Accounting & Tax Updates

January 3, 2014 by

NAIC Update

This memo summarizes the key investment accounting updates from the NAIC and FASB, which may impact insurance companies. These updates should be taken into consideration when preparing the 2013 annual statement.

Risk-Based Capital (RBC) – Life

The RBC formula for commercial mortgages in good standing has been updated and the Mortgage Experience Adjustment Factor (MEAF) has been eliminated. The new calculation involves segregating loans into different risk cohorts based on their debt service coverage (DSC) and loan-to-value (LTV) and each risk cohort has a specific RBC charge. Insurers with high quality loan portfolios can expect a reduction in their related RBC as a result of the updated calculation. See below for the categorizations and factors:

Office, Industrial, Retail and Multi Family Loan-to-Value

	Loan-to-Value
Debt Service Coverage	<55%	55%	75%	85%	100%	105%	>105%
<0.95	CM2	CM3	CM3	CM4	CM4	CM5	CM5
0.95	CM2	CM2	CM3	CM3	CM4	CM4	CM4
1.15	CM2	CM2	CM2	CM2	CM3	CM3	CM3
1.50	CM1	CM1	CM1	CM2	CM3	CM3	CM3
1.75	CM1	CM1	CM1	CM2	CM2	CM2	CM2
>1.75	CM1	CM1	CM1	CM2	CM2	CM2	CM2

Source: NAIC

Hotels and Specialty Commercial

	Loan-to-Value
Debt Service Coverage	<60%	60%	70%	80%	90%	115%	>115%
<0.90	CM4	CM4	CM4	CM4	CM5	CM5	CM5
0.90	CM3	CM3	CM3	CM4	CM3	CM3	CM3
1.10	CM3	CM3	CM3	CM4	CM4	CM4	CM4
1.45	CM2	CM2	CM3	CM3	CM3	CM3	CM3
1.85	CM1	CM2	CM2	CM2	CM2	CM3	CM3
>1.85	CM1	CM2	CM2	CM2	CM2	CM3	CM3

Source: NAIC

Risk Cohort	Factor
CM1	0.009
CM2	0.0175
CM3	0.0300
CM4	0.0500
CM5	0.0750

Source: NAIC

It is also important to note that the updated RBC instructions require insurers to maintain specific information (49 different data elements) about each loan. Each of the required data elements are described in detail in the Life RBC instructions.

Annual/Quarterly Filings

Asset Valuation Reserve (AVR) (2013-19BWG)

Mortgage Loan factors associated with the Default Component and the Equity and Other Invested Asset Component have been updated. These changes were a response to the removal of the Mortgage Experience Adjustment Factor. More changes are expected in 2014, which should make the AVR consistent with the 2013 Life RBC changes. The updated factors are noted below:

MORTGAGE LOANS	Basic Contribution	Reserve Objective	Maximum Reserve
Farm Mortgages	0.0035	0.0100	0.0130
Commercial Mortgages – All Other	0.0035	0.0100	0.0130
In Good Standing with Restructured Terms	0.0035	0.0100	0.0130

Schedule BA / AVR

Additional categories have been added to the Schedule BA and AVR:

Working Capital Finance Investments – previously this asset class was considered non-admitted; see below for more information regarding SSAP 105 – Working Capital Finance Investments (2012-38BWG).

Joint Ventures, Partnerships, and Limited Liability Companies with characteristics of Mortgage Loans (affiliated and unaffiliated) – this “characteristics of Mortgage Loans” subcategory was added so there would consistency with the securities classified as Fixed or Variable Interest Rate Investments that have Underlying Characteristics of Mortgage Loans (2013-02BWG).

Guaranteed State Low Income Housing Tax Credit and Non-guaranteed State Low Income Housing Tax Credit – the State Low Income Housing Tax Credit category has been split into guaranteed and non-guaranteed. This change makes the reporting of the Federal Low Income Housing Tax Credits consistent with the State Low Income Housing Tax Credit (2012-34BWG). Investors will note a reduction in the AVR and RBC factors.

2013 AVR FACTORS
ALL OTHER INVESTMENTS	Basic Contribution	Reserve Objective	Maximum Reserve
Class 1 Working Capital Finance Investments	0.0000	0.1000	0.1000
Class 2 Working Capital Finance Investments	0.0000	0.1250	0.1250

INVESTMENTS WITH THE UNDERLYING CHARACTERISTICS OF MORTGAGE LOANS
Farm Mortgages	0.0030	0.0100	0.0130
Commercial Mortgages – All Other	0.0030	0.0100	0.0130
In Good Standing with Restructured Terms	0.0030	0.0100	0.0130

LOW INCOME HOUSING TAX CREDIT INVESTMENTS
Guaranteed State Low Income Housing Tax Credit	0.0003	0.0006	0.0010
Non-guaranteed State Low Income Housing Tax Credit	0.0063	0.0120	0.0190

Schedule D

Certain exchange traded funds (ETF’s) noted in the Purposes and Procedures Manual of the NAIC Securities Valuation Office can now be reported as preferred stock on the Schedule D Part 2 Section 2. Previously these ETF’s would have been reported as common stock and therefore had higher RBC and AVR charges (2013-01BWG).

