Insurance Asset Management

JUNE 2010

Another Step Closer to Fair Value Accounting

Peter Rolls The Financial Accounting Standards Board (FASB) has recently proposed significant new accounting
Vice President, guidelines in its Exposure Draft on Accounting for Financial Instruments and Revisions to the Accounting
Head of Insurance for Derivative Instruments and Hedging Activities.
Accounting
One of the Exposure Draft’s most notable changes is its expanded use of fair value. This paper focuses on
those fair value-related proposals that may directly impact companies’ investment portfolios. In particular, it
covers classification and measurement of financial instruments, credit impairment measurement and financial
statement presentation.
The proposed new guidelines are aimed at improving the usefulness of financial instrument reporting
within financial statements and to: 1) Provide financial statement users with a more timely and
representative depiction of an entity’s involvement in financial instruments; 2) Provide more timely
recognition of credit impairments; and 3) Foster international comparability of financial instruments
within financial statements, with a goal of eventual US GAAP/IFRS convergence.
The FASB is accepting feedback to the Exposure Draft through September 30, 2010, and the final
Accounting Standards Update (ASU) is targeted for release in the first half of 2011.

Classification and measurement New proposed categories

of financial instruments
The goal of these changes is to provide financial statement
users with a more timely and representative depiction
of an entity’s involvement in financial instruments.
Under current accounting guidance, entities have three
options for classifying and measuring financial assets:1
n Trading: Financial instruments acquired for the
sole purpose of profiting from short-term price
fluctuations. These securities are recognized on
the balance sheet at fair value with changes in
fair value measured as a component of Earnings.
n Held to Maturity (HTM): Debt instruments
acquired with the “positive intent and ability” to
hold until maturity. These fixed income assets are
recognized at amortized cost on the balance sheet
with no fair value re-measurement impact to
Equity or Earnings other than for impairments.
n Available for Sale (AFS): Financial instruments
that are not classified as either Trading or Held to
Maturity. These securities are recognized on the
balance sheet at fair value. Changes in fair value
are reflected in the Equity section and measured
within Accumulated Other Comprehensive
Income (AOCI) (other than for impairments).
Under the Exposure Draft’s proposed guidelines,
substantially all financial assets will be recognized
in one of only two possible “carry value” categories:
n Fair Value through Profit and Loss (FVTPL):
Recognized at fair value on the balance sheet
with changes in fair value reflected in Earnings.
FVTPL represents the new default categorization
for financial instruments. The principles of this
category remain consistent with the previous
Trading classification under FAS 115.
n Fair Value through Other Comprehensive Income
(FVTOCI): Fixed income investments recognized at
fair value on the balance sheet with changes in fair
value recognized in Equity as part of AOCI. This
categorization is similar to the FAS 115 AFS
categorization, but it must be elected upon initial
recognition of the asset with additional restrictive
categorization requirements.
Other proposed changes
The HTM classification for fixed income assets has
been eliminated, as companies will no longer be
permitted to carry debt instruments on the balance
sheet at amortized cost. (However, HTM will be
retained in the Liability section for some debt issued

