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Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0102
Re: Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies - File No. S7-16-02
Dear Mr. Katz:
The American Insurance Association (AIA) is a trade association of 410 property-casualty insurance companies that write policies throughout the United States and around the world. Most of our members are affiliates of publicly held groups that are registrants with the Securities and Exchange Commission (SEC).
The financial condition and operating results of property-casualty insurers are dependent, to a greater extent than most other industries, on the use of estimates, i.e., in determining the amounts that would liquidate all the insurer's liabilities remaining on incurred claims as of the valuation date. On average, loss reserves represent about two-thirds of an insurer's liabilities. These loss reserves include not only those claims that the insurer knows about, but also claims that have occurred and have not yet been reported. The estimation process includes the amount of dollars that will be paid on the reported claims and the number of claims as well as the dollar amount that will be paid for the unreported claims. These estimations also play a significant role in determining what prices insurers will charge on future policies. Accordingly, the estimation process is critical in evaluating the present and future financial condition and operations of property-casualty insurers.
A number of variables may affect insurers' loss reserves, such as the type of insurance written and insurers' procedures in evaluating and paying claims. There are a number of acceptable quantitative methods of estimating loss reserves (with no clear and consistent advantage of one method over another in most cases) and subjective elements are often present. At any reporting date, it is almost certain that insurers' reported loss reserves are not the actual amounts that would liquidate all remaining claim liabilities. The estimation of loss reserves is difficult when all of the factors that may affect claims settlement are known, but experience has shown that unexpected changes, such as developments in the tort system, may not be predictable and may effect significant changes in estimates of loss reserves as new information becomes available. One measure of a company's evaluation process is its record of estimation of past loss reserves and there are various accepted actuarial techniques for doing such computations.
For these reasons, AIA believes that disclosures concerning the estimation process are critical to a fair presentation of insurers' financial statements and also believes that the SEC's current quantitative approach to reporting property-casualty estimates, as discussed below, is a more informative approach to dealing with estimates and should be considered for other industries. Additionally, we agree with the proposed rule's objectives and believe that those objectives can be better achieved through improved qualitative disclosures. AIA is pleased to comment on this proposed SEC rule on disclosure in the Management's Discussion and Analysis (MD&A) sections of reports filed with the SEC. We have organized our comments in response to the broad categories of the SEC's solicitation of comments included in the proposed rule.
We solicit comment with regard to broadening the scope of our proposals to achieve a more expansive objective.
AIA notes that there are currently disclosures in other parts of the affected reports that describe the effects of a change from one accounting policy to another preferable accounting policy under GAAP. In such instances, we do not believe that disclosure would be improved by repeating the disclosure in or moving the disclosure to the MD&A.
AIA is concerned about the confusion that may result from requiring in the MD&A a discussion of the impact that alternative acceptable, but not selected, accounting policies would have had on a company's financial statements. This point is particularly demonstrated in the application of a complex accounting standard such as SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which allows companies the alternative of applying "fair value" accounting for derivatives rather than "hedge accounting" even in cases where the derivatives are highly effective for hedging purposes. If a company chose to apply "fair value" accounting, the cost and complexity of developing disclosure information for an accounting policy that the company elected not to apply (i.e., "hedge accounting"), would result in confusion, rather than transparency, in the MD&A and the cost would not justify the result. AIA fully supports accurately and clearly describing the accounting policy the company actually elected to apply when initially adopting a new policy. However, we do not believe that the reader is well served by also discussing another complex policy that the company elected not to apply.
Similarly, AIA is concerned about the confusion that may result from requiring in the MD&A a discussion of the effects of an accounting policy that a company did not choose in unusual transactions. For example, prior to the adoption of SFAS No. 141, Business Combinations, had such a requirement been in place, a company would have been required to disclose the effect that application of the "pooling of interests" accounting method would have had if that had been an acceptable alternative to the "purchase accounting" method that was actually applied. The additional effort would have required tremendous resources on the part of the reporting enterprise and would likely have confused readers of the financial statements.
AIA believes that there is currently significant disclosure of the processes that companies use in making estimates and, for the property-casualty industry, how those estimates have been changed from year to year. For example, there is currently a requirement in the SEC Industry Guide 6 that insurers must provide a fairly detailed analysis of their estimation process. We are not certain what additional disclosures would be helpful and we are wary of overwhelming the reader by including detailed information related to the actuarial science that underlies much of the process.
AIA believes that there would be a problem in requiring a company to discuss the impact of a choice among accounting methods that are used in the company's industry. The problem would be that, unlike the choice in accounting for construction-type contracts, for example, a company might not be aware of what accounting methods are being used in the industry, especially when it is a new accounting standard that is involved and it is being applied for the first time.
