A New Era In Loss Reserving?
By Marc Oberholtzer, Christine Radau, and James Svab
International and U.S. accounting standard setters are hard at work rewriting the rules governing insurance contracts. Extensive changes are possible, such as property/casualty loss reserves being discounted and adjusted to include a margin for uncertainty. Given the resources demanded by short-term concerns, including both the economic environment and regulatory reform, what are insurers doing now and what should they consider doing in the near future?
In 2011 the International Accounting Standards Board (IASB) is likely to adopt a new international financial reporting standard (IFRS) for insurance contracts. If you work for a U.S. insurer, you may think there is no need to read any further. However, insurers currently reporting under U.S. GAAP also should take note of this potential change because the Financial Accounting Standards Board (FASB, the author of U.S. GAAP) has been working with the IASB since 2008 to develop a joint IASB/FASB insurance contracts standard. The most recent key developments include:
- July 2010—IASB exposure draft proposing future accounting for insurance contracts.
- September 2010—FASB discussion paper containing its preliminary views based on the IASB’s proposals, supplemented with additional FASB-specific perspectives.
- December 2010—Joint IASB/FASB roundtables held on comments submitted.
- January 2011 to present—Bimonthly IASB/FASB meetings to debate and vote on key aspects of the proposals.
While they have worked jointly on the project over the past few years, the IASB and the FASB have issued separate proposals. Deliberations continue to address both constituents’ comments and the differences that exist between the two Boards’ proposals, and, at this point, there is still uncertainty on the details and timing of final standards. However, it is clear that, if adopted, the proposals would call for significant changes in the financial reporting for insurance contracts.
For the majority of property/casualty products, the most significant potential change would be to change the reporting of loss reserves from an undiscounted basis to a measurement of claims and expenses developed under a “building block” approach. The loss reserve component would be determined using an estimate of the mean undiscounted amount of future cash flows, a reduction for the time value of money, and addition of a “margin” to reflect uncertainty. The building blocks would be updated at each reporting date during the contracts’ coverage and claim settlement periods.
While both the IASB and FASB models include a “margin,” a significant difference emerged between the two proposals in how it is determined. The IASB specified that the margin be determined in an explicit manner using one of three prescribed methods, so that the greater the uncertainty in the liabilities, the greater the margin. On the other hand, the FASB specified that an implicit margin be determined based on the initial pricing and expected cash flows, with the margin released over the coverage period and the claim settlement period.
During comment periods last fall, many insurers provided feedback to the IASB and FASB on the proposed measurement approach and other key components of the standard, including financial statement presentation, disclosures, and timing. In particular, many U.S.-based property/casualty insurers raised concerns about the challenges and complexity of moving to a broader measurement model that incorporates discounting and margins, among other things.
While uncertainty remains on both the content and timing of a new insurance contract standard for U.S. GAAP, it is worthwhile to consider the impact of the proposed changes to the reporting of loss reserves. In particular, the discounting of property/casualty loss reserves would add a new dimension to the reserving process. Payment patterns and yield curves would need to be maintained and updated each reporting period with current information, and changes in each would need to be disclosed within the financials. Even more challenging would be calculating explicit margins for uncertainty. If the IASB version of the proposal is adopted requiring an explicit risk adjustment, this would require the development and maintenance of new complex actuarial models for many companies, designed to be updated regularly with current information.
It will take significant effort to implement the debated proposals, and now is a good time for actuaries, together with their colleagues in accounting, human resources, risk management, and IT, to begin discussing how to prepare for change. As a first step, we suggest insurers consider the following:
- Insurers should closely follow the standard-setting process and assess the adequacy of their current resources to implement and sustain the proposed changes. The demands on the actuarial function may increase significantly, especially if discounting and explicit risk margins are required. Because of the expanded volume of data that actuaries would need to process, as well as the extensive modeling that would be necessary, some companies have expressed concern that the added workload may place a strain on their ability to adhere to their close process and reporting timetable.
- Some companies are taking a strategic approach to getting ready by evaluating pre-existing project plans in order to determine whether or not they should modify their scope and timing in light of IASB and FASB developments. It may be advisable to break large systems and process change projects into smaller components and address only those that are unlikely to be impacted by the new standard to avoid any unnecessary duplication of effort or rework. Some companies are finding reasons to address deferred maintenance issues in data management, modeling, analysis and other areas.
- For those insurance companies that have implemented enterprise risk management (ERM) programs or use economic capital modeling (ECM), the proposals may provide an opportunity to further integrate these activities with the financial reporting process. Many of the same concepts in the proposed standards overlap with those being addressed in ongoing Solvency II initiatives for parent companies of U.S.-based IFRS preparers. Accordingly, companies that have implemented ERM or ECM programs, and those that are currently supporting Solvency II initiatives, should consider the potential requirements under the current proposals, particularly relating to explicit risk adjustments, and seek opportunities to leverage synergies.
Looking even further into the future, the new accounting model under either of the proposals likely would result in greater earnings volatility and different profit emergence than today. This could have broad implications for product design, pricing, and investor relations as well as reinsurance strategies.
A new international financial reporting standard for insurance contracts has been evolving for many years and is expected to become a reality soon. The U.S. is considering a revised standard as well. With loss reserves comprising the largest part of an insurer’s balance sheet, actuaries should be aware of and ready for the potential changes to the measurement model that could result from the new standard. Now is the time to consider staffing levels, systems capabilities, data availability, and models needed for estimating liabilities under a building block approach. Actuaries should be prepared to play a large role in the transformation that could come under the measurement approach for insurance contracts proposed by the IASB and the FASB.
Marc Oberholtzer, FCAS, MAAA, is a principal with PwC in Philadelphia. Christine Radau, FCAS, MAAA, is a director for PwC in the Hartford, CT, office. James Svab, CPA, is an accounting advisory partner for PwC in Chicago.