Discounting & Risk Margins – P/C Liabilities
• Implementation issues
• Discounting alternatives – pros/cons
CAS Presentation to the IASB – February 15, 2005
Slide 1
Discounting & Risk Margins – P/C Liabilities
Implementation issues
Background Statements
1.
“One size does not fit all”
Tremendous variation across products
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Short tail versus long tail
High volume versus low volume
Long history versus no history
Homogeneous vs. Heterogeneous
High frequency/low severity vs. Low frequency/High
severity
Hence, the same model(s) will not work for all lines,
accident years.
CAS Presentation to the IASB – February 15, 2005
Slide 2
Discounting & Risk Margins – P/C Liabilities
Implementation issues
Background Statements
2.
Aggregate analysis, not transactions
3.
Booked liability made up of many pieces
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4.
Two major U.S. insurers – about 175 different review lines each
Two U.K. reinsurers – 50 to 100 different lines each
U.S. single state personal lines insurer – 5 to 10 diff. lines
Recognition lags unavoidable (Not enough time to
understand the quarter before booking the quarter )
5.
Initial transition is not trivial
(analysis, systems, procedures)
CAS Presentation to the IASB – February 15, 2005
Slide 3
Discounting & Risk Margins – P/C Liabilities
Implementation issues – “Day 2”
Too many pieces to update the analysis each quarter.
Must rely on pre-set tables of factors to meet booking deadlines
Review, update of tables would be done periodically
Tendency to not change prior assumption until reasonable likely
that change is warranted
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Assumptions are “sticky” (they tend not to change until change is
material)
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Result is “step” changes, not gradual changes. This is the
situation currently, and various proposals (such as fair value)
will not change it.
CAS Presentation to the IASB – February 15, 2005
Slide 4
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
1. Don’t discount, no explicit margins
(When policy written, up front earnings hit from nominal claim
liability, over time earnings help from investment income.)
PRO
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Easier to accomplish
Requires fewer assumptions than other alternatives
Understood by current analysts, users
Provides for implicit risk margin, generally thought to be a function of
payout tail.
Easy to calculate surrogate for economic value if discount/risk margin
offset
Avoids forcing companies to discount liabilities that some view as
deficient in aggregate.
Minimizes noise from capital markets as to time value of money
Avoids choice of discount rate in markets/countries without robust bond
market
In many markets, due to lower level of litigiousness, liabilities are
predominately short tailed and time value is not an issue
CAS Presentation to the IASB – February 15, 2005
Slide 5
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
1. Don’t discount, no explicit margins
CON
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Creates incentives for non-economic transactions
Arbitrage potential, as markets seek out alternative structures where time
value more readily recognized
Non-comparable across product lines
Non-comparable across industries, if accounting rules differ.
Can be a poor surrogate for economic value, as some long tail lines are
actually low risk – e.g., annuity claims
Overstates uncertainty & cost of some long tail lines – e.g., must provide
nominal estimate of amts. payable in distant future with small present
value but high (and highly uncertain) nominal value
Doesn’t reflect economics, as seen by ability to purchase reinsurance
products to get around the accounting.
Penalizes growth, overstates income during times of shrinking volume.
CAS Presentation to the IASB – February 15, 2005
Slide 6
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
2. Discount, no risk margin
(Maximizes up front earnings)
PRO
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Relative easy to accomplish (for most products)
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Avoids the biggest judgment calls (relative to risk margin)
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Should reduce use of some of the products bought principally for
accounting reasons
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Improves comparability across products
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Improves comparability across industries
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Relatively easy to understand
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Could reduce estimation uncertainty, in situations where uncertainty
comes mostly from the tail with large nominal value but small present
value.
CAS Presentation to the IASB – February 15, 2005
Slide 7
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
2. Discount, no risk margin
CON
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Overstates income at initial writing of business
Implementation would acerbate any existing problem with deficient booked
claim liabilities.
Creates short-term noise that may distort true economics, especially if
short-term fluctuations are not realizable when in company’s favor (nor
capable of being forced on the company when not in their favor –
LIQUIDITY, REALISABILITY CONCEPTS)
Ignores product risk profiles – hence can result in even worse
comparability than not discounting (especially if risk is function of payout
tail).
May be difficult to accomplish in countries without a robust bond market.
(a con for nearly all discounting approaches)
CAS Presentation to the IASB – February 15, 2005
Slide 8
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
3. Discount, benchmark or “rule of thumb” margin
(simplified, standardized approach to obtain most of “economic
value” advantages)
PRO
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Easier to understand than “mark to model” economic value
approaches
Less expensive to implement
Less training required to implement
Economic value surrogate with best comparability across the
insurance industry
Should eliminate most products designed solely for accounting
reasons
Overall ,achieves most of the benefits of “economic value” at
minimum costs
CAS Presentation to the IASB – February 15, 2005
Slide 9
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
3. Discount, benchmark or “rule of thumb” margin
CON
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Uncertain who would pick the benchmark
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More work than earlier alternatives, for imperfect economic value
surrogate
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Uncertain how benchmarks would be maintained/updated,
especially as economy changes or new products are developed.
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Risk that the benchmark does not result in comparability across
product lines, industries
CAS Presentation to the IASB – February 15, 2005
Slide 10
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
4. Discount, theoretical margin
(Time value of money, with risk margin probably “mark to
model”. Could be higher or lower than undiscounted.)
PRO
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Should reflect economic value, for best comparability across
products, companies, industries
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Eliminate products designed to circumvent accounting rules
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Theoretically, can adapt to new products, environments
CAS Presentation to the IASB – February 15, 2005
Slide 11
Discounting & Risk Margins – P/C Liabilities
Discounting Alternatives
4. Discount, theoretical margin
CON
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Calibration not possible where no market exists
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Can be very expensive to maintain,
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Questionable reliability due to calibration problems
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Given calibration problems, comparability may be worsened
across products, companies, industries
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Questionable relevancy if no secondary market exists for the
liabilities, such that any “gains” cannot be realised nor “losses”
forced upon a company.
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Results may be difficult to understand, even for management and
others in the business.
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Final result may not be materially different from undiscounted
approach, despite significant work.
CAS Presentation to the IASB – February 15, 2005
Slide 12
Discounting & Risk Margins – P/C Liabilities
Concluding remarks
CAS Presentation to the IASB – February 15, 2005
Slide 13