The Fair Value of Insurance Liabilities

389 Pages·1998·8.877 MB·English

by  Robert C. Wilkins (auth.), Irwin T. Vanderhoof, Edward I. Altman (eds.)

THE FAIR VALUE OF INSURANCE LIABILITIES
The New York University Salomon Center Series
on Financial Markets and Institutions
VOLUME 1
The titles published in this series are listed at the end of this volume.
THE FAIR VALUE OF
INSURANCE LIABILITIES
Edited by
IRWIN T. VANDERHOOF
and
EDWARD I. ALTMAN
Stern School of Business
New York University
STERN•
Leonard N. Stem School of Business '
SPRINGER-SCIENCE+BUSINESS MEDIA, B.V.
A C.I.P. Catalogue record for this book is available from the Library of Congress
ISBN 978-1-4419-5178-6 ISBN 978-1-4757-6732-2 (eBook)
DOI 10.1007/978-1-4757-6732-2
Printed an acid-free paper
Ali Rights Reserved
© 1998 Springer Science+Business Media Dordrecht
Originally published by Kluwer Academic Publishers in 1998
No part of the material protected by this copyright notice may be reproduced or
utilized in any form or by any means, electronic or mechanical,
including photocopying, recording or by any information storage and
retrieval system, without written permission from the copyright owner.
Table of contents
Introduction
Irwin T. Vanderhoof . vii
Welcome
Frederick D.S. Choi XVll
1. Background on fair value accounting of insurance company
assets and liabilities
Robert C. Wilkins . . . . . . . . . . . . . . . 1
2. Comparison of methods for fair-value life insurance liabilities
Arnold A. Dicke . . . . . . . . . . . . . . . . 7
3. Fair valuation of life insurance company liabilities
Douglas C. Doll et a/. . . . . . . . . . . 21
Discussion
David F. Babbel . . 115
4. Experience in implementing fair value of insurance liabilities
Dennis L. Carr . . . . . . . . . . . . . . . . . 127
Discussion
J. Peter Duran . . . . . . . . . . . . . . . . . . 133
Joseph E. Crowne . . . . . . . . . . . . . . . . . 137
5. Allowing for asset, liability, and business risk in the valuation of
a life company
Shyam J.B. Mehta . . . . . . . . . . . . . . . . 143
Discussion
Phelim Boyle 197
6. A market-value accounting framework for insurance companies
Mark Griffin . . . . . . . . . . . . . . . 201
Discussion
Joan Lamm-Tennant . 211
7. Option adjusted value of the firm
David N. Becker . . . . . . 215
Discussion
Kim Staking 289
v
vi Table of contents
8. The cash flow method for valuing liabilities in Canada
Allan Brender . . . . . . . . . . . . . . . 297
9. The derivation and application of accounting standards to the
market value of liabilities
Christopher D. O'Brien . . . . . . . . . . . . . . 303
The indexed discount rate method for fair valuation of liabilities
S. Michael McLaughlin . . . . . . . . . . . . . . . 331
Is Paul vs. Virginia dead?
Krzysztof M. Ostaszewski 351
Remarks
Joan Lamm-Tennant . 361
List of contributors 363
Index . . . . . 371
IRWIN T. VANDERHOOF
New York University
Introduction: fair value of insurance liabilities
The formal papers in this volume are responses to a call for papers on the
subject of 'market' value of insurance liabilities sponsored by the Society of
Actuaries. 'Fair value' and 'market value' are viewed as equivalent ideas by
F ASB. The discussions were prepared for a conference jointly sponsored by
the Society of Actuaries and the Salomon Center at the NYU Stern School of
business. Both the call for papers and the conference were inspired by the
decision of the Accounting Standards Board and the SEC that at least some
assets of insurance companies should be reported on a basis of market value
rather than amortized cost. In addition, in the future mutual companies will
have to make reports using generally accepted accounting principles (GAAP)
rather than only using statutory accounting methods.
These new standards seem to require rethinking of the accounting and
financial operations of insurance companies, banks, and other financial interme
diaries, for they are all subject to the same requirements.
