Fair Value Accounting

1
Fair Value Accounting
E. Daniel Thomas, PricewaterhouseCoopers,
LLP Emmanuel Bardis, Towers Perrin Moderator Chr
is Nyce, KPMG LLP

• CAS Casualty Loss Reserve Seminar
• September 2005

2
Overview of the Session

1. Background on Fair Value
2. PwC Approach
3. Towers Perrin Approach
4. Update on IFRS 4 Current Events

3
Fair Value Background
4
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.
5
Why Fair Value

• Rooted in SL 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 PC Loss Reserves
• Does fair value give this intended advantage if
  no active market exists

6
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

7
Fair Value
Fair Value - including Market Participant
Strategies
Strategicor Investment Value
Going Concern Basis - Stand Alone Value
Liquidation Value
Strategic Buyer
Bargain Hunter
Financial Buyer
Marketplace Participant
Value
Lower
Higher
8
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

9
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

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What is the Impact of Fair Value Applied to Loss
Reserves to PC Companies

• Its 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

11
PwC Paper
12
Outline of PwC Research

• CAS Project Objectives Scope Exclusions
• Data
• Modeling Approaches
• Findings
• Significant Issues

13
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

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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

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CAS scope exclusions

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

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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)

17
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

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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

19
Discount factor models
20
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.

21
MVM by company personal auto liability
22
MVM by method for one company personal auto
liability
23
MVM by company size - personal auto liability
24
MVM by company workers compensation
25
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 MVMs 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)

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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
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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.

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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)

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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
  MVMs 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.

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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
• MVMs 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.

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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

32
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

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Towers Perrin Paper
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Research Approach

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

35
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

36
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

37
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

38
Derived payment patterns for discounting vary by
company
39
Derived payment patterns also vary over time
40
The impact of discounting varies with the level
of interest rates
41
We inferred the Market Risk Margin from
historical margins observed in the insurance
market
42
Ex-post market economic pricing margins vary over
time, reflecting the cycle and interest rates
43
The pricing cycle is different in Workers
Compensation, and the cycle amplitude is larger
44
The amplitude is greatest for Medical
Professional Liability, and the long-term average
margin is low
45
We measured pricing volatility across companies
as well as over time
46
We selected pricing risk margins via a simple
risk-return framework
47
The margins produced by the two methods are
different, and also vary over time
48
Market risk margins vary by company
49
Reserve Risk Margins also by size of company
50
Fair values by component element
51
In addition to balance sheet effects, we also
analyzed the impact on income statements
Calendar Year
52
By one measure, fair value doesnt improve the
transparency of income
53
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.

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Fair Value Accounting and IFRS
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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

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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

57
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

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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

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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