General Purpose Insurance Accounting

1. General Purpose Insurance Accounting Michael G. McCarter, FCAS, MAAA Vice President, AIG CAS CLRS Session FR 7 September 11, 2007

2. Introduction • Prelude – the rise of the standards setters • The perfect storm for international accounting standards • IASB Insurance Contracts Phase II • FASB, the SEC, and you • EU Solvency II, the IAIS, and the NAIC • Conclusion: Brave new world, or the Emperor’s new clothes?

3. Warning! • The magic date of November 16 is approaching! • Potential commenters are searching for common ground with each other • Opinions, especially on matters of detail, may well change if more agreement may result • Therefore, pay more attention to my questions than my answers!

4. Prelude – the rise of the standards setters • Old style standards setter: FASB • FASB is delegated its authority to set standards for U.S. GAAP by the SEC • SEC retains practical authority over some significant areas of U.S. GAAP • SEC is in Washington, DC and may be influenced by Congress and the President

5. Prelude – the rise of the standards setters • New style standards setter: (surprise) the NAIC • The NAIC had no authority to be a standards setter. It is not a regulator, but a trade association for regulators. • However, in the accounting codification project it took the status of insurance regulatory accounting standard setter from the states who had responsibility

6. Prelude – the rise of the standards setters • The NAIC demonstrates the power of “agreeing to agree” • It is now the most important regulatory accounting standards setter • Since it is not a part of government, it has problematic standards of due process • Through the accreditation process, it can exercise influence over state governments

7. Prelude – the rise of the standards setters • Another new style standards setter: the IASB • Descended from old IASC founded in 1973 (older than FASB) • No official delegated authority from any government (to start with) • Acted with alacrity to take advantage of perceived need for international standards

8. The perfect storm • Asian financial crisis 1998 • Caused G8 to issue ritual call for improved accounting standards and reporting • Old IASC recognized an opportunity • Old IASC “standards” merely collected more commonly used options for different accounting areas

9. The perfect storm • New IASC project to revise its standards to select the best, “principles-based” approach • Project coincided with EU need for EU-wide accounting standards • IASC reorganized itself into the IASB to meet U.S. (FASB and SEC) objections as to its process and funding

10. The perfect storm • Once the IASC/IASB had done what the U.S. said it should, the U.S. was committed to work with the IASB towards the obvious goal of a single world-wide set of high quality accounting standards • Another example of the power of “agreeing to agree”

11. The perfect storm • EU agrees to adopt IASB IFRS effective January 1, 2005 (even though no complete set of IFRS existed when adopted, when implemented, or even today) • “Norwalk Agreement” commits FASB and the IASB to work towards “convergence” of U.S. GAAP and IFRS

12. The perfect storm • IASB lauded itself on its “principles-based” standards that would not be subject to the abuses of the “rules-based” FASB approach • Multiple major projects (Conceptual Framework, Revenue Recognition, Financial Statement Presentation) amount to re-building car while racing around the track

13. IASB Insurance Contracts Phase II • Old IASC had never completed an insurance contracts accounting standard • Recognized as a major need, but the new IASB could not complete an insurance accounting standard in time for the EU IFRS implementation • IASB developed IFRS 4 (Insurance Contracts Phase I) as a placeholder

14. IASB Insurance Contracts Phase II • IASB issued “Discussion Paper: Preliminary views on insurance contracts” in May 2007 • Comments are due November 16, 2007 • FASB has also issued the discussion paper with a “wraparound” asking for comments by November 16, 2007 as to whether FASB should take up the insurance contracts accounting project as well

15. IASB Insurance Contracts Phase II • To reiterate, comments are being developed as we speak • Here are some of the major issues covered by the “DP” • Note: The “DP” approach is based on “principles” that have nothing to do with the ideas underlying current U.S. GAAP for insurance

16. IASB Insurance Contracts Phase II • Measurement of insurance liabilities is to be on a “market consistent” basis using a “current exit value” (CEV) approach • CEV may not be the same as “fair value”, but to date no difference between CEV and “fair value” has been identified • CEV based on three “building blocks”: current estimates, time value of money, market risk and service margins

17. IASB Insurance Contracts Phase II • Current estimates: explicit, unbiased, market-consistent, probability-weighted current estimate of contractual cash flows • Discount rates based on current market interest rates to apply to these cash flows • Explicit and unbiased estimates of margins that market participants would require to bear risk (risk margin) and to provide services, if any (service margin)

18. IASB Insurance Contracts Phase II • Margins are not “entity specific” – they are to reflect a market participant, not the specific insurer being accounted for • Margins reflect the pooling of similar risks in a portfolio, but not the diversification benefits of other portfolios of the insurer • Insurance liabilities should reflect their own credit standing (as assets)

19. IASB Insurance Contracts Phase II • Question: Liabilities don’t trade – they are settled. Why is “market-consistent” a relevant consideration for liabilities? • Question: There is no benchmark for ever verifying the correct “market risk margin” for a liability. How does this “mark-to-unverifiable-model” add reliable information for investors?

20. IASB Insurance Contracts Phase II • Question: Insurers are obliged to settle claims in accordance with contract terms. Why should liability valuations be reduced by the “own credit stance” when the insurer cannot benefit from that haircut? • Question: If we accept “market consistent” for argument’s sake, why is no diversification credit allowed when markets, rating agencies, and even solvency regulators recognize the validity of the concept in many circumstances?

21. IASB Insurance Contracts Phase II • Question: Why should an insurer use a “market participant” service margin lower than its actual costs that generates an artificial day one profit at inception only to reverse as the actual service costs emerge? • Question: Why are life and non-life insurance presumed to use the same accounting treatment when no existing accounting system treats them together and the relative underwriting and investment risks are very different?

