Gutterman-Chambers by fanzhongqing


									Credit Standing in the Fair Value of Liabilities

                         Sam Gutterman
                   FSA, FCAS, MAAA, FCA, HonFIA


                          Mo Chambers
                 FCIA, FSA, MAAA, HonFIA, HonFASI

                           Presented to the

                     Thomas P. Bowles Jr. Symposium:
    Fair Valuation of Contingent Claims and Benchmark Cost of Capital

                           April 10-11, 2003
                  Georgia State University, Atlanta, GA
                         Credit Standing in the Fair Value of Liabilities


Over the past decade a gradual change in the financial reporting paradigm in the direction of fair
value has taken shape, both on a national and international level. Although certainly not
finalized and with significant pockets of opposition appearing, both the International Accounting
Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in the United
States have indicated that it is their general desire to move to this basis eventually.

Although the use of fair values is being addressed for many elements in an entity’s balance sheet,
special focus has been directed at financial assets and liabilities. Of particular current interest to
actuaries, these cover the measurement of financial instruments (both assets and liabilities).
Although at this time, it seems as if eventually all financial assets and liabilities will be valued on
this basis, the ultimate extent and timeframe for this movement has not yet been confirmed. In
the interest of consistency in financial statements, many have advocated that, where assets are
valued on a fair value basis, the value of liabilities (on the part of the issuers or obligees) should
be as well.

While most actuaries and accountants involved in the discussion have a general understanding
of, and comfort with, what the measurement of the fair value of most financial assets would be,
there remains a great deal of controversy surrounding the determination of the fair value of
liabilities. Currently, one of the most contentious issues in the development of an agreed upon
methodology to determine the fair value of certain liabilities has been whether, and if so how, to
reflect the expected risk associated with the credit standing of the entity that bears the
responsibility for fulfilling the obligation. One reason for this controversy is that, while many
financial instruments held as assets (the right to receive future cash flows upon fulfillment of
specified conditions) are traded or sold in active markets and as a result have an observable
market value, the obligations themselves (recorded as a liability by the entity obliged to fulfil
them) generally are not.

The objective of this paper is not to determine the final answer to the question of whether the
entity’s own credit standing risk should be reflected in its liabilities in a fair value accounting
environment, but rather to present a discussion of the issues involved. Thereby, we intend to
alert actuaries and others to these developments and hope that this presentation of the issues will
assist in reaching an appropriate resolution of the matter. The authors do not expect this paper to
generate a final answer. The positions taken on either side of the question are, by many of the
participants in the debate, so totally entrenched as to render a consensus solution impossible.


A few definitions are needed to provide a framework for this discussion:

     Liability. A liability is “a present obligation of the entity arising from past events, the
      settlement of which is expected to result in an outflow from the entity of resources
      embodying economic benefits”1 Typically, this obligation is fulfilled as a result of future

    IASB Framework, paragraph 49

                       Credit Standing in the Fair Value of Liabilities

    cash flows (or their equivalent). As such, their value is affected by expectations and risk
    preferences associated with the amount and timing of other cash flows.

   Asset. An asset is a “resource controlled by an entity as a result of past events and from
    which future economic benefits are expected to flow to the entity.”2

   Financial liability. A financial liability is “any liability that is a contractual obligation: (1) to
    deliver cash or another financial asset to another entity; or (2) to exchange financial
    instruments with another entity under conditions that are potentially unfavourable”3.

   Fair value. Fair value is “the amount for which an asset could be exchanged, or a liability
    settled, between knowledgeable, willing parties in an arm’s length transaction”4. Fair values
    have sometimes been measured through observations of market values (“the amount
    obtainable from the sale, or payable on the acquisition, of a financial instrument in an active
    market”). However, if a sufficiently active market does not exist for the financial instrument,
    the fair value would be an estimate of what the market value would be if an active market did
    exist. Many believe that exit value, that is the amount that a willing buyer would pay for the
    financial instrument, is the most appropriate indication of a fair value. If reliable and
    relevant observations are not available, for instance in the case in which an active market
    does not exist, a present value based model of future cash flows associated with the financial
    instrument, is often used as a surrogate for its market value.

   Risk. In this context, risk is the financial effect, usually adverse, of uncertain future events.
    An efficient market will incorporate in the market price of a financial instrument many types
    of risk, including credit standing risk. Credit risk can include both default risk and volatility

   Credit standing. Credit standing is the assessment by an outside party, such as a rating
    organization or a financial institution offering credit to an entity, of the financial
    creditworthiness of the entity.

   Credit standing risk. Credit standing risk is the general risk associated with possible future
    deterioration of credit standing of the entity(s) responsible for fulfilling the applicable future
    obligation. This term also can incorporate the financial effect of a less than complete
    fulfillment of the terms of a particular obligation. As such, it has elements of both total
    default risk and partial default risk wherein only part of the obligation is completed. In some
    cases, a significant deterioration in credit standing may precipitate liquidity problems, such
    as in a ‘run-on-the-bank’ for a financial institution, which may in turn lead to an inability to
    fulfil the obligation. Although both credit standing risk and default risk can be affected by
    the overall financial condition of an entity, within the context of this paper relating to a
    specific obligation, they both relate to only performance relative to the specific obligation.
    The uncertainty associated with payment may only involve the timing of payment and not the
    amount; in such cases, the impact would be the difference in the present value of the actual
  IASB Framework, paragraph 53
  IAS 32, paragraph 5
  IAS 32, paragraph 5

                         Credit Standing in the Fair Value of Liabilities

      payments and the present value of promised payments. Note that most publicly available
      credit ratings relate to the financial condition of the entity as a whole, rather than to that
      applicable to a specific obligation.

     Default risk. Default risk is the risk associated with the possible inability of a party to fulfil a
      specific financial obligation or set of obligations, for example, as a result of becoming
      insolvent. Usually it refers to a complete inability to satisfy its obligations and,
      consequently, a total loss. It represents an important subset of credit standing risk.

     Going concern. “The financial statements are normally prepared on the assumption that an
      entity is a going concern and will continue in operation for the foreseeable future. Hence, it
      is assumed that the entity has neither the intention, nor the need, to liquidate or curtail
      materially the scale of its operations. If such an intention or need exists, the financial
      statements may have to be prepared on a different basis and, if so, the basis used is
      disclosed”5. Note that other accounting regimes, such as the one adopted by the FASB, do
      not assume that a going concern is a fundamental concept underlying financial statements.

The issue

Although the methodology for the determination of the fair value of many types of assets has
been discussed extensively, it is only during the last several years that the fair value of liabilities
has been given a significant amount of attention. In a fair value accounting system, an asset that
is freely traded in an efficient market is expected to have a reported value that reflects its market
value fairly closely. The use of unadjusted transaction prices has been attacked in some cases,
including (1) where significant control exists, because of the possible existence of a control
premium (the difference between the value of a firm as a whole and the sum of the value of all of
its shares that arises from the ability of a controlling shareholder to shape that entity’s destiny)
and (2) where a blockage discount arises, because of difficulty in selling a large block of
securities, (arising from the difficulty of obtaining the market price of a large block of shares at
one time due to a possible reluctance of purchasers to buy such a block at a single point in time).
In addition, transaction costs are usually ignored. As a result, the use of transaction prices may
not in all cases be indicative of an asset’s fair value.

Even when a market exists for this risk, practical measurement issues arise, including the choice
of which market to use if a financial instrument is available in many markets, and which
transaction price to use – the last transaction of a trading period (which can get complicated in
twenty four hour worldwide exchanges) or an average value over a period of time such as a day.
These issues are beyond the scope of this discussion, although they will be discussed to some
extent later in the “Measurement” section. Nevertheless, for this paper, we will assume that a
standard approach will have been established, which relates the reported fair value of an asset to
its market value in a fairly direct manner.

It is widely accepted that the value that the participants in a market place upon a financial
instrument incorporates, in some measure, an expectation of the likelihood that the nominal

    IASB Framework, paragraph 23

                          Credit Standing in the Fair Value of Liabilities

value of the asset is, or will be, realizable. Market considerations can differ for different asset

     Equity assets. A common example of an equity asset is a common share (stock). Since the
      issuer of shares has no contractual obligation to the owner of the asset, the expected future
      cash flows associated with the asset are based on an assessment of the future financial
      prospects of the issuing entity and how the market will react to these prospects.

     Debt assets. The owner’s (or beneficiary’s) expectation is based upon the terms of the
      specific contractual obligation undertaken by the party expected to be responsible for
      fulfilling the obligation (usually the issuer). The market price of the financial instrument as
      an asset generally incorporates an assessment of the likelihood that the issuer will be able to
      fulfill its contractual obligation. The assessment of this likelihood may incorporate the credit
      standing of the issuer.

In an efficient market for a specific obligation, observations of the market could be used to
measure the cost of the credit standing risk on an entity’s own obligations by taking the traded
value of a risk-free entity (the safest government security at that duration) compared to that of
the entity in question. This can be done in the case of a financial instrument as an asset that is
traded in a market. Although responsibility for some customer obligations are transferred
through securitization and reinsurance, obligations themselves are rarely traded on efficient
relevant markets.

