Alphabet Soup:
The Fate of FSP EITF 03-1: OTTI

By Jeff Tetrick, CFO
AASCIF Finance and Investment Committee
Pinnacol Assurance, Colorado

As chief financial officer with oversight of a large, fixed-income portfolio – more than $1 billion – the thought that EITF 03-1: OTTI (Emerging Issues Task Force 03-1: Other Than Temporary Impairment) might be implemented concerned me deeply. For years, I have worked diligently on the asset/liability duration match program. With headlines proclaiming that interest rates would revert to higher levels, I struggled to avoid the “capital gains now in anticipation of higher rates soon” trap.

At one point, Pinnacol Assurance’s board of directors even discussed taking $120 million of gains on the portfolio – the result being that if rates didn’t increase shortly, we were further ahead pressing out on duration. That discussion was in 2003, at about the same time that EITF 03-1: OTTI entered the radar screen of those that held fixed-income securities. And with this blip on the radar, inconsistencies started to appear. OTTI was in conflict with the available-for-sale arguments we had just gone through for generally-accepted-accounting-principles (GAAP) financial-statement reporting.

The OTTI proposal required recording – through income – the market-value decrease resulting from the increase in long-term interest rates. For years, the asset/liability matching of duration has been an important concept of prudent portfolio management, which we have continually tried to impress upon our board and investment committees. And while not an issue for U.S. AASCIF members, the guidance offered by the EITF appeared to diverge from international accounting standards (IAS). In fact, some in the industry speculated that efforts to achieve some level of standardization between GAAP and IAS were being intentionally derailed.

Finally – and maybe most critically – OTTI seemed to be an attempt to disclose, within the financial statement reporting process, information that was already available. In other words, if a reader of the financial statements was interested in the impact of market value on a fixed-income portfolio, the information was readily available through existing disclosures.

We reported on OTTI at our audit committee meetings, investment committee meetings, and to our board of directors. From a risk-management perspective, it was critical that all were aware that under this proposal, fixed-income securities “available for sale” might be required to record “impairment” through net income, even though the impairment only resulted from interest rate movement and not a change in the credit-worthiness of either company. OTTI consumed much of our thought and discussion in 2004 – not only as stewards of crucial financial assets, but to avoid the shock factor when these figures appeared on Pinnacol’s year-end financial statement.

Fortunately, the feedback that the EITF received on this issue was loud and clear, and it boiled down to nearly universal opposition to the proposal. Industry reaction was so strong that implementation was deferred at the end of 2004 “until further study and analysis.”

I reported to our board that we needed to be aware of the concerns and impact that this would have upon Pinnacol’s reported financial statements. We also discussed long-term interest rates and speculated that they would surely rise.

Where are we today, at the end of second quarter 2005? Interest rates, while at the short end of the curve, are increasing, as orchestrated by Alan Greenspan. However, 10-year treasury notes (a good tracking security for our liabilities) continue to show the levels we saw in late 2002. I can only be grateful that we held to our duration discipline strategy.

And where is EITF 03-1: OTTI? On July 13, 2005, I received an e-mail from Angie Ritter at PIMCO Specialty Markets, LLC, which stated in part:

“To summarize, the Board concluded there should be an FSP (FASB Staff Position) drafted that would supercede EITF 03-1 and require recognition of other than temporary impairments in accordance with the guidance that existed prior to EIFT 03-1. The FSP is expected to be issued final in July 2005 with no comment period because it incorporates no new guidance. I believe all recipients will view this as excellent news!”

Did we dodge a bullet? The impact of FSP EITF 03-1: OTTI on Pinnacol would have been substantial: a charge-through-income of more than $80 million if interest rates had moved up 100 basis points.

However, we did learn some valuable lessons along the way:

• We recognized the issue early and communicated our concerns to our board and appropriate committees.
• We monitored the issue constantly.
• We prepared for the ramifications.
• While concerned, we didn’t over-react.

I suspect that as we monitor industry trends going forward, these lessons will continue to serve us well.

Jeff Tetrick can be reached at 303-361-4861 or jeff.tetrick@pinnacol.com.