Flashcards in Chapter 2 Deck (51):
Bonds and preferred stocks are sometimes referred to as fixed income securities.
*Their market value is largely dependent on the current interest rate environment.
* Valuation of bonds: The amount paid plus or minus any premium or discount amortized to date to adjust the value to par or face amount by the maturity date.
Bonds are classified into 3 categories:
U.S. Government Bonds, Municipal Bonds, and Corporate bonds:
*bonds secured by physical assets
*Are not secured but are backed by general credit.
Sinking fund bonds
*Require funds to be set aside for the periodic redemption of the bonds during their lifetime. A trustee is usually involved, receiving the payments from the borrower at specified times and disbursing the payment of principal and interest.
*Are bonds issued on the same date but with sequential maturity dates that usually cover a span of several years. The interest rates on serial bonds of the same issue may vary. They differ from sinking fund bonds in that each serial bond has a definite maturity date, whereas sinking fund bonds are called on random selection by a trustee to satisfy the mandatory retirement provisions.
contain provisions allowing them to be converted into a specific number of shares of preferred and/or common stock, under *predetermined conditions and at stated prices throughout the lifetime of the bonds.
Mortgage-backed securities (MBS) or Asset-backed securities (ABS)
*are treated as bonds and reported in Schedule D.
Collateralized mortgage obligations (CMOs) or collateralized bond obligations (CBOs) are MBS backed by a pool of individual mortgage loans or bonds and are discussed later in this chapter.
U.S. Government Bonds Characteristics:
*a. Treasury Bills - maturity date of 1 yr or less.
*b. Treasury Notes - maturity between 1 and 5 yrs.
*c. Treasury Bonds - maturity dates in excess of 5 yrs
*d. Other - e.g., GNMA.
Municipal Bonds Characteristics.
are issued by state, county, and city governments, as opposed to the federal government and are generally federal tax exempt to the bondholder, i.e., the interest paid on these debt securities is free of federal income taxes to the recipient.
a.*General Obligation - of states, territories and possessions, as well as of political subdivisions, are backed by the taxing authority of the issuer and considered relatively safe as to interest and principal because their basic strength lies in the ability of the issuer to levy taxes.
b. *Revenue - Special revenue municipal bonds differ in that they are not backed by the right of the municipality to levy taxes to satisfy interest or principal. Rather, they depend on the revenue generating ability of a particular project for interest and principal payments. Although revenue bonds may bear the name of a municipality, customarily the borrower’s purpose is to make a major improvement such as building a highway, sewage disposal unit, electric or gas distribution system, bridge, tunnel, or hospital.
Corporate bonds characteristics
are separated by the NAIC between public utilities and industrial and miscellaneous.
Preferred Stocks characteristics
Valued at Cost. The par value of preferred stock generally represents the initial capital paid into the issuing corporation by preferred stockholders.
Prior claim to dividends paid from earnings over the holders of common stock and also have prior claim in the event of liquidation of the issuing corporation. Has a limited, and frequently fixed, income return per year.
*Preferred stocks remain outstanding as long as the corporation is a going concern. Unless redeemable by contract or at the option.
*Although gaining this priority in earnings, preferred stock usually loses the common stock privilege of voting power and has a limited, and frequently fixed, income return per year. Frequently, preferred stock only has voting rights when scheduled dividend payments have not been paid.
Four types of preferred stock as to dividend rights
non-cumulative, cumulative, participating, and Dutch Auction.
Non-cumulative preferred stockholder has no
right to dividends that may have been passed or omitted in any previous accounting year.
Participating preferred stock shares in the operating profits of the issuer in accordance with a predefined formula described in the prospectus.
*Dutch Auction preferred stock has adjustable dividend rates that are determined by bids competitively received from corporate holders. These shares are also known as money market preferred stock.
Step-up preferred stock characteristics.
*is a preferred stock that has cash flow characteristics of a debt instrument.
Their valuation would be more consistent with the valuation of redeemable preferred stock. As such, it would be valued at cost or amortized cost for those securities with a designation of 1 to 3. All other step-up preferred stock would be reported at the lower of cost, amortized cost or fair value.
Common Stocks Characteristics
Valued at Market Value.