An additional Bond Characteristic (7) was added for Mandatory Convertible Securities (2013-01BWG).

A new Foreign code was established “G” for securities issued in Canada that are denominated in U.S. dollars.

A new electronic column has been added to all detail investment schedules to include Legal Entity Identifiers (LEIs). The LEI system is not fully operational; therefore some securities may not have a LEI. The reporting of LEI’s is only required if they are available (2012-30BWG)

Additional Schedule D “Codes” have been established for Federal Home Loan Bank (FHLB) Capital Stock and securities pledged as collateral to FHLB. These codes are noted in the Investment Schedules General Instructions, within the Annual Statement Instructions (2013-23BWG).

Note 17C Wash Sales (2012-35BWG)

The illustrative footnote, which is electronically captured, was modified so that wash sales of unrated securities, preferred stock or securities other than bonds can be captured in the disclosure.

Note 5A Mortgage Loans (2013-14BWG)

An aging analysis of past due mortgage loans aggregated by type (Farm, Residential Insured, Residential All other, Commercial Insured, Commercial All Other, and Mezzanine) was added. Also, disclosures related to investments in impaired loans should be aggregated by type. The required format is presented in the instructions.

Note 5D Loan-backed and Structured Securities (SAPWG-2013-15)

The CUSIP level disclosure of other-than-temporary impairments (OTTI’s) has been clarified to only require the disclosure of OTTI’s that have been recorded in the current reporting period.

Note 21C / 5H Restricted Assets (2013-16BWG)

Disclosures related to Restricted Assets have been expanded and moved from Note 21 to Note 5. The expansion of the disclosure is primarily focused on investments in the Federal Home Loan Bank.

Statutory Accounting Guidance

SSAP No. 26 – Bonds, Excluding Loan-backed and Structured Securities (SAPWG 2013-01 and SAPWG 2013-21)

SSAP No. 26 has been updated to require mandatory convertible securities to be reported at the lower of fair value or amortized cost during the period prior to conversion. It is also important to note that the SVO is rating these securities as 6S; the “S” subscript is an indication of “other non-payment risk.” Prior to 2013 the NAIC Securities Valuation Office (SVO) had designated these securities as common stock.

Guidance has been added to SSAP No. 26 to clarify that make-whole call provisions should not be taken into account when calculating the effective yield and amortization under the required yield-to-worst method.

SSAP No. 43R – Loan-Backed and Structured Securities (SAPWG 2013-16)

Clarification has been added so that insurers are not required to purchase the prior year’s CMBS or RMBS modeling results for newly acquired securities. This will keep insurers from having to purchase stale modeled data for the purpose of preparing the quarterly filings.

SSAP No. 105 – Working Capital Finance Investments (SAPWG 2013-10)

This new SSAP was adopted at the NAIC Fall Meeting and is effective January 1, 2014. It allows Working Capital Finance Investments to be admitted assets if they meet the following conditions:

The program is rated by the SVO.
The maturity of supporting receivables cannot exceed one year.
The program must provide an annual independent report on controls at a service organization related to or an annual audit of the internal controls of the consolidated group of which the finance agent is part, which does not note any material weaknesses related to servicing.
The obligor must waive defenses to payment and confirm the amount and a due date.

NAIC Securities Valuation Office

Egan Jones has been added to the list of Credit Rating Providers. Its ratings can therefore be used when determining filing exempt NAIC designations.

At the Fall NAIC meeting, the Valuation of Securities Task force resolved that the new Structured Agency Credit Risk (STACR) security, issued by Freddie Mac falls under the scope of SSAP No. 26 – Bonds, Excluding Loan-backed and Structured Securities and needs to be filed with the SVO. The December 31, 2013 Purposes and Procedures Manual of the NAIC Securities Valuation Office will note that it is not filing exempt.

FASB Update

On May 26, 2010, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) related to Financial Instruments (Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities). Since then, the FASB has been obtaining comments from U.S. stakeholders and working with the International Accounting Standards Board (IASB) to achieve convergence with IFRS 9 – Financial Instruments. The FASB has grouped this project into three topics: (1) Classification and Measurement, (2) Credit Impairment and (3) Hedge Accounting. Below are status updates for each of these topics at year-end 2013:

Classification and Measurement – Final document is expected for the first half of 2014

On February 14, 2013 FASB issued the proposed Accounting Standards Update, Financial Instruments – Overall (Subtopic 825-10) – Recognition and Measurement of Financial Assets and Financial Liabilities. The proposal included a “solely payment of principal and interest” (SPPI) model. Under the proposed ASU, one should first consider the characteristics of the cash flows associated with the financial instrument. An instrument can be classified as FV-OCI or Amortized Cost if the expected contractual cash flows relate solely to the receipt of principal and interest on the principal amount outstanding. If the instrument does not meet this test, it must be classified as FV-NI.

