Posts Tagged ‘INT 09-04’
The NAIC has proposed a modification to SSAP No. 43R that will change the method in which non-agency residential mortgage-backed securities are assigned NAIC designations. This change was deemed necessary as the Acceptable Rating Organization (ARO) ratings do not distinguish between RMBS securities with different forecasted recovery values.
The NAIC has contracted with an independent vendor, PIMCO, for the fourth quarter of 2009, for the purpose of forecasting losses for 18,000+ non-agency RMBS cusips held by insurance companies. PIMCO will utilize forecast assumptions related to economic conditions and loan level details to calculate an expected loss and corresponding intrinsic price (100 – expected loss) for each modeled security. Once an intrinsic price is derived, the model will provide carrying value ranges associated with the six NAIC rating designations for each security. A set of ranges will be provided for life companies and another set of ranges provided for P&C companies for each CUSIP. Insurers are to use these ranges in a multi-step process to (1) determine the securities’ carrying value (amortized cost or fair value), (2) determine the RBC charge associated with each RMBS, and (3) determine the NAIC rating to be reported in the Annual Statement.
The NAIC provided a security as an example of how the new methodology will work. In this example, the intrinsic price is $76, indicating a modeled loss of $24. For this example, as will be the case with each modeled non-agency RMBS, the NAIC also provided a grid to guide insurance companies through the process of determining carrying value and RBC treatment for year-end reporting.
The lower of cost or fair market value rules will not change as a result of the revised SSAP 43R guidance. An RMBS that is rated NAIC 3-6 and held by a P&C company or one that is rated NAIC 6 and held by a Life company is still carried at the lower of amortized cost or market (LCOM). However, the method to determine the rating has changed.
The first step of the RMBS ratings process involves identifying the NAIC designation for the purpose of determining the security’s carrying value (amortized cost or fair value). An insurer does this by applying a security’s amortized cost to the above grid to determine its corresponding rating. This rating is then applied to the P&C or Life LCOM rules to determine if the security shall be carried at amortized cost or market. In the example above, a P&C company with an amortized cost of $80 for the sample security will carry the position at LCOM due to the corresponding NAIC 4 rating.
The second step of the RMBS ratings process involves the determination of the security’s RBC charge and the NAIC rating that will be reported in the Annual Statement. In the example above, if fair market value for the sample security is $65, the P&C company will carry the position at $65 (LCOM), hold the item as an NAIC 1 for Annual Statement reporting purposes, and incur a 0.3% RBC factor in the asset risk calculation. An unrealized loss of $15 will affect capital & surplus on the balance sheet.
Amortized cost = $80
Fair value = $65
Step 1: Amortized cost of $80 translates to a NAIC 4, which triggers LCOM. Security is carried at fair value $65.
Step 2: Carrying value of $65 translates to a NAIC 1, which is the rating reported in the Annual Statement. Security has an RBC charge of 0.3%.
The assessment of market activity and market pricing to determine abnormal or inactive markets as described in SSAP Interpretation 09-04: Application of the Fair Value Definition (INT 09-04) is not affected by the proposed guidance. Under INT 09-04, assets that trade in active markets are valued using a market approach given the availability of observable inputs to arrive at fair value. INT 09-04 also provides guidance in identifying the assets for which a model price can be selected over a quoted market price for determining fair value in an inactive market.
The Valuation of Securities Task Force held a conference call on November 30th for the purpose of discussing the modeler’s assumptions. It remains unclear how assumptions related to home price depreciation will translate to collateral/deal specific forecasted default rates and loss severities. We’ll be closely following the details of the model assumptions to assess how they may differ from AAM’s quarterly modeling assumptions and will coordinate with clients as more information becomes available.
Joseph A. Borgmann, CPA
There has been a flurry of activity in the investment accounting world this past month related to fair value accounting and OTTI. All of which could have an impact on your first quarter reporting. We had been waiting for the dust to settle before we summarized the new guidance as outlined below:
FSP FAS 157-4: Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly
Effective Date: Reporting periods ending after June 15, 2009; early adoption (along with FSP FAS 115-2 and 124-2 and FSP FAS 107-1 and APB 28-1) is permitted for periods ending after March 15, 2009.
This FSP stresses that the objective of fair value measurement has not changed. It still should represent the Company’s best estimate of the consideration that would be exchanged in an orderly transaction. It is noted that the emphasis on using quoted prices for fair value measurement “has resulted in a misapplication of Statement 157 when estimating the fair value of certain financial assets.” Therefore, the purpose of this FSP is to clarify situations in which a Company should deviate from using quoted prices for fair value measurement. These situations exist when the volume and level of trading activity for a security have significantly decreased and the quotes generated from these transactions are not “orderly” (distressed or liquidation sales). Below are the factors noted in the FSP that indicate that a market is abnormal/inactive and the related price quotes are not from orderly transactions.
a. There are few recent transactions.
b. Price quotations are not based on current information.
c. Price quotations vary substantially either over time or among brokers.
d. Indexes that previously were highly correlated with the fair values are demonstrably uncorrelated with recent indications of fair value.
e. There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the Company’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risk.
f. There is a wide bid-ask spread or significant increase in the bid-ask spread.
g. There is a significant decline or absence of a market for new issuances.
h. Little information is released publicly (for example, a principal-to-principal market).
Price Quote is Not Orderly
a. There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current marketing conditions.
b. There was a usual and customary marketing period, but the seller marketed only to a single market participant.
c. The seller is in or near bankruptcy or receivership (distressed), or the seller was required to sell to meet regulatory or legal requirements (forced).
d. The transaction price is an outlier when compared with other recent transactions for the same or similar security.
