Casualty Actuarial Society Meeting Fair Value Accounting and the Actuary

1. International Accounting StandardsforInsurance ContractsFair Value Implications forProperty/Casualty Insurancein the United States Casualty Actuarial Society Meeting Fair Value Accounting and the Actuary New Orleans - November 11, 2003 Robert Miccolis, FCAS, MAAA CAS Representative to IAA Insurance Accounting Committee’s Subcommittee on International Actuarial Standards

2. Questions about Accounting Developments • What is the IASB? (International Accounting Standards Board) • What is an IFRS? (International Financial Reporting Standard) • What is an IAS? (International Accounting Standard) • Why is this important? • What is the role of the FASB? • Will US GAAP change? • What will happen to regulatory STAT? • What impact will this have on US actuarial work? • When does this all happen?

3. Who is the IASB? • The body that sets global accounting standards for all companies permitted or required to follow its standards • The European Community, as agreed by the EU Parliament, will require all “listed” companies in the EC to adhere to accounting standards set by the IASB starting in 2005. • A few countries currently are using IAS as their local accounting standard (with exceptions)

4. Accounting for Insurance Contracts • The IASB has been working on many aspects of reconciling accounting differences and advancing a consistent global approach across industries • The IASB Insurance Project regarding accounting for insurance contracts was started over 2 years ago • The focus is specifically on insurance contracts and not on insurance companies

5. Why is a global insurance accounting standard required? • Common global insurance accounting practices are needed to eliminate differences that can be material • GAAP financial reporting can not rely on regulatory accounting, particularly for organizations with multi-national operations • Insurance contracts will no longer be excluded from international accounting standards

6. History and Looking Forward • 1997 Steering committee set up by the IASC • 1999 Issues paper • 2001 DSOP developed as precursor to Exposure Draft • May 2002 Project splits into 2 Phases • Phase 1 Exposure Draft 7/31/2003, comments 10/31/2003 • Final Phase 1 standard issued in 2004 for 2005 financials • Fair Value “disclosures” in year end 2006 financials • Phase 2 implementation (fair value) by 2007 (sunset)

7. IASB Insurance Proposal: The Two Phase Approach • Phase 1 - interim solution - quick fixes to be in place by 2005 • common definition of insurance • limited and temporary dispensation from existing IFRS • application of IAS 39, Financial Instruments, for contracts issued by insurers that fail the definition of insurance • requires significant disclosures about projected cash flows, types of insurance contracts, risk management, etc. • Phase 2 – a standard for recognition and measurement issues for insurance contracts, including fair value

8. IASB Definition of Insurance Contract The Phase I proposes a definition of an insurance contract as: “a contract under which one party (the insurer) accepts significant insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary” (other than an event that is only a change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar other variable). A reinsurance contract is defined as: “an insurance contract issued by one insurer (the reinsurer) to indemnify another insurer (the cedant) against losses on an insurance contract issued by the cedant”

9. Guidance on the Definition of Insurance • The meaning of “significant” insurance risk • If, and only if, it is plausible that an insured event will cause a significant change in present value of insurer’s net cash flows • Even if the insured event is extremely unlikely • Even if the contingent cash flows (for insured events) is a small proportion of the expected (probability-wtd) PV of all cash flows • However, there needs to be a plausible scenario that produces a non-trivial change in the PV of contract cash flows • For most property/casualty insurance contracts, there should not be an issue regarding this definition. • Lack of risk transfer would be problem (not just reinsurance)

10. What is included in Phase 1? • Financial contracts written as “insurance” (or reinsurance) • IAS 39 applies to insurance products failing the definition of insurance but exposed to financial risk (not insurance or financial, then service contract) • Changes to the valuation of “insurance” contracts are excluded from Phase 1 • Ceded reinsurance – must be reported as an asset • Insurance Liabilities – Direct plus Assumed • Assets – include All Ceded Reinsurance Recoverables • Reinsurance Assets – discounting proposed

11. Phase 2 decisions • Phase 2 to be developed upon these principles: • Definition of insurance – no change from phase 1 • Asset & Liability approach rather than Deferral and Matching • Fair Value measurement • Independent valuation of Assets vs. Liabilities • Profit “at inception” - no greater than zero

