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"Managing Insurer Asbestos Risks"


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This article discusses insurer attempts to manage asbestos liabilities and the financial implications of asbestos claims for insurers.

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"Managing Insurer Asbestos Risks"

  1. 1. InsurancedigestSharing insights on key industry issues*Americas edition • June 2004
  2. 2. The Americas Insurance digestis published three times a year,to address the key issues drivingthe insurance industry. If you wouldlike to discuss any of the issuesraised in more detail, please contactthe individual authors or theEditor-in-chief, whose details arelisted at the end of each article.We would also welcome yourfeedback and comments onInsurance digest, and as such,we enclose a Feedback Fax Replyform. Your feedback will help us toensure that our publications areaddressing the issues that you feelmost strongly about.
  3. 3. Contents Americas edition • June 2004Editor’s Comment 2John S. ScheidCorporate governance and Sarbanes-Oxley – Boon or bust for D&O insurers? 4Leslie J. HawkesIn the wake of the recent corporate scandals, insurers providing directors and officers liability insurance have seen the numberof D&O claims increase at an accelerating rate and the loss costs for these claims skyrocket. Will a renewed focus on corporategovernance and the introduction of the Sarbanes-Oxley Act 2002 actually improve insurers’ profit potential for this line of business,or will it set the standards so unrealistically high that lawsuits and loss costs will only continue to increase and cut into profits?International Financial Reporting Standards continue to progress 10David Scheinerman and William GoldsteinIFRS preparers will be required to adopt IAS 32 Revised and IAS 39 Revised for financial statements covering annual periodsbeginning on or after January 1, 2005. The scope of the revised standards is very wide, and the revisions provide further definitionand modified guidance in key areas. This article provides an overview of the provisions of the revised standards, highlightingsignificant changes and notable differences from US GAAP.Managing insurer asbestos risks 18Claire A. LouisThe financial implications of asbestos for the insurance industry, with losses estimated to be in the billions, are significant.This article examines how the industry has managed its asbestos exposure in the past and how insurers are leveraging lessonslearned to address current asbestos challenges. It also looks at efforts to legislate asbestos reform at the federal and state leveland considers the potential impact of the Sarbanes-Oxley Act of 2002 on insurer financial statement disclosures relative toasbestos liabilities and the monitoring of the controls environment surrounding insurers asbestos claims management.Managing General Agents and the implications of Sarbanes-Oxley – 26Legislating good business practicesKey Coleman, Steven Sumner and Anthony GrazianoThe Managing General Agent continues to be an excellent vehicle for the distribution of products and services of its insurerpartners. However, the Sarbanes-Oxley Act of 2002 ‘raises the bar’ in terms of corporate oversight, controllership and controlsover the financial reporting process for those insurers that do business with them.Supervision in insurance-affiliated broker dealers: 34Yesterday’s leading practices are today’s expected practicesEllen Walsh and Stephen KoslowVital insurance companies constantly change over time with new product offerings, target markets, distribution channels andoperating platforms. With these changes come increased risks that require enhancements to your NASD-required supervisorystructure. This article provides suggestions on maintaining an effective compliance program for your insurance-affiliatedbroker/dealer.
  4. 4. Editor’s Comment JOHN S. SCHEID: CHAIRMAN, AMERICAS INSURANCE GROUP Welcome to the ever, insurers will need to better understand Welcome to the June 2004 edition the risks they are insuring, and one would of Americas think that with the greater transparency June 2004 edition Insurance Digest. in financial reporting and independent assurance on controls, D&O writers will be of Americas With the first four months of 2004 better equipped to underwrite this risk. Insurance Digest. now in the record books, Our second article continues our focus on International Financial Reporting Standards many companies (IFRS) with a discussion of progress towards are seeing evidence of a growing global and adoption by some for financial statements regional economy. True there still remains covering annual periods beginning on uncertainty; however, most companies are or after January 1, 2005. This article, looking ahead to key challenges. It is some co-authored by David Scheinerman and of these challenges that form the content of Bill Goldstein, discusses the revised standards this edition of Insurance Digest. on financial instruments. IAS 32R and IAS 39R offer opportunities to reassess asset Clearly, corporate governance reform classifications and address derivative/hedge following the Sarbanes-Oxley legislation accounting effectiveness testing to name is a focus area for many insurers. Our first just a few. These revised standards represent article, authored by Leslie Hawkes, looks at a significant change from the initial standards recent trends in directors and officers liability and therefore IFRS preparers will benefit insurance. With increased corporate from a detailed review of the new provisions. responsibility for financial reporting and For many, continued uncertainty over many internal controls, will the D&O insurers be technical provisions within IFRS is making better able to assess the underwriting risks conversion more difficult. The required and offer better coverage? Today more than changes in accounting for financial2 Insurance digest • PricewaterhouseCoopers
