Key points in brief:

• Topic 1: How do you eat an elephant?

• Topic 2: What does Phase 2 of IFRS 4 mean for general insurers?

• Topic 3: Need for quality in actuarial reserving GI

PwC Actuarial Services NewsletterTopic 1: How do you eat an elephant?

IFRS 4 Phase 2 requires more from insurers than Solvency II.

Insurers that are well advanced in their preparations for IFRS 4 Phase 2 estimate that the costs of implementation of IFRS range from around the same as for the implementation of Solvency II to costs that are three times as much.

Market valuation has increasingly been applied in the insurance sector for some years now, for instance due to the introduction of the Liability Adequacy Test, market-consistent embedded value and of course Solvency II itself. The upcoming change to ‘market value’ for insurance liabilities

another instance of reporting at market value, but it involves complicated changes. This article deals with the practical implications of IFRS 4 Phase 2 1. In addition, we cite a number of lessons learned during the preparation for Solvency II: how do you deal with something with the scope of IFRS 4 Phase 2? Or, how do you eat an elephant?

Focus on the income statement

Solvency II is the focus of IFRS on the income statement2. Solvency II and other reporting based on market value focus on the statement of

income statement on market value is a new development for most insurers.

Before turning to the implications of

income statement. These apply to life insurers and non-life insurers to the extent that they do not use the simplified premium allocation method for short-term contracts3.

The income statement is explained further in the illustration and the paragraphs below.

• During the term of an insurance contract, the contractual service margin (CSM) and the risk adjustment are released in the income statement. The release of the CSM in particular means

other market value reporting metrics.

1

2

3

The IASB is currently still developing the model for participating contracts. Once all the decisions for participating contracts have been made, a paper will be drafted in which an assessment will be made as to the extent to which these decisions will also have to be applied to the building block approach (as described in this article).

The big difference lies in the basis of the metrics: prudential supervision for Solvency II and accounting (external communication) for IFRS. We focus here on the practical differences such as the income statement.

No further explanation of the premium allocation method is presented here.

• The ‘interest expense’ for the interest accrual of the provision, including the CSM, is recognised in the income statement. This necessary interest is calculated on the basis of the 'locked-in' curve: this is the curve at the time of inception of the insurance contract.

• Insurers may choose whether the change in the provision resulting from changes to the discount curve (change to the 'current' discount curve) is recognised in the income statement or in other comprehensive income ('OCI') as part of equity. For traditional insurance contracts, this change in the discount curve is not applied to the CSM. The insurer’s choice of the income statement or OCI will usually be driven by the way in which changes in the value of investments are presented (in the income statement or as OCI).

under IFRS (IFRS 4 Phase 2) may at first sight appear to be no more than

Phase

that IFRS 4 Phase 2 is different from

• Lastly, during the term of the

between the actual development and the development expected on

recognised in the income state-

The income statement under IFRS 4 Phase 2

The issues described above are the main cause of the practical consequences for insurers:

Volatility in results and complex analysis: for current IFRS reporting, the Liability Adequacy Test (LAT) is performed, for which a 'market value' is already calculated. However, this

test shows that the provision carried is too low. Under IFRS 4 Phase 2, the

the current value, with the inevitable volatility in results that this entails. Furthermore, the components of

due to changes to assumptions, riskadjustment, required interest, premiums

and disclosed. A clear and reliable analysis of variations is therefore essential.

Data: It should be obvious that a great deal of data will be needed to perform all the necessary calculations. This concerns the 'locked-in' interest curve for determining the necessary interest, but also the expected cash

and to be able to calculated changes to and releases from the CSM. This data will need to be established. Since

from those of IFRS 4 Phase 2, more data will need to be recorded in most

under IFRS 4 Phase 2 and Solvency II.

Models and systems: The models and systems will have to take account of the elements of IFRS 4 Phase 2, including a CSM, which are expressed

the ledger. We expect many new interfaces will be needed. Apart from

on the development of the results in the management information will also be desirable. Moreover, one should remember that the valuation for tax purposes will not change for the time being, so the models or systems that are used for results for tax purposes may not be forgotten either: if for instance results are produced by a new (projection) system, this system must also be able to make calculations for tax purposes.

