Fair Value Accounting for Property-Casualty Insurance Liabilities

The accounting standards boards have adopted fair value measures for financial assets and liabilities, subject to reasonable constraints from established practice and uncertainties in the new procedures. FASB and IASB standards since 1992 have espoused a consistent fair value perspective for long-term bonds, common stocks, and derivative securities. The benefits of fair value for relevance, reliability, and transparency cannot be gainsaid. For assets and liabilities with liquid markets, fair values are easily measured. For property-casualty policy benefit reserves, which are not traded, fair values are disputed: - Financial economists use the present values at a risk-free rate as the fair value. - Some company actuaries and state regulators advocate additional risk margins. Much of this dispute stems from misunderstanding about risk margins in efficient markets and the cost of holding capital in a regulated industry. - Financial economists are correct that underwriting risks are diversifiable and are not compensated by higher returns in efficient markets. Risk margins would not be warranted in fair value policy benefit reserves if insurers did not hold capital above the present values of future loss payments or there no double taxation of corporate profits. - Insurers are correct that risk margins are needed in regulated markets with capital requirements, double taxation, and other costs of holding capital. These margins are based on financial theory, not on the actuarial risk load literature. This paper explains fair value accounting for property-casualty insurance. The fair values of policy benefit reserves - the present values at the risk-free rate plus the risk margin for the cost of holding capital - are based strictly on financial theory. They assume that underwriting risk is diversifiable and receives no additional return in efficient markets. The cost of holding capital for property-casualty insurance operations is debated. We present the range of views and explain the implications for fair value accounting. We provide readers with the tools to judge fair value positions; we do not provide a single fair value estimate. Many fair value issues have been obscured by partisan lobbying: some parties wish low loss reserves with no risk margins and others wish high loss reserves with material risk margins. It behooves actuaries to provide clear and objective analyses, with no motive other than the proper market-based estimates of unpaid losses.