CAS Casualty Loss Reserve Seminar

1. CAS Casualty Loss Reserve Seminar Fair Value Accounting E. Daniel Thomas, PricewaterhouseCoopers LLP Christina Gwilliam, Towers Perrin Moderator Don Rainey, Milliman

2. Overview • Brief history of fair value • PwC paper • Towers Perrin paper • IFRS 4 update

3. Brief history of Fair Value • In the beginning, accounting was simple: • Assets valued at historical cost – reliable, but not relevant • Early 1980s -- Savings & Loans Crisis, banks were in trouble: • Sell assets where market value over book value • Keep assets where market value under book value • Result was hidden insolvency • Proposed solution – Fair Value accounting

4. What is Fair Value? • “The price at which an asset or liability could be exchanged in a transaction between knowledgeable unrelated willing parties.” • Fair value hierarchy exists: • Market value, if sufficient market exists; else • Market value of similar items with active markets, adjusted for differences; else • Present value estimate of future cash flows, including an adjustment for risk.

5. Brief history of Fair Value • 1990s – Capital markets became increasingly global • Differing accounting standards are impediment to free flowing capital across borders, with perception of lack of transparency • International Accounting Standards Board (IASB) • The European Union wants consistency within its borders • European Union has decided to move toward the IASB’s approach to accounting (i.e. Fair Value)

6. Why should I care? • You clearly should if you have a European parent • But SEC is in favor of eventual consistency (“convergence”) • SEC controls U.S. GAAP for publicly owned companies • FASB also in favor of convergence • FASB and IASB agreed not to introduce anything that furthers the gap to some joint work on the issue • FASB has unofficially agreed to join with the IASB in a limited joint project on insurance contracts

7. Practical applications • Discussion at IASB has at times been theoretical and academic • Life insurance industry wanted a “real world” test of fair value • IAA and ACLI teamed up to conduct such tests • What about P/C Insurance? • In 2003, CAS sponsored research into practical applications • PwC and Towers Perrin contributed to this research

8. PwC Paper

9. Outline of PwC Research • CAS Project Objectives & Scope Exclusions • Data • Modeling Approaches • Findings • Significant Issues

10. CAS project – objectives • Evaluate impact of the application of fair value principles on U.S. insurance company loss and LAE reserves • Identify significant issues associated with the usefulness of fair values in insurance company financial statements

11. Research specifications • Use publicly available data (e.g. Schedule P) • 3 lines of business: • Personal Auto Liability (shorter tail) • Workers’ Compensation (long tail – stable) • Medical Malpractice, Claims Made (long tail – volatile) • Measure impact of: • Discounting • Market risk load

12. CAS project – scope exclusions • Credit risk • Adequacy of booked reserves • Correlation adjustments across lines of business • Impact of fair value on other balance sheet items

13. Fair Value measurement • Active trading markets for loss reserves do not exist • Fair value measurement was based on models using market concepts: • Undiscounted estimate of future payments; • Discounted for time value of money, plus • Margin for risk and uncertainty (“Market Value Margin” or “MVM”).

14. PwC modeling approaches • Discount Factor Models • Duration • Matched to yield curve • MVM Models • Development method – standard deviation • Stochastic simulation – standard deviation • Stochastic simulation – percentile distribution • Return on Capital

15. PwC modeling calibration approach • Calibrated to Cost of Capital Method at year-end 2002 • Straight average of three companies (1 large, 1 medium, 1 small) • All lines assume a 10% target rate of return on capital

16. Discount factor models

17. Findings – discount modeling • Well-defined approaches are available. • In general, we observed no significant differences between duration and matching approaches. • Results can be affected by interest rate fluctuations and shape of the yield curve.

18. MVM by company – personal auto liability

19. MVM by method for one company– personal auto liability

20. MVM by company size - personal auto liability

21. MVM by company– workers’ compensation

22. Findings – MVM modeling • Indications for MVM varied, sometimes significantly: • by method, for a given company and year-end; • over time, for a given company and MVM method. • The ranking of MVM’s by method tended to vary over time: • No method consistently was the highest nor the lowest. • For smaller companies, the MVM tended to be larger (measured as a percentage of the loss reserves)

23. Findings – Fair Value impact on balance sheet (loss reserves) • Personal auto liability: FV reserves were generally greater than U.S. GAAP reserves • Workers’ compensation: FV reserves were generally less than or close to the U.S. GAAP reserves • Medical malpractice claims-made: We did not consider the results of our testing to be meaningful. • Impact of moving to fair value reserves tended to be greater for smaller companies (i.e., higher MVM charge). Based on the model calibrations

24. Findings – Fair Value impact on income statement (incurred losses) • Under FV, prior accident year development may not be benchmarked to zero (due to relative changes in discount and MVM). • Leveraged impact of reserve changes would likely increase volatility of incurred losses.

25. Significant issues - modeling • Dealing with real data • Measures of variation • The constraint to accept booked reserves as mean of distribution impacts: • Expected payment and reporting patterns • Variability of experience in relation to expectations • Variation from the tail/prior accident year bucket • Variation for certain liabilities not amenable to statistical analysis (e.g. asbestos & environmental)

26. Significant issues - MVM estimation • Variety of approaches exist, but no single approach universally preferred or accepted. • Professional guidance may be needed on acceptable methods or calibration procedures for calculating MVM’s to gain industry practice consistency. • Single industry guideline for MVM calculation unlikely to be appropriate. • Calibration of MVM models can be challenging and will significantly affect the results.

27. Significant issues - financial statement presentation (1) • How should accounting standards treat the 3 elements of fair value reserves: • As flowing through the income statement or as a direct charge to surplus? • Any presentation separating current and prior accident year contributions may require MVM allocation judgments: • MVM’s are statistically non-additive, so any split by accident year may require allocation judgment. • Judgments may also be required for disclosures by business unit or line of business.

28. Significant issues - financial statement presentation (2) • The required disclosure for prior accident year development may become confusing. • One-year development of prior reserves would not necessarily be benchmarked to 0. • Disclosure of the components of one-year development of prior year-end reserves could be quite complicated.

29. Assessment of P/C actuarial methods • Estimating undiscounted reserves: GOOD • Discounting estimated future payments: GOOD • Estimating market value margins: DEVELOPING • Calibration of MVM methods: EMERGING

30. Towers Perrin Paper

31. Background to IFRS 4 • Work of the IASB • 2002: Split Phase I (2005) / Phase II (2008?) • 2004: IFRS 4 • European Union has said IFRS is compulsory for stock exchange listed companies from January 1, 2005 • International Financial Reporting Standards (IFRS) address 3 major questions in the arena of insurance accounting: • What is an insurance contract? • What do you have to disclose? • How do you measure insurance contracts? – Phase II

32. Phase I – IFRS 4 • Product classification • Catastrophe and equalization provisions prohibited • Restrictions on changes to accounting policies • Requirement for liability adequacy testing • Impairment of reinsurance • Disclosure

33. Phase II • Currently undecided if Fair Value will be basis for Phase II (2008)