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International Financial Reporting StandardOn Insurance Contracts

Business Practice and Necessary DataIn General Insurance Companies

(Interim Report)

June 1, 2004

IFRS Project TeamOf the General Insurance Association of Japan

Copyright 2004, the General Insurance Association of Japan

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Introduction

This report addresses business practice in insurance accounting and related necessarydata on the assumption that the IFRS on Insurance Contracts has been introduced toJapanese general insurance companies.

The possible developments of the IFRS on Insurance Contracts are uncertain yet but,according to the official schedule of the IASB, an exposure draft is scheduled to becompleted in June 2005. On the assumption that the draft will be adopted asaccounting standards in fiscal 2007/2008, there remain two to three years only forimprovement of the existing data systems, etc. In the circumstances, we decided toprepare an interim report at this stage, although the fact remains that variousassumptions on such matters as details of accounting standards are still flexible. Timewill come, sooner or later, when it becomes necessary to publish a final report basedupon new accounting standards, etc. It is expected that a drastic review will have to bemade, in particular, of the value of embedded derivatives.

There is a report of study made on the IFRS on Insurance Contracts, which is “TheInternational Financial Reporting Standards (Part I and Part II)” published by theActuarial Study Group of the General Insurance Association of Japan. The reportcontains extremely useful data supplied by the Underwriting Reserve Project Team ofactuarial aspects on the measurement of insurance liabilities from a theoreticalapproach. The present report should be regarded as a work done by reconstructing theteam’s accomplishment from the aspects of business practice at the balance sheet date.

It should be mentioned here that, as was the case with the above report by the projectteam, this report does not represent the official views of the General InsuranceAssociation of Japan or indicate the direction it is going to take in the future.

IFRS Project TeamOf the General Insurance Association of Japan

Hidenobu GOToshihiro MIYAZAKI

Motoi FUJISAKIJunji FURUKI

Shigeru TAGUCHI, Leader (*)Nobuyasu IWAKIRIHidenori HANADA

Yasuhiro NISHIMOTOToshio OGATATomoi NODA

(*)E-Mail:shigeru.taguchi@tokiomarine.co.jp

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Contents

1. ASSUMPTIONS IN THIS REPORT 4

1.1. Trends in IFRSs and their effect on the Japanese insurance industry 4

1.2. Trends in IFRS on Insurance Contracts 4

1.3. Definition of fair value 4

2. BUSINESS PRACTICE AND NECESSARY DATA: GENERALMATTERS 7

2.1. Classification of books of insurance contracts 7

2.2. Underwriting reserves (ordinary general insurance) 10

2.3. Underwriting reserves (the third sector insurance such as nursing care expensesinsurance) 14

2.4. Underwriting reserves (savings type insurance) 18

2.5. Outstanding loss reserves 20

2.6. Outgoing reinsurance 23

3. BUSINESS PRACTICE AND NECESSARY DATA: INDIVIDUALMATTERS 29

3.1. Discount rates and own credit-standing 29

3.2. Treatment of natural hazard risks 31

3.3. Estimate of parameters related to expenses 32

3.4. Treatment of insurance having strong public nature 36

3.5. Handling of cases short of data 37

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1. ASSUMPTIONS IN THIS REPORT

1.1. Trends in IFRSs and their effect on the Japanese insuranceindustry

There is no doubt about the growing influence of the international financial reportingstandards (IFRSs). In the EU, for example, the IFRSs will be enforced upon all listedcompanies in the region from the year 2005, while, in the United States, a project isnow under way in collaboration with the IASB for the purpose of the US-GAAP andthe IFRSs being converged into one by 2007 – 2010. A decision to introduce the IFRSrests with each individual country, and in Japan the Corporate Accounting Council ofthe Financial Service Agency set to work on the advisability of giving the approval ofusing the IFRSs to corporations listed in the stock exchanges in the country. Speaking,in particular, of the IFRS on Insurance Contracts, it would cause certain effects, oneway or other, on insurance accounting in Japan by way, for example, of the disclosureof fair value and the enforcement of rigid liability adequacy tests.

1.2. Trends in IFRS on Insurance ContractsThe IASB has been making a review of the IFRS on Insurance Contracts in the twophases of provisional standards meeting with EU’s 2005 standards (phase 1) and full-scale standards to be introduced from 2007 onwards. Of these two, phase 1 hasalready taken shape but as far as phase 2 is concerned the direction it will take in thefuture is uncertain, as of the end of June 2004. For this reason it has been necessary torely in this report on various assumptions which may change as deliberations advancein the IASB.

Main assumptions in this report are as follows:

Phase 2 of the IFRS on Insurance Contracts is based, fundamentally, on theDSOP.

However, it will be supplemented by the tentative conclusions in the IASBmeeting in January 2003 (hereinafter referred to as the tentative conclusions).

The content of the tentative conclusions was made open in BC6-BC8 of the Basis forConclusions in IFRS 4 concerning Phase 1 of the IFRS on Insurance Contracts. Theconclusions once retracted in the November 2003 meeting of the IASB are nowconsidered to be a most likely scenario. In July 2004, the IASB plans to resumediscussion on phase 2 with the intention of completing the exposure draft in June2005.

1.3. Definition of fair value

1.3.1. IASB’s viewsA most important assumption in this report is the issue of defining the fair value ofinsurance liabilities. The following definition has been used by the IASB commonlyin various criteria such as IAS 16 (Property, Plant and Equipment), 17 (Accounting

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for Leases), 18 (Revenue), 19 (Retirement Benefit Costs), 22 (BusinessCombinations), 32 (Financial Instruments: Disclosure and Presentation), 38(Intangible Assets), 39 (Financial Instruments: Recognition and Measurement):

Fair value: Amount for which an asset could be exchanged, or a liability settledbetween knowledgeable, willing parties in an arm’s length transaction.

1.3.2. Treatment in DSOPOn the basis of the above common definition, the DSOP announced in 2002 the twotypes of approaches to measuring insurance liabilities, which are exit value and entryvalue as defined below:

Exit value (DSOP 3.41): The amount that the Insurer would pay another Insurerin exchange for transferring all of the obligations associated with the insuranceliability to that other Insurer.

Entry value (DSOP 3.40): The amount of the premium (perhaps net of acquisitioncosts) that the Insurer would charge in current market conditions if it were toissue new contracts that created the same remaining contractual rights andobligations.

The DSOP obviously supports the exit value and proposes, as a specific method, theuse of the present value of future cash flows after adjustments for risk and uncertainty.

1.3.3. Treatment in the tentative conclusionsOn the other side, the tentative conclusions provide for the lower limit to fair value bystating that in the absence of market evidence to the contrary, the estimated fair valueof an insurance liability shall not be less, but may be more, than the entity wouldcharge to accept new contracts with identical contractual terms and remainingmaturity from new policyholders. The lower limit is considered to be identicalvirtually with the entry value in the DSOP, provided that acquisition costs are treatedlikewise in both cases.

1.3.4. Treatment in IAS 32 and IAS 39IAS 32 (Financial Instruments: Disclosures and Presentation) and IAS 39 (FinancialInstruments: Recognition and Measurement) of the revised IAS came into effect inDecember 2003, although these are not related to insurance. The guidelines in IAS 39divide the methods of measuring fair value into cases where the market of financialinstruments is active or not active and refers, in connection with the latter case, to themethod of establishing fair value by using valuation techniques like a discounted cashflow analysis, etc. This shows that parameter adjustments (calibration) are made byusing any observable market transactions in the same instrument or any availablemarket data, from the standpoint of making maximum use of market inputs at the timeof measuring fair value. This way of approach is useful for considering the fair valueof insurance liabilities.

1.3.5. Treatment in this reportAs explained above, the fair value of insurance liabilities on the basis of both theDSOP and the tentative conclusions is “the exit value or the entry value, whichever isthe larger”. In practice, therefore, it is necessary to measure both exit and entry values,

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except in cases where one is obviously larger than the other or cases wheremeasurement is not possible. In case of exit value, it is desirable to make themaximum use of market information in the measurement of fair value. In the light ofthe above, this report will address the following four kinds of methods (two times twokinds) for measuring underwriting reserves. In this report no preference for one overthe others is indicated.

Exit value(principle method)

All assumptions for measuring insurance liabilities are replacedby best estimate assumptions at the balance sheet date.

Exit value(simple method)

As above in principle, but pricing assumptions at the balancesheet date are used for part of assumptions for measuringinsurance liabilities.

Entry value Pricing assumptions at the balance sheet date are used for allassumptions for measuring insurance liabilities.

Entry value(basis reflectingsurrender cases)

As above in principle, but an adjustment is made for long-term contracts by taking surrender and lapse cases intoaccount to avoid possible overestimation or underestimationwhich may arise unless surrender and lapse values of contractsare reflected in the measurement of insurance liabilities.

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2. BUSINESS PRACTICE AND NECESSARY DATA:GENERAL MATTERS

2.1. Classification of books of insurance contractsBooks of insurance contracts mean calculation units at the time of measuring the fairvalue of insurance liabilities, and the DSOP gives the following explanation:

5.61 Measurement of insurance contracts should focus on books of insurancecontracts that are subject to substantially the same risks, rather than on individualinsurance contracts. Measurement of the book of contracts should reflect all benefitsof diversification and correlation within that book of contracts (to the extent that theyare readily determinable), but should not reflect the benefits of diversification andcorrelation outside that book of business.

The classification of books is a vital point in the measurement of insurance liabilitiesbecause, according to the DSOP, the amount of fair value may be different dependingupon such classification. However, there do not exist any concrete and objectivestandards for such classification and it becomes necessary to establish books ofcontracts without losing balance between theoretical reasonableness and feasibility. Itis not desirable to change the classification of books at each balance sheet date, andthe classification once established should continuously be used unless there is anyrational reason for change. Therefore, a deliberate study is needed for establishing theclassification of books at the time of introducing the IFRS. The following give asummary of viewpoints on books regarding items addressed in 2.2 and after:

2.1.1. Underwriting reserves (exit value)In ordinary general insurance (vide 2.2), it is expected that considering fluctuations inthe estimate of incurred losses in the future, some adjustments will be needed toreflect risk and uncertainty. For this reason, the book of underwriting reserves may bemade identical to that of outstanding loss reserves (vide2.5), although theclassification of books should be different in cases where the nature of risk isconsidered to be obviously different between not-incurred losses and incurred lossesor where loss ratios, etc. are subject to material fluctuations.

In the third sector insurance such as nursing care expenses insurance (vide 2.3), acustomized nature is generally strong and, therefore, should be handled on anindividual contract basis. In practice, however, books of insurance contracts may beestablished on the basis of collective units of age, sex, coverage, etc.

In savings type insurance (vide 2.4), the amount of surrender and lapse premiums isthe most important factor for measurement and it is considered necessary to establishbooks based, at least, on the current classification for calculating surrender and lapsevalues (by periods of insurance, expired periods of risks, methods of payment, etc.)

2.1.2. Underwriting reserves (entry value)The entry value is understood to be based upon pricing assumptions at the balancesheet date but the same classification as the existing books for calculating unearned

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premiums, premium reserves, or reserves for refunds based upon premiums atinception is considered sufficient. However, a need to apply more detailedclassification than the existing books will arise in connection with the deduction ofacquisition costs and adjustments for rate revisions.

