1 DISCOUNTING OF PROPERTY-CASUALTY LOSS RESERVES (S. Feldblum, 4 Oct 11) Background: Reserve Valuation and Solvency Monitoring Before 1986, statutory full value loss reserves provided federal income tax benefits to U.S. insurers, since nominal incurred losses were an offset to taxable income. After the 1986 Tax Reform Act, only discounted reserves are an offset to taxable income: no tax benefit accrues from statutory full value loss reserves. Full value loss reserves provided solvency margins and tax benefits before 1986 without extra costs to insurers. With the tax benefits eliminated, investors are more concerned with the capital costs of holding full value loss reserves and they want financial reporting that reflects the time value of money. Full value loss reserves and gross unearned premium reserves were justified as implicit risk margins for uncertain liabilities. Since the advent of risk-based capital requirements in 1994, solvency monitoring uses discounted reserves, with explicit capital requirements instead of implicit accounting margins. The NAIC s risk-based capital formula now uses a 5% reserve valuation rate for its reserving risk and written premium risk charges. Reserve discounting at a 5% rate in the 2000 s produce valuations close to fair value. RBC uses a different framework than fair value accounting, but the implied reserve valuation rates are similar. Loss reserve valuations by rating agencies affect their ratings, which are closely watched by investors and insurers. Ratings affect insurers business strategy, and potential downgrades may force an insurer to reinsure or sell blocks of business. The agencies calculate fair values of loss reserves for their capital models. A. M. Best s and Standard and Poor s follow the RBC format, though with more conservative discount rates. Moody s and Fitch use stochastic capital models, with an investment yield as the implicit valuation rate. Post-codification statutory accounting The adoption of the NAIC Accounting Practices and Procedures Manual on January 1, 2001, culminated a multi-year effort of the NAIC Accounting Policies and Procedures Task Force to codify statutory accounting policies. As outlined in Statement of Statutory Accounting Principles (SSAP) #65, statutory accounting requires full value reserves except in three circumstances. 1. Tabular reserve discounts are permitted on the indemnity portion of workers compensation long term disability claims (pension cases) and on long term disability claims from accident and health insurance policies. These are annuity claims on impaired lives. Just as they are discounted by life insurers, they may be discounted by property-casualty insurers. Tabular discounts are not permitted for medical benefits or for loss adjustment expenses, even if these benefits are paid on the same claims. 2. Non-tabular reserve discounts are permitted for monoline (primarily single-state) medical malpractice writers, so that private doctors mutual insurers need not raise additional capital. 3. Non-tabular reserve discounts may be allowed by the insurance commissioner of the insurer s domiciliary state so that a stable but poorly capitalized insurer can continue operating with low statutory surplus. 1 Full value statutory reserves include expected inflation but no non-tabular discount. Suppose a permanently disabled employee receives workers compensation loss of income (indemnity) benefits of $800 a week, increasing each year with the change in the CPI, and medical (home nursing) benefits of about $500 a week, increasing with wage inflation for nurses. The indemnity reserve is an increasing life annuity with a discount rate ranging from 3.5% to 5.0%. The medical reserve is an increasing life annuity
2 with no discount. Expected inflation in nurses wages is included, but not the discount for the time value of money, since medical reserves are not discounted. TABULAR VS NON-TABULAR DISCOUNTS Tabular discounts are based upon a mortality or morbidity table. Statutory accounting permits them for the indemnity (wage replacement) portion of workers' compensation pension cases or long-term disability claims. They may not be applied to the medical benefits or loss adjustment expenses associated with these claims. The Annual Statement Instructions say that Tabular reserves by accident year are indemnity reserves calculated using discounts determined with reference to actuarial tables which incorporate interest and contingencies such as mortality, remarriage, inflation, or recovery from disability applied to a reasonably determinable payment stream. 