International Accounting – Emerging Issues Fair Value Accounting Update

1. International Accounting – Emerging Issues Fair Value Accounting Update Gareth Kennedy

2. Section I Agenda • Overview of the International Accounting Standards Board (IASB) Discussion Paper (DP) with tentative American Academy of Actuaries (AAA) Working Group (WG) feedback: • Measurement model • Estimate of future cash flows • The time value of money • Risk margins • Unit of account • Reinsurance

3. Overview of the IASB DPMeasurement Model • Single measurement model to be used for future cash flows: • For P&C and Life insurance contracts • For insurance and reinsurance contracts • During claims period and pre-claims period • DP proposes that insurance liabilities be measured at Current Exit Value (CEV) Continued

4. Overview of the IASB DPMeasurement Model • Definition of CEV: • “…the amount an insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to a market participant.” • IASB has not yet identified any significant difference between the notion of CEV and fair value Continued

5. To measure CEV the IASB proposes that three explicit building blocks are required for insurance contracts: Overview of the IASB DPMeasurement Model Risk and service margin Effect of the time value of money Estimated future cash flows

6. Overview of the IASB DPEstimate of Future Cash Flows • IASB’s preliminary view is that cash flows should be: • Explicit • Consistent with observable market prices • Unbiased • Current • Exclude entity specific cash flows

7. Overview of the IASB DPThe Time Value of Money • Requires that best estimates of future cash flows are explicitly reduced for the time value of money • Discount rate should be based on current market rates for cash flows with the same timing as the weighted average contract cash flows Continued

8. Overview of the IASB DPThe Time Value of Money • DP does not specify a discount rate although it is presumed by many that a risk-free rate or close to one will be used • P&C members of the AAA WG believe discounting with the addition of a separate risk margin is compliant with Actuarial Standard of Practice 20 and is a good measure of economic value

9. Overview of the IASB DPRisk Margins • IASB’s preliminary view is: • “the risk margin should be an explicit and unbiased estimate of the margin that market participants require for bearing risk” • It is not intended as a shock absorber for unexpected losses nor to enhance the insurer’s solvency • “the observed price for a transaction with a policyholder …. should not override an unbiased estimate of the margin another party would require to take over the insurer’s contractual rights and obligations” Continued

10. Overview of the IASB DPRisk Margins • The last point may result in profits or losses at a policy’s inception • Some IASB members are in favor of an alternative definition that calibrates the risk margin to the premium at inception, combined with a liability adequacy test • Supporters of CEV believe this is an entry value approach Continued

11. Overview of the IASB DPRisk Margins • IASB does not plan to prescribe what methods are appropriate to develop a risk margin • Instead the IASB will publish attributes that the methods should have and leave industry practitioners to develop further guidance

12. Overview of the IASB DPUnit of Account • Definition: “portfolio of contracts that are subject to broadly similar risks and managed together as a single portfolio” • When developing risk margins, the DP proposes that it should be calculated at a unit of account level • No benefit of diversification beyond unit of account

13. Overview of the IASB DPReinsurance • There is a lack of mirror accounting and recognition between a ceded reinsurance asset and an assumed liability in the DP for a reinsurance contract written on a policies attaching basis • DP argues remaining asset has little contractual value if underlying policies are issued at CEV • Reinsurance liability would be valued using all future cash flows

14. Section II Agenda • Comparison of DP to Financial Accounting Standards Board (FASB) Statements 157 and 159: • FASB Statement 159 • FASB Statement 157 • Comparison to IASB DP

15. FASB Statements 157 and 159FAS 159 – Fair Value Option • Provides a voluntary election to account for certain assets and liabilities at their fair value – including P&C insurance liabilities • Provides a one-time chance to elect fair value option for any existing liabilities without affecting income • Option is irrevocable and all future changes in fair value must be recognized in income

16. FASB Statements 157 and 159FAS 157 – Fair Value Measurement • Defines fair value for financial reporting purposes under U.S. GAAP as the “… price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” • Market based not entity specific entity specific measurement • Statement is not insurance specific

17. FASB Statements 157 and 159Comparison of FAS 157 to IASB DP • FAS 157 more general than IASB DP • Principles from DP currently fit well into the more general FAS 157 principles • Impact of FAS 157 currently optional for P&C insurance liabilities – IASB standard that will arise from DP will be compulsory

18. International Accounting – Emerging IssuesFair Value Accounting Update Gareth Kennedy 312-879-4459 gareth.kennedy@ey.com