An Approach for Measurement of the Fair Value of Insurance Contracts by Sam Gutterman, David Rogers, Larry Rubin, David Scheinerman

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1 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma Absrac The paper explores developmes hrough 2006 i he applicaio of marke-cosise coceps o he measureme of fair values of liabiliies for fiacial reporig purposes. A se of crieria is preseed ha should be useful i he evaluaio of proposed fair value measureme approaches where ipus based o prices observed i a acive marke wih reliable rasacio prices are o available. Based o hese crieria, oe approach is examied ha migh serve as a basis for he fair value measureme of he liabiliy of life isurace coracs ad oher fiacial isrumes issued by isurers. The margi uder his approach is deermied i a maer similar o ha currely used uder U.S. GAAP for a ivesme corac, a Fudig Agreeme Backed Noe Issuace Program (FANIP), which is calibraed o is rasacio price. The approach is geeralized by use of a isurace example, a 20-year erm life isurace policy, o illusrae he coceps ivolved as hey migh be applied o isurace coracs. I par, his idicaes ha a cosise approach o he measureme of he liabiliy for hese wo ypes of coracs is pracical ad desirable, hus o requirig ha coracs issued by isurers be classified (e.g., as isurace, ivesme, or derivaive) ad ca be applied i a cosise maer bewee differe ypes of reporig eiies. Several addiioal issues ha are releva o fair value measureme are also discussed, icludig he reame of expeses, operformace risk, ad a cash value floor. 1. Backgroud Accouig sadard seers have give icreased emphasis o he use of fair value as a fiacial reporig measureme basis. Ideed, boh he FASB ad he IASB have idicaed ha heir log-erm objecive is o have all fiacial asses ad fiacial liabiliies measured a heir fair value. Amog he reasos for his objecive are he icreased imporace of he fiacial markes as a source of capial ad fuds for risk akig ad a belief ha ecoomic-relaed values are he mos releva. May accouig sadard seers have reached he coclusio ha properly esablished ad reliably measured fair values for fiacial asses ad fiacial liabiliies provide more meaigful iformaio ha aleraive approaches for users of fiacial saemes. I 2000 he Joi Workig Group of Sadard Seers recommeded ha all fiacial asses ad fiacial liabiliies be measured o a fair value basis. However, his recommedaio was o advaced i was oo large a sep o ake a he ime. Subsequely, i 2001 he Fiacial Accouig Sadard Board (FASB) published Cocep Saeme No. 7, Usig Cash Flow Measureme ad Prese Value i Accouig Measureme (CON 7). CON 7 deals wih various measureme aspecs of fair value bu does o address whe fair value should be applied. I recogizes ha reliable marke-based price iformaio from which o measure fair value is o always available by esablishig a hierarchy of fair value measureme ha rages from direcly observable releva rasacio prices o model-based values o eiy-specific ipus. I Jue 2004 he FASB followed wih a exposure draf eiled Fair Value Measuremes, whose objecive was o provide guidace o how o measure fair value, agai o addressig whe such measures should be applied. SFAS 157, Fair Value Measuremes, was adoped i Sepember 2006 ad was exposed i November 2006 by he Ieraioal Accouig Sadards Board (IASB) o is sakeholders for commes ad possible fuure adopio. SFAS 157 effecively upgrades a ehaced CON 7 o a sadard i he accouig hierarchy ad is effecive for fiscal years begiig afer November 15,

2 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma Eve afer may years of discussio, a cosesus regardig whe o recogize ad how o measure fair values reliably usig a mark-o-model approach is sill beig sough. We believe ha a priciple-based approach is criical o he developme of a viable fair value accouig model for isurace coracs, where releva ad reliable marke prices are seldom observable. Such a approach should be oe capable of accommodaig he specrum of produc variaio ad ehacig he cosisecy of fiacial reporig values across jurisdicios ad producs. Such a fair value mehodology should be based o he prese value of all fuure cash flows relaig o a isurer s curre obligaios. I coras wih loss recogiio or liabiliy adequacy ess ha recogize oly impairmes or icreases i expeced coss, a fair value approach should reflec boh improvemes ad deerioraio i projeced experiece. We recogize ha, alhough clearly applicable o he accouig for a busiess combiaio ad embedded isurace derivaives whe fair values are applicable, a cosesus has o bee reached regardig wheher he fair value accouig objecive will apply o he geeral accouig of isurace coracs. I ay eve, we hope ha his paper will assis i he deliberaios uderway by he IASB i phase 2 of is Isurace Coracs projec ad subsequely by he FASB i is covergece effors. Alhough we specifically address coracs i which o coracual or legal lik bewee asses ad liabiliies exis, he crieria ad priciples discussed should be applicable o hose coracs as well. I addiio, alhough he paper should equally apply o life, healh, ad propery & casualy isurace coracs, i does o address posclaim liabiliies. 2. Defiiios A fair value fiacial reporig sysem is a accouig sysem i which values of asses ad liabiliies ha are o coracually or legally liked are measured idepedely (1) based o observed rasacio prices from a releva acive marke from which reliable prices or markebased ipus ca be obaied or (2) if hese crieria cao be me, based o esimaes of such prices as if such a marke did exis. Two quie similar bu o ideical defiiios of fair value measureme are he followig: 1 1. The price ha would be received o sell a asse or paid o rasfer a liabiliy i a orderly rasacio bewee markeplace paricipas. (FASB, SFAS 157.5) 2. The amou for which a asse could be exchaged, or a liabiliy seled, bewee kowledgeable, willig paries i a arm s legh rasacio. (IASB, IAS 39.11) 3. Fair Value Esimaes I SFAS 157 he FASB has developed a hierarchy of valuaio ipus o be used as a basis for fair value esimaes. This hierarchy cosiss of hree levels, wih level 1 beig he mos reliable, all else beig equal. I is impora o oe ha i all circumsaces a fair value is a esimae, eve whe based o curre observed prices. The followig is a summary of SFAS 157 s caegorizaio of fair value ipus: 1 Noe ha i is aicipaed ha he IASB will cosider covergig wih he proposed FASB defiiio. 2

