The future of insurance contracts
Moderator: Lou Gutzwiller, partner, EY financial services office
Panellists: Jennifer Weiner, partner, EY financial services office
Mark Wilcox, SVP and chief accounting officer, RenaissanceRe
Lou Gutzwiller: What is RenRe’s perspective on the FASB’s proposal?
Mark Wilcox: The Financial Accounting Standards Board (FASB) has put a lot of time and effort into developing a high quality standard and although the ultimate standard might not look like it is today, it was time well spent and it will be for the good.
When you think about the process they have been through over the last couple of years they have been open and transparent, there have been numerous roundtables, discussion groups, conferences and meetings. For the exposure draft, they asked for feedback on 48 questions, covering every aspect and principle embedded in those standards.
Not only do they say ‘what do you think?’, but they also ask ‘what would you prefer?’. You could not ask for a more open and transparent process.
That said, what is RenRe’s perspective? Overall, when you look back to 2010 when the discussion paper first came out, we were generally supportive of the new standard and the notion of converging towards a global standard.
We were willing to make some changes to our accounting model and incur some costs and time and effort to converge for the sake of one global standard. We write risks around the world and it would be useful if all our clients used the same accounting for re/insurance and if finance teams in our various subsidiaries prepared our financial results in the same manner.
However, the facts and circumstances are a little bit different today, because the FASB did split with the IASB and we now have a different standard. With that you have to step back and question what is it about this standard that is preferable to what we have today. Is it preferable when you think through the issues and the complexity within the standards—is it better? Do the benefits exceed the costs?
There are some great ideas in the standard, some are sophisticated, but we did not really believe that when you added it all together that the benefits exceeded the costs. Our recommendation to the FASB is really to take a wait-and-see approach, continue to work on this, make targeted changes to the extent that users and preparers have issues with the standard.
Let’s fix issues and have more consistency, but do it on a targeted basis. Let’s not throw out the history we have with respect to our financial results and those of our peers by making a wholesale change and let’s wait and see what happens with the rest of the world when the new IASB exposure draft is implemented.
LG: Hearing Mark’s view and having had the opportunity to read the comment letters that came out, do you think the FASB was surprised with the feedback in this latest round?
Jennifer Weiner: In some of the areas it was what they were expecting, for example the decision on catastrophes.
Some of the things were surprising. The FASB knew there were issues that were going to come back, they thought the answers were theoretically correct so it was not that they were making a decision knowing it was going to come back, it was making a decision that is theoretically sound from an accounting perspective, but knowing that it is an issue with the industry, and that is always a struggle.
There were some other areas with unintended consequences, so for instance ‘portfolio’ was debated at six different meetings. I heard a lot of different interpretations of the word and that is really why you have an exposure draft as well as such things as a model of when you use which model. More unintended consequences came out as people got into it. They were surprised in some areas and in other areas the expected information came out.
One of the areas that was a bit surprising was the interpretation of probability, of weighted mean, and I would say the reason for that is that after the 2010 discussion paper people added the word ‘mean’ to the discussion.
They said they would be fine and now everyone has cut into it. That is something that could have been fixed had people been really upfront and said ‘okay we are interpreting it differently because the FASB is open to listening and working with people’. As I said, my role during those years was really as a facilitator, working with industry, helping explain what industry does, what they are thinking, to the board and helping industry understand where the board is coming from.
Gutzwiller: RenRe recently participated in the field testing process. Could you talk about the effort involved and the issues involved in implementation?
Wilcox: Overall it was a great exercise. The exposure draft came out at the end of June and any of us in this room know that we have a day job to do in the month of July in terms of closing the book and quarterly and board reporting. Then we had a few vacations to interrupt our schedule in August and it was probably not until early September that we turned to the field testing in earnest.
We had to deliver by October 4, but when you are trying to adopt a 409-page standard that has just been dropped in your lap in 30 days you are going to make some simplified assumptions.
We also had to make some interpretative assumptions in terms of what the words actually meant. Over time there will be lots of implementation guides and lots of knowledge experts out there who will interpret the words, but today that is a green field so we had to make judgement calls along the way.
We did that and we documented our field testing with the FASB, but they asked us to go back and restate our 2011 balance sheet, restate our December 2012 balance sheet on a consolidated basis and restate our 2012 income statement.
They asked for comparatives and we said ‘one is enough’. But we did do it on a quarterly basis, so we did a little extra homework for them.
Of course this is all hypothetical proforma and we went with that exercise, but it was a pretty Herculean task to get it done. It helped us understand what was in the standard and what the FASB was getting at. It is such a big document, people have really only scratched the surface. It is not until you get into it that you understand it in detail and we hope that will serve us well over the long term.
Weiner: It is good to talk about the field testing because some of the comments that came out were that the FASB should do field testing. This has not yet been really been done by the FASB, so it was a struggle to try and get them to agree to do it because they thought it was going to be too much. Everyone said ‘you need to test this to see what the results are, to see if there are any unintended consequences based on these decisions’ and that is what they tried to do.
Clearly a three-month time frame for that is not a long time. You really cannot give a year to try and test a proposal so it was a good effort, it was greatly appreciated that RenRe and 15 other insurance companies participated and you will see some changes come through as a result.
