allowance for loan and lease losses - fms inc for loan and lease losses simplified view of the fas 5...
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Allowance for Loan andLease LossesMonday, June 17, 2013 9:10 AM-10:10 AM
Presented by:Jamie MayerManaging DirectorGrant Thornton LLP175 West JacksonChicago, IL 60604P: 312-602-8766E:[email protected]
www.fmsinc.org | 800-ASK-4FMS
Presented by:Jamie MayerManaging DirectorGrant Thornton LLP175 West JacksonChicago, IL 60604P: 312-602-8766E:[email protected]
DisclaimerThis presentation is not a comprehensive analysis ofthe subject matters covered and may include proposedguidance that is subject to change before it is issued infinal form. All relevant facts and circumstances,including the pertinent authoritative literature, need tobe considered to arrive at conclusions that comply withmatters addressed in this presentation. The views andinterpretations expressed in the presentation are thoseof the presenters and the presentation is not intended toprovide accounting or other advice or guidance withrespect to the matters covered.
www.fmsinc.org | 800-ASK-4FMS
This presentation is not a comprehensive analysis ofthe subject matters covered and may include proposedguidance that is subject to change before it is issued infinal form. All relevant facts and circumstances,including the pertinent authoritative literature, need tobe considered to arrive at conclusions that comply withmatters addressed in this presentation. The views andinterpretations expressed in the presentation are thoseof the presenters and the presentation is not intended toprovide accounting or other advice or guidance withrespect to the matters covered.
slide 2
Agenda• Allowance for loan and lease losses
– Basic concepts– Common issues– Best practices– Regulatory views
• Troubled debt restructurings
www.fmsinc.org | 800-ASK-4FMS
• Allowance for loan and lease losses– Basic concepts– Common issues– Best practices– Regulatory views
• Troubled debt restructurings
slide 3
Allowance for loan and lease lossesBasic concepts• A loss should be estimated and accrued by a charge to
income when both (ASC 450-20-25-2):– information available before the financial statements
are issued or are available to be issued indicates that itis probable that an asset had been impaired at the dateof the financial statements
– the amount of the loss can be reasonably estimated• A loan is impaired when, based on current information and
events, it is probable that a creditor will be unable tocollect all contractual principal and interest as scheduledin the loan agreement (ASC 310-10-35-10)
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• A loss should be estimated and accrued by a charge toincome when both (ASC 450-20-25-2):– information available before the financial statements
are issued or are available to be issued indicates that itis probable that an asset had been impaired at the dateof the financial statements
– the amount of the loss can be reasonably estimated• A loan is impaired when, based on current information and
events, it is probable that a creditor will be unable tocollect all contractual principal and interest as scheduledin the loan agreement (ASC 310-10-35-10)
slide 4
Allowance for loan and lease lossesBasic concepts, continued• The ALLL is an estimate of loan losses incurred from
inception of the loan (or acquisition) up to the date of thefinancial statements, reduced by losses confirmed andcharged off.
• Losses are usually not immediately known. It takes timefor the borrower and extent of loss to be identified anddetermined. Thus, the ALLL is an estimate.
• The estimate is usually based on past experience with theborrower and/or loan type, adjusted for current events andconditions.
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• The ALLL is an estimate of loan losses incurred frominception of the loan (or acquisition) up to the date of thefinancial statements, reduced by losses confirmed andcharged off.
• Losses are usually not immediately known. It takes timefor the borrower and extent of loss to be identified anddetermined. Thus, the ALLL is an estimate.
• The estimate is usually based on past experience with theborrower and/or loan type, adjusted for current events andconditions.
slide 5
Allowance for loan and lease lossesOverview
FAS 5(ASC 450)
FAS 114(ASC 310-10-35)
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FAS 114(ASC 310-10-35)
SOP 03-3(ASC 310-30)
Total Allowance
slide 6
Allowance for loan and lease lossesSimplified view of the FAS 5allowance computation
FAS 5 Reserve [ Loan CategoryBalance ]
HistoricalCharge off Rate
AdjustmentFactor
[ LossDiscoveryPeriod ]
(type & grade)
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AdjustmentFactor
Loan trialbalance
• Charge off policy and process• Charge off tracking in relation to
prior risk grading of loans• Risk grade process• Aging / re-aging process of loans• Collateral valuation process
Economicanalysisprocess
Loss periodanalysisprocess
Lossevent C/O
(Past due date)watch list
Loan officershould know
Loss suspectedloan reviewsslide 7
Qualitative and environmentalfactors (2006 Interagency policystatement on ALLL)• Changes in lending policies and procedures• Changes in economic and business conditions• Changes in the nature and volume of the portfolio and in the terms of loans• Changes in the experience, ability, and depth of lending management and
other relevant staff• Changes in the volume and severity of past due loans, the volume of
nonaccrual loans, and the volume and severity of adversely classified orgraded loans
• Changes in the quality of the institution’s loan review system• Changes in the value of underlying collateral for collateral-dependent loans• Existence and effect of any concentrations of credit, and changes in the
level of such concentrations• Effect of other external factors such as competition and legal and regulatory
requirements on the level of estimated credit losses in the institution’sexisting portfolio.