3 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma Level 1 ipus. Wheever observable, hese are quoed prices for ideical asses or liabiliies i he pricipal marke (or mos advaageous marke if here is o pricipal marke) ha he eiy has he abiliy o access a he measureme dae. If such prices are quoed i erms of bid ad asked prices, he esimae represes he price wihi he bid-asked spread a which markeplace paricipas would currely rasac exchages. Level 2 ipus. If quoed prices for ideical asses or liabiliies are o available or if direcly or idirecly observed marke prices are o reliable, level 2 ipus iclude hose based o he followig: a. Quoed prices for similar asses or liabiliies i a acive marke b. Quoed prices for ideical or similar asses or liabiliies i markes ha are o acive i which here are few rasacios, he prices are o curre, quoaios vary subsaially, or for which lile iformaio is available publicly c. Marke ipus oher ha quoed prices such as ieres raes ad d. Marke ipus derived pricipally from or corroboraed by oher observable marke daa hrough such echiques as aalysis of correlaios. If a sigifica adjusme is made o a level 2 ipu, he i migh resul i a ype 3 fair value. Level 3 ipus. Fair value esimaes ha iclude level 3 ipus icorporae uobservable marke ipus ha are o able o be corroboraed by observable marke daa. These arise i siuaios i which here is lile, if ay, marke aciviy for he asses or liabiliies. These, however, have o be developed cosiderig he assumpios ha marke paricipas would use o price he asses or liabiliies. The eiy s ow daa ca be used, as log as iformaio is o available o idicae ha marke paricipas would use differe assumpios. Accordig o his hierarchy, fair values are esimaed o he basis of he resuls of oe or more valuaio echiques ha make maximum use of marke ipus, wih as lile reliace o uobservable marke ipus as possible. I is impora o realize ha o be characerized as a fair value mehod, he ipus made wihi level 3 have o be cosidered from he perspecive of marke paricipas. By ecessiy his may have o ivolve ierally developed assumpios of heoreical marke ipus based o he eiy s ow daa. These assumpios would be adjused o exclude facors specific o he reporig eiy if iformaio is available ha idicaes ha marke paricipas would use differe assumpios. The primary differece bewee level 2 ad level 3 ipus is ha level 2 ipus are based o a model ha reflec some form of reliable marke daa, whereas level 3 ipus are oally based o models. I ay case, a fair value measureme echique should reasoably reflec how he marke could be expeced o price he asse or liabiliy by icorporaig all he facors ha marke paricipas would cosider i agreeig o a price ad be as cosise as possible wih acceped ecoomic mehodologies. I addiio, he ipus o he valuaio echique should reasoably represe marke expecaios ad measures of he risk-reur facors ihere i he asse or liabiliy beig measured. Sice he liabiliies of few isurace coracs are raded i a acive marke, he fair value of mos such liabiliies would be cosidered o be based o level 3 ipus. Discussios of fair value measureme ofe focus o he measureme of fair value a corac icepio, someimes referred o as a day 1 value, raher ha is value subseque o origiaio, someimes referred o as day 2. 3

4 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma 4. Day 1 Values The IASB s guidace wih respec o fiacial isrumes i IAS 39 AG76 idicaes ha he bes evidece of he fair value of a fiacial isrume a iiial recogiio is he rasacio price, he so-called day 1 value. AG76 goes o o say ha his is he case uless he fair value of ha isrume is evideced by compariso wih oher observable curre marke rasacios i he same isrume (i.e., wihou modificaio or repackagig) or based o a valuaio echique whose variables iclude oly daa from observable markes. To he exe ha a releva ad reliable rasacio price or marke ipu is o observable, a fair value would be esimaed reflecig prices ha marke paricipas would be expeced o pay (or demad) a day 1, wheher i was acquired or assumed a ha ime. Such ipus are currely used as a basis for mos hisorical cos ad deferral ad machig accouig sysems whose accouig objecive is o mach coss ad correspodig reveue. SFAS idicaes ha he reporig eiy shall cosider facors specific o ha rasacio price o represe he fair value of he asse or liabiliy a iiial recogiio. For example, he reporig eiy cosiders wheher he rasacio is bewee relaed paries, wheher i occurred uder duress, whe he ui of accou represeed by he rasacio price is differe from he ui of accou for he asse or liabiliy measured a fair value, ad wheher he marke i which he rasacio occurs is differe from he pricipal (he mos advaageous) marke. 5. Day 2 ad Subseque Values Sice mos isurace coracs are log erm i aure, fiacial saemes of eiies issuig hem are grealy affeced by he subseque measureme of heir liabiliies. As a resul, i is criical ha day 1 ad day 2 values be sysemaically ad cosisely measured. The IASB has cocluded i IAS 39 AG76A ha for fiacial isrumes, The subseque measureme of he fiacial asse or fiacial liabiliy ad he subseque recogiio of gais ad losses shall be cosise wih he requiremes of his Sadard. The applicaio of paragraph AG76 may resul i o gai or loss beig recogized o he iiial recogiio of a fiacial asse or fiacial liabiliy. I such a case, IAS 39 requires ha a gai or loss shall be recogized afer iiial recogiio oly o he exe ha i arises from a chage i a facor (icludig ime) ha marke paricipas would cosider i seig a price. As a example, IAS 39 AG77 idicaes ha if he fiacial isrume is a deb isrume (such as a loa), is fair value ca be deermied by referece o he marke codiios ha exised a is acquisiio or origiaio dae ad curre marke codiios or ieres raes currely charged by he eiy or by ohers for similar deb isrumes (i.e. similar remaiig mauriy, cash flow paer, currecy, credi risk, collaeral ad ieres basis) ad If codiios have chaged sice he mos rece marke rasacio, he correspodig chage i he fair value of he fiacial isrume beig valued is deermied by referece o curre prices or raes for similar fiacial isrumes, adjused as appropriae, for ay differeces from he isrume beig valued. Accordig o SFAS 157, chages sice iiial recogiio are cosidered i subseque remeasuremes, cosiderig chages i he marke ad oher releva facors. 6. The Pricipal Marke The deermiaio of he pricipal marke ca be a impora cosideraio i he applicaio of marke-based ipus o fair value measureme. SFAS 157. describes a pricipal marke as he 4

5 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma marke i which he reporig eiy would sell he asse or rasfer he liabiliy wih he greaes volume ad level of aciviy for he asse or liabiliy. I goes o o idicae ha i he absece of a pricipal marke, he mos advaageous marke (i he case of a liabiliy, he marke wih he price ha miimizes he amou ha would be paid o rasfer he liabiliy o a markeplace paricipa of comparable credi sadig) for he asse or he liabiliy should be used. Two commo families of markes have bee ideified ha should be cosidered: 1. The reail or so-called busiess-o-cosumer marke. Observed rasacio prices of he asse or liabiliy i a reail marke are used i a ery price or cusomer cosideraio model. 2. The wholesale or so-called busiess-o-busiess marke. Values based o iformaio from a wholesale or resale marke are used i a exi price model. A fair value based o his marke represes a esimae of he price ha marke paricipas would be expeced o pay or demad whe a asse is sold or a liabiliy is exchaged or seled. As discussed laer, i may be problemaic o rely o a busiess-o-busiess pricipal marke for isurace coracs. Sice i mos cases here is o acive marke for isurace coracs, he mos advaageous marke would presumably lead o he use of a busiess-o-busiess or exi price model. I he pricipal marke i which rasacios ivolvig a asse or a liabiliy are observable, ery ad exi prices are ofe presumed o be he same a iiial recogiio, abse persuasive evidece o he corary. 2 Neverheless, he use of a busiess-o-busiess marke as he pricipal marke usually would be expeced o produce he smalles measureme of he liabiliy, i par because of he higher profi margis ofe associaed wih a reail, i coras wih a wholesale, marke. I should be oed ha ay model used would have o reflec he isureds risk characerisics, produc feaures, ad expeced policyholder behavior of he specific coracs beig measured. Also, give he diverse aure of produc lies offered ad disribuio chaels used by may isurers, he pricipal marke may differ bewee a eiy s busiess aciviies ad may deped o he ui of accou beig cosidered. I coras o may fiacial isrumes raded i acive markes, here have bee few, if ay, markes i which he liabiliies of isurace ad relaed coracs have bee raded or rasferred or from which reliable marke-based ipus ca be observed. Alhough reisurace, mergers & acquisiios, ad life seleme (U.S.) markes have bee pu forh as possible sources of price iformaio, (1) hey currely do o provide appropriae day 2 marke ipus, (2) he limied breadh, liquidiy, ad frequecy of observable prices i hese markes make i a challege o develop reliable iformaio ha is also releva, (3) rasacio prices i hese markes may o be cosise wih uderlyig coss as subsequely expeced by a marke paricipa, ad (4) ay such large marke rasacio is impaced by eiy-specific ad sraegic cosideraios, such as he achieveme of scale, desire o eer cerai markes, ad aaime of desired diversificaio. If a marke paricipa expecs o reduce is average cos of admiisraio or o reduce he poeial volailiy of is moraliy/morbidiy experiece hrough he purchase of a addiioal volume of life isurace coracs, i may be willig o pay a higher average price per corac 2 Examples of possible excepios iclude he relaively low combied raio ofe experieced by may accideoly lump-sum beefi coracs ad marke prices i a very hard or uderpriced marke. 5

