There are a number of actuarial issues for general (property and casualty) insurance in addition to provisions for catastrophes or equalization reserves. This paper covers those; provisions for catastrophes are addressed in a separate paper. There are also some issues involved here that are common with the life insurance issues e.g., discounting approach including interest rate selected and the market value margin. Those are pointed out here, but not dealt with in depth other than the aspects of the issues that are specific to general insurance.. The issues addressed here include discounting of loss provisions, salvage and subrogation, policy liabilities other than loss provisions, the DAC asset, insurance related assessments and reinsurance. General The use of present values of future cash flows in measuring the liabilities in the P&C business is comparable with the approach considered appropriate for life insurance. Therefore, we believe the approach of risk adjusted valuation as described in the paper on fair value of insurance liabilities is applicable in P&C too. That would imply measuring cash flows on a best estimate plus a market value margin, with the latter being a reflection of the market for the risk of uncertainties in these cash flows. Discounting for P&C Loss Provisions We support the use of present value in measuring general insurance claim liabilities. Present value is an integral part of the actuarial approach to measurement. For example, the Canadian Institute of Actuaries has specifically and unanimously stated that the recognition of the time value of money is an integral part of accepted actuarial practice. We believe that discounting the liabilities of property & casualty insurance companies would enhance the fair presentation of their financial statements. Discounting is common practice for life insurance liabilities, but not now for general insurance liabilities. But that is not because the basic principles should be different for these two types of insurance, but rather because as a practical matter discounting did not seem warranted in the past. Circumstances have changed over time, and we should now consider discounting consistently all insurance liabilities. Present value techniques are actually quite useful at capturing the current costs of some types of uncertainty. We believe that discounting enhances matching of revenue and costs. Without the recognition of present value, many lines of business appear to be written at an underwriting loss. This is clearly not the basis reflected in the pricing of the products. In fact, companies often report (nondiscounted) underwriting losses in aggregate, which are offset by investment income to produce an overall profit. This makes it very hard to determine the sources of profit e.g., how much investment income was anticipated in the underwriting and pricing decisions. 1
The general practice of not discounting P&C loss provisions has often been suggested to be an implicit compensation for inflationary and other development of claims. Using a discounting approach would imply the inclusion of the expected value of all ultimate costs as the starting point for determining claim liabilities. This would include recognition of all future cost drivers, such as inflation and other expected adverse development of claims. It would also include all internal and external costs of settling claims (claim expenses). Estimated recoveries (reinsurance, salvage, and subrogation) should be recognized at the same time and on a similar basis. In setting P&C claims provisions, all (future) developments impacting the ultimate amount of these claims should be reflected explicitly in the calculations. Whether or not to disclose that separately in the accounts is a question of giving more or less explicit insight to the readers of the annual reports. When discounting and inflation are included in the amounts in the balance sheet, we believe that an appropriate disclosure as to the main factors should be included. Salvage and Subrogation A strong case can be made that insurers should be permitted to recognize provisions for future salvage and subrogation recoveries, and common actuarial techniques should support doing that. As defined in IAS 32, Fair value is the amount that an asset could be exchanged or a liability settled, between knowledgeable willing parties in an arm s length transaction. Furthermore, it is considered that a prospective basis of measurement is consistent with a fair value accounting framework and with the IASC s definitions of assets and liabilities. With regards to the recognition of anticipated salvage and subrogation, three alternatives are possible: explicit recognition, implicit recognition, or explicit prohibition. By way of definition: Explicit recognition is the inclusion as either an asset or as a contra- of an explicit amount of anticipated future subrogation and/or salvage recoveries on claims that have occurred prior to the financial statement valuation date - liability in the financial statements. Implicit recognition is the valuation of future liability payments on claims occurring prior to the financial statement valuation date at a level that contemplates anticipated future subrogation and/or salvage recoveries that are consistent with historical collections of such items, but the value of which is not explicitly determined or stated. Implicit recognition might occur if standard actuarial techniques are applied to historical data that is net of (i.e. includes) actual subrogation and salvage recoveries to date. By applying standard actuarial techniques to such data, the assumption is being made that the relationship that existed in the past between loss payments and subsequent salvage and subrogation recoveries will continue 2