  5. 5. instruments will undoubtedly require change Key Coleman, Steve Sumner and in insurance-affiliated broker procedures, processes and systems. Anthony Graziano discuss the critical need Maintaining a reasonable supervisory structureAlthough the scale of change will vary from for insurers who work with Managing General is essential in managing both financial andcompany to company, we have yet to find a Agents (MGAs) to focus on controls intended operational risk. It also helps to protect thecompany whose detailed analysis has indicated to manage all processes outsourced to reputation that all insurers have worked hardthat the impact will be less than first thought. MGAs. Sarbanes-Oxley is mandating a level to maintain. of formalized control and documentation ofFor several insurers asbestos litigation all processes affecting the financial reporting I hope you find this edition of Insurancehas been an increasingly difficult challenge process that has not typically been done in Digest interesting. Please do continue tosince the mid-1980s. Claire Louis examines either the insurer or MGA. Our authors identify provide us with feedback on the topics youhow the insurance industry has managed ten critical success factors for insurers and would like to see addressed in future issues.its asbestos exposure over the years and MGAs to consider. Use of MGAs offers Copies of this publication and the Asia-Pacificconsiders some lessons learned when insurers some good benefits but only if strong and European editions are available on ouraddressing today’s challenges of increasing communication and all risk/control website ( insurance coverage disputes, considerations are addressed.reinsurance reimbursement and fine-tuningclaims practices and processes. Claire Today’s demands for corporate responsibilitydiscusses the evolution of asbestos litigation and the ever-increasing regulatory expectationstogether with national and state initiatives can be considered yet another burden to beto attempt some asbestos litigation reform. faced. Insurance companies offering generalBased on our work with insurers, there does securities, investment advisory servicesseem to be good results from strong claims and banking/trust products have increasedmanagement practices, processes and the range of their supervisory risks and John S. Scheidclinical procedures coupled with a thorough responsibilities. As a result, several insurers Editor-in-chiefinternal control environment to further have thoroughly re-evaluated their supervisorymitigate financial, operational and regulatory system. Ellen Walsh and Steve Koslow Tel: 1 646 471 5350risk in this area. discuss key considerations for supervision Insurance digest • PricewaterhouseCoopers 3
  6. 6. Corporate governance and Sarbanes-Oxley – Boon or bust for D&O insurers? AUTHOR: LESLIE J. HAWKES4 Insurance digest • PricewaterhouseCoopers
  7. 7. Sarbanes-Oxley and other legislation require insurers to betterunderstand the risks they accept and to tighten underwriting standards. CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS?The Sarbanes-Oxley Act (SOA), a positive effect on the operation settlement amounts and thecorporate governance, enterprise- of the nation’s corporations in premium levels insurers arewide risk management, internal general. Will all this attention charging for this coverage.controls – all are terms that have to improved controls really ensurebeen in the forefront of the news that our corporations are being In 1995, in an attempt to stemrecently. However, the notions run by directors and officers who the tide of certain securityof corporate governance, risk are truly responsible and forthright class-action lawsuits, Congressmanagement, and internal individuals faithfully and honestly passed the Private Securitiescontrols are not new concepts. looking out for the shareholders’ Litigation Reform Act (PSLRA).These are the responsibilities best interests? Given the This legislation was intended toto which directors and officers extremely complex organizational decrease the number of ‘frivolous’ D&O insuranceof corporations supposedly have structure of most of today’s larger lawsuits by making it more difficultbeen regularly attending in their corporations, is it realistic to to file such suits. At the time of has been aroundroles as directors and officers expect that a single small group the passage of this legislation, for many years,since the beginning of time. at the top can provide the level of we were experiencing anYet whenever the topic turns control and oversight now expected extremely soft insurance cycle. but never beforeto recent corporate scandals as a result of new legislation and In the property and casualtyand accounting misstatements, the renewed concern with market, capacity was abundant has it receivedthese terms are bandied about corporate governance? and insurers were competing the level ofquite regularly as new and for business by offering moreimproved tactics that must But the $64,000 question coverage for lower prices. recognitionbe implemented in order to (or should it be the $64 billion Insurers offering D&O insurance question?) that D&O insurers began increasing coverage limits, experiencedreverse the current trend towardcorporate malfeasance. really want answered is: Will all of decreasing retentions, providing in the most this attention to the requirements broader coverage, and loweringPartially as a result of the recent of the SOA, corporate prices to attract more business. recent times.corporate scandals, insurers that governance, and internal controls Certain insurers began widelyprovide directors and officers actually improve insurers’ profit providing entity coverage,liability insurance have seen the potential for this line of business, also known as Side C coverage,number of D&O claims increase or will it set the standards so that covers the corporation itselfat an accelerating rate and the unrealistically high that lawsuits in the event of a shareholderloss costs for these claims and loss costs will only continue claim. Insurers were also attachingskyrocket. Recent awards to increase and to cut into profits? liberal severability response to shareholders’ Severability provisions arelitigation in cases such as Recent Trends in Directors and designed for the protection ofCendant and Waste Management Officers Liability Insurance innocent directors and officershave boggled the mind. D&O insurance has been around in the event of misdeeds by other for many years, but never before directors or officers. One exampleD&O insurers, investors, of the applicability of the has it received the level ofand regulators alike are left severability provision is that recognition experienced in thewondering if this legislation, material misstatements by certain most recent times. D&O claimsregulation, and renewed attention directors or officers on the original are on the rise. So, too, are theto corporate governance will have application for coverage without magnitude of D&O litigation Insurance digest • PricewaterhouseCoopers 5
