Financial instruments are initially recognized at fair value and are subsequently accounted for at fair value or amortized cost depending on the financial instrument classification. The classification depends on the purpose for which the financial instruments were acquired and their characteristics. The fair value of a financial instrument on initial recognition is normally the transaction price, i.e., the fair value of the consideration given.
Subsequent to initial recognition, the fair values are determined based on available information. Financial instruments classified as FVTPL or AFS are carried at fair value, while all others are carried at amortized cost. The fair values of investments, excluding commercial loans, are based on quoted bid market prices, where available, or observable market inputs. Observable market inputs include quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets, inputs that are observable but are not prices such as interest rates and credit risks, and inputs that are derived from or corroborated by observable market data. The fair values of commercial loans and other financial instruments are measured at amortized cost using the effective interest rate method.
All short-term investments, equities (including preferred stocks, common stocks, and pooled funds), and bonds, except those voluntarily designated as FVTPL, are designated as AFS. Changes in fair value are recorded, net of income taxes, in OCI in the consolidated statement of comprehensive income until the disposal of the financial instrument, or when an impairment loss is recognized. When the financial instrument is disposed of, the gain or loss is reclassified from accumulated other comprehensive income to recognized gains on investments in the consolidated statement of comprehensive income.
We have voluntarily designated a portion of our bonds as FVTPL. We have no other FVTPL financial assets. Changes in fair values as well as gains and losses on disposal of FVTPL financial instruments are recorded in recognized gains on investments in the consolidated statement of comprehensive income with the related tax impact included in income tax (recovery) expense. Gains and losses on the sale of FVTPL financial instruments are calculated on an average cost basis. Changes in the fair value of the FVTPL financial instruments are reflected within net (loss) income in the consolidated statement of comprehensive income, so it is not necessary to record an impairment loss when there has been a significant or prolonged decline in the fair value of FVTPL financial instruments.
The designation of the FVTPL bond portfolio aims to reduce the accounting mismatch in net (loss) income that would otherwise be generated by the fluctuations in fair values of underlying claim liabilities due to changes in interest rates. In compliance with OSFI guidelines, we manage the FVTPL portfolio’s quantum and duration so that the impact of changes in interest rates on claim liabilities and the FVTPL portfolio reasonably offset each other.
Bonds and short-term investments are valued on a discounted cash flow basis. The inputs into the discounted cash flow model for the bonds and short-term investments are an estimate of the expected cash flows discounted at a pre-tax risk-free rate plus an appropriate adjustment for credit risk.
Note 2 — “Summary of significant accounting policies”, and Note 5 — “Investments”, of the audited consolidated financial statements provide further details pertaining to the classification and measurement of our financial instruments.
For a discussion of risks and the management of our risks, refer to Section 12 — “Risk management”, Financial risks, included in our MD&A below.