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.