On December 18, 2013, the FASB tentatively decided to no longer move forward with their SPPI model. Further, the FASB decided to retain current guidance related to the bifurcation of embedded derivatives. Under this tentative decision, reporting entities can continue to bifurcate the embedded options within convertible securities and account for them as “trading” (fair value through net income), leaving the bond component to be classified as available-for-sale (fair value through other comprehensive income).

Credit Impairment – Final document is expected for the first half of 2014

On December 20, 2012 the FASB issued a proposed Accounting Standards Update, Financial Instruments – Credit Losses. The proposal 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 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.

The proposed ASU also changes the way interest income is recognized on securities where the entity does not expect to receive substantially all the principal or substantially all of the interest.

If it is not probable that substantially all of the principal will be received, the entity should stop recognizing interest; all cash receipts should be applied to the carrying value of the security until it reaches zero. Any additional cash received should be applied to the allowance, thereby causing the recognition of income.

If it probable that substantially all of the principal will be received, but not substantially all of the interest. The entity can only recognize interest income as the related cash payments are received.

The proposed ASU also notes that an allowance for expected credit losses shall be established upon the acquisition of a purchased credit-impaired asset

Hedge Accounting

The FASB obtained comments in April 2011, but has not begun the re-deliberations.

Written by:

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.

January 3, 2013 by

FASB

Financial Instruments

On May 26, 2010, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) related to Financial Instruments (Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities). Since then, FASB has been obtaining comments from U.S. stakeholders and working with the International Accounting Standards Board (IASB) to achieve convergence with IFRS 9 – Financial Instruments. FASB has grouped this project into three topics: (1) Classification and Measurement, (2) Credit Impairment and (3) Hedge Accounting. Below are status updates for each of these topics as of year end 2012:

Classification and Measurement – Unannounced Effective Date

Below is a summary of the current and proposed financial instrument classifications:

Current Classifications	Proposed Classifications
Trading	Fair Value Net Income (FVNI)
Available-for-sale	Fair Value Through Other Comprehensive Income (FVOCI)
Held-to-maturity	Amortized Cost

Under the proposed ASU, one should first consider the characteristics of the cash flows associated with the financial instrument. An instrument can be classified as Fair Value Through Other Comprehensive Income (FVOCI) or Amortized Cost if the expected contractual cash flows relate solely to the receipt of principal and interest on the principal amount outstanding. Interest is defined as consideration for the time value of money and the embedded credit risk of the instrument. If the instrument does not meet this test, it must be classified as Fair Value New Income (FVNI). If it does meet this test, the instrument should then be classified under one of the following business models:

Instrument is being held to collect contractual cash flows
Instrument is being held to collect contractual cash flows and sell
Other

Classification and Measurement Decision Tree

Classification and Measurement Decision Tree

There are several notable differences between current classification and measurement guidance and the proposed ASU:

Entities no longer have the option to classify any instrument as FVNI (Fair Value Option)
Reclassifications are permitted, under certain circumstances
Hybrid financial assets (convertible bonds) shall be measured in their entirety; bifurcation of host and embedded derivative is no longer permitted

Credit Impairment – Unannounced Effective Date

On December 20, 2012, FASB issued a proposed ASU related to the recognition of credit losses (Financial Instruments – Credit Losses).

Prior to this proposed ASU, FASB and the IASB considered a three-bucket impairment model. Assets with insignificant credit deterioration were included in Bucket 1. Assets with more than insignificant credits deterioration or assets where it is possible that the contractual cash flows may not be collected were included in Buckets 2 and 3. An allowance for Bucket 1 assets included credit losses that the entity expected to incur over the next 12 months. The Bucket 2 and 3 allowances included the expected credit losses to be incurred over the entire life of the assets.

The newly proposed ASU eliminates the three-bucket model and simply requires 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 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.

The proposed ASU also changes the way interest income is recognized on securities where the entity does not expect to receive substantially all of the principal or substantially all of the interest.

If it is probable that substantially all of the principal will be received, but not substantially all of the interest, the entity can only recognize interest income as the related cash payments are received.

The proposed ASU also notes that an allowance for expected credit losses shall be established upon the acquisition of a purchased credit-impaired asset. The portion of the purchased discount related to the expected credit loss can not be recognized as interest income. For example, if a 100 par value security is purchased at $70, with expected credit losses of $10, the entity can only record $20 of accretion ($30 discount less $10 credit loss).

The ASU includes expanded disclosures related to the following:

Credit-quality information
1. How management monitors the credit quality of debt securities
2. Assessment of the quantitative and qualitative risks arising from the credit quality of the debt securities
Allowance for Expected Credit Losses
1. Method and information used to develop the allowance
2. Description of any economic circumstances impacting or changing the allowance from one period to the next
Roll forward of the amortized cost of debt securities
Reconciliation between fair value and amortized cost for FVOCI debt securities
Information related to securities that are past due
Information related to securities where the entity is not accruing interest
Information related to purchased credit-impaired securities
Bifurcation of purchase discount between expected credit losses and other factors
Information related to collateralized financial assets

Hedge Accounting

FASB obtained comments in April 2011, but has not begun the re-deliberations.

