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Allianz Group Annual Report 2009 Notes to the Consolidated Financial Statements Fair value of financial instruments The Allianz Group applies the IAS 39 fair value measurement rules to determine the fair value of financial instruments. Active markets – quoted market price The fair values of financial instruments that are traded in active markets are based on quoted market prices or dealer price quotations on the last exchange trading day prior to and at the balance sheet date. The quoted market price used for a financial asset held by the A llianz Group is the current bid price; the quoted market price used for financial liabilities is the current ask price. No active markets – valuation techniques If the market for a financial instrument is not active, the fair value is determined by using valuation techniques. The valuation techniques used are based on market observable inputs when available. Such market inputs include references to recently quoted prices for identical instruments from an active market, quoted prices for identical instruments from an inactive market, quoted prices for similar instruments from active markets and quoted prices for similar instruments from inactive markets. Market observable inputs also include interest rate yield curves, option volatilities and foreign currency exchange rates. Where observable market prices are not available, fair value is based on appropriate valuation techniques using non-market observable inputs. Valuation techniques include net present value techniques, the discounted cash flow method, comparison to similar instruments for which observable market prices exist and other valuation models. In the process, appropriate adjustments are made for credit risks. No active market – equity instruments Equity securities are measured at fair value where the ownership interest is less than 20 % and when the fair value is reliably measurable. If the fair value cannot be measured reliably, unquoted equity instruments and derivatives linked to such instruments are stated at cost until a fair value can be measured reliably. These financial instruments are subject to the normal impairment procedures. Amortized cost of financial instruments The amortized cost of a financial instrument is the amount at which the financial instrument is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization using the effective interest rate method of any difference between that initial amount and the maturity amount, and minus any subsequent reduction for impairment or uncollectability. 222 Recognition of a day one profit or loss If the fair value of a financial instrument differs from its initial transaction price (i.e. by comparing it to other observable current market transactions or by using a technical valuation model incorporating only observable market data), it is required that the recognition of a “day one profit or loss“ is consistent with the subsequent measurement of the financial instrument with all the other requirements regarding the calculation of fair value. A profit or loss should be recognized after initial recognition only to the extent that it arises from a change in a factor that market participants would consider in setting a price. Subsequent measurement of financial instruments The subsequent measurement of financial instruments depends on their classification as follows: Financial assets and liabilities carried at fair value through income Financial assets and liabilities carried at fair value through income include financial assets and liabilities held for trading and financial assets and liabilities designated at fair value through income. Financial assets and liabilities are classified as held for trading if they have been principally acquired or incurred for the purpose of generating a profit from short-term fluctuations in price or for the purpose of selling in the near future. Financial assets held for trading consist of debt and equity securities and derivative financial instruments with positive fair values that do not meet the criteria for hedge accounting. Financial liabilities held for trading primarily consist of derivative financial instruments with negative fair values that do not meet the criteria for hedge accounting. Derivative financial instruments include separated embedded derivatives of hybrid financial instruments. Financial assets and liabilities carried at fair value through income are measured at fair value. Changes in fair value are recognized directly in the consolidated income statement. The recognized net gains and losses include dividends and interest of the underlying financial instruments. A financial instrument may only be designated at inception as held at fair value through income and cannot be subsequently changed. Notes to the Consolidated Financial Statements Allianz Group Annual Report 2009 Available-for-sale investments Available-for-sale investments comprise debt and equity securities that are designated as available-for-sale or are not classified as held-to-maturity, loans and advances to banks and customers, or financial assets carried at fair value through income. Available-for-sale investments are recorded at fair value. Unrealized gains and losses, which are the difference between fair value and cost or amortized cost, are included as a separate component of other comprehensive income, net of deferred taxes and the latent reserve for premium refunds to the extent that policyholders will participate in such gains and losses on the basis of statutory or contractual regulations when they are realized. When an available-for-sale investment is derecognized or determined to be impaired, the cumulative gain or loss previously recorded in shareholders’ equity is transferred and recognized in the consolidated income statement. Realized gains and losses on securities are generally determined by applying the average cost method at the subsidiary level. Available-for-sale equity securities are measured at fair value where the ownership interest is less than 20 % and when the fair value is reliably measurable. Available-forsale equity securities include investments in limited partnerships. The Allianz Group records its investments in limited partnerships at cost, where the ownership interest is less than 20 %, and when the limited partnerships do not have a quoted market price and fair value cannot be reliably measured. In general, the A llianz Group accounts for its investments in limited partnerships with ownership interests of 20 % or greater using the equity method due to the rebuttable presumption that the limited partner has no control over the limited partnership. Held-to-maturity investments Held-to-maturity investments are debt securities with fixed or determinable payments and fixed maturities for which the Allianz Group has the positive intent and ability to hold to maturity. These securities are recorded at amortized cost using the effective interest method over the life of the security, less any impairment losses. Amortization of premium or discount is included in interest and similar income. Loans and advances to banks and customers Loans and advances to banks and customers are non-derivative financial assets with fixed or determinable payments, that are not quoted in an active market, are not classified as available-for-sale investments or held-to-maturity investments, financial assets held for trading, or financial assets designated at fair value through income. Loans to banks and customers are initially recorded at fair value plus trans- action