Residual Tranche Accounting: Choosing Between Practical Expedient and Allowable Earned Yield

 

New accounting rules for residual tranches can have an immediate and negative impact on insurers’ financial statements, as it understates the value of the residual tranches on the balance sheet and understates the investment income on the income statement. Clearwater breaks down the available options and how we can help to navigate these changes.

For insurers considering how to comply with the National Association of Insurance Commissioners (NAIC) plethora of new guidelines, the changes to accounting for residual tranches (the highest-risk portion of a structured finance product) is one of the most significant, with the potential for an immediate negative impact on insurers’ balance sheets, and their long-term costs.

While the goal is to ensure that companies are not overstating profits, and are properly accounting for risk, there are a number of effects, including:

  1. A shift in the portfolio’s composition may require the insurer to exit certain transactions to comply with regulatory capital requirements or optimize risk exposure, making residual tranche investments less appealing
  2. Changed capital treatment, with higher capital requirements and therefore costs
  3. Residual tranches previously held at higher valuations may need to be marked down
  4. Income from these instruments cannot be marked as such until the Book Adjusted Carrying Value (BACV) is zero

Choosing the Right Accounting Solution

Insurers applying new accounting standards have two options for accounting for residual tranches, each with distinct advantages and drawbacks.

The default is the practical expedient method in which cash flows are treated as a reduction in the BACV and cannot be reflected as income until the BACV reaches zero. This solution is simple and easy to implement. But the significant changes to how residuals are accounted for could lead to a lumpy balance sheet, with significant delays in recognizing income and an understatement of the investment value. For insurance firms with minimal exposure to residual tranches or those already following a conservative accounting approach, the practical expedient method offers a straightforward, low-effort solution.

The alternative is to apply the Allowable Earned Yield (AEY) method which, while requiring more effort, will allow insurers to smooth out income recognition over time, avoiding large hits to the balance sheet. In turn, this results in improved financial ratios and profitability metrics without artificially depressing earnings. Firms with larger exposures to residual tranches or those that rely more heavily on investment income are likely to find AEY more attractive.

Using AEY to Better Manage the Balance Sheet and Minimize Impact of Artificial Loss of Earnings

With AEY, insurers can choose the accounting measurement method that best suits their financial strategy:

  • Consistently recognize interest income based on predetermined effective yield when cash is received
  • At lower of amortized cost or market value, with temporary reductions in fair value being recorded as unrealized losses.

For Clearwater clients, the practical expedient method is provided by default, with no need for clients to do anything – the updates will be automatically applied.

For those firms who wish to apply the AEY method, Clearwater offers support for this via a premium package, seamlessly integrated into existing accounting processes and applying an automated process to allocate and report on these instruments.

A fixed yield is set when the asset is added to the portfolio and used calculate a “cumulative potential income” (CPI). Income received up to the CPI amount is recognized as income, while any excess reduces the amortized cost of the residual tranche. If the total income is less than the CPI amount, the remaining CPI is carried over for future recognition. If accounting for residuals is likely to impact your financial statement, talk to us today about how we can smooth the process of applying the AEY method to your accounting.

Key Changes at a Glance: Residual Tranche Accounting on 1/1/25 

No matter which accounting method you choose, here’s what you can expect when the new rules take effect: 

  1. Balance adjustments:
    • The BACV of residuals as of 12/31/2024 becomes the starting BACV for 1/1/2025. 
    • Any unrealized losses recorded before 2025 will be converted to realized losses and reported on Schedule BA Part 3—even if there were no disposal transactions.                   This is necessary because, before 2025, residuals were measured differently depending on their legal form: 
      • Equity-form residuals: Valued at either market value or the equity method. 
      • Debt-form residuals: Valued at amortized cost or the lower of cost or market (LOCM) method. 
  1. Accrued interest and dividends reset to zero 
  2. No more interest or dividend accruals, amortization of premium, or accretion of discount after 2024

Changes Based on Your Chosen Accounting Method 

Practical Expedient Method: 

  • Cash distributions reduce the amortized cost of the residual tranche 
  • Interest income cannot be recognized until the amortized cost reaches zero 
  • Residuals will continue to be reported on Schedule BA Part 1 with a zero BACV and any applicable interest income until the security is either unwound or no longer classified as a residual 

Allowable Earned Yield (AEY) Method: 

  • Cash distributions can be recognized as interest income immediately based on the predetermined AEY rate 
  • Any excess cash flow beyond the AEY amount reduces the amortized cost 
  • If cash flows fall short of AEY, the unrecognized portion is carried forward for future income recognition 

Clearwater clients using either method will not need to change the data they send us. We’ll automatically attribute the distributions properly, regardless of method, and properly account for GAAP treatment without any changes. Connect with us today if you want to know more.  

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