1 Fair Value Accounting in Insurance Michael G. McCarter CLRS - New Orleans September 10, 2001.
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Transcript of 1 Fair Value Accounting in Insurance Michael G. McCarter CLRS - New Orleans September 10, 2001.
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Fair Value Accounting in Insurance
Michael G. McCarterCLRS - New OrleansSeptember 10, 2001
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Introduction
It’s not just fair value, it’s “Performance Reporting”!
FASB continues to advocate fair value for assets and liabilities.
IASB reorganizes; makes Insurance Contracts a high priority.
What’s “entity specific value”?Update on actuarial efforts.
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Financial Digest, June ‘01
Accounting is now a free-for-all“Corporate financial accounting has
now become so changeable, inconsistent, undisciplined and uncomparable that its primary function - enabling both managers and investors to measure a company’s performance - is threatened.”
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Financial Digest, June ‘01
Some key problems:Inconsistent application of rules.‘Pro forma’ earnings.Those refreshing big baths.Time-value-of-money and fair value
rules.Alice’s Wonderland is here.
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Financial Digest, June ‘01
Under fair value accounting, a troubled company could write down the value of a liability and boost its earnings.
Former FASB Chairman Beresford: “Gains for doing badly and losses for improving? Come on.”
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The Economist, Aug 16, ‘01
“Fair value” accounting for all financial assets and liabilities is on its way. Banks and companies hate the idea.
Compromise has created a mess.Solution: impose fair value rules for all
financial instruments.Banks: horrified at the volatility and its
impact on P/E ratios, capital costs.
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The Economist, Aug 16, ‘01
Assigning fair value can be tricky and subjective process.
Often relies on companies’ and banks’ internal models and estimates.
Banking supervisors warn about fair value.
Fair-value accounting should make for a more transparent and sound financial system.
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Performance Reporting
Fair value discussions have focused on balance sheet.
Income statement was an afterthought, derived simply from change in balance sheet entries.
Recognition that investors and managers care about earnings is forcing standard setters to take a step back.
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Performance Reporting
IASB has made Performance Reporting one of its major priorities, while Fair Value of Financial Instruments takes a back seat.
FASB is about to adopt a major agenda item on reporting financial performance.
FASB will work with the IASB.
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Performance Reporting
FASB issues:Elements of financial performance
and consistency of presentation.Increasing use of pro forma reporting
indicating declining reliance on net income.
No consensus on key financial measures.
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Performance Reporting
Relation to fair value?Current fair value reporting in notes
to financial statements little used or understood.
Without agreed-upon performance measures, new fair value measures may not fare much better.
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Performance Reporting
FASB could standardize and require disclosures some are doing voluntarily.
“Sacrifice of freedom” but gain in comparability, consistency, credibility.
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Performance Reporting
IASB concerned about inconsistent treatment of existing fair value changes.
Proposal: single statement of recognized income and expense, including all changes in net assets other than those arising from capital transactions.
Implication: Fair value changes would be “above the line”.
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Performance Reporting
Conclusion:FASB and IASB have heard the
concern about the income statement impact of fair value, and are going to study it.
No proposal on the horizon is likely to satisfy all interested parties.
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FASB and Fair Value
February, 2000 - FASB issues Concept Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements.
Adopted expected value cash flow estimates rather than “most likely” best estimates.
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FASB and Fair Value
Adopted fair value as measurement objective when employing present value.
Included impact of entity’s own credit standing in the measurement of its liabilities.
Concept statement not an accounting standard, but used to develop new and revised accounting standards.
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FASB and Fair Value
Concept Statement has been controversial.
Summer 2001, FASB issued 4 “Understanding the Issues” papers to explain its position.
Available on www.fasb.org
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FASB and Fair Value
1: Expected Cash FlowsWhy the old “most likely” standard was
not the best target for estimated cash flows.
Application example: Estimated liability using 3 scenarios discounted at risk-free rate and judgment probability weighted to arrive at “fair value”.
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FASB and Fair Value
2: Initial Measurements of Liabilities at Fair Value.
Requires the profit element a 3rd party would include in a contract to settle the liability.
Rationale for fair value: Market price most relevant measure, trumps lack of observability. Also, most comparable.
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FASB and Fair Value
3: Measuring Fair ValueDeveloping an estimate when no
ready market price is available.Assume “highest and best use”, no
information asymmetries, buyer that wants the specific item, transaction in the most favorable market.
Examples of non-financial assets.
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FASB and Fair Value
3: Measuring Fair Value (Cont.)Hierarchy of fair value estimates: quoted
market, prices for similar assets and liabilities, valuation techniques.
