International Financial Reporting Standards Applied to Property and Casualty Insurance presented to CLRS by Scott Drab & Jim Christie

2  Cross-border capital flows highlight the need for consistent, understandable financial information  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 Background

3  There is now a phased approach to insurance contracts.  The IASB’s objective for Phase I is to implement some components of the insurance project by 2005, without delay to Phase II Phased Approach for Insurance IAS INSURANCE PROJECT IAS INSURANCE PROJECT Phase I – Implement by 2005 Phase II – Implement Fair Value by 2007 / 8 (?)

4 Property & Casualty – Phase 1 Key Phase I Issues  Defining Insurance  Accounting for insurance contracts  Disclosures

5 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

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

7 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

8 Prohibited policies  The following accounting policies are prohibited  Setting up catastrophe provisions  Setting up claims equalisation provisions  Offsetting of reinsurance assets and direct liabilities

9 Mandated policies  The following accounting policies are mandated if they are not already present  Liability adequacy testing  Impairment of reinsurance assets

10 Liability Adequacy Test  Current liability adequacy test applies if  Test at each reporting date using current estimates of future cash flows  If these are greater than current liability, liability is increased and deficiency flows through profit and loss

11 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 to it  The impact of the event can be reliably measured  Impairment may be reversed

12 Policies that may continue  The following existing practices may continue but companies may not switch to these where they are not already applied  Undiscounted liability basis  Deliberate overstatement of liabilities  Deferred acquisition costs approach

13 Policies that may be started  The following accounting policies can be started subject to certain restrictions  Use of current market discount rates  Use of shadow accounting  Use of asset based discount rates

14 Phase I Insurance disclosure requirements IFRS 4 Two high level principles: Principle 1 – Explanation of recognised amounts Principle 2 –Amount, timing and uncertainty of cash flows  Implementation guidance - runs to 61 paragraphs – but does not create additional requirements! Fair Value Disclosure for insurance contract assets and liabilities

15 Principle 1 - Explain  Accounting policies  Amounts  Assumptions  Changes in liabilities  Gain or loss on buying reinsurance

16 Principle 2 – Cash Flows  Terms and conditions  Segment information  Risk management policies and objectives  Insurance risks covered  Run off triangles (loss reserve development)  Other risks

17  Scope – all insurance contracts  Asset/liability model, rejecting deferral and matching  Where liabilities are independent of asset returns, unless  Policyholder benefits directly related to asset returns; e.g, linked products  Guidance needed for performance-related products  Intended to be consistent with IAS 39 Phase 2

18 Accounting Basis  Proposal  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 reserving process  Reserves for expenses  Gain or loss at issue  Renewals/Future Premiums  Proposal  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 reserving process  Reserves for expenses  Gain or loss at issue  Renewals/Future Premiums

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

20 Market Value Margins  Proposal  Reserves will require a market value margin consistent with observed risk preferences of market  Margin incorporated either by adjusting discount rates or adjusting cashflows  Consider both diversifiable and non diversifiable risks  Impact  Need to develop suitable approach and discounting assumptions  Need for enhanced disclosures  Proposal  Reserves will require a market value margin consistent with observed risk preferences of market  Margin incorporated either by adjusting discount rates or adjusting cashflows  Consider both diversifiable and non diversifiable risks  Impact  Need to develop suitable approach and discounting assumptions  Need for enhanced disclosures

21  Future premiums only included where  Uncancelable continuation or renewal rights constraining insurer’s ability to re-price; and  Rights lapse if the policyholder ceases premiums  No net gain at inception (ignoring indirect costs) unless market evidence  Same derecognition rules as financial assets and liabilities will apply to insurance  Reflect all Guarantees and Options Other Fair Value Issues

22 1) Model Risk  the risk that the wrong model was used to estimate the insurer’s liabilities 2) Parameter Risk  the risk of misestimating the parameters for the model used to estimate the insurer’s claim liabilities 3) Process Risk  the risk that remains due to random variation, even if the correct model and the correct parameters are used to estimate the insurer’s claim liabilities 3 Types of Loss Reserve Risk

23  IAS Draft Statement of Principle 5.4: “The entity- specific value or fair value of an insurance liability or insurance asset should always reflect both diversifiable and non-diversifiable risk.”  This implies that model risk, parameter risk, and process risk should be modeled. What types of risk does the MVM include?

