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Loss Reserve Discounting – International Accounting Ralph Blanchard, FCAS CAS representative to the IAA Insurance Accou

Loss Reserve Discounting – International Accounting Ralph Blanchard, FCAS CAS representative to the IAA Insurance Accounting Committee. OVERVIEW. Current int’l standard Future proposed standard Fair value mechanics Prognosis – U.S. Options. CURRENT INTERNATIONAL STANDARD. There isn’t any

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Loss Reserve Discounting – International Accounting Ralph Blanchard, FCAS CAS representative to the IAA Insurance Accou

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  1. Loss Reserve Discounting – International Accounting Ralph Blanchard, FCASCAS representative to the IAA Insurance Accounting Committee

  2. OVERVIEW Current int’l standard Future proposed standard Fair value mechanics Prognosis – U.S. Options 2004 CAS Spring Meeting – Loss Reserve Discounting

  3. CURRENT INTERNATIONAL STANDARD There isn’t any IFRS 4 (phase I of ins. Project) Effective in 2005 Interim step Can’t go to undiscounted Can move to discounted using current rates Can’t move to discounted using asset returns Company acquisition – fair value acquired reserves 2004 CAS Spring Meeting – Loss Reserve Discounting

  4. PROPOSED FUTURE STANDARD Phase II of project Exposure Draft mid 2005? Implement 2007? (2008?) 2004 CAS Spring Meeting – Loss Reserve Discounting

  5. PHASE II OUTLOOK • “In the Board’s view, discounting of insurance liabilities results in financial statements that are more relevant and reliable” (IFRS 4, BC 126) • Tentative phase II conclusions (IFRS 4, BC 6) • “Assets and liabilities arising from insurance contracts should be measured at fair value” • Should gain at inception be allowed under fair value? 2004 CAS Spring Meeting – Loss Reserve Discounting

  6. PHASE II OUTLOOK (CONT.) • “As implied by the definition of fair value: • An undiscounted measure is inconsistent with fair value” • (ii) Discount rate should not reflect expected asset returns • (iii) Adjust for risk • (iv) Adjust for credit standing – i.e, likelihood that insurer will pay its claims. Include effect of co-guarantors (e.g., guarantee funds) 2004 CAS Spring Meeting – Loss Reserve Discounting

  7. FAIR VALUE MECHANICS Time value of money Payment pattern – non-issue Discount rate Risk free rate, not invested asset return “Risk-free assets are those assets with readily observable market prices whose cash flows are least variable for a given maturity and currency.” (Nov. 2001 DSOP, par. 6.2) U.S. Treasury rates Alternative View – High-grade corporate, adj. (default, volatility risk) 2004 CAS Spring Meeting – Loss Reserve Discounting

  8. FAIR VALUE MECHANICS Risk adjustment “fair value should include an adjustment for the premium that marketplace participants would demand for risks and mark-up in addition to the expected cash flows” (IFRS 4, BC 6c (i) ). IASB preference – calibrate to the market Many ways to estimate the risk, BUT can it be reliably calibrated? Is the theory workable in practice? 2004 CAS Spring Meeting – Loss Reserve Discounting

  9. FAIR VALUE MECHANICS Credit standing Fair value … should reflect the credit characteristics [of the insurer], including the effect of [co-guarantors, such as guarantee funds].” (IFRS 4, BC 6c (iv) Theory, not practice Adjust for co-guarantors (e.g., Guarantee fund, insured?), Reflect bankruptcy priority Method? 2004 CAS Spring Meeting – Loss Reserve Discounting

  10. FAIR VALUE MECHANICS Credit standing (cont.) May not be adopted by EU, FASB Regulator influence Precedent for regulatory influence No one doing currently BUT - Canadian standard for pension lump sum commutations? 2004 CAS Spring Meeting – Loss Reserve Discounting

  11. FAIR VALUE MECHANICS Alternative approach No profit at issue: Entry price = fair value Initial loss reserve = zero profit reserve Exit vs. entry price (standard is exit price) 2004 CAS Spring Meeting – Loss Reserve Discounting

  12. U.S. PROGNOSIS IASB-FASB Convergence Agreement FASB probably will expose phase II expos. draft in U.S. FASB has a fair value project – Discounting part of fair value SEC has supported fair value for “acquired” liabilities But what about normal insurance liabilities? – uncertain if practical problems can be suitably met. 2004 CAS Spring Meeting – Loss Reserve Discounting

  13. OPTIONS • No discounting? • Discounting with • Market calibrated risk adjustment • Rules of Thumb for risk adjustment • No risk adjustment? • Discounting sounds likely for IASB (2008?) • U.S. GAAP?? • (unlikely for U.S. stat.) 2004 CAS Spring Meeting – Loss Reserve Discounting

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