"Managing Insurer Asbestos Risks"

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Americas edition • June 2004

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Contents

Americas edition • June 2004

Editor’s Comment 2
John S. Scheid

Corporate governance and Sarbanes-Oxley – Boon or bust for D&O insurers? 4
Leslie J. Hawkes
In the wake of the recent corporate scandals, insurers providing directors and officers liability insurance have seen the number
of D&O claims increase at an accelerating rate and the loss costs for these claims skyrocket. Will a renewed focus on corporate
governance 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 10
David Scheinerman and William Goldstein
IFRS preparers will be required to adopt IAS 32 Revised and IAS 39 Revised for financial statements covering annual periods
beginning on or after January 1, 2005. The scope of the revised standards is very wide, and the revisions provide further definition
and modified guidance in key areas. This article provides an overview of the provisions of the revised standards, highlighting
significant changes and notable differences from US GAAP.

Managing insurer asbestos risks 18
Claire A. Louis
The 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 lessons
learned to address current asbestos challenges. It also looks at efforts to legislate asbestos reform at the federal and state level
and considers the potential impact of the Sarbanes-Oxley Act of 2002 on insurer financial statement disclosures relative to
asbestos liabilities and the monitoring of the controls environment surrounding insurers asbestos claims management.

Managing General Agents and the implications of Sarbanes-Oxley – 26
Legislating good business practices
Key Coleman, Steven Sumner and Anthony Graziano
The Managing General Agent continues to be an excellent vehicle for the distribution of products and services of its insurer
partners. However, the Sarbanes-Oxley Act of 2002 ‘raises the bar’ in terms of corporate oversight, controllership and controls
over the financial reporting process for those insurers that do business with them.

Supervision in insurance-affiliated broker dealers: 34
Yesterday’s leading practices are today’s expected practices
Ellen Walsh and Stephen Koslow
Vital insurance companies constantly change over time with new product offerings, target markets, distribution channels and
operating platforms. With these changes come increased risks that require enhancements to your NASD-required supervisory
structure. This article provides suggestions on maintaining an effective compliance program for your insurance-affiliated
broker/dealer.

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 financial

2 Insurance digest • PricewaterhouseCoopers

instruments will undoubtedly require change Key Coleman, Steve Sumner and in insurance-affiliated broker dealers.
to procedures, processes and systems. Anthony Graziano discuss the critical need Maintaining a reasonable supervisory structure
Although the scale of change will vary from for insurers who work with Managing General is essential in managing both financial and
company to company, we have yet to find a Agents (MGAs) to focus on controls intended operational risk. It also helps to protect the
company whose detailed analysis has indicated to manage all processes outsourced to reputation that all insurers have worked hard
that the impact will be less than first thought. MGAs. Sarbanes-Oxley is mandating a level to maintain.
of formalized control and documentation of
For several insurers asbestos litigation all processes affecting the financial reporting I hope you find this edition of Insurance
has been an increasingly difficult challenge process that has not typically been done in Digest interesting. Please do continue to
since the mid-1980s. Claire Louis examines either the insurer or MGA. Our authors identify provide us with feedback on the topics you
how 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-Pacific
considers some lessons learned when insurers some good benefits but only if strong and European editions are available on our
addressing today’s challenges of increasing communication and all risk/control website (www.pwc.com/financialservices).
asbestos insurance coverage disputes, considerations are addressed.
reinsurance reimbursement and fine-tuning
claims practices and processes. Claire Today’s demands for corporate responsibility
discusses the evolution of asbestos litigation and the ever-increasing regulatory expectations
together with national and state initiatives can be considered yet another burden to be
to attempt some asbestos litigation reform. faced. Insurance companies offering general
Based on our work with insurers, there does securities, investment advisory services
seem to be good results from strong claims and banking/trust products have increased
management practices, processes and the range of their supervisory risks and John S. Scheid
clinical procedures coupled with a thorough responsibilities. As a result, several insurers Editor-in-chief
internal control environment to further have thoroughly re-evaluated their supervisory
mitigate financial, operational and regulatory system. Ellen Walsh and Steve Koslow Tel: 1 646 471 5350
risk in this area. discuss key considerations for supervision john.scheid@us.pwc.com

