Loss Reserve Discounting –
International Accounting
Ralph Blanchard, FCAS
CAS representative to the IAA Insurance
Accounting Committee
OVERVIEW
Current int’l standard
Future proposed standard
Fair value mechanics
Prognosis – U.S.
Options
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
2
CURRENT INTERNATIONAL STANDARD
There isn’t any
IFRS 4 (phase I of ins. Project)
Effective in 2005
Interim step
Can’t go to undiscounted
Can move to discounted using current rates
Can’t move to discounted using asset returns
Company acquisition – fair value acquired reserves
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
3
PROPOSED FUTURE STANDARD
Phase II of project
Exposure Draft mid 2005?
Implement 2007? (2008?)
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
4
PHASE II OUTLOOK
“In the Board’s view, discounting of insurance liabilities
results in financial statements that are more relevant and
reliable” (IFRS 4, BC 126)
Tentative phase II conclusions (IFRS 4, BC 6)
“Assets and liabilities arising from insurance contracts
should be measured at fair value”
Should gain at inception be allowed under fair value?
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
5
PHASE II OUTLOOK (CONT.)
“As implied by the definition of fair value:
(i)
An undiscounted measure is inconsistent with
fair value”
(ii)
Discount rate should not reflect expected
asset returns
(iii) Adjust for risk
(iv) Adjust for credit standing – i.e, likelihood that
insurer will pay its claims. Include effect of
co-guarantors (e.g., guarantee funds)
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
6
FAIR VALUE MECHANICS
Time value of money
Payment pattern – non-issue
Discount rate
Risk free rate, not invested asset return
“Risk-free assets are those assets with readily
observable market prices whose cash flows are least
variable for a given maturity and currency.” (Nov. 2001
DSOP, par. 6.2)
U.S.
R. Blanchard
Treasury rates
Alternative View – High-grade corporate, adj.
(default, volatility risk)
2004 CAS Spring Meeting – Loss Reserve Discounting
7
FAIR VALUE MECHANICS
Risk adjustment
“fair value should include an adjustment for the premium
that marketplace participants would demand for risks
and mark-up in addition to the expected cash flows”
(IFRS 4, BC 6c (i) ).
IASB preference – calibrate to the market
Many ways to estimate the risk,
BUT can it be reliably calibrated?
Is the theory workable in practice?
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
8
FAIR VALUE MECHANICS
Credit standing
Fair value … should reflect the credit characteristics [of
the insurer], including the effect of [co-guarantors, such as
guarantee funds].” (IFRS 4, BC 6c (iv)
Theory, not practice
Adjust for co-guarantors (e.g., Guarantee fund, insured?),
Reflect bankruptcy priority
Method?
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
9
FAIR VALUE MECHANICS
Credit standing (cont.)
May not be adopted by EU, FASB
Regulator influence
Precedent for regulatory influence
No one doing currently
BUT - Canadian standard for pension lump sum commutations?
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
10
FAIR VALUE MECHANICS
Alternative approach
No profit at issue:
Entry price = fair value
Initial loss reserve = zero profit reserve
Exit vs. entry price (standard is exit price)
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
11
U.S. PROGNOSIS
IASB-FASB Convergence Agreement
FASB probably will expose phase II expos. draft in U.S.
FASB has a fair value project –
Discounting part of fair value
SEC has supported fair value for “acquired” liabilities
But what about normal insurance liabilities? – uncertain if
practical problems can be suitably met.
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
12
OPTIONS
1. No discounting?
2. Discounting with
Market calibrated risk adjustment
Rules of Thumb for risk adjustment
No risk adjustment?
Discounting sounds likely for IASB (2008?)
U.S. GAAP??
(unlikely for U.S. stat.)
R. Blanchard
2004 CAS Spring Meeting – Loss Reserve Discounting
13