Copyright © 2004 by the American Academy of Actuaries CLRS Casualty Loss Reserve Seminar September 13-14, 2004 Implications of New International Accounting Standards for Insurance Companies

Copyright © 2004 by the American Academy of Actuaries CLRS NEW ACCOUNTING RULES WILL APPLY 2005 for IFRS reporting companies. EU-listed companies and the Caribbean. Australia - possible early adoption. FASB has stated intention to converge GAAP with IFRSs US GAAP changes not that far off

Copyright © 2004 by the American Academy of Actuaries CLRS Contributors to Presentation Burt Jay, FSA, MAAA AAA VP - Financial Reporting AAA Representative to IAA Standards Subcommittee Dave Congram, ASA, FCIA, FIA Canadian Task force to develop process to implement IAA standards in Canada Author, several IAA Exposure Drafts Bob Miccolis, FCAS, MAAA CAS Representative to IAA Standards Subcommittee Chairman, ASB Casualty Operating Committee Member, IAA Standards Drafting Group

Copyright © 2004 by the American Academy of Actuaries CLRS Why is a global insurance accounting standard required? Common global insurance accounting needed to eliminate differences that can be material GAAP financial reporting cannot rely on regulatory accounting, particularly for multi-nationals Insurance contracts will no longer be excluded from international accounting standards IASB has been reconciling accounting differences towards a consistent global approach across industries

Copyright © 2004 by the American Academy of Actuaries CLRS Primary International Standards Affecting Insurance Companies IFRS 4, adopted March 2004 (effective 1 st qtr 2005 for companies reporting under IAS/IFRS) IAS 32 and 39, Amended December 2003 (Financial Instruments) Existing IAS 18 Revenue (Service Contracts)

Copyright © 2004 by the American Academy of Actuaries CLRS PRIMARY PROVISIONS OF IFRS 4 Applies to Insurance Contracts—must have “significant insurance risk” to use IFRS 4 IFRS 4 allows insurance contracts to be accounted under local GAAP, with certain restrictions (no CAT or equalization reserves) Liability adequacy test required

Copyright © 2004 by the American Academy of Actuaries CLRS WHAT ABOUT NON-INSURANCE CONTRACTS Contracts issued by insurance companies that do not meet definition of insurance are considered to be either financial instruments (investment contracts) or service contracts

Copyright © 2004 by the American Academy of Actuaries CLRS SERVICE CONTRACTS Generally, contracts that are neither insurance contracts or financial instruments (investment contracts) are service contracts Claim service contracts (ASOs) Self insurance (basic risk financing) Deductibles Service component of a financial instrument (investment contract), or an insurance contract, may have to be separated Covered by IAS 18

Copyright © 2004 by the American Academy of Actuaries CLRS IAA Actuarial Standards Exposure Drafts Actuarial Practice Contract Classification Measurement Liability Adequacy Testing Changes in Accounting policy Embedded Derivatives Discretionary Participating Features Current Estimates Disclosure Reinsurance Stochastic Models International Actuarial Practice Guideline IAPG (IAA Class 4 Standard)

Copyright © 2004 by the American Academy of Actuaries CLRS IAA Exposure Draft - Actuarial Practice Specific guidance Disclosures Scope and adequacy of Professional Services Accounting requirements a)Classification b)Unbundling and Embedded derivative separation c)Measurement d)Participation e)Liability Adequacy Test f)Accounting Disclosure Relevant Knowledge Material Inconsistencies General guidance

Copyright © 2004 by the American Academy of Actuaries CLRS IAA Exposure Draft - Classification Paper Significant insurance risk IFRS 4 Insurance Contains service elements Contains Discretionary Participation Feature? IAS 18 Service Contract Measurement Create financial assets or liabilities? Embedded Derivative Test No Yes Deposit Component Yes Tests Yes No Service Element Financial Instrument IAS 39 Financial Instrument Measurement Tests Financial Instrument

Copyright © 2004 by the American Academy of Actuaries CLRS IAA Exposure Draft - Measurement Paper Measurement approaches addressed Amortized Cost model Fair Value model Stage of completion Structure Approach Models and assumptions Updating Accounting Constraints

Copyright © 2004 by the American Academy of Actuaries CLRS Revised IAS 39: Measurement Financial Instrument Amortized Cost Fair Value Entire Contract Options and Guarantees considered Contains Embedded Derivatives Fair Value Option Pricing Models Amortised Cost Option Pricing Models Financial Markets Valuation Technique Market Calibration Derivative Host YES NO Election Held for Trading YES NO

