fair value accounting naic catf - december 3, 2000 fair value ralph blanchard

NAIC CATF - December 3, 2000

Fair Value Accounting

FAIR VALUE

Ralph Blanchard



•Definition of Fair Value

•Who is proposing it?

•Insurance application - significant issues

•Actuarial response

•CAS white paper Format

PreviewsFindings

•Next steps - actuarial orgs

•Next steps - accounting standard setters

Overview



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What is “Fair Value?”

“DICTIONARY” DEFINITIONS

“an estimate of the price an entity would have realized if it hadsold an asset or paid if it had been relieved of a liability on thereporting date in an arm’s-length exchange motivated by normalbusiness considerations.” (FASB)

“the amount for which an asset could be exchanged, or a liabilitysettled, between knowledgeable, willing parties in an arm’s length transaction.” (IASC)



What is “Fair Value” - Part 2

SHORT WORKING DEFINITION

• The market value, if a sufficiently active market exist, OR• An estimated market value, otherwise

ESTIMATED MARKET VALUE

present value of future expected cash flows, adjusted for:• risk• market imperfections• “similar factors if market-based information is available

to estimate those adjustments” (FASB)

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Who is Proposing It?

FASB: Preliminary Views - Financial Instruments at Fair Value• Focus is financial instruments• Insurance defined as financial instrument, usually• Comment deadline was May 31, 2000

IASC: Insurance Issues Paper• Focus is insurance• Discount all insurance liabilities• Fair value insurance liabilities IF all other

financial instruments at fair value• Comment deadline was May 31, 2000

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Insurance Application - Significant issues?

All Insurance?• Only indemnity contracts at fair value?• What about services? (e.g., HMO)• What about option of cash/service? (e.g., Property)• What about composite contracts? (e.g., WC)

Discounting

Risk Provision• Reliably measurable?• “Market price”• Independent of holder?• Diversifiable vs. non-diversifiable risk?

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Insurance Application - Significant Issues? Part 2

UPR replaced with unexpired contract reserve• No premium deficiency reserve• No Deferred Acquisition asset (DAC)• Include renewals in the fair value?• Return premium as a floor?

Credit standing• Liability lower for shaky company?

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Actuarial Response

CAS special task force on fair value liabilities• Research• White paper www.casact.org/research/tffvl/index.htm

AAA Fair Value Task Force• Responsed to FASB, IASC

International Actuarial Association (IAA)• Responsed to IASC

CAS liaison to IAA

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CAS White Paper - FormatA. Background, including a definition and history of fair value

in generalB. Fair Value in the insurance contextC. Alternatives to Fair Value Accounting for p/c insurance liabilitiesD. Methods for Estimating Fair ValueE. Implementation Issues surrounding the fair valuing of p/c ins. liabilitiesF. Accounting Presentation Issues, including alternative income statement

or balance sheet formats in a “fair value” world.G. Accounting Concepts, or how well fair value accounting and the issues

discussed in the earlier sections would be viewed in the context of generalaccounting concepts (such as reliability, relevance and representationalfaithfulness).

H. Credit Standing and Fair Value Liabilities, a discussion of issues relatedto the reflection of credit standing in determining the fair value of liabilities.

I. Professional ReadinessJ. Summary and ObservationsK. Technical Appendices

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CAS White Paper - Preview - Fair Value Pros and Cons

Potential advantages - Fair Value• Consistency with assets. • Eliminate accounting arbitrage. • Consistency with other financial instruments. • Relevance.

Potential disadvantages - Fair Value• Difficulty in measuring. • Greater estimation reliance. • Volatility in earnings. • Cost. • Unintended or unexpected consequences.

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CAS White Paper - Preview - Methods

1 - CAPM2 - IRR3 - Single-period RAD (Risk-Adjusted Discount)4 - Methods Based on Underwriting Data5 - Actuarial Distribution-Based Risk Loads6 - Reinsurance market prices7 - Direct estimation of market values8 - Distribution Transform Method9 - “Rule of thumb” MethodsOthers?

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CAS White Paper - findings

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1) New requirement2) Alternatives for fair value3) Expected value versus best estimate4) Multiple methods5) Continuum from pricing methods6) “Typical” line/”typical” company limitation of most current

methods7) A fair value accounting standard would lead to new research8) When market prices and “fair value” estimates are in conflict

• Market disequilibrium• Market disruption• Information asymmetry• Significant intangibles



CAS White Paper - findings Part 2

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9) Implications of risk margin approaches without valueadditivity

10) Susceptibility to actuarial estimate11) Increased reliance on judgmental estimates in financials12) Historical comparisons13) Gross vs. net.14) Tax issues15) Credit standing reflection in valuing liabilities16) Actuarial workload requirements17) Professional Readiness18) Standards vs. Principles



Next Steps - Actuarial orgs.

CAS• Decide on next steps after White Paper• Participate in future IAA

discussion/workproducts relative to IASC

AAA• Continued dialog with FASB on “fair value”• Document actuarial issues with fair value• Future comments to IASC?

AND/OR• Contribute to IAA

IAA• Continued dialog with IASC on “fair value”• Contribute to IASC Discounting discussion.

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Next Steps - Accounting Standard Setters

IASC• Field test and case studies (2000-2001)• Draft Statement of Principles (2001)• Exposure Draft of Proposed IAS (2002)• Final Standard (2003)• Transition Period (2004)• Effective (2005)

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SEC• Determine if statements filed under IASC standards will be

accepted in U.S.• Comment deadline was May 15, 2000



Next Steps - Accounting Standard Setters

FASB• Review comments to-date.• Issue JWG fair value document (non-insurance).• Follow / influence IASC work on Insurance and fair value.• Would like to have fair value of financial liabilities

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Joint Working Group (JWG)• Partnership of accounting standard setters (e.g, FASB,

IASC, U.K., Germany, Japan, et al.• December(?) 2000 discussion drafts• Includes ins. enterprises, excludes ins. contracts• Exposure drafts would follow, then Standards



Speed of Accounting Pronouncements

“The Board’s Experience with Fair Value of Financial Instruments...

The accounting profession, the SEC, bank regulators, and someproviders of financial statement had urged the Board to deal with the subject comprehensively because the existing authoritativeguidance was incomplete and inadequate. …resulted in ad hocand inconsistent reporting practices. In 1986, the board agreed to undertake a major project on financial instruments.”

(from FASB “Financial Accounting Series, No. 206-D/February 29, 2000, page 7) bolded font not in the original text

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fair value accounting naic catf - december 3, 2000 fair value ralph blanchard

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