Investments

1. 37th Annual Insurance Tax Conference Investments Tax Update

2. Agenda • Section 166 and Bad Debt Issues • Hedging • REMICs/Re-REMICs • Gain Recognition 37th Annual Insurance Tax Conference

3. 37th Annual Insurance Tax Conference Section 166 and Bad Debt Issues 3 37th Annual Insurance Tax Conference

4. Bad Debt Deduction/Worthlessness IRC Section 166 • Section 166(a) allows an ordinary deduction for both partial and complete worthlessness on certain bad debts. • For corporate taxpayers, section 166(a) is applicable to all debt instruments that are not section 165(g) securities. • A debt instrument is a section 165(g) security if it is: • Issued by a corporation or a government entity, and • Issued with interest coupons or in registered form. 4 37th Annual Insurance Tax Conference

5. Bad Debt Deduction/Worthlessness • Timing – Wholly Worthless Debts: • Deduction allowed for complete worthlessness for debt that became wholly worthless during the taxable year • Taxpayer bears the burden of proof that the debt became worthless during the year (i.e., that it was not worthless in some prior period) 5 37th Annual Insurance Tax Conference

6. Bad Debt Deduction/Worthlessness • Timing – Partially Worthless Debts: • Deduction allowed for a debt that becomes partially worthless during the taxable year. • Taxpayer bears the burden of proof, same as with wholly worthless debts • Charge-off requirement – deduction allowed only to the extent “charged off” debt during the tax year [section 166(a)(2)] • “Specific debts” only – section 1.166-3(a)(1) • Generally necessary to reduce carrying value on balance sheet 6 37th Annual Insurance Tax Conference

7. I.R.C. §166: LB&I Directive Related to Partial Worthlessness Deduction for Insurance Companies • Companies’ and the IRS’s practices varied as to the tax treatment of such losses-- should tax treatment follow statutory treatment? • Independently determining partial worthlessness amounts imposes significant burden on both insurance companies and LB&I. • The Directive sets forth simplifying rule for determining when IRS examining agent should not challenge an insurance company’s partial worthlessness deductions for certain securities. • The Directive clarifies that if an insurance company claims a partial worthlessness deduction for eligible securities but does not meet the Directive’s requirements, regular audit procedures apply. 7 37th Annual Insurance Tax Conference

8. I.R.C. §166: LB&I Directive Related to Partial Worthlessness Deduction for Insurance Companies • Under Directive, IRS examiners should not challenge insurance company’s partial worthlessness deduction under section 166(a)(2) for “eligible securities” if the company complies with certain requirements. • “Eligible securities” are investments in loan-backed and structured securities within the scope of SSAP 43R, subject to section 166, and not subject to section 165(g)(2)(C). • Partial worthlessness deduction = SSAP 43R credit-related impairment charge-offs for the same debt instruments, as reported on NAIC statement, adjusted for any non-credit-related portion of the charge-offs. 8 37th Annual Insurance Tax Conference

9. I.R.C. §166: LB&I Directive Related to Partial Worthlessness Deduction for Insurance Companies • Tax basis of eligible securities may not be less than the post-charge-off statutory carrying value under SSAP 43R as adjusted for non-credit impairment. • For Directive to apply, an insurance company must use the SSAP 43R credit-related impairment charge-off amount for all eligible securities that are partially worthless. • For consolidated returns, adoption of the Directive is on a company-by-company basis. 9 37th Annual Insurance Tax Conference

10. I.R.C. §166: LB&I Directive Related to Partial Worthlessness Deduction for Insurance Companies • For companies not under exam, Directive may be implemented by filing an amended return. • For an insurance company under examination, the IRS agent should consult with the company and determine whether to revise its partial worthlessness deduction for the tax years under exam, or whether to file amended federal income tax returns for the relevant years. • Application of Directive is optional. 10 37th Annual Insurance Tax Conference

11. 37th Annual Insurance Tax Conference Hedging 37th Annual Insurance Tax Conference

12. 3 Requirements to Be a Hedging Transaction Entered into in the normal course of a trade or business “Primarily” to manage certain risks From holding ordinary property or incurring certain obligations Hedging – Requirements for tax hedge 12 37th Annual Insurance Tax Conference

13. Straddle rules do not apply Losses deferred to extent of unrecognized gains on offsetting position Section 1256 rules do not apply Mark to market 60/40 LTCG/STCG split Ordinary treatment on gains and losses Better matching of income and expense Hedging – Benefits of hedge treatment 13 37th Annual Insurance Tax Conference

