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«A dissertation submitted for the award of the degree of Master of Science in Actuarial Management Department of Actuarial Science and Statistics Cass ...»

-- [ Page 1 ] --

New Accounting Standards: the Fair

Value of Life Insurance Liabilities

by

Enrico Biffis

February 2003

A dissertation submitted for the award of

the degree of Master of Science

in

Actuarial Management

Department of Actuarial Science and Statistics

Cass Business School, City of London

NEW ACCOUNTING STANDARDS: THE FAIR VALUE OF

LIFE INSURANCE LIABILITIES

Abstract

In this dissertation we present an overview of the proposals of the International Accounting Standards Board for measurement of insurance assets and liabilities at market value. The Board has not yet finalised a standard for insurance contracts, but a Draft Statement of Principles has been published, providing indication of how fair value accounting will be implemented. We focus on life insurance liabilities and discuss many implementation issues from an actuarial perspective. First, we cover the underpinnings of the Board’s proposals, underlining the differences that they present with other accounting standards and reporting methodologies. Then, we deal with measurement issues, outlining the key features of the valuation approaches proposed. Finally, we present an example based on an insurance product sold in the italian market to show the differences between prudential, embedded value and fair value reporting.

i Contents

1. Introduction 1

2. Background 1

3. Fair Value Accounting: Principles 3

3.1. Insurance Contracts 4

3.2. Asset and Liability Measurement Approach. 6

3.3. Fair Value and Entity-specific Value. 7

3.4. Prospective Approach and Direct Method. 9

3.5. Backing Assets. 11

3.6. Neutrality. 11

3.7. Bundled Contracts. 11

4. Fair Value Accounting: Measurement Issues 12

4.1. Amount and Timing of Cash Flows. 12

4.2. Adjustments for Risk and Uncertainty 19

4.3. Performance-linked contracts 31

5. Numerical Example 34

5.1. Characteristics of the insurance policy 35

5.2. Example of product valuation 37

6. Conclusion 54

7. References 55

1. Introduction In this dissertation, we present a survey of the proposals of the International Accounting Standard Board (IASB) for measurement of insurance liabilities at market value. We concentrate on life insurance business and look at the issues arising from the implementation of the IASB’s principles by examining them froman actuarial perspective. In particular, we consider market value accounting in the context of the experience the actuarial community has matured over the years in embedded value and prudential reporting.

The dissertation is organised as follows: In Section 2, we give an overview of the trends which are leading the insurance industry towards market value

based accounting. In section 3, we present the most relevant principles proposed by the IASB, paying particular attention to the debated issues of:

definition of insurance contract and of insurance risk; distinction between fair value and entity-specific value; adoption of an asset and liability measurement approach as opposed to a deferral-and-matching approach.

In Section 4 we deal with measurement issues. Namely, we examine the IASB’s views on: estimation of future cash flows; adjustments for risk and uncertainty; replicating portfolio approach; choice of the discount rate to reect the time value of money. Non-profit business is mainly covered, because some issues concerning performance-linked contracts have not been settled yet. We give some indications for with-profit and unit-linked business consistent with the meetings the IASB has been holding recently.

In Section 5, we propose a numerical example for a unit-linked deferred annuity product sold in the italian market. We try to apply the IASB’s proposals to determine the fair value of the product. Particular emphasis is posed on the estimation of market value margins, i.e. the adjustments for risk and uncertainty to the estimation of future cash flows. Results are used to compare fair value reporting with embedded value and prudential reporting.

Finally, section 6 draws some conclusions on the practical implementation of the IASB’s proposals.

–  –  –

Insurance is an important and increasingly international industry which has no official international standard for financial reporting. Indeed, a great diversity in accounting practices for insurers currently exists and consistency with regulation of other sectors, such as banking or securities, is questionable at least.

In the last few years, however, significant changes in the standards for insurance companies have been taking place, with regard to statements prepared both in accordance with Generally Accepted Accounting Principles (GAAP) and in accordance with regulatory principles (see, for example, Vanderhoof and Altman (1998), Gutterman (2001) and Acutis et al. (2002)).

These changes are driven by major trends, such as, for example, the increasing importance of capital markets, globalisation of business and convergence of accounting standards worldwide. In particular, multinational enterprises are becoming more and more important and the products offered by the financial services industry are increasingly similar. The traditional distinctiveness of the insurance industry is under pressure.





The need for transparency is another key driving factor. Many users of financial statements feel that the current system has not responded sufficiently to market changes and cannot cope with their needs. Several investors and analysts simply do not understand insurers’ reports and often complain that current insurance accounting is an impenetrable ‘black box’. That does not help the market in valuing appropriately insurance business and has led to lower price/earnings multiples for the insurance industry over the years (Gutterman (2001)).

The boom of derivatives market and the recent techniques developed in modern financial theory have affected and enriched current actuarial practice.

