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Current Expected Credit Losses Expect delays & unforeseen consequences Presented by: Lauren Hellman, CPA, CFE

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Page 1: Current Expected Credit Losses - BKD

Current Expected Credit LossesExpect delays & unforeseen consequences

Presented by: Lauren Hellman, CPA, CFE

Page 2: Current Expected Credit Losses - BKD

Current Expected Credit LossesExpect delays & unforeseen consequences

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• Impacts of ASU 2016-13 on debt securities• Inclusion of HTM debt securities in CECL model

• Targeted changes to AFS debt securities impairment model

• Mortgage loans held for investment• Purchase credit deteriorated accounting• Reinsurance recoverables

Key Takeaways

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Must follow CECL model of ASU

Impacts of ASU 2016-13 on Debt Securities

ASU provides separate impairment model Modified version of today’s OTTI model

Held-to-maturity (HTM) debt securities

Available-for-sale(AFS) debt securities

Purchase credit deteriorated (PCD)

Debt securities purchased after original issuance must consider if PCD accounting applies

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Key CECL considerations potentially affecting estimating credit losses

• Management’s determination of zero loss securities (under ASC 326-20-30-10)

• Pooling considerations• Determining CECL life• Historical losses – either internal or external sources• Can use either DCF or non-DCR methodologies • No fair value floor for estimating credit losses

HTM Debt Securities Under CECL

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CECL Calculation Refresher

Historical lifetime

loss experience

Current conditions

adjustment

Forecast adjustment

Current expected credit loss

Adjustments to historical lifetime loss experience

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Three potential outcomes for HTM debt securities under CECL

1. Management determines & documents zero loss (no CECL reserve)

2. Management determines a CECL allowance is necessary (CECL reserve)

3. Management determines CECL reserve is technically necessary but decides it is not material (no CECL reserve)

NOTE: This would need to be considered for each different pool of (or individual) HTM debt securities

HTM Debt Securities Under CECL

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Probability of Default & Loss Given Default Concept (PD/LGD)

Probability of Default (PD): The probability of a bond defaulting over the contractual life of the bond

Loss Given Default (LGD): The percentage of the amount charged off compared to the exposure at default

Exposure at Default: The outstanding balance (book value) of the bond

How to Calculate CECL Reserve?

CECL allowancePD LGD Exposure

at Default

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Don’t have loss experience in your HTM debt securities portfolio?

• One solution may be to use external PD/LGD data from your bond accounting firm

Using External Data for PD/LGD Model

… or maybe just

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Defining a Bond Default• Default is assumed to take place

on the earliest of the following• Date their rating is revised

down to “D”• Date a debt payment was

missed• Date a distressed exchange

offer was announced; or• Date the debtor filed for, or

was forced into, bankruptcy

Loss Given Default• Municipal expected loss model

must also consider recovery rates of municipal defaults

• Recovery rates: the value creditors actually receive at the resolution of default relative to what they should have contractually received (par value)

Bond Default & Loss Given Default Concepts

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• How do we model the expected loss of a municipal bond? • Ratings agencies, such as S&P, calculate the probability of ratings

moving from one rating to another over a given time horizon• Example: An “AA” credit may remain “AA” over its lifetime, or it

could migrate to “A” (1.16% probability), then to “BBB” (0.68%) & then default (0.00%)

Municipal Expected Loss Model

Source: S&P 2017 Annual U.S. Public Finance Default Study & Ratings Transitions

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• Callable bonds: bonds that can be redeemed or paid off by the issuer prior to the bonds’ maturity date

• When an issuer calls its bonds, it pays investors the call price (usually the par value) together with accrued interest to date

• Market rates down = more bonds called• Market rates up = fewer bonds called• What is the life of a callable bond?

Determining CECL Life of Bonds

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• Many municipalities choose not to get a bond issue rated

• You are likely already using third-party municipal credit analysis as part of your muni credit program

• Nonrated securities need to be pooled together based on credit metrics & related back to a Moody’s &/or S&P rating

• From there, the security will go through the same probability of default & loss given default model as the rated counterparts

Nonrated Municipal Securities

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Zero Credit Loss HTM Debit Securities (ASU 326-20-30-10)

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• ASC 326-20-30-10 requires an entity to include a measure of expected credit losses even if that risk is remote

• However, an entity is not required to measure expected credit losses in which management’s expectation of nonpayment is zero at default (zero credit loss)

• Standard does not specify financial assets that would be zero loss. Therefore, it’s up to management’s judgement

Zero Credit Loss HTM Debt Securities

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• This will be an exercise of documentation• Guidance on how to document zero loss HTM debt

securities• Example 8 in the implementation guidance illustrates the

process to document a conclusion of zero credit losses on HTM U.S. Treasury securities

• At the 2017 AICPA Banking Conference members of AICPA DIEP & FASB’s TRG presented a process to document consultation of zero credit loss on HTM U.S. Agency & GSE MBS (see example of next slide)

• AICPA FinRec also issued a white paper

Zero Credit Loss HTM Debt Securities

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Examples of documentation from AICPA Conference

Zero Credit Loss HTM Debt Securities

• 40+ years of history of no credit losses to investors• Payments are explicitly guaranteed by U.S.• Underlying mortgage loans are either insured by FHA or

guaranteed by VA, both U.S. agencies• U.S. can print currency to retire GNMA’s obligations

Securities issued by Ginnie Mae, a

U.S. agency

• P&I payments are guaranteed by the issuing agency• Explicit guarantee by the U.S. to subject to a cap (part of the

purchase agreement when the agencies were taken into conservatorship in 2008)

• Widely believed to have an implied guarantee by the U.S.• Long history of no credit losses to investors

