The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman Execuive summary Over he las decades, accouning sandard seers have given greaer emphasis o he use of fair value as a financial reporing measuremen basis. Among he reasons for his rend are he increased imporance of he financial markes as a source of capial and funds for risk-aking and a growing emphasis on economic relaed values. Many accouning sandard seers have reached he conclusion ha properly esablished and reliably measured fair values for financially-relaed asses and liabiliies provide more meaningful informaion han alernaive approaches for he users of financial saemens. We explore recen developmens in he applicaion of marke consisen conceps o fair values used for financial reporing purposes. We presen a se of crieria ha should be useful o evaluae proposed fair value measuremen mehods where inpu based on prices observed in an acive marke wih reliable ransacion prices are no available. Based on hese crieria, we examine one approach ha migh serve as a basis for fair value measuremen of life insurance conracs liabiliies and oher financial insrumens issued by insurance companies. To suppor our examinaion we have used he curren reamen of a funding agreemen issued in a Funding Agreemen backed Noe Issuance Program (FANIP), an invesmen conrac, under U.S. GAAP as a model. We expand on his model o a 20 year erm insurance conrac o illusrae he conceps involved as applied o insurance conracs. In par his illusraes ha a consisen approach o he measuremen of hese wo ypes of conracs is pracical and we conend desirable. In he examples given, he price for risk was held consan over he conrac duraion for simpliciy of illusraion. Neverheless, in he case in which i would be appropriae for his margin o vary over ime, we believe i can be easily adaped. Several addiional issues ha are relevan o fair value measuremen are discussed. The risk margin is assessed in relaion o a heoreical reamen of expenses implied by he ransacion price of a conrac. Possible alernaive reamens of he credi sanding associaed wih a funding agreemen as par of a FANIP is explored. We also discuss he advanages of eliminaion of he demand deposi floor, alhough we recognize ha wihou changes o fair value measuremen guidance o non-insurance conracs, his may inroduce an inconsisency of reamen beween ypes of conracs. Background In 2000, he Join Working Group of Sandard Seers recommended ha all financial asses and financial liabiliies be measured on a fair value basis. However, heir recommendaion was no advanced i was oo large a sep o ake a he ime. Subsequenly, in 2001 he Financial Accouning Sandard Board ( FASB ) published Concep Saemen No. 7, Using Cash Flow Measuremen and Presen Value in Accouning Measuremen ( CON 7 ). CON 7 deals wih various measuremen aspecs of fair value, bu does no address when fair value should be applied. I recognizes ha reliable marke-based price informaion from which o measure fair value is no always available by esablishing a hierarchy of fair 1
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman value measuremen ha ranges from direcly observable relevan ransacion prices o model based values on eniy-specific inpus. In June 2004, he FASB followed wih an exposure draf eniled Fair Value Measuremen, whose objecive was o provide guidance on how o measure fair value, again no addressing when such measures should be applied. A he ime his was wrien, i is expeced ha a sandard will be adoped in he second quarer of 2006 by he FASB and will subsequenly be exposed by he Inernaional Accouning Sandards Board ( IASB ) o is consiuens for commens and possible fuure adopion. If adoped, he resuling Saemen of Financial Accouning Sandard would effecively upgrade an enhanced CON 7 o a sandard in he accouning hierarchy. On March 15, 2006, he FASB produced a working draf of Accouning Sandard No. 15X, Fair Value Measuremen ( Working Draf ). Even afer many years of discussion, a consensus regarding when o recognize and how o reliably measure fair values using a mark-o-model approach is sill being sough. We believe ha a principle-based approach is criical o he developmen a viable fair value accouning model for insurance conracs, where reliable marke prices are seldom observable. Such an approach should be one capable of accommodaing he specrum of produc variaion and enhancing he consisency of financial reporing values across jurisdicions and producs. Such a fair value mehodology should be based on he presen value of all fuure cash flows relaing o an insurer s curren obligaions. In conras wih loss recogniion or liabiliy adequacy ess ha only recognize impairmens or increases in expeced coss, a fair value approach should reflec boh improvemens and deerioraion in projeced experience. We recognize ha, alhough clearly applicable o he accouning for business combinaions and embedded insurance derivaives, a consensus has no been reached regarding wheher he fair value accouning objecive will apply o he general accouning of insurance conracs. In any even, we hope ha his paper will assis in he deliberaions underway by he IASB in phase 2 of is Insurance Conracs projec and subsequenly by he FASB in is convergence effors. Alhough we specifically address conracs in which no conracual or legal link beween asses and liabiliies exis, he crierion and principles discussed should be applicable o hose conracs as well. In addiion, alhough he paper should equally apply o life and propery & casualy insurance conracs, i does no address pos-claim liabiliies. Definiion A fair value financial reporing sysem is an accouning sysem in which values of asses and liabiliies ha are no conracually or legally linked are measured independenly (1) based on observed ransacion prices from a relevan acive marke from which reliable prices or marke based inpus can be obained or (2) if hese crieria canno be me, based on esimaes of such prices as if such a marke did exis. Two quie similar bu no idenical definiions of fair value measuremen are 1 : 1 Noe ha i is anicipaed ha he IASB will consider converging wih he proposed FASB definiion 2