Common stock represents pure ownership with all of the associated risks. The market values are volatile, fluctuating with numerous external factors. Dividends on common stock are completely discretionary on the part of the issuer’s board of directors.
*Common stockholders are the last to receive any payment in the event of liquidation. They are also last to receive any income earned, but they are entitled to receive all earnings declared as dividends, without general limitation.
can be issued separately or sometimes are issued with bonds and stocks, allowing the holder to buy shares of common stock some time in the future. Warrants may be traded like the common stocks to which they originally were attached.
A mutual fund is a pool of investments registered with the Securities and Exchange Commission (SEC) and marketed through investment broker/dealers and managed by an investment adviser.Mutual fund investments can be used by an insurer to diversify investment portfolios while limiting risks. The accounting for mutual fund shares in a life insurance company’s general portfolio is virtually no different than accounting for another common stock.
The selling of a security with the intent to acquire the same or substantially the same security within a short period of time. For tax purposes, losses on wash sales are generally not deductible unless the reacquisition takes place more than 30 days later.
Bond and Stock accounting
Recorded at cost. Asset values change for amortization of premium or discount and for market valuation changes where appropriate (impairment or equity securities, for example).
*is a proportionate distribution of new stock to all shareholders. Stock dividends are disbursed to common stockholders in addition to cash dividends as a method of capitalizing earnings on the corporation’s books.
*For tax, GAAP, and SAP purposes, *no income is recognized; but the basis of the stock is reallocated proportionately to the total shares held.
For the issuing company, the capital stock amount is increased and the surplus decreased for the par value of the stock distributed.
(Like stock dividends) are also distributions of new stock issued proportionately to all shareholders. Stock splits are generally distributions of shares by the corporation to increase the number of shares outstanding.They differ from stock dividends in that they affect value per share versus retained earnings.
Zero Coupon Convertible Bonds
are comprised of a bond and a warrant (an embedded
derivative). In certain cases a zero coupon convertible bond may be purchased at a premium, due to the value of the bonds. The convertible bond is accounted for as a bond, with no value attributed to the warrant. As a result, a zero coupon convertible bond purchased at a premium may result in a negative yield due to the value of the bond exceeding the bond discount. The premium on a zero coupon convertible bond shall be written off immediately upon purchase, to prevent a negative yield.
In contrast to a coupon bond where the interest can be reinvested only at then current rates, the zero coupon bond locks in a constant rate and postpones reinvestment risk or benefit. The zero coupon bond pays no interest but is purchased at a substantial discount. The investor receives the equivalent of interest compounded over the life of the bond.
*are charged to borrowers of private placement bonds for the promise of funds. They are considered part of future yield and are spread over future periods, similar to GAAP.
*these are considered financing transactions rather than sale and repurchase transactions and are recorded as collateralized loans.
*If accounted for as a financing transaction, an equivalent security is purchased, a liability is recorded for the amount of the proceeds received, and the transferred securities are not removed from the accounting records. The liability is reported as borrowed money in the Statutory Statement and identified as arising from, and related to, a repurchase transaction.
*The difference between the proceeds and the amount at which the securities will be subsequently reacquired is recorded as interest expense calculated using the interest (constant yield) method.
*If the transaction does not meet the criteria for financing accounting, the transaction is considered a sale and purchase separately. As in securities lending, the statutory guidance requires that repurchase agreements be secured by cash or cash equivalents of at least 102 percent of the transferred security’s
market value. If the collateral market value is less than 102 percent, then the value of the transferred securities is reduced by the amount of the collateral deficiency. SSAP No. 45, Repurchase Agreements, Reverse Repurchase Agreements, and Dollar Repurchase Agreements, addresses these agreements, provides guidance regarding similarity,
limits the exchange period to 12 months, and continues the accounting as collateralized landings.
Dollar repurchase and dollar reverse repurchase agreements
*Are defined as repurchase or reverse repurchase agreements involving debt instruments that are pay through securities collateralized by the Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC); pass through certificates sponsored by GNMA; mortgage participation certificates issued by FHLMC or similar securities issued by FNMA.
use to address or hedge interest rate or market volatility, to enhance investment income (income generation transactions), and to protect or raise profit margins. Synthetic or derivative investment instruments fall into two classes: notional and cash market instruments.
