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Fair Value Accounting. E. Daniel Thomas, PricewaterhouseCoopers, LLP Emmanuel Bardis, Towers Perrin Moderator Chris Nyce, KPMG LLP. CAS Casualty Loss Reserve Seminar September 2005. Overview of the Session. Background on Fair Value PwC Approach Towers Perrin Approach

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fair value accounting

Fair Value Accounting

E. Daniel Thomas, PricewaterhouseCoopers, LLP

Emmanuel Bardis, Towers Perrin

Moderator

Chris Nyce, KPMG LLP

September 2005

CAS Casualty Loss Reserve Seminar

September 2005

overview of the session
Overview of the Session
  • Background on Fair Value
  • PwC Approach
  • Towers Perrin Approach
  • Update on IFRS 4 Current Events

September 2005

fair value background

Fair Value Background

September 2005

definition of fair value
Definition of Fair Value
  • Assumptions based on a hypothetical transaction between marketplace participants
    • Buyer-specific synergies excluded
  • Where prices in active markets for identical or similar assets are not available, valuation techniques are used
    • In-use or in-exchange valuation premise, based on highest and best use for asset

“The price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties.”

September 2005

why fair value
Why “Fair Value”
  • Rooted in S&L crisis
    • Incentive to sell undervalued assets and keep overvalued assets
    • Led to insolvency
  • Solution-Value assets at market
    • No incentive to buy or sell for accounting reasons
  • Leads to question related to P&C Loss Reserves
    • Does fair value give this intended advantage if no active market exists

September 2005

background fair value
Background – Fair Value
  • Practical interpretation of definition of Fair Value
    • Market Value, if a sufficiently active market exists
    • Estimated Market Value, otherwise
  • Possible approaches to estimating market value
    • Similar transactions
    • Risk adjusted present value of cash flows
  • Accounting guidance gives a hierarchy of alternatives
    • Priority is given to market prices for identical or similar assets, where available
    • Emphasizes the use of market inputs
    • Multiple valuation approaches should be considered

September 2005

fair value
Fair Value

Fair Value - including Market Participant Strategies

“Strategic”or

“Investment” Value

“Going Concern” Basis -

“Stand Alone” Value

Liquidation

Value

Strategic Buyer

Bargain Hunter

Financial Buyer

Marketplace Participant

Value

Lower

Higher

September 2005

when fair value for property casualty loss and loss expense reserves may be required
When Fair Value for Property Casualty Loss and Loss Expense Reserves may be Required
  • Under GAAP, when a business combination has occurred (FAS 142)
  • Under International Financial Reporting Standards (IFRS), phase II implementation for insurance contracts
  • As part of a holding company evaluation of possible impairment of an insurance reporting unit
  • Under GAAP, (FIN 45) for all companies (including non-insurers) for certain contingent contractual obligations entered into after 12/31/2002

September 2005

approaches to fair valuing loss and loss expense reserves
Approaches to Fair Valuing Loss and Loss Expense Reserves
  • If possible, use a comparable market transaction
    • But this is expected to be rarely possible, if ever
      • Some reserve transfers have taken place, but rarely motivated by “normal business considerations” when “neither is acting under compulsion”, i.e. often an element of distress in one of the parties
      • Usually these contracts transfer only a minimal amount of risk, so the problem of fair value of the residual risk remains
      • Few bidders are usually available
      • Insurance liability portfolios are not homogeneous, comparable transactions are unusual
      • Information on the liabilities is usually asymmetric, seller has more knowledge
      • Especially lately, extensive legal scrutiny of these transactions are changing the nature and availability of bidders
      • Often, a seller cannot divest the legal obligation for the liabilities, and remains at least contingently liable

September 2005

what is the impact of fair value applied to loss reserves to p c companies
What is the Impact of Fair Value Applied to Loss Reserves to P&C Companies
  • It’s unclear
    • Differing approaches and assumptions can get to different answers
    • No current guidelines as to how to do this
    • Diversity of situations in different countries
    • How to change or amortize is unclear
  • 2003: CAS sponsors research into how this might work
  • PwC, Towers answer the call

September 2005

pwc paper
PwC Paper

September 2005

outline of pwc research
Outline of PwC Research
  • CAS Project Objectives & Scope Exclusions
  • Data
  • Modeling Approaches
  • Findings
  • Significant Issues

September 2005

cas project objectives
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

September 2005

cas research specifications
CAS 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

September 2005

cas scope exclusions
CAS scope exclusions
  • Credit risk
  • Adequacy of booked reserves
  • Correlation adjustments across lines of business
  • Impact of fair value on other balance sheet items

September 2005

fair value measurement
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”)

September 2005

pwc modeling approaches
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

September 2005

pwc modeling calibration approach
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

September 2005

findings discount factor modeling
Findings – discount factor 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.