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• Changes in lending policies and procedures• Changes in economic and business conditions• Changes in the nature and volume of the portfolio and in the terms of loans• Changes in the experience, ability, and depth of lending management and
other relevant staff• Changes in the volume and severity of past due loans, the volume of
nonaccrual loans, and the volume and severity of adversely classified orgraded loans
• Changes in the quality of the institution’s loan review system• Changes in the value of underlying collateral for collateral-dependent loans• Existence and effect of any concentrations of credit, and changes in the
level of such concentrations• Effect of other external factors such as competition and legal and regulatory
requirements on the level of estimated credit losses in the institution’sexisting portfolio.
slide 8
Environmental factors(SEC SAB 102)• Levels of and trends in delinquencies and impaired
loans• Levels of and trends in charge-offs and recoveries• Trends in volume and terms of loans• Effects of any changes in risk selection and
underwriting standards, and other changes in lendingpolicies, procedures, and practices
• Experience, ability, and depth of lendingmanagement and other relevant staff
• National and local economic trends and conditions• Industry conditions• Effects of changes in credit concentrations
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• Levels of and trends in delinquencies and impairedloans
• Levels of and trends in charge-offs and recoveries• Trends in volume and terms of loans• Effects of any changes in risk selection and
underwriting standards, and other changes in lendingpolicies, procedures, and practices
• Experience, ability, and depth of lendingmanagement and other relevant staff
• National and local economic trends and conditions• Industry conditions• Effects of changes in credit concentrations
slide 9
Allowance for loan and lease lossesFAS 5 common questions/issues
• Are those the only factors one needs to consider?• Does a bank need to have an adjustment factor for
each suggested adjustment factor?• Can a bank have a negative adjustment factor?• Does the adjustment factor always need to be
defined in basis points?• Does a bank only need to support the change in the
adjustment factor or the entire adjustment factor?• Is an "unallocated allowance" appropriate?• Can we simply look to our peers?
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• Are those the only factors one needs to consider?• Does a bank need to have an adjustment factor for
each suggested adjustment factor?• Can a bank have a negative adjustment factor?• Does the adjustment factor always need to be
defined in basis points?• Does a bank only need to support the change in the
adjustment factor or the entire adjustment factor?• Is an "unallocated allowance" appropriate?• Can we simply look to our peers?
slide 10
Allowance for loan and lease lossesLoss discovery period
Loss events culminatein the borrower’sinability to repay theloan.
The borrower begins tomiss payments, andproblems becomeevident to the lender.
The lender hassufficient informationto confirm the loss andtake the charge-off.
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Loss discovery period
Performance continues sothat the loss is not visible.
Performance deterioratesso that the loss becomesvisible to the lender.
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Allowance for loan and lease lossesWhat impacts the loss discoveryperiod?• Nature and type of loan
– Commercial real estate vs. commercial– Asset based vs. unsecured– Owner occupied vs. investors/developers loans
• Loan terms– Interest only vs. P&I monthly
• Underwriting / pricing• Loan administration process
– Frequency and nature of contact with borrower– Collection of third party credit information– Loan covenants
• Loan review function• Charge-off policy
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• Nature and type of loan– Commercial real estate vs. commercial– Asset based vs. unsecured– Owner occupied vs. investors/developers loans
• Loan terms– Interest only vs. P&I monthly
• Underwriting / pricing• Loan administration process
– Frequency and nature of contact with borrower– Collection of third party credit information– Loan covenants
• Loan review function• Charge-off policy
slide 12
Allowance for loan and lease lossesExample
• Bank has a portfolio of CRE loans totaling $10 billionthat have not been individually identified as impaired
• Adjusted charge-off rate is 2%• Loss confirmation period is 2 years
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• Bank has a portfolio of CRE loans totaling $10 billionthat have not been individually identified as impaired
• Adjusted charge-off rate is 2%• Loss confirmation period is 2 years
FAS 5 Reserve [ Loan categorybalance ]
[ Loss discoveryperiod ]
Adjustedhistorical
charge-off rate
$10 billion 2% 2 years$400 million
slide 13
Allowance for loan and lease lossesFAS 114 Estimation Components
Loan by LoanAnalysis
• Measure theimpairment inaccordance with SFAS114
• Estimate impairment byeither:- FV of collateral less
cost to sell if loan iscollateral dependentOR
- Present value ofexpected cash flows
Loans Determinedto be Impaired
