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Insights for Impairment Analysis Paul Moran, PwC Robert Lindsay, Clearwater Analytics

Transcript of Insights for Impairment Analysisd1pvbs8relied5.cloudfront.net/resources/user-conference/2017/... ·...

Insights for Impairment AnalysisPaul Moran, PwC

Robert Lindsay, Clearwater Analytics

Learning Objectives

• Understand ASU 2016-13 and how impairment processes should change under the CECL method

• Learn best practices for qualitative and quantitative impairment analysis

• Understand the common issues and questions our clients ask about impairment

ASU 2016-13: Background

How familiar are you with ASU 2016-13?

Very Familiar7%

Somewhat Familiar55%

Not Familiar38%

ASU 2016-13 – Background

• “Incurred loss” model in current US GAAP criticized for delaying recognition of losses

• Current US GAAP does not allow recognition of credit losses that are expected but do not yet meet the “probable” threshold

• During the financial crisis, users devalued financial institutions based on their forward-looking expectations of credit losses before accounting losses were recognized

• Objective of ASU 2016-13:

» Provide users with more decision-useful information about expected credit losses

» Replace the incurred loss model with an expected losses model

» Model requires consideration of a broader range of information to inform credit loss estimates

FINANCIAL ASSETS MEASURED AT AMORTIZED COST

HTM debt securities Trade receivables

Financing receivables and loans Re-insurance receivables

ASU 2016-13 – What’s in scope?

FINANCIAL ASSETS MEASURED AT FVOCI

Available for sale (“AFS”) debt securities

LEASE RECEIVABLES

Net investment in leases recognized by a lessor

CERTAIN OFF-BALANCE SHEET CREDIT EXPOSURES

Off balance sheet loan commitments Standby letters of credit

Financial guarantees (not accounted for as insurance)

Current Expected Credit Losses Model (CECL) –What’s in scope?Applies to financial assets measured at amortized cost and certain off-balance sheet credit exposures

EXCLUDED FROM SCOPE

Available for sale (“AFS”) debt securities

Loans held for sale

Policy loan receivables

Financial assets where the fair value option (“FVO”) has been elected

Equity instruments and equity method investments

Derivatives

Related party loans to entities under common control

IN SCOPE

HTM debt securities

Financing receivables and loans

Trade receivables

Re-insurance receivables

Loan commitments

Lease receivables

Financial guarantees

Purchased credit deteriorated assets recorded at amortized cost

CECL Impairment Model – Summary of ChangesCURRENT US GAAP SUMMARY OF CHANGES

ASC 450 (FAS 5) for incurred losses in the loan portfolio (collectively evaluated for impairment)

• Replace incurred loss model (over loss emergence period) with current expected credit losses model (CECL), over the full lifetime of the loan

• Reflects contractual life less prepayments, but without consideration of renewals, extensions or modifications (unless TDR is expected)

• Inclusion of forward-looking information (e.g., macroeconomic variables) either through the model or through the qualitative framework

• Revert to historical information beyond the reasonable and supportable forecast period

• Off-balance sheet commitments — consider the period over which the commitment is legally binding, unless unconditionally cancelable

ASC 310 (FAS 114) specific valuation allowances

• No threshold for identification of individually impaired loans• Continue to maintain practical expedient for collateral dependent loans• Measurement approach is similar to today when using discounted cash flow

modelling approach

CURRENT US GAAP SUMMARY OF CHANGES

ASC 310-40 TDRs • Measured using the CECL model – DCF no longer required although impact of concession must be recognized

• No change to criteria for identifying a TDR

ASC 310-30 purchase credit impaired

• More than insignificant credit deterioration (PCD)• Basis “grossed up” to reflect expected loss estimate • Initial credit loss will not be recognized in income (since FV day 1)• Changes (+ / -) going forward recognized immediately in income• Follow an “accrete to contractual” interest model

CECL Impairment Model – Summary of Changes

AFS Debt Securities Impairment Model

How does it work?The AFS debt security credit loss model retains today’s “intent to sell” and “more-likely-than-not” (MLTN) requirement to sell guidance.

How does it work?

• Similar approach to impairment guidance under ASC 320 with the following changes:

» Modified approach will require impairment losses to be accounted for as an allowance subject to future reversal upon credit improvements

» Duration of loss is no longer a consideration in determining whether a security is impaired

» No forecasts of future recoveries post balance sheet date

• No explicit requirement to evaluate the historical volatility of the fair value of a security

• Measurement and recognition of credit losses are “capped” at the excess of amortized cost over fair value

• Measurement of credit loss based on the present value of an entity’s best estimate of expected cash flows

Example of Qualitative FactorsThe following list is not intended to be all-inclusive:

• Changes in market interest rates

• Changes in liquidity

• The extent to which the fair value is less than the amortized cost basis

• Payment structure of the debt security

• Industry analyst reports and forecasts

• Credit ratings

• Value of underlying collateral

• Financial condition of a guarantor

AFS Debt Securities Model – Before and AfterCONSIDERATION CURRENT US GAAP NEW REQUIREMENTS

Unit of account Individual security Individual security

Is the security underwater? Yes Yes

Does the entity intend to sell? Yes Yes

Is it more likely than not the entity will be required to sell?