6 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma for hese addiioal coracs ha if i were buyig a sigle idividual corac. However, such cosideraios are specific o ha marke paricipa ad ha purchase. I ay eve, wheher he ui of accou of measureme is he idividual corac or porfolio, he effec of hese facors is o releva o is fair value; raher, i would affec ecoomic capial. A similar siuaio arises i he asse maageme marke. For example, a ivesme maager ca reduce is average cusodial fees ad reduce he volailiy of is expeced credi losses hrough he purchase of a greaer volume of differe bods. These beefis are o cosidered releva i deermiig he fair value of a idividual bod, alhough he marke may recogize his i he sale price of a ivesme maager. Neverheless, he marke value of he ivesme maager is o releva i deermiig he marke value of a bod. A addiioal example is he life seleme marke i which hird-pary marke paricipas reflec very differe margis ad iceives ha hose i he ormal life isurace marke. Separaely, he price oe eiy is willig o pay for he acquisiio of a eire eiy ca be very differe from wha aoher marke paricipa would be willig o pay, i par because of a corol premium, he value associaed wih poeial fuure sales ad reewals, ad differe plas ad abiliies for operaig he eiy. The less releva or reliable he marke ipus represe, he greaer he eed o rely o models o esimae he hypoheical price a which marke paricipas would be willig o buy or sell ideical or similar asses or liabiliies had here bee a marke wih reliable price iformaio. I is impora o oe ha here is o uresriced acive busiess-o-busiess referece marke i he Uied Saes ad cerai oher couries for isurace coracs, as uder applicable isurace laws a isurer cao uilaerally rasfer is obligaios o a hird pary ad ovae hem o he policyholder. Uless policyholder cose is obaied uder a assumpio reisurace arrageme, he origial wrier of he corac reais he primary obligaio o he policyholder. For example, if a o-assumpio reisurer were o fail before a isured eve occurs, he direc isurer would remai obligaed o fulfill he coracual obligaios o he policyholder. The scarciy of assumpio reisurace rasacios i he U.S. marke idicaes ha a acive busiess-o-busiess marke does o currely exis i he Uied Saes ha ca provide reliable marke ipus. Thus, he oly curre marke where isurace liabiliies are raded wih miimal rasacio-specific disorio is he busiess-o-cosumer marke o day 1. I his busiess-ocosumer referece marke, he cusomer cosideraio (icludig fuure premiums) may be viewed as beig a reasoable basis for he fair value a which boh a policyholder is willig o pay for ad a life isurer is willig o provide a give se of isurace beefis. I coras, he use of ipus from a busiess-o-busiess marke ivolvig isurers wih a similar raig may yield somewha differe fair value esimaes, because observable ipus may o be sufficie o provide a sufficiely reliable fair value relaive o a hypoheical marke paricipa. Observable ipus iclude variaios i he exe of compeiio ad price sesiiviy i he marke ad developme ad acquisiio coss ecessary o access he marke. Expese levels, icludig he cos of ovaio for a corac ha heoreically should be miimal if he eiies credi raig ad brad value are equivale bu ha migh ivolve cosiderable fricioal coss, are oher assumpios ha marke paricipas would use i pricig he isurace corac bu ha are ypically uobservable. I a perfecly compeiive marke, a eiy should be idiffere bewee a isurace corac from a ew policyholder ad a similar corac origiaed from aoher isurace carrier, as log as he expeced reur is he same. Similarly, i such a marke a policyholder 6

7 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma should be idiffere bewee he ulimae obligor of is beefis, so log as he credi sadig of he wo obligors is he same ad he fuure premiums, credis, charges, ad oguaraeed elemes are he same. This idifferece ad he crieria se ou below will be saisfied if he ui of accou is he idividual isurace corac. We coed ha a sigifica differece bewee esimaes based o exi value ad a cusomer cosideraio model relaes o he differe use of he ui of accou bewee he porfolio ad he idividual corac, respecively. Boh reflec he exposure-specific aure of he isurace risks, ad boh ca be viewed as a surrogae for or a esimae of a marke-based exi value. A ui of accou based o a porfolio reflecs he effec of he purchase of ha porfolio ha migh iclude a smaller amou of volailiy (i.e., reducio i process risk) ad possibly a improveme i he ihere ecoomies of scale, boh of which should o be refleced i he fair value of liabiliies; raher, hey should be refleced i capial as a iagible ha should be refleced whe he beefis are achieved. A assumig isurer ordiarily would be willig o coiue coverage a he same premium rae he policyholder is currely payig, sice he reur o he assumig eiy would be he same as i would have received if i had direcly issued he corac. I a cusomer cosideraio model, he assumig eiy would be idiffere bewee receivig i he fuure he same amou of moey from he rasferrig eiy or direcly from he isured, sice he eiy s reur would be he same. A impora corollary is ha he value would also equal he amou a policyholder would demad o release a eiy from is obligaios (seleme value as defied by he IASB), sice he policyholder would pay he same amou o a differe isurer wih he same credi sadig ad receive ideical beefis while maiaiig fuure premiums a he same level. Alhough oguaraeed eleme paymes may vary depedig o he eiy s oguaraeed eleme policy, i ca be assumed ha he curre policy will coiue, uless i ca be demosraed ha marke paricipas would o coiue he curre eiy s oguaraeed eleme policy. Therefore, alhough cocepually a exi value would be more cosise wih fair value coceps, because of he lack of releva ad reliable values, he fall-back marke ha is o a he same ime he pricipal marke for isurace coracs ca be esimaed hrough use of a cusomer cosideraio model. Whe eiy-specific characerisics are elimiaed ad he ui of accou is he idividual isurace corac, hese values would be he same. 7. Accouig Model Crieria Reflecig he above discussio, we believe ha he followig crieria should be applied o assess he meris of a accouig model for measureme of he fair value of liabiliies for isurace coracs: 1. Cosisecy bewee day 1 ad day 2 measureme approaches. 2. Cosisecy bewee compoes of ad bewee isurace coracs. I is impora for a corac s compoes o be measured o a cosise basis. Mos isurace coracs cosis of a budle of such compoes (e.g., deposi, isurace, service, ad embedded derivaives, as well as opios ad guaraees) ha for may coracs ca be quie difficul o measure separaely i a oher ha arbirary maer. To avoid discoiuiies bewee he liabiliies for isurace coracs, fiacial isrumes, ad service coracs, as well as heir various compoes, i would be desirable o use a cosise measureme framework across coracs ad coracual compoes. 7

