Accounting for (Non-Life) Insurance in Australia

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1 IASB MEETING, APRIL 2005 OBSERVER NOTE (Agenda Item 3a) Accounting for (Non-Life) Insurance in Australia Tony Coleman & Andries Terblanche Presentation to IASB 19 April 2005

2 Agenda Australian Non-Life Insurance Business - Users of Discounting and Risk Margins Background to Australian Insurance Market Insurance Basics Why use Risk Margins? Consistency & Reliability Use of Accounting Results by Management Practical Issues In Conclusion The Vital Role of Disclosure

3 A Bird s Eye View of Australian Non-life Insurance Relatively Small, but Sophisticated Market 11 th largest insurance market in the world with direct, gross private sector premiums of approx A$26Bn (US$20Bn) (Australian Prudential Regulatory Authority Sept 2004) Enters the world top 10 after allowance for public sector (A$5Bn of compulsory workers compensation and motor bodily injury insurance), Foreign-based business (Lloyd s etc) Australia 1% of world GDP, 2% of global non-life insurance premiums Profitable (since 2001!) Approx A$3Bn of insurance profit in 2003 (Insurance Council of Australia - Aug 2004). A$4Bn in 2004? Industry underwriting profits in each of last three years First time for two consecutive years underwriting profits in industry in more than 25 years A Wide Range of Products Personal Lines/Commercial Lines almost 50/50 Short tail/long tail around 60/40 by premium (including public sector etc) All standard insurance products sold anywhere in the world are freely available in Australia

4 A Bird s Eye View.. Recent Developments Market Rationalisation Significant recent takeover/merger activity. The Big 5 now write approx 70% of the gross direct market premium (10 years ago the top 5 insurers wrote around 40%) Four of the Big 5 are now Australian-owned (and publicly listed), increasing the focus on profitability. (10 years ago the majority of the top 10 insurers were foreignowned) HIH The collapse of Australia s 2 nd largest non-life insurer in 2001 had significant ramifications for the market (availability of cover, pricing of products, public confidence in general) HIH was the first significant non-life insurance failure for over 20 years Lack of discipline in reserving (and hence pricing) practices was seen to be a significant contributory factor Misuse of finite (financial) reinsurance was a contributing factor Subsequent Royal Commission had many (61) recommendations

5 A Bird s Eye View.. Current Issues Improved Prudential Regulation and Risk Management Not all as a result of HIH. Regulatory reform was already happening (although significantly enhanced by HIH fallout). APRA introduced major prudential reform from 1 July Increased audit intensity at a global level (Enron, Parmalat etc), reviews by ASX, the competition regulator (ACCC) and reform of selling practices (FSRA) Liability Tort Reform A reaction to the increasing compensation culture has seen legal restrictions introduced to control access to compensation for liability (casualty) insurance claims (especially relating to bodily injury. Each state has dealt separately with the issues leading to complicated effects on insurance pricing and a market expectation of reduced premiums Latent Claims Asbestos-related claims are creating a significantly increasing liability for past exposures (although not at USA levels) Potential future, as yet unrecognised latent claims are a growing concern for the industry

6 Accounting Standard (AASB 1023 before 1 Jan 2005) Assets at market value, through P&L A/c Discounting of liabilities at risk free interest rates (via PS300) Vulnerable to manipulation via financial (finite) reinsurance (as demonstrated by HIH) Silent on use of Risk Margins Market practice on risk margins varied widely HIH had none, but others maintained various PoA up to 90% Australian adoption of IFRS from 1 January 2005 and HIH fallout lead to a new AASB1023, requiring use of risk margins, disclosure of central estimates and liability Probability of Adequacy (PoA) disclosure requirements

7 A Reminder of Insurance Basics Outcomes of risks from individual policies are unknown when underwritten However, when many similar risks are underwritten, expected results of total portfolio become more predictable Claims are driven by: - Frequency (or probability) of a claim event occurring; and - Severity (or size) of a claim if it occurs Risks inherent in different classes of insurance vary over a spectrum : - High frequency / low severity (eg motor) outcomes relatively easy to predict reliably - Low frequency / high severity (eg earthquake) outcomes harder to predict reliably 21 November,

8 Simple Illustration of the Insurance Risk Process To help discuss the concept of accounting for uncertainty: Assume we roll a dice 100 times to represent the results of underwriting 100 insurance policies in one year. If 1 is result, insurer pays a claim of $1 If 2 is result, insurer pays a claim of $2 If 3 is result, insurer pays a claim of $3 If 4 is result, insurer pays a claim of $4 If 5 is result, insurer pays a claim of $5, BUT If 6 is result, there is no claim at all. Assume all claims will be paid 1 year after policies are underwritten and That the dice can be rolled at any time during that year.