A ROMANTIC VIEW OF ACCOUNTING
Characterizing this as 'romantic' is intended to absolve me from strict adherence
to whatever facts may be pertinent.
Let us first consider the romantic history of accounting and its contribution
to literature and science. It is generally accepted that the oldest written piece
of literature still existent is the Epic of Gilgamesh, dating to the Sumerian
civilization, but there are written records that predate even this ancient lay.
These are scraps of parchment containing notes of items and prices. They are
trade documents and accounting records. Sacred scripture could be, and often
was, memorized. Accounting records keep changing and they may have to go
from hand to hand rather quickly. Memories were inadequate for this purpose.
Records of debt might be traded and records were needed so that a legal status
could be attained. Only writing was adequate for these purposes.
The records of every civilization support the idea that writing was not
developed to allow poetry or plays to be written. It was not developed to allow
the writing of sacred texts. It was developed for accounting. The poetry and
plays were just a side benefit.
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I. Vanderhoof and E. Altman (eds.), The Fair Value of Insurance Liabilities, rii-xt·.
© 1998 Kluwer Academic Publishers.
viii /. T. Vanderhoof
Similarly, it seems unlikely that mathematics was devised so that people
could develop number theory or Euclidean geometry. The basis of mathematics
was counting and the reason for counting was the need for accounting records.
Even one old meaning of the phrase 'to account for' is to give an explanation.
Accounting has therefore been closely allied and behind the underpinning of
mathematics and science.
Being the basis for literature, mathematics, and science should be enough
to qualify accounting for some romantic treatment.
Let us consider a simplified history of accounting to see how we arrived at
our present kinds of problems. Let's start with the situation of the Roman
merchant Severius. He sells the jars called amphora for a certain number of
the coins called denarii. He buys for one and sells for two, thereby showing a
1% [100%???] profit. (Percentage calculations were hard with Roman numer
als). If the business owns only its inventory, then he can conveniently measure
his profit in terms of the number of denarii in his safe hole. His concern with
accounting at this stage is simply whether he is conducting his business properly
and how to improve profits. He will measure his wealth in terms of denarii.
On the other hand, that may not work. If he has recently purchased a large
number of amphora, then his denarii may be down even though his wealth has
not decreased. He can measure his actual wealth only by taking into consider
ation the inventory as well as the amount of cash in hand. How should we
measure the value of the inventory? One way would be to value the inventory
at current market prices. In this case we would have to decide whether to use
a seller's price or a buyer's price. When describing his wealth to his significant
other, he might use the price at which he thought he could sell the jars. If he
were optimistic, this might be much larger than the price at which he bought.
If he wanted to use his wealth as a basis for borrowing more money to
allow the purchase of more inventory, then he would certainly use the higher
price. On the other hand, the lender might reject this valuation. The lender
might well say that the proper basis would be the price at which the items
were purchased. At least that should be clearly determinable. This might be a
basis for determining the ability to repay the loan. This conservative approach
might be more comfortable for the lender. However, even this might fail. The
wholesale market for amphora might have collapsed, and the more conservative
value of market should be used. A current American approach to this problem
would be to use cost if consideration of the market made it possible to believe
that this would be recouped. In some countries the choice has been to use the
lower of cost or the lowest market value ever observed.
Severius has now borrowed money for a radical expansion of inventory. He
has found some Greeks that are charging prices that seem to make the sales a
gift. He therefore borrows and buys all he can.
There is then a question as to what the market really is. His inventory now
exceeds the demand for jars for the next several years. If he tried to sell, even
at the buyer's price, there would be no buyers. There is now a real question as
to what is meant by market price. However, despite the fact that there may be
Introduction: fair value of insurance liabilities ix
a question of the liquidation value of this inventory, if we can establish that
the business is a going concern, that it will continue for a long period in the
future, then we can treat the valuation of the inventory on that basis. We do
not have to treat it as market value in a panic sale.
His next problem is to find a place to store all these items. He is able to
borrow more funds to build a special purpose warehouse for the jars. He is
now in a situation where the debts clearly exceed the market value of his
possessions. In the case of the warehouse, there is not even a buyer available.