2.1.3. Outstanding loss reservesThis report (vide 2.5) stands on the assumption of adopting a stochastic approach toreserving and, as a result, the issue of diversification and correlation mentioned in theDSOP comes to the fore, thus making it necessary to make a careful review of theclassification of books of insurance contracts on outstanding loss reserves.Fundamentally, the current classes of business can be used as the base but they can bechanged into larger or smaller units in consideration of the sizes of books, classes ofrisks covered, kinds of cash flows, periods of insurance, types of contracts, etc.

Basically, it is desirable to diversify books but excessive diversification woulddiminish reference data and enlarge fluctuations in the outcome of estimate to theextent that the outcome does not match the actual situations of risks. Also, asmentioned in the DSOP, an excessive diversification of books will not reflect thebenefits of correlation between books and result in making the sum total of thereserves excessive.

The following gives a summary of points to be considered in relation to each class ofbusiness. The diversification or otherwise of those classes should be consideredcarefully by taking the features of each product sold by the respective companies intoaccount:

2.1.3.1 Automobile insuranceClassification may be made according to the types of coverage such as bodily injury,property damage, personal injury, physical damage, injury to passengers, etc.

2.1.3.2 Fire insuranceA need to diversify a book of contracts is little because, generally, the length of timefrom the occurrence of an insured event to the completion of claims payment is shortand also because the amount of IBNR is not large. Diversification could be madeaccording to locations, risks, construction, etc. However, large-scale natural hazardrisks, which are clearly different in nature from other risks, may be dealt with by wayof an independent book of business.

2.1.3.3 Personal accident insuranceA need to diversify a book of contracts is little in this class also. Diversification couldbe made according to the types of coverage (loss of life, physical impediment,hospitalization, outpatient, etc.) or the types of professions. Or classification may bemade between group contracts and individual contracts.

2.1.3.4 Liability insuranceDiversification on the basis of a special agreement which is applied to each risk is notdesirable from the standpoint of the scale of a book of contracts. A need fordiversification should be considered with respect to risks which are important and areof a reasonable scale such as product liability insurance.

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2.1.3.5 The third sector insurance such as nursing care expensesA careful study is required because, in general, there is no sufficient volume ofinsurance claims data. From the standpoint of risks, diversification may be made withrespect to age, sex and coverage; however, from the standpoint of the scale of a bookof contracts, the grouping of contracts should be considered from the aspect of ageclassification, etc.

2.1.3.6 Marine insuranceBasically, classification may be made according to the current classes of business(hull, cargo and transport). In diversifying or grouping books of contracts, it isnecessary to consider the facts that the number of contracts is not large and that theamount of a claim varies greatly case by case.

2.1.3.7 Other kinds of general insuranceBasically, classification may be made according to the existing classes of business.With respect, however, to classes of business of which the number of contracts issmall, their combination with any other class of business should be considered.

2.1.3.8 Compensation segment of savings type insuranceBasically, this should be included in the same books of business as those of generalclasses of business because risks covered are often the same with those covered undergeneral classes of business. However, in cases where risks are considered different, innature, from each other for reasons of longer periods of insurance, variance in theclasses of customers, etc., the book of contracts may be made different from books ofbusiness in general classes of contracts.

2.1.3.9 Same risks across classes of insuranceIn some cases liability insurance, etc. are included in risks covered in other classes ofinsurance when they are components of risks covered under the general conditions ofinsurance or when they are covered by way of an endorsement to other classes ofinsurance. Concerning such risks which are the same across more than two classes ofinsurance, a theoretical approach could be to put them together across classes ofinsurance. In practice, however, it will be more realistic to put together those whichare important from the point of cost-effectiveness and to include others in theprincipal classes of insurance.

2.1.4. ReinsuranceReinsurance contracts are more individual, in nature, than direct insurance contractsand it is necessary to consider the unit of measuring fair value case by case.

In outgoing reinsurance contracts, for example, the measurement of fair value may bemade on a treaty basis. However, with respect to important facultative reinsurancecontracts or contracts in which a profit commission or a reinsurance commissionadjustment plays an important part, the measurement will have to be made on anindividual basis (vide 2.6). Or classification may be made on the basis of reinsurancecompanies to reflect credit risk or on the basis of group companies to set-offtransactions between group companies.

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In incoming reinsurance contracts, on the other hand, many cases are expected whereinformation on individual original contracts cannot be obtained fully andclassification may be made on a treaty basis (vide 3.5).

2.2. Underwriting reserves (ordinary general insurance)Underwriting reserves will be addressed by dividing them into the three categories of“ordinary general insurance”, “the third sector insurance such as nursing careexpenses insurance”, and “savings type insurance”. In this context the third sectorinsurance means a type of general insurance of which risk (in terms of accidentoccurrence ratios or insured amounts as pricing assumptions) increases or decreasesgradually with the passage of time in the period of insurance, and savings typeinsurance refers to the portion of savings premiums in insurance contracts whichpromises the payment of maturity refunds upon expiration of the period of insurance.Ordinary general insurance means classes of insurance other than these, as follows:

General insurance contracts of which the period of insurance does not exceed oneyear

General insurance contracts of which the period of insurance exceeds one yearbut of which risk does not increase or decrease gradually with the passage of timein the period of insurance (long-term fire insurance, long-term personal accidentinsurance, etc.)

Individuality is weak in insurance contracts of these types and it is consideredeffective to calculate underwriting reserves on a book-of-contracts basis. This reportdeals here with ordinary general insurance, addressing the third sector insurance suchas nursing-care expense insurance and savings type insurance later in 2.3 and 2.4. Togeneral insurance contracts of which the period of insurance exceeds one year (long-term fire insurance, long-term personal accident insurance, etc.) may be applied amethod of calculation similar to that for the third sector insurance such as nursing careexpenses insurance, from the viewpoint of elevating accuracy in calculation.

2.2.1. Exit value (principle method)

2.2.1.1 Basic conceptAs mentioned in 1, the measurement of exit value requires a forecast of the amountand timing of cash flows in the future. A strict method considered for such purposes isto rely upon the collective risk theory or DFA models. However, their feasibility isnot high at this stage and this report proposes instead a method of estimating futureloss ratios, loss adjustment expense ratios, and maintenance expense ratios fromtrends in the accident year statistics in recent years and applying them to estimatedearned premiums in the future. Any adjustment for risk and uncertainty can be madeby margins of error in estimated loss ratios and loss adjustment expense ratios throughthe analysis of the actual loss ratios and loss adjustment expense ratios in the pastaccident years. As far as long-term contracts are concerned, it is necessary to considerthe surrender and lapse of contracts in addition to 2.2.1.2 and 2.2.1.3 mentionedbelow.

2.2.1.2 Business practiceFor example, the following methods may be used:

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underwriting reserves = present value of estimated losses, estimated lossadjustment expenses, estimated commissions, and estimated maintenanceexpenses - present value of estimated receivable premiums + adjustments for riskand uncertainty

estimated losses = estimated earned premiums x estimated loss ratio estimated loss adjustment expenses = estimated losses x estimated loss

adjustment expense ratio estimated commissions = estimated receivable premiums x estimated commission

rate estimated maintenance expenses = estimated receivable premiums x estimated

maintenance expense ratio adjustments for risk and uncertainty = quantity of risk x cost of capital

Here: estimated earned premiums = adjusted gross premiums x period of earned

premiums / period of insurance (as a rule, on a daily pro rata basis) adjusted gross premiums: total amount of premiums for the contract concerned,

after premium rate revision and retrospectively adjusted premiums (auditpremiums, retrospectively rated premiums, profit commissions, no claim returnpremiums, etc.) and revaluation of assumed interest rate at inception (vide2.2.3.1)

estimated loss ratio: estimated by analyzing actual loss ratios, etc. estimated loss adjustment expense ratio: estimated by analyzing actual loss

adjustment expense ratios, etc. estimated commission rate: Vide 3.3 estimated maintenance expense ratio: Vide 3.3 quantity of risk: margins of error in estimated loss ratio and estimated loss

adjustment expense ratio (e.g. 99% CTE) cost of capital: actual measurement in the company concerned or in the market

(e.g. average pre-tax ROE)

In conversion to the present value, discount rates based on market yields at thebalance sheet date (vide 3.1) are used. For discount purposes, it is necessary toforecast the timing of cash flows, by, for example, the following means:

estimated losses, estimated loss adjustment expenses, adjustments for risk anduncertainty: Estimation is made by addition to the accident year of periods fromthe accident year to payment years (payment ratios from period to period afterthe occurrences of accidents).

estimated maintenance expenses: These are assumed to be incurred evenly duringthe unexpired period.

estimated receivable premiums, estimated commissions: Normally it should bepreferable to add the average period of delay in settlement to the month scheduledfor payment, but it would suffice to regard scheduled payment months assettlement months.

2.2.1.3 Necessary data in-force contract information (risk attachment dates, payment methods, insurance

periods, payment periods, insured amounts, etc.) estimated receivable premiums adjusted gross premiums

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best estimate assumptions (loss ratios, loss adjustment expense ratios,commission rates, maintenance expense ratios, etc.)

margins of error in estimated loss ratio and estimated loss adjustment expenses cost of capital discount rates based on market yields at the balance sheet date payment ratios from period to period after the occurrences of accidents

2.2.2. Exit value (simple method)When it is clear that there are no material differences between the amounts calculatedat the assumptions based upon the best estimate at the balance sheet date and thosecalculated at the pricing assumptions at the balance sheet date, the amounts calculatedat the pricing assumptions at the balance sheet date may be used as exit value for thepurpose of reducing labor. For example, with respect to classes of insurance of whichrates proportionate to risks can be established and also of which loss ratios, lossadjustment expense ratios, etc. are stable, the pricing assumptions at the balance sheetdate may be used as the assumptions.

2.2.3. Entry value

2.2.3.1 Basic conceptAs mentioned in 1, the entry value means “the amount of premium which the Insurerwould charge in current market conditions if it were to issue new contracts thatcreated the same remaining contractual rights and obligations”. In the case of ordinarygeneral insurance, the amount of unearned premiums calculated on premiums at thebalance sheet date (instead of at the time of accepting business) may be used as entryvalue. However, the following adjustments are needed for current unearnedpremiums:

2.2.3.1.1 Elaboration on unearned premium ratioAt present unearned premiums are calculated by the 1/12th method at the end of themonth, etc., but it should be preferable to elaborate on the unearned premiums ratioby calculating the ratio on the base, in principle, of the 1/365 method (daily pro rata).For practical purposes, however, the 1/24th method at the middle of the month isconsidered sufficient. The current practice is to use premium-booking dates as thebasis of calculating unearned premiums, but it is necessary to alter the method to onebased upon the definition of fair value (the amount of liability for the outstandingperiod of insurance). In other words, there is a need for calculating unearnedpremiums on a risk attachment basis in order to attain consistency between thecalculation of unearned premiums and the unexpired period of insurance.