When an active relevant market is not available from which to determine appropriate reporting
values directly, a discounted cash flow technique can be used to estimate fair values. Several
bases for such models could be used, including estimating the present value of the following
concepts relating to their “exit” values:

     The amount that the entity would expect to pay in exchange for the remaining payments as
      due under the terms of the obligation, i.e., the expected cost of a new obligation with the
      same expected future cash flows associated with same future obligations, or

     The amount that the entity would expect to pay someone else to take over the obligation. In
      this case, the “someone else” would be subject to its own credit standing risk. Since such a
      third party entity’s identity cannot be determined at the time of valuation, either the original
      entity’s credit standing risk could be assumed or the value should be assumed to be free of
      credit standing risk.

As will be shown, some argue that inconsistencies in initial measurement may result if credit
standing risk is not reflected. The first accounting pronouncement covering this risk is in
Concept Statement No. 7 of the Financial Accounting Standards Board (FASB) where it states
that “The most relevant measure of a liability always reflects the credit standing of the entity
obligated to pay.6 Others point out that, if it is, significant inconsistencies may arise in

    FASB Concept Statement No. 7, paragraph 78

                       Credit Standing in the Fair Value of Liabilities

subsequent measurement when changes in credit standing risk occur. The treatment of this risk
in the valuation of liabilities is the focus of this paper.

Partly due to limited historical applications, there has been less attention given to the
measurement of the fair value of liabilities than fair value of assets, except in cases such as
accounting for business combinations. It has been suggested that, where an efficient market for a
debt asset exists, the fair value of a liability should equal to the fair value reported by the owner
of the corresponding debt asset, reflecting the value that the market places upon it as an asset. If
such a market does not exist, proponents of reflecting credit standing would reflect the
probability of expected payment of the cash associated with the obligation.

Since the market is presumed to incorporate in its valuation its composite assessment of the
likelihood that the obligation will be satisfied (i.e., reflects the default risk of the current party
who bears the obligation), proponents of reflecting credit standing have suggested that in a fair
value system, the value of a liability should also reflect the likelihood that the obligation will be
satisfied (i.e., that the value assigned to the liability should also reflect the credit standing of the
obligated entity).

Others, however, not convinced of the validity of this proposition, are concerned about
anomalies that its adoption as a standard could generate, question its relevance, and doubt
whether this effectively provides meaningful financial information regarding the entity’s
financial performance or condition. The focus of this paper is to review and evaluate the
arguments on both sides of this question and to stimulate further discussion of the issue.

Users of financial statements

The emphasis given specific elements of general-purpose financial statements may vary
depending upon the user of the statements. Therefore, the values presented in public financial
statements may not equally satisfy all the needs of every reader. Nevertheless, it is important
that accounts be transparent and provide useful (and not misleading or non-transparent)
information for their users. Consequently, it is important to consider who the potential users of
such financial reports are and how they would use this information. In other words is this
information valuable or does it somehow distort the values reported. In doing so, the needs of
the users and pertinent markets involved should be addressed.

Users of these financial reports include the following:

   Owners and potential owners of the entity that bears the responsibility for fulfilling the
    obligation. These users are interested in the extent to which these obligations affect the rest
    of its operations, limit their financial flexibility and require a certain regular amount of funds
    to satisfy these obligations, since until the obligation has been completed it is a fixed cost of
    doing business. Owners are often the ones for whose needs general-purpose accounting is
    primarily aimed. Although moral hazard (in this case, the incentive not to fulfill an
    obligation) may arise, their primary interest is to assess the value (cost) and risks associated
    with their obligations.

                       Credit Standing in the Fair Value of Liabilities

   Creditors. Creditors need to assess the financial condition of the entity that is responsible for
    fulfillment of the obligation, as to whether and when they will be paid. They may wish to
    assess it independently of a market assessment (if an efficient market existed, the information
    is assumed to be equally available to all with a common assessment of risk).

   Managers. If there is a market for an entity’s obligations, its managers should assess the
    implications of activities in it. To remain ignorant of the financial impact of the market’s
    assessment of the entity’s own credit standing risk could be viewed is a sign of poor
    management, since this risk affects its cost of new debt and capital. Nevertheless, it would
    be quite unusual and of questionable integrity for management to assume that the entity
    might not honor its obligations. Management planning and decision-making should
    recognize the costs associated with potential changes in the entity’s credit standing.

   Customers. Customers or suppliers need to validate whether they should deal with an entity.
    An assessment of a company’s long-term outlook is particularly relevant in the case of a
    company that sells long term promises. As a result, public policy can be affected, sometimes
    requiring the involvement of a regulator.

   Regulators. One of the most important functions of a regulator of an entity is to monitor and
    evaluate its solvency. In this context, it does not seem reasonable to include the effect of the
    entity’s own credit standing risk in the assessment. The information the regulator seeks
    would be used to determine whether the public interest is likely to be affected adversely by
    the financial condition of the entity.

In summary, it is important for several types of users to develop independent assessments of the
probability that the entity will satisfy its obligations. This suggests that it might also be useful to
have information regarding the market’s assessment of the company’s financial condition
available, even though management may be reluctant voluntarily to disclose the effect of any
adverse assessment by the market of its own credit standing risk.

The rest of this paper will focus on whether it would be appropriate to adjust the liability value
included in the balance sheet of an entity to reflect the entity’s credit standing.

Types of obligations and relevant characteristics

The obligations, the amount or timing of whose future cash flows might be affected by the credit
standing of the responsible party, can be categorized in several ways. Such a categorization
might provide useful insight into this issue and might indicate whether a practical rule is needed
to segment liabilities between those for which it is appropriate to reflect the entity’s credit
standing and those for which it is not.

One potentially useful classification of these liabilities is the following:

   General obligations, including accounts payable, unsecured debts, and collateralized

                      Credit Standing in the Fair Value of Liabilities

   Customer obligations, including outstanding property/casualty claims, life insurance
    contract liabilities, and bank demand deposits.

   Fiduciary obligations held on behalf of others, including pension plan liabilities and in
    some cases separate accounts of life insurance companies. Both these and customer
    obligations are entered into on behalf of others.

An alternative categorization of these first two types of obligations includes interest bearing or
accruing (e.g., zero coupon bonds) obligations and those that are not interest bearing or accruing
(e.g., many insurance contracts). Another split of the two is whether or not their credit standing
could be changed if they were traded.

The credit standing risk issue is applicable to all types of liabilities (excluding those
corresponding to equity and those for which another party bears ultimate responsibility).
However, for many current liabilities the effect of the reflection of credit standing risk would not
be material because of the short-term nature of the obligations involved.

Several aspects of these liabilities will be useful in the following discussion including:

1. The bearer of the responsibility for fulfillment of the obligation. In some cases, by
   contract or agreement, the ultimate obligation remains with the original party even if the
   obligation is exchanged after its issue. In others, some or all of the responsibility may be
   exchanged as well. For a particular obligation, whether (or the extent to which) the
   responsibility can be transferred by sale or settlement may affect its recognition for
   accounting purposes in a financial reporting system that incorporates value, or realizable
   value, on sale or exchange. While the entity currently responsible for an obligation would
   usually be the relevant one, the entity(s) expected to be responsible when the commitment
   comes due becomes relevant if its measurement reflects expected cash flows.

    For example, in the U.S. at the present time it is difficult either to exchange or to transfer
    insurance obligations, except through reinsurance. Sales of blocks of business have
    occurred, but this market is neither deep nor efficient, so it is unlikely that timely or
    meaningful measurement can be derived directly from the prices of these transactions. In
    many such sales, the responsibility for the obligation is transferred, but that is not always the

    In the case of fiduciary obligations, it is not always obvious which entity is obligated to
    fulfill the promise. For example, for pension plans, the associated trust may be the entity
    from which the obligation lays, and for which credit standing would be relevant. Assuming
    that there is governmental backup, credit standing risk of the private market would be of little
    relevance in any event (except in the case of unfunded plans).

2. Markets for obligations. If an efficient, active market exists, there will be more evidence to
   determine whether or not credit standing risk is reflected in market price. For liabilities,
   though, there are few, if any, such markets and those that do exist are thin and relatively
   inactive. To the extent that such markets do not exist, recognition becomes more problematic

                      Credit Standing in the Fair Value of Liabilities

   respecting either whether, or to what extent, credit standing risk should be reflected. There
   has been some trend toward an increase in markets for a number of obligations, for example
   through securitization.

3. Responsibility in exchange. Does the entity have to complete the obligation if it exchanges
   the liability? The continuation of the responsibility can vary significantly by type of
   obligation and within each type.

4. Third party guarantees. In some cases, a third party will fully or partially guarantee to
   undertake the obligation. To the extent that such a guarantee exists, the credit standing risk
   associated with a specific liability would be expected to reflect the credit standing risk of the
   third party guarantor or credit enhancer (assuming that it is better than that of the original
   obligee). The market price for the asset side of an obligation would be expected to reflect
   such a guarantee. This would support the contention that, for a liability with an explicit or a
   sufficiently strong implicit guarantee, credit standing risk should be reflected only to the
   extent that the obligation is not expected to be fulfilled by the guarantor.

5. Regulators. Regulators typically exist in an industry because an industry’s products or
   services affect the public interest. Regulators often either provide some type of a guarantee
   of payment for the obligation of certain entities or require that such a guarantee be provided
   through private means. Examples include a government guarantee for bank deposits or a
   guarantee fund sponsored by the insurance industry. This guarantee might be provided
   through law, regulation or contract. In certain cases, it arises as a result of the general
   environment (such as a government agency authorized to take over a bank or insurer before
   insolvency occurs in order to assure payment to the policyholders and/or investors).