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• Measure theimpairment inaccordance with SFAS114
• Estimate impairment byeither:- FV of collateral less
cost to sell if loan iscollateral dependentOR
- Present value ofexpected cash flows
CollateralValuation Function
LoanAdministration Loan Review
Loans NotImpaired Remainin FAS 5 Pools
slide 14
Allowance for loan and lease lossesSources for identifying impairedloans• Internally generated listings such as
– Watch lists– Past due reports– Overdraft listings– Loans to insiders– Nonaccrual loans– Restructured loans (not just TDRs)– Loan concentrations– Loans with non-standard payment terms (i.e. interest reserves)
• Historical loss experience by type of loan or risk rating• Results of loan review, internal audit and compliance reviews• Loans to borrowers in industries or countries experiencing economic
instability• Inquiries of relationship manager• Understanding changes in underwriting and collection policies
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• Internally generated listings such as– Watch lists– Past due reports– Overdraft listings– Loans to insiders– Nonaccrual loans– Restructured loans (not just TDRs)– Loan concentrations– Loans with non-standard payment terms (i.e. interest reserves)
• Historical loss experience by type of loan or risk rating• Results of loan review, internal audit and compliance reviews• Loans to borrowers in industries or countries experiencing economic
instability• Inquiries of relationship manager• Understanding changes in underwriting and collection policies
slide 15
Allowance for loan and lease lossesOther issues
• Releases of the ALLL• Yield/earnings pressure• New/less familiar loan products• HELOCs• Junior/second lien loans• Outdated appraisals• CRE risk remains elevated
– Difficult workouts– Modifications, interest-only structures– Risk rating accuracy
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• Releases of the ALLL• Yield/earnings pressure• New/less familiar loan products• HELOCs• Junior/second lien loans• Outdated appraisals• CRE risk remains elevated
– Difficult workouts– Modifications, interest-only structures– Risk rating accuracy
slide 16
Allowance for loan and lease lossesBest practices
• Document, document, document!• ALLL estimates should be based on comprehensive,
well-documented, and consistently applied analysisof the loan portfolio
• The ALLL should take into consideration all availableinformation as of the financial statement date,including environmental factors such as industry,geographical, economic, and political factors
• Arriving at an appropriate ALLL involves a highdegree of management judgment and results in arange of estimated losses
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• Document, document, document!• ALLL estimates should be based on comprehensive,
well-documented, and consistently applied analysisof the loan portfolio
• The ALLL should take into consideration all availableinformation as of the financial statement date,including environmental factors such as industry,geographical, economic, and political factors
• Arriving at an appropriate ALLL involves a highdegree of management judgment and results in arange of estimated losses
slide 17
Allowance for loan and lease lossesBest practices, continued• Historical loss history is only the starting point in
determining "FAS 5" adjustments– Must understand what historical loss data is and is not
capturing– Incorporate all internal and external factors that would
likely cause estimated credit losses to differ fromhistorical loss experience
• Consider whether changes in the environment or otherfactors warrant a change in the ALLL methodology
• ALLL methodology should not be overly mechanical– Step back and ask whether the methodology and
process is resulting in an appropriate ALLL
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• Historical loss history is only the starting point indetermining "FAS 5" adjustments– Must understand what historical loss data is and is not
capturing– Incorporate all internal and external factors that would
likely cause estimated credit losses to differ fromhistorical loss experience
• Consider whether changes in the environment or otherfactors warrant a change in the ALLL methodology
• ALLL methodology should not be overly mechanical– Step back and ask whether the methodology and
process is resulting in an appropriate ALLLslide 18
Allowance for loan and lease lossesUses of metrics/ratio analysis inALLL• Ratio analysis is a supplemental tool for evaluating
overall reasonableness of ALLL– May identify additional issues or factors that previously had
not been considered in the ALLL estimation process, whichmay warrant adjustments to ALLL.
– Inappropriate to make adjustments to the ALLL when it hasbeen properly computed and supported under theinstitution’s methodology for the sole purpose of reporting anALLL that corresponds to the peer group median, a targetratio, or a budgeted amount
• Generally, ratio's should be computed at a moregranular basis than total loans
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• Ratio analysis is a supplemental tool for evaluatingoverall reasonableness of ALLL– May identify additional issues or factors that previously had
not been considered in the ALLL estimation process, whichmay warrant adjustments to ALLL.
