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Fair Value Accounting in Insurance

Michael G. McCarterCLRS - New OrleansSeptember 10, 2001

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IntroductionIt’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.

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Financial Digest, June ‘01Accounting 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.”

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Financial Digest, June ‘01Some 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.

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Financial Digest, June ‘01Under 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.”

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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.

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The Economist, Aug 16, ‘01Assigning 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.

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Performance ReportingFair 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.

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Performance ReportingIASB 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.

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Performance ReportingFASB 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.

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Performance ReportingRelation 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.

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Performance ReportingFASB could standardize and require

disclosures some are doing voluntarily.

“Sacrifice of freedom” but gain in comparability, consistency, credibility.

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Performance ReportingIASB 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”.

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Performance ReportingConclusion: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.

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FASB and Fair ValueFebruary, 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.

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FASB and Fair ValueAdopted 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.

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FASB and Fair ValueConcept Statement has been

controversial.Summer 2001, FASB issued 4

“Understanding the Issues” papers to explain its position.

Available on www.fasb.org

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FASB and Fair Value1: Expected Cash FlowsWhy 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”.

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FASB and Fair Value2: 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.

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FASB and Fair Value3: Measuring Fair ValueDeveloping 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.

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FASB and Fair Value3: 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.

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FASB and Fair Value4: Credit Standing and Liability

MeasurementCase 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.

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FASB and Fair Value4: 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.”

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FASB and Fair ValueNote: 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.

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FASB and Fair ValueConclusion: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.

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FASB and Fair ValueConclusion (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.

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IASB and Insurance ContractsNew 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.

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IASB and Insurance ContractsNew 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.

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IASB and Insurance ContractsHigh 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.

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IASB and Insurance ContractsSteering 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.

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IASB and Insurance ContractsIASB developing commitments from

many other bodies, including:FASBAustralian Accounting Standards

BoardIOSCOSEC

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IASB and Insurance ContractsChapter 1: Introduction and ScopeDefinitions, Risk Transfer

Requirements.Insurance is not gambling, or vice

versa.

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IASB and Insurance ContractsChapter 2: Single Recognition and

Measurement Approach for All Forms of Insurance

Principles not separate for “general insurance” (P&C insurance) and life insurance.

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IASB and Insurance ContractsChapter 2: (Cont.)Recognition based on asset and

liability measurement approach, not deferral and matching.

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IASB and Insurance ContractsChapter 3: Measurement: Overall IssuesInsurance 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.

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IASB and Insurance ContractsChapter 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.

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IASB and Insurance ContractsChapter 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.

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IASB and Insurance ContractsChapter 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.

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IASB and Insurance ContractsFuture chapters:Estimating future cash flowsRisk and uncertaintyDiscount ratePerformance-linked contractsReinsuranceAccounting by policyholders

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IASB and Insurance ContractsConclusion: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.

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IASB and Insurance ContractsConclusion: (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.

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Actuaries and Fair ValueCAS 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.

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Actuaries and Fair ValueCAS 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.

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Actuaries and Fair ValueCAS 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.

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Actuaries and Fair ValueBowles Symposium, May 2001Two 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.

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Actuaries and Fair ValueBowles 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.

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Actuaries and Fair ValueAAA Fair Value Task Force, chaired by Burt

Jay of Mutual of OmahaIn 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

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Actuaries and Fair ValueAAA 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”.

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Actuaries and Fair ValueAAA 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.

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Actuaries and Fair ValueInternational Actuarial AssociationIAA 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.

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Actuaries and Fair ValueConclusion:Actuarial profession has been active and

influential in the ongoing development of international accounting and regulatory standards.

However, this is mainly due to the efforts of a relatively small number of actuaries who may or may not reflect your views.

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Actuaries and Fair ValueConclusion: (Cont.)The CAS is working on an RFP for

case studies of fair value accounting applied to general insurance.

If you think fair value is an important issue, either for good or bad, make yourself heard.

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ConclusionsThere’s a great deal of smoke and fire,

both internationally and domestically, about the issues of fair value and performance reporting. There will be significant changes in capital markets financial reporting, and those changes will ultimately affect US insurers, whether or not they currently report on a GAAP basis.

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Conclusions (Cont.)Many academics, consultants, and

standards setters think financial statements should bear more directly on company valuation, even if that requires increased subjectivity. Accordingly, they are pushing for fair value, intangible assets, and revised performance measures.

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Conclusions (Cont.)The International Accounting Standards

Board is quickly building a critical mass of influence as the national standards setters are under pressure to agree on increasingly uniform standards. FASB may see the IASB as an opportunity to get some things implemented more easily than could happen in the US.

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Conclusions (Cont.)The IASB will seriously consider

adopting an entity-specific value approach to accounting for insurance contracts. Such an adoption of “fair value lite” would in turn likely influence both US GAAP and international insurance regulatory accounting standards setters.

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Conclusions (Cont.)A “fair value” world will significantly

change the jobs of most people who attend the CLRS. Now would be a good time to think about whether you think that is a good thing or a bad thing.

Actuaries are having an influence on the course of events, but very few actuaries are spending much time on this issue.

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FinaleAs a larva, the sea squirt has a brain-

like ganglion that allows it to sense its environment and swim around.

As an adult, the sea squirt attaches itself to a stationary object and then digests most of its own brain.

Whether you favor or oppose fair value, don’t emulate the sea squirt.