14. Generally The timing rules that govern hedging transactions require taxpayers to choose a method that clearly reflects income (§1.446-4) To clearly reflect income, the method must reasonably match the timing of income/loss from the hedging transaction with the hedged asset Taking gains or losses into account when realized may not clearly reflect income Once taxpayer chooses method, it must apply that method consistently Hedging – Tax Accounting 14 37th Annual Insurance Tax Conference

15. Identification is critical To achieve ordinary gain/loss treatment, the hedge must be properly identified Identification required before the close of business on the day the hedge is entered into--Section 1221(a)(7) Identification for non-tax purposes may not be sufficient In tax books and records, TP must include a sufficient description of the accounting method used for each type of hedging transaction Description must show how clear reflection standard is met Hedging – Issues 15 37th Annual Insurance Tax Conference

16. Potential for character whipsaw Gains are ordinary and losses are capital If the requirements for a hedge are met, but the hedge is not properly identified, timing rules still apply. Revenue Ruling 2003-127 IRS administrative issues Lack of guidance on hedging transactions Lack of understanding of insurance products and hedging by IRS agents Internal communication issues Risk management/hedging departments not always communicating with tax Different GAAP, Stat and tax rules and terminology Single entity approach Taxpayer must elect entity by entity hedging approach Hedging – Issues (continued) 16 37th Annual Insurance Tax Conference

17. Equity Index Annuities Guaranteed minimum return with equity kicker based on an index MTM may be appropriate matching Derivatives to hedge future fee revenue against market declines Derivatives to hedge against product surrenders in event of future interest rate increases Hedging – Application for insurance companies 17 37th Annual Insurance Tax Conference

18. Pre-2008, generally some form of mark-to-market Generally not significant statutory or tax reserves for these benefits from 2003-2008 Product riders were not “in the money”, so there were net losses on the derivatives Market declines in 2008 produced significant economic liabilities and statutory reserves. Significant corresponding gains on the derivatives Companies decided to “refine” their methods Various approaches Recognize net losses----If there is a net gain, thenrecognize to the extent of current claims or reserve deduction. Defer any excess and repeat the next year. Mark to market and spread all gains and losses over actuarially determined timeframe. Accounting method change issues Hedging--Variable products 18 37th Annual Insurance Tax Conference

19. ACLI has undertaken an industry issue resolution (IIR) initiative Sponsored by LB&I Goal is to provide certainty in the tax treatment of derivatives used in hedging the guaranteed minimum death and living benefits of variable annuity products issued by insurers Development of a “safe harbor” method Administrability Simplicity Hedging—Variable Products Industry Issue Resolution 19 37th Annual Insurance Tax Conference

20. 1) Determine hedge gains or losses on all guaranteed minimum benefit hedge positions using a mark-to-market method. For this purpose, mark-to-market gains and losses would include all periodic swap receipts and payments 2) Recognize net losses currently Recognize net gains to the extent of current deductions—reserve increase and claims Defer excess gains to recognize against future losses or deductions. Subsequent losses offset deferred gains before being deducted. Recognize deferred gains on a FIFO basis. If no deductions within a five year period, recognize the gain no slower than the following five years ORIGINAL PROPOSED SAFE HARBOR METHOD 20 37th Annual Insurance Tax Conference

21. Proposal Revised on October 26, 2012 Determine hedge gains or losses on all guaranteed minimum benefit hedge positions using a mark-to-market method. For this purpose, mark-to-market gains and losses would include all periodic swap receipts and payments HEDGE GAINS 1) Any net hedge gains for a year are used first to offset and reduce any unrecognized losses carried forward from preceding years on a FIFO basis. 2) Recognize net gains to the extent of current deductions—reserve increase and claims Remaining gains carried forward Any deferred gains remaining after 5 years, recognized ratably over succeeding 5 years (10 year max deferral) REVISED PROPOSED SAFE HARBOR METHOD 21 37th Annual Insurance Tax Conference

22. HEDGE LOSSES 1) Any net hedge losses for a year are used first to offset and reduce any unrecognized gains carried forward from preceding years on a FIFO basis. 2) Net losses to the extent of increases in tax reserves are carried forward and treated as losses in succeeding year Remaining losses are deducted currently Any deferred losses remaining after 5 years, recognized no slower than ratably over succeeding 5 years (10 year max deferral) REVISED PROPOSED SAFE HARBOR METHOD 22 37th Annual Insurance Tax Conference