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman 1. The price ha would be received for an asse or paid o ransfer a liabiliy in a ransacion beween markeplace paricipans a he measuremen dae." (FASB Working Draf) 2. The amoun for which an asse could be exchanged, or a liabiliy seled, beween knowledgeable, willing paries in an arm s lengh ransacion. (IASB IAS 39.11) Fair value esimaes Based on commens received on is exposure draf and subsequen deliberaions, he FASB has revised is hierarchy of valuaion inpus o be used as a basis for fair value esimaes. This hierarchy consiss of hree levels, wih level 1 being he mos reliable, all else being equal. I should be noed ha in all circumsances, a fair value is an esimae, even when based on curren observed prices. The following is a summary of he Working Draf s caegorizaion of fair value inpus. Level 1 inpus. Whenever observable, quoed prices for idenical asses or liabiliies in he principal marke ha he eniy has he abiliy o access a he measuremen dae. If such prices are quoed in erms of bid and asked prices, he esimae represens he price wihin he bid-asked spread a which markeplace paricipans would currenly ransac exchanges. Level 2 inpus. If quoed prices for idenical asses or liabiliies are no available or if observed marke prices are no reliable, level 2 inpus include: a. quoed prices for similar asses or liabiliies in an acive marke, b. idenical or similar asses or liabiliies in markes ha are no acive in which here are few ransacions, he prices are no curren, quoaions vary subsanially, or for which lile informaion is available publicly, c. marke inpus oher han quoed prices such as ineres raes, and d. marke inpus derived principally from or corroboraed by oher observable marke daa hrough such echniques as exrapolaion and inerpolaion. Level 3 inpus. Fair value esimaes ha include level 3 inpus incorporae unobservable marke inpus ha are no able o be corroboraed by observable marke daa. These would arise in siuaions in which here is lile, if any, marke aciviy for he asses or liabiliies. These however have o be developed considering he assumpions ha marke paricipans would use o price he asses or liabiliies. The eniy s own daa can be used, as long as informaion is no available o indicae ha marke paricipans would use differen assumpions. According o his hierarchy, fair values are esimaed on he basis of he resuls of one or more valuaion echniques ha make maximum use of marke inpus, wih as lile reliance on unobservable marke inpus as possible. I is imporan o realize ha o be characerized as a fair value mehod, he inpus made wihin level 3 have o be considered from he perspecive of marke paricipans. By necessiy his may have o involve inernally developed assumpions of heoreical marke inpus based on he eniy s own daa. These assumpions would be adjused o exclude facors specific o he reporing eniy if informaion is available ha indicaes ha 3
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman marke paricipans would use differen assumpions. The primary difference beween level 2 and level 3 inpus is ha level 2 inpus are based on a model ha reflec some form of reliable marke daa, while level 3 inpus are oally based on models. In any case, a fair value measuremen echnique should reasonably reflec how he marke could be expeced o price he asse or liabiliy by incorporaing all he facors ha marke paricipans would consider in agreeing o a price and be as consisen as possible wih acceped economic mehodologies. In addiion, he inpus o he valuaion echnique should reasonably represen marke expecaions and measures of he risk-reurn facors inheren in he asse or liabiliy being measured. Since he liabiliies of few insurance conracs are raded in an acive marke, he fair value of mos such liabiliies would be considered o be based on level 3 inpus. Discussions of fair value measuremen ofen focus on he measuremen of fair value a conrac incepion, someimes referred o as a day 1 value, raher han is value subsequen o originaion, someimes referred o as day 2. Day 1 values The IASB s guidance wih respec o financial insrumens in IAS 39 AG76 indicaes ha he bes evidence of he fair value of a financial insrumen a iniial recogniion is he ransacion price, he so-called day 1 value. AG76 goes on o say ha his is he case unless he fair value of ha insrumen is evidenced by comparison wih oher observable curren marke ransacions in he same insrumen (i.e., wihou modificaion or repackaging) or based on a valuaion echnique whose variables include only daa from observable markes. To he exen ha a relevan and reliable ransacion price or marke inpu is no observable, a fair value would be esimaed reflecing prices ha marke paricipans would be expeced o pay (or demand) a day 1, wheher i was acquired or assumed. Such inpus are currenly used as a basis for mos hisorical cos and deferral and maching accouning sysems whose accouning objecive is o mach coss and corresponding revenue. The Working Draf (paragraph 17) indicaes ha he reporing eniy mus consider specific facors for ha ransacion price o represen he fair value of he asse or liabiliy a iniial recogniion. For example he reporing eniy considers wheher he ransacion is beween relaed paries, wheher i occurred under duress, when he uni of accoun represened by he ransacion price is differen from he uni of accoun for he asse or liabiliy measured a fair value, and wheher he marke in which he ransacion occurs is differen from he principal (he mos advanageous) marke. Day 2 and subsequen values Since mos insurance conracs are long-erm in naure, financial saemens of companies issuing hem are grealy affeced by he subsequen measuremen of heir liabiliies, i is criical ha day 1 and day 2 values be sysemaically and consisenly measured. The IASB has concluded in IAS 39 AG76A ha for financial insrumens, The subsequen measuremen of he financial asse or financial liabiliy and he subsequen recogniion of gains and losses shall be consisen wih he 4
