Insurance contract accountIng: edgIng towards a … | Willis Re Insurance Contract Accounting The...

1 | Willis Re Solvency II Willis Re Solvency II | 2

Insurance contract accountIng: edgIng towards a global standard

global and local reinsurance Willis Re employs reinsurance experts worldwide. Drawing on this highly professional

resource, and backed by all the expertise of the wider Willis Group, we offer you every

solution you look for in a top tier reinsurance advisor. One that has comprehensive

capabilities, with on-the-ground presence and local understanding.

Whether your operations are global, national or local, Willis Re can help you make

better reinsurance decisions - access worldwide markets - negotiate optimum terms –

and boost your business performance.

How can we help?To find out how we can offer you an extra depth of service

combined with extra flexibility, simply contact us.

Begin by visiting our website at www.willisre.com or calling your local office.

willis limited, registered number: 181116 england and wales.registered address: 51 lime street, london ec3M 7dQa lloyd’s broker. authorised and regulated by the Financial services authority.

© copyright 2010 willis re Inc. all rights reserved: the views expressed in this report are not necessarily those of willis re Inc., its parent companies, sister companies, subsidiaries or affiliates (hereinafter “Willis”). This report and its contents are provided for informational purposes only, do not constitute professional advice and are not intended to be relied upon. willis is not responsible for the accuracy or completeness of the contents herein and expressly disclaims any responsibility or liability for the reader’s application of any of the contents herein to any analysis or other matter, or for any results or conclusions based upon, arising from or in connection with the contents herein, nor do the contents herein guarantee, and should not be construed to guarantee, any particular result or outcome.

Willis Rethe willis building51 lime streetlondon ec3M 7dQTel: +44 (0)20 3124 6000Fax: +44 (0)20 3124 8223

www.willis.com

Willis Re Inc.one world Financial center200 liberty street3rd Floornew York, nY 10281Tel: +1 (212) 915 7600

october 2010

8990/10/10

David SimmonsManaging director willis analyticsTel: +44 (0)20 3124 8917email: [email protected]

Angela Bowerndivisional directorwillis re InternationalTel: +44 (0)20 3124 7843email: [email protected]

Adrian Hammondexecutive directorwillis Market securityTel: +44 (0)1473 223 329email: [email protected]

Contents

The New International Financial Reporting Standards – what you need to know? .......................2

Background .......................................................................................................................................3

Global scope of IFRS for insurance contracts ................................................................................. 4

Differences with Solvency II ............................................................................................................ 4

A new way of thinking and reporting .............................................................................................. 4

What is the margin? .........................................................................................................................5

Deferred acquisition costs ............................................................................................................... 6

Cash flow calculation ....................................................................................................................... 6

Discounting – the time value of money .......................................................................................... 6

Short-duration contracts ................................................................................................................. 6

Moving from local standards to IFRS ............................................................................................. 6

Reinsurance ......................................................................................................................................7

Tax implications ...............................................................................................................................7

Other points to consider ...................................................................................................................7

Having your say ................................................................................................................................7

Glossary ........................................................................................................................................... 8

Willis Re Insurance Contract Accounting | 1

2 | Willis Re Insurance Contract Accounting

The New International Financial Reporting Standards – what you need to know?The world is moving towards convergence in insurance accounting standards. The latest consultation papers show that implementation is on course for 2013. The impacts could be profound, both in terms of numbers produced and the organisational impact upon companies, particularly those in Europe already struggling with regulatory change. What are the key facts and potential consequences for insurers and insurance professional?



BackgroundIn 2008, the U.S.’s Financial Accounting Standards Board (FASB) joined the London-based International Accounting Standards Board’s (IASB) project to develop a new insurance accounting standard. The aim is to finalise the new standard in 2011 for likely implementation in 2013.

