Embedded Derivatives in Insurance Contracts
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Transcript of Embedded Derivatives in Insurance Contracts
Embedded Derivativesin Insurance Contracts
Draft International Actuarial Standard of Practice
Stefan Engeländer
Formal Basis
IFRS 4.7: Apply IAS 39 to embedded derivatives
IAS 39.2 (e): Scope includes such derivatives
IAS 39.9: Definition of a derivative IAS 39.10:Definition of an embedded
derivative IAS 39.11: Guidance for embedded
derivatives IAA Draft International Actuarial Standard of
Practice „Embedded Derivatives“
International Actuarial Standards of Practice
Issued by the IAA Drafted and proposed by the International
Actuarial Standards Subcommittee Subsidiary to national standards Member organizations of IAA obliged to
transform in own standards “Embedded Derivative” will be Class IV,
merely educational
Concept of Derivatives
Concentration of financial risk inherent in normal investments by trading it separately
Significantly subject to changes in market views of values Causes an unusual risk exposure, therefore special
consideration required Best measurement at market value
In some cases derivatives artificially combined with other features causing a non-derivative contract If actually artificial (not closely-related) separation
required to identify concentrated risk properly
Critical Consideration of Concept
Derivative refers only to a very specific risk There are many significant risks, especially
options and guarantees, not covered by that concept
Especially in insurance business very exotic form of risk
Accounting concentration on that exotic risk might distract from more relevant risks
Actually relevant only in case of traded risks, insurance business often based on non-traded factors (natural disasters, longevity)
Identification of a Derivative
Financial instrument No insurance contract Value changes in response to changes of a
specified market factor Initial net investment significantly smaller
than for comparable primary investment Settled at future date
Time up to settlement date exposes to changes of market factors
Market Factor
Market factor defined by IAS 39.9 (a) (as amended by IFRS 4.C6) as:“interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract”
Insurance risk is a non-financial variable specific to the policyholder transferred to the insurer
Market factors are therefore: All financial variables All non-financial variables not specific to a party
Market Factor
IFRS 4 changed the definition of a market factor, by limiting the general reference to “other variable”
Otherwise as well any insurance would be a derivative, since as well the occurrence of a claim can be seen as “other variable”
Therefore, the definition was limited to actual market relevant variables, rather than variables specific to a party
Market Factor
Market factors are variables applicable for all market participants
Examples of market factors Market interest rates Market price of a bond Market assessment of credit standing of an entity Price index Market assessment of commodities Longevity of population Weather conditions Index of natural disasters
Specific Non-Financial Variables
Specific non-financial variables are variables relevant only for the parties of the contract
Examples of specific non-financial variables Occurrences affecting the condition of a good Life expectation of a party Health condition of a party (guaranteed
insurability) Employment situation of a party Claims development of a portfolio of a party Cost situation of a party Individual investment policy of a party Actual insolvency of a party Any deliberate action of a party
Specified Market Facor
The market factor has to be specified to qualify a derivative Cash flows under the contract are directly
determined based on a market factor specified in the contract
Actions of the parties influencing the cash flows of the contract are subject to the development of specified market factors, not necessarily written in the contract but obvious at outset of the contract, eg development of market prices for alternative investments
Not qualifying: During the contract duration appears a new aspect causing that future cash flows are subject to a market factor
Effect of the market factor
Value of contract changes in response to changes of market factor Basis fair value of the contract, not book value,
considering all uncertainties in measurement Significant impact required, as well in comparison
with all other impacting risks Right to exchange one right with another right at
fair value has always the fair value zero, ie value of that right does not change
Obligation to settle in future at cost, as well on a portfolio level, to be seen as value zero, except if at outset clear, that ability to settle below market
Short term initial advantages in long term contracts to be ignored
Effect of the market factor
Value of contract changes in response to changes of market factor
The fair value of the contract need to change in response to changes of market factor- effects to individual cash flows under the contract do not necessarily affect the value of the contract! Example: Unit linked contracts, the benefit changes in
response to unit price, but the value of the entire contract is ideally always zero since any cash flow is exchanged at market value in units
Effect of the market factor
Examples of such effects External factors determine the amount of cash
flows Index-linked benefits Interest linked to indices, eg weather conditions Annuity conversion rate linked to population longevity
External factors determine the occurrence of cash flows Cancellation of a fixed-interest investment in dependence
from current market interest rates Payment due if a specific event occurs which is not
specific to a party
In those cases it has to be checked, whether the effect of the market factor impacts significantly the fair value of the contract
Comparison with Alternative Investment
IAS understands a derivative as concentrated risk from normal (primary) investments
A derivative is not a primary investment The payment is merely a risk price rather
than an investment A derivative has therefore a lower net initial
payment than that primary investment from which the derivative risk origins
That difference in initial net payment is a defining characteristic of a derivative
Comparison with Alternative Investment
Derivatives and insurance similar Both contain cash flows subject to variables Both cover concentrated risk Both charge a risk premium rather than being an investment
used for commercial processes
Difference between derivative and insurance Definition: Only financial instruments in the scope of IAS 39
can be derivatives Derivatives cover mainly market risks (ie the assessment of
market participants of future economic use of items), while insurance cover actual risks endangering the economic position of the policyholder directly
Insurance risks are usually stochastic risks and can be usually mitigated by the Central Limit Theorem since large number of identical distributed and independent risks are available
Derivatives are subject to inpredictible market behavior
Alternative Primary Investment
For qualifying as derivative, there needs to be an alternative primary investment subject to the same market factor
A primary investment is a funding of a commercial process subject to commercial risks and chances