  8. 8. CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS? continuedknowledge of innocent directors a director or officer without into the contract to provide the the restriction of variousand officers could lead to an the protection provided by coverage, they never would have consulting services beinginsurer nullifying coverage. D&O coverage. agreed to write D&O insurance in provided by public accountingThe severability provision would the first place.4 firms that are also providingprovide coverage for the The corporate and accounting accounting and audit services toinnocent directors or officers scandals of 2001 and 2002 were Since the full impact of the past an SEC registrant. One might askwhile nullifying it for those extreme eye-openers to D&O few years will remain unknown what these outcomes have to doresponsible for the insurers, yet in terms of loss- for several years to come, D&O with D&O insurance. It is notmisstatements. In anticipation of generating incidents, they were insurers have become much these provisions, but rather twodecreased numbers of lawsuits more akin to the proverbial straw more conservative in providing other significant areas of theas a result of PSLRA, insurers that broke the camel’s back than coverage. In addition to charging SOA that will have the greatestwere willingly decreasing an epiphany-creating event. much higher premiums for D&O impact on the D&O exposuresdeductibles, retentions, and The aforementioned softening insurance, insurers skilled at faced by SEC registrants subjectcoinsurance amounts in addition insurance market of the 1990s, providing this type of coverage to the charging much lower rates. combined with the dot-com bust are being much more selective of the few years leading up to about which businesses they Sections 302 and 404 of TheUnfortunately, the intended 2001 and 2002, had already are willing to insure and what Sarbanes-Oxley Act of 2002consequences of the 1995 begun to take a significant toll coverage grants they are willing Section 302 of the SOAlegislation were not realized, on D&O insurers’ profitability as to provide. Over the past two essentially requires companiesand in reality, the direct opposite the loss experience of the D&O years, some insureds have seen subject to the SOA to develop,occurred. In the three years that insurance line significantly their rates skyrocket, and, in implement, and institutionalizefollowed the passage of PSLRA, worsened during this period. general, rates are increasing a set of comprehensive internalthe number of securities class- The most notable of the anywhere from 30 percent to controls over all aspects of theiraction lawsuits that were filed corporate scandals – Enron, 300 percent, depending upon financial reporting to ensure thatincreased by 75 percent.1 WorldCom, and Tyco – have the type of organization and need reported financial statements areIn 1998, the Securities Litigation subsequently had a marked for limits and coverage. Insurers free from any materialUniform Standards Act was impact on the D&O marketplace. clearly are cutting back on entity misstatements that wouldpassed and did appear to stem However, it will take literally years coverage and severability and are mislead investors or regulators.the tide, at least for a couple of before all of the actual impact severely increasing retentions Section 404 of the SOA requiresyears, but now the number of created by these events will be and deductibles. that the company’s externalsuits is again rising. fully known and understood. auditors review and test these Many of the D&O insurers Enter Sarbanes-Oxley controls and attest to theIt was not too long ago that only involved with these corporations The Sarbanes-Oxley Act of 2002 effectiveness of the controls.the largest and most notable are attempting to invoke certain was enacted in direct response tocorporations purchased D&O policy provisions, such as the corporate scandals in an attempt The essence of the SOA,insurance as a regular practice. regulatory exclusion2 or the to bring investor confidence back particularly Sections 302 andToday, directors and officers of security law violation exclusion3, to the capital markets and to 404, is the requirement that allvirtually all types of to exclude coverage for some of create oversight for the accounting corporate directors and officersorganizations, particularly these scandals. Some insurers profession. Two key outcomes of exercise a much higher degreepublicly traded companies and are attempting to rescind the SOA were, first, the creation of control, take a much moreSecurities and Exchange coverage altogether by alleging of a public accounting oversight comprehensive view of allCommission (SEC) registrants, that the insured corporation entity, the Public Company internal controls, and fullyare fully aware that they simply acquired the coverage through Accounting Oversight Board assess how these controls affectcannot afford to take the misrepresentation and, had these (PCAOB), which is designed all aspects of the organization.personal risk associated with D&O insurers known the full to oversee the public accounting A summary of Sections 302serving in the capacity of picture when they first entered profession; and second, and 404 of the SOA follows5:1. PricewaterhouseCoopers LLP Securities Litigation Study (2002).2. The regulatory exclusion is included in most D&O contracts and excludes coverage for proceedings brought by regulatory agencies.3. Some D&O policies exclude coverage for losses which emanate from violations of security laws.4. ‘Enron and the D&O Aftermath – Tips and Traps for the Unwary.’ See Summary of the Sarbanes-Oxley Act of 2002 located at Insurance digest • PricewaterhouseCoopers
