2004 Casualty Loss Reserve Seminar
September 13-14, 2004
Implications of New International
Accounting Standards for Insurance
Companies
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 1
NEW ACCOUNTING RULES WILL APPLY
2005 for IFRS reporting companies.
EU-listed companies and the Caribbean.
Australia - possible early adoption.
FASB has stated intention to converge GAAP
with IFRSs
US GAAP changes not that far off
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 2
Contributors to Presentation
Burt Jay, FSA, MAAA
AAA VP - Financial Reporting
AAA Representative to IAA Standards Subcommittee
Dave Congram, ASA, FCIA, FIA
Canadian Task force to develop process to implement
IAA standards in Canada
Author, several IAA Exposure Drafts
Bob Miccolis, FCAS, MAAA
CAS Representative to IAA Standards Subcommittee
Chairman, ASB Casualty Operating Committee
Member, IAA Standards Drafting Group
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 3
Why is a global insurance accounting
standard required?
Common global insurance accounting needed to
eliminate differences that can be material
GAAP financial reporting cannot rely on regulatory
accounting, particularly for multi-nationals
Insurance contracts will no longer be excluded from
international accounting standards
IASB has been reconciling accounting differences
towards a consistent global approach across industries
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 4
Primary International Standards Affecting
Insurance Companies
IFRS 4, adopted March 2004 (effective 1st qtr
2005 for companies reporting under IAS/IFRS)
IAS 32 and 39, Amended December 2003
(Financial Instruments)
Existing IAS 18 Revenue (Service Contracts)
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CLRS - 2004 5
PRIMARY PROVISIONS OF IFRS 4
Applies to Insurance Contracts—must
have “significant insurance risk” to use
IFRS 4
IFRS 4 allows insurance contracts to be
accounted under local GAAP, with
certain restrictions (no CAT or
equalization reserves)
Liability adequacy test required
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CLRS - 2004 6
WHAT ABOUT NON-INSURANCE
CONTRACTS
Contracts issued by insurance
companies that do not meet definition
of insurance are considered to be either
financial instruments (investment
contracts) or service contracts
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CLRS - 2004 7
SERVICE CONTRACTS
Generally, contracts that are neither insurance
contracts or financial instruments (investment
contracts) are service contracts
Claim service contracts (ASOs)
Self insurance (basic risk financing)
Deductibles
Service component of a financial instrument
(investment contract), or an insurance
contract, may have to be separated
Covered by IAS 18
Copyright © 2004 by the
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CLRS - 2004 8
IAA Actuarial Standards Exposure Drafts
International Actuarial Practice Guideline
IAPG (IAA Class 4 Standard)
Actuarial Practice
Contract Classification
Measurement
Liability Adequacy
Testing
Changes in Accounting
policy
Embedded Derivatives
Discretionary Participating
Features
Current Estimates
Disclosure
Reinsurance
Stochastic Models
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 9
IAA Exposure Draft - Actuarial Practice
Specific guidance
Disclosures
Scope and adequacy of Professional Services
Accounting requirements
a) Classification
b) Unbundling and Embedded derivative separation
c) Measurement
d) Participation
e) Liability Adequacy Test
f) Accounting Disclosure
Relevant Knowledge
Material Inconsistencies
General guidance
Copyright © 2004 by the
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CLRS - 2004 10
IAA Exposure Draft - Classification Paper
Significant
insurance risk
Create financial
assets or liabilities?
No
Yes
IFRS 4
Insurance
Tests
Embedded
Derivative Test
Deposit Component
No
Yes
Yes
Contains
Discretionary
Participation
Feature?