Copyright © 2004 by the American Academy of Actuaries CLRS Other IAA Practice Guidelines Liability Adequacy Testing Changes in Accounting policy Embedded Derivatives Discretionary Participating Features Current Estimates Disclosure Reinsurance Stochastic Models

Copyright © 2004 by the American Academy of Actuaries CLRS Property/Casualty Insurance Accounting Classification – retroactive risk considered insurance; no special risk transfer rules for ceded reinsurance Ceded Reinsurance – valued separately as an asset Unbundling – only required if deposit obligations not fully recognized Liability Adequacy Testing – Premium Deficiency Reserve – if no existing test, level of aggregation is broadly similar risks managed as a portfolio Changes in Accounting policy – only if “improvement” no less reliable, no less relevant

Copyright © 2004 by the American Academy of Actuaries CLRS Property/Casualty Insurance Accounting Embedded Derivatives – certain types of contracts, particularly reinsurance, that include index triggers may be affected Current Estimates – needed for liability adequacy test, changes in accounting policy Disclosure – several difficult and very broad requirements Reinsurance asset impairment – not based on reinsurer ratings

Copyright © 2004 by the American Academy of Actuaries CLRS Changes to P/C Actuarial Practice Impact on US P/C actuarial practice will depend on FASB view of timing to converge with IASB FASB plans relative to IASB exposure drafts and standards Views of Insurance Regulators on avoiding 2+ sets of books US based insurers with European (or Australian) parents US based insurers with significant European operations US listed insurers who are also listed on EU/AU exchanges Disclosure – several difficult and very broad requirements Some version of Fair Value will be difficult to avoid

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value The main concern about IAS is that they require assets and liabilities to be valued at market value Market value must be based on an active market with a high volume of transactions In the absence of a market value, fair value is to be used, based on a valuation using appropriate methods Such appropriate fair value methods or models should be based on observable market transactions

Copyright © 2004 by the American Academy of Actuaries CLRS Highlights of Fair Value (Phase II) Discounting of P/C Liabilities Reserves for unpaid loss and loss adjustment expenses Reserves for unexpired risks (UPR) Market Value Margins – added to discounted liabilities Reflects risk and uncertainty in reserves Reflects “market” price (margin) for reserve risk Reflects “mark-up” for transaction cost of selling reserves Credit risk adjustment (controversial) Credit Risk Adjustment Liability adjustment for credit characteristics of the contract Reflecting any government guarantees or legal preferences

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value Concepts Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction. Fair value is measured, at the balance sheet date, as: the most probable price reasonably obtainable in the market, the best price reasonably obtainable by the seller, and the most advantageous price reasonably obtainable by the buyer “Knowledgeable, willing parties” both a willing buyer and a willing seller both reasonably informed about the characteristics of the asset, and state of the market as of the balance sheet date

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value Concepts There is a presumption that an enterprise is a going concern without any intention or need to liquidate, curtail materially the scale of its operations or undertake a transaction on adverse terms. Fair value is not, therefore, the amount that an enterprise would receive or pay in a forced transaction, involuntary liquidation or distress sale.

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value - No active and liquid market When there is not frequent activity in a market, the market is not well established or small volumes are traded, quoted market prices may not be indicative of the fair value of the instrument. Estimation techniques may be used to determine fair value if there is sufficient reliability. Techniques that are well established include reference to the current market value of another instrument that is substantially the same, such as discounted cash flow analysis and option pricing models

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value Models Fair Value “Model” needed to estimate value No active and liquid market Small volume market prices not indicative of fair value Fair Value Model should have certain characteristics: Mimics market price behavior of an active market Can be validated by observable market values Model assumptions are current and based on observable data

Copyright © 2004 by the American Academy of Actuaries CLRS References to Credit (IAS 39) The discount rate equals the prevailing market rate of interest for financial instruments having substantially the same terms and characteristics, including the creditworthiness of the debtor, the remaining term. Valuation techniques should incorporate the assumptions that market participants would use in their estimates of fair values, including assumptions about prepayment rates, rates of estimated credit losses, and interest or discount rates.

Copyright © 2004 by the American Academy of Actuaries CLRS Reliability of Fair Value Estimates (IAS 39) Often, an enterprise will be able to make an estimate of the fair value of a financial instrument that is sufficiently reliable to use in financial statements. The fair value of a financial instrument is reliably measurable if: a) the variability in the range of reasonable fair value estimates is not significant for that instrument, or b) if the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value.

