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NOTE: NO OLD EXAM QUESTIONS HAVE BEEN ASKED ON THIS PAPER
Accounting Practices and Procedures Manual - Preamble
Question: Define “Accounting”
Answer:
“Accounting” is the process of accumulating and reporting financial information about an economic unit. Users
of accounting information include:
- management
- investors
- potential investors
- lenders
- investment analysts
- regulators
- customers
Accounting Practices and Procedures Manual - Preamble
Question: Explain the concept of “Conservatism” as it relates to financial reporting by insurance enterprises
Answer:
Financial reporting for insurers requires substantial judgment and estimates. If there is adverse variation from
the initial estimates, the ability to meet policyholder obligations is reduced. It is therefore important to be
conservative when developing estimates, in order to provide a margin of protection against adverse
development. In addition, valuation procedures should aim to prevent sharp fluctuations in surplus.
Accounting Practices and Procedures Manual - Preamble
Question: Explain the concept of “Consistency” as it relates to reporting financial information to determine
an insurer’s financial condition and the development and application of statutory accounting principles
Answer:
It is important to be consistent in reporting so regulators can get an accurate picture of the financial condition
of the firm. However, the environment is always changing, and in addition, accounting issues are emerging. In
some cases, it may be necessary to recognize these changes (by making changes to the accounting principles
used in reporting), in order to provide a more accurate representation.
Accounting
Accounting Practices and Procedures Manual - Preamble
Question: Define a “material” item
Answer:
A “material” item is one that is large enough that the users of the information will be influenced by it. Whether
an item is material or not depends on the nature of the item.
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Accounting Practices and Procedures Manual - Preamble
Question: Give examples where the nature of an item determines whether it is material or not.
Answer:
1. if an accounting adjustment puts the insurer in danger of being in breach of a regulatory requirement, it
should receive a lower materiality threshold than if the position were stronger.
2. a miscategorization of assets or liabilities that would not be material in amount to the basic financial
statements, but would cause the insurer to trigger an event under the RBC requirements, may be material
3. Amounts which are too small to warrant disclosure under normal circumstances may be considered material
if they arise from abnormal events
4. A lower amount of deviation will be considered material, as the attainable degree of precision increases.
For example, accounts payable usually can be estimated more accurately than can be contingent liabilities
arising from litigation, and a deviation considered to be material in the 1st case may be quite trivial in the 2nd
case.
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Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of Deferred Acquisition Cost (DAC) between Statutory and GAAP
accounting
How is DAC calculated? What is another name for DAC?
Answer:
DAC is an asset that is established under GAAP to defer the recognition of acquisition expenses to match the
recognition of earned premium.
Statutory does not recognize DAC and all acquisition expenses are recognized as they are incurred
Aka Prepaid Expenses andDeferred Policy Acquisition Cost (DPAC)
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of Non-Admitted Assets between Statutory and GAAP
accounting
Answer:
To reflect that certain assets are not readily liquid, they are considered non -admitted for purposes of
determining the company’s statutory surplus (Sap)
e.g - Furniture, fixturnes and Equipment
GAAP accounting does not have non-admitted assets . Certain items may be written off, such as balances over
90 days due if deemed uncollectible.
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Define and describe differences in treatment of Deferred Tax Asset (DTA) between Statutory and
GAAP accounting
Answer:
When an existing liability will eventually create a greater income tax deduction than currently reflected to-date
in tax returns, the resulting future tax benefit is called a “deferred tax asset”.
DTA arises from temporary differences btw insurers income from its income statement and taxable income.
Example: dicounted reserves under tax laws
GAAP recognizes full DTA balance, but it can be lowered by a valuation allowance if, according to subjective
judgement based on evidence, it is more likely than not that the DTA will not be realized.
Under SAP there is a strict admissibility test for all DTAs in addition to a valuation allowance. This can lead to
less DTAs in SAP basis financial statements.
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Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of Bonds and redeemable preferred stocks between Statutory
and GAAP accounting.
Answer:
GAAP:
- If held for trading (intent of selling within hours or days of purchase), value at fair value, with changes in fair
value recognized in income statement (as earnings)
- If held as "available for sale" (has readily determinable fair values and company has the intent to sell before
maturity, but to hold for at least a year), value at fair value, with changes in fair value recorded as other
comprehensive income (change in unrealized cap gains/losses?), resulting in a direct change to the value of
surplus (and assets), and not a change to the income statement.
- If the intention is to be held to maturity, value at Amortized cost
Statutory:
- Investment Grade Bonds and higher rated redeemable preferred stocks - must be held at amortized cost.
- Non-investment grade bonds and lower rated redeemable preferred stocks - must be held at lower of
amortized cost and fair value.
Changes in carrying value attributed to changes in fair value are recorded as direct changes to surplus.
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of common stocks and non-redeemable preferred stocks
between Statutory and GAAP accounting
Answer:
Statutory – all common and non-redeemable preferred stocks recorded at the fair value
Changes in carrying value attributed to changes in fair value are recorded as direct changes to surplus.