2 Tabular discount are like reserve valuation for immediate annuities. Seriously injured claimants are disabled lives, with shorter life expectancies and smaller discounts. Many permanently disabled workers now have soft tissue injuries like carpal tunnel syndrome and lower back sprains, with average mortality. Non-tabular discounts are determined from aggregate payment patterns, not mortality tables. Loss payment patterns are reasonably stable in most lines of business and are used for policy pricing. Statutory accounting does not permit non-tabular discounts for property-casualty reserves except for the second and third instances listed in the previous section. Illustration: A construction worker paralyzed after a fall from a scaffold is receiving weekly indemnity benefits of $1,000 for an expected remaining life of 40 years. The undiscounted reserve is 40 years 52 weeks $1,000 per week = $2.08 million. A rough estimate of the discounted reserve (a life annuity with a $1,000 weekly benefit) is / = $949,285 $950,000, using an average payment in 20 years. The insurer also pays for the medical portion of workers compensation insurance: home health care visits, rehabilitation treatment, and periodic nursing and physician care. The current cost of about $600 a week increases with inflation and deterioration of the worker s condition over time. Based on analysis of inflation and development patterns, the undiscounted reserve is $3.5 million and the discounted reserve is $1.4 million. This is a non-tabular discount for medical costs and is not appropriate for statutory accounting, though the benefits are paid to the same claimant. Tabular discounts apply to indemnity benefits (income replacement), whose payments are made according to a fixed schedule. TABULAR DISCOUNTS AND IBNR CLAIMS Tabular discounts are permitted on both case and incurred but not reported (IBNR) reserves. Tabular discounts on known claims (case reserves) are determined from the weekly benefit, the discount rate, the mortality table, and the age, sex, and impairment status of the injured worker. The term tabular discounts for IBNR claims needs explanation. In most lines of business, IBNR claims are not yet reported. Tabular discounts depend on the injured worker s sex, age, and disability rating; if a claim has not been reported, the sex, age, and disability rating are not known. Workers compensation injuries are reported quickly, since state statutes require the employer or its insurer to begin payments within 2 to 4 weeks of the worker s injury. IBNR claim emergence for permanent total disability claims should not be material. 3 Workers compensation IBNR claims are primarily reclassification of cases, not the emergence of new cases, sometimes called IBNER: incurred but not enough reported. Many permanent total disability cases begin as sprains or strains of the back or neck. They are temporary total cases, and no tabular discount is
3 applied. Some employees do not return to work, and their claims are reclassified as permanent total disability cases. The majority of permanent total disability cases may not be identified until four or five years after the accident date. The reserving actuary estimates the emergence pattern of permanent disability cases from temporary cases and applies an average severity determined from the experience of mature years. Illustration: At December 31, 20X7, the insurer has 12,000 unsettled temporary total cases involving sprains or strains of the neck or back for accident year 20X7. Historically, 0.15% of these claims become pension cases, so the estimated 20X7 unreported pension count is 18 cases. For accident year 20X2, the average remaining cost of a permanent total disability case at 12/31/20X7 is $700,000. In hindsight, the average cost of these cases at 12/31/20X2 (with 5 more years of payments) would have been $840,000, and the average tabular discount would have been 20%. If the workers compensation indemnity loss severity trend is 6% per annum, the average cost for a 20X7 permanent total disability claim is $840, = $1,124,109. The average tabular discount per claim is 20% $1,124,109 = $224,822. The tabular discount for 18 IBNR claims is 18 $224,822 = $4,046,794. DYNAMIC DISCOUNT RATES Life insurance and annuity policy reserves are held at discounted values on statutory financial statements. Before 1980, as market interest rates changed, state regulations specifying maximum permitted discount rates changed as well. The 1980 and 1990 Standard Valuation Laws for life insurance and annuity products used dynamic discount rates. The maximum allowable statutory rate varies with the yield on investment grade corporate bonds minus a margin that depends on the characteristics of the insurance product. Post-codification statutory accounting uses a similar dynamic rate for non-tabular reserve discounts 4 (when discounting is permitted). The maximum discount rate is limited to the lower of! The yield on Treasury notes with maturity matched to the average reserve maturity.! The insurer s investment yield minus 1.5 percentage points. 5 The insurer s investment yield is! The average yield on invested assets if they exceed policyholder reserves (at year end). 6! The average yield on total assets if invested assets are less than policyholder reserves. 7 Illustration: A property-casualty insurer applies non-tabular discounts to certain reserves. December 31, 20XX loss reserves: $120 million December 31, 20XX unearned premium reserves: $50 million Average investment yield on invested assets during 20XX: 9.5% per annum December 31, 20XX 1 total statutory assets: $195 million December 31, 20XX total statutory assets: $205 million 20XX investment income earned (line 8 of U&IE): $14 million Average maturity of unpaid losses: Five years 5 year Treasury note rate on December 31, 20XX 7.5% per annum Policyholder reserves are $120 million + $50 million = $170 million, the yield on invested assets in 20XX is 9.5%, and the Treasury rate on bonds with maturities matched to unpaid losses is 7.5%.