  9. 9. CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS? continuedSection 302: the assessment made by the Directors & Officers Liability insurance? It depends uponCorporate Responsibility management of the issuer. Insurance and Sarbanes- whom you ask.for Financial Reports An attestation made under Oxley: What Happens Next? this section shall be in Some insurers believe that the• The CEO and CFO of each Before we can know what future accordance with standards SOA will set the standards issuer shall prepare a lies ahead for the D&O insurance for attestation engagements so high that it will be nearly statement to accompany market, we first have to ask how issued or adopted by the impossible to meet them. the audit report to certify this legislation and increased Board (PCAOB). Similarly, the rules and the ‘appropriateness of the attention to corporate controls regulations set forth by the SOA financial statements and will affect the way our • Directs the SEC to require will be sufficiently complicated disclosures contained in the corporations will actually be run each issuer to disclose and complex that missing one or periodic report, and that those going forward. Will the SOA really whether it has adopted a code two requirements will open the financial statements and help to clean up the perception of ethics for its senior financial doors to increased shareholder disclosures fairly present, that many investors have of officers and the contents of litigation. John W. Keogh, the in all material respects, the corporate United States: that that code. president and chief executive operations and financial corporations are being poorly run officer of National Union Fire condition of the issuer.’ • Directs the SEC to revise its (or worse yet, being deceptively Insurance Co., a Pittsburgh A violation of this section must regulations concerning prompt run) and that lawsuits are the subsidiary of AIG, one of the be knowing and intentional to disclosure on Form 8-K to way to recoup monies lost in nation’s largest D&O insurers, give rise to liability. require immediate disclosure making bad investments? quoted in the October 9, 2003 ‘of any change in, or waiver issue of American Banker putsSection 404: There are those who believe that of,’ an issuer’s code of ethics. it this way, ‘God forbid you onlyManagement Assessment this new legislation and attention did 999 of the 1,000 things youof Internal Controls With the full implementation of to corporate governance will do need to do for Sarbanes-Oxley.’ the SOA (being phased in for nothing more than add layers of• Requires each annual This insurer believes that certain size companies in 2004 bureaucracy at the corporation report of an issuer to contain ‘Sarbanes-Oxley creates a and 2005), no longer will the CEO level and layers of regulation at an ‘internal control report,’ roadmap for plantiffs.’6 of an entity be able to say that he the government level. However, which shall: or she was unaware that the CFO others hope and believe that Still others believe that the (1) state the responsibility was misstating financial results to putting the spotlight and the increased transparency in of management for bolster share prices. The SOA onus on all members of the ‘C’ financial reporting and the actual establishing and will require that all corporate suite will prove to be very fruitful need for corporations to maintaining an adequate officers and directors understand in decreasing the opportunity for document, implement, and internal control structure the controls in place to ensure corporate greed to go undetected. institutionalize controls over and procedures for integrity over financial reporting As time progresses, the recent financial reporting will help D&O financial reporting; and and that they attest to the trend of corporate scandals will insurers separate the wheat from effectiveness of those controls. become a footnote to a process the chaff when it comes to (2) contain an assessment, whereby all investors stand on determining which organizations as of the end of the Like other legislation before it, equal footing and, with the are good D&O risks and which issuer’s fiscal year, of the the full effects of the SOA will proper amount of research, have are not worthy of their time, effectiveness of the internal take quite some time to shake the ability to be treated fairly by attention, and capital. control structure and out. There are still many more the capital markets. procedures of the issuer questions being asked than Clearly, insurers will need to do for financial reporting. being answered, and it will So what will be the effect of this a much more thorough job to not be until well into 2004 legislation and the other trends better understand the risk they Each issuer’s auditor shall before some of these questions toward increased corporate are insuring. This will require attest to, and report on, are answered. governance and scrutiny on the increased specialization in future of directors and officers6. Gjertsen, Lee Ann, ‘Scandal Responses Seen Multiplying D&O Risks,’ American Banker, 168, no. 195 (October 2003). Insurance digest • PricewaterhouseCoopers 7
  10. 10. CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS? continuedunderwriting for a line of business Summarythat is already one of the most These clearly are tumultuousspecialized in the market today. times for both the buyers and theD&O underwriters will have to do sellers of directors and officersa much more diligent review of liability insurance. Assimilating allthe more transparent financial of the recent changes into thestatements and disclosures. underwriting of D&O coverageUnderwriters will have to be able will be an essential step into review the level of controls insurers’ attempts to improveimplemented and understand their profitability in this line ofhow they permeate the business. The Sarbanes-Oxleyorganization. If D&O underwriters Act and a renewed attention todo this, however, they will corporate governance shouldimprove the quality of their help D&O insurers improve theunderwriting of the corporations quality of their books of businessto whom they provide coverage. and, subsequently, their profitThey will be willing to provide potential for this line of business.coverage only to those entities Will this actually prove to be thethat have adequate controls in case? Only time will This, in turn, will makecoverage for noncompliant Leslie Hawkes is a managerorganizations prohibitively in the Actuarial & Insuranceexpensive or nonexistent. Management Solutions (AIMS)Those organizations that cannot practice of PricewaterhouseCoopersfind or afford D&O insurance will LLP. She has over 23 years ofbe unable to attract quality experience in the property-directors and officers and soon casualty insurance industry.will cease to exist. The preceding article was originally printed in ‘The John Liner Review’, Vol. 17, No. 4 (Winter 2004) and is reprinted here with permission from The Standard Publishing Corporation. AUTHOR Leslie J. Hawkes Manager, Actuarial and Insurance Management Solutions Tel: 1 646 471 7424 Insurance digest • PricewaterhouseCoopers
