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Accounting & Tax Updates

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Coronavirus Disease 2019 (COVID-19) is a global pandemic that is affecting insurers, individuals and the economy as a whole.  With the increasing amount of cases that are resulting in “Stay at home orders,” the closing of non-essential  businesses,  and an increase in unemployment, some borrowers are having trouble making payments on loans.  In response to COVID-19, the Financial Condition (E)Committee issued guidance on March 27, 2020 to encourage insurers to work with borrowers who are unable to make contractual payment obligations because of the effects of COVID-19.  

The committee supports the use of prudent loan modifications that can mitigate the impact of COVID-19 on the economy.  The committee adopted INT 20-03:  Troubled Restructuring Due to COVID-19 and INT 20-04:  Mortgage Loan Impairment Assessment Due to COVID-19 that are discussed below.

INT 20-03:  Troubled Restructuring Due to COVID-19

This interpretation adopts the provisions detailed in the March 22, 2020 “Interagency Statement on Loan Modifications and Reporting for Financial Institutions working with customers affected by the Coronavirus.”  This interpretation addresses SSAP No. 36-Troubled Debt Restructuring and determines that a short term modification made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not considered troubled debt restructurings (TDR).  Any modification or deferral programs mandated by the federal or state will not be considered TDR.  Institutions are reminded that loans that have been restructured as described under this statement will continue to be eligible as collateral at the FRB’s discount window based on the usual criteria.  This interpretation is effective for the specific purpose to address loan modifications in response to COVID-19 and will be considered nullified when no longer available.

INT 20-04:  Mortgage Loan Impairment Assessment Due to COVID-19

This interpretation was adopted to address the impact of mortgage loan forbearance or prudent modifications on the statutory accounting and reporting requirements for mortgage loans, as well as investments with underlying mortgage loans in response to COVID-19, that were current as of December 31, 2019.  Investments in the scope of this interpretation include: 

  1. SSAP No. 37—Mortgage Loans:  All mortgage loans in scope of SSAP No. 37.   
  2. SSAP No. 30—Common Stock: SEC registered investments with underlying mortgage loans (e.g., mortgage-backed mutual funds).
  3. SSAP No. 43R—Loan-backed and Structured Securities: Securities in scope of SSAP No. 43R with underlying mortgage loans. This includes residential and commercial mortgage backed securities (RMBS & CMBS), and credit risk transfers (CRTs) issued through government sponsored enterprises (GSEs). Other investments in scope of SSAP No. 43R are also captured within this interpretation if the underlying investments predominantly reflect mortgage loan products. 
  4. SSAP No. 48—Joint Ventures, Partnerships and Limited Liabilities Companies: Investments in scope of SSAP No. 48 that have underlying characteristics of mortgage loans. These investments could include private equity mortgage loan funds.

For modification programs designed to provide temporary relief for borrowers due to COVID-19, current as of December 31, 2019, the  reporting entities may presume that borrowers are current on payments and are not experiencing financial difficulties at the time of the modification for purposes of determining impairment status and thus no further impairment analysis is required for each loan modification in the program. The exceptions granted in this interpretation are detailed as follows:  

  1. SSAP No. 37—Mortgage Loans:  Provide a limited-time exception for assessing impairment under SSAP No. 37, paragraph 16, for mortgage loans with payments (either principal or interest) that have short-term deferrals or modifications in response to COVID-19. This interpretation shall not delay impairment assessments for reasons other than the short-term deferral or modification of interest or principal payments in response to COVID-19 and shall not delay recognition of realized losses if a reporting entity believes a mortgage loan is OTTI.  RBC categories for mortgage loans will stay the same as classified for 12.31.2019 even if there is a deferment of payments from the effects of COVID-19.
  1. SSAP No. 30—Common Stock:  Provide a limited-time exception for assessing OTTI under SSAP No. 30, paragraph 10, and INT 06-07 due to fair value declines for SEC registered funds that have underlying mortgage loans that have been deferred or modified in response to COVID-19 unless the reporting entity intends to sell the security. If the entity has made a decision to sell the security, recognition of the OTTI shall continue to be required. As these investments are reported at fair value, declines in fair value would continue to be reported as unrealized losses.
  1. SSAP No. 43R—Loan-backed and Structured Securities: Provide a limited-time exception for assessing OTTI under SSAP No. 43R, paragraphs 30-36, due to fair value declines in investments that have underlying mortgage loans deferred or modified in response to COVID-19 unless the reporting entity intends to sell the security. If the entity has made a decision to sell the security, then recognition of an OTTI shall continue to be required.  For RMBS/CMBS securities that are financially modeled as of December 31, 2019, will keep the same NAIC designation and will not change even if there is a deferment of principal and interest from the effects of COVID-19.
  1. SSAP No. 48—Joint Ventures, Partnerships and Limited Liabilities Companies: Provide a limited-time exception for assessing OTTI under SSAP No. 48 due to fair value declines in investments that have underlying mortgage loans deferred or modified in response to COVID-19 unless the entity intends to sell the security. Additionally, an OTTI shall be assessed if factors other than the mortgage loan forbearance or modification have resulted with a decline that is considered other than temporary, or the reporting entity does not believe it is probable they will collect the carrying amount of the investment.  RBC categories for Schedule BA mortgages will stay the same as classified for December 31, 2019, even if there is a deferment of payments from the effects of COVID-19.

The exceptions granted in this interpretation are applicable for the March 31st and June 30th, 2020 (1st and 2nd quarter) financial statements and only in response to mortgage loan forbearance or modifications granted in response to COVID-19. As the exceptions provided in this interpretation are not applicable in the September 30, 2020 (3rd quarter) financial statements, this interpretation will automatically expire as of September 29, 2020.

Sources: “Statutory Accounting Principles (E) Working Group, INT 20-03 –Troubled Debt Restructuring Due to COVID-19” “Statutory Accounting Principles (E) Working Group, INT 20-03 –Troubled Debt Restructuring Due to COVID-19” “Financial Condition (E) Committee Memo on COVID-19”

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Quarterly and Annual Filings

Updated Administrative Symbols, Market Indicators, and General Interrogatory (2018-07 BWG MOD)

• S -Additional or other non-payment risk

• FE -Filing Exempt

• FM -Financially Modeled RMBS/CMBS subject to SSAP 43R

• AM- Analytically Modeled subject to SSAP 43R

• YE -Year-end carry over

• IF –Initial Filing carry over

• PL -Private Letter Rating- (Securities issued on or after Jan. 1, 2018)

• PLGI -Private Letter Rating -reported on General Interrogatory – (Securities issued prior to Jan. 1, 2018)

• Z -Insurer  Self-designated because reporting status of security is in transition