8 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma The imporace of his icosisecy ca be see from he experiece of U.S. GAAP measureme of liabiliies ad reveue of various coracs issued by isurers (e.g., he disicio bewee SFAS 60 radiioal life, SFAS 97 uiversal life-ype, ad SFAS 97 ivesme coracs). Examples of he imporace of cosisecy across corac ypes ca be iferred from he rece discussios regardig corac classificaio ad risk rasfer of reisurace coracs. 3. Cosisecy bewee he measureme approaches used for all fiacial coracs, wheher asses or liabiliies, fiacial isrumes, or isurace coracs. This ype of cosisecy is paricularly impora i he measureme of isurace coracs ad log-erm coracs subjec o IAS 39 (someimes referred o as ivesme coracs). This measureme cosisecy would reduce he eed for ad imporace of classifyig coracs ad heir compoes as isurace coracs o achieve a paricular accouig reame. I addiio, cosise measureme of well-mached asses ad liabiliies would allow boh he asse ad liabiliy sides of he balace shee o be similarly resposive o chages i ieres raes ad oher perie ecoomic facors. To he exe hey are o well mached, he fiacial saeme would properly reflec he ecoomic impac of he mismach i earigs. Icosise accouig reame ha ca creae large differeces i measureme ad preseaio currely exiss for apparely similar producs offered i differe jurisdicios, i idusries wihi he same jurisdicio, ad eve i he same idusry where here are oly mior chages i he ecoomics or eve he form of a corac. Mos accouig sysems icorporae some form of mixed aribue model of accouig. For example, he sysems of some jurisdicios specify he use of deposi accouig for cerai isurace corac liabiliies wih sigifica fiacial isrume-like compoes ad fair value accouig for cerai derivaive-like feaures wihi isurace coracs. Differeces i he defiiio of reveue ca sigificaly affec he fiacial saeme preseaio of a corac ha i ur ca affec is desirabiliy. 4. Cosisecy wih acceped ecoomic pricig mehodologies. Sice he fair value of a fiacial isrume is idepede of he holder of he isrume, i should o recogize eiy-specific facors, icludig diversificaio beefis ad beefis of ecoomies of scale. Neverheless, such facors associaed wih he corac would be refleced, as hey represe he essece of wha is beig measured. Some view marke-based prices as amous ha iclude provisios such as expeses ad cos of capial ad would expec a fair value mehod o do he same. However, he price assumed o cover hese coss is idepede of he specific eiy s acual or projeced coss. A eiy whose acual coss are less he his marke-based expese charge would have a addiioal source of profi, while a eiy whose coss are greaer ha ha of a hypoheical marke paricipa would have a egaive impac o earigs. 5. Cosisecy bewee sadards. Fair value measureme should be cosise wih oher key sadards, such as reveue recogiio. Similar feaures ad compoes i hese producs should be measured i a similar ad logical maer. Curre discussios of hese poeial sadards or coceps appear o be movig i he direcio of reflecig cusomer cosideraios, alhough exposure drafs addressig his cocep have o ye emerged. If his approach is adoped, cosisecy wih a

9 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma cusomer cosideraio measureme model would become eve more appropriae. The cos of services provided or risk bore aleraively migh be used as a commo basis for recogizig reveue. Oher approaches ha migh be used o resolve hese icosisecies i measureme iclude a wider use of fair value or a cosisely derived basis for prospecive measureme. 6. Cosisecy across ui of accou. Similar o he case of a fiacial isrume, i is appropriae o recogize he idividual life isurace corac as he ui of accou so ha he liabiliy is o iflueced by he size of he book of busiess, alhough i would be appropriae o reflec exposure-specific risk characerisics. As i ay fiacial isiuio, a isurer s asses are equal o is liabiliies plus equiy. Some of he facors ha ifluece he amou of equiy a isurer eeds o hold iclude he expeced effec of volailiy of operaig resuls, expese losses uil criical mass is achieved, ad he level of expeced profiabiliy. These accouig elemes i ur are iflueced by he size of he eiy s book of busiess, ad hece he equiy per ui is a fucio of he size of he book. Alhough a larger ad more diversified eiy should be able o hold lower equiy per ui, his does o imply ha a lower liabiliy per ui is appropriae. 7. Use of iformaio from a marke, eve if a hypoheical oe, from which releva marke ipus ca be observed or esimaed, which is liquid, free of he ifluece of diversificaio, ecoomies of scale, ad oher iflueces, as well as o he exe possible free of cosrais ha may disor pricig (e.g., he eed for policyholder cose i a busiess-o-busiess marke).. A Proposed Approach A measureme mehod ha ca mee boh he defiiio of fair value ad his se of crieria is similar o oe used i U.S. GAAP for a oal reur swap. Alhough his approach has had limied applicaio o dae i he measureme of isurace liabiliies, excepios i U.S. GAAP have icluded he guidace icluded i Derivaive Iformaio Group (DIG) Issue B36 for derivaives ad for cerai guaraeed livig beefis icluded i variable auiies. Wha follows describes his mehod ad suggess ha i migh be cosidered for wider applicaio. Sice marke paricipas are geerally risk averse, a risk premium or cos of risk (a amou greaer ha he expeced cos, someimes referred o as a risk margi, risk adjusme, or marke value margi) i marke prices is eeded. For example, he premium payable for erm life isurace is usually greaer ha is expeced moraliy claims cos ad associaed expeses. This effec ca also be see i (1) credi spreads o deb securiies ha almos always exceed he correspodig expeced defaul losses ad (2) forward raes i he yield curve ha ypically overesimae where fuure raes head. Through risk miigaio sraegies icludig diversificaio, poolig, uderwriig, risk sharig, corac paricipaio, ad hedgig, isurers aemp o ake advaage of his risk premium. We believe a fiacial reporig sysem usig fair value objecives should provide for recogiio of earigs whe a eiy demosraes heir success i implemeig hese sraegies raher ha a he icepio of a corac: ha is, a isurer would recogize he beefis of diversificaio whe he gai from diversificaio is realized ad o earlier. Ne icome i such a sysem would be recogized wih he release of a markeplace paricipa s risk ad service premium, as well as differeces bewee acual ad expeced experiece ha could geerae eiher gais or losses. 9

