Systematic Value INVESTMENT CLASSIFICATION PROJECT: MARKET INSIGHT PAPER

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1 MARKET INSIGHT PAPER INVESTMENT CLASSIFICATION PROJECT: Systematic Value In 2013, the Statutory Accounting Principles (E) Working Group (SAPWG) started work on Ref # , a comprehensive investment classification project for Statements of Standard Accounting Practice (SSAP). This project was started after regulators in the industry expressed concerns over the inconsistent and unclear nature of investment SSAPs. The goal for this project was to clarify definitions and the scope of SSAPs, review reporting procedures and measurement methods, and address conflicting guidance to create consistent and understandable valuation and reporting methods of investment SSAPs.

2 2 MARKET INSIGHT PAPER SSAP No. 26 Bonds To help be more consistent with GAAP and to make SSAP No. 26 Bonds more comprehensive, a definition of a security was incorporated to be compatible with GAAP and SSAP No. 37 guidance. A requirement for bonds to have a contractual amount due was also included in SSAP No. 26. Exceptions to this requirement have been added, revised, and clarified for hybrids, bank loans, convertible bonds, trust preferred securities, and more. The exception that has generated the most discussion has been SVO-identified funds. Systematic Value Essentially, systematic value changes the carrying value of a bond ETF by comparing the interest received during a period to the income that would be recognized under a constant yield approach based on the current cash flows of the bond ETF. This method of amortizing a fund is unprecedented in GAAP and SSAP and has raised many questions from regulators, Interested Parties, and insurers on the appropriateness of this treatment and if this treatment could be implemented consistently by every insurer. SVO-IDENTIFIED FUNDS Recent work on Ref # has centered around SVOidentified funds, which are funds that are approved by the Securities Valuation Office (SVO) to be classified as bonds or preferred stock. In reviewing current guidance, the SAPWG considered original cost an unacceptable measurement method for these instruments since original cost does not reflect market changes and had no clear impairment guidance. SAPWG initially pushed for a fair value approach so that these assets would be valued in a manner consistent with other funds. However, there was substantial pushback from small insurers and bond ETF providers about the volatility that a fair value approach would produce, possibly discouraging small insurers from investing in these assets. Historically, small insurers benefit the most from bond ETFs and are most likely to invest in them. These insurers use bond ETFs as a way to access the corporate bond market at a low cost, and to allow for more diversification within their portfolio than they could otherwise achieve by investing directly in bonds. Considering this factor, BlackRock and other major bond ETF providers proposed an alternative calculation method called systematic value. After two years of meetings, debate, and calls, the SAPWG arrived at a new measurement method. The new guidance will require reporting entities to report these bond ETFs at fair value unless an irrevocable election is made to use systematic value. This election needs to be done at the CUSIP level at the time of purchase, or at year-end 2017 reporting if the insurer already holds the investment. Systematic Value Calculation Systematic value recognizes income or expense to reflect changes in the bond ETF s future cash flows. This method also produces less fluctuation than fair value, but still reflects market changes over time as interest rates rise or fall. Calculating systematic value is similar to the process for mortgage-backed securities in SSAP No. 43R. To calculate systematic value: Start with the original cost at acquisition. Using the initial investment and the cash flows of the bond at acquisition, determine the book yield that will be used for the next reporting period. After a distribution from the fund has been received after one month, compare your distribution or interest received to the effective interest, which is calculated as the book value x original cost. The difference between those two numbers is either amortization or accretion on the fund. If the distribution exceeds effective interest, reduce the book value and take an expense, or vice versa. Once the above is completed, recalculate book yield using the new carrying value and the new aggregate cash flows using the current value as the cost of investment. Start the process over for the next month.