National Instruments: Options, both puts and calls, warrants, futures, interest rate swaps, and caps, floors, and collars are notional instruments which, by definition, are contracts where the risks of changes in value are transferred without a transfer or exchange of the notional amount.
Cash market instruments: These are distinguished from other instruments that focus on customizing cash flows, such as collateralized mortgage obligations
(CMOs) or bond obligations (CBOs) or asset backed securities (ABS).
Cash Market Instruments
Focus on customizing cash flows. These instruments are packages of assets that are subdivided in various forms as tranches. These securities are frequently subject to prepayment risk, that is, prepayments may significantly increase the risk associated with the various types of securities that are backed by pools of mortgage loans. These instruments are typically issued by a special purpose entity, which may be organized in a variety of legal forms, such as a trust, a corporation, or a partnership.
Examples include CMOs, real estate mortgage investments conduits (REMIC), and IO or PO strips (interest only/principal only).
Asset-backed Security (ABS)
A security that is collateralized by loans, leases, unsecured receivables, or installment contracts on personal property (as opposed to real estate) such as computers, automobiles, or credit cards. A CBO is a form of ABS.
Mortgage-backed Securities (MBS)
A generic term that refers to securities backed by mortgages, including passthrough securities, mortgage backed bonds, mortgage pay through securities, and CMOs.
Pass-through Mortgage backed Security
A security representing an undivided ownership interest in an underlying pool of mortgages. The cash flow from the underlying mortgages is “passed through” to the security holder as monthly payments of principal, interest, and prepayments. The security holders become the owners of the underlying mortgages. Pass through securities have been guaranteed by the GNMA and issued by the FNMA and FNLMC as well as by private institutions.
Collateralized Mortgage Obligation (CMO)
CMO are most like debt instruments because they have stated principal amounts and traditional defined interest rate terms. Classified as Bonds. Purchased discount or premium is amortized using a traditional interest method.
A type of mortgage pay through bond (a debt obligation of the issuer, secured by mortgage collateral owned by the issuer,whose cash flow is related to the cash flow on the mortgage collateral) characterized by a multiclass (or multi-tranch) serialized structure. CMOs are partitioned into several classes (tranches) of bonds of serialized priority by which bonds are redeemed.
CMOs may be collateralized by FHA-insured or VA-guaranteed mortgages; conventional mortgages; whole loans; GNMA, FMNA, FHLMC pass-through MBS; or any combination thereof.
CMOs are collateralized by mortgage loans or MBS that are transferred to a trust or pool by a sponsor, and the issue is structured so that collections from the underlying collateral provide the cash flow to make principal and interest payments on the obligations,
or tranches, of the issue.
An acronym for real estate mortgage investment conduit. A REMIC is a vehicle created under the Tax ReformAct of 1986 for issuing MBS. REMICS may be structured as corporations, partnerships, trusts, or as a segregated pool of assets and will not be subject to taxation at the issuer level if in compliance with the requirements of the Act.
*CMO tranches that receive principal payments based on the relative position of a tranch in a deal. The first or the earliest tranch is the recipient of all principal payments until it is retired. Subsequently, the next tranch in the sequence receives all principal cash flows. Earlier tranches, therefore, can provide a cushion or call protection to later tranches if the cycle of prepayments reverses.
Planned Amortization Class (PACs)
Distinguished from a conventional CMO class
by two features. First, a PAC amortizes principal at a schedule that is predetermined as long as the prepayments on the collateral remain within a broad range of speeds termed as the collar. Second, a PAC can make principal payments at the same time as some or all of the other classes.
Created from the principal payments remaining after the PAC schedules are defined. In general, companion classes have second claim on excess principal and pay sequentially until all of the companions are retired. At the pricing prepayment assumption, companion classes pay simultaneously with the PACs. At very slow constant prepayment rates, they must wait to receive principal until the PACs have been retired. At very high speeds, they pay simultaneously with the short-term average life PACs and are retired quickly, after which the PACs themselves must absorb excess paydowns and are retired ahead of schedule.
