The FASB s Financial Instruments Project, IFRS and Solvency II

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Monica Turner
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1 The FASB s, IFRS and Solvency II SCCIA 2011 Annual Conference September 13, :30-10:30 AM Presenters Jim Murphy, CPA Audit Partner Johnson Lambert & Co. LLP (904) Gregory Larcher, FCAS, MAAA Regional Director and Actuary Aon Risk Solutions Global Risk Consulting Actuarial and Analytics (410) Presentation Overview FASB s current financial instruments project Assessing investment impairments Solvency II 1

2 THE FASB S FINANCIAL INSTRUMENTS PROJECT Turmoil in the financial markets promises to bring back investment valuation as a key issue on 2011 RRG audits Fair value accounting Other than temporary impairment (OTTI) GAAP is currently undergoing a significant transition as the FASB and IASB attempt to eliminate differences between US GAAP and International Financial and Reporting Standards (IFRS) The current duel-entry accounting model was not developed to track financial instruments (stocks and bonds) Lower of aggregate cost or market (portfolio) Held-to-maturity, available-for-sale, trading Fair value option 2

3 Should the balance sheet (and S/H equity) reflect market driven changes that may never affect the value the holder expects to recover? e.g., interest rate changes to a bond portfolio When and how should changes in fair value be reflected within the income statement? Insurance company investment portfolios are often large enough that valuation changes could eclipse underwriting results In 2006, the FASB unleashed its Financial Instrument Project to improve and simplify the reporting for financial instruments Stated goals Measure all financial instruments at fair value Simplify hedge accounting Converge with IFRS They are yet to reach the Mendoza line The FASB s initial attempt at the new standard was to account for all investments at fair value Fair value through net income (FV-NI) Fair value through other comprehensive income (FV- OCI) This category was so onerous that it probably wasn t a realistic option However, the exposure draft met stark opposition and the FASB realized that it had to rethink the proposal 3

4 In January 2011, a new exposure draft was issued The current proposal added an amortized cost classification for certain fixed maturity securities FV-NI FV-OCI Amortized cost No harm, no foul Reclassifications between portfolios are not permitted However, there remains some key changes that financial statement preparers need to be aware Equity securities Presentation Impairment recognition Fair value option Proposed Changes - Equity Securities Marketable equity securities will be continue to be valued at fair value with changes being reported within net income Increasingly important to explain the components of net income to boards and regulators Eliminates OTTI for equities Non-marketable equity securities valued at cost or using the equity method Need to update value in light of observable price changes 4

5 Proposed Changes -Fixed Maturity Securities Carried at fair value or amortized cost Changes in fair value can be reported through net income or other comprehensive income based on the initial classification Amortization of purchase premium or discount will continue to be reported in net income Realized gains on FV-OCI will continue to be reported in net income Proposed Changes -Fixed Maturity Securities Recognition of credit losses on debt securities Current model is to identify specific losses in the period incurred FASB thinks recognizing investment losses during crisis periods gives accounting a bad image (?) Proposed Changes -Fixed Maturity Securities Proposal would add a three-bucket approach to recognizing impairments Bucket 1 Allowance for specific uncollectible amounts (bankruptcy of the issuer) Bucket 2 Allowance for possible future defaults on a specific industry sector or geographic concentration Bucket 3 Allowance for statistically expected future losses (similar to a loan loss reserve based on credit ratings or an AVR) Allowance for 12 months of expected losses 5

6 Proposed Changes - Where We Stand A number of issues remain to be worked out before the new standard can be exposed for final acceptance Implementation date is likely years away (2015+) We suggest that you continue to monitor developments, and assess the impact on your RRG s portfolios Current decisions to date at under Projects RECENT MARKET EVENTS AND OTTI ASSESSMENT FOR 2011 AUDITS Other Than Temporary Impairment Recent bear markets suggest that year-end 2011 may present many of the same investment accounting challenges experienced in and Standard is subjective Decided to sell or might have to sell a security for less than the cost basis Does not reasonably expect to recover all contractual interest and principal 6

7 Other Than Temporary Impairment Most difficult to assess securities that are not traded in active markets Private equities Asset backed bonds (CMO s, ABO s, etc.) Assessing Impairments Review securities trading below cost Basic rule of thumb: formally evaluate investments that have declined 20% under cost basis for six consecutive months Consider whether any significant underwriting losses (e.g., catastrophes) could require the sale of investments Compare individual equity holdings to peer companies or mutual funds within that sector Introduction to Solvency II Impact on Captive Owners Gregory Larcher, FCAS, MAAA Aon Risk Solutions Global Risk Consulting Actuarial and Analytics (410)

8 Introduction to Solvency II Solvency II is a risk based approach to regulatory capital regarded as state-of-the art by supervisors around the world. Solvency II is constructed by way of a three pillar approach Pillar 1 being the quantitative calculation of regulatory capital Pillar 2 the qualitative justification to the regulator and Pillar 3 the disclosure requirements to all stakeholders. Pillar 1 requires regulatory capital based on: The standard model (likely approach for captive owners) or a partial internal model (requires additional expertise) or a full internal model. Solvency II for Captive Owners No special provisionsare made for captive insurance companies. Proportionality principle requirements are to be applied in a manner which is proportionate to the nature, scale and complexity of the risk inherent in the business of an insurer. In currently form Solvency II is likely to result in: increases in regulatory capital requirements, Increases in operational costs and greater disclosure for most companies in the market. What are Regulators Doing? Digesting the results of Quantitative Impact Study 5 (QIS 5) and implications for final Solvency Capital Requirements (SCR) formulas. Already hinted at refinements to QIS 5 formulation Debating timetable for introduction of full SII regulations up to 10 year delay post 2013 for SCR?? no delay for introduction of Pillar II governance?? Setting out pre-approval process for first wave approval for internal models. 8

9 What are Captive Owners Doing? Prepare and review QIS 5 regulatory capital results Cost / benefit analysis for partial internal capital model Looking at internal model validation requirements Documentation of all material model components Recording explicit justification and support for component design and parameter values Creating their Own Risk Solvency Assessment (ORSA) How Does Captive Surplus Stack Up? Distribution of Solvency Capital Requirement Continental Europe 40% 35% 30% 31% 23% 20% 10% 11% 0% Less Than 75% 75% to 120% 120% to 200% More than 200% Note: based on QIS 5 results and a limited sample size may not be representative of entire population and final Solvency II rules. How Does Captive Surplus Stack Up? 40% 37% Distribution of Solvency Capital Requirement Other European Domiciles 30% 27% 20% 20% 16% 10% 0% Less Than 75% 75% to 120% 120% to 200% More than 200% Note: based on QIS 5 results and a limited sample size may not be representative of entire population and final Solvency II rules. 9

10 What are Bermuda and Cayman Doing? Cayman not presently looking to adopt Solvency II Risk Management Rule (2010) Bermuda Monetary Authority (BMA) is seeking third country equivalency. BMA does not plan to subject captive owners to Solvency II in accordance with the proportionality principle. It is unclear at this time whether EU Commission will agree with the BMA s position. Conclusions Implementation schedule still to be determined It appears the impact of regulatory capital on captive owners will vary by domicile within the European Union. Bermuda s ability to achieve third party equivalency may be impacted by treatment of captive insurance companies. NAIC RBC working group currently exploring similar issues! Questions 10

Comparison of the FASB s and the IASB s Proposed Models for Financial Instruments (as of May 2010)

Comparison of the FASB s and the IASB s Proposed Models for Financial Instruments (as of May 2010) The following table provides a side-by-side comparison of the FASB s and the IASB s proposed models for