GAAP:
- If held for trading (intent of selling within hours or days of purchase), value at fair value, with changes in fair
value recognized in income statement (as earnings)
- If held as "available for sale" (has readily determinable fair values and company has the intent to sell before
maturity, but to hold for at least a year), value at fair value, with changes in fair value recorded as other
comprehensive income (change in unrealized cap gains/losses?), resulting in a direct change to the value of
surplus, and not a change to the income statement.
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in balance sheet presentation of Reinsurance between Statutory and GAAP
accounting for Prospective reinsurance
Answer:
Statutory:
1. loss reserves are shown net of reinsurance recoverables and so is UEPR
2. Recognizes a Provision for Reinsurance
NOTE: Reinsurance recoverables on paid L&LAE is shown as an asset.
GAAP:
1. Liabilities are shown as gross of anticipated ceded reinsurance recoverables
2. anticipated ceded reinsurance recoverables (on loss rsvs, UEPR and paid Recovs) are shown as assets
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3. GAAP does not recognize a Provision for Reinsurance
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Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of retroactive reinsurance ceded reserves between Statutory
and GAAP accounting
Answer:
Statutory: for undiscounted recoveries from reinsurer, allows recognition of a negative write in (contra)
liability and not as ceded loss reserves, that produces a surplus benefit that is recorded as "special surplus
funds". Any gain to the ceding company (excess of the negative write-in liability over the consideration paid
for the reinsurance) is treated as write-in gain in other income and restricted as special surplus until the actual
paid reinsurance recovery is in excess of the consideration paid.
GAAP: U.S. GAAP requires ceded reserves to be recorded as a reinsurance asset. Any gain is deferred, thereby
resulting in no immediate income or surplus benefit. The deferred gain is amortized
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of Structured Settlements between Statutory and GAAP
accounting
Answer:
Statutory: Annuity purchase price is recorded as a paid loss (reserve goes to 0) by liab insurer and the claim is
closed if claimant signs a release and obligation of insurer to claimant has ceased. If insurer remains
contingently liable to claimant, the accounting is the same, but the contingent liability is disclosed in the Notes
to the Financial Statements.
GAAP: same as Statory if the claimant signs a release and thus, obligation of insurer to the claimant has
ceased.
If insurer remains contingently liable to claimant (to cover the case when the annuity company becomes
insolvent), GAAP accounting treats annuity like reinsurance. Insurer sets up a loss reserve = annuity value and
records an offseting reinsurance recoverable for the same amount.
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Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of Acquisition Accounting between Statutory and GAAP
accounting
Answer:
Statutory:
Under SAP, business combinations that create parent-subsidiary relationships are accounted for as a statutory
purchase. Under statutory purchase accounting, the assets and liabilities of the acquired entity are recorded at
their historical SAP carrying values. The difference btw purchase price and book value (assets-liabs or statutory
surplus) of the acquired entity, is called goodwill. Goodwill is limited in the aggregate to 10% of the acquiring
entity’s capital and surplus (adjusted to exclude any goodwill, electronic data processing equipment and
operating system software, and net DTAs) for its most recently filed Annual Statement. Goodwill is amortized
to unrealized capital gains and losses over the period in which the acquiring entity benefits economically, not
to exceed 10 years.
Alternatively, transactions are accounted for as a statutory merger if equity of one entity is issued in exchange
for equity of the second entity, with the equity in the second entity then canceled. Prospectively, only one
entity exists.
GAAP:
Under U.S. GAAP, all business combinations are accounted for using purchase accounting, which requires all
assets and liabilities of the acquired entity to be recorded at fair value (including all identifiable intangible
assets). Goodwill represents the difference between the purchase price and the fair value of the net assets
(Assets – Liabs) of the acquired entity. Goodwill is not amortized but is evaluated for possible impairment on a
regular basis.
Statutory:
- assets and liabs or purchased company are valued using stat acct rules
- Goodwill = purchase price - statutory surplus (Assets – Liabs, aka book value)
- Goodwill amortized over a maximum of 10 years
GAAP:
- newly purchased assets and liabs are valued at fair value
- Goodwill = purchase price - (fair value of assets - fair value of liabs)
- Goodwill is not amortized, but instead frozen and can change when company does annual impairment
testing.
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Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of discounting of Loss Reserves between Statutory and GAAP
accounting
Answer:
Statutory: Where discounting is allowed, tabular discounting standards don’t specify a discount rate, but
typically 3.5%/year is used. For non-tabular reserve discounts, the discount rate should be determined in
accordance with Actuarial Standard of Practice 20, but capped at the lesser of:
1. The company’s net rate of return on statutory invested assets minus 1.5%
2. The current yield to maturity on a U.S. Treasury debt instrument with a duration that is consistent to the
payment of the claims (often 5 years)
GAAP: it is permissible to apply the same discount calculated under SAP for GAAP purposes. In addition, an
alternative discount rate could be used as long as the alternative rate “is reasonable on thefacts and
circumstances applicable to the registrant at the time the claims are settled.”
