Transcript !@ Quality In Everything We Do International Financial Reporting Standards Applied to Property and Casualty Insurance Jim Christie and Scott Drab November 2004

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Quality In Everything We Do
International Financial Reporting Standards
Applied to Property and Casualty Insurance
Jim Christie and Scott Drab
November 2004
Background
 Cross-border capital flows highlight the need for
consistent, understandable financial information BUT
insurance accounting has significant local variations
 The International Accounting Standards Board (“IASB”) is
developing a single set of global accounting standards
 Many countries committed to the objective of global
“harmonisation”
 Drivers for new approach
 Historical cost accounting models lack relevance
 Solvency-based approaches do not provide an accurate picture of
financial performance
 Convergence of banking and insurance industries
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Phased approach
for insurance
 A phased approach to insurance contracts.
Phase I – Implement by 2005
IAS
INSURANCE
PROJECT
Phase II – Implement Fair
Value by 2007 / 8 (?)
 Objective for Phase I is to implement some components of
the insurance project by 2005, without delay to Phase II.
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Property & Casualty – Phase 1
Key Phase I Issues
Defining Insurance
Accounting for insurance contracts
Disclosures
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Definition of Insurance
 A contract under which the insurer accepts
significant insurance risk by agreeing to
compensate the beneficiary if the insured event
adversely affects the policyholder
(Insurance Contracts (Phase I) paraphrased with emphasis added)
 Significant means at least one scenario with payment
of commercial substance with an amount that is not
trivial
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Insurance vs Financial Risk
 Financial risk is risk of possible future change in
specified interest rate, security price, commodity
price, foreign exchange rate, index of prices or rates,
a credit rating or credit index or similar variable
 Insurance risk is risk from contingent events other
than financial risk
If both financial risk and significant insurance
risk are present, contract classified as insurance
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Insurance Contract
Accounting
 During Phase I, existing accounting policies apply with
certain modifications
 Prohibited – certain accounting policies are prohibited as they do not
meet the IFRS framework
 Mandated – certain accounting policies must be implemented if they are
not already in the existing accounting policies
 Allowed to continue, but not start – certain accounting policies that do
not meet the IFRS framework can continue, but cannot be implemented.
 Can be started – certain accounting policies can be introduced.
 Existing accounting policies are those in the primary
financial statements
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PROHIBITED
accounting policies
The following policies are prohibited
 Catastrophe provisions
 Claim equalisation provisions
 Offsetting of reinsurance assets and
direct liabilities
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MANDATED
accounting policies
The following policies are mandated
if not already present
 Liability adequacy testing
 Impairment of reinsurance assets
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Liability Adequacy Test
 Current liability adequacy test applies IF
1. Test at each reporting date using current
estimates of future cash flows, AND
2. If these are greater than current liability,
liability is increased and deficiency flows
through profit and loss
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IMPAIRMENT of
reinsurance assets
 Reinsurance asset is reduced and reduction
flows through income statement if it is impaired
 Reinsurance asset is impaired if:
 Objective evidence of an event after initial inception
that the cedant may not receive all amounts due
 The impact of the event can be reliably measured
Impairment may be reversed
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Accounting policies that
may CONTINUE
The following policies may continue but
companies may not switch to these if they
are not already in use
 Undiscounted liability basis
 Deliberate overstatement of liabilities
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 Deferred acquisition costs approach
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Accounting policies that
may be STARTED
The following accounting policies may be
started, subject to certain restrictions
 Use of current market discount rates
 Use of shadow accounting
 Use of asset based discount rates
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Phase I Insurance
disclosure requirements
IFRS 4 has two high level principles:
Principle 1 – Explanation of recognised amounts
Principle 2 –Amount, timing and uncertainty of cash flows
Fair Value Disclosure for insurance contract assets and liabilities
 Implementation guidance - runs to 61 paragraphs – but
does not create additional requirements!
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Principle 1 - EXPLAIN
 Accounting policies
 Amounts
 Assumptions
 Changes in liabilities
 Gain or loss on buying reinsurance
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Principle 2 – CASH FLOWS
 Terms and conditions
 Segment information
 Risk management policies & objectives
 Insurance risks covered
 Run off triangles (claim development)
 Other risks
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PHASE 2
 PHASE 2 (in 2007?)
