Casualty Actuarial Society Practical discounting and risk adjustment issues relating to property/casualty claim liabilities Research conducted by PricewaterhouseCoopers Presented by Sam Gutterman, FCAS, FSA, MAAA IASB Board – February 15, 2005 PwC PwC

Outline Project objectives & specifications Measurement approaches Findings Significant issues

Research objectives Given a set of fair value principles, evaluate the effect of discounting and risk adjustment on loss and loss adjustment expense (LAE) claim liabilities of US property/casualty insurance companies Identify significant issues associated with discounting and risk adjustment in loss and LAE claim liabilities

Measurement objectives Active markets for claim liabilities do not exist Entity-specific experience was used Claim liability measurement components Undiscounted estimate of future payments Assumed undiscounted losses were estimated appropriately Discount for time value of money Margin for risk and uncertainty (“Market Value Margin” / “MVM”) Did not reflect correlation across lines of business No adjustment for own credit risk other than in aggregate cost of capital

Research specifications Used publicly available entity-specific loss data only Schedule P from US regulatory Annual Statements Lines of business studied Personal Auto Liability (shorter tail, although in some countries this coverage would be considered long tail) Workers Compensation (long tail – stable) Medical Malpractice, claims-made (long tail – volatile) Evaluated ten companies for each line of business

Measurement approaches Liability elements studied and measurement approaches evaluated Discount factor models Duration Matched to yield curve MVM models Development (Mack) method using standard deviations Stochastic simulation using standard deviations Stochastic simulation using percentile distribution Return on capital

Measurement calibration Calibrated to the Cost of Capital Method at calendar year-end 2002 Capital equal to US regulatory minimum Risk Based Capital requirement 10% target rate of return on capital for each company Arithmetic average of calibrations for 3 companies 1 large, 1 medium, 1 small

Findings – discounting

Findings – discounting Given a payment pattern, well-defined approaches are available In general, no significant differences between duration and matching approaches were identified Discounted results are affected by Interest rate fluctuations Shape of the yield curve Expected payment pattern and tail (time until claim resolution) Significant uncertainty can be associated with payment patterns In most cases, will be less than for amount of ultimate losses Will require additional calculations, but generally not onerous

MVM by company (increasing by size) Personal Auto Liability

MVM by company (increasing by size) Workers Compensation

MVM by method for one company Personal Auto Liability

MVM by method for one company Workers Compensation

MVM by company for one method Personal Auto Liability

MVM by company size Personal Auto Liability

Discounting & MVM by company Workers Compensation

Findings – MVM measurement Indications for MVMs varied, sometimes significantly By method, for a given company and year-end Over time, for a given company and MVM method The ranking of size of MVMs by method tended to vary over time No method was consistently the highest nor the lowest For smaller companies, MVMs tended to be larger (when measured as a percentage of claim liabilities)

Findings – effect on claims liabilities Personal Auto Liability FV claim liabilities were generally greater than undiscounted/non-risk adjusted claim liabilities Workers Compensation FV claim liabilities were generally less than or close to the undiscounted/non-risk adjusted claim liabilities Medical Malpractice claims-made We did not consider the results of our testing to be meaningful, as there was too much statistical variation in results Impact of moving to fair value of claim liabilities tended to be greater (due to larger MVMs) for smaller companies Based on the model calibrations

Findings – effect on incurred losses Current accident year incurred Fair Value losses were generally greater than undiscounted/non-risk adjusted losses Relativities affected by calibration benchmark applied Accident year FV liability development benchmark would not be zero Due to relative changes in discount and MVM Leveraged effect of changes in claim liability would likely increase volatility of incurred losses

Significant issues Modeling measurement Real data issues Measures of variation Releasing constraint of acceptance of booked claim liabilities as expected (unbiased) ultimate amount of losses will affect Expected payment and claim notification patterns Variability of experience in relation to expectations Variation from the tail/prior accident year bucket Affected by study period, level of aggregation and degree of homogeneity of claims selected Risk and variation inherent in certain claim liabilities are not be easy to analyze quantitatively (e.g. asbestos and environmental)

Significant issues MVM estimation Variety of approaches exist, but no single approach currently preferred or accepted Further professional research, guidance and education needed regarding acceptable methods and calibration procedures for calculating MVMs to obtain consistent and comparable results Single industry guideline for all lines of business and companies unlikely to be appropriate Calibration of MVM models Challenging Can significantly affect the results

Significant issues Financial statement presentation Based on currently available approaches, non-additivity of MVMs requires judgmental allocation among Accident years Lines of business Business units Accident year development disclosures may be confusing Development of prior claim liabilities would not necessarily be benchmarked to zero Component analysis of one-year development of prior year-end claim liabilities quite complicated Solution might be triangular analysis shown on an undiscounted, non-risk adjusted basis

Assessment of P&C actuarial methods Estimating undiscounted claim liabilities Good Discounting estimated future payments Estimating market value margins Developing Calibration of MVM methods Emerging