9 Illustration What is the liability of the Insurer after all policies are written but BEFORE any dice have been rolled? The higher the amount reserved the greater the probability will be that there are adequate (sufficient) funds to pay all claims.

10 Illustration: Level of Reserving (before any dice are thrown) From the well known nature of this distribution we can confidently predict that results will be such that : Probability of Adequacy $ 50% % % 272

11 Illustration: The Law of Large Numbers & Reliability of Estimates CoVs Coefficient of Variation (CoV) used to measure Volatility C o V = Standard Deviation of Distribution / Mean of Distribution { Note that Standard Deviation = Square Root of Variance } If only 1 throw : Mean = [ ] / 6 = Variance = [(1.5)+(0.5)+(0.5)+(1.5)+(2.5)+(2.5) ] / 6 = Hence CoV = (Square Root of 2.917) / 2.5 = / 2.5 = 0.68 Hence CoV = 68% of the mean

12 Illustration: The Law of Large Numbers & Reliability of Estimates - CoVs If we have 100 throws : Mean = 100 x 2.5 = 250 Variance = 100 x = Standard Deviation = Square Root of = C o V = / 250 = Here CoV = 6.8% of the Mean If we have 10,000 throws : Mean = 10,000 x 2.5 = 25,000 Variance = 10,000 x = 29,167 Standard Deviation = Square Root of 29,167 = C o V = / 25,000 = Now CoV = < 1% of the Mean

13 Illustration - Premium & Profit For simplicity, assume all expenses of operation are incurred at outset and total $40. Suppose insurer charges $3 per throw to policyholders. Hence total premium = $300 Expected underwriting profit = $300 - $250 - $40 = $10 (A lower profit will occur 50% of the time and higher profit will occur 50% of the time) Is $10 the profit that can be reported as earned? If so, when can it be reported as earned? 21 November,

14 Capital Requirement Irrespective of the liability adopted for general purpose financial reporting, the insurer needs $500 to operate without any probability of going bankrupt and has to meet expenses of $40 at the outset after receiving $300 in premiums paid at the outset. Hence, the actual Capital the insurer needs at the outset to be sure of being able to meet it s commitments is: $ $ 40 - $ 300 = $ 240 This capital requirement is in addition to the cash generated by the contracts at the outset of : $ $ 40 = $ November,

15 Projected Profit / (Loss) & Return on Capital Assume no taxes are payable and that capital and cash flows can be invested at a risk free rate of 5% p.a. Then the expected results will be as set out below : Source of Profit Funds Interest Best Worst Expected Held Earned Profit/ Profit/ Profit/ 5%) (Loss) (Loss) (Loss) Policy Contracts (227) 23 Capital Total (215) 35 The expected rate of return on capital employed will be : = 35 / 240 = 14.6 % p.a.

16 Level of Liability (before any dice are thrown) Assume that the insurer decides to adopt a liability at the outset equal to the central estimate of the liability of $250, plus a risk margin equal to its expected profit from the product contract cash flows of $23, all discounted at the risk free rate of 5% Hence liability at the outset would be : = ( $ $ 23 ) / 1.05 = $ 260

17 Profit / (Loss) at Outset Hence, if the expenses of $40 incurred at the outset are expensed in full at the outset the profit reported at outset will be : = $300 $260 $40 = $ Nil Alternatively, if the non-claim expenses are amortised over the year the profit at outset will be : = $300 - $260 = $40 (Note however that this second treatment implies booking all premiums and full liability for claims expenses at outset, but deferring non-claim expenses which seems inconsistent)

18 Consistency of Liability PoA Setting the liability at the end of the year at $273 by including a $23 risk margin in the liability equates to setting the probability of adequacy (PoA) of the liability marginally in excess of 90% (recalling that the 90% PoA was $272). Hence the PoA can be used to consistently calibrate the size of risk margins for outstanding claims (where, by definition, there is no unexpired risk premium remaining in the cash flows). Further, this would be consistent with a fair value of the liability if the markets/insurer s required rate of return on capital employed was 14.6% p.a.