We seek comment on the proposed definition of critical accounting estimates.
AIA believes that the proposed definition of "critical accounting estimates" is appropriate and will result in disclosure of insurers' most important estimates, i.e., its loss reserves. We also agree that a company is likely to identify three to five critical accounting estimates under the proposed definition We believe that setting a minimum percentage impact on results of operations in the second criterion of the definition would sacrifice relevance for comparability and would seem to be incompatible with SAB No. 99 on materiality.
We request comment on the proposed identification and analysis of changes.
AIA supports the concept of informing readers of critical accounting areas, including policies and estimates, but believes that objective is better achieved through better qualitative disclosure instead of the proposed quantitative disclosures. We believe that readers will not only find the proposed disclosures confusing, but that they will also cause readers to question the overall accuracy of the financial statements.
AIA believes the MD&A should clearly describe the nature of the estimates that management has made and disclose the amounts actually reported in the financial statements so that the reader can gain a better understanding of the financial accounting estimates and the sensitivity of operating results to those estimates. We believe, however, that the nature of insurers' loss reserves would often render meaningless the two alternative disclosures proposed to reflect the possible changes. The first alternative (near-term changes in the most material assumptions) is limited because the most significant possible changes relate to the long-term changes that may occur with respect to several of the assumptions, not the near-term changes resulting from the most material assumptions. The second alternative (estimate the ends of the range of reasonably possible amounts) is misleading because it does not reflect the probabilities of each possible outcome within the range and identification of the endpoints of a subjective process are not reliably definable or determinable. Use of the second alternative, therefore, is limited.
AIA believes that a better alternative that would be applicable to most registrants, when dealing with complex estimates based on non-financial market assumptions or assumptions with less than robust data, would be to require disclosure of the estimate "run-off", i.e., how the value of the initial estimate changed over time, with required re-estimation on a periodic basis. This would give readers information on the relative reliability of the estimates, allow readers to make comparisons between the accuracy of various companies' estimates, and would force those making the estimates to track their own accuracy. This type of approach is already used in the property/casualty industry for the estimated liability for claims and claim adjustment expense and is required by the SEC Industry Guide 6, i.e., the ten-year loss reserve development table. Although some refinements to the table requirement may be in order, the approach used is generally more suitable to evaluating financial data that is heavily based on estimates and should be considered for similar types of estimates used by other industries.
We solicit comment on the proposed disclosure of past material changes in critical accounting estimates.
AIA believes that the existing reporting framework already requires material changes in accounting estimates to be disclosed. APB 20 on Accounting Changes requires companies to disclose material changes in estimates that affect present and future periods. The MD&A rules require the discussion of changes in trends or uncertainties and, for property/casualty insurers, there is currently significant disclosure of past material changes within the development triangles required in Guide 6, which requires several years of historical data to be displayed.
AIA is unclear about how companies would be expected to identify in their financial statements and overall financial performance the effects of material changes in critical estimates during the past three years.
We request comment on the proposed disclosure about discussions between senior management and the audit committee regarding the development, selection and disclosure of critical accounting estimates.
Currently, senior management discusses critical accounting estimates with the audit committee to ensure that the committee is aware of and understands the estimation process for the most material and subjective estimates. AIA believes that role is appropriate and supports the audit committee involvement in reviewing the development, selection, and disclosure of critical accounting estimates. If the proposal is seeking to enhance the degree of audit committee involvement with the financial statements, we do not believe that MD&A disclosure is an effective, or appropriate, means to affect what is a corporate governance matter.
With regard to the suggestion that the SEC could amend Item 306 of Regulation S-K and Regulation S-B to require that the audit committee disclose whether the audit committee has reviewed and discussed with senior management the development, selection and disclosure regarding critical accounting estimates, we believe that Item 306 disclosures accurately reflect the appropriate role of the audit committee, and require no amendment. The audit committee asserts its responsibility to monitor and review management's financial reporting process and procedures, but is not professionally engaged in the practice of actuarial science, accounting or auditing. The audit committee relies on the information provided to it and on the representations made by management and the independent auditors that the financial statements have been prepared in accordance with generally accepted accounting principles. To the extent there are disagreements between management and the external auditors over the application of accounting principles to an entity's specific transactions and events or the basis for management's judgments about accounting estimates, we believe that it is appropriate that the audit committee should rely upon the external auditors to discuss such disagreements with the committee, whether or not the disagreements were satisfactorily resolved, if the matters individually, or in the aggregate could be significant to the entity's financial statements or the auditor's report.