Use entity’s own assumptions on future cash flows if there’s no contrary market data.
Include overhead-type costs in cash flows.
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FASB and Fair Value
4: Credit Standing and Liability Measurement
Case study of zero coupon note issue.Asserts that taking loss upon credit
upgrade is economic reality and therefore correct accounting.
Asserts stockholder’s equity should never go below zero.
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FASB and Fair Value
4: Credit Standing and Liability Measurement (Cont.)
Footnote quote: “Nobel Laureate Robert Merton(’s) … analysis is unfamiliar to many accountants and actuaries, but it is a cornerstone of modern financial economics.”
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FASB and Fair Value
Note: Nobel Laureate Robert Merton was also a partner in Long-Term Capital Management where he was able to extensively “test” his analyses.
See Inventing Money, by Nicholas Dunbar and When Genius Failed.
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FASB and Fair Value
Conclusion:FASB is pushing hard for fair value.FASB believes accounting
statements should be directly relevant to valuing enterprises, and is willing to add substantial subjectivity to statements to achieve that goal.
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FASB and Fair Value
Conclusion (Cont.):FASB is considering an agenda
project on intangible assets as well.Wayne Upton, major author of FASB
statements on fair value, has just become director of research for IASB.
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IASB and Insurance Contracts
New IASB formed in April, 2001.Met standards set by FASB and the
SEC.Paul Volcker, former chairman of the
Federal Reserve, is head of the IASB’s Board of Trustees.
EU currently plans to adopt IASB standards for 2005 reporting.
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IASB and Insurance Contracts
New IASB downgraded priority of JWG Financial Instruments project.
Staying with IAS 39 which adopts an “entity specific value” rather than “fair value” standard.
Fair value not dead, just not highest priority as IASB attempts to get standards ready for EU adoption.
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IASB and Insurance Contracts
High priority to Insurance Contracts project, but now to be based on entity-specific-value rather than fair value for the time being.
Still considering next steps. Old Insurance Steering Committee has officially been replaced with new Insurance Advisory Committee.
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IASB and Insurance Contracts
Steering Committee was actually responsible for drafting old IASC Insurance Contracts documents.
Now IASB itself to be responsible for drafting. Advisory Committee just advisory.
Old Steering Committee still producing semi-secret DSOP on Insurance Contracts.
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IASB and Insurance Contracts
IASB developing commitments from many other bodies, including:
FASBAustralian Accounting Standards
BoardIOSCOSEC
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IASB and Insurance Contracts
Chapter 1: Introduction and ScopeDefinitions, Risk Transfer
Requirements.Insurance is not gambling, or vice
versa.
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IASB and Insurance Contracts
Chapter 2: Single Recognition and Measurement Approach for All Forms of Insurance
Principles not separate for “general insurance” (P&C insurance) and life insurance.
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IASB and Insurance Contracts
Chapter 2: (Cont.)Recognition based on asset and
liability measurement approach, not deferral and matching.
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IASB and Insurance Contracts
Chapter 3: Measurement: Overall IssuesInsurance assets and liabilities should
be measured at entity-specific value (while IAS 39 is in place.)
ESV represents the value of an asset or liability to the entity that holds it, and may reflect factors not available (or not relevant) to other market participants.
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IASB and Insurance Contracts
Chapter 3: (Cont.)ESV can differ from FV if insurer has
skills that allow it to maximize asset inflows or minimize liability outflows, or if insurer views on estimates, risks, prices, or credit standing differ from market’s views.
ESV could be same as FV in given situation.
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IASB and Insurance Contracts
Chapter 3: (Cont.)Rejected cost accumulation basis
and embedded value basis (popular with UK life insurers).
Prefer prospective to retrospective approaches.
Prefer exit values to entry values.
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IASB and Insurance Contracts
Chapter 3: (Cont.)Requires discounting unless not material.Value of liabilities should not be affected
by the asset portfolio held.No overstatement of insurance liabilities
to impose implicit solvency or capital adequacy requirements.
No Lloyd’s-type accounting methods.
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IASB and Insurance Contracts
Future chapters:Estimating future cash flowsRisk and uncertaintyDiscount ratePerformance-linked contractsReinsuranceAccounting by policyholders
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IASB and Insurance Contracts
Conclusion:Unclear at this time what IASB will do
with DSOP. At minimum will consider it for several meetings. It may become basis for exposure draft.
Even without full fair value, would represent a major change in accounting standards if adopted for US P&C insurers.
