separate Accounts

10.01 This chapter discusses separate accounts of life insurance entities. Separate accounts, also known as variable accounts, are used to support variable annuity contracts and variable life insurance policies (hereinafter referred to together as variable contracts). Separate accounts are often registered investment companies under the Investment Company Act of 1940 (the 1940 Act), without an applicable exemption.¹ A variable contract is both a security registered under the Securities Act of 1933 (the 1933 Act) and an insurance policy filed with, and approved and regulated by, state insurance departments.

10.02 A variable contract is a contractual arrangement that combines some features of an investment company (the contract holder assumes the risk of investment gain or loss) with certain traditional insurance features (the insurance company assumes the risk of mortality and administrative expenses). A significant difference between a traditional or fixed annuity and a variable annuity is that, in sponsoring a fixed annuity, the insurance company assumes the risk of investment gain or loss and guarantees the contract holder a specified interest rate. In a variable annuity, the contract holder assumes the risk of investment gain or loss because the value of the contract holder’s account varies with the investment experience of the specific portfolio of securities (that is, the securities held in the separate account). In both fixed and variable annuities, the insurance company (rather than the separate account) assumes the mortality risk and administrative expenses. Certain other nontraditional annuity products, such as equity indexed annuities, have emerged. Equity indexed annuities represent, in effect, a combination of a fixed annuity with a derivative so that the investor is exposed to investment risk without investing in a specific portfolio of securities. Fixed and equity indexed annuities are not further discussed in this guide. Variable contracts are funded by and issued through separate accounts of insurance entities. A registered separate account is either an open-end investment company or a unit investment trust (UIT).

10.03 A separate account, as defined by the FASB Accounting Standards Codification (ASC) Master Glossary, is a separate investment account established and maintained by an insurance entity under relevant state insurance law to which funds have been allocated for certain contracts of the insurance entity or similar accounts used for foreign originated products. It includes separate accounts and subaccounts or investment divisions of separate accounts.

10.04 A separate account is not a legal entity but an accounting entity with accounting records for variable contract assets, liabilities, income, and expenses segregated as a discrete operation within the insurance entity. The insurance company’s other separate accounts and its general account do not affect the results of a particular variable contract separate account. State insurance regulatory authorities require combined separate accounts to file an annual statement. The separate account is not taxed separately for federal and state tax purposes; it is included with the operations of the insurance entity. However, under federal regulation, variable annuity and variable life products are securities. For purposes of the 1940 Act, a separate account is an independent entity, separate from the insurance company, and it cannot rely on the act’s exemption for insurance companies.

10.05 The following approaches are used to invest the underlying assets of variable contracts:

a.     Direct investment by the separate account in individual securities (the separate account is an open-end investment company)

b.     Investment in a registered investment company formed to receive proceeds from such contract holders (the separate account is a UIT)

c.     Investment in a registered investment company that sells shares to the public (the separate account is a UIT), an approach available only for tax-qualified variable annuities

10.06 Similar to an open-end investment company organized as a series fund, separate accounts are frequently structured with multiple subaccounts. Each subaccount has a unique investment strategy, and in the case of a separate account organized as a UIT, individual subaccounts will invest in different underlying investment companies. This structure allows contract holders to allocate their amount invested among various investment choices. Financial position and results of operations are maintained and reported separately for each subaccount within the separate account.

History

10.07 In 1959, the Supreme Court ruled that variable annuities constitute securities subject to registration with the SEC. In 1964, the U.S. Court of Appeals for the Third Circuit ruled that separate accounts funding variable annuities are investment funds that are separable from the insurance entity and, therefore, not exempted from the 1940 Act.

10.08 The insurance industry introduced investment annuities in the mid-1960s as a further variation of variable annuities. Investment annuities allowed individual contract holders to select specific investment vehicles. Custodian accounts were established with a third party, usually a bank, in which contract holders deposited cash or other assets. The insurer received an annual fee, usually based on a percentage of the invested assets. Although the account’s assets were owned by the insurer, they were segregated for the benefit of contract holders, who directed their investments and could sell or exchange them at any time. Further, it was possible to fully or partially redeem investment annuities before the annuity payout period began by paying the insurer a penalty. Assets remaining in an account at the contract holder’s death accrued to the insurer as a terminal premium. Investment annuities are no longer treated as annuities for federal income tax purposes.²

10.09 The first variable annuity wrapped using mutual fund shares as its underlying investment vehicle (a wraparound annuity) was developed in 1972. A wraparound annuity differs from other variable annuities because it is based on shares of an underlying investment vehicle, not on a pro rata share of individual stocks, bonds, and other investments owned by a separate account. The wraparound annuity separate account’s assets typically are invested in a fixed income fund, an equity fund, a liquid assets fund, or some combination of these funds. The contract holder may allocate all or a portion of each payment among those investments.