4 ! If the investable assets are more than $170 million, the insurer s investment yield of 9.5% on invested assets minus the statutory margin of 1.5% is 8.0%. The maximum statutory discount rate is the lower of 8.0% and 7.5%, or 7.5% per annum.! If the investable assets are less than $170 million, the yield on total assets of $14 million / ½ ($195 + $205) million = 7.0%, minus the statutory margin of 1.5%, is 5.5%. The maximum permitted statutory discount rate is the lower of 5.5% and 7.5%, or 5.5% per annum. The discount rates for tabular reserve discounts are specified in state statutes, ranging from 3.5% to 5%. RISK-BASED CAPITAL, DISCOUNTING: TABULAR VS NON-TABULAR Statutory solvency monitoring is based on risk-based capital requirements, which uses discounted reserves, not nominal reserves. The reserving risk charge in the NAIC risk-based capital formula uses the IRS discounting procedures and loss payment patterns, with a 5% discount rate instead of the IRS s 60 month moving average of federal mid-term rates. The written premium risk charge uses discounted loss ratios, with the same 5% discount rate. RBC discount factors are not dynamic. The investment income offsets in the reserving and written premium risk charges were computed in 1994, using industry loss payment patterns in the 1993 Schedule P. These offsets were updated in by the American Academy of Actuaries committee on riskbased capital. State solvency regulation includes monitoring an insurer s risk-based capital ratio, or the company s adjusted surplus divided by its risk-based capital requirements. Adjusted surplus is policyholders surplus minus non-tabular reserve discounts, and these discounts are added to loss reserves before the reserving risk charge is computed. Tabular discounts are not removed from surplus or added to loss reserves. 8 Re-classifying a non-tabular discount as tabular does not change statutory surplus, but it increases RBC adjusted surplus, decreases the reserving risk charge, and raises the RBC ratio. A financially distressed insurer may seek to avoid regulatory intervention by classifying nontabular discounts as tabular. The risk-based capital ratio is often used as an indicator of financial strength, so even financially sound insurers may have incentive to classify reserve discounts as tabular and increase capital. To avoid improper use of these discounts, tabular discounts are not permitted for medical benefits or loss adjustment expenses. Illustration: An insurer has surplus of $500 million and RBC requirements of $400 million. It has loss reserves of $800 million, with tabular discounts of $50 million and non-tabular discounts of $100 million, and a reserving risk charge of 15% (on average). Its RBC loss reserves for the reserving risk charges are $800 million + $100 million = $900 million, and its RBC ratio is ($500 million $100 million) / $400 million = 100%. Classifying $50 million of non-tabular discounts as tabular makes its RBC loss reserves $800 million + $50 million = $850 million and its RBC requirements $400 million $50 million 15% = $ million. Its RBC ratio is ($500 million $50 million) / $392.5 million = %. GAAP permits discounting when the payment schedule is reasonably fixed and determinable. Current U.S. GAAP guidance as codified in Accounting Standards Codification (ASC) S99 says that discounting may be elected for liabilities that are reasonably fixed and determinable. If discounting is elected, liabilities are discounted at the rates used for reporting to state regulatory authorities or a rate
5 based on the facts and circumstances at the time claims are settled. Reasonably fixed and determinable is similar to the statutory rule for tabular discounts in SSAP 65. The justification of the GAAP treatment is that determining fair value reserves requires assumptions for the payment schedule and the discount rate. There is no accepted means of choosing the discount rate or testing whether a past choice was correct. GAAP places primary importance on objective, verifiable, and consistent standards; some analysts say these standards are not met by discounted reserves. 9 DISCLOSURE Loss reserve discounts are disclosed in Schedule P, the Statement of Actuarial Opinion, and the Notes to the Financial Statements. Schedule P: Non-tabular discounts are disclosed by line of business and accident year, separately for losses and loss adjustment expenses, in Schedule P, Part 1. This disclosure is necessary to gross up discounted reserves before IRS loss reserve discounting. Tabular discounts by line of business and accident year may be inferred from a comparison of Schedule P, Part 1, with Schedule P, Part This implied disclosure does not meet IRS requirements; explicit disclosure in the Notes is needed. Statement of Actuarial Opinion: The Appointed Actuary comments on loss reserve discounts that may affect reserve adequacy in the Statement of Actuarial Opinion; see section 11 of the actuarial opinion part of the NAIC Instructions. Notes to the Financial Statements: Note 32 of the 2010 Annual Statement discloses the discount rate, the basis for the rate, the discount, and the discounted liability. 