Changes in cashflows related to future services

Incomestatement

(investmentresult)

Incomestatement

(underwritingresult)

Changes in discount rates

(update currentmarket rates)

Interest on insurance liability at inception rate

(unwind of discount rate)

Probabilityweighted

discountedexpected

present valueof cash flows

OCI

Changes in cash flowsrelated to

past and currentservices

Release of contractual

service margin

Riskadjustment

Release of risk adjustmentrelating to

current period

Upd

ate

for c

urre

nt

estim

ates

rela

ting

to

futu

re c

over

age

Contractualservice margin

Separated elements Alternative model: Premium allocation approach

flows ('expected differences').

flows and features in order to allocate

cases, as well as because of the differences

Impact on business

Other than the more obvious direct implications mentioned above, there are other areas in which IFRS 4 Phase

Timing of reports: Most insurers

5 and 12 weeks after year end, in February or March. For Solvency II, up to 20 weeks is now permitted (solo) – this term will change to 14 weeks in a couple of years. If elements of the Solvency II reporting process are used for IFRS 4 Phase 2, the issue will be how to accelerate the reporting process so that the IFRS results and underlying details can be produced on time. Another possibility would be to introduce a new parallel reporting process for IFRS.

Product development and pricing:

will change due to IFRS 4 Phase 2. This is particularly important for pricing

not be directly recognised, but will pass through the CSM and be spread over the term of the contract. Losses have to be recognised and disclosed directly. Loss-making products will thus become much more visible and will also cause volatility in the income statement.

ALM and hedging: Financial risk management will change due to the

and increased volatility in the income statement. Whether the IFRS reality or the Solvency II reality should be leading in this will require consideration. In addition, the models used for ALM and hedging will have to be adjusted.

People and processes: The complexity of IFRS 4 Phase 2 requires close cooperation between finance, the actuarial department and risk. Training will be needed for several departments (pricing, reporting, investor relations) and for several layers of management: both the preparers and the users of the more

to be trained. This is the same message as was applicable to Solvency II - in practice it is now clear that training was needed in order to understand

For external stakeholders such as shareholders, analysts and others, making the results comprehensible will be an item of note that requires extensive communication. The remuneration system may also be

will, for example, no longer consist of premiums in relation to the savings component of insurance contracts with life insurers, and the concept

change (for all insurers). How does

as they currently stand?

Lessons from Solvency II

The items described are the main practical changes involved as a result of the new IFRS 4. However, major changes are something we have experienced many times before in the

from Solvency II that are relevant in this light are:

•

•

• Do not allow the process to become a party for the quants or the actuaries:

years were mainly concerned with working on complicated actuarial models and less attention was given to governance and reporting.

• Good cooperation between the various disciplines is needed: this is

actuarial experts, and IT (for data, systems and models). Do not forget the business either: product development and ALM have already been mentioned in this article.

• Do not treat this as a standalone project, arrange the transition to 'business as usual' at an early stage.

The IASB is still engaged with certain elements of the new standard (partici-pating contracts) and also still has to

items such as the intended level of detail (unit or account). The impact of the elements of the intended standard that are established, however, is of

take account of the requirements of IFRS 4 Phase 2 for current projects in the (Solvency II) reporting process (as regards conversions, data warehouses and process enhancements). What will bring you to the ultimate goal ofimplementation of IFRS 4 Phase 2 with all its practical implications isoversight, a plan, and step-by-step implementation of that plan.

How do you eat an elephant? One bite at a time.

Start early, but not too early. Only start to make final plans or start rebuilding systems once the main principles have been properly thought out and you know where you need to begin. Make a plan for the entire process and start with the items that are already established.

However, you can start now by thinking about the impact. Think about any budget planning or mid-term planning for the next 2-3 years and the budget that is needed for a project that will be need to be started between now and 2017. To be able to do that, an analysis of the impact needs to be made - and the analysis can definitely be done even though some items are not yet certain.

Topic 2: What does phase 2 of IFRS 4 mean for general insurers?

of the standard to start thinking about what it will mean for general insurers. Many believe that the impact on

contracts which suggests relatively low impact; we question, though, whether this conclusion is correct.

Is simple the right option in all cases?

For reporting unexpired risk two main approaches are available, the general approach, known as the building block approach (the 'BBA')

approach (the 'PAA'). The PAA, being similar to the principles (in many current accounting regimes) of an unearned premium reserve (in the treatment of the unexpired risk), is certainly where many general insurers are expecting to land. However there are important elements to consider.

Whilst contracts of no more than 12 months can automatically be treated under the PAA, a longer contract will require a test to ensure whether the PAA reasonably approximates the BBA. It is not clear that many longer term contracts will pass this test.

Consideration should also be given to the fact that the PAA is a cash-based approach, a contract with instalment premiums will be accounted for based on the cash that has been received rather than the full contracted premium. For example, premium instalments outstanding at the end of the accounting period would not be considered even though they are contracted. Some may view this as not being aligned with their true exposure.

