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IFRS Insurance ContractsPhase II Exposure Draft
Alexander Hotel9 March 2011
• James Archer• Steven Hardy• Andrew Kay• Grainne Loughnane• Donna McEneaney• Brian Morrissey• Emer O’Connell
Working Groupslide 2
Agenda
• Introduction to the Exposure Standard• Feedback from the Consultation Process• Comparison to Solvency II
slide 3
Current status of project
– IASB Exposure Draft (July 2010)– Comments by 30 November 2010
– FASB Discussion Paper (Sept 2010)– Comments by 15 December 2010
– Final IASB standard expected by June 2011– Effective date
– Reporting period ending 31 December 2013??
slide 4
Scope
Insurance and reinsurance contracts (NOT insurance enterprises)
CHANGES from IFRS 4
FINANCIAL INSTRUMENTS with a DPF – in scope providing that the contracts participate in the same pool of assets or profit and loss as insurance contracts
FIXED FEE SERVICE CONTRACTS – outside scope
FINANCIAL GUARANTEE CONTRACTS – inside scope
slide 5
Definition of an insurance contract
No change to definition of insurance contract in IFRS 4–Changes to definition of significant insurance risk:
There must be a scenario in which the present value of net cash outflows can exceed the present value of the premiums
The effect of the time value of money must be taken into account when determining the significance of benefits payable on an insured event
slide 6
Recognition
• An entity should recognise an insurance contract liability or asset at the earlier of:
i.e. when it can no longer withdraw from its obligation to provide insurance coverage or to reassess the risk of the particular policyholder and as a result to change the price
to fully reflect that risk
12
the date when the insurer is bound by the terms of the contract; and
the date when the insurer is first exposed to risk under the contract
i.e. when the contract is signed
slide 7
Proposed measurement modelsThe three (or four) ‘building blocks’
Proposed IASB model Proposed FASB model
Risk adjustment
To adjust for the effects of uncertainty about the amount and timing of future
cash flowsResidual margin
To eliminate any gain at inception and released over time
(not remeasured)
Composite margin
To eliminate any gain at inception and released over time
(not remeasured)
Unbiased probability-weighted current estimates of future cash flows
Discounted using current rates to reflect the time value of money
slide 8
Servicing costsexclude costs that do not directly relate to
contracts or contract activities (e.g. general overheads)
Entity specific inputsbut market inputs should be consistent with market prices
Sophisticated stochastic modelling might only be required in some case
(e.g. financial options and guarantees)
Incremental acquisition costsinclude costs that are incremental at individual
policyholder level in fulfilment cash flows
Inherited estateinclude expected payments to
current and future policyholders
Contract boundariesright to reassess risk at
individual policyholder level
Building Block 1 Expected value of future cash flows
slide 9
Building Block 2Time value of money
Non-participating contracts:
Risk free rate plus adjustment for illiquidity
Not reflected in present value of fulfilment cash flows either at initial recognition or subsequently
Participating contracts:
Measurement should reflect linkage to underlying assets
Discount rate:
Own credit risk:
slide 10
Building Block 3Risk adjustment
The risk adjustment should be estimated at portfolio level – contracts that are broadly similar and managed together in a single pool
Confidence levelConditional Tail
Expectation (CTE)Cost of Capital (CoC)
The risk adjustment shall be the maximum amount that the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows
exceed those expected
This requirement is not intended to preclude ‘replicating portfolio’ approaches
Disclosure of confidence level required if CTE or CoC approach is used
Objective:
Permitted techniques:
slide 11
Residual margin
• Allocation of ‘day-one’ profit released to profit and loss over the coverage period in a systematic way– On the basis of passage of time, but– On the basis of the expected timing of incurred claims and benefits if that
pattern differs significantly from the passage of time• Pattern of recognition should make allowance for lapses• Interest is accreted using a ‘locked-in’ discount rate• At cohort level – determined by similar date of inception and
coverage period• Presented as part of the insurance contract liability
slide 12
Building BlocksExample
An insurer has priced a single premium of 100
PV of
Total acquisition costs of 20 - non incremental 5 and incremental (e.g. commission) 15
Expected present value of cash inflows 100
Expected present value of cash outflows (65)