2.2.3.1.2 Lump-sum booking of installment base contractsIn contracts on an installment basis, it should be noted that the amount of premiumsreceivable from policyholders in the future remains unaltered before and after therevaluation of an insurer’s liability (an amount payable in the future) at the time ofcalculating entry value. A method to cope with this situation would be to obtainunearned premiums on an adjusted gross premium basis by establishing unearnedpremiums on the base of total written premiums (on a risk attachment basis) afterrevaluation and deduct the discount value of premiums receivable in the future off theunearned premiums thus obtained.

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2.2.3.1.3 Deduction of acquisition costs (company’s expenses for new contracts,commissions)

Currently acquisition costs are included in the calculation of unearned premiums.Since, however, it is considered that acquisition costs are to be deducted off theamount chargeable to customers, there is a need for calculating unearned premiumsafter deduction of acquisition costs off premiums received at inception.

2.2.3.1.4 Rate revisionUnearned premiums need to be adjusted when premium rates are revised before thebalance sheet date. It seems acceptable to make this adjustment by applying, forreasons of cost-effectiveness, the average of revised rates to larger books of contracts

2.2.3.1.5 Retrospectively adjusted premiumsUnearned premiums need to be adjusted also when retrospectively adjusted premiumssuch as audit premiums, retrospectively rated premiums, profit commissions, noclaims return premiums, etc. are expected to take place. In the estimate ofretrospectively adjusted premiums, it would be acceptable to apply the average ofretrospectively adjusted amounts to larger books of contracts, except in cases wherecontracts are material and of highly individual nature.

2.2.3.1.6 Reevaluation of assumed interest ratesFor long-term contracts, it is necessary to reevaluate unearned premiums, which arediscounted at assumed interest rates at inception, at assumed interest rates at thebalance sheet date.

2.2.3.2 Business practiceFor example, the following methods may be used:

underwriting reserves = unearned premiums on an adjusted gross premium basisx (1-acquisition cost ratio) - discount value of contractual receivable premiumsnet of commissions

acquisition cost ratio = acquisition costs / adjusted gross premiums

In conversion to the discount value, assumed interest rate at the balance sheet date isused. If, for the purposes of disclosure, a classification into losses, loss adjustmentexpenses, maintenance expenses, etc. is needed, the following formulas may be used:

losses = unearned premiums on an adjusted gross premium basis x assumed lossratio at the balance sheet date

loss adjustment expenses = unearned premiums on an adjusted gross premiumbasis x assumed loss adjustment expense ratio at the balance sheet date

maintenance expenses = unearned premiums on an adjusted gross premium basisx assumed maintenance expense ratio at the balance sheet date

adjustment for risk and uncertainty = underwriting reserves - losses - lossadjustment expenses - maintenance expenses

Here: unearned premiums on an adjusted gross premium basis = discount value of

[adjusted gross premiums x unearned premiums ratio] adjusted gross premiums: total amount of premiums for the contract concerned,

after premium rate revision and retrospectively adjusted premiums (auditpremiums, retrospectively rated premiums, profit commissions, no claim return

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premiums, etc.) and revaluation of assumed interest rates at inception (vide2.2.3.1)

unearned premiums ratio: in principle, on a risk attachment basis. 1/365 method

2.2.3.1 Necessary data in-force contracts information (risk attachment dates, payment methods,

insurance periods, payment periods, insured amounts, etc.) contractual receivable premiums net of commissions adjusted gross premiums unearned premiums ratios acquisition cost ratios (company’s expenses for new contracts, commissions) pricing assumptions (assumed loss ratios, assumed loss adjustment expense ratios,

assumed maintenance expense ratios, assumed interest rates, etc.) at the balancesheet date

2.2.4. Entry value (basis reflecting surrender cases)When new contracts on the same conditions are selected, it would generally bepossible to calculate adjusted gross premiums because of the existence of contractshaving the same conditions on insured amounts and the scope of coverage. Withrespect, however, to long-term contracts of which surrender and lapse values arelinked to assumed interest rates, it is necessary to consider them separately fromothers because, if assumed interest rates change following reevaluation, surrender andlapse values in new contracts are different from those in the original contracts eventhough the insured amounts and the scope of coverage are the same. Hence, there is aneed for adjusting such differences to total premiums on new contracts becauseamounts payable to policyholders are those agreed under the original contracts. Inpractice, at the time of revaluation following changes in assumed interest rates, theeffect of the economic value of surrender and lapse values can be reflected in entryvalue.

2.3. Underwriting reserves (the third sector insurance such asnursing care expenses insurance)

The method of measuring underwriting reserves for the following types of insurancewill be considered here:

General insurance contracts of which the period of insurance exceeds 1 year andin which the pricing assumptions like the accidence occurrence ratio, etc. increaseor decrease with the passage of time (nursing care expenses insurance, cancerinsurance, long-term medical insurance, etc.)

General insurance contracts of which the period of insurance exceeds 1 year andin which the insured amount increases or decreases with the passage of time(compensation segment of savings type personal accident insurance, etc.)

These types of insurance are largely different from contract to contract and, inprinciple, underwriting reserves for them should be calculated individually. Inpractice, however, considering a heavy workload, etc. involved in such calculation, itwould be realistic to calculate them on a book of contracts basis made up of ages, etc.

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2.3.1. Exit value (principle method)

2.3.1.1 Basic conceptFor the same reasons as in ordinary general insurance, this report proposes a methodof establishing exit value by calculating the present value of future cash flows basedon the best estimate of assumptions applicable to the closed book contracts at thebalance sheet date, by regarding the value as the expected value of the (books of)contracts concerned and by adjusting it for risk and uncertainty in accordance with thecost of capital method, etc.

2.3.1.2 Business practiceThe following are examples:

underwriting reserves = present value of estimated losses, estimated lossadjustment expenses, estimated commissions, estimated maintenance expenses,estimated surrender and lapse premiums, and estimated no claim returnpremiums - present value of estimated receivable premiums + adjustments forrisk and uncertainty

For a certain measurement period (e.g. monthly or quarterly), estimated losses = contractual insured amounts x in-force ratio x estimated

accident occurrence ratio x estimated claims payment ratio against insuredamounts or

estimated losses = contractual premium funds reevaluated at assumed interestrate (separately for generations of pricing) x in-force ratio x estimated loss ratio.The losses are allocated to later cash flow periods by payment ratios from periodto period after occurrences of accidents.

estimated loss adjustment expenses = estimated losses x estimated lossadjustment expense ratio (adjusted for future management principle, as the needarises)

estimated commissions = estimated receivable premiums x estimated commissionrate (by payment methods) - estimated surrender and lapse premiums x estimatedcommission rate (by payment methods)

estimated maintenance expenses = number of contracts at the balance sheet date xin-force ratio x estimated maintenance expenses per contract

estimated surrender and lapse premiums = contractual surrender and lapsevalues x in-force ratio x estimated surrender and lapse ratio

estimated no claim return premiums = contractual no claim return values x in-force ratio x no claim ratio

estimated receivable premiums = contractual receivable premiums x in-forceratio (by payment methods and by expired periods)

adjustments for risk and uncertainty = quantity of risk x cost of capital

Here: in-force ratio: a product of series of [1 - estimated surrender and lapse ratio] estimated accident occurrence ratio, estimated claims payment ratio against

insured amounts, estimated loss ratio, estimated loss adjustment expense ratio,estimated surrender and lapse ratio, and estimated no claim ratio: estimated byanalyzing entity specific or market statistics.

estimated commission rate: Vide3.3 estimated maintenance expenses per contract: Vide3.3

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quantity of risk = underwriting reserves based on conservative assumptions -underwriting reserves excluding adjustments for risk and uncertainty

cost of capital : actual measurement in the company concerned or in the market(e.g. average pre-tax ROE)

In conversion to the present value, discount rates based on market yields at thebalance sheet date (vide 3.1) are used.

2.3.1.3 Necessary data in-force contract information (risk attachment dates, payment methods, insurance

periods, payment periods, insured amounts, etc.) contractual surrender and lapse values contractual no claim return values contractual receivable premiums best estimate assumptions (estimated accident occurrence ratios, estimated

claims payment ratios against insured amounts, estimated loss ratios, estimatedloss adjustment expense ratios, estimated surrender and lapse ratios, andestimated no claim ratios, estimated commission rates, estimated maintenanceexpenses per contract, etc.)

underwriting reserves based on conservative assumptions underwriting reserves excluding adjustments for risk and uncertainty cost of capital discount rates based on market yields at the balance sheet date payment ratios from period to period after the occurrences of accidents

2.3.2. Exit value (simple method)As in ordinary general insurance, when there are no material differences between theamounts calculated at the presumed assumptions based upon the best estimate at thebalance sheet date and those calculated at the pricing assumptions at the balance sheetdate, the amount calculated at the pricing assumptions may, for the purpose of savinglabor, be used as exit value. However, concerning long-term contracts, which areconsidered to be highly sensitive to interest rates and surrender and lapse ratios, itwould be necessary to amend discount rates and surrender and lapse ratiosaccordingly.

2.3.3. Entry value

2.3.3.1 Basic conceptIn the third sector insurance such as nursing care expenses insurance, unearnedpremiums and premium reserves calculated at pricing assumptions at the balancesheet date can be considered usable as entry value. However, it is necessary to adjustthe current unearned premiums and premium reserves for the following points. Withrespect, in particular, to long-term contracts, there may be cases where entry valuedoes not exist at all because of the passage of a long time since the products ceased tobe sold in the market. For such contracts the measurement of entry value is impossibleand there is no way of setting up a lower limit to the fair value of entry value.

2.3.3.1.1 Elaboration on unearned premium ratioCurrently unearned premiums are calculated by the 1/24th method in the middle ofthe month, etc., but it should preferably be elaborated by calculating unearned

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premiums on the basis of the 1/365th method (daily pro rata). In practice, however,the 1/24th method in middle of the month is considered sufficient.

Now, in some contracts unearned premiums are calculated on the basis of premium-booking dates. For these contracts it is necessary to adjust unearned premiums on arisk attachment basis in order to maintain consistency between the calculation ofunearned premiums and the periods of insurance.

2.3.3.1.2 Deduction of acquisition costs (company's expenses for new contractsand commissions)

In some current contracts subject to standard underwriting reserves, acquisition costsare included in the calculation of unearned premiums. With respect to these contracts,acquisition costs are considered to be deducted off amounts chargeable topolicyholders and unearned premiums should be calculated by excluding acquisitioncosts from premiums at inception.

2.3.3.1.3 Rate revisionUnearned premiums need to be adjusted when premium rates are revised before thebalance sheet date. Premiums receivable in the future should remain unchanged asthey were at inception.

2.3.3.1.4 Discount ratesConcerning discount rates part of the pricing assumptions, it is necessary to use theassumed interest rates at the balance sheet date applicable to contracts havingidentical terms and conditions.

2.3.3.2 Business practiceThe following is an example:

underwriting reserves = discount value of assumed losses, assumed lossadjustment expenses, assumed maintenance expenses, assumed surrender andlapse premiums, and assumed no claim return premiums - discount value ofcontractual receivable premiums net of commissions

In conversion to the discount value, assumed interest rates at the balance sheet dateare used. Here, assumed losses, assumed loss adjustment expenses, assumedmaintenance expenses, assumed surrender and lapse premiums, assumed no claimsreturn premiums are based on pricing assumptions such as assumed accidentoccurrence ratios at the balance sheet date. If maintenance expenses are notexplicitly classified in pricing assumptions, the company’s expenses are classified byusing actual acquisition costs (company’s expenses for new contracts, commissions).