Disclosures about Liquidity Risk and Interest Rate Risk

On June 27, 2012 FASB issued a proposed ASU, Disclosures about Liquidity Risk and Interest Rate Risk. The proposed ASU requires insurance companies to make the following liquidity risk and interest rate risk disclosures:

Liquidity Risk Disclosures

Liquidity gap maturity analysis – Financial asset and financial liability classes are grouped by expected maturity in a tabular analysis.
Available liquid funds – Unencumbered cash and liquid assets shall be presented in a tabular format.

Interest Rate Risk Disclosures

Re-pricing gap analysis – The financial asset and financial liability classes’ weighted-average yield and duration along with an analysis showing how the financial asset and financial liability classes would re-price over certain time intervals.

Interest rate sensitivity analysis – The impact on the entities net income and equity under various scenarios:
1. Parallel shifts
  1. Up 100 basis points
  2. Up 200 basis points

Down 100 basis points

Down 200 basis points

Flattening shifts
1. Increase short-end by 100 basis points
2. Decrease short-end by 100 basis points
Steepening shifts
1. Decrease short-end by 100 basis points
2. Increase short-end by 100 basis points

The disclosures are required in interim and annual periods for public insurance companies and annually for private insurance companies.

NAIC

Notes to the Financial Statements

For many of the notes to the financial statements, the NAIC is requiring that a specific presentation format be used. The standard formats are illustrated in the Annual Statement Instructions and allow the NAIC to electronically capture the data for further analysis.

Fair Value Note 20(A)2 – Level 3 Rollforward – The purchases, sales, issues and settlements previously were reported net. Now each item should be disclosed individually.

Fair Value Note 20(C) – Insurance companies must disclose the fair value of all investments, segregated by the fair value hierarchy (Level 1, 2, or 3) and grouped by asset type. This disclosure is similar to Note 20(A)1, which requires insurance companies to disclose the fair value of securities carried at fair value, segregated by the fair value hierarchy (Level 1, 2, or 3) and grouped by asset type.

Subprime Note 21(G) – There is now a specific format noted for investments with subprime exposure, which includes Actual Cost, BACV, Fair Value, OTTI.

Schedule D Reports

Security Classifications

The guidelines for classifying securities between the U.S. Government classification and the U.S. Special Revenue and Special Assessment Obligations and all Non-Guaranteed Obligations of Agencies and Authorities of Governments and Their Political Subdivisions (Special Revenue) classification has changed. Securities issued by agencies noted on the “U.S. Government Full Faith and Credit – Filing Exempt” list should be classified as U.S. Government and securities issued by agencies noted on the “Filing Exempt Other U.S. Government Obligations if issued and either fully guaranteed or insured by” list should be classified as Special Revenue. These lists can be found in Part 2, Section 4 of the 2012 Purposes and Procedures Manuals of the NAIC Securities Valuation Office. Here are some of the notable changes:

	Previous Classification	Current Classification
FNMA or FHLMC Agency Debt	U.S. Government	Special Revenue
Multi-class GNMA MBS	Special Revenue	U.S. Government

Maturity Date Column

The Maturity Date column now includes the final stated legal maturity date for all securities. Previously, this column included the maturity date that generated the lowest yield (call date) for securities purchased at a premium.

New Electronic Columns

Three new electronic columns were added. These additions are related to the Maturity Date Column change noted above.

Effective Maturity Date – maturity date (stated legal maturity date or call date) used for yield-to-worst amortization method, as required by SSAP 26
Call Date – call date used in relation to the effective maturity date noted above
Call Price – call price associated with the call date used in relation to the effective maturity date noted above

Electronic Fair Value Hierarchy/Method Used to Obtain the Fair Value

Fair Value Hierarchy has been added to this electronic column. Previously this column only included the Method Used to Obtain the Fair Value:

“a” – rate determined by pricing service
“b” – rate determined by stock exchange
“c” – rate determined by broker or custodian
“d” – rate determined by insurer
“e” – rate published in the NAIC Valuation of Securities

Now this electronic column should include both the Fair Value Hierarchy and the Method Used to Obtain the Fair Value. For example “2a” in this column would represent a Level 2 security, where the fair value was obtained from a pricing service.

NAIC Ratings

SSAP No. 43R Loan-Backed and Structured Security Ratings

A three page flow chart has been added to the General Investments section of the Annual Statement Instructions. The flow chart illustrates the process of determining NAIC designations for SSAP 43R securities and can be a helpful reference.