6. To whom the obligation is owed. The nature or type of obligation may influence whether
   credit standing risk should be reflected, particularly if customer or fiduciary obligations are
   involved. Historically, the financial services industry’s products have been subject to close
   governmental oversight, due to certain historical abuse and the difference in sophistication
   between the entity and its customers. Due in part to public policy considerations, the receipt,
   for example of cash flows associated with certain financial obligations, particularly those of a
   potentially long-term nature, may be protected to a greater degree than those of other

   Credit standing risk can affect the cost of borrowing. What is less clear is the extent to which
   credit standing risk affects the price for which a financial instrument, such as insurance or a
   demand deposit, can be sold or exchanged, and the future settlement value of the resulting

7. Certain financial instruments or embedded options, such as interest rate swaps or embedded
   call options in a callable bond, can take on either positive or negative values. As a result,
   they may be considered pseudo-assets at certain times and liabilities at others. The
   consequent question is whether it would be inconsistent to adjust for credit standing risk
   when the instrument is an asset while ignoring it when it is a liability. Insurance liabilities
   can take on either positive or negative values. If it is determined that inconsistent rules

                          Credit Standing in the Fair Value of Liabilities

      should be applied to assets and liabilities, possible approaches that could be taken include a
      categorization of both situations as either an asset or a liability or to develop special

The arguments

The following discussion of the primary arguments that have been raised relates to the possible
recognition and measurement of credit standing risk in liabilities. The first three arguments have
been presented as favoring this recognition, while the others have been presented as opposing it.

      1. The relationship between the value of an obligation as a liability and the same
         obligation as an asset

          It is often assumed that if an efficient market for a financial instrument exists, the market
          fully reflects all relevant information available, including the expected probability that an
          associated obligation will be fulfilled. The financial economics’ principle of consistency
          of market recognition of assets and liabilities would demand that the fair value of a
          liability be equal to its fair value as an asset held by another (the symmetry argument)7.
          Not to do so, it is argued, would be inconsistent with the concept underlying fair values.
          Though the process of validating the estimation of a fair value in an inefficient market is
          less clear, the application of efficient market concepts still seems the most appropriate

          In addition, the value of an obligation should mirror what would happen if it were
          exchanged (its fair value). If it doesn’t, inappropriate business decisions may be made
          solely because of the effect of accounting rules rather than for valid economic reasons
          (accounting arbitrage).

          Nevertheless, it has been asserted that such comparisons are, in practice, only possible for
          debt assets (and their corresponding non-equity liabilities), since the balance sheet value
          of an equity instrument (that corresponds to debt obligations) is not specifically assigned
          a value; rather, it is treated as a residual part of capital.

          Opponents suggest that, particularly for liabilities other than general obligations, the
          assertion that in a fair value accounting system the reported value of one entity’s debt
          liability must be equal to the value at which another holds it as an asset is neither
          necessary nor proven, and certainly is not an acceptable benchmark for assigning values
          for many liabilities. For example, the value of a life insurance contract as an asset of a
          policyowner might be viewed as equal to the cash surrender value of the contract, i.e. the
          value for which it could currently be exchanged. That value, being a current demand
          amount, is not influenced by the credit standing risk of the insurer, because by contract it
          can be settled for cash today. In the extreme, a policyholder with a terminal illness would
          set the asset value of the insurance contract at a level close to its face amount. (Note that
          this view is not the case for an insurance company assigning a fair value to a ceded

    FASB Concept Statement No. 7, paragraph 84-85

                 Credit Standing in the Fair Value of Liabilities

   reinsurance contract where the likelihood of receiving payment from a reinsurer should
   be reflected in the determination of the transaction’s resultant asset value.)

   Moreover, customer obligations taking the form of insurance contracts or demand
   deposits may involve public policy considerations that demand regulatory involvement to
   assure that policyholders’ expectations are fulfilled.

   The argument continues that if credit standing were to become significantly impaired, the
   entity may not (1) be able to exchange the obligation or (2) be able to do so on an
   economically advantageous basis. The more material the reported benefit of exercising
   that option becomes, the more unlikely it is that the entity has sufficient funds available
   to settle it. As the entity becomes less able to exercise the option, the reported liability
   value would decrease. The consequent information provided to the users of its financial
   statements could then turn out to be both inappropriate and misleading because the cost
   of meeting the obligation would not have changed.

2. Fair values and market realities

   Proponents argue that ignoring credit standing for a class of obligations traded in an
   active market can lead to a difference between market value (assuming that such values
   are based on discounted expected future cash flows reflecting the risk associated with
   those cash flows) and reported value. This difference is referred to by Black and Scholes
   as a “default put option." If this value is not reported (whether as an asset, a contra-
   liability or implicitly in the value of the liability), to achieve an immediate reported
   profit, the entity might exchange its obligation and that may not be in its best economic
   interest. Thus it is reasoned that business decisions that rely on such accounting
   arbitrage, rather than on sound economic reasons, might lead to inferior business

   It is further argued that even if the obligation were not so traded, the economic reality of
   credit standing risk would still exist. So, even if not observable, the difference in
   economic value (between a risk-free and non-risk free obligation) would exist in any
   event. It is asserted that this position is validated through both common sense and entry
   values, in which a lender or consumer is willing to charge a lower interest rate or pay a
   higher premium for an obligation with a better credit risk. To ignore this would be to
   report values inconsistent with both market and economic realities.

   This is particularly apparent at the initiation of the obligation assumed (when usually
   there is a larger one-time “credit discount” compared with the typical smaller subsequent
   changes reflecting changes in normal credit standing). This may lead, for practical
   reasons, to the compromise approach for certain liabilities described later in this paper.

   This initial measurement effect is particularly evident in the case of an entity entering
   into an obligation for the first time. Lack of initial recognition of credit standing would
   result in a loss being incurred every time an entity takes on debt. It is argued that this
   consequence is not consistent with the voluntary nature of such contracts.

                        Credit Standing in the Fair Value of Liabilities

        The increase in the availability of credit derivatives to hedge against credit standing risk
        inherent in a wide variety of financial instruments indicates that there is a cost for such
        credit standing risk. To ignore its effect is to invite inappropriate business decisions that
        would reflect accounting requirements rather than economic reality.

        Some counter such arguments by pointing out that, at least for investment grade financial
        instruments, this credit risk is not significant compared to the imprecision of measuring
        other risks and modeling the underlying cash flows. Therefore, at least for relatively
        small credit risks, even though there might be some economic value indicated the size of
        any adjustment for this purpose should be ignored.

        In addition, some opponents believe that, as a result of a lack of a relevant market, the
        fair value of a liability should never be able or be allowed to reflect all economic
        realities. For example, current international insurance financial reporting proposals do
        not reflect the probabilities of all contract renewals, realization of expected investment
        margins or intangible items. In a practical sense, it may not make sense to reflect the
        complex, and in most cases relatively small, effect of credit standing risk in the
        calculation of fair values, while ignoring other risks and expectations that can be of far
        greater significance to economic and business reality.

    3. Other inconsistencies associated with the lack of reflection of credit standing

        As mentioned in Argument 2, to ignore credit standing risk in measurement of general
        debt could produce an immediate loss. For example, the present value of an obligation in
        one year of $1,000 is $950 (corresponding to an interest rate of about five percent), but
        because of a poor credit standing, an entity might only receive $910. If credit standing
        risk was ignored, the reported value of the obligation would be $950, with an immediate
        reported loss of $40, while if credit standing risk was reflected, there would be no initial

        Some have contended that such a loss represents an unacceptable result. For one thing
        this might significantly reduce the incentive for non-risk free entities to borrow, which
        would not only be against public policy, but would be inconsistent with the expectations
        of management who expects to make a profit from its borrowing activities. Conversely,
        others argue that such a loss reflects the market perceptions of the current financial
        condition of the entity and should be so reported. In any case, it may be difficult to
        communicate the consequence of this approach to the lay public. Heckman8 has made a
        strong case for reporting an initial loss in these situations.

        This inconsistency is less obvious in the case of a number of non-general debt
        obligations. Some argue that the price demanded by a customer to enter into a
        transaction with a financial institution must be influenced by the credit worthiness of that
        institution, i.e., a potential insured will demand a lower price from a weaker institution.

 Heckman, Philip E., Ph.D., ACAS, MAAA. 2003. “Credit Standing and the Fair Value of Liabilities: A

                  Credit Standing in the Fair Value of Liabilities

   However, except in extreme cases, this assertion has yet to be proven by market
   experience in the insurance sector. Moreover, even if this were to be observed, unless the
   entity’s financial situation is substantially at risk, it is most likely not significant
   compared with other market considerations.

   In addition, due to the nature of the promises involved and past actions of regulators,
   most insurance customers assume that no credit standing risk exists (in part due to actual
   or perceived guaranteed safety-net system). This difference between general and non-
   general obligations may lead to different conclusions on whether to reflect credit standing

4. Use of the proper market

   Opponents counter Argument 2 by pointing out that the markets where these default put
   options exist are markets in which assets, rather than liabilities, are traded. All market
   participants are investors seeking to buy or sell financial instruments that have been
   issued by third parties. In fact, in such a market the third party issuer of the instrument is
   usually barred from participation. This limitation is imposed to maintain market order.
   When the issuer seeks to repurchase its own instruments, market trading generally is
   suspended and repatriation transactions are concluded off-market. This belies the
   proponents’ argument that the asset value can represent the liability value because the
   issuer can always repurchase in the market at the market price. In all known orderly
   markets this is not the case.