– Inappropriate to make adjustments to the ALLL when it hasbeen properly computed and supported under theinstitution’s methodology for the sole purpose of reporting anALLL that corresponds to the peer group median, a targetratio, or a budgeted amount
• Generally, ratio's should be computed at a moregranular basis than total loans
slide 19
Agenda• Allowance for loan and lease losses
– Basic concepts– Common issues– Best practices– Regulatory views
• Troubled debt restructurings
www.fmsinc.org | 800-ASK-4FMS
• Allowance for loan and lease losses– Basic concepts– Common issues– Best practices– Regulatory views
• Troubled debt restructurings
slide 20
Troubled debt restructuringsBasic concepts
• A debt restructuring is a TDR if both (ASC 310-40-15-5):– Borrower is experiencing financial difficulties– Creditor has granted a concession to the borrower
• Evaluate based upon individual facts and circumstancesand requires judgment– A creditor should consider all aspects of a
restructuring to determine whether it has granted aconcession
– Creditor may conclude that a debtor is experiencingfinancial difficulties, even though the debtor is notcurrently in payment default
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• A debt restructuring is a TDR if both (ASC 310-40-15-5):– Borrower is experiencing financial difficulties– Creditor has granted a concession to the borrower
• Evaluate based upon individual facts and circumstancesand requires judgment– A creditor should consider all aspects of a
restructuring to determine whether it has granted aconcession
– Creditor may conclude that a debtor is experiencingfinancial difficulties, even though the debtor is notcurrently in payment default
slide 21
Troubled debt restructuringsPractice issues
Are TDR's considered impaired loans?Quick answer - Yes• A loan is impaired when, based on current information and
events, it is probable that a creditor will be unable to collect allamounts due according to the contractual terms of the loanagreement (both principal and interest will be collected asscheduled). (ASC 310-10-35-16)
• For a loan that has been restructured in a troubled debtrestructuring, the contractual terms of the loan agreement refersto the contractual terms specified by the original loanagreement, not the contractual terms specified by therestructuring agreement (ASC 310-40-35-8)
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Are TDR's considered impaired loans?Quick answer - Yes• A loan is impaired when, based on current information and
events, it is probable that a creditor will be unable to collect allamounts due according to the contractual terms of the loanagreement (both principal and interest will be collected asscheduled). (ASC 310-10-35-16)
• For a loan that has been restructured in a troubled debtrestructuring, the contractual terms of the loan agreement refersto the contractual terms specified by the original loanagreement, not the contractual terms specified by therestructuring agreement (ASC 310-40-35-8)
slide 22
Troubled debt restructuringsPractice issues, continuedAre loans restructured in a TDR always considered animpaired loan which must be accounted for under FAS114?• Yes, these loans stay in the individually evaluated for
impairment bucket permanently– No FAS 5 allowance permitted, impairment
measured under FAS 114• Discussed by FASB Board on January 30, 2008
– Some FASB Board members indicated that it maybe permissible to group loans under a FAS 114approach (ASC 310-10-35-21)
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Are loans restructured in a TDR always considered animpaired loan which must be accounted for under FAS114?• Yes, these loans stay in the individually evaluated for
impairment bucket permanently– No FAS 5 allowance permitted, impairment
measured under FAS 114• Discussed by FASB Board on January 30, 2008
– Some FASB Board members indicated that it maybe permissible to group loans under a FAS 114approach (ASC 310-10-35-21)
slide 23
Troubled debt restructuringsPractice issues, continuedRequired disclosures for impaired loans• For each balance sheet (ASC 310-10-50-15(a))
– The amount of recorded investment in impaired loans for which there is• A related allowance for credit losses determined in accordance with
ASC 310-10-35 (FAS 114) and the amount of that allowance• No related allowance for credit losses determined in accordance with
ASC 310-10-35– Total unpaid balance of impaired loans
• For each income statement (ASC 310-10-50-15(c))– Average recorded investment in the impaired loans– Amount of interest income recognized during the time within that period that
the loans were impaired– Amount of interest income recognized using a cash-basis method of
accounting during the time within that period that the loans were impaired (ifpracticable).