2.3.3.3 Necessary data in-force contract information (risk attachment dates, payment methods, insurance

periods, payment periods, insured amounts, etc.) contractual receivable premiums net of commissions actual acquisition costs (company’s expenses for new contracts, commissions) pricing assumptions (assumed accident occurrence ratios, assumed claims

payment ratios against insured amounts, assumed loss ratios, assumed lossadjustment expense ratios, assumed surrender and lapse ratios, and assumed no

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claim ratios, assumed maintenance expenses per contract, assumed interest rates,etc.) at the balance sheet date

2.3.4. Entry value (basis reflecting surrender cases)As mentioned in 2.2.4, the effect of the economic value of surrender and lapse valuesmay be reflected in entry value at the time of reevaluation following changes in theassumed interest rates.

2.4. Underwriting reserves (savings type insurance)This part addresses issues peculiar to savings type insurance such as reserves forrefunds (underwriting reserves for maturity refunds, etc.), reserves for dividends topolicyholders (underwriting reserves for policyholders’ dividends, etc.), etc. At thisstage, the insurability of savings type insurance is not clear, but this report stands onthe assumption that it is unnecessary to unbundle savings type insurance for reasonsof total loss lapse and that it is insurable because there is an important transfer of riskin savings type insurance in its entirety

2.4.1. Reserves for refunds

2.4.1.1 Exit valueThe estimate of maturity refunds (including annuity benefits) in savings typeinsurance may well be made by a deterministic approach.

2.4.1.1.1 Business practiceFor example, the following method is possible. Surrender and lapse ratios areconsidered to be correlated with market yields, assumed interest rates, levels ofinsured amounts for compensatory segments and the ages of the insured but, at thisstage, it would be practically difficult to quantify such correlation. The following isbased on condition that surrender and lapse ratios by periods of insurance and expiredperiods of risks are used as they are:

reserves for refunds = present value of estimated maturity refunds and estimatedsurrender and lapse premiums - present value of estimated receivable premiums

Here, for a certain measurement period (e.g. monthly or quarterly), estimated maturity refunds = contractual maturity refunds x in-force ratio (by

periods of insurance and expired periods of insurance to be calculated by thecontinued product of surrender and lapse ratios)

estimated surrender and lapse premiums = contractual surrender and lapsevalues x in-force ratio x estimated surrender and lapse ratio excluding total losslapse ratio

estimated receivable premiums = contractual receivable premiums x in-forceratio (by payment methods and by expired periods)

in-force ratio: a product of series of [1 - estimated surrender and lapse ratio]

In conversion to the present value, discount rates based on market yields at thebalance sheet date (vide 3.1) are used.

2.4.1.1.2 Necessary Data

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in-force contract information (risk attachment dates, payment methods, insuranceperiods, payment periods, etc.)

contractual maturity refunds contractual surrender and lapse values contractual receivable premiums best estimate assumptions (estimated surrender and lapse ratios, estimated total

loss lapse ratios, etc.) discount rates based on market yields at the balance sheet date

2.4.1.2 Entry valueIn savings type insurance, reserves for refunds calculated using pricing assumptions atthe balance sheet date may be used as entry value. In the case of installment basiscontracts, however, there is a need for deducting discount values of premiumsreceivable at assumed interest rates at the balance sheet date off reserves for refundsreevaluated on the basis of lump-sum payment contracts. In cases where a product,which is not sold any longer, is not available in the market, it would be possible to useassumed interest rates for analogous savings type insurance having the period ofinsurance similar to the remaining period of insurance of the product concerned.

[Necessary Data] in-force contract information (risk attachment dates, payment methods, insurance

periods, payment periods, etc.) contractual maturity refunds contractual surrender and lapse values contractual receivable premiums pricing assumptions (assumed surrender and lapse ratios, total loss lapse ratios,

assumed interest rates, etc.) at the balance sheet date

2.4.1.3 Entry value (base reflecting surrender cases)Concerning reserves for refunds in savings type insurance also, the effect of theeconomic value of surrender and lapse values may be reflected in entry value at thetime of revaluation following change in assumed interest rates. In savings typeinsurance, however, there are cases where the size of refund funds is so large thattheir effect cannot be ignored.

2.4.2. Reserves for dividends to policyholdersIn the IFRS on Insurance Contracts, the treatment of cases where dividends arediscretionary is uncertain at this stage. Therefore, this report deals with the reservesby dividing them into “allocated” and “non-allocated” in the light of constructiveobligations which are frequently referred to in discussions in the IASB (DSOP 4.21,etc.)

2.4.2.1 AllocatedThe existing clauses often make it clear that policyholders’ dividends are calculatedon the basis of “reserves for dividends to policyholders” at the end of the businessyear preceding to the dividend year. So, it would be possible to deal with the matterby dividing insurance policies into policies guaranteeing the prescribed interest ratethroughout the period and those without such guarantee, as follows:

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2.4.2.1.1 Insurance policies other than those guaranteeing the prescribedinterest rate throughout the period

Dividends to policyholders are not supposed to be less than the reserves for dividendsto policyholders established at the end of the preceding year, except when dividendsto policyholders are not paid for reasons of surrender and lapse, etc. and it isconsidered necessary to recognize the amount of the reserves as actual liabilities,Therefore, the need arises to discount the current “reserves for dividends topolicyholders” at a rate based on the market yield at the balance sheet date, plusinterests at rates prescribed annually for each future term.

2.4.2.1.2 Insurance policies guaranteeing the prescribed interest ratethroughout the period

Investment yields in the future and management decisions may affect “reserves fordividends to policyholders” appropriated in the past and cause policyholdersdividends to become lower than those reserves. In other words, it is possible underpolicy conditions that “reserves for dividends to policyholders” should be reduced forreasons of investment yields or management decisions. Therefore, it is not unlikelythat “reserves for dividends to policyholders” in this type of policies should not bedeemed as coming under obligations in real terms. However, a final judgment shouldbe made in the light of trends in the IASB, etc.

2.4.2.2 Non-allocatedPolicy conditions are not considered to be explicit about the use of non-allocatedportions of “reserves for dividends to policyholders” for policyholders’ dividends.Further, in the Insurance Business Law the portions are dealt with as those similar to“reserves for dividends to policyholders” allocated for policyholders’ dividends.These facts are considered to prove that non-allocated portions of “reserves fordividends to policyholders” do not come under real obligations.

2.4.3. Policy loansDSOP 4.42 deals with policy loans as a repayment of the insurance liability, thusnecessitating a forecast for the future. The amount of policy loans made can beobtained by multiplying the estimated reserves for refunds by the ratio of loanseffected and the amount of repayment can be estimated on the basis of the averagerepayment period. For the reason, however, future loan interest rates are notprescribed, it would be extremely difficult to estimate future repayments, withoutstanding on the assumption that loans will be made at market rates at the balancesheet date. In fact, it is highly probable that an estimate made would end up being ameaningless number.

2.5. Outstanding loss reserves

2.5.1. Basic conceptIn current practice, insurance liabilities related to incurred losses are evaluated byclassifying them into case reserves and IBNR reserves. However, in an approachbased on the estimate of future cash flows, evaluation is made by basically using lossdevelopment data and uniting both of these reserves. Also, cash flows are estimated

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not only of losses but also of loss adjustment expenses and are included in theevaluation of insurance liabilities.

In the actuarial field of general insurance, various methods for calculating reserveshave been studied and this report develops its ideas on the basis of using a stochasticapproach to reserving. As examples of the stochastic approach, there are Mack'smodel, Bayesian models, Random-walk model, Over-dispersed Poisson model, etc.

2.5.2. Business practiceFor example, there are the following methods:

outstanding loss reserves = present value of estimated losses of accidents alreadyoccurred and estimated loss adjustment expenses of accidents already occurred +adjustments for risk and uncertainty

estimated losses of accidents already occurred: expected amount of future lossesof accidents already occurred obtainable by a stochastic reserving method

estimated loss adjustment expenses of accidents already occurred = estimatedlosses of accidents already occurred x estimated loss adjustment expense ratio

adjustments for risk and uncertainty = quantity of risk x cost of capital quantity of risk: obtained from probability distribution of losses and loss

adjustment expenses of accidents already occurred (e.g. 99%CTE) cost of capital: actual measurement in the company concerned or in the market

(e.g. average pre-tax ROE)

Estimated losses of accidents already occurred are calculated separately forindemnities, incidental expenses, and salvage and subrogation recoveries (expensesand recoveries with little impact on indemnities may not be separated.) For estimatedloss adjustment expense ratio please refer to 3.3.3. Estimated loss adjustmentexpenses of accidents already occurred may also be calculated separately for theinitial stage, outstanding stage, and paid stage.

Mack's model makes it rather easy to calculate both estimated losses of accidentsalready occurred and the quantity of risk. According to this method, the present valueof estimated losses of accidents already occurred may be obtained by estimatingincurred losses from loss development by means of chain-ladder models, developingthem into cash flows from period to period (by applying, for example, payment ratiosfrom period to period after the occurrences of accidents obtainable from thedevelopment of paid losses), and discounting them at discount rates based on marketyields at the balance sheet date. Concerning the quantity of risk, on the other hand,VaR, CTE, etc. can be calculated on the basis of standard deviations in estimatedultimate losses obtained by Mack's model, on the assumption that the spread of lossesis symmetrical.

It should be noted that Mack's model places 100 % credibility on empiricalinformation, with the result that fluctuations in chain-ladder data causes fluctuationsin estimated ultimate losses. To avoid such cases it would be advisable to considerusing the Benktander model or Bayesian models, which combines prior informationwith empirical information based on the Credibility theory.

In the above calculation, adjustments for risk and uncertainty are assumed to be madewith respect to the present discount value of estimated losses of accidents already

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occurred. In this connection, DSOP5.13 states that adjustments for risk anduncertainty should be reflected preferably in the future cash flows. However,adjustments by this method entail a huge volume of calculation and the methodindicated above would be considered to meet practical purposes.

2.5.3. Necessary data necessary data for applying Mack's model paid losses and loss adjustment expenses (attributed to books of contracts) by

accident year (, or quarter, month, date, etc.) and by calendar year (, or quarter,month, date, etc.) separately for indemnities, incidental expenses, salvage andsubrogation recoveries

case outstanding losses and loss adjustment expenses (attributed to books ofcontracts) by accident year (, or quarter, month, date, etc.) and by calendar year (,or quarter, month, date, etc.) separately for indemnities, incidental expenses,salvage and subrogation recoveries

factors disturbing regular loss development (Vide 2.5.4.1) such as inflation rates,large claims, scale of the book of contracts, foreign exchange, etc.

discount rates based on market yields at the balance sheet date

The following data may also become necessary depending upon methods employed: written and earned premiums on an annual (, or quarterly, monthly, daily, etc.) number of paid claims by accident year (, or quarter, month, date, etc.) and by

calendar year (, or quarter, month, date, etc.) number of case outstanding claims by accident year (, or quarter, month, date,

etc.) and by calendar year (, or quarter, month, date, etc.) prior information concerning probability distributions followed by losses and loss

adjustment expenses.

