to calibrate or validate their value? Heck, I’ve yet to see a perfect market!
ACHILLES: OK, OK, too many questions to take on at once.
Let’s start from the beginning of our race, even though I’ve already won it. All else being equal, it’s pretty well known that
an estimate determined by reference to a market (even an imperfect one), or through a consensus of individual buyers and
sellers, is better than an estimate by an individual (say, a lonely
preparer).
TORTOISE: Although that might be the case, how relevant
can it be if there are no reliable prices for trades in similar financial instruments or insurance contracts to check against?
Are you implying that prices set in, say, the credit-default-swap
market be used? Hasn’t that source been discredited? And in
many cases, such a transfer or trade would be illegal, so an adjustment to the market price of a similar item can’t possibly be
relevant. Remember, the very existence of a market can change
behavior. This would force us into the dreaded black hole of an
internal black-box model!
ACHILLES: Black hole, my trusty iPod! (Even though neither
will be invented for two millennia.) I trust my actuary’s model
to provide reliable estimates of the price of a trade, if there’d
been a market. I am confident that practice will emerge to address such problems and to provide a realistic assessment of
the compensation needed for the cost of bearing risk. Actuarial
models are likely to be used on both sides of any price negotiation anyway, right?
TORTOISE: OK, but now you seem to be arguing that we
should go down another theoretical hole. A price would have to
be estimated (even though there will never be such a price), in a
market that doesn’t exist, by a market participant who probably
wouldn’t tell me its real view if asked.
ACHILLES: It sounds like I haven’t convinced you so far. Let’s
get back to basics. A fair value is just an estimate with a specific
objective. It can provide the basis for key assumptions used underlying the calculation of this value in a model. It may not be
perfect, but it’s better than the alternatives and worth striving
for. Nothing beats markets for quantifying risk and uncertainty.
For insurance contracts, such an estimate may be built from a
variation of the three building blocks described in the IASB’s
2007 discussion paper on insurance contracts.
TORTOISE: OK, I like building blocks—they remind me of
when I was a young turtle. But how do blocks relate to fair
value? Any value can be determined on the basis of building
“Fair value is the price that
would be received to sell an
asset or paid to transfer
a liability in an orderly
transaction between
market participants at the
measurement date.”
statement of the Financial accounting standards Board
no. 157.5, Fair Value Measurements
blocks, but I thought that we were dealing with unobservable
inputs to a hypothetical measure.
ACHILLES: Geez, I’ll have to treat you as I would a baby
turtle. First, there’s the basis for any prospective measure—the
expected value of future cash flows, time value of money and
reflection of their risks. How much more basic and straightforward can I get? In doing that, we recognize current market
conditions using reasonable judgment and diligence.
TORTOISE: That makes some sense. But you still have to convince me that these can be used to estimate a phantom price
in practice.
ACHILLES: OK, I’ll use an insurance contract as an example.
Even if you don’t like fair value theory, we have to agree that
actuarial models would be used to estimate mortality of life
insurance or annuities (or cash flows as they develop for prop-erty/casualty claims), as these would be the same no matter
who was obligated to pay them.
TORTOISE: [Reluctantly nods in agreement]
ACHILLES: Now that we agree on this, let’s work on the harder stuff like the expense assumption. This is important because
expenses are larger in percentage terms for insurance than for
most financial instruments (where the majority is treated as period costs). It would be unusual to find a relevant market from
which such an assumption can be observed, and anyway, it’s
too closely related to the contracts being valued to be treated
as period costs. So they have to be estimated on an expected-value basis.
TORTOISE: [Nodding ever more wearily]
ACHILLES: And consider margins, whether for risk or for
something else. If a day-one profit isn’t allowed, they would
be based on actual and expected premiums and on an acceptable actuarial model to reflect the compensation for taking on
risk, reflecting market-risk preferences. The model would most