• GI -General Interrogatory– (Only used for self-designated 5 designations)

• F -Sub-paragraph D Company – Insurer self-designated

• * – Limited to NAIC Designations 6

Please note the symbols P and RP for Perpetual and Redeemable Preferred stock have been eliminated and new reporting lines have been added to the Schedule D 2.1.  Effective date Annual 2019

SSAP 43 R – Loan Backed and Structured Securities  – Elimination of Modified Filing Exempt (MFE) (2018-19)

Since the adoption of Modified Filing Exempt(MFE), the impact that it has on securities has been evaluated.  It was noted by the Task Force that MFE would negatively impact the implementation of the more granular risk-based capital (RBC) framework.  After this evaluation, there are revisions to SSAP No. 43R—Loan-backed and Structured Securities to eliminate the modified filing exempt process in determining the final NAIC designation for CRP rated securities.  All securities subject to SSAP No. 43R that are not Financially Modeled (FM) and have a CRP rating will be required to use the “other” process.  This process uses the equivalent NAIC designation to the CRP rating without adjustment.

Effective date March 2019 with the option to early adopt for Year End 2018. Early adoption is an “all or nothing” approach.  As such, the MFE approach must be used for all applicable securities if early adopting. 

Summary Investment Schedule Updates (2018-16)

With the revisions to the summary investment schedule, the categories will more closely align to the underlying investment schedules, allowing for cross-checks and less manual allocations. The revisions will also incorporate public and non-public allocations for common stock and mortgage loans categories.

Effective date Annual 2019.

SSAP 43 R – Loan Backed and Structured Securities –  Clarification reporting NAIC Designations as Weighted Averages (2018-03)

This agenda item addresses whether securities acquired at different purchase prices, can report NAIC designations under a weighted average method under the “financial modeling” process.  The Statutory Accounting Principles Working Group adopted, as final, revisions that require securities with differing NAIC designations by lot to be reported in aggregate at the lowest NAIC designation or in groupings by differing NAIC designations.

SSAP 26 R – Bonds – Prepayment Penalties (2018-32)

The previous guidance that was adopted to clarify the calculation of investment income for prepayment penalty and/or acceleration fees for bonds liquidated prior to scheduled termination, only addressed situations when amounts received exceeded par.  This revision provides guidance for called bonds when the amount received is less than par. In the event the Book Adjusted Carrying Value (BACV) is greater than consideration received, the entire difference should be reported as income. If there is a process in place to identify prepayment penalty or acceleration fees, these should be reported as income.  After this determination, the difference between the remaining consideration and the BACV should be reported as realized gain.  

Structured Notes (2018-18)

During the 2019 Spring National Meeting, the Statutory Accounting Principles (E) Working Group adopted as final, to clarify the accounting and reporting guidance for Structured notes.

Pursuant to the adopted definition, a structured note is defined as an investment that is structured to resemble a debt instrument, where the contractual amount of the instrument to be paid at maturity is at risk for other than the failure of the borrower to pay the contractual amount due. Structured notes reflect derivative instruments (i.e. put option or forward contract) that are wrapped by a debt structure. The adopted revisions include the following:

1. SSAP No. 2R—Cash, Drafts, and Short-term Investments:  Derivative instruments shall not be reported as cash equivalents or short-term instruments regardless of their maturity date.

2. SSAP No. 26R—Bonds:  Structured notes are explicitly excluded from the scope of SSAP No. 26R.

Although these instruments are structured to resemble a debt instrument with a “debt wrapper” these instruments are not bonds.

3. SSAP No. 43R—Loan-Backed and Structured Securities:  Structured notes that are mortgage-referenced securities are in scope of SSAP No. 43R.

4. SSAP No. 86—Derivatives:  Structured notes, excluding mortgage-referenced securities in scope of SSAP No. 43R, are considered derivative instruments and shall be captured in scope of SSAP No. 86.

The Structured Note Disclosure Note 5O, is no longer required.  Effective date December 31, 2019. 

Add Designation Column to Schedule D, Part 2, Section 2 (2019-3BWG MOD)

A NAIC designation column will be added to the Schedule D, Part 2, Section 2 for use with mutual funds.  This will identify fund investments that have been assigned an NAIC designation by the SVO under the instructions in the Purposes and Procedures Manual.  Effective date Annual 2019.

Clarification of the Wash Sale Disclosure (2019-22)

The Statutory Accounting Principles (E) Working Group adopted to clarify that only investments that meet the definition of a wash sale in accordance with SSAP No. 103R that cross reporting periods are subject to the wash sale disclosure.  This eliminates the need to report transactions that meet the wash sale criteria in SSAP No. 103R that are within the same reporting period.  Wash sales that cross either a quarterly or annual reporting period must be disclosed.

Freddie Mac Single Security Initiative (2019-02) – INT 19-02-Single Security Initiative

The Statutory Accounting Principles (E) Working Group adopted INT 19-02 Single Security Initiative to incorporate a limited-scope exception to SSAP No. 26R Bonds and SSAP No. 43R to require Freddie Mac securities exchanged in accordance with the Single Security Initiative to recognize the new security at amortized cost, rather than fair value.  Furthermore, consistent with Freddie Mac’s treatment, the float compensation received shall be recognized as an adjustment to the cost basis of the security.  The interpretation will be nullified when the exchange conversion process has been terminated.

43R Equity Investments (2019-21)

During the Summer National Meeting, the Working Group exposed revisions to SSAP No. 43R – Loan-backed and Structured Securities to exclude collateralized fund obligations, and similar structures that reflect underlying equity interest, from the scope of the statement, as well as prevent existing equity assets from being repackaged as securitizations and reported as long-term bonds.  It appears the Valuation of Securities Task Force is leaning towards making these securities ineligible for FE status, which means the  SVO would rate them on a case-by-case basis for 2020 year-end, but industry groups are voicing concerns. 

GAAP Updates

Credit Losses/Impairments

In June 2016, the FASB issued Financial Instruments – Credit Losses (Topic 326):  Measurement of Credit Losses on Financial Instruments (ASU 2016-13). This standard includes the current expected credit loss (CECL) method, which requires reporting entities to establish an allowance for credit losses that are expected to be incurred over the lifetime of the assets. At each reporting period, the allowance should represent Management’s current estimate of the expected credit losses. The estimate should be calculated after grouping the financial assets into pools based on their risk characteristics. If a financial asset cannot be grouped into a pool, it can be evaluated individually. The movement in this allowance would be recognized in income. Therefore, this model allows for an immediate reversal of credit losses recognized on assets that have an improvement in expected cash flows.

