Posts Tagged ‘Investment Accounting’

On Monday, November 29, 2010, the NAIC approved revisions to SSAP No. 100 – Fair Value Measurements (SSAP 100). The new guidance imposes new fair value disclosure requirements, which are effective for the December 31, 2010 reporting. AAM has developed reporting that will satisfy these new fair value disclosures. Our investment accounting clients can seamlessly use these new reports for their disclosure requirements, while non-investment accounting clients may have reconciling differences between the output of these reports and what should be disclosed using the reporting entity’s internal values.

Information on assets and liabilities that are measured and reported at fair value shall be disclosed within the revised SSAP 100 reporting requirements. The term “reported” corresponds with SSAP’s reporting requirements in determining if a security shall be carried at amortized cost or carried at the lower of amortized cost or market.

Below is a summary of the new reporting requirements…

To: Industry and Interested Persons
From: Mike Moriarty, Chair of the Valuation of Securities (E) Task Force
Members of the Valuation of Securities (E) Task Force
Re: Disclosure of Model and Assumptions to be used to Determine Risk – Based Capital for Residential Mortgage Backed Securities (RMBS) for the Year Ending 2009
Date: November 24, 2009

1. Introduction — On October 14, 2009 the Valuation of Securities (E) Task Force adopted a proposal that for year end 2009 reporting purposes, risk-based capital (RBC) for residential mortgage securities (RMBS) would be determined using a financial model instead of NAIC ARO credit ratings (the RMBS proposal). The RMBS proposal was adopted by the Financial Conditions (E) Committee on October 14, 2009 and adopted in turn by the NAIC Executive Committee and Plenary on November 5, 2009. On October 20, the NAIC Executive Committee authorized the NAIC staff to initiate a request for proposal process to identify financial modeling firms who could perform the assessment of insurer owned RMBS securities. The staff concluded this assignment and on November 17, 2009 recommended to the NAIC Executive Committee the selection of PIMCO Advisory to conduct the 2009 year end valuation of RMBS securities (the NAIC engagement). This recommendation was accepted. The Task Force held a regulator to regulator call on November 24, 2009 to hear a presentation from the SVO staff, PIMCO Advisory and NAIC consultants on the RFP process, PIMCO Advisory’s non-agency mortgage model and the assumptions that drive that model. This document summarizes the presentation made by PIMCO Advisory and the SVO staff to the Task Force and is released in anticipation of a public meeting to be held November 30, 2009 at which time the Task Force will present the detailed proposal to industry representatives and other interested persons.

2. The Model — The NAIC engagement requires PIMCO Advisory to conduct a loan level analysis of US RMBS using their proprietary non-agency mortgage model. The PIMCO Advisory analytical process actually refers to and consists of four sub-steps: a macroeconomic model, a mortgage loan credit model, a capital structure model, (often referred to as a waterfall model) and a final valuation. This final valuation is used to map securities to the current RBC process. This section provides an overview of the modeling process and identifies the kind of underlying assumptions that drive it.

a. The macroeconomic model projects future macroeconomic variables, specifically home price appreciation/depreciation (HPA/HPD) and interest rates. PIMCO Advisory’s HPA/HPD median-case scenarios are derived from a market standard regional and national HPA/HPD forecast. PIMCO Advisory also projects multiple HPA/HPD scenarios around this median using a proprietary time series model. While many macroeconomic assumptions, such as employment are embedded in the market standard HPA/HPD forecast to which the model is calibrated, they are not explicit variables utilized by PIMCO Advisory’s model. Forward-looking interest rates are another primary dynamic variable. Future interest rate paths are based on implied forward money market and mortgage interest rates. The projected mortgage rate curve is a function of 5- and 10-year swap rates and credit spreads.

b. The mortgage loan credit model projects loan performance based on macroeconomic variables (HPA and interest rate forecasts) and qualitative loan characteristics. Qualitative loan characteristics include static variables such as FICO, original loan to value ratio (LTV) and property type, as well as dynamic variables such as current loan to value mortgage rate resets and others.