1
Current accounting regulations for financial investment assets are outlined in ASC 320 (Formerly FAS 115 – Accounting for Certain Investments in Debt and Equity Securities).
JUNE 2010
JUNE 2010
by an entity that qualifies for the Amortized Cost
exception). As a result, fair value reporting for
fixed income investments will be required for
balance sheet presentation. The FASB’s elimination
of HTM accounting diverges from current
International Accounting Standards Board guidance
within IFRS 9 – Financial Instruments, which
retains the Amortized Cost classification option for
qualifying debt securities. Both Boards will consider
comments submitted by interested parties in
response to the Exposure Draft proposal in order to
develop more consistent guidance as the draft
progresses.
Another distinction between the new framework
and existing rules is that an investment instrument’s
categorization as FVTPL or FVTOCI at initial
recognition cannot be changed, while existing FAS
115 guidance allows investment transfers between
carry value classifications in “rare” circumstances.
Realized gains/losses on investment dispositions and
coupon/dividend income will continue to be
recognized in Earnings regardless of whether the
associated investment is carried as FVTOCI or
FVTPL. However, this proposed treatment
represents another point of divergence between US
GAAP and IFRS rules. Under IFRS 9, the unrealized
gain/loss on FVTOCI assets currently remains in
Equity, as Other Comprehensive Income, upon
disposition of the asset. That is, the unrealized
gain/loss does not get reclassified, or “recycled,”
into realized gain/loss in Earnings. We would expect
the Boards to address this significant difference in
future policy updates.
Summary of Proposed Investment Classification Changes
Existing US GAAP Guidelines
Trading
Available for Sale (AFS)
Held to Maturity (HTM)
Entities can choose any of 3 classifications
based on intent and ability to hold
Classification may change during life
of investment holding
2
FVTOCI qualifications differ substantially from qualifications for asset classification under AFS.
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FVTOCI classification requirements
Entities that wish to recognize periodic changes in
fixed income investment market values within
Other Comprehensive Income rather than Earnings
must formally elect FVTOCI classification. They
must do so at initial recognition of the investment,
or they will be irrevocably defaulted to FVTPL.
Instruments must meet all of the following three
tests in order to qualify for FVTOCI:
n Business model test: Attempts to determine the
reasons for holding financial instruments within
the context of an entity’s overall operations and
business strategy. In order to qualify, entities will
be required to assert that they do not intend to
actively trade an instrument or portfolio of
instruments. Rather, the investment’s purpose
should be to collect associated cash flows over
the longer term. The company may demonstrate
its intent to hold by showing that it has
historically held a significant proportion of
similar instruments for long time periods relative
to their contractual terms.
n Contractual cash flow obligation: Requires that
investments with FVTOCI classification have
minimal cash flow variability. To meet the
contractual cash flow obligation, the entity must
show that the investment represents a principal
debt instrument with a formal maturity date and
that its contractual terms identify all cash flows
to be paid to the investor through maturity. The
instrument’s terms cannot allow it to be prepaid
or settled in a manner that would not allow the
investor to recover “substantially all” of its
original investment.
FASB Exposure Draft Proposals
Fair Value Through Profit and Loss (FVTPL)
Fair Value Through Other Comprehensive Income (FVTOCI)2
[No longer applicable]
FVTPL is the default classification; FVTOCI must be elected and meet specific
classification criteria
Classification at initial recognition and irrevocable thereafter

