Risk Theoretic Issues in the Discounting of Loss Reserves

The discounting of property/casualty loss reserves to reflect the time value of money has been controversial issue for some time and recent activity in this area has been significant. In 1986 Congress passed landmark legislation to require discounting for income tax purposes. The National Association of Insurance Commissioners has formed a study group to further explore the advisability of discounting for statutory reporting purposes. Some state Insurance Departments have already begun to permit discounting in the statutory Annual Statement for some lines of business in which discounting had traditionally been prohibited. The AICPA is also studying the implementation of reserve discounting as it relates to GAAP financial reporting. Many insurance companies have been engaging in de facto discounting to some degree by means of overly optimistic reserving assumptions and/or by the purchase of financial reinsurance. In the public debate over discounting it has been pointed out, though not always appreciated, that a fundamental feature of property/casualty loss liabilities is their uncertainty. Opponents of discounting have argued that carrying loss reserves on an undiscounted basis is an implicit recognition of this uncertainty or risk. According to the argument the amount by which undiscounted reserves exceed their discounted value provides a buffer against this uncertainty, a "risk margin" of sorts. For several years now, the CAS Committee on Theory of Risk has been studying and discounting the issue of uncertainty in loss liabilities, particularly as it relates to the discounting of loss reserves. The Committee takes no official position on the discounting issue itself other than to agree with those observers who state that the issue can only be considered in the context of the purpose for which the financial statement is prepared; the issue can conceivable have a different resolution for statutory purposes, for example, than for tax purposes. Moreover, the Committee takes no official position on the proper accounting treatment to reflect uncertainty in reserves, regardless of the accounting context. Rather, our focus has been in the areas of I) identifying the sources of uncertainty, ii) expressing the uncertainty in dollar value terms. We hope that this status report on our activities to date will be of value to those professional committees currently debating the discounting issue and its accounting treatment and also to the regulatory bodies ultimately responsible for the resolution of the debate. We also hope to receive feedback from these audiences to assist us in directing and focusing our further research.