10.10 Variable life insurance was first offered for sale in the United States in 1976, after having been successful for several years in the Netherlands, the United Kingdom, and Canada. Early variable life insurance policies were fixed premium contracts providing coverage for the whole of life. Death benefits and cash values varied in relation to the investment experience of a separate pool of assets. Today, most variable life insurance policies are of the variable universal life design. These newer variable life policies allow the policy owner to vary the amount of premium paid and, depending on premiums and investment experience, may expire with or without value.

Product Design

10.11 A significant objective of a variable annuity contract is to provide an investment that is responsive to changes in the cost of living and that can be used to accumulate investment funds before retirement and to pay benefits after retirement. Before retirement, the accumulated value of the individual account varies with investment performance and may be withdrawn by the contract holder in whole or part with possible surrender charges, tax liabilities, or both, including possible tax penalties. A contract holder may elect to receive the accumulated value of the individual account at retirement in a lump sum, in periodic payments that are fixed or variable, or in a combination of both (depending on the options available under the particular contract). Periodic payments also may extend for various durations (for example, over the life of the annuity holder, over a defined period, or over the combined lives of the annuity holder and a designated beneficiary, (a joint and survivor annuity).

10.12 If a lump sum is elected, the contract owner receives the account value at the payment date. If a fixed payment is chosen, the contract owner will receive (a) a fixed periodic payment that is based upon the account value at the date of conversion to payout and (b) actuarial considerations. See paragraphs 10.18–.19 for a discussion of the methodology typically used when a variable benefit option is selected. More recent innovations permit contract owners to obtain a lump-sum commutation of a portion of the contract even after payments commence, guarantees of minimum account or payment values, or periodic payments adjusted for inflation.

10.13 The provisions of a variable annuity contract may require periodic payments to the sponsoring insurance entity by contract holders. Alternatively, the contract could call for a single premium payment or provide for other methods of payment. Products typically are designed as front-end loaded or back-end loaded, as specified in the prospectus. Products with a front-end load deduct sales charges from the contract holder’s purchase payments, whereas back-end loaded products reduce the surrender value by contractually specified charges, if any. The net payment is used to buy accumulation units of the separate account. The value of the separate account at any time is allocated among contract holders based on the number and value of their accumulation units representing their interest in the separate account. The concept of the accumulation unit and the unit value are analogous to fund shares and net asset value per share. The total value of the contract holder’s accumulation units is the amount available to the contract holder at any time.

10.14 If a contract holder dies during the accumulation period, the death benefit varies, depending on the terms of the contract. The value of the death benefit is determined as of the valuation date and paid according to the applicable laws and regulations governing the payment of death benefits. Death benefits may be based upon the contract value at the time of death, contract value as of a stated anniversary date, or total premiums paid. If a contract holder dies after the annuity commencement date, the death benefit is the amount specified in the annuity option selected by the contract holder (under certain options, the death benefit can be zero).

10.15 Typically, the insurance entity charges the separate account a specified amount for investment management services (if the separate account is organized as an open-end investment company), an amount for administrative expenses, and fees for mortality and expense risks assumed. Certain of these charges (for example, administrative charges) may be recovered through an annual contract charge, affected through a redemption of units. The insurance entity assumes the risk that the annuitant’s mortality will be less favorable (that is, he or she will live longer) than the rates assumed (mortality risk) and that administration and investment expenses will exceed the fee charged (expense risk). The mortality risk charge also covers the risk that the account value at death will be insufficient to fund the minimum benefit.

10.16 The insurance entity also assumes the mortality risk by incorporating annuity rates into the contract, which cannot be changed. Variable annuity payments are computed based on contractually specified mortality tables. The insurance entity retains the longevity risk, regardless of the method of payout that the contract holders elect, and may be obligated to continue payments, although contract holders or their beneficiaries, depending on the payment options selected, may live longer than anticipated. The insurance entity may bear additional mortality risk if it offers a guaranteed minimum death benefit under which a minimum payment is made to a beneficiary if the annuity holder dies before the payout period commences. To compensate the insurance entity for assuming this mortality risk, a mortality risk premium, which is an amount usually computed as a percentage of the daily net asset value of the separate account, is deducted from the separate account. If the mortality risk premium is insufficient to compensate the insurance entity for its costs, the loss is assumed by the insurance entity. Conversely, if the mortality risk premium is greater than its costs, the excess is the insurance entity’s gain.

