Request for Proposals: Putting Mark to Market on a Going Concern Basis
July 30, 2009
- Casualty Actuarial Society (CAS)
The CAS was organized in 1914 as a professional society for the promotion of actuarial and statistical science as applied to insurance other than life insurance, such as automobile, liability other than automobile, workers compensation, fire, homeowners, commercial multiple peril, and others. Such promotion is accomplished by communication with those affected by insurance, presentation and discussion of papers, attendance at seminars and workshops, collection of a library, research and other means. The membership of the CAS includes over 4,600 actuaries employed by insurance companies, industry advisory organizations, national brokers, accounting firms, educational institutions, state insurance departments, the federal government and independent consultants.
- Committee on Theory of Risk (COTOR)
The Committee on Theory of Risk is charged to propose, encourage, and monitor research and other projects concerning the actuarial and financial evaluation of risk in insurance contracts and operations in support of the CAS Centennial goals.
- CAS Interest in the Subject, Conceptual Background
Many Casualty actuaries are involved with reserving and other valuation functions. Actuaries working in Enterprise Risk Management (ERM) are also concerned with the asset book of the risk enterprise. Both are frequently called on to opine on the adequacy of surplus, both on statutory (SAP) and GAAP bases. Whether dealing with assets or liabilities, the actuary works by estimating cash flows over multiple future periods and then aggregating these cash flows in some meaningful fashion.
These aggregation methods are the province not of actuaries, but of accountants. For this research project, we are interested not in statutory, but in GAAP valuation rules as promulgated by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). This area began with the fair value initiative undertaken in the closing decade of the last century and is currently in ferment, as proposed rules and dates for implementation have changed over time.
Under the fair value paradigm, assets and liabilities representing instruments trading in an active and liquid market must be valued at the current market asset price. Thus assets are valued as if for immediate sale and liabilities are discounted for the enterprise’s own credit standing. A consequence of the liability valuation rule is that a credit downgrade leads to an income surge and an equity boost. Less familiar, but newly prominent in the context of toxic assets and market failures, is the consequence that illiquid assets must be marked to value in thin, erratic markets.
Valuation of assets for immediate sale and of liabilities for distressed settlement is characteristic of liquidation accounting. According to both FASB and the IASB, GAAP and IFRS (International Financial Reporting Standards) apply not to firms in liquidation but to going concerns. Thus it appears that Fair value/mark-to-market is liquidation accounting imposed on going concerns.
Insofar as they report under GAAP/IFRS, it appears that actuaries are called upon to present results in the absence of a clear theory of going concern valuation, compromising professional standards and exposing actuaries to ruinous litigation. The CAS has an interest in conducting research that will provide guidance to financial actuaries whether they report under SAP or GAAP/IFRS or both.
We believe that mark-to-market accounting must be addressed not piecemeal, but in a thorough, balanced fashion. For instance there are efforts currently underway, under IASB auspices, to define fair value for insurance liabilities. The balance is currently tipping toward use of fulfillment value, undiscounted for own credit standing. This makes perfect sense; but doing so without correcting accounting for debt would place insurance companies, which rely minimally on debt financing, in competition in the capital markets with companies that rely on it heavily and thus would be allowed to discount the bulk of their liabilities. This inequity has already caused prominent insurance companies to shift emphasis from doing business to managing results, with disastrous consequences. Likewise, addressing asset issues without also addressing liabilities would inflate equity estimates and make it easier for distressed firms to hide their true financial situation from stakeholders.
- Preliminary Sources
We cite here a few sources which expand on the topics described above. The designated research team will be expected to compile a comprehensive research bibliography.
The liability valuation issue is treated in Heckman, NAAJ, January 2004, where the argument is made for risk-free valuation of liabilities.. The same approach to liability valuation is extended in Chasteen and Ransom, Accounting Horizons, July 2007, to an ingenious method of accounting for cash flows. They propose recording the risk-free value of the obligation as the liability rather than recording the consideration for taking on the liability. However, the credit penalty (risk-free value less consideration) does not pass through income, penalizing earnings; rather it is charged directly against equity. This recognizes that the default option is an asset of the owners and not of the enterprise itself.
Furthermore, if the enterprise goes to the open market to repurchase its own debt, any gains due to credit standing will flow back to equity without affecting income.
There is also a considerable relevant literature in finance. Part of it consists in a series of articles by Robert Shiller and others attempting to explain why market prices for publicly traded firms are far more volatile than the ultimate shareholder dividends paid by those firms. Many relevant articles are reprinted in or referred to in Shiller's book Market Volatility. Another considerable literature, on "noise trading,” was inspired by Fischer Black's 1985 article, in the Journal of Finance, on Noise. In this case, the major focus was on the difference between traders with knowledge of fundamental value or data and those whose trades are based on more ephemeral information concerning market trends and other potentially misleading data. "Noise trading can lead to a potentially large divergence between the fundamental value of an asset (its "true" value) and its market value, which may reflect the actions of many "noise traders."
Further background on the CAS approach to this and similar problems is to be found on the CAS website in the CAS White Paper on Fair Valuation of Liabilities and in the archives of the Risk Premium Project.
- Research Goals
It is understood that the research team will approach each topic by first amassing a research bibliography, which they will search for a resolution of the problem that they deem satisfactory. If such is found, they will present and explicate it in a form suitable for an audience of casualty actuaries. Otherwise original research is in order.
