Fair Value Accounting in Insurance

1. Fair Value Accounting in Insurance Michael G. McCarter CLRS - New Orleans September 10, 2001

2. Introduction • It’s not just fair value, it’s “Performance Reporting”! • FASB continues to advocate fair value for assets and liabilities. • IASB reorganizes; makes Insurance Contracts a high priority. • What’s “entity specific value”? • Update on actuarial efforts.

3. Financial Digest, June ‘01 • Accounting is now a free-for-all • “Corporate financial accounting has now become so changeable, inconsistent, undisciplined and uncomparable that its primary function - enabling both managers and investors to measure a company’s performance - is threatened.”

4. Financial Digest, June ‘01 • Some key problems: • Inconsistent application of rules. • ‘Pro forma’ earnings. • Those refreshing big baths. • Time-value-of-money and fair value rules. • Alice’s Wonderland is here.

5. Financial Digest, June ‘01 • Under fair value accounting, a troubled company could write down the value of a liability and boost its earnings. • Former FASB Chairman Beresford: “Gains for doing badly and losses for improving? Come on.”

6. The Economist, Aug 16, ‘01 • “Fair value” accounting for all financial assets and liabilities is on its way. Banks and companies hate the idea. • Compromise has created a mess. • Solution: impose fair value rules for all financial instruments. • Banks: horrified at the volatility and its impact on P/E ratios, capital costs.

7. The Economist, Aug 16, ‘01 • Assigning fair value can be tricky and subjective process. • Often relies on companies’ and banks’ internal models and estimates. • Banking supervisors warn about fair value. • Fair-value accounting should make for a more transparent and sound financial system.

8. Performance Reporting • Fair value discussions have focused on balance sheet. • Income statement was an afterthought, derived simply from change in balance sheet entries. • Recognition that investors and managers care about earnings is forcing standard setters to take a step back.

9. Performance Reporting • IASB has made Performance Reporting one of its major priorities, while Fair Value of Financial Instruments takes a back seat. • FASB is about to adopt a major agenda item on reporting financial performance. • FASB will work with the IASB.

10. Performance Reporting • FASB issues: • Elements of financial performance and consistency of presentation. • Increasing use of pro forma reporting indicating declining reliance on net income. • No consensus on key financial measures.

11. Performance Reporting • Relation to fair value? • Current fair value reporting in notes to financial statements little used or understood. • Without agreed-upon performance measures, new fair value measures may not fare much better.

12. Performance Reporting • FASB could standardize and require disclosures some are doing voluntarily. • “Sacrifice of freedom” but gain in comparability, consistency, credibility.

13. Performance Reporting • IASB concerned about inconsistent treatment of existing fair value changes. • Proposal: single statement of recognized income and expense, including all changes in net assets other than those arising from capital transactions. • Implication: Fair value changes would be “above the line”.

14. Performance Reporting • Conclusion: • FASB and IASB have heard the concern about the income statement impact of fair value, and are going to study it. • No proposal on the horizon is likely to satisfy all interested parties.

15. FASB and Fair Value • February, 2000 - FASB issues Concept Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. • Adopted expected value cash flow estimates rather than “most likely” best estimates.

16. FASB and Fair Value • Adopted fair value as measurement objective when employing present value. • Included impact of entity’s own credit standing in the measurement of its liabilities. • Concept statement not an accounting standard, but used to develop new and revised accounting standards.

17. FASB and Fair Value • Concept Statement has been controversial. • Summer 2001, FASB issued 4 “Understanding the Issues” papers to explain its position. • Available on www.fasb.org

18. FASB and Fair Value • 1: Expected Cash Flows • Why the old “most likely” standard was not the best target for estimated cash flows. • Application example: Estimated liability using 3 scenarios discounted at risk-free rate and judgment probability weighted to arrive at “fair value”.

