Ref #2015-23
Statutory Accounting Principles Working Group
Maintenance Agenda Submission Form
Form A
Issue: Prepayment Penalties and Presentation of Callable Bonds – Bifurcation of Agenda Item 2015-04
Check (applicable entity):
P/C Life Health
Modification of existing SSAP
New Issue or SSAP
Description of Issue:
Based on comments received from interested parties, staff recommended that the Working Group bifurcate the contents of agenda item 2015-04: Prepayment Penalties and Amortization of Callable Bonds into two separate Form A’s. The topic of amortization on callable bonds (including bonds with make whole call provisions) will continue to be documented in agenda item 2015-04; with the topics of accounting for prepayment penalties and presentation of callable bonds (including make whole call provisions) being documented in this agenda item (2015-23).
SSAP No. 26—Bonds, Excluding Loan-backed and Structured Securities currently has guidance requiring prepayment penalties and acceleration fees received upon liquidation of a bond prior to its scheduled termination date to be reported as investment income upon receipt. However, this guidance is conflicting with existing annual statement instructions, as well as how information currently flows on Schedule D-Part 4. Furthermore, with the differences in types of calls (e.g., make-whole call provisions), the “penalty” may not be as easily identifiable (e.g., a standard call price of 105 indicates a penalty of 5).
This agenda item requests Working Group direction on how they would like to proceed with the accounting treatment of prepayment penalties and acceleration fees, either as investment income (current SSAP No. 26 guidance) or as realized capital gains (subject to authoritative literature within SSAP No. 7—Asset Valuation Reserve and Interest Maintenance Reserve). A key issue discussed throughout this document and posed to the Working Group, is whether they believe that prepayment penalties should be reflected within IMR, or if the current accounting treatment is appropriate. To illustrate the impact to IMR under the current accounting treatment (investment income) and the proposed option of realized capital gains, staff has documented examples below.
Investment Income
Consideration / Par Value / BACV at Disposal Date / Gain (Loss)BACV-Par / Penalty
Investment Income
Consideration-Par / Decrease to IMR**
1/1/2016
Call Exercised / 104 / 100 / 102 / (2) / 4 / 2
** As illustrated, the holder of the bond recognizes two accounting benefits at the exercise date; 1) The loss recognized (BACV less Par) will decrease the IMR liability (balance sheet benefit) and 2) The penalty recognized as investment income (Consideration less Par) would increase revenue (income statement benefit).
Realized Capital Gains
Consideration / Par Value / BACV at Disposal Date / Gain (Loss)BACV-Par / Penalty
Gain (Loss)
Consideration-Par / Net Increase to IMR*
1/1/2016
Call Exercised / 104 / 100 / 102 / (2) / 4 / 2
* As detailed above, if this scenario was accounted for under the current accounting treatment of investment income, the holder of the bond would recognize two accounting benefits at exercise date. As shown in this table, the gains/losses at the exercise date offset, leaving an increase to the IMR liability of 2.
To determine the consistency of reporting (on Schedule D-Part 4) across entities for a bond called under a make whole call provision, staff reviewed a CUSIP, which impacted 21 reporting entities, noting that 15 of the entities reported the difference between Consideration and BACV (at the call date) within the Realized Gain/Loss Column (Col. 18) and with no investment income recorded in column 20 (therefore differing from SSAP No. 26 and Schedule D-Part 4 instructions). Additionally, these 15 entities all reported bond interest equal to the same percentage of Par in column 20. Therefore, it appears that (at least for purposes of Schedule D-Part 4) some entities are electing to record the prepayment penalties as realized gains and not within investment income. For those entities using this reporting, staff welcomes comments on whether these balances are included or excluded from the IMR calculation.
Existing Authoritative Literature:
SSAP No. 26—Bonds, Excluding Loan-backed and Structured Securities:
14. A bond may provide for a prepayment penalty or acceleration fee in the event the bond is liquidated prior to its scheduled termination date. Such fees shall be reported as investment income when received.
SSAP No. 37—Mortgage Loans:
(Staff Note: Similar language is also included in SSAP No. 37 for investment income.)
11. A mortgage loan may provide for a prepayment penalty or acceleration fee in the event the loan is liquidated prior to its scheduled termination date. Such fees shall be reported as investment income when received.