to exist in the future, and as such, future anticipated loss payments are reduced by future anticipated subrogation and salvage recoveries. Explicit prohibition is the requirement that any potential for future salvage and subrogation recoveries be excluded from the financial statements. Under this alternative, the recognition of salvage and subrogation recoveries can only be made when the recovery is actually collected. In the absence of any instructions to the contrary, the most likely result in practice is implicit recognition. For those types of insurance products that have historically demonstrated a substantial amount of subrogation and/or salvage recoveries, the concept of explicit prohibition ignores the underlying cause and effect relationship that gives rise to the subrogation and/or salvage recoveries. This cause and effect relationship is recognized in the marketplace as having a definite and quantifiable value. The value that is recognized is material in amount. For example, in the U.S., the propertycasualty industry reported anticipated subrogation and salvage accruals of $7.4 billion. While this amounted to only two percent of the total reported loss and loss adjustment expense liability for the industry in the aggregate, for one line of business in particular (automobile physical damage), it represented over thirty percent of the gross loss and loss adjustment expense liability. Any company looking to either purchase another company s book of outstanding automobile physical damage claims or sell their own book of outstanding automobile physical damage claims to another entity will of necessity value the anticipated future value of subrogation and salvage inherent in the open claims in making its assessment of the fair value of that company s business. For these reasons, we believe that the inclusion of anticipated future subrogation and salvage in the presentation of financial statement data is consistent with the prospectively measured fair value accounting framework towards which the IASC is working. Disclosing these amounts separately may alleviate most of the concerns about reflecting those values. Policy Liabilities Other than Claim Provisions Current Situation Most discussions of these reserves for insurance classify insurance contracts into one of two categories: 1. Those where the insured has the right to renew the contract, and at a guaranteed rate. 2. Those where the insured does not have the guaranteed right to renew. However, when and if the contract is renewed the new rates are contractually based on the experience during 3
the current contract. (We are primarily referring to group and reinsurance contracts here, not to contracts such as personal automobile insurance with a bonus-malus rating system, which also to some extent sets the terms for the renewal rates based on experience.) 3. Those where the insured has no guaranteed right to renew and/or the insurance company has the right to adjust the rate. Contracts of the first type are classified as long term contacts, and provisions (and DAC assets) held for them often reflect the projected experience over the expected life of the contract. On a fair value basis, that projection of experience is typically based on expected or best estimate experience assumptions, perhaps with a provision for adverse deviation added (for some contracts, reserves are equal to current cash values). The second type of contract is generally on a multi-year basis, but generally not treated as a longterm contract. In the conditions of the contract it is stated that rates are adjusted when renewed on the basis of experience. The third types of policies are treated as short term, and the policy provisions other than loss provisions reflect just the period from the balance sheet date to the next policy renewal date. Typically, this is a pro rata unearned premium reserve. A corresponding one year pro rata Deferred Acquisition Cost (DAC) asset may be held to spread recognition of the acquisition cost over the one-year term of the policy as well. Recommendation In reality, there are more classes of policies than just two. Each of the following classes of policies occur frequently in some markets: 1. The insured has the right to renew at a guaranteed rate. a) The insurer has no discretion to change the rate actually charged. b) The insurer has discretion to change the rate actually charged, subject to a maximum limit (e.g., indeterminate premium policies in the U.S). 2. The insured does not have a guaranteed right to renew. However, when and if the contract is renewed the new rates are contractually based on the experience during the current contract. In essence in these contracts both the reinsured and the insurer have the expectation that they will renew, at rates based experience. (Again, we are primarily referring to group and reinsurance contracts here, not to contracts such as personal automobile insurance with a bonus-malus rating system, which also to some extent sets the terms for the renewal rates based on experience.) 4
3. The insurer s right to not renew the policy and or to change the rate charged at renewal is subject to some limits - typically regulatory restrictions. 4. The insured has full rights to not renew the policy and/or to raise the rates actually charged. In case (2), contracts (primarily group or reinsurance) that, if renewed, base renewal rates on experience during the current contract, the issue is that although renewal is not assured, the willingness to renew the contract increases when experience is rather favorable. In that case the renewal rates generally are not only based on future expectations but also include a kind of payment from the insurer to the policyholder for the favorable past claims experience. This might be considered similar as to policyholder dividend in life insurance business. That might imply that profits during the current contract term due to better experience than anticipated should be set aside in accordance with the experience rate clauses in the contract. This area is a difficult issue in current practice, and should be carefully considered as part of the IAS for insurance project. Some argue that in case (3), and perhaps case (4), the liability should reflect the experience beyond the next renewal date. In some cases, there may be clear expectations of losses based on limitations on rate changes or non-renewal rights. In other cases, there may be expectations of higher profits on renewal (e.g., in a direct marketing business, where a large amount is invested in acquiring the business in order to obtain a multiple year stream of profits, where arguably