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.

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• Clarifies that securities that have been downgraded since purchase from a rating of ‘AA’ or higher to a rating below ‘AA’ are not within the scope of EITF 99-20. Rather, FAS 115 applies for OTTI guidance.
• Specifies that securities within the scope of EITF 99-20 that have had an adverse change in cash flows since purchase shall be considered for other-than-temporary impairment analysis proscribed in FAS 115. Previously under EITF 99-20, securities within its scope were automatically considered other-than-temporarily impaired if there was an adverse change in the security’s projected cash flows, even if the security did not otherwise meet the OTTI criteria noted in FAS 115.
• Specifies that the cash flow projections used in an EITF 99-20 analysis should represent the investors best estimate of the amount and timing of principal and interest payments. Previously, the cash flow projections were to represent what a market participant would use to determine the fair value of the related security. A disconnect between the two streams of cash flows could occur if for example a worst case cash flow scenario was used to determine a security’s fair value.

The FASB is accepting comments on this FSP until December 30, 2008. It is expected to become effective for interim and annual reporting periods ending after December 15, 2008.

Joseph A. Borgmann, CPA
Vice President
Investment Accounting

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

Issued: November 5, 2008
Effective: January 1, 2009, with early adoption permitted

This pronouncement requires that when recording an other-than-temporary impairment related to a loan backed security, the security’s cost basis should be reduced to its fair value. Prior to the adoption of SSAP No. 98 and 99, the cost basis of an other-than-temporarily impaired loan backed security was written down to its undiscounted estimate of future cash flows.

Loan backed securities that have been previously impaired should be reviewed to determine if an additional write-down is warranted.

SSAP No. 99 — Accounting for Certain Securities Subsequent to an Other-Than-Temporary Impairment

Issued: September 23, 2008
Effective: January 1, 2009, with early adoption permitted

This pronouncement requires that after writing down a bond or redeemable preferred stock, whereby the cost basis of the security is reduced to its fair value, the difference between the new cost basis and the estimated recovery value (the new premium or discount) should be amortized or accreted over the remaining life of the security.

SSAP No. 99 also clarifies that any bond premium that is written-off upon recognition of an impairment shall be recorded as a realized loss versus a reduction to investment income.

Other Relevant Statutory Guidance:
INT 06-07: Definition of “Other Than Temporary”

One of the key concepts of this OTTI guidance is that there are two types of impairments – interest related impairments and credit related impairments. An interest related impairment is obviously caused by changes in the risk free interest rate, but also includes general credit spread widening due to “supply/demand imbalances” or “perceived higher/lower risk of an entire sector”. From a recognition standpoint, an interest related OTTI adjustment should be recorded when the holder has the intent to sell the position.

In contrast, a credit related impairment should be recognized when it is deemed other-than-temporary. Since we are currently experiencing a market where many securities have been trading at severely depressed levels, it is important to assess the issuers’ ability to make principal and interest payments when they are due. If the issuer is showing signs that indicate the inability to make these payments, the impairment should be considered credit related. If the issuer remains financially sound, the impairment is most likely interest related.

Annual Statement Changes
2008-22BWG

Effective: 2008 Annual Statement

With the adoption of 2008-22BWG comes a new (electronic) column to the Schedule D Parts 1 and 2, which indentifies the source of the fair value/market value used in the statement. Below are the codes that are to be noted in this column:

a — price is from a pricing service

b — price is from a stock exchange

c — price is from a broker or the insurer’s custodian **

d — price is determined by the insurer

e — price is from the SVO

** Broker must be approved by the insurer as a counterparty for buying and selling securities or be an underwriter of the security being valued and the broker’s or custodian’s pricing policy must be retained by the insurer.

Similar to AAM’s SFAS 157 level one, two, or three reporting, AAM will provide a year-end report to our client’s that specify our valuation sources in the format outlined above.

Joseph A. Borgmann, CPA
Vice President
Investment Accounting

Background

Securities are priced at AAM using a fully documented process consistent with FAS 157 that begins with a feed from leading pricing services. For securities that are not priced by the services, we obtain an observable input from a third party source, generally the broker-dealer that was the primary underwriter or is a lead market maker. In addition, our sector specialists review the prices obtained from the pricing services and, if an observable input would result in a more accurate price, then the sector specialist will document the source and change the price to the more accurate price.