10 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma Perhaps oe of he simples producs a isurer ca provide is he guaraee of a specified level of ieres for a give umber of years. I he Uied Saes hese coracs are referred o as fudig agreemes. I reur for a cash premium, he policyholder is guaraeed o receive his cash cosideraio wih ieres o a cerai dae i he fuure. The policyholder i his isace is a special purpose vehicle ha uses he fudig agreeme as collaeral i order o issue medium-erm oes. This ype of program is ypically referred o as a Fudig Agreeme Backed Noe Issuace Program (FANIP). The yield o he fudig agreeme is equal o he yield o he oe plus a spread o cover acquisiio coss. I depeds o he credi qualiy of he isurer over he period of he corac, expressed as a spread over he risk-free rae, o a fixed- or floaig-rae basis. The isurer ypically ivess he premiums (proceeds from he fudig agreeme) i fixed-icome securiies such ha he differece i he spreads from hese securiies ad he spreads available from he fudig agreeme, mius expeced defauls, produces a accepable expeced profi margi. To he exe ha he coracual erms of he asses ad liabiliies are perfecly mached, defauls do o occur over he corac period, ad credi spreads do chage, he use of fair value accouig will resul i he emergece of profis i a maer cosise wih he differece i spreads. The fudig agreeme is cosidered a isurace liabiliy uder isurace law bu is o a isurace corac uder U.S. GAAP. Neverheless, we believe ha he approach is a useful oe o examie because of is simpliciy ad o help deermie wheher a cosise approach migh be used for he measureme of he fair value of he liabiliies for boh ivesme ad isurace coracs. To furher examie such a cosise approach, is applicaio o a 20-year erm life isurace corac follows subsequely. Referece o a FANIP is o he fudig agreeme sold i he maer described above. The isurer agrees o exchage or swap he cash flows o is liabiliy for he cash flows o a machig asse. For simpliciy, he cash flow paymes/beefis are assumed o occur a he ed of he period. The premiums are paid a he begiig of he period. A issue of he FANIP, he wo ses of cash flows are equalized accordig o he equaio PREM = LCF /(1 + S + CS), = 1 where PREM = sigle premium for he FANIP = umber of cash flow payme periods = ime period S = LIBOR spo rae measured as of he valuaio dae for ime period LCF = liabiliy cash flow durig ime period CS = credi spread (relaig o operformace risk) he borrower mus pay for he marke o accep he borrower s credi risk relaive o he FANIP. 3 This is equal o he sum of expeced defauls of he borrower, plus he risk premium demaded by he marke o ake o he credi risk of he borrower as i relaes o he FANIP. The premium is he exchaged for a machig asse such ha 3 See secio 12, The Applicaio of Noperformace Risk i Deermiig Liabiliies, for furher discussio. 10

11 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma where = 1 ACF /( 1+ S + ED + R) = LCF /(1 + S + CS), ACF = asse cash flows durig period ED = expeced defaul losses for he asse durig period R = risk premium, he amou i excess of he expeced defaul rae ha risk-averse marke paricipas demad o ake o credi risk over he period of he FANIP ad ha sellers are willig o pay o miigae is associaed credi risk. Should marke expecaios be me, he isurer s earigs durig a period would equal he differece i he risk premium ad he eiy s credi spread imes he amou borrowed: = 1 LCF /(1 + S = 1 + CS) ( R CS). So, for example, if a eiy issued a FANIP for $100 payig LIBOR + % ad used he proceeds o purchase a five-year bod yieldig LIBOR %, he earigs would equal $100 ( ) or $0.45 i each year. A valuaio of a oal reur swap is similar o a geeralized versio of he FANIP example. Uder a oal reur swap, he isurer borrows moey by issuig a corac whose liabiliy ca exclude isurace risk as i he FANIP example, whose beefi is codiioal o he occurrece of he isured eve as i erm life isurace. I he specific case of a FANIP, by payig he premium he purchaser of he oal reur swap exchages a curre defied amou of cash for he righ o receive fuure cash flows. This obligaio o pay he fuure cash flows represes he liabiliy of he eiy providig he FANIP (he swap couerpary). A issue, he value of he asses ad he liabiliies are equal. I his example, he asse is iiially cash, which is he exchaged for oe or more oher asses. Aalogously i a erm life isurace corac, he ecoomic asse is he righ o receive fuure premiums. The formula for equaig he asses ad liabiliies for a erm corac of years/payme periods is where PREM /(1 + S + ED + R) = EDB /(1 + S + CS) = 1 = 1 PREM = expeced premiums durig ime EDB = expeced deah beefis durig ime. All he values i his equaio are eiher kow or ca be esimaed usig eiher acuarial or fiacial mehods. A policyholder is uder o coracual obligaio o coiue o pay premiums for he erm isurace corac. The policyholder has he coracual opio o discoiue premium paymes ad o allow he coverage o cease. Failure o pay is he exercise of a opio ad o a defaul. Give ha a policyholder cao defaul, he value of ED is 0. The value of R he is deermied. R ca be viewed as beig equal o he risk premium a equilibrium; i his case, he purchase price of he erm isurace corac equals he amou ha a policyholder is willig o pay ad wha a isurer demads o accep he rasfer of he isurace risk. Havig solved for he risk premium for he erm corac ad assumig he marke does o idicae ha he risk premium should be chaged (we discuss he facors ha ca lead o a, 11