Regulatory developments in Europe, Switzerland and increasingly elsewhere have pushed the industry to measure their business on an economic basis; some have been doing this voluntarily in order to better understand, measure and manage business performance. Whilst a reasonable approximation in many circumstances, the PAA does not represent a full economic basis, it lacks an account of the full premium as noted above, it does not discount for the timing of

and does not include, pre-claim, an explicit allowance for risk (or capital charge). For some this could be perceived to be a limitation.

So what of the alternative, the BBA? For those contracts longer than 12 months that fail the test of ‘reasonable

approximation’ then it will be necessary

to adopt the BBA model. If this turns

portfolios, and we believe it could

range of multi-year products, insurers face the prospect of having to report

risk with a mixture of the PAA and the BBA. Reporting under multiple standards (IFRS, Local GAAP, Solvency II, Swiss Solvency Test, etc.) is already one of the industry’s biggest

with a mixture of bases rather than a single basis may not be a popular choice. That said, for some insurers where only a limited number of contracts would require the adoption of the BBA model, materiality may allow for the use of a single PAA model for all business. But even then, lest it be

the fact that the BBA will be necessary

for the expired part of the risk anyway.

New KPIs better than the old KPIs?

Aside from the question about the choice of approach, IFRS 4 Phase 2 sets a new basis by which performance is reported and this will almost certainly change how many stakeholders view the business. So what new KPIs will

Performance of general insurance business is typically measured using a combined ratio. It has the advantage of being easy to understand and easy

to calculate at low levels of granularity

in the business. However, it has its

value of money and higher capital costs associated with long-tailed lines of business. The new standard over-comes these limitations. Under the

(the day 1 contractual service margin) is a much closer representation of economic value. The economic value added is visible on the balance sheet and therefore comparable across IFRS reporters.

This type of analysis brings new issues though; if stakeholders in

the future form judgements on the economic value that is added each period, shouldn’t the whole business be managed on this metric? This will

economic value of portfolios at the same level of granularity at which they manage their portfolios. To do this, capital servicing costs (allowancefor risk) should be allocated to a portfolio level and most will need to invest in developing existing infra-structure to calculate an economic value added metric at the same level of granularity. Solvency II calculations can be leveraged here but for some,

Additional complexity brings additional communication challenges. If well- explained and well-understood, the new standard will bring more clarity to strategic decisions and reward

contributions to value will become

at all levels will need time to understand the new standard, increasing manage-ment time around strategic decisions and creating frustration. Shareholders

investor updates and communication is clear and provides greater trans-parency into business performance. Whilst training of management and stakeholders will help, it is also likely that being able to clearly identify the

(and having the infrastructure to do that) will be a feature of successful communication.

The factors around the PAA and BBA, and the way performance is reported require careful consideration; the PAA may not be the low impact solution some believe it to be, and regardless of the PAA decision many additional and more granular calculations are required (there are important considerations around risk adjustment and contractual service margin for example). Front-runners will currently be giving careful thought to these issues and making plans around the necessary investments in systems and data.

Phase

investment.

Phase

Assuring quality through benchmarking – the ‘leading practice’

What has proven useful in practice to prevent leaks in quality is bench-marking the reserving process of insurers in a systematical way. We do that by applying the ‘leading practice’ benchmark.

The ‘leading practice’ benchmark is measuring the quality of reserving in several dimensions – each evaluated

ratings calculated on the basis of the answers. We rated several insurers in

to this one standard. As a result, we are able to actually compare the performance of our clients to peers - in detail and overall.

Topic 3: Need for quality in actuarial reserving GI

Motivation

are discovered too late, it is also obligatory for Solvency II and IFRS 4 Phase 2 to assure the quality and reliability of the calculation of best estimates and inherent uncertainty in technical provisions. In some heavy-tailed LoBs reserving is the most important driver for pricing the business correctly, e.g. in some areas of commercial liability books.

Some examples that limit the quality of reserving, sometimes even severely, are:

• is often a severe limitation for actuaries hindering them from performing adequate analyses, e.g. to see trends in (sub-)BoBs, since data is only processed at LoB-level.

• A possible quick-win, especially common with big insurers, is

communication between

pricing or claims handling.

• We see a homogenous use of softwa-re and methods in major parts of the market. Nevertheless, the challenge of methods (e.g. by comparing different methods or by backtesting) is significantly different between insurers, possibly causing material differences in reserves.