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Phase 2
 Scope – all insurance contracts
 Based on asset/liability model, rejecting
current deferral/matching model
 Where liabilities are independent of asset
returns, unless
 Policyholder benefits directly related to
asset returns; e.g, linked products
 Intended to be consistent with IAS 39
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Accounting Basis
 Proposed
 Move to “underwriting year” accounting, thus no smoothing of results
with UPR and DAC
 Liabilities measured at Fair Value
 Issues
 Extra volatility of the insurance result
 Potential changes to the IT systems
 Loss ratios for new products to be estimated from day one
 Re-engineering of claim reserving process
 Reserves for expenses
 Gain or loss at issue
 Renewals/Future Premiums
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Discounting
 Proposed
 Discounting of reserves will become mandatory
 Discounting at risk free rate, plus a spread for credit, and MVM’s
 Valuing options and guarantees
 Impact
 Projection of expected cash flows
 Selection of suitable economic assumptions consistent with market data
 Need to consider all future events including legislation and technology
 Re-engineering of the actuarial reserving process
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Market Value Margins
 Proposed
 Reserves will require a market value margin consistent with observed
market risk preferences
 Market value margin incorporated either
 by adjusting discount rates OR
 By adjusting cashflows
 Consider both diversifiable and non diversifiable risks
 Impact
 Need to develop suitable approach and discounting assumptions
 Need for enhanced disclosures
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Other Fair Value Issues
 Future premiums only included where
 Uncancelable continuation or renewal rights constraining
insurer’s ability to re-price; and
 Rights lapse if the policyholder ceases premiums
 No net gain at inception (ignoring indirect costs) unless
market evidence
 Same derecognition rules used for financial assets and
liabilities will apply to insurance
 Reflect all guarantees and options
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Types of Estimation Risk
1) Model Risk
 the risk that the wrong model was used to estimate the insurer’s liabilities
2) Parameter Risk
 the risk of misestimating the parameters for the model used to estimate the
insurer’s claim liabilities
3) Process Risk
 the risk that remains due to random variation, even if the correct model and the
correct parameters are used to estimate the insurer’s claim liabilities
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What of risks does MVM include?
 IAS Draft Statement of Principle 5.4:

“The entity-specific value or fair value of an insurance
liability or insurance asset should always reflect both
diversifiable and non-diversifiable risk.”
 This implies that model risk, parameter risk,
and process risk should be modeled.
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However …
 IAS Draft Statement of Principle, Section 5.10:

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while it is “conceptually preferable” to
reflect parameter risk and model risk, “it
is appropriate to exclude such adjustments
unless there is persuasive evidence that
enables an insurer to [quantify] them by
reference to observable market data.”
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What is the market’s
risk preference?
The Fair Value of policy liabilities reflects the risk
preferences of the insurance market.
What is the insurance market’s risk preference?
The 60th percentile of the distribution?
The 75th percentile?
The 95th percentile?
IAS Draft Standard of Principles: the risk preference
is “inevitably subjective” (Section 5.29)
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Some practical techniques
to model the MVM
1) Canadian Provision for Adverse Deviation
 Includes Parameter Risk & Model Risk
2) Initial Expected Profit Margin
 Process Risk, Parameter Risk, & Model Risk
3) Poisson Frequency / Lognormal Severity Simulation
 Process Risk
4) Mack’s Approach
 Process Risk, Parameter Risk, & potentially Model Risk
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Canadian Provision for
Adverse Deviation (PFAD)

Three components to Provision for Adverse Deviation:
1. Claims Development (2.5% to 15% of discounted gross liabilities)
2. Discount Rate (50 to 200 basis points on interest rate)
3. Reinsurance Recovery (0% to 15% of discounted ceded claim liabilities)

The MVM could be set equal to the claims development PFAD.

The PFAD does not attempt to model process risk (i.e. size of the
company is not considered when determining the PFAD).
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Initial Expected Profit Margin
 If insurance markets are efficient, the DSOP
suggests there should be no gain at issue
 Consequently if a profit is indicated at issue, any
theoretical MVM should be scaled so that the result is
simply breakeven
 Are P&C insurance markets efficient?
 Are there situations where a gain at issue would be
permitted?
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Frequency / Severity
Simulation
 Determine the distribution of loss reserves using a Monte
Carlo approach
 Frequency often assumed to be Poisson distributed
 Severity often assumed to be lognormally distributed
 Data requirements:
 Pending counts (ultimate counts – closed counts)
 Unpaid Claims (case + IBNR)
 Coefficient of Variation for severity (can be based on historical or
industry data)
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Mack Method
Mack Method can be applied to:
 Paid Losses
 Incurred Losses
 Historical Recorded Ultimate Losses
Source: Measuring the Variability of Chain Ladder Estimates by
Thomas Mack
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Conclusions on MVM
 Many judgments required under IFRS 4 requirements:
1) Should one include parameter & model risk in MVM?
2) How should the risk preference of the market be
measured?
3) What approach should be used to model the MVM?
4) Given that you have selected an approach, how
should you select your MVM?
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Conclusions on MVM
 Many judgments required under IFRS 4 requirements:
1) Should one include parameter & model risk in MVM?
2) How should the risk preference of the market be
measured?
3) What approach should be used to model the MVM?
4) Given that you have selected an approach, how
should you select your MVM?