How can the accountant look at this situation? Well, if he is still able to sell
this product at a traditional price, then the warehouse can be valued at some
version of cost. From the point of view of wealth this activity has not impaired
the value of the business. We still, however, need to consider the expenses
involved.
While the problem of too much inventory can be related to the 'going
concern' view of a company, the problem of expenditures for fixed assets, like
a building, require another insight. In this case, that is provided by the matching
of revenues and expenses. The building will be used over many years; therefore,
the expense of it must also be spread over many years in calculating the
net income.
While it is nice that Severius was so easily able to find a lender to finance
his expansion, that lender might also have some concerns and requirements.
Obviously, the lender would be concerned about the honesty of the representa
tions in the ledgers. He might require that someone independent check the
books. The lender would also be concerned about the relative attractiveness
of this loan vs. others that were also available to him. Because of this concern,
the lender would try to impose some sort of consistency between the accounting
treatment used by different borrowers. The worm in the accounting apple now
appears. Unless great care is taken, borrowers will try to manage the accounts
instead of managing the business. Accounting, which should help the manage
ment of the business and the understanding of the business by outsiders,
becomes a driving force. Managing the appearance may become as important
as managing the business.
The final great conceptual evolution of accounting took place in the Middle
Ages. A monk, Brother Pacioli, wrote a book on double entry bookkeeping.
An undigested piece of mutton and an extra glass of Benedictine are equally
suspect in this. While the idea is surely a great step forward, when actually
trying to implement it, there are often problems. The great advantage of double
entry bookkeeping is that it is easier to find wrong entries, both accidental and
intentional. Since every entry is made as both a debit to one account and a
credit to another, income or asset or expense or liability, if the two totals are
not consistent, we know there has been an error. Unfortunately, while it is easy
to determine that there is a wrong entry, it may not be so simple to determine
exactly where the error is.
Life insurance companies, prizing a reputation for eccentricity, often talk as
if they use single entry accounting. They cite the fact that the reserve calculation
x I. T. Vanderhoof
is done on an inventory basis and a bulk adjustment made to income and
liabilities. Lots of such adjustments are made. Life insurance accounting is like
that of any other business from this point of view.
ONWARD TO FAS 115
The justification for the fanciful view of accounting is that it illustrates that
the essential accounting approaches are understandable in terms of the smallest
business. Matching revenue and expenses, the going concern principle, and the
need for consistency are the principles that must guide our efforts. They can
all be illustrated in terms of the simplest examples. However, what does that
lead to in terms of life insurance accounting?
Life insurance accounting could be portrayed as a maverick kind of opera
tion - hardly obeying the rules. I have already mentioned the double entry
accounting question. There was supposed to be another crucial difference. It
was that life insurance accounting was supposed to be based on liquidation
values, not going concern values.
Well, this was clearly not true. If you were concerned with liquidating values,
you would always use market values for assets. There was a clear methodology
built up so that market values were practically hidden. The objective was not
to provide a liquidating values statement. The objective was to provide a
financial statement that would demonstrate the ability of the company to pay
claims when due and to provide a gradual development of surplus. These
accounting objectives would reduce the possibility of policy holder runs against
the companies. This was always a significant danger when many of the assets
were illiquid.
A second crucial objective was that the company should have significant
hidden values. This would allow the regulators to take over the companies
while there was enough embedded value to allow the policy holders to be paid
off in full. This was accomplished by using low interest rates in the valuation
requirements and by writing off expenses rather than amortizing them.
Two of the basic principles of accounting were being implemented in life
insurance accounting. The statutory statements were on a going concern basis,
despite industry protestations to the contrary, and there was excellent consis
tency between years and companies. Consistency was generally mandated by
the laws of the states. Statutory accounting was not a total failure. Some
companies are using it as the basis for both management and reporting because
of the consistency factor.
A third principle was ignored, however. That was that there should be
reasonable matching between the timing of revenue and expenses. The possible
mismatch created by the use of a low valuation interest rate might have been
tolerated as long as the differences were small. The difference caused by the
writing off of acquisition expenses in the year of issue of a new policy was too
much for investors to bear. The well-managed companies that were rapidly