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: Describe differences in treatment of Salvage and Subro between Statutory and GAAP accounting
Answer:
SAP:
Schedule P reserves are stated gross OR net of anticipated salvage and subro. If “Net”, then column 23 in
Schedule P discloses the amount of anticipated salvage and subro.
GAAP (Net):
Estimated realizable salvage and subrogation is subtracted from the unpaid loss estimates.
IASA 14 (GAAP)/Blanchard - Basic Insurance Accounting - Selected Topics
Question: Describe the main differences between GAAP and Statutory accounting
Answer:
Statutory acct:
1. Focuses on balance sheet/surplus adequacy
2. Is designed to measure company's ability to meet obligations to policyholders and claimants
3. Is less focused on earnings in a given year
4. Mainly used by regulators in their supervisory responsibilities.
GAAP acct:
1. Focuses on income statement/earnings, based on accrual accounting.
2. Is designed to provide info about the economic resources of a firm
3. Needs to meet varying needs of different users of finl statements
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Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: What are the two most commonly referred to tables in the annual 10-K of an insurer?
Answer:
1. Changes in aggregate reserves
2. The reserve runoff table.
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: What is the “Changes in Aggregate Reserves table” used for?
Answer:
Shows change in reserve estimate over the course of the calendar year for each of the last 3 years, gross and
net of reinsurance recoverables on unpaid losses.
Odomirock, Ch.22, U.S. GAAP, Including Additional SEC Reporting
Question: What is the “Reserve Runoff table” used for?
Answer:
By reviewing the total reserve development, either nominally or as a percentage of the starting reserve, users
of the financial statement can evaluate management’s past judgment in setting reserves.
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Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: Under Purchase GAAP (P-GAAP), what is the purchaser of an entity required to state and why is
that relevant to actuaries?
Answer:
The purchaser is required to state at fair value the assets and liabilities of the purchased entity.
If fair value of assets – fair value of liabilities (aka implied capital) is < purchase price, then the difference is
defined as goodwill and a goodwill asset is established. If implied capital > purchase price, then difference is
recognized as an operating gain into income. Actuaries may be asked to estimate the fair value of loss and LAE
reserves and to estimate the value of business acquired (VOBA).
Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: How is fair value defined in the GAAP Accounting Standards Codification (ASC) and how is fair
value of insurance liabilites determined?
Answer:
The price at which an orderly transaction to sell the asset or to transfer the liability would take place between
market participants at the measurement date under current market conditions.
Since there is not a deep and liquid market for insurance liabs, then a “mark to model” approach is used in
which liabilities are estimated.
* Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: What are the main components of the fair value of insurance liabilities?
Note: Compare this to IFRS and Solvency II
Answer:
1. The expected value of the nominal future cash flows related to liabilities incurred, for loss and LAE, as of the
date of the transaction.
2. The reduction in those cash flows for the time value of money at a risk-free rate plus an element for the
illiquid nature of the liabilities. This discount rate is meant to reflect the characteristics of the underlying
liabilities.
3. A risk adjustment to compensate an investor for bearing the risk associated with the liabilities. This is meant
to reflect the expected net present value of profit that an investor would demand in return for the risk
inherent within the liabilities
Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: What are the the two main methods of determining expected nominal cash flows?
Answer:
By Line of business:
1. Use the payout pattern based on the loss reserve development that the actuary would have selected in the
course of his or her review of the reasonableness of management’s recorded reserve.
2. Utilize the implied pattern based on the ratios of paid loss to ultimate loss by accident year.
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* Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: Define and describe how the discount rate for the time value of money is determined.
Answer:
Definition: This is effectively the risk-free rate plus an element for the illiquidity of the liability, typically less
than 100 basis points. This does NOT include an adjustment for the underlying risk in the outcomes for the
purchasing entity.
The liquidity premium arises from the fact that there is a greater opportunity for the purchaser to utilize the
asset transferred to support the liability for their own gain until the liability comes due. Thus, for the seller of
a liability, there is a higher opportunity cost, which means a higher discount rate.
* Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: Describe the main approach to calculating the risk adjustment used in determining the fair value of
the loss reserves.
Answer:
The cost of capital approach is simply the present value of the future returns on capital that an investor would
require for bearing the risk in the expected cash flows. This represents a market-based valuation.
Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: List and describe factors that would effect the estimate of the reserves and how they would effect
the reserve estimate.
Answer:
1. Length of payout pattern: length of tail of LOB affects the length of the payout pattern. The Time Value of
Money discount increases as the length increases and vice versa. The cost of capital increases and thus, the
risk adjustment increases.
In addition, the shorter payout pattern affects how long capital needs to be held. The less time the capital is
held, the lower the future capital charges that can accumulate. Thus, the required capital ratio is smaller and
the cost of capital is smaller and the risk adjustment is smaller.
2. Interest rates on treasuries:
The Time Value of Money discount increases as U.S. treasury rates increase and vice versa.
3. Degree of reserve variability by LOB: lower degree of reserve variability associated with LOB leads to a
lower required capital ratio and the cost of capital is smaller and the risk adjustment is smaller.