10.17 The insurance entity undertakes to pay the expenses of the separate account and may or may not charge the account a direct fee for the services rendered. Regardless of whether any fees are charged for specific services, the insurance entity charges an expense risk premium to the separate account. This charge is to compensate the insurance entity for accepting the risk that expense charges will be insufficient to cover the entity’s cost of providing administrative and other services, including payments to third parties, to the separate account. The annuity contract usually provides that this expense risk charge may vary but sets a maximum.

10.18 The amount of the first annuity payment of a variable annuity is determined by applying a factor in the applicable annuity table to the contract value as of the date on which annuity payments begin, in accordance with the annuity option specified in the application. The first payment is divided by the value of an annuity unit, a unit of measure used to calculate variable annuity payments and establish the number of annuity units for each monthly payment. The number of annuity units for a particular annuitant, determined on the annuity commencement date, remains fixed during the annuity payment period.

10.19 Under a variable benefit option, the amounts of the second and subsequent payments are determined by multiplying the fixed number of annuity units by the annuity unit value on the date on which the payments are due. Thus, subsequent payments vary in accordance with the underlying investment performance of the separate account and the resulting annuity unit value.

10.20 Variable life insurance policies have many of the same variable features as variable annuities. The premium for a variable life policy, less an expense or sales load and mortality charge, is invested in a separate account. The policy owner may specify, within limits, where this cash value is to be invested. Several options may be available, including various kinds of money market, fixed income, and equity funds.

10.21 The policy’s death benefit and cash value vary directly with the performance of the fund(s) selected. However, a guaranteed minimum death benefit is available, providing a floor of protection regardless of the investment performance of the fund(s). Investment risk in excess of any guaranteed minimum death benefit is borne by the policy owner. The insurance entity retains only expense and mortality risk, as well as the risk of paying guaranteed minimum death benefits in excess of the value of the fund(s) in which the policyholder invested.

10.22 In all other respects, a variable life insurance policy works like a traditional whole life policy, and a variable universal life policy works like a common universal life policy. All the normal riders and attachments are typically available on variable products. Further information on life insurance contracts can be found in the AICPA Audit and Accounting Guide Life and Health Insurance Entities.

Contracts in the Payout (Annuitization) Period

10.23 As stated previously, a variable annuity payment option provides an annuity with payment amounts that are not predetermined but vary according to the results of the underlying investment. The payout (annuitization) period begins when amounts accumulated under the contract (the contract value) are applied under the method-of-payment option selected by the contract holder. At each financial reporting date, the separate account financial statements include an aggregate amount of net assets allocated to future contract benefits for the contracts in the payout (annuitization) period.

10.24 The net assets allocated to future contract benefits, sometimes referred to as the annuity reserve account, is the total of an actuarial computation of the discounted amount of the expected annuity payments for each contract or group of contracts based principally on the annuity payments at the current annuity unit value multiplied by the individuals’ expected mortality rates based upon an annuity table.

10.25 For variable life contracts, the insurance entity charges the separate account for the cost of fixed premium variable life insurance coverage based on traditional methodology, which can be calculated using standard techniques. The charge for variable universal life insurance policies is usually determined in accordance with the National Association of Insurance Commissioners Universal Life Insurance Model Regulation.

SEC Registration

10.26 A separate account is established by resolution of the insurance entity’s board of directors or trustees in accordance with the insurance laws of the state of domicile. It is subject to policy-form approval and other requirements in each state in which the entity offers the contract. Courts have determined that variable contracts and separate accounts are subject to registration and regulation under the 1933 Act and the 1940 Act, respectively. The registrant is the separate account.

10.27 In addition to accumulation units and net assets allocated to future annuity contract benefits established at the separate account level, as described previously, certain separate accounts withhold the mortality and expense payments from the insurance entity. Instead of paying the charges to the insurance entity in cash, the separate account may apply accumulation units or net assets to the insurance entity’s own account. This may occur either at the discretion of the sponsoring insurance entity to build investible assets or at the requirement of the state insurance commission. (Under insurance regulations of certain states certain separate accounts have been required to withhold payments to the insurance entity.) The purpose of this holdback is to protect contract holders against adverse mortality in the event that the insurance entity is unable to fulfill its responsibilities to insulate the separate account from mortality risk. If the holdback is maintained in the form of accumulation units or otherwise participates in the investment experience of the separate account, it should be reported in net assets by the separate account under the caption “Retained in variable account by insurance entity.” If the holdback does not participate in the investment experience of the separate account (that is, it is fixed in amount), it should be reported by the separate account as a liability.

