Posts Tagged ‘SSAP 43R’

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.

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.

Example:
P&C Company
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
Vice President
Investment Accounting

On September 14, 2009, the Statutory Accounting Principles Working Group adopted SSAP 43R, which provides guidance on recording other-than-temporary impairments (OTTI) on loan-backed and structured securities. The new pronouncement will supersede SSAP No. 98 – Treatment of Written downs When Quantifying Changes in Valuation and Impairments, an Amendment of SSAP No. 43 – Loan-Backed and Structured Securities, as well as, paragraph 13 of SSAP No. 99 – Accounting for Certain Securities Subsequent to an Other-Than-Temporary Impairment. It will be officially adopted at the NAIC’s fall meeting next week and will become effective for September 30, 2009 reporting. This memo outlines the new guidance, with the focus being on securities held by clients of AAM. Since SSAP 43R was based on FSP FAS 115-2 and 124-2: Recognition and Presentation of Other-Than-Temporary Impairments, it may be helpful to read this memo in conjunction with our April 24, 2009 memo (attached), which covered the newly adopted FSP.

When the holder of a loan-backed or structured security (“security”) with an unrealized loss position either has the intent to sell the security or does not have the intent and ability to hold the security for a period of time sufficient to recover the amortized cost basis, the security is OTTI and must be written down to fair value. The write-down shall be recognized in earnings as a realized loss.

When the holder of a security with an unrealized loss position does not intend to sell the security and has the intent and ability to hold the security for a period of time sufficient to recover the amortized cost, the security must be classified into one of three categories:

Category One

Category One includes securities that when purchased, were not of high credit quality (rated below AA) or securities that can be contractually prepaid or otherwise settled in such a way that the reporting entity would not recover substantially all of its investment (interest only strips). For these securities, the best estimate of future cash flows shall be used along with the current yield being used to accrete the security as the discount rate to determine a present value of the expected cash flows. If this present value is less than the amortized cost of the security, the security must be written down to this present value amount. The write-down shall be recognized in earnings as a realized loss. Using the effective interest rate method, the security shall be prospectively accreted over its remaining life to the undiscounted estimate of principal recovery.

Category Two

Category Two includes securities where the collection of all contractual cash flows are not probable. Category Two excludes securities that can be included in Category One. For these securities, the best estimate of future cash flows shall be used along with the security’s effective interest rate (book yield) immediately prior to the recognition of the OTTI as the discount rate to determine a present value of the expected cash flows. If this present value is less than the amortized cost of the security, the security must be written down to this present value amount. The write-down shall be recognized in earnings as a realized loss. Using the effective interest rate method, the security shall be prospectively accreted over its remaining life to the undiscounted estimate of principal recovery.

Category Three

Category Three includes securities where the collection of all contractual cash flows are probable. Category Three excludes securities that can be included in Category One or Two. For these securities, the best estimate of future cash flows shall be used along with the security’s effective interest rate at the acquisition of the security (trade yield) as the discount rate to determine a present value of the expected cash flows. If this present value is less than the amortized cost of the security, the security must be written down to this present value amount. The write-down shall be recognized in earnings as a realized loss. Using the effective interest rate method, the security shall be prospectively accreted over its remaining life to the undiscounted estimate of principal recovery.

AVR/IMR Implications

When an OTTI is recorded because there is intent to sell or the holder does not have the intent and ability to hold the security for a period of time sufficient to recover the amortized cost basis, the security is written down to fair value. The total loss recorded shall be bifurcated between the interest related loss and the non-interest related loss.

View diagram in original PDF.

The interest related portion shall be recorded through the IMR and the non-interest related portion shall be recorded through the AVR.

Transition

A cumulative effect adjustment shall be made to the July 1, 2009 balance of unassigned surplus for impairments recorded prior to July 1, 2009 under SSAP No. 98 or SSAP No. 43. The adjustment shall be calculated by comparing the present value of the cash flows and the amortized cost basis of the security as of July 1, 2009. The discount rate used to calculate the present value of the cash flows shall be the rate in effect before recognizing any OTTI.

Disclosures

Please refer to SSAP 43R for new disclosure requirements.

Joseph A. Borgmann, CPA
Vice President
Investment Accounting