“S” Subscript – Effective January 2013

Some securities may be considered bonds per the scope of SSAP 26. However, the Securities Valuation Office (SVO) classifies them as preferred or common equity. The SVO’s reclassification is a response to features that cause the securities to resemble the risk profile of equity versus debt. Debt securities that are mandatorily convertible into common equity or debt securities where the issuer can defer interest payments for an extended period are examples of these “Non-Payment Risks.” The SVO will include an “S” subscript to the NAIC designations of these securities, which will indicate that the security contains “non-payment risk” and will indicate that the security’s designation has been “notched.”

Risk Retention Groups (RRGs)

Some RRGs prepare a Property and Casualty (P&C) Annual Statement using Generally Accepted Accounting Principles (GAAP). A section has been added to the P&C Annual Statement Instructions, which provides related guidance to RRGs.

Ongoing…

NAIC Designation Recalibration Project

The Valuation of Securities Task Force (VOS) continues to work on the Recalibration Project, which may result in additional NAIC designations for corporate and municipal securities that are more in-line with historical default rates.

RBC Bond Factors

The C-1 Factor Review Subgroup continues to review the RBC bond factors, but changes are on the horizon.

Written by:

Joseph A. Borgmann, CPA
Director of Investment Accounting
joe.borgmann@aamcompany.com
For more information, contact:

Colin T. Dowdall, CFA, Director of Marketing and Business Development
colin.dowdall@aamcompany.com

30 North LaSalle Street
Suite 3500
Chicago, IL 60602
312.263.2900

www.aamcompany.com

August 21, 2012 by

IRS Directive Related to Partial Worthlessness Deduction for Eligible Securities Reported by Insurance Companies

On July 30, 2012, the IRS issued a directive that instructs Large Business & International Examiners to not challenge an insurance company’s partial worthlessness deduction of eligible securities related to credit impairment write-downs in accordance with SSAP 43R.

As a result, an opportunity may exist to accelerate for tax purposes the loss from the eligible impaired securities as well as to convert what could have been capital losses into ordinary tax deductions. For some companies this may provide cash inflow through tax savings as well as possibly improve the company’s statutory surplus and risk-based capital positions through the tax recognition of impairments currently reported as deferred tax assets.

Unlike traditional tax accounting method changes, the IRS has offered an administrative solution that provides flexibility to the company with respect to what year the Company recognizes the loss and the manner in which the company reports to the IRS the adoption of this tax position.

The directive provides specific procedures the company must follow in computing the loss and certifications the company must sign and present to the IRS upon request.

Due to the IRS flexibility in application and the uniqueness of each company’s tax position, it may be advantageous to run a scenario analysis of the different IRS alternatives to find the position that best suits the company’s tax posture.

If you have any questions or would like assistance in analyzing and applying the IRS Directive Related to Partial Worthlessness Deduction for Eligible Securities Reported by Insurance Companies (View Directive (IRS website)) feel free to contact Joe Borgmann or AAM’s Tax Advisor, Jason Simkin of SIMKIN CPA, LLC, The Insurance Tax Advisory Firm.

Written by:

Joseph A. Borgmann, CPA
Director of Investment Accounting
312.263.2900
joe.borgmann@aamcompany.com

Jason Simkin, CPA
SIMKIN CPA, LLC – The Insurance Tax Advisory Firm
972.308.0044
jason.simkin@aamcompany.com

April 3, 2012 by

Global Legal Entity Identifier (LEI)

A recent reporting requirement will impact insurers’ statutory filings and increase transparency for regulators and risk managers. The accounting update below discusses the new Global Legal Entity Identifier (LEI) program, its benefits to the finance industry, and the related NAIC reporting requirements.

Background

With the desire of the global community to identify systematic risk, it has been determined that a key component to managing risk is having a consistent global identifier for every legal entity. The Legal Entity Identifier program was created by the G20 and the Financial Stability Board (FSB). It was designed to create and apply a single, universal standard identifier on an international basis to any organization or firm (including insurance companies) involved in issuing derivative contracts or other financial securities. The LEI system is a unique, 20 character, alphanumeric code. Local Operating Units around the globe will assign LEIs, as well as validate and maintain reference data. In August 2012, the Depository Trust & Clearing Corporation and SWIFT (a global provider of secure financial messaging services) launched a website (www.ciciutility.org), which includes interim identifiers called US Commodity Futures Trading Commission Interim Compliant Identifiers (CICIs). Once the global LEI system is implemented and operational, it is expected that the CICI’s will transition into the global LEI system. Progress updates can be found on the FSB website www.financialstabilityboard.org/publications.

Benefits of using a Global Legal Entity Identifier

A universal standard identifier for each legal entity will allow regulators to complete more accurate global data aggregations for systemic risk across related issuers, asset classes and geographies. It will also allow for regulators to better identify concentrations and emerging risks, improve risk management capabilities, and facilitate information sharing. For risk managers in financial institutions, the global LEI system will increase the effectiveness of tools used to identify exposures to counterparties.