10.28 Initially, variable contract issuers registered as management investment companies because they invested their assets directly in the open market and, therefore, resembled typical mutual funds in their investment objectives. The 1940 Act has a number of technical requirements for a management investment company. Among them are requirements for an elected board of directors, proxy statements, and other requirements for publicly held corporations. A separate account of a life insurance company is not a legal entity. Under state insurance laws, it is owned by and forms a part of the life insurance company. Therefore, the requirements for a board of directors, proxy statements, and the like, are inconsistent with the status of the separate account as part of the life insurance company. Further, a separate account cannot exist as an entity apart from the life insurance company.

10.29 Accordingly, since 1969, a number of separate accounts have registered under the 1940 Act as UITs to avoid some technical requirements for entities registered as management investment companies under that act. Further, the form of a UIT satisfies the need for separate accounting for the performance of specific pools of assets of group annuity contracts, personal annuity contracts, and annuity contracts subject to different tax rules. The UIT form may also accommodate lower expense charges and more flexibility in adding new products.

10.30 Relevant SEC Registration and Reporting Forms include Form N-3, Form N-4, and Form N-6. The auditor should become familiar with the requirements of each of these forms.

•     Form N-3 is the registration statement for variable annuity separate accounts registered as management investment companies under the 1940 Act and the 1933 Act.

•     Form N-4 is the registration statement for variable annuity separate accounts registered as UITs under the 1940 Act and the 1933 Act.

•     Form N-6 is the form for insurance company separate accounts that are registered as UITs and that offer variable life insurance policies.

Auditing Considerations³

10.31 Because most features of a variable annuity and variable life contract are similar to those of a mutual fund, the auditing guidance in other chapters of this guide also applies to these variable contracts. However, major differences exist between variable annuities and mutual funds in accounting for contracts in the payout period and in the calculation of the net assets allocated to contracts in the payout period (annuity reserve account). In addition, when a separate account organizes as a UIT investing in a mutual fund, other audit issues can arise. Finally, the auditor should consider various issues arising due to unique aspects of the taxation of insurance entities.

10.32 Mortality and interest rate assumptions (based on the annuity option selected by the contract holder, the contract holder’s age at issue, and the date of issue of the annuity) are the two most significant factors in determining the annuity reserve account. The auditor should become satisfied with the annuity reserve account by consulting published tables for the appropriate factors and testing that those factors have been appropriately applied to the master file containing all outstanding contracts in the payout period. Similarly, the auditor should become satisfied with the determination of amounts receivable from or payable to the insurance entity based on its mortality experience on contracts in the payout period (see paragraph 10.34). A broad outline of procedures to be followed in auditing actuarial computations is described in the AICPA Audit and Accounting Guide Life and Health Insurance Entities.

10.33 For variable life contracts, the net assets maintained by the separate account (excluding any amounts held for the account of the insurance entity) are analogous to the cash value of the underlying insurance policies. The liability for death benefits is held by the insurance entity.

10.34 As stated previously, the insurance entity assumes certain risks in issuing variable annuities and variable life contracts. If mortality experience on annuity contracts in the payout period runs favorably or unfavorably to the insurer’s estimate (see paragraphs 10.23–.25), it does not affect the separate account but creates an amount payable to or receivable from the insurance entity, respectively. Among the factors that may be evaluated in examining the financial statements of a separate account funding a variable annuity is the insurance entity’s ability to perform if the variable annuity’s assets are insufficient to meet the variable annuity’s obligations.

10.35 When the separate account is organized as a UIT, certain considerations can arise due to the relationship between the separate account and underlying investment company. If the auditor of the separate account is not the auditor of the fund, the separate account auditor should consider the effect, if any, that this has on the audit. The fiscal year-ends of the separate account and underlying investment company are often the same. In most cases, the underlying investment company is registered under the 1940 Act such that the audited financial statements of the fund will usually be available to the separate account auditor from public sources as audit evidence with respect to the fund’s value. If the underlying investment company is not registered under the 1940 Act, the separate account auditor might consider what communications with the fund auditor are appropriate and, in general, may consider what other steps are appropriate, including those steps described in paragraphs 5.91–.96 of this guide, to rely on the work of another auditor or perform other procedures.