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman requiremens of his Sandard. The applicaion of paragraph AG76 may resul in no gain or loss being recognized on he iniial recogniion of a financial asse or financial liabiliy. In such a case, IAS 39 requires ha a gain or loss shall be recognized afer iniial recogniion only o he exen ha i arises from a change in a facor (including ime) ha marke paricipans would consider in seing a price. As an example, IAS 39 AG77 indicaes ha if he financial insrumen is a deb insrumen (such as a loan), is fair value can be deermined by reference o he marke condiions ha exised a is acquisiion or originaion dae and curren marke condiions or ineres raes currenly charged by he eniy or by ohers for similar deb insrumens (i.e. similar remaining mauriy, cash flow paern, currency, credi risk, collaeral and ineres basis) and If condiions have changed since he mos recen marke ransacion, he corresponding change in he fair value of he financial insrumen being valued is deermined by reference o curren prices or raes for similar financial insrumens, adjused as appropriae, for any differences from he insrumen being valued. According o he Working Draf, changes since iniial recogniion are considered in subsequen remeasuremens, considering changes in he marke and oher relevan facors. The principal marke The deerminaion of he principal marke is an imporan consideraion in he applicaion of marke based inpus o fair value measuremen in he Working Draf. Paragraph describes he principal marke as he marke in which he reporing eniy would sell or oherwise dispose of he asse or ransfer he liabiliy wih he greaes volume and level of aciviy for he asse or liabiliy. Two common families of markes have been idenified ha should be considered: 1. The reail or so-called business-o-consumer marke. The use of observed ransacion prices of he asse or liabiliy in a reail marke is also referred o as an enry price or cusomer consideraion model. 2. The wholesale or so-called business-o-business marke. The derivaion of values based on informaion from a wholesale or re-sale marke has been referred o as an exi price model. A fair value based on his marke represens an esimae of he price ha marke paricipans would be expeced o pay or demand when an asse is sold or a liabiliy is exchanged or seled. As discussed laer, i may be problemaic o rely on a business-o-business principal marke for insurance conracs. According o paragraph 15 of he Working Draf, if here are muliple markes, he principal marke for a liabiliy is he marke wih he price ha minimizes he amoun ha would be paid o ransfer he liabiliy o a markeplace paricipan of comparable credi sanding. In mos cases his would lead o he use of a business-o-business or exi price model. 5
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman Ye in he principal marke in which a ransacion for an asse or a liabiliy occurs, enry and exi prices are presumed o be he same a iniial recogniion, absen persuasive evidence o he conrary 2. Neverheless, using a business-o-business marke as he principal marke would usually be expeced o produce he smalles measuremen of he liabiliy, a leas because of he higher profi margins someimes associaed wih a reail raher han a wholesale marke. I should be noed ha any model used reflecs he risk characerisics, produc feaures and expeced policyholder behavior of he specific conrac. Also, given he diverse naure of produc lines offered and disribuion channels used by many insurers, he principal marke may differ for an eniy s business aciviies and may depend on he uni of accoun being considered. In conras o many financial insrumens raded in acive markes, here have been few, if any, markes in which he liabiliies of insurance and relaed conracs have been raded or ransferred or from which reliable marke-based inpus can be observed. Alhough reinsurance, mergers/acquisiion and life selemen (U.S.) markes have been pu forh as possible sources of price informaion, hey currenly do no provide appropriae day 2 marke inpus. The limied breadh, liquidiy and frequency of observable prices in hese markes make i a challenge o develop reliable informaion ha is also relevan. In addiion, ransacion prices in hese markes may no be consisen wih underlying coss as subsequenly expeced by a marke paricipan. Any large marke ransacion, such as a reinsurance reay or merger/acquisiion is impaced by eniy-specific and sraegic consideraions, such as he achievemen of scale, desire o ener cerain markes, and aainmen of desired diversificaion. If an insurer expecs o reduce is average cos of adminisraion or o reduce he poenial volailiy of is moraliy/morbidiy experience hrough he purchase of an addiional volume of life insurance conracs, he insurer may be willing o pay a higher average price per conrac for hese addiional conracs han if he insurer were buying a single individual conrac. However, hose facors are specific o ha eniy and ha purchase. When he uni of accoun is he individual conrac hese facors are no relevan o is fair value; raher, i would affec economic capial. A similar siuaion arises in he asse managemen marke. For example, an invesmen manager can reduce is average cusodial fees and reduce he volailiy of expeced credi losses hrough he purchase of a greaer volume of differen bonds. These benefis are no considered relevan in deermining he fair value of an individual bond, alhough he marke may recognize his in he sale price of an invesmen manager. However, he marke value of he invesmen manager is no relevan in deermining he marke value of a bond. An addiional example is he life selemen marke in which hird pary marke paricipans reflec very differen margins and incenives han in he normal life insurance conrac. The price one eniy is willing o pay for he acquisiion of an enire company can be very differen han wha anoher marke paricipan would be willing o pay, in par due o a conrol premium and he value associaed wih poenial fuure sales and renewals. The less relevan or reliable he marke inpus, he greaer he need o rely on models o esimae he hypoheical price a which 2 Examples of possible excepions include he relaively low combined raio ofen experienced by many accidenonly lump sum benefi conracs and marke prices in a very hard or underpriced marke. 6
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman marke paricipans would be willing o buy or sell idenical or similar asses or liabiliies had here been a marke wih reliable price informaion. I is imporan o noe ha here is no unresriced acive business-o-business reference marke in he U.S. and cerain oher counries for insurance conracs, as under insurance laws an insurance company canno unilaerally ransfer is obligaions o a hird pary and novae hem o he policyholder. Unless policyholder consen is obained under an assumpion reinsurance arrangemen, he original wrier of he conrac reains he primary obligaion o he policyholder. For example, if a non-assumpion reinsurer was o fail before an insured even occurs, he direc insurance company would sill be obligaed o fulfill he conracual obligaions o he policyholder. The scarciy of assumpion reinsurance ransacions in he U.S. marke indicaes ha an acive business-o-business marke does no currenly exis in he U.S. ha can provide reliable marke inpus). Thus, he only curren marke where insurance liabiliies are raded wih minimal ransacion specific disorion is he business-o-consumer marke on day 1. In his business-o-consumer reference marke, he cusomer