n Non-hybrid instruments (embedded derivatives):
If the investment is a structured fixed income
product, there must be a clear and close
relationship between the host instrument and the
underlying derivative in order to qualify for
FVTOCI treatment. Instruments that do not meet
the clearly and closely related requirements
outlined in Topic 815 – Derivatives and Hedging
will not qualify for this category.
Investment instruments with no FVTOCI
classification option
FVTOCI election is not an option for many
instrument types. Classification requirements under
the Exposure Draft for excluded asset classes
include the following:
n Trading fixed income instruments: Fixed income
investments unable to meet the FVTOCI election
requirements outlined above must be classified as
FVTPL.
n Equities: Because equity instruments typically do
not have a principal amount, or contractually
stated cash flows, the FASB’s view is that a
measurement other than fair value does not
provide predictive value to the financial
statement user. Therefore, equities can only be
classified as FVTPL under the new guidance
(except certain strategic investments accounted
for under the equity method).
n Hybrid instruments (embedded derivatives):
Inability to prove a clear and close relationship
between the host instrument and the underlying
derivative will require the entire hybrid financial
instrument (both host and underlying) to be
recognized as FVTPL.
Are the securities any of the following?
n Trading fixed income
n Equity investments
n Embedded derivatives
n Derivates
No
Non-trading fixed income securities?
Yes
Does investment meet business model requirement
of not actively trading the investment?
Yes
Does the investment have limited variability contractual
cash flows and a formal maturity date?
Yes
INSURANCE ASSET MANAGEMENT SOLUTIONS
INSURANCE ASSET MANAGEMENT SOLUTIONS
n Derivatives: These instruments will continue to
be marked to market with fair value changes
measured in Earnings. The FVTPL classification
has no impact to derivatives reporting versus
previous accounting rules.
Credit Impairment Measurement
The goal of these changes is to provide more timely
recognition of credit impairments.
Calculation methodology
The Exposure Draft enhances the single impairment
model for loan assets, debt securities and beneficial
interests with credit losses. It allows an entity to
evaluate losses on an individual asset or pool basis.
The proposal will accelerate impairment loss
recognition as it will be measured based on the change
in present value of estimated cash flows attributable
to credit without regard to whether or not a loss is
“probable.” The change clarifies that an entity
should not wait for a default or other cash flow
shortfall to conclude that a credit impairment exists.
At each balance sheet date, entities with FVTOCI-
categorized financial instruments must assess
whether or not impairments need to be recognized.
The Exposure Draft clarifies that “an entity should
recognize credit impairments at each reporting
period when it does not expect to collect all amounts
due according to the contractual terms of the
financial asset.” It also dictates that the entity
calculate net present value using an effective interest
rate discount methodology to determine the amount
of credit related impairment. Other-than-temporary-
impairment credit losses would continue to be
bifurcated and run through Income in the period
Yes
For illustrative purposes only.
Fair Value Through Profit
and Loss (FVTPL)
No
Fair Value Through Other
Comprehensive Income (FVTOCI)
No (May be elected)
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JUNE 2010
that such impairment is identified, with a
corresponding credit to an allowance account for
credit losses that is presented as a contra-asset
account in the balance sheet.
Impairment classification considerations
The Exposure Draft proposal states that in
determining the prospective collectability of cash
flows associated with an asset, an entity must
consider all available information relating to past
events, and existing conditions of the investment.
The document refers to factors such as economic
variables associated with the issue, issuer and
industry, remaining payment terms of the
instrument, credit concentrations and potential
political implications, among others, as viable
reference points.
The Exposure Draft also states that it is inappropriate
to automatically conclude that a financial asset
remains unimpaired simply because its fair value
exceeds its amortized cost. It also clarifies that
every decline in fair value is not necessarily
representative of a credit impairment. As with
current accounting guidance, an entity will be
required to assess whether or not an impairment is
other-than-temporary when the fair value of the
Summary of proposed impairment measurement changes
Existing US GAAP Guidelines
Focus on probable incurred losses
No specific guidance for establishing a discount rate to use in
calculating net present value
Credit impairment reversal prohibited
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debt security is less than its amortized cost basis at
the balance sheet date. The Exposure Draft’s
objective is to require entities to more carefully
assess whether or not the current fair value is
indicative of a credit impairment resulting from the
inability to collect contractual cash flows from the
borrower or issuer.
Impairment reversals
Another substantive proposed change in the
Exposure Draft involves the ongoing assessment of
securities that have had a credit impairment
recognized in Earnings and display an improvement
in the amount and/or timing of expected cash
flows. The Exposure Draft states that an entity may
subsequently recognize a reversal of credit
impairment expense in Earnings (less than or equal
to the amount of the previous impairment amount)
in the period in which cash flow expectations
improve. Any improvement in cash flows above
previously recognized credit impairment losses
should be expressed through the recalculation of
the security’s effective interest rate. This change
moves US GAAP closer to IFRS guidance, which
has historically allowed impairment reversals based
on an asset’s recovery.
FASB Exposure Draft Proposals
Focus on the larger set of past events and current conditions to
assess collectability of cash flows
Calculate net present value of cash flows discounted at the
effective interest rate of the security
Credit impairment reversal permitted under specific conditions

