Fair Value Accounting and Actuaries - 2003 Edition

1. Fair Value Accounting and Actuaries - 2003 Edition Michael G. McCarter, FCAS, MAAA American International Group, Inc. C.L.R.S. Chicago - September 2003

2. The FASB Report, July 31, 2003 • “On June 4, 2003, the Board added a project to its agenda to codify and improve the guidance for measuring fair value.” • “The near-term objective is to … establish a framework for fair value measurements …” • “A longer-term objective is to improve the related conceptual guidance …”

3. Fair Value Measurement • FASB Project Update - September 3, 2003 • Near-term objective: Statement on how to measure fair value. • Longer-term objective: Conceptual guidance on when to measure fair value considering the qualitative characteristics of relevance and reliability.

4. Revised Definition • FASB revised the definition of fair value to refer to “the amount at which an asset or liability could be exchanged between knowledgeable unrelated willing parties when neither is acting under compulsion.”

5. Objective • “The objective of a fair value measurement is to estimate the single agreed-upon exchange price between willing parties in a transaction other than in a forced liquidation or distress sale.” • “The definition … is intended to apply for all assets and liabilities (including financial instruments) measured at fair value.”

6. Implications - FASB • FASB is clearly moving towards a fair value measurement model for many assets and liabilities, including financial instruments (probably including insurance). • FASB believes fair value meets its criteria of relevance and reliability. • Fair value means secondary market trading value.

7. IASB Exposure Draft • ED 5 - Insurance Contracts [Comments due on Halloween] • Paragraph 30: “An insurer shall disclose the fair value of its insurance liabilities and insurance assets.” • Paragraph 33: “… not … for dates before 31 December 2006.”

8. IASB Exposure Draft • ED 5 - Basis for Conclusions • Paragraph BC140: “The Board must resolve several significant issues about fair value, both conceptual and practical, in phase II. Therefore, some argue that disclosing the fair value of insurance liabilities and insurance assets in phase I is premature.”

9. IASB Exposure Draft • ED 5 - Implementation Guidance • Paragraph IG60: “… The Board acknowledges the need for further guidance on fair value and will develop it as phase II of the project progresses.”

10. IASB Exposure Draft • PwC Summary of ED 5 • Page 7: “… companies … will be expected to provide disclosure of the fair value of their liabilities from year end 2006. From a theoretical viewpoint, this presents insurers with a challenge, as fair value for insurance contracts is not yet defined.”

11. Implications - IASB • The IASB is even more clearly moving towards a fair value measurement model for many assets and liabilities, including financial instruments and definitely including insurance. • However, it is harder to say what the IASB means by fair value for insurance contracts, since it has declined to define it.

12. Actuaries and Fair Value • Accounting standard setters are clearly moving towards fair value. • The admitted problems of measurement and reliability make it uncertain they will achieve that goal. • What does this mean for actuaries, particularly U.S. casualty actuaries?

13. For Actuarial Consultants • Fair value is wonderful! Bring it on ASAP! • Projects to discount liabilities using market interest rates and somehow adjusting for risk! • New financial and management reporting systems that need somehow to be made comprehensible! • Many, many billable hours!

14. For Actuaries as Executives • Liability estimation • Underwriting performance measurement • Financial performance measurement • Dealing with volatility of returns • Dealing with unhappy capital markets • Dealing with product pricing implications • Dealing with required short-term focus

15. Liability Estimation • Fair value doesn’t mean simple discounting, but discounting at constantly varying market rates of interest and incorporating estimated market risk premiums. • Louise Francis at last year’s CLRS summarized the techniques described by the CAS Fair Value Task Force in its August 2000 white paper (available on CAS site).

16. Liability Estimation • But does the work to develop and continually update “market based” discount rates and risk premiums add value? • What has been the greater problem for casualty insurers - dealing with fluctuating interest rates or properly estimating their claims liabilities? • Fair value takes your eye off the ball.

17. Underwriting Performance • How do successful companies measure underwriting performance for P&C products? • Combined ratio and underwriting income. • What is the theme of article after article on the problems of the global reinsurance industry? • “Lost control of their combined ratio.”

18. Underwriting Performance • What have combined ratio and underwriting income to do with investment returns? • Nothing. Underwriters need to make a buck if they’re to have a margin to cover any mistakes. • Can’t you adjust combined ratios for investment income? • Sure, but not for managing underwriting.

19. Underwriting Performance • Underwriting P&C insurance involves long term commitments to clients that in general do not permit re-pricing on a daily basis. • Cash-flow underwriting works fine to lower prices, but doesn’t seem to work when prices need to go higher. • Fair value measures intertwine the underwriting and investment operations.

20. Financial Performance • Fair value goes with the asset / liability accounting model, not the traditional revenue / expense or deferral and matching model. • FASB and the IASB have projects developing asset / liability accounting model financial statements.

21. Financial Performance • What FASB and the IASB have in common is that net income goes away. No more “above the line” and “below the line”. • Standard setters hate the “manipulation” of net income that goes on when companies choose whether or not to realize capital gains or losses.

22. Financial Performance • So for FASB and the IASB, all changes in the fair value of assets and liabilities, whether realized or unrealized, will flow through the single comprehensive statement of income. • Reported changes in performance will be dominated in many quarters by the impact of transient changes in the capital markets.

23. Financial Performance • Investment analysts are not asking for this change (except for AIMR). • FASB’s User Advisory Committee made clear that investment analysts do not consider all forms of income equal, and that they make the adjustments they choose in the current “mixed attribute” system.

24. Volatile Returns • Running changes in fair value through the performance measures means volatile returns. • While many financial assets can reasonably be presumed to have “fair values” whose values are closely linked with interest rates, it is not so clear that claims liabilities bear that neat relationship.