Mortgage prepayment, delinquency and default are modeled using a transition rate methodology. Each loan underlying the RMBS is initially classified as performing or non-performing, then projected forward as it transitions between current and delinquent states or terminates through prepayment or default. This projection is done on an individual-loan basis. The probability of a loan transitioning among these states is estimated based on historical patterns, loan-level characteristics and macroeconomic variables. These transition probabilities are calculated using sub-models segmented by collateral type (sub-prime, Alt-A, jumbo etc.) and product type (fixed rate, adjustable rate) to capture the different behavior of these mortgage types. Once the probabilities are calculated, a Monte-Carlo simulation is used in which a random drawing against these calculated probabilities determines how the loan transitions or terminates each month.

The loss severity of defaulted loans is projected based on collateral deficiency (unpaid balance less REO sales price), lost interest (accrued as servicer advances), expenses (legal, property taxes, brokerage fees), and mortgage insurance considerations. Severity is driven by the projected HPA through the current marked-to-market cumulative LTV, as well as historical severity, mortgage rates, credit profile and loan types.

The severity, prepayment and default rates are used to calculate loan-level cash flows, which are aggregated into mortgage pool-level cash flows.

c. Once generated, pool-level cash flows are passed through the capital structure model to calculate the specific security’s principal losses. The model captures the set of rules that determine which bonds get paid principal and interest as mortgages pay off and which bonds take losses as mortgages default. The rules are determined by a deal’s legal documents.

d. A discount rate is applied to each bond’s losses to arrive at a net present value. The interest rate used to discount the bond flow will be the bond’s effective coupon rate.

Valuations are calculated under multiple scenarios because many bonds are highly non-linear and may have low or zero losses under the median scenario but suffer large losses under a more stressful scenario. In the multiple scenario approach used, the mortgage credit model and capital structure model are used to calculate the present value of losses under each HPA/HPD scenario, each of which has an associated probability. The final valuation is the probability weighted present value of losses.

3. Assumptions — The Task Force, in consultation with PIMCO Advisory, consultants and SVO staff has determined that the following assumptions will be used to value RMBS:

a. The median HPA scenario will be PIMCO Advisory’s standard base case scenario.

b. PIMCO Advisory will use its internal model to calculate four additional HPA paths (two more conservative and two more aggressive). The running of the additional paths is necessary to capture the credit convexity or “cuspiness” of the bonds.

c. The additional HPA paths will be constructed such that the median case scenario has a 50% probability of occurring, the aggressive and the conservative scenarios each have a 22.5% probability of occurring and the most aggressive and most conservative have a 2.5% chance.

d. The final valuation will be the probability weighted average of the present values of all losses under each HPA scenario.

e. All losses will be discounted at the bond’s effective coupon rate.

View the original PDF for the table that summarizes relevant probability weights for the HPA scenarios.

4. Quality Assurance/Control
In addition to PIMCO Advisory’s extensive internal quality control process, the SVO and consultants will conduct quality control checks of the valuation process. These checks will help to ensure that the valuation process is of the quality required. The SVO will run both aggregate quality analytics and randomly sampled CUSIP-specific bottoms-up assessments. Additionally, the SVO has confirmed that PIMCO has appropriate procedures in place to ensure that the analysis is free from conflicts of interest.

Disclaimer: 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. Any opinions and/or recommendations expressed are subject to change without notice.

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.

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:

GAAP

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.

Abnormal/Inactive Market
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.

SSAP

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
Vice President
Investment Accounting

Last week, FASB exposed the proposed FSP EITF 99-20-a, Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20. The FSP makes the following amendments and clarifications:

• 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

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

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

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

As an insurance asset manager, we have the following goals for the pricing of securities for our clients. Our primary goal is to develop a process that provides the most accurate price possible as of a given date, whether or not the pricing source is an electronic feed from one of the leading providers or other observable inputs. In addition, we stand ready to support valuations directly to clients for their own benefit or to support their audit and/or regulatory reviews. Our discussions with several accounting firms in conjunction with their 2007 audits suggest an increased focus on the pricing of securities as a direct result of FAS 157 and its implementation. Although FAS 157 is not effective until the fiscal year beginning after November 15, 2007, auditors seem to be testing as if it was effective at calendar year end 2007. We have observed a varied testing approach to year-end pricing among different audit firms and across different offices of the same audit firm. This is not unusual in the first year after the adoption of a new FASB statement. Our concern is the audit community, in its attempt to document pricing adequacy, may permanently impact the ability of the investment management industry to achieve its primary pricing goal of pricing accuracy. A recommended solution is outlined below.

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.

The Summary

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