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Modeling Phase 2
 How would the IASB proposed accounting system compare to US
GAAP for a hypothetical Property/Casualty insurance company?
 We worked with the Group of North American Insurance
Enterprises (GNAIE) to model a P&C insurer reporting under US
GAAP and the IASB proposed accounting system.
 We started with very basic assumptions and then showed the
incremental effects of:
1.
MVMs
2.
Growth in Earned Premium
3.
Deteriorating Loss Ratios
4.
Duration mismatches
5.
Own credit risk
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Assumptions of the
Steady State Model
State
Model
Scenario Assumptions
1998
1999
2000
2001
1
Number of Policies
5,000
5,000
5,000
5,000
2
Growth Rate
N/A
0.0%
0.0%
0.0%
3
Loss Ratio
70.0%
70.0%
70.0%
70.0%
4
Risk-Free Interest Rate
FLAT 0.0%
FLAT 0.0%
FLAT 0.0%
FLAT 0.0%
5
Gross Market Value Margin - Total
0.00%
0.00%
0.00%
0.00%
6
Ceded Market Value Margin - Total
N/A
N/A
N/A
N/A
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Quality of Insurer
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Effect of Quality of Insurer on Gross MVM
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Quality of Reinsurer
N/A
N/A
N/A
N/A
0.00%
0.00%
0.00%
0.00%
N/A
N/A
N/A
N/A
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Effect of Quality of Reinsurer on Ceded MVM
0.00%
0.00%
0.00%
0.00%
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Expense Ratios - Including Change in DAC
25.5%
25.5%
25.5%
25.5%
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Acquisition Expense Ratio
17.5%
17.5%
17.5%
17.5%
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Operating Expense Ratio
8.0%
8.0%
8.0%
8.0%
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US GAAP Tax Rate
35.0%
35.0%
35.0%
35.0%
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Fair Value Balance Sheet
in a Steady State
1998
1999
2000
2001
2002
459,680
465,530
471,380
477,230
483,080
Reinsurance Receivable
0
0
0
0
0
Unpaid Loss and Loss Expenses Recoverable
0
0
0
0
0
Ceded MVM Provision - Total Risk
0
0
0
0
0
Ceded Credit Risk Provision - Reinsurer Credit Risk
0
0
0
0
0
Reinsurance Asset
0
0
0
0
0
Assets
Invested Assets
Other Assets
220
220
220
220
220
Total Assets
459,900
465,750
471,600
477,450
483,300
288,400
288,400
288,400
288,400
288,400
0
0
0
0
0
(0)
(0)
(0)
(0)
(0)
Liabilities
Direct Unpaid Loss and Loss Expenses
Gross MVM Provision - Total Risk
Gross Credit Risk Provision - Own Credit Risk
Net Unpaid Loss and Loss Expenses
288,400
288,400
288,400
288,400
288,400
3,150
3,150
3,150
3,150
3,150
0
0
0
0
0
Total Liabilities
291,550
291,550
291,550
291,550
291,550
Total Equity
168,350
174,200
180,050
185,900
191,750
Total Liabilities and Equity
459,900
465,750
471,600
477,450
483,300
Tax Liability
Other Liabilities
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Fair Value Income Statement
in a Steady State
1998
1999
2000
2001
2002
Revenue from Operations
200,000
200,000
200,000
200,000
200,000
Total Net Loss and Loss Expenses Incurred
140,000
140,000
140,000
140,000
140,000
0
0
0
0
0
Release in Net MVM Provision - Total Risk
(0)
(0)
(0)
(0)
(0)
Net Credit Risk Provision
(0)
(0)
(0)
(0)
(0)
0
0
0
0
0
51,000
51,000
51,000
51,000
51,000
9,000
9,000
9,000
9,000
9,000
Investment Income
0
0
0
0
0
Investment and Interest Expense
0
0
0
0
0
Net Income Before Taxes
9,000
9,000
9,000
9,000
9,000
Taxes - Calculated on US GAAP Net Income
3,150
3,150
3,150
3,150
3,150
Net Income
5,850
5,850
5,850
5,850
5,850
COM BINED CURRENT & PRIOR BUSINESS
Net MVM Provision - Total Risk
Release in Net Credit Risk Provision
Expenses
Underwriting Income
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Differences in US GAAP & Fair Value:
Interest Rates = 5%, MVMs = 12%
Comparison of US GAAP and FV Equity
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1998
1999
2000
2001
2002
US GAAP
170,832
192,335
214,543
237,479
261,167
Fair Value
178,176
199,679
221,887
244,823
268,511
Difference
7,344
7,344
7,344
7,344
7,344
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Differences in US GAAP & Fair Value:
Interest Rates = 5%, MVMs = 12%
Effects of FV-Specific Elements on FV Equity
As compared to US GAAP Equity
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20
10
0
-10
-20
Premium Recognition
Discounting Effects
MVM Effects
-30
-40
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Effects of Written Growth
on the Steady State Model
Effects of MVM and Discounting on FV Net Income
1998
1999
2000
2001
2002
Addition of MVM Provision