19. FASB and Fair Value • 2: Initial Measurements of Liabilities at Fair Value. • Requires the profit element a 3rd party would include in a contract to settle the liability. • Rationale for fair value: Market price most relevant measure, trumps lack of observability. Also, most comparable.

20. FASB and Fair Value • 3: Measuring Fair Value • Developing an estimate when no ready market price is available. • Assume “highest and best use”, no information asymmetries, buyer that wants the specific item, transaction in the most favorable market. • Examples of non-financial assets.

21. FASB and Fair Value • 3: Measuring Fair Value (Cont.) • Hierarchy of fair value estimates: quoted market, prices for similar assets and liabilities, valuation techniques. • Use entity’s own assumptions on future cash flows if there’s no contrary market data. • Include overhead-type costs in cash flows.

22. FASB and Fair Value • 4: Credit Standing and Liability Measurement • Case study of zero coupon note issue. • Asserts that taking loss upon credit upgrade is economic reality and therefore correct accounting. • Asserts stockholder’s equity should never go below zero.

23. FASB and Fair Value • 4: Credit Standing and Liability Measurement (Cont.) • Footnote quote: “Nobel Laureate Robert Merton(’s) … analysis is unfamiliar to many accountants and actuaries, but it is a cornerstone of modern financial economics.”

24. FASB and Fair Value • Note: Nobel Laureate Robert Merton was also a partner in Long-Term Capital Management where he was able to extensively “test” his analyses. • See Inventing Money, by Nicholas Dunbar and When Genius Failed.

25. FASB and Fair Value • Conclusion: • FASB is pushing hard for fair value. • FASB believes accounting statements should be directly relevant to valuing enterprises, and is willing to add substantial subjectivity to statements to achieve that goal.

26. FASB and Fair Value • Conclusion (Cont.): • FASB is considering an agenda project on intangible assets as well. • Wayne Upton, major author of FASB statements on fair value, has just become director of research for IASB.

27. IASB and Insurance Contracts • New IASB formed in April, 2001. • Met standards set by FASB and the SEC. • Paul Volcker, former chairman of the Federal Reserve, is head of the IASB’s Board of Trustees. • EU currently plans to adopt IASB standards for 2005 reporting.

28. IASB and Insurance Contracts • New IASB downgraded priority of JWG Financial Instruments project. • Staying with IAS 39 which adopts an “entity specific value” rather than “fair value” standard. • Fair value not dead, just not highest priority as IASB attempts to get standards ready for EU adoption.

29. IASB and Insurance Contracts • High priority to Insurance Contracts project, but now to be based on entity-specific-value rather than fair value for the time being. • Still considering next steps. Old Insurance Steering Committee has officially been replaced with new Insurance Advisory Committee.

30. IASB and Insurance Contracts • Steering Committee was actually responsible for drafting old IASC Insurance Contracts documents. • Now IASB itself to be responsible for drafting. Advisory Committee just advisory. • Old Steering Committee still producing semi-secret DSOP on Insurance Contracts.

31. IASB and Insurance Contracts • IASB developing commitments from many other bodies, including: • FASB • Australian Accounting Standards Board • IOSCO • SEC

32. IASB and Insurance Contracts • Chapter 1: Introduction and Scope • Definitions, Risk Transfer Requirements. • Insurance is not gambling, or vice versa.

33. IASB and Insurance Contracts • Chapter 2: Single Recognition and Measurement Approach for All Forms of Insurance • Principles not separate for “general insurance” (P&C insurance) and life insurance.

34. IASB and Insurance Contracts • Chapter 2: (Cont.) • Recognition based on asset and liability measurement approach, not deferral and matching.

35. IASB and Insurance Contracts • Chapter 3: Measurement: Overall Issues • Insurance assets and liabilities should be measured at entity-specific value (while IAS 39 is in place.) • ESV represents the value of an asset or liability to the entity that holds it, and may reflect factors not available (or not relevant) to other market participants.