If it is evident that the quotes are not a result of an orderly transaction, little or no weight shall be placed on the quote when estimating the fair value of the security. If the Company can not conclude that a quote is from an orderly transaction, the company should obtain sufficient collaborative evidence to support the Company’s fair value estimate.
FSP FAS 115-2 and 124-2: Recognition and Presentation of Other-Than-Temporary Impairments
Effective Date: Reporting periods ending after June 15, 2009; early adoption (along with FSP FAS 157-4 and FSP FAS 107-1 and APB 28-1) is permitted for periods ending after March 15, 2009
This FSP has significantly changed the GAAP Other Than Temporary Impairment (OTTI) model. In the previous model, a company needed to assert that it had the ability to hold an impaired security for a period of time sufficient to allow for a recovery in its fair value to its amortized cost basis. This requirement has changed to a) the company asserting that it does not intend to sell the debt security or b) that it is more likely than not the company will not be required to sell the debt security before its anticipated recovery. The new model also includes the concept of bifurcating an impairment loss between the credit related portion of the loss and the non-credit related portion of the loss. Additionally, the new model includes a comparison of the present value of expected cash flows of a security to its amortized cost basis and to its fair value to determine how an OTTI write-down shall be recorded. Before we go into detail on the methodology behind this comparison, it is important to understand how the present value of the expected cash flows of a security shall be calculated and how the impairment loss shall be bifurcated under this new FSP.
When estimating the stream of cash flows, the company should take into consideration all available information regarding the security. This should include, but is not limited to, prepayment assumptions, expected default assumptions, and the current condition of guarantor of the security. If the security is within the scope of EITF 99-20, the discount rate used in the present value calculation should equal the security’s current book yield (effective interest rate). If the security does not fall under EITF 99-20, the yield of the security at acquisition can be used.
In regard to the bifurcation of the impairment loss, the difference between the present value of the estimated cash flows and the amortized cost basis is considered the credit related portion of the loss. The difference between the present value of the estimated cash flows and the fair value is considered a non-credit related portion of the loss.
View diagram in original PDF.
Now to the new model:
The existence of a credit loss (amortized cost is greater than the present value of the expected cash flows) indicates that a security is OTTI.
Company intends to sell the impaired security at a loss.
- OTTI write-down is required. The difference between Amortized Cost and Fair Value is recognized as a loss in earning.
It is more likely than not that the Company will be required to sell the security for an amount less than the current present value of the expected cash flows.
- OTTI write-down is required. The difference between Amortized Cost and Fair Value is recognized as a loss in earning.
Company does not intend to sell the OTTI security at a loss and it is more likely than not that the Company will not be required to sell the security for an amount less than the current present value of the expected cash flows.
- OTTI write-down is required. The credit loss is recognized through earnings. The non-credit loss is recognized in accumulated other comprehensive income.
- Upon recording the OTTI write-down, the cost basis of the security will equal the present value of the expected cash flows. Using the effective interest rate method, the security shall then be accreted over its remaining life to the undiscounted estimate of principal recovery. If the security is classified as available-for-sale, the accretion shall be recognized in earnings. If the security is classified as held-to-maturity, the accretion is recognized in accumulated other comprehensive income.
Company does not intend to sell a security that was written down in a prior period and it is more likely than not that the Company will not be required to sell the security before recovery of its amortized cost.
- The Company shall reclassify a portion of the previously recorded impairment from retained earnings to accumulated other comprehensive income.
- The amount of the reclassification shall equal the difference between the amortized cost of the security and the present value of the expected cash flows. The security’s yield, prior to the impairment write-down, shall be used as the discount rate to calculate the present value.
- Using the effective interest rate method, the security shall then be accreted over its remaining life to the undiscounted estimate of principal recovery. If the security is classified as available-for-sale, the accretion shall be recognized in earnings. If the security is classified as held-to-maturity, the accretion is recognized in accumulated other comprehensive income.
The FSP also requires additional disclosures and a specific presentation related to OTTI write-downs. Please refer to the pronouncement for details.
FSP FAS 107-1 and APB 28-1: Interim Disclosures About Fair Value of Financial Instruments
Effective Date: Reporting periods ending after June 15, 2009; early adoption (along with FSP FAS 157-4) is permitted for periods ending after March 15, 2009
This FSP requires companies to include FAS 107 disclosures in the quarterly reporting. It also requires disclosure of the methods and significant assumptions used to estimate the fair values and a description of any changes in these methods and assumptions during the period.
INT 09-04: Application of the Fair Value Definition – EXPOSURE DRAFT
Comment period: Ending April 30, 2009
Tentative Effective Date: Periods ending on or after March 31, 2009
The current version of this exposure draft reiterates the guidance in FSP FAS 157-4: Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. Refer to the paragraphs above for details regarding this FSP.
SSAP No. 98: Treatment of Cash Flows When Quantifying Changes in Valuation and Impairments, an Amendment of SSAP No. 43 – Loan-Backed and Structured Securities
The NAIC has delayed the effective date of SSAP 98 until September 30, 2009, with early adoption permitted. Previously, it was effective January 1, 2009. SSAP 98 requires insurers to write down other-than-temporarily impaired loan-backed securities to fair value. With its delay, insurers can continue to apply guidance in SSAP 43, which requires other-than-temporarily impaired loan-backed securities to be written down to the undiscounted estimate of future cash flows.
Joseph A. Borgmann, CPA