Insurance digest • PricewaterhouseCoopers 3

Corporate governance
and Sarbanes-Oxley –
Boon or bust for D&O insurers?
AUTHOR: LESLIE J. HAWKES


Sarbanes-Oxley and other legislation require insurers to better
understand 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 the
corporate governance, enterprise- of the nation’s corporations in premium levels insurers are
wide risk management, internal general. Will all this attention charging for this coverage.
controls – all are terms that have to improved controls really ensure
been in the forefront of the news that our corporations are being In 1995, in an attempt to stem
recently. However, the notions run by directors and officers who the tide of certain security
of corporate governance, risk are truly responsible and forthright class-action lawsuits, Congress
management, and internal individuals faithfully and honestly passed the Private Securities
controls 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 to
to which directors and officers extremely complex organizational decrease the number of ‘frivolous’ D&O insurance
of corporations supposedly have structure of most of today’s larger lawsuits by making it more difficult
been regularly attending in their corporations, is it realistic to to file such suits. At the time of has been around
roles 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 an
Yet whenever the topic turns control and oversight now expected extremely soft insurance cycle. but never before
to recent corporate scandals as a result of new legislation and In the property and casualty
and accounting misstatements, the renewed concern with market, capacity was abundant
has it received
these terms are bandied about corporate governance? and insurers were competing the level of
quite regularly as new and for business by offering more
improved tactics that must But the $64,000 question coverage for lower prices. recognition
be 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,
experienced
reverse the current trend toward
corporate malfeasance. really want answered is: Will all of decreasing retentions, providing in the most
this attention to the requirements broader coverage, and lowering
Partially 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 widely
provide 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 itself
at an accelerating rate and the unrealistically high that lawsuits in the event of a shareholder
loss costs for these claims and loss costs will only continue claim. Insurers were also attaching
skyrocket. Recent awards to increase and to cut into profits? liberal severability provisions.
in response to shareholders’ Severability provisions are
litigation in cases such as Recent Trends in Directors and designed for the protection of
Cendant and Waste Management Officers Liability Insurance innocent directors and officers
have 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 example
D&O insurers, investors, of the applicability of the
has it received the level of
and regulators alike are left severability provision is that
recognition experienced in the
wondering if this legislation, material misstatements by certain
most recent times. D&O claims
regulation, and renewed attention directors or officers on the original
are on the rise. So, too, are the
to corporate governance will have application for coverage without
magnitude of D&O litigation


CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS? continued

knowledge of innocent directors a director or officer without into the contract to provide the the restriction of various
and officers could lead to an the protection provided by coverage, they never would have consulting services being
insurer nullifying coverage. D&O coverage. agreed to write D&O insurance in provided by public accounting
The severability provision would the first place.4 firms that are also providing
provide coverage for the The corporate and accounting accounting and audit services to
innocent directors or officers scandals of 2001 and 2002 were Since the full impact of the past an SEC registrant. One might ask
while nullifying it for those extreme eye-openers to D&O few years will remain unknown what these outcomes have to do
responsible for the insurers, yet in terms of loss- for several years to come, D&O with D&O insurance. It is not
misstatements. In anticipation of generating incidents, they were insurers have become much these provisions, but rather two
decreased numbers of lawsuits more akin to the proverbial straw more conservative in providing other significant areas of the
as a result of PSLRA, insurers that broke the camel’s back than coverage. In addition to charging SOA that will have the greatest
were willingly decreasing an epiphany-creating event. much higher premiums for D&O impact on the D&O exposures
deductibles, retentions, and The aforementioned softening insurance, insurers skilled at faced by SEC registrants subject
coinsurance amounts in addition insurance market of the 1990s, providing this type of coverage to the SOA.
to 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 The
Unfortunately, the intended 2001 and 2002, had already are willing to insure and what Sarbanes-Oxley Act of 2002
consequences of the 1995 begun to take a significant toll coverage grants they are willing
Section 302 of the SOA
legislation were not realized, on D&O insurers’ profitability as to provide. Over the past two
essentially requires companies
and 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 institutionalize
followed the passage of PSLRA, worsened during this period. general, rates are increasing
a set of comprehensive internal
the number of securities class- The most notable of the anywhere from 30 percent to
controls over all aspects of their
action lawsuits that were filed corporate scandals – Enron, 300 percent, depending upon
financial reporting to ensure that
increased by 75 percent.1 WorldCom, and Tyco – have the type of organization and need
reported financial statements are
In 1998, the Securities Litigation subsequently had a marked for limits and coverage. Insurers
free from any material
Uniform Standards Act was impact on the D&O marketplace. clearly are cutting back on entity
misstatements that would
passed 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 requires
years, but now the number of created by these events will be and deductibles.
that the company’s external
suits 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 the
It 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 to
corporations 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 and
Today, directors and officers of security law violation exclusion3, to the capital markets and to 404, is the requirement that all
virtually all types of to exclude coverage for some of create oversight for the accounting corporate directors and officers
organizations, particularly these scandals. Some insurers profession. Two key outcomes of exercise a much higher degree
publicly traded companies and are attempting to rescind the SOA were, first, the creation of control, take a much more
Securities and Exchange coverage altogether by alleging of a public accounting oversight comprehensive view of all
Commission (SEC) registrants, that the insured corporation entity, the Public Company internal controls, and fully
are fully aware that they simply acquired the coverage through Accounting Oversight Board assess how these controls affect
cannot 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 302
serving 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 http://www.iwancray.com/articles.htm.
5. Summary of the Sarbanes-Oxley Act of 2002 located at http://www.aicpa.org/info/sarbanes_oxley_summary.htm.



Section 302: the assessment made by the Directors & Officers Liability insurance? It depends upon
Corporate 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 puts
Section 404: There are those who believe that
of,’ an issuer’s code of ethics. it this way, ‘God forbid you only
Management Assessment this new legislation and attention
did 999 of the 1,000 things you
of 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 officers

6. Gjertsen, Lee Ann, ‘Scandal Responses Seen Multiplying D&O Risks,’ American Banker, 168, no. 195 (October 2003).



underwriting for a line of business Summary
that is already one of the most
These clearly are tumultuous
specialized in the market today.
times for both the buyers and the
D&O underwriters will have to do
sellers of directors and officers
a much more diligent review of
liability insurance. Assimilating all
the more transparent financial
of the recent changes into the
statements and disclosures.
underwriting of D&O coverage
Underwriters will have to be able
will be an essential step in
to review the level of controls
insurers’ attempts to improve
implemented and understand
their profitability in this line of
how they permeate the
business. The Sarbanes-Oxley
organization. If D&O underwriters
Act and a renewed attention to
do this, however, they will
corporate governance should
improve the quality of their
help D&O insurers improve the
underwriting of the corporations
quality of their books of business
to whom they provide coverage.
and, subsequently, their profit
They will be willing to provide
potential for this line of business.
coverage only to those entities
Will this actually prove to be the
that have adequate controls in
case? Only time will tell.
place. This, in turn, will make
coverage for noncompliant Leslie Hawkes is a manager
organizations prohibitively in the Actuarial & Insurance
expensive or nonexistent. Management Solutions (AIMS)
Those organizations that cannot practice of PricewaterhouseCoopers
find or afford D&O insurance will LLP. She has over 23 years of
be 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
leslie.j.hawkes@us.pwc.com


International Financial Reporting
Standards continue to progress
AUTHORS: DAVID SCHEINERMAN AND WILLIAM GOLDSTEIN


IAS 32 Revised, Financial Instruments: Disclosure and Presentation
and IAS 39 Revised: Recognition and Measurement were published
in December 2003 and amended in April 2004.

INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS

Introduction preparers, particularly first-time The scope of the revised standards
adopters, account for financial is very broad, and the revisions
Preparers of International
instruments, and provide an provide further definition and
Financial 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 39
Revised for financial statements
For those companies currently • Scope – certain financial
covering annual periods beginning
preparing US-GAAP financial guarantee contracts and loan
on or after January 1, 2005.
statements, the revised standards commitments are excluded;
The revised standards on financial
embody much of what is included
instruments, IAS 32R and IAS
39R, 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 initial
2003 clarifying principles making
‘Accounting for Declarative recognition, may choose to revised standards
the standards easier to apply. measure any financial asset
These standards affect companies
Instruments’ and SFAS 140 is very broad...
‘Accounting for Transfer and or liability at fair value through
in all industries, not just financial the profit and loss account;
Security of Financial Assets and
services. Among other changes, purchased loans that are not
Extinguishments of Liabilities’.
the revised standards are likely quoted in an active market may
to 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


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 follows
This article provides an overview The critical feature in identifying transaction occurred, an initial
the classification of the related
of 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 initial
December 2003 changes and exchange another financial Figure 2 provides a framework for carrying value of the financial
notable differences from instrument) under conditions that distinguishing between a financial instrument unless the instrument
US 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




Figure 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

Financial liabilities are classified Reclassification of assets between This is consistent with SFAS 115 • It requires no or a smaller
either as ‘financial liabilities at categories will likely be relatively and US GAAP accounting. initial investment than required
fair value through profit or loss’ uncommon under revised IAS 39 to purchase the underlying
or as ‘other financial liabilities’. and is prohibited into and out of Embedded derivatives financial instrument; and
Liabilities at fair value through the fair value through profit or loss Revised IAS 39 maintains the
profit or loss may be classified criteria. Reclassification from held- • It is settled at a future date
definition of a derivative as a
as held for trading or designated to-maturity as a result of a change (note: there is not a
financial instrument with all
to 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 required
amendment 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



recognized (bifurcated) and Generally, a financial asset transfer of substantially all the Similarly, under US GAAP, in the
accounted 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 are
Derecognition 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 the
for 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 income
IAS 39 sets out the criteria for Financial assets categorized as
neither transferred nor retained, statement. If only part of a
derecognition 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 financial
accounting treatment. are measured at fair value, with
entity’s continuing involvement. instrument is allocated based
changes in fair value included in
Under US GAAP, derecognition is on relative fair value at the date
The revisions to IAS 39 clarify the net profit or loss for the
based 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 at
necessary 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.




Fair value is ‘the amount for IFRS requires an entity to
which an asset could be consider impairment when there
exchanged, or a liability settled, is an indicator of impairment,
between knowledgeable, willing such as: the deterioration in the
parties in an arm’s length creditworthiness of a
transaction.’ Revised IAS 39 counterparty; an actual breach
provides a hierarchy to be used of contract; a high probability of
in determining a financial bankruptcy; or the disappearance
instrument’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 ‘other
2. 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 documentation
Similar to US GAAP, realization of risk (and the change is also 2. When measuring hedges of
must include the entity’s risk
gains on initial recognition of a recognized immediately in the foreign entity investments,
management objective and
financial instrument are expected income statement); ineffectiveness is recognized
strategy for undertaking
to be rare. in the income statement.
the hedge.
2. Cash flow hedges, including
Impairment losses are incurred hedges of foreign currency If the hedging relationship
All derivatives that involve an
if, and only if, there is objective risk associated with firm comes to an end (e.g., the
external party may be designated
evidence of impairment as a commitments, for which the hedging instrument is sold),
as hedging instruments (except
result 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-derivative
recognition of the asset. directly in equity. The gain or not pass effectiveness tests)
instrument may only be
Expected losses as a result of loss is ‘recycled’ to the income or the hedging relationship is
designated as a hedging
future events, no matter how statement when the hedged revoked, then hedge accounting
instrument of foreign currency
likely, are not recognized. cash flows affect income; and must be discontinued. Hedge
risk. The fundamental principle is
effectiveness requires two
Both IFRS and US GAAP have that the hedged item creates an
3. Hedges of a net investment in separate tests which must be
similar requirements for the exposure to risk that could affect
a foreign operation, for which applied prospectively and
impairment of financial assets. the income statement.
the gain or loss on the hedging retrospectively:



• 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 developments
Based on the recently issued and proposed changes and
amended IAS 39, most portfolio evaluate their potential impact
hedges of interest rate risk to their business.
(sometimes referred to as
‘macro’ hedges) will qualify for
fair value hedge accounting.

