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Transcript of © 2004 Deloitte Application of IAS/IFRS to Life Insurance – Some practical issues Jan Kamieniecki...
© 2004 Deloitte
Application of IAS/IFRS to Life Insurance – Some practical issues
Jan Kamieniecki
Lisbon, 7 July 2004
2 © 2004 Deloitte
Agenda
Background to IAS Implementation
Topics for discussion:
Some current implementation issues
Managing a life business in an IAS world
3 © 2004 Deloitte
State of Play of Insurance Project
EU committed to implement IAS from 2005 for quoted companies in consolidated accounts
Subsidiarity for non-consolidated accounts and for unquoted companies
Requires an opening balance sheet as at 1/1/2004
And reconciliation to local GAAP
Insurance standard is just one of many
IAS have taken pragmatic 2-phase approach to insurance Implies a transitional period
More difficult to pilot result without certainty as to endgame
Need to make a strategic choice
4 © 2004 Deloitte
• IFRS 1 – First Time Adoption of IFRS
• IAS 8 – Accounting Policies
• IAS 18 – Revenue
• IAS 19 – Pensions
• IAS 32 – Financial Instruments: Disclosure & Presentation
• IAS 37 – Provisions, Contingent Liabilities and Assets
• IAS 39 – Financial Instruments: Recognition and Measurement
• IAS 40 – Real Estate
Many subtle issues arise that are non-specific to insurance
Many other IASs Driving Insurance Accounting include
5 © 2004 Deloitte
IFRS 4: Insurance Contracts (Phase I)
Pragmatic approach to meeting the 2005 EU deadline
Provides specific and uniform definition of insurance
=> Classification of products as “insurance” or “financial”
This IFRS allows insurers to use of local GAAP for:
“insurance” contracts
savings contracts with discretionary profit sharing (WP)
Liability Adequacy Test is required
Equalisation and catastrophe reserves are not permitted
Unallocated surplus not allowed; either equity or liability
Some guidance on implementing IAS 32 and 39 for products classified as financial instruments
Presentation and disclosure requirements
6 © 2004 Deloitte
Phase II of the Insurance Project
Exposure Draft expected in 2005
Comprehensive standard on recognition and measurement for “insurance contracts”
Based on fair values
Replaces temporary dispensations and interim standards from Phase I
Implement final standard by 2007???
7 © 2004 Deloitte
Definition of “insurance contract”
As per Appendix A of IFRS 4:
“A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder.”
8 © 2004 Deloitte
Definition of “significant insurance risk”
As per Appendix B of IFRS 4: “If and only if, an insured event could cause an insurer to pay significant additional
benefits in any scenario, excluding scenarios that lack commercial substance.” “This condition is met even if the insured event is extremely unlikely.”
rule of thumb for risk contracts – does the DB exceed surrender or maturity value just after the initial premium is paid?
It may be reasonable to say:
Risk is significant if sum at risk >= x% of reserves
Similar rules for survivorship contracts
9 © 2004 Deloitte
Insurance versus Financial Risk
“Financial risk” is defined:
“Risk of a possible future change in one or more of a specified interest rate,
security price, commodity price, exchange rate, index or similar variable”
A contract classified as financial, can become insurance (e.g. deferred annuity)
“Insurance risk” is defined:
“Risk other than financial risk”
A contract classified as insurance at inception remains insurance throughout
“A contract that exposes the issuer to financial risk
without significant insurance risk is not an insurance
contract”
10 © 2004 Deloitte
Examples of Classification
insurance contracts:
Term Assurance
Life contingent annuities
and pensions
Deferred annuity with rate
guaranteed at issue
Disability and medical cover
Waiver of premium rider
Pure endowments
financial instruments:
Savings contract with no profit
sharing
Accumulation phase of non-
guaranteed deferred annuity
Simple unit linked products
Financial guarantees where
holder not exposed to loss
11 © 2004 Deloitte
Liability Adequacy Test (LAT)
Shall carry out a LAT at each reporting date if no test meeting IFRS 4 minimum requirements already in place
Uses current estimates of insurance contracts’ future cash flows
Any deficiency in liabilities to be recognised immediately in profit and loss account
LAT required for what is not accounted for at FV: IAS 39 contracts valued at amortised cost
Insurance contracts products not at FV
Contracts with a DPF not at FV
LAT may be an issue if: High guaranteed interest rates are not matchable by assets
Deterioration in anticipated experience from technical basis
Allowance for expenses in technical basis not adequate
Deferred acquisition costs not all recoverable
12 © 2004 Deloitte
Liability Adequacy Test - Methodology
Projection of all insurance cashflows on a best-estimate basis, discounting using risk-free yield curve
Result compared to liability, net of any DAC asset
Any loss is immediately recognised in revenue account
Loss to recognise =
max(0, LAT Liability – Current Liability net of DAC)
Aggregation must be at least at portfolio level or for funds managed together.