  11. 11. CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS? continued Insurance digest • PricewaterhouseCoopers 9
  12. 12. International Financial Reporting Standards continue to progress AUTHORS: DAVID SCHEINERMAN AND WILLIAM GOLDSTEIN10 Insurance digest • PricewaterhouseCoopers
  13. 13. IAS 32 Revised, Financial Instruments: Disclosure and Presentationand IAS 39 Revised: Recognition and Measurement were publishedin December 2003 and amended in April 2004. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESSIntroduction preparers, particularly first-time The scope of the revised standards adopters, account for financial is very broad, and the revisionsPreparers of International instruments, and provide an provide further definition andFinancial Reporting Standards opportunity to reassess their modified guidance in key areas(IFRS) will be required to adopt asset classifications. such as:IAS 32 Revised and IAS 39Revised for financial statements For those companies currently • Scope – certain financialcovering annual periods beginning preparing US-GAAP financial guarantee contracts and loanon or after January 1, 2005. statements, the revised standards commitments are excluded;The revised standards on financial embody much of what is includedinstruments, IAS 32R and IAS39R, were issued in December in SFAS 115, ‘Accounting for Debt • Classification of financial The scope of the and Equity Securities,’ SFAS 133, assets and liabilities – on initial2003 clarifying principles making ‘Accounting for Declarative recognition, may choose to revised standardsthe standards easier to apply. measure any financial assetThese standards affect companies Instruments’ and SFAS 140 is very broad... ‘Accounting for Transfer and or liability at fair value throughin all industries, not just financial the profit and loss account; Security of Financial Assets andservices. Among other changes, purchased loans that are not Extinguishments of Liabilities’.the revised standards are likely quoted in an active market mayto change the way all IFRS be carried at amortized cost; FIGURE 1 Scope of revised standards overview Within Scope of Within Scope of Out of Scope Revised IAS 32 and IAS 39 Revised IAS 32 Only Debt and equity instruments, Investments in subsidiaries, and cash and cash equivalents associates and joint ventures Loans and receivables Lease receivables and payables (subject to derecognition, impairment, and embedded derivative provisions) Derivatives, including embedded Derivatives on entity’s Own use commodity contracts derivatives and on subsidiaries, own shares Financial guarantees based on related parties, and joint ventures loss incurred by holder Own debt Own equity Tax balances Employee benefits Insurance contracts Weather derivatives Loan commitments held for trading, Other loan commitments unless cannot be net settled and other criteria (required by 12/03 revisions) Source: PricewaterhouseCoopers Insurance digest • PricewaterhouseCoopers 11
  14. 14. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continued• Hedge accounting – hedging Scope A financial instrument is Initial recognition and of firm commitments are now classified as equity when it classification Generally, anything that meets treated as fair value hedges; represents a residual interest the definition of a financial IFRS, through revised IAS 39, in the net assets of the issuer. instrument is within the scope and US GAAP require an entity• The ‘derecognition’ model – Liabilities and equity components of IAS 32 and IAS 39, unless to recognize a financial asset substantially rewritten, of compound financial specifically exempted. (Figure 1 or liability on its balance sheet but retains the concepts instruments are accounted for provides an overview of what when, and only when, it becomes of rewards and control to separately. Derivatives on own is included in the scope of the party to the contractual determine inclusion within shares are classified as equity revised standards). provisions of the financial the financial statements; if they only result in delivery of instrument. Initial measurement Debt/Equity classification a fixed number of an entity’s• Fair value determination – of the financial instrument at fair shares or cash; otherwise, guidance changed and Revised IAS 32 establishes value, which will usually be the they are treated as derivatives, augmented; and principles for distinguishing same as the fair value of the accounted for under IAS 39. between a liability and equity. consideration given or received.• Certain disclosure requirements The substance of a financial If a financial instrument is valued The treatment of interest, moved from IAS 39 to IAS 32. instrument, rather than its legal by reference to a more favorable dividends, gains and losses form, governs its classification. market than the one in which the in the income statement followsThis article provides an overview The critical feature in identifying transaction occurred, an initial the classification of the relatedof the provisions of the revised a liability is the existence of an profit is recognized. Transaction financial instrument.standards, highlighting significant obligation to pay cash (or to costs are included in the initialDecember 2003 changes and exchange another financial Figure 2 provides a framework for carrying value of the financialnotable differences from instrument) under conditions that distinguishing between a financial instrument unless the instrumentUS GAAP. are potentially unfavorable to liability or equity instrument. is carried at fair value through the issuer. profit or loss. FIGURE 2 Financial liability and equity instruments framework Instrument Cash obligation Cash obligation for Settlement in fixed Classification for principle coupon/ dividends number of shares Ordinary stock n/a n/a n/a Equity Redeemable preferred ✓ ✓ n/a Liability stock, with 5% fixed dividend subject to distributable profits Redeemable preferred ✓ n/a n/a Liability for principal stock with discretionary Equity for dividends dividends Convertible bond into ✓ ✓ ✓ Liability for bond and fixed number of shares equity for conversion option Convertible bond into ✓ ✓ n/a Liability shares equal to value of the liability Source: PricewaterhouseCoopers12 Insurance digest • PricewaterhouseCoopers