Tests
Financial Instrument
IAS 18
Service Contract
Measurement
Service
Element
No
Contains
service elements
Financial
Instrument
IAS 39
Financial Instrument
Measurement
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CLRS - 2004 11
IAA Exposure Draft - Measurement Paper
Measurement approaches addressed
• Amortized Cost model
• Fair Value model
• Stage of completion
Structure
•
•
•
•
Approach
Models and assumptions
Updating
Accounting Constraints
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 12
Revised IAS 39: Measurement
Fair Value Entire
Contract
Valuation
Technique
Market
Calibration
Options and
Guarantees considered
YES
Option Pricing
Models
Financial
Markets
Election
Held for
Trading
Derivative
Host
YES
Fair Value
Option Pricing
Models
NO
Amortized
Cost
Contains
Embedded
Derivatives
NO
Amortised
Cost
Copyright © 2004 by the
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CLRS - 2004 13
Other IAA Practice Guidelines
Liability Adequacy Testing
Changes in Accounting policy
Embedded Derivatives
Discretionary Participating Features
Current Estimates
Disclosure
Reinsurance
Stochastic Models
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CLRS - 2004 14
Property/Casualty Insurance Accounting
Classification – retroactive risk considered insurance;
no special risk transfer rules for ceded reinsurance
Ceded Reinsurance – valued separately as an asset
Unbundling – only required if deposit obligations not
fully recognized
Liability Adequacy Testing – Premium Deficiency
Reserve – if no existing test, level of aggregation is
broadly similar risks managed as a portfolio
Changes in Accounting policy – only if “improvement”
no less reliable, no less relevant
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CLRS - 2004 15
Property/Casualty Insurance Accounting
Embedded Derivatives – certain types of contracts,
particularly reinsurance, that include index triggers
may be affected
Current Estimates – needed for liability adequacy
test, changes in accounting policy
Disclosure – several difficult and very broad
requirements
Reinsurance asset impairment – not based on
reinsurer ratings
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CLRS - 2004 16
Changes to P/C Actuarial Practice
Impact on US P/C actuarial practice will depend on
FASB view of timing to converge with IASB
FASB plans relative to IASB exposure drafts and standards
Views of Insurance Regulators on avoiding 2+ sets of books
US based insurers with European (or Australian) parents
US based insurers with significant European operations
US listed insurers who are also listed on EU/AU exchanges
Disclosure – several difficult and very broad requirements
Some version of Fair Value will be difficult to avoid
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CLRS - 2004 17
Fair Value
The main concern about IAS is that they require
assets and liabilities to be valued at market value
Market value must be based on an active market with
a high volume of transactions
In the absence of a market value, fair value is to be
used, based on a valuation using appropriate
methods
Such appropriate fair value methods or models
should be based on observable market transactions
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 18
Highlights of Fair Value (Phase II)
Discounting of P/C Liabilities
Reserves for unpaid loss and loss adjustment expenses
Reserves for unexpired risks (UPR)
Market Value Margins – added to discounted liabilities
Reflects risk and uncertainty in reserves
Reflects “market” price (margin) for reserve risk
Reflects “mark-up” for transaction cost of selling reserves
Credit risk adjustment (controversial)
Credit Risk Adjustment
Liability adjustment for credit characteristics of the contract
Reflecting any government guarantees or legal preferences
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CLRS - 2004 19
Fair Value Concepts
Fair value is the amount for which an asset could be exchanged
between knowledgeable, willing parties in an arm's length
transaction.
Fair value is measured, at the balance sheet date, as:
the most probable price reasonably obtainable in the market,
the best price reasonably obtainable by the seller, and
the most advantageous price reasonably obtainable by the
buyer
“Knowledgeable, willing parties”
both a willing buyer and a willing seller
both reasonably informed about the characteristics of the
asset, and state of the market as of the balance sheet date
Copyright © 2004 by the
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CLRS - 2004 20
Fair Value Concepts
There is a presumption that an enterprise is a going
concern without any intention or need to liquidate,
curtail materially the scale of its operations or
undertake a transaction on adverse terms.
Fair value is not, therefore, the amount that an
enterprise would receive or pay in a forced transaction,
involuntary liquidation or distress sale.
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CLRS - 2004 21
Fair Value - No active and liquid market
When there is not frequent activity in a market, the
market is not well established or small volumes are
traded, quoted market prices may not be indicative of
the fair value of the instrument.
Estimation techniques may be used to determine fair
value if there is sufficient reliability.
Techniques that are well established include reference
to the current market value of another instrument that
is substantially the same, such as discounted cash flow
analysis and option pricing models
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CLRS - 2004 22
Fair Value Models
Fair Value “Model” needed to estimate value
No active and liquid market
Small volume market prices not indicative of fair
value
Fair Value Model should have certain characteristics:
Mimics market price behavior of an active market
Can be validated by observable market values
Model assumptions are current and based on
observable data
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CLRS - 2004 23
References to Credit (IAS 39)
The discount rate equals the prevailing market rate of
interest for financial instruments having substantially
the same terms and characteristics, including the
creditworthiness of the debtor, the remaining term.
Valuation techniques should incorporate the
assumptions that market participants would use in
their estimates of fair values, including assumptions
about prepayment rates, rates of estimated credit
losses, and interest or discount rates.
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CLRS - 2004 24
Reliability of Fair Value Estimates (IAS 39)
Often, an enterprise will be able to make an estimate
of the fair value of a financial instrument that is
sufficiently reliable to use in financial statements.
The fair value of a financial instrument is reliably
measurable if:
a) the variability in the range of reasonable fair value
estimates is not significant for that instrument, or
b)
if the probabilities of the various estimates within
the range can be reasonably assessed and used in
estimating fair value.
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CLRS - 2004 25
Reliability of Fair Value Estimates (IAS 39)
The fair value of a financial asset or financial liability
may be determined by one of several generally
accepted methods.
