General Purpose Insurance Accounting

General Purpose General Purpose Insurance AccountingInsurance Accounting

IntroductionIntroduction Prelude – the rise of the standards settersPrelude – the rise of the standards setters The perfect storm for international The perfect storm for international

accounting standardsaccounting standards IASB Insurance Contracts Phase IIIASB Insurance Contracts Phase II FASB, the SEC, and youFASB, the SEC, and you EU Solvency II, the IAIS, and the NAICEU Solvency II, the IAIS, and the NAIC Conclusion: Brave new world, or the Conclusion: Brave new world, or the

Emperor’s new clothes?Emperor’s new clothes?

Warning!Warning! The magic date of November 16 is The magic date of November 16 is

approaching!approaching! Potential commenters are searching Potential commenters are searching

for common ground with each otherfor common ground with each other Opinions, especially on matters of Opinions, especially on matters of

detail, may well change if more detail, may well change if more agreement may resultagreement may result

Therefore, pay more attention to my Therefore, pay more attention to my questions than my answers!questions than my answers!

Prelude – the rise of the Prelude – the rise of the standards settersstandards setters

Old style standards setter: FASBOld style standards setter: FASB FASB is delegated its authority to set FASB is delegated its authority to set

standards for U.S. GAAP by the SECstandards for U.S. GAAP by the SEC SEC retains practical authority over SEC retains practical authority over

some significant areas of U.S. GAAPsome significant areas of U.S. GAAP SEC is in Washington, DC and may be SEC is in Washington, DC and may be

influenced by Congress and the influenced by Congress and the PresidentPresident


New style standards setter: (surprise) New style standards setter: (surprise) the NAICthe NAIC

The NAIC had no authority to be a The NAIC had no authority to be a standards setter. It is not a regulator, standards setter. It is not a regulator, but a trade association for regulators.but a trade association for regulators.

However, in the accounting codification However, in the accounting codification project it took the status of insurance project it took the status of insurance regulatory accounting standard setter regulatory accounting standard setter from the states who had responsibilityfrom the states who had responsibility


The NAIC demonstrates the power of The NAIC demonstrates the power of “agreeing to agree”“agreeing to agree”

It is now the most important regulatory It is now the most important regulatory accounting standards setteraccounting standards setter

Since it is not a part of government, it Since it is not a part of government, it has problematic standards of due processhas problematic standards of due process

Through the accreditation process, it can Through the accreditation process, it can exercise influence over state exercise influence over state governmentsgovernments


Another new style standards setter: the Another new style standards setter: the IASBIASB

Descended from old IASC founded in Descended from old IASC founded in 1973 (older than FASB)1973 (older than FASB)

No official delegated authority from any No official delegated authority from any government (to start with)government (to start with)

Acted with alacrity to take advantage of Acted with alacrity to take advantage of perceived need for international perceived need for international standardsstandards

The perfect stormThe perfect storm Asian financial crisis 1998Asian financial crisis 1998 Caused G8 to issue ritual call for Caused G8 to issue ritual call for

improved accounting standards and improved accounting standards and reportingreporting

Old IASC recognized an opportunityOld IASC recognized an opportunity Old IASC “standards” merely Old IASC “standards” merely

collected more commonly used collected more commonly used options for different accounting areasoptions for different accounting areas

The perfect stormThe perfect storm New IASC project to revise its New IASC project to revise its

standards to select the best, standards to select the best, “principles-based” approach“principles-based” approach

Project coincided with EU need for EU-Project coincided with EU need for EU-wide accounting standardswide accounting standards

IASC reorganized itself into the IASB to IASC reorganized itself into the IASB to meet U.S. (FASB and SEC) objections meet U.S. (FASB and SEC) objections as to its process and fundingas to its process and funding

The perfect stormThe perfect storm Once the IASC/IASB had done what Once the IASC/IASB had done what

the U.S. said it should, the U.S. was the U.S. said it should, the U.S. was committed to work with the IASB committed to work with the IASB towards the obvious goal of a single towards the obvious goal of a single world-wide set of high quality world-wide set of high quality accounting standardsaccounting standards