Gutzwiller: Without going into too much detail could you give us a sense the results of the field testing?
Wilcox: I will stay away from the numbers but talk qualitatively about some of the changes. Start with the balance sheet and you start with the assets. We saw a decrease in assets and part of that was due to reclassification against the unearned premium reserve.
We also had quite a few reclassification adjustments; we interpreted loss-related premium to be excluded from premium to be netted against losses. We had a fairly large receivable on our balance sheet related to loss-related premiums that came down as an asset and was netted against the liabilities. So the assets came down.
On the liability side, in addition to those changes, which were netted against the liabilities, we also had the impact of discounting, so we had to discount our loss reserves. For most that is probably going to be the biggest change.
When you look at RenRe, we are a short tail writer of property cat, so we don’t have a highly leveraged balance sheet. If you look at our liabilities to our capital we are 0.5 to 1. Many of our peers have a much more leveraged balance sheet so for us the impact of discounting is less significant but that said, it was still significant. It was a material adjustment to the balance sheet.
We had to model our future expected losses for all of our premiums, and estimate when those losses would come in, in accordance with perils and geographies that were covered in the contracts.
In total the liabilities came down more than the assets—we had an increase in equity so our capital base did go up, and those results were not insignificant. When you think about the income statement the impact was interesting, it was more muted. We were not sure what to expect but it did change matters marginally from a net income perspective.
I talked a little about the reclassification adjustments, the P&L change, the composition of premiums and losses—all changed. You have the reclassification of things like profit expenses that are generally netted against expenses, these get netted off against ceded premiums so ceded premiums go down and expenses go up, the same with the loss-related premium.
Premium goes down, losses go down, those are just adjustments, but with the reclassifications nothing happened really from a bottom line perspective.
We thought the earned premiums might have a big impact but when you look at it over the course of a year you have your opening adjustment and your closing adjustments, you pull some back, but then you push some forward. Then you have the discounting so the losses did go down a little bit but that is partially offset by the unwinding discount as you pay the claims.
Interestingly one of the bigger adjustments related to foreign currency. All insurance balances that are non-US or non-functional currency denominated have to be revalued. We write some risks in foreign currencies. Today those do not get revalued. Under this standard you have to revalue those risks.
Those were the major changes—changes in the composition—but not a big impact on the bottom line. We went through the exercise on a quarterly basis and the impact of the premium owing is significant, but on an annual basis it is not such a big deal.
As regards underwriting ratios, we did take look at that. Most people will find their loss ratio will go down, so you are discounting the reserves, and the losses go down, the acquisition expenses go up and then the combined ratio goes up because you have less premium. For us it was not significant, it did not change the trend for that one particular period we looked at.
Gutzwiller: I know the field testing included a trip to the FASB and a presentation to the FASB board. There will be some interest in your thoughts on that process.
Weiner: That was probably the most satisfying thing about going through this field testing process. It was a lot of hard work and effort but we got to have two hours of undivided attention from the FASB. The FASB was interested in what we had to say. They were in a listening mode but they played their cards very close to their chest.
We were not there to pat them on the back or say what a great job they did, we were there to present our comment letter, essentially that the field testing had thrown up a host of issues with the standard. They were interested in some of the unintended consequences; it was very gratifying at the end, time well spent.
Gutzwiller: When you take a step back what did you think of the overall process?
Wilcox: It depends on how management measures and evaluates and keeps a score card for its financial results. If you are a traditional re/insurance company, the senior management team spends a lot of time looking at that, a lot of incentive compensation is based on ROE and people are constantly focused on the quarterly earnings and how you did for that year.
So for most people the answer to your question, will this new model more faithfully represent the economics of the business versus the way we do it today, is no. For us, it is a little bit more complicated. We are in the business of insuring infrequent but severe events. So from a GAAP perspective the results are what they are. And a lot of it is outside of our control.
We also look at our book from an economic perspective on an expected basis, taking one step further than the FASB the IASB model. We use the building blocks approach where it is an expected loss model with a risk adjustment margin that reflects reserves development and the capital associated with that.
In a way the economic model that we use internally is more in line with that which the IASB is proposing and what US GAAP is. That said, would we want to report our results on an expected basis, would I want to sit here every quarter and sign off on our financial statements and want our auditors want to sign off on our financial statements based on 40,000 year simulations? I think the answer is no.
Using the model that exists today to track these infrequent, but severe events, you wait for them to happen and then you record your liability when that happens, your best estimate, to project and forecast what might happen in the future, essentially to predict those cash flows and put them on the balance sheet as a liability. Today we have the tools and the technology to do that, but we don’t think it is necessarily results in a better way to present our financial results, we much prefer the incurred loss model as it exists today rather than the expected loss model.
Gutzwiller: Discounting has been a hot topic. Where might that issue go in the next round?
Weiner: There is a practical expedient that says if you pay out the claim within one year of the insured event occurring you don’t have to discount. However, some people have said that it is hard to do because within the portfolio certain contracts or claims may be discounted and others not.
It was interesting to see the comment letters because before people were saying there is no time value of money. Now people are a little more honest and have recognised that there is a time factor to money—that $10 today is not the same as $10 10 years from now. That said, most people did not want to have discounting.