Although this standard includes most debt instruments,  securities classified as available-for-sale (AFS) are not included in the CECL model.  However, the credit loss guidance for AFS securities will be moved from Topic 320 to Topic 326, along with some targeted changes:

• An allowance for credit losses would be calculated at the individual security level each reporting period.  The allowance would be equal to the amount that amortized cost exceeds the present value of expected future cash flows.  However, the  valuation allowance for credit losses shall not exceed the unrealized holding loss.

• This approach allows for impairment losses to be reversed as credit losses or the impaired status evaporates.

• The requirement to consider the length of time a security has been underwater to determine if a credit loss exists would be removed.

• The requirement to consider additional declines in fair value or recoveries subsequent to the balance sheet date would no longer be required when estimating if a credit loss exists.

• An allowance for credit losses roll-forward disclosure will be required each reporting period.

In addition to AFS securities, the FASB decided to remove the following financial assets from the proposal’s scope:

• Loans made to participants by defined contribution employee benefit plans

• Policy loan receivables of an insurance entity

• Pledge receivables of a not-for-profit entity

• Related party loans and receivables

ASU 2016-13 will be effective for public, SEC filing entities, excluding entities eligible to be Smaller Reporting Companies as defined by the SEC, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  For all other entities, it will be effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.  

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Reproduced with permission from Jason Simkin, CPA | Simkin CPA, LLC – The Insurance Tax Advisory Firm

Just in time for the Government Shutdown, the IRS has issued the discount factor information necessary to run a calculation of the potential tax reform implications for Unpaid Loss, LAE, and Salvage/Subrogation reserves and recoverables. Up to this point companies have generally not updated their financials for the tax implications of this major item. Many of you have probably put a note in your 2017 financials stating that this and other aspects of the tax reform implementation would be accounted for in 2018. Thus, you are now faced with a decision for your year-end financials on if and how to use the specified factors to generate a tax reform adjustment for tax provision. A few important observations:

1) What types of Companies are affected?

All P&C companies, as well as Life & Health companies that write certain A&H products (ex. Group Health, Med Sup, other A&H products excluding guaranteed renewable/non-cancelable, etc.)

2) What was provided in the Revenue Procedure?

a) Estimated Discount Factors to apply to all lines of business for the 2018 accident year (based on concepts in the Proposed Regulations)
b) Estimated Discount Factors to apply to all lines of business for 2017 and prior accident years to calculate the tax reform implementation adjustment to be amortized beginning in 2018 (based on concepts in the Proposed Regulations)

3) Were there any surprises in the Revenue Procedure?

One area that may provide a significantly more material impact to your financials than many were expecting is the approach to computing the tax reform adjustment and future discount factors for all accident years prior to 2018. The approach may be significantly more material as the change covered more years and more aspects of the calculation methodology than many anticipated. These are the potential computations of the tax reform adjustment that were considered, as well as the IRS’ selection in the Revenue Procedure:

a) Not Selected – Follow the 2016 and prior IRS historical industry payment pattern/discount factors and continue to run off those accident years under historical IRS patterns. For the 2017 year the unpaid losses and LAE would be computed using historical industry payment patterns but with the 2017 corporate bond rate.
b) Not Selected – Follow the 2016 and prior IRS historical industry payment pattern but replace the discount factor for those years with a corporate bond rate for that vintage year. For the 2017 year the unpaid losses would be computed using IRS historical industry payment patterns but with the corporate bond rate.
c) IRS Revenue Procedure Selection – The following is the summary from our firm’s discussions with Kathryn Sneade, the principle author of the Regulation and Revenue Procedure, as you will find that some of the underlying assumptions are not explicitly discussed in the Revenue Procedure. Thus, the following may ultimately be changed/clarified in future IRS commentary. Kathryn explained that for 2017 and prior they basically discarded all vintaged historical payment patterns and discount rates for all accident years 2017 and prior. They replaced those payment patterns and discount factors with the 2018 payment pattern and 2018 corporate bond rate. Thus, all years 2017 and prior are not only recomputed with a new discount rate but also with a new payment pattern independent of the payment pattern for that vintage year. For future years (i.e. 2019 and forward) she stated that they would go back to each accident year being vintaged with respect to payment pattern and interest rate. However, the 2018 and prior accident years would continue to use the 2018 payment pattern and corporate rate. Depending on the lines of business you write and the specific accident years you have with unpaid losses the materiality of this approach may be substantially more than you anticipated.

4) Will the factors in the Revenue Procedure change and are the underlying concepts final or estimates?

The factors, which affect all accident years from 2018 and prior, were generally based on the IRS concepts and positions taken in the Proposed Regulations published in November. While unusual, the IRS released the Revenue Procedure with computational results of principles still open to change, and with the provision that it may revise them further after the Regulations are finalized.

5) Will the factors be finalized before company financials are issued?

A hearing for the public to comment on the Proposed Regulations took place on December 20th. The Comment period for the Revenue Procedure is open until February 6, 2019. It’s also not clear how long the Government Shutdown will last and whether it could cause a delay in this area. Thus, it’s possible that there will not be Final Regulations and a final Revenue Procedure until after many companies publish year-end 2018 IFRS/GAAP/STAT financials. This leaves you with a decision to make whether your applicable financial statement guidance (i.e. GAAP/IFRS/STAT) requires you to book a tax reform implementation adjustment based on the new Revenue Procedure, as well as how to account for any future change in the computations after the Regulation and Revenue Procedures are finalized.

Jason Simkin, CPA
Simkin CPA, LLC – The Insurance Tax Advisory Firm
5757 Alpha Road Suite 622, Dallax, TX 75240
Email: jasonsimkin@simkincpa.com
Office: 972-308-0044
Cell: 806-252-9069

The “IRS Tax Reform 2018 and Prior Disc Factors” and “Proposed Regulations – Discounted Unpaid Loss and Salvage and Sub” are provided as supplements in the corresponding PDF document.

Disclaimer: AAM is not providing tax advice. You should consult with your own tax advisor.

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What Does It Mean for Insurers?

by Jason Simkin, CPA and Peter Wirtala, CFA

Updated December 22, 2017:   The speculation, negotiations, and Congressional votes are over, and the tax reform bill has passed. At this writing President Trump has just signed the bill in a private event, concluding a political roller coaster that has made headlines repeatedly throughout the year. So, which provisions made it into the final bill, and which were modified or dropped?

First, as widely expected, corporate tax rates have fallen to a flat 21% rate, bringing them much closer to the average of other developed nations. Individual tax brackets have been significantly readjusted as well, though that is not our focus in this paper. The new rates will go into effect for tax year 2018, as the 1-year delay proposed by the Senate was ultimately rejected.

