Fair Value AccountingFair Value Accounting

Mike Grillaert

KPMG LLP

September 23, 2002

Mike Grillaert

KPMG LLP

September 23, 2002

Casualty Loss Reserve Seminar

Fair Value at the FASBFair Value at the FASB

FASB began fair value project in 1986

SFAS No. 107, Disclosures about Fair Value of Financial Instruments, issued in 1991

SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, issued in 1993

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, issued in 1998

FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value Accounting Measurements, issued in 2000

A comprehensive Exposure Draft to come, but when???

FASB began fair value project in 1986

SFAS No. 107, Disclosures about Fair Value of Financial Instruments, issued in 1991

SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, issued in 1993

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, issued in 1998

FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value Accounting Measurements, issued in 2000

A comprehensive Exposure Draft to come, but when???

Fair Value: The FASB’s Ultimate GoalFair Value: The FASB’s Ultimate Goal

Paragraph 334 of Statement 133 . . .

The Board is committed to work diligently toward resolving , in a timely manner, the conceptual and practical issues related to determining the fair values of financial instruments and portfolios of financial instruments. Techniques for refining the measurement of the fair values of all financial instruments continue to develop at a rapid pace, and the Board believes that all financial instruments should be carried in the statement of financial position at fair value when the conceptual and measurement issues are resolved.

Paragraph 334 of Statement 133 . . .

The Board is committed to work diligently toward resolving , in a timely manner, the conceptual and practical issues related to determining the fair values of financial instruments and portfolios of financial instruments. Techniques for refining the measurement of the fair values of all financial instruments continue to develop at a rapid pace, and the Board believes that all financial instruments should be carried in the statement of financial position at fair value when the conceptual and measurement issues are resolved.

Why Is Fair Value Relevant?Why Is Fair Value Relevant?

Investors and Creditors are primarily interested in assessing the amounts, timing, and uncertainty of future net cash flows. Information is relevant if it helps with such an assessment.

Information based on prices that reflect the market’s assessment, under current conditions, of the present values of the future cash flows is more relevant than information based on old market prices.

Investors and Creditors are primarily interested in assessing the amounts, timing, and uncertainty of future net cash flows. Information is relevant if it helps with such an assessment.

Information based on prices that reflect the market’s assessment, under current conditions, of the present values of the future cash flows is more relevant than information based on old market prices.

What is Fair Value?What is Fair Value?

Since December of 2001, the FASB has made the following decisions:

Fair value of a financial instrument should be an estimated exit price—the price that would have been received or paid if it had been sold, exchanged, or settled on the measurement date.

Commissions paid on acquisitions, originations, sales, incurrences, or settlements of financial instruments should not be included in the determination of fair value; they should be reported as expense in the period in which they are incurred.

The effects of changes in an entity’s own creditworthiness and credit risk premium should be included in determining the fair value of that entity’s liabilities.

Since December of 2001, the FASB has made the following decisions:

Fair value of a financial instrument should be an estimated exit price—the price that would have been received or paid if it had been sold, exchanged, or settled on the measurement date.

Commissions paid on acquisitions, originations, sales, incurrences, or settlements of financial instruments should not be included in the determination of fair value; they should be reported as expense in the period in which they are incurred.

The effects of changes in an entity’s own creditworthiness and credit risk premium should be included in determining the fair value of that entity’s liabilities.

Fair Value and Concept Statement No. 7Fair Value and Concept Statement No. 7

February, 2000—FASB issued Concept Statement No. 107, Using Cash Flow Information and Present Value in Accounting Measurements.

Adopted expected value cash flow estimates rather than “most likely” best estimates.

Adopted fair value as measurement objective when employing present value.

Included impact of entity’s own credit standing in the measurement of its liabilities.

February, 2000—FASB issued Concept Statement No. 107, Using Cash Flow Information and Present Value in Accounting Measurements.

Adopted expected value cash flow estimates rather than “most likely” best estimates.

Adopted fair value as measurement objective when employing present value.

Included impact of entity’s own credit standing in the measurement of its liabilities.

Fair Value and Concept Statement No. 7 (cont.)

Fair Value and Concept Statement No. 7 (cont.)