23. Even if a company only partially hedges, the full net tax deduction for all guaranteed minimum benefits would be taken into account Cost of hedge included in basis Valuation of MTM would follow statutory accounting Simplicity/Administration Transition Rule Adoption would be a change in accounting method Audit Protection if adopted in 2012 or 2013 Audit protection applies to affiliates and prior years SAFE HARBOR: ADDITIONAL DETAILS 23 37th Annual Insurance Tax Conference

24. 37th Annual Insurance Tax Conference REMICs/Re-REMICs 37th Annual Insurance Tax Conference

25. REMICs - Generally • What is a “REMIC?” • REMICs • A REMIC is a type of securitization vehicle that holds a fixed pool(s) of mortgages (or REMIC issued MBS) and issues to investors multiple classes of securities (“interests”) backed by that pool(s) of mortgages. The securitization of REMIC issued MBS (versus mortgage loans) is generally referred to as a “Re-REMIC.” • For tax purposes, the owner of the underlying mortgages or MBS is treated as contributing the mortgages to the REMIC in exchange for REMIC interests/MBS that may then be sold to investors. The REMIC interests are treated as newly created debt obligations of the REMIC. • REMIC interests represent an undivided interest in the underlying mortgages - the principal and interest paid on the underlying mortgages held by a REMIC flow through to REMIC interest holders based on the payment waterfall set by the REMIC deal documents. • Generally, all cash received by the REMIC must go out to its interest holders. 25 37th Annual Insurance Tax Conference

26. REMICs - Generally • REMICs are not taxed at the entity level, but must meet a number of requirements to maintain REMIC status: • In order to qualify as a REMIC, an entity or pool of assets must make a REMIC tax election, and, among other things, follow certain rules as to composition of assets. Further, the REMIC must structure investors’ interests as any number of classes of “regular” interests and a single class of “residual” interests. • If a REMIC fails to meet the requirements for REMIC qualification, it will generally be subject to the rules applying to taxable mortgage pools, and taxed at the entity level. • Because of the favorable tax treatment afforded to REMICs, REMICs are generally the vehicle of choice in issuing mortgage backed securities. 26 37th Annual Insurance Tax Conference

27. REMIC Regular Interests • The classes of regular interests issued by a REMIC are similar to tranches of debt, and, for federal income tax purposes, are treated as debt obligations of the REMIC. A regular interest must: • be issued on the REMIC’s start-up date; • be designated as a regular interest; • have a fixed term and interest payments based on a fixed or qualified variable rate; • and unconditionally entitle the holder to receive a specified principal amount. • Regular interests are typically issued in multiple classes of descending priority in the payment waterfall set by the REMIC’s deal documents. • The REMIC’s deal documents set forth how the cash flows, including prepayments, from the underlying mortgages are allocated to each class. The total cash payment and the stated coupon for each class is also set by the deal documents. • REMICs generally have a “sequential pay” structure subject to which all classes receive a stated coupon, but only the highest outstanding class receives principal. 27 37th Annual Insurance Tax Conference

28. REMIC Residual Interests • A residual interest in a REMIC is similar to equity in the REMIC and is a tax concept designed to ensure the current collection of tax on all of the REMIC’s taxable income. • A REMIC’s taxable income is the taxable interest income from the underlying mortgages, less the tax interest expense on the REMIC interests. • From a tax perspective, a REMIC resembles a partnership. The REMIC’s taxable income or loss is computed then allocated among the holders of the residual interests as taxable ordinary income or loss. The REMIC itself is not subject to tax. • If the structure of a REMIC’s regular interests mirrored the underlying mortgage pool exactly, there would generally be no difference between the REMIC’s taxable income and expense. However, because in the typical REMIC structure: • the underlying collateral is a fixed pool of fixed rate mortgages; but • the REMIC interests generally have a sequential pay structure, with senior interests having lower yields and shorter terms, and junior interests having higher yields and longer terms; • a REMIC’s taxable interest income generally does not match its taxable interest expense in each period. 28 37th Annual Insurance Tax Conference