Secondly, the bill repeals the corporate Alternative Minimum Tax, a feature of the tax law that historically limited the use of tax-exempt municipal bond income for insurers. Existing AMT credits can be used to reduce regular taxable income in future years according to a simple formula. The repeal of the AMT is one of several provisions likely to significantly alter the relative value of tax-exempt municipal bonds for insurers. This will be discussed in more detail below.

Other noteworthy general corporate tax provisions that survived into the final version include:
– Immediate expensing of a large category of business property and fixed capital investments
– Limitation of the deduction for net interest expense to 30% of adjusted taxable income
– NOL carrybacks generated from 2018 onward are no longer permitted for life insurance or noninsurance companies; however, they can be carried forward indefinitely to reduce taxable income up to a limit of 80% taxable income. Property/casualty insurers’ NOL carryback (2 years) and carryforward (20 years) limits remain unchanged in the final bill.
– Significant reductions in deductibility of business meal and entertainment expenses and certain employee fringe benefits.
– Modest reduction in the percentage of dividend income eligible for the Dividends Received Deduction
– Public company executive compensation disallowance has been expanded significantly

In addition to sweeping corporate tax reform, the final bill also has a number of provisions specifically affecting the insurance industry. These include:

For life insurers:
o The small life insurance company deduction (which shields a portion of income from taxation for life insurers below $500 million in assets) is repealed.
o Tax-deductible reserves are set at 92.81% of actuarial reserves
o The policyholders’ share of investment income is set at 30%, and company share at 70%. Previously this required a complicated formula to calculate.
o Capitalization rates on policy acquisition costs are being increased by approximately 20%, and the 120 month amortization period is being extended to 180 months.
o Changes in methods of measuring reserves will be amortized over a time frame consistent with other general changes in accounting methods instead of 10 years.
o Remaining Policyholder Surplus Account deferred tax is accelerated and payable in 8 annual installments.

For P&C insurers:
o The company’s share of tax-exempt investment income declines from 85% to 75%
o A number of changes are made to the computation of tax reserves that are likely to increase taxable income, including:
 Using the corporate bond yield curve instead of historical industry payment patterns
 Extension of loss payment pattern computations
 Repealing the election to use company-specific, rather than industry-wide, historical loss payment patterns
– Though not a specific provision of the new law, the change in corporate rates will require revaluation of deferred tax assets/liabilities, in addition to affecting future development of the interest maintenance reserve and asset valuation reserve. For most insurance companies (small life companies being a notable exception) the revaluation will result in a substantial decrease in the net deferred tax asset/liability reported in surplus.
– For many insurance companies one unexpected consequence could be a further reduction in statutory surplus due to a decrease in the admitted DTA beyond that caused by the rate change. This can occur due to the statutory computation of the admitted asset. While complex and outside of the scope of this memo, generally deferred tax assets may be admitted based on a three-prong computation, one prong of which is a hypothetical carryback to recover taxes paid in the prior year. As mentioned above, the ability to carry back net operating losses is being repealed for life insurers, so their maximum admitted net deferred tax asset will now be limited to the other two prongs of the computation. P&C companies won’t be affected by this issue since they retain NOL carrybacks in the new law.
– Relatedly, for life insurers reporting under GAAP/IFRS accounting, the elimination of net operating loss carrybacks may place pressure on or require a valuation allowance against existing deferred tax assets in the company’s equity.
– Finally, many parts of the NAIC’s risk-based capital ratio calculation involve net-of-tax calculations, which will be significantly affected by the change in rates.

The above are the key provisions of interest to US insurers. Companies with significant overseas operations and cross-border affiliate transactions will be affected by the switch to a more territorial tax regime, cash repatriation opportunity, and base erosion minimum taxes, but we omit detailed discussion of these provisions for brevity.

How will tax reform affect insurer investment strategies? Probably in multiple ways, dependent in part on how investment markets respond. Historically P&C insurers have been major investors in tax-exempt municipal bonds, whereas life insurers have mostly avoided the sector due to limited ability to benefit from the tax exemption. This latter limitation is changing, as the “company share” of life insurer investment income is now being set at 70% (vs now 75% for P&C insurers), meaning both types of companies will have similar ability to benefit from municipals. However, demand for municipal bonds is typically set at the margin by taxpayers in the highest brackets, who have the most to gain from the exemption.

Under the new law all corporate income is taxed at 21%, but the highest individual rate is 37%. From this we would expect that high-income individual investors would receive the greatest benefit from munis, and thus be willing to pay the highest prices for them. This will potentially set market yields on munis at levels that are less attractive to insurers relative to other bond sectors (which are now subject to a much lower tax rate).

To illustrate this effect, it is common for insurers to calculate a “gross-up factor” to compare after-tax yields on tax-exempt bonds vs. after-tax yields on taxable bonds. Under the previous regime, for an insurer paying a 35% tax rate this factor was 1.4577, so a tax-exempt bond yielding a nominal 2.50% and a taxable bond yielding 3.64% produced the same level of after-tax income. Under the new regime this factor will decline to 1.200 (1.186 for life insurers), because while the tax-exempt bond produces the same after-tax yield as before (the change in proration offsets the change in the tax rate), the taxable bond now has a much lower rate than before. To compete with the 3.64% taxable bond, the tax-exempt bond must now yield 3.03%. But yields may not rise that far in practice, since the top rate for individual taxpayers (who comprise the majority of the market) isn’t moving much, so their supply/demand calculus may not change much.

For this reason, we expect the new law may lead to a gradual decline in tax-exempt municipal holdings by insurers, though this will partly depend on how the market ultimately adjusts in practice. Partly offsetting this potential is that, to the extent insurers continue to hold munis, life insurers may find this sector now makes sense in their portfolios where previously it did not. It’s also worth mentioning that the proposed limit on deductibility of interest expense could impact the supply of corporate bond issuance in certain sectors, which would in turn affect supply and demand across other bond sectors. This possibility will bear close attention as we move into 2018.

After months of speculation and uncertainty the saga of the tax reform of 2017 has drawn to a close, and insurers can now evaluate the impact of the law on their tax planning strategies, deferred tax assets/liabilities, and investment portfolios.

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. 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.  This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. 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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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INVESTMENT ACCOUNTING CHANGES
EVERY INSURANCE INVESTMENT OFFICER NEEDS TO KNOW

2016 Statement and statutory accounting changes

Quarterly and Annual Filings

[toc]

Schedule D Part 1 Guidance (2016-02BWG)

In December 2015, the Statutory Accounting Working Group issued a document to provide guidance on how to complete the description, issuer, issue, and capital structure information on Schedule D Part 1. In February 2016, the document was modified and added to the Annual Statement instructions. For Annual 2016 Schedule D parts 1 through 6 will have electronic only columns for Issuer, Issue, and ISIN to create consistency across the schedules. The electronic only column on Schedule D Part 1 for the Capital Structure Code was reduced to 4 categories shown below:

1. Senior Secured Debt
2. Senior Unsecured Debt
3. Subordinated Debt
4. Other

Effective Annual 2016.

