Posts Tagged ‘Fair Value Measurements’

Executive Summary

As the reverberations from the Subprime Mortgage Crisis continue to impact the economy, capital markets and ultimately structured products securities, insurance companies face ongoing issues related to valuation guidance prescribed by the NAIC and FASB for these securities. While the Subprime Crisis has been well-documented and vetted through the mainstream media, there has been a dearth of education for investors regarding appropriate and practical methods for valuing these fixed income securities, especially the scenario modeling of cash flows to derive a fair value estimate. The following discussion is divided into two parts. The first part provides a framework for constructing a cash flow model that can be used by insurance companies in conjunction with their internal/external asset management to develop fair value estimates for nonagency RMBS. The second part is an auditor’s perspective on what assumptions create significant variability in the financial reporting process, and as such are more likely to be questioned by auditors.

Background

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157: Fair Value Measurements (FAS 157), which provided a universal framework for fair value estimations. The standard called for valuation to occur from an “exit” price standpoint, or the value a buyer would receive to sell an asset or paid to transfer a liability in an active market. Subsequently, the financial markets experienced the most significant recession since the 1930’s, causing a plethora of valuation difficulties as markets saw trading volume temper to the point of inactivity. These difficulties have caused FASB to make several modifications to FAS 157, which are now included within FASB Accounting Standards Codification (ASC) Topic 820 – Fair Value Measurements and Disclosures.

Non-agency residential mortgage backed securities (non-agency RMBS) represent one particular market that has experienced these valuation issues. Insurers have traditionally been significant investors in RMBS and other asset-backed securities due to the historically attractive risk-adjusted yield opportunities. However, the housing market began to “bubble” as lending practices across the U.S. grew more creative while borrower classifications became more convoluted as further variability was introduced into borrowers’ rates. Ultimately, the “housing bubble” burst, causing these securitized pools of mortgage loans to lose significant value as homeowners continued to struggle to make mortgage payments, thus slowing, or in some cases ending, the cash flow to security holders. The financial crisis exposed the fact that many security owners may not have fully understood the securitization process and makeup of the mortgages underlying their investment. Financial reporting problems resulted across many industries and the accounting community called for accounting standards to further expand fair value and impairment definitions.

For entire document, view original document (PDF) below.

When SFAS Statement 157, Fair Value Measurements was issued in September 2006, the Statement’s underlying concepts of fair value (an exit price) and the fair value hierarchy (more emphasis is to be placed on market transactions when determining a security’s fair value) seemed reasonable. It was understood at the time that a level 3 price, which is a fair value calculated based on unobservable market inputs, would carry less weight by market analysts. However, in that benign market environment it was not a challenging task to obtain reasonable and observable market data to support fair value measurements. Today, with liquidity and trading volumes near all time lows, it can be difficult to obtain observable market data to support a fair value. Further, even when there is observable market data, it can be challenging to ascertain if the market data is related to orderly transactions between two willing parties, which should only be used to support a true exit price, or if the transactions are a result of distressed sales or forced liquidations.

This past September the FASB and the SEC released a document that answered questions surrounding fair value accounting. Below are several excerpts from the memo:

• “The determination of fair value often requires significant judgment”
• “Determining whether a particular transaction is forced or disorderly requires judgment”
• “The determination of whether a market is active or not requires judgment”
• “Determining whether impairment is other-than-temporary is a matter that often requires the exercise of reasonable judgment based upon the specific facts and circumstances of each investment”

The individuals who are deeply involved with establishing the fair values of investments or making impairment decisions should completely agree with the bullet points above. There are several characteristics that are indicative of an impaired security (length of time and severity of unrealized loss position) or transactions resulting from an inactive market (significant spread between bid and ask prices). However. making these ultimate decisions requires the input and judgment of those most familiar with the underlying facts and circumstances of the particular situation. Therefore, I would first like to encourage insurance companies to review their internal policies surrounding the determination of impaired securities and consider using the wording “reasonable judgment” as a component of your impairment policy. Secondly, I encourage these insurance companies to schedule some time with their asset manager to discuss the specific details surrounding any securities that, on the surface, appear to be other-than-temporarily impaired.

We recently met with a well respected Chicago based accounting firm to discuss FASB 157 and OTTI related issues. The members of this firm were impressed to see the level of security-specific information available to AAM’s clients and believed that their firm’s audit procedures could be completed much more efficiently if this information was available to them. It is apparent that auditors will be requiring more investment related information in discussions regarding impairments. AAM acknowledges this, believes the audit community should agree with this concept of reasonable judgment and is prepared to provide you with the necessary information to be prepared for your upcoming audit.

Joseph A. Borgmann, CPA
Vice President
Investment Accounting