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Stable Value Industry Wrestles with Wrap Valuation

Under new accounting guidelines adopted last year by the Financial Accounting Standards Board (FASB), stable value funds can continue to rely on contract-value accounting as long as benefit-responsive requirements are met. However, FASB changed stable value funds’ presentation and disclosures in financial statements. Funds are now required to report the fair value of all assets including investment contracts—including wrap contracts. To do that, stable value sponsors must assign a fair value to the wraps.

As described in the Second Quarter 2006 issue of Stable Times (see “Stable Value Managers Embrace New Guidelines Affirming Book-Value Accounting), an SVIA task force has been working to recommend a valuation approach for wrap contracts.

At the SVIA’s annual forum in Washington, D.C., in October, Laura Powers, a director with BlackRock, reviewed the three valuation methods prescribed by FASB.

Powers characterized the three methods evaluated as the income approach, the market approach, and the cost approach. The income approach includes converting future cash flows to a single present value or using option-pricing models. However, when the SVIA task force asked three wrap providers to calculate the value of a wrap contract for a sample portfolio using option-pricing models, Powers said, the resulting valuations ranged from $12,000 to $2.5 million, demonstrating that it suffers from “a clear lack of consistency.”

The market approach considers observable market prices for comparable assets and liabilities, which in the case of wrap contracts do not exist. One variation on this technique—matrix pricing—would involve characterizing and grouping wrap contracts by common factors. Wrap providers would then price each group, and their assessments would be used as the basis for valuing individual contracts. This would require cooperation between different wrap providers in the industry, which could require some convincing. For example, of 10 wrap providers questioned by the task force, Powers said, three indicated they wouldn’t participate in such an effort. Their response, she theorized, wasn’t so much an indication that they didn’t want to work with their industry colleagues but rather a concern about the difficulty and practicality of such an approach.

The cost approach calculates the value of a wrap contract by looking at what it would cost to purchase a replacement contract. The challenge, Powers conceded, would be to get a wrap provider to price a competitor’s product, which she said would not be practical. Therefore, existing wrap providers will be required to provide a “replacement cost” of the contract given current risk characteristics of the stable value fund.

Ultimately, Powers said, the task force may recommend a valuation approach that combines different aspects of the three methodologies, particularly the cost and income approaches. For example, the fund manager might use the cost approach to determine the current value of a wrap contract by getting a bid to replace it from a wrap provider. Then, it could use the income approach to determine the present value of the fee payments related to the contract. The fair value of the wrap contract would be the difference between its present value of the replacement cost at the reporting date and the present value of the actual wrap fee.

Fund managers and plan sponsors who use these products will need to settle on a methodology soon. They are required to disclose the value of their investment contracts in their annual reports for plan years ending after December 15, 2006. Powers encouraged them to work closely with their auditors to make sure they are familiar with what’s being done. She also suggested that fund managers encourage their auditors to work closely with their colleagues at the national level so that the same auditing firm isn’t endorsing different solutions in different parts of the country.

The task force has been working with the Big Four accounting firms to get their input on this FSP implementation issue. The dialogue has been positive. The task force has also been asked to discuss wrap valuation with the AICPA’s Investment Companies Expert Panel and Employee Benefit Plans Panel. The discussions should occur sometime in late October or early November.

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