   In its deliberations with respect to accounting for insurance contracts, the IASB has
   defined the fair value of a liability as the value at which a willing, well informed buyer
   would assume a liability from a willing, well informed seller in a similar position.
   Because its regulatory environment requires obtaining policyholder approval before such
   a transaction can occur, such transfers are next to impossible in the U.S. Nevertheless, in
   other jurisdictions they are not infrequent, though they do not constitute what would be
   accepted as an “active market”. Where transfers of blocks of policy liabilities occur,
   there is no evidence that the credit rating of either of the parties is a determinant of the
   price negotiated. Although this could be viewed as representing a high transaction cost, it
   may also be an example of a blocking factor in action.

5. A possible illogical or misleading result

   Opponents of the recognition of an entity’s own credit standing risk in valuing its
   liabilities will usually first point out that such recognition can lead to internally illogical,
   if not misleading, results. For instance, during a period in which the entity’s credit
   standing deteriorates, the value of its obligations would decrease, with resultant increases
   in reported profitability and a potential improvement in the level of the entity’s capital
   and surplus. In the other extreme, if an entity takes action to enhance its credit-
   worthiness, its reported profitability would suffer, as it would have to write up the value
   of its liabilities to reflect the improvement in its credit standing risk. Many users of
   financial statements will neither understand, nor accept, such anomalies or explanations

              Credit Standing in the Fair Value of Liabilities

of changes in financial condition and performance measurement. And, as is readily
apparent, management can be presented with a perverse disincentive – if its financial
condition improves, its capital and surplus will decrease.

To expand on this illogical situation, if an entity decreases the reported value of its
liability to reflect a depressed credit rating, but subsequently enhances its credit standing
gradually over time and ultimately pays all of the amounts owed, over time it will
experience losses as its obligations are met. It can be viewed as being illogical that the
fulfillment of a known and expected obligation, generally considered a good thing, would
result in a loss, a bad thing. In fact, an incentive for management to create the situation
to default on the obligation (moral hazard) may thus be created.

Proponents of credit standing risk reflection claim that this apparently illogical result is a
result of only focusing on the value of a single balance sheet entry rather than the
financial statement of the entity as a whole. If the condition that contributed to the
change in credit standing is reflected simultaneously elsewhere in the financial statements
(assuming that the market is reasonably efficient with respect to timely and transparent
communication of this information), it would be inappropriate to look solely at the
marginal impact of the change in the entity’s liabilities. They contend that an
inconsistency can only arise to the extent that the cause of the change in credit standing is
not reflected in the entity’s reported assets and liabilities, which would be rare.

A change in credit standing can of course result from a change in intangibles or for
reasons not reflected in the accounts of the entity, e.g., as a result of a decrease in
intellectual capital, loss of brand value, market anticipation of future higher debt costs
(particularly if additional debt or equity is expected to be needed) or increase in liquidity
risk. One could argue that the reason why this issue has arisen in the first place is that
current financial reporting is unable to reflect all sources of change in credit standing.

The counter-argument continues that the apparent increase in profitability (if credit
standing worsens) is precisely the effect that would be recorded in financial statements if
the entity were to exchange (settle) its obligation in the market for its then fair value,
consistent with the intent of fair value reporting. Moreover, the argument continues, if
the entity had to finance the retirement of its debt obligation by taking on a new
obligation, the latter obligation would be available only on a basis reflecting the entity’s
then current credit standing. Therefore, although the result considered in isolation is
apparently illogical, it may be consistent with both the entity’s change in market realities
and perceptions.

The counter-argument points out that intangible values and changes in these values are
generally not reflected directly in the balance sheet (except in a business combination in
which the transaction price is relied upon to determine the value of the total intangible,
thus not relying on a model; otherwise intangibles will not be reported until rules can be
designed to account for intangibles in a reliable manner). As long as financial reporting
does not explicitly and effectively address changes in intangibles, and since changes in
intangibles contribute to the change in credit risk, in the aggregate the results may prove

                 Credit Standing in the Fair Value of Liabilities

   illogical. However, it is not appropriate to avoid enhancing one aspect of financial
   reporting simply because another area is less than perfect. That is, two wrongs do not
   make a right, at least to the extent that the source of the change in credit standing is a
   change in intangible assets or liabilities.

   Another example of this concern with inconsistent results is to compare the financial
   statements of two entities with the same tangible assets and liabilities but a different
   crediting standing. The entity with the worse credit standing would record a lower value
   for its liabilities and, thus, a higher capital value. Although some may understand that
   this is a result of intangibles, it can present potentially misleading financial results.

   Reflection of credit standing in the value of liabilities could lead to financial reporting
   instability (the “yo-yo” argument). Consider, for example, that without reflection of
   credit standing risk reported, values are assets = 100, liabilities = 99, and surplus = 1. In
   most such cases with a thin surplus level, significant credit standing / entity default risk
   would exist. However, if inclusion of an estimate of such credit standing risk reduces the
   value of the liability by 15, the consequent capital and surplus account becomes +16.
   Although unlikely, if this were recognized as the economic worth of the entity, the
   market (or rating agencies or loan providers) might reassess the credit standing risk to 5.
   Although again unlikely, it illustrates the possible oscillating instability of reported
   financial values. Which value would be recognized? Could it stabilize? One
   commentator has indicated that, taken to the extreme, this argument would lead to an
   entity technically never being declared insolvent / bankrupt until it has exhausted all of its
   assets. Neither this extreme result nor an unstable one is desirable.

6. Treatment of a credit standing risk adjustment

   Advocates of credit standing risk adjustments are divided in terms of how to express this
   adjustment. Some believe that it should be reflected as an adjustment to the discount
   rate. However, because insurance contracts can be complex instruments and can generate
   both positive and negative cash flows (e.g., premiums, benefits, expenses), such an
   approach can have a different effect on different obligations (discussed further in the
   “Measurement” section below).

   Although it could be argued that the value of this put could provide information regarding
   the cost to the entity of incurring this risk or through its application the total value of the
   obligations could be determined, until the information is available in the context of fair
   valuation it is difficult to determine how it could be used in practice.

   Advocates have indicated that to provide more transparent accounts, it would be
   preferable to express the net effect of this adjustment separately as a credit put to help
   meet the information need of certain users of financial statements described above. If it
   simply represents a desire to disclose the effect of entity-wide risk, other disclosures,
   such as a risk-based solvency margin, determined on the basis of an appropriate
   aggregation of all business and insurance risks to which an insurer is subject, might be a
   preferable alternative.

                         Credit Standing in the Fair Value of Liabilities

          In sum:

          (1) in many cases, the effect of credit standing can be quite difficult to separate from the
              underlying value, such in general debt,

          (2) if this proves impractical in certain cases, a rule would have to be developed to
              separate those financial instruments to which such an adjustment would be made,

          (3) the IASB Framework would not classify this put option as an asset, since it is not “a
              resource controlled by the entity as a result of past events and from which future
              economic benefits are expected to flow”9,

          (4) to include it by netting it with liabilities would represent a lack of transparency and if
              it is determined that such an adjustment should be made, then this approach would, in
              effect, hide this useful information.

          This would lead to a conclusion that, at best, it would be reflected either as a contra-
          liability or in the Notes to the entity’s financial statement. Including it in the Notes
          reinforces the fact that it is an entity-wide adjustment and may not be appropriate to be
          determined on a contract-by-contract basis. If reported as a contra-liability, proponents
          find themselves treating this in a manner inconsistent with the presentation of a
          corresponding asset (see Argument 1 above).

      7. The going concern assumption

          According to the IASB’s Framework, financial statements prepared according to IFRSs
          should only be presented on the basis that an entity is a going concern. The Framework
          states, “financial statements are normally prepared on the assumption that an enterprise is
          a going concern and will continue in operation for the foreseeable future. Hence, it is
          assumed that the enterprise has neither the intention nor the need to liquidate or curtail
          materially the scale of its operations; if such an intention or need exists.”10 Upon
          liquidation, an entity’s accounts may be prepared according to a different set of
          assumptions. Nevertheless, if the entity operates on a going concern basis today, many
          claim that it is reasonable to expect that it will continue to operate so in the future and,
          therefore, that the obligation will be met as called for in the applicable contracts. Note
          that in some accounting systems, such as U.S. GAAP, a going concern assumption is not

          The going concern principle has been adopted as an underlying assumption of an
          accounting system so that the user of financial statements can determine for
          herself/himself an entity’s potential inability to meet its obligations. To recognize a
          company’s own credit standing risk in the value of its liabilities would intrude upon this
          goal. To do so would suggest that this underlying going concern assumption might have

    IASB Framework, paragraph 53.
     IASB Framework, paragraph 23.

                  Credit Standing in the Fair Value of Liabilities

   to be reconsidered. Under this view, if a going concern were assumed, then the trigger
   for reflection of the effect of credit impairment would occur at the point when it is
   recognized that the entity is no longer a going concern.

   Proponents of recognition of credit standing risk argue that it is appropriate to reflect
   probability in an accounting recognition principle. That is, it is inappropriate to reflect
   only those situations in which it is more likely than not that an entity is not failing to
   maintain its going concern status. In fact they suggest that a probability measure should
   be taken into account in recognition of a future failure scenario.