12 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma chage i he secio 11, Evaluaig he Risk Premium ), he fair value liabiliy a ime y is equal o -y -y LIAB EDB /( 1 S CS) PREM /(1 S R). y y 9. Geeralizig he Model o Hadle Acquisiio Coss The sale of mos isurace coracs sold o idividuals usually requires sigifica up-fro coss icludig commissios, markeig, ad uderwriig expese. Correspodig coss i he FANIP example cosis primarily of sales ad brokerage commissios, which are relaively small i compariso. As a resul of hese acquisiio coss, he oal e amou of cash or asses reaied by he isurer a he ime of sale of a isurace corac is sigificaly less ha he oal amou received. The approach currely followed for isurace coracs uder U.S. GAAP is o capialize acquisiio coss of a variable cos aure i he form of a deferred acquisiio cos asse (DAC). This avoids he recogiio of a loss whe isurace coracs are wrie a a expeced ecoomic profi over he lifeime of he coracs. Differeces of opiio exis regardig wheher i is appropriae o recogize he capializaio of such coss, i par because of a cocer ha DAC does o saisfy he defiiio of a asse. A aleraive approach ha migh address hese cocers is o replace he DAC-ype formulaio (eiher as a asse or a coraliabiliy) by recogizig as a addiio o he prese value of expeced fuure cash flows uder he corac he differece bewee he prese value of he expeced premiums o be received ad he prese value of expeced beefis provided for he iiial deferred cos i he followig formulaio. I he case of he FANIP: PREM AcqCos 1 y LCF /( 1 S CS), where AcqCos = acquisiio cos. For a erm life isurace corac, a similar adjusme would be made: ( 1 PREM /( 1 S R) ) AcqCos 1 EDB /(1 S CS). I is impora o oe ha he acquisiio cos i a fair value model is o he same as he acquisiio cos as currely defied uder U.S. GAAP, i which acquisiio coss are defied as he acual variable expeses icurred by he isurer durig he period o acquire he busiess. This is a eiy-specific value ha would be icosise wih crieria 5 above. Isurace producs are priced based o eiy-specific expeced acquisiio coss. A eiy eerig io a corac eiher direcly wih a cosumer or hrough he purchase of a corac from aoher isurer would expec o pay he equivale of he corac s acquisiio cos if he eiy expecs o ear he risk charge i demads. If expecaios are achieved (i.e., acual acquisiio coss are equal o acquisiio coss expeced i pricig), he corac yields is expeced pricig reur. I he perfecly compeiive marke assumed i a fair value world, marke-implied acquisiio coss would equal he acquisiio coss assumed i marke prices. I such a marke, a eiy ha has lower acquisiio coss ha is compeior will likely reduce is price o maximize is volume a is required reur. Is prices will he have a lower marke-implied acquisiio cos, ye wih he same risk premium. Theoreically, he firs eiy s produc cao 12

13 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma exis. The fac ha i does exis implies eiher ha he eiy sellig his produc provides some addiioal service ha cusomers are willig o pay for or ha he marke is perfecly compeiive afer all. The addiioal service provided may be represeed by ohig more ha he addiioal cos o he eiy of providig iformaio o he cosumer i a marke where reachig cosumers is more cosly. This implies ha a eiy ha ca acquire busiess a a lower acquisiio cos ha implied i marke prices will experiece a year 1 profi, ad a eiy whose acquisiio coss are greaer ha hose marke-implied will experiece a year 1 loss. However, marke paricipas will likely expec a year 1 gai/loss of Term Life Example of he Proposed Approach The followig example illusraes he proposed approach for our 20-year erm life isurace corac, alog wih he assumpios used: A 20-year erm life isurace corac issued a age 40, wih a level face amou of $100,000 Level aual premiums = $20 Moraliy = 35% of he Sociey of Acuaries selec ad ulimae age eares birhday moraliy able for osmokig males Commissios ad oher deferrable acquisiio coss icluded i he price (o ecessarily acual expeses) = 55% of firs-year premium Noperformace risk (credi spread) of isurer = % The Appedix shows he deailed assumpios ad resuls, icludig lapse raes, moraliy raes, ad LIBOR spo raes by duraio (he LIBOR spo raes were as of Jue 15, 2004, wih values ierpolaed for years 6, 11 14, ad 16 19). The resulig risk premium i his example is %. See he Appedix for more deailed assumpios ad releva calculaios. This represes he risk premium he isurer ears from is obligaio o pay a deah beefi ad is equivale o he isurer ivesig he proceeds by borrowig a asse yieldig LIBOR + %. Assumig he risk premium is o updaed ad here is o chage i he issuer s credi sadig, he he fair value liabiliy a he ed of year y would be equal o LIAB y = EDB /(1 + S ) = y = y PREM /(1 + S ) Assumig fuure spo raes are equal o curre forward spo raes, i each of he firs 10 policy years he edig liabiliy ad e icome would be (assumig all asses are ivesed i 10- year zero coupo bods yieldig LIBOR + %) as show i Table 1. 13

14 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma Policy Year Table 1 Firs 10 Year Values for he Term Life Isurace Example Chage i Chage Fair Value Beefi Acquisiio i of Asses Paymes Coss Liabiliy Liabiliy Ne Icome Premium 1 $20 $11 $172 $451 $5 $5 $ To he exe ha he fiacial marke ad corac performace uwids as expeced, he asses ad liabiliies remai well mached, ad he marke s percepio of risk does chage, earigs uder he proposed approach will o experiece sigifica volailiy. I coras, whe ay of hese facors chage, heir effec would be immediaely recogized i icome Evaluaig he Risk Premium I he above erm isurace example, he risk premium was held cosa for simpliciy of illusraio. However, he realiy of markes is ha risk premiums do o remai cosa. Neverheless, if i is decided ha i would be appropriae for his margi o be chaged over ime, i should be easy o adap such a feaure. I fac, o recogizig a chage i he risk premium would be icosise wih a impora cocep uderlyig he measureme of fair values, he use of curre esimaes ad assumpios. For example, i would reflec rece experiece, which has see large swigs i he value of he risk premium i credi isrumes ad i he propery ad casualy isurace uderwriig cycle. While he risk premium i a life or healh isurace produc is likely o flucuae less ha would be he case for credi isrumes or propery & casualy isurace (as he appeie for risk i mos life isurace markes does o ormally chage as ofe), he isurer sill has o assess periodically he appropriaeess of is risk premium ad updae is assumpios accordigly. Marke facors ha migh idicae a chage i he risk premium i a lie of busiess iclude The exi of eiies or rece ew eras A chage i prices i respose o a shif i level of compeiio A dramaic swig i he volume or mix of busiess sold A chage i reisurace capaciy, especially due o he exi ad erace of reisurers The developme of aleraive risk rasfer mechaisms Emergig uceraiy regardig he effec o moraliy or morbidiy of a epidemic Sigifica chages i persisecy or oher experiece. 4 Sice i his simplified example asses ad liabiliies are o perfecly mached, some earigs volailiy is evide. 14

