Casualty Loss Reserve Seminar
September 14, 2004
Fair Value Accounting
Christina Link Gwilliam
©Towers Perrin
Research Approach
 Database
 GAAP adjustments
 Discounting
 Market Risk Margins
 Impact on reported financial results
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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
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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



6 Workers Compensation insurer
6 Medical Professional Liability insurer
1 Personal Auto Liability insurer
 Non-Tabulars represented 1-32% of reported claims
 Tabular discounts could not be effectively removed due to data
limitations
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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
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Derived payment patterns
for discounting vary by company
Variation in Payment Patterns Across Companies — At Year-End
2002
Average Time To Payment (In Years)
6
5
4
3
2
1
Personal Auto Liability
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Workers Compensation
Medical Prof. Liability
5
Derived payment patterns also vary over time
Dispersion and Trends in Average Time to Payment
Medical Professional Liability
8
Average Time to Payment (In Years)
20 companies
Composite
7
6
5
4
3
2
1
1990
1991
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1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
6
The impact of discounting
varies with the level of interest rates
Impact of Varying Interest Rates,
(Calculated By Discounting 2002 Year-End Liabilities at Historical Rates)
20%
1.00
3-Year Rate
PAL
Average Discount Factors
16%
0.90
14%
12%
0.85
10%
MPL
0.80
WC
8%
6%
0.75
4%
0.70
2%
Annual Yield on
3-Year Zero Coupon Treasury Strip
18%
0.95
0%
0.65
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
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We inferred the Market Risk Margin from
historical margins observed in the insurance market
Margin reflecting
entity-specific amount of
risk in claim liabilities
Observe Normative
Insurance Pricing Margins
Observe Amount of
Insurance Market Risk
Derive Risk Margin for
Claim Liabilities
Measure Amount of Risk
Claim Liabilities
in
Empirically observed
market price per unit
of insurance risk
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Ex-post market economic pricing margins vary
over time, reflecting the cycle and interest rates
Empirical Pricing Margins from 1976 to 2002
Personal Auto Liability and Physical Damage
Empirical Pricing Market Risk Margin
20%
18%
16%
14%
Average Margin Over
27-Year Period = 5.5%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
Years in Which Premiums Were Earned and Coverage Was Provided
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The pricing cycle is different in Workers
Compensation, and the cycle amplitude is larger
Empirical Pricing Margins from 1976 to 2002
Workers Compensation
40%
Empirical Pricing Market Risk Margin
35%
30%
Average Margin Over
27-Year Period = 10.7%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
-30%
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
Years in Which Premiums Were Earned and Coverage Was Provided
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The amplitude is greatest for Medical Professional
Liability, and the long-term average margin is low
Empirical Pricing Margins from 1976 to 2002
Medical Professional Liability
60%
Empirical Pricing Market Risk Margin
50%
40%
Average Margin Over
27-Year Period = 8.0%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
Years in Which Premiums Were Earned and Coverage Was Provided
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We measured pricing volatility
across companies as well as over time
Empirical Pricing Volatility for Medical Professional Liability
5.0
4.5
4.0
3.5
Ratio of actual
cost of claims to
expected cost in
pricing
3.0
2.5
2.0
1.5
17
14
11
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Company
2002
2001
2000
1998
1996
1997
4
1999
Statement Date
8
1995
0.5
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1.0
1
12
We selected pricing risk margins
via a simple risk-return framework
Empirical Insurance Pricing Risk Margins — Risk Versus Return
Selected Pricing MRMs
Empirical Pricing MRMs
Empirical Pricing MRMs
20%
Med Malpractice
Selected
Margin is 15%
18%
Market Risk Margins
16%
14%
Workers Comp
Selected
Margin is 10%
12%
10%
Personal Auto
Selected
Margin is 5%
8%
6%
Workers Comp
Empirical Average
Margin is 10.7%
Med Malpractice
Empircal Average
Margin is 8.0%
4%
Personal Auto
Empirical Average
Margin is 5.5%
2%
0%
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
Volatility (CV) of Pricing Margins
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The margins produced by the two
methods are different, and also vary over time
Derived Risk Margins for Claim Liabilities
Personal Auto Liability — 20 Company Composite
6%
Reserve Market Risk Margin
(Percent of NPV Liabilities)
5%
Mack Method
HFB Method
Selected
Pricing MRM
4%
3%
2%
1%
0%
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Liabilities as of Year-End Statement Date
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Market risk margins vary by company
Derived Risk Margins for Claim Liabilities
Using HFB Method — Personal Auto Liability
14%
20 Companies
Industry Composite
Percent of NPV Liabilities
12%
10%
Selected
Empirical
Pricing MRM
8%
6%
4%
2%
0%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Liabilities as of Year-End Statement Date
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Reserve Risk Margins also by size of company
Average Reserve Risk Margins -- By Size of Company
Composite of Measured Reserve Risk Across Companies and Year
Mack Method
Ratio to largest
HFB Method
Ratio to largest
Product
Size Tier
Personal Auto Liab.
Smallest
Middle
Largest
0.028
0.023
0.018
1.54
1.30
1.00
0.04
0.03
0.02
1.55
1.15
1.00
Workers Comp.
Smallest
Middle
Largest
0.022
0.023
0.021
1.03
1.08
1.00
0.03
0.02
0.02
1.18
0.97
1.00
Medical Mal.
Smallest
Middle
Largest
0.076
0.058
0.044
1.74
1.34
1.00
0.11
0.08
0.07
1.68
1.15
1.00
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Fair values by component element
Components of Fair Value at Year-End 2002
(Composite of Companies)
1.00
0.95
Pers. Auto. Liab.
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Workers Comp.
HFB MRM
Mack MRM
Discount
Nominal
HFB MRM
Mack MRM
Discount
Nominal
HFB MRM
Mack MRM
Discount
0.90
Nominal
Ratio to Nominal Liabilities
1.05
Medical Prof. Liab.
17
In addition to balance sheet effects,
we also analyzed the impact on income statements
Operating Ratios — 20 Company Composite
Workers Compensation
120%
US GAAP
Fair Value
110%
100%
90%
80%
70%
60%
50%
40%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Calendar Year
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By one measure, fair value
doesn’t improve the transparency of income
Correlations Between Reported Operating Ratios and Economic Margins
Using Matched Investment Strategy
Pers. Auto Liability
Correlation
Gain
Workers' Comp.
Correlation
Gain
Correlation
Gain
Economic vs US GAAP
55%
Economic vs Fair Value (Mack)
59%
4%
45%
3%
32%
18%
Economic vs Fair Value (HFB)
59%
4%
47%
5%
31%
17%
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42%
Medical Prof. Liability
14%
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