29. REMIC Residual Interests • The typical pattern in a REMIC with a sequential pay structure is higher taxable interest income than interest expense in earlier years and the reverse in later years. The residual captures this timing difference. • Types of Residual Interests • Some residuals are structured to receive cash remaining in the REMIC after full payment of all the outstanding REMIC regular interests – these residuals (“economic” residuals) may receive cash distributions, but must also capture the timing difference between the REMIC’s income and expense. • However, a residual interest is generally structured so it will not receive any cash distributions from the REMIC (a “non-economic” residual, or “NER”). • As a result of the timing differences between a REMIC’s income and expense, the holder of a NER typically has taxable “phantom” or “excess inclusion” income (“EII”) during the earlier part of the life of the REMIC, and phantom tax losses during the later part of the REMIC’s life. 29 37th Annual Insurance Tax Conference

30. REMIC Residual Interests • The NER holder will increase its basis in the NER by the amount of EII, then reduce basis as the NER produces tax losses. The NER holder may take losses only to the extent of its basis in the NER. • In general, total EII will equal total tax losses over the life of the REMIC. • Because the NER holder will not receive cash distributions from the REMIC to cover its tax liability in earlier years, there is a carrying cost to holding the NER (i.e., the present value of the tax cost in the earlier years exceeds the present value of the tax losses/benefit in later years). As a result, an acquirer is typically paid an inducement fee to compensate the acquirer for the carrying cost of owning the NER. • Although a NER is similar to equity, a REMIC is generally considered a separate entity from the NER holder. The NER holder is not considered to earn directly the REMIC’s income items, nor is it considered to hold the REMIC’s assets subject to the indebtedness represented by the REMIC regular interests. 30 37th Annual Insurance Tax Conference

31. Example of a REMIC Structure • Originator lends money to Mortgagors, Mortgagors use loan proceeds to purchase real property. Originator receives mortgages secured by interests in the real property. • Originator sells mortgage pool to Depositor for cash. • Depositor contributes pool of mortgages to Trust, Trust makes a REMIC tax election. • REMIC issues REMIC interests to Depositor in exchange for mortgage pool. • For tax purposes, the Depositor no longer owns the mortgage pool. The Depositor owns all of the REMIC interests, of which the regular interests are treated as new debt obligations of the REMIC. • Depositor sells “regular” REMIC interests to Investors for cash. • Investors receive principal and interest on regular REMIC interests as principal and interest is paid on the underlying mortgages, subject to the terms of the payment waterfall set in the deal documents. • Depositor pays an acquirer to take the “residual” interest.

32. REMICs vs. Other Securitization Vehicles • Use of a REMIC provides tax certainty with respect to treatment of REMIC classes. • Types of collateral • Generally, REMICs may only hold “qualified mortgages” or certain “permitted investments.” • Other vehicles may not have REMIC-like tax restrictions on types of underlying collateral, however if the underlying collateral is MBS, the taxable mortgage pool rules may apply. • Source of income • A REMIC residual interest will always yield U.S. source income. • No explicit rules for REMIC regular interests. • If a non-REMIC securitization vehicle (e.g., a CDO issuer) is incorporated in a foreign jurisdiction, e.g., Bermuda, interest income on the issued debt will generally be foreign source income whether or not the underlying collateral is issued by U.S. issuers. • REMIC Trusts - PLR 201229003 32 37th Annual Insurance Tax Conference

33. 37th Annual Insurance Tax Conference Gain Recognition 37th Annual Insurance Tax Conference

34. Underlying positions are marked to market as of the day prior to entering the straddle Gains (or losses) are capital in nature Five Requirements for identified mixed straddle Cannot be part of pre-existing straddle The value of each position in the straddle must not be less than the basis. Appreciated securities must be actively traded. - To be actively traded a ‘debt market’ must exist. There are five conditions to meet for a debt market to exist Identified Mixed Straddle 34 37th Annual Insurance Tax Conference

35. Offsetting positions (1256 contracts) must substantially diminish the risk of loss on the appreciated securities. - Generally, positions are presumed to be offsetting (and substantially diminish risk) if the value of 1 position ordinarily varies inversely with the value of at least 1 other position. 5) Positions must be clearly identified before the close of the day the straddle is entered into. Internal identification (books and records) Identified mixed straddle account Independent identification-ID test is presumed met if independent identification Identified Mixed Straddle Continued 35 37th Annual Insurance Tax Conference

36. Timeframe to hold offsetting positions Economic substance < 1 day to 31 days Amortize “premium” from new basis? Audit Defense Identified Mixed Straddle: Other Issues 36 37th Annual Insurance Tax Conference