Quality In Everything We Do International Financial Reporting Standards Applied to Property and Casualty Insurance presented to OCCA by Jim Christie November 2004

2 Quality In Everything We Do  Cross-border capital flows highlight the need for consistent, understandable financial information BUT insurance accounting has significant local variations  The International Accounting Standards Board (“IASB”) is developing a single set of global accounting standards  Many countries committed to the objective of global “harmonisation”  Drivers for new approach  Historical cost accounting models lack relevance  Solvency-based approaches do not provide an accurate picture of financial performance  Convergence of banking and insurance industries Background

3 Quality In Everything We Do  A phased approach to insurance contracts.  Objective for Phase I is to implement some components of the insurance project by 2005, without delay to Phase II. Phased approach for insurance IAS INSURANCE PROJECT IAS INSURANCE PROJECT Phase I – Implement by 2005 Phase II – Implement Fair Value by 2007 / 8 (?)

4 Quality In Everything We Do Property & Casualty – Phase 1 Key Phase I Issues  Defining Insurance  Accounting for insurance contracts  Disclosures

5 Quality In Everything We Do Definition of Insurance  A contract under which the insurer accepts significant insurance risk by agreeing to compensate the beneficiary if the insured event adversely affects the policyholder (Insurance Contracts (Phase I) paraphrased with emphasis added)  Significant means at least one scenario with payment of commercial substance with an amount that is not trivial

6 Quality In Everything We Do  Financial risk is risk of possible future change in specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable  Insurance risk is risk from contingent events other than financial risk If both financial risk and significant insurance risk are present, contract classified as insurance Insurance vs Financial Risk

7 Quality In Everything We Do Insurance Contract Accounting  During Phase I, existing accounting policies apply with certain modifications  Prohibited – certain accounting policies are prohibited as they do not meet the IFRS framework  Mandated – certain accounting policies must be implemented if they are not already in the existing accounting policies  Allowed to continue, but not start – certain accounting policies that do not meet the IFRS framework can continue, but cannot be implemented.  Can be started – certain accounting policies can be introduced.  Existing accounting policies are those in the primary financial statements

8 Quality In Everything We Do PROHIBITED accounting policies  The following policies are prohibited  Catastrophe provisions  Claim equalisation provisions  Offsetting of reinsurance assets and direct liabilities

9 Quality In Everything We Do MANDATED accounting policies  The following policies are mandated if not already present  Liability adequacy testing  Impairment of reinsurance assets

10 Quality In Everything We Do Liability Adequacy Test  Current liability adequacy test applies IF 1. Test at each reporting date using current estimates of future cash flows, AND 2. If these are greater than current liability, liability is increased and deficiency flows through profit and loss

11 Quality In Everything We Do IMPAIRMENT of reinsurance assets  Reinsurance asset is reduced and reduction flows through income statement if it is impaired  Reinsurance asset is impaired if:  Objective evidence of an event after initial inception that the cedant may not receive all amounts due  The impact of the event can be reliably measured  Impairment may be reversed

12 Quality In Everything We Do Accounting policies that may CONTINUE  The following policies may continue but companies may not switch to these if they are not already in use  Undiscounted liability basis  Deliberate overstatement of liabilities  Deferred acquisition costs approach

13 Quality In Everything We Do Accounting policies that may be STARTED  The following accounting policies may be started, subject to certain restrictions  Use of current market discount rates  Use of shadow accounting  Use of asset based discount rates

14 Quality In Everything We Do Phase I Insurance disclosure requirements IFRS 4 has two high level principles: Principle 1 – Explanation of recognised amounts Principle 2 –Amount, timing and uncertainty of cash flows  Implementation guidance - runs to 61 paragraphs – but does not create additional requirements! Fair Value Disclosure for insurance contract assets and liabilities

15 Quality In Everything We Do Principle 1 - EXPLAIN  Accounting policies  Amounts  Assumptions  Changes in liabilities  Gain or loss on buying reinsurance

16 Quality In Everything We Do Principle 2 – CASH FLOWS  Terms and conditions  Segment information  Risk management policies & objectives  Insurance risks covered  Run off triangles (claim development)  Other risks

17 Quality In Everything We Do PHASE 2  PHASE 2 (in 2007?)

18 Quality In Everything We Do  Scope – all insurance contracts  Based on asset/liability model, rejecting current deferral/matching model  Where liabilities are independent of asset returns, unless  Policyholder benefits directly related to asset returns; e.g, linked products  Intended to be consistent with IAS 39 Phase 2

19 Quality In Everything We Do  Proposed  Move to “underwriting year” accounting, thus no smoothing of results with UPR and DAC  Liabilities measured at Fair Value  Issues  Extra volatility of the insurance result  Potential changes to the IT systems  Loss ratios for new products to be estimated from day one  Re-engineering of claim reserving process  Reserves for expenses  Gain or loss at issue  Renewals/Future Premiums  Proposed  Move to “underwriting year” accounting, thus no smoothing of results with UPR and DAC  Liabilities measured at Fair Value  Issues  Extra volatility of the insurance result  Potential changes to the IT systems  Loss ratios for new products to be estimated from day one  Re-engineering of claim reserving process  Reserves for expenses  Gain or loss at issue  Renewals/Future Premiums Accounting Basis

