CAS Casualty Loss Reserve Seminar
Fair Value Accounting
E. Daniel Thomas, PricewaterhouseCoopers LLP
Christina Gwilliam, Towers Perrin
Moderator
Don Rainey, Milliman
1
Overview
• Brief history of fair value
• PwC paper
• Towers Perrin paper
• IFRS 4 update
2
Brief history of Fair Value
• In the beginning, accounting was simple:
– Assets valued at historical cost – reliable, but not relevant
• Early 1980s -- Savings & Loans Crisis, banks were in trouble:
– Sell assets where market value over book value
– Keep assets where market value under book value
• Result was hidden insolvency
• Proposed solution – Fair Value accounting
3
What is Fair Value?
“The price at which an asset or liability could be exchanged in a
transaction between knowledgeable unrelated willing parties.”
Fair value hierarchy exists:
1. Market value, if sufficient market exists; else
2. Market value of similar items with active markets, adjusted
for differences; else
3. Present value estimate of future cash flows, including an
adjustment for risk.
4
Brief history of Fair Value
• 1990s – Capital markets became increasingly global
• Differing accounting standards are impediment to free flowing
capital across borders, with perception of lack of transparency
• International Accounting Standards Board (IASB)
• The European Union wants consistency within its borders
• European Union has decided to move toward the IASB’s
approach to accounting (i.e. Fair Value)
5
Why should I care?
• You clearly should if you have a European parent
• But SEC is in favor of eventual consistency (“convergence”)
– SEC controls U.S. GAAP for publicly owned companies
– FASB also in favor of convergence
• FASB and IASB agreed not to introduce anything that furthers
the gap to some joint work on the issue
– FASB has unofficially agreed to join with the IASB in a
limited joint project on insurance contracts
6
Practical applications
• Discussion at IASB has at times been theoretical and academic
• Life insurance industry wanted a “real world” test of fair value
– IAA and ACLI teamed up to conduct such tests
• What about P/C Insurance?
– In 2003, CAS sponsored research into practical applications
• PwC and Towers Perrin contributed to this research
7
PwC Paper
8
Outline of PwC Research
• CAS Project Objectives & Scope Exclusions
• Data
• Modeling Approaches
• Findings
• Significant Issues
9
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
10
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
11
CAS project – scope exclusions
• Credit risk
• Adequacy of booked reserves
• Correlation adjustments across lines of business
• Impact of fair value on other balance sheet items
12
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”).
13
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
14
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
Class
Personal Auto Liability
Workers Compensation
Medical Malpractice
15
Development Method Stochastic Method
SD Multiple
SD Multiple
1.2
1.0
1.5
2.0
1.5
2.3
Stochastic Method
Percentile
90%
92%
95%
Discount factor models
Average discount factor by year for Personal Auto Liability
Discount factor
10.0%
9.0%
8.0%
7.0%
6.0%
Duration
5.0%
Matched
4.0%
3.0%
2.0%
1.0%
0.0%
1998
1999
2000
Year
16
2001
2002
Findings – discount 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.
17
MVM by company – personal auto liability
MVM by Company at Year-End 2002
100%
90%
80%
MVM %
70%
60%
ROC MVM
50%
40%
30%
20%
10%
0%
0
2
4
6
Company
18
8
10
12
MVM by method for one company
– personal auto liability
MVM by Method - Company C(M)
18%
16%
14%
Develop SD
MVM %
12%
Stoch SD
10%
Percentile
ROC
8%
6%
4%
2%
0%
1998
1999
2000
Year-End
19
2001
2002
MVM by company size - personal auto liability
MVM for All Companies and All years
70%
60%
MVM (%)
50%
MVM vs.
Company
Size
40%
30%
20%
10%
0%
0
200,000
400,000
600,000
Reserves ($000)
20
800,000
1,000,000
MVM by company– workers’ compensation
MVM by Company at Year-End 2002
100%
90%
ROC MVM
80%
MVM %
70%
60%
50%
40%
30%
20%
10%
0%
0
2
4
6
Company
21
8
10
12
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 nor the lowest.
• For smaller companies, the MVM tended to be larger
(measured as a percentage of the loss reserves)
22
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
23
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.
24
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)
25
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.
26
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.
27
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 0.
–Disclosure of the components of one-year development of
prior year-end reserves could be quite complicated.
28
Assessment of P/C actuarial methods
Estimating undiscounted reserves:
GOOD
Discounting estimated future payments:
GOOD
Estimating market value margins:
Calibration of MVM methods:
29
DEVELOPING
EMERGING
Towers Perrin Paper
30
Background to IFRS 4
• Work of the IASB
– 2002: Split Phase I (2005) / Phase II (2008?)
– 2004: IFRS 4
• European Union has said IFRS is compulsory for stock
exchange listed companies from January 1, 2005
• International Financial Reporting Standards (IFRS) address 3
major questions in the arena of insurance accounting:
– What is an insurance contract?
– What do you have to disclose?
– How do you measure insurance contracts? – Phase II
31
Phase I – IFRS 4
• Product classification
• Catastrophe and equalization provisions prohibited
• Restrictions on changes to accounting policies
• Requirement for liability adequacy testing
• Impairment of reinsurance
• Disclosure
32
Phase II
• Currently undecided if Fair Value will be basis for Phase II (2008)
33