International Accounting StandardsforInsurance Contracts
Fair Value Implications forProperty/Casualty Insurancein the United StatesCasualty Actuarial Society MeetingFair Value Accounting and the ActuaryNew Orleans - November 11, 2003 Robert Miccolis, FCAS, MAAACAS Representative to IAA Insurance Accounting Committees Subcommittee on International Actuarial Standards
Questions about Accounting DevelopmentsWhat is the IASB? (International Accounting Standards Board)What is an IFRS? (International Financial Reporting Standard)What is an IAS? (International Accounting Standard)Why is this important?What is the role of the FASB?Will US GAAP change?What will happen to regulatory STAT?What impact will this have on US actuarial work?When does this all happen?
Who is the IASB?The body that sets global accounting standards for all companies permitted or required to follow its standards
The European Community, as agreed by the EU Parliament, will require all listed companies in the EC to adhere to accounting standards set by the IASB starting in 2005.
A few countries currently are using IAS as their local accounting standard (with exceptions)
Accounting for Insurance ContractsThe IASB has been working on many aspects of reconciling accounting differences and advancing a consistent global approach across industries
The IASB Insurance Project regarding accounting for insurance contracts was started over 2 years ago
The focus is specifically on insurance contracts and not on insurance companies
Why is a global insurance accounting standard required?Common global insurance accounting practices are needed to eliminate differences that can be material
GAAP financial reporting can not rely on regulatory accounting, particularly for organizations with multi-national operations
Insurance contracts will no longer be excluded from international accounting standards
History and Looking Forward1997 Steering committee set up by the IASC1999 Issues paper2001 DSOP developed as precursor to Exposure DraftMay 2002 Project splits into 2 PhasesPhase 1 Exposure Draft 7/31/2003, comments 10/31/2003Final Phase 1 standard issued in 2004 for 2005 financialsFair Value disclosures in year end 2006 financialsPhase 2 implementation (fair value) by 2007 (sunset)
IASB Insurance Proposal: The Two Phase ApproachPhase 1 - interim solution - quick fixes to be in place by 2005common definition of insurancelimited and temporary dispensation from existing IFRSapplication of IAS 39, Financial Instruments, for contracts issued by insurers that fail the definition of insurancerequires significant disclosures about projected cash flows, types of insurance contracts, risk management, etc.
Phase 2 a standard for recognition and measurement issues for insurance contracts, including fair value
IASB Definition of Insurance ContractThe Phase I proposes a definition of an insurance contract as:a contract under which one party (the insurer) accepts significant insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary(other than an event that is only a change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar other variable).
A reinsurance contract is defined as: an insurance contract issued by one insurer (the reinsurer) to indemnify another insurer (the cedant) against losses on an insurance contract issued by the cedant
Guidance on the Definition of InsuranceThe meaning of significant insurance riskIf, and only if, it is plausible that an insured event will cause a significant change in present value of insurers net cash flowsEven if the insured event is extremely unlikelyEven if the contingent cash flows (for insured events) is a small proportion of the expected (probability-wtd) PV of all cash flowsHowever, there needs to be a plausible scenario that produces a non-trivial change in the PV of contract cash flows
For most property/casualty insurance contracts, there should not be an issue regarding this definition.Lack of risk transfer would be problem (not just reinsurance)
What is included in Phase 1?Financial contracts written as insurance (or reinsurance)IAS 39 applies to insurance products failing the definition of insurance but exposed to financial risk (not insurance or financial, then service contract)Changes to the valuation of insurance contracts are excluded from Phase 1Ceded reinsurance must be reported as an assetInsurance Liabilities Direct plus AssumedAssets include All Ceded Reinsurance RecoverablesReinsurance Assets discounting proposed
Phase 2 decisions Phase 2 to be developed upon these principles:Definition of insurance no change from phase 1Asset & Liability approach rather than Deferral and MatchingFair Value measurementIndependent valuation of Assets vs. LiabilitiesProfit at inception - no greater than zero
Impact on US P/C CompaniesPressure from financial regulators (SEC) and financial markets for a common global financial accounting reporting standards
Commitment of FASB and other accounting bodies for convergence of accounting standards
Europe & Australia will be first, then others (US) will follow due to global business and financial markets
Time to comment on fair value issues is right now
Changes to P/C Actuarial PracticeFair Value will be difficult to avoid
Impact on US P/C actuarial practice will depend onFASB view of timing to converge with IASBFASB plans relative to IASB exposure drafts and standardsViews of Insurance Regulators on avoiding 2+ sets of booksUS based insurers with European (or Australian)parents US based insurers with significant European operationsUS listed insurers who are also listed on EU/AU exchanges
Principles and standards have to be developed nowFair Value Issues papers by CAS, AAA and GIRO (2002)CAS research on fair value measurement (Sept. 03 Mar. 04)
Fair ValueThe main concern about IAS is that they require assets and liabilities to be valued at market value
Market value must be based on an active market with a high volume of transactions
In the absence of a market value, fair value is to be used, based on a valuation using appropriate methods
Such appropriate fair value methods or models should be based on observable market transactions
Highlights of Fair Value (Phase II)Discounting of P/C LiabilitiesReserves for unpaid loss and loss adjustment expensesReserves for unexpired risks (UPR)
Market Value Margins added to discounted liabilitiesReflects risk and uncertainty in reservesReflects market price (margin) for reserve riskReflects mark-up for transaction cost of selling reserves Credit risk adjustment (controversial)
Credit Risk Adjustment Liability adjustment for credit characteristics of the contractReflecting any government guarantees or legal preferences
Fair Value ConceptsFair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction. Fair value is measured, at the balance sheet date, as: the most probable price reasonably obtainable in the market, the best price reasonably obtainable by the seller, and the most advantageous price reasonably obtainable by the buyerKnowledgeable, willing parties both a willing buyer and a willing seller both reasonably informed about the characteristics of the asset, and the state of the market as of the balance sheet date.
Fair Value ConceptsThere is a presumption that an enterprise is a going concern without any intention or need to liquidate, curtail materially the scale of its operations or undertake a transaction on adverse terms.
Fair value is not, therefore, the amount that an enterprise would receive or pay in a forced transaction, involuntary liquidation or distress sale.
Fair Value - No active and liquid marketWhen there is not frequent activity in a market, the market is not well established or small volumes are traded, quoted market prices may not be indicative of the fair value of the instrument.
Estimation techniques may be used to determine fair value if there is sufficient reliability.
Techniques that are well established include reference to the current market value of another instrument that is substantially the same, such as discounted cash flow analysis and option pricing models
Fair Value ModelsFair Value Model needed to estimate valueNo active and liquid marketSmall volume market prices not indicative of fair value
Fair Value Model should have certain characteristics:Mimics market price behavior of an active marketCan be validated by observable market valuesModel assumptions are current and based on observable data
References to Credit (IAS 39)The discount rate equals the prevailing market rate of interest for financial instruments having substantially the same terms and characteristics, including the creditworthiness of the debtor, the remaining term.
Valuation techniques should incorporate the assumptions that market participants would use in their estimates of fair values, including assumptions about prepayment rates, rates of estimated credit losses, and interest or discount rates.
Reliability of Fair Value Estimates (IAS 39)Often, an enterprise will be able to make an estimate of the fair value of a financial instrument that is sufficiently reliable to use in financial statements.
The fair value of a fin