Another example of the power of Another example of the power of “agreeing to agree”“agreeing to agree”

The perfect stormThe perfect storm EU agrees to adopt IASB IFRS EU agrees to adopt IASB IFRS

effective January 1, 2005 (even effective January 1, 2005 (even though no complete set of IFRS though no complete set of IFRS existed when adopted, when existed when adopted, when implemented, or even today)implemented, or even today)

““Norwalk Agreement” commits FASB Norwalk Agreement” commits FASB and the IASB to work towards and the IASB to work towards “convergence” of U.S. GAAP and IFRS“convergence” of U.S. GAAP and IFRS

The perfect stormThe perfect storm IASB lauded itself on its “principles-IASB lauded itself on its “principles-

based” standards that would not be based” standards that would not be subject to the abuses of the “rules-subject to the abuses of the “rules-based” FASB approachbased” FASB approach

Multiple major projects (Conceptual Multiple major projects (Conceptual Framework, Revenue Recognition, Framework, Revenue Recognition, Financial Statement Presentation) Financial Statement Presentation) amount to re-building car while amount to re-building car while racing around the trackracing around the track

IASB Insurance Contracts IASB Insurance Contracts Phase IIPhase II

Old IASC had never completed an Old IASC had never completed an insurance contracts accounting insurance contracts accounting standardstandard

Recognized as a major need, but the Recognized as a major need, but the new IASB could not complete an new IASB could not complete an insurance accounting standard in time insurance accounting standard in time for the EU IFRS implementationfor the EU IFRS implementation

IASB developed IFRS 4 (Insurance IASB developed IFRS 4 (Insurance Contracts Phase I) as a placeholderContracts Phase I) as a placeholder


IASB issued “Discussion Paper: Preliminary IASB issued “Discussion Paper: Preliminary views on insurance contracts” in May 2007views on insurance contracts” in May 2007

Comments are due November 16, 2007Comments are due November 16, 2007 FASB has also issued the discussion paper FASB has also issued the discussion paper

with a “wraparound” asking for comments with a “wraparound” asking for comments by November 16, 2007 as to whether by November 16, 2007 as to whether FASB should take up the insurance FASB should take up the insurance contracts accounting project as wellcontracts accounting project as well


To reiterate, comments are being To reiterate, comments are being developed as we speakdeveloped as we speak

Here are some of the major issues Here are some of the major issues covered by the “DP”covered by the “DP”

Note: The “DP” approach is based on Note: The “DP” approach is based on “principles” that have nothing to do “principles” that have nothing to do with the ideas underlying current with the ideas underlying current U.S. GAAP for insuranceU.S. GAAP for insurance


Measurement of insurance liabilities is to Measurement of insurance liabilities is to be on a “market consistent” basis using a be on a “market consistent” basis using a “current exit value” (CEV) approach“current exit value” (CEV) approach

CEV may not be the same as “fair value”, CEV may not be the same as “fair value”, but to date no difference between CEV but to date no difference between CEV and “fair value” has been identifiedand “fair value” has been identified

CEV based on three “building blocks”: CEV based on three “building blocks”: current estimates, time value of money, current estimates, time value of money, market risk and service marginsmarket risk and service margins


Current estimates: explicit, unbiased, Current estimates: explicit, unbiased, market-consistent, probability-weighted market-consistent, probability-weighted current estimate of contractual cash flowscurrent estimate of contractual cash flows

Discount rates based on current market Discount rates based on current market interest rates to apply to these cash flowsinterest rates to apply to these cash flows

Explicit and unbiased estimates of Explicit and unbiased estimates of margins that market participants would margins that market participants would require to bear risk (risk margin) and to require to bear risk (risk margin) and to provide services, if any (service margin)provide services, if any (service margin)


Margins are not “entity specific” – they Margins are not “entity specific” – they are to reflect a market participant, not are to reflect a market participant, not the specific insurer being accounted forthe specific insurer being accounted for

Margins reflect the pooling of similar Margins reflect the pooling of similar risks in a portfolio, but not the risks in a portfolio, but not the diversification benefits of other diversification benefits of other portfolios of the insurerportfolios of the insurer

Insurance liabilities should reflect their Insurance liabilities should reflect their own credit standing (as assets) own credit standing (as assets)


Question: Liabilities don’t trade – they Question: Liabilities don’t trade – they are settled. Why is “market-consistent” are settled. Why is “market-consistent” a relevant consideration for liabilities?a relevant consideration for liabilities?