25. Volatile Returns • Managing volatility of returns under the asset / liability performance measures will require smart people working hard to get back even close to today’s volatility. • Is that a productive use of those resources? • Have we actually improved our understanding of the business?

26. Unhappy Capital Markets • Investors like predictable, not volatile returns. • Forcing insurers to run transient market volatility through their performance measures will cause insurer shares to be less attractive, share prices to fall, and required returns to increase to compensate for the volatility.

27. Product Pricing • Higher required returns on capital or requirements for more capital to bear the greater volatility of results causes the required return on capital incorporated in product pricing to be increased. • If competition means that these higher required prices can’t be achieved, the market will cause share prices to fall.

28. Short-term Focus • Fair value treats every blip in the capital markets as significant, requiring managers to figure out how to manage those blips. • Time spent managing short-term capital markets blips is time not spent on real marketing, underwriting, and claims issues.

29. Implications for Actuaries • Given that fair value is the “right answer” according to all of these very smart accountants, shouldn’t we just start focusing on how to implement fair value? • Well, no. As defined (or undefined), fair value for liabilities is based on some confusions that will ultimately cause the concept to collapse.

30. Implications for Actuaries • If actuaries understand the flaws in fair value, they can convey that understanding to their companies. • If companies understand the flaws in fair value, companies can begin to use their resources to resist being made the victims of an intellectual fad that is already on its way out.

31. Conceptual Flaws • A question: If fair value for liabilities is and has been so obviously the coming thing in accounting theory for the last several years, why hasn’t a good definition and conceptual framework already been adopted? • Accounting standards setters have already devoted years of work to this issue.

32. Conceptual Flaws • Here it is: • Fair value means “trading market value in secondary markets”. • So, only things that trade, at least conceptually, can have a relevant fair value. • LIABILITIES DON’T TRADE! So liabilities don’t have a relevant fair value.

33. Liabilities Don’t Trade • Suppose liabilities did trade. • Suppose I owe you $100. I choose to pay the homeless guy on the corner $5 to take over my obligation to you. You come to me for your money. • I tell you I’ve traded away my obligation to you. Go collect from the homeless guy (good luck). I’ve just made $95 risk-free.

34. Liabilities Don’t Trade • There must be something wrong, you say, and you’re right. • The something wrong is the notion that liabilities trade. • As we’ve just seen, if liabilities could trade all values in financial markets would crash to zero virtually instantaneously.

35. Liabilities Don’t Trade • What would an asset be worth if the obligor could trade away its obligation without constraint? • The answer - nothing. • Assets trade - I can sell my asset to whomever I choose. Liabilities don’t trade.

36. Again Conceptual Flaws • If this is so clear, why isn’t fair value for liabilities already dead? • Desire: Accounting standard setters desperately yearn for a clean standard for liabilities that eliminates subjectivity and potential for manipulation.

37. Again Conceptual Flaws • Religion of markets: Markets are a great organizing and valuing tool whose virtues, great as they are, have been exaggerated and misunderstood. Market values can be wrong, if what you’re looking for is true value.

38. Again Conceptual Flaws • Confusion: The definition of a financial instrument includes both assets and liabilities. What is not understood is that the bundle of assets and liabilities that may comprise a financial instrument breaks down into separate assets and liabilities as soon as the financial instrument has been issued in its primary market.

39. Again Conceptual Flaws • More confusion: The issuer of the financial instrument is not free to trade the obligation he’s just taken on. He certainly can trade the asset he has received. In the secondary, trading market (where fair value lives), financial instruments don’t really exist. Assets do, and liabilities do, but liabilities don’t trade.

40. Again Conceptual Flaws • But what about an entity buying back its own debt? This has been published as an example of trading a liability. • Who has control of the “liability” and determines whether or not there’s a trade? The asset holder, of course. Buying back debt is just a typical asset trade, except that the purchaser is also the obligor.

41. More Conceptual Flaws • The illusion that liabilities trade is responsible for the purely goofy idea that liability valuation should reduce as an entity’s credit standing deteriorates. In turn, this makes the balance sheet less meaningful and less informative to users attempting to distinguish between insurers on the basis of solvency or credit quality.

42. More Conceptual Flaws • A very popular accounting concept today is the conceptual framework, the foundation of a principles-based system. • Conceptual frameworks used to be guidelines; now, they’re being treated like mathematical postulates. But a postulate that doesn’t accord with reality creates a system that doesn’t either.

43. More Conceptual Flaws • Fair value goes with a very absolutist treatment of the conceptual framework. • Accounting standards can be derived in a definition-theorem-proof form that doesn’t have to pay attention to practical considerations since it is about “truth”. • Since fair value is wrong for liabilities, the existing conceptual framework is wrong.

44. What Should Be Done? • Fair value may well have a place in measuring assets. • We all have an interest in good international accounting standards. Once the illusion of fair value for liabilities is banished, we can work on the real job of improving existing insurance accounting standards.

45. What Will Happen? • Insurers from Europe, Asia, and North America have begun to realize the problems with fair value accounting. • A group of twelve North American insurance enterprises wrote to the IASB in June to express concerns. • French President Chirac actually got involved in IASB issues in the EU.

46. What Will Happen? • Still, fair value has momentum, and it forms a vital component of the movement to “principles-based” accounting standards that is supported by Congress and the SEC. • It is stunning that even though no fair value accounting system exists in the world, the standards setters wish to toss insurers into that ocean to see if they swim.

47. Summary • FASB and the IASB are pushing towards a fair value, asset / liability accounting model system for insurance. • Fair value for insurance liabilities is fatally flawed on a conceptual basis. • If more actuaries speak out, there is hope for a more reasonable approach to accounting.