writing the costs off when incurred but deferring recognition of the corresponding gain over many years may be too conservative). In general, many property and casualty actuaries comfortable with current practice, where experience beyond the next contract renewal is not recognized until it occurs. On the other hand, this may be inconsistent with the practice on many long duration contracts with very similar terms e.g., indeterminant premium life insurance contracts where the expected experience beyond the next contract renewal date is recognized, and the insurers right to change the rates is only reflected to the extent it is expected to be used. Regardless of whether experience beyond the next renewal date is projected, there may still be a question about the use of the unearned premium reserve to reflect the liability up to the next premium due date. The unearned premium reserve is an historic cost accounting approach. In a fair value liability accounting model, the expected losses to emerge out of the coverage to be provided to that next renewal date would be a better measure. In many cases, that will be very close to the unearned premium reserve less the DAC asset. But in many other cases the answer may be substantially different. A more precise estimate of that amount could easily be done as an additional step to the typical actuarial loss reserve analysis, which increasingly companies perform in any case. Adding that step would not be difficult, and would give a better fair value estimate of the liability that will arise out of coverage to the next anniversary. While that approach may seem more consistent with fair values in theory, many general insurance actuaries are very comfortable with the current Unearned Premium less DAC approach, and question the wisdom of changing from something which has worked pretty well. 5
A closely related issue is the reflection of experience rating (already covered in part above). Premium refunds resulting from experience rating provisions in insurance contracts should be reflected in the balance sheets, reflecting the best estimates of the expected refunds consistent with the loss estimates. The usual liability questions of whether and how to discount reserves for future loss payments, at what discount rate if discounted, and how to build in market value margins exist here as well. Those issues should be handled in a manner consistent with their resolution for other types of insurance liabilities. DAC Asset Clearly, under a fair value based liability, rather than an unearned premium reserve, the Deferred Acquisition Cost (DAC) asset is not appropriate. This approach is similar as the one described in the separate DAC position paper. Note that, given the position on DAC discussed in the separate paper on DAC, some would advocate that the recognition of the acquisition costs be included in the calculation of the fair value of expected cash flows until the next renewal date to spread recognition of profits over the contract term (possibly viewed as being a form of market value adjustment). And, as noted above, many do not wish to abandon the familiar, time-tested Unearned Premium less DAC approach to balance sheet values. Insurance Related Assessments In some jurisdictions there are assessments on insurers to pay for things such as claims against insolvent insurers, industry costs to cover otherwise uninsurable risks, second injury funds for worker accidents. The costs of these assessments should be accrued at the time the business which gives rise to the assessment is done. Reinsurance We agree with the Steering Committee that there is no reason to set different accounting requirements for reinsurers, as the issues for accounting do not differ. Different accounting rules might result in inconsistency and non-economic behavior. We agree with the Steering Committee that gains and losses on reinsurance should be recognized immediately. The issue of large gains on Present Value reinsurance is an issue, but not one that should change this opinion, and it is an issue that is eliminated if all values are discounted appropriately. We agree with the Steering Committee that there is no basis for offsetting amounts due from reinsurers against related insurance liabilities on the balance sheet. This is the way U.S. GAAP is now done, as well as the standard way for the EEC. 6
The Steering Committee recommends that the income statement also be presented on a gross basis. This extends the income statement significantly, and makes it more difficult to read. The Committee gives arguments both ways and many of us find the argument in favor of netting to be better. Paragraph 54 of IAS 37 specifies that a provision may be presented in the income statement net of the amount recognized for a reimbursement, and this seems to be the more reasonable way to treat reinsurance. This is still standard for U.S. GAAP. Some actuaries have found netting in the income statement to be easier to understand than the European statements that do not net reinsurance, while others take the opposite view. We agree with the Steering Committee that de-recognition of a liability is appropriate only when the obligation is discharged, cancelled, or expires. On the question of whether there are any special considerations in measuring assets and liabilities under reinsurance contracts, we believe the answer is no. The Steering Committee has made no comment on this issue yet. We agree that the concepts of how much uncertainty is required to be a real reinsurance contract, and whether bundled contracts should be unbundled is best left to the general discussion on insurance, and that there should not be a separate definition for reinsurance. We note that these concepts have been difficult to apply in practice in the U.S. If all financial instruments are valued at fair value, this issue would be less important From a pure actuarial perspective, we agree with the efforts to eliminate Fund Accounting. We note, however, that this will cause operational problems in some parts of the industry, which feel they do not have the data necessary to adopt a different method. But many actuaries feel this is no longer an appropriate argument. 15 March 1999 7