Question: There is no benchmark for Question: There is no benchmark for ever verifying the correct “market risk ever verifying the correct “market risk margin” for a liability. How does this margin” for a liability. How does this “mark-to-unverifiable-model” add “mark-to-unverifiable-model” add reliable information for investors?reliable information for investors?


Question: Insurers are obliged to settle claims Question: Insurers are obliged to settle claims in accordance with contract terms. Why in accordance with contract terms. Why should liability valuations be reduced by the should liability valuations be reduced by the “own credit stance” when the insurer cannot “own credit stance” when the insurer cannot benefit from that haircut?benefit from that haircut?

Question: If we accept “market consistent” for Question: If we accept “market consistent” for argument’s sake, why is no diversification argument’s sake, why is no diversification credit allowed when markets, rating agencies, credit allowed when markets, rating agencies, and even solvency regulators recognize the and even solvency regulators recognize the validity of the concept in many circumstances?validity of the concept in many circumstances?


Question: Why should an insurer use a Question: Why should an insurer use a “market participant” service margin lower “market participant” service margin lower than its actual costs that generates an than its actual costs that generates an artificial day one profit at inception only to artificial day one profit at inception only to reverse as the actual service costs emerge?reverse as the actual service costs emerge?

Question: Why are life and non-life insurance Question: Why are life and non-life insurance presumed to use the same accounting presumed to use the same accounting treatment when no existing accounting system treatment when no existing accounting system treats them together and the relative treats them together and the relative underwriting and investment risks are very underwriting and investment risks are very different?different?


Question: Why is the whole discussion Question: Why is the whole discussion focused on balance sheets when focused on balance sheets when management and investors are at least management and investors are at least equally concerned with performance equally concerned with performance measurement (notably for non-life measurement (notably for non-life underwriting results and combined ratios)?underwriting results and combined ratios)?

Question: Why is there no plan for serious Question: Why is there no plan for serious testing of these proposals before simply testing of these proposals before simply requiring them for one of the world’s requiring them for one of the world’s major industries?major industries?

FASB, the SEC, and youFASB, the SEC, and you ““I only do business in the U.S., so I I only do business in the U.S., so I

don’t have to worry about the IASB don’t have to worry about the IASB IFRS for insurance contracts”IFRS for insurance contracts”

Incorrect. FASB is committed to (and Incorrect. FASB is committed to (and is working hard on) converging U.S. is working hard on) converging U.S. GAAP with the IASB’s IFRS, and it GAAP with the IASB’s IFRS, and it would be stunning if FASB decided would be stunning if FASB decided not to participate in the Insurance not to participate in the Insurance Contracts Phase II projectContracts Phase II project

FASB, the SEC, and youFASB, the SEC, and you FASB has already been considering FASB has already been considering

insurance accounting issues insurance accounting issues (reinsurance accounting and (reinsurance accounting and bifurcation, and insurance risk transfer)bifurcation, and insurance risk transfer)

The SEC is increasing the pressure on The SEC is increasing the pressure on FASB to work towards convergenceFASB to work towards convergence

You can anticipate that U.S. GAAP You can anticipate that U.S. GAAP insurance accounting will face insurance accounting will face reconsideration in light of the “DP”reconsideration in light of the “DP”

FASB, the SEC, and youFASB, the SEC, and you SEC Proposed Rule released July 2, SEC Proposed Rule released July 2,

20072007 ““Acceptance from Foreign Private Acceptance from Foreign Private

Issuers of Financial Statements Issuers of Financial Statements Prepared in Accordance with Prepared in Accordance with International Financial Reporting International Financial Reporting Standards without Reconciliation to Standards without Reconciliation to U.S. GAAP”U.S. GAAP”

Comments due September 24, 2007Comments due September 24, 2007

FASB, the SEC, and youFASB, the SEC, and you SEC Concept Release on August 7, SEC Concept Release on August 7,

20072007 ““Concept Release on Allowing U.S. Concept Release on Allowing U.S.

