Sun Life 2010 Annual Report Download - page 30

derivative. The fair value of interest rate and cross-currency swaps and forward contracts is determined by discounting expected future
cash flows using current market interest and exchange rates for similar instruments. Fair value of common stock index swaps and
options is determined using the value of underlying securities or indices and option pricing models using index prices, projected
dividends and volatility surfaces.
In 2009, we adopted amendments to CICA Handbook Section 3862, Financial Instruments – Disclosures. The amendments include
enhanced disclosures related to the fair value of financial instruments and the liquidity risk associated with financial instruments.
Specifically, assets and liabilities are categorized based on a three level hierarchy as follows:
Level 1: Fair value is based on unadjusted quoted prices for identical assets or liabilities in an active market. The types of assets and
liabilities classified as Level 1 generally include U.S. Treasury and agency securities, cash and cash equivalents, and exchange-traded
equities.
Level 2: Fair value is based on quoted prices for similar assets or liabilities in active markets. Valuation is based on significant
observable inputs or inputs that are derived principally from or corroborated with observable market data through correlation or other
means. The types of assets and liabilities classified as Level 2 generally include government bonds, certain corporate and private
bonds, certain asset-backed securities and derivatives.
Level 3: Fair value is based on valuation techniques that require one or more significant inputs that are not based on observable
market inputs. These unobservable inputs reflect the Company’s estimates about the assumptions market participants would use in
pricing the asset or liability. The types of assets and liabilities classified as Level 3 generally include commercial mortgage-backed
securities (“CMBS”), residential mortgage backed securities (“RMBS”), certain structured products and certain corporate bonds.
As pricing inputs become more or less observable, assets are transferred between levels in the hierarchy. For a financial instrument
that transfers into Level 3 during the reporting period, the entire change in fair value for the period is included in the Level 3
reconciliation schedule in Note 5.A.iii to our 2010 Consolidated Financial Statements. For transfers out of Level 3 during the reporting
period, the change in fair value for the period is excluded from the Level 3 reconciliation schedule in Note 5.A.iii to our 2010
Consolidated Financial Statements. Transfers into Level 3 occur when the inputs used to price the financial instrument lack observable
market data and as a result, no longer meet the Level 1 or 2 definition at the reporting date. During the current reporting period,
transfers into Level 3 were primarily related to a significant reduction in the trading activity of certain types of securities, which resulted
in a change to the pricing source. Transfers out of Level 3 occur when the pricing inputs become more transparent and satisfy the
Level 1 or 2 definition at the reporting date. During the current reporting period, transfers out of Level 3 were primarily related to
observable market data being available at the reporting date, thus removing the requirement to rely on inputs that lack observability. If
a financial instrument is transferred into and out of Level 3 during the same period, it is not included in the Level 3 reconciliation
schedule in Note 5.A.iii to our 2010 Consolidated Financial Statements. Total gains and losses in earnings and OCI (loss) are
calculated assuming transfers into or out of Level 3 occur at the beginning of the period.
Transfers into and out of Level 3 were $319 million and $442 million, respectively, for the year ended December 31, 2010. The total
amount of the net realized/unrealized gains/ (losses) related to securities transferred out of Level 3 during the period, which were
excluded from the Level 3 reconciliation, was approximately $54 million.
Real estate held for investment is initially recorded at cost and the carrying value is adjusted towards fair value each quarter by 3% of
the difference between fair value and carrying value. The fair value of real estate is based on external appraisals, using expected future
net cash flows discounted at current market interest rates.
Mortgages and corporate loans are recorded at amortized cost. The fair value of mortgages and corporate loans is determined by
discounting the expected future cash flows using current market interest rates with similar credit risks and terms to maturity.
Due to their nature, the fair values of policy loans and cash are assumed to be equal to their carrying values, which is the amount these
items are recorded on the balance sheet. Cash equivalents and short-term securities are recorded at fair value, which is determined
based on market yields.
Other invested assets designated as HFT and AFS are primarily investments in segregated funds and mutual funds. These are
reported on the Consolidated Balance Sheets at fair value, which is determined by reference to quoted market prices. Other invested
assets designated as AFS also include investments in limited partnerships, which are accounted for at cost.
Other-than-Temporary Impairment of Financial Assets and Allowance for Investment Losses
Changes in the fair value of AFS bonds and stocks are recorded as unrealized gains and (losses) in OCI.
AFS bonds are tested for impairment on a quarterly basis. Objective evidence of impairment includes financial difficulty of the issuer,
bankruptcy or defaults and delinquency in payments of interest or principal. Where there is objective evidence that an AFS bond is
impaired and the decline in value is considered to be other-than-temporary, the loss accumulated in OCI is reclassified to net gains
(losses) on AFS assets in the Company’s Consolidated Statement of Operations. If the fair value of an AFS bond recovers after an
impairment loss is recognized and the recovery can be objectively related to an event occurring after the impairment loss is recognized
in net income, the impairment loss is reversed, and the amount of the impairment loss reversal is recorded in net income. During the
year ended December 31, 2010, we did not have any impairment loss reversals on AFS bonds. Following impairment loss recognition
or reversal, AFS bonds continue to be recorded at fair value with changes in fair value recorded in OCI and tested quarterly for further
impairment loss or reversal. Interest is recognized on previously impaired AFS bonds in accordance with the effective interest rate
method.
AFS stocks are tested for impairment on a quarterly basis. All equity instruments in an unrealized loss position are reviewed quarterly
to determine if objective evidence of impairment exists. Objective evidence of impairment for an investment in an equity instrument
includes, but is not limited to, the financial condition and near-term prospects of the issuer, including information about significant
changes with adverse effects that have taken place in the technological, market, economic or legal environment in which the issuer
operates that may indicate that the carrying amount will not be recovered, and a significant or prolonged decline in the fair value of an
26 Sun Life Financial Inc. Annual Report 2010 Management’s Discussion and Analysis