2.5.4. Issues arising in business practice

2.5.4.1 Regular loss developmentThe existence of proper loss development is a prerequisite reserving method. In cases,therefore, where actual loss results contain any factors which disturb regulardevelopment, the table of loss development must be used after appropriateadjustments. Should it possible to reasonably anticipate such factors, those factorsshould be incorporated in a future estimate. It is also considered necessary to keepregularity in books of contracts which compose units for loss development.

2.5.4.2 Model risks and parameter risksIn a stochastic approach to reserving, the future is forecast by applying data toprobability models; that is to say, there exist model risks. In some models it isnecessary to specify probability distribution and its parameters (mean values, standarddeviations, etc.), which means that there also exist parameter risks. A careful reviewis needed to ensure that model and parameter risks are appropriate for each book ofcontracts.

2.5.4.3 Books of contracts of which periods of claims payment are long anduncertain

Nursing care expenses insurance, long term disability insurance, etc., are featured forthe facts that it takes a long time from the occurrence of an insured event until the

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completion of claims payment and that it is not clear at the time of the occurrence ofthe event when the payment of claims will be completed. Coupled with the fact that itis not sufficiently long since these types of insurance began to be sold, lossdevelopment data needed for estimating the future have not been fully stored and,therefore, it is not necessarily proper to use the above-mentioned methods as they are.For example, it is a general practice to calculate outstanding loss reserves by applyingthe length of the average expectation of life or the expected length of disability to theinsured amount by contract to contract. For the reason, however, of long periods ofpayment needed, it would be necessary to take into account a discount element on thebasis of ratios in terms of periods needed from the occurrence of claims to thepayment of claims (vide 2.3). Further, IBNR reserves which are not included in thiscalculation need to be forecast from the average delay ratios on the reporting ofaccidents.

2.5.4.4 Natural disastersOutstanding loss reserves for natural disasters are also in need of classification intolarge-scale natural disasters and others, as explained later in 3.2. It is not appropriateto apply the above methods to large-scale natural disasters which have rarelymanifested themselves during the past period of observation (in other words,empirical data are unavailable). In the circumstances, outstanding loss reserves fornatural disasters must be estimated from broad and overall aspects of incurred lossesbooked between the accident date and the balance sheet date, information on retainedcontracts (insured amounts, etc.) in the disaster area, the severity of the disaster, etc.Further, special points, if any, in loss adjustment systems should be taken into accountin the calculation of loss adjustment expenses. Regarding other natural disasters, onthe other hand, the above methods may be applied without any particular problemsexcept when occurrence ratios of such disasters and the severity of damage are largelyat variance with those of ordinary risks. In such cases, it is necessary to classify booksof contracts accordingly.

2.5.4.5 Asbestos claims, etc.Methods using loss development capture specific trends from past results and estimatethe future on the assumption that such trends will continue to stay. Therefore, it is notappropriate to apply the methods to claims related to asbestos suits, environmentalpollution suits, etc. which do not conform to such assumption. A method which cantake care of this situation would be to forecast final incurred losses on the unit basesof the insured and polluted sites depending upon the importance of cases involved. Incases where such a method is not feasible or where the degree of importance is low, itwould be practical to adopt a simple method of going by market benchmarksaccording to the survival ratio or past empirical rules.

2.6. Outgoing reinsuranceOutgoing reinsurance is a means of a risk-hedge against the direct insurance businessof an insurance company and, theoretically, it is considered possible to measure theinsurance assets of ceded contracts on the basis of insurance liabilities under directinsurance contracts. However, relationships between direct insurance contracts are notalways proportional with each other. In the circumstances, the following studyaddresses issues from the standpoint of proportional and non-proportionalrelationships.

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As opposed to direct insurance business which, generally, is measured in terms ofinsurance liabilities, outgoing reinsurance business is measured in terms of insuranceassets. The tentative conclusions for phase 2 in IFRS 4 (BC6) state that the estimatedfair value of an insurance liability should not be less, but may be more, than the entitywould charge to accept new contracts with identical contractual terms and remainingmaturity from new policyholders. This is understood to mean that whereas the fairvalue of insurance liabilities should not be less than entry values, there is no suchlimit for insurance assets. On this understanding, the following study deals withapproaches to measuring the exit value of reinsurance assets.

A big difference between direct insurance contracts and reinsurance contracts lies inthe fact that attributes of parties to contracts are largely different from each other, forthe reason that direct insurance contracts are transactions with general consumers,while reinsurance contracts are transactions with third parties known as reinsurershaving a professional knowledge of insurance, and this fact is the basis of thefollowing review. Also, in the case, for example, of clean-cut reinsurance contracts inwhich the transfer of credit and debts is made between third parties with effect fromthe date of concluding a treaty between them, it is possible to consider that thetransfer price should be in terms of fair value because the transfer of credit and debtsis accompanied by the actual transfer of money. In the following, therefore, adistinction is made between clean-cut and run-off contracts, in addition to adistinction between proportional and non-proportional contracts, in the measurementof insurance liabilities.

2.6.1. Proportional reinsuranceProportional reinsurance is divided into quota share reinsurance and surplusreinsurance. These contracts are proportional to direct insurance contracts and themeasurement of their fair values can be made by using methods employed for directinsurance contracts. On the other hand, it is reasonable to separate clean-cutreinsurance contracts from others, as explained later.

2.6.1.1 Clean-cut proportional reinsurance contracts

2.6.1.1.1 Basic conceptClean-cut reinsurance contracts are the types of business in which all reinsuranceobligations transferred to reinsurers are retransferred to other reinsurers on thetermination date of reinsurance treaties. The kinds of obligations transferred between reinsurers include the following:

Expired portion (obligations during the expired periods of risks): the amount ofobligations at the time of transfer corresponds to the amount of outstandingclaims regarding incurred losses.

Unexpired portion (obligations during the unexpired periods of risks): the amountof obligations at the time of transfer corresponds to the amount of paidreinsurance premiums for unexpired periods of risks

Reinsurers for the current year are relieved of remaining obligations after thetermination date of treaties and are bound to pay cedants reinsurance premiumscorresponding to the unexpired periods of risks. The amount of the remaining

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obligations are calculated by cedants according to the terms and conditions of thetreaties, and if the termination date falls on the balance sheet date, the amount itselfbecomes fair value because settlement between the old and new reinsurers is made onthe basis of the amount calculated by the cedants according to the terms andconditions of the treaties.

2.6.1.1.2 Business practiceBusiness practice on different kinds of obligation under clean-cut reinsurancecontracts are as follows:

Expired portion: The amount of obligation ordinarily corresponds to the amountof outstanding reinsurance claims at the termination date of a treaty. However,there are cases of obtaining the amount by applying a coefficient to an amountcorresponding to outstanding reinsurance claims. Profit commissions orreinsurance commission adjustments, if any, under treaties which have alreadyterminated need to be calculated individually according to treaty terms andconditions.

Unexpired portion: Calculation is ordinarily made by cedants who inform theirreinsurers of the result. The amount of obligation is obtained by multiplyingwritten premiums of one underwriting year by a coefficient provided for undertreaties (net, usually, of reinsurance commission rates)

In the above business practice, calculation is made as of the termination date of atreaty and since the date is usually March 31st, figures in books closed as of the endof March become equal to those calculated in the current business practice. In caseswhere the balance sheet date is not the same as the termination date of a treaty (e.g.interim closing of books), calculation is considered possible by the use of a coefficientadjusted for the length of period.

There are cases where a recovery takes place after passage of a certain length of timebecause of changes in outstanding reinsurance claims. An important point is how totake care of such cases.

2.6.1.1.3 Necessary dataThe following data are necessary for each treaty (calculation to be by the respectivedirect-writing companies):

estimated outgoing reinsurance premiums contractual recoverable reinsurance claims (including IBNR) contractual reinsurance commission rates contractual profit commissions and adjusted reinsurance commissions

2.6.1.1.4 Short-cut methods for proportional reinsuranceIn principle, proportional reinsurance contracts are accepted on the same terms andconditions as those under direct insurance contracts (that is to say, as original). Evenif outgoing reinsurance contracts show bad results, cedants can recover adversebalances from reinsurers. In this regard, there can be a simple method of applyingcession ratios on a written or earned premiums basis to fair value liabilities relating todirect insurance contracts. (This method is applicable not only to clean-cutreinsurance contracts above but also to run-off reinsurance contracts below.)

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2.6.1.2 Run-off proportional reinsurance contracts (proportional reinsurancecontracts other than clean-cut contracts)

2.6.1.2.1 Basic conceptThe measurement of fair value will be made by division into expired and unexpiredportions also. The expired portion, as is the case with clean-cut treaties, correspondsto outstanding reinsurance claims. In the unexpired portion on the other hand, inwhich unlike clean-cut contracts obligations are not transferred on the terminationdates of contracts, the measurement of cash flows must be made individually. Thismeasurement of cash flows in respect of the unexpired portion may be made by aformula like “estimated earned premiums x estimated loss ratio”, as is the case withthe measurement of exit value in direct insurance contracts.

2.6.1.2.2 Business practice Expired portion: The portion represents an amount corresponding to outstanding

reinsurance claims and recoveries are calculated from original claims for eachtreaty. Profit commissions and reinsurance commission adjustments under treatieswhich have already terminated are calculated individually according to treatyterms and conditions.

Unexpired portion: Cash flows are generated by multiplying future earnedpremiums on reinsurance by loss ratios, surrender and lapse ratios, etc.Coefficients used for multiplication are obtained by measuring loss ratios andsurrender and lapse ratios treaty by treaty or by applying those in originalcontracts. Profit commissions and adjusted reinsurance commissions undertreaties which have not yet terminated are calculated individually according totreaty terms and conditions on the basis of used loss ratios.

2.6.1.2.3 Necessary dataThe following data are necessary for each treaty:

estimated outgoing reinsurance premiums estimated recoverable reinsurance claims (including IBNR) estimated profit commissions and adjusted reinsurance commissions estimated loss ratios (transferable from direct insurance data estimated surrender and lapse ratios (transferable from direct insurance data)

2.6.1.2.4 Surplus contractsIn quota share contracts which are in parallel relationships with direct contracts, dataunder direct contracts can be used likewise. However, in surplus contracts, in whichno such relationships exist, loss ratios are the same with each other but differencescould arise with respect to the standard deviation. This fact should not be lost sight ofwhen adjustments are made for risk and uncertainty by using the standard deviation.As to outstanding reinsurance claims, an IBNR portion must be calculated and,additionally, there may be cases where it becomes necessary to calculate those claimstreaty by treaty or on an individual contract basis.

2.6.2. Non-proportional reinsuranceUnlike proportional reinsurance, outgoing reinsurance contracts on a non-proportionalbasis do not function in parallel with direct insurance contracts, and the greater part ofcontracts is on a run-off basis. The following addresses issues on this understanding.