Issuers to Prepare Financial Issuers to Prepare Financial Statements in Accordance with Statements in Accordance with International Financial Reporting International Financial Reporting Standards”Standards”

Comments due November 13, 2007Comments due November 13, 2007

FASB, the SEC, and youFASB, the SEC, and you Talk about pressure for convergenceTalk about pressure for convergence If IFRS are allowed on U.S. markets If IFRS are allowed on U.S. markets

without reconciliation (which seems to without reconciliation (which seems to be the direction), competition between be the direction), competition between accounting systems will start day oneaccounting systems will start day one

If U.S. GAAP and IFRS converge for If U.S. GAAP and IFRS converge for insurance accounting, what does that insurance accounting, what does that mean for insurance regulatory mean for insurance regulatory accounting?accounting?

EU Solvency II, the IAIS, and EU Solvency II, the IAIS, and the NAICthe NAIC

As the EU adopted (mostly) the IASB’s IFRS to As the EU adopted (mostly) the IASB’s IFRS to unify accounting standards across its member unify accounting standards across its member states, it is now adopting the Solvency II states, it is now adopting the Solvency II directive to unify insurance regulationdirective to unify insurance regulation

Solvency II is designed around the three Solvency II is designed around the three pillars of capital requirements, regulatory pillars of capital requirements, regulatory examinations, and disclosure requirements examinations, and disclosure requirements that were pioneered for banks under Basel IIthat were pioneered for banks under Basel II

Solvency II is designed to provide EU insurers Solvency II is designed to provide EU insurers with competitive regulatory advantages over with competitive regulatory advantages over non-EU insurersnon-EU insurers


Solvency II has two required capital Solvency II has two required capital calculations, the Solvency Capital Requirement calculations, the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (SCR) and the Minimum Capital Requirement (MCR)(MCR)

SCR tends to be based on internal models that SCR tends to be based on internal models that use concepts similar to the IASB’s CEV conceptuse concepts similar to the IASB’s CEV concept

SCR is intended to represent the amount of SCR is intended to represent the amount of capital required to make the probability of capital required to make the probability of failure 0.5% or 1 in 200 years.failure 0.5% or 1 in 200 years.

MCR is intended to be a simpler formula MCR is intended to be a simpler formula approachapproach


Issue: Should solvency measurements and Issue: Should solvency measurements and financial reporting measurements be the financial reporting measurements be the same?same?

Not necessarily – “different horses for Not necessarily – “different horses for different courses”different courses”

Accounting makes entities comparable Accounting makes entities comparable across industries, while solvency focuses on across industries, while solvency focuses on insuranceinsurance

Solvency considers cat exposure, Solvency considers cat exposure, accounting only cats that have happenedaccounting only cats that have happened


Issue: Should equally secure insurers be Issue: Should equally secure insurers be treated the same way, no matter where treated the same way, no matter where they are located?they are located?

Yes, if you are interested in market Yes, if you are interested in market competition to serve consumerscompetition to serve consumers

EU Solvency II may disadvantage U.S. EU Solvency II may disadvantage U.S. insurers by claiming U.S. insurance insurers by claiming U.S. insurance regulation does not meet their standardsregulation does not meet their standards

Implication: Less diversification credit for Implication: Less diversification credit for U.S. insurersU.S. insurers


The IAIS is developing international The IAIS is developing international standards and best practices for standards and best practices for insurance regulationinsurance regulation

It appears to be largely modeling its It appears to be largely modeling its approach on that of the EUapproach on that of the EU

The NAIC participates on IAIS The NAIC participates on IAIS committeescommittees

The NAIC may be helping to build The NAIC may be helping to build standards that will come back to haunt itstandards that will come back to haunt it


No country but the U.S. has a separate No country but the U.S. has a separate regulatory accounting system for insuranceregulatory accounting system for insurance