Copyright © 2004 by the American Academy of Actuaries CLRS Reliability of Fair Value Estimates (IAS 39) The fair value of a financial asset or financial liability may be determined by one of several generally accepted methods. Occasionally, the variability in the range of reasonable fair value estimates is so great and the probabilities of the various outcomes are so difficult to assess that the usefulness of a single estimate of fair value is negated.

Copyright © 2004 by the American Academy of Actuaries CLRS Can Fair Value for insurance be reliably determined? IASB has not decided – practical issues to be resolved IASB recognizes that fair values can not be observed directly from market transactions IASB sees fair values for insurance using estimates based on models IASB realizes very little data exists for some risks IASB sees insurance fair value estimates as not less than what the entity would charge for new contracts

Copyright © 2004 by the American Academy of Actuaries CLRS Is Fair Value relevant for non-traded long term liabilities? IASB – fair value measurement is not intended as a representation that an insurer could, or should, transfer insurance liabilities to another party. IASB – fair value of an insurance liability can be regarded as a market-based representation of the value of the future contractual cash flows.

Copyright © 2004 by the American Academy of Actuaries CLRS Credit Risk Adjustment – One View Credit risk adjustments do seem to be a separable component of the “ fair ” market value of financial instruments (such as a bond) in active markets. Where the cash flows are certain, one could compute a credit risk adjustment as the difference between market value and the present value at a risk free rate. Alternatively, the credit risk adjustment could be the addition to the discount rate that produces a present value of cash flows equal to the market value.

Copyright © 2004 by the American Academy of Actuaries CLRS Credit Risk Adjustment – One View With uncertain cash flows, there is no clear division in market value between the “ market value margin ” that compensates for the uncertainty of the cash flows and the credit risk adjustment. However, if the credit risk adjustment is measured solely in terms of the discount rate, then the market value margin would be the difference between the market value (no credit risk) for uncertain cash flows, and the market value (no credit risk) for fixed cash flows equal to the expected value of the uncertain cash flows.

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value and the Capital Markets View Economists in the capital markets field routinely estimate fair market values for many kinds of securitization instruments, some with active markets and others without. In capital markets, the concept of credit risk adjustment for liabilities is relates to how much HIGHER the fair value of liabilities should be above the present value of cash flows at a risk free rate. This means that the fair value of liabilities INCREASES as the credit characteristics worsen.

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value and the Credit Enhancement View The fair value of the liability for the entity obligated to make payments can be viewed as made up of: a. The present value of the cash flows discounted at the risk free rate, plus b. The market price of a guarantee to make those payments. To sell the liability would require a credit enhancement premium if the credit rating had dropped from when the liability was issued. Thus, the credit risk adjustment within the fair value of liabilities is equivalent to a theoretical credit enhancement premium.

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value and the Credit Enhancement View Applying this view to insurance, the fair value of an entity ’ s insurance liabilities should INCREASE because of a drop in the entity ’ s credit standing. When the credit standing drops too low, the fair value of the insurance liabilities increases to the point of reducing the surplus to threaten the solvency of the entity, or indicating insolvency.

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value and the Market Calibration View The fair value of insurance liabilities should reflect market value, including both market value margin and the credit risk adjustment. The insurance contract obligations at inception can be viewed as pricing a policy at the market value. IBNR can be viewed as pricing tail coverage at the market value.

Copyright © 2004 by the American Academy of Actuaries CLRS Fair Value and the Market Pricing View Market Value Pricing could be viewed as the market price of a representative portfolio of policies. This market value price would reflect the uncertainty of the insurers cash flows from these policies. If differences in observable market prices are consistently related to the credit standing of the insurer, then the liabilities of the lower credit rated insurers would have a HIGHER fair value if the insurers with better credit can get higher market prices.

Copyright © 2004 by the American Academy of Actuaries CLRS Precedents for reflecting credit in the measurement of liabilities? Existing loan models (IAS 39) require the borrower to recognize the liability initially at the amount of the proceeds received (less transaction costs incurred) This measures the liability at the contractual amounts payable (interest and principal), discounted at the prevailing interest rates at inception for a loan with those credit characteristics. Initial measurement of the liability reflects its credit characteristics.

Copyright © 2004 by the American Academy of Actuaries CLRS Why should an insurer report a profit if credit quality of its liabilities deteriorates? IASB – excluding credit characteristics of a liability from its measurement would require an arbitrary exception to the general principle of measurement at fair value When the IASB considers performance reporting issues for insurance contracts (phase II), it will consider whether the effects of liability changes due to changes in credit characteristics should be disclosed separately.