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© 2007 Towers Perrin 2
US GAAP for insurers is changing….
GAAP ClassicIncome statement focusComparability and consistency valued highly
New GAAPBalance sheet focusComparability and consistency decline in significance
© 2007 Towers Perrin 3
So what’s new?
SOP 05-1 – Internal Replacements
SFAS 157 – Fair Value Measurement
SFAS 159 – Fair Value Option
© 2007 Towers Perrin 4
SOP 05-1
Addresses accounting for internal replacementsInternal replacements defined as “modification in product benefits, features, rights or coverages”If contract modifications affect integrated features and the contract is substantially changed— existing DAC is written off— new DAC is set up for the replacement policyIf contract is substantially unchanged, then existing DAC is continued
© 2007 Towers Perrin 5
What is an integrated feature?
Benefit that can ONLY be determined in conjunction with the base policy
E.g., GMxB
Non-integrated features do not affect the base contract directly
E.g., term rider on annuitiesNon-integrated features do not affect the accounting for the base contract
© 2007 Towers Perrin 6
Criteria for substantial change
A policy is substantially unchanged if ALL of the following apply
No change in insured risk, event or coverage periodNo change in the nature of the investment rightsNo additional premium required (unless specified at contract inception)No net reduction in account valueNo change in participation featuresNo change in accounting classification
© 2007 Towers Perrin 7
SOP 05-1 – TPA clarifications
AICPA released TPAs to assist in interpretation of SOP
Main clarification is narrow interpretation of substantially unchanged for group contracts
Net result is that many large group writers were forced to reduce DAC
Some issue with GLBs on VAAddition of new GLB will typically result in a substantially changed contractSome uncertainty as to whether changing a GLB (e.g., from GMAB to GMWB) is a substantial change
© 2007 Towers Perrin 8
SFAS 157 - FASB Definition of Fair Value
In September 2006, FASB issued SFAS 157 – Fair Value Measurements
Defined fair value as exit valueEstablished a framework for calculating fair values for GAAP
For liabilities, fair value defined as:Price to transfer a liability in an orderly transactionbetween market participants at the measurement dateIn other words – current exit value
© 2007 Towers Perrin 9
FASB Definition of Fair Value
Orderly transaction presumes the transaction is exposed to the market for an appropriate period to allow for reasonable valuation (i.e., not a “fire sale”)
Market participants are defined as:IndependentKnowledgeableWilling and able to transactActive in the principal market— The market with the greatest volume and level of
activity for the liability— If no principal market, then the most
advantageous market to the seller is used
© 2007 Towers Perrin 10
Fair Value and Convergence
IFRS Phase 2 on insurance accounting requires fair value
Largely similar to SFAS 157 (current exit value)
Solvency II (European capital standard) also based on similar concepts
Norwalk Agreement and others indicate convergence in accounting between North America and Europe is coming
SEC pressure to “speed up” conversion
Fair values likely here to stay
© 2007 Towers Perrin 11
Valuation Techniques
SFAS 157 describes three applicable valuation techniques for calculating fair values
Market approachUses market prices and other relevant market information
Income approachUses discounted cash flows
Cost approachUses current replacement cost
Currently, expectation is that insurance liabilities will be valued using Income approach
© 2007 Towers Perrin 12
Applying the Income Approach
Projected cash flows
Time value of money
Allowance for risk
IFRS Phase 2 Building Blocks
© 2007 Towers Perrin 13
Projected cash flows
Underlying assumptionsShould be “consistent with market”Should consider all available information— Possible to use information outside standard
actuarial sourcesBest estimate?Prudence in assumptions?