NAIC Requirement

Effective March 31, 2013, the NAIC has added an electronic-only column to the annual and quarterly detail investment schedules. This new column should include the LEI numbers for mortgagors, counterparties, depositories, and the issuers of equity and fixed income securities. However, it is important to note that the Global LEI system has not yet been implemented. Therefore, LEI numbers are not currently available. Further, the NAIC does not require insurers to report the interim CICIs. The NAIC is monitoring the development of the global LEI system and will post updates to the Blanks E Working Group web page https://www.naic.org/committees_e_app_blanks.htm.

Written by:

Stacy L. Crook
Vice President, Investment Accounting

January 3, 2012 by

Compared to the past several years, 2011 was relatively a quiet year in terms of new and significant changes in the way we account for investments. This summarizes the changes that did occur and the investment accounting topics that are on the horizon.

NAIC

Structured Securities Rating Process

The NAIC designations for all securities that fall under the scope of SSAP No. 43R are calculated based on any of the following:

The NAIC’s (PIMCO’s) RMBS Model
The NAIC’s (Blackrock’s) CMBS Model
The Modified FE (Filing Exemption) Rule
A SVO (Securities Valuation Office) generated designation

In late 2010 (effective 2011), the NAIC expanded the scope of SSAP No. 43R to essentially include all securities issued from a trust or securities where the holders’ only recourse is to the assets within the trust and not the ultimate issuer (parent company). This change caused securities such as hybrids, military housing, credit tenant lease (CTL) and equipment trust certificates (ETCs) to become SSAP-43R securities. Given the expanded scope of SSAP No. 43R and the fact that the Modified FE rule penalizes premium dollar BBB to CCC securities, the industry wanted the Modified FE rule to go away. Opponents to the rule argued that it is not realistic that a single CUSIP, purchased at different prices, could have different designations and that the Modified FE rule could create arbitrage opportunities. After much deliberation, the Modified FE rule remains effective, but two important and positive changes were made:

Modified FE Rule Changes:

CTLs and ETCs were carved out of its scope. The NAIC designations for these asset classes shall either be equal to an SVO generated designation or calculated by converting the security’s ARO ratings to an NAIC equivalent.

The rating “staleness” criteria was removed. The rule previously required that all ARO ratings used when applying the rule be based on a review that occurred not more than 12 months from the reporting date. Since recent SEC and European Union requirements were put in place in 2011 which requires securities to be reviewed annually, the NAIC was comfortable removing this staleness criteria.

In 2010, the NAIC designations of structured securities ended with a “Z*” suffix to indicate that the asset class was under regulatory review. Since the asset class is no longer under review, one of the following new suffixes should be used instead:

AM – Indicates the designation was calculated using ARO ratings in conjunction with the Modified FE rule.

FM – Indicates the designation was calculated using RMBS/CMBS modeled data.

SM – This indicator is included in the Annual Statement Instructions. However, at the Fall 2011 meeting of the Valuation of Securities Task Force, it was eliminated and therefore should not be used.

Below is a link to a useful flowchart, which outlines the process of rating SSAP 43R securities:

www.naic.org/documents/structured_securities_modified_fe_43r_flow_chart_final.pdf

Filing Exemption Lists for Government Securities

The SVO made several significant changes to the Filing Exemption Lists for Government Securities. The most notable change was the addition of the FDIC.

FASB

Fair Value Measurement (ASC 820)

In May 2011 the Financial Accounting Standards Board (FASB) amended the current Fair Value Guidance by issuing ASU No. 2011-04. The primary purpose of its issuance was to achieve converged U.S. GAAP/IFRS guidance. Although the amendment was quite large from a size (pages) perspective, it does not significantly change the application of existing fair value guidance. However, it may require additional disclosures.

Below are the significant accounting principles related clarifications/amendments in general terms:

The “highest and best use” principle can not be applied to financial assets since they are perceived to only have one use.

The fair value of a company’s own illiquid equity interests, distributed in situations such as business combinations, or liabilities where a quoted price for the transfer if an identical or similar liability is not available, should be based on the value of the instrument from the perspective of the asset holder.

Certain criteria must be met for portfolios managed specifically with a risk management strategy to be measured as a whole versus at an individual security basis (hedging).

Clarification is provided regarding the inclusion of premiums and discounts when measuring fair value. Illiquidity discounts should be incorporated in fair value, but a “block discount” (odd lot) should not be incorporated.

Below are significant disclosure amendments / additions:

Disclosure of any reasons for all transfers between Level 1 and Level 2 (only required for public companies).

Expansion of quantitative and qualitative inputs used in the measurement process of Level 2 and 3 securities. These disclosure requirements mirror the Annual Statement’s Note 20 (4).

Description of the Valuation Process surrounding Level 3 Pricing
- Description of Company’s Valuations Group, whom the Group reports to, and its internal reporting policies
- Frequency and methods used to test pricing models (back testing)
- Process used to examine changes in fair value across reporting periods
- Support that third-party pricing is in accordance with ASC 820

Sensitivity of Level 3 pricing to changes in the significant unobservable inputs. Below is an example disclosure taken from an Accounting Standards Update:

The significant unobservable inputs used in the fair value measurement of the reporting entity’s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption^[1].