SSAP No. 43R—Loan-Backed and Structured Securities:
(Staff Note: Similar language is also included in SSAP No. 43R for investment income.)
11. A loan-backed or structured security may provide for a prepayment penalty or acceleration fee in the event the investment is liquidated prior to its scheduled termination date. These fees shall be reported as investment income when received.
Additional Information – Superseded SSAP Guidance:
INT 99-04: Recognition of Prepayment Penalties Upon Adoption of Codification:
1. SSAP No. 37 requires insurers to report a prepayment penalty or acceleration fee as investment income when received. Currently, some insurers record these fees as realized gains and thus amortize them through IMR. SSAP No. 37 also stipulates a change resulting from the adoption of the statement be accounted for as a change in accounting principle. Upon adoption of Codification, it is probable that some insurers might continue to amortize the existing gain included in IMR and recognize subsequent fees as investment income.
2. Should an insurer release all unamortized amounts included in IMR and related to prepayment penalties upon adoption of Codification and recognize such change in accordance with SSAP No. 3— Accounting Changes and Corrections of Errors (SSAP No. 3)?
INT 99-04 Discussion
3. The working group reached a consensus to instruct insurer’s to release all unamortized amounts included in IMR related to prepayment penalties upon adoption of Codification and recognize such change in accordance with SSAP No. 3.
Activity to Date (issues previously addressed by SAPWG, Emerging Accounting Issues WG, SEC, FASB, other State Departments of Insurance or other NAIC groups): The topic addressed in this agenda item was previously discussed and exposed for comment at the Spring 2015 National Meeting, as outlined in agenda item 2015-04. Comment Letters addressing agenda item 2015-04 are included as an attachment to the Summer 2015 National Meeting Materials.
As detailed in the INT 99-04 excerpt above, prior to codification, some insurers were recording prepayment penalties and acceleration fees on mortgage loans as realized gains and amortizing through IMR. While the intent of INT 99-04 was to no longer have prepayment penalties or acceleration fees recognized as realized gains upon adoption of Codification (and release all unamortized amounts within IMR); it was noted, through discussions with regulators and interested parties, that some insurers would still record these fees as realized gains and amortize through IMR. If the Working Group chooses to recognize prepayment penalties and acceleration fees as realized capital gains for bonds, staff also recommends revisions to SSAP No. 37—Mortgage Loans to clarify this accounting treatment.
Information or issues (included in Description of Issue) not previously contemplated by the SAPWG: None
Staff Recommendation:
Summary: It is recommended that the Working Group move agenda item 2015-23 to the nonsubstantive active listing and expose for comment three potential options for the accounting and presentation treatment for prepayment penalties. The three options include: 1) maintaining current treatment of investment income, 2) reported as realized capital gains, subject to the authoritative literature within SSAP No. 7—Asset Valuation Reserve and Interest Maintenance Reserve and 3) reported as realized capital gains, but excluded from the calculation of IMR. Based on comments received, it is requested that the Working Group direct staff on the accounting and presentation treatment they prefer. Based on the Working Group’s direction, staff will prepare revisions (for exposure at a future meeting of the Working Group) to SSAP Nos. 26, 37 and 43R (as applicable) and the Annual Statement Blanks and Instructions (as applicable) to clarify the accounting treatment and reporting presentation for prepayment penalties and acceleration fees.
As further detailed in the “Additional Discussion” section, staff request comments from the Working Group and interested regulators on the following:
· Do the current instructions/schedules for IMR provide the appropriate level of detail for review and analysis, or would additional schedules and/or instructions be beneficial?
· Would a disclosure pertaining to callable bonds (including make whole call provisions) would be beneficial?
Additional Discussion Supporting the Proposed Accounting Treatments of Prepayment Penalties:
As noted throughout the agenda item and comments received from interesting parties, the key issue surrounding prepayment penalties is whether the penalties should be subject to IMR and the authoritative literature in SSAP No. 7. Based on review of interested parties’ comments and discussion with NAIC staff, there appears to be diversity in the reporting of prepayment penalties, both on Schedule D and the calculation of IMR. In addition, based on review of the Annual Statement Blanks and Instructions for IMR, it appears that there is not a clear way for regulators to identify which individual securities were included or excluded from the calculation of IMR.
