1 September 2005 Fair Value Accounting CAS Casualty Loss Reserve Seminar September 2005 E. Daniel Thomas, PricewaterhouseCoopers, LLP Emmanuel Bardis, Towers Perrin Moderator Chris Nyce, KPMG LLP

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 2 September 2005 Overview of the Session 1. Background on Fair Value 2. PwC Approach 3. Towers Perrin Approach 4. Update on IFRS 4 Current Events

3 September 2005 Fair Value Background

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 4 September 2005 Definition of Fair Value Assumptions based on a hypothetical transaction between marketplace participants Buyer-specific synergies excluded Where prices in active markets for identical or similar assets are not available, valuation techniques are used In-use or in-exchange valuation premise, based on highest and best use for asset “The price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties.”

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 5 September 2005 Why “Fair Value” Rooted in S&L crisis Incentive to sell undervalued assets and keep overvalued assets Led to insolvency Solution-Value assets at market No incentive to buy or sell for accounting reasons Leads to question related to P&C Loss Reserves Does fair value give this intended advantage if no active market exists

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 6 September 2005 Background – Fair Value Practical interpretation of definition of Fair Value Market Value, if a sufficiently active market exists Estimated Market Value, otherwise Possible approaches to estimating market value Similar transactions Risk adjusted present value of cash flows Accounting guidance gives a hierarchy of alternatives Priority is given to market prices for identical or similar assets, where available Emphasizes the use of market inputs Multiple valuation approaches should be considered

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 7 September 2005 Fair Value Liquidation Value “Going Concern” Basis - “Stand Alone” Value “Strategic” or “Investment” Value Bargain Hunter Financial Buyer Strategic Buyer Lower Higher Value Fair Value - including Market Participant Strategies Marketplace Participant

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 8 September 2005 When Fair Value for Property Casualty Loss and Loss Expense Reserves may be Required Under GAAP, when a business combination has occurred (FAS 142) Under International Financial Reporting Standards (IFRS), phase II implementation for insurance contracts As part of a holding company evaluation of possible impairment of an insurance reporting unit Under GAAP, (FIN 45) for all companies (including non-insurers) for certain contingent contractual obligations entered into after 12/31/2002

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 9 September 2005 Approaches to Fair Valuing Loss and Loss Expense Reserves If possible, use a comparable market transaction But this is expected to be rarely possible, if ever Some reserve transfers have taken place, but rarely motivated by “normal business considerations” when “neither is acting under compulsion”, i.e. often an element of distress in one of the parties Usually these contracts transfer only a minimal amount of risk, so the problem of fair value of the residual risk remains Few bidders are usually available Insurance liability portfolios are not homogeneous, comparable transactions are unusual Information on the liabilities is usually asymmetric, seller has more knowledge Especially lately, extensive legal scrutiny of these transactions are changing the nature and availability of bidders Often, a seller cannot divest the legal obligation for the liabilities, and remains at least contingently liable

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 10 September 2005 What is the Impact of Fair Value Applied to Loss Reserves to P&C Companies It’s unclear Differing approaches and assumptions can get to different answers No current guidelines as to how to do this Diversity of situations in different countries How to change or amortize is unclear 2003: CAS sponsors research into how this might work PwC, Towers answer the call

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 11 September 2005 PwC Paper

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 12 September 2005 Outline of PwC Research CAS Project Objectives & Scope Exclusions Data Modeling Approaches Findings Significant Issues

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 13 September 2005 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

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 14 September 2005 CAS 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

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 15 September 2005 CAS scope exclusions Credit risk Adequacy of booked reserves Correlation adjustments across lines of business Impact of fair value on other balance sheet items

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 16 September 2005 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”)

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 17 September 2005 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

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 18 September 2005 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

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 19 September 2005 Discount factor models

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 20 September 2005 Findings – discount factor 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.

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 21 September 2005 MVM by company – personal auto liability

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 22 September 2005 MVM by method for one company – personal auto liability

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 23 September 2005 MVM by company size - personal auto liability

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 24 September 2005 MVM by company– workers’ compensation

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 25 September 2005 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 or the lowest. For smaller companies, the MVM tended to be larger (measured as a percentage of the loss reserves)

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 26 September 2005 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

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 27 September 2005 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.

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 28 September 2005 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)

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 29 September 2005 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.

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 30 September 2005 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.

