The Actuary Magazine December 2004- Emerging Issues Advisory Group Issue Paper On Fair Value Liabilities

Emerging Issues Advisory Group Issue Paper on Fair Value Liabilities

By Larry N. Stern

Deck: A change in the method used for financial reporting is on the way. The questions, "what are the changes" and "what they mean to you" are answered here.

This article is adapted from a summary from the Emerging Issues Advisory Group (EIAG) to the Life Practice Advancement Group (LPAC). It is based on discussions with practioners dealing with fair value reporting and is time sensitive to the third–quarter of 2004. It also draws upon personal research from published articles and SOA sponsored seminars pertaining to the topic.

A New Approach

The International Accounting Standards Board (IASB) has been working since the late 1980s to establish a financial reporting model for all companies. The mission of the IASB is, "To develop a single set of high–quality, understandable and enforceable global accounting standards that require transparent and comparable information in financial statements and other financial reporting to help participants in the various capital markets of the world and other users of the information make economic decisions."

Under this new framework for financial reporting, the IASB proposes to abandon the concept of "deferral and matching" (the characteristics of GAAP) in favor of an "asset and liability" approach under which the fair value of assets and fair value of liabilities will be determined independently. This approach could have significant consequences for the insurance and financial services industries. Among the most critical issues are:

  • The time period until the IASB standards are to be effective,
  • The definition of "fair value," and
  • The methodology to be used for calculating fair value.

Opportunities and Threats

The framework for uniform financial reporting was completed in 1989. Since then, a number of accounting standards have been developed. By the end of 2004, it was expected the European Union (EU) companies would report using the IASB basis. However, an insurance standard has not been issued. Instead, a Draft Standard of Principles (DSOP) originally put forth in 2001 had been in revision and was expected to be finalized by the end of 2003. The IASB determined the approach would be too complex to put in place by 2005. Instead, the IASB has introduced a two–phased approach and released International Financial Reporting Standards (IFRS) 4 as the final insurance standard for Phase I. IFRS 4 enhances existing accounting and expands existing disclosure requirements.

Beginning in 2005, all companies listed in the European Union (EU) will be required to report earnings in accordance to IFRS. Some EU member states will also require non–listed companies to report under this new accounting framework. In addition, all Australian reporting companies will report under IFRS by 2005.

Under IASB proposals, products will be classified as either insurance or investment. Standards for financial reporting will differ based on the definition for each product. Under Phase I, insurance contracts and investment contracts with "discretionary participation features" will be accounted for in accordance with IFRS 4. This will allow companies to continue existing accounting policies (so–called "local" GAAP) with respect to these contracts. All other investment contracts (those without "discretionary participation features") will be accounted for under IAS 39. The one exception–investment management services, when considered separately as a component of an investment contract, may be accounted for under IAS 18.

The IASB intends to move forward to develop the Phase II insurance contract standard with discussions taking place by mid–2004. The Phase II standard is expected to be adopted by 2006 with implementation by 2008.

Product classification is key to those contracts that are affected under Phase I accounting:

  • An insurance contract is defined as "a contract that exposes the insurer to identified risks of loss from events or circumstances occurring or discovered within a specified period, including death, survival (annuity), sickness, disability, property damage, injury to others, and business interruption." Examples include term insurance, whole life insurance and most property/casualty insurance contracts.
  • An investment contract is defined as all other contracts. This could include some "insurance" related contracts, such as contracts containing only financial, lapse or expense risks; unit linked or variable contracts containing minimal death benefits and/or some financial reinsurance contracts.

Unbundling of contracts is required to recognize deposit components or features of insurance contracts not currently fully recognized on the balance sheet such as certain obligations under reinsurance treaties.


The clock is ticking. Financial reporting in accordance with IASB standards will be required. The bottom line is, which methods should be employed to determine fair value? Fair Value is an attempt to measure the market value that would be achieved in a transaction between a willing buyer and a willing seller. The IASB, FASB, AAA and ACLI have all undertaken efforts to develop plausible methods for fair value reporting—with accelerated efforts since the late 1990s.

The foundation of the IASB new standards in the fair value of assets and liabilities is to be determined independently. Companies use asset/liability management to try to correlate the maturity of their assets with those of their liabilities in order to minimize or control their exposure to interest rate changes. It seems reasonable to utilize a fair value accounting system—both the pricing function and the investment management function reflect current investment market conditions and interest rate conditions. Using fair value accounting based on these principles completes the circle—financial results would be measured within the same context of the same market conditions for pricing and investment management.

The fair value of most financial assets is easily determinable, based on recent prices paid in anactive market. However, the fair value of most liabilities is less easily determinable. Many financial liabilities are not actively traded in any market. Herein lies the major problem—controversy and differences of opinion have arisen from the various organizations� attempts to propose a method to determine fair value of liabilities within the concepts put forth by the IASB. Whatever method is used, the fair value of liabilities should move over time in sync with the market value of assets, leading to fewer balance sheet distortions.

A fair value method for liabilities should meet the following criteria:

  1. It must be independent of the specific assets used to support the liabilities.
  2. It must be objective, as far as possible.
  3. It should be consistent with other actuarial methods in common use.
  4. It should be general enough to deal with the wide range of insurance contracts in existence.
  5. It should be simple to understand.

The method used to determine the fair value of liabilities would be based on the expected present value of future liability cash flows. Best estimate assumptions, constantly updated, would reflect economic conditions of the market, past experience of the company, and future anticipated experience. Issues currently being debated include the following:

  • What is the appropriate discount rate? The present value of future cash flows is sensitive to the discount rate assumption, which in turn can be a subjective choice unless clearly defined.
  • What adjustments should be considered for risk and uncertainty? Should these be reflected in the discount rate—an adjustment to a "risk free" rate?
  • Should the company's own credit standing be taken into account? To the extent the company's ratings are reduced, the discount rate would be increased. However, this results in a reduction in the present value of expected cash flows. It seems counter–intuitive that shareholders' equity should increase as the company's financial position deteriorates or its credit rating drops—because stock prices typically fall under such circumstances.
  • How should future premiums be reflected? To the extent the policyholder has an option to pay a premium, it is not guaranteed or non–cancelable by the company and should not be considered in the present value of expected cash flows.

More Discussion

Fair value accounting is not an emerging issue—it has been the subject of numerous seminars, articles, and presentations. It continues to be discussed among the many actuarial and accounting organizations. In fact, there will be more sessions at SOA meetings like the SOA sponsored seminar held in November on International Accounting Standards for Insurers.

Recommendations from the EIAG for the SOA include the following:
  • Continue to be actively involved in planning these sessions.
  • Encourage members who are most knowledgeable with this issue to author articles and keep the members up–to–date on current developments.
  • Encourage members of its Sections to participate in the discussions providing input to the organizations developing the approach for determining fair value calculations.

As the time for the new standards to become effective draws near, the SOA should plan teaching sessions to assist members in understanding the standards and planning for their implementation.

Larry N. Stern is President of Canterbury Consulting, LLC and chairs the Emerging Issues Advisory Group for the Life Practice Area.