US GAAP Update What s New SEAC Fall Meeting Noel Harewood November 15, 2007 2007 Towers Perrin
US GAAP for insurers is changing. GAAP Classic Income statement focus Comparability and consistency valued highly New GAAP Balance sheet focus Comparability and consistency decline in significance 2007 Towers Perrin 2
So what s new? SOP 05-1 Internal Replacements SFAS 157 Fair Value Measurement SFAS 159 Fair Value Option 2007 Towers Perrin 3
SOP 05-1 Addresses accounting for internal replacements Internal replacements defined as modification in product benefits, features, rights or coverages If contract modifications affect integrated features and the contract is substantially changed existing DAC is written off new DAC is set up for the replacement policy If contract is substantially unchanged, then existing DAC is continued 2007 Towers Perrin 4
What is an integrated feature? Benefit that can ONLY be determined in conjunction with the base policy E.g., GMxB Non-integrated features do not affect the base contract directly E.g., term rider on annuities Non-integrated features do not affect the accounting for the base contract 2007 Towers Perrin 5
Criteria for substantial change A policy is substantially unchanged if ALL of the following apply No change in insured risk, event or coverage period No change in the nature of the investment rights No additional premium required (unless specified at contract inception) No net reduction in account value No change in participation features No change in accounting classification 2007 Towers Perrin 6
SOP 05-1 TPA clarifications AICPA released TPAs to assist in interpretation of SOP Main clarification is narrow interpretation of substantially unchanged for group contracts Net result is that many large group writers were forced to reduce DAC Some issue with GLBs on VA Addition of new GLB will typically result in a substantially changed contract Some uncertainty as to whether changing a GLB (e.g., from GMAB to GMWB) is a substantial change 2007 Towers Perrin 7
SFAS 157 - FASB Definition of Fair Value In September 2006, FASB issued SFAS 157 Fair Value Measurements Defined fair value as exit value Established a framework for calculating fair values for GAAP For liabilities, fair value defined as: Price to transfer a liability in an orderly transaction between market participants at the measurement date In other words current exit value 2007 Towers Perrin 8
FASB Definition of Fair Value Orderly transaction presumes the transaction is exposed to the market for an appropriate period to allow for reasonable valuation (i.e., not a fire sale ) Market participants are defined as: Independent Knowledgeable Willing and able to transact Active in the principal market The market with the greatest volume and level of activity for the liability If no principal market, then the most advantageous market to the seller is used 2007 Towers Perrin 9
Fair Value and Convergence IFRS Phase 2 on insurance accounting requires fair value Largely similar to SFAS 157 (current exit value) Solvency II (European capital standard) also based on similar concepts Norwalk Agreement and others indicate convergence in accounting between North America and Europe is coming SEC pressure to speed up conversion Fair values likely here to stay 2007 Towers Perrin 10
Valuation Techniques SFAS 157 describes three applicable valuation techniques for calculating fair values Market approach Uses market prices and other relevant market information Income approach Uses discounted cash flows Cost approach Uses current replacement cost Currently, expectation is that insurance liabilities will be valued using Income approach 2007 Towers Perrin 11
Applying the Income Approach Projected cash flows Time value of money IFRS Phase 2 Building Blocks Allowance for risk 2007 Towers Perrin 12
Projected cash flows Underlying assumptions Should be consistent with market Should consider all available information Possible to use information outside standard actuarial sources Best estimate? Prudence in assumptions? Practical considerations indicate continued use of company experience studies for mortality, persistency Expense assumptions an important consideration 2007 Towers Perrin 13
Time value of money Reflecting the time value of money central to fair value concept FASB defines US risk-free rate as based on treasury rates Note that this is not prescribed for other currencies Some areas (e.g., Europe) show preference for swap curve 2007 Towers Perrin 14
Allowance for risk Under traditional methods (e.g., actuarial appraisals), risk is reflected through an addition to the discount rate Addition may be based on application of CAPM Financial theory suggests that this approach may be overly simplistic Under financial economics, cash flows adjusted for correlation with market Risk-adjusted cash flows then discounted at riskfree rates Overall intent is to reflect market compensation for bearing risk Theory may suggest that only undiversifiable risk requires compensation 2007 Towers Perrin 15
Alternative Approaches Direct Method Calculate fair value directly by discounting policyholder cash flows Indirect Method Calculate fair value of shareholder cash flows (embedded value) Fair value of liabilities is difference between fair value of assets and embedded value IFRS appears to favor Direct Method explicitly Girard (2000) and others have shown equivalence of these two approaches 2007 Towers Perrin 16
Some technical issues to consider Risk margins Allowance for nonperformance Treatment of options and guarantees 2007 Towers Perrin 17
Risk margins As noted, allowance for risk at market levels is required One method for allowing for nonfinancial risk is the cost of capital method Proposed by the IAA Calculate units of risk via required capital measure Required capital measure may be regulatory or economic Calculate margin per unit Based on required market return on capital Difficult to calibrate in real life IAA examples use 4% and 6% 2007 Towers Perrin 18
Allowance for nonperformance risk Nonperformance risk widely held to mean own-credit risk Requirement is to reflect own-credit risk in liability Evaluation of credit risk for company s specific rating class Evaluation of credit risk within class Will lead to a lower liability Alternative view is that insurance liabilities are overcollateralized Implies a higher rating than general debt 2007 Towers Perrin 19
Treatment of options and guarantees Requires consideration of embedded options and guarantees beyond SFAS 133 Previously exempt components now within scope (e.g., GMDB, interest rate guarantees) Current expectation is that all options and guarantees will be valued on a risk-neutral (market-consistent) basis Will likely require stochastic techniques 2007 Towers Perrin 20
What does it mean for reporting entities? Required determinations Unit of account (most likely block) Principal market M&A vs Reinsurance vs Capital Markets Valuation technique Direct vs. Indirect Level of inputs (for disclosures) Insurance inputs almost certainly Level 3 2007 Towers Perrin 21
SFAS 159 Fair Value Option Permits entities to choose to measure most financial instruments at fair value Optional only, no requirement to change accounting Establishes disclosure requirements for reporting these fair values in financial statements 2007 Towers Perrin 22
SFAS 159 applies to most financial assets and liabilities Statement defines financial liability as a contract that imposes an obligation to deliver cash Appendix A clearly indicates that insurance and reinsurance contracts are included Exemptions include: Deposit liabilities withdrawable on demand May include certain Group Annuity business accounted for under FAS 91 FAS 87 and FAS 106 employer obligations 2007 Towers Perrin 23
There is a fair amount of flexibility Election is made on a contract-by-contract basis Election will be made on acquisition Election is irrevocable (except for remeasurement events, e.g. purchase) One-time opportunity at effective date to revalue inforce business 2007 Towers Perrin 24
but significant disclosures are required Reasons for electing the fair value option Fair value component of each balance sheet line Gains and losses in income statement due to changes in fair value Valuation techniques, methods and significant assumptions used to estimate fair values The level within the heirarchy which the fair values fall E.g., if most significant inputs are level 3, the fair value is classified as a Level 3 value Reconciliation of beginning and ending balances for level 3 fair values 2007 Towers Perrin 25
Pricing Considerations What GAAP measures are in use? GAAP profit margin GAAP ROE both single measure and emergence PV of GAAP profits Often used as a supplement to statutory pricing 2007 Towers Perrin 26
Pricing Considerations How will these measures look in a Fair Value context? Gain/loss at issue Viability of ROE Analysis of movement in equity will become more meaningful Similar to embedded value analysis, with focus on VNB-type figure 2007 Towers Perrin 27