• Even though there is a high degree of professional behaviour among actuaries in the industry, it is common for analysts with some years of experience in their company not to question their methods anymore. This creates a systemic blank spot for trends and limits the sensibility of the reserving. Sometimes this is also driven by an expert judgement.

• Today, it is common to have external

independent actuaries doing re-projections of major parts of the book on a regular basis. Nevertheless

we see a tendency to focus only on a limited scope when workingwith external independentactuaries, like methods or data.That results in missing easy winsin the broader picture.

Our advice

The aim of management is to arrive at an adequate and reliable calculation of best-estimate claims and premium provisions, including allowance for reinsurance and an appropriate estimation of inherent risk and uncertainty, taking into account the business and process environment of reserving. This way management is addressing the rising external pres-sure to have a high-quality actuarial reserving, and can also reduce volatility in reserves. We have seen how high-quality reserving was able to detect trends in data that otherwise would

the market as to how reserves are set. We see potential for improvement that is, with some insurers, severe.

be reached by easy means, not needing more resources in the long term than are already in place.Illustration 'Leading

practice' benchmark

Our view on the market

Data availability and granularity

reserving actuaries and otherdepartments of the insurer, e.g.

(1) Leadership

(2)Data

(4)Communication

(5)Staff

Disclosure(7)

(6)PeerReviews

(3)Methods

The interview was conducted by Thomas Hull, Partner Actuarial Services.

Thomas: Hello Dirk, welcome to PwC. We’d like to get some of your views on the reserving topic outlined above. Why do you think it is essential to have a high-quality reserving pro-

reserving for some time now?

Dirk: Sure, and undertakings have indeed developed hugely over the last decade. But today, compared to ten years ago, best estimate reserving has

on various other areas in companies. I just want to mention capital and other regulatory requirements, pricing, ratings and transactions. When you watch a football game from 10 or even more years ago, you notice that time can change things dramatically. You might have developed your skills, but you have had to in order to play in the same league as before!

Thomas: You mentioned the new regulations. Some current and soon to be implemented regulations put some additional weight on proper reserving.

Dirk: That’s right. Next to being a fundamental part of the balance sheet and input for capital calculations for non-life (re-)insurers, the reserving methodology and its related data questions are clearly the focus of the newly implemented actuarial func-tion. In particular, the adequacy of the

are still volatile…

Dirk: A certain stability of reserving methods and the results is one of the key goals of reserving departments. In the future, people in charge will have

-rences, e.g. from one year to another. Therefore, the choice of methods and, most of all, a stable and adequate data basis are crucial.

Interview on reserve quality with Dirk Grönke, new Director for Actuarial Services in GermanyOn April 1st, Dirk Grönke started as a director with PwC Actuarial Services in Germany. His focus is on actuarial consultancy for non-life (re-)insurance undertakings and the quantitative areas of risk management. One of his main hobbies is soccer, the active as well as the passive part.

Phone: +49 221 2084 129

Email: dirk.groenke@de.pwc.com data that was used for reserving plays an essential role. Many companies ask themselves whether the data used is appropriate and how they can assure this today and in the future.

Thomas: High quality at a given point in time is good. But the results

Thomas: How can companies achieve high quality and stable reser-ves while still being able to report within deadlines that are getting shor-ter and shorter?

Dirk: Important point! Indeed, requi-rements for increased reporting speed seem to have risen steadily and will actually rise even further. Hence, not only the reserving itself but the whole reserving process needs a quality

needs a lot of training, so that in the game, some basic parts do work auto-matically. You just have 90 minutes!

Thomas: Dirk, thank you for these insights.

We gratefully acknowledge the support of Frank den Bieman, Annette van Berge Henegouwen, David Skinner, Frank Schönfelder, Dirk Grönke, Matthias Liermann and Laura Barella for their work, without which the present articles could not have been completed.

Actuarial Services – Your Contacts

Switzerland

Thomas Hull Tel: +41 58 792 2510 thomas.hull@ch.pwc.com

Germany

Dr. Clemens Frey Tel: +49 89 579 06236 clemens.frey@de.pwc.com

The Netherlands

Jan-HuugLobregt Tel: +31 88 792 7463 jan-huug.lobregt@nl.pwc.com

The Netherlands

Bas van de Pas Tel: +31 88 792 6989

bas.van.de.pas@nl.pwc.com

This publication is intended to be a resource for our clients, and the information therein was correct to the best of the authors’ knowledge at the time of publication. Before

entity. Please see www.pwc.com/structure for further details.