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 31 September 2005 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 zero Disclosure of the components of one-year development of prior year-end reserves could be quite complicated

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 32 September 2005 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

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 33 September 2005 Towers Perrin Paper

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 34 September 2005 Research Approach Database GAAP adjustments Discounting Market Risk Margins Impact on reported financial results Conclusions Reliability Relevance

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 35 September 2005 Database Schedule P and the Insurance Expense Exhibit (IEE) 20 company groups selected representing market shares of 60% for Personal Auto Liability 50% for Medical Professional Liability 25% for Workers Compensation

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 36 September 2005 Convert Statutory Annual Statement information into Current GAAP Deferred policy acquisition cost (DPAC) asset estimated Policy acquisition ratio averaged 10% for Medical Professional Liability 15% for Workers Compensation 17% for Personal Auto Liability Remove Non-Tabular discounts Non-Tabular discounts present in 4 Workers Compensation insurer 3 Medical Professional Liability insurer 1 Personal Auto Liability insurer Tabular discounts could not be effectively removed due to data limitations

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 37 September 2005 Discounting Interest rates Risk-free rate US government securities Payout patterns Company specific supplemented by industry Wide variations in average-time-of-payment across companies Slight shifts over time, more pronounced for Medical Professional Liability

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 38 September 2005 Derived payment patterns for discounting vary by company

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 39 September 2005 Derived payment patterns also vary over time

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 40 September 2005 The impact of discounting varies with the level of interest rates

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 41 September 2005 We inferred the Market Risk Margin from historical margins observed in the insurance market Observe Normative Insurance Pricing Margins Observe Amount of Insurance Market Risk Empirically observed market price per unit of insurance risk Measure Amount of Risk in Claim Liabilities Derive Risk Margin for Claim Liabilities Margin reflecting entity-specific amount of risk in claim liabilities

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 42 September 2005 Ex-post market economic pricing margins vary over time, reflecting the cycle and interest rates

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 43 September 2005 The pricing cycle is different in Workers Compensation, and the cycle amplitude is larger

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 44 September 2005 The amplitude is greatest for Medical Professional Liability, and the long-term average margin is low

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 45 September 2005 We measured pricing volatility across companies as well as over time

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 46 September 2005 We selected pricing risk margins via a simple risk-return framework

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 47 September 2005 The margins produced by the two methods are different, and also vary over time

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 48 September 2005 Market risk margins vary by company

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 49 September 2005 Reserve Risk Margins also by size of company

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 50 September 2005 Fair values by component element

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 51 September 2005 Calendar Year In addition to balance sheet effects, we also analyzed the impact on income statements

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 52 September 2005 By one measure, fair value doesn’t improve the transparency of income

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 53 September 2005 Conclusions Reliability: open question regarding the reliability of the estimation of discounts and market risk margins Payment patterns are entity specific Pricing risk margins are based on volatile data Stochastic methods that measure reserving risk produce different results Relevance: the preparation of Fair Value estimates is complex and will require considerable education of actuaries and others.

54 September 2005 Fair Value Accounting and IFRS

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 55 September 2005 IFRS Background Situation prior to IFRS Many different accounting rules in many jurisdictions Difficulties in comparing results between insurers Creates a barrier to capital flows between jurisdictions Insurance project started in issues paper Draft Statement of Principals followed 2002 project split into phase I and phase II 2004 IFRS 4 promulgated as implementation to phase I Implementation in many jurisdictions (EU) 1/1/2005 Goal of Phase I interim improvements in accounting for insurance contracts Require filers to disclose information about those contracts

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 56 September 2005 Provisions of Phase I that may affect Reserves Separate and separately test gross liabilities and ceded reinsurance Gross liabilities subject to liability adequacy test Reinsurance assets subject to impairment test Does not permit Catastrophe or Equalization reserves Defines insurance contracts Adds disclosure requirements Amounts in financial statements that arise from insurance contracts Amount, timing, and uncertainty of future cash flows Introduces rules around changes in accounting policy

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 57 September 2005 Phase I Provisions on Changes in Accounting Policy Disallows changes in accounting policy is it makes results an less relevant or any less reliable Allows if current practice but bans introduction of: Undiscounted reserves But a rebuttable presumption that introducing future investment margins makes accounting less relevant and reliable Non-uniform accounting policies in subsidiaries Measuring insurance liabilities with excessive prudence

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 58 September 2005 What About Phase II “Past work is a useful resource, but we are not bound by it”- Starting anew Fair Value model to be evaluated along with others Timelines have pushed out (per 1/2005 project plan) Discussion paper: end 2005 or later Exposure draft: mid 2007 or later Final standard mid 2008 or later Implementation ??? Broad industry participation CAS study presented to working group-February 2005

C:\Documents and Settings\bardise\Desktop\FV CLRS Sept 11-12\CLRS 2005 FV Panel Combined Ver2.ppt 59 September 2005 What About US GAAP Addressed on project under “convergence” IASB (primarily) produces discussion paper IASB and FASB publish paper for comment Joint project follows with objective of a “identical or substantially similar” standard Canadian CASB approves project aimed at following suit