=> impact on loss recognised
Options and guarantees can be valued at intrinsic value i.e. current best estimate scenario
13 © 2004 Deloitte
Some insurance contracts contain an insurance component and a deposit component
Unbundling is required if both these conditions are met: can measure deposit component separately current accounting policies do not require to otherwise recognise all obligations
and rights arising from the deposit component
To unbundle a contract, an insurer shall: apply IFRS 4 to the insurance component apply IAS 39 to the deposit component
Some forms of Universal Life may be affected
Financial reinsurance may be affected
Unbundling
14 © 2004 Deloitte
Embedded Derivatives
If the derivative is not insurance itself apply decision tree in deciding whether to split:
Is hybridmarked to fairvalue through
earnings?
Is the embeddeda stand-alone
derivative?
Is itclosely related?
No Yes No
Yes No Yes
Do Not Split Embedded
Sp
lit & A
pp
ly IAS
39
15 © 2004 Deloitte
Embedded Derivatives
Embedded Derivatives: Exception to IAS 39:
An insurer need not separate a policyholder’s option to surrender an insurance contract for a fixed amount (or for an amount based on a fixed amount and an interest rate) even if the exercise price differs from the carrying amount of the host Insurance Liability
However, an insurer shall separate a put option or cash surrender option embedded in an insurance contract if the surrender value varies based on the change in an equity or commodity price or index
“a derivative is a financial instrument with all three of the following characteristics:
1. Its value changes in response to the change in a specified interest rate, index,…
2. It requires little initial net investment … and
3. It is settled at a future date.”
16 © 2004 Deloitte
FV is defined in IAS 39 as ‘the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm's length transaction. IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument: [IAS 39 Appendix A, paragraphs AG69-82]’
Hierarchy of valuation: Published prices in an active market
Recent transactions where no active market
Other valuation techniques where neither available
Fair Value
17 © 2004 Deloitte
Fair Value Liability
Best estimate assumptions for projection
Pre-tax risk free rates for discounting
Market consistent calculations: Independent of asset performance
No investment returns included in cash flows
If policyholders’ benefits dependent on management decision and/or investment returns
=> stochastic approach required
18 © 2004 Deloitte
Fair Value Calculations for IAS 39
FV(t) = max(PVrfr(best estimate policy CFs)+ VoG(t), SV(t))
Where:
PVrfr = Present Value at the risk free rate
CFs = Cash Flows
VoG = Value of Guarantee (e.g. Return of Premium => use Black Scholes)
SV = Surrender Value
Where, for a SP Unit Linked contract:
PVrfr(Policy CFs) = Fund Value(t) + PV(expenses – charges)
– PV(surrender penalties) + PV(DB in excess of fund)…
Fair value limited to deposit floor
19 © 2004 Deloitte
Fair Value Amendment
IASB have asked for comments on a proposed FV amendment
FV limited to contracts where one of these conditions applies: Embedded derivative is contained
Contractually linked to performance of specified assets
Changes in FV substantially offset by changes in FV of another instrument
FV must be “verifiable”
20 © 2004 Deloitte
Amortised Cost Method
AC(0) = initial premium received – initial external costs AC(t) = {AC(t-1) + Premiums – Benefits paid} rolled up at EIR
Where:
EIR = Effective Interest Rate calculated at issue and locked-in, using best estimate at inception
EIR = IRR(best estimate of future policy cash flows)
Where: Policy cash flows are:
Those exchanged between policyholder and insurer Include surrenders Exclude expenses and commissions
21 © 2004 Deloitte
What Does it Mean for Reinsurance?
