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A Principles-Based Valuation System: Is it the Answer for Canada?

A Principles–Based Valuation System: Is it the Answer for Canada?
by Gordon Creber

Rules–based valuation systems fall somewhat short when it comes to meeting the accounting tests of relevance and reliability. A principles–based valuation system may be the answer to this challenge.

There is a great deal of focus on financial reporting in the world today. Securities commissions are concerned about comparability, both historically within an entity, between entities within an industry and between industries. In no industry is this more pronounced than the insurance industry. Herein, the regulators add a separate dimension of complexity. Their historical solvency concerns have–due to the now prevalent use of reinsurance–been expanded to include geopolitical comparability and transparency. The diversity of users of financial statements has expanded over time. Insurance entity financial reporting continues to evolve. Relevance and reliability must continue to guide the evolution.

How Did It Start?
Government recognition of the public policy need to protect insurance policyholders against the severe impacts of insurance company insolvency led to regulatory financial reporting requirements. These requirements were codified sets of rules and thus we started with rules–based reserving systems for valuation of insurance liabilities. These rules–based reserving requirements have tended to be simplistic, at least initially, with conservative (high) incidence rates and (low) discount rates. Initially, policyholder premiums, sales and administrative expenses and lapsation were ignored. As expenses increased and prices declined, these systems were modified to allow for limited deferral of sales expense and required recognition of future administrative expense, if such recognition resulted in an increase in the liability.

Further modifications have been required as products evolved to provide options beyond the basic risk coverage and as conservative valuation assumptions resulted in apparent premium deficiencies. These rules–based systems had the advantage of being simple with easily auditable results. The level of conservatism within the liability allowed the regulator time to react to companies encountering difficulty.

Limitations
Rules–based reserving systems have a number of inherent shortcomings. This type of system has difficulty in adequately handling product complexity and product enhancements due to the use of simplistic conservative assumptions. They also tend to be slow to recognize and effectively deal with new risks arising in the business environment. The additional requirements may be in conflict with existing requirements creating complexities that defeat the initial simplicity of these systems. These work around solutions often result in excessive conservatism in the liability required for some products (e.g., preferred life insurance where the standard mortality assumption has generated excessive conservatism in the liability) and inadequate liabilities for other products (e.g., guarantees in investment fund annuities where low interest assumptions have not provided sufficient risk margin). As company solvency has been the financial reporting driver, conservatism rather than best estimates of the entity's liabilities have resulted in period income not being useful either for historical or inter–company performance comparisons.

The need for entity performance comparisons became more important with the public trading of the shares of insurance corporations. In the United States this led to the creation of a two–tier financial reporting system: regulatory reporting with rules based on a solvency focus and generally accepted accounting principles (GAAP) reporting with rules based on an income comparison driver. Note that rules–based GAAP reporting systems also must grapple with the challenges created by product evolution.

Historically, Canada also adopted a rules–based regulatory reporting system. However, Canada is one of the few jurisdictions that have avoided a two–tier financial reporting system. The introduction of Canadian GAAP as acceptable regulatory reporting was the result of a significant cooperative effort between the accounting profession, the actuarial profession and the insurance regulator. Period income reporting is driven by entity comparability considerations. This is achieved by using the change in management's best estimate valuation of assets and liabilities, which includes only a limited reasonable margin for adverse deviation. Solvency is viewed by way of a total balance sheet approach rather than the traditional approach of relying on conservatism in the reserve liability.

It was recognized by all parties that such a principles–based approach to valuation of insurance liabilities would be more flexible, but would rely heavily on proper performance by the actuarial and accounting professions. To this end, the Insurance Act created the role of an appointed actuary. In doing so, the legislation not only outlined the duties of this position, but also created a right of access to information and provided certain legal protections to the professional operating in this role.

Challenges
Since the introduction of Canadian GAAP, a number of concerns have arisen. The regulator and actuarial profession struggle with narrowing the range of practice in handling different product characteristics and economic situations while avoiding the inherent weakness of a drift back to a rule–based system. The regulator has introduced a requirement for peer review of the work of the appointed actuary. More recently there has been a move to require certification of those professionals who would undertake the role of appointed actuary. The audit of insurance entity reporting has also increased in complexity, moving from complete reliance on the work of the actuarial professional to the development of extensive audit requirements. It is uncertain where this will end; however, Canada is committed to the introduction of international standards. The current direction of these standards appears to include principles–based valuation of insurance liabilities.

Change is on the Horizon
The U.S. Securities and Exchange Commission (SEC) is working towards replacing Financial Accounting Standards Board (FASB) GAAP with the international standards GAAP. This could bring principles–based valuation of insurance into effect without the protections provided the actuarial professional as in Canada. Principles–based valuation techniques have been used in testing the adequacy of some National Association of Insurance Commissioners minimum solvency reserves. At the present time, the American Academy of Actuaries is exploring how the current system might be replaced by a principles–based valuation system in the near term.

Geopolitical differences in reporting requirements have given rise to accounting arbitrage opportunities resulting in the creation of reinsurance products with more focus on taking advantage of the arbitrage than on risk transfer. As international financial reporting standards and regulatory monitoring approaches converge, this arbitrage should disappear.

Rules–based valuation systems are increasingly unable to meet the accounting tests of relevance and reliability. Principles–based valuation system may be the answer to this challenge. A principles–based valuation system requires the highest quality in the work of the professionals involved. The public must be satisfied that the work of the professionals, be they actuaries or auditors, meets a reasonability standard.


Gordon R. Creber, FSA, FCIA, MAAA, has 30 years experience in the insurance industry and has served in the roles of chief financial officer, chief actuary, appointed actuary in Canada and as a valuation actuary in the United States. He can be reached at grcreber@sympatico.ca.

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