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2.6.2.1 Basic conceptNon-proportional reinsurance contracts will also be addressed by classifying themeasurement of fair value into expired and unexpired portions. The expired portioncorresponds, as in other cases, to the amount of receivable reinsurance premiums. Inthe measurement of the unexpired portion, on the other hand, for the reasons that thegreater part of contracts is on a non-proportional basis and that cash flows are not inparallel with those under direct insurance contracts, it is difficult to generate cashflows thereunder. In order to generate strict future cash flows under, especially,excess of loss contracts, it becomes necessary to do extensive simulations reflectingreinsurance programs. Thus, there are great differences in the measurement of fairvalue between proportional and non-proportional contracts.

On the other hand, most of ordinary excess of loss reinsurance contracts are annualand it would not be unreasonable to measure fair value on the basis of prices at theinception of reinsurance contracts, considering the facts that the setting of prices ismade in the reinsurance market in which both cedants and reinsurers are participants;and that the renewal of contracts are generally annual.

As far as natural hazard risks are concerned, it would be possible to calculate theamount of possible reinsurance recovery by way of a simulation used in themeasurement of insurance liabilities under direct insurance contracts. Under excessof loss treaties covering earthquakes, liabilities may be reduced simply in proportionto the passage of time. Under excess of loss treaties covering typhoons, on the otherhand, adjustments are needed to reflect seasonal factors.

2.6.2.2 Business practice Expired portion: Recoverable reinsurance claims are calculated by treaties on the

base of direct claims. In cases where there should arise a contractual orconstructive obligation to pay reinstatement premiums, it should be calculatedunder the treaty terms.

Unexpired portion: This is a most difficult part in the measurement of reinsuranceassets and the following are some of the methods which are considered to beworkable:

An unexpired portion of reinsurance premiums (net of reinsurance commissions)adjusted to reflect the latest market situation is regarded as fair value.

Reference prices quoted by reinsurers are regarded as fair value. (It is possiblethat in the future reinsurers may offer services for measuring fair value.)

Simulations are done at the company. In the case, especially, of reinsurancecovering natural hazard risks, it is considered desirable to obtain the amount ofdirect loss by means of simulations for reasons of consistency with directinsurance liabilities and arrive at the amount to be recovered under the scheme ofreinsurance (vide 3.2).

2.6.2.3 Necessary dataThe following data are needed for each treaty. (Some of them can be dispensed withdepending upon the method employed.)

outgoing reinsurance premiums adjusted to reflect the latest market situation (netof reinsurance commissions)

unearned outgoing reinsurance premiums adjusted to reflect the latest marketsituation (net of reinsurance commissions)

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estimated recoverable reinsurance claims (including IBNR) estimated profit commissions and adjusted reinsurance commissions estimated loss ratios (transferable from direct insurance data estimated surrender and lapse ratios (transferable from direct insurance data reference prices quoted by reinsurers simulation results

2.6.3. Reinsurers’ credit standingReinsurers’ credit standing must be taken into account in accordance with the creditratings of each reinsurer. For this reason, it is necessary to classify the above-mentioned insurance assets into groups of reinsurers. In the event that theclassification according to reinsurers is not possible at the stage of measuringinsurance assets, classification must be made by some other reasonable means.

2.6.4. Offsetting under reinsurance contracts between group companiesInsurance assets and liabilities concerning reinsurance transactions made betweenaffiliate companies are accompanied by differences even in the same transactions,depending upon terms and conditions used by the respective affiliate companies fordiscount rates, scales of books of contracts, pric Estimated losses of accidents alreadyoccurred ing assumptions, etc. In order to make strict offsetting in the consolidatedclosing of accounts, it is necessary to deduct data in original contracts (outgoingpremiums, incoming premiums) before measuring insurance assets and liabilities,instead of canceling out insurance assets and liabilities between affiliate companies.However, except for cases material in the size of money, it is considered acceptable toleave a balance of offsetting, as is the case with other consolidated closing of accounts.

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3. BUSINESS PRACTICE AND NECESSARY DATA: INDIVIDUAL MATTERS

3.1. Discount rates and own credit-standing

3.1.1. Discount rates on terms for which there exist no market ratesDSOP 6.21 refers to the method of estimating discount rates (risk-free rates) along theyield curve in cases where market rates are not easily available. In practice, theUnderwriting Reserves Project Team (Part II) considers various options in its reportand introduces, as a practical approach, the method of extrapolating market rates byusing forward rates applicable to the longest terms in existence.

On the other hand, for reasons of a small volume of forward rate transactionsavailable, the report suggests that extrapolated rates would not be appropriate withoutmaking some corrective adjustments. Regarding discount rates for ultra-long-termmaturity cases, it is desirable to secure comparability between companies.

3.1.2. Effect of inflationIn determining cash flows and discount rates, the DSOP permits approaches in bothreal inflation-adjusted terms and in nominal terms before inflation adjustments. Inpractice, the latter approach of using market rates as they are is considered simpler.However, with respect to operating expenses and claims, etc. it is necessary to takethe effect of inflation into account, depending upon their importance, because cashflows in nominal terms are subject to the effect of inflation.

3.1.3. Deduction of risk premiumsWhen yield rates are used as the base of discount rates of bonds, it should be kept inmind that yield rates are inclusive of premiums for the risk of the bond issuer itselfbecoming insolvent. For this reason, the conversion of yield rates into risk-free ratesrequires a deduction of those risk premiums. For example, Japanese governmentbonds include insolvency premiums which, strictly speaking, need to be deducted butwhich, in practice, could be ignored.

3.1.4. Reflection of credit characteristics

3.1.4.1 Description in DSOP and tentative conclusions in IASBIt is stated in Principle 4.8 that the entity-specific values of an insurance liabilityshould not reflect the insurer’s own credit standing but that conceptually fair valueshould reflect the insurer’s own credit standing. According to the tentativeconclusions in January, 2003, the measurement of insurance liabilities should bebased on fair value and, more over, the measurement of fair value should reflect thecredit characteristics of insurance contracts including the effect of guarantee by theprotection of policyholders, government insurance, etc.

3.1.4.2 Reflection of credit characteristicsAccording to the DSOP, the insurer’s own credit standing should be reflected, butthere is room for discussion about whether measurement by which deterioration in the

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credit standing leads to a reduction in liabilities should be considered appropriatefrom the standpoint of conformity to purposes. Considering also the fact that the fairvalue is defined as transfer value to a third party in market transactions, the situationin which the amount of payment required at the time of transferring liabilities to athird party diminishes when a debtor’s own credit standing is not good would notexist except in circumstances where the debtor himself can redeem the bonds, etc.issued by himself by purchasing them in the market. This is a point not to be lost sightof. The following addresses the methods by which the insurer’s own credit standing isreflected and then those by which the reliability of insurance contracts is reflected.

3.1.4.3 Reflection of the insurer’s own credit standingWhen the insurer’s own credit standing is reflected, there would be a method of usingyield rates of bonds, which are at the same level with the insurer’s credit rating, asdiscount rates. In this connection, it is necessary to continue using credit ratings bythe same rating company and thus prevent the choice of rating companies frombecoming arbitrary. From the viewpoint of comparability, the ratings used and thenames of the rating companies should be disclosed.

3.1.4.4 Reflection of the credit characteristics of insurance contractsTo reflect the credit characteristics of insurance contracts, there can be two methods;one is to incorporate the reduction of burden by the government guarantee, etc. andthe other is to make adjustments in discount rates. However neither of them seems afeasible and comparable method.

As a method to incorporate the reduction of burden by the government guarantee, etc.into the estimate of future cash flows, the average probability of insolvency ofinsurers participating in the market may be reflected in the cash flows. This is basedon the thought that since fair value is defined as the price of transfer to third parties inmarket transactions, prices will not change by the probability of insolvency ofindividual companies. A problem, however, exists in this country because the smallnumber of insurance companies makes it difficult to get a highly reliable estimate ofthe average probability of insolvency.

On the other hand, in adjustments for discount rates, a difficulty exists in decidingupon the extent of adjustment, a method, for example, is to use discount rates basedupon the average levels of rating standardized in the insurance industry. At this stage,however, any adjustment of discount rates for reasons of the insurer’s own creditstanding may be dispensed with in the circumstances where the spread ofgovernment’s regulations such as policyholders’ protection is still rather limited now.

3.1.4.5 Case of entry valueIn the case of entry value, no adjustment is necessary because it is considered that thecredit characteristics of insurance contracts are implicitly reflected in premiumsthemselves.

3.1.5. Use of weighted average discount ratesAs is the case with accounting for retirement benefits, it is possible to employ amethod of uniformly applying weighted average discount rates calculated accordingto the amount and timing of cash flows, instead of separately applying discount ratesdifferentiated according to terms. Should this method be approved, there would be the

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possibility of a mismatch between assets side and liabilities side because the termfactors of interest rates are not reflected in this method.

3.1.6. Discount rates in foreign-currency cash flowsConcerning the evaluation of foreign currency cash flows, DSOP 6.29 holds theprinciple that estimated cash flows in foreign currency should be discounted using therisk-free rate for the foreign currency and should be translated into the measurementcurrency using the spot rate at the balance sheet date. The DSOP refers, on the otherhand, to an alternative method of discounting cash flows in the reporting currencyusing the risk-free rate for the reporting currency. In practice, the latter method shouldbe accepted widely.

3.2. Treatment of natural hazard risksNatural hazard risks like windstorm, flood, earthquake, etc. can be classified intolarge-scale natural hazard risks to which, during a short span of time, the law of largenumbers fails to work properly and natural hazard risks which have high frequencyand which can be dealt with like ordinary hazard risks. The following focuses on thetreatment of large-scale natural hazard risks in the measurement of the fair value ofunderwriting reserves:

3.2.1. Basic conceptThe measurement of exit value explained in 2.2 was made by estimating future lossratios through the analysis of past loss ratios. However, there are an extremely fewcases where large-scale natural disasters occur, and it follows that the past loss ratiosdo not reflect catastrophic factors properly. For this reason, future losses arising fromlarge-scale natural disasters need to be estimated on the basis of information otherthan the past experiences.

As means of estimating future losses due to catastrophic disasters, there are, forexample, two methods; one is to estimate future losses by multiplying the totalinsured amount of retained contracts by the latest standard rate corresponding tolarge-scale natural hazard risks (hereinafter called “the standard rate method”), whichmethod is comparatively simple but should be reviewed periodically because of theneed to see that the standard rate reflects the actual situation of risks at the balancesheet date; the other is to estimate future losses by means of the Monte Carlosimulation based on engineering models or theoretical distribution models concerninglarge-scale natural hazard risks (hereinafter called “the simulation method”). Themerit of the simulation method is found in the way of estimating the probabilitydistribution of both direct and reinsurance claims by repeating simulations for tens ofthousand times or more. The demerits of the method are an extremely heavy load onsystems and big differences in results depending upon models used.

3.2.2. Business practice

3.2.2.1 Standard rating methodThe following formula may be applied separately by inception years (quarters, months,dates, etc.) and by insurance periods:

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estimated losses = total sum of [insured amounts x standard rate for large-scalenatural disasters x unearned premiums ratio] by locations, risks, construction, etc.

