Download - CAS Casualty Loss Reserve Seminar
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CAS Casualty Loss Reserve Seminar
Fair Value Accounting
E. Daniel Thomas, PricewaterhouseCoopers LLP
Christina Gwilliam, Towers Perrin
Moderator
Don Rainey, Milliman
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Overview
• Brief history of fair value
• PwC paper
• Towers Perrin paper
• IFRS 4 update
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Brief history of Fair Value
• In the beginning, accounting was simple:
– Assets valued at historical cost – reliable, but not relevant
• Early 1980s -- Savings & Loans Crisis, banks were in trouble:– Sell assets where market value over book value– Keep assets where market value under book value
• Result was hidden insolvency
• Proposed solution – Fair Value accounting
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What is Fair Value?
“The price at which an asset or liability could be exchanged in a transaction between knowledgeable unrelated willing parties.”
Fair value hierarchy exists:1. Market value, if sufficient market exists; else2. Market value of similar items with active markets, adjusted
for differences; else3. Present value estimate of future cash flows, including an
adjustment for risk.
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Brief history of Fair Value
• 1990s – Capital markets became increasingly global
• Differing accounting standards are impediment to free flowing capital across borders, with perception of lack of transparency
• International Accounting Standards Board (IASB)
• The European Union wants consistency within its borders
• European Union has decided to move toward the IASB’s approach to accounting (i.e. Fair Value)
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Why should I care?
• You clearly should if you have a European parent
• But SEC is in favor of eventual consistency (“convergence”)– SEC controls U.S. GAAP for publicly owned companies– FASB also in favor of convergence
• FASB and IASB agreed not to introduce anything that furthers the gap to some joint work on the issue– FASB has unofficially agreed to join with the IASB in a
limited joint project on insurance contracts
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Practical applications
• Discussion at IASB has at times been theoretical and academic
• Life insurance industry wanted a “real world” test of fair value– IAA and ACLI teamed up to conduct such tests
• What about P/C Insurance? – In 2003, CAS sponsored research into practical applications
• PwC and Towers Perrin contributed to this research
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PwC Paper
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Outline of PwC Research
• CAS Project Objectives & Scope Exclusions
• Data
• Modeling Approaches
• Findings
• Significant Issues
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CAS project – objectives
• Evaluate impact of the application of fair value principles on U.S. insurance company loss and LAE reserves
• Identify significant issues associated with the usefulness of fair values in insurance company financial statements
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Research specifications
• Use publicly available data (e.g. Schedule P)
• 3 lines of business:– Personal Auto Liability (shorter tail)– Workers’ Compensation (long tail – stable)– Medical Malpractice, Claims Made (long tail – volatile)
• Measure impact of:– Discounting– Market risk load
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CAS project – scope exclusions
• Credit risk
• Adequacy of booked reserves
• Correlation adjustments across lines of business
• Impact of fair value on other balance sheet items
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Fair Value measurement
• Active trading markets for loss reserves do not exist
• Fair value measurement was based on models using market concepts:- Undiscounted estimate of future payments;- Discounted for time value of money, plus- Margin for risk and uncertainty (“Market Value Margin”
or “MVM”).
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PwC modeling approaches
• Discount Factor Models– Duration– Matched to yield curve
• MVM Models– Development method – standard deviation– Stochastic simulation – standard deviation– Stochastic simulation – percentile distribution– Return on Capital
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PwC modeling calibration approach
• Calibrated to Cost of Capital Method at year-end 2002
• Straight average of three companies (1 large, 1 medium, 1 small)
• All lines assume a 10% target rate of return on capital
ClassDevelopment Method
SD MultipleStochastic Method
SD MultipleStochastic Method
Percentile
Personal Auto Liability 1.2 2.0 90%Workers Compensation 1.0 1.5 92%Medical Malpractice 1.5 2.3 95%
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Discount factor models
Average discount factor by year for Personal Auto Liability
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
1998 1999 2000 2001 2002
Year
Dis
cou
nt
fact
or
Duration
Matched
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Findings – discount modeling
• Well-defined approaches are available.
• In general, we observed no significant differences between duration and matching approaches.