Schedule D Part 1A Section 1 and Schedule D Part 1B (2015-25BWG)

For Schedule D, Part 1A, Section 1 (annual) and Schedule D, Part 1B (quarterly), the reference to “non-rated” was removed from the instructions and clarification instructions were added for Footnote “d” of Schedule D, Part 1A, Section 1 and Footnote “a” of Schedule D, Part 1B. The footnotes should include the total book/adjusted carrying value amount of securities reported in Schedule DA and Schedule E, Part 2 for the current statement filing by NAIC category.

Effective Annual 2016.

Foreign Codes (2016-06BWG)

The number of foreign codes on Schedule D have been reduced from 12 to 4 (see below) and the foreign code matrix has been removed.

A. For Canadian securities issued in Canada denominated in U.S. Dollars
B. For those securities that meets the definition of foreign provided in the Supplemental Investment Risk Interrogatories and pays in currency other than U.S. dollars
C. For foreign securities issued in the U.S. and denominated in U.S. dollars
D. For those securities that meet the definition of foreign provided in the Supplemental Investment Risk Interrogatories denominated in U.S. dollars (e.g. Yankee bonds, Eurodollar bonds)

Effective Annual 2016.

Bond Characteristics (2016-07BWG MOD)

The Schedule D Part 1 Annual Statement Instructions have added clarification to the Bond Characteristics Code column. If bonds have more than one characteristic, then the characteristics should be separated with a comma. If none of the characteristics apply, then leave it blank. The new bond characteristics are below:

  1. Bonds that are callable at the discretion of the issuer and the call price will never be below par based on a specified formula for the payoff amount generally referred to as a “make whole call provision.”
  2. Bonds that are callable at the discretion of the issuer and the call price will never be below par with a specified payoff amount based on a fixed schedule.
  3. Bonds that are callable at the discretion of the issuer at a price that can be less than par.
  4. Bonds in which the timing of payments of principal, as well as the amounts and timing of payments of interest can vary based on a pool of underlying assets or an index. This should include agency and non-agency residential mortgaged-backed securities (RMBS); some commercial mortgaged-backed securities (CMBS); as well as similar Loan-backed or Structured Securities. This excludes those flagged with #1, 2, or 3.
  5. Variable coupon bonds where the interest payments vary during the life of the transaction, but NOT as is typically based on a fixed spread over a well-established interest rate index such as LIBOR, prime rate or a government bond yield. This includes coupons that vary based on the performance of indices that are not interest rate related such as equity indices, commodity prices or foreign exchange rates. This also includes coupons where the spread to the index is not fixed for the entire life of the transaction. This excludes basic floating rate and adjustable rate notes with fixed spreads over an interest rate index.
  6. Terms that may result in principal (or initial investment) not being repaid in full for reasons other than a payment default by the issuer or defaults within a pool of assets underlying a Loan-backed or Structured Security. (This includes Insurance-Linked securities such as catastrophe bonds, Interest Only Strips (IOs), mortgage-referenced transactions or other issuer obligations that are not actually backed by a pool of assets but where the obligation to pay is tied to an index or performance or a pool of assets).
  7. Bonds where the issuer’s obligation to make payments is determined by the performance of a different credit other than that of the issuer, which could be either affiliated or unaffiliated. (These securities are often referred to as credit-linked notes. This does not include Loan-backed or Structured Securities).
  8. Mandatory convertible bonds. Bonds that are mandatorily convertible into equity, or, at the option of issuer, convertible into equity, or whose terms provide for payment in the form of equity instead of cash.
  9. Other types of options solely at the discretion of the issuer that could affect the timing or amount of payments of principal and interest, not otherwise reported in 1-8.

Effective Annual 2016.

Note 5 – Restricted Assets (2016-12BWG MOD)

The disclosure for Restricted assets was renamed “Gross Admitted and Non-admitted Restricted” and a column was added for “Total Non-admitted restricted assets.”

Effective Annual 2016.

Note 5 – 5* Securities (2016-14BWG MOD)

A new disclosure has been added for 5* Securities. The disclosure will include a comparison of the annual reporting period to the prior annual reporting period and will include the following:

  • The number of 5* securities
  • Investment type
  • Book adjusted carrying value
  • Fair value

Effective Annual 2016.

SVO Identified Funds (2016-18BWG MOD)

As part of the Investment Classification Project to clearly identify securities, Bond Mutual Funds and Bond Exchange Traded Funds that are approved to be reported as bonds on Schedule D Part 1 and DA Part 1, will have a separate reporting category section called “SVO Identified Funds”. The new category lines are as follows:

  • Exchange Traded Funds – as Identified by the SVO
  • Bond Mutual Funds – as Identified by the SVO

With the addition of the new category, the column 3 code {*} for Bond Mutual Funds and {#} Exchange Traded Funds have been removed from Schedule D Part 1.

A new section for SVO Identified Funds was added to the Schedule D Part 1A Section 1 along with a new column for “No Maturity Date.”

Effective Annual 2016.

General Interrogatories (2016-22BWG)

The General Interrogatories Part 1 question regarding investment managers and broker dealers has been modified to highlight the extent of an insurer’s use of investment managers. This includes identification of all investment managers, advisors, broker/dealers, and individuals making investment decisions on behalf of the insurer. The new requirements are below:

  • Both Internal and External
  • Affiliated or Unaffiliated
  • % of investments handled

Effective Annual 2016.

Removal of the Class 1 List from the P&P Manual (2016-05) and Movement of Money Market Mutual Funds (2016-33 BWG)

  • Effective October 14, 2016, under regulations recently adopted by the U.S. Securities and Exchange Commission (SEC), institutional prime money market funds are required to report a floating net asset value (NAV) instead of a stable net asset value (NAV). The money market mutual funds included in the NAIC’s Class 1 List in Part Six, Section 2 (b) (ii) of the Purposes and Procedures Manual (P&P Manual) fit the SEC definition of institutional prime funds. Therefore, such money market funds can no longer report stable NAV and accordingly will no longer be eligible for bond treatment under statutory accounting. For this reason, the Class 1 List has been removed from the P&P Manual. For Annual 2016, all money market mutual funds will be considered short-term and be reported on Schedule DA. The former Class 1 money market mutual funds will be renamed to “All other money market mutual funds” and accounted for under SSAP No. 30—Investments in Common Stock (excluding investments in common stock of subsidiary, controlled or affiliated entities). There will be no change to the accounting for the money market mutual funds on the ‘NAIC U.S. Direct Obligations/Full Faith and Credit Exempt List’ that are accounted for under SSAP No. 26—Bonds, excluding Loan-backed and Structured Securities. Going forward, effective Annual 2017, all money market mutual funds will be reported on Schedule E Part 2.