Practical considerations indicate continued use of company experience studies for mortality, persistency
Expense assumptions an important consideration
© 2007 Towers Perrin 14
Time value of money
Reflecting the time value of money central to fair value concept
FASB defines US risk-free rate as based on treasury rates
Note that this is not prescribed for other currenciesSome areas (e.g., Europe) show preference for swap curve
© 2007 Towers Perrin 15
Allowance for risk
Under traditional methods (e.g., actuarial appraisals), risk is reflected through an addition to the discount rate
Addition may be based on application of CAPM— Financial theory suggests that this approach may
be overly simplistic
Under financial economics, cash flows adjusted for correlation with market
Risk-adjusted cash flows then discounted at risk-free rates
Overall intent is to reflect “market” compensation for bearing risk
Theory may suggest that only undiversifiable risk requires compensation
© 2007 Towers Perrin 16
Alternative Approaches
Direct MethodCalculate fair value directly by discounting policyholder cash flows
Indirect MethodCalculate fair value of shareholder cash flows (embedded value)Fair value of liabilities is difference between fair value of assets and embedded value
IFRS appears to favor Direct Method explicitly
Girard (2000) and others have shown equivalence of these two approaches
© 2007 Towers Perrin 17
Some technical issues to consider
Risk margins
Allowance for nonperformance
Treatment of options and guarantees
© 2007 Towers Perrin 18
Risk margins
As noted, allowance for risk at market levels is required
One method for allowing for nonfinancial risk is the cost of capital method
Proposed by the IAACalculate units of risk via required capital measure— Required capital measure may be regulatory or
economicCalculate margin per unit— Based on required “market” return on capital— Difficult to calibrate in real life— IAA examples use 4% and 6%
© 2007 Towers Perrin 19
Allowance for nonperformance risk
Nonperformance risk widely held to mean own-credit risk
Requirement is to reflect own-credit risk in liabilityEvaluation of credit risk for company’s specific rating classEvaluation of credit risk within classWill lead to a lower liability
Alternative view is that insurance liabilities are over-collateralized
Implies a higher rating than general debt
© 2007 Towers Perrin 20
Treatment of options and guarantees
Requires consideration of embedded options and guarantees beyond SFAS 133
Previously exempt components now within scope (e.g., GMDB, interest rate guarantees)
Current expectation is that all options and guarantees will be valued on a risk-neutral (market-consistent) basis
Will likely require stochastic techniques
© 2007 Towers Perrin 21
What does it mean for reporting entities?
Required determinationsUnit of account (most likely block)Principal market— M&A vs Reinsurance vs Capital MarketsValuation technique— Direct vs. IndirectLevel of inputs (for disclosures)— Insurance inputs almost certainly Level 3
© 2007 Towers Perrin 22
SFAS 159 – Fair Value Option
Permits entities to choose to measure most financial instruments at fair value
Optional only, no requirement to change accounting
Establishes disclosure requirements for reporting these fair values in financial statements
© 2007 Towers Perrin 23
SFAS 159 applies to most financial assets and liabilities
Statement defines financial liability as “a contract that imposes…an obligation…to deliver cash”
Appendix A clearly indicates that insurance and reinsurance contracts are included
Exemptions include:Deposit liabilities withdrawable on demand— May include certain Group Annuity business
accounted for under FAS 91FAS 87 and FAS 106 employer obligations
© 2007 Towers Perrin 24
There is a fair amount of flexibility…
Election is made on a contract-by-contract basisElection will be made on acquisitionElection is irrevocable (except for remeasurementevents, e.g. purchase)One-time opportunity at effective date to revalue inforce business
© 2007 Towers Perrin 25
…but significant disclosures are required
Reasons for electing the fair value option
Fair value component of each balance sheet line
Gains and losses in income statement due to changes in fair value
Valuation techniques, methods and significant assumptions used to estimate fair values
The level within the heirarchy which the fair values fallE.g., if most significant inputs are level 3, the fair value is classified as a Level 3 value
Reconciliation of beginning and ending balances for level 3 fair values
© 2007 Towers Perrin 26
Pricing Considerations
What GAAP measures are in use?GAAP profit marginGAAP ROE — both single measure and emergencePV of GAAP profits
Often used as a supplement to statutory pricing