The Impact of International Financial Reporting Standards On U.S. Property/Casualty Actuarial Practice

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1 Nov. 5, 2010 The Impact of International Financial Reporting Standards On U.S. Property/Casualty Actuarial Practice Kris DeFrain, FCAS, MAAA, CPCU Director of Actuarial and Statistical, NAIC Even before the financial crisis there was a desire to create high quality, transparent, and comparable information in general purpose financial statements around the world; the idea has gained even more momentum after the financial crisis. As part of this effort, there is a push for the development of a single set of high quality, globally accepted accounting standards. In June 2010, the Group of Twenty (G-20) Finance Ministers and Central Bank Governors, of which the U.S. is a member, re-emphasized the importance of achieving a single set of high-quality improved global accounting standards. There are currently two major sets of accounting standards -- International Financial Reporting Standards (IFRS) adopted by the International Accounting Standards Board (IASB) and U.S. Generally Accepted Accounting Principles (US GAAP) drafted by the Financial Accounting Standards Board (FASB). The memorandum of understanding between the IASB and FASB indicates an intention to converge their accounting standards wherever practical 1. As a result, there is potential for one set of international accounting standards to emerge. In 2007 the Securities and Exchange Commission (SEC), the ultimate body responsible for U.S. public accounting standards, began to accept financial statements from foreign private issuers that are prepared in accordance with IFRS without reconciliation to U.S. GAAP. The SEC might expand acceptance of IFRS by allowing U.S. issuers to utilize IFRS or by possibly switching from a GAAP to an IFRS requirement. When it comes to U.S. insurance company regulatory reporting, the statutory accounting principles (SAP) could also be affected by international accounting concepts. SAP guidance is currently developed by U.S. insurance regulators, deciding whether to adopt, modify or reject each change that is made to GAAP. Since GAAP and IFRS are converging, international accounting will, at a minimum, seep into SAP. And, just like with the SEC, U.S. insurance regulators are also considering the utilization of IFRS (with modification for regulatory solvency purposes). With all of these changes underfoot, concepts used in international accounting should be understood by all practicing actuaries. IFRS spans numerous accounting subjects from inventories to cash flows to earnings per share. Significant changes from current practice now being discussed by the IASB include accounting for financial instruments, fair-value measurement, leases, consolidation and revenue recognition. But of most importance to 1 The IASB and FASB have a joint project for insurance accounting, although insurance accounting has not been included in the memorandum of understanding.

2 insurance company actuaries are the upcoming revisions to IFRS 4 - Insurance Contracts. IFRS 4 - Insurance Contracts IFRS 4 applies to virtually all insurance contracts (including reinsurance contracts) that an entity issues and to reinsurance contracts that it holds. It does not apply to other assets and liabilities of an insurer, such as financial assets and financial liabilities currently within the scope of IFRS 9 Financial Instruments. The current IFRS 4 standard for insurance contracts, referred to as Phase I, was promulgated in 2004 with few requirements other than elimination of catastrophe and equalization provisions (both provisions for possible claims under contracts that are not in existence at the reporting date), requirements for an adequacy test for insurance liabilities and an impairment test on reinsurance assets, prohibition of the offsetting of insurance liabilities with reinsurance recoverables, and requirements of certain disclosures. Insurers have temporarily been exempt from some other IFRSs until Phase II of the insurance contracts work is completed. Phase II is expected to replace the status quo of what some refer to as some excessively prudent approaches common in some countries with a more disciplined approach. Phase II began with a 2007 paper on the Preliminary Views on Insurance Contracts and has reached a milestone with the publication of an exposure draft of the revised IFRS 4 in July The current -- and proposed -- definition of an insurance contract in IFRS 4 is a "contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder." Notably, compensate is used rather than current U.S. wording of indemnify; and the trigger to meet the definition includes only an assessment of insurance risk, and does not have to include timing risk to qualify the contract as an insurance contract, as is required in the U.S. today for reinsurance. The proposed recognition of an insurance contract liability under the exposure draft would begin when an insurer becomes party to the insurance contract, which can be earlier than the effective date of insurance coverage. Measurement of the insurance contract liabilities in the exposure draft of Phase II is described using a three-building block approach: 1. Unbiased probability-weighted expected (mean) cash flows 2. Time value of money (discounting) 3. Margin (s)

