SAP - Bond in good standing

[sixblackout]

Is the year-to-year increase in a bond bought at a discount (which is being amortized) interest income or an unrealized gain?

[frank_exams]

Quick note:

Without digging up a reference, I would say it should be interest income. For example, if you buy a zero at a discount, you will be taxed every year until maturity on imputed interest. I believe this is consistent with the way constant yield amortization works.

Frank

[oopsieny]

Originally Posted by sixblackout

Is the year-to-year increase in a bond bought at a discount (which is being amortized) interest income or an unrealized gain?

If you mean the market value appreciation of the bond? In SAP, bond just carried at amortized value regardless of MV.

[sixblackout]

Originally Posted by oopsieny

If you mean the market value appreciation of the bond? In SAP, bond just carried at amortized value regardless of MV.

No I'm talking about the change in the amortized value from one year to the next...is it investment income or an unrealized capital gain.

Frank seems to think that it is included in Line 9, Net investment income earned, of the Statement of Income. Does anyone else have any thoughts?

[Plant Food]

Originally Posted by sixblackout

Does anyone else have any thoughts?

I do.

Suppose you buy a $1,000 par value 10% annual coupon bond for $900 on 12/21/00. Coupons are paid on 7/1/01, 7/1/02 and the par value is paid on 12/31/02. Assume, for simplicity, that the amortized cost on 12/31/01 is $950 and that it's NAIC class 1 so that it's carried at amortized cost. Forget about taxes. Suppose surplus at 12/31/00 is $900.

At 12/31/00 cash is decreased by $900 and the bonds is increased by $900. There is no effect on the income statement. Surplus is still at $900.

At 12/31/01 cash is increased by $100 for the coupon and bonds is increased by $50 for the change in amortized cost.
Investment income earned is $100. The $50 in amortization is an increase in adjustment that shows up in the "Exhibit of Capital Gains (Losses)." It's then carried over to the "Change in Net Unrealized Capital Gains" adjustment to surplus. So surplus is now 1,050.

At 12/31/02 cash has increased by $100 for the coupon, and $1,000 for the par value paid.
The income statement is going to show investment income earned of $50 and realized capital gain of $100. Note that the $100 capital gain is in the first column of the Exhibit of Capital Gains (Losses) and the increases by adjustment column is 0. So "Change in Net Unrealized Capital Gains" is zero. This is where examiners have repeatedly stumbled. They take the "Change in Net Unrealized Capital Gains" literally and think that it's the difference between two balance sheet items called "Unrealized Capital Gains" (See, for example, 2005 #33).

I'm not 100% sure on the taxes but here goes. For 2001, the tax on the unrealized capital cain of $50 leads to a deferred tax liability of 17.50 but the net change in unrealized capital gains would still be $50. The $100 of investment income earned would give a federal and foreign income taxes incurred amount of $35. The liability page would have current federal and foreign income tax of $35 and a deferred tax liability of $17.50. So surplus is 1050-35-17.50=997.5. The income statement would show
Net Investment Income Earned=100
Federal Income Taxes Incurred=35
Net Income = 65
Change in Net Unrealized Capital Gains=50
Change in Net Deferred Income Tax=(17.50)

So Surplus=900+65+50+(17.50)=997.50.

[Didon]

Originally Posted by Plant Food

[a bunch of stuff that I'm sure is correct]

la la la la I can't hear you

[sixblackout]

Originally Posted by Plant Food

I do.

Suppose you buy a $1,000 par value 10% annual coupon bond for $900 on 12/21/00. Coupons are paid on 7/1/01, 7/1/02 and the par value is paid on 12/31/02. Assume, for simplicity, that the amortized cost on 12/31/01 is $950 and that it's NAIC class 1 so that it's carried at amortized cost. Forget about taxes. Suppose surplus at 12/31/00 is $900.

At 12/31/00 cash is decreased by $900 and the bonds is increased by $900. There is no effect on the income statement. Surplus is still at $900.

At 12/31/01 cash is increased by $100 for the coupon and bonds is increased by $50 for the change in amortized cost.
Investment income earned is $100. The $50 in amortization is an increase in adjustment that shows up in the "Exhibit of Capital Gains (Losses)." It's then carried over to the "Change in Net Unrealized Capital Gains" adjustment to surplus. So surplus is now 1,050.

