Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Fair Value White Paper Overview Ralph Blanchard

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS Task Force on Fair Value Liabilities Members: Ralph Blanchard Bob Butsic Catherine Cresswell Louise Francis Aaron Halpert Phil Heckman Gerry Kirschner Contributors David Appel, Paul Brehm, Roger Hayne, Gary Josephson, Joe Lebens, Steve Lowe, Glenn Meyers, Elizabeth Smith, Pat Teufel, Gary Venter, COPLFR Sarah Krutov Mike McCarter Gary Nickerson Stewart Sawyer Ernest Wilson Bryan Young

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th What is Fair Value? Why? What does it mean for insurance? Why a CAS white paper? Goals of the white paper CAS white paper Format Previews of each section Findings Next steps Overview

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Slide 2 of 19 What is “Fair Value?” Economic value - ideally the market value, if a sufficiently active market exists. Why the interest in “fair value?” If accounting is not at economic value, results are easy to manipulate via buying and selling (e.g., Savings & Loan crisis of the 1980’s)

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th What does it mean for insurance? If a sufficiently active market does not exist, the fair value must be estimated. The biggest items of interest to actuaries and insurance investors that must rely on fair value estimates. Loss reserves Unearned premium (“provision for unexpired risk”) Items that disappear. Deferred acquisition cost (DAC) assets Premium deficiency reserves Open issues. Renewals, other intangibles, “credit standing”? Slide 3 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th What does it mean for insurance? - part 2 What’s involved in estimating a fair value? present value of future expected cash flows, adjusted for: risk market imperfections “similar factors if market-based information is available to estimate those adjustments” (FASB) Slide 4 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Why a CAS white paper? Why now? In December 1999, the FASB and the IASC issued proposals calling for the reporting of insurance liabilities at fair value. Both required comments by May 31, CAS Leadership decided that the research into fair value issues needed to be expanded, in order to assist the AAA in preparing a response to these proposals and any future developments in this area. (The initial CAS leadership focus was just the IASC proposal.) Slide 5 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Why a CAS white paper? Why now? - part 2 FASB: Preliminary Views - Financial Instruments at Fair Value Focus is financial instruments Insurance defined as financial instrument, usually Comment deadline was May 31st IASC: Insurance Issues Paper Focus is insurance Discount all insurance liabilities Fair value insurance liabilities IF all other financial instruments at fair value Comment deadline was May 31st Slide 6 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Goals of the white paper Aid in the AAA Fair Value Task Force responses to FASB IASC Assist CAS liaison (Steve Lowe) to the International Actuarial Association (IAA) and their response to the IASC Become a general resource for CAS members and other parties on this issue, relative to P&C insurance liabilities. (Primary audience is actuaries.) Slide 7 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Format A.Background, including a definition and history of fair value in general B.Fair Value in the insurance context C.Alternatives to Fair Value Accounting for p/c insurance liabilities D.Methods for Estimating Fair Value E.Accounting Presentation Issues, including alternative income statement or balance sheet formats in a “fair value” world. F.Implementation Issues surrounding the fair valuing of p/c ins. liabilities G.Accounting Concepts, or how well fair value accounting and the issues discussed in the earlier sections would be viewed in the context of general accounting concepts (such as reliability, relevance and representational faithfulness). H.Credit Standing and Fair Value Liabilities, a discussion of issues related to the reflection of credit standing in determining the fair value of liabilities. I.Professional Readiness J.Summary and Observations K.Technical Appendices Slide 8 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Preview - Introduction Fair Value potential advantages Consistency with assets. Eliminate accounting arbitrage. Consistency with other financial instruments. Relevance. Fair Value potential disadvantages Difficulty in measuring. Greater estimation reliance. Volatility in earnings. Cost. Unintended or unexpected consequences. Slide 9 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Preview - Alternatives to Fair Value Undiscounted expected value Present value at a risk-free interest rate Present value using an industry-standard risk-adjustment Mixture of fair value and alternatives Entity-specific measurement Cost-accumulation measurement Slide 10 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Preview - Methods 1 - CAPM 2 - IRR 3 - Single-period RAD (Risk-Adjusted Discount) 4 - Methods Based on Underwriting Data 5 - Actuarial Distribution-Based Risk Loads 6 - Reinsurance market prices 7 - Direct estimation of market values 8 - Distribution Transform Method 9 - “Rule of thumb” Methods Others? Slide 11 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Preview - Presentation What would a reserve development triangle look like under a fair value system. Should it include risk margins? Should it reflect changes in interest rates? Slide 12 of 19 CAS White Paper - Preview - Implementation What properties should risk margins have? Should they reflect process risk? Should they reflect value additivity?

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Preview - Accounting Concepts The desired traits of an accounting system are: Relevance Reliability Comparability and Consistency Neutrality Cost Benefit Slide 13 of 19 CAS White Paper - Preview - Credit Standing Should the fair value of a company’s liabilities reflect its credit standing?

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - Professional Readiness Do actuaries currently have a theoretical understanding of fair value concepts adequate to estimate liabilities under a fair value standard? Are models currently available that can be used by actuaries to estimate fair value liabilities? Are actuaries prepared to implement these models and make these estimates in practice? What steps can the profession take to aid individual actuaries in implementing effective processes for fair valuation of insurance liabilities for their companies or their clients? Slide 14 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - findings 1)New requirement 2)Alternatives for fair value 3)Expected value versus best estimate 4)Multiple methods 5) Continuum from pricing methods 6)“Typical” line/”typical” company limitation of most current methods 7)A fair value accounting standard would lead to new research 8)When market prices and “fair value” estimates are in conflict Market disequilibrium Market disruption Information asymmetry Significant intangibles Slide 15 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th CAS White Paper - findings Part 2 9) Implications of risk margin approaches without value additivity 10) Susceptibility to actuarial estimate 11)Increased reliance on judgmental estimates in financials 12)Historical comparisons 13)Gross vs. net. 14) Tax issues 15)Credit standing reflection in valuing liabilities 16)Actuarial workload requirements 17)Professional Readiness 18)Standards vs. Principles Slide 16 of 19

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Next Steps IASC Review comments (138 as of Aug. 23) this fall Draft Statement of Principles Final Statement of Principles Exposure Draft of Proposed International Accounting Standard International Accounting Standard (ETA of 2004?) Slide 17 of 19 SEC Determine if statements filed under IASC standards will be accepted in U.S. Comment deadline on this question was May 15, 2000

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Next Steps - (part 2) FASB Review comments Next steps? Committed to fair value of financial assets Would like to have fair value of financial liabilities Slide 18 of 19 AAA, IAA Monitor developments and respond accordingly Enhance comment writing/consensus building process CAS, SOA Continue research and educational efforts

Fair Value of Insurance Liabilities - CAS White Paper 2000 CLRS - September 19th Speed of Accounting Pronouncements “The Board’s Experience with Fair Value of Financial Instruments... The accounting profession, the SEC, bank regulators, and some providers of financial statement had urged the Board to deal with the subject comprehensively because the existing authoritative guidance was incomplete and inadequate. …resulted in ad hoc and inconsistent reporting practices. In 1986, the board agreed to undertake a major project on financial instruments.” (from FASB “Financial Accounting Series, No. 206-D/February 29, 2000, page 7) bolded font not in the original text Slide 19 of 19