Fair Value Accounting

Fair Value Accounting E. Daniel Thomas, PricewaterhouseCoopers, LLP Emmanuel Bardis, Towers Perrin Moderator Chris Nyce, KPMG LLP September 2005 CAS Casualty Loss Reserve Seminar September 2005

Overview of the Session • Background on Fair Value • PwC Approach • Towers Perrin Approach • Update on IFRS 4 Current Events September 2005

Fair Value Background September 2005

Definition of Fair Value • Assumptions based on a hypothetical transaction between marketplace participants • Buyer-specific synergies excluded • Where prices in active markets for identical or similar assets are not available, valuation techniques are used • In-use or in-exchange valuation premise, based on highest and best use for asset “The price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties.” September 2005

Why “Fair Value” • Rooted in S&L crisis • Incentive to sell undervalued assets and keep overvalued assets • Led to insolvency • Solution-Value assets at market • No incentive to buy or sell for accounting reasons • Leads to question related to P&C Loss Reserves • Does fair value give this intended advantage if no active market exists September 2005

Background – Fair Value • Practical interpretation of definition of Fair Value • Market Value, if a sufficiently active market exists • Estimated Market Value, otherwise • Possible approaches to estimating market value • Similar transactions • Risk adjusted present value of cash flows • Accounting guidance gives a hierarchy of alternatives • Priority is given to market prices for identical or similar assets, where available • Emphasizes the use of market inputs • Multiple valuation approaches should be considered September 2005

Fair Value Fair Value - including Market Participant Strategies “Strategic”or “Investment” Value “Going Concern” Basis - “Stand Alone” Value Liquidation Value Strategic Buyer Bargain Hunter Financial Buyer Marketplace Participant Value Lower Higher September 2005

When Fair Value for Property Casualty Loss and Loss Expense Reserves may be Required • Under GAAP, when a business combination has occurred (FAS 142) • Under International Financial Reporting Standards (IFRS), phase II implementation for insurance contracts • As part of a holding company evaluation of possible impairment of an insurance reporting unit • Under GAAP, (FIN 45) for all companies (including non-insurers) for certain contingent contractual obligations entered into after 12/31/2002 September 2005

Approaches to Fair Valuing Loss and Loss Expense Reserves • If possible, use a comparable market transaction • But this is expected to be rarely possible, if ever • Some reserve transfers have taken place, but rarely motivated by “normal business considerations” when “neither is acting under compulsion”, i.e. often an element of distress in one of the parties • Usually these contracts transfer only a minimal amount of risk, so the problem of fair value of the residual risk remains • Few bidders are usually available • Insurance liability portfolios are not homogeneous, comparable transactions are unusual • Information on the liabilities is usually asymmetric, seller has more knowledge • Especially lately, extensive legal scrutiny of these transactions are changing the nature and availability of bidders • Often, a seller cannot divest the legal obligation for the liabilities, and remains at least contingently liable September 2005

What is the Impact of Fair Value Applied to Loss Reserves to P&C Companies • It’s unclear • Differing approaches and assumptions can get to different answers • No current guidelines as to how to do this • Diversity of situations in different countries • How to change or amortize is unclear • 2003: CAS sponsors research into how this might work • PwC, Towers answer the call September 2005

PwC Paper September 2005

Outline of PwC Research • CAS Project Objectives & Scope Exclusions • Data • Modeling Approaches • Findings • Significant Issues September 2005

CAS project objectives • Evaluate impact of the application of fair value principles on U.S. insurance company loss and LAE reserves • Identify significant issues associated with the usefulness of fair values in insurance company financial statements September 2005

CAS research specifications • Use publicly available data (e.g. Schedule P) • 3 lines of business: • Personal Auto Liability (shorter tail) • Workers’ Compensation (long tail – stable) • Medical Malpractice, Claims Made (long tail – volatile) • Measure impact of: • Discounting • Market risk load September 2005

CAS scope exclusions • Credit risk • Adequacy of booked reserves • Correlation adjustments across lines of business • Impact of fair value on other balance sheet items September 2005

Fair Value measurement • Active trading markets for loss reserves do not exist • Fair value measurement was based on models using market concepts • Undiscounted estimate of future payments; • Discounted for time value of money, plus • Margin for risk and uncertainty (“Market Value Margin” or “MVM”) September 2005

PwC modeling approaches • Discount Factor Models • Duration • Matched to yield curve • MVM Models • Development method – standard deviation • Stochastic simulation – standard deviation • Stochastic simulation – percentile distribution • Return on Capital September 2005

PwC modeling calibration approach • Calibrated to Cost of Capital Method at year-end 2002 • Straight average of three companies (1 large, 1 medium, 1 small) • All lines assume a 10% target rate of return on capital September 2005

Discount factor models September 2005

Findings – discount factor modeling • Well-defined approaches are available. • In general, we observed no significant differences between duration and matching approaches. • Results can be affected by interest rate fluctuations and shape of the yield curve. September 2005

