International Financial Reporting Standards Applied to Property and Casualty Insurance Jim Christie and Scott Drab November 2004

1
International Financial Reporting
StandardsApplied to Property and Casualty
Insurance Jim Christie and Scott Drab November
2004
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Background

• Cross-border capital flows highlight the need for
  consistent, understandable financial information
  BUT insurance accounting has significant local
  variations
• The International Accounting Standards Board
  (IASB) is developing a single set of global
  accounting standards
• Many countries committed to the objective of
  global harmonisation
• Drivers for new approach
• Historical cost accounting models lack relevance
• Solvency-based approaches do not provide an
  accurate picture of financial performance
• Convergence of banking and insurance industries

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Phased approach for insurance

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

Phase I Implement by 2005
IAS INSURANCE PROJECT
Phase II Implement Fair Value by 2007 / 8 (?)
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Property Casualty Phase 1

• Key Phase I Issues
• Defining Insurance
• Accounting for insurance contracts
• Disclosures

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Definition of Insurance

• A contract under which the insurer accepts
  significant insurance risk by agreeing to
  compensate the beneficiary if the insured event
  adversely affects the policyholder
• (Insurance Contracts (Phase I) paraphrased with
  emphasis added)
• Significant means at least one scenario with
  payment of commercial substance with an amount
  that is not trivial

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Insurance vs Financial Risk

• Financial risk is risk of possible future change
  in specified interest rate, security price,
  commodity price, foreign exchange rate, index of
  prices or rates, a credit rating or credit index
  or similar variable
• Insurance risk is risk from contingent events
  other than financial risk
• If both financial risk and significant insurance
  risk are present, contract classified as insurance

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Insurance Contract Accounting

• During Phase I, existing accounting policies
  apply with certain modifications
• Prohibited certain accounting policies are
  prohibited as they do not meet the IFRS framework
• Mandated certain accounting policies must be
  implemented if they are not already in the
  existing accounting policies
• Allowed to continue, but not start certain
  accounting policies that do not meet the IFRS
  framework can continue, but cannot be
  implemented.
• Can be started certain accounting policies can
  be introduced.
• Existing accounting policies are those in the
  primary financial statements

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PROHIBITEDaccounting policies

• The following policies are prohibited
• Catastrophe provisions
• Claim equalisation provisions
• Offsetting of reinsurance assets and direct
  liabilities

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MANDATED accounting policies

• The following policies are mandated if not
  already present
• Liability adequacy testing
• Impairment of reinsurance assets

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Liability Adequacy Test

• Current liability adequacy test applies IF
• Test at each reporting date using current
  estimates of future cash flows, AND
• If these are greater than current liability,
  liability is increased and deficiency flows
  through profit and loss

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IMPAIRMENT of reinsurance assets

• Reinsurance asset is reduced and reduction flows
  through income statement if it is impaired
• Reinsurance asset is impaired if
• Objective evidence of an event after initial
  inception that the cedant may not receive all
  amounts due
• The impact of the event can be reliably measured
• Impairment may be reversed

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Accounting policies that may CONTINUE

• The following policies may continue but companies
  may not switch to these if they are not already
  in use
• Undiscounted liability basis
• Deliberate overstatement of liabilities
• Deferred acquisition costs approach

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Accounting policies that may be STARTED

• The following accounting policies may be started,
  subject to certain restrictions
• Use of current market discount rates
• Use of shadow accounting
• Use of asset based discount rates

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Phase I Insurance disclosure requirements

• IFRS 4 has two high level principles

Principle 1 Explanation of recognised amounts
Principle 2 Amount, timing and uncertainty of
cash flows
Fair Value Disclosure for insurance contract
assets and liabilities

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

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Principle 1 - EXPLAIN

• Accounting policies
• Amounts
• Assumptions
• Changes in liabilities
• Gain or loss on buying reinsurance

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Principle 2 CASH FLOWS

• Terms and conditions
• Segment information
• Risk management policies objectives
• Insurance risks covered
• Run off triangles (claim development)
• Other risks

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PHASE 2

• PHASE 2 (in 2007?)

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Phase 2

• Scope all insurance contracts
• Based on asset/liability model, rejecting current
  deferral/matching model
• Where liabilities are independent of asset
  returns, unless
• Policyholder benefits directly related to asset
  returns e.g, linked products
• Intended to be consistent with IAS 39

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Accounting Basis

• Proposed
• Move to underwriting year accounting, thus no
  smoothing of results with UPR and DAC
• Liabilities measured at Fair Value
• Issues
• Extra volatility of the insurance result
• Potential changes to the IT systems
• Loss ratios for new products to be estimated from
  day one
• Re-engineering of claim reserving process
• Reserves for expenses
• Gain or loss at issue
• Renewals/Future Premiums

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Discounting

• Proposed
• Discounting of reserves will become mandatory
• Discounting at risk free rate, plus a spread for
  credit, and MVMs
• Valuing options and guarantees
• Impact
• Projection of expected cash flows
• Selection of suitable economic assumptions
  consistent with market data
• Need to consider all future events including
  legislation and technology
• Re-engineering of the actuarial reserving process

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Market Value Margins

• Proposed
• Reserves will require a market value margin
  consistent with observed market risk preferences
• Market value margin incorporated either
• by adjusting discount rates OR
• By adjusting cashflows
• Consider both diversifiable and non diversifiable
  risks
• Impact
• Need to develop suitable approach and discounting
  assumptions
• Need for enhanced disclosures

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Other Fair Value Issues

• Future premiums only included where
• Uncancelable continuation or renewal rights
  constraining insurers ability to re-price and
• Rights lapse if the policyholder ceases premiums
• No net gain at inception (ignoring indirect
  costs) unless market evidence
• Same derecognition rules used for financial
  assets and liabilities will apply to insurance
• Reflect all guarantees and options

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Types of Estimation Risk

• Model Risk
• the risk that the wrong model was used to
  estimate the insurers liabilities
• Parameter Risk
• the risk of misestimating the parameters for the
  model used to estimate the insurers claim
  liabilities
• Process Risk
• the risk that remains due to random variation,
  even if the correct model and the correct
  parameters are used to estimate the insurers
  claim liabilities

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What of risks does MVM include?