On the Horizon

FASB – Accounting for Financial Instruments

In May 2010, FASB released the Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. This exposure draft (ED) broadened the use of fair value measurement among financial instruments. However, since its release, there have been several changes that have scaled back this expansion. For example, the original ED required financial assets such as loans, core deposit liabilities and an entity’s own debt to be measured at fair value; the current version allows amortized cost. Additionally, the original ED required financial instruments that contained an embedded derivative (convertible bonds) to be measured at fair value with changes in value recorded in net income (FAS 115 Trading Classification). The current version retains the ability to bifurcate the host contract and the embedded derivative. Overall, the current guidance requires the classification and measurement of financial assets to be dependent on the characteristics of the financial assets as well as the entity’s investment strategy. The ability of a security to be prepaid such that the investor would not recover substantially all of the initial investment (interest only strips) is an example of a characteristic that would force a fair value through net income classification. Further, a company could have different measurement classifications for the same investment, if these same financial assets are held in different portfolios, with different investment strategies. Below is a summary of the three proposed measurement classifications: Fair Value with changes recorded in Other Comprehensive Income (FV-OCI), Fair Value with changes recorded in Net Income (FV-NI), and Amortized Cost (AC).

FV-NI	FV-OCI	AC
Derivatives or hedging instruments not designated as cash flow hedges or instruments to hedge a net investment in a foreign operation	Investment transferred to the issuer will be returned to the investor at maturity	Investment transferred to the issuer will be returned to the investor at maturity
Instruments that can be contractually prepaid such that the initial investment will not be substantially recovered	Total return strategy by either collecting contractual cash flows or selling the investment	Investments that are associated with consumer lending or financing activities
Marketable equity instruments	Interest rate or liquidity risk management strategy by holding or selling the investment	Investments that give the holder the ability to manage credit risk through negotiation with counterparty
At purchase, the investment is held for sale		Sales or settlements only acceptable if they are made to manage risk or more specifically to reduce credit loss
Measurement
Initially measured at Fair Value	Initially measured at transaction price	Initially measured at transaction price
Note: Subsequent reclassifications are not permitted

The ED is also proposing a new “three bucket” approach to the review and recognition of impairments:

Bucket 1	Bucket 2	Bucket 3
Securities with little or no credit loss deterioration since acquisition	Securities with significant credit loss deterioration since acquisition	Securities with significant credit loss deterioration since acquisition
Impairment allowance calculation based on expected losses associated with pools of assets	Impairment allowance calculation based on expected losses associated with pools of assets	Impairment allowance calculation based on expected losses of the individual assets
Impairment allowance shall represent the pool’s losses that are expected to occur over the next 12 months	Impairment allowance shall represent the pool’s losses that are expected to occur over the lifetime of the assets	Impairment allowance shall represent the individual asset’s losses that are expected to occur over their lifetime

The “pools” associated with Buckets 1 and 2 are asset groupings, based on similar investment and risk characteristics.

The expected loss amount calculation shall be calculated based on a range of possible outcomes. Estimates of the likelihood of each outcome shall be made and the expected loss value should be a probability-weighted average. The guidance mentions that a loss rate method, which incorporates probabilities of default and loss given a default or a collateral valuation method would also be acceptable for calculating expected losses.

Transfers between the buckets can occur as credit deteriorates or when it improves.

It is important to note that this guidance is still being developed. Similar guidance (IFRS 9) has been issued by the International Accounting Standards Board (IASB) and its effective date has recently been extended to January 1, 2015. This extension was primarily made so the final U.S. GAAP guidance could be evaluated before IFRS 9 becomes effective.

NAIC Designation Recalibration Effort

The NAIC has studied the historical default rates, by ARO rating, levels and determined that different asset segments have significantly different historical default rates. For example, the default rates of Aaa corporate securities are comparable to the default rates of Ba and B non-general obligation municipal securities. Therefore, it is proposed that the ARO rating/NAIC designation mapping be different for the following asset segments:

Corporate Securities
Municipals
Asset-backed Securities

In addition to mapping changes, the proposal includes the expansion of NAIC designations, such that there could be an NAIC +1 and an NAIC 1. Given the number of factors (Asset Valuation Reserve, Risk-Based Capital, Modified FE Rule, Investment Policy) impacted by the NAIC designations, this proposal will be heavily deliberated.

Written by:

Joseph A. Borgmann, CPA
Vice President
Investment Accounting

[1] Financial Accounting Standards Board of the Financial Accounting Foundation, Accounting Standards Update, Fair Value Measurement(Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, No. 2011-04, May 2011, 128.

December 3, 2010 by

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, which are relevant to the types of securities managed by AAM:

The fair value measurements at the reporting date and the source of the fair value measurements.

The fair value measurements reported by AAM are obtained primarily from independent pricing services. When a security’s fair value is not available from an independent pricing service, the pricing is obtained from broker-dealer quotes or internally derived estimates based on expected future cash flows discounted at relevant market rates.