  15. 15. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continuedFigure 3 lists the four classification categories of financial assets and their key provisions under IFRS and US GAAP are: FIGURE 3 Financial asset classifications under IFRS and US GAAP Asset Classification IFRS Provisions US GAAP Provisions Financial assets at fair • Assets acquired or originated principally for generating short-term profits Similar to IFRS frequent buying and selling value through profit or from trading usually indicates a trading instrument. loss (previously • Derivatives No option to designate, the classification is ‘trading’ assets) • Any financial asset designated at initial recognition; may not be reclassified based on prescribed classification definitions. Held-to-maturity (HTM) • Financial assets with fixed or determinable payments and fixed maturity Similar to IFRS. investments that an entity has positive intent and ability to hold to maturity (assessed at each balance sheet date) • Excludes originated loans and equity securities • If an entity sells more than an insignificant amount of HTM securities, the entity will generally be prohibited from using the HTM classification for any financial assets for 2 years and must reclassify existing HTM instruments as available for sale Loans and receivables • Non-derivative financial assets with fixed or determinable payments that All debts receivable that are not securities are originated by the entity are not quoted on an active market recognized at amortized cost. • Includes loans acquired as a participation in a loan from another entity or purchased by the entity (provided for by revised IAS 32) • Must recover all of its initial investment from the financial asset (other than due to credit deterioration) to be classified as a loan or receivable (provided by revised IAS 32) • May be classified and accounted for as held-to-maturity, ‘fair value through profit or loss’, or available for sale Available-for-sale • All financial assets not classified in another category are classified as Similar to IFRS. Changes in fair value reported in financial assets available for sale other comprehensive income. • Includes equity securities other than those classified as at fair value through income Source: PricewaterhouseCoopersFinancial liabilities are classified Reclassification of assets between This is consistent with SFAS 115 • It requires no or a smallereither as ‘financial liabilities at categories will likely be relatively and US GAAP accounting. initial investment than requiredfair value through profit or loss’ uncommon under revised IAS 39 to purchase the underlyingor as ‘other financial liabilities’. and is prohibited into and out of Embedded derivatives financial instrument; andLiabilities at fair value through the fair value through profit or loss Revised IAS 39 maintains theprofit or loss may be classified criteria. Reclassification from held- • It is settled at a future date definition of a derivative as aas held for trading or designated to-maturity as a result of a change (note: there is not a financial instrument with allto this category at inception. of intent or ability are treated as requirement for net of the following characteristics:If adopted, a proposed sales and generally result in the settlement, as requiredamendment to IAS 39 would whole category being ‘tainted’ and • Its value changes in response by US GAAP FAS 133).restrict the application of fair remeasured at fair value, with any to changes in an ‘underlying’value for liabilities to situations gain or loss recognized in equity. Derivatives embedded within price or index;satisfying certain strict criteria. a host contract are separately Insurance digest • PricewaterhouseCoopers 13
  16. 16. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continuedrecognized (bifurcated) and Generally, a financial asset transfer of substantially all the Similarly, under US GAAP, in theaccounted for separately if: (or part of an asset) is risks and rewards; control is then transfers of financial assets, derecognized when: applied as a secondary test. each entity that is a party to the• The economics of the transaction recognizes only the embedded derivative are not • The rights to the cashflows A financial liability is removed assets it controls and liabilities it ‘closely related’ to those of from the asset expire; from the balance sheet only has incurred. In addition, a party the host contract; when it is extinguished. can only derecognize assets • The rights to the cashflows Extinguishment occurs when the when control has been• The embedded derivative and substantially all the risks obligation in the contract is surrendered, and derecognize would meet the definition of and rewards of ownership of discharged, cancelled, or liabilities only when they have a derivative on a stand-alone the asset are transferred; expired. A transaction is been extinguished. basis; and accounted for as a collateralized • An obligation to transfer the borrowing if the transfer does not Subsequent measurement,• The entire contract is not cashflows from the asset is satisfy the conditions for fair values, and impairment carried at fair value. assumed and substantially all derecognition. The classification of a financial the risks and rewards areDerecognition asset determines the subsequent transferred; and On derecognition of a financial measurement of the asset.Derecognition is the term used asset in its entirety, the difference • Control of the asset is Figure 4 summarizes thefor removal of an asset or liability between the carrying amount transferred, even if substantially principles:from the balance sheet. Revised and the consideration received all the risks and rewards are is included in the incomeIAS 39 sets out the criteria for Financial assets categorized as neither transferred nor retained, statement. If only part of aderecognition of financial assets those at fair value through profit in which case the asset is financial asset is derecognized,or liabilities and the resulting or loss (including trading assets) recognized to the extent of the the carrying value of the financialaccounting