A new GAAP accounting standard that allows insurers to select financial assets and liabilities to be reported at fair value is upon us. The new standard presents insurance company managers with serious challenges in choosing which assets and liabilities to report using fair-value accounting, and in making appropriate disclosures about their choices.
The Financial Accounting Standards Board has issued its Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities." At the same time, FASB established a new standard for measuring "fair value"–Financial Accounting Standards No. 157, "Fair Value Measurements."
For the first fiscal year beginning after Nov. 15, 2007, entities reporting under U.S. generally accepted accounting principles (GAAP) can choose to measure many financial instruments at fair value.
FAS No. 159 has serious repercussions for insurance companies. For the first time, an election may be made to account for financial assets and liabilities–including loss reserves and reinsurance recoverables–on a fair-value basis.
Under fair-value reporting, the reported value is supposed to represent "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date." This includes investment securities even if an insurer plans to hold them to maturity.
For loss reserves, this can include discounting to present value, since the market typically gives recognition to the time value of money in market transactions involving the transfer of insurance liabilities.
Reinsurance recoverables could be affected by the perceived credit quality of the reinsurer, since the market would typically take this into account.
The option may be applied instrument by instrument. This means portions of an investment portfolio may be revalued. It also means insurance and reinsurance contracts may be selectively revalued.
The potential trouble in making a choice is that the fair-value election of only certain assets or liabilities could be viewed as manipulative if not done in a principled way that is properly disclosed to investors. This is particularly true if the result of the election is short-term improvement.
The fair-value option, once elected, is irrevocable. A business entity will report unrealized gains and losses on items for which the fair-value option has been elected in its earnings at each subsequent reporting date.
The practical effect of a fair-value election, contrary to most conventional commentary, may be a one time "boost" in taking assets or liabilities up to a fair value, and thereafter increased volatility, as a periodic "mark to market" or "mark to model" valuation is required.
Under the transition provisions of FAS 159, entities are allowed to reconsider the accounting for eligible financial instruments existing on the adoption date. Entities report the effect of the remeasurement to fair value at the time of the adoption as a cumulative-effect adjustment to the opening balance of retained earnings. This will have the effect of recording certain unrealized losses directly in retained earnings, without any income statement impact.
Commentators have expressed concern over this effect of a FAS 159 election. Indeed, the Center for Audit Quality has warned auditors to look out for companies that choose to fair value underwater securities so as to move the loss directly to retained earnings, and then replace those securities with similar instruments that are not fair valued. Such short-term maneuvers violate the principles of FAS 159.
A concern with FAS 159 implementation could be hindsight challenges to what assets and liabilities were selected–and, more importantly, why.
If only undervalued assets or overvalued liabilities are selected (with a corresponding positive impact to the entity's accounts), or if only loss positions are selected (with a resulting avoidance of income statement impact), some regulators may later accuse those involved in making the selection of "cherry picking" to enhance financial results.
In response, a careful, rational decision-making process and robust documentation FAS 159 implementation would be prudent.
Moreover, the disclosures required to accompany fair-value reporting could create some new traps.
FAS 159 requires companies to disclose information to enable users of its financial statements to understand management's reason for electing or partially electing the fair-value option. Management must be careful about making selections based on a conclusion that fair-value reporting results in a "truer" depiction of the economic value of a particular asset or liability.
This carries the implication that fair value will always be used when doing so presents a truer picture.
FAS 159 also requires disclosure of how changes in fair value affect earnings. Management should have a solid grasp of all of the factors that could interject volatility into reported values for assets and liabilities so that complete disclosure is made and there are no surprises.
While FAS 157 generally promotes "mark to market," there are securities which are harder to value.
Some securities can only be "marked to matrix" using "observable market data" for similar or comparable assets, or "marked to model" based on managements' best judgment and assumptions–including "assumptions about the assumption market participants would use in pricing the asset."
Complex structures, such as finite reinsurance products, could be particularly susceptible to volatility as a result of the need to rely on matrices and models.
(It should be noted that one reason for finite reinsurance–the ability to design a program that could allow discounting–would be obviated with the fair-value option choice applying a present value discount to the underlying business).
As the degree of pricing precision decreases, the potential for "after the fact" challenges to selection of certain assets for "fair-value" treatment increases. Again, documentation of the selection process and a defensible, rigorous selection criteria seem prudent, especially with the less easily marketable or tradable assets.
FAS 159 is part of the trend toward "principles-based" standards, and should be considered in light of the FASB-articulated principle–to mitigate volatility in reported earnings. However, comparability among insurance companies will suffer, as those making different FAS 159 elections will no longer be comparable.
Finally, insurance companies need to think carefully about all possible consequences of moving to fair-value accounting, including difficulty in reliable bases for making valuations.
For example, application of the fair-value option to an insurance contract requires fair valuing all claims and obligations under the same contract–which for a reinsurance treaty could possibly require fair valuing all underlying contracts that the treaty reinsures.
However, insurers might lack access to adequate information to do this reliably. The recent market turmoil in CDOs caused by subprime lending demonstrates the difficulty of valuing illiquid financial instruments and relying on models that involve rapidly changing assumptions.
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