Concept statement not an accounting standard, but used to develop new and revised accounting standards.

Concept Statement has been controversial.

FASB has issued 4 “Understanding the Issues” papers to explain its position.

Concept statement not an accounting standard, but used to develop new and revised accounting standards.

Concept Statement has been controversial.

FASB has issued 4 “Understanding the Issues” papers to explain its position.

FASB’s Next StepsFASB’s Next Steps

In March 2002, the Board temporarily suspended deliberations to focus on other, higher priority projects.

In September 2002, the Board expects to recommence deliberations on the scope of the proposed standard. This issue includes:The definition of financial instrumentsNonfinancial instruments that may be included in the

scopeFinancial instruments that may be excluded from the

scopeContracts that are very similar to specific financial

instruments.

In March 2002, the Board temporarily suspended deliberations to focus on other, higher priority projects.

In September 2002, the Board expects to recommence deliberations on the scope of the proposed standard. This issue includes:The definition of financial instrumentsNonfinancial instruments that may be included in the

scopeFinancial instruments that may be excluded from the

scopeContracts that are very similar to specific financial

instruments.

FASB’s Next Steps (cont.)FASB’s Next Steps (cont.)

Other Issues to be addressed in the proposed Exposure Draft:

Form and content of the required disclosure including presentation of changes in fair value

Disclosure of other matters, for example risk exposures, measurement sensitivity, and valuation policies and methods.

Other Issues to be addressed in the proposed Exposure Draft:

Form and content of the required disclosure including presentation of changes in fair value

Disclosure of other matters, for example risk exposures, measurement sensitivity, and valuation policies and methods.

Brief History of IASBrief History of IAS

International Accounting Standards Board (IASB) has been working since the late 1980s to develop a financial reporting model for all companies.

Framework completed in 1989Standards (IAS) developed since thenAn insurance standard has not been issued

Insurance project started in 1997 “Issues Papers” delivered in 1999 Draft Statement of Principles (DSOP) developed end of 2001 DSOP revision targeted for 2002, most likely end of 2003

International Accounting Standards Board (IASB) has been working since the late 1980s to develop a financial reporting model for all companies.

Framework completed in 1989Standards (IAS) developed since thenAn insurance standard has not been issued

Insurance project started in 1997 “Issues Papers” delivered in 1999 Draft Statement of Principles (DSOP) developed end of 2001 DSOP revision targeted for 2002, most likely end of 2003

Possible Insurance Contract TreatmentPossible Insurance Contract Treatment

The treatment described in the following slides are mostly the compilations of the thoughts surrounding the direction of IAS for insurance contracts.

Most of the items look to the Draft Statement of Principles and also look to the general IAS Framework for consistency with IAS objectives.

The final insurance contract accounting will likely differ from what is described herein and the differences could be significant.

IAS Definition of Insurance ContractIAS Definition of Insurance Contract

An insurance contract is a contract that exposes the insurer to identified risks of loss from events or circumstances occurring or discovered within a specified period, including death, survival (annuity), sickness, disability, property damage, injury to others, and business interruption.

Deferral & Matching vs Asset/Liability Approach

Deferral & Matching vs Asset/Liability Approach

Deferral and Matching

Not supported in DSOP

Asset & Liability ApproachSupported in DSOP

Fair ValueEntity Specific Value

Under each method, total profit is the same, but the emergence of profit is markedly different

Entity Specific Value – IAS Approach• Value of asset/liability to the firm

that holds it• May reflect factors not available or

relevant to the market• PV = costs firm will incur in settling

liability with PH/beneficiaries• Consistent with IAS 39

Comparison of MethodsComparison of Methods

Deferral & Matching• Emphasis on income statement• Expenses are deferred to match

future income• Profit emerges over term of

contract• No gain on sale

Fair Value – FASB Approach• Value for which asset/liability could

be exchanged between knowledgeable persons in an arms length transaction.

• PV = amount firm would have to pay a third party to assume liability.