15 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma The risk premium is o ecessarily he same across produc ypes. For example, if expeced divideds are refleced, a paricipaig corac would o ecessarily require as large a risk margi as a oparicipaig corac because of he risk buffer ha divideds provide. Similar reame of oguaraeed elemes would also be appropriae. I ay eve, i would be appropriae o disclose whe a chage i he risk premium is made. Geerally, give he sabiliy of he life isurace rae-makig process ad he relaively log imeframes bewee chages i premium or fee levels of may life isurers, we aicipae ha i may isaces he risk premium may prove relaively sable. However, furher research is warraed o validae his asserio. 12. The Applicaio of Noperformace Risk i Deermiig Liabiliies A area of sigifica coeio i he discussio of measureme of he fair value of liabiliies of fiacial isiuios has bee he reflecio of a eiy s ow credi spread as a resul of chages i is credi sadig. SFAS idicaes ha i is appropriae o reflec he operformace risk relaig o he liabiliy. This is he risk ha he obligaio will o be fulfilled ad affecs he volume a which he liabiliy is rasferred. The eiy s operformace risk icludes, bu may o be limied o, he effec of he reporig eiy s ow credi risk (or credi sadig), as refleced i is credi spread over he expeced duraio of he obligaio over he lifeime of he corac. The ofe cied cause for his cocer is where deerioraio i he credi oulook for a eiy resuls i a decrease i he fair value of is liabiliies, resulig i wha appears o be a uwarraed ad poeially misleadig icrease i boh icome ad capial durig he accouig period. Sigifica debae ad emoio has bee geeraed aroud he desirabiliy of such a resul. The criics cocer wih his resul i a regulaory coex is ha i would creae a poeially misleadig assessme of he eiy s fiacial codiio. As a resul, i is claimed ha he use of such a adjusme for solvecy reporig could be corary o public policy, ad hus o recommeded for ha purpose. However, i has o be oed ha isurers are required o reflec heir credi spread i valuig heir geeral deb over he duraio of ha deb (assumig ha i is measured o a radig or available-for-sale basis). Sice he amou of capial ad a eiy s credi sadig are direcly relaed, he use of credi spread i valuig liabiliies would explicily recogize ha eiies ha seek higher raigs eed o hold a higher level of asses o suppor he same amou of obligaios. Argumes supporig such a adjusme could use he reame of a FANIP program uder U.S. GAAP as a example, which icorporaes he eiy s credi raig as i would affec he measureme of is liabiliies of such programs, i par o ehace machig is asses ad liabiliies. I addiio, his ca be viewed as beer capurig he eiy s fiacial codiio i a fair value world, as evideced by he observable effec of a eiy buyig back is oes a a discou upo a raigs dowgrade. Noe ha his aalogy is somewha weak i he case of a isurace corac liabiliy, as i is highly ulikely ha such a eiy would be able o similarly sell is obligaios uless forced o by a regulaor. The amou of ecoomic capial ha a eiy holds o suppor is credi sadig ca provide useful iformaio for a ivesor ha is aempig o beer udersad he poeial for is fuure divided disribuios. A eiy whose objecive is o maiai a higher raig will 15

16 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma usually have less capial available o disribue o shareholders, sice i mus wihhold a higher level of asses o suppor is obligaios. If a busiess-o-cusomer marke is used as a basis of fair valuaio, he effec of a eiy s credi raig, e of expeced regulaory guaraees, is implicily icluded i he premium level a issue (i.e., if credi sadig were o recogized, he liabiliy would have o be icreased a ha ime, hus resulig i a loss a issue ha would modify he above mehodology). Afer issue, he eiy (cosise wih marke expecaios) would likely chage is expeced oguaraeed elemes o reflec he chage i is credi sadig. Sice he effec of he credi raig is hus already implicily refleced i he premiums, charges, ad hus risk premiums i a corac, igorig he raig would require a gross-up of he liabiliy, which would be boh difficul o esimae ad quie mior if he expeced effec of regulaory guaraees are also refleced. Thus, he cocer wih his issue is o wih is effec a issue. Raher, i primarily relaes o a chage i credi sadig afer issue. Bu such a chage i credi sadig likely would be caused by chages i he marke value of is asses. By reflecig chages i he amou of he liabiliy, he liabiliy i such cases he would become beer mached wih he asses, alhough admiedly a imig differece may arise. Cosise wih he implici use of credi sadig i measurig liabiliies ad recogizig he role of credi i measurig earigs, a approach ha migh serve o reduce he dissaisfacio wih boh approaches o reflec credi sadig would cosis of he followig: The differece i valuig he expeced beefi sream i he examples above ad valuig he beefi sream o a risk-eural basis would be show separaely i he balace shee as a allocaio of capial. Chages i liabiliies due o chages i credi sadig migh o be cosidered as par of operaig earigs, bu raher cosidered i a maer cosise wih ieres-relaed capial gais/losses. Chages i liabiliies due o chages i credi sadig he would be show o he balace shee as a reallocaio bewee liabiliies ad capial. 13. Miimum Cash Value Floor Oe impora opio i coracs wih a voluary ermiaio opio i may fiacial isrumes ad isurace coracs is he opio o surreder a corac for is curre book value. While erms for coracs wih cacellaio righs ca differ sigificaly, hey all eail a pu opio for a value ha is referred o as he demad deposi value. This has prove o be a coroversial issue for several ypes of fiacial isiuios. I baks his is referred o as a core deposi iagible. Propoes of such a floor sugges ha i represes he value of he cusomer relaioship ha should o be fair valued as i is a iagible asse. We agree wih hose bakers who coed ha i is appropriae o reflec his iagible i fiacial saemes if is value ca be reliably measured ad ha i is refleced i observable or expeced rasacio or rasfer values. We believe ha o oly should his limiaio be elimiaed i he case of busiess combiaios, bu i should be elimiaed i obusiess combiaios as well. IAS 39 sipulaes ha he fair value of he liabiliy of a fiacial isrume whose curre accou balace is available o demad (i.e., a demad deposi) cao be less ha he amou available o demad. This differece represes he amou he deposior would receive (or a leas eed agais oher payable amous) upo he cacellaio of all righs ad obligaios of he corac, reflecig he derecogiio of a corac. Neverheless, he demad 16

17 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma deposi (he cash value i he case of a life isurace corac) is rarely he amou ha a hird pary would require for assumig he liabiliy. Alhough his miimum liabiliy migh be appropriae for a fiacial isrume raded i efficie markes where marke rasacios reflec his floor, we do o believe ha i preses a reasoable cosrai o balace shee values whe used o measure he liabiliies of isurace coracs. Is use i some cases could lead o a uwarraed loss a corac issue. The primary argume i favor of his floor is ha recordig a liabiliy less ha his amou recogizes he effec of he cusomer relaioship iagible ivolved. Excep i he case of a busiess combiaio, such a cusomer relaioship iagible is geerally o recogized i fiacial saemes. I a busiess combiaio, i would be refleced i he balace shee as a ideifiable cusomer relaioship iagible. The liabiliy, followig his argume, is he curre amou ha ca be demaded. This represes he wors-case liabiliy if all policyholders were o ake advaage of he opioaliy available. We do o agree wih his logic, i par because of is lack of recogiio of observable rasacios for hese coracs. The more useful, meaigful, ad marke-cosise approach for a isurace corac is o recogize all expeced coracual cash flows ha ca be reliably measured, as o oly are all of hese cash flows recogized i he rasacio price of he corac i boh a busiess-o-cosumer marke ad a busiess-obusiess marke as i he laer i represes he exi price ha a willig buyer would pay. For example, he use of calculaed liabiliy of 100 ad a cash value of 110 may imply ha he cos o replace he corac is greaer ha 110 because of he effec of expeses (e.g., commissios ad premium axes) o cosidered i a prospecive measure of he liabiliy. I addiio, he calculaed value properly reflecs currely esimaed probabiliies for a porfolio of similar coracs, as well as he price a willig buyer would be willig o pay if such a purchase was possible. I also would o reflec ha some policyholders healh had deerioraed ad hey are o loger isurable ( guaraeed isurabiliy ). For hem, replacig a corac may o be possible a ay price. A aleraive calculaio, oe ha is specific o he healh of each isured, would require iformaio ha is rarely available ad impracical o obai. A large dispariy bewee he liabiliy for a corac ad he amou of is demad deposi migh idicae a greaer ake-up rae of he pu opio ha would occur whe he differece is small or oexise. I a approach ha icorporaes policyholder behavior i he measureme of a liabiliy, curre expecaios would capure he circumsaces ivolved. I summary, by igorig expeced policyholder behavior, he cosrai of a demad deposi floor iroduces a bias io he measureme of liabiliies ha is icosise wih boh ery ad exi fair value models. Eve if cosidered a iagible asse, a reliably measurable pu opio should o be igored. Ay cocers regardig he fac ha measureme does o adequaely address he risk associaed wih he pu opio are more appropriaely addressed i solvecy assessme. However, we recogize ha if his approach is implemeed for isurace coracs ad a chage is o made for ivesme coracs, a icosisecy bewee producs ad idusries would currely resul. We ecourage accouig sadard seers o rejec such a posiio for o-isurace coracs as well. 14. Cosisecy wih SFAS 157 The approach described above relies upo he assessme of a hypoheical rasacio bewee wo willig paries: a life isurer ad is policyholder. Observaio of such a rasacio would measure how much he isurer would eed o charge a policyholder for a life isurace corac o cover a isurace risk for he policyholder s curre demographic characerisics (e.g., 17