Yes Yes

Does a “credit loss” exist?Yes, consider qualitative factors such as duration and extent of unrealized loss

Yes, certain qualitative factors can no longer be considered

Direct write-down method for credit losses? YesNo, record through an allowance if a credit loss exists

Measurement of credit lossDifference between the amortized cost basis and PV of ECFs; can exceed total unrealized loss

Difference between the amortized cost basis and PV of ECFs; capped at total unrealized loss

AFS Debt Securities Model – Example

• Assume “Company ABC” acquires a debt security on January 1, 2016 for $1,000 with the following terms:

• Company ABC classifies the debt security as an available for sale debt security

• On December 31, 2016, the fair value of the security is $800

• Company ABC does not intend to sell the security

• It is not more likely than not that Company ABC will be required to sell the security

Maturity date December 31, 2021

Coupon rate 5% paid annually

Maturity date December 31, 2020

AFS Debt Securities Model – Example (cont.)

YEAR CONTRACTUAL CASH FLOWS CASH FLOWS EXPECTED AT 12/31/16 DECREASE IN EXPECTED CASH FLOWS

2016 $50 $50 $0

2017 $50 $50 $0

2018 $50 $50 $0

2019 $50 $50 $0

2020 $1,050 $900 $150

Total cash flows $1,250 $1,100 $150

PV of cash flows $1,000 $882 $118

AFS Debt Securities Model – Example (cont.)

Step 1: The security is impaired because the fair value ($800) is less than amortized cost ($1,000)

Step 2: Company ABC does not intend to sell the security

Step 3: It is not more likely than not that Company ABC will be required to sell the security

Step 4: Determine whether the loss is related to credit or non-credit factors:

• A credit loss exists because the PV of cash flows ($882) is less than the amortized cost basis of the security ($1,000)

• The total impairment of $200 is separated into the credit loss of $118 and the non-credit component of $82

AFS Debt Securities Model – Example (cont.)

After the impairment, the amortized cost basis will still be $1,000 and the security will be carried at its fair value of $800 as shown in the following table:

Amortized cost basis on December 31, 2016 $1,000

Allowance for credit losses ($118)

Net value on December 31, 2016 $882

Noncredit loss ($82)

Fair value on December 31, 2016 $800

AFS Debt Securities Model – Example (cont.)

• Company ABC records the following journal entry on December 31, 2016:

DR/(CR) LINE ITEM $ $

Dr Provision expense 118

Dr OCI 82

Cr Allowance for credit losses 118

Cr AFS security – unrealized loss 82

AFS Debt Securities Model – Example (cont.)

• Assume that one year later, on December 31, 2017, the fair value of the debt security remains at $800

• Company ABC does not intend to sellthe security

• It is not more likely than not that Company ABC will be required to sellthe security

• At December 31, 2017, Company ABC re-estimates the expected cash flows of the security

• To calculate the present value, the cash flows are discounted at 5%, the original effective interest rate on the security

AFS Debt Securities Model – Example (cont.)

YEAR CONTRACTUAL CASH FLOWSCASH FLOWS EXPECTED AT 12/31/17

DECREASE IN EXPECTED CASH FLOWS

2017 $50 $50 $0

2018 $50 $50 $0

2019 $50 $50 $0

2020 $1,050 $930 $120

Total cash flows $1,200 $1,080 $120

PV of cash flows $1,000 $901 $99

AFS Debt Securities Model – Example (cont.)

Step 1: Security is impaired because the fair value ($800) is less than amortized cost ($1,000)

Step 2: Company ABC does not intend to sell the security

Step 3: Not more likely than not that Company ABC will be required to sell the security

Step 4: Determine whether the loss is related to credit or non-credit factors:

• Credit loss exists because the PV of cash flows ($901) is less than the amortized cost basis of the security ($1,000)

• Total impairment of $200 is separated into the credit loss of $99 and the non-credit component of $101

Investor Corp would adjust the allowance for credit losses by $19, to reduce it from $118 to $99 and then increase the amount allocated to noncredit impairment in OCI by the same amount

AFS Debt Securities Model – Example (cont.)

• After the impairment, the amortized cost basis will still be $1,000 and the security will be carried at its fair value of $800 as shown in the following table:

Amortized cost basis on December 31, 2017 $1,000

Allowance for credit losses at January 1, 2017 ($118)

Adjustment to allowance on December 31, 2017 $19

Net value on December 31, 2017 $901

Non-credit loss in OCI at January 1, 2017 ($82)

Adjustment to OCI on December 31, 2017 ($19)

Fair value on December 31, 2017 $800

AFS Debt Securities Model – Example (cont.)