consideraion (including fuure premiums) is he basis for he fair value ha boh a policyholder is willing o pay and a life insurance company is willing o provide hose insurance benefis. In conras, he use of inpus from a business-o-business marke involving insurance companies wih a similar raing may yield somewha differen fair value esimaes, because observable inpus may no be sufficien o provide a sufficienly reliable fair value relaive o a hypoheical marke paricipan. Observable inpus include variaions in he exen of compeiion and pricesensiiviy in he marke and developmen and acquisiion coss necessary o access he marke. Expense levels, including he cos of novaion for a conrac ha heoreically should be minimal if he companies credi raing and brand value are equivalen bu which migh involve considerable fricional coss, are oher assumpions ha marke paricipans would use in pricing he insurance conrac bu which are ypically unobservable. In a perfecly compeiive marke a company should be indifferen beween an insurance conrac from a new policyholder and a similar conrac originaed from anoher insurance carrier, as long as he expeced reurn is he same. Similarly, in such a marke a policyholder should be indifferen beween he ulimae obligor of is benefis, so long as he credi sanding of he wo obligors is he same and he fuure premiums, credis, charges and non-guaraneed elemens are he same. This indifference and he crieria se ou below will be saisfied if he uni of accoun is he individual insurance conrac. We conend ha he primary difference beween esimaes based on exi value and a cusomer consideraion model relaes o he differen use of he uni of accoun beween he porfolio and he individual conrac, respecively. Boh reflec he exposure-specific naure of he insurance risks. A uni of accoun based on a porfolio reflecs he effec of he purchase of ha porfolio ha migh include a smaller amoun of volailiy (i.e., reducion in process risk) and possibly an improvemen o economies of scale, boh of which should no be refleced in he fair value of liabiliies; raher, i should be refleced in capial as an inangible ha should be refleced when he benefis are achieved. 7
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman An assuming insurance company would ordinarily be willing o coninue coverage a he same premium rae he policyholder is currenly paying since he reurn o he assuming company would be he same as i would have received if i had direcly issued he conrac. In oher words, in he cusomer consideraion model he assuming company should be indifferen as o wheher i received his sum from he ransferring company or direcly from he insured, since he company's reurn would be he same. An imporan corollary is ha he value would also equal he amoun a policyholder would demand o release a company from is obligaions (selemen value as defined by he IASB), since he policyholder would pay he same amoun o a differen insurance company wih he same credi sanding and receive idenical benefis while mainaining fuure premiums a he same level. Alhough non-guaraneed elemen paymens may vary depending on he eniy s non-guaraneed elemen policy, i has o be assumed ha he curren policy will coninue, unless i can be demonsraed ha marke paricipans would no coninue he curren eniy s non-guaraneed elemen policy. Therefore, alhough concepually an exi value would be more consisen wih fair value conceps, due o he lack of relevan and reliable values, he fall-back marke ha is no he same ime he principal marke for insurance conracs, can be esimaed hrough use of a cusomer consideraion model. When eniy- specific characerisics are eliminaed and he uni of accoun is he individual insurance conrac hese values are he same. Crieria Reflecing he above discussion, we believe ha he following crieria should be applied o assess he meris of an accouning model for he measuremen of he fair value of liabiliies for insurance conracs: 1. Consisency beween day 1 and day 2 measuremen approaches. 2. Consisency beween componens of and beween insurance conracs. I is imporan o measure a conrac s componen pars on a consisen basis. Mos insurance conracs consis of a bundle of componens (e.g., deposi, insurance, service and embedded derivaives, as well as opions and guaranees) ha for many conracs can be quie difficul o measure separaely in an oher han arbirary manner. To avoid disconinuiies beween he liabiliies for insurance conracs, financial insrumens and service conracs, as well as heir various componens, i would be desirable o use a consisen measuremen framework across conracs and conracual componens. The imporance of his inconsisency can be seen from he experience of U.S. GAAP measuremen of liabiliies and revenue of various conracs issued by insurance companies (e.g., he disincion beween SFAS 60 radiional life, SFAS 97 universal lifeype and SFAS 97 invesmen conracs). Examples of he imporance of consisency across conrac ypes can be inferred from he recen discussions regarding conrac classificaion and risk ransfer of reinsurance conracs. 3. Consisency beween he measuremen approaches used for all financial conracs, wheher asses or liabiliies, financial insrumens or insurance conracs. This concern for
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman consisency is paricularly relevan beween he measuremen of insurance conracs and long-erm conracs subjec o IAS 39 (someimes referred o as invesmen conracs). Measuremen consisency would reduce he imporance of classifying conracs and heir componens as insurance conracs o achieve a paricular accouning reamen. In addiion, consisen measuremen of well mached asses and liabiliies would allow boh he asse and liabiliy side of he balance shee o be similarly responsive o changes in ineres raes and oher economic facors. In he even hey are no well mached, his would enable he economic impac of he mismach o be properly refleced in earnings. Inconsisen accouning reamen currenly exiss for apparenly similar producs offered in differen jurisdicions and indusries wihin he same jurisdicion, and even in he same indusry where minor changes in he economics or even he form of a produc creae large differences in measuremen and presenaion. Mos jurisdicions have some form of mixed aribue model of accouning. For example, cerain jurisdicions specify he use of deposi accouning for cerain insurance conrac liabiliies wih significan financial insrumen-like componens and fair value accouning for cerain derivaive-like feaures wihin insurance conracs. Differences in he definiion of revenue can significanly affec he financial saemen presenaion of a conrac, which in urn can affec is desirabiliy. 