MVM by company – personal auto liability September 2005

MVM by method for one company– personal auto liability September 2005

MVM by company size - personal auto liability September 2005

MVM by company– workers’ compensation September 2005

Findings – MVM modeling • Indications for MVM varied, sometimes significantly: • by method, for a given company and year-end; • over time, for a given company and MVM method. • The ranking of MVM’s by method tended to vary over time: • No method consistently was the highest or the lowest. • For smaller companies, the MVM tended to be larger (measured as a percentage of the loss reserves) September 2005

Findings – Fair Value impact on balance sheet (loss reserves) • Personal auto liability: FV reserves were generally greater than U.S. GAAP reserves • Workers’ compensation: FV reserves were generally less than or close to the U.S. GAAP reserves • Medical malpractice claims-made: We did not consider the results of our testing to be meaningful. • Impact of moving to fair value reserves tended to be greater for smaller companies (i.e., higher MVM charge). Based on the model calibrations September 2005

Findings – Fair Value impact on income statement (incurred losses) • Under FV, prior accident year development may not be benchmarked to zero (due to relative changes in discount and MVM). • Leveraged impact of reserve changes would likely increase volatility of incurred losses. September 2005

Significant issues - modeling • Dealing with real data • Measures of variation • The constraint to accept booked reserves as mean of distribution impacts: • Expected payment and reporting patterns • Variability of experience in relation to expectations • Variation from the tail/prior accident year bucket • Variation for certain liabilities not amenable to statistical analysis (e.g. asbestos & environmental) September 2005

Significant issues - MVM estimation • Variety of approaches exist, but no single approach universally preferred or accepted. • Professional guidance may be needed on acceptable methods or calibration procedures for calculating MVM’s to gain industry practice consistency. • Single industry guideline for MVM calculation unlikely to be appropriate. • Calibration of MVM models can be challenging and will significantly affect the results. September 2005

Significant issues - financial statement presentation (1) • How should accounting standards treat the 3 elements of fair value reserves: • As flowing through the income statement or as a direct charge to surplus? • Any presentation separating current and prior accident year contributions may require MVM allocation judgments: • MVM’s are statistically non-additive, so any split by accident year may require allocation judgment. • Judgments may also be required for disclosures by business unit or line of business. September 2005

Significant issues - financial statement presentation (2) • The required disclosure for prior accident year development may become confusing • One-year development of prior reserves would not necessarily be benchmarked to zero • Disclosure of the components of one-year development of prior year-end reserves could be quite complicated September 2005

Assessment of P/C actuarial methods • Estimating undiscounted reserves: GOOD • Discounting estimated future payments: GOOD • Estimating market value margins: DEVELOPING • Calibration of MVM methods: EMERGING September 2005

Towers Perrin Paper September 2005

Research Approach • Database • GAAP adjustments • Discounting • Market Risk Margins • Impact on reported financial results • Conclusions • Reliability • Relevance September 2005

Database • Schedule P and the Insurance Expense Exhibit (IEE) • 20 company groups selected representing market shares of • 60% for Personal Auto Liability • 50% for Medical Professional Liability • 25% for Workers Compensation September 2005

Convert Statutory Annual Statement information into Current GAAP • Deferred policy acquisition cost (DPAC) asset estimated • Policy acquisition ratio averaged • 10% for Medical Professional Liability • 15% for Workers Compensation • 17% for Personal Auto Liability • Remove Non-Tabular discounts • Non-Tabular discounts present in • 4 Workers Compensation insurer • 3 Medical Professional Liability insurer • 1 Personal Auto Liability insurer • Tabular discounts could not be effectively removed due to data limitations September 2005

Discounting • Interest rates • Risk-free rate • US government securities • Payout patterns • Company specific supplemented by industry • Wide variations in average-time-of-payment across companies • Slight shifts over time, more pronounced for Medical Professional Liability September 2005

Derived payment patterns for discounting vary by company September 2005

Derived payment patterns also vary over time September 2005

The impact of discounting varies with the level of interest rates September 2005

Margin reflecting entity-specific amount of risk in claim liabilities Observe Normative Insurance Pricing Margins Derive Risk Margin for Claim Liabilities Observe Amount of Insurance Market Risk Measure Amount of Risk in Claim Liabilities Empirically observed market price per unit of insurance risk We inferred the Market Risk Margin from historical margins observed in the insurance market September 2005

Ex-post market economic pricing margins vary over time, reflecting the cycle and interest rates September 2005

The pricing cycle is different in Workers Compensation, and the cycle amplitude is larger September 2005

The amplitude is greatest for Medical Professional Liability, and the long-term average margin is low September 2005

We measured pricing volatility across companies as well as over time September 2005

We selected pricing risk margins via a simple risk-return framework September 2005

The margins produced by the two methods are different, and also vary over time September 2005

Market risk margins vary by company September 2005

Reserve Risk Margins also by size of company September 2005

Fair values by component element September 2005

Fair Value Accounting