International Accounting Standards for Insurance Contracts Implications for Property/Casualty Insurance in the United S

1. International Accounting StandardsforInsurance ContractsImplications forProperty/Casualty Insurancein the United States Casualty Loss Reserve Seminar Session 7 – International Reserving Issues September 8-9, 2003 Robert Miccolis, FCAS, MAAA CAS Representative to IAA Insurance Accounting Committee’s Subcommittee on International Actuarial Standards

2. Questions • 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. IASB • The body that sets 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. IAS & IFRS • Currently, standards promulgated by the IASB are designated as an IAS, for example IAS 39. • IRFS will become the new designation, as a better description of what these standards are to be used for, i.e., financial reporting. Current IAS designations have not been changed. • IAS 39 has had the most attention for insurance. It’s application has excluded “insurance” contracts, but the IASB has proposed a more precise definition of an insurance contract vs. a “financial instrument” (or investment contract) which would be valued differently than currently allowed for insurance contracts.

5. IAS 39 • The main concern about IAS 39 is that it requires contracts (assets and liabilities) to be valued at market • In the absence of a market value, fair value is to be used, based on a valuation using appropriate methods • Many life & annuity insurance contracts contain both pure insurance and investment (“financial”) components • Some P/C contracts, e.g. financial/finite reinsurance, can also have both components

6. Accounting for Insurance Contracts • The IASB has been working on many aspects of reconciling accounting differences and advancing a consistent approach across industries • The IASB Insurance Project was started over 2 years ago with the issuance of a DSOP – Draft Statement of Principles regarding accounting for insurance contracts • Notice that the focus is specifically on insurance contracts and not on insurance companies

7. Why is an insurance standard required? • Insurance contracts are now excluded from most IFRS • Globally no common insurance accounting practice and the differences are material • There are many features unique to insurance, for example, the discretion that management have in designing some contracts

8. 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 issued July 31, 2003 • Final Phase 1 standard issued in 2004 for 2005 financials • Fair Value “disclosures” in year end 2006 financials • Phase 2 implementation by 2007 (sunset)

9. Revised IASB Insurance Proposals: 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 • guidance on IAS 39 • significant disclosures required • Phase 2 – a standard covering recognition and measurement issues for insurance contracts, including fair value

10. Phase 1 – Insurance Contracts Phase 1 is expected to result in a new standard which will: • Introduce a common definition of insurance across all standards; • Include guidance on the implementation of IAS 32 and 39 for insurance; • Specify disclosures required for insurance (very significant); • Avoid the need for implementing major changes to accounting systems for insurance contracts prior to completion of phase 2. This involves a temporary dispensation from certain existing IFRS. The timetable for Phase 1: • 31 July 2003 exposure draft - comments due 31 Oct 2003 and, • a standard published in the first half of 2004.

11. Phase 1 Dispensation from IAS/IFRS • IAS 8 – Covers what to do when there is no Accounting Standard • Dispensation from IAS 8 for Insurance Contracts to allow the use of local GAAP, and including: • Deferred acquisition costs • Unearned premium reserves (pro rata basis) • Embedded value measurement • Allow companies to adopt accounting changes, but only if the change is more relevant and reliable (closer to fair value)

12. Phase 1 Dispensation from IAS/IFRS • No further dispensation for insurers • e.g. from the requirements of IFRS 39 for contracts that do not meet the definition of insurance • Why allow dispensation? • Avoids major changes to accounting systems prior to final standard on insurance (in phase 2) • Allows investors familiar with embedded values (DAC, UPR, etc.) to continue to rely on them

13. IASB New 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”

14. Common Definition of Insurance • The definition is required for identifying: • Which insurance products fall within existing standards (IAS), for example, IAS 39 - those products that are more akin to savings than protection (investment risk as opposed to insurance risk) • The scope of temporary dispensation in Phase 1

15. 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)

16. What is included in Phase 1? • Financial contracts written as “insurance” (or reinsurance) • IAS 39 applies to insurance products failing 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 • Prepare for Phase 2 – Fair Value measurement

17. Phase 2 – Insurance Contracts • Phase 2 will then lead to a comprehensive standard on the recognition and measurement for insurance contracts. • This standard would replace temporary dispensations and the Phase 1 interim accounting standards. • This final Phase 2 standard is expected to be published in time for full implementation by 2007. (Exposure Draft planned for 2004.)

18. 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 • Deferral and Matching is replaced • UPR no longer a liability (replace with unexpired risk reserve) • DAC no longer an asset • Fair Value measurement • Independent valuation of Assets vs. Liabilities • Profit “at inception” likely to be no greater than zero

19. 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 technical issues is right now

20. 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 parents • US based insurers with significant European operations • US listed insurers who are also listed on EU exchanges • Principles and standards have to be developed now • Fair Value Issues papers by CAS, AAA and GIRO (2002) • CAS proposes research on fair value measurement (Sept. 2003)

21. 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 • Own credit risk adjustment (controversial) • Own Credit Risk • Reduction in liabilities based on credit standing • Offset by any government guarantees or legal preferences

22. More information is available on www.IASplus.com www.IASB.org.uk