AUTHORS

David Scheinerman
Principal Consultant, Actuarial Insurance
Management Solutions
Tel: 1 860 240 2046
david.c.scheinerman@us.pwc.com

William Goldstein
Senior Manager, Assurance Services
Tel: 1 646 471 7253
william.goldstein@us.pwc.com


Managing insurer asbestos risks
AUTHOR: CLAIRE A. LOUIS


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 the
management of asbestos liabilities is a mature enterprise. If they are to maintain the
confidence of shareholders and rating agencies, insurers must practice a sound risk
management strategy, which is aligned with the ever shifting nature of asbestos litigation.

MANAGING INSURER ASBESTOS RISKS

Introduction since the late 1990s; the surge With the increase in reinsurance
in policyholder bankruptcies disputes related to asbestos
Despite the general introduction
and related ‘pre-packs’; case liabilities, Sarbanes-Oxley provides
of the asbestos exclusion into
management efficiencies that more reason than ever for insurers
general liability policies in the
favor plaintiffs, force defendants to reassess the reasonableness
mid-1980s, the insurance industry
and insurers into unfavorable of their provisions for reinsurance
in 2004 continues to try to come
settlements, and encourage the recoverables. Past assumptions
to grips with its historical
filing of more claims; skyrocketing regarding the expected level of
asbestos liabilities. Analysts and
jury awards; non-products-related payments from reinsurers may
rating agencies alike identify
exposures; the recent emergence no longer be valid. As such, it is
asbestos as one of the major
factors impeding insurance
of ‘mixed dust’ (asbestos and silica) possible that insurers may find In 2003 alone,
claims; and increasing reinsurance themselves having to adjust the
industry growth. This article will
disputes. We will discuss efforts level of their provisions.
US insurers
discuss insurers’ attempts to
manage asbestos liabilities and
to legislate asbestos reform at the strengthened
federal and state levels. Increased regulatory and ratings
the 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 even
and A.M. Best, estimate that
statement disclosures relative insolvency are some of the perils
US insurance industry asbestos
to asbestos liabilities and related faced by insurers with asbestos
losses may reach $65 billion1.
reinsurance recoverables and liabilities. Those insurers that
According to Morgan Stanley,
the monitoring of the controls recognize and mitigate these risks
US insurers increased asbestos
environment surrounding insurer through a consistent, disciplined
reserves by close to 70%
asbestos claims management. program of asbestos portfolio
between 1998 and 2003.
The quality of insurer reporting management, which includes
In 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, and
significant actions, the projected
controls for collecting and thoroughness in loss presentation
shortfall between the insurance
appropriately analyzing relevant, to reinsurers stand the best
industry’s estimated $39 billion in
accurate, and complete asbestos chance of weathering this ‘Perfect
future asbestos-related costs and
claim data and managing their Storm,’ which asbestos litigation
existing reserves is $20 billion3.
asbestos exposures. Sarbanes- has become. Indeed, legislative
We will examine how the industry Oxley provides the impetus for relief from asbestos liabilities at
managed its asbestos exposure insurers to enhance their asbestos the federal level in the near term
in the past and how insurers are claims processes and controls is far from certain as there is a
leveraging lessons learned to and, in so doing, reduce lack of complete stakeholder
address current asbestos uncertainty on the balance sheet consensus. As with tort reform
challenges: the significant increase and realize new opportunities to so far, insurers’ greatest hope for
in unimpaired asbestos claim filings limit their liabilities. meaningful change in the existing

1. 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.