10.36 If the underlying fund and separate account have different year-ends, questions may arise regarding auditing investment valuation. As noted in the preceding paragraph, the auditor of the separate account usually has available audited financial statements to provide audit evidence with respect to the value of the investment in the fund. When the fund is not audited at the separate account year-end date, the auditor should consider what other audit procedures might be appropriate to substantiate the separate account’s valuation, including, for investments in investment companies not registered under the 1940 Act, the procedures discussed in paragraphs 5.91–.96 of this guide. Audit procedures for investments in investment companies registered under the 1940 Act might include confirmation of shares outstanding and period-end net asset values with the investment company’s transfer agent and review of the most recent interim (quarterly or semiannual) filing of the investment company containing portfolio information.

10.37 The auditor’s report is typically addressed to the board of directors or trustees of the sponsoring insurance entity and the contract holders of the separate account.

Taxation of Variable Contracts

10.38 Variable annuity contracts are designed for use primarily by individuals for personal savings or retirement plans, which, under the provisions of the IRC, may be qualified or nonqualified plans. Variable life contracts are designed for individuals to provide market-sensitive cash surrender values and death benefits. The ultimate effect of federal income taxes on the contract value, annuity payments, cash values, death benefits, and economic benefit to the contract owner, annuitant, or beneficiary depends on the separate account’s tax status, the purpose for which the contract is purchased, and the individual’s tax and employment status. The discussion in this section is general and not intended to be an all-inclusive and comprehensive treatise on the current tax status of variable annuities.

10.39 If an annuity contract qualifies as such under the IRC, a contract holder is generally not taxed on increases in the value of the contract until he or she receives payment in a lump sum or as an annuity under the settlement option elected, nor is he or she taxed upon the investment buildup in cash values. Although the assets and liabilities of the separate account are segregated from the sponsoring life insurance entity’s regular business, it is not considered a separate taxable entity. The tax treatment of the separate account depends upon the character of the contracts held by the separate account. If the contracts qualify as variable contracts that are adequately diversified (see paragraphs 10.49–.51), then IRC Section 817 dictates the taxation of the separate account. If the contracts do not qualify as variable or are not adequately diversified, then the activity of the separate account will be governed by the tax rules applicable to life insurance entities under IRC Subchapter L. The separate account is not subject to the tax rules applicable to regulated investment companies (RICs) under IRC Subchapter M.

10.40 Under IRC Section 817, reinvested investment income is applied to increase insurance entity reserves under the contracts, and the increase in reserves is deductible from income. Usually a provision for federal income taxes on investment income or gains is not necessary; therefore, a provision is not made in the variable annuity separate account financial statements.

10.41 IRC Section 817(g) provides that a variable annuity contract will be taxed in the same manner as a traditional or fixed annuity if the payments under the variable contract are computed based on recognized mortality tables and the investment return of the individual segregated account.

10.42 When the UIT approach was developed using mutual funds as the underlying investment, insurers relied on several tax rulings as the basis for treating mutual fund wraparounds similarly to traditional variable annuities.

10.43 In Revenue Ruling 80-274, the IRS concluded that the position of a contract holder of an annuity wrapped around a savings account is as if the investment had been maintained or established directly with a savings and loan association. Thus, the contract holder is taxed on a current basis on the separate account income.

10.44 Revenue Ruling 81-225 states that, for federal income tax purposes, the insurance entity, not the contract holder, will be considered the owner of mutual fund shares underlying investments for an annuity contract, provided that such shares are unavailable to the public. Accordingly, under that ruling, if the mutual fund shares are not available to the public, the contract holder is not treated as the owner of the shares, and dividends applicable to such shares are not currently includable in the contract holder’s gross income.

10.45 On August 18, 2003, the IRS published Revenue Rulings 2003-91 and 2003-92. The IRS described Revenue Ruling 2003-91 as a safe harbor from which taxpayers may operate and referred to Revenue Ruling 2003-92 as having clarified and amplified Revenue Ruling 81-225.

10.46 Revenue Ruling 2003-91 described a situation in which a separate account used for funding variable contracts was divided into various subaccounts. The contracts and subaccounts were issued under the following conditions:

•     The contract holder could not select or direct a particular investment to be made by the separate account or subaccounts; all investment decisions are made by the insurance entity or separate account in their absolute discretion.

•     Investment strategies of the subaccounts are sufficiently broad to prevent a contract holder from making particular investment decisions through investing in a subaccount.

•     Only the insurance entity could add or substitute subaccounts or investment strategies and the insurance entity does not communicate or consult with any contract holder regarding investment selection or strategy.