Targeted Amortization Class (TACs)
modification of the PAC bond concept. Like PACs, the TAC has priority of receiving principal payments based on a predetermined schedule, provided that the prepayments remain at the expected pricing speed for
the life of the TAC. This in contrast to the collar or range of prepayments in the case of PACs.
Accrual Bonds (“Z” Tranches)
CMO tranches that do not receive any cash payments until all tranches preceding it are retired. Instead, interest income is capitalized until it starts paying down.
The equity interest in an ABS or CMO transaction. In general, the residual holder will receive the difference between the cash flows derived from the collateral and those applied to make payments to the bond holders and to pay trust expenses. The cash flows to the residual owner are critically dependent on the prepayment rate of the underlying collateral.
SAP Accounting for CMOs
regular interest in a CMO is similar to a bond and is reported at cost at acquisition.
Revenue Calculation: The effective life can fluctuate with changes in the prepayment rates of the underlying mortgages. Methods to factor prepayment uncertainty into the amortization of discount and premium are: Prospective and Retrospective method.
Retrospective and prospective method for SAP accounting for CMOs
Prospective Method: effective yield be recalculated at each reporting date if there has been a change in the underlying assumptions. No change in the carrying amount is required to be recognized unless the undiscounted anticipated cash flow is less than the carrying amount of the investment, that is, the effective yield cannot be negative.
Retrospective or cumulative catchup method: changes both the effective yield, if there has been a change in the underlying assumption, and the asset balance so that expected future cash flows produce a return on the investment equal to the return now expected over the life of the investment.
a retrospective adjustment of the carrying value for high-risk CMOs. However, a prospective adjustment of yield is allowed for CMO residuals. Either approach can be used.
are complex financial instruments whose values depend on the values of one or more underlying assets or financial indexes.Notional contracts can be
one sided or two sided, depending on whether the risk of changes in value can move in either direction and affect the contract holder. Stock options, call contracts, and put contracts are technically neither stocks nor bonds.
Two sided contracts: Swaps and futures
One sided Contracts: options, caps, and floors.
Interest Rate Swaps
An interest rate swap is a contractual agreement between two parties to exchange interest rate payments, e.g., fixed for variable, based on a specified amount of underlying assets or liabilities, known as the notional amount, for a specified period. The swap does not involve an exchange of principal.The cash exchanged between the parties is usually the net interest differential only. In general, interest rate swaps are off-balance-sheet items, disclosed in the footnotes to the financial statements.
Financial Futures or Interest rate futures
*Represents a firm commitment to buy or sell a specific amount of a certain financial instrument, to be executed at a specific date, at an established price. Are contracts based on financial instruments whose prices fluctuate with interest rate changes.
*Financial futures are generally bought on margin, which, in the futures market, is a good faith amount paid to open and maintain a position.The most common financial futures are in Eurodollars, Ginnie Maes, Treasury bonds, or Treasury notes.
*Futures transactions are shown in Schedule DB.
Insurance companies, with a substantial portion of their assets invested in interest rate sensitive instruments, may find financial futures to be an effective means for hedging against market risk.
Tax consideration: the federal income taxation of transactions involving futures contracts is quite complex. Accordingly, tax counsel should be sought
Futures Versus Options
The differences between futures and options are several, even though either or both may be used to meet investment or hedging objectives.
• An options holder has no requirement to fulfill the contract as a futures contract holder does.
• An option holder has no daily margin requirement.
• Risk is limited for option buyers to the amount of option premium; futures holders must perform under the contract.
• Option contracts provide rights throughout the option period, whereas futures contracts have a specified delivery date.
• Fluctuations in the values of futures affect investors regardless of the direction of the movement; options contracts are one sided.
Investment in Subsidiaries and Affiliates
NAIC guidelines define a subsidiary as any organization directly or indirectly owned or controlled by the insurer, with the assumption that 10 percent or more of voting securities constitutes control. Investments in subsidiaries are generally carried at one of the following bases:
(1) Market value for a partially owned, publicly traded subsidiary, meeting specified criteria.
(2) SAP net worth for an insurance subsidiary plus, in some jurisdictions, unamortized goodwill, subject to limitations on admissibility.
