Accounting & Tax Updates

November 5, 2008 by

SSAP No. 98 – Treatment of Cash Flows When Quantifying Changes in Valuation and Impairments, an Amendment of SSAP No. 43 – Loan-backed and Structured Securities

Issued: November 5, 2008

Effective: January 1, 2009, with early adoption permitted

This pronouncement requires that when recording an other-than-temporary impairment related to a loan backed security, the security’s cost basis should be reduced to its fair value. Prior to the adoption of SSAP No. 98 and 99, the cost basis of an other-than-temporarily impaired loan backed security was written down to its undiscounted estimate of future cash flows.

Loan backed securities that have been previously impaired should be reviewed to determine if an additional write-down is warranted.

SSAP No. 99 – Accounting for Certain Securities Subsequent to an Other-Than-Temporary Impairment

Issued: September 23, 2008

Effective: January 1, 2009, with early adoption permitted

This pronouncement requires that after writing down a bond or redeemable preferred stock, whereby the cost basis of the security is reduced to its fair value, the difference between the new cost basis and the estimated recovery value (the new premium or discount) should be amortized or accreted over the remaining life of the security.

SSAP No. 99 also clarifies that any bond premium that is written-off upon recognition of an impairment shall be recorded as a realized loss versus a reduction to investment income.

Other Relevant Statutory Guidance:

INT 06-07: Definition of “Other Than Temporary”

One of the key concepts of this OTTI guidance is that there are two types of impairments – interest related impairments and credit related impairments. An interest related impairment is obviously caused by changes in the risk free interest rate, but also includes general credit spread widening due to “supply/demand imbalances” or “perceived higher/lower risk of an entire sector”. From a recognition standpoint, an interest related OTTI adjustment should be recorded when the holder has the intent to sell the position. In contrast, a credit related impairment should be recognized when it is deemed other-than-temporary. Since we are currently experiencing a market where many securities have been trading at severely depressed levels, it is important to assess the issuers’ ability to make principal and interest payments when they are due. If the issuer is showing signs that indicate the inability to make these payments, the impairment should be considered credit related. If the issuer remains financially sound, the impairment is most likely interest related.

Annual Statement Changes

2008-22BWG

Effective: 2008 Annual Statement

With the adoption of 2008-22BWG comes a new (electronic) column to the Schedule D Parts 1 and 2, which indentifies the source of the fair value/market value used in the statement. Below are the codes that are to be noted in this column:

a – price is from a pricing service

b – price is from a stock exchange

c – price is from a broker or the insurer’s custodian **

d – price is determined by the insurer

e – price is from the SVO

** Broker must be approved by the insurer as a counterparty for buying and selling securities or be an underwriter of the security being valued and the broker’s or custodian’s pricing policy must be retained by the insurer.

Similar to AAM’s SFAS 157 level one, two, or three reporting, AAM will provide a year-end report to our client’s that specify our valuation sources in the format outlined above.

Joseph A. Borgmann, CPA
Vice President
Investment Accounting

Disclaimer: This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. Any opinions and/or recommendations expressed are subject to change without notice.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.

February 4, 2008 by

FAS 157 Audit Tests of Security Pricing

A recommendation to insurance companies and their auditors

As an insurance asset manager, we have the following goals for the pricing of securities for our clients. Our primary goal is to develop a process that provides the most accurate price possible as of a given date, whether or not the pricing source is an electronic feed from one of the leading providers or other observable inputs. In addition, we stand ready to support valuations directly to clients for their own benefit or to support their audit and/or regulatory reviews. Our discussions with several accounting firms in conjunction with their 2007 audits suggest an increased focus on the pricing of securities as a direct result of FAS 157 and its implementation.

Although FAS 157 is not effective until the fiscal year beginning after November 15, 2007, auditors seem to be testing as if it was effective at calendar year end 2007. We have observed a varied testing approach to year-end pricing among different audit firms and across different offices of the same audit firm. This is not unusual in the first year after the adoption of a new FASB statement. Our concern is the audit community, in its attempt to document pricing adequacy, may permanently impact the ability of the investment management industry to achieve its primary pricing goal of pricing accuracy. A recommended solution is outlined below.

Background

Securities are priced at AAM using a fully documented process consistent with FAS 157 that begins with a feed from leading pricing services. For securities that are not priced by the services, we obtain an observable input from a third party source, generally the broker-dealer that was the primary underwriter or is a lead market maker. In addition, our sector specialists review the prices obtained from the pricing services and, if an observable input would result in a more accurate price, then the sector specialist will document the source and change the price to the more accurate price.