costs, and subsequently recorded at amortized cost using the effective interest rate method. Interest income is accrued on the unpaid principal balance, net of charge-offs. Using the effective interest method, net deferred fees and premiums or discounts are recorded as an adjustment of interest income yield over the lives of the related loans. Loans and advances to banks and customers include reverse repurchase (“reverse repo”) agreements and collateral paid for securities borrowing transactions. Reverse repo transactions involve the purchase of securities by the Allianz Group from a counterparty, subject to a simultaneous obligation to sell these securities at a certain later date, at an agreed upon price. If substantially all of the risks and rewards of the securities remains with the counterparty over the entire lifetime of the agreement of the transaction, the securities concerned are not recognized as assets. The amounts of cash disbursed are recorded under loans and advances to banks and customers. Interest income on reverse repo agreements is accrued over the duration of the agreements and is reported in interest and similar income. Securities borrowing transactions generally require the Allianz Group to deposit cash with the security’s lender. Fees paid are reported as interest expense. Funds held by others under reinsurance contracts Funds held by others under reinsurance contracts assumed relate to cash deposits to which the Allianz Group is entitled, but which the ceding insurer retains as collateral for future obligations of the A llianz Group. The cash deposits are recorded at face value, less any impairments for balances that are deemed to be not recoverable. Financial assets for unit-linked contracts Financial assets for unit-linked contracts are recorded at fair value with changes in fair value recorded in net income together with the offsetting changes in fair value of the corresponding financial liabilities for unit-linked contracts. Liabilities to banks and customers Liabilities to banks and customers are subsequently measured at amortized cost. Herein included are repurchase (“repo”) agreements and securities lending transactions. Repo transactions involve the sale of securities by the Allianz Group to a counterparty, subject to the simultaneous agreement to repurchase these securities at a certain later date, at an agreed price. If substantially all of the risks and rewards of the securities remains with the A llianz Group over the entire lifetime of the transaction, the securities concerned are not derecognized by the A llianz Group. The proceeds of the sale are reported under liabilities to 223 Allianz Group Annual Report 2009 Notes to the Consolidated Financial Statements banks or customers. Interest expense from repo transactions is accrued over the duration of the agreements and reported in interest and similar expenses. In securities lending transactions the A llianz Group generally receives cash collateral which is recorded as liabilities to banks or customers. Fees received are recognized as interest income. Investment contracts with policyholders Fair value for investment and annuity contracts are determined using the cash surrender values of policyholders’ and contract holders’ accounts. Financial liabilities for unit-linked contracts The fair value of financial liabilities for unit-linked contracts is equal to the fair value of the financial assets for unit-linked contracts. Financial liabilities for puttable equity instruments Financial liabilities for puttable equity instruments include the minority interests in shareholders’ equity of certain consolidated investment funds. These minority interests qualify as a financial liability of the Allianz Group, as they give the holder the right to put the instrument back to the Allianz Group for cash or another financial asset (“puttable instrument”). These liabilities are required to be recorded at redemption amount with changes recognized in income. Certified liabilities, participation certificates and subordinated liabilities Certified liabilities, participation certificates and subordinated liabilities are subsequently measured at amortized cost, using the effective interest method to amortize the premium or discount to the redemption value over the life of the liability. Financial guarantee contracts Financial guarantee contracts issued by the A llianz Group are those contracts that require a payment to be made to reimburse the holder for a loss it incurs because the specified debtor fails to make a payment when due in accordance with the terms of a debt instrument. Financial guarantee contracts which are not accounted for as insurance contracts are recognized initially at fair value. Subsequently, unless the financial guarantee contract was designated at inception as at fair value through income, the issuer measures it at the higher of the best estimate of the expenditure required to settle the present obligation and the amount initially recognized less cumulative amortization when appropriate. 224 Impairment of financial assets Impairment of held-to-maturity and available-for-sale debt securities A held-to-maturity or available-for-sale debt security is impaired if there is objective evidence that a loss event has occurred after initial recognition of the security and up to the relevant date of the A llianz Group’s consolidated balance sheet, and that loss event has negatively impacted the estimated future cash flows, i.e. all amounts due according to the contractual terms of the security are not considered collectible. The evaluation of whether a held-to-maturity or available-for-sale debt security is impaired requires analysis of the underlying credit of the relevant issuer and involves significant management judgment. In particular, current publicly available information relating to the issuer and the particular security is considered relating to factors including, but not limited to, evidence of significant financial difficulty of the issuer and breach of contractual obligations of the security, such as a default or delinquency on interest or principal payments. The A llianz Group also considers other factors which could provide objective evidence of a loss event, including the probability of bankruptcy and the lack of an active market due to financial difficulty. The presence of either a decline in fair value below amortized cost or the downgrade of an issuer’s credit rating does not by itself represent objective evidence of a loss event, but may represent objective evidence of a loss event when considered with other available information. If a held-to-maturity debt security is impaired based on the Allianz Group’s impairment review process, the related impairment loss is measured as the difference between the security’s carrying amount and the present value of estimated future cash flows, discounted at the security’s original effective interest rate. If an available-for-sale debt security is impaired based on the A llianz Group’s impairment review process, the related impairment loss is measured as the difference between the security’s acquisition cost (net of any principal repayment and amortization) and current fair value, less any previously recognized impairment losses. In a subsequent period, if the fair value of an available-forsale debt security instrument increases and the increase can be objectively related to an event occurring after the recognition of an impairment loss, such as an improvement in the debtor’s credit rating, the impairment is reversed through impairments of investments (net).