Especially difficult in case of non-financial market factors like Longevity of a population Weather conditions Index of natural disasters
Alternative Primary Investment
Examples for alternative primary investments subject to such non-financial market factors Cost of living in case of longevity of a population
equivalent to a life-contingent annuity Investment in weather dependant activities like
agriculture, tourism or open air events Investment in buildings in an area of increased
geotectonic activity
Initial Net Investment
Price paid for achieving the rights Not just the initial contribution in case of
regular payment contracts To be modified for
Modified for risk exposure in comparison to alternative investment by modifying the risk price without changing the funding component
Included servicing cost is servicing is no part of alternative investment
Comparison of Initial Net Investments
Initial net investment needs to be so significantly lower than for alternative investment that it is clear, that it is merely concentrated risk rather
than investment (even onerous by intention) it outweighs the differences between different
available alternative investments and different prices charged in markets for those
It is significant as well considering whether the relationship between funding component and risk price in the alternative investment is large or small
Example
Right to get an life-contingent annuity at a future date at a price reflecting longevity of the population at that date and at market interest rate Specified non-financial market factor longevity of
population and financial market factor market interest rate
Value of right always zero Alternative investments
Fixed interest instrument Life-contingent annuity Both no difference in initial net investment
Example
How to style a derivative based on longevity of a population? Right to receive the difference between the price
of a life-contingent annuity today and the price of that at future longevity of a population
Embedded Derivatives
An embedded derivative is a component of a non-derivative contract, that would be a derivative if it was seen as a stand-alone contract Component of a contract
Basis is an identifiable feature of a contract, which can be isolated without any artificial split
The component containing that feature is the sum of all parts of the contract related to that feature to enable to be a reasonable contract if it were a stand-alone feature
Such related features are especially prices charged and other economically required features
Such related features may need artificial splits of contractual features, eg if one single price is charged for the entire contract
Notional split of prices in the contract shall not be considered except that split reflects economic reality
Embedded Derivative Cash Flows
Embedded derivative cash flows are cash flows under the contract that change in respond to changes of a specified market factor
For identifying embedded derivative cash flows contractual cash flows shall not be artificially split No split of a risk-free cash flow in two negatively
correlated cash flows No split of a cash flow changing in respond to a
specified market factor in a cash flow responding to a non-specified factor, eg a non-specified interest rate, and the deviation of that factor to the specified market factor
Double Trigger
An insurance contract is no derivative by definition
A component including significant insurance risk (measured in comparison to the component only) is therefore no embedded derivative
A cash flow double triggered by insurance risk and derivative risk is therefore no embedded derivative cash flow A benefit payable in case of occurrence of an
insured event but amount market factor triggered An option, whose execution is triggered by market
factor as well by eg health condition under coverage of guaranteed insurability
Behavior of Parties
Options are contract features allowing parties to influence cash flows unilaterally
Behavior in executing options might be triggered by specific circumstances of parties (health condition,
financial situation eg in case of unemployment, legal situation eg in relation to state social security) If creating significant insurance risk, the component is no
embedded derivative market considerations considering alternative
instruments available in the market Might cause that cash flow is subject to a specified
market factor
Guaranteed Insurability
Guaranteed insurability is a feature of contracts guaranteeing that in future insurance coverage is
provided and that at normal terms disregarded of individual development of
insurability, ie without risk examination
In case of a significant chance of a significant impairment of insurability, that feature is qualified as insurance contract if considered stand-alone
A component containing such a qualified feature is no embedded derivative
Separation Requirements
IAS 39.11 requires an embedded derivative to be separated and measured at fair value if it is not closely related to the host contract
Closely related means that the economic risks and characteristics of the component, especially those qualifying as derivative, are not the same as in the host contract
It is not possible to style the component reasonably in a manner that those economic risks and characteristics appear only in the component
and the entire contract is not already measured at fair value with changes through P&L
An embedded derivative only treated as such if reflecting economic reality of the reporting entity (no intend to make use of the derivative option)
Examples of Closely Related Risks
Fixed interest rates in component closely related to (assumingly) fixed interest rate inherent in insurance pricing Limited prolongation, prepayment or surrender rights,
cancellable current premium payment at fixed terms are closely related
Unlimited prolongation rights of a deposit component extent of insurance component at predetermined terms not closely related
Modification of fixed interest by market factors in a range of 0-2*i is closely related
Any embedded derivative not measurable separated from the insurance contract is to be seen as closely related
Entire Contract at Fair value
No separation required if entire contract already measured at fair value with changes through P&L It is sufficient that the component containing the
embedded derivative, eg the deposit component, is measured at fair value and contained with that value in the insurance liability
Typical example unit-linked contracts, where assets and liabilities are reported consistently at fair value
Fair Value of the Embedded Derivative
Fair value measurement required in accordance to guidance by IAS 39
Major difficulties can be expected in case of embedded derivatives in insurance contracts, especially for non-specific non-financial variables
Measurement approaches will require an extended degree of assumptions mainly based on judgment rather than on observable data
Measurement of the Host Contract
Application of existing accounting policy to the host contract may cause significant difficulties
Assuming that initial recognition of the host contract reflects fair value, initial measurement equals amount of existing accounting policy for entire contract minus fair value of embedded derivative
Subsequent measurement should be the measurement of existing accounting policy for the entire contract minus subsequent measurement of embedded derivative according existing accounting policy