19 Illustration: Summary of Insurance Liability Issues We have shown how the uncertainties of the insurance risk process can be accounted for BUT we have only allowed for changes in our modelled outcomes assuming no change in the underlying process or it s parameters. If the process parameters start to change, but the process is modelled correctly, this leads to Parameter Risk. We also need to account for the fact that our model of the system is likely to be less than perfect (e.g. perhaps the dice, unknown to us, was actually a loaded dice). This is Model Risk. Additionally, we have assumed in our example that the process does not change, but it probably will over time (e.g. a player moves address and forgets to role the dice (or lapses ). This is Process Risk. In a true insurance risk situation, we need to account for all three types of risk in addition to basic random statistical fluctuations in outcome.

20 Critical Issues in Reserving Estimation of claims trends (frequency & severity) Interest Rate used to calculate present values Measures of Uncertainty Probability of Sufficiency (50%, 75%, 90%) Co-efficient of Variation (Std Dev/Mean) Market Benchmarks 50% 90% 50% 90% Low Co V High Co V 21 November,

21 Linking PoA With Market Value Why 75% PoA? Compared: NPV (at Cost of Capital) of requirement to hold funds in excess of the central estimate up to 99.5 th percentile of outstanding claims at Risk Free Rate: i.e. initial capital needed less NPV of expected releases as claims are settled Assumed: Claims log-normally distributed (i.e. skewed outcomes) CoV s constant over run-off of claims Realistic returns on capital Tested: Short, Medium and Long Tailed classes

22 Linking PoA With Market Value - Conclusions For classes modelled: Percentile liability representing a realistic result varies significantly by duration: Around 55%-60% for short tail Around 80%-90% for long tail Around 75% is reasonable for a typical mixed portfolio with allowance for diversification 75% PoA is just one possible benchmark Risk Margins can be set in other ways

23 Balancing Liabilities and Assets Accounting for assets is easy just let the market (for the majority of assets) be the model (and the means of valuation) Even though there is no real market for most insurance liabilities we can measure the liability on a basis consistent with the asset approach Adequate Disclosure is the key! Discounting the liabilities at an appropriate rate (the risk free rate) is essential. Future cash flows can, and should, be derived for even the most simple of liability estimation methods, and hence enable the application of discount rates to all claim liabilities. Risk margins create the market value adjustment for the level of uncertainty adopted The value of non-life insurance liabilities should not change when backed by different types of assets. Probability of Adequacy is one way of providing the disciplined structure. There are others (e.g. Tail VAR or use of profit margins).

24 Using the Accounting Figures to Manage the Business Results Tend to be Volatile But, so is the business! Discount rates may change with market movements, but active asset/liability management can ameliorate this effect A prospective approach to unexpired risk speeds up recognition of both profits & losses Disclosure and Discipline (Actuarial Standards) are Vital -- Risk margins should not vary much over time as a percentage of the central estimate Transparency of reporting means that trends in business outcomes are recognised at an earlier stage (and therefore tend to have a lesser once-off effect on results) Diversification effects are still subject to a range of approaches Hence Result Smoothing is Difficult Everything is auditable! Internal and external reporting are entirely consistent

25 Consistency of Market Results Initial Regulator s Data on Use of Risk Margins Shows Some Variation (Source: APRA May 2003): Outstanding Claims Liability Industry risk margins as a % of Central Estimate 75% Probability of Sufficiency Level Insurance Class Standard Mean Deviation Compulsory Third Party Long Tail 10% 7% Domestic Motor Vehicle Short Tail 6% 3% Employers Liability (Workers Compensation) Long Tail 8% 9% Householders Short Tail 6% 7% Professional Indemnity Long Tail 10% 9% Public & Product Liability Long Tail 8% 8% Travel Short Tail 8% 9% Fire & Industrial Special Risks Short Tail 7% 16% Inwards Reinsurance Various 11% 15% Other Various 17% 22%

26 Consistency of Market Results in Australia On a Practical Level, Consistency is Improving Central estimate is now clearly the mean of the distribution of potential outcomes (not the median, or the mode!) Before APRA there was a wide range of usage of risk margins. Now, 75% PoA for all insurance liabilities (including premium liabilities) tends to be the minimum. Companies are converging around 90% PoS of liability for outstanding claims as a market standard Market analysts (users) very interested in liability disclosures Diversification allowances are still an area of some divergence, but increased disclosure is starting to supply some answers Not uniformly transparent (yet), but getting there!

