Fair Value White Paper Overview

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Fair Value White PaperOverview

• Ralph Blanchard

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CAS Task Force on Fair Value Liabilities

• Members
• Ralph Blanchard
• Bob Butsic
• Catherine Cresswell
• Louise Francis
• Aaron Halpert
• Phil Heckman
• Gerry Kirschner

Sarah Krutov Mike McCarter Gary Nickerson Stewart
Sawyer Ernest Wilson Bryan Young
Contributors David Appel, Paul Brehm, Roger
Hayne, Gary Josephson, Joe Lebens, Steve Lowe,
Glenn Meyers, Elizabeth Smith, Pat Teufel, Gary
Venter, COPLFR
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Overview

• What is Fair Value? Why?
• What does it mean for insurance?
• Why a CAS white paper?
• Goals of the white paper
• CAS white paper
• Format
• Previews of each section
• Findings
• Next steps

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What is Fair Value? Economic value - ideally
the market value, if a sufficiently active
market exists. Why the interest in fair
value? If accounting is not at economic
value, results are easy to manipulate via
buying and selling (e.g., Savings Loan crisis
of the 1980s)
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What does it mean for insurance?
If a sufficiently active market does not exist,
the fair value must be estimated. The biggest
items of interest to actuaries and insurance
investors that must rely on fair value
estimates. Loss reserves Unearned premium
(provision for unexpired risk) Items that
disappear. Deferred acquisition cost (DAC)
assets Premium deficiency reserves Open
issues. Renewals, other intangibles, credit
standing?
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What does it mean for insurance? - part 2
Whats involved in estimating a fair value?
present value of future expected cash flows,
adjusted for

• risk
• market imperfections
• similar factors if market-based information is
  availableto estimate those adjustments (FASB)

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Why a CAS white paper? Why now?
In December 1999, the FASB and the IASC issued
proposals calling for the reporting of insurance
liabilities at fair value. Both required comments
by May 31, 2000. CAS Leadership decided that the
research into fair value issues needed to be
expanded, in order to assist the AAA in preparing
a response to these proposals and any future
developments in this area. (The initial CAS
leadership focus was just the IASC proposal.)
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Why a CAS white paper? Why now? - part 2
FASB Preliminary Views - Financial Instruments
at Fair Value

• Focus is financial instruments
• Insurance defined as financial instrument,
  usually
• Comment deadline was May 31st
• http//www.rutgers.edu/Accounting/raw/fasb/new/ind
  ex.html

IASC Insurance Issues Paper

• Focus is insurance
• Discount all insurance liabilities
• Fair value insurance liabilities IF all other
  financial instruments at fair value
• Comment deadline was May 31st
• http//www.iasc.org.uk/frame/cen3_113.htm

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Goals of the white paper

• Aid in the AAA Fair Value Task Force responses to
• FASB
• IASC

Assist CAS liaison (Steve Lowe) to the
International Actuarial Association (IAA) and
their response to the IASC http//www.actuaries.or
g/Public/Committees/IASCI/indexe.htm
Become a general resource for CAS members and
other parties on this issue, relative to PC
insurance liabilities. (Primary audience is
actuaries.)
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CAS White Paper - Format
A. Background, including a definition and history
of fair value in general B. Fair Value in the
insurance context C. Alternatives to Fair Value
Accounting for p/c insurance liabilities D. Method
s for Estimating Fair Value E. Accounting
Presentation Issues, including alternative income
statement or balance sheet formats in a fair
value world. F. Implementation Issues
surrounding the fair valuing of p/c ins.
liabilities G. Accounting Concepts, or how well
fair value accounting and the issues discussed
in the earlier sections would be viewed in the
context of general accounting concepts (such as
reliability, relevance and representational faith
fulness). H. Credit Standing and Fair Value
Liabilities, a discussion of issues related to
the reflection of credit standing in determining
the fair value of liabilities. I. Professional
Readiness J. Summary and Observations K. Technical
Appendices
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CAS White Paper - Preview - Introduction

• Fair Value potential advantages
• Consistency with assets.
• Eliminate accounting arbitrage.
• Consistency with other financial instruments.
• Relevance.
• Fair Value potential disadvantages
• Difficulty in measuring.
• Greater estimation reliance.
• Volatility in earnings.
• Cost.
• Unintended or unexpected consequences.