Statutory Accounting Updates Adopted for 2017

Prepayment Penalties and Presentation of Callable Bonds (2015-23)

After much discussion and review, there are revisions to SSAP No. 26—Bonds, excluding Loan-backed and Structured Securities and SSAP No. 43R—Loan-backed and Structured Securities to clarify the amount of investment income and/or realized capital gains/losses to be reported upon disposal of an investment. Below is a summary of the revisions:

  • Prepayment penalties or acceleration fees should be reported as investment income when received.
  • The amount of investment income should be calculated as total proceeds less par value.
  • The amount of realized gain/loss should be calculated as the difference between book adjusted carrying value and par value.

A new disclosure will be added to Note 5 that will require the reporting entity to identify the amount of investment income generated as a result of a prepayment penalty and/or acceleration fee, such as with a make-whole call. This update will be effective January 1, 2017 with prospective treatment. Since some companies are already using this method, early adoption is permitted.

GAAP Updates

Classification and Measurement

In January 2016, the Financial Accounting Standards Board (FASB) issued Financial Instruments – Overall (Subtopic 825-10):  Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01).  The FASB has been working on this project for over 3 years and ultimately has issued guidance that does not significantly change the existing classification and measurement model.  It is effective for public entities fiscal years and interim periods beginning after December 15, 2017.  For non-public entities, it is effective for fiscal years beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2019.  Below is a summary of the key components:

  • The current classification model will remain in place, except for equity securities.
  • Equity securities, including funds that are invested in debt instruments, will be measured at fair value through net income, with the following two exceptions:
    • Equity securities that qualify for Equity Method accounting
    • Equity securities that do not have readily determinable fair values may qualify for the “practicability exception” and therefore will be measured at cost, less any impairments, plus or minus any price changes observed from an orderly transaction.
  • The new standard establishes qualitative indicators to consider when determining if an equity security that is, accounted for under the “practicability exception” is impaired and would therefore be written down to its estimated fair value. These qualitative indicators include:
    • A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee
    • A significant adverse change in the regulatory, economic, or technological environment of the investee
    • A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates
    • A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment
    • Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.
  • Eliminates some fair value disclosures found in ASC 825-10-50-10 related to financial instruments not measured at fair value:

  • Requires entities to present financial assets and liabilities separately by measurement category (available-for-sale, trading and held-to-maturity) and form (securities, loans, and receivables).
  • Clarifies that entities should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in conjunction with other deferred tax assets.

Bifurcation of Embedded Derivatives – Contingent Put and Call Options

In March 2016, the FASB issued Derivatives and Hedging (Topic 815):  Contingent Put and Call Options in Debt Instruments (ASU 2016-06).  This standard outlines a four step approach (see below) to determine if an embedded contingent put or call option should be bifurcated from its host and accounted for separately.  When evaluating a contingent put or call option, one shall not take into account the event that triggers the contingent option.  Assume a bond contains an option where the investor can put the bond at 101 when the Dow Jones Index breaches 20,000, the feature related to being able to put the bond at 101 would be assessed in the four step process.   The feature related to the Dow Jones Index breaching 20,000 would not be assessed.  In practice, entities had reviewed both of these components, which led to reporting variations and ultimately led the FASB to issue this clarification.

Four Step Method:

Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.
Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.
Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.
Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.

For public entities it is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. For non-public entities, it is effective for fiscal years beginning after December 15, 2017 and interim periods within beginning after December 15, 2018. Early adoption is permitted.

Equity Method

In March 2016, the FASB issued Investments –Equity Method and Joint Ventures (Topic 323):  Simplifying the Transition to the Equity Method of Accounting (ASU 2016-07).  This amendment removes the requirement that entity retrospectively make financial adjustments when an available-for-sale or cost method investment subsequently qualifies for Equity Method accounting.  The new guidance allows an entity to adjust the basis to account for the additional interest, if applicable, and recognize any OCI unrealized gain/loss in earnings.  It is effective for all entities for fiscal years beginning after December 15, 2016.

Credit Losses/Impairments

In June 2016, the FASB issued Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13). This standard includes the current expected credit loss (CECL) method, which requires reporting entities to establish an allowance for credit losses that are expected to be incurred over the lifetime of the assets. At each reporting period, the allowance should represent Management’s current estimate of the expected credit losses. The estimate should be calculated after grouping the financial assets into pools based on their risk characteristics. If a financial asset cannot be grouped into a pool, it can be evaluated individually. The movement in this allowance would be recognized in income. Therefore, this model allows for an immediate reversal of credit losses recognized on assets that have an improvement in expected cash flows.

Although this standard includes most debt instruments, securities classified as available-for-sale (AFS) are not included in the CECL model. However, the credit loss guidance for AFS securities will be moved from Topic 320 to Topic 326, along with some targeted changes that are mentioned below:

  • An allowance for credit losses would be calculated at the individual security level each reporting period. The allowance would be equal to the amount that amortized cost exceeds the present value of expected future cash flows. However, the valuation allowance for credit losses shall not exceed the unrealized holding loss.
  • This approach allows for impairment losses to be reversed as credit losses or the impaired status evaporates.
  • The requirement to consider the length of time a security has been underwater to determine if a credit loss exists would be removed.
  • The requirement to consider additional declines in fair value or recoveries subsequent to the balance sheet date would no longer be required when estimating if a credit loss exists.
  • An allowance for credit losses roll-forward disclosure will be required each reporting period

In addition to AFS securities, the FASB decided to remove the following financial assets from the proposal’s scope:

  • Loans made to participants by defined contribution employee benefit plans
  • Policy loan receivables of an insurance entity
  • Pledge receivables of a not-for-profit entity
  • Related party loans and receivables

ASU 2016-13 will be effective for public, SEC filing entities for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  For public, non-SEC filing entities, it will be effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.  For all other entities, it will be effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years beginning after December 15, 2021.

Statement of Cash Flows – Restricted Cash

In November 2016, the FASB issued Statement of Cash Flows (Topic 230):  Restricted Cash (ASU 2016-18).  This amendment requires entities to include restricted cash and cash equivalents with the cash and cash equivalents reported on the Statement of Cash Flows.  In addition, the standard requires a reconciliation of cash, cash equivalents, and restricted cash reported on the Statement of Financial Position that agrees with the total cash, cash equivalents, and restricted cash reported on the Statement of Cash Flows.

ASU 2016-18 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted.