12. Impact on US P/C Companies • Pressure from financial regulators (SEC) and financial markets for a common global financial accounting reporting standards • Commitment of FASB and other accounting bodies for “convergence” of accounting standards • Europe & Australia will be first, then others (US) will follow due to global business and financial markets • Time to comment on fair value issues is right now

13. Changes to P/C Actuarial Practice • Fair Value will be difficult to avoid • Impact on US P/C actuarial practice will depend on • FASB view of timing to converge with IASB • FASB plans relative to IASB exposure drafts and standards • Views of Insurance Regulators on avoiding 2+ sets of books • US based insurers with European (or Australian)parents • US based insurers with significant European operations • US listed insurers who are also listed on EU/AU exchanges • Principles and standards have to be developed now • Fair Value Issues papers by CAS, AAA and GIRO (2002) • CAS research on fair value measurement (Sept. ‘03 – Mar. ‘04)

14. Fair Value • The main concern about IAS is that they require assets and liabilities to be valued at market value • Market value must be based on an active market with a high volume of transactions • In the absence of a market value, fair value is to be used, based on a valuation using appropriate methods • Such appropriate fair value methods or models should be based on observable market transactions

15. Highlights of Fair Value (Phase II) • Discounting of P/C Liabilities • Reserves for unpaid loss and loss adjustment expenses • Reserves for unexpired risks (UPR) • Market Value Margins – added to discounted liabilities • Reflects risk and uncertainty in reserves • Reflects “market” price (margin) for reserve risk • Reflects “mark-up” for transaction cost of selling reserves • Credit risk adjustment (controversial) • Credit Risk Adjustment • Liability adjustment for credit characteristics of the contract • Reflecting any government guarantees or legal preferences

16. Fair Value Concepts • Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction. • Fair value is measured, at the balance sheet date, as: • the most probable price reasonably obtainable in the market, • the best price reasonably obtainable by the seller, and • the most advantageous price reasonably obtainable by the buyer • “Knowledgeable, willing parties” • both a willing buyer and a willing seller • both reasonably informed about the characteristics of the asset, and the state of the market as of the balance sheet date.

17. Fair Value Concepts • There is a presumption that an enterprise is a going concern without any intention or need to liquidate, curtail materially the scale of its operations or undertake a transaction on adverse terms. • Fair value is not, therefore, the amount that an enterprise would receive or pay in a forced transaction, involuntary liquidation or distress sale.

18. Fair Value - No active and liquid market • When there is not frequent activity in a market, the market is not well established or small volumes are traded, quoted market prices may not be indicative of the fair value of the instrument. • Estimation techniques may be used to determine fair value if there is sufficient reliability. • Techniques that are well established include reference to the current market value of another instrument that is substantially the same, such as discounted cash flow analysis and option pricing models

19. Fair Value Models • Fair Value “Model” needed to estimate value • No active and liquid market • Small volume market prices not indicative of fair value • Fair Value Model should have certain characteristics: • Mimics market price behavior of an active market • Can be validated by observable market values • Model assumptions are current and based on observable data

20. References to Credit (IAS 39) • The discount rate equals the prevailing market rate of interest for financial instruments having substantially the same terms and characteristics, including the creditworthiness of the debtor, the remaining term. • Valuation techniques should incorporate the assumptions that market participants would use in their estimates of fair values, including assumptions about prepayment rates, rates of estimated creditlosses, and interest or discount rates.

21. Reliability of Fair Value Estimates (IAS 39) • Often, an enterprise will be able to make an estimate of the fair value of a financial instrument that is sufficiently reliable to use in financial statements. • The fair value of a financial instrument is reliably measurable if: • the variability in the range of reasonable fair value estimates is not significant for that instrument, or • if the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value.

22. Reliability of Fair Value Estimates (IAS 39) • The fair value of a financial asset or financial liability may be determined by one of several generally accepted methods. • Occasionally, the variability in the range of reasonable fair value estimates is so great and the probabilities of the various outcomes are so difficult to assess that the usefulness of a single estimate of fair value is negated.