11 Tabular discounts are shown by line of business, separately for case and IBNR (bulk) reserves. Non-tabular discounts are shown by line of business, separately for case reserves, IBNR reserves, defense and cost containment (ALAE) reserves, and adjusting and other (ULAE) reserves. Non-tabular discounts in the Notes should reconcile with the Schedule P, Part 1, discounts for losses and loss adjustment expenses. 12 CHANGES IN DISCOUNT RATES If discount rates have changed from those used in the previous year's Annual Statement, the insurer discloses! The discounted liabilities at the current and previous rates.! The change in the discounted liability that results from the change in the discount rate. The amounts in this disclosure exclude the current year's liabilities. Illustration: An insurer has $100 million of undiscounted reserves at December 31, 20X7, which it holds at discounted values on its balance sheet. Of these reserves, $15 million are accident year 20X7 claims and $85 million are from previous accident years. At the 4% per annum valuation rate used in 20X7, the discounted reserves from previous accident years are $63 million in 20X7. In 20X6 the company used a 3.5% discount rate. The discounted value of the pre-20x7 reserves at year end 20X7 would have been $66 million had the company used a 3.5% discount rate. The disclosure in the Note to the Financial Statements is! The pre-20x7 discounted liabilities at the current rate: $63 million! The pre-20x7 discounted liabilities at the previous rate: $66 million! The change in the discounted liability: $63 million $66 million = $3 million! The discount itself: $85 million $63 million = $22 million.
6 CHANGE IN ESTIMATE Changes in estimates differ from changes in accounting practice.! A change in an estimate flows through the income statement. A 20X7 increase in a reserve for a claim that occurred in 20X5 is a 20X7 incurred loss.! A change in an accounting practice is a direct charge or credit to surplus, not a revenue or expense that flows through the income statement. A change in the discount rate is a change in an estimate, not a change in accounting practice, but a decision to discount where discounting was not used before is a change in accounting practice. If a company holds reserves discounted at a 6.8% rate in 20X6 and at a 6.3% rate in 20X7, the company records an incurred loss for the year even through the expected ultimate value of the losses has not changed. 13 Endnotes 1 Undiscounted values are also termed nominal values or ultimate values. Discounted values are also termed market values or fair values. 2 See also SSAP No. 65, Property and Casualty Contracts, paragraph 11: Tabular reserves are indemnity reserves that are calculated using discounts determined with reference to actuarial tables which incorporate interest and contingencies such as mortality, remarriage, inflation, or recovery from disability applied to a reasonably determinable payment stream. Tabular reserves shall not include medical loss reserves or loss adjustment expense reserves. 3 Latent occupational injuries to workers in underground mines and certain other hazardous employments were substantial in the mid-20 th century; now attorneys prefer to pursue these claims through the tort system. 4 No maximum discount rate is specified for tabular discounts, since the discount rate is often set by the state statute at a conservative 3.5% or 4.0%. 5 A maximum discount rate is also specified for the third test used to set the unearned premium reserve for long duration property-casualty contracts (such as product warranty contracts) with two changes in the maximum permitted rate: (1) the Treasury yield is for five year notes, not for securities with maturities matched to the maturities of the loss reserves, and (2) the insurer s yield is the yield on invested assets, with no requirement that invested assets be as large as policyholder reserves. 6 Policyholder reserves are loss reserves plus unearned premium reserves. 7 See SSAP Number 65, Property and Casualty Contracts, paragraph 12: When establishing discounted loss reserve liabilities prescribed or permitted by the state of domicile using a non-tabular method... the rate used [shall not] exceed the lesser of the following two standards: $ If the reporting entity's statutory invested assets are at least equal to the total of all policyholder reserves, the reporting entity's net rate of return on statutory invested assets, less 1.5%, otherwise, the reporting entity's average net portfolio yield rate less 1.5% as indicated by dividing the net investment income earned by the average of the reporting entity's current and prior year total assets; or $ The current yield to maturity on a United States Treasury debt instrument with maturities consistent with the expected payout of the liabilities. Non-invested assets include premiums receivable, accrued retrospective premiums, deferred tax assets, and non-investment real estate. If the company s invested assets cover its reserves, it uses the yield on its invested assets; if they do not cover reserves, it uses overall asset yield. 8 The reserving risk charge for workers compensation assumes that insurers apply tabular discounts wherever permitted. The Schedule P reserves are assumed to be discounted, so no further adjustment is
