Midwest Actuarial Forum March 17, 2006 International Accounting and the Casualty Actuary Sam Gutterman, FCAS, FSA PricewaterhouseCoopers

Page 2 International Accounting and the Casualty Actuary Agenda International Accounting Organizations − The IASB and the FASB − The IAIS and the NAIC IASB activities − Background − Current status − Current discussions and the future IAIS activities

Page 3 International Accounting and the Casualty Actuary International accounting organizations (1) Why is everything suddenly international ? Globalization of commerce Increase in reach of multi-national insurers and reinsurers Enhancement of standards and regulation Old national methods have not always worked -Lack of accounting transparency -Inadequate international financial institution regulation In some cases, this is where the action is

Page 4 International Accounting and the Casualty Actuary International accounting organizations (2) The International Accounting Standards Board Formerly the International Accounting Standards Committee −About 27 years old −Standards were primarily for countries without an existing accounting standards organization Reformulated five years ago as the IASB −Originally charged by IOSCO and the G7 to develop a high quality set of international accounting standards, as opaque accounting was blamed as being a significant contributor to the Asian financial crisis of , which spread into Russia and South America −Beginning in 2005, standards of the IASB (referred to as International Financial Reporting Standards or IFRS) are now used by 95 countries, including those in the European Union

Page 5 International Accounting and the Casualty Actuary The IASB and the FASB The current buzzword is “convergence” −Pressure continues to mount for a convergent set of internationally recognized accounting standards −For a while, it looked like US GAAP would be sufficient −For lots of reasons, including European dislike of detailed US GAAP rules, this approach did not win out October 2002, a general agreement was reached to converge over time −Goal – is to have a single global set of high quality, transparent standards that are useful for economic decision-making −Reality – gradual progress through mutual cooperation January 2006, this was confirmed with a specific 3 year plan

Page 6 International Accounting and the Casualty Actuary International accounting organizations (3) The International Association of Insurance Supervisors About 15 years old Originally a talking shop among national supervisors Currently setting guidance for use by national supervisors Emphasis on principles, looked at to as a guide for supervisory activities In the same building as the Basel Committee

Page 7 International Accounting and the Casualty Actuary The IAIS and the NAIC The NAIC has tended to be quite insular, as has been the case for most U.S. regulatory bodies due to large size of the U.S. market Upon pressure by the OECD and the G7, international financial industry regulators have become quite active because of the increasing dominance of multi-national financial institutions The IAIS has launched a set of very aggressive regulatory projects, but is still looked at as providing guidance as opposed to imposed international solutions The NAIC has recently become quite involved in IAIS activities

Page 8 International Accounting and the Casualty Actuary International accounting organizations (4) The International Federation of Accountants Association of 163 national accounting organizations in 120 countries Includes: -International Auditing and Attestation Board Responsible for international auditing standards -International Public Accounting Standards Board -International Education of Accountants -International Ethics Standards Board Was recently reorganized to better emphasize the public interest and public oversight

Page 9 International Accounting and the Casualty Actuary The IASB and Insurance Contracts The history 1997 – IASC started Insurance project 1999 – IASC Insurance Issues Paper 2001 – Draft Statement of Principles – never completed 2002 – IASB split insurance contracts project into two segments -Phase 1, a compromise short-term fix to meet Europe 2005 deadline 2003 – Exposure Draft (ED 5) March 2004 – published IFRS 4, Insurance contracts January 2005 – implemented in Europe along with rest of IFRS -Phase 2, a more rigorous solution currently in development

Page 10 International Accounting and the Casualty Actuary The IASB – Current Status Convergence The FASB and the IASB has agreed on convergence, with an uncertain pace Insurance Contracts is a modified joint project −The IASB is taking the lead −The FASB will distribute Discussion Paper to its stakeholders  Depending on responses will participate in Exposure Draft development −Whether the identical or similar standard will be issued remains to be determined

Page 11 International Accounting and the Casualty Actuary The IASB – Current Status Current projects affecting insurance Insurance contracts Conceptual framework −Including definition of assets and liabilities Fair value measurement −Will expose to stakeholders after corresponding FASB standard issued Business combinations −Common Exposure Draft issued, negative response, could include discounting, risk adjustment and renewals

Page 12 International Accounting and the Casualty Actuary The IASB – Current Status Current projects affecting insurance (cont’d) IAS 37 – Provisions −For self-insurance, might be fair value Revenue recognition −May not be premiums, might be risk transfer Performance reporting −What is income, how it should be displayed

