international financial reporting standards applied to property and casualty insurance presented to...
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International Financial Reporting StandardsApplied to Property and Casualty Insurance
presented to CLRS by Scott Drab & Jim Christie
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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
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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 forInsurance
IASINSURANCE
PROJECT
IASINSURANCE
PROJECT
Phase I – Implement by 2005Phase I – Implement by 2005
Phase II – Implement Fair Value by 2007 / 8 (?)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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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
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Insurance ContractAccounting
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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Prohibited policies
The following accounting policies are prohibited
Setting up catastrophe provisions
Setting up claims equalisation provisions
Offsetting of reinsurance assets and direct liabilities
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Mandated policies
The following accounting policies are mandated if they are 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
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 to it
The impact of the event can be reliably measured
Impairment may be reversed
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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
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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
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Phase I Insurance disclosurerequirements
IFRS 4 Two high level principles:
Principle 1 – Explanation of recognised amountsPrinciple 1 – Explanation of recognised amounts
Principle 2 –Amount, timing and uncertainty of cash flowsPrinciple 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 liabilitiesFair Value Disclosure for insurance contract assets and liabilities
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Principle 1 - ExplainPrinciple 1 - Explain
Accounting policies
Amounts
Assumptions
Changes in liabilities
Gain or loss on buying reinsurance
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Principle 2 – Cash FlowsPrinciple 2 – Cash Flows
Terms and conditions
Segment information
Risk management policies and objectives
Insurance risks covered
Run off triangles (loss reserve development)
Other risks
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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 2Phase 2
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Accounting BasisAccounting BasisAccounting BasisAccounting 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
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DiscountingDiscountingDiscountingDiscounting
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
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Market Value MarginsMarket Value MarginsMarket Value MarginsMarket 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
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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
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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
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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 theMVM include?
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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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The Fair Value of loss liabilities reflects the risk preferences of the insurance market.
What is the Insurance Market’s risk preference? The 75th percentile of the loss reserve distribution? The 95th 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 75th percentile of the loss reserve distribution? The 95th percentile?
IAS Draft Standard of Principles: the risk preference is “inevitably subjective” (Section 5.29)
What is the Insurance Market’sRisk Preference?
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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?
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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).
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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 MarginInitial Expected Profit Margin
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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)
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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.
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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.
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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
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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.
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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.
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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?