No change in basis of underlying insurance and no offsetting
Unbundling separable deposit components of financial reinsurance
Future uncertain event can be quantum of loss: retrospective (re) insurance allowed.
Net accounting - if positive difference between cost and ceded liability at outset then “recognised on systematic and rational basis over the underlying period of risk exposure.”
Infoline - IFRS for UK Life Insurers - May 2004
22
Financial ProductIAS 39
Insurance Product(with or without DPF)
Is significant Insurance Risk
transferred?
Embedded option?
Unbundlingrequired?
DPF?
No Yes
NoYes Yes
No Yes
AC orif possible
FV?
Embedded option?
Entire contractValued at AC
Separate and FV option. Host
contract valued at AC
Separate and FV Embedded Option.
Host uses local GAAP or better +
LAT
Phase II: FVPhase I: Current method or better
+ LAT
Financial Component(IAS39) at AC or FV
No
Yes No
Yes
AC
Closely related and/or
Insurance?
Closely related and/or
Insurance?
Fair value
No Yes
23 © 2004 Deloitte
Disclosure Requirements
Objective is to better understand risk exposure
Describe business through management’s eyes
What is required for disclosure:
Quantitative and qualitative measures
Management, concentration and mitigation of risks
Assumptions and sensitivity analysis
Extensive claim development information
Embedded derivatives for which it is not required to measure at
fair value:
Disclose information about exposures to interest rate risk or market risk
24 © 2004 Deloitte
Some Current Issues
Classification
Choice of AC vs FV
Treatment of non-allocated surplus
Treatment of DAC
Auditability
25 © 2004 Deloitte
Classification
Generally unproblematic but: Absence of definition of materiality
Requirement for substance over form
Note need for materiality in profit-sharing & discretion
Some contracts may be insurance for one type of policyholder, and a financial instrument for another … need to look at policyholder profile
Do clients take up switching etc options?
Does existence of any survivorship benefit make the contract insurance?
26 © 2004 Deloitte
Choice of AC vs FV
Will FV amendment apply?
What does “substantially offset” in FV amendment mean?
Generally aim is to manage balance-sheet and revenue account impact
Need to look at matching assets as well as insurance liabilities
Use of AC limits flexibility in asset management
FV may create extra volatility where there are closely related options, or matching is poor
Historic data for assumptions at time of issue for FV
27 © 2004 Deloitte
Treatment of non-allocated surplus
Where assets are at FV this may include “unrealised” capital gains
Standards require classification of all items as equity or liability
This may require an explicit formulation of future bonus policy, and consequently an appropriate allocation of items into each category
Future changes in bonus policy may have a (geared ?) impact on the bottom line
28 © 2004 Deloitte
Treatment of DAC
DAC not consistent with a FV approach Possible approach to unbundle administration component of contract and to value
under IAS 18.
Split into acquisition and maintenance expenses a significant factor
Amortisation based in proportion to run-off of expense margins
Only relevant if surrender penalties exist
29 © 2004 Deloitte
Auditability
FV, LAT require best estimate projections, not dissimilar to existing Embedded Value Approach
Embedded Values have often been documented to a lower standard than audit information
Experience analyses
Documented choice of assumptions
Systems for fair values
Auditing stochastic valuations introduces new complications
This may require a significant investment in new processes and systems
30 © 2004 Deloitte
Some other implementation issues
1st time application
Restatements and/or comparatives
FX implications
System limitations
Forecast / planning implications
Ability to provide data for disclosure information
Extent of disclosure – competitive information considerations
31 © 2004 Deloitte
Managing a life business in an IAS world
Key performance indicators
Investment Strategy
Profit-sharing strategy
All this may lead to changes in contract design
32 © 2004 Deloitte
Key Performance Indicators
Premium income and reserves superseded Provide comparatives
League tables may change
Need to restate corporate targets/ review strategy
Potential need to review incentive plans
33 © 2004 Deloitte
Investment Strategy
IAS may highlight a mis-match
Or may introduce greater volatility
Possible solutions include Strategic asset re-allocation
Tactical hedging
Strategic framework may need to be disclosed Will this create a competitive disadvantage?
34 © 2004 Deloitte
Profit-sharing strategy
Will need to be formulated more explicitly For FV calculations
For attribution of un-allocated surplus
Likely to need to be disclosed
Will this create competitive issues?
Will disclosure affect strategy?
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