Page 13 International Accounting and the Casualty Actuary The IASB – Current Status IFRS 4 Insurance Contracts Definition of insurance – focus is on significant insurance risk (other than financial risk) −Have not explicitly focused on reinsurance risk transfer −Contracts not insurance are either investment or service Generally, entity’s accounting policy is local GAAP that is grandfathered −Can change if more relevant or more reliable than current accounting policy Liability adequacy test −OK to use local GAAP test if it considers all future cash flows

Page 14 International Accounting and the Casualty Actuary The IASB – Current Status IFRS 4 Insurance Contracts Reinsurance asset impairment test No liability for future claims on future contracts −No equalization or catastrophe liabilities No offset of reinsurance against insurance Allows profit/loss on ceded reinsurance, with proper disclosure Can have mismatch of asset / liability bases −More of a problem for life insurance Requires expanded disclosure of accounting policy and risk

Page 15 International Accounting and the Casualty Actuary The IASB – Current Status Selected other requirements IAS 32 and ED 7 – Financial Instruments: Disclosure and Presentation −Includes fair value option for liabilities – choice if certain conditions met IAS 39 – Financial Instruments: Recognition and Measurement −For investment contracts – choice of fair value and amortized cost IAS 18 – Revenue −Amortized deferred Transaction Cost (DTC) asset for service contracts, e.g., third party administrative or asset management contracts Assets −Similar to US GAAP, with same 3 categories – amortized cost, held to maturity, and trading, with derivatives always at fair values

Page 16 International Accounting and the Casualty Actuary The IASB – Current Discussions Insurance Contracts – Phase 2 Started in earnest in September 2004 −With first meeting of IASB’s Insurance Working Group −Dealing with contracts rather than companies  Due to desire for consistency across industries Board held several educational sessions beginning in January 2005 No final decisions reached yet

Page 17 International Accounting and the Casualty Actuary The IASB – Current Discussions Insurance Contracts – Phase 2 constraints Consistency with current Framework −But Framework currently being reviewed for the long-term Board has declared it is not wedded to fair values −But so far, looks like prospective values −Discounting is almost a sure thing  But North American P&C industry still fighting it −Risk margin to be explicitly reflected  If calibrated to a market value, referred to as a market value margin (MVM) Minimum deposit floor, unless IAS 39 changed

Page 18 International Accounting and the Casualty Actuary The IASB – Current Discussions Claims Liability – Phase 2 Major components (refinements to be added) 1.Current expected values 2.Discounted −Possibly at risk free rates 3.Risk adjusted −Key outstanding issue −Different approaches being studied by IAA −How: currently being discussed  As a function of cost of capital?  By confidence interval or conditional tail expectation?

Page 19 International Accounting and the Casualty Actuary The IASB – Current Discussions Contract liability Three choices still being studied −Unexpired risk liability – exit value, business-to-business  Prospective using current assumptions  Possible to have profit at issue −Unexpired risk liability – current entry value, business-to-customer  Initially no profit-at-issue  Prospective using current market prices of similar contracts  Similar to exit value, except possibly risk margin fixed at inception −Unearned premium less current DAC balance All subject to a liability adequacy test, although the same as exit value Revenue – if risk related, might have revenue throughout claims process

Page 20 International Accounting and the Casualty Actuary The IASB – Current Discussions Risk margins Of interest to both to the IASB and the IAIS Through discount rate or cash flows What is the purpose of an explicit risk margin in a financial statement −How prudent should the liability be? How to calibrate? What risks to include? −For claims liability – should it be:  Included in the price that a buyer will demand to take on the insurance risk or  Reflect historical claim development fluctuation over a specific time period? −For contract liability – should it be:  Total profit and risk margin – the aggregate pricing load or  Reinsurance price-sensitive factor that could swing with the underwriting cycle?

Page 21 International Accounting and the Casualty Actuary The IASB – Current Timetable Insurance Contracts – Phase 2 IASB Discussion PaperDecember 2006 Exposure draft 2007 / first half of 2008 ? Final standard 2009 ? Effective 2011 ?

Page 22 International Accounting and the Casualty Actuary IAIS Activities Attempting to reinvent worldwide regulatory accounting −Based on general principles −Enhance insurance regulation −Financial statement components, capital adequacy assessment −Liabilities possibly consistent with IFRS  Controversial −Very difficult, as culture can vary significantly by jurisdiction Working with the IASB and the IAA −Recently the IAIS asked the IAA to develop acceptable approach to assess liabilities and financial condition – the Roadmap −Not all countries have RBC  Some have flat amount of minimum capital −Wrestling with very basic questions