Financial Statement Presentation
The goal of these changes is to foster international
comparability of financial instruments within financial
statements, with a goal of eventual US GAAP/IFRS
convergence.
As mentioned above, current financial instrument
classifications are presented in financial statements
in the following way:
n Trading: Assets are presented on the balance
sheet at fair value with changes in fair value
recognized in Earnings.
n Held to Maturity: These fixed income
instruments are reported at amortized cost on
the balance sheet with no routine fair value
measurement impact to Equity or Earnings
(other than impairments).
n Available for Sale: Assets are presented on the
balance sheet at fair value with changes in fair
value reflected in the AOCI section of Equity.
Under the Exposure Draft proposal, financial
instruments will be displayed separately on the
balance sheet depending on whether fair value
changes are recognized in Earnings or Other
Comprehensive Income.
n FVTPL presentation: An entity will be required
to present on the balance sheet one line item
representing the fair value amount of
investments whose changes in fair value are
recognized in Earnings (Earnings). This
presentation is similar to that of the previous
Trading category.
n FVTOCI presentation: An entity will be required
to present each of the following as separate line
items on the balance sheet:
– Amortized cost
– Credit loss allowances
– Fair value adjustment (Fair value – (amortized
cost – credit loss))
– Fair value
Summary of proposed financial statement presentation changes
Existing US GAAP Guidelines
AFS – Fair value on balance sheet and changes in fair value
reported in Equity
Trading – Fair value on balance sheet with changes in fair value
reported in Earnings
INSURANCE ASSET MANAGEMENT SOLUTIONS
Exposure Draft Implications
For insurance companies, asset liability mismatch
may cause increased earnings volatility resulting
from a company’s measurement of financial assets
at fair value through Earnings while insurance
liabilities will continue to use cost based attributes
in many cases.
Further, while the financial statement impact of
eliminating required bifurcation of embedded
derivatives may be debated, the proposal may
simplify financial reporting because companies will
no longer have to dedicate time and resources to
operationally extracting derivatives from their host
instruments and determining valuations.
The new proposals regarding impairment impact
financial reporting in two key ways. First,
companies will carry more financial instruments at
fair value, with changes flowing through Earnings.
This change should eliminate the need for routine
impairment assessment. Second, companies will
now be able to reverse previously recognized
impairments when cash flow expectations improve.
This reversal can lead to earnings relief in
subsequent periods from prior credit-driven
declines. Previously, companies following IFRS
guidelines had an advantage over US GAAP filers,
as the former were able to reverse impairments.
Now companies using each set of guidelines are on
a level playing field.
Overall, the new FASB guidelines appear likely to
lead to greater volatility of individual company
earnings and/or equity, largely due to the restrictions
on the use of the FVTOCI category and the
elimination of the HTM, or amortized cost, category.
That is, the proposals may have a direct impact on
a company’s Income Statement and the Equity
section of the Balance Sheet, depending on the
FASB Exposure Draft Proposals
FVTOCI – Separate line items in the Equity section for amortized
cost, credit loss allowances, fair value adjustment, fair value
FVTPL – One line item representing fair value of financial
instruments whose fair value is recognized in Earnings
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JUNE 2010

industries in which such companies operate, and

their individual ability to meet the proposed FVTOCI
qualifications for their fixed income portfolio. The Exposure Draft addresses a broad
range of topics, including the following:
Looking Ahead
The Exposure Draft comment period is open n Classification and measurement of
financial instruments
through September 30, 2010. The IASB and FASB
Boards will hold a series of roundtables beginning n Credit impairment measurement
in October 2010 to analyze industry feedback n Financial statement presentation
before final guidance is developed. n Core deposit and hybrid financial liabilities
As such, all information in this document should be n Short-term receivables and payables
considered tentative based on the FASB proposal n Unconsolidated equity investments and
status and expected subsequent decisions based upon loan commitments
the Boards’ review of industry constituent comments. n Hedge accounting
The final Accounting Standards Update is targeted n Debt issued by reporting entities
for release in the first half of 2011. Upon adoption
You can find the Exposure Draft in its entirety
of the ASU, entities will be required to record a at www.fasb.org.
cumulative-effect adjustment to the balance sheet
for the reporting period that immediately precedes
the effective date. The cumulative-effect adjustment
will be calculated in accordance with Topic 250 on
Accounting Changes and Error Corrections. This
would require an entity to restate its preceding
period balance sheet with the first statements issued
after the ASU effective date. Early adoption would
not be permitted.

Peter Rolls joined Goldman Sachs Asset Management as Head of Insurance Accounting in June
2007. In this role, Peter is responsible for implementing and overseeing client prescribed accounting
policies that meet insurance accounting standards as well as supervising the investment accounting
and reporting function for Goldman Sachs Asset Management insurance clients. Previously, Peter
was an Assistant Vice President at Munich Re America where he was responsible for the daily
oversight of the investment accounting operation, and managed a team responsible for conducting
analysis and reporting for the firm’s investment portfolio. He also held positions in accounting at
Prudential Financial, Princeton Financial Systems, Sumitomo Marine Management (USA), Inc., and
Sun Alliance USA Insurance Group. Peter graduated from Richard Stockton State College with a
BA in Accounting in 1991.

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