treatment. are measured at fair value, with entity’s continuing involvement. instrument is allocated based changes in fair value included inUnder US GAAP, derecognition is on relative fair value at the date The revisions to IAS 39 clarify the net profit or loss for thebased on control. Legal isolation of transfer and the gain or loss that derecognition is to be period. All other (non-trading)of assets even in bankruptcy is accounted for on the initially assessed based on financial assets are carried atnecessary for derecognition. derecognized part. amortized cost. The carrying amount of a FIGURE 4 Summary of principles of financial assets financial instrument carried at amortized cost is computed as the amount to be paid at Financial Assets Measurement Changes in Impairment test maturity adjusted for any carrying amount (if objective evidence) unamortized original premium or discount, net of any Financial assets at fair Fair value Income statement No* origination fees or transaction value through profit or loss costs and any principal repayments. The financial Loans and receivables Amortized cost Income statement No** instrument is amortized using the effective interest method, Held-to-maturity Amortized cost Income statement Yes* which uses the rate of interest investments necessary to discount the cashflows through expected Available-for-sale Fair value Equity Yes* maturity or derecognition date financial assets in order to equal the amount at * This is consistent with the accounting under US GAAP; initial recognition. ** SFAS 114 and 118 requires companies to evaluate loans for impairment. Source: PricewaterhouseCoopers14 Insurance digest • PricewaterhouseCoopers
  17. 17. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continuedFair value is ‘the amount for IFRS requires an entity towhich an asset could be consider impairment when thereexchanged, or a liability settled, is an indicator of impairment,between knowledgeable, willing such as: the deterioration in theparties in an arm’s length creditworthiness of atransaction.’ Revised IAS 39 counterparty; an actual breachprovides a hierarchy to be used of contract; a high probability ofin determining a financial bankruptcy; or the disappearanceinstrument’s fair value: of an active market for an asset.1. If there is an active market, Generally US GAAP requires the the quoted market price is write-down of financial assets to be used. when an entity considers a decline in fair value to be ‘other2. If no active market, valuation than temporary’. Indicators of techniques, incorporating all impairment are: the financial factors that market health of the counterparty; participants would consider whether the investor intends to in setting a price, consistent hold the security for a sufficient with the economics and period to permit recovery in methodologies for pricing value; the duration and extent financial instruments. that the market value has been Hedge accounting can be instrument is recognized below cost; and the prospects of applied to three types of directly in equity.3. If there is no active market for a forecasted market price recovery. hedging relationships: an equity instrument and the US GAAP is similar to IFRS in the range of reasonable fair value Hedge accounting 1. Fair value hedges, for which accounting for hedging of financial estimates is significant and the gain or loss from the instruments except as follows: IAS 39 allows for hedge no reliable estimate can be hedging instrument is accounting, subject to strict made, an entity is permitted recognized immediately in the 1. US GAAP does not consider requirements, including the to measure the equity income statement, and the a basis adjustment on cash existence of formal instrument at cost less carrying amount of the hedged flow hedges of forecasted documentation and the impairment as a last resort. item is adjusted for the gain or transactions; achievement of effectiveness loss attributable to the hedged tests. Their documentationSimilar to US GAAP, realization of risk (and the change is also 2. When measuring hedges of must include the entity’s riskgains on initial recognition of a recognized immediately in the foreign entity investments, management objective andfinancial instrument are expected income statement); ineffectiveness is recognized strategy for undertakingto be rare. in the income statement. the hedge. 2. Cash flow hedges, includingImpairment losses are incurred hedges of foreign currency If the hedging relationship All derivatives that involve anif, and only if, there is objective risk associated with firm comes to an end (e.g., the external party may be designatedevidence of impairment as a commitments, for which the hedging instrument is sold), as hedging instruments (exceptresult of a past event that gain or loss from the hedging one of the hedge criteria is no certain written options).occurred subsequent to the initial instrument is recognized longer met (e.g., the hedge does An external non-derivativerecognition of the asset. directly in equity. The gain or not pass effectiveness tests) instrument may only beExpected losses as a result of loss is ‘recycled’ to the income or the hedging relationship is designated as a hedgingfuture events, no matter how statement when the hedged revoked, then hedge accounting instrument of foreign currencylikely, are not recognized. cash flows affect income; and must be discontinued. Hedge risk. The fundamental principle is effectiveness requires twoBoth IFRS and US GAAP have that the hedged item creates an 3. Hedges of a net investment in separate tests which must besimilar requirements for the exposure to risk that could affect a foreign operation, for which applied prospectively andimpairment of financial assets. the income statement. the gain or loss on the hedging retrospectively: Insurance digest • PricewaterhouseCoopers 15