Time Line

1997 to 2004

2004

2005

May 2007

November 2007

2008

July 2010

September 2010

November 2010

December 2010

2011

2013

IASB develop a IFRS for insurance contracts

Phase 1, IASB issue IFRS 4: insurance contracts

EU listed companies required to prepare consolidated financial statements using IFRS

Phase 2, IASB publish discussion paper

End of insurer comment period

US FASB join IASB to produce one standard for insurance contracts

IASB release Exposure Draft

FASB produce Discussion Paper

End of IASB insurer comment period

End of FASB insurer comment period

Final Standard

Proposed first implementation

Figure 1: Timeline for implementation

The new standard will replace the interim IASB standard, an International Financial Reporting Standard (IFRS) 4 and U.S. GAAP.

Listed EU companies are required to prepare their consolidated financial statements under IFRSs and a number of other countries including Singapore and Hong Kong have also adopted IFRS. Similarly other countries base their accounting standards wholly or in part on U.S. GAAP.

Many major economies, including Japan, Korea, India, Brazil, Canada and Mexico have announced that they will adopt the new IFRS standard.

In July 2010 the IASB produced their latest consultation paper on phase two of the new standard, the Insurance Contracts Exposure Draft (ED). In September 2010 the FASB produced a Discussion Paper (DP) on the new standard. Responses to these documents are due by the end of November and mid-December respectively.

But the proposals are not finalised. There are differences between the IASB and FASB and differences between both and the developing Solvency II approach.

This paper aims to give an overview of the proposed changes and their impacts, aimed at an insurance/reinsurance professional without an accounting background or a prior knowledge of the topic. The paper is deliberately non-technical. If you find you wish to learn more or discuss any aspect of the proposals please do not hesitate to contact us.

The differences with existing standards are startling and the implications huge, particularly if moving from a local standard with very different rules on reserving. The likely implementation date is right in the middle of Europe’s Solvency II implementation process, a process being shadowed in a number of other territories around the world. The additional workload on companies will be considerable but the benefit should be, at last, comparable insurance accounts from around the world.


Differences with Solvency IIThe differences between accounting and regulatory rules are not surprising, Solvency II is essentially aimed at ensuring policyholders are protected, it considers at the 1 in 200 risk level.

By contrast, accounting standards look at mean or average results. IASB and FASB place a premium on making sure that profits and losses are properly recognised.

This means that, for example, whilst diversification is a major issue for Solvency II for IASB/FASB it is less important and not a major concern.

A number of differences emerge, as we discuss below. This is to be expected, both Solvency II and the IFRS are developing standards, it is hoped that convergence will grow. However, it is likely that the reconciliation of differences between IASB and FASB will have greater priority than between IFRS and Solvency II.

A new way of thinking and reportingThe proposed IFRS potentially could lead to insurance accounts looking radically different to what we are used to; focusing on changes to margin rather than premiums, claims and commission.

In many ways the principles are similar to those adopted in Solvency II but there are differences; the devil is in the detail.

The building blocks of the new measurement model

Residual marginContract profit (reported over the life of the contract)

Risk adjustmentAn assessment of the uncertainty about the amount of future cash flows

Time value of moneyAn adjustment that used an interest rate to convert future cash flows in to current amounts

Current estimates of future cash flowsThe amounts the insurer expects to collect from premiums and pay out for claims,benefits and expenses, estimated using up-to-date information

Totalinsurance

liability

Figure 3: IASB Building block proposal – Source IASB

IFRSs by JurisdictionIFRS Allowed IFRS Mandatory IFRS Not Allowed Transitioning to IFRS Not Known / Not Applicable

Global scope of IFRS for insurance contracts

Figure 2: IFRS for insurance contracts for listed companies (based upon data from a number of primary and secondary sources, given potential differences in definition it cannot be guaranteed to be definitive)


Insurance transactions are to be valued as follows:

• The expected cash flow of the contract is established.• The cash flow is discounted to present value.• A margin is added (split into two elements in the

IASB version).

The IASB does propose that a simplified process be allowed for contracts with a period of around one year with no embedded options or derivatives that affect the variability of cash flows. However, insurers will need to check whether the contract is onerous (i.e., unprofitable), which will still require a cash flow analysis to be prepared.