While the intent of a make whole call provision is to make the bond holder “whole” if the issuer elects to call the bond prior to maturity, it has been identified that an increasing number of bonds being called under this provision are leading to negative total returns for the bond holder. (A negative total return is a LOSS to an insurer.) This occurs when the loss recognized (BACV less Par) exceeds the prepayment penalty received (Consideration less Par). Additionally, research indicates that bonds containing make whole call provisions have frequently been listed as “non-callable” on bond indexes. Therefore, there is concern that an insurer could potentially be holding a callable bond as a result of the make whole call provision and not be aware it is callable. Also, while there are instructions for Schedule D to identify callable bonds, it appears that the reporting of this information is inconsistent across entities.
Based on the comments received, staff has documented three proposed options for the accounting treatment of prepayment penalties. The purpose of these options is to provide greater transparency regarding the reporting of callable bonds (including those with make whole call provisions) and prepayment penalties. Staff recommends that the Working Group review these options and direct staff to proceed with drafting revisions for the accounting treatment that they prefer.
Based on the direction elected by the Working Group, staff will proceed with drafting proposed revisions to SSAPs, Annual Statement Blanks and Instructions (and draft a blanks proposal) and Disclosures. Below, staff has identified the following areas to be considered by the Working Group for potential revisions (if applicable based on WG direction). Staff welcomes comments from regulators and interested parties on potential revisions to aid in the transparency and reporting of callable bonds, including those with make whole call provisions.
Staff Note: The Investment Reporting (E) Subgroup is currently discussing revisions to the presentation of Schedule D. The actions taken by this subgroup and the Blanks (E) Working Group will be considered when drafting proposed revisions to Annual Statement Blanks and Instructions.
Schedule D-Part 1:
· Revisions to instructions/blanks to identify callable bonds, including those with make whole call provisions
Schedule D-Part 4:
· Revisions to instructions/blanks to identify bonds that were sold, redeemed, or otherwise disposed of as a result of a call provision (including make whole call).
· Revisions to instructions/blanks to identify the amount of investment income recognized as a result of a call provisions (including make whole call).
IMR:
· Revisions to clarify the accounting treatment for prepayment penalties.
SSAP Nos. 26, 37 and 43R:
· Revisions to clarify the accounting treatment for prepayment penalties.
· Revisions to SSAP No. 26 to create a disclosure pertaining to callable bonds (including bonds with make whole call provisions).
Option One: Continued treatment as investment income (Penalties do not impact IMR)
Based on the current guidance within SSAP No. 26, paragraph 14, these prepayment and acceleration fees are classified as investment income. The following would be recognized at the call date (when called prior to scheduled termination date).
· Call Price in excess of Par = Prepayment Penalty (or Acceleration Fee) = Investment Income
· BACV in excess of Par (Premium) = Loss
· Par in excess of BACV (Discount) = Gain
Currently, Schedule D-Part 4 does not include a column specific for investment income. However, per the Annual Statement instructions, the proportionate share of investment income directly related to the securities reported shall be included within column 20 (Bond Interest/Stock Dividends Received during the Year). If these fees continue to be reported as investment income, staff would recommend revisions to Schedule D-Part 4, which would show the investment income generated upon disposal of callable bonds (i.e. the prepayment penalty) as the current reporting comingles the penalty with bond interest. Additionally, the annual statement instructions for Schedule D-Part 4, Column 18 specifies that the realized gain (loss) on disposal should be the difference between the Consideration received (Column 7) and the Book Adjusted Carrying Value at Disposal Date (Column 16). If a portion of the Consideration (for the penalty/fee) is deemed to be investment income (Column 20), then revisions to the annual statement instructions for Column 18 would be needed to clarify the presentation of disposals of callable bonds on Schedule D-Part 4.
During review of some entities Schedule D-Part 4, which had bonds disposed of as a result of a make whole provision; balances reported were being manipulated (i.e. consideration, column 7), so the appropriate gain/loss was shown in column 18 (i.e. the balance that would impact IMR), and the remainder of the schedule balances flowed (with the prepayment penalty reflected in column 20). If the Working Group elects to continue to have these fees reported as investment income, staff would recommend that the Working Group consider whether they are concerned with the manipulation of this schedule and whether revisions to the Annual Statement Instructions are necessary to eliminate this manipulation.