(3) Audited GAAP net worth for a non-insurance subsidiary with significant ongoing operations beyond the holding of assets that are primarily for the direct
or indirect benefit or use of the reporting entity or its affiliates.
(4) SAP net worth for a non-insurance SCA entity that has no significant ongoing operations other than to hold assets that are primarily for the direct or indirect benefit or use of the reporting entity or its affiliates.
The NAIC limits the statutorily admissible goodwill to 10 percent of an insurer’s prior period statutory capital and surplus, excluding DP equipment, goodwill and deferred tax assets, and requires that goodwill be written off over a period not to exceed 10 years.
Bonds and Stocks operating functions
• Review of investment or credit risk.
• Authorization for trading.
• Execution of transactions.
• Managing income and expenses.
• Recording investment activity.
• Safeguarding assets.
• Valuation of securities.
*investment department: responsible for evaluation of risk, rate of return, authorization and execution of transactions, and reporting to senior management or the board of directors on these aspects of investing.
*Safeguarding securities may be a function for the treasurer or controller.
*The insurance accountant is more concerned with overseeing income and expenses, recording activity, and valuation for financial reporting; however, the investment department is also involved in these functions.
*Primary sources of a life insurance company's earnings are:
*mortality gains, expense gains, and investment gains. These gains arise if the insurance company realizes a greater margin than priced for in the product design.
*If the company can realize a greater return than that priced for, investment gains result. It’s difficult, though not impossible, for an insurance company to distinguish itself from its competition in the expense and mortality areas; however, investments can produce distinctive gains, and each company has a different investment philosophy.
Call Option and Put Option?
* A call option gives the buyer the right, for a price (the option premium), to buy shares of an indicated security
at a stated price (the strike price) until a stated expiration date.
*A put contract gives the buyer the right to sell a security at a stated price until a stated expiration date.
Accounting and Hedging Overview
Three elements were needed to qualify for GAAP hedge accounting treatment
Historically, three elements were needed to qualify for GAAP hedge accounting treatment under FAS No. 80, Accounting for Futures.
*The item being hedged must
• contribute to the company’s exposure to interest rate or price risk.
• The transaction entered into must be formally designated as a hedge transaction.
• And lastly, the item being purchased as a hedge must be effective in offsetting the risk exposure previously identified.
These elements are incorporated in SSAP No. 31. Moreover, many jurisdictions set forth their own requirements.
*A long hedge involves entering into a contract to buy, taken when interest rates are expected to fall, to lock in yields on a hypothetical future purchase of a security. If rates fall, the difference between the higher sell price in a later contract and the lower buy price will produce a gain on the futures transaction. If interest rates rise, a loss would be incurred. A short hedge, or the hedge of an existing position, involves entering into a contract to sell, taken when interest rates are expected to rise. If rates rise, prices will fall, which means that a contract to sell at today’s price can be closed out later with a contract to buy at a lower price. The combined effect is to protect the investor against a decline in market value of the underlying security to be sold in the future.
Bond and stocks systems, processes and control
• The portfolio manager is authorized to buy or sell securities and execute related agreements on behalf of the company.
• The controller is responsible for preparing and maintaining. Accounting records that completely describe all security holdings and transactions.
• The treasurer is responsible for the receipt and disbursement of all funds and usually is responsible for the receipt, delivery, and safeguarding of all securities.
• Control for accounting for bonds or stocks should begin with the portfolio manager.
• The portfolio manager’s signature authorizes the Treasurer’s Department to disburse funds for the transaction.
• The Controller’s Department should be able to determine that the Treasurer’s Department disburses or receives sufficient funds for the purchase or sale. The Controller’s Department records the transaction on the company’s books after all of the details have been found to be in agreement with the broker’s confirmation.
• The final step in the control of acquisitions or dispositions belongs to the portfolio manager. The Controller’s Department prepares the entry on the company’s books and should prepare two reports.
1. One report, to the Board of Directors or Investment Committee, should be a complete report of all transactions involving securities, to be used as part of the minutes of the board or committee meeting and to be preserved as a permanent record.
2. The second report, and an updated listing of securities held, should be for the portfolio manager only.