Other countries use general purpose Other countries use general purpose accounting for insurance regulatory accounting for insurance regulatory purposespurposes

Thus, the IAIS has taken an active interest Thus, the IAIS has taken an active interest in the IASB insurance contracts project as in the IASB insurance contracts project as likely to affect reports used by their likely to affect reports used by their membersmembers


The IAIS develops comments on The IAIS develops comments on various IASB proposalsvarious IASB proposals

The NAIC provides comments to the The NAIC provides comments to the IAIS to influence the development of IAIS to influence the development of those commentsthose comments

The NAIC is being encouraged to also The NAIC is being encouraged to also comment directly to the IASB since comment directly to the IASB since the NAIC represents regulators of the the NAIC represents regulators of the world’s largest insurance marketplaceworld’s largest insurance marketplace


When FASB and the IASB agree on an When FASB and the IASB agree on an insurance contracts accounting standard, insurance contracts accounting standard, that standard will become the de facto that standard will become the de facto global insurance regulatory standard, even global insurance regulatory standard, even if it confuses solvency regulationif it confuses solvency regulation

Accordingly, the pressure for U.S. insurance Accordingly, the pressure for U.S. insurance regulators to adopt it will be intenseregulators to adopt it will be intense

Therefore, it is important to fix the IASB Therefore, it is important to fix the IASB proposal now if you’re going to be unhappy proposal now if you’re going to be unhappy with it as either a general purpose or with it as either a general purpose or regulatory accounting standardregulatory accounting standard

Brave new world, or the Brave new world, or the Emperor’s new clothes?Emperor’s new clothes?

Standard setters not responsible to Standard setters not responsible to anyone save themselves have increasing anyone save themselves have increasing roles in the global marketplaceroles in the global marketplace

The IASB has embraced the untested The IASB has embraced the untested “mark to model” CEV version of fair value “mark to model” CEV version of fair value as the right means of accounting for as the right means of accounting for insurance liabilities, even though they’ve insurance liabilities, even though they’ve made no attempt to verify that it is an made no attempt to verify that it is an effective accounting approach for effective accounting approach for insuranceinsurance


What is the value of “market What is the value of “market consistency” when insurance liabilities consistency” when insurance liabilities do not trade?do not trade?

Why is no attention paid to key Why is no attention paid to key management measures of non-life management measures of non-life insurance performance such as insurance performance such as underwriting profit or combined ratio?underwriting profit or combined ratio?

Why is there no plan for testing and Why is there no plan for testing and validating these proposals before validating these proposals before implementing them?implementing them?


The result of the Insurance Contracts The result of the Insurance Contracts Phase II project will be coming to Phase II project will be coming to financial statements near you, either financial statements near you, either through adoption of the same through adoption of the same standard by FASB or through the standard by FASB or through the SEC’s permitting use of IFRS without SEC’s permitting use of IFRS without reconciliationreconciliation

When that happens, it is likely When that happens, it is likely insurance regulatory accounting will insurance regulatory accounting will move the same waymove the same way


Insurance solvency regulation need not Insurance solvency regulation need not follow insurance accounting standards, follow insurance accounting standards, but right now they are running in parallelbut right now they are running in parallel

The CEV approach to liability valuation The CEV approach to liability valuation has serious issues when applied to has serious issues when applied to solvencysolvency

If you care, comment! Consider joining If you care, comment! Consider joining GNAIE, the Group of North American GNAIE, the Group of North American Insurance EnterprisesInsurance Enterprises

GNAIE Member CompaniesGNAIE Member Companies ACEACE American American

International GroupInternational Group Allstate Insurance Allstate Insurance

CompanyCompany AXIS CapitalAXIS Capital Electric InsuranceElectric Insurance GenworthGenworth The HartfordThe Hartford

Manulife FinancialManulife Financial Metropolitan Life Metropolitan Life

InsuranceInsurance New York Life New York Life

InsuranceInsurance Principal FinancialPrincipal Financial Prudential FinancialPrudential Financial XL CapitalXL Capital

General Purpose Insurance Accounting

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