22. IASB Insurance Contracts Phase II • Question: Why is the whole discussion focused on balance sheets when management and investors are at least equally concerned with performance measurement (notably for non-life underwriting results and combined ratios)? • Question: Why is there no plan for serious testing of these proposals before simply requiring them for one of the world’s major industries?

23. FASB, the SEC, and you • “I only do business in the U.S., so I don’t have to worry about the IASB IFRS for insurance contracts” • Incorrect. FASB is committed to (and is working hard on) converging U.S. GAAP with the IASB’s IFRS, and it would be stunning if FASB decided not to participate in the Insurance Contracts Phase II project

24. FASB, the SEC, and you • FASB has already been considering insurance accounting issues (reinsurance accounting and bifurcation, and insurance risk transfer) • The SEC is increasing the pressure on FASB to work towards convergence • You can anticipate that U.S. GAAP insurance accounting will face reconsideration in light of the “DP”

25. FASB, the SEC, and you • SEC Proposed Rule released July 2, 2007 • “Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to U.S. GAAP” • Comments due September 24, 2007

26. FASB, the SEC, and you • SEC Concept Release on August 7, 2007 • “Concept Release on Allowing U.S. Issuers to Prepare Financial Statements in Accordance with International Financial Reporting Standards” • Comments due November 13, 2007

27. FASB, the SEC, and you • Talk about pressure for convergence • If IFRS are allowed on U.S. markets without reconciliation (which seems to be the direction), competition between accounting systems will start day one • If U.S. GAAP and IFRS converge for insurance accounting, what does that mean for insurance regulatory accounting?

28. EU Solvency II, the IAIS, and the NAIC • As the EU adopted (mostly) the IASB’s IFRS to unify accounting standards across its member states, it is now adopting the Solvency II directive to unify insurance regulation • Solvency II is designed around the three pillars of capital requirements, regulatory examinations, and disclosure requirements that were pioneered for banks under Basel II • Solvency II is designed to provide EU insurers with competitive regulatory advantages over non-EU insurers

29. EU Solvency II, the IAIS, and the NAIC • Solvency II has two required capital calculations, the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR) • SCR tends to be based on internal models that use concepts similar to the IASB’s CEV concept • SCR is intended to represent the amount of capital required to make the probability of failure 0.5% or 1 in 200 years. • MCR is intended to be a simpler formula approach

30. EU Solvency II, the IAIS, and the NAIC • Issue: Should solvency measurements and financial reporting measurements be the same? • Not necessarily – “different horses for different courses” • Accounting makes entities comparable across industries, while solvency focuses on insurance • Solvency considers cat exposure, accounting only cats that have happened

31. EU Solvency II, the IAIS, and the NAIC • Issue: Should equally secure insurers be treated the same way, no matter where they are located? • Yes, if you are interested in market competition to serve consumers • EU Solvency II may disadvantage U.S. insurers by claiming U.S. insurance regulation does not meet their standards • Implication: Less diversification credit for U.S. insurers

32. EU Solvency II, the IAIS, and the NAIC • The IAIS is developing international standards and best practices for insurance regulation • It appears to be largely modeling its approach on that of the EU • The NAIC participates on IAIS committees • The NAIC may be helping to build standards that will come back to haunt it

33. EU Solvency II, the IAIS, and the NAIC • No country but the U.S. has a separate regulatory accounting system for insurance • Other countries use general purpose accounting for insurance regulatory purposes • Thus, the IAIS has taken an active interest in the IASB insurance contracts project as likely to affect reports used by their members

34. EU Solvency II, the IAIS, and the NAIC • The IAIS develops comments on various IASB proposals • The NAIC provides comments to the IAIS to influence the development of those comments • The NAIC is being encouraged to also comment directly to the IASB since the NAIC represents regulators of the world’s largest insurance marketplace

35. EU Solvency II, the IAIS, and the NAIC • When FASB and the IASB agree on an insurance contracts accounting standard, that standard will become the de facto global insurance regulatory standard, even if it confuses solvency regulation • Accordingly, the pressure for U.S. insurance regulators to adopt it will be intense • Therefore, it is important to fix the IASB proposal now if you’re going to be unhappy with it as either a general purpose or regulatory accounting standard

36. Brave new world, or the Emperor’s new clothes? • Standard setters not responsible to anyone save themselves have increasing roles in the global marketplace • The IASB has embraced the untested “mark to model” CEV version of fair value as the right means of accounting for insurance liabilities, even though they’ve made no attempt to verify that it is an effective accounting approach for insurance

37. Brave new world, or the Emperor’s new clothes? • What is the value of “market consistency” when insurance liabilities do not trade? • Why is no attention paid to key management measures of non-life insurance performance such as underwriting profit or combined ratio? • Why is there no plan for testing and validating these proposals before implementing them?

38. Brave new world, or the Emperor’s new clothes? • The result of the Insurance Contracts Phase II project will be coming to financial statements near you, either through adoption of the same standard by FASB or through the SEC’s permitting use of IFRS without reconciliation • When that happens, it is likely insurance regulatory accounting will move the same way

39. Brave new world, or the Emperor’s new clothes? • Insurance solvency regulation need not follow insurance accounting standards, but right now they are running in parallel • The CEV approach to liability valuation has serious issues when applied to solvency • If you care, comment! Consider joining GNAIE, the Group of North American Insurance Enterprises

40. ACE American International Group Allstate Insurance Company AXIS Capital Electric Insurance Genworth The Hartford Manulife Financial Metropolitan Life Insurance New York Life Insurance Principal Financial Prudential Financial XL Capital GNAIE Member Companies