(16,800)
(16,800)
(21,000)
(26,250)
(32,813)
Release of MVM Provision
16,800
16,800
17,745
20,186
23,868
Addition of Discount
14,324
14,324
17,905
22,381
27,977
(14,324)
(14,324)
(14,986)
(16,896)
(19,977)
0
0
(336)
(578)
(945)
Unwinding of Discount
Net Impact of MVM & Discount
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Effects of Written Growth
on the Steady State Model
Underw riting Incom e - US GAAP and Fair Value
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
1998
1999
2000
US GAAP
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2001
2002
Fair Value
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Effects of Deteriorating Loss Ratios
on the Steady State Model
Effects of Recognition of Losses on Unearned Premium
1999
2000
2001
2002
Losses on Net WP*-UEP** Under FV
(10,000)
(15,000)
(20,000)
(20,000)
Losses on Net UEP Under US GAAP
0
10,000
15,000
20,000
(10,000)
(5,000)
(5,000)
0
Impact on FV Underwriting Income
* WP: Written Premium
** UEP: Unearned Premium
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Effects of Deteriorating Loss Ratios
on the Steady State Model
Underw riting Incom e - US GAAP and Fair Value
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
1998
1999
2000
US GAAP
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2001
2002
Fair Value
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1998-2002 Interest Rate Yields
Sample Table of Treasury Zero-Coupon Yields
Maturity (Years)
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1997
1998
1999
2000
2001
2002
1.0
5.59% 4.58% 6.07% 5.39% 2.18% 1.32%
2.0
5.75% 4.59% 6.35% 5.17% 3.11% 1.62%
3.0
5.77% 4.60% 6.40% 5.12% 3.66% 2.01%
4.0
5.78% 4.61% 6.44% 5.08% 4.08% 2.42%
5.0
5.80% 4.61% 6.48% 5.04% 4.52% 2.85%
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Effects of Real Interest Rates
on the Steady State Model
Unde rw riting Incom e - US GAAP and Fair Value
20,000
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
1998
1999
2000
US GAAP
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2001
2002
Fair Value
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Effects of Increasing Duration
Ne t Incom e Afte r Taxe s - Fair Value
60,000
50,000
40,000
30,000
20,000
10,000
0
1998
1999
2000
2001
2002
-10,000
-20,000
Asset Mat urit y Mat ched
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Asset Mat urit y of 3.0
Asset Mat urit y of 6.0
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Effects of Own Credit Standing
Provision
Unde rw riting Incom e - US GAAP and Fair Value
50,000
0
1998
1999
2000
2001
2002
-50,000
-100,000
-150,000
-200,000
US GAAP
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Fair Value
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Effects of Own Credit Standing
Provision
Claim Payment Patterns
Year
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1
2
3
4
5
6
7
8
9
10
Decelerated
37.0%
15.0%
18.0%
12.0%
6.0%
4.8%
3.6%
1.8%
1.2%
0.6%
Actual
45.0%
15.0%
15.0%
10.0%
5.0%
4.0%
3.0%
1.5%
1.0%
0.5%
Accelerated
53.0%
15.0%
12.0%
8.0%
4.0%
3.2%
2.4%
1.2%
0.8%
0.4%
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Effects of Changing Payout Pattern
Underw riting Incom e - US GAAP and Fair Value
11,000
10,000
9,000
8,000
7,000
1998
1999
US GAAP
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2000
FV - 8% MVM
2001
2002
FV - 16% MVM
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Effects of Changing MVM
Unde rw riting Incom e - US GAAP and Fair Value
20,000
10,000
0
1998
1999
2000
2001
2002
-10,000
-20,000
-30,000
-40,000
-50,000
-60,000
-70,000
-80,000
US GAAP
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FV - MVM 12% to 16%
FV - MVM 12% to 8%
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Effects of Different MVMs in a
Fluctuating Environment
Unde rw riting Incom e - US GAAP and Fair Value
20,000
10,000
0
1998
1999
2000
2001
2002
-10,000
-20,000
-30,000
-40,000
-50,000
-60,000
-70,000
-80,000
US GAAP
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FV - 8% MVM
FV - 16% MVM
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Final Comments
 Should accounting statements reflect the financial
effects of asset-liability mismatch?
 How large should the MVM be?
 How comparable will two similar companies be under
FV?
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Questions
[email protected]
[email protected]
“The Impact of an Anticipated Fair Value Accounting
Framework on US GAAP Reporting Property &
Casualty Insurers” : www.GNAIE.org
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