- Filtering Trading Noise
In its pure form, marking to market means using the price from the most recent trade as the reported value of an asset. Such a value is of questionable utility because it is corrupted with trading noise. A firm in liquidation has little choice but to use such a value. But a going concern has little interest in posting a value that may jump tomorrow and drop the next day. This problem is aggravated by the fact that trading noise is in a positive feedback loop that amplifies and prolongs excursions from underlying values reflecting the productivity of the asset. The research goal here is to find a suitable method for filtering trading noise in market asset values to obtain values more suitable for financial reporting.
The pure application of fair value/mark to market requires using spot asset prices to value both assets and liabilities. One way to pose the difference between fair value/mark to market accounting and the desired going concern accounting is in terms of financial options. As we have noted a firm in liquidation must use spot market prices to value its assets. A going concern has the option to defer redemption of its assets in a planned and orderly fashion or even to wait for the contractual cash flows to be realized. We suggest that the value of this option makes up the difference between the liquidation value (“fair” value, spot price) and the going concern value. Likewise a firm which holds itself out as a going concern does not have the option to default on its liabilities and still remain a going concern. Thus, we believe the appropriate going concern valuation of a liability consists in finding the credit penalty (pro-rata default option, cost of surety, or what-have-you) and adding it back to the spot asset price of the liability.
- Valuing the Liquidity Option
The research team will investigate means of putting a value on the liquidity option in order to achieve going-concern asset valuations. We expect that they will study assets both in normal and in troubled markets with emphasis on those typically held by insurers. We further expect that the futures markets will be a part of this study, both as a means of valuing the effect of redemption deferral and as a means of carrying out the noise filtering discussed under Goal A.
- Valuing the Default Option
The research team will study means of valuing the cost of surety – or default option – for various types of liabilities. It is expected that the surety market for bond issues may provide empirical guidance. Property/casualty reinsurance prices may also be useful though they are corrupted to some extent by the underwriting cycle. We shall expect a finding as to whether and for which types of liability a reliable value can be found for the default option and recommendations for preferred methods of doing so.
- Quantifying Linkages
Intuitively, other things being equal, a decrease in the liquidity option will be associated with an increase in the cost of surety. Thus the gap between assets and liabilities which defines net worth can close more rapidly than one expects from looking at fair value/mark-to-market numbers.
The research team will study how the two options covary and will express this linkage in quantitative terms for typical asset/liability profiles.
- Filtering Trading Noise
- Proposal Requirements
Proposals should include a clear outline of the work that will be performed and the time frame in which it will be performed (including key dates). The more specific the better.
This proposal should be reviewed in conjunction with the attached Research Agreement which defines the terms and conditions under which the work is performed.
The proposal should be accompanied by the resumes of the researcher(s), indicating how their background, education, and experience bear on their qualifications to undertake the research. Respondents should demonstrate their interest in and familiarity with the application of [research topic] by including a resume (if a firm, of the principal consultant(s) performing or directing the work) showing relevant work/research experience and professional accomplishments (e.g.. papers published).
The preferred composition of the research team is interdisciplinary. Accounting, finance, and the major actuarial disciplines should all be represented. It is further preferred that the research findings represent a consensus of the project team. Any divergence of opinion among the members should be disclosed and elucidated.
The contract will be awarded by the CAS to the respondent who, in the judgment of COTOR and entirely on the basis of his or her written proposal, is best able to perform the work as specified herein. If COTOR determines that no proposal meets the requirements of the RFP, then no contract will be awarded.
Receipt of proposals will be acknowledged. respondent with a list of all. Respondents not awarded the contract will be so informed shortly thereafter.
Interested researchers should submit their proposals and any questions in writing to:
- Richard A. Derrig, COTOR Vice-Chair Casualty Actuarial Society
4350 N. Fairfax Dr. Suite 250
Arlington, VA 22203
Phone: (703) 276-3100
Fax: (703) 276-3108
- Chairperson: Steve Mildenhall
Vice Chairperson: Richard A. Derrig
The proposals will be reviewed by members of a subcommittee whose membership is yet to be determined.
- Richard A. Derrig, COTOR Vice-Chair Casualty Actuarial Society
- Research Funding
Funding for this research is principally through the CAS but may include other research funding organizations. The amount of funds available for this project has not been determined at this time. The final scope of the project will be decided by the committee based on the research costs for various items and the expected results of the project.
- August 1, 2009 Publication of RFP.
August 17, 2009 Deadline for questions (must be written) from researchers regarding the RFP.
August 29, 2009 All written questions together with their answers will be distributed to all proposers.
September 12, 2009 Proposal deadline - end of business day
September 28, 2009 Proposal selection by COTOR
December 7, 2009 Draft Report due.
January 8, 2010 Final Report Due.
- August 1, 2009 Publication of RFP.
- Presentation, Ownership and Publication of Report
If asked, the researcher(s) agree to be available to present the report at a CAS meeting or seminar. The findings should be published in a refereed journal. If travel is required, reasonable expenses will be paid in addition to the compensation provided in Section 8. The researchers may also be expected to present results in a research monograph and at meetings of accounting standard-setting organizations; these activities should be priced out separately.
As a condition of selection, the CAS requires that all right, title, and interest, including copyright and patent, in and to the report be owned by the CAS. The selected researcher must sign a formal Agreement (attached) that assigns all such rights to the CAS. Of course, in any publication of the report, the researcher will receive appropriate credit. The CAS may publish the report in any CAS publication, including electronic versions such as on its Web site or on compact discs.
- Research Agreement
A standard research agreement will be provided to the researcher(s).