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SVIA Working Group Looks at Accounting Issue

On December 29, 2005, the Financial Accounting Standards Board (FASB) released FASB Staff Position (FSP) Nos. AAG INV-1 and SOP 94-4-1¹ . Even now, the FASB pronouncement should be viewed positively because it recognized stable value accounting or contract value during a time when there are few if any exceptions to market value. FASB’s pronouncement validated the appropriateness of contract value for stable value funds.

The FSP clarified the applicability of the AICPA’s SOP 94-4, which had been the accounting reference for stable value funds used by corporate defined contribution plans. FASB strengthened the benefit-responsive criteria that was the heart of the AICPA standard and established some new disclosure requirements.

To account for a stable value fund at contract value, FASB requires that the stable value fund meet all of the following criteria:

FASB’s benefit-responsive criteria and financial statement presentation is required for all private-sector stable value funds that issue financial statements. The FSP does not apply to state and local governmental plans that use stable value since the Governmental Accounting Standards Boards has oversight over these entities.

For financial statement presentation, the FASB requires reporting:

To make this presentation, GICs and wrapper contracts, which are also called wraps, must be part of the schedule of investments and reconciled to the corresponding line items in the financial statements. For the schedule of investments, the fair value of each investment contract must be shown along with the underlying investment held by the fund, the wrapped portfolio of assets. An adjustment from fair to contract value is also required for each fully benefit-responsive contract. Lastly, the credit rating for the issuer or wrap provider must be shown.

Since wrap contracts are non-transferrable, determining fair market value is not as straightforward as with a bond or stock. Before the FSP, wrap contracts were valued simply as the difference between the overall fund’s contract value and the market value of the underlying fund’s assets.

The Stable Value Investment (SVIA)’s Working Group on Wrap Valuation² has been studying two possible approaches to determine the wrap’s value. They are based on income or replacement cost.

The income approach uses valuation techniques to measure future cash flows. The Working Group used Black-Scholes options pricing and Monte Carlo simulations. Based on initial testing by the group, the Monte Carlo simulation appeared somewhat better than option pricing. The group’s chair, Laura Powers, a Director at Merrill Lynch Investment Management, explains, “Option pricing is not a perfect fit. Wrap contracts behave more like insurance than a derivative or put option. You would not use an option pricing model to value insurance. Plus, the option only has value when the fund or plan is in distress, which negates an option’s concept of being a ‘going concern.’”

The group also ran a sample of Monte Carlo simulations. The sample produced a wide range of results based on the factors used by a wrapper and/or manager. The sample also showed that slight variances in input produced wildly different values.

The group also reviewed replacement cost and matrix pricing as a way to determine the fair value of the wrap. Replacement cost is simply the cost of replacing the contract today, present valued over the duration of the contract or the termination notice period of the contract if longer. Replacement cost is easy to calculate and represents the cost quoted by the issuers incorporating their assumptions about the risk of withdrawals over various paths of interest rates. However, this approach may be burdensome because wrappers will have to re-price all contracts, and valuations should remain pretty stable as market conditions change.

A matrix price approach would attempt to type wrap contracts and put them into buckets based on common factors such as: average credit quality of the portfolio, buffer size, cash flow, contract size, duration of the portfolio, market-to-book value ratio, withdrawal protocols, and whether the fund was a pool or separate account. Wrappers would price these buckets and their responses would be consolidated for use in valuing wraps with similar characteristics. While this approach might seem like less work for wrappers, it would not recognize all the determinants that wrappers use in pricing contracts. Matrix pricing would not recognize the differences in the way wrappers weight various factors in determining a wrap’s price.

Matrix pricing would provide a process and a level of independence from a specific wrapper in determining the value of the wrap. The process and independence may produce a more consistent method of valuation across the spectrum for all wraps.

“The Working Group’s goal was not to recommend or specify a valuation method. It was to prompt discussions on methodology in the stable value community,” says Powers. “The Association wanted to foster discussions between stable value funds and their respective auditors on which methodology makes the most sense for a specific fund.” The new standard and presentation is required for all stable value funds issuing financial statements after December 15, 2006. That is why she urged wrappers and managers in a June 7th conference call³ to start talking with their respective auditors about this issue. “You need to know that your valuation method works, not only for you but for your auditor prior to year-end,” concludes Power.

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