4. Use of a principal marke, even if a hypoheical one, from which relevan marke inpus could be observed or esimaed which is liquid, free of he influence of diversificaion, economies of scale and oher influences, as well as o he exen possible free of consrains ha may disor pricing (e.g., he need for policyholder consen in he business o business marke). 5. Consisency wih acceped economic pricing mehodologies. Since he fair value of a financial insrumen is independen of he holder of he insrumen, i should no recognize eniy-specific facors, including diversificaion benefis and benefis of economies of scale. Neverheless, such facors associaed wih he conrac would be refleced. Some view marke-based prices as amouns ha include provisions such as expenses and cos of capial and would expec a fair value mehod o do he same. However, he price assumed o cover hese coss is independen of he specific company's acual or projeced coss. A company whose acual coss are less hen his marke based expense charge would have an addiional source of profi, while a company whose coss are higher han ha of a hypoheical marke paricipan would have a negaive impac on earnings. 6. Consisency beween sandards. Fair value measuremen should be consisen wih oher key sandards, such as revenue recogniion. Similar feaures and componens in hese producs should be measured in a similar and logical manner. Curren discussions of hese poenial sandards or conceps appear o be moving in he direcion of reflecing cusomer consideraions, alhough exposure drafs addressing his concep have no ye emerged. If his approach is adoped, consisency wih a cusomer consideraion measuremen model would become even more appropriae. The cos of services provided or risk borne migh alernaively be used as a common basis for recognizing revenue. 9
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman Oher approaches ha migh be used o resolve hese inconsisencies in measuremen include a wider use of fair value or a consisenly derived basis for heir prospecive measuremen. 7. Consisency across uni of accoun. Similar o he case of a financial insrumen, i is appropriae o recognize he individual life insurance conrac as he uni of he accoun so ha he liabiliy is no influenced by he size of he book of business, alhough i would be appropriae o reflec exposure-specific risk characerisics. As in any financial insiuion, an insurance company s asses are equal o is liabiliies plus capial. Some of he facors ha influence he amoun of capial an insurer needs o hold include he expeced effec of volailiy of operaing resuls, expense losses unil criical mass is achieved and he level of expeced profiabiliy. These iems in urn are influenced by he size of he company s book of business and hence he capial per uni is a funcion of he size of he book. Alhough a larger and more diversified eniy should be able o hold lower capial per uni, his does no imply ha a lower liabiliy per uni is appropriae. A proposed approach A measuremen mehod ha can mee boh he definiion of fair value and his se of crieria is similar o one used in U.S. GAAP for a oal reurn swap. Alhough his approach has had limied applicaion o dae in he measuremen of insurance liabiliies, excepions in U.S. GAAP include he guidance included in DIG Issue B-36 for derivaives and for cerain guaraneed living benefis included in variable annuiies. Wha follows describes his mehod and suggess ha i should be considered for wider applicaion. Since marke paricipans are generally risk averse, a risk premium or cos of risk (an amoun greaer han he expeced cos, someimes referred o as a risk margin, risk adjusmen or marke value margin) in marke prices is always needed. For example, he premium payable for erm life insurance is greaer han he expeced moraliy claims cos and associaed expenses. This effec can also be seen in (1) credi spreads on deb securiies ha almos always exceed he corresponding expeced defaul losses and (2) forward raes in he yield curve ha ypically overesimae where fuure raes head. Through risk miigaion sraegies such as diversificaion, pooling, underwriing, risk sharing, conrac paricipaion and hedging, insurance companies aemp o ake advanage of his risk premium. We believe a financial reporing sysem using fair value objecives should provide for recogniion of earnings when an eniy demonsraes heir success in implemening hese sraegies raher han a incepion of he conrac, i.e., an insurer recognizes he benefis of diversificaion when he gain from diversificaion is realized and no earlier. Ne income in such a sysem would be recognized wih he release of a markeplace paricipan s risk premium, as well as differences beween acual and expeced experience which could generae eiher gains or losses. Perhaps one of he simples producs an insurance company can provide is he guaranee of a specified level of ineres for a given number of years. In he U.S. hese conracs are referred o as funding agreemens. In reurn for a cash premium, he policyholder is guaraneed o receive his cash consideraion wih ineres on a cerain dae in he fuure. The policyholder in his insance is a special purpose vehicle which uses he funding agreemen as collaeral in order o 10
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman issue medium erm noes. These programs are ypically referred o as a Funding Agreemen backed Noe Issuance Program ( FANIP ). The yield on he funding agreemen is equal o he yield on he noe plus a spread o cover acquisiion coss and depends on he credi qualiy of he insurance eniy over he period of he conrac, expressed as a spread over he risk free rae, on a fixed or floaing rae basis. The insurer ypically invess he premiums (proceeds from he Funding Agreemen) in fixed income securiies such ha he difference in he spreads from hese securiies and he spreads available from he Funding Agreemen, minus expeced defauls produces an accepable expeced profi margin. To he exen ha he conracual erms of he asses and liabiliies are perfecly mached, defauls do no occur over he conrac period, and credi spreads don change, he use of fair value accouning will resul in he emergence of profis in a manner consisen wih he difference in spreads. The funding agreemen is considered an insurance liabiliy under insurance law bu is no an insurance conrac under U.S. GAAP. Neverheless, we believe ha he approach is a useful one o examine, because of is simpliciy and o help deermine wheher a consisen approach migh be used