More widespread discounting of loss reserves appears to be a likely consequence of the changes being proposed. The discount rate would be adjusted each period which introduces a greater level of volatility to liabilities within quarterly and interim results. There will be considerable IT and operational changes required. Reinsurance can be an effective tool for insurers to manage the potential increased volatility in reported liabilities.

What is the margin?It is here that the key differences arise between IASB and FASB and between both and Solvency II. Under Solvency II, the margin added reflects the potential transfer cost of the asset.

The accounting margins represent something very different.

Under the IASB proposal there are two margins added:

• Risk Adjustment: reflecting uncertainty in the cash flows.

• Residual Margin: added to ensure that no-immediate

profit is booked.

The FASB proposes to combine the Risk Adjustment and Residual Margin into one Composite Margin. Discussions continue about which of these two approaches to take.Why are these differences important? The answer is that profit recognition will depend upon how the margins are released. If the contracts are modelled to make a mean loss, that loss must be recognised immediately, but profit is recognised over the life of the contract depending upon actual claim experience.

The Risk Adjustment (IASB) needs to be re-measured each reporting period, with differences recorded in profit and loss. The Residual Margin (IASB) and Composite (FASB) are released as the contract unwinds in light of experience.

The IASB is not explicit in defining how the Risk Adjustment should be calculated suggesting three potential methods, each with scope for interpretation, although some guidance is given. Unless a common method is ultimately agreed, standards could vary company by company, country by country.

The example below shows how liability and performance is monitored:

Liability atend of year

Liability atstart of year

Expectedcash flows

20 -5

-3

-1 +2

+1 14

Change in riskadjustment

Release ofresidualmargin

Interest onliability

Unexpectedcash flows

Items in profit or loss

Non-P&L changes Changes that go through profit or loss

Expected cash flows Change in risk adjustment Interest on liabilityActual cash receipts and payments Change in the uncertainty about the Interest on the liability in the current periodthat were expected amount of future cash flows

Release of residual margin Unexpected cash flows The reduction in the residual margin Actual cash receipts or payments that were during the current period not expected, as well as changes in the estimated of future cash flows

Figure 4: Changes in insurance liability and performance for an example contract – Source IASB


Deferred acquisition costsOne heated area of discussion has focused upon acquisition costs. Earlier IFRS proposals made no allowance for acquisition costs in the calculation of Residual Margin. Current proposals allow ‘incremental acquisition costs’ to be taken into account before the Residual Margin is calculated. Incremental acquisition costs are the marginal cost of writing a particular contract, but not the share of fixed costs allocated to a contract or portfolio. This will allow an element of acquisition costs to be deferred, but less than allowed under some standards now (IFRS 4 is quiet on this issue). Non-incremental expenses will need to be recognised as a cost when incurred. Clearly this could lead to an initial hit to earnings when transferring from one standard to another.

Cash flow calculationThe requirement to calculate a mean or average cash flow adds a significant accounting and information load onto insurers. The cash flow information should be informed by industry/market data, historical data and other undefined relevant sources. It should be probability weighted; all possible outcomes should be considered. This will clearly add a significant workload to organisations, often organisations already under strain trying to comply with new regulatory requirements.

Discounting – the time value of moneyUnder Solvency II discount rates are set by taking a swap rate (swap is a derivative in which one party exchanges a stream of interest payments for another party’s stream of cash flows) plus an illiquidity premium (the extra return demanded by investors as compensation for holding assets that may be difficult to convert into cash). The illiquidity premium will differ depending upon the nature of the asset.

The IASB ED implies that the discount rate used be based on the appropriate risk-free rate with adjustment for characteristics unique to the liability, i.e. an illiquidity adjustment. But, unlike US GAAP, the discount rate should not reflect the characteristics of the asset backing the liabilities. It remains to be seen how much flexibility there will be in interpreting this rule, discussions continue. Again, if no standard emerges, differences in interpretation will emerge.