Also, AIA believes that it would be too burdensome and not necessarily meaningful to require that the audit committee discuss with senior management whether a company's accounting policies diverge from the policies applied by other companies in the same industry. Without knowing the specific facts and circumstances of another company's accounting policy determination process (e.g., an evaluation of specific customer contract language), it is difficult, at best, to know if such comparisons are meaningful.
We solicit comment with respect to independent auditor examinations of the proposed MD&A disclosure regarding critical accounting estimates.
AIA believes that the current requirement that auditors determine whether an MD&A is consistent with the financial statements is appropriate. AIA understands that the auditors are not currently prepared to examine the proposed disclosures relating to critical accounting estimates in accordance with Attestation Standards, especially as they relate to alternative accounting policies not selected.
We do not believe that it would be appropriate to require an audit of disclosures of accounting policies, and the effects thereof, of an accounting policy that a company did not adopt.
We seek comment on the proposed disclosures related to initial adoption of accounting policies.
AIA believes that the proposed disclosures about initial adoption of accounting policies that relate to the nature of the accounting principles and the method of applying those principles are valuable.
AIA believes that there should be a disclosure of sufficient information to clearly describe the new accounting policy and the type of transaction(s) to which it applies. We believe the nature of the disclosure and its content will vary based on the policy and type of transaction. We also believe that a requirement to seek the assistance of auditing firms to evaluate the impact of a choice among accounting methods that are used in the company's industry is problematic because of the possible proprietary nature of certain aspects of such information, i.e., the specific contract language that a competitor has with its customers.
We solicit comment on the disclosure presentation aspects of the proposals.
AIA believes that, if the proposed disclosures are adopted, such disclosures are more meaningful if they are integrated into the other discussions of financial condition, changes in financial condition, results of operations and liquidity and capital resources when the proposed disclosure is closely related to an aspect discussed in those separate sections of the MD&A.
We request comment regarding the application of safe harbors for forward-looking information to the proposed MD&A disclosure.
AIA does not believe that further guidance is needed with respect to the safe harbor rules, and we understand that the existing safe harbor statutes (and rules) will cover the disclosures mandated by the proposal.
We also solicit comment on general aspects of the proposals.
AIA supports the concept of informing readers of critical accounting areas, including policies and estimates. We believe, however, that this objective can be accomplished with better qualitative disclosures surrounding the policies and estimates. We believe that the SEC should require MD&A to describe the nature of the estimate, the nature of the assumptions made, and any forward looking information that might be informative to understand the context of the estimate.
With regard to the insurance industry, the FASB has issued Preliminary Views on Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value (Preliminary Views). It indicates that when little or no market price information is available, the entity should use its own assumptions about estimating the present value of expected cash flows. AIA believes that this is the situation for the property-casualty insurance claim liabilities (i.e., loss reserves). Preliminary Views recognize the limitations of using internally estimated cash flows in determining fair value and explain why it is the last choice of a measurement technique.
As mentioned above, SEC disclosure guidance in Guide 6 requires the preparation of a table that details loss reserve development over a ten-year period. AIA questions how the loss reserve development table could be prepared under fair value accounting standards and whether such table would lose its relevance as a result of fair value accounting. Thus, an extremely useful tool in measuring the effectiveness of loss reserve estimates could be lost if fair value were adopted for property-casualty insurers.
With regard to the proposal to audit the initial adoption of an accounting policy, AIA does not believe that it would be appropriate to require an audit of disclosures of accounting policies, and the effects thereof that a company did not adopt. The cost of both quantifying the effects (i.e., identifying both the cost of the method selected and the method or methods that were not selected) and subjecting the quantification and disclosure to audit would not be cost justified and would only confuse readers of the financial statements.
We solicit comment regarding the potential cost of compliance with the proposals.
The SEC has estimated that the average amount of time it would take to prepare the application of critical accounting policies disclosure for registration statements would be approximately 34 hours. A sample of AIA members considered the probable number of hours it would take to comply with this SEC proposal and determined that a reasonable estimate would be 100 hours for internal preparations and 200 hours for auditor verification. It is possible that the significant role of estimation in the preparation of financial statements of property-casualty insurance companies accounts for this difference in estimated time.
Accounting estimates play a critical role in the financial statements of property-casualty insurers. AIA believes that the SEC's current quantitative approach to reporting property-casualty estimates is a more informative approach to dealing with estimates and should be considered for other industries. Additionally, we agree with the proposed rule's objectives and believe that those objectives can be better achieved through improved qualitative disclosures.
Finally, AIA is concerned about the additional preparation time that the proposed disclosure would entail, especially in light of the accelerated reporting requirements that the SEC has recently proposed.
Vice President - Financial Reporting and
Associate General Counsel