8. The relationship between the risks associated with an entity’s assets and the value of
   its liabilities

   Some advocates of fair value of liabilities argue that the characteristics and risks of an
   entity’s assets should not influence the value of the entity’s liabilities, in part due to the
   entity’s ability to sell the assets independently of liabilities (though many have
   questioned that assertion). In fact, this is a fundamental assumption of the IASB’s
   current proposals for financial instruments, except in respect of those that are directly
   linked to a set of assets (performance-linked products).

   Those advocates indicate that recognition of the entity’s credit standing risk is an
   exception, in that it is a risk inherent in the liabilities. Naturally, others think the same
   way about the assets underlying and providing funding for the liabilities, but discussion
   of that issue is outside the scope of this paper. Nevertheless, if the general rule of
   independence of assets and liabilities were consistently applied, this entity-wide risk
   would not be recognized. Others believe that this is the very way that the total risk
   associated with actual assets held (including asset/liability management risk) could be
   incorporated into the measurement of liabilities.

   An insurance company (or other financial institution offering financial products) involves
   of a bundle of risks, in the aggregate sometimes referred to as the enterprise risk. In
   some cases, these risks can be observed or measured separately. Many of these risks are
   not generally considered in the measurement of liabilities. But in fact, the credit standing
   risk is identical to the enterprise risks, consisting of the net effect of all of the risks since
   that affects the likelihood of paying the liabilities of the entity. Thus, it is argued that this
   risk should not be applied at the liability level at all since, even if it is appropriate, it
   should be considered on an entity-wide basis, possibly as a disclosure item.

   Proponents present the counter argument that the concept of fair value should be
   independent of the entity as a whole on the ground that the financial instrument is
   tradable or can be treated independently. In fact, they say, their fair value is
   appropriately reflected in its value as an asset, the estimated exit price of the financial

   One way of viewing the credit standing risk of an insurer is as a reduction in (or offset to)
   the market value margin (MVM) of the liability. This would seem an appropriate

                 Credit Standing in the Fair Value of Liabilities

   approach if the liability would incorporate all of the entity’s risks. However, in a fair
   value system, the liability MVMs include neither the risks associated with the entity’s
   assets nor those associated with the mismatch or mismanagement of an insurer’s assets
   and liabilities.

9. The impact of an exchange or sale

   By definition, the fair value of a liability represents the amount for which a liability can
   be settled. Two possible approaches are (1) the fulfillment of the obligation subsequent
   to the time of valuation, and (2) the exchange or sale of the responsibility for the
   obligation to another party (note that in some cases the responsibility for a particular
   obligation cannot be exchanged as long as the entity is financially able to fulfil it).

   If the obligation for performance is transferred through sale or exchange, the credit
   standing risk of the original responsible party is no longer meaningful. Since the fair
   value concept is predicated on what a liability could be settled for, the party with whom it
   would be settled (assuming that the responsibility for fulfillment is also exchanged) is
   more relevant to ultimate performance. However, in most cases, it is impossible to
   determine in advance who will be the subsequent obligee and what will be its credit
   standing at the time.

   The lack of such knowledge of whose credit standing should be reflected results in a
   potentially unmeasurable expected value, unless a key assumption is made. Three
   possibilities exist:

      New credit standing worse than the current one. Assuming that the creditor had a
       veto power, it has been argued that an entity would not be able to exchange an
       obligation with an entity with a lower credit standing because the creditor (customer)
       would not consent to the replacement. In certain regulated industries such a veto
       power exists, while in others it does not. If the obligation were an interest-bearing
       debt and such a buyer could be found, the sale or exchange price for such a liability
       would be higher than would otherwise be the case. On the other hand, if it were a
       non-interest bearing obligation (in the case of most customer obligations), the
       exchange value would not be affected. For fiduciary obligations, it would be
       reasonable to assume that the fiduciary would not permit an exchange to result in the
       responsible party having a lower credit standing.

      New credit standing the same as the current one. This is the easy assumption to
       make, both because the same credit standing can be assumed and, if an interest-
       bearing debt is involved, the current level of interest payable can be assumed to
       continue. For a customer or fiduciary obligation, even if the new credit standing will
       be the same as the current one (or if a different credit standing existed) there would
       no additional price paid; in fact, credit standing normally would not at all be relevant.

      New credit rating better than the current one. It has been argued that if an
       interest-bearing obligation were involved, the entity would have to pay an additional

                 Credit Standing in the Fair Value of Liabilities

       amount to induce someone else with a superior credit standing to agree to a settlement
       transaction. This additional amount could be viewed as being consistent with the
       impact of the purchase of a credit derivative or credit enhancement / guarantee. As a
       result, if this were to occur, the net effect economically would be to assume the same
       credit standing would continue after an exchange. On the other hand, if a
       considerable difference in credit standing existed and a significant credit standing risk
       was involved, the additional price may not be affordable. For a customer obligation,
       again, credit rating may not be relevant.

   Opponents counter that although this analysis sounds OK, it has no basis in fact.
   Transactions involving non-interest bearing securities happen all of the time wherein
   prices do not depend upon the credit standing or expected credit standing of either of the
   two parties. Although in times of credit crunches or hard markets, there tends to be a
   flight to quality, the prices associated with securitization, reinsurance or sales are not
   based on differences in credit standing. Given these arguments, a case could be made for
   treating interest bearing and non-interest bearing obligations differently, with the former
   assuming a similar credit standing and the latter not being affected in any case.

   The following summarizes this discussion. Whether or not the entity actually sells the
   liability, arguments relating to the assumptions relating to the new entity’s credit standing
   are relevant if an interest bearing liability is involved, particularly in the case of a
   transfer. If focus is on what the actual credit standing of the successor entity would be,
   no conclusion can be reached, since its identity cannot be known in advance. Rational
   expectations would be consistent with no credit standing change upon an exchange.
   However, if a customer or fiduciary obligation is involved, since credit standing should
   not affect the price, then no credit standing risk adjustment should be made to such a

10. The effect of public or private guarantees

   Guarantees (credit enhancements) serve to improve the likelihood that an obligation will
   be fulfilled. They may be purchased or be provided through government sponsorship or
   encouragement (e.g., bank deposit guarantees by a governmentally related entity or
   insurance company insolvency pool funded by insurance companies on a non-voluntary
   basis). Alternatively, such a guaranty could be purchased from a financial guarantee
   insurance company. Typically, these credit enhancements are transferable.

   Consistent with the rest of this paper, in measuring the fair value of a liability, it is more
   important that an obligation will be fulfilled than who will ultimately pay it. If a
   guarantor is obliged to complete an unfulfilled obligation, the value of this credit
   enhancement should be reflected independently of the source of funds. Consequently,
   even if the credit standing risk of the entity obliged to perform were involved, it would be
   inconsistent to ignore the existence of an effective guarantee or collateral.

   In certain regulated industries, such as insurance and banking, the regulator has the
   authority to take over a troubled entity at, or usually before, the time that the company

                      Credit Standing in the Fair Value of Liabilities

       becomes insolvent. If this occurs, the responsibility to assure that the entity’s obligations
       are fulfilled may ultimately rest with the regulator. If this authority is credible because
       fulfillment of such an obligation is within the ambit of public interest, the need for a
       credit standing risk adjustment is eliminated. The same argument can be made with
       respect to government or industry funds that make good on policies in a failed financial

       If it is determined that, for the jurisdiction involved, this guarantee is not likely to be
       completely fulfilled, any adjustment for credit standing risk would be reduced
       proportionally by the extent of the expected effectiveness of the guarantee.

       It is interesting that, where credit standing is reflected in the liability, the effect of such a
       guaranty would be to increase the liability of the company because the probability of
       payment to the beneficiary or insured is enhanced. This result appears on the surface to
       be consistent with the benefit that is provided by the guarantor. Nevertheless, despite the
       fact that the real consequence with respect to the insurer’s and insured’s risks may be the
       same, it is inconsistent with the net balance sheet effect of obtaining reinsurance. Some
       have suggested that either there is a flaw in the logic of a credit standing adjustment or in
       the further adjustment to reflect the effect of such a guaranty.

What information is most useful to the user?

The objective of financial reporting is to provide the user with useful and meaningful financial
information. It is worthwhile to ponder for a moment what information is most meaningful. In
the case of an inefficient or nonexistent market for a liability, discounted cash flows can be used
to value the liability. These cash flows can be viewed from various perspectives, including the

   From the perspective of the entity currently responsible for the obligation, the expectation
    that the obligation will be fulfilled is both appropriate and reasonable. Once an insurance
    contract is sold, the responsibility for any loss that occurs is rarely sold or exchanged. In the
    absence of a market in which the obligation could be sold, a reduced value would never be
    used in corporate cash flow or financial planning. Any reduction in the reported value of an
    outstanding obligation would not be useful to the entity internally – imagine executive
    compensation being based on performance measures reflecting the probability of lack of
    fulfilling financial promises – or externally. Any implicit adjustment would only contribute
    to a reduction in the transparency of financial statements. Information about the value of the
    entity’s obligations (whether exchangeable or not) should not be clouded or aggregated with
    a market-based or estimated discount.

   From the perspective of an owner of the entity, an explicit qualitative and quantitative
    assessment of the material risks to which an entity is subject contributes to an enhanced
    understanding of the entity’s operation and financial condition, and should be properly
    communicated through such vehicles as an MD&A discussion. Communication of such risks
    is vitally important. However, a reduction in liabilities resulting from enterprise risk does not

                         Credit Standing in the Fair Value of Liabilities

      seem likely to contribute to such knowledge. In fact, by increasing reported capital as a
      result of a riskier financial condition seems more likely to hide the risks involved.