  18. 18. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continued• Prospective effectiveness Conclusion testing must be performed IFRS continues to evolve and will at inception of the hedge have significant impact on the and at each reporting date financial statements of IFRS during the life of the hedge. preparers, as evidenced by the This test requires the entity recent revised IAS 32 and IAS 39. to demonstrate that it expects The revised standards are a changes in the fair value or significant change from the initial cash flows of the hedged standards and have essentially item to be almost fully offset rewritten the rules for derecognition. (i.e., nearly 100%) by the change in fair value of the IFRS preparers and those entities hedging instrument. considering adopting/converting their accounting policies to• Retrospective effectiveness IFRS will benefit from a detailed testing is performed at each assessment of the provisions reporting date throughout the of the revised standards, life of the hedge in given the potential required accordance with the hedge changes in the way entities documentation methodology. account for financial instruments, which may therefore require Similar to US GAAP substantial changes to systems, requirements for hedge processes, and documentation. effectiveness, the objective is As IFRS is in a period of to show that the actual results significant change, it’s essential of the hedge are within the that IFRS preparers continue range of 80-125%. to monitor the developmentsBased on the recently issued and proposed changes andamended IAS 39, most portfolio evaluate their potential impacthedges of interest rate risk to their business.(sometimes referred to as‘macro’ hedges) will qualify forfair value hedge accounting. AUTHORS David Scheinerman Principal Consultant, Actuarial Insurance Management Solutions Tel: 1 860 240 2046 William Goldstein Senior Manager, Assurance Services Tel: 1 646 471 7253 Insurance digest • PricewaterhouseCoopers
  19. 19. INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continued Insurance digest • PricewaterhouseCoopers 17
  20. 20. Managing insurer asbestos risks AUTHOR: CLAIRE A. LOUIS18 Insurance digest • PricewaterhouseCoopers
  21. 21. The mounting costs of asbestos litigation continue to take their toll on insurers.Increasingly, smaller, regional, and specialty insurers are being drawn into the fray.These companies may be especially vulnerable because they lack the knowledge,experience, infrastructure, processes, and resources of insurers for which themanagement of asbestos liabilities is a mature enterprise. If they are to maintain theconfidence of shareholders and rating agencies, insurers must practice a sound riskmanagement strategy, which is aligned with the ever shifting nature of asbestos litigation. MANAGING INSURER ASBESTOS RISKSIntroduction since the late 1990s; the surge With the increase in reinsurance in policyholder bankruptcies disputes related to asbestosDespite the general introduction and related ‘pre-packs’; case liabilities, Sarbanes-Oxley providesof the asbestos exclusion into management efficiencies that more reason than ever for insurersgeneral liability policies in the favor plaintiffs, force defendants to reassess the reasonablenessmid-1980s, the insurance industry and insurers into unfavorable of their provisions for reinsurancein 2004 continues to try to come settlements, and encourage the recoverables. Past assumptionsto grips with its historical filing of more claims; skyrocketing regarding the expected level ofasbestos liabilities. Analysts and jury awards; non-products-related payments from reinsurers mayrating agencies alike identify exposures; the recent emergence no longer be valid. As such, it isasbestos as one of the majorfactors impeding insurance of ‘mixed dust’ (asbestos and silica) possible that insurers may find In 2003 alone, claims; and increasing reinsurance themselves having to adjust theindustry growth. This article will disputes. We will discuss efforts level of their provisions. US insurersdiscuss insurers’ attempts tomanage asbestos liabilities and to legislate asbestos reform at the strengthened federal and state levels. Increased regulatory and ratingsthe financial implications of asbestos reserves agency scrutiny, reduced profits,asbestos for insurers. We will consider the potential potential ratings downgrades, impact of the Sarbanes-Oxley impaired reinsurance recoveries, by $5.204 billion.Rating agencies, including Fitch Act of 2002 on insurers’ financial shareholder actions, and evenand A.M. Best, estimate that statement disclosures relative insolvency are some of the perilsUS insurance industry asbestos to asbestos liabilities and related faced by insurers with asbestoslosses may reach $65 billion1. reinsurance recoverables and liabilities. Those insurers thatAccording to Morgan Stanley, the monitoring of the controls recognize and mitigate these risksUS insurers increased asbestos environment surrounding insurer through a consistent, disciplinedreserves by close to 70% asbestos claims management. program of asbestos portfoliobetween 1998 and 2003. The quality of insurer reporting management, which includesIn 2003 alone, US insurers of asbestos liabilities varies conservative reserve provisioning;strengthened asbestos reserves considerably. Not all insurers have aggressive claims management;by $5.204 billion2. Despite these robust, formalized processes and and consistency, accuracy, andsignificant actions, the projected controls for collecting and thoroughness in loss presentationshortfall between the insurance appropriately analyzing relevant, to reinsurers stand the bestindustry’s estimated $39 billion in accurate, and complete asbestos chance of weathering this ‘Perfectfuture asbestos-related costs and claim data and managing their Storm,’ which asbestos litigationexisting reserves is $20 billion3. asbestos exposures. Sarbanes- has become. Indeed, legislativeWe will examine how the industry Oxley provides the impetus for relief from asbestos liabilities atmanaged its asbestos exposure insurers to enhance their asbestos the federal level in the near termin the past and how insurers are claims processes and controls is far from certain as there is aleveraging lessons learned to and, in so doing, reduce lack of complete stakeholderaddress current asbestos uncertainty on the balance sheet consensus. As with tort reformchallenges: the significant increase and realize new opportunities to so far, insurers’ greatest hope forin unimpaired asbestos claim filings limit their liabilities. meaningful change in the existing1. Jardine Lloyd Thompson, ‘Insurance Market Overview,’ December 2003, citing AM Best report October 2003, p. 22.2. This PricewaterhouseCoopers estimate is based on a review of insurer data reported through mid-January 2004.3. A.M. Best, 2003. Insurance digest • PricewaterhouseCoopers 19