• Company ABC records the following journal entry on December 31, 2017:

DR/(CR) LINE ITEM $ $

Dr Allowance for credit losses 19

Dr OCI 19

Cr Provision expense 19

Cr AFS security – unrealized loss 19

Operational Considerations

Operational Impacts CECL

Data requirements — How will companies get the data necessary to conduct this analysis?

• Probability of default

• Loss given default

• Forward-looking economic scenarios

Method of pooling/segmentation for HTM securities

• Data required to facilitate change disclosures

Review process for allowances and recoveries

• Coordination between accounting and finance

Operational Impacts – AFS Securities

Impacts on systems

• For example, a new ledger account will need to be created to track a valuation allowance subject to reversal.

Assessment frequency

• Both positive and negative changes to cash flow expectations impact the allowance account. More cash flow modeling will be required.

Elimination of certain qualitative filters

• Although qualitative filters may still be used, more cash flow modeling may be required given the removal of some commonly used qualitative filters.

Write-offs and recoveries

• Companies will need to develop accounting policies and internal controls for recognizing write-offs and recoveries.

Disclosures

Disclosures

• Current disclosure requirements to disclose the roll-forward of allowance for credit loss accounts for

receivables will be extended to the majority of financial instruments in scope of the standard, includingAFS

debt securities

Allowance for credit loss roll-forward schedule

• Current disclosure requirements related to credit quality indicators for receivables will be extended to others in scope financial instruments, including held to maturity securities

• Will not be applicable to AFS debt securities or short term trade receivables

• Disclosures for loans are expanded to require disaggregation of loans by credit quality and year of origination

Credit quality indicators

Statutory Accounting

Statutory Accounting

• Discussed at 2017 Summer National Meeting (SAPWG)

» Exposed for comment without a comment deadline

» Regulators/staff have not given a position or indication of a preference

• SSAP is intended to be more conservative than US GAAP

» New standard is to correct delayed recognition of losses

» Conservative change

• GAAP/SSAP differences are generally unwanted without very good reasons

Statutory Accounting - Industry Concerns

• Insurance industry was strongly against inclusion of reinsurance receivables in scope of ASU 2016-13

• SSAP already has mechanisms for expected credit loss

» Asset valuation reserve (life/fraternal only)

» Risk-based capital asset concentration factors

• Significant effort spent since 2014 reworking these factors

» SSAP 43R price point modeling for RMBS/CMBS

» Conservative non-admission requirements for receivables

» AFS model doesn’t apply to statutory accounting

• Applying the CECL model to all AC assets would have a lot of GAAP/SSAP differences

ASU 2016:13 –Clearwater Response

What will Clearwater do?

• Development work on allowances is underway due to IFRS 9

» Similar standard, different scope/process

» IFRS 9 is broader in scope and requires a stage evaluation

• Expect clients to have different requirements/request

» Some to feed us a percent

» Some to feed us a number

» Some want to be as hands off as possible

• Now is the time to start conversations/offer feedback

Beneficial Interests

Beneficial Interests

• Assets within the scope of ASC 325-40 will apply the CECL or AFS debt security impairment models based on their classification as HTM or AFS

Initial Recognition:

• The PCD approach is applied to beneficial interests:

» That meet the definition of PCD

» Where there is a significant difference between contractual and expected cash flows at the date of recognition

» Other beneficial interests will apply CECL or AFS debt security models

Beneficial Interests

Subsequent Measurement:

• Model requires the use of the DCF method

• Changes in expected cash flows are:

» Analyzed to determine if they impact the allowance account

» If such changes do not impact the allowance account, they are reflected through changes in accretable yield

» Accretable yield is expected cash flows in excess of reference amount

» Reference amount is initial investment/amortized cost basis – cash received to date – write offs + yield accreted to date

Effective Date and Transition

ASU 2016-13 – Effective Dates and Transition

• PBEs that are SEC filers – annual and interim periods in fiscal years beginning after December 15, 2019

• PBEs that are not SEC filers – annual and interim periods in fiscal years beginning after December 15, 2020

• All other entities:

» Annual periods in fiscal years beginning after December 15, 2020

» Interim periods in fiscal years beginning after December 15, 2021

ASU 2016-13 – Effective Dates and Transition

• Generally, a cumulative effect adjustment to opening retained earnings will be required upon adoption

• Debt instruments that experienced other-than-temporary impairment

» Debt instruments that experienced other-than-temporary impairment write downs prior to adoption will adopt the new requirements of the ASU prospectively

» Previous write-downs are not reversed and past OTTI is not recalculated

• Financial assets for which ASC 310-30 (SOP 03-3) was previously applied

» Prospective application required

Questions?

Reminders

• Take the post-session survey in the Clearwater Events app

• Session presentations are available on the app

• Take the Clearwater Client Benchmark Survey in room 440 and earn Clearwater swag.

• Don’t miss the Monday networking reception from 4:30 to 6:30 p.m.