• Results can be affected by interest rate fluctuations and shape of the yield curve.
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MVM by company – personal auto liability
MVM by Company at Year-End 2002
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0 2 4 6 8 10 12
Company
MV
M %
ROC MVM
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MVM by method for one company– personal auto liability
MVM by Method - Company C(M)
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
1998 1999 2000 2001 2002Year-End
MV
M %
Develop SD
Stoch SD
Percentile
ROC
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MVM by company size - personal auto liability
MVM for All Companies and All years
0%
10%
20%
30%
40%
50%
60%
70%
0 200,000 400,000 600,000 800,000 1,000,000
Reserves ($000)
MV
M (
%)
MVM vs.CompanySize
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MVM by company– workers’ compensation
MVM by Company at Year-End 2002
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0 2 4 6 8 10 12
Company
MV
M %
ROC MVM
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Findings – MVM modeling
• Indications for MVM varied, sometimes significantly:– by method, for a given company and year-end;– over time, for a given company and MVM method.
• The ranking of MVM’s by method tended to vary over time:– No method consistently was the highest nor the lowest.
• For smaller companies, the MVM tended to be larger (measured as a percentage of the loss reserves)
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Findings – Fair Value impact on balance sheet (loss reserves)
• Personal auto liability: FV reserves were generally greater than U.S. GAAP reserves
• Workers’ compensation: FV reserves were generally less than or close to the U.S. GAAP reserves
• Medical malpractice claims-made: We did not consider the results of our testing to be meaningful.
• Impact of moving to fair value reserves tended to be greater for smaller companies (i.e., higher MVM charge).
Based on the model calibrations
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Findings – Fair Value impact on income statement (incurred losses)
• Under FV, prior accident year development may not be benchmarked to zero (due to relative changes in discount and MVM).
• Leveraged impact of reserve changes would likely increase volatility of incurred losses.
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Significant issues - modeling
• Dealing with real data
• Measures of variation– The constraint to accept booked reserves as mean of
distribution impacts: Expected payment and reporting patterns Variability of experience in relation to expectations
– Variation from the tail/prior accident year bucket– Variation for certain liabilities not amenable to statistical
analysis (e.g. asbestos & environmental)
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Significant issues - MVM estimation
• Variety of approaches exist, but no single approach universally preferred or accepted.
• Professional guidance may be needed on acceptable methods or calibration procedures for calculating MVM’s to gain industry practice consistency.
• Single industry guideline for MVM calculation unlikely to be appropriate.
• Calibration of MVM models can be challenging and will significantly affect the results.
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Significant issues - financial statement presentation (1)
• How should accounting standards treat the 3 elements of fair value reserves:– As flowing through the income statement or as a direct
charge to surplus?
• Any presentation separating current and prior accident year contributions may require MVM allocation judgments:– MVM’s are statistically non-additive, so any split by
accident year may require allocation judgment.– Judgments may also be required for disclosures by
business unit or line of business.
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Significant issues - financial statement presentation (2)
• The required disclosure for prior accident year development may become confusing.
–One-year development of prior reserves would not necessarily be benchmarked to 0.
–Disclosure of the components of one-year development of prior year-end reserves could be quite complicated.
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Assessment of P/C actuarial methods
Estimating undiscounted reserves: GOOD
Discounting estimated future payments: GOOD
Estimating market value margins:DEVELOPING
Calibration of MVM methods: EMERGING
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Towers Perrin Paper
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Background to IFRS 4
• Work of the IASB– 2002: Split Phase I (2005) / Phase II (2008?)– 2004: IFRS 4
• European Union has said IFRS is compulsory for stock exchange listed companies from January 1, 2005
• International Financial Reporting Standards (IFRS) address 3 major questions in the arena of insurance accounting:– What is an insurance contract?– What do you have to disclose?– How do you measure insurance contracts? – Phase II
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Phase I – IFRS 4
• Product classification
• Catastrophe and equalization provisions prohibited
• Restrictions on changes to accounting policies
• Requirement for liability adequacy testing
• Impairment of reinsurance
• Disclosure
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Phase II
• Currently undecided if Fair Value will be basis for Phase II (2008)