23. Can Fair Value for insurance be reliably determined? • IASB has not decided – practical issues to be resolved • IASB recognizes that fair values can not be observed directly from market transactions • IASB sees fair values for insurance using estimates based on models • IASB realizes very little data exists for some risks • IASB sees insurance fair value estimates as not less than what the entity would charge for new contracts

24. Is Fair Value relevant for non-traded long term liabilities? • IASB – fair value measurement is not intended as a representation that an insurer could, or should, transfer insurance liabilities to another party. • IASB – fair value of an insurance liability can be regarded as a market-based representation of the value of the future contractual cash flows.

25. Credit Risk Adjustment – One View • Credit risk adjustments do seem to be a separable component of the “fair” market value of financial instruments (such as a bond) in active markets. • Where the cash flows are certain, one could compute a credit risk adjustment as the difference between market value and the present value at a risk free rate. • Alternatively, the credit risk adjustment could be the addition to the discount rate that produces a present value of cash flows equal to the market value.

26. Credit Risk Adjustment – One View • With uncertain cash flows, there is no clear division in market value between the “market value margin” that compensates for the uncertainty of the cash flows and the credit risk adjustment. • However, if the credit risk adjustment is measured solely in terms of the discount rate, then the market value margin would be the difference between • the market value (no credit risk) for uncertain cash flows, and • the market value (no credit risk) for fixed cash flows equal to the expected value of the uncertain cash flows.

27. Fair Value and the Capital Markets View • Economists in the capital markets field routinely estimate fair market values for many kinds of securitization instruments, some with active markets and other without. • In the capital markets, the concept of credit risk adjustment for liabilities is relates to how much HIGHER the fair value of the liabilities should be above the present value of the cash flows at a risk free rate. • This means that the fair value of liabilities INCREASES as the credit characteristics worsen.

28. Fair Value and the Credit Enhancement View • The fair value of the liability for the entity obligated to make payments can be viewed as made up of: • The present value of the cash flows discounted at the risk free rate, plus • The market price of a guarantee to make those payments. • To sell the liability would require a credit enhancement premium if the credit rating had dropped from when the liability was issued. • Thus, the credit risk adjustment within the fair value of liabilities is equivalent to a theoretical credit enhancement premium.

29. Fair Value and the Credit Enhancement View • Applying this view to insurance, the fair value of an entity’s insurance liabilities should INCREASE because of a drop in the entity’s credit standing. • When the credit standing drops too low, the fair value of the insurance liabilities increases to the point of reducing the surplus to threaten the solvency of the entity, or indicating insolvency.

30. Fair Value and the Market Calibration View • The fair value of insurance liabilities should reflect market value, including both market value margin and the credit risk adjustment. • The insurance contract obligations at inception can be viewed as pricing a policy at the market value. • IBNR can be viewed as pricing tail coverage at the market value.

31. Fair Value and the Market Pricing View • Market Value Pricing could be viewed as considering the market price of a representative portfolio of policies. • This market value price would reflect the uncertainty of the insurers cash flows from these policies. • If differences in observable market prices are consistently related to the credit standing of the insurer, then the liabilities of the lower credit rated insurers would have a HIGHER fair value if the insurers with better credit can get higher market prices.

32. Precedents for reflecting credit in the measurement of liabilities? • Existing loan models (IAS 39) require the borrower to recognize the liability initially at the amount of the proceeds received (less transaction costs incurred) • This measures the liability at the contractual amounts payable (interest and principal), discounted at the prevailing interest rates at inception for a loan with those credit characteristics. • Initial measurement of the liability reflects its credit characteristics.

33. Why should an insurer report a profit if credit quality of its liabilities deteriorates? • IASB – excluding credit characteristics of a liability from its measurement would require an arbitrary exception to the general principle of measurement at fair value • When the IASB considers performance reporting issues for insurance contracts (phase II), it will consider whether the effects of liability changes due to changes in credit characteristics should be disclosed separately.

34. More information is available on www.IASplus.com www.IASB.org.uk IASB 2003 Bound Volume