The primary approaches used for measurement purposes (namely historical cost and deferral-and-matching: see section 3) are now being questioned by many. There is an increasing awareness of the limits they present in picturing a company’s profitability and many believe their popularity is due more to practical reasons rather than sound financial underpinnings.

Changes in financial reporting for insurance companies are characterised by a switch towards market value accounting. Standards regarding the asset side of the balance sheet have witnessed a more readily and effective implementation of fair value principles,1 putting insurers in the awkward situation of marking only one side of the balance sheet to market, thus distorting equity and earnings of the company.

Steps toward fair valuation of the liability side of the balance sheet have been more slow and difficult, since a true market for insurance liabilities does In 1993, for example, issuance of the Statement of Financial Accounting Standards No. 115 in the US.

not exist or is very thin at least. In January 1994, the American Academy of Actuaries appointed a Fair Valuation of Liabilities Task Force to address the issue. The aim was to study and catalog the methodologies which capture the economics of insurance liabilities, intentionally ignoring GAAP. The Task Force assembled a ‘white paper’ (see Doll et al. (1998)) that set the basis for further study and discussion.

In 1997, the Board (IASB) of the former International Accounting Standards Committee (IASC)2 set up a Steering Committee to carry out the initial work on an ‘Insurance Contracts’ project. In December 1999, the Steering Committee published an Issues Paper (see IASC (1999)) which attracted 138 comment letters from financial institutions, supervisory authorities and insurance companies worldwide. The Steering Committee reviewed the comment letters and developed a report to the IASB in the form of a Draft Statement of Principles (IASB (2001), referred to as DSOP henceforth), which is available on the IASB’s web site.3 In June 2000, the IASB’s work was given great motivation by the communication by the European Community that all listed EU companies should prepare IAS consolidated accounts by 2005 at the latest and that EU Member States would be free to extend the requirement to unlisted companies and individual accounts. However, in 2002 the IASB recognised that an International Financial Reporting Standard (IFRS)4 will not be in place by 2005 (see the IASB’s website and Wright (2002)). In May 2002, the Board decided to split its project on insurance contracts into two phases. Phase I is an interim solution which will enable insurers to implement part of the proposals by 2005. Phase II, the definitive solution, is meant to be completed by the end of 2007.

3. Fair Value Accounting: Principles

In this section we go through the underpinnings of the IASB’s proposals on market value accounting of (life) insurance liabilities. The proposals undergo The International Accounting Standards Board (IASB), known as International Accounting Standards Committee (IASC) until early 2001, is an independent privatelyfunded body based in London, UK. Its objectives are the formulation and publication in the public interest of accounting standards for financial statements and the promotion of their acceptance and observance worldwide.

www.iasb.org.uk The standards formulated by the IASB, once called International Accounting Standards (IAS), are now being published as International Financial Reporting Standards (IFRS).

continue discussion and improvement, so we try to use the most up-to-date information available to the public at the time of writing. When needed, we specify whether a principle implementation concerns the IASB’s Insurance Project as a whole or just Phase I of the project.

The Insurance Project of the IASB is aimed at issuing an IFRS to be used in general purpose financial statements directed toward the common information needs of a wide range of users. It will cover insurance contracts of all enterprises and will not deal with the treatment of assets held by insurers, other than assets arising under insurance contracts.

3.1. Insurance Contracts. The DSOP proposes a single recognition and measurement approach for all forms of insurance contracts, regardless of the type of risk underwritten (principle 2.1). In particular, it is argued that the only helpful distinction between general and life insurance is, for financial reporting purposes, the length of the insurer’s price commitment.

Insurance is treated as general insurance if the insurer is committed to a pricing structure for less than twelve months, as life insurance otherwise.

The definition of insurance contract given by the DSOP goes as follows (principle 1.2):

An insurance contract is a contract under which one party (the insurer) accepts significant insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary.

The definition is necessary in order to distinguish insurance contracts from financial instruments covered by IAS 39 (Financial Instruments: Recognition and Measurement) or by a successor standard resulting from the JWG Draft,5 and from other assets, such as provisions (covered by IAS 37) or intangible assets (covered by IAS 38).

The key feature of the definition is the reference to a significant insurance risk taken over by the insurer. The DSOP recognises uncertainty (or risk) In December 2000, the Joint Working Group of Standard Setters (JWG) published a Draft Standard and Basis for Conclusions, Financial Instruments and Similar Items (referred to as JWG Draft henceforth). While IAS 39 prescribes measurement at fair value for a portion of financial assets and liabilities, a successor standard could introduce fair value measurement for the substantial majority of financial assets and liabilities. This has relevant implications for the choice between Fair Value and Entity-specific Value in measurement of insurance liabilities (see section 3.3).

as the essence of an insurance contract, and assumes that at least one of the

following must be uncertain at the inception of a contract:



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