3.2.2.2 Simulation methodThe method makes it possible to estimate claims on retained contracts.

3.2.3. Treatment of long-term insurance contracts, etc.

3.2.3.1 Standard rating methodIn long-term insurance contracts, future losses need to be discounted to the presentvalue in accordance with the following formula by developing them along with thetiming of the generation of cash flows. Concerning long-term contracts accepted inthe past, there could be cases where insured amounts classified on the basis ofcalculation units are not available and where some sort of supposition is needed.

3.2.3.2 Simulation methodOrdinarily, simulations show the results of retained contracts for a period of 1 year.Therefore, calculation is needed of future cash flows in the subsequent years.

3.2.4. Necessary data (standard rating method) insured amounts by locations, risks, construction standard rate for large-scale natural disasters by locations, risks, construction unearned premiums ratio by locations, risks, construction

3.3. Estimate of parameters related to expensesThis part deals with the estimation of parameters related to expenses which becomesnecessary for estimating future maintenance and loss adjustment expenses used formeasuring exit value or for deducting acquisition costs included in premiums at thetime of measuring entry value. If the assumed expenses, etc. are established in thestatements of the methods of calculating insurance premiums and underwritingreserves, the estimation of the future operation cost ratio may be possible on thatassumption. However, the classification of the assumed expenses into acquisitioncosts and maintenance expenses is restricted to savings type insurance, etc. Further,even if the assumed expenses are classified into acquisition costs and maintenanceexpenses, a periodical review of the adequacy of their levels is needed especially ofexit value. For these reasons, the actual results of acquisition costs and maintenanceexpenses are indispensable for such review in both exit value and entry cases.

3.3.1. Commissions and collecting expensesCommission rates and collecting expense ratios can be used when they are establishedin the above-mentioned statements. If otherwise, they can be estimated by thefollowing means:

3.3.1.1 Commissions recognized as acquisition costsCommissions other than collecting expenses per premiums are used for estimation.[Necessary Data]

commissions other than collecting expenses for the current year by classes ofbusiness

premiums for the current year by classes of business

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3.3.1.2 Collecting expenses recognized as maintenance expensesCollecting expenses per premiums are used for estimation.[Necessary Data]

collecting expenses for the current year by classes of business premiums for the current year by classes of business

3.3.2. Operating expenses and general administration expenses

3.3.2.1 Calculation method based on actual resultsThis is a method of calculating unit prices using the results of operating expenses andgeneral administration expenses.

3.3.2.1.1 Classification of personnel expenses into acquisition costs andmaintenance expenses

The simplest method would be to make classification into acquisition costs andmaintenance expenses by regarding personnel expenses in production departments asacquisition costs and personnel expenses in general administration departments asmaintenance expenses. To improve accuracy, classification into departments orexpenditure items is not sufficient and it is necessary to conduct a detailed work timeanalysis, etc. before the allocation of personnel expenses to acquisition costs andmaintenance expenses. [Necessary data]

classification of personnel expenses according to departments concernedexpenditure items

ratios of allocation to acquisition costs and maintenance expenses by work timeanalysis, etc.

3.3.2.1.2 Classification of non-personnel expenses and taxes into acquisitioncosts and maintenance expenses

Concerning non-personnel expenses and taxes, it is necessary to subdivide not onlydepartments but also expenditure items so that an appropriate decision can be madeon the classification of acquisition costs and maintenance expenses.[Necessary data]

classification of non-personnel expenses according to spending departments andexpenditure items

3.3.2.1.3 Estimate of future maintenance expensesFuture maintenance expenses are forecast by using the results of maintenanceexpenses calculated in 3.3.2.1.1 and 3.3.2.1.2 above. To be specific, the proportion ofthe maintenance expenses for the current year to the earned premiums or the averagebalance of the retained contracts (the average unit price) by classes of business maybe calculated and be applied to the estimated earned premiums or average balance ofthe retained contracts in the future. Maintenance expenses could vary by means ofpayment but, on the assumption that the composition ratios of payment methods, etc.will stay unchanged in the future, it would be sufficient to use common unit prices forall payment methods.[Business practice]

estimated maintenance expenses = estimated earned premiums x estimatedmaintenance expense ratio

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estimated maintenance expense ratio = maintenance expenses for the currentyear / earned premiums for the current year

[Necessary data] maintenance expenses for the current year by classes of business earned premiums for the current year by classes of business estimated earned premiums by classes of business

3.3.2.2 Calculation method based on unit prices per caseThis is a method of fixing, by classes of business, such factors such as per-minute unitprice and average processing time in the current compulsory automobile liabilityinsurance and of adding up per-case unit prices obtained on those factors. Importantpoints in this approach are whether it is possible to establish an appropriate standardprocessing time, etc., regarding maintenance expenses and whether the total amountobtained by this method is consistent with the booked amount.

3.3.3. Loss adjustment expensesThe simplest method is to calculate the proportion of paid loss adjustment expenses topaid claims by classes of business for the current year and apply it to the estimatedamounts of future losses (for both incurred and not-incurred losses). However, incases where the payment of a claim is made over a long period of time, theassumption that loss adjustment expenses are incurred in proportion to insuranceclaims does not stand and it is possible that loss adjustment expenses are incurred, in aconcentrated fashion, at the time when accident are reported or when an agreement onthe amount of payment is made. In these cases, it is necessary to take into account thefuture numbers of accident notices and claims payment, in addition to incurred losses.

3.3.3.1 Business practice estimated loss adjustment expenses = estimated losses x estimated loss

adjustment expense ratio estimated loss adjustment expense ratio = paid loss adjustment expenses for the

current year / paid claims for the current year

3.3.3.2 Necessary data paid loss adjustment expenses for the current year by classes of business paid claims for the current year by classes of business estimated losses

3.3.4. Allocation between classes of insuranceThe current practice of allocation may be applied as it is except when incidentalchanges are needed depending upon the methods of classification into acquisitioncosts and maintenance expenses mentioned in 3.3.2 above.

3.3.5. Points to be noted in the estimate of future expensesThe estimate of future maintenance expenses and loss adjustment expenses should bemade by reflecting the forecast of future expenses. This forecast needs to be made bytaking into account inflation factors and expenditure trends peculiar to companies.

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3.3.5.1 Inflation factorsFor a precise description of differences in a future burden between countries whereprices are expected to rise and countries where prices are expected to fall, it isnecessary to incorporate inflation factors into the forecast of expenses or disclose suchfactors as assumed information. If the forecast of inflation rates is made separately bycompanies, it becomes necessary to secure comparability between the respective data.The situation may be complemented with the disclosure of information by assumingthat for the purposes of estimating expenses, there will be no price fluctuations.

DSOP 4.112 Some believe that cash flows and discount rates should be determined inreal (inflation-adjusted) terms. However, in countries where the government does notissue index-linked securities, real interest rates would need to be estimatedsubjectively from other market data and this may undermine their reliability.Therefore, others believe that discount rates should reflect nominal (stated) interestrates and those cash flows should be estimated in nominal terms. In principle, bothapproaches give the same answer. Therefore, this DSOP proposes to permit bothapproaches.

3.3.5.2 Expenditure trends peculiar to companiesIt cannot be said of any companies that the unit price of maintenance expenses, etc. inthe current year will continue unchanged. Although the DSOP considers that thegeneral efficiency in the market should be reflected in fair value, it is practicallydifficult to take into account the industry level at the time of establishing expenses.Basically, it would be realistic to use the unit price of maintenance expenses, etc. inthe current year as the base and deduct or reflect the effect only in cases where therewere events which materially affected the maintenance expenses in the current year orwhere it is expected that events materially affecting future expenses will occur.[Necessary data]

events which have materially affected maintenance expenses for the current yearand the amount affected

events which will materially affect future maintenance expenses and thereasonable estimate of the amount to be affected

3.3.6. Handling of overheadsThe DSOP considers that overheads which can be allocated on a reasonable andconsistent basis should be reflected in future cash flows, but there are no concretestandards for the scope of overheads. As far as overheads which are allocated to thecompany’s expenses part of underwriting expenses in the current financial statementsare concerned at least, they should be divided into acquisition costs, maintenanceexpenses and loss adjustment expenses. However, if some of the company’s expensesare expressed in such a way that admits of the existence of common expenses whichare neither underwriting expenses nor investment expenses nor expensescorresponding to any other income, those common expenses may not be attributed toany book of contracts.

DSOP 4.141 The future cash flows used to determine entity-specific value or fairvalue should include overheads that can be directly attributed to a book of insurancecontracts, or allocated to it on a reasonable and consistent basis. These overheadsshould include a reasonable charge for the consumption of all assets used to generatethe cash flows concerned. All other overheads should be excluded.

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3.4. Treatment of insurance having strong public nature

3.4.1. Compulsory automobile liability insuranceCompulsory automobile liability insurance is a type of insurance which is highly ofpublic nature aimed at providing financial security to traffic accident victims. This is acompulsory insurance based upon the Automobile Liability Security Law and for thisreason, for example, except in cases where there are legitimate reasons, insurancecompanies have no right to refuse applications of this insurance. It is run on a no loss /no profit basis and under the Law the balance between earnings and expenses andinvestment gains must be set aside for underwriting reserves.

The present underwriting reserves in compulsory automobile liability insurance iscomposed of the following 4 types:

Obligatory reserves: balances of risk premiums until the end of the 4thunderwriting year

Adjustment provisions: obligatory reserves carried forward at the end of the 5thunderwriting year, being provisions for a future deficit in risk premiums

Investment gains reserves: investment gains arising from reserved funds inrespect of risk premiums

Loading premiums reserves: balances and investment gains in respect of loadingpremiums

The following deals with underwriting reserves in compulsory automobile insuranceon the assumption that the existing no loss/no profit principle will be maintained. Inthis insurance, present underwriting reserves are considered "constructive obligations"for the reasons that it is compulsory for both policyholders and insurers, that a speciallaw (Automobile Liability Security Law) provides for the establishment of thereserves and that the reserves serve, in essence, as adjustment funds for futurepremium rates. Therefore, it is considered appropriate to continue the presentpractice in respect of underwriting reserves in compulsory automobile insurance.

If the measurement of fair value is made in the same way as for insurance in general,it should, desirably, be done by methods common to all insurance companies as is thecase with the treatment of underwriting reserves, in consideration of the facts thatthis insurance has a strong public nature and that it is operated by way of poolingarrangements for all insurance companies. In this case, for example, there could be amethod by which reinsuring companies recognize their respective shares of businesson the basis of fair value which the pool office calculates according to data reportedby each company. When fair value is measured on a closed book base, similarly toordinary general insurance, it is expected that the fair value becomes lower than thecurrent amount of underwriting reserves. However, the current amount should be keptas the minimum amount because, as far as compulsory automobile insurancecontinues to be operated under the Automobile Liability Security Law, the reserveswill be appropriated for adjustment funds, etc. in the future. Therefore, any amountof the current underwriting reserves in excess of the fair value needs to be booked asa provision for liability or a voluntary reserve in capital.

