Fitch Believes Future Impairments May Overshadow New Fair Value Guidance for U.S. Life Insurers
More News related to Press Releases
- T-WORKS Launches Board Marker Projector Screen - A New Generation of Board Screen
- Van Nuys Airport's 80th Anniversary Event Honors Life-Saving Medical Flight Crews
- Microsemi Board Supports CEO; Governance Committee Reviewing Academic Credentials
- U.S. Must Own Up to Misdeeds, Says Grawemeyer Religion Winner
- CFIA/Warning: Allergy Alert-Undeclared Milk in Sunridge Farms Organic Dark Chocolate Almonds
NEW YORK--(BUSINESS WIRE)--
Recently, the SEC and FASB issued a joint statement (1) 'clarifying' guidance on mark-to-market rules for valuing balance sheet assets in the current market environment. The new guidance essentially gives management discretion to use their own estimates (Level 3 in the fair value hierarchy (2)) in those cases where market observations (often classified as Level 2 in the fair value hierarchy) do not reflect orderly transactions in this illiquid market. However, management estimates must incorporate current market participant expectations of future cash flows and include appropriate risk premiums, which Fitch believes may limit any significant benefit in valuation.
Companies - including U.S. life insurers - have typically marked-to-market structured securities using broker quotes or related index pricing on a GAAP or IFRS basis, which has led to significant unrealized losses reflected on the GAAP/IFRS balance sheet as a reduction of shareholders equity. Although this guidance may be considered potentially positive from a current valuation perspective, any benefit could be overshadowed by the aging of existing unrealized losses on structured and other securities that may need to be recognized as other than temporary impairments (OTTI), in Fitch's view. Thus, the clarifying guidance may not ease future capital pressures for U.S. life insurance companies, and such potential capital pressures continue to support Fitch's Negative Outlook for U.S. life insurance ratings.
On a U.S. statutory basis, impairments have been moderate through the first half of 2008 due in part to the less onerous nature of statutory impairment tests for structured securities relative to GAAP/IFRS. Therefore, many insurers have recognized impairments on a GAAP/IFRS basis, but not on a statutory basis - this is an important distinction. Under statutory accounting principles, most bonds are carried at amortized cost. Under GAAP/IFRS, most bonds are carried at fair value. Fitch believes that over the next several quarters insurers will more closely align their statutory impairment practices to GAAP/IFRS as new regulatory guidance is introduced. This will likely mean increased statutory impairments. Therefore, Fitch believes that current statutory capital for the industry is overstated relative to economic capital due to the less onerous accounting for structured securities.
Under the SEC/FASB guidance, companies could measure fair value for structured securities using a discount of expected cash flows, which in Fitch's view is an approximation of true economic value of the securities. In Fitch's opinion, expected cash flows from certain tranches of residential mortgage backed security (RMBS) portfolios originated in particular years may be higher than the current market value indicates. Fitch also believes that expected cash flows from certain pockets of exposure are susceptible to significant losses - particularly Alt A and subprime RMBS originated in 2005, 2006 and 2007. OTTI on these securities should reflect the high level of losses expected.
The Troubled Asset Relief Program (TARP) may set future market prices for structured securities that will be used by all market participants regardless of participation in the program. This would constitute a Level 1 valuation in the fair value hierarchy that would supersede management's estimates.
In the near term Fitch believes RMBS market illiquidity is manageable. As long as life insurers have sufficient liquidity to meet near-term policyholder obligations, they can hold RMBS securities on their balance sheets. Life insurers' risk management programs typically include strict asset/liability matching of durations. In most cases, life insurers average liability durations are between 5 and 10 years, which gives life insurers flexibility in buying and selling securities when managing their investment portfolios. However, if market illiquidity persists and/or policyholders lose confidence in the industry, assets may have to be liquidated sooner than expected and at a significant loss. Regardless of market liquidity, if material cash flow losses begin to emerge on these securities, then the life insurance industry's capital adequacy will be adversely affected.
Notes
(1) The joint statement from the SEC and FASB on Sept. 30, 2008 was confirmed in a FASB Staff Position paper released on Oct. 10, 2008.
(2) The fair value hierarchy is described in FASB Statement No. 157, Fair Value Measurements.
Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
Source: Fitch Ratings
Stocks Mentioned
Related Entities
Sign up for StreetInsider Free!
Receive full access to all new and archived articles, unlimited portfolio tracking, e-mail alerts, custom newswires and RSS feeds - and more!