Risk adjustment (10)
Incremental acquisition costs * (15)
Expected present value of fulfilment cashflows 10
Residual margin (10)
Contract asset/liability at inception Nil
slide 13
Reinsurance ceded
• Expected cash inflows and risk adjustment– Use same measurement as for the underlying direct insurance contracts
for expected present value of future cash inflows and the risk adjustment
If this measurement exceeds the net consideration (i.e. premiums less commission) paid by the cedant, the difference is recognised as a gain in profit or loss at initial measurement
If the net consideration paid by the cedant exceeds this measurement the excess is the residual margin at initial measurement
At initial recognition
Deduct: allowance for credit losses on expected value basis
slide 14
Unit-linked contracts
• Address existing measurement and presentation mismatches where other IAS standards deal with asset
• Unbundling could impact most significantly on unit linked business• Specific presentation requirements (much less detail):
IAS 32 treasury sharesIAS 16 owner occupied property
Single line - assets underlying
unit-linked contracts
Single line - liabilities linked to
pool of unit-linked assets
Income and expense from pool
of assets underlying unit-linked
contracts
Income and expense from
unit-linked contracts
slide 15
Embedded derivatives and unbundling
Financial and/or service components closely related to
insurance coverage?
Is the embedded derivative an insurance contract?
Are cash flows of ED interdependent of insurance component?
IAS 39/IFRS 9Revenue Recognition/IAS 18
or IAS 39/IFRS 9?
What are we trying to achieve?
Embedded derivatives Unbundling
slide 16
Modified approach Premium allocation approach
Pre-claims Post-claims
Modified approach is required for contracts that meet both of the following definitions:
•The coverage period is approximately 12 months or less
•The contract does not contain embedded options or other derivatives that significantly affect the variability of cash flows
Claims liabilities are measured in accordance with the general measurement model (i.e. using the 3 building blocks but with no residual margin)
slide 17
Transition
• At the beginning of the earliest period presented– Determine the PVFC of each portfolio of insurance contracts– Derecognise any existing insurance contracts balances (including DAC
balances etc)– Record the difference (positive or negative) in retained earnings
Example transition calculation £
PVFC (625)
Carrying value of insurance contract liabilities at transition (850)
Previously recognised DAC balance at transition 150
Net increase in retained earnings 75
PresentationStatement of Comprehensive Income (SOCI)
Summarised margin presentation
All premiums are treated as deposits and all claims and benefits are treated as repayments to the policyholder
Disclosure of premiums and claims expenses is presented in the notes onlyas part of the reconciliation of opening and closing contract balances
slide 19
PresentationSummarised margin illustration in SOCI
Description – required analysis On face of OCI statement
Underwriting margin Yes
Change in risk adjustments
Release of residual marginsDisaggregation could be included in
notes
Gains and losses at initial recognition Yes
Losses on contracts acquired in a portfolio transfer
Gains on reinsurance contracts bought by a cedant
Losses at initial recognition of an insurance contract
Disaggregation could be included in notes
Non-incremental acquisition costs Yes
Experience adjustments and changes in estimates Yes
Differences between actual cash flows and previous estimates
Changes in estimates of cash flows and discount rates
Impairment losses on reinsurance contracts
Disaggregation could be included in notes
Interest on Insurance liabilities Yes
slide 20
Disclosures
• Disclosure requirements in IFRS 4 and IFRS 7 are the starting point
• Additional disclosures include:– A more detailed reconciliation of changes in contract balances including
disclosures about changes in risk adjustments and residual margins– Information about the effect of the regulatory frameworks in which the
insurer operates (eg minimum capital requirements)– A translation of risk adjustments into a confidence level for disclosure (if
CTE and/or CoC is used)– A measurement uncertainty analysis (similar to level 3 fair value
disclosures)
Aggregation/disaggregation principle:Useful information should not be obscured by either the inclusion of a large amount of insignificant details or the aggregation of items that have different
characteristics
slide 21
Feedback from Consultation Process
slide 22
Responses to the IASB and FASB proposals
• The responses were from insurers, trade organisations and accounting firms worldwide.