Asset & Liability• Emphasis on balance sheet• Profit or loss results from change in

value of assets & liabilities• On initial recognition: provision for

risk and uncertainty• Possible gain on sale

Best estimate assumptions

- Stochastic modeling techniques strongly implied- Probability weighted approach- Options measured using option pricing techniques- No reference to underlying assets (except variable)

Asset/Liability - Entity Specific ValuationAsset/Liability - Entity Specific Valuation

Value of Insurance Contract =PV (all future cash flows including policyholder dividends)

Discount rate should be the risk free rate.

Market value margins (MVM) added to best estimate to adjust for risk and uncertainty.

- How to determine the level of MVM is being heavily debated (level prescribed in insurance standard?, left to company to decide?, left to company to decide?)

Impact for US CompaniesImpact for US Companies

Which Companies are affected?

- Companies listed on EU or Australian exchanges- Companies that report to EU or Australian parents- Companies that report to parents where the regulators are

requiring IAS.- Companies that wish to compare to their peer group, where

similar companies report on an IAS basis

Conversions to IAS are expected to take two phases

- IAS standards other than insurance, including IAS 39 work for insurance companies (by year end 2005)

This work has already started at some companies -- now is the time to get large projects started

- Insurance standard conversions once the standard has been set (estimated effective at year end 2007)

Which Companies are affected?

- Companies listed on EU or Australian exchanges- Companies that report to EU or Australian parents- Companies that report to parents where the regulators are

requiring IAS.- Companies that wish to compare to their peer group, where

similar companies report on an IAS basis

Conversions to IAS are expected to take two phases

- IAS standards other than insurance, including IAS 39 work for insurance companies (by year end 2005)

This work has already started at some companies -- now is the time to get large projects started

- Insurance standard conversions once the standard has been set (estimated effective at year end 2007)

FRR 60 – SEC Cautionary Advice Regarding Disclosure About Critical Accounting PoliciesFRR 60 – SEC Cautionary Advice Regarding

Disclosure About Critical Accounting Policies

Describe “critical” accounting policies

MD&A should be balanced and responsive, and linkages to FS effects should be explained in plain English

Audit committees should review accounting policy selection, application, and disclosure before finalization

Describe “critical” accounting policies

MD&A should be balanced and responsive, and linkages to FS effects should be explained in plain English

Audit committees should review accounting policy selection, application, and disclosure before finalization

Proposed Rule – Critical Accounting Policies

Proposed Rule – Critical Accounting Policies

Proposed rule released May 10, 2002

Issued as follow-up to FRR 60 (still in effect)

Would require a separate caption in MD&A section of annual reports, registration statements and proxy and information statements discussing critical accounting estimates and initial adoption of accounting policies

Proposed rule released May 10, 2002

Issued as follow-up to FRR 60 (still in effect)

Would require a separate caption in MD&A section of annual reports, registration statements and proxy and information statements discussing critical accounting estimates and initial adoption of accounting policies

What is Proposed Disclosure for Critical Accounting Estimates?

What is Proposed Disclosure for Critical Accounting Estimates?

For each critical accounting estimate:

- identify and describe the estimate, assumptions and reasonably likely changes

- Disclose significance to the financial statements and, where material, identification of the line items affected by the estimate;

- identify and discuss segments affected by the estimate (if any);

For each critical accounting estimate:

- identify and describe the estimate, assumptions and reasonably likely changes

- Disclose significance to the financial statements and, where material, identification of the line items affected by the estimate;

- identify and discuss segments affected by the estimate (if any);

What is Proposed Disclosure for Critical Accounting Estimates?

What is Proposed Disclosure for Critical Accounting Estimates?

For each critical accounting estimate:

- provide a quantitative discussion of the sensitivity of reported numbers to changes in estimates, either using possible changes in assumption(s) or a range of estimates;

- a quantitative and qualitative discussion of the changes in estimates for the past three years; and

- Disclose whether or not senior management has discussed the selection of estimates with the audit committee.

For each critical accounting estimate:

- provide a quantitative discussion of the sensitivity of reported numbers to changes in estimates, either using possible changes in assumption(s) or a range of estimates;

- a quantitative and qualitative discussion of the changes in estimates for the past three years; and

- Disclose whether or not senior management has discussed the selection of estimates with the audit committee.