7 needed. Surplus is not adjusted so that property-casualty insurers holding reserves for permanent total disability cases are treated the same as life insurers holding reserves for impaired life annuities. 9 The December 1990 AICPA Discussion Document on Present Value Procedures agrees that discounting is necessary to fairly estimate profitability but that it is hard to set objective standards for discounting. Both GAAP and statutory accounting permit discounting for life insurance policy reserves, annuity reserves, and pension plan liabilities. The GAAP choice of discount rate is discussed in SFAS 87 for pension plan liabilities. The discount rate for determination of book profits is discussed in SFAS 97 for universal life-type contracts and in SFAS 125 for participating contracts issued by mutual life insurance companies. 10 The implied tabular discount is the current valuation in Schedule P, Part 2, minus the incurred loss plus defense and cost containment expenses (but not adjusting and other expenses) in Part The Annual Statement Instructions for the Notes of the Financial Statements say: State whether any of the liabilities for unpaid losses or unpaid loss adjustment expenses are discounted, including liabilities for Workers' Compensation. If the company is required to respond in the affirmative for non-tabular discounting, it must also respond in the affirmative to Schedule P, Interrogatory 4, and complete Columns 32 and 33 of Part 1, Part 1A, etc., of Schedule P. If the answer is in the affirmative, furnish the following information for each line of business affected: a. If a tabular basis is used: i. Identify table used. ii. Rate(s) used to discount. iii. The amount of discounted liability reported in the financial statement. iv. The amount of tabular discount, by the line of business and reserve category (i.e., case and IBNR). Definition of Tabular Reserves: Tabular reserves by accident year are indemnity reserves that are calculated using discounts determined with reference to actuarial tables which incorporate interest and contingencies such as mortality, remarriage, inflation, or recovery from disability applied to a reasonably determinable payment stream. This definition shall not include medical loss reserves or any loss adjustment expense reserves. b. If a non-tabular basis is used: i. Rate(s) used to discount and the basis for the rate(s) used. ii. Amount of non-tabular discount disclosed by line of business and reserve category (i.e., case, IBNR, Defense and Cost Containment expense, and Adjusting and Other expense.) iii. The amount of non-tabular discount reported in the statement. c. If the rate(s) used to discount prior accident years' liabilities have changed from the prior annual statement or if there have been changes in the key discount assumptions such as payout patterns: a. Amount of discounted current liabilities at current rate(s) assumption(s). (Exclude the current accident year.) b. Amount of discounted current liabilities at previous rate(s) assumption(s). (Exclude the current accident year.) c. Change in discounted liability due to change in interest rate(s) assumption(s). (1 2) d. Amount of non-tabular discount, by line of business and reserve category (i.e., case, IBNR, Defense and Cost Containment expense, and Adjusting and Other expense.)
8 12 Before the 1986 Tax Reform Act, the statutory full value loss reserves enabled property-casualty insurers to partially defer federal income taxes on underwriting operations; this deferment was removed by the revenue offset and loss reserve discounting provisions in the 1986 Act. The solvency monitoring in the risk-based capital formula uses discounted reserves as well. The current rationale for undiscounted loss reserves on statutory financial statements is a mix of conservatism, disagreement on the proper discount rate, and the need for undiscounted loss reserves for the Schedule P reserve adequacy tests. The received wisdom is that the statutory requirement for full value loss reserve helps consumers by ensuring the solidity of insurers. In truth, the use of undiscounted reserves raises premium rates, lowers the return on invested capital, and encourages the use of economically inefficient reinsurance practices designed to circumvent the statutory rules. 13 Cf. SSAP No. 65 Property and Casualty Contracts Paragraph 13: In accordance with SSAP No. 3, Accounting Changes and Corrections of Errors, a change in the discount rate used in discounting loss reserves shall be accounted for as a change in estimate. SSAP No. 3 requires changes in estimates to be included in the statement of income in the period the change becomes known.