MANAGING INSURER ASBESTOS RISKS continued

system for compensating PPG, and, most recently, Equitas’ defense verdict. The first plaintiff
asbestos claimants may very $575 million settlement with verdict in an asbestos injury
well lie with the states and local Halliburton are notable examples. lawsuit – Borel v. Fiberboard
judiciary. Inactive dockets in Corporation – was returned in
several states, including In turn, settling insurers look to 1973, also in Beaumont.
Massachusetts and Baltimore, their reinsurers for
have experienced some success reimbursement of asbestos claim By 1974, asbestos lawsuits had
in prioritizing compensation costs. In the past insurers could been filed in many jurisdictions.
Those insurers that for those claimants who are usually rely on reinsurers to By the early 1980s, more than
functionally impaired. promptly pay asbestos losses 20,000 asbestos claims had
recognize and Texas, Ohio, and Michigan with few, if any, questions asked. been filed. Asbestos claim filings
are among the states that are Although reinsurers continue to decreased in the early 1990s,
mitigate their risks pay valid asbestos losses, but sharply increased in the late
pondering whether to establish
through a consistent, inactive dockets for unimpaired reinsurance disputes are 1990s following several failed
asbestos claims. becoming more common as attempts to reach global
disciplined program reinsurers, experiencing ever asbestos settlements5. The 2002
of asbestos portfolio Given the high stakes of greater pain from their own Rand report estimated that more
asbestos litigation, it is no small asbestos liabilities and increasing than 600,000 asbestos injury
management... stand wonder that insurers and scrutiny from their own claims had been filed by 20006.
defendant policyholders are reinsurers, are fine tuning their The majority of new asbestos
the best chance of availing themselves of every claims practices, processes, and claim filings involve claimants
weathering this reasonable means to limit their controls to minimize any possible who have no functional
asbestos exposure. Inventory risk associated with the vetting of impairment7.
‘Perfect Storm,’ which settlements with plaintiffs, sales cedant asbestos losses.
of operations or business lines Increasingly, arbitration panels Figures 1 and 2 depict the
asbestos litigation with asbestos liabilities, and so- and the courts are demonstrating evolution of asbestos litigation
has become. called ‘pre-pack’ reorganization greater willingness to lend a from the 1970s through the
plans are strategies used by sympathetic ear to reasonable present. Defense strategies and
asbestos defendants to achieve reinsurer arguments that perhaps case management procedures
this end. Defendants in formerly they should not be obliged to which appeared to be efficient
robust traditional industries follow the fortunes of their and cost-effective in the early
such as building products, cedants, whose loss presentation days of asbestos litigation
petrochemical, and appears to be arbitrary and does ultimately led to an exponential
manufacturing, who are now not mirror the terms and growth in asbestos claim filings
fighting for their very survival, provisions of the policy contract and claim costs. The resulting
often have nowhere to turn but or reinsurance contract wordings. increase in defendant liabilities
to their historical insurance Continuing reinsurer insolvencies has triggered nearly 90
programs to fund the asbestos threaten to further slow down bankruptcy filings with the
liability-related initiatives that and impair the level of likelihood of more to follow.
may mean the difference reinsurance collections for More than 6,000 companies have
between life or death. This has asbestos losses. been sued in asbestos injury
increased the level of asbestos lawsuits8. The magnitude of
insurance coverage disputes, Evolution of asbestos litigation defendant liabilities has not been
which has ultimately led to lost on insurers (and their
The first asbestos injury lawsuit
a number of recent major reinsurers) who have steadily
was filed in 1966 in Beaumont,
settlements between defendants increased reserves to cover their
Texas4; the case was tried to a
and insurers. Western MacArthur, share of asbestos losses.

4. Stephen J. Carroll, et al., Asbestos Litigation Costs and Compensation: An Interim Report (2002), Rand Institute for Civil Justice, at 6.
5. Carroll, at 27.
6. Carroll, at 51.
7. Carroll, at 41.
8. Carroll, at 49.


"Managing Insurer Asbestos Risks"

"Managing Insurer Asbestos Risks"

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