3 Impairment Concerns Systematic value will reflect a falling bond ETF price slower than the market will. For this reason, the SAPWG adopted detailed impairment guidance for these securities to ensure that if there is a material decline in fair value, future expected cash flows, or NAIC designation, a reporting entity should impair the asset. If insurers elect to use systematic value on a bond ETF, they must review these three criteria for impairment at least quarterly. 1. If the NAIC designation declines, it may be other-thantemporarily impaired 2. If the Net Asset Value (NAV or fair value) materially declines, then the asset may need to be impaired 3. If the Net Present Value of future expected cash flows materially declines related to either the prior period or the date of acquisition, the asset may need to be impaired For AVR filers, the guidance determining whether a realized gain or loss is credit- or interest-related is similar to what currently exists for bonds. This guidance applies to Life, Accident, and Health companies. Impairment guidance is not changing for P&C or Title companies since this update concerns how impairment losses are allocated in the AVR versus the IMR. If there is a recognized other-thantemporary impairment for an SVO-identified investment, the credit-loss impairment is recognized through AVR and the interest-related impairment is recognized through IMR. Considerations for Adopting Systematic Value Systematic value requires more effort to calculate, so it is most worthwhile for insurers that have a sizeable bond ETF holding. Those considering it also need to make sure they can get data from bond ETF providers. While the three largest bond ETF providers BlackRock, State Street Global Advisors, and Vanguard are making this data publicly available and free of charge, some other ETF providers have not done so. Systematic value cannot be calculated without the underlying cash flows on the fund. Since this calculation is new, it will be watched closely by auditors as it is being adopted. Insurers need to be able to document and understand this calculation. Insurers should also perform impairment testing at least quarterly by reviewing the Present Value of expected cash flows as well as paying attention to the NAV and NAIC designation. For SVO-identified investments held at systematic value, the guidance requires assessment of otherthan-temporary impairment in response to adverse changes in estimated cash flows. Systematic Value Over Time Source: BlackRock. For illustrative purposes only.

4 4 MARKET INSIGHT PAPER Transitioning to Systematic Value Per the NAIC s guidance, insurers must decide whether or not they will use systematic value for each bond ETF they hold. There will be a code code to denote whether or not the entity elects to value SVO-identified funds as systematic value, (if there is no code, fair value should be used). For insurers who elect to use systematic value, the current original cost reporting method will be used for 2017 annual reporting and the systematic value method will be used for 2018 reporting. If insurers elect to not use systematic value, fair value will be used for 2017 annual reporting. It is important for insurers to carefully consider which treatment will best suit their company. Once this election is made, it is irrevocable. The change in valuation for bond ETFs will have a minimal impact for most insurers, but those with significant investments in the security type should evaluate now whether adopting systematic value is right for their organization. Clearwater Analytics is dedicated to keeping insurers up-to-date on the latest regulatory guidance updates and changes. Subscribe to Clear Insights: Clearwater s digital publication, and check our Resources Center for the latest news on Ref #

5 Appendix Example Scenario For future reference: If an existing bond ETF is not currently on the SVO-identified funds list and is later added, insurers can elect to start using systematic value at that point using the BACV at the time that the fund is moved to Schedule D Part 1 to calculate original book yield. A company purchases 10,000 shares of an SVO-identified fund on August 1, 2017 for $105.1/share. The initial book yield is calculated to be 4.5%. Purchase Date Shares Original Price Acquisition Yield Original Cost 8/1/ , % 1,051,000 On August 31, 2017 the company receives a distribution of $0.0335/share. The company compares this distribution to the effective interest (calculated as the prior systematic value multiplied by the book yield or original cost in the first month of using systematic value) to determine how to to adjust the ETF s carrying value. The company then recalculates the book yield based upon the updated cash flows from the fund for use in the next month s calculation. Distribution Effective Interest Book Yield Accretion (Amortization) NAV/ Share Systematic Price Fair Value Systematic Value 8/1/ % ,051,000 1,051,000 8/31/ % (3,349.61) ,047,800 1,051,591 9/30/ % (3,339.60) ,052,300 1,052,203

6 WORLDWIDE OFFICES Boise, Idaho Edinburgh, UK INQUIRIES Clearwater Analytics is the leading provider of web-based investment portfolio accounting, reporting, and reconciliation services for corporate treasuries, insurance companies, and investment managers. Clearwater aggregates, reconciles, and reports on more than $2.2 trillion in assets across thousands of accounts daily. For more than a decade, Clearwater has helped firms such as AIG, Mutual of Omaha, Knights of Columbus, CopperPoint Mutual Insurance Company, Group Health Companies, The Main Street America Group, SBLI, C.V. Starr & Co., Sagicor, Wilton Re., and WellCare streamline their investment and accounting operations. Clearwater remains committed to continuous improvement and encourages insurers to rethink how they approach their investment accounting and reporting challenges. Copyright 2017 Clearwater Analytics. All rights reserved. This material is for information purposes only. Clearwater makes no warranties, express or implied, in this summary. All technologies described herein are registered trademarks of their respective owners in the United States and/or other countries. INS v