Occasionally, the variability in the range of
reasonable fair value estimates is so great and the
probabilities of the various outcomes are so difficult
to assess that the usefulness of a single estimate of
fair value is negated.
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CLRS - 2004 26
Can Fair Value for insurance be reliably determined?
IASB has not decided – practical issues to be resolved
IASB recognizes that fair values can not be observed
directly from market transactions
IASB sees fair values for insurance using estimates
based on models
IASB realizes very little data exists for some risks
IASB sees insurance fair value estimates as not less
than what the entity would charge for new contracts
Copyright © 2004 by the
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CLRS - 2004 27
Is Fair Value relevant for non-traded
long term liabilities?
IASB – fair value measurement is not intended as a
representation that an insurer could, or should,
transfer insurance liabilities to another party.
IASB – fair value of an insurance liability can be
regarded as a market-based representation of the
value of the future contractual cash flows.
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CLRS - 2004 28
Credit Risk Adjustment – One View
Credit risk adjustments do seem to be a separable
component of the “fair” market value of financial
instruments (such as a bond) in active markets.
Where the cash flows are certain, one could
compute a credit risk adjustment as the difference
between market value and the present value at a
risk free rate.
Alternatively, the credit risk adjustment could be the
addition to the discount rate that produces a present
value of cash flows equal to the market value.
Copyright © 2004 by the
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CLRS - 2004 29
Credit Risk Adjustment – One View
With uncertain cash flows, there is no clear division
in market value between the “market value margin”
that compensates for the uncertainty of the cash
flows and the credit risk adjustment.
However, if the credit risk adjustment is measured
solely in terms of the discount rate, then the market
value margin would be the difference between
the market value (no credit risk) for uncertain cash flows,
and
the market value (no credit risk) for fixed cash flows equal
to the expected value of the uncertain cash flows.
Copyright © 2004 by the
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CLRS - 2004 30
Fair Value and the Capital Markets View
Economists in the capital markets field routinely
estimate fair market values for many kinds of
securitization instruments, some with active markets
and others without.
In capital markets, the concept of credit risk
adjustment for liabilities is relates to how much
HIGHER the fair value of liabilities should be above
the present value of cash flows at a risk free rate.
This means that the fair value of liabilities
INCREASES as the credit characteristics worsen.
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CLRS - 2004 31
Fair Value and the Credit Enhancement View
The fair value of the liability for the entity obligated
to make payments can be viewed as made up of:
a. The present value of the cash flows discounted at
the risk free rate, plus
b. The market price of a guarantee to make those
payments.
To sell the liability would require a credit
enhancement premium if the credit rating had
dropped from when the liability was issued.
Thus, the credit risk adjustment within the fair value
of liabilities is equivalent to a theoretical credit
enhancement premium.
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CLRS - 2004 32
Fair Value and the Credit Enhancement View
Applying this view to insurance, the fair value of an
entity’s insurance liabilities should INCREASE
because of a drop in the entity’s credit standing.
When the credit standing drops too low, the fair
value of the insurance liabilities increases to the
point of reducing the surplus to threaten the
solvency of the entity, or indicating insolvency.
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CLRS - 2004 33
Fair Value and the Market Calibration View
The fair value of insurance liabilities should reflect
market value, including both market value margin
and the credit risk adjustment.
The insurance contract obligations at inception can
be viewed as pricing a policy at the market value.
IBNR can be viewed as pricing tail coverage at the
market value.
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American Academy of Actuaries
CLRS - 2004 34
Fair Value and the Market Pricing View
Market Value Pricing could be viewed as the market
price of a representative portfolio of policies.
This market value price would reflect the uncertainty
of the insurers cash flows from these policies.
If differences in observable market prices are
consistently related to the credit standing of the
insurer, then the liabilities of the lower credit rated
insurers would have a HIGHER fair value if the
insurers with better credit can get higher market
prices.
Copyright © 2004 by the
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CLRS - 2004 35
Precedents for reflecting credit in the
measurement of liabilities?
Existing loan models (IAS 39) require the borrower to
recognize the liability initially at the amount of the
proceeds received (less transaction costs incurred)
This measures the liability at the contractual amounts
payable (interest and principal), discounted at the
prevailing interest rates at inception for a loan with
those credit characteristics.
Initial measurement of the liability reflects its credit
characteristics.
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 36
Why should an insurer report a profit if credit
quality of its liabilities deteriorates?
IASB – excluding credit characteristics of a liability
from its measurement would require an arbitrary
exception to the general principle of measurement at
fair value
When the IASB considers performance reporting
issues for insurance contracts (phase II), it will
consider whether the effects of liability changes due
to changes in credit characteristics should be
disclosed separately.
Copyright © 2004 by the
American Academy of Actuaries
CLRS - 2004 37