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FAIR VALUE

FAIR VALUE. Ralph Blanchard. Overview. Definition of Fair Value Who is proposing it? Insurance application - significant issues Actuarial response CAS white paper Format Previews Findings Next steps - actuarial orgs Next steps - accounting standard setters. What is “Fair Value?”.

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FAIR VALUE

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  1. FAIR VALUE Ralph Blanchard

  2. Overview • Definition of Fair Value • Who is proposing it? • Insurance application - significant issues • Actuarial response • CAS white paper • Format • Previews • Findings • Next steps - actuarial orgs • Next steps - accounting standard setters

  3. What is “Fair Value?” “DICTIONARY” DEFINITIONS “an estimate of the price an entity would have realized if it had sold an asset or paid if it had been relieved of a liability on the reporting date in an arm’s-length exchange motivated by normal business considerations.” (FASB) “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” (IASC) Slide 2 of 16

  4. What is “Fair Value” - Part 2 SHORT WORKING DEFINITION • The market value, if a sufficiently active market exist, OR • An estimated market value, otherwise ESTIMATED MARKET VALUE present value of future expected cash flows, adjusted for: • risk • market imperfections • “similar factors if market-based information is availableto estimate those adjustments” (FASB) Slide 3 of 16

  5. Who is Proposing It? FASB: Preliminary Views - Financial Instruments at Fair Value • Focus is financial instruments • Insurance defined as financial instrument, usually • Comment deadline is May 31st IASC: Insurance Issues Paper • Focus is insurance • Discount all insurance liabilities • Fair value insurance liabilities IF all other financial instruments at fair value • Comment deadline is May 31st Slide 4 of 16

  6. Insurance Application - Significant issues? All Insurance? • Only indemnity contracts at fair value? • What about services? (e.g., HMO) • What about option of cash/service? (e.g., Property) • What about composite contracts? (e.g., WC) Discounting Risk Provision • Reliably measurable? • “Market price” • Independent of holder? • Diversifiable vs. non-diversifiable risk? Slide 5 of 16

  7. Insurance Application - Significant Issues? Part 2 UPR replaced with unexpired contract reserve • No premium deficiency reserve • No Deferred Acquisition asset (DAC) • Include renewals in the fair value? • Return premium as a floor? Credit standing • Liability lower for shaky company? Slide 6 of 16

  8. Actuarial Response CAS special task force on fair value liabilities • Research • White paper (late May/early June) • www.casact.org/research/tffvl/index.htm AAA Fair Value Task Force • Responses to FASB, IASC International Actuarial Association (IAA) • Response to IASC CAS liaison to IAA (Steve Lowe) Slide 7 of 16

  9. CAS White Paper - Format A. Background, including a definition and history of fair value in general B. Fair Value in the insurance context C. Alternatives to Fair Value Accounting for p/c insurance liabilities D. Methods for Estimating Fair Value E. Implementation Issues surrounding the fair valuing of p/c ins. liabilities F. Accounting Presentation Issues, including alternative income statement or balance sheet formats in a “fair value” world. G. Accounting Concepts, or how well fair value accounting and the issues discussed in the earlier sections would be viewed in the context of general accounting concepts (such as reliability, relevance and representational faithfulness). H. Credit Standing and Fair Value Liabilities, a discussion of issues related to the reflection of credit standing in determining the fair value of liabilities. I. Professional Readiness J. Summary and Observations K. Technical Appendices Slide 8 of 16

  10. CAS White Paper - Preview - Fair Value Pros and Cons • Potential advantages - Fair Value • Consistency with assets. • Eliminate accounting arbitrage. • Consistency with other financial instruments. • Relevance. • Potential disadvantages - Fair Value • Difficulty in measuring. • Greater estimation reliance. • Volatility in earnings. • Cost. • Unintended or unexpected consequences. Slide 9 of 16

  11. CAS White Paper - Preview - Methods 1 - CAPM 2 - IRR 3 - Single-period RAD (Risk-Adjusted Discount) 4 - Methods Based on Underwriting Data 5 - Actuarial Distribution-Based Risk Loads 6 - Reinsurance market prices 7 - Direct estimation of market values 8 - Distribution Transform Method 9 - “Rule of thumb” Methods Others? Slide 10 of 16

  12. CAS White Paper - findings 1) New requirement 2) Alternatives for fair value 3) Expected value versus best estimate 4) Multiple methods 5) “Typical” line/”typical” company limitation of most current methods 6) A fair value accounting standard would lead to new research 7) When market prices and “fair value” estimates are in conflict • Market disequilibrium • Market disruption • Information asymmetry • Significant intangibles Slide 11 of 16

  13. CAS White Paper - findings Part 2 8) Implications of risk margin approaches without value additivity 9) Increased reliance on estimates in financial statements 10) Historical comparisons 11) Gross versus net provisions? 12) Legal entity vs. consolidated reporting. 13) Credit standing reflection in valuing liabilities 14) Actuarial workload requirements 15) Professional Readiness 16) Standards vs. Principles Slide 12 of 16

  14. Next Steps - Actuarial orgs. CAS • Draft workproducts to AAA, IAA • Draft workproducts to CAS liaison to IAA • White paper (late May/early June) AAA • Comment letter to FASB • Comment letter to IASC • Contribute to IAA • Monograph (with CAS white paper?) IAA • Comment letter to IASC Slide 13 of 16

  15. Next Steps - Accounting Standard Setters IASC • Review comments this fall • Draft Statement of Principles • Final Statement of Principles • Exposure Draft of Proposed International AccountingStandard • International Accounting Standard (ETA of 2004?) SEC • Determine if statements filed under IASC standards will be accepted in U.S. • Comment deadline - May 15 Slide 14 of 16

  16. Next Steps - Accounting Standard Setters FASB • Review comments • Next steps? • Committed to fair value of financial assets • Would like to have fair value of financial liabilities Slide 15 of 16

  17. Speed of Accounting Pronouncements “The Board’s Experience with Fair Value of Financial Instruments... The accounting profession, the SEC, bank regulators, and some providers of financial statement had urged the Board to deal with the subject comprehensively because the existing authoritative guidance was incomplete and inadequate. …resulted in ad hoc and inconsistent reporting practices. In 1986, the board agreed to undertake a major project on financial instruments.” (from FASB “Financial Accounting Series, No. 206-D/February 29, 2000, page 7) bolded font not in the original text Slide 16 of 16

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