24 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.”

25  The Fair Value of loss liabilities reflects the risk preferences of the insurance market.  What is the Insurance Market’s risk preference? The 75 th percentile of the loss reserve distribution? The 95 th percentile?  IAS Draft Standard of Principles: the risk preference is “inevitably subjective” (Section 5.29)  The Fair Value of loss liabilities reflects the risk preferences of the insurance market.  What is the Insurance Market’s risk preference? The 75 th percentile of the loss reserve distribution? The 95 th percentile?  IAS Draft Standard of Principles: the risk preference is “inevitably subjective” (Section 5.29) What is the Insurance Market’s Risk Preference?

26 1) Canadian Provision for Adverse Deviation  Includes Parameter Risk & Model Risk 2) Initial Expected Profit Margin  Process Risk, Parameter Risk, & Model Risk 3) Poisson Frequency / Lognormal Severity Simulation  Process Risk 4) Mack’s Approach  Process Risk, Parameter Risk, & potentially Model Risk What are some practical techniques that could be used to model the MVM?

27 Canadian Provision for Adverse Deviation (PFAD)  There are three parts of the Canadian Provision for Adverse Deviation (PFAD) : 1. Claims Development (2.5% to 15% of discounted gross liabilities) 2. Reinsurance Recovery (0% to 15% of discounted ceded claim liabilities) 3. Discount Rate (50 to 200 basis points on interest rate)  The MVM could be set equal to the claims development portion of the PFAD.  The PFAD does not attempt to model process risk (I.e. size of the company is not considered when determining the PFAD).

28  If insurance markets are efficient, the DSOP suggests there should be no gain at issue  Consequently if a profit is indicated at issue, any theoretical MVM should be scaled so that the result is simply breakeven  Are P&C insurance markets efficient?  Are there situations where a gain at issue would be permitted? Initial Expected Profit Margin

29 Poisson Frequency / Lognormal Severity Simulation  Exhibit A in the appendix provides an example of this approach  Determine the distribution of loss reserves using a Monte Carlo approach  Frequency is assumed to be Poisson distributed  Severity is assumed to be lognormally distributed  Data requirements:  Pending counts (ultimate counts – closed counts); can be found in Schedule P  Loss Reserves (case + IBNR); can also be found in Schedule P  Coefficient of Variation for severity (can be based on historical or industry data)

30 Advantages of Simulation Approach  The data needed to calculate this method are readily available  The simulations could be run on Microsoft Excel or other readily available software  The method is already in use by some insurance entities to estimate process risk.  Parameters used in simulation are fairly easy to disclose and results can be replicated by outsiders.

31 Disadvantages of Simulation Approach  Actual insurer’s data may not fit the distributions prescribed by the actuary  The method only measures process risk.  All claims with payment may not have the same coefficient of variation parameters  The method is dependent on the insurer having adequate reserves.

32 Mack Method  Exhibits 1-4 in the appendix provide an example of this approach  Mack Method could be applied to:  Paid Losses  Incurred Losses  Historical Recorded Ultimate Losses Source: Measuring the Variability of Chain Ladder Estimates by Thomas Mack

33 Advantages of the Mack Method  The data needed to calculate this method are readily available  This method can calculate process risk, parameter risk, and potentially model risk.  This method does not make any assumptions about the underlying distribution of the insurer’s losses.  This method can be readily calculated on a spreadsheet  An insurer that historically under-reserves will have a larger MVM than one that accurately estimates its reserves if the ultimate loss version of this approach is used.

34 Disadvantages of the Mack Method  This method assumes that future losses will develop in the same way that losses have developed historically.  The Mack method relies on a number of implicit assumptions  For long tailed reserves, a number of years of experience are needed to estimate the variance in reserves.  This method can provide strange results for lines of business with sparse data.  This approach is not commonly used for valuing MVMs.

35 Conclusions on the MVM  More judgments by actuary required under proposed IASB requirements: 1) Should the insurance company include parameter and model risk in their MVM? 2) How should the risk preference of the market be measured? 3) What approach should be used to model the MVM? 4) Given that you have selected your approach, how should you select your MVM?  Do the additional judgments help the world’s capital markets make sounder economic decisions?

36 Questions