September 2005

findings mvm modeling
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 or the lowest.
  • For smaller companies, the MVM tended to be larger (measured as a percentage of the loss reserves)

September 2005

findings fair value impact on balance sheet loss reserves
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

September 2005

findings fair value impact on income statement incurred losses
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.

September 2005

significant issues modeling
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)

September 2005

significant issues mvm estimation
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.

September 2005

significant issues financial statement presentation 1
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.

September 2005

significant issues financial statement presentation 2
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 zero
    • Disclosure of the components of one-year development of prior year-end reserves could be quite complicated

September 2005

assessment of p c actuarial methods
Assessment of P/C actuarial methods
  • Estimating undiscounted reserves: GOOD
  • Discounting estimated future payments: GOOD
  • Estimating market value margins: DEVELOPING
  • Calibration of MVM methods: EMERGING

September 2005

towers perrin paper
Towers Perrin Paper

September 2005

research approach
Research Approach
  • Database
  • GAAP adjustments
  • Discounting
  • Market Risk Margins
  • Impact on reported financial results
  • Conclusions
    • Reliability
    • Relevance

September 2005

database
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

September 2005

convert statutory annual statement information into current gaap
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
      • 4 Workers Compensation insurer
      • 3 Medical Professional Liability insurer
      • 1 Personal Auto Liability insurer
  • Tabular discounts could not be effectively removed due to data limitations

September 2005

discounting
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

September 2005

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

Derive Risk Margin for Claim Liabilities

Observe Amount of Insurance Market Risk

Measure Amount of Risk in Claim Liabilities

Empirically observed market price per unit of insurance risk

We inferred the Market Risk Margin from historical margins observed in the insurance market

September 2005

ex post market economic pricing margins vary over time reflecting the cycle and interest rates
Ex-post market economic pricing margins vary over time, reflecting the cycle and interest rates

September 2005

the pricing cycle is different in workers compensation and the cycle amplitude is larger
The pricing cycle is different in Workers Compensation, and the cycle amplitude is larger

September 2005

slide44
The amplitude is greatest for Medical Professional Liability, and the long-term average margin is low

September 2005

in addition to balance sheet effects we also analyzed the impact on income statements
In addition to balance sheet effects, we also analyzed the impact on income statements

Calendar Year

September 2005

by one measure fair value doesn t improve the transparency of income
By one measure, fair value doesn’t improve the transparency of income

September 2005

conclusions
Conclusions
  • Reliability: open question regarding the reliability of the estimation of discounts and market risk margins
    • Payment patterns are entity specific
    • Pricing risk margins are based on volatile data
    • Stochastic methods that measure reserving risk produce different results
  • Relevance: the preparation of Fair Value estimates is complex and will require considerable education of actuaries and others.

September 2005

ifrs background
IFRS Background
  • Situation prior to IFRS
    • Many different accounting rules in many jurisdictions
    • Difficulties in comparing results between insurers
    • Creates a barrier to capital flows between jurisdictions
  • Insurance project started in 1997
    • 1999 issues paper
    • Draft Statement of Principals followed
    • 2002 project split into phase I and phase II
  • 2004 IFRS 4 promulgated as implementation to phase I
    • Implementation in many jurisdictions (EU) 1/1/2005
    • Goal of Phase I
      • interim improvements in accounting for insurance contracts
      • Require filers to disclose information about those contracts

September 2005

provisions of phase i that may affect reserves
Provisions of Phase I that may affect Reserves
  • Separate and separately test gross liabilities and ceded reinsurance
    • Gross liabilities subject to liability adequacy test
    • Reinsurance assets subject to impairment test
  • Does not permit Catastrophe or Equalization reserves
  • Defines insurance contracts
  • Adds disclosure requirements
    • Amounts in financial statements that arise from insurance contracts
    • Amount, timing, and uncertainty of future cash flows
  • Introduces rules around changes in accounting policy

September 2005

phase i provisions on changes in accounting policy
Phase I Provisions on Changes in Accounting Policy
  • Disallows changes in accounting policy is it makes results an less relevant or any less reliable
  • Allows if current practice but bans introduction of:
    • Undiscounted reserves
      • But a rebuttable presumption that introducing future investment margins makes accounting less relevant and reliable
    • Non-uniform accounting policies in subsidiaries
    • Measuring insurance liabilities with excessive prudence

September 2005

what about phase ii
What About Phase II
  • “Past work is a useful resource, but we are not bound by it”- Starting anew
  • Fair Value model to be evaluated along with others
  • Timelines have pushed out (per 1/2005 project plan)
    • Discussion paper: end 2005 or later
    • Exposure draft: mid 2007 or later
    • Final standard mid 2008 or later
    • Implementation ???
  • Broad industry participation
    • CAS study presented to working group-February 2005

September 2005

what about us gaap
What About US GAAP
  • Addressed on project under “convergence”
    • IASB (primarily) produces discussion paper
    • IASB and FASB publish paper for comment
    • Joint project follows with objective of a “identical or substantially similar” standard
    • Canadian CASB approves project aimed at following suit

September 2005