International Accounting – Emerging Issues Fair Value Accounting Update

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International Accounting – Emerging Issues International Accounting – Emerging Issues Fair Value Accounting UpdateFair Value Accounting Update

Gareth KennedyGareth Kennedy

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© 2007 Ernst & Young LLP

Section I Agenda Overview of the International Accounting

Standards Board (IASB) Discussion Paper (DP) with tentative American Academy of Actuaries (AAA) Working Group (WG) feedback:– Measurement model– Estimate of future cash flows– The time value of money– Risk margins– Unit of account– Reinsurance

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Overview of the IASB DPMeasurement Model

Single measurement model to be used for future cash flows:– For P&C and Life insurance contracts

– For insurance and reinsurance contracts

– During claims period and pre-claims period

DP proposes that insurance liabilities be measured at Current Exit Value (CEV)

Continued

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Definition of CEV:– “…the amount an insurer would expect to pay at

the reporting date to transfer its remaining contractual rights and obligations immediately to a market participant.”

IASB has not yet identified any significant difference between the notion of CEV and fair value

Continued

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To measure CEV the IASB proposes that three explicit building blocks are required for insurance contracts:

Estimated future cash flows

Effect of the time value

of money

Risk and service margin

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Overview of the IASB DPEstimate of Future Cash Flows

IASB’s preliminary view is that cash flows should be:– Explicit

– Consistent with observable market prices

– Unbiased

– Current

– Exclude entity specific cash flows

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Overview of the IASB DPThe Time Value of Money

Requires that best estimates of future cash flows are explicitly reduced for the time value of money

Discount rate should be based on current market rates for cash flows with the same timing as the weighted average contract cash flows

Continued

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Overview of the IASB DPThe Time Value of Money

DP does not specify a discount rate although it is presumed by many that a risk-free rate or close to one will be used

P&C members of the AAA WG believe discounting with the addition of a separate risk margin is compliant with Actuarial Standard of Practice 20 and is a good measure of economic value

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Overview of the IASB DPRisk Margins IASB’s preliminary view is:

– “the risk margin should be an explicit and unbiased estimate of the margin that market participants require for bearing risk”

– It is not intended as a shock absorber for unexpected losses nor to enhance the insurer’s solvency

– “the observed price for a transaction with a policyholder …. should not override an unbiased estimate of the margin another party would require to take over the insurer’s contractual rights and obligations” Continued

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Overview of the IASB DPRisk Margins

The last point may result in profits or losses at a policy’s inception

Some IASB members are in favor of an alternative definition that calibrates the risk margin to the premium at inception, combined with a liability adequacy test

Supporters of CEV believe this is an entry value approach

Continued

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Overview of the IASB DPRisk Margins

IASB does not plan to prescribe what methods are appropriate to develop a risk margin

Instead the IASB will publish attributes that the methods should have and leave industry practitioners to develop further guidance

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Overview of the IASB DPUnit of Account

Definition: “portfolio of contracts that are subject to broadly similar risks and managed together as a single portfolio”

When developing risk margins, the DP proposes that it should be calculated at a unit of account level

No benefit of diversification beyond unit of account

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Overview of the IASB DPReinsurance

There is a lack of mirror accounting and recognition between a ceded reinsurance asset and an assumed liability in the DP for a reinsurance contract written on a policies attaching basis

DP argues remaining asset has little contractual value if underlying policies are issued at CEV

Reinsurance liability would be valued using all future cash flows

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Section II Agenda

Comparison of DP to Financial Accounting Standards Board (FASB) Statements 157 and 159:– FASB Statement 159

– FASB Statement 157

– Comparison to IASB DP

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FASB Statements 157 and 159FAS 159 – Fair Value Option

Provides a voluntary election to account for certain assets and liabilities at their fair value – including P&C insurance liabilities

Provides a one-time chance to elect fair value option for any existing liabilities without affecting income

Option is irrevocable and all future changes in fair value must be recognized in income

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FASB Statements 157 and 159FAS 157 – Fair Value Measurement Defines fair value for financial reporting

purposes under U.S. GAAP as the “… price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”

Market based not entity specific entity specific measurement

Statement is not insurance specific

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FASB Statements 157 and 159Comparison of FAS 157 to IASB DP

FAS 157 more general than IASB DP

Principles from DP currently fit well into the more general FAS 157 principles

Impact of FAS 157 currently optional for P&C insurance liabilities – IASB standard that will arise from DP will be compulsory

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International Accounting – Emerging IssuesFair Value Accounting Update

Gareth Kennedy

312-879-4459

[email protected]

International Accounting – Emerging Issues Fair Value Accounting Update

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