Fannie Mae & Freddie Mac MBS

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AFS Debt Securities

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• Other-than-temporary impairment (OTTI) is mostly gone

• Credit losses related to AFS debt securities should be recorded through an allowance of credit losses

• Amount of credit loss is limited to the amount by which fair value is below amortized cost

• Must use the discounted cash flow method to calculate a potential reserve

• Time is no longer a factor in determination

AFS Debt Securities

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• Other factors to consider• May aggregate similar CUSIP numbers• If the entity intends to sell the debt security or is more likely

than not required to sell before recovery, then any allowance shall be written off & security written down to fair value

• To assess whether a credit loss exists, entity shall compare PV of cash flows expected to be collected with the security’s amortized cost

• Discount expected cash flows at the effective interest rate implicit in the security at the date of acquisition

• Prospective transition approach for debt securities for which an OTTI was recorded before the effective date

AFS Debt Securities

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Mortgage Loans Held for Investment

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• Develop an estimate of expected lifetime credit losses (based on amortized cost basis) considering all available & relevant information (maybe internal or external) including

• Historical loss experience• Asset-specific adjustments• Current conditions adjustments • Reasonable & supportable forecast adjustments

Mortgage Loans Held for Investment

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• Amortized cost basis includes• Unpaid principal balance• Accrued interest• Premiums & discounts• Write-offs• Fair value hedge adjustments

• Current conditions & supportable forecast adjustments• “An entity is not required to search all possible information that

is not reasonably available without undue cost and effort” ASU 326-20-30-7

• Adjustments can be made qualitatively &/or quantitatively • Methodologies for pooling, forecast length, reversion period

may vary among pools

Mortgage Loans Held for Investment

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• Common models/methods for CECL• Loss rate approaches

• Cumulative loss rate (a/k/a static pool or cohort)• Migration• Vintage• Weighted Average Remaining Maturity (WARM)

• Probability of default/loss given default• Discounted cash flow

• Model selection should be done in tandem with evaluating your data inventory & pool segmentation

Mortgage Loans Held for Investment

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• The remaining life method uses average annual charge-off rates & remaining life to estimate allowance for credit losses

• For amortizing assets, the remaining contractual life is adjusted by the expected scheduled payments & prepayments

• The average annual charge-off rate is applied to the amortization adjusted remaining life to determine the unadjusted lifetime historical charge-off rate

WARM

Lifetime historical

charge-off rate

Average annual charge-off rate

Amortization adjusted

remaining life

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Purchase Credit Deteriorated (PCD)

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• As an entity purchases debt securities or receivables from other entities, it must consider if they meet the definition of PCD

• Per ASC 326 Glossary: “Acquired financial assets that as of the date of acquisition have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment”

• “More-than-insignificant” is not defined; therefore, judgement must be applied

• Considerations in determining “more-than-insignificant”• Zero loss securities• Downgrade of ratings since issuance? • Investment grade vs. subinvestment grade?• Delinquent as of acquisition date? • Placed on nonaccrual status?• Credit spreads have widened beyond the threshold specified in policy

PCD Assets

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Reinsurance Recoverables

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• CECL requires entities to separate credit risk from other risks that affect the collectability of financial assets held at amortized cost

• ASC 944 requires reinsurance recoverables be measured at net present value; hence ASU 2019-04 which clarified that FASB intended for reinsurance recoverables be subject to the CECL model

Reinsurance Recoverables

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Breaking it down to the components• Recoverables on paid claims

• Generally, credit risk is expected to be low due to short-term period (usually within 30-60 days) & usually little to no history of credit default

• Analysis of allowance likely requires less robust analysis • Recoverables on unpaid claims

• Generally, credit risk is higher due to longer duration of the period in question – could be decades in some cases

• Analysis of allowance likely requires more robust analysis• Pooling of similar risks to determine allowance

• Starting with reinsurer and then disaggregate risks with each reinsurer such as duration or geography or line of business

Reinsurance Recoverables

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Calculating the allowance• Probability of default (PD) “the chances of a default”

• Regression analysis: Most sophisticated method using economic conditions & entity-specific assumptions & data

• Qualitative adjustment analysis: Starts with historical analysis and then layers in forward-looking qualitative factors like interest rate environment or health of economy

• External vendor reliance: Starts with rating agency and then layers in the specific credit exposure

Reinsurance Recoverables

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Calculating the allowance• Loss Given Default (LGD) “the actual loss when in default”

• Integral collateral & credit enhancements• Letters of credit, funds withheld, etc.• In conjunction with the reinsurance contract – not separately set up

• Collateral top-off provisions• Can the reinsurer make good on its agreement to “top-off” collateral if

it has declined below the required levels? • 100% LGD option

• Worst-case scenario assumption• Could be an expeditious method when it’s not determined to be

material

Reinsurance Recoverables

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• Can the allowance be $0?• It is possible to arrive at $0 allowance; however, documentation

of historical credit loss experience adjusted for current conditions & supportable forecasts is necessary

• This is a very high bar to reach – i.e., this assumes the remote possibility that the insurer will incur a credit loss

• Could the reinsurer sustain a single or a series of catastrophes in near succession?

• Could the global economy cause strain to collateral values?• Could the global economy cause strain to the reinsurer’s liquidity to pay

claims or “top off” collateral?• Expect more auditor scrutiny

Reinsurance Recoverables

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Lauren Hellman | [email protected]

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Lauren Hellman | [email protected]

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The information contained in these slides is presented by professionals for your information only and is not to be considered as legal advice. Applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor or legal counsel before acting on any matters covered.

BKD, LLP is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.nasbaregistry.org.