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CAS White Paper - Preview - Alternatives to Fair
Value

• Undiscounted expected value
• Present value at a risk-free interest rate
• Present value using an industry-standard
  risk-adjustment
• Mixture of fair value and alternatives
• Entity-specific measurement
• Cost-accumulation measurement

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CAS White Paper - Preview - Methods
1 - CAPM 2 - IRR 3 - Single-period RAD
(Risk-Adjusted Discount) 4 - Methods Based on
Underwriting Data 5 - Actuarial
Distribution-Based Risk Loads 6 - Reinsurance
market prices 7 - Direct estimation of market
values 8 - Distribution Transform Method 9 -
Rule of thumb Methods Others?
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CAS White Paper - Preview - Presentation
What would a reserve development triangle
look like under a fair value system. Should
it include risk margins? Should it reflect
changes in interest rates?
CAS White Paper - Preview - Implementation
What properties should risk margins have?
Should they reflect process risk?
Should they reflect value additivity?
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CAS White Paper - Preview - Accounting Concepts

• The desired traits of an accounting system are
• Relevance
• Reliability
• Comparability and Consistency
• Neutrality
• Cost Benefit

CAS White Paper - Preview - Credit Standing
Should the fair value of a companys liabilities
reflect its credit standing?
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CAS White Paper - Professional Readiness

• Do actuaries currently have a theoretical
  understanding of fair value concepts adequate to
  estimate liabilities under a fair value standard?
• Are models currently available that can be used
  by actuaries to estimate fair value liabilities?
• Are actuaries prepared to implement these models
  and make these estimates in practice?
• What steps can the profession take to aid
  individual actuaries in implementing effective
  processes for fair valuation of insurance
  liabilities for their companies or their clients?

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CAS White Paper - findings
1) New requirement 2) Alternatives for fair
value 3) Expected value versus best
estimate 4) Multiple methods 5) Continuum from
pricing methods 6) Typical line/typical
company limitation of most current methods 7) A
fair value accounting standard would lead to new
research 8) When market prices and fair value
estimates are in conflict

• Market disequilibrium
• Market disruption
• Information asymmetry
• Significant intangibles

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CAS White Paper - findings Part 2
9) Implications of risk margin approaches
without value additivity 10) Susceptibility to
actuarial estimate 11) Increased reliance on
judgmental estimates in financials 12) Historical
comparisons 13) Gross vs. net. 14) Tax
issues 15) Credit standing reflection in valuing
liabilities 16) Actuarial workload
requirements 17) Professional Readiness 18) Standa
rds vs. Principles
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Next Steps
IASC

• Review comments (138 as of Aug. 23) this fall
• Draft Statement of Principles
• Final Statement of Principles
• Exposure Draft of Proposed International
  AccountingStandard
• International Accounting Standard (ETA of 2004?)

SEC

• Determine if statements filed under IASC
  standards will be accepted in U.S.
• Comment deadline on this question was May 15, 2000

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Next Steps - (part 2)
FASB

• Review comments
• Next steps?
• Committed to fair value of financial assets
• Would like to have fair value of financial
  liabilities

• AAA, IAA
• Monitor developments and respond accordingly
• Enhance comment writing/consensus building
  process

• CAS, SOA
• Continue research and educational efforts

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Speed of Accounting Pronouncements
The Boards Experience with Fair Value of
Financial Instruments...
The accounting profession, the SEC, bank
regulators, and some providers of financial
statement had urged the Board to deal with the
subject comprehensively because the existing
authoritative guidance was incomplete and
inadequate. resulted in ad hoc and inconsistent
reporting practices. In 1986, the board agreed
to undertake a major project on financial
instruments.
(from FASB Financial Accounting Series, No.
206-D/February 29, 2000, page 7) bolded font not
in the original text
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