AAM Investment Accounting Update – January 2012

Compared to the past several years, 2011 was relatively a quiet year in terms of new and significant changes in the way we account for investments.   This summarizes the changes that did occur and the investment accounting topics that are on the horizon.


Structured Securities Rating Process

The NAIC designations for all securities that fall under the scope of SSAP No. 43R are calculated based on any of the following:

  1. The NAIC’s (PIMCO’s) RMBS Model
  2. The NAIC’s (Blackrock’s) CMBS Model
  3. The Modified FE (Filing Exemption) Rule
  4. A SVO (Securities Valuation Office) generated designation

In late 2010 (effective 2011), the NAIC expanded the scope of SSAP No. 43R to essentially include all securities issued from a trust or securities where the holders’ only recourse is to the assets within the trust and not the ultimate issuer (parent company). This change caused securities such as hybrids, military housing, credit tenant lease (CTL) and equipment trust certificates (ETCs) to become SSAP-43R securities. Given the expanded scope of SSAP No. 43R and the fact that the Modified FE rule penalizes premium dollar BBB to CCC securities, the industry wanted the Modified FE rule to go away. Opponents to the rule argued that it is not realistic that a single CUSIP, purchased at different prices, could have different designations and that the Modified FE rule could create arbitrage opportunities. After much deliberation, the Modified FE rule remains effective, but two important and positive changes were made:

Modified FE Rule Changes:

  • CTLs and ETCs were carved out of its scope. The NAIC designations for these asset classes shall either be equal to an SVO generated designation or calculated by converting the security’s ARO ratings to an NAIC equivalent.
  • The rating “staleness” criteria was removed. The rule previously required that all ARO ratings used when applying the rule be based on a review that occurred not more than 12 months from the reporting date. Since recent SEC and European Union requirements were put in place in 2011 which requires securities to be reviewed annually, the NAIC was comfortable removing this staleness criteria.

In 2010, the NAIC designations of structured securities ended with a “Z*” suffix to indicate that the asset class was under regulatory review. Since the asset class is no longer under review, one of the following new suffixes should be used instead:

AM – Indicates the designation was calculated using ARO ratings in conjunction with the Modified FE rule.

FM – Indicates the designation was calculated using RMBS/CMBS modeled data.

SM – This indicator is included in the Annual Statement Instructions. However, at the Fall 2011 meeting of the Valuation of Securities Task Force, it was eliminated and therefore should not be used.

Below is a link to a useful flowchart, which outlines the process of rating SSAP 43R securities:


Filing Exemption Lists for Government Securities

The SVO made several significant changes to the Filing Exemption Lists for Government Securities. The most notable change was the addition of the FDIC.


Fair Value Measurement (ASC 820)

In May 2011 the Financial Accounting Standards Board (FASB) amended the current Fair Value Guidance by issuing ASU No. 2011-04. The primary purpose of its issuance was to achieve converged U.S. GAAP/IFRS guidance. Although the amendment was quite large from a size (pages) perspective, it does not significantly change the application of existing fair value guidance. However, it may require additional disclosures.

Below are the significant accounting principles related clarifications/amendments in general terms:

  • The “highest and best use” principle can not be applied to financial assets since they are perceived to only have one use.
  • The fair value of a company’s own illiquid equity interests, distributed in situations such as business combinations, or liabilities where a quoted price for the transfer if an identical or similar liability is not available, should be based on the value of the instrument from the perspective of the asset holder.
  • Certain criteria must be met for portfolios managed specifically with a risk management strategy to be measured as a whole versus at an individual security basis (hedging).
  • Clarification is provided regarding the inclusion of premiums and discounts when measuring fair value.   Illiquidity discounts should be incorporated in fair value, but a “block discount” (odd lot) should not be incorporated.

Below are significant disclosure amendments / additions:

  • Disclosure of any reasons for all transfers between Level 1 and Level 2 (only required for public companies).
  • Expansion of quantitative and qualitative inputs used in the measurement process of Level 2 and 3 securities. These disclosure requirements mirror the Annual Statement’s Note 20 (4).
  • Description of the Valuation Process surrounding Level 3 Pricing
    • Description of Company’s Valuations Group, whom the Group reports to, and its internal reporting policies
    • Frequency and methods used to test pricing models (back testing)
    • Process used to examine changes in fair value across reporting periods
    • Support that third-party pricing is in accordance with ASC 820
  • Sensitivity of Level 3 pricing to changes in the significant unobservable inputs. Below is an example disclosure taken from an Accounting Standards Update:

The significant unobservable inputs used in the fair value measurement of the reporting entity’s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption[1].