4. Discount rate on risk margin: The low discount rates effectively increase the risk margin as the present
value of the future returns on capital is higher. U.S. treasury rates (risk-free rate) are a component of the
discount rate (see 2 above).
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Odomirock, Ch.23, Fair Value Under Purchase GAAP
Question: List other methods of determining the risk adjustment besides the cost of capital and a weakness
of these methods.
Answer:
1. 75th percentile of the discounted distribution of outcomes
2. Risk adjustment is judgmentally selected as a % of reserves limited to a max of 20%
3. Tail Value at risk (T-VaR)
Weakness: These other methods lack any calibration to the market
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* DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: What are the two major accounting standards and who drafted each one?
Answer:
1. International Financial Reporting Standards (IFRS) – drafted by the International Accouting Standards Board
(IASB)
2. Generally Accepted Accounting Principles (GAAP) – drafted by Financial Accouting Standards Board (FASB)
Note: These two standards are merging.
DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: Why is it important for Actuaries to become familiar with IFRS Standards? Most important aspect
to be familiar with?
Answer:
1. The SEC now accepts IFRS financial statements from foreign private insurers without reconciling to U.S.
GAAP.
2. The SEC may allow US issuers to use IFRS statements.
Most important aspect of IFRS standards for actuaries: IFRS 4 – Insurance Contracts
DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: How could IFRS affect SAP?
Answer:
SAP guidance is currently developed by U.S. insurance regulators, deciding whether to adopt, modify or reject
each change that is made to GAAP. Since GAAP and IFRS are converging, international accounting will, at a
minimum, seep into SAP.
DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: What are the requirements of Phase 1 of IFRS, which is currently in effect?
Answer:
1. Elimination of catastrophe & equalization provisions
2. Adequacy test of insurance liabilities & impairment test of reinsurance assets (recoveries)
3. Prohibition of offsetting insurance liabilities with reinsurance recoverables
4. Certain disclosures
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* DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: What is the definition of an insurance contract in the IFRS standards and how does it differ from
the US wording?
Answer:
Definition: An ins. contract is a “contract under which one party (the insurer) accepts significant insurance risk
from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain
future event (the insured event) adversely affects the policyholder.
Differences:
1. “Compensate” is used instead of “indemnify”
2. The trigger to meet the defn only includes an assessment of insurance risk, but does not include “timing
risk”, as is required in the US for reinsurance
3. Liability is recognized when an insurer becomes party to a contract, which can be earlier than the effective
date of insurance coverage.
* DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: What are the steps to measuring the liabilities in an insurance contract under in the exposure draft
of Phase II of IFRS?
Note: Compare to Fair Value
Answer:
Note: This is assessment of the reserve
1. The Calculation of unbiased probability weighted expected (mean) cash flows
2. Application of Discounting of insurance liabilities to reflect the time value of money: use a risk free rate with
adjustments to reflect currency, liquidity, cash flow timing
3. Application of Margins: covers risk and uncertainty about the risk and uncertainty associated with expected
cash flows.
DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: Describe 5 key desirable characteristics of risk margins that are in the IASB Exposure Draft of IFRS
Note: Compare to Fair Value
Answer:
1. The less that is known about the current estimate and its trend, the higher the risk margins should be.
2. Risks with low frequency and high severity will have higher risk margins than risks with high frequency and
low severity.
3. For similar risks, contracts that persist over a longer timeframe will have higher risk margins than those of
shorter duration.
4. Risks with a wide probability distribution will have higher risk margins than those risks with a narrower
distribution.
5. To the extent that emerging experience reduces uncertainty, risk margins will decrease, and vice versa.
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DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: List several recommendations regarding risk margins:
Answer:
Calculations of risk margins should:
1. Utilize a consistent methodology for the entire lifetime of the contract,
2. Be consistent with the determination of current estimates
3. Be consistent with sound insurance pricing
4. Vary by product based on risk differences between products
5. Consider the ease of calculation
* DeFrain – The Impact of International Financial Reporting Standards on US Prop/Cas Actuarial Practice
Question: List and describe the 3 current approaches to determine risk margins identified by the Exposure
Draft of IFRS. In addition, list any strengths or weaknesses of the methods.
Answer:
1. Confidence level (VaR) technique: the extra amount to be added to the expected
value to result in a specific probability that the insurer has sufficient funds to pay for the liabilities
2. Conditional Tail Expectation (CTE)/ Tail Value at Risk (TVaR):
= (Probability weighted average of all scenarios in the chosen tail of the distributin minus the mean estimate).
This has the advantage over VaR that it reflects the skewed distributions. Regulatory oversight or actuarial
practice would apply higher level of capital for products whose risk distributions are more highly skewed using
this method.
3. Cost of capital method: the amount necessary to produce an adequate return, after factoring in the
investment return. Note: In Fair Value, this is the method that best represents a market-based valuation
According to the International Actuarial Association (IAA), this is the most risk sensitive method, and it is most
closely related to pricing risk in other industries. However, it is the most difficult to implement.
* Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: Describe the general differences between IFRS and current U.S. GAAP:
Answer:
1. IFRS is more conceptual (principle-based) with little application guidance and U.S. GAAP is more rules-based,
with specific application guidance.
2. As a result of 1, use of IFRS requires relatively more reliance on judgement and less reliance on detailed
rules.
3. IFRS is more transparent because of expanded footnote disclosures companies must have in order to explain
how they interpret and apply IFRS in their organization. Companies are required to disclose more information
about estimated amounts used in the preparation of financial statements than GAAP does.
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Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: Give examples of disclosures that companies need to make under IFRS:
Answer:
1. Judgments made by management in applying accounting policies
2. Key assumptions about the future
3. Key sources of uncertainty at the balance sheet date
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: What does IFRS 4 address?
Answer:
It address Financial Reporting for insurance contracts and NOT Accounting for those contracts.
* Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Insurance Risk”, how do GAAP and IFRS differ?
Answer:
If both financial risk & significant insurance risk are present, the contract is treated as insurance.
IASB (IFRS) defines significant insurance risk as significant if, and only if, an insured event could cause an
insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial
substance. This standard is actually weaker than GAAP, as GAAP requires that it is reasonably possible that the
reinsurer may realize a significant loss.
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Liability Adequacy Testing”, how do GAAP and IFRS differ?
Answer:
GAAP: GAAP accounting does test for premium deficiencies. These are recorded as liabilities and as equity.
IFRS: The insurer needs to assess whether its insurance liabilities are adequate at each reporting date, with a
liability adequacy test. This is based on current estimates of future cash flows, including the cost of handling
the claims, and any options or guarantees. Any deficiencies in recorded liabilities are reported in current
earnings.
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Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Impairment Testing of Reinsurance Assets”, how do GAAP and IFRS differ?
Answer:
GAAP: Ceding entity should evaluate the collectability of reinsurance receivables to determine that the
reinsurer has the financial soundness and ability to honor its commitment under the contract
IFRS: Ceding entity must determine whether an impairment has occurred in reinsurance assets. A reinsurance
contract is considered impaired only when there is objective evidence that the ceding entity might not receive
all amounts under the terms of the contract.
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Selection of Accounting Principles”, how do GAAP and IFRS differ?
Answer:
GAAP: insurers have the option to change the policies as long as they can justify that they are preferable to the
current.
IFRS: Insurers have the option to change policies if:
1. The change makes the financial statements more relevant to the user’s decisions, without being less reliable
OR
2. The change makes the statements more reliable, without being less relevant
WHERE:
Reliable: the information about an item is representationally faithful, free of material errors, and free of bias.
Relevant: the item can make a difference in the user’s decisions
* Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Prohibiting Offsetting”, how do GAAP and IFRS differ?
Answer:
GAAP: does not allow offsetting of insurance assets against the related insurance liabilities unless certain
specific criteria are met
IFRS: Does not allow:
1. Offsetting of insurance liabilities against related insurance assets
2. Offsetting of income/ expense from a reinsurance contract against expense/ income from a related
insurance contract
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Disclosures”, how do GAAP and IFRS differ?
Answer:
GAAP: Must differentiate btw short-duration and long-duration contracts.
Within short duration contracts, must specify those that are prospective vs. retroactive contracts.
IFRS: The insurer needs to disclose information that identifies & explains the amounts in its financial
statements that are generated by insurance contracts. This would involve disclosing its accounting policies for
recording the assets, liabilities, income and expenses associated with the insurance contracts.
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In addition, if the insurer cedes business, it must disclose the gains/ losses from buying reinsurance.
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Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: In terms of “Valuation Principles”, how do GAAP and IFRS differ?
Answer:
GAAP: Market losses and resulting capital fluctuations associated with “available for sale” securities are listed
separately.
IFRS: Market losses and resulting capital fluctuations associated with “available for sale” securities are NOT
listed separately.
* Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: What is the fundamental accounting changes when going from GAAP to IFRS?
How is profit affected?
Answer:
GAAP: Records the revenue associated with the insurance premium and associated acquisition costs over the
duration of the contract.
IFRS: recognizes the present value of all premiums and expenses as soon as the contract is signed: the present
value of premium impacts assets & premium income; while the present value of claims & expenses impacts
expenses and liabilities.
Effect on profit: Essentially the difference between the two is just a timing difference: over the course of the
policy, the total profit recognized should be the same.
* Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: What are two reasons that there is a potential increase in volatility of results in IFRS?
Answer:
1. IFRS does not allow an unearned premium reserve, so the incoming revenue will not be smoothed over time
2. IFRS also does not recognize deferred acquisition costs
* Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: What does Fitch believe will be the impact on ratings of insurance companies caused by increased
volatility of results and why?
Answer:
IFRS should not have an adverse impact on ratings (unless the transparency does reveal that there is additional
risk) because the new transparency from IFRS will be beneficial to users.
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: How does IFRS handle catastrophe reserves and how does that compare to GAAP?
Answer:
Similar to GAAP accounting, IFRS does not allow insurers to maintain reserves for a future unknown
catastrophe.