3 In the first building block, the IASB methodology of cash flow estimation is described as measurement of fulfillment value, which is similar conceptually to current U.S. valuation that is based upon measuring the settlement value of insurance claims. Methodologies to measure insurance liabilities are not prescribed, however observable elements of the measurements (e.g. interest rates) should be market consistent where reliable prices can be observed in relevant markets and should include all rights and obligations. The requirement for market consistency is confusing to some given that insurance liabilities are not traded on a deep and liquid market. In any case, the selections of parameters and assumptions will require significant actuarial evaluation and judgment, as actuaries are accustomed. Discounting of insurance liabilities, the second building block, would be required. The objective of applying a discount rate to a future cash flow is to reflect the time value of money. The discount rate(s) to use will not be prescribed, but for typical property/casualty business, is currently proposed to be a risk-free interest rate with some adjustments to reflect such factors as the currency, liquidity, and timing of the cash flow. For the third building block, there is recognition that a significant element underlying insurance liabilities is the risk and uncertainty associated with the expected cash flows. The IASB has proposed use of a risk adjustment to adjust for the effects of uncertainty about the amount and timing of future cash flows and a residual margin to eliminate any gain at inception of the contract 2. Actuaries will likely be quantifying the risk adjustment. The International Actuarial Association (IAA) drafted a paper titled Measurement of Liabilities for Insurance Contracts: Current Estimates and Risk Margins, April 14, 2009, that reiterates five key desirable characteristics of risk margins previously identified by the International Association of Insurance Supervisors (IAIS) and slightly rephrased in the IASB Exposure Draft: 1. The less that is known about the current estimate and its trend, the higher the risk margins should be. 2. Risks with low frequency and high severity will have higher risk margins than risks with high frequency and low severity. 3. For similar risks, contracts that persist over a longer timeframe will have higher risk margins than those of shorter duration. 4. Risks with a wide probability distribution will have higher risk margins than those risks with a narrower distribution. 5. To the extent that emerging experience reduces uncertainty, risk margins will decrease, and vice versa. 2 The IASB and FASB have proposed alternative approaches. FASB proposed use of one combined margin for the third building block, called a composite margin.

4 The IAA also recommends that calculations of risk margins should utilize a consistent methodology for the entire lifetime of the contract, be consistent with the determination of current estimates, be consistent with sound insurance pricing, vary by product based on risk differences between products, and consider the ease of calculation. The actuarial profession is likely going to need to enhance the guidance provided to the practicing actuaries in development risk adjustments. At present, the Exposure Draft has identified three approaches that it proposes will be acceptable for this purpose 3 : 1. The Confidence Level (VaR) technique expresses uncertainty in terms of the extra amount that must be added to the expected value so that the probability that the actual outcome will be less than the amount of the liability (including the risk adjustment) over the selected time period equals the target level of confidence. 2. The conditional tail expectation (CTE) and tail value at risk (TVaR) calculates the mean of losses within a certain band (or tail) of pre-defined percentiles. With the CTE method, the margin is calculated as the probability-weighted average of all scenarios in the chosen tail of the distribution less the mean estimate. 3. The cost of capital method is based on the amount of return, in addition to the amount earned by the insurer from its investment of capital, required for the total return for the insurance enterprise to be adequate. The IAA studied risk margin methodologies and did not recommend a particular approach, but arrived at the following conclusions: The cost of capital method (without simplification) is the most risk sensitive and is the method most closely related to pricing risk in other industries. However, in part as a result, some consider it more challenging to implement than the other methods. Within the quantile family of methods, CTE approaches are conceptually sounder than confidence level (VaR) approaches, with the differences being significant for products with more skewed risk distributions. To the extent that confidence levels are specified for risk margins or capital measurement in the cost of capital method, these can better represent appropriate capital levels for this purpose. Regulatory oversight or actuarial practice would apply higher levels for products whose risk distributions are more highly skewed. At present there is an exception to the three-building block approach for short-duration contracts. The simplified measurement approach for short-duration contracts would be roughly similar to the U.S. unearned premium reserve approach but require much more complicated calculations. The new IFRS-4 Insurance Contracts standard (Phase II) is expected to be finalized in June 2011, with expectations for implementation in 2013 or later. 3 Feedback to the IASB is expected to request that the methods for risk margin calculation not be limited.

5 U.S. Actuarial Practice International accounting has an impact on U.S. actuarial practice, indirectly because international accounting can influence U.S. GAAP and SAP and directly because some foreign issuers are using IFRS when filing with the SEC. The use of IFRS in the U.S. might expand. U.S. actuaries will need to understand the concepts in IFRS and be able to determine insurance contract liabilities through the three-building block approach.