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Casualty Actuarial SocietyInsurance Accounting for ActuariesMay 17, 2005

Presented by: Kevin Wick, FCAS, MAAA

PricewaterhouseCoopers

Financial Reporting Context

“The most appropriate reserve within a range of actuarially sound estimates depends on … the financial reporting context in which the reserve will be presented.”

• Current Loss Reserving Principles


Financial Reporting Context

“The most appropriate reserve within a range of actuarially sound estimates depends on … the financial reporting context in which the reserve will be presented.”

• Current Loss Reserving Principles

“Loss reserves are utilized for a variety of purposes, including financial reporting, valuation, commutation and ratemaking.”

“The context in which loss reserves are presented may indicate elements to be reflected in the loss reserves.”• Proposed Loss Reserving Principles


Financial Statements

• Purpose is to communicate financial information to the users

• Standards established on how to account for various items

• Objective is to account for various items in accordance with standards

- reaction of users not relevant• A good financial statement is one

that accounts for all the items appropriately

- results may be good or bad


Current Accounting Standards for Loss Reserves

• “Best estimate” of the unpaid claim costs

• Basic consistency between GAAP and Statutory

• Conceptual framework for current guidance

- SFAS 5: Accounting for Contingencies (March 1975)


Key issues confronted when accounting guidance (SFAS 5) established

• Overall issue- “Accounting Accruals”

versus “Financial Decisions”• Specific contentions

1. Financial “protection” provided by accruals

2. Income fluctuation

3. Comparability of financial statements


“Accounting Accruals” versus “Financial Decisions”

“Accounting Accruals”• Simply a method of allocating

costs among accounting periods• No effect on an enterprise’s

cash flow

“Financial Decisions”• Choosing how to financially deal

with a contingency• Example includes “to buy first

dollar insurance coverage or be self-insured”

• FASB “…the presence or absence of an accrued credit on the balance sheet will have no effect on the consequences of that decision”


Contention 1: Financial “protection” provided by accruals

Contention• Accruals provide financial

“protection” similar to reinsurance• Without reserve margins,

enterprises will be forced to purchase insurance or reinsurance because they will not have the protection provided by the reserve margin


Contention 1: Financial “protection” provided by accruals

Contention• Accruals provide financial

“protection” similar to reinsurance• Without reserve margins,

enterprises will be forced to purchase insurance or reinsurance because they will not have the protection provided by the reserve margin

FASB Response• “accruals … in no way protect the

assets available ... to pay claims”• “Accrual, in and of itself, provides

no financial protection that is not available in the absence of accrual”


Contention 2: Income fluctuation

Contention• It is important to set aside

reserves to avoid reporting net income that fluctuates widely from period to period


Contention 2: Income fluctuation

Contention• It is important to set aside

reserves to avoid reporting net income that fluctuates widely from period to period

FASB Response• “Financial statement users have

indicated that information about earnings variability is important to them”

- Consider both “expected” return and “variability”

• “If the nature of the business is such that there are variations in periodic net income, that fact should not be obscured”


Contention 3: Comparability of financial statements

Contention• Regular periodic accrual of

losses, whether or not they have occurred, is justified on the grounds of comparability of financial statements- Self-insurance costs versus

insurance costs- Various amounts of

reinsurance purchased


Contention 3: Comparability of financial statements

Contention• Regular periodic accrual of

losses, whether or not they have occurred, is justified on the grounds of comparability of financial statements- Self-insurance costs versus

insurance costs- Various amounts of

reinsurance purchased

FASB Response• “to report activity when there has

been none would obscure a fundamental difference in circumstances between enterprises that transfer risks and others that do not”


Principles/Quotes underlying SFAS 5

• “The sole result of accrual, for financial accounting and reporting purposes, is allocation of costs among accounting periods”

• “The use of an accounting reserve does not reduce or eliminate risk”

• “Earnings fluctuations are inherent in risk retention, and they should be reported as they occur”

• “The Board cannot sanction the use of an accounting procedure to create the illusion of protection from risk when, in fact, protection does not exist”


What is the Financial Reporting Perspective?

“The consulting actuary continues to feel that conservative reserve margins are necessary because of the uncertainty in original reserve estimates due to the limited experience base, large potential swings in ultimate liabilities, and the Company’s relatively small total capital position”



Financial Reporting Perspective• Translation “The consulting actuary

seems to be having trouble distinguishing between funding for uncertain reserves versus financial reporting of uncertain reserves.”

“The consulting actuary continues to feel that conservative reserve margins are necessary because of the uncertainty in original reserve estimates due to the limited experience base, large potential swings in ultimate liabilities, and the Company’s relatively small total capital position”



“I know my reserve point estimate is well above all the indications from my methods. The 2004 loss year looks extremely favorable but the 2005 year is much worse. Lowering the reserves will just create large swings in their claim costs”



Financial Reporting Perspective• Translation “It is imperative that the

users of the financial statements be kept unaware of the risks this company is involved with”

“I know my reserve point estimate is well above all the indications from my methods. The 2004 loss year looks extremely favorable but the 2005 year is much worse. Lowering the reserves will just create large swings in their claim costs”



“I have some concerns regarding the various changes at the Company … I believe it is appropriate to be conservative at this time”



Financial Reporting Perspective• Is what this actuary “believes”

relevant? • Translation “I am ignorant of the

financial reporting standards my work is being used for”

“I have some concerns regarding the various changes at the Company … I believe it is appropriate to be conservative at this time”



“The reserves are presented both reasonably and conservatively…it is much more likely than not they will develop favorably…my actuarial judgment calls (used for deriving my BEST estimate) tended to be conservative…I can see your concern regarding the bias…my preference is to bring the estimates down over the next few years.”



Financial Reporting Perspective• Translation “I am going to help this

company misrepresent their financial statements, but mind you only for a few years. An added bonus on this approach is the company will be able to take advantage of tax deductions they are not entitled to”

“The reserves are presented both reasonably and conservatively…it is much more likely than not they will develop favorably…my actuarial judgment calls (used for deriving my BEST estimate) tended to be conservative…I can see your concern regarding the bias…my preference is to bring the estimates down over the next few years.”



“As long as a company maintains the same level of conservatism in their reserves, the income is not distorted”



Financial Reporting Perspective• Translation “it is okay to

misrepresent financial statements as long as you do it consistently”

• Why would you do this?

“As long as a company maintains the same level of conservatism in their reserves, the income is not distorted”



“Accounting tells the story, it does not write the story”



Financial Reporting Perspective• Translation “I can distinguish

between my role in financial reporting versus my role in making financial decisions”

“Accounting tells the story, it does not write the story”

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Documents

financial accounting

financial information

financial protection

accounting reserve

accruals contention

financial statements

accounting periods

income fluctuation contention