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Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: How does IFRS categorize investment strategies and how does that compare to GAAP?
Answer:
IFRS requires that the investment assets of insurers are grouped into the following categories:
1. Held to maturity: historic cost less amortization
2. Available for sale: “marked to market”. Changes in market value are recorded in reserves
3. Held for trading: “marked to market”. Changes in market value are recorded as income
This is very similar to the GAAP requirements, and so there should not be a big impact on the investment
strategies.
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: What are the requirements for IFRS Product Design and what are the implications for insurance
products?
Answer:
IFRS requires that some insurance contracts that have both insurance and investment features be unbundled
and accounted for separately. As a result, some products, that may be less profitable on a stand-alone
(without benefits of investment) basis, may need to be modified or discontinued. In addition, some products
(e.g. life insurance contracts) may need to be modified (shortened) to reduce the volatility.
Lindbergh and Seifert – A New Paradigm on the Horizon, IFRS and Implications for the Insurance Industry
Question: What do IFRS requirements do for Matching of insurance assets to liabilities.
Answer:
Many US states currently require that insurers match the durations of their investment asset portfolios to the
duration of liabilities. IFRS should make it easier to assess that insurers are appropriately matching, due to the
increased level of disclosures and transparency. This will provide extra motivation for insurers to match
appropriately.
Odomirock, Ch. 24, International Financial Reporting Standards
Question: Describe the reasons that the IASB and the FASB are currently engaged in a joint project to develop
a new accounting standard for insurance contracts?
Answer:
1. There is diversity of accounting practices around the world for insurance contracts.
2. Existing standards were overly influenced by regulatory prudence, which does not provide an accurate
picture of the economics of a company.
3. A deferral and matching model is not currently in favor.
4. Investors in life insurance companies in Europe do not currently rely on the accounting information
presented but on supplemental measures such as market consistent embedded value.
5. Most current approaches for accounting for insurance contracts are inconsistent with the accounting for
other industries.
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* Odomirock, Ch. 24, International Financial Reporting Standards
Question: Under IASB rules, in IFRS 4, what needs to be present for a contract to be defined as an insurance
contract?
Answer:
Both financial risk and significant insurance risk must be present.
Odomirock, Ch. 24, International Financial Reporting Standards
Question: How does IASB define financial risk and insurance risk in IFRS 4?
Answer:
Financial risk is defined as the risk of a possible future change in one or more of a specified interest rate,
financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating, or
credit index or other finl variable or other non-financial variable not specific to a party to the contract.
Insurance risk is risk, other than financial risk, transferred from the holder of a contract to the issuers.
* Odomirock, Ch. 24, International Financial Reporting Standards
Question: Under IASB rules, in IFRS 4, what constitutes significant insurance risk and how does that compare
to the U.S. GAAP definition of significant insurance risk?
Answer:
Insurance risk is: “Significant if, and only if, an insured event could cause an insurer to pay significant additional
benefits in any scenario, excluding scenarios that lack commercial substance.”
This is a weaker standard for risk transfer than that currently in U.S. GAAP, which requires that it is “reasonably
possible” that the reinsurer may realize a significant loss from the transaction. This latter standard appears to
require more than just one scenario of economic substance.
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Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: What was the original purpose of the creation of the Solvency regulations in Europe?
Answer:
To develop a new, more risk-focused set of regulatory capital requirements.
Odomirock - ch25 (pg 240-244) Solvency II
Question: What is the purpose of Solvency II regulations in Europe?
Answer:
To link the required capital of insurance companies to their risk profile.
Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: Describe current capital requirements in Europe and their weaknesses.
Answer:
They are based on a simple factor-based model, with required regulatory capital requirement set as a function
of premium writings and loss reserves for property/casualty insurance.
Weaknesses: The approach has limited risk sensitivity, particularly in its failure to recognize asset risks. A
more comprehensive approach is necessary.
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: List & briefly describe the 3 pillars of Solvency II
Answer:
-Pillar 1: Quantitative Requirements: addresses various quantitative requirements, like solvency requirements
-Pillar 2: Supervisory Review (Governance): provides supervisors with a means to identify troubled firms and
the ability to intervene; focused on the qualitative aspects of supervision.
-Pillar 3: Supervisory Reporting/ Public Disclosure: increases the transparency of the insurer’s risks and capital
position
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: What are the 3 quantitative requirements of Pillar 1?
Answer:
1. Calculation of technical provisions (reserves).
2. Rules relating to calculation of solvency requirements.
3. Rules relating to Investment Management.
Odomirock - ch25 (pg 240-244) Solvency II
Question: What is Pillar I referred to as?
Answer:
The “measurement” approach or the “total balance sheet” approach.
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Odomirock - ch25 (pg 240-244) Solvency II
Question: Under Pillar I of Solvency II, how are assets recorded?
Answer:
Non-insurance assets are recorded using the measurement approach under International Financial Reporting
Standards (IFRS).
Reinsurance assets are measured in the same way as insurance liabilities.