 

Written by:

Joe Borgmann, CPA, Director of Investment Accounting
and
Stacy Crook, Vice President Investment Accounting

 

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training.  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. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

 

by

2014 Investment Accounting Changes

Every Insurance Investment Officer Needs to Know

Joe Borgmann, CPA, Director of Investment Accounting at AAM reviews significant changes that every investment officer should keep in mind as the annual statement process kicks into high gear.  Joe is a regular participant in various NAIC and FASB working groups and is a regular speaker at insurance conferences, helping to break down the complex world of insurance investment accounting into simple terms.  Some of the topics covered in Joe’s annual report include the following:

Update on FASB Financial Instruments Project and various other targeted GAAP changes:

  • Hybrid Instrument Bifurcation
  • Government Guaranteed Mortgage Loans
  • Repurchase Agreements
  • Investments in Qualified Affordable Housing Projects

Key Investment Updates from the NAIC:

  • SSAP No. 40R – Real Estate Investments
  • Investment Classification Project
  • Various Annual and Quarterly Statement Updates

FASB Update

Impairment of Financial Instruments

On December 20, 2012, the Financial Accounting Standards Board (FASB) issued the proposed Accounting Standards Update (ASU), Financial Instruments – Credit Losses. This proposal includes the current expected credit loss (CECL) method, which requires reporting entities to establish an allowance for credit losses that are expected to be incurred over the lifetime of the assets. At each reporting period, the allowance should represent Management’s current estimate of the expected credit losses. The estimate should be calculated after grouping the financial assets into pools based on their risk characteristics. If a financial asset cannot be grouped into a pool, it can be evaluated individually. The movement in this allowance would be recognized in income. Therefore, this model allows for an immediate reversal of credit losses recognized on assets that have an improvement in expected cash flows.

On August 13, 2014, the FASB decided to remove securities classified as available-for-sale (AFS) from the scope of their December 2012 proposal. The impairment guidance for AFS securities will remain in ASC Topic 320. However, several targeted changes can be expected:

  • An allowance would be used to recognize impairments. This approach allows for impairment losses to be reversed as credit losses or the impaired status evaporates.
  • The requirement to consider the length of time a security has been underwater to determine if a credit loss exists would be removed.
  • The requirement to consider additional declines in fair value or recoveries subsequent to the balance sheet date would no longer be required when estimating if a credit loss exists.

In addition to AFS securities, in October 2014, the FASB decided to remove the following financial assets from the proposal’s scope:

  • Loans made to participants by defined contribution employee benefit plans
  • Policy loan receivables of an insurance entity
  • Pledge receivables of a not-for-profit entity
  • Related party loans and receivables

The FASB also decided in this update that they would not include guidance related to when an entity should stop accruing income on related securities.

Classification and Measurement of Financial Assets

In February and April of 2013, the FASB issued the proposed Accounting Standards Update, Financial Instruments – Overall – Recognition and Measurement of Financial Assets and Financial Liabilities. Throughout 2014, the FASB has deliberated the update and below are several of the key points:

  • The FASB is no longer attempting to converge with the IASB on classification and measurement.
  • The current classification and measurement model will remain in place, except for equities.
  • Equities will be measured at fair value through net income, with the following two exceptions.
    • Equities can be measured using the equity method if they meet the criteria noted in ASC Topic 323.
    • Some equities may qualify for the “practicability exception,” which relates to equities that do not have readily determinable fair values.
  • The Fair Value Option, under Accounting Standards Codification (ASC) Topic 825 will remain in place.
  • The requirement to bifurcate embedded derivatives within a hybrid instrument that are not clearly and closely related to its host contract will remain in place.

Bifurcation of Embedded Derivatives Within a Hybrid Instrument Issued in the Form of a Share (Convertible Preferred Stock)

Within GAAP, embedded derivatives that are not clearly and closely related to their host contract will typically be bifurcated and accounted for separately and embedded derivatives that are clearly and closely related to their host contract will typically not be bifurcated. The conversion features within a convertible instrument generally have equity like characteristics. If the preferred stock component (the host) of a hybrid instrument is considered more debt like and the conversion feature (the embedded derivative) is more equity like, the host and the embedded derivative would generally not be considered clearly and closely related and therefore be bifurcated. However, if the preferred stock component was more like a typical equity instrument, the host and the embedded derivative would both be more equity like and therefore could be considered clearly and closely related and therefore not bifurcated.

In November 2014, the FASB issued ASU 2014-16, Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity. Within this update, the FASB clarifies that one must evaluate all components of the hybrid instrument to assess if the host is more akin to debt or equity. This evaluation should consider the exact substance of each relevant component and weight them according to how they impact the overall risks and rewards of the investment. For example, a security could have redemption rights, which would generally allow one to argue that the host is more debt-like. However, the update instructs users to evaluate the redemption rights in detail to determine the substance of the redemption rights. For example, redemption rights that are contingent have less substance than non-contingent or mandatory rights. Under current practice, users may not perform such detailed evaluation or may not consider all of the components of a hybrid instrument as a whole, which is prescribed in the new update.

The update is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. For all other entities it is effective for fiscal years beginning after December 15, 2015, and interim periods within fiscal years beginning after December 15, 2016.

Foreclosure of Certain Government Guaranteed Mortgage Loans

In August 2014, the FASB issued the proposed Accounting Standards Update, Receivables – Troubled Debt Restructurings by Creditors. The ASU clarifies that when a mortgage loan, with an inseparable government guarantee enters foreclosure, the mortgage loan is derecognized and a new receivable is established. The new or other receivable should represent the amount of unpaid principal and interest associated with the original loan that is expected to be collected. Previously, some companies accounted for the foreclosed loans as real estate. This ASU is effective for the year-end 2014 for public entities and year-end 2015 for other entities.

Repurchase Agreements

In June 2014, the FASB issued the proposed Accounting Standards Update, Transfers and Servicing – Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. Under this update, Repurchase-to-Maturity and Repurchase Financing arrangements are accounted for as secured borrowings. Repurchase-to-Maturity transactions settle at the same time the transferred security matures. Previously these transfers were generally accounted for as sales. Repurchase financings are arrangements where a security is transferred and at the same time a repurchase agreement is established. These transactions were previously evaluated to determine if they were linked or should be accounted for separately. Linked arrangements could be combined and accounted for as a forward. Under this update, the transfer and the repurchase agreement would be accounted for separately. The transfer would be treated as a sale and a purchase and the repurchase agreement would be accounted for as a secured borrowing by both parties involved.