•     Investments in the subaccounts are only available through the purchase of variable contracts and are not otherwise publicly available.

10.47 The IRS concluded that such an account did not provide the contract holder direct or indirect control over the separate account or any subaccount asset; thus, the holder would not be considered the tax owner of the underlying assets. The IRS also observed that the ability to allocate premiums or transfer funds between subaccounts did not indicate sufficient control for the contract holder to be treated as the owner, for tax purposes, of the underlying assets.

10.48 Conversely, Revenue Ruling 2003-92 addressed a situation in which an insurance entity proposed to offer deferred variable contracts under which certain qualified purchasers could invest in a limited number of subaccounts, each of which represented an interest in a specific investment partnership that is not publicly traded. If interests in the partnership were also available for purchase by the general public (that is, outside the variable contract structure), the IRS held that the qualified purchaser contract holder, not the insurance entity, would be the owner, for tax purposes, of the partnership interest. However, if interests in the partnership were only available for purchase within variable contract structures, the insurance entity would be considered the owner of the partnership interest.

10.49 IRC Section 817(h) and the regulations thereunder require the investments of a separate account (or the underlying mutual fund, if the separate account is a UIT) to be adequately diversified to qualify as an annuity contract under IRC Section 72 (qualification under IRC Section 72 is necessary to avoid current taxation of both current and built-up earnings of the contract). In order for the separate account to be adequately diversified, the fair value of the largest holding may not exceed 55 percent of the fair value of total assets, the 2 largest holdings may not exceed 70 percent, the 3 largest holdings may not exceed 80 percent, and the 4 largest holdings may not exceed 90 percent (measured on a quarterly basis). Regulation 1.817-5(b)(1) describes what assets must be included in the calculation and what assets may be excluded.

10.50 U.S. government securities are subject to IRC Section 817(h) diversification rules. The treatment of U.S. government securities for purposes of determining separate account diversification is different from that applied to RICs. Under IRC Section 817(h), each government agency or instrumentality is treated as a separate issuer for purposes of diversification testing.

10.51 As an alternative to the general diversification standards described previously, IRC Section 817(h)(2) provides safe harbor diversification standards that are similar to those for RICs and often easier to administer. However, the safe harbor diversification rules differ from those of RICs in that the total assets of the separate account represented by cash, cash items (including receivables), U.S. government securities, or securities of other RICs may not exceed 55 percent of the value of total assets in the account. Regulation 1.817-5(b)(3) provides special rules that apply to a segregated asset account with respect to variable life insurance contracts.

10.52 IRC Section 72(s) provides that a contract should not be treated as an annuity for tax purposes unless it provides for certain required distributions in the event of the contract holder’s death.

10.53 IRC Section 72(q) imposes certain penalties on early withdrawals from annuity contracts.

10.54 The federal excise tax rules governing the timing and amounts of distributions do not apply to insurance-related mutual funds if no taxable investors are present. Further, in organizing the separate account, the sponsoring insurance entity may invest taxable seed money of up to $250,000 without subjecting the fund to the excise tax rules (IRC Section 4982).

10.55 Dividends and distributions from the fund to the separate account are usually reinvested. As a result, some insurance funds do not actually pay any dividends or distributions. Rather, they satisfy their fund-level tax qualification tests by using a procedure known as consent dividends (IRC Section 565). Under this procedure, with annual written consent from each investor (that is, the separate accounts), distributions are deemed to be passed through from the fund to the investors. This is manageable operationally because, in practice, the number of separate accounts invested in a single fund is limited.

Illustrative Financial Statements

10.56 The financial statements illustrated in this chapter are for variable annuity separate accounts registered as UITs. For separate accounts with multiple subaccounts, the financial position and results of operations generally should be presented separately for each subaccount. This kind of arrangement is presented with individual columns for each subaccount. The total information for the separate account as a whole is not meaningful. Accordingly, a subaccount that is similar to a series mutual fund is the reporting entity, and the auditor’s report could be modified to cover the individual subaccounts (see paragraph 12.24 of this guide). The financial statements of a subaccount may also be presented as if the subaccount were a separate entity. Variable annuity separate accounts registered as management investment companies would prepare financial statements that conform to those presented in chapter 7, “Financial Statements of Investment Companies,” of this guide, although certain financial statement notes that follow would also apply. Under the requirements of SEC Form N-4, variable annuity separate accounts registered as UITs present a period-end statement of assets and liabilities, a statement of operations for the most recent year, and a statement of changes in net assets for the most recent two years in the same manner as a registered investment company. This format is illustrated in the exhibit. Variable life separate accounts registered as UITs on Form N-6 also would follow the form of the exhibit. Certain contract charges (for example, cost of insurance) would be shown on the statement of changes in net assets, which is similar to the presentation of annuity contract charges.