27 Practical Experience Central Estimates Few challenges to existing methodology in Australia Central estimate value has been adjusted for inflation and discounted at a risk free rate for many years Increased focus reinsurance to turn gross into net values Confirmed the central estimate as the mean of the distribution of potential outcomes Benefits Expanded actuarial influence to virtually 100% of insurance liabilities Improved internal management discipline Better quality and quantity of data Stronger communication links with Board and senior management More transparency of approach Developed linkage to risk margin work

28 Practical Experience Risk Margins Challenges have been significant and fundamental What does 75% (or 85% or 90%) probability of adequacy mean and how should it be estimated? (We may be able to estimate parameter risk accurately, but what about model risk and process risk?) There was (alarmingly) little global literature upon which to base an approach The Institute of Actuaries of Australia and APRA contributed to research Adequate Actuarial Standards (APRA GPS210 and IAAust PS 300) were vital Diversification allowances are still a challenge Benefits have emerged Improved understanding of companies approaches (if not yet full consistency) Established thinking that a margin is needed More management focus on true drivers of business risk

29 Practical Experience Premium Liabilities (for APRA reporting & LAT for AASB 1023) Challenges were again fundamental A new discipline was needed (as actuaries had tended not to venture into the accounting preserve of unearned premiums ) The methods were basically an extension of claim reserving methodology (but with some variation to allow for risk differences) The full challenge has yet to be met (since AASB 1023 accounting standard is only just starting to examine risk prospectively) Benefits are already apparent Clear linkage with the pricing process Clarifies gross and net issues Encourages usage of dynamic financial analysis techniques (especially for low frequency claims)

30 Minimum Disclosure Recommended 1. Central Estimate of Liability for Outstanding Claims 2. Total Liability for Outstanding Claims (so that (1.) (2.) = Total Risk Margin) 3. Estimated Probability of Adequacy (Sufficiency) of (2.) 4. Separate analysis of (2.) and (3.) shown for : (a) total short tail (<1 year to paid claim) portfolios, and (b) total long tail (> 1 year to paid claim) portfolios 5. Separate analysis of (1.) to (4.) by currency of liability 6. Details for each liability of mean term and discount rates and inflation rates (including judicial or superimposed inflation) used 7. Details of movement in central estimates over past year

31 An Australian Example of Disclosure Promina Ltd - 31 December 2004 ($m) Direct Net Central Estimate (Discounted) Risk Margin (Discounted) 85 th percentile 90 th percentile RM RM% RM RM% Change Outstanding Claim Provision (Discounted) Australia CTP % % Short-tail and Other % % New Zealand % % 0 9 Intermediated Australia CTP % % 2 81 Liability % % Workers compensation % % Asbestos % % Short-tail and other % % New Zealand % % Total 1, % % 52 2,076

32 Promina Limited - 31 December 2004 The following average inflation (normal and superimposed) rates and discount rates were used in the measurement of net outstanding claims Australia New Zealand 31 Dec Dec Dec Dec 2003 For the succeeding year Inflation rate 7.4% 8.1% 3.0% 3.0% Discount rate 5.3% 5.6% 6.3% 6.0% For subsequent years Inflation rate 7.4% 8.1% 3.0% 3.0% Discount rate 5.3% 5.6% 6.3% 6.0% The weighted average expected term to settlement of the outstanding claims from the balance date is estimated to be: 3.2 yrs 3.1 yrs 1 yr 2.2 yrs

33 In Conclusion Insurance Isn t Black and White Outcomes are nearly always uncertain If we introduce appropriate standards, we can account for the Grey By introducing the concept of a distribution of potential outcomes and requiring clear disclosure about PoS used Risk Margins provide the framework to achieve this Meaningful, bench-markable disclosure is key to consistency Management of the insurance business is improved by the added transparency and discipline introduced

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