     From the perspective of the owner of the obligation as an asset, it is appropriate for expected
      cash flows to reflect the probability of receipt of the cash flows owed, as that is consistent
      with the definition of an asset.

If this difference in perspective is reflected, the value of an obligation as an asset would not be
the same as that obligation as a liability, thus contradicting the symmetry of value argument,
apparently highly valued in financial economics.

At times, it is difficult to obtain complete agreement regarding what constitutes useful
information. Indeed, “the objective of financial statements is to provide information about the
financial position, performance and changes in financial position of an enterprise that is useful to
a wide range of users in making economic decisions.”11 In fact, as can be seen in the earlier
discussion of the users of financial reports, the uses of financial reporting information are
diverse. Transparent presentation that does not hide significant information is needed. For
example, since some users will want to make their own assessment of credit standing or other
risks of an entity. Netting such a risk adjustment doesn’t provide such information.

Other users want to know the total value of the obligations to which the entity is committed. If
available, a market assessment of this risk would be helpful, but is rarely available. Unless
appropriate disclosure is provided, it can be difficult to understand or agree with estimates of
such a market assessment of the entity’s credit standing risk even it does exist. Estimates are
often all that be developed for this risk adjustment (see the “Measurement” section for a further
discussion). In some cases an independent assessment of this risk would be valuable. If not
disclosed separately, it would be quite impossible for the user to discern. In fact, it has been
suggested that the application of own credit standing makes less clear to the public or
investors/owners what the financial condition of the entity is.

One use of fair values is in impairment tests, where the reported values of such reported values
such as goodwill, derived from a business combination, are tested for adequacy to evaluate
expected recoverability. Inherently, the purpose of such a test is to determine the extent to which
the value of an asset may have been overstated or the amortized cost of a liability understated. It
does not seem logical to reflect a credit standing reduction in conducting such a test.

The case for the use of the fair value of an asset directly related to market transaction prices and
therefore reflective of the credit standing of the issuer is reasonable on the basis of an arm’s
length view of a sale of that asset. However, it can be argued that the arm’s length view is not
necessarily appropriate for use in the valuation of a liability. Thus it may be appropriate to
modify, or at least to re-interpret, the definition of the fair value of a liability. It may be
sufficient to provide full disclosure (all the components) to the reader, permitting the reader of
the financial statement to assess the entity’s credit standing risk.

     IASB Framework, paragraph 12

                        Credit Standing in the Fair Value of Liabilities

To some users, the ultimate question to be addressed by published financial statements is “Can
the entity meet its obligations?” If it does, then the entity should communicate its accounts in a
manner consistent with its intention to meet its obligations, by valuing those obligations based on
one hundred percent probability of meeting them. To do otherwise suggests that management
questions its own integrity and its intent and ability to fulfill its promises. For management of an
entity to incorporate, in its public financial statements, a valuation of its liabilities which is
reduced to reflect the market’s assessment of the likelihood that the associated obligations will
not be met, has been viewed by some to be tantamount to a denial by management of its
responsibility to fulfill those obligations. To ask it to estimate what the impact of this potential
lack of fulfillment seems strange, contradictory and even perverse.

Should treatment of credit standing risk vary by type of obligation?

Some who deal with other than general (customer or fiduciary) obligations believe that the nature
of these obligations (or the relationship between the party to whom the obligation is owed and
the party that is responsible) should determine whether their associated liabilities are affected by
credit standing risk. This belief is based on the implied promises due to the public policy aspects
of the fiduciary relationship involved, and these in turn influence the relative priority among the
parties at risk, the insurance-related stakeholders and the shareholders. Although clear guidance
would be needed to distinguish general from non-general obligations to avoid accounting
arbitrage, the application of such a distinction may be desirable.

In many cases, government has determined that the public interest demands that certain long-
term financial promises be kept, for example by a financial institution or employee benefit plan,
either by the original issuer, another financial institution or trust, or a publicly or privately
funded guaranty organization. Although in some cases such guarantees are imperfect, they are
sufficiently solid that many would consider them to be reliable.

An entity’s credit standing affects the interest rates at which it can borrow in the market or
through a financial institution. As such, it may be appropriate for its credit standing risk to be
reflected in the value of a general obligation. However, Heckman has asserted12 that this is an
outdated legacy of traditional GAAP, so entrenched as to have mistakenly become axiomatic.
Nevertheless, it is even less clear that this credit standing affects the value for which a non-
general obligation can be exchanged. It may be appropriate for further research to be conducted
regarding this hypothesis.

Due to the nature of exit values, if the obligation were potentially saleable or exchangeable, the
credit standing of the current obligee does not in any case affect the probability that a future cash
flow is paid. In addition, customers of a regulated financial industry, such as insurance or
banking, expect that the promises will be kept (and public policy may lead to enforcement of
these promises, sometimes backed up through such measures as nationalization or forced
mergers). As a result, except in extreme cases in which a fire sale occurs (companies reducing
premiums due to cash flow needs), entry prices for promises have not varied by the amount of
credit standing risk. In addition, the purchase price of a block of business (which constitute a

  Heckman, Philip E., Ph.D., ACAS, MAAA. 2003. “Credit Standing and the Fair Value of Liabilities: A

                      Credit Standing in the Fair Value of Liabilities

group of financial promises) also does not reflect credit standing risk of either party in the sale.
In summary, in such markets if values were to be reflective of either entry or exit pricing or
settlement values, credit standing risk would not be reflected.

If an insurer’s policy liabilities were to be adjusted to reflect a lower credit standing, not
accompanied by a corresponding change in tangible assets or other liabilities, the consequent
smaller liabilities would result in a larger capital and surplus account attributable to its
shareholders. Proponents argue that this result “preserves shareholder value” and distributes the
decline in credit worthiness more equitably between the creditors (in this case policyholders) of
the entity and its owners. However, opponents point out that such an approach unrealistically
inflates the shareholders’ capital and surplus account because, in most if not all jurisdictions, as
an insurer approaches insolvency, the interests of the policyholders become paramount. At the
point of insolvency, obligations to policyholders are met first. Once they are met in full, any
residual assets are used to meet general obligations. Consequently, the attempt to “preserve
shareholder value” is to report a value that does not exist and can never be realized.

Measurement issues

Whichever view is adopted, practical measurement issues will likely be encountered. The
following discusses some of these issues and should be considered in determining whether to
reflect such credit standing risk. With respect to some of the more difficult issues, guidance for
use by preparers of financial statements may be needed.

1. Which credit standing. In today’s complex world, it can be difficult at times to determine
   which risk to incorporate in a price or value. It has been argued that it is not desirable to
   adopt accounting rules applying to one’s own obligations that can be manipulated through
   the use of related organizations, such as holding companies or subsidiaries. Thus, obligations
   between entities within a consolidated group should be reported on consistent bases in order
   to avoid creation of false capital. This potential problem is shared with other inter-group
   transactions. The following is a list of some of the organizational decisions that have to be

       a. Entity or consolidated entity. In some cases different components of cost or
          financial condition are the responsibility of different entities within a group. For tax,
          convenience, or other purposes, more or less surplus might be held in a parent holding
          company, or expenses could be subject to an expense treaty or service agreement.
          Should each individual company be rated separately or should the consolidated group
          be considered? Typically credit rating is assigned to the consolidated entity.

       b. Multi-national issues. In the case of a multi-national company, when considering
          the credit standing risk should one consider the consolidated group, individual
          company within a specific country, the financial instrument, or a tranche within the
          instrument. In some cases, a subsidiary in a particular company has a different credit
          rating than its parent that might be in a different country. Because of regulatory
          priorities, different coverages might have different priority of recovery in an adverse

                      Credit Standing in the Fair Value of Liabilities

       c. Participating business. It is not clear whether the same adjustment approach would
          be applicable to liabilities for participating business. Because of the relative security
          of funds and minority interests involved, in some cases the security involved for a
          particular block of participating policies might be different from those that are not

       d. Separate account business. For U.S. separate account business used for variable or
          unit-linked business, liabilities are shielded from the bankruptcy of the insurance
          company. Presumably this fiduciary aspect of the contracts would not result in a
          credit-risk adjustment. However, this legal shield does not apply to many European
          insurers. As a result, for these companies, if a reduction in liabilities is made for
          credit-standing risk at the same time that corresponding assets are unaffected, as
          funds in the separate account grow, a gain will be reported while as it decreases, a
          loss will be reported. This appears to the authors to be an illogical result.

2. Ceded reinsurance. In some cases, it is unclear who bears the responsibility for fulfilling a
   contract obligation. For instance, particularly if substantial reinsurance is involved, should
   the credit standing risk of the reinsurer(s) or the primary insurer be used in the measurement
   of the primary insurer’s liability? Although it could be argued that by definition reinsurance
   transfers risk, for most reinsurance the ultimate risk is still borne by the primary insurer. In
   fact, all parties involved may bear responsibility for fulfilling the obligation, either in a
   primary or secondary capacity.

   The credit standing risk of the reinsurer(s) can relate to and affect the net credit standing risk
   adjustment of the primary insurer on the portion ceded, as well as resulting in a reduction of
   the overall credit standing risk of the primary insurer. A new or revised reinsurance structure
   can therefore affect both the risk adjustment on the block reinsured and the block retained.