10.57 Certain disclosures required of registered investment companies for compliance with SEC rules and regulations are not presented in the following illustrative financial statements because they are not otherwise required by U.S. generally accepted accounting principles. In addition, certain disclosures are impractical due to the characteristics of the separate account. These disclosures include the following:

•     The total cost, for federal income tax purposes, of the portfolio of investments according to Rules 12-12 and 12-12B⁴ of Regulation S-X.

•     The components of net assets presented as a separate schedule or in the notes to the financial statements according to Rule 6-05.5 of Regulation S-X. However, the net asset value per unit at the beginning and end of each period and the total net assets at the end of the period are to be provided for the most recent five years.

10.58 As stated in FASB ASC 946-205-50-31, separate accounts with more than two levels of contract charges or net unit values per subaccount may elect to present the required financial highlights for contract expense levels that had units issued or outstanding during the reporting period (including number of units, unit fair value, net assets, expense ratio, investment income ratio, and total return) for either

a.     each contract expense level that results in a distinct net unit value and for which units were issued or outstanding during each reporting period or

b.    the range of the lowest and highest level of expense ratio and the related total return and unit fair values during each reporting period.

The calculation of the ranges for the total return and unit fair values should correspond to the groupings that produced the lowest and highest expense ratios.

10.59 Paragraphs 32–34 of FASB ASC 946-205-50 explain that the financial highlights table in the separate account’s financial statements should state clearly that the expense ratio considers only the expenses borne directly by the separate account and excludes expenses incurred directly by the underlying funds or charged through the redemption of units. If the ranges of expense ratios, total returns, and unit fair values are presented, the insurance enterprise should disclose instances in which individual contract values do not fall within the ranges presented (for example, if a new product is introduced late in a reporting period and the total return does not fall within the range). The expense disclosure should also include ranges of all fees that are charged by the separate account and a description of those fees, including whether they are assessed as direct reductions in unit values or through the redemption of units for all policies contained within the separate account.

10.60

ABC Variable Annuity Separate Account I
of ABC Life Insurance Company
Statement of Assets and Liabilities
December 31, 20X8

10.61

ABC Variable Annuity Separate Account I
of ABC Life Insurance Company
Statement of Operations
for the Year Ended December 31, 20X8

10.62

ABC Variable Annuity Separate Account I
of ABC Life Insurance Company
Statement of Changes in Net Assets
for the Years Ended December 31, 20X8 and 20X7

10.63

ABC Variable Annuity Separate Account I
of ABC Life Insurance Company
Notes to Financial Statements

1. Organization

The ABC Variable Annuity Separate Account I (Separate Account I), a unit investment trust registered under the Investment Company Act of 1940, as amended, was established by ABC Life Insurance Company (ABC) on April 1, 20XX, and exists in accordance with the regulations of the New York Insurance Department. Separate Account I is a funding vehicle for individual variable annuity contracts. Separate Account I currently consists of two investment divisions: Money Market and Equity Index, each of which is treated as an individual separate account. Each investment division invests all its investible assets in the corresponding portfolio of ABC Investment Fund, Inc.

Under applicable insurance law, the assets and liabilities of Separate Account I are clearly identified and distinguished from ABC’s other assets and liabilities. The portion of Separate Account I’s assets applicable to the variable annuity contracts is not chargeable with liabilities arising out of any other business ABC may conduct.

2. Significant Accounting Policies

Investments are made in the portfolios of ABC Investment Fund and valued at fair value based on the reported net asset values of such portfolios, which in turn value their investment securities at fair value. Transactions are recorded on a trade date basis. Dividend income and realized gain distributions are recorded on the ex-distribution date.

Realized gains and losses on the sales of investments are computed on the basis of the identified cost of the investment sold.

Net assets allocated to contracts in the payout period are computed according to the 1983a Individual Annuitant Mortality Table. The assumed investment return is 3.5 percent unless the annuitant elects otherwise, in which case the rate may vary from 3.5 percent to 7 percent, as regulated by the laws of the respective states. The mortality risk is fully borne by ABC and may result in additional amounts being transferred into the variable annuity account by ABC to cover greater longevity of annuitants than expected. Conversely, if amounts allocated exceed amounts required, transfers may be made to the insurance entity.