for he measuremen of he fair value of he liabiliies for boh invesmen and insurance conracs. To furher examine such a consisen approach, is applicaion o a 20 year erm life insurance conrac follows. The following describes he measuremen of he liabiliy for a FANIP. When we refer o FANIP we mean he funding agreemen sold in he manner described above. The insurer agrees o exchange or swap he cash flows on is liabiliy for he cash flows on a maching asse. For simpliciy, he cash flow paymens/benefis are assumed o occur a he end of he period. The premiums are paid a he beginning of he period. A issue, he wo ses of cash flows are equalized according o he equaion: n Pr em = LCF /(1 + S + CS) where = 1 Pr em = single premium for he FANIP n = number of cash flow paymen periods = ime period S = LIBOR spo rae measured as of he valuaion dae for ime period LCF CS = liabiliy cash flow during ime period = credi spread he borrower mus pay in order for he marke o accep he borrower s credi risk relaive o he FANIP 3. This is equal o he sum of expeced defauls of he borrower, plus he risk premium demanded by he marke o ake on he credi risk of he borrower as i relaes o he FANIP. The premium is hen exchanged for a maching asse such ha: 3 See The use of credi spread in deermining liabiliies below for furher discussion. 11
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman n = 1 ACF where: /( 1+ S ACF ED R + ED + R) = n = 1 LCF /(1 + S = asse cash flows during period + CS) = expeced defaul losses for he asse during period = risk premium, he amoun in excess of he expeced defaul rae ha risk averse marke paricipans demand o ake on credi risk over he period of he FANIP and ha sellers are willing o pay o miigae is associaed credi risk. Should marke expecaions be me, he insurance company s earnings during a period would equal he difference in he risk premium and he company s credi spread imes he amoun borrowed: n = x 1 LCF /(1 + S + CS) x( R CS) So for example if a company issued a FANIP for $100 paying LIBOR + % and used he proceeds o purchase a 5 year bond yielding LIBOR + 1.00%, hen earnings would equal $100 x (.01 -.0045) or $0.45 in each year. A oal reurn swap valuaion is a generalized version of he FANIP example. Under a oal reurn swap, he insurance company borrows money by issuing a conrac whose liabiliy can exclude insurance risk as in he FANIP example whose benefi is condiional on he occurrence of he insured even as in erm life insurance. In he more specific case of he FANIP, by paying he premium he purchaser of he oal reurn swap exchanges a curren defined amoun of cash for he righ o receive fuure cash flows. This obligaion o pay he fuure cash flows represens he liabiliy of he eniy providing he FANIP (he swap counerpary). A issue, he value of he asses and he liabiliies are equal. In his example, he asse is iniially cash which is hen exchanged for one or more oher asses. Analogously in a erm life insurance conrac, he economic asse is he righ o receive fuure premiums. The formula for equaing he asses and liabiliies for a erm conrac of n years/paymen periods is: n = 1 Pr n em /(1 + S + ED + R) = EDB /(1 + S + CS) = 1 where: Pr em EDB = = expeced premiums during ime expeced deah benefis during ime All he values in his equaion are eiher known or can be esimaed using eiher acuarial or financial mehods. 12
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman A policyholder is under no conracual obligaion o coninue o pay premiums for he erm insurance conrac. The policyholder has he conracual opion o disconinue premium paymens and o allow he coverage o cease. Failure o pay is he exercise of an opion and no a defaul. Given ha a policyholder canno defaul, he value of ED is 0. The value of R is hen deermined. R can be viewed as being equal o he risk premium a equilibrium (in his case he purchase price of he erm insurance conrac equals he amoun ha a policyholder is willing o pay and wha an insurance company demands in order o accep he ransfer of he insurance risk). Having solved for he risk premium for he erm conrac and assuming he marke does no indicae ha he risk premium should be changed (we discuss he facors can lead o a change in he Evaluaing he risk premium secion below), he fair value liabiliy a ime y is equal o: n n EDB /(1 + S + CS) = y = y Re s = Pr em /(1 + S + R). y Generalizing he model o handle acquisiion coss The sale of mos insurance conracs sold o individuals usually requires significan up-fron coss including commissions, markeing, and underwriing expense. Corresponding coss from he FANIP example consis primarily of sales and brokerage commissions, which are relaively small in comparison. As a resul of hese acquisiion coss, he oal ne amoun of cash or asses reained by he insurance company a he ime of sale of an insurance conrac is significanly less han he oal amoun received. The approach currenly followed for insurance conracs under U.S. GAAP is o capialize acquisiion coss of a variable cos naure in he form of a deferred acquisiion cos asse (DAC). In par his avoids he recogniion of a loss when insurance conracs are wrien a an expeced economic profi over he lifeime of he conracs. Differences of opinion exis as o wheher i is appropriae o recognize he capializaion of such coss, in par due o a concern ha DAC does no saisfy he definiion of an asse. An alernaive approach ha migh address hese concerns is o replace he DAC-ype formulaion (eiher as an asse or a conra-liabiliy) by recognizing as an addiion o he presen value of expeced fuure cash flows under he conrac: he difference beween he presen value of he expeced premiums o be received and he presen value of expeced benefis provided for he iniial deferred cos in he following formulaion. In he case of he FANIP: Pr em AcqCos = where: n = 1 LCF /(1 + S AcqCos = Acquisiion Cos. + CS) For he erm life insurance conracs, a similar adjusmen would be made: 13
