!@ Quality In Everything We Do International Financial Reporting Standards Applied to Property and Casualty Insurance presented to OCCA by Jim Christie

!@Quality In Everything We Do

International Financial Reporting Standards

Applied to Property and Casualty Insurance presented to OCCA by Jim Christie

November 2004

2 !@Quality In Everything We Do

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

Background


A phased approach to insurance contracts.

Objective for Phase I is to implement some components of the insurance project by 2005, without delay to Phase II.

Phased approach for insurance

IASINSURANCE

PROJECT

IASINSURANCE

PROJECT

Phase I – Implement by 2005Phase I – Implement by 2005

Phase II – Implement Fair Value by 2007 / 8 (?)Phase II – Implement Fair Value by 2007 / 8 (?)


Property & Casualty – Phase 1

Key Phase I Issues

Defining Insurance

Accounting for insurance contracts

Disclosures


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


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

Insurance vs Financial Risk


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


PROHIBITEDaccounting policies

The following policies are prohibited

Catastrophe provisions

Claim equalisation provisions

Offsetting of reinsurance assets and direct liabilities


MANDATED accounting policies

The following policies are mandated if not already present

Liability adequacy testing

Impairment of reinsurance assets


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


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


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

Deferred acquisition costs approach


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


Phase I Insurance disclosure requirements

IFRS 4 has two high level principles:

Principle 1 – Explanation of recognised amountsPrinciple 1 – Explanation of recognised amounts

Principle 2 –Amount, timing and uncertainty of cash flowsPrinciple 2 –Amount, timing and uncertainty of cash flows

Implementation guidance - runs to 61 paragraphs – but does not create additional requirements!

Fair Value Disclosure for insurance contract assets and liabilitiesFair Value Disclosure for insurance contract assets and liabilities


Principle 1 - EXPLAIN

Accounting policies

Amounts

Assumptions

Changes in liabilities

Gain or loss on buying reinsurance


Principle 2 – CASH FLOWS

Terms and conditions

Segment information

Risk management policies & objectives

Insurance risks covered

Run off triangles (claim development)

Other risks


PHASE 2

PHASE 2 (in 2007?)


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

Phase 2


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

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

Accounting Basis


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

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

Discounting


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

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

Market Value Margins


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

Other Fair Value Issues


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

Types of Estimation Risk


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.

What of risks does MVM include?


However …

IAS Draft Statement of Principle, Section 5.10:

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.”


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)

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)

What is the market’srisk preference?


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

Some practical techniques to model the MVM


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).


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?

Initial Expected Profit Margin


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)


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


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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Questions

Documents

!@ Quality In Everything We Do International Financial Reporting Standards Applied to Property and Casualty Insurance presented to OCCA by Jim Christie