The operations of Separate Account I are included in the federal income tax return of ABC, which is taxed as a life insurance entity under the provisions of the IRC. Under the current provisions of the IRC, ABC does not expect to incur federal income taxes on the earnings of Separate Account I to the extent that the earnings are credited under the contracts. Based on this, no charge is being made currently to Separate Account I for federal income taxes. ABC will review periodically the status of this policy in the event of changes in the tax law. A charge may be made in future years for any federal income taxes that would be attributable to the contracts.

Separate Account I follows the accounting and reporting guidance in FASB Accounting Standards Codification 946. The preparation of financial statements in accordance with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect amounts reported therein. Actual results could differ from these estimates.

3. Investments

As described in note 2, Separate Account I measures the fair value of its investment in ABC Investment Fund on a recurring basis. GAAP establishes a hierarchy that prioritizes inputs to valuation methods. The three levels of inputs are as follows:

•     Level 1. Unadjusted quoted prices in active markets for identical assets or liabilities that Separate Account I has the ability to access.

•     Level 2. Observable inputs other than quoted prices included in level 1 that are observable for the asset or liability either directly or indirectly. These inputs may include quoted prices for the identical instrument on an inactive market, prices for similar instruments, interest rates, prepayment speeds, credit risk, yield curves, default rates, and similar data.

•     Level 3. Unobservable inputs for the asset or liability, to the extent observable inputs are not available, representing Separate Account I’s own assumptions about the assumptions that a market participant would use in valuing the asset or liability, and that would be based on the best information available.

The following table summarizes the inputs used to value Separate Account I’s assets measured at fair value as of December 31, 20X8.⁶

There were no transfers between level 1 and level 2 during the year.

The cost of purchases and proceeds from sales of investments for the year ended December 31, 20X8 were as follows:

4. Expenses and Related-Party Transactions

ABC deducts a daily charge from the net assets of Separate Account I equivalent to an effective annual rate of 0.25 percent for administrative expenses and 0.75 percent for the assumption of mortality and expense risks. ABC also deducts an annual maintenance charge of $35 for each contract from the ABC Retirement Reserves Contract value. The maintenance charge, which is recorded as a redemption in the accompanying statement of changes in net assets, is waived on certain contracts.

Additionally, during the year ended December 31, 20X8, management fees were paid indirectly to ABC Management Company, an affiliate of ABC in its capacity as adviser to ABC Investment Fund. The fund’s advisory agreement provides for a fee at the annual rate of 0.15 percent of the average net assets of the Money Market Fund and 0.45 percent of the average net assets of the Equity Index Fund.

[Other: Consider disclosures of other fees to affiliates not otherwise disclosed, such as sales load charges retained by the insurance entity.]

5. Changes in Units Outstanding

The changes in units outstanding for the years ended December 31, 20X8 and 20X7 were as follows:

6. Unit Values

A summary of unit values and units outstanding for variable annuity contracts, net investment income ratios, and expense ratios, excluding expenses of the underlying funds, for each of the five years in the period ended December 31, 20X8, follows:

a.     The following format should be presented if the insurance enterprise chooses to disclose each contract expense level that results in a distinct net unit value and for which units were issued or outstanding during each of the five years ended December 31, 20X8.

b.     The following format should be presented if the insurance enterprise chooses to present the range of the lowest to highest level of expense ratio and the related total return and unit fair values during each of the five years ended December 31, 20X8. Certain of the information is presented as a range of minimum to maximum values based on the product grouping representing the minimum and maximum expense ratio amounts.

c.     An insurance enterprise may choose to present all expenses that are charged by the separate account in either a table or narrative format. The disclosure should list all fees that are charged by the separate account and a description of those fees, including whether they are assessed as direct reductions in unit values or through the redemption of units for all policies contained within the separate account. For this example, expenses disclosed are based on the ranges of all products within the separate account; the expenses may also be listed in more detail (for example, individual charges broken out by products within the separate account) in either table or narrative format.

Alternatively, the expense ratio represents the annualized contract expenses of ABC Variable Annuity Separate Account I for the period indicated and includes only those expenses that are charged through a reduction of the unit value. Included in this category are mortality and expense charges and the cost of any riders that the policyholder has elected. These fees range between 1.00 percent and 2.65 percent, depending on the product and options selected. Expenses of the underlying fund portfolios and charges made directly to contract owner accounts through the redemption of units are excluded. For this separate account, charges made through the redemption of units ranged from $10 to $30 per policy annually.