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IASB and Insurance Contracts
Conclusion: (Cont.)ESV is still on a discounted basis which
measures performance on an asset and liability basis, not a deferral and matching basis.
ESV does not require estimates of a market transaction price for insurance liabilities, so may be easier to adopt than FV.
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Actuaries and Fair Value
CAS White Paper on Fair Valuing P/C Insurance Liabilities was completed in August, 2000 and presented at last year’s CLRS by task force chair Ralph Blanchard and task force member Louise Francis.
Available for download from CAS website.Did not focus explicitly on ESV, but many of
the concepts discussed are applicable.
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Actuaries and Fair Value
CAS White Paper (Cont.)Still a very good place to start to
understand FV of insurance liablities.Points out many of the practical issues
that accounting standards setters may not give sufficient attention to, including the limitations of information derived from the insurance marketplace for FV purposes.
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Actuaries and Fair Value
CAS White Paper (Cont.)The Executive Summary and the first
four sections provide a good overview.
A number of possible methods for estimating market risk adjustments are discussed in some detail in the technical appendix.
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Actuaries and Fair Value
Bowles Symposium, May 2001Two days of papers from Life
actuaries on fair value.FV and ESV showed substantial
increase in volatility of results compared to current US GAAP for life insurers. Volatility was good - keeps CFO’s on their toes.
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Actuaries and Fair Value
Bowles Symposium, May 2001 (Cont.)FV and ESV also magnify current year
impact of any assumption changes.Many presenters felt FV provided a
superior picture of the insurer, although it will be a significant implementation burden.
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Actuaries and Fair Value
AAA Fair Value Task Force, chaired by Burt Jay of Mutual of Omaha
In 2000, developed comments on FASB Preliminary Views on Financial Instruments at Fair Value.
Also in 2000, developed comments on IASB Insurance Issues paper.
Raised concerns on “own credit risk” issue
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Actuaries and Fair Value
AAA Fair Value Task Force (Cont.)Now finishing comment letter on JWG
Draft Standard on Financial Instruments.JWG Draft “scopes out” insurance
contracts, but would have substantial impact on future insurance contract standard if adopted since insurance contracts are also “financial instruments”.
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Actuaries and Fair Value
AAA Fair Value Task Force (Cont.)Could use more input from casualty
actuaries.Life actuaries are very smart, but
insurance risk just isn’t as significant in many of the products they deal with.
Expect to comment on future IASB drafts.
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Actuaries and Fair Value
International Actuarial AssociationIAA committees have been very
active in developing comments on IASB and IAIS activities.
One can easily develop the dread condition of “comment overload” if you attempt to follow everything that is going on.
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Actuaries and Fair Value
Conclusion:Actuarial profession has been active and
influential in the ongoing development of international accounting and regulatory standards.
However, this is mainly due to the efforts of a relatively small number of actuaries who may or may not reflect your views.
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Actuaries and Fair Value
Conclusion: (Cont.)The CAS is working on an RFP for
case studies of fair value accounting applied to general insurance.
If you think fair value is an important issue, either for good or bad, make yourself heard.
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Conclusions
There’s a great deal of smoke and fire, both internationally and domestically, about the issues of fair value and performance reporting. There will be significant changes in capital markets financial reporting, and those changes will ultimately affect US insurers, whether or not they currently report on a GAAP basis.
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Conclusions (Cont.)
Many academics, consultants, and standards setters think financial statements should bear more directly on company valuation, even if that requires increased subjectivity. Accordingly, they are pushing for fair value, intangible assets, and revised performance measures.
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Conclusions (Cont.)
The International Accounting Standards Board is quickly building a critical mass of influence as the national standards setters are under pressure to agree on increasingly uniform standards. FASB may see the IASB as an opportunity to get some things implemented more easily than could happen in the US.
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Conclusions (Cont.)
The IASB will seriously consider adopting an entity-specific value approach to accounting for insurance contracts. Such an adoption of “fair value lite” would in turn likely influence both US GAAP and international insurance regulatory accounting standards setters.
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Conclusions (Cont.)
A “fair value” world will significantly change the jobs of most people who attend the CLRS. Now would be a good time to think about whether you think that is a good thing or a bad thing.
Actuaries are having an influence on the course of events, but very few actuaries are spending much time on this issue.
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Finale
As a larva, the sea squirt has a brain-like ganglion that allows it to sense its environment and swim around.
As an adult, the sea squirt attaches itself to a stationary object and then digests most of its own brain.
Whether you favor or oppose fair value, don’t emulate the sea squirt.