On the Horizon

FASB – Accounting for Financial Instruments

In May 2010, FASB released the Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. This exposure draft (ED) broadened the use of fair value measurement among financial instruments. However, since its release, there have been several changes that have scaled back this expansion. For example, the original ED required financial assets such as loans, core deposit liabilities and an entity’s own debt to be measured at fair value; the current version allows amortized cost. Additionally, the original ED required financial instruments that contained an embedded derivative (convertible bonds) to be measured at fair value with changes in value recorded in net income (FAS 115 Trading Classification). The current version retains the ability to bifurcate the host contract and the embedded derivative. Overall, the current guidance requires the classification and measurement of financial assets to be dependent on the characteristics of the financial assets as well as the entity’s investment strategy. The ability of a security to be prepaid such that the investor would not recover substantially all of the initial investment (interest only strips) is an example of a characteristic that would force a fair value through net income classification. Further, a company could have different measurement classifications for the same investment, if these same financial assets are held in different portfolios, with different investment strategies.   Below is a summary of the three proposed measurement classifications: Fair Value with changes recorded in Other Comprehensive Income (FV-OCI), Fair Value with changes recorded in Net Income (FV-NI), and Amortized Cost (AC).

Derivatives or hedging instruments not designated as cash flow hedges or instruments to hedge a net investment in a foreign operation Investment transferred to the issuer will be returned to the investor at maturity Investment transferred to the issuer will be returned to the investor at maturity
Instruments that can be contractually prepaid such that the initial investment will not be substantially recovered Total return strategy by either collecting contractual cash flows or selling the investment Investments that are associated with consumer lending or financing activities
Marketable equity instruments Interest rate or liquidity risk management strategy by holding or selling the investment Investments that give the holder the ability to manage credit risk through negotiation with counterparty
At purchase, the investment is held for sale   Sales or settlements only acceptable if they are made to manage risk or more specifically to reduce credit loss
Initially measured at Fair Value Initially measured at transaction price Initially measured at transaction price
Note: Subsequent reclassifications are not permitted

The ED is also proposing a new “three bucket” approach to the review and recognition of impairments:

Bucket 1 Bucket 2 Bucket 3
Securities with little or no credit loss deterioration since acquisition Securities with significant credit loss deterioration since acquisition Securities with significant credit loss deterioration since acquisition
Impairment allowance calculation based on expected losses associated with pools of assets Impairment allowance calculation based on expected losses associated with pools of assets Impairment allowance calculation based on expected losses of the individual assets
Impairment allowance shall represent the pool’s losses that are expected to occur over the next 12 months Impairment allowance shall represent the pool’s losses that are expected to occur over the lifetime of the assets Impairment allowance shall represent the individual asset’s losses that are expected to occur over their lifetime

The “pools” associated with Buckets 1 and 2 are asset groupings, based on similar investment and risk characteristics.

The expected loss amount calculation shall be calculated based on a range of possible outcomes. Estimates of the likelihood of each outcome shall be made and the expected loss value should be a probability-weighted average. The guidance mentions that a loss rate method, which incorporates probabilities of default and loss given a default or a collateral valuation method would also be acceptable for calculating expected losses.

Transfers between the buckets can occur as credit deteriorates or when it improves.

It is important to note that this guidance is still being developed. Similar guidance (IFRS 9) has been issued by the International Accounting Standards Board (IASB) and its effective date has recently been extended to January 1, 2015. This extension was primarily made so the final U.S. GAAP guidance could be evaluated before IFRS 9 becomes effective.

NAIC Designation Recalibration Effort

The NAIC has studied the historical default rates, by ARO rating, levels and determined that different asset segments have significantly different historical default rates. For example, the default rates of Aaa corporate securities are comparable to the default rates of Ba and B non-general obligation municipal securities. Therefore, it is proposed that the ARO rating/NAIC designation mapping be different for the following asset segments:

  • Corporate Securities
  • Municipals
  • Asset-backed Securities

In addition to mapping changes, the proposal includes the expansion of NAIC designations, such that there could be an NAIC +1 and an NAIC 1. Given the number of factors (Asset Valuation Reserve, Risk-Based Capital, Modified FE Rule, Investment Policy) impacted by the NAIC designations, this proposal will be heavily deliberated.

Written by:

Joseph A. Borgmann, CPA
Vice President
Investment Accounting

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

[1] Financial Accounting Standards Board of the Financial Accounting Foundation, Accounting Standards Update, Fair Value Measurement(Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, No. 2011-04, May 2011, 128.

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