Investments in Qualified Affordable Housing Projects

In January 2014, the FASB issued the proposed Accounting Standards Update, Investments – Equity Method and Joint Ventures, Accounting for Investments in Qualified Affordable Housing Projects. Under certain conditions, this update allows reporting entities to select a new proportional amortization method, whereby the initial cost of the investment is amortized in proportion to the tax credits and other tax benefits it receives and reports the amortization of the investment and tax benefits as a component of income tax expense (benefit) on a net basis. Previously, there were strict requirements that must be met, which would allow a reporting entity to use an effective yield amortization method. If these requirements were not met, the investment would be accounted for under the equity method or cost method. The update will ultimately allow more entities to avoid using the cost method or equity method to account for these types of investments.

Within SAPWG Ref # 2014-24 – ASU 2014 -01 Accounting for Investments in Qualified Affordable Housing Projects, the Statutory Accounting Principles Working Group (SAPWG) rejected the proportional amortization method option that is prescribed within the ASU. To allow for comparability, SSAPs normally do not allow for elective accounting treatment. Statutory guidance related to qualified affordable housing projects is included in SSAP No. 93—Accounting for Low Income Housing Tax Credit Property Investments and requires a modified amortization method. It also requires gross presentation of the tax benefits achieved and the amortization of the investment.

NAIC Update

Statutory Accounting Guidance

SSAP No. 40R – Real Estate Investments – Revised and Issue Paper No. 149 – Wholly-Owned Single Real Estate Property in an LLC

On December 12, the SAPWG adopted SSAP No. 40R – Real Estate Investments – Revised and Issue Paper No. 149 – Wholly-Owned Single Real Estate Property in an LLC. This updated guidance will shift single member and single-asset LLCs, where the insurer is the sole member and has complete control of the underlying real estate, from Schedule BA to Schedule A. Under the scope of Schedule BA, these LLCs are measured using the GAAP equity method. Effective Jan. 1, 2015, these LLCs will follow SSAP 40 accounting and reporting guidance, which measures these LLCs at depreciated cost, less encumbrances and also must maintain an appraisal. Since there are differences between the accounting prescribed in SSAP No. 40 and the GAAP Equity Method, we should expect this change to impact the carrying value of these LLCs. We can also expect favorable changes to the risk-based capital (RBC) treatment:

RBC Charge Schedule A Schedule BA
Life 15% 23% + 20% on any encumbrance
Property and Casualty 10% 20%

Investment Classification Project (Ref #2013-36)

Late in 2013, the NAIC initiated a project to review the overall scope and definitions included in many of the investment related SSAPs. Much of the current SSAP guidance places more emphasis on the structure of an investment (LLC, Partnership, etc.) rather that its substance (underlying investments/risk). It is believed that because RBC categories and charges are based upon the SSAP classification, the NAIC fields many questions by insurers seeking clarification and/or justification to have investments classified in such a way to optimize RBC treatment. The recent change in the accounting and reporting of wholly owned real estate LLCs is an example of an argument an insurer could make for a change in current SSAP. Overall the insurance industry supports this project, but believes the NAIC should exercise extreme caution when making changes. One possible outcome of the project could include new accounting guidance and capital treatment for investments in funds (exchange-traded funds, mutual funds, etc.) that focuses more on the underlying assets versus the structure of the fund.

Quarterly and Annual Filings

Schedules A, B, and BA – Underlying Property Information

An electronic column has been added to capture the postal codes of real estate reported on Schedule A or BA or the postal codes associated with the underlying real estate of loans reported on Schedule B or BA. Postal codes are required for the Schedule BA mortgage loan and real estate rows; if available. If multiple postal codes relate to a particular investment, each postal code should be listed from highest to lowest value associated with the underlying properties and separated by commas. Also, the state column has been modified to accept three character country codes.

Note 5 – Structured Notes (2014-06BWG)

Structured notes are bonds issued directly from a corporation, municipality, or government entity with either:

  • Interest and/or principal payments that are linked to prices or payment streams related to an index or indices or to assets that have value unrelated to the issuer’s credit quality
  • Interest and/or principal payments that are the result of a formula that contains leverage

If the index or indices or the asset(s) that have value that is unrelated to the issuer’s credit quality are related to real estate, the structured note is considered mortgage referenced.

The new data captured disclosure is effective in the fourth quarter of 2014 and requires the following:

  • CUSIP
  • Actual Cost
  • Fair Value
  • Book/adjusted Carrying Value
  • Mortgage Referenced (Y/N)

Note 5 – Restricted Assets (2013-23BWG)

Investments in the Federal Home Loan Bank (FHLB) were added to the restricted assets disclosure. These changes were effective in the first quarter of 2014.

Note 5 – Working Capital Finance Investments (2013-13BWG)

A new disclosure was added for Working Capital Finance Investments. Book/adjusted carrying value by NAIC designation and aggregate maturity distribution on the underlying working capital finance programs must be disclosed. This is a data captured disclosure and is effective in the fourth quarter of 2014.

Note 5 – Offsetting and Netting of Assets and Liabilities (2013-26BWG)

The gross asset and liability amounts, which can be offset in accordance with SSAP. 64 – Offsetting and Netting of Assets and Liabilities, shall be disclosed. This note was effective in the third quarter of 2014.

AVR Default Component and Equity and Other Invested Assets Component (2013-27BWG)

Blank changes were made to bring the AVR in line with the RBC changes made in 2013 for commercial mortgages.

Valuation of Securities (VOS) Task Force

Catastrophe-Linked Bonds

An amendment to the Purposes and Procedures Manual of the NAIC Investment Analysis Office (P&P Manual) was adopted to include catastrophe-linked bonds in the 5*/6* rule noted in Part Two, Section Five of the P&P Manual.

Credit Rating Providers (CRP) / NAIC Designations

An amendment to the P&P Manual was adopted to clarify that NAIC designations are assigned to a specific issue/security. One cannot use broad issuer ratings (an issuer’s senior unsecured rating) to derive an NAIC designation.

An amendment has been adopted, which requires NAIC CRP ratings to:

  • Be monitored at least annually
  • Be assigned to a specific security identifier (CUSIP)
  • Apply to securities where the issuer guarantees repayment of principal and make interest/dividend payments
  • Express an opinion as to the likelihood of the payment of contractual cash flows

U.S. Securities and Exchange Commission (SEC) Money Market Fund (MMF) Net Asset Value (NAV) Rule Change

In July 2014, the SEC announced that institutional prime MMFs would no longer be granted an exception to use a stable NAV of $1/share. Effective October 14, 2016, they will be required to use a floating NAV, which represents the value of the underlying investments, on a per share basis. Due to the extended timeframe before this rule change becomes effective, the NAIC is deferring any action. It is also important to note that this rule change does not impact the MMFs on the NAIC U.S. Direct Obligations/Full Faith and Credit Exempt List.

Written by:

JosephABorgmann

Joe Borgmann, CPA
Director of Investment Accounting

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. 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. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.