36. IASB and Insurance Contracts • Chapter 3: (Cont.) • ESV can differ from FV if insurer has skills that allow it to maximize asset inflows or minimize liability outflows, or if insurer views on estimates, risks, prices, or credit standing differ from market’s views. • ESV could be same as FV in given situation.

37. IASB and Insurance Contracts • Chapter 3: (Cont.) • Rejected cost accumulation basis and embedded value basis (popular with UK life insurers). • Prefer prospective to retrospective approaches. • Prefer exit values to entry values.

38. IASB and Insurance Contracts • Chapter 3: (Cont.) • Requires discounting unless not material. • Value of liabilities should not be affected by the asset portfolio held. • No overstatement of insurance liabilities to impose implicit solvency or capital adequacy requirements. • No Lloyd’s-type accounting methods.

39. IASB and Insurance Contracts • Future chapters: • Estimating future cash flows • Risk and uncertainty • Discount rate • Performance-linked contracts • Reinsurance • Accounting by policyholders

40. IASB and Insurance Contracts • Conclusion: • Unclear at this time what IASB will do with DSOP. At minimum will consider it for several meetings. It may become basis for exposure draft. • Even without full fair value, would represent a major change in accounting standards if adopted for US P&C insurers.

41. IASB and Insurance Contracts • Conclusion: (Cont.) • ESV is still on a discounted basis which measures performance on an asset and liability basis, not a deferral and matching basis. • ESV does not require estimates of a market transaction price for insurance liabilities, so may be easier to adopt than FV.

42. Actuaries and Fair Value • CAS White Paper on Fair Valuing P/C Insurance Liabilities was completed in August, 2000 and presented at last year’s CLRS by task force chair Ralph Blanchard and task force member Louise Francis. • Available for download from CAS website. • Did not focus explicitly on ESV, but many of the concepts discussed are applicable.

43. Actuaries and Fair Value • CAS White Paper (Cont.) • Still a very good place to start to understand FV of insurance liablities. • Points out many of the practical issues that accounting standards setters may not give sufficient attention to, including the limitations of information derived from the insurance marketplace for FV purposes.

44. Actuaries and Fair Value • CAS White Paper (Cont.) • The Executive Summary and the first four sections provide a good overview. • A number of possible methods for estimating market risk adjustments are discussed in some detail in the technical appendix.

45. Actuaries and Fair Value • Bowles Symposium, May 2001 • Two days of papers from Life actuaries on fair value. • FV and ESV showed substantial increase in volatility of results compared to current US GAAP for life insurers. Volatility was good - keeps CFO’s on their toes.

46. Actuaries and Fair Value • Bowles Symposium, May 2001 (Cont.) • FV and ESV also magnify current year impact of any assumption changes. • Many presenters felt FV provided a superior picture of the insurer, although it will be a significant implementation burden.

47. Actuaries and Fair Value • AAA Fair Value Task Force, chaired by Burt Jay of Mutual of Omaha • In 2000, developed comments on FASB Preliminary Views on Financial Instruments at Fair Value. • Also in 2000, developed comments on IASB Insurance Issues paper. • Raised concerns on “own credit risk” issue

48. Actuaries and Fair Value • AAA Fair Value Task Force (Cont.) • Now finishing comment letter on JWG Draft Standard on Financial Instruments. • JWG Draft “scopes out” insurance contracts, but would have substantial impact on future insurance contract standard if adopted since insurance contracts are also “financial instruments”.

49. Actuaries and Fair Value • AAA Fair Value Task Force (Cont.) • Could use more input from casualty actuaries. • Life actuaries are very smart, but insurance risk just isn’t as significant in many of the products they deal with. • Expect to comment on future IASB drafts.

50. Actuaries and Fair Value • International Actuarial Association • IAA committees have been very active in developing comments on IASB and IAIS activities. • One can easily develop the dread condition of “comment overload” if you attempt to follow everything that is going on.