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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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?

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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!

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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

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Liability Estimation

• Fair value doesnt mean simple discounting, but
  discounting at constantly varying market rates of
  interest and incorporating estimated market risk
  premiums.
• Louise Francis at last years CLRS summarized the
  techniques described by the CAS Fair Value Task
  Force in its August 2000 white paper (available
  on CAS site).

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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.

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Underwriting Performance

• How do successful companies measure underwriting
  performance for PC 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.

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Underwriting Performance

• What have combined ratio and underwriting income
  to do with investment returns?
• Nothing. Underwriters need to make a buck if
  theyre to have a margin to cover any mistakes.
• Cant you adjust combined ratios for investment
  income?
• Sure, but not for managing underwriting.

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Underwriting Performance

• Underwriting PC 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 doesnt 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).
• FASBs 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.

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Volatile Returns

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

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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.

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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 cant be achieved, the market will cause
  share prices to fall.

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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.

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Implications for Actuaries

• Given that fair value is the right answer
  according to all of these very smart accountants,
  shouldnt 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.

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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
  hasnt a good definition and conceptual framework
  already been adopted?
• Accounting standards setters have already devoted
  years of work to this issue.

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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 DONT TRADE! So liabilities dont
  have a relevant fair value.

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Liabilities Dont 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 Ive traded away my obligation to you.
  Go collect from the homeless guy (good luck).
  Ive just made 95 risk-free.

34
Liabilities Dont Trade

• There must be something wrong, you say, and
  youre right.
• The something wrong is the notion that
  liabilities trade.
• As weve just seen, if liabilities could trade
  all values in financial markets would crash to
  zero virtually instantaneously.

35
Liabilities Dont 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 dont trade.

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Again Conceptual Flaws

• If this is so clear, why isnt 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.

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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 youre 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.

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Again Conceptual Flaws

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

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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 theres a trade? The asset
  holder, of course. Buying back debt is just a
  typical asset trade, except that the purchaser is
  also the obligor.

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More Conceptual Flaws

• The illusion that liabilities trade is
  responsible for the purely goofy idea that
  liability valuation should reduce as an entitys
  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.

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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,
  theyre being treated like mathematical
  postulates. But a postulate that doesnt accord
  with reality creates a system that doesnt either.

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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 doesnt 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.

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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.

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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.

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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.

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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.