18 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma aaied age) ad risk classificaio (e.g., preferred class), he curre fiacial siuaio o day 1, ad he curre marke-based risk premium. The basis for he esimae would be he isurer s assessme of corac beefis ad he cosumer marke i which isurace coracs are currely issued. Ay day 2 esimaes would reflec updaes i hese facors. SFAS discusses hree differe valuaio approaches ha ca be used o measure a fair value: a marke approach, a icome approach, ad a cos approach. The mehod described i he approach described i his paper is closes o he marke approach. The basis for measureme is he amou a idividual purchasig a ew corac from he isurer would pay o rasfer he isurace risk as expressed i erms of a ery price or cusomer cosideraio model. The liabiliy for a isurace corac would be based o level 3 ipus of SFAS 157 s fair value hierarchy, eve hough i is preferable o base a fair value esimae o marke-based ipus wherever possible. Neverheless, he oly acive curre marke from which reliable marke observable ipu is available ha ca mee he se of fair value crieria described above is he ew issue marke. The resuls of prese value echiques ha ca be used as level 3 ipus for boh day 1 ad day 2 measuremes are furher clarified i Appedix B of SFAS 157. The applicaio of hese echiques is cosise wih he se of fair value crieria described i secio 7, "Accouig Objecives Crieria." Paragraph B2 liss he followig six elemes ha a prese value echique should capure i a fair value esimae: 1. A esimae of fuure cash flows 2. Possible variaios i he amou ad imig of cash flows 3. The ime value of moey represeed by he risk-free ieres rae 4. The price for bearig he uceraiy ihere i he cash flows 5. Oher case-specific facors, such as liquidiy ad marke imperfecios 6. I he case of a liabiliy, he operformace risk ha icludes he eiy s ow crediworhiess. Iems 2, 4, ad 5 are capured i he risk premium as described i he approach preseed here, while iems 1, 3, ad 6 are direcly icorporaed i he calculaio of he expeced cash flows. The discou rae adjusme echique describes he discouig of a sigle se of expeced cash flows ad a discou rae ha ca fully icorporae he risks ihere i he cash flows, where he discou rae is derived from he risks of comparable asses or liabiliies i a marke. The discou rae used would be derived from he ew issue isurace marke. The mehod oulied above appears o saisfy SFAS 157 s requiremes, ad we believe ha i is he oly mehod ha has bee preseed o dae ha mees he fair value crieria give i his paper. Furher developme ad esig of he oal reur swap mehodology described here should be coduced o esure is pracicaliy ad he reasoableess of is resuls. A rerospecive aalysis of resuls for sample produc lies or eiies over a marke cycle may provide addiioal isigh io is reliabiliy ad he exe ha i is represeaioally faihful. As wih mos fiacial reporig sysems, deailed aribuio aalysis ad appropriae disclosure of he resuls ad heir assumpios will be crucial for users o ierpre ad esure heir recepiviy o relyig upo hem. 1

19 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma 15. Ackowledgmes The auhors would like o hak Doald Dora of PricewaerhouseCoopers for his isighs i reviewig his paper. A previous versio of his paper, based o a workig draf versio of SFAS 157 addressig fair value measuremes, was preseed a he 2006 Ieraioal Cogress of Acuaries i Paris ad is icluded i is Trasacios. Refereces Fiacial Accouig Sadards Board Cocep Saeme No. 6, Elemes of Fiacial Saemes. Norwalk, CT: FASB Cocep Saeme No. 7. Usig Cash Flow Measureme ad Prese Value i Accouig Measureme. Norwalk, CT: FASB Derivaives Implemeaio Group, Saeme 133 Implemeaio Issue No. B36, Embedded Derivaives: Modified Coisurace Arragemes ad Deb Isrumes Tha Icorporae Credi Risk Exposures Tha Are Urelaed or Oly Parially Relaed o he Crediworhiess of he Obligor uder Those Isrumes. Norwalk, CT: FASB Saeme of Fiacial Accouig Sadards No. 60, Accouig ad Reporig by Isurace Eerprises. Norwalk, CT: FASB Saeme of Fiacial Accouig Sadards No. 157, Fair Value Measuremes. Norwalk, CT: FASB. Guerma, S., D. Y. Rogers, L. H. Rubi, ad D. C. Scheierma. The Fair Value of Isurace Coracs. Trasacios of he 2006 Ieraioal Cogress of Acuaries. Oawa: Ieraioal Acuarial Associaio. Ieraioal Accouig Sadards Board IAS 1, Reveue. March. Lodo: IASB IAS 39, Fiacial Isrumes: Recogiio ad Measureme. Augus. Lodo: IASB. Joi Workig Group of Sadard Seers Draf Sadard ad Basis for Coclusios, Fiacial Isrumes ad Similar Iems. December. Lodo: Ieraioal Accouig Sadards Commiee. 19

20 A Approach for Measureme of he Fair Value of Isurace Coracs by Sam Guerma, David Rogers, Larry Rubi, David Scheierma Policy Year Expeced Amou of Isurace $1,000,000 9,47 00, ,400 65,90 599, , , ,61 423,655 39, ,90 32, , , ,93 234, , ,26 11,033 Expeced Premium $ Expeced Beefis $ Appedix Term Life Isurace Corac Example LIBOR Spo Raes Moraliy Raes/1000 Wihdrawal Raes 2.43% % Credi Spread % Toal Less Acquisiio Cos Ne of Acquisiio Cos Prese Value of Beefis $ $3,34 $334 Risk Premium % Prese Value of Premiums $ $4,25 - $451 $334 20