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman ( n n Pr em /(1 + S + R) ) AcqCos = = 1 = 1 EDB /(1 + S + CS) I is imporan o noe ha he acquisiion cos in a fair value model is no he same as he acquisiion cos as currenly defined under U.S. GAAP, in which acquisiion coss are defined as he acual variable expenses incurred by he insurance company o acquire he business. This is an eniy-specific value which would be inconsisen wih crieria 5 above. Insurance producs are priced based on eniy-specific expeced acquisiion coss. A company enering ino a conrac eiher direcly wih a consumer or hrough he purchase of a conrac from anoher insurer would expec o pay he equivalen of he acquisiion cos if he company expecs o earn he risk charge i demands. If expecaions are achieved, he conrac yields is expeced pricing reurn if acual acquisiion coss are equal o acquisiion coss expeced in pricing. In a perfecly compeiive marke assumed in a fair value world, marke implied acquisiion coss would be equal o he acquisiion coss assumed in marke prices. In his marke, a company ha has lower acquisiion coss han is compeior will end o reduce is price o maximize is volume a is required reurn. Is prices will hen have a lower marke implied acquisiion cos ye he same risk premium. Theoreically, he firs company's produc can no exis. The fac ha i does exis implies eiher ha he company selling his produc provides some addiional service ha cusomers are willing o pay for or ha he marke isn perfecly compeiive afer all. The addiional service provided may be represened by nohing more hen he addiional cos o he company of providing informaion o he consumer in a marke where reaching consumers is more cosly. This implies ha a company ha can acquire business a a lower acquisiion cos han implied in marke prices will experience a year 1 profi, and a company whose acquisiion coss are greaer hen marke implied will experience a year 1 loss. However marke paricipans would expec year 1 expeced gain/loss of 0. Term life example of he proposed approach The following example illusraes he proposed approach for our 20 year erm life insurance conrac, along wih he assumpions used. A 20 year erm life insurance conrac issued a age 40, wih a level face amoun of $100,000 Level annual premiums = $20 Moraliy = 35% of he 1990 95 Sociey of Acuaries selec and ulimae age neares birhday moraliy able for nonsmoking males 14
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman Commissions and oher deferrable acquisiion coss included in he price (no necessarily acual expenses) = 55% of firs year premium Credi spread of insurance company = % The Appendix shows he deailed assumpions, including lapse raes, moraliy raes and LIBOR spo raes by duraion (he LIBOR spo raes were as of 6/15/04 wih values inerpolaed for years 6, 11-14, and 16-19). The resuling risk premium in his example is %. See he Appendix for more deailed assumpions and relevan calculaions. This represens he risk premium he insurance company earns from is obligaion o pay a deah benefi when a covered moraliy even occurs. This is equivalen o he insurance company invesing he proceeds by borrowing an asse yielding LIBOR + %. Assuming he risk premium is no updaed and here is no change in he issuer s credi sanding, hen he fair value liabiliy a he end of year y would be equal o: 20 Re s = EDB /(1 + S +.0055) Pr em /(1 + S +.0672). y = y 20 = y Assuming fuure spo raes are equal o curren forward spo raes, he liabiliy a he end and ne income in each of he nex 10 years would be (assuming all asses are invesed in 10 year zeros yielding LIBOR + %): Policy year Change in fair value of asses Change in liabiliy Benefi Acquisiion Ne Premium paymens coss Liabiliy Income 1 $ 20 $ 11 $ 172 $ 451 - $ 5 - $ 5 $ 213 2 730 43 209 371 377 17 3 657 7 233 679 30 195 4 594 113 246 950 271 190 5 540 137 265 1,176 226 16 6 492 159 294 1,349 173 14 7 447 17 332 1,461 112 11 411 199 356 1,529 6 16 9 37 22 366 1,569 40 200 10 347 270 377 1,56 16 224 To he exen ha he financial marke and conrac performance unwinds as expeced, he asses and liabiliies remain well mached, and he marke s percepion of risk doesn change, earnings under he proposed approach will no experience significan volailiy. When any of hese facors change, heir effec would be immediaely recognized in income. 4 4 Since in his simplified example asses and liabiliies are no perfecly mached, some earnings volailiy is eviden. 15
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman Evaluaing he risk premium In his erm insurance example, he risk premium was held consan. The realiy of markes is ha risk premiums do no remain consan. In fac, no recognizing a change in he risk premium would be inconsisen wih an imporan concep underlying he measuremen of fair values. For example, recen experience has seen large swings in he value of he risk premium in credi insrumens and in he propery and casualy insurance underwriing cycle. While he risk premium in a life insurance produc is likely o flucuae less han in he case for credi insrumens or propery & casualy insurance (as he risk appeie in mos life insurance markes does no normally change as ofen), he insurer sill has o periodically assess he appropriaeness of is risk premium. Marke facors ha migh indicae a change in risk premiums in a line of business include: The exi of companies or recen new enrans A change in prices in response o a shif in level of compeiion A dramaic swing in he volume of business sold A change in reinsurance capaciy, especially due o he exi and enrance of reinsurers The developmen of alernaive risk ransfer mechanisms Emerging uncerainy regarding he effec on moraliy of an epidemic Significan changes in persisency or oher experience. The risk premium is no necessarily he same across produc ypes. For example, if expeced dividends are refleced, a paricipaing conrac would no require as much risk margin as a nonparicipaing conrac because of he risk buffer ha dividends provide. In any even, i would be appropriae o disclose a change in he risk premium. Generally, given he sabiliy of he life insurance rae-making process and he relaively long imeframes beween changes in premium levels of many life insurance companies, we anicipae ha in many insances he risk premium may prove relaively sable. However, furher research is warraned o validae his asserion. The use of credi sanding in deermining liabiliies An area of significan conenion in he discussion of measuremen of he fair value of liabiliies of financial insiuions has been he reflecion of a company s own credi spread as a resul of changes in is credi sanding. The ofen cied cause for his concern is where deerioraion in he credi oulook for a company resuls in a decrease in he fair value of is liabiliies, resuling in an unwarraned and poenially misleading increase in boh income and capial during he accouning period. Significan debae and emoion has been generaed around he desirabiliy of such a resul. The criics concern wih his resul in a regulaory conex is ha i would creae a poenially misleading assessmen of he eniy s financial condiion. As a resul, i is claimed ha he use of 16