Short-duration contractsAs discussed above, the ED of the IASB allows basic contracts of one year or less, where the contract does not contain embedded options or guarantees, to be accounted on a ‘traditional’ insurance basis. There is still a need to consider mean cash flow development in order to assess whether the contract is profitable.

For most non-life companies this implies that there could be two different insurance reports within their financial returns; some (for an average non-life company most) reported on a ‘traditional’ basis, some on the new margin basis. The FASB is uncomfortable with this and has explicitly asked for views on this aspect. The IASB seems more comfortable with reporting of short-duration contracts being on a different basis, but again seeks insurer views.

Moving from local standards to IFRSIn Europe and the US, companies will be moving from IFRS 4 or US GAAP to the new IFRS standard. Changes will be evolutionary. But where a company is moving directly from a local accounting standard to the new IFRS standard, then significant changes may occur. Particular areas of concern relate to equalisation, catastrophe and IBNR reserves.

Many current local accounting standards allow companies to put aside reserves for claims equalisation, particularly in connection with catastrophic risks, for example in Japan, Philippines, Vietnam and India. These reserves are often calculated by agreed formulae. Similarly IBNR reserves may be defined in a similar formulaic way.

Under the proposed IFRS (and IFRS 4 and US GAAP), such equalisation and catastrophe reserves are not permitted. The aim of these provisions is to smooth the results of companies, allowing them to build up tax free surplus in good years to pay claims in a bad year. If the ability to make these reserves is taken away then annual results will become far more volatile and there will be transition issue of recognising existing reserve provisions.

Certainly, reinsurance will grow in importance, providing profit and loss smoothing in a tax efficient manner.

Changes to IBNR reserve will be harder to predict. By implication formulaic methods will need to be replaced with actuarial best estimates of likely development.


ReinsuranceOutward reinsurance contracts need to be accounted in a similar fashion to inwards business. Mean weighted cash flows should take into account expected premiums (including reinstatements), commissions (offset against premium) and expected losses. No margin is applied however. Allowance must be made for potential reinsurer failure in the calculation.

It is possible that the new IFRS standard will increase the volatility of insurance results, given dependency upon matched discount rates and market asset valuations. Once again, the value of reinsurance as a result smoother will increase.

Tax implicationsThe implementation of both the new Insurance Contracts Standard and Solvency II could have an impact on tax issues for Insurers, specifically with regard to the changes in profit recognition. Tax authorities in the United Kingdom and elsewhere have already been in discussion with regulatory bodies in relation to the tax implications of the new regimes and this may have implications at transition and on an ongoing basis for Insurers. It is recommended that the tax departments within insurers perform a review of the potential tax impact of the new insurance standard/Solvency II and then discuss any transitional tax measures with their tax authority.

Other points to consider• The IFRS includes all contracts that meet the standard

definition of insurance. Not all contracts that an insurance

company writes will necessarily be covered. Some existing

local regulatory schemes may have broader definitions to

include, for example, semi-finite covers with low levels

of risk transfer. FASB has excluded contracts where the

insured has some discretionary participation in non-

guaranteed benefits.

• Firms are required to unbundle contracts where elements

are not closely related to the insurance coverage specified

in the contract (examples are given). There is no discretion

to unbundle if this rule is not applicable.

• An insurer is deemed liable in the accounts when a

contract is entered into or when cover commences,

whichever is the earlier. Capturing this information may

well have system implications for many insurers.

• Where business is assumed or ceded as part of a portfolio

transfer, any consideration received will be treated as a

premium. Similarly when an entity takes on a liability,

it measures that liability at fair value.

Having your sayWithin the ED, a number of questions have been raised which insurers/reinsurers can comment on up until November 30, 2010. Similarly responses to the FASB DP are required by December 15. The links below can be used to access the questions raised and we advise that you recommend your accounting colleagues to read the full exposure draft (and if US based, the discussion paper), assess what impact it will have on your business and respond to the questions highlighted:

IASB ED link:http://www.ifrs.org/NR/rdonlyres/508B3E26-4355-46E6-ACCF-248E76AD3457/0/ED_Insurance_Contracts_Standard_WEB.pdf

FASB DP link:http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175821311059&blobheader=application/pdf


GlossaryDiscounted cash flow – is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

DP – (Discussion Paper) is FASB’s response to IASB’s Exposure Draft, also seeking feedback and comment.

