1 CAS Casualty Loss Reserve Seminar Fair Value Accounting E. Daniel Thomas, PricewaterhouseCoopers LLP Christina Gwilliam, Towers Perrin Moderator Don Rainey, Milliman

2 Overview Brief history of fair value PwC paper Towers Perrin paper IFRS 4 update

3 Brief history of Fair Value In the beginning, accounting was simple: –Assets valued at historical cost – reliable, but not relevant Early 1980s -- Savings & Loans Crisis, banks were in trouble: –Sell assets where market value over book value –Keep assets where market value under book value Result was hidden insolvency Proposed solution – Fair Value accounting

4 What is Fair Value? “The price at which an asset or liability could be exchanged in a transaction between knowledgeable unrelated willing parties.” Fair value hierarchy exists: 1.Market value, if sufficient market exists; else 2.Market value of similar items with active markets, adjusted for differences; else 3.Present value estimate of future cash flows, including an adjustment for risk.

5 Brief history of Fair Value 1990s – Capital markets became increasingly global Differing accounting standards are impediment to free flowing capital across borders, with perception of lack of transparency International Accounting Standards Board (IASB) The European Union wants consistency within its borders European Union has decided to move toward the IASB’s approach to accounting (i.e. Fair Value)

6 Why should I care? You clearly should if you have a European parent But SEC is in favor of eventual consistency (“convergence”) –SEC controls U.S. GAAP for publicly owned companies –FASB also in favor of convergence FASB and IASB agreed not to introduce anything that furthers the gap to some joint work on the issue –FASB has unofficially agreed to join with the IASB in a limited joint project on insurance contracts

7 Practical applications Discussion at IASB has at times been theoretical and academic Life insurance industry wanted a “real world” test of fair value –IAA and ACLI teamed up to conduct such tests What about P/C Insurance? –In 2003, CAS sponsored research into practical applications PwC and Towers Perrin contributed to this research

8 PwC Paper

9 Outline of PwC Research CAS Project Objectives & Scope Exclusions Data Modeling Approaches Findings Significant Issues

10 CAS project – objectives Evaluate impact of the application of fair value principles on U.S. insurance company loss and LAE reserves Identify significant issues associated with the usefulness of fair values in insurance company financial statements

11 Research specifications Use publicly available data (e.g. Schedule P) 3 lines of business: –Personal Auto Liability (shorter tail) –Workers’ Compensation (long tail – stable) –Medical Malpractice, Claims Made (long tail – volatile) Measure impact of: –Discounting –Market risk load

12 CAS project – scope exclusions Credit risk Adequacy of booked reserves Correlation adjustments across lines of business Impact of fair value on other balance sheet items

13 Fair Value measurement Active trading markets for loss reserves do not exist Fair value measurement was based on models using market concepts: -Undiscounted estimate of future payments; -Discounted for time value of money, plus -Margin for risk and uncertainty (“Market Value Margin” or “MVM”).

14 PwC modeling approaches Discount Factor Models –Duration –Matched to yield curve MVM Models –Development method – standard deviation –Stochastic simulation – standard deviation –Stochastic simulation – percentile distribution –Return on Capital

15 PwC modeling calibration approach Calibrated to Cost of Capital Method at year-end 2002 Straight average of three companies (1 large, 1 medium, 1 small) All lines assume a 10% target rate of return on capital

16 Discount factor models

17 Findings – discount modeling Well-defined approaches are available. In general, we observed no significant differences between duration and matching approaches. Results can be affected by interest rate fluctuations and shape of the yield curve.

18 MVM by company – personal auto liability

19 MVM by method for one company – personal auto liability

20 MVM by company size - personal auto liability

21 MVM by company– workers’ compensation

22 Findings – MVM modeling Indications for MVM varied, sometimes significantly: –by method, for a given company and year-end; –over time, for a given company and MVM method. The ranking of MVM’s by method tended to vary over time: –No method consistently was the highest nor the lowest. For smaller companies, the MVM tended to be larger (measured as a percentage of the loss reserves)

23 Findings – Fair Value impact on balance sheet (loss reserves) Personal auto liability: FV reserves were generally greater than U.S. GAAP reserves Workers’ compensation: FV reserves were generally less than or close to the U.S. GAAP reserves Medical malpractice claims-made: We did not consider the results of our testing to be meaningful. Impact of moving to fair value reserves tended to be greater for smaller companies (i.e., higher MVM charge). Based on the model calibrations

24 Findings – Fair Value impact on income statement (incurred losses) Under FV, prior accident year development may not be benchmarked to zero (due to relative changes in discount and MVM). Leveraged impact of reserve changes would likely increase volatility of incurred losses.

25 Significant issues - modeling Dealing with real data Measures of variation –The constraint to accept booked reserves as mean of distribution impacts:  Expected payment and reporting patterns  Variability of experience in relation to expectations –Variation from the tail/prior accident year bucket –Variation for certain liabilities not amenable to statistical analysis (e.g. asbestos & environmental)

26 Significant issues - MVM estimation Variety of approaches exist, but no single approach universally preferred or accepted. Professional guidance may be needed on acceptable methods or calibration procedures for calculating MVM’s to gain industry practice consistency. Single industry guideline for MVM calculation unlikely to be appropriate. Calibration of MVM models can be challenging and will significantly affect the results.

27 Significant issues - financial statement presentation (1) How should accounting standards treat the 3 elements of fair value reserves: –As flowing through the income statement or as a direct charge to surplus? Any presentation separating current and prior accident year contributions may require MVM allocation judgments: –MVM’s are statistically non-additive, so any split by accident year may require allocation judgment. –Judgments may also be required for disclosures by business unit or line of business.

28 Significant issues - financial statement presentation (2) The required disclosure for prior accident year development may become confusing. – One-year development of prior reserves would not necessarily be benchmarked to 0. – Disclosure of the components of one-year development of prior year-end reserves could be quite complicated.

29 Assessment of P/C actuarial methods Estimating undiscounted reserves:GOOD Discounting estimated future payments:GOOD Estimating market value margins:DEVELOPING Calibration of MVM methods:EMERGING

30 Towers Perrin Paper

31 Background to IFRS 4 Work of the IASB –2002: Split Phase I (2005) / Phase II (2008?) –2004: IFRS 4 European Union has said IFRS is compulsory for stock exchange listed companies from January 1, 2005 International Financial Reporting Standards (IFRS) address 3 major questions in the arena of insurance accounting: –What is an insurance contract? –What do you have to disclose? –How do you measure insurance contracts? – Phase II

32 Phase I – IFRS 4 Product classification Catastrophe and equalization provisions prohibited Restrictions on changes to accounting policies Requirement for liability adequacy testing Impairment of reinsurance Disclosure

33 Phase II Currently undecided if Fair Value will be basis for Phase II (2008)