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3.4.2. Earthquake insurance on dwelling risksLike compulsory automobile liability insurance, this insurance also has a strongpublic nature and is, in fact, the government-cum-private sector business with theback of reinsurance arrangements with the government, because once a hugeearthquake occurs, an enormous amount of claims will have to be paid. Theestablishment of underwriting reserves concerning earthquake insurance is providedfor in detail in Article 7 of the Enforcement Regulations. In the circumstances, it isconsidered appropriate to stay on with the current business practice, as is the casewith compulsory automobile liability insurance.

If the measurement of fair value is made in the same way as for ordinary generalinsurance, it is desirable to employ methods common to all insurance companies inorder to secure comparability because large-scale natural hazard risks like earthquakesare covered and also because this insurance is based on a reinsurance system for ajoint account of the government and the private sector. In this case, for example, theycan be a method by which the Japan Earthquake Reinsurance Company, etc. calculatefair value for all insurance companies based on data received from direct writingcompanies and all reinsuring companies recognize their respective shares. Anyamount of the current underwriting reserves in excess of the fair value needs to bebooked as the provision for liabilities or voluntary reserves on the capital side.

3.5. Handling of cases short of dataThe measurement of fair value requires preparation for supporting data. In practice,for various reasons, there are cases where sufficient data are not available. Inincoming reinsurance, for example, it is difficult to obtain detailed data on individualcontracts at the same level with direct writing business. Points to be noted in caseswhere data are insufficient for the measurement of insurance liabilities are as followsfor each of the 3 methods:

Exit value: a lack of detailed data in direct contracts (contracts accepted solely,those led by other insurers) makes the estimate of future cash losses difficult,failing to secure the reliability of fair value. Therefore, it becomes necessary tomake arrangements for preparing detailed data or for commissioning work tothird parties having detailed data.

Entry value: desirable for the purposes of feasibility because the volume of dataneeded is limited as compared with exit value.

Exceptional method: in cases of an extreme shortage of data, insurance liabilitiesmay be recognized by a balance method. The DSOP admits the non-recognitionof underwriting profits or underwriting losses (a balance method) as anexceptional treatment when a reliable estimate of MVM is not possible.

The following deals with practical aspects in typical cases of data shortage:

3.5.1. Coinsurance led by other insurance companiesIn coinsurance led by other insurance companies, it is basically desirable to measurefair value by methods similar to those used for ordinary direct insurance contracts.MT bordereaux in current coinsurance transactions contain fundamental contract datasuch as policy numbers, attachment dates, insured amounts and insurance premiums,as well as fundamental claims data such as policy numbers, accident dates, and paid

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losses. However, data are not necessarily as full and as precise as those on acompany’s own contracts or coinsurance contracts led by the company in respect ofitems which are not needed for booking or adjustments. For this reason, incoinsurance led by other insurers it is necessary to improve the quality of data to thelevel of those for ordinary direct insurance contracts, by making a review of data and,as the need arises, of input items.

On the other hand, there can be a method of relying on the amount of fair valuemeasured by a leading insurer, all other insurers dispensing with the trouble to do themeasurement by themselves. However, prudence is required for adopting this methodbecause it is highly possible that the contracts concerned are not separately dealt within the calculation made by the leading insurers and also because it becomes difficultto reflect the related data in outgoing reinsurance business, etc.

In practice, there is a month’s delay, in general, between booking, etc. by the leadingcoinsurers and those by other insurers. In order to remove the effect of such delay, itis necessary for the other insurers to be informed, in the process of closing, of figuresin the month of the balance sheet date by the leading companies. Practically, however,this is often difficult because of closing schedules and it becomes necessary to copewith the situation by making adjustments according to ratios based on actual results inthe past or doing without any adjustments for lack of importance. In this connection,the accounting of premiums on an accrual basis adopted in the United States serves asa reference.

3.5.2. Domestic incoming reinsuranceIn incoming reinsurance, as opposed to direct insurance, the exposures of originalindividual contracts are not known and the following handling is required accordingto the types of reinsurance. A delay of accounting statements mentioned above existshere also.

3.5.2.1 Measurement of fair value

3.5.2.1.1 Proportional reinsuranceOutstanding loss reserves (an expired portion) can be made by generating anddiscounting future cash flows through a statistical approach based on paid and caseoutstanding losses reported by cedants.

Underwriting reserves (an unexpired portion) can be made by estimating anddiscounting cash flows generated by premiums receivable (net of commissions) andclaims to incur in the future by means of a chain- ladder model, etc. As a simplermethod, it would be possible to multiply estimated earned premiums by the estimatedloss ratio obtainable through the calculation of outstanding loss reserves.

For practical purposes, the issue of classifying units of account comes up. However, ifno distortion should be caused by combining accounts on the basis of classes ofbusiness, there would be no need to make a treaty-by-treaty calculation, except incases where amounts involved are large. Profit commissions, etc. are considered to bereflected latently by incorporating them into the actual accounting of premiums andclaims but, as above, an individual estimate is needed for material cases.

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3.5.2.1.2 Non-proportional reinsuranceOutstanding loss reserves (an expired portion) can be made, as is the case withproportional reinsurance, by generating and discounting future cash flows through astatistical approach based upon paid and outstanding losses reported by cedants.

Concerning underwriting reserves (an unexpired portion), reinsurance premiumsreceived may be regarded as fair value at the time of concluding the reinsurancecontracts concerned, as mentioned in 2.6.2. Therefore, on and after the conclusiondate unearned premiums calculated on the basis of reinsurance premiums lessreinsurance commissions can be regarded as fair value.

As far as domestic incoming reinsurance is concerned, it would be possible to beinformed directly from cedants of the amount of fair value or data relating to theestimated cash flows which are needed to measure fair value.

3.5.2.2 Necessary dataThe following data regarding incoming reinsurance contracts are needed separatelyfor underwriting years and accident years:

premiums (separately for gross premiums, refunds and profit commissions, etc.) commissions (separately for normal commissions and adjustment reinsurance

commissions) losses (also needed are data by accident years and, in the case of non-proportional

reinsurance, gross amounts for cedants) case outstanding losses (same as the above)

3.5.3. Incoming reinsurance from abroadBasic concepts same as those for domestic reinsurance apply. However, the existenceof brokers which is a feature of overseas reinsurance causes a considerable time lagbetween the occurrence of an event and the arrival of account statement at reinsurers.Further, there exist risks unique to overseas business such as asbestos suits and claimsrelated environmental pollution. Considering these points, the measurement of fairvalue in overseas reinsurance business requires attention to the following points:

A time lag in the arrival of account statements, etc. is considered to exist alwaysand it is necessary to make adjustments in important cases. For example, in caseswhere the estimate of delayed cash flows (premiums, claims, etc.) can be madefrom the past data on the receipt of money, etc. with a certain degree of reliability,it is possible to employ the method of reflecting the expired portion in themeasurement of fair value. Concerning outstanding loss reserves for run-offreinsurance contracts, a time lag from the standard date of data may be adjustedfor booking purposes. In this connection, business practice in U.S. insurancecompanies will be helpful.

To dispel foreign exchange fluctuations, it is necessary to prepare data bycurrency to currency. For example, it is possible to use the method of measuringfair value in an original currency and then converting it into yen or, conversely,the method of converting original currencies into yen and then measuring fairvalue in yen (vide 3.1). In the latter method, it is unnecessary to classify books ofcontracts by currencies because original currencies are all converted into yen.

For reasons of the existence of risks unique to overseas business, it is necessary toset up books of business corresponding to actual risks, independently of books ofcontracts for domestic insurance.

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3.5.4. Pooling contractsSome of domestic direct insurance contracts are arranged on a pool reinsurance basis.In the pool reinsurance, risks in original insurance contracts accepted by individualcompanies are ceded to the pool and are ceded back to the members of the pool atpredetermined shares. Insurance risks shared by the pool members as incomingreinsurance are parallel with each other. This feature should be considered in themeasurement of fair value.

3.5.4.1 Pooling contracts of which the whole (a major part) of original contractsare ceded to the pool

As examples of these contracts, there are risk premium portions of compulsoryautomobile liability insurance, earthquake insurance on dwelling risks and atomicenergy insurance. In these cases, the amount of fair value actually retained net by therespective companies is one related to the reinsured amount. Therefore, the point ishow to grasp fair value related to reinsured contracts. In practice, one method is tomeasure fair value relating to reinsurance by measuring fair value in original contractsand multiplying it by the proportion of cession shares to reinsurance shares; anothermethod is to measure fair value relating to reinsurance by measuring the total fairvalue of the pool and multiplying it by the reinsurance share of the pool.

In the former method, it is possible that risk models, etc. used for the measurement offair value should be different from company to company for the reasons that the riskportfolio of original contracts of a company might be different from the total riskportfolio of the pool (which is in a proportional relationship with the risk portfolio ofthe reinsured business) because of differences in territories or channels of business,etc., and that classes of business reinsured through pools are often those coveringcatastrophic losses like earthquake insurance on dwelling risks or atomic energyinsurance. As a result, there is a strong likelihood of the amount of fair value beinglargely different from company to company.

In the latter method, on the other hand, standards for measuring fair value arecommon to all member companies. However, there will arise disparities between thetotal amount of fair value which the respective direct writing companies measure withrespect to contracts ceded from direct contracts and the total fair value of the pool as awhole. And in cases where the measurement of fair value is made en bloc bycollecting data from all companies, there arises a time lag between standard data datesand balance sheet dates, necessitating adjustments by the monthly distributions ofdirect contracts, etc. Additionally, there are points on which prudence is required inpractical application like the reflection of the credit standing of other pool members inthe measurement of fair value, etc.

3.5.4.2 Ordinary pooling reinsurance contractsThe importance of ordinary pooling reinsurance contracts (for example, the bodilyinjury liability insurance pool) is considered small as a class of business as a wholeand the fair value of reinsurance contracts may be arrived at by obtaining the fairvalue of the company’s own direct insurance contracts and multiplying it by theproportion of the share of incoming reinsurance to the share of outgoing reinsurance.

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In closing

As mentioned in Introduction, the exposure draft of the IFRS on Insurance Contracts(phase 2) is scheduled to be completed in 2005. Any comments on the exposure draftor on the draft should be made by carefully taking feasibility into account. The ProjectTeam hopes that this interim report will be found useful for such purposes. Forexample, the following points had better be taken up at an early stage. In other words,it should be pointed out clearly that the IFRS on Insurance Contracts would encounterpractical difficulties, unless the following points could be cleared:

Underwriting reserves in ordinary general insurance (vide 2.2)The Project Team considers that the concept of unearned premiums should bepermitted in the measurement of the fair value of underwriting reserves. To bespecific, the use of entry value mentioned in this report should be permitted. However,the Project Team considers that when the premiums at inception is clearly deficient,the measurement needs to be made by exit value (principle method), in which casenatural hazard risks need to be treated with care (vide 3.2).

Use of a simple method in the calculation of outgoing reinsurance (vide 2.6)The Project Team considers that the use of the short-cut method proposed in 2.6should be permitted because, in outgoing reinsurance contracts, it is practicallydifficult to make adjustments on a contract to contract basis.

Treatment of cases short of data (vide 3.5)The Project Team considers that entry value or an exceptional method (a balancebasis) should be permitted in cases like incoming reinsurance or pool reinsurancecontracts where it is difficult to obtain information at the same level with directinsurance contracts.