It is important to point out that in volatile markets the prices provided by a pricing service may not reflect the fair value of a security at that point in time. In general, their pricing assumptions tend to lag the market movements. Thus, after spreads have widened and prices have dropped, as has happened over the past few quarters, prices from the services on average tend to be higher than true market prices. The reverse is likely to be true when yield spreads contract quickly.

We have observed that our clients’ auditors tend to accept the accuracy of pricing service information with little or no scrutiny. However, the process of using observable inputs to generate a more accurate price tends to result in significant scrutiny and testing. We stand ready to fully support these observable inputs and provide detail as to the source. This is fully consistent with FAS 157. We begin to have concerns when our clients’ auditors attempt to support this information with a confirmation from the broker-dealer pricing source. Our concern is that any attempt to obtain a signed confirmation from the pricing source will inevitably lead to policies by the broker-dealer community that prohibit their assistance with pricing. Broker-dealers currently provide pricing as a courtesy to their customers and will understandably avoid any legal risk associated with a signed confirmation.

In discussions with clients and third party insurance investment consultants, we have learned that at least some of the other insurance asset management providers rely exclusively on the pricing feed from a pricing service. This is understandable in light of the heightened attention associated with using observable inputs to develop more accurate prices. If this is the case, then the security prices that their clients receive may not fully reflect the decline in market value in this spread-widening environment associated with a ‘flight to quality’.

Recommendation

Most insurance asset managers undergo a SAS 70 review of operational controls so that their clients can rely on the manager’s processes and procedures. The SAS 70 reviews that were performed for 2007 covered a number of areas, including pricing. Since FAS 157 was adopted late in the year, is not effective until 2008 for nearly all of our clients and the audit testing procedures for security pricing is currently being developed by the accounting firms, 2007 SAS 70 reviews did not involve detailed and rigorous testing of pricing policies and procedures. At AAM, we plan to significantly expand our 2008 SAS 70 review to include this testing. In the meantime, we are prepared to provide documentation to clients as to the pricing source for 2007 audits. We are not willing to ask that our pricing sources sign letters for pricing confirmation. This requirement will inevitably lead to their refusal to provide observable inputs for pricing purposes. If we are not able obtain accurate observable inputs from the brokerage community, our only pricing source will be pricing feeds from a third party provider that contain prices that do not accurately reflect fair value. We do not believe this is the intent of FAS 157 and owe it to our clients to avoid this outcome.

We are distributing this to clients, prospects and third party consultants and ask them to discuss this with their auditors. We would welcome any questions or feedback.

Last week, as the FASB decided not to defer the November 15, 2007 effective date of FAS 157, GAAP filers lost all hope for the ability to delay its adoption and preparation of related disclosures. The pronouncement requires companies to group their investments into the following categories:

Level 1 — Rate is an unadjusted quote from an active market
Level 2 — Rate was derived from “observable” inputs
Level 3 — Rate derived from some “unobservable” inputs

FAS 157 also requires companies to disclose a 1/1/2007 – 12/31/2007 roll-forward of their Level 3 investments. For reference, Citigroup’s 10Q SEC filing for June 2007 includes a good example of these disclosures.

To aid our clients in preparing these FAS 157 disclosures, AAM will be providing a report to clients that groups our pricing between the three categories. Please contact your client service representative for more information.

The Details

AAM obtains our pricing primarily from Interactive Data Corporation (IDC). Security prices that are not available from IDC or securities where the IDC prices are not reflective of fair value are priced based upon broker quotes.

Based on guidance received from IDC, we believe that the IDC prices used by AAM can be considered either Level 1 or Level 2. In addition, based on a review of how other companies have implemented FAS 157 and our interpretation of these new disclosure requirements, we believe broker-provided pricing can be considered Level 2. In the rare event where there are securities that are priced internally at AAM, using internal assumptions (without the support of broker-provided information), we will classify these securities as Level 3 for FAS 157. As with any newly issued accounting guidance, we strongly urge you to discuss your application of the guidance with your auditors and would appreciate any feedback.

On the NAIC Horizon

The NAIC – Securities Valuation Office (SVO) has put forth a proposal that a new Schedule D column be added, which requires insurers to classify investments among the following categories:

1 — Rate is determined by SVO
2 — Rate is determined by an approved pricing service
3 — Rate is determined by a stock exchange.
4 — Rate is determined by a broker or custodian
5 — Rate is determined by the insurer

This proposal is currently being looked at by the NAIC Blanks Working Group and will likely be added to the agenda this December for comment. We do not anticipate that this proposal will be implemented for year 2007 statutory reporting.

Joseph A.Borgmann, CPA
Vice President
Investment Accounting