   If the primary insurer and its reinsurer(s) do not share the same current credit standing,
   inconsistencies can result and calculations can become quite complicated, particularly if the
   reinsurer shares vary by contract duration. For example, if primary insurers with different
   credit standing reinsure similar blocks of business with the same reinsurer with a higher
   credit standing than either of the original insurers, the net liability of the two primary insurers
   would be different even though the ultimate credit security would be similar, that is, that of
   the reinsurer. If the primary insurer with a poor credit standing totally reinsures a block of
   business with a high quality reinsurer, it may not make sense to use the primary insurer’s
   credit standing; otherwise the primary insurer would experience an immediate profit at the
   time of the reinsurance transaction. Due to the complexity of many reinsurance programs, it
   may be quite difficult and complex to determine the effect over time of the relative
   responsibility for fulfillment. A practical approach might be to recognize the credit standing
   of the better of the primary and reinsurer’s credit standing.

   However, most accounting standard setters that have recently addressed reinsurance
   accounting have taken the view that the accounting credit to be taken for the reinsurance of a
   block of business should be presented as an asset rather than a contra-liability in the accounts

                      Credit Standing in the Fair Value of Liabilities

   of the primary insurer, without an implicit offset. Underlying this approach is the assumption
   that the risks associated with a primary insurer are independent of those of the reinsurers
   involved. In fact, this is often not the case, as many of the risks borne by insurers are highly
   correlated. Thus, any potential partial credit impairment could theoretically be incorrect.

3. Third party guarantees. If reflected, the effect of a guarantee would have to be determined
   and applied to the probability of a risk event. Of course, if an efficient market is available
   from which to judge the reduction in discount, the discount could be determined from a study
   of transaction prices. However if not, this may prove somewhat difficult to estimate, since
   the credit standing risk discount would be less than the credit standing risk discount of either
   entity. If the two sets of credit standing risk were perfectly positively correlated (of one), the
   net discount would be equal to that of the guarantor; if there is no correlation, the net
   discount would be equal to

       1 – (1 - risk discount for the entity) * (1 – risk discount for the guarantor).

   If market indications were not available, a practical rule would have to be developed to
   provide guidance to such a determination.

   If the guarantor in a regulated industry is an industry-sponsored fund, the credit standing risk
   evaluation will depend on an assessment of the percentage of the customer obligations that is
   expected to be covered by that fund. In some cases, the death benefit might be guaranteed
   while a surrender benefit might not be. This assessment may be difficult although, due to the
   reduction described in the preceding paragraph, differences in the resulting adjustment may
   not be material in size. In the insurance industry, as enhanced minimum risk based capital
   requirements are adopted and met over time, credit standing risk should be reduced. If
   surplus were contributed or additional equity purchased, the extent of the credit risk
   adjustment would change.

4. Obligation or entity specific risk determination. Any credit standing risk adjustment
   would most likely be obligation specific, rather than entity specific. While the market may
   reflect general credit standing, it does not always do so in a direct or explicit manner. A
   decline in market value following a deterioration of credit standing can simply reflect a
   change in the demand for a higher return as a result of a perceived increase in risk. In fact,
   the contractual obligation of the debtor need not have changed, any more than it would have
   changed had the debtor realigned its assets to better match the expected cash flows needed to
   fulfill its obligations. In most cases, credit standing is determined at the entity level and not
   at the level of the particular obligation. On the surface, it would be inappropriate for a long-
   term credit assessment of an entity to be applied to the reported value of a short-term

5. Credit standing risk of potential transferee. To the extent that the obligation that forms
   the basis of a liability is transferable, whose credit standing should be reflected? A solution
   mentioned earlier could be to assume that the same credit standing risk continues. Another
   possible solution could be to recognize the better of the overall credit standing risk of the
   industry in the aggregate or the company. An obvious practical problem that would need to

                      Credit Standing in the Fair Value of Liabilities

   be resolved to make an industry-specific approach work is how such an industry credit
   standing risk would be measured and by whom it would be determined. The issue would
   also involve who makes up the “industry” and how a single adjustment factor could be
   applied to an individual entity or liability.

6. Timing of cash flows involved. The period of time over which the obligation will fall due
   and the size of this obligation (as well as the cumulative amount of other obligations)
   compared to the amount of the resources available to the entity will affect the degree of
   relevant credit standing risk. For example, a life insurance obligation payable over fifty
   years (assuming no back-up guarantees) certainly would be affected to a greater degree by
   credit standing risk than would a short-term account payable. The extent to which this risk
   would be expected to affect future payments may require complex calculations, possibly with
   different credit standing risk adjustments applied to cash flows expected to be paid in
   different future eras, or in fact to different tranches or uses of cash flows. Uniform
   application (if no efficient market existed for the obligation) to a variety of situations within
   an entity might be neither practical nor appropriate.

7. Effect on the income statement. For purposes of reporting, the timing of recognition of
   such a risk can be important. Market assessment could be expected to be effective in the
   same period. However, depending on the nature of the underlying source of risk and whether
   it is based on market or internal assessment (the entity may have different information
   available to it than does the market), the timing of reflection can be different from the
   market’s identification. In addition, different sources of risk may or may not be reflected
   elsewhere in the entity’s balance sheet. For example, because fair values don’t reflect the
   risks associated with asset/liability matching or intangible assets, the liability itself will not
   reflect this risk while an entity-determined credit standing risk would. Thus, the income
   statement would be affected differently depending on the mix of risks involved.

8. Partial guarantees. Partial credit guarantees also could lead to practical measurement
   issues. For example, a government might guarantee only a certain portion of a bank’s
   demand deposits. Also, even though an insurer might be regulated, the parent company may
   not be subject to regulation. On conceptual grounds for obligations with such partial
   guarantees, the adjustment for credit standing risk would differ depending on the portion of
   the individual liability that is effectively guaranteed and the financial resources expected to
   provide such guarantees.

9. Default, credit or credit standing risk. Credit risk includes the risk of volatility. The
   discussion in this paper only covers the part of this more general risk associated with the
   inability / unwillingness to settle obligations. Inclusion of market observation of credit risk
   would overstate the credit standing risk. On the other hand, credit standing risk does not just
   cover the probability of insolvency, since it is likely that a certain percentage of the insurance
   obligation will be settled even if bankruptcy occurs. As a result, just reflecting the
   probability of insolvency would overstate any adjustment. It can be difficult to isolate this

                          Credit Standing in the Fair Value of Liabilities

10. Credit standing risk and return on capital. It has been suggested by some that a return on
    capital should be considered in the measurement of the fair value of liabilities for those
    liabilities whose value cannot be determined from market observation, just as any investor
    would demand a return on their capital invested in the business. Because entities’ costs of
    capital differ depending on the entities’ relative credit standing risk, it is claimed that
    liabilities calculated in accordance with a return-on-capital model will reflect credit standing
    risk. Note that current methods used to estimate this cost of capital, usually an overall spread
    over the risk free rate or a constant cost of capital, is not a particularly satisfactory approach,
    but may be useful as an approximation in some cases. If further refinement or differentiation
    were called for, then measurement of the credit standing risk would then have to employ
    other methods.

11. How to measure it. Although significant discussion has occurred recently regarding
    whether to recognize credit standing risk for liabilities, far less attention has been directed to
    how to proceed when it cannot be directly measured in a market or through a difference in
    interest rate charged that is directly related to the risk involved. As mentioned above,
    difficulties include the application of entity-wide risk to instrument-specific cash flows.

       FASB Concept Statement No. 7 provides the following measurement guidance: “The effect
       of an entity’s credit standing on the measurement of its liabilities is usually captured in an
       adjustment to the interest rate … and is well suited to liabilities with contractual cash flows.
       An expected cash flow approach may be more effective when measuring the effect of credit
       standing on other liabilities.”13 For most insurance liabilities, it would appear that the more
       appropriate approach would be a risk adjustment applied to the obligation’s expected cash
       flows. To be consistent with fair valuation, this risk would have to be updated on a regular
       basis (accountants refer to this process as a “fresh start”), although for practical reasons some
       believe that for certain products it would be better to lock in the initial level of risk at the
       time that a contract is issued or a loss is incurred in the case of a loss reserve.

       It may be relatively easy to identify a market-based interest rate spread that reflects the
       current difference between the overall rating by a recognized rating agency and
       corresponding government fixed income securities (an explanation of whether a single
       overall rate or duration specific rates should be applied to the expected cash flows for each
       future period is outside the scope of this paper, though the more accurate approach would be
       to use rates/spreads that vary by duration). However, the method or considerations used to
       select a credit spread applied to other assumptions may not be so easy to determine and
       consistently apply, and without suitable guidance could result in widely different
       quantification. Moreover, outside North America not all insurers have been assigned such a
       rating; in many cases, even those that have been assigned one, were developed in respect of
       general debt, not necessarily related to the insurer’s insurance liabilities. Guidance may even
       be needed on the seemingly simple question of what is the credit standing of an entity, let
       alone what is the credit standing applicable to a consumer liability.