The fair value of securities carried at market, segregated by the fair value hierarchy.

The fair value hierarchy can be summarized as follows:

Level 1 – Quoted prices (unadjusted) that are obtainable at the measurement date and taken from active markets for identical assets
Level 2 – Prices based on observable market data, other than quoted prices included within Level 1
Level 3 – Prices based on unobservable market data

Below is the illustrative example of this disclosure that is included in SSAP 100:

(In millions)	Level 1	Level 2	Level 3	Total
Perpetual Preferred Stock
Industrial and Miscellaneous
Parent, Subsidiaries and Affiliates
Total Perpetual Preferred	$	$	$	$

Redeemable Preferred Stock
Industrial and Miscellaneous
Parent, Subsidiaries and Affiliates
Total Redeemable Preferred	$	$	$	$

Bonds
U.S. Governments
Industrial and Miscellaneous
Hybrid Securities
Parent, Subsidiaries and Affiliates
Total Bonds	$	$	$	$

Common stock
Industrial and Miscellaneous
Parent, Subsidiaries and Affiliates
Total Common Stock	$	$	$	$

Derivatives
Interest rate contracts
Foreign exchange contracts
Credit contracts
Commodity futures contracts
Commodity forward contracts
Total Derivatives	$	$	$	$

Separate account assets
Total	$	$	$	$

The amounts of any transfers between Level 1 and Level 2, the reasons for the transfers and the reporting entity’s policy for determining when transfers between levels are recognized.

This disclosure only relates to securities held at the reporting date.

Transfers into a fair value hierarchy level shall be disclosed and discussed separately from transfers out of a fair value hierarchy level.

The reporting entity’s policy for determining when transfers are recognized can include the following:

The value of the security on the actual date of the event or change in circumstances that caused the transfer
The value of the security at the beginning of the reporting period
The value of the security at the end of the reporting period

A description of the valuation techniques and the inputs used for Level 2 and Level 3 securities with the reasoning of any changes in valuation techniques noted.

The valuation techniques are noted below:

Market approach – The use of market generated transactions to produce a fair value. The market approach includes Level 1 securities as these fair values are equal to a security’s relevant market quote. The market approach also includes matrix priced securities (Level 2). Matrix pricing is a method by which securities are valued using similar benchmark quoted securities.
Income Approach – The use of a security’s estimated future cash flows and a discount rate indicative of market conditions to calculate a fair value.
Cost approach – The replacement cost, adjusted for obsolescence. This approach is not used by AAM.

Regarding the disclosure of inputs used to determine fair value, the guidance suggests including quantitative information such as prepayment rates, estimated credit losses, interest rates or discount rates. The guidance also suggests disclosure of the investment characteristics that are considered in the determination of the relevant inputs. The following characteristics are noted in the guidance that would relate to RMBS:

Types of underlying loans
Collateral
Guarantees or other credit enhancements
Seniority level of the tranches of securities
Year of issue
Weighted-average coupon of the underlying loans
Weighted-average maturity of the underlying loans
Geographical concentration of the underlying loans
Credit ratings of the securities

A reconciliation from the opening balances to the closing balances of all securities that had Level 3 pricing during the reporting period. The reasons for any transfers into or out of the Level 3 hierarchy shall also be separately disclosed and discussed.

The reporting entity’s policy for determining when transfers are recognized for this disclosure must be consistent with Level 1 / Level 2 transfer disclosure noted above.

Below is the illustrative example of this disclosure that is included in SSAP 100. Note that the purchases, issuances, sales, and settlements are reported net. For the December 31, 2011 reporting, it is probable these items will be reported gross.

Roll Forward		Loan-Backed and Structured Securities (NAIC 3-6)		Derivatives	Other Fund Investments
		Residential Mortgaged-Backed Securities	Commercial Mortgage-Backed Securities	Credit Contracts	Hedge Fund High-Yield Debt Securities	Private Equity	Total

Beginning Balance		$	$	$	$	$	$
Transfers into Level 3	(a) (b)
Transfers out of Level 3	(c)
Total Gains or Losses
Included in Net Income
Included in Surplus
Purchases, issuances, sales and settlements
Purchases
Issuances
Sales
Settlements
Ending Balance		$	$	$	$	$	$

Example Footnotes:	(a)	Transferred from Level 2 to Level 3 because of lack of observable market data due to decrease in market activity for these securities
	(b)	The reporting entity’s policy is to recognize transfers in and transfers out as of the actual date of the event or change in circumstances that caused the transfer.
	(c)	Transferred from Level 3 to Level 2 because observable market data became available for these securities.
		Note: For liabilities measured at fair value, a similar table should be presented.

In addition to requiring the Level 3 purchases, issuances, sales, and settlements on a gross basis in 2011, the NAIC has discussed adding an electronic column to any annual statement schedule that discloses fair values, which would include the fair value hierarchy for each line item.

Joseph A. Borgmann, CPA
Vice President
Investment Accounting