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Required disclosures for impaired loans• For each balance sheet (ASC 310-10-50-15(a))
– The amount of recorded investment in impaired loans for which there is• A related allowance for credit losses determined in accordance with
ASC 310-10-35 (FAS 114) and the amount of that allowance• No related allowance for credit losses determined in accordance with
ASC 310-10-35– Total unpaid balance of impaired loans
• For each income statement (ASC 310-10-50-15(c))– Average recorded investment in the impaired loans– Amount of interest income recognized during the time within that period that
the loans were impaired– Amount of interest income recognized using a cash-basis method of
accounting during the time within that period that the loans were impaired (ifpracticable).
slide 24
Troubled debt restructuringsPractice issues, continuedCan I stop disclosing a TDR as an impaired loan?• Yes – in limited and rare circumstances the disclosures on
the previous slide need not be included in years after therestructuring
• Must meet both of the following conditions (ASC 310-40-50-2)– The restructuring agreement specifies an interest rate
equal to or greater than the rate that the creditor waswilling to accept at the time of the restructuring for anew loan with comparable risk
– The loan is not impaired based on the terms specifiedby the restructuring agreement.
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Can I stop disclosing a TDR as an impaired loan?• Yes – in limited and rare circumstances the disclosures on
the previous slide need not be included in years after therestructuring
• Must meet both of the following conditions (ASC 310-40-50-2)– The restructuring agreement specifies an interest rate
equal to or greater than the rate that the creditor waswilling to accept at the time of the restructuring for anew loan with comparable risk
– The loan is not impaired based on the terms specifiedby the restructuring agreement.
slide 25
Troubled debt restructuringsPractice issues, continued
Should the change in the impairment measurementfrom FAS 5 to FAS 114 for a TDR result in adecrease in the ALLL?Considerations• The modification has not changed the fact that the
borrower is experiencing financial difficulty• Should reflect that uncertainty about the timing and
amount of cash flows of a TDR• Impairment measured based on the original loan terms,
not the modified loan• Was there a potential charge-off at time of restructuring?
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Should the change in the impairment measurementfrom FAS 5 to FAS 114 for a TDR result in adecrease in the ALLL?Considerations• The modification has not changed the fact that the
borrower is experiencing financial difficulty• Should reflect that uncertainty about the timing and
amount of cash flows of a TDR• Impairment measured based on the original loan terms,
not the modified loan• Was there a potential charge-off at time of restructuring?
slide 26
Allowance for loan and lease lossesResources• Joint Interagency Letter to Financial Institutions (1999)• Interagency Policy Statement on Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Institutions(2001)
• SEC SAB 102 – Selected Loan Loss Allowance MethodologyDocumentation Issues (2001)
• Interagency Policy Statement on the Allowance for Loan and LeaseLosses, including the related question and answers (2006)
• Interagency Supervisory Guidance on Allowance for Loan and LeaseLosses Estimation Practices for Loans and Lines of Credit Secured byJunior Liens on 1-4 Family Residential Properties (2012)
• OCC Bank Accounting Advisory Series (BAAS) (June 2012)• FDIC call report instructions
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• Joint Interagency Letter to Financial Institutions (1999)• Interagency Policy Statement on Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Institutions(2001)
• SEC SAB 102 – Selected Loan Loss Allowance MethodologyDocumentation Issues (2001)
• Interagency Policy Statement on the Allowance for Loan and LeaseLosses, including the related question and answers (2006)
• Interagency Supervisory Guidance on Allowance for Loan and LeaseLosses Estimation Practices for Loans and Lines of Credit Secured byJunior Liens on 1-4 Family Residential Properties (2012)
• OCC Bank Accounting Advisory Series (BAAS) (June 2012)• FDIC call report instructions
slide 27
Allowance for loan and lease lossesResources, continued• Troubled Debt Restructurings: Supervisory Guidance on
Accounting and Reporting Requirements (OCC 2012)• SEC September 2012 Slide Presentation: Update from the
Division of Corporation Finance, 2012 AICPA NationalConference on Banks & Savings Institutions
• SEC CF Disclosure Guidance Topic No. 5: Staff ObservationsRegarding Disclosures of Smaller Financial Institutions
• Federal Reserve Bank -http://www.communitybankingconnections.org
• http://www.fdic.gov/bank/analytical/banking• http://www.occ.gov/topics/credit/index-credit.html• Grant Thornton whitepapers
– Adjustment factors– Loss discovery periods
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• Troubled Debt Restructurings: Supervisory Guidance onAccounting and Reporting Requirements (OCC 2012)
• SEC September 2012 Slide Presentation: Update from theDivision of Corporation Finance, 2012 AICPA NationalConference on Banks & Savings Institutions
• SEC CF Disclosure Guidance Topic No. 5: Staff ObservationsRegarding Disclosures of Smaller Financial Institutions
• Federal Reserve Bank -http://www.communitybankingconnections.org
• http://www.fdic.gov/bank/analytical/banking• http://www.occ.gov/topics/credit/index-credit.html• Grant Thornton whitepapers
– Adjustment factors– Loss discovery periods
slide 28
Questions
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slide 29