       The desire to incorporate the probability of default by duration might require the use of
       accurate stochastic entity-wide financial models, not only incorporating the probability of
     FASB Concept Statement No. 7, paragraph 82

                          Credit Standing in the Fair Value of Liabilities

     bankruptcy and resultant policyholder and government behavior, but also providing for the
     proportion of benefits that would be lost and the timing thereof. In doing so, the many
     measurement issues involved, including others not mentioned above (such as the extent to
     which planned new business and likely risk management strategies should be incorporated),
     would have to be addressed before this concept was implemented. Practical simplification
     techniques should be developed to approximate the results of the otherwise complicated
     conceptual modeling that would be needed. Alternatively, a percent of the cost of capital
     might also be used, though it is unclear, without extensive testing, how appropriate such an
     approach would be. In summary, if it is decided to incorporate credit standing risk in the
     measurement of customer or fiduciary liabilities, further research will be needed to identify
     the principles underlying acceptable methodologies that can be applied to such measurement.

If, to avoid manipulation, a distinction were made between general obligations and other
obligations, practical rules would have to be developed to distinguish between these types of
liabilities14. Similarly, rules would be needed covering how to reflect the existence of guarantees
of a government or industry based back-up facility; it would be helpful if an outside entity
provides this guarantee effectiveness rating.

If it was decided that credit standing should be reflected only at initial issue and subsequent
changes therein would be ignored, similar measurement issues would arise, requiring that an
estimate of the current market assessment of the original credit position be made independently
of the effect of any subsequent change. This may be difficult in practice if a substantial number
of such obligations exist. The issues encountered in determining the value may be difficult
enough, but not insurmountable, for a bond. However, for a company with long-term insurance
obligations (in some cases with millions of policies, each with unique risk characteristics and
calculations), the impact of the credit standing at issue would have to be applied to the future
period over which expected cash flows are assumed to occur. Conceivably, that assessment
could be different for each year of issue, or even each partial year of issue, and need constant
reassessment at each accounting period.

If a change in credit standing risk arises from changes in both intangible and tangible (measured
through reported values) assets and liabilities, it may be argued that it would be technically
appropriate to reflect credit standing risk only to the extent that the source of the change in credit
standing risk is reflected in tangible assets and other liabilities. Otherwise, the illogical result
noted above in Argument 5 would arise, even if the perspective of the entire entity were taken.
This problem arises from the difficulty of assigning values to intangible assets and liabilities.
Although such an approach may be judged by some to be conceptually appropriate, it may prove
impossible in practice to implement such a system due to the difficulty in determining the
contribution that these sources make to overall credit standing risk. To the extent that a change
in credit standing risk is related to sources other than those reflected in tangible assets or
liabilities, the illogical result of reflecting credit standing risk noted above will always result. If
it was determined that it was partly due to an intangible effect or effect not reflected in reported
assets or liabilities, it might prove to be impractical to quantify the tangible effect.

  FASB Concept Statement No. 7, paragraph 85 indicates “there is no convincing rationale for why the initial
measurement of some liabilities would necessarily include the effect of credit standing (as in a loan for cash) while
others might not”

                      Credit Standing in the Fair Value of Liabilities

In summary, as long as there is no active market in credit standing risk, the value of the entity’s
credit standing risk for a particular obligation may be difficult to quantify or at the minimum
would require substantial judgment, especially for small entities with no available credit rating or
for companies with a complicated cash flow structure. Some have contended that rating agencies
(in the U.S. there are currently four “nationally recognized statistical rating organizations,” e.g.,
Moody’s) could provide a rating for this purpose. Even if this were the case for areas in which
such a service currently exists, such ratings are not available in many areas and for many entities.
Possibly more importantly, they are not available for many types of obligations or product
segments. It also may prove difficult to estimate such a value if different rating agencies assign
different credit ratings to an entity or to particular obligations. Such general ratings can be
difficult to estimate and may not apply in determining credit standing risk for long-term
obligations such as insurance or a retirement program, contracts that have cash flows that would
be expected to occur over long periods of time.

Possible compromise

A compromise option might be to reflect credit standing or expected credit standing risk at the
time the obligation is undertaken, while ignoring the effect of subsequent changes in credit
standing. Such a compromise value can be viewed as representing the sum of the value of a
financial instrument without reflecting credit standing risk and the credit standing risk discount.
The latter is not a financial instrument itself and thus might not have to be valued using fair
value, rather using historical costs. Constantly updating the initial level of credit standing risk
could be a significant challenge.

Although this overcomes some of the issues described above, other practical problems would
result from this approach. In addition, it does not completely meet one of the objectives of fair
value reporting, i.e., two otherwise similar future obligations should be valued at the same
amount regardless of when the obligation was initiated. The result of this compromise approach
would constitute a deviation from fair values as they have been defined.


The objective of this paper is to present an objective discussion of this issue. We hope that this
objective has been accomplished. Although relatively limited conclusions have been reached in
this paper, a few final observations can be made. We follow these by disclosing our own current

The fact that apparent inconsistencies may result from the application or non-application of
credit standing risk has contributed to the controversial nature of this issue. It is an issue in
which practical issues may significantly affect the ultimate conclusion. If no reliable market is
available from which to derive obligation-specific credit standing risk adjustments, it may prove
difficult to identify such risk adjustments for liabilities. Although a compromise solution is
possible (reflection of extent of credit standing at the time of initial measurement, while not
reflecting changes in credit standing risk level subsequently) and may avoid some of the extreme

                       Credit Standing in the Fair Value of Liabilities

problems described in this paper, the compromise has its own practical and conceptual problems,
with its result not being conceptually acceptable in any event.

We believe that the two principal arguments raised in favor of reflecting credit standing in the
fair valuation of all obligations are:

1. Values recorded for assets and liabilities relating to the same obligation should be equal.

2. At the initial recognition of the existence of a debt, the market’s pricing of that debt
   incorporates the credit standing of the issuer. If that credit standing risk recognition were
   ignored, an immediate loss would be recorded on the books of the issuer any time a debt is

To the extent that the source of a change in the credit standing of an entity is already reflected in
its tangible assets, some of the apparent inconsistencies in reported profit and loss, as well as
changes in the size of its liabilities noted in this paper may not arise. However, if the change in
credit standing arises from changes in intangible assets or liabilities, recognition of the effect of
such change in reported liabilities would result in an inconsistency in the reported values of the
entity’s assets and liabilities. Further, to the extent that these risks are not recognized in the
same financial reporting period, inconsistent income statement results will be generated.

Although providing for such a risk in an insurer’s own policyholder liability can in some cases
provide useful information to informed shareholders who understand the conceptual base of such
an adjustment, this information, particularly if embedded in the accounts, is likely to provide
misleading and irrelevant information to other users, such as policyholders, creditors and

A case has been made to support differentiating the recognition of credit standing risk between
general obligations and customer / fiduciary obligations. This position is taken in recognition of
the non-interest bearing nature of most customer obligations and of the guarantees available in
some customer and fiduciary obligations, particularly those involving financial intermediaries
where public policy considerations may be involved due to the nature of the promises made.
Thus, even if it were determined to be appropriate to reflect credit standing risk in certain general
liabilities, it may not be appropriate to do so for other types of obligations.

Even if credit standing risk is reflected in the value of the liability, it is our conclusion that this
risk should reflect the risk associated with the party expected to fulfill the obligation. Thus, the
credit standing risk associated with a guarantor (e.g., regulator or insurer) would have to be

The importance of reporting financial values on a going concern basis will be heavily influenced
by the underlying assumptions of the accounting model used and by the perspectives of the users
to whom the financial information is provided. For example, international accounting standards
are based on the going concern principle, while U.S. accounting standards are not. If it is
important to assess an entity under the assumption of a going concern, an entity’s own credit
standing risk should not, in our view, be reflected in the reported value of its liabilities. If an

                      Credit Standing in the Fair Value of Liabilities

organization is a going concern, it can and should be expected to meet its obligations in all
respects. To reflect a depressed credit standing in valuing those obligations is to suggest that not
all such obligations will be met, which amounts to a denial of the going concern principle.

To the extent that the sources of the change in credit standing risk are not reflected in financial
reporting, it would be inappropriate to recognize the effect of the change. To do otherwise may
lead to misleading financial results. Nevertheless, an entity’s own credit standing risk is useful
information that may be appropriate to be disclosed in a Note to the financial statements.

After consideration of the arguments on both sides of the question, the authors admit to being
persuaded that the case against reflection of credit standing of the entity in the reported value of
liabilities, at least with respect to customer and fiduciary obligations, is the stronger position.
This assessment derives from their view that financial statements should be straightforward,
transparent, and logical and, above all, should serve the public interest. The majority of the
arguments against reflection of credit standing in the liability valuation support those principles.
To reflect this risk properly in a modeling framework, the practical measurement issues and, at
least on a conceptual level, the methodology to be used appear to be quite significant problems.


   Financial Accounting Standards Board Preliminary Views on Major Issues Related to
    Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Values,
    December 1999.
   Financial Accounting Standards Board Statement of Financial Accounting Concept No. 7
    Using Cash flow Information and Present Value in Accounting Measurements, February
   Gutterman, Sam, FSA, FCAS, MAAA, FCA, HonFIA. 2000. “The Valuation of Future
    Cash Flows: An Actuarial Issues Paper”, Fair Value of Insurance Business. Kluwer
    Academic Publishers.
   Heckman, Philip E., Ph.D., ACAS, MAAA. 2003. “Credit Standing and the Fair Value of
    Liabilities: A Critique.”
   International Accounting Standards Board (IASB), Framework and Standards.
   Joint Working Group of Standard Setters, Draft Standard and Basis for Conclusions,
    Financial Instruments and Similar Items, December 2000.
   Staff of the Financial Accounting Standards Board, Credit Standing in Liability
    Measurement, March 1999.


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