• IAS Draft Statement of Principle 5.4
• The entity-specific value or fair value of an
  insurance liability or insurance asset should
  always reflect both diversifiable and
  non-diversifiable risk.
• This implies that model risk, parameter risk, and
  process risk should be modeled.

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However

• IAS Draft Statement of Principle, Section 5.10
• while it is conceptually preferable to reflect
  parameter risk and model risk, it is appropriate
  to exclude such adjustments unless there is
  persuasive evidence that enables an insurer to
  quantify them by reference to observable market
  data.

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What is the marketsrisk preference?

• The Fair Value of policy liabilities reflects the
  risk preferences of the insurance market.
• What is the insurance markets risk preference?
• The 60th percentile of the distribution?
• The 75th percentile?
• The 95th percentile?
• IAS Draft Standard of Principles the risk
  preference is inevitably subjective (Section
  5.29)

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Some practical techniques to model the MVM

• Canadian Provision for Adverse Deviation
• Includes Parameter Risk Model Risk
• Initial Expected Profit Margin
• Process Risk, Parameter Risk, Model Risk
• Poisson Frequency / Lognormal Severity Simulation
• Process Risk
• Macks Approach
• Process Risk, Parameter Risk, potentially Model
  Risk

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Canadian Provision for Adverse Deviation (PFAD)

• Three components to Provision for Adverse
  Deviation
• Claims Development (2.5 to 15 of discounted
  gross liabilities)
• Discount Rate (50 to 200 basis points on interest
  rate)
• Reinsurance Recovery (0 to 15 of discounted
  ceded claim liabilities)
• The MVM could be set equal to the claims
  development PFAD.
• The PFAD does not attempt to model process risk
  (i.e. size of the company is not considered when
  determining the PFAD).

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Initial Expected Profit Margin

• If insurance markets are efficient, the DSOP
  suggests there should be no gain at issue
• Consequently if a profit is indicated at issue,
  any theoretical MVM should be scaled so that the
  result is simply breakeven
• Are PC insurance markets efficient?
• Are there situations where a gain at issue would
  be permitted?

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Frequency / Severity Simulation

• Determine the distribution of loss reserves using
  a Monte Carlo approach
• Frequency often assumed to be Poisson distributed
• Severity often assumed to be lognormally
  distributed
• Data requirements
• Pending counts (ultimate counts closed counts)
• Unpaid Claims (case IBNR)
• Coefficient of Variation for severity (can be
  based on historical or industry data)

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Mack Method

• Mack Method can be applied to
• Paid Losses
• Incurred Losses
• Historical Recorded Ultimate Losses
• Source Measuring the Variability of Chain Ladder
  Estimates by Thomas Mack

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Conclusions on MVM

• Many judgments required under IFRS 4
  requirements
• Should one include parameter model risk in MVM?
• How should the risk preference of the market be
  measured?
• What approach should be used to model the MVM?
• Given that you have selected an approach, how
  should you select your MVM?

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Conclusions on MVM

• Many judgments required under IFRS 4
  requirements
• Should one include parameter model risk in MVM?
• How should the risk preference of the market be
  measured?
• What approach should be used to model the MVM?
• Given that you have selected an approach, how
  should you select your MVM?

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Modeling Phase 2

• How would the IASB proposed accounting system
  compare to US GAAP for a hypothetical
  Property/Casualty insurance company?
• We worked with the Group of North American
  Insurance Enterprises (GNAIE) to model a PC
  insurer reporting under US GAAP and the IASB
  proposed accounting system.
• We started with very basic assumptions and then
  showed the incremental effects of
• MVMs
• Growth in Earned Premium
• Deteriorating Loss Ratios
• Duration mismatches
• Own credit risk

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Assumptions of the Steady State ModelState
Model
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Fair Value Balance Sheetin a Steady State
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Fair Value Income Statementin a Steady State
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Differences in US GAAP Fair ValueInterest
Rates 5, MVMs 12
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Differences in US GAAP Fair ValueInterest
Rates 5, MVMs 12
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Effects of Written Growth on the Steady State
Model
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Effects of Written Growth on the Steady State
Model
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Effects of Deteriorating Loss Ratioson the
Steady State Model
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Effects of Deteriorating Loss Ratios on the
Steady State Model
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1998-2002 Interest Rate Yields
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Effects of Real Interest Rateson the Steady
State Model
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Effects of Increasing Duration
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Effects of Own Credit StandingProvision
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Effects of Own Credit StandingProvision
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Effects of Changing Payout Pattern
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Effects of Changing MVM
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Effects of Different MVMs in a Fluctuating
Environment
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Final Comments

• Should accounting statements reflect the
  financial effects of asset-liability mismatch?
• How large should the MVM be?
• How comparable will two similar companies be
  under FV?

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Questions

• Jim.K.Christie_at_ca.ey.com
• Scott.Drab_at_ey.com
• The Impact of an Anticipated Fair Value
  Accounting Framework on US GAAP Reporting
  Property Casualty Insurers www.GNAIE.org