* Odomirock - ch25 (pg 240-244) Solvency II
Question: Under Pillar I of Solvency II, how are liabilities recorded?
Answer:
The technical provisions (reserves) consist of the discounted best estimate of the liabilities and their associated
risk margin. These are meant to represent the fair market value of the insurance liabilities, and although
principles based, the approach to calculating them is fairly prescriptive. The best estimate of the liabilities is
the expected value of the cash flows discounted using a risk-free rate plus an illiquidity premium. The risk
margin is calculated using a cost of capital method with the cost of capital above the risk-free rate (R-i from
Chapter 23) equal to 6%. The required capital at each point in time is the SCR. Note: this is similar to Fair Value
and IFRS.
PV (Cash flows using risk-free rate plus illiquidity premium) + Risk Margin
Cost of capital = Risk Free Rate + 6% (?????????????????) (from chapter 23 (Fair Value) in Odomirock?)
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: Describe how technical provisions (reserves) are valued by Solvency II?
(Calculation of Reserves)
Answer:
They are valued according to the IFRS definition of fair value. That is, they must be market-consistent and
based on their current exit value.
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: Briefly describe the 2 types of capital requirements that apply to insurers under Solvency II.
(Solvency Requirements)
Answer:
-Solvency Capital Requirement (SCR): the necessary economic capital to be held to limit the probability of ruin
of the firm to 0.5% (aka 99.5% VaR) over the next year
-Minimum Capital Requirement (MCR): the absolute minimum amount of capital that the insurer can hold
In between, the SCR and MCR, a company may be subject to supervisory action.
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Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: List 3 types of risk that are considered by Solvency II, but not by the P&C SAP RBC formula
Answer:
-Operational
-Life
-Health Insurance
Odomirock - ch25 (pg 240-244) Solvency II
Question: What kind of models does Solvency II allow insurers to use and under what conditions in order to
calculate SCR?
Answer:
The SCR can be calculated using the standard model (a spreadsheet model provided by the regulator), an
approved internal model or a mix of both.
Conditions needed to obtain approval for an internal model:
1. Demonstrate that the model is used in running the business
2. Model must be validated by an independent third party
3. Model must be documented appropriately.
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: What kind of models does Solvency II encourage insurers to use to determine capital requirements
and provide 2 reasons why it is better that firms use these models to determine their risk exposure.
What is the expected effect of using these models?
(Solvency Requirements)
Answer:
Solvency II encourages use of internal models that must be approved by supervisor.
Advantages of using internal models:
-Better alignment between the firm risk and capital requirements
-Stronger risk management culture
Expected effect: Firms that use internal models are expected to see a reduction in their required capital when
compared to the standard formula.
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: How does Pillar I deal with Investment risk and what’s the reason for this approach?
(Investment Management)
Answer:
It eliminates quantitative investment limits and asset eligibility criteria. It removes rules-based restrictions on
insurer investments.
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Reasoning: The combination of the IFRS –consistent valuation of assets and Solvency II capital requirements
should account for all quantifiable risks and the prudent person standard will apply for insurer investments.
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* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: Describe components of the Pillar 2 of Solvency II, Supervisory Review
Answer:
-Supervisory Review Process (SRP) involves reviewing/ evaluating
• That the insurer’s strategies, processes & reporting procedures comply with Solvency II
• The firm’s risks & its ability to evaluate those risks
It’s focused on the qualitative aspects of supervision: adequacy of a company’s internal controls, risk
management processes, and corporate governance.
-Firms must conduct an ORSA: an internal assessment of the solvency need based on the risk profile.
Odomirock - ch25 (pg 240-244) Solvency II
Question: List and describe the functional areas that must be addressed by the supervisory activities of Pillar
2, Supervisory Review
Answer:
Internal audit:
1. Produce a report at least annually to the board of directors on any deficiencies of the internal controls and
any shortcomings in compliance with internal policies and procedures. This function should have unrestricted
access to information and staff.
Actuarial:
1. Ensure the reasonability of methods and assumptions used in calculating the technical provisions
2. Provide a look-back analysis of best estimates against experience.
3. Provide opinions on the overall underwriting policy and adequacy of reinsurance arrangements.
Risk management:
1. Monitoring the risk management function and maintaining an aggregated view.
2. Ensure the integration of any internal model with the risk management function.
Compliance:
1. Ensure the internal control system is effective to comply with all applicable laws and regulation, promptly
reporting any major compliance issues to the board of directors.
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: As part of Pillar 2 in Solvency II, Supervisory Review, what is ORSA and what are its objectives?
Answer:
Pillar 2 requires firms to conduct their “Own Risk and Solvency Assessment” (ORSA), an internal assessment of
their overall solvency needs given their specific risk profiles.
Objectives:
1. Should be a tool for the firm’s own decision making.
2. It is a tool for supervisors to better understand the risk profile of the firm.
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* Odomirock - ch25 (pg 240-244) Solvency II
Question: As part of Pillar 2 in Solvency II, Supervisory Review, what are the minimum items that an ORSA
should comprise?