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman such an adjusmen for solvency reporing could be conrary o public policy and hus no recommended for ha purpose. However, i has o be noed ha insurance companies have reflec heir credi spread in valuing heir general deb relaive o he duraion of ha deb. Since he amoun of capial and a company s credi sanding are direcly relaed, he use of credi spread in valuing liabiliies would explicily recognize ha companies ha seek higher raings need o hold a higher level of asses o suppor he same amoun of obligaions. Argumens supporing such an adjusmen could use he FANIP programs as an example, which incorporaes he company s credi raing as i would affecs he measuremen of is liabiliies of such programs, in par o enhance maching is asses and liabiliies. In addiion, his can be viewed as beer capuring he company s financial condiion in a fair value world, as evidenced by he observable effec of a company buying back heir noes a a discoun upon a raings downgrade. Noe ha his analogy is somewha weak in he case of an insurance conrac liabiliy, as i is highly unlikely ha such a company could similarly sell heir obligaions unless forced o by a regulaor. The amoun of economic capial ha a company holds o suppor is credi sanding can provide useful informaion for an invesor who is aemping o beer undersand he poenial for is fuure dividend disribuions. A company whose objecive is o mainain a higher raing will usually have less available o disribue o shareholders since i mus wihhold a higher level of asses o suppor is obligaions. If a business-o-cusomer marke is used as a basis for fair valuaion, he effec of a company s credi raing, ne of expeced regulaory guaranees, is implicily included in he premium level a issue (if credi sanding were no recognized, he liabiliy would have o be increased a ha ime, hus resuling in a loss a issue which would modify he above mehodology). Afer issue, he eniy (consisen wih marke expecaions) would likely change is non-guaraneed elemens o reflec he change in credi sanding. Since he effec of credi raing is hus already implicily refleced in he premiums, charges, and hus risk premiums in a conrac, ignoring he raing would require a gross-up of he liabiliy, ha would be boh difficul o esimae and quie minor if regulaory guaranees are also refleced. Thus he concern wih his issue is no wih is effec a issue, bu raher only o a change in credi sanding afer issue. Bu such a change in credi sanding would likely be caused by changes in he marke value of is asses. By reflecing changes in he amoun of he liabiliy, he liabiliy would hen become beer mached wih he asses, alhough admiedly a iming difference may arise. Consisen wih he implici use of credi sanding in measuring liabiliies and recognizing he role of credi in measuring earnings, an approach o reflec credi sanding would consis of he following: The difference in valuing he expeced benefi sream in he examples above and valuing he benefi sream on a risk neural basis would be beer shown in he balance shee as an allocaion of capial. 17
The Fair Value of Insurance Conracs by Sam Guerman, David Rogers, Larry Rubin, David Scheinerman Changes in liabiliies due o changes in credi sanding migh no be considered as par of operaing earnings, bu raher considered in a manner consisen wih ineres relaed capial gains/losses. Changes in liabiliies due o changes in credi sanding would hen be shown on he balance shee as a re-allocaion beween liabiliies and he capial allocaion. Minimum cash value floor One imporan opion in conracs wih a volunary erminaion opion in many financial insrumens and insurance conracs is he opion o surrender a conrac for is curren book value. While erms for producs wih cancellaion righs can vary significanly, hey all enail a pu opion for a value ha is referred o as he demand deposi value. This has proven o be a conroversial issue for several ypes of financial insiuions. In banks, his is referred o as a core deposi inangible. Proponens of he floor sugges ha i represens he value of he cusomer relaionship ha should no be fair valued as i is an inangible asse. We agree wih bankers who conend ha i is appropriae o reflec his inangible in financial saemens if is value can be reliably measured and ha i is refleced in observable or expeced ransacion or ransfer values. We believe ha no only should his limiaion be eliminaed in he case of business combinaions, bu i should be eliminaed in non-business combinaions as well. IAS 39 sipulaes ha he fair value of he liabiliy of a financial insrumen whose curren accoun balance is available on demand (i.e., a demand deposi) canno be less han he amoun available on demand. I represens he amoun he deposior would receive upon he cancellaion of all righs and obligaions of he conrac, reflecing he de-recogniion of a conrac. However, he demand deposi (he cash value in he case of a life insurance conrac) is rarely he amoun ha a hird pary would require for assuming he liabiliy. Alhough his minimum liabiliy may be appropriae for financial insrumens raded in efficien markes where marke ransacions reflec his floor, we do no believe ha i presens a reasonable economic consrain on economic values when used o measure he liabiliies of insurance conracs. Is use in some cases can lead o an unwarraned loss a conrac issue. The primary argumen in favor of his floor is ha recording a liabiliy less han his amoun recognizes he effec of he cusomer relaionship inangible involved. Excep in he case of a business combinaion such cusomer relaionship inangibles are generally no recognized in financial saemens. In a business combinaion, i would be refleced as an idenifiable cusomer relaionship inangible. The liabiliy, following his argumen, is he curren amoun ha can be demanded. This represens he worse case liabiliy if all policyholders were o ake advanage of he opionaliy available. We do no agree wih his logic, in par due o is lack of recogniion of observable values for hese conracs. The more useful and meaningful and marke-consisen approach for an insurance conrac is hrough recogniion of all expeced conracual cash flows ha can be reliably measured, as no only are all of hese cash flows recognized in he ransacion price of he conrac in a business-o-consumer marke, bu i is also recognized in a business-obusiness marke as he exi price ha a willing buyer would pay. For example, a conrac wih a calculaed liabiliy of 100 and a cash value of 110 may imply ha he cos o replace he conrac is greaer han 110 because of expenses (e.g., commissions and 1