20 Quality In Everything We Do  Proposed  Discounting of reserves will become mandatory  Discounting at risk free rate, plus a spread for credit, and MVM’s  Valuing options and guarantees  Impact  Projection of expected cash flows  Selection of suitable economic assumptions consistent with market data  Need to consider all future events including legislation and technology  Re-engineering of the actuarial reserving process  Proposed  Discounting of reserves will become mandatory  Discounting at risk free rate, plus a spread for credit, and MVM’s  Valuing options and guarantees  Impact  Projection of expected cash flows  Selection of suitable economic assumptions consistent with market data  Need to consider all future events including legislation and technology  Re-engineering of the actuarial reserving process Discounting

21 Quality In Everything We Do  Proposed  Reserves will require a market value margin consistent with observed market risk preferences  Market value margin incorporated either  by adjusting discount rates OR  By adjusting cashflows  Consider both diversifiable and non diversifiable risks  Impact  Need to develop suitable approach and discounting assumptions  Need for enhanced disclosures  Proposed  Reserves will require a market value margin consistent with observed market risk preferences  Market value margin incorporated either  by adjusting discount rates OR  By adjusting cashflows  Consider both diversifiable and non diversifiable risks  Impact  Need to develop suitable approach and discounting assumptions  Need for enhanced disclosures Market Value Margins

22 Quality In Everything We Do  Future premiums only included where  Uncancelable continuation or renewal rights constraining insurer’s ability to re-price; and  Rights lapse if the policyholder ceases premiums  No net gain at inception (ignoring indirect costs) unless market evidence  Same derecognition rules used for financial assets and liabilities will apply to insurance  Reflect all guarantees and options Other Fair Value Issues

23 Quality In Everything We Do 1) Model Risk  the risk that the wrong model was used to estimate the insurer’s liabilities 2) Parameter Risk  the risk of misestimating the parameters for the model used to estimate the insurer’s claim liabilities 3) Process Risk  the risk that remains due to random variation, even if the correct model and the correct parameters are used to estimate the insurer’s claim liabilities Types of Estimation Risk

24 Quality In Everything We Do  IAS Draft Statement of Principle 5.4 :  “The entity-specific value or fair value of an insurance liability or insurance asset should always reflect both diversifiable and non-diversifiable risk.”  This implies that model risk, parameter risk, and process risk should be modeled. What of risks does MVM include?

25 Quality In Everything We Do However …  IAS Draft Statement of Principle, Section 5.10 :  while it is “conceptually preferable” to reflect parameter risk and model risk, “it is appropriate to exclude such adjustments unless there is persuasive evidence that enables an insurer to [quantify] them by reference to observable market data.”

26 Quality In Everything We Do  The Fair Value of policy liabilities reflects the risk preferences of the insurance market.  What is the insurance market’s risk preference?  The 60 th percentile of the distribution?  The 75 th percentile?  The 95 th percentile?  IAS Draft Standard of Principles: the risk preference is “inevitably subjective” (Section 5.29)  The Fair Value of policy liabilities reflects the risk preferences of the insurance market.  What is the insurance market’s risk preference?  The 60 th percentile of the distribution?  The 75 th percentile?  The 95 th percentile?  IAS Draft Standard of Principles: the risk preference is “inevitably subjective” (Section 5.29) What is the market’s risk preference?

27 Quality In Everything We Do 1) Canadian Provision for Adverse Deviation  Includes Parameter Risk & Model Risk 2) Initial Expected Profit Margin  Process Risk, Parameter Risk, & Model Risk 3) Poisson Frequency / Lognormal Severity Simulation  Process Risk 4) Mack’s Approach  Process Risk, Parameter Risk, & potentially Model Risk Some practical techniques to model the MVM

28 Quality In Everything We Do Canadian Provision for Adverse Deviation (PFAD)  Three components to Provision for Adverse Deviation: 1. Claims Development (2.5% to 15% of discounted gross liabilities) 2. Discount Rate (50 to 200 basis points on interest rate) 3. Reinsurance Recovery (0% to 15% of discounted ceded claim liabilities)  The MVM could be set equal to the claims development PFAD.  The PFAD does not attempt to model process risk (i.e. size of the company is not considered when determining the PFAD).

29 Quality In Everything We Do  If insurance markets are efficient, the DSOP suggests there should be no gain at issue  Consequently if a profit is indicated at issue, any theoretical MVM should be scaled so that the result is simply breakeven  Are P&C insurance markets efficient?  Are there situations where a gain at issue would be permitted? Initial Expected Profit Margin

30 Quality In Everything We Do Frequency / Severity Simulation  Determine the distribution of loss reserves using a Monte Carlo approach  Frequency often assumed to be Poisson distributed  Severity often assumed to be lognormally distributed  Data requirements:  Pending counts (ultimate counts – closed counts)  Unpaid Claims (case + IBNR)  Coefficient of Variation for severity (can be based on historical or industry data)

31 Quality In Everything We Do Mack Method  Mack Method can be applied to:  Paid Losses  Incurred Losses  Historical Recorded Ultimate Losses Source: Measuring the Variability of Chain Ladder Estimates by Thomas Mack

32 Quality In Everything We Do Conclusions on MVM  Many judgments required under IFRS 4 requirements: 1) Should one include parameter & model risk in MVM? 2) How should the risk preference of the market be measured? 3) What approach should be used to model the MVM? 4) Given that you have selected an approach, how should you select your MVM?

33 Quality In Everything We Do Questions