At 12/31/02 cash has increased by $100 for the coupon, and $1,000 for the par value paid.
The income statement is going to show investment income earned of $50 and realized capital gain of $100. Note that the $100 capital gain is in the first column of the Exhibit of Capital Gains (Losses) and the increases by adjustment column is 0. So "Change in Net Unrealized Capital Gains" is zero. This is where examiners have repeatedly stumbled. They take the "Change in Net Unrealized Capital Gains" literally and think that it's the difference between two balance sheet items called "Unrealized Capital Gains" (See, for example, 2005 #33).

I'm not 100% sure on the taxes but here goes. For 2001, the tax on the unrealized capital cain of $50 leads to a deferred tax liability of 17.50 but the net change in unrealized capital gains would still be $50. The $100 of investment income earned would give a federal and foreign income taxes incurred amount of $35. The liability page would have current federal and foreign income tax of $35 and a deferred tax liability of $17.50. So surplus is 1050-35-17.50=997.5. The income statement would show
Net Investment Income Earned=100
Federal Income Taxes Incurred=35
Net Income = 65
Change in Net Unrealized Capital Gains=50
Change in Net Deferred Income Tax=(17.50)

So Surplus=900+65+50+(17.50)=997.50.

Thanks for the explanation. Why is the investment income only $50 at 12/31/02?

[frank_exams]

I think there's evidence for both arguments (mine and Plant Food).

Let's take the coupons out for a moment to make the situation more transparent.

Stepping back from insurance, if you own a zero-coupon bond (or any bond for that matter), you have to pay taxes on imputed income every year. Period. These are not deferred tax liabilities, they're paid at the end of each year. The method of imputation is constant yield, which is the method of amortization according to IASA 2 for investment-grade bonds, mortgage loans, and others.


Let's look at an easy example. Suppose you paid 826.45 for a two-year zero coupon bond, par value 1000. The yield to maturity is 10%. At the end of year 1, via the constant yield method, the bond is worth 909.09 = 1000/1.1. The IRS would tax you on the difference 909.09 - 826.45 = 82.64. You may argue that this is an unrealized gain, but I'm hesitant to call it that. The problem is, the bond's actual market value at the end of year 1 depends on the one year spot rate at the time. As an extreme example, if the spot rate were 0%, then the bond would be worth 1000/1 = 1000 at the end of year one. On the other hand, if the one-year spot jumps to 20%, then the market value would be 833.33 = 1000/1.2. This is just to illustrate the disconnect between the statuory value (909.09) of the asset and the market value (1000 or 833.33).

Finally, another year later, you'll pay taxes on 1000 - 909.09 = 91.91, fully accounting for the entire discount you had at time of purchase.


Now, there's evidence pointing toward Plant Food's treatment. Namely, IASA 9, p.11 says that changes in valuation are generally considered to be unrealized capital gains. It's difficult to tell from context whether they're talking about 4X and ex-dividend changes or if this includes adjustments due to premium/discount on the bond. There's also the word "generally", but that's mincing words.



Let me conclude. Changes in valuation of bonds, stocks, and other investment items are generally recorded as Unrealized Capital Gains and Lossses. These will affect the Deferred Tax Liability, unless the insurer is a "dealer in securities", whence by IRC 475, these gains/losses would count as ordinary income. Barring that, a bond's increase in value would flow through to deferred taxes until settlement/maturity (IASA 13-9, 13-24). Ah, but here's the rub! I would be somewhat surprised if the IRS allowed insurers an exemption on imputed income, which is essentially what the deferred tax liability gives. The insurer won't pay taxes on gains until settlement, which is the same as the old system where you don't get taxed until you have a realized gain. This was a loophole which was discovered and quickly closed with the 1986 Tax Reform Act. The tax break was that good; just imagine if the bond expiry was distant!



Having said all that, if this were on the exam, I'd probably chalk up the gain to unrealized, just on the basis of IASA 9, p.11. They're not really looking for in-depth answers on the exam, anyway.

Just some food for thought.

Frank

[Plant Food]

Originally Posted by sixblackout

Why is the investment income only $50 at 12/31/02?

The investment income is $150 it's just broken up into two lines on the income statement.

"Net Investment Income Earned" (line 9) is $50.
"Net Realized Capital Gains" (line 10) is $100.
"Net investment gain (loss)" (line 11=line 9+line 10) is $150.

The tax stuff I included is all wrong. Everything is net of taxes. I'm not sure what stuff goes in the deferred tax asset/liability place. I'll put it on my list of things to get to this weekend.

[sixblackout]

Shouldn't it be $100 for the coupon and $100 for the realized capital gain?