It is important to point out that in volatile markets the prices provided by a pricing service may not reflect the fair value of a security at that point in time. In general, their pricing assumptions tend to lag the market movements. Thus, after spreads have widened and prices have dropped, as has happened over the past few quarters, prices from the services on average tend to be higher than true market prices. The reverse is likely to be true when yield spreads contract quickly.

We have observed that our clients’ auditors tend to accept the accuracy of pricing service information with little or no scrutiny. However, the process of using observable inputs to generate a more accurate price tends to result in significant scrutiny and testing. We stand ready to fully support these observable inputs and provide detail as to the source. This is fully consistent with FAS 157. We begin to have concerns when our clients’ auditors

attempt to support this information with a confirmation from the broker-dealer pricing source. Our concern is that any attempt to obtain a signed confirmation from the pricing source will inevitably lead to policies by the broker-dealer community that prohibit their assistance with pricing. Broker-dealers currently provide pricing as a courtesy to their customers and will understandably avoid any legal risk associated with a signed confirmation.

In discussions with clients and third party insurance investment consultants, we have learned that at least some of the other insurance asset management providers rely exclusively on the pricing feed from a pricing service. This is understandable in light of the heightened attention associated with using observable inputs to develop more accurate prices. If this is the case, then the security prices that their clients receive may not fully reflect the decline in market value in this spread-widening environment associated with a ‘flight to quality’.

Recommendation

Most insurance asset managers undergo a SAS 70 review of operational controls so that their clients can rely on the manager’s processes and procedures. The SAS 70 reviews that were performed for 2007 covered a number of areas, including pricing. Since FAS 157 was adopted late in the year, is not effective until 2008 for nearly all of our clients and the audit testing procedures for security pricing is currently being developed by the accounting firms, 2007 SAS 70 reviews did not involve detailed and rigorous testing of pricing policies and procedures.

At AAM, we plan to significantly expand our 2008 SAS 70 review to include this testing. In the meantime, we are prepared to provide documentation to clients as to the pricing source for 2007 audits. We are not willing to ask that our pricing sources sign letters for pricing confirmation. This requirement will inevitably lead to their refusal to provide observable inputs for pricing purposes. If we are not able obtain accurate observable inputs from the brokerage community, our only pricing source will be pricing feeds from a third party provider that contain prices that do not accurately reflect fair value. We do not believe this is the intent of FAS 157 and owe it to our clients to avoid this outcome.

We are distributing this to clients, prospects and third party consultants and ask them to discuss this with their auditors. We would welcome any questions or feedback.

Joseph A. Borgmann
Vice President – Investment Accounting

October 23, 2007 by

The Summary

Last week, as the FASB decided not to defer the November 15, 2007 effective date of FAS 157, GAAP filers lost all hope for the ability to delay its adoption and preparation of related disclosures. The pronouncement requires companies to group their investments into the following categories:

Level 1 – Rate is an unadjusted quote from an active market
Level 2 – Rate was derived from “observable” inputs
Level 3 – Rate derived from some “unobservable” inputs
FAS 157 also requires companies to disclose a 1/1/2007 – 12/31/2007 roll-forward of their Level 3 investments. For reference, Citigroup’s 10Q SEC filing for June 2007 includes a good example of these disclosures.

To aid our clients in preparing these FAS 157 disclosures, AAM will be providing a report to clients that groups our pricing between the three categories. Please contact your client service representative for more information.

The Details

AAM obtains our pricing primarily from Interactive Data Corporation (IDC). Security prices that are not available from IDC or securities where the IDC prices are not reflective of fair value are priced based upon broker quotes.

Based on guidance received from IDC, we believe that the IDC prices used by AAM can be considered either Level 1 or Level 2. In addition, based on a review of how other companies have implemented FAS 157 and our interpretation of these new disclosure requirements, we believe broker-provided pricing can be considered Level 2. In the rare event where there are securities that are priced internally at AAM, using internal assumptions (without the support of broker-provided information), we will classify these securities as Level 3 for FAS 157. As with any newly issued accounting guidance, we strongly urge you to discuss your application of the guidance with your auditors and would appreciate any feedback.

On the NAIC Horizon

The NAIC – Securities Valuation Office (SVO) has put forth a proposal that a new Schedule D column be added, which requires insurers to classify investments among the following categories:

Rate is determined by SVO
Rate is determined by an approved pricing service
Rate is determined by a stock exchange.
Rate is determined by a broker or custodian
Rate is determined by the insurer

This proposal is currently being looked at by the NAIC Blanks Working Group and will likely be added to the agenda this December for comment. We do not anticipate that this proposal will be implemented for year 2007 statutory reporting.

Joseph A. Borgmann
Vice President – Investment Accounting