ED – (Exposure Draft) is a preliminary release of a statement by the IASB, which offers the text of the proposed statement for comment. The official statement, which may be modified as a result of constructive criticism of the exposure draft, will be issued after the exposure draft has been circulated for several months.

EU – (European Union) is an association of 27 European States, with a single market in goods and services. IFRS is the common financial accounting regime for companies within the EU.

Fair value – also called fair price (in a commonplace conflation of the two distinct concepts), is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.

FASB – (Financial Accounting Standards Board) is a private, not-for-profit organisation whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public’s interest. The Securities and Exchange Commission (SEC) designated the FASB as the organisation responsible for setting accounting standards for public companies in the U.S. It was created in 1973, replacing the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB) of the American Institute of Certified Public Accountants (AICPA).

GAAP – (Generally Accepted Accounting Principle) is a term used to refer to the standard framework of guidelines for financial accounting used in any given jurisdiction which are generally known as Accounting Standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements.

IASB – (International Accounting Standards Board) is an independent, privately-funded accounting standard-setter based in London. The IASB was founded on April 1, 2001 as the successor to the International Accounting Standards Committee (IASC). It is responsible for developing International Financial Reporting Standards (the new name for International Accounting Standards issued after 2001), and promoting the use and application of these standards.

IFRS – (International Financial Reporting Standards) are principle – based Standards, Interpretations and the Framework adopted by the IASB.

Present value – is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful ‘like to like’ basis.

Solvency II – is the updated set of regulatory requirements for insurance firms that operate in the European Union. It is scheduled to come into effect at the beginning of 2013.

1 | Willis Re Solvency II Willis Re Solvency II | 2

Insurance contract accountIng: edgIng towards a global standard

global and local reinsurance Willis Re employs reinsurance experts worldwide. Drawing on this highly professional

resource, and backed by all the expertise of the wider Willis Group, we offer you every

solution you look for in a top tier reinsurance advisor. One that has comprehensive

capabilities, with on-the-ground presence and local understanding.

Whether your operations are global, national or local, Willis Re can help you make

better reinsurance decisions - access worldwide markets - negotiate optimum terms –

and boost your business performance.

How can we help?To find out how we can offer you an extra depth of service

combined with extra flexibility, simply contact us.

Begin by visiting our website at www.willisre.com or calling your local office.

willis limited, registered number: 181116 england and wales.registered address: 51 lime street, london ec3M 7dQa lloyd’s broker. authorised and regulated by the Financial services authority.

© copyright 2010 willis re Inc. all rights reserved: the views expressed in this report are not necessarily those of willis re Inc., its parent companies, sister companies, subsidiaries or affiliates (hereinafter “Willis”). This report and its contents are provided for informational purposes only, do not constitute professional advice and are not intended to be relied upon. willis is not responsible for the accuracy or completeness of the contents herein and expressly disclaims any responsibility or liability for the reader’s application of any of the contents herein to any analysis or other matter, or for any results or conclusions based upon, arising from or in connection with the contents herein, nor do the contents herein guarantee, and should not be construed to guarantee, any particular result or outcome.

Willis Rethe willis building51 lime streetlondon ec3M 7dQTel: +44 (0)20 3124 6000Fax: +44 (0)20 3124 8223

www.willis.com

Willis Re Inc.one world Financial center200 liberty street3rd Floornew York, nY 10281Tel: +1 (212) 915 7600

october 2010

8990/10/10

David SimmonsManaging director willis analyticsTel: +44 (0)20 3124 8917email: [email protected]

Angela Bowerndivisional directorwillis re InternationalTel: +44 (0)20 3124 7843email: [email protected]

Adrian Hammondexecutive directorwillis Market securityTel: +44 (0)1473 223 329email: [email protected]

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