Answer:
1. The overall solvency needs, taking into account the specific risk profile, approved risk tolerance limits and
the business strategy of the undertaking
2. The compliance with the capital requirements and compliance with the requirements regarding technical
provisions
3. The extent to which the risk profile of the undertaking deviates significantly from the assumptions
underlying the SCR, calculated with the standard formula or with its partial of full internal model
(Deviations from assumptions underlying the SCR)
* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: Describe Pillar 3 of Solvency II and its purpose.
Answer:
Pillar 3: Supervisory Reporting/ Public Disclosure: increases the transparency of the insurer’s risks and capital
position. Firms are required to annually disclose information on their solvency and financial condition.
Purpose: provide the market with sufficient information to enable it to properly exercise its disciplinary
function.
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* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: There are several differences between US Regulation & Solvency II.
A. List and describe differences regarding the Role of Internal Models
B. List and describe other differences
Answer:
A.
1) Use of models: internal models are encouraged in Solvency II for the purposes of determining
capital requirements, but are only being slowly introduced in the US
2) Model Review: In Solvency II, supervisors review the models and need to grant permission only if
the company complies with certain standards. In the US, the regulators rely on the insurer’s actuaries
to ensure that the model and its results are appropriate.
3) Model Metrics: metrics for internal models are different. In Solvency II, capital requirements are
targeted at a 99.5% VaR. In the U.S., internal models are generally calibrated based on TailVar or
Conditional Tail Expectation, which accounts for the magnitude of the potential loss in excess of the
VaR threshold.
4) In the U.S., a company is required to use internal models to establish its capital requirements if it
engages in certain types of business in which certain risks are not normally well-captured in the
standard factor-based formula. In Solvency II, internal models are seen as generally superior to the
standard approach b/c they better align the relationship btw risk and capital.
B.
1) Capital Requirements: In Solvency II attempts to frame its capital requirement around a consistent
standard – the 99.5% VaR. In the U.S., the standard formula for capital requirements is not calibrated
to a VaR or TVaR target
2) Investment Restrictions: In Solvency II, investment regulation consists of a Prudent Person approach
instead of strict investment restrictions. In the U.S. investment regulations vary across states and
states generally maintain a blend of rules-based and prudent-person approaches to investment
regulation.
3) ORSA (Own Solvency and Risk Assessment) doesn’t have anything comparable inU.S.
4) Risks captured for capital requirements differ: Most notably, Solvency II includes catastrophe risk
and operational risk, neither of which is captured in U.S. RBC.
5) Calculation of technical provisions/reserves: Solvency favors a market-consistent approach. In the
U.S., the greatest present value of the deficit under several possible scenarios is calculated, then apply
a conditional tail expectation (or Tail VaR) to determine the required reserves.
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* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question:
a. List 3 reasons behind the shift from rules based to principal based regulation
b. List 3 assumptions behind the argument that principal based regulation is superior
Answer:
a.
- due to increasing complexity of the insurance market, the rules based approaches cannot adequately
address the differences among companies
-insurers will try game the system of rules based regulation
-rules based systems tend to stifle evolution
b.
-companies have an incentive to properly manage risk
-regulators can distinguish between firms that did and did not effectively manage risk
-regulators would take action once they identify a firm that did not effectively manage its risk
Vaughn – The Implications of Solvency II for US Insurance Regulation
Question: Under the assumption that “regulators can distinguish between firms that did and did not
effectively manage risk “explain Type I and Type II errors that may arise in the US regulatory system.
What was thought to be a way to reduce these errors?
Answer:
Type I error: companies that are destined to fail are treated as healthy
Type II error: healthy companies are incorrectly identified as troubled.
Regulators relying on company internal models was thought to be a solution to these errors.
Vaughn – The Implications of Solvency II for US Insurance Regulation
Question:
a. List 4 criticisms of internal models that were revealed after the financial crisis.
b. Give 2 reasons that the internal models make it more likely that supervisors will make Type 1 or Type 2
errors.
Answer:
a.
-the inputs to the model were often too optimistic, because they were based on periods of good experience
-the models are based on an assumption that the past can fully predict the future
-the models did not account for large changes in correlation during bad times
-certain risks were ignored (eg liquidity risk)
b.
-models rely on discretion and are therefore harder to evaluate
-supervisors need technically competent staff to properly evaluate the models
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* Vaughn – The Implications of Solvency II for US Insurance Regulation
Question:
Briefly describe 3 advantages of US regulation over Solvency II
Answer:
-US has a series of checks and balances (eg regulators from several states review each insurer), which means
that there is less chance that a mistake will get through)
- US has a combination of principles based and rules based regulation, which reduces the chance of errors,
which still accounting for the increasing complexity of insurance
-US has additional supervisory tools which help compensate for the deficiencies of RBC: On-site examinations,
off-site financial analysis, other tools.
Vaughn – The Implications of Solvency II for US Insurance Regulation
Question:
Briefly describe two justifications for using internal models in solvency regulation.
Answer:
-They more closely align firm risk with capital requirements
-They promote a risk management culture.