• 53% of respondents believed the proposed measurement model would increase the relevance of financial reporting for insurers.
• More than 30% did not believe the proposed model would produce relevant information. These repondents were mostly from North America.
• Volatility of profits, discount rate, presentation, residual margin, unbundling and transition process were key concerns.
slide 23
Expected PV of future cash flows
• Key proposal: the liability measurement should be the present value of a contract’s net cash flows.
• Over 80% agreed at least in principle• Concern expressed about the implications for P&C and that the
standard may limit the use of some traditional actuarial approaches.
• Concern that stochastic modelling should not be mandated in all cases.
slide 24
Acquisition Costs and Servicing Costs
• Under the proposals, only acquisition costs that are incrementalat the individual policy level would be included in the PVFCF
• Nearly 50% of respondents disagreed, mostly insurers. Other bodies were more in favour.
• Concern is that excluding non-incremental costs artificially inflates the residual margin and may result in day one losses for profitable contracts.
• Also under the proposals, servicing costs would be limited to those incurred at the portfolio level, i.e. excluding overheads.More clarity requested in what expenses should be included in the fulfilment cash flows
slide 25
Discount Rate – non-par contracts
• Key proposal: the discount rate should be consistent with the insurance liability regarding timing, currency and liquidity, but should exclude asset market risks and the insurer’s own credit risk.
• Over 70% agreed in principle• However concerns about determining the discount rate
– Subjectivity in the liquidity adjustment– Determining a risk free rate in countries without an active government
bond market or other suitable financial instruments• Many respondents preferred an asset based rate e.g. high
quality corporate bond, adjusted downwards, or based on insurers own assets
• A variety of methods have been discussed by the Boards.
slide 26
One or Two Margins?
• IASB preference is– PV of fulfilment cash flows– plus risk margin– plus residual margin
• FASB preference is– PV of fulfilment cash flows– plus composite margin
• Strong support for explicit risk margin in Europe – consistent with MCEV and Solvency II. Also supported in Australia and Canada.
• US, Japan and China respondents preferred the composite margin. Primary objection was perceived subjectivity in determining the risk margin.
slide 27
Estimating the Risk Adjustment
• The ED allows three approaches: (1) confidence level; (2) conditional tail expectation; and (3) cost of capital.
• Over 70% disagreed with this proposal.• The IASB concluded that permitting a wide range of techniques
would lead to lack of comparability.• Most respondents thought the standard should be principles
based and not prescriptive in this area.• Limiting the techniques may hinder development of new
techniques.
slide 28
Remeasurement of the Residual Margin
• The residual margin is determined on initial recognition and locked in. It is recognised in profit and loss over the coverageperiod.
• 60% of respondents disagreed.• Most thought the residual margin should be adjusted for
changes in non-financial assumptions.• However the residual margin should not be adjusted for
changes in financial variables since these would be reflected inasset values.
slide 29
Unbundling
• Proposal: if a component is not closely related to the insurancecontract, then it should be unbundled
• 60% of respondents agreed at least in principle• However, lack of clarity on what “closely related” means• Example given in the draft standard relating to unit-linked
seems to suggest the investment component must be unbundled
slide 30
Modified measurement approach for short-duration contracts• Proposal: this would be required for short-duration contracts
that meet the criteria. Short-duration defined as 12 months or less.
• 70% of respondents thought this approach should be permitted but not required.
• About 50% disagreed with the fixed 12 month horizon, suggesting 3 years or a mix of criteria.
slide 31
Contract boundary
• The contract boundary distinguishes future cash flows that relate to an existing contract from those that relate to future insurance contracts.
• Proposal: the boundary is the point at which the insurer either– is no longer required to provide coverage; or– has the right to reprice for the particular policyholder.
• 70% of respondents agreed in principle• Concerns expressed by health insurers subject to regulatory
constraints on repricing. The proposal would extend the contract duration so they would no longer be short-duration.
slide 32
Presentation of the Statement of Comprehensive Income• Proposal: a summarised presentation based on margins.
Premiums and claims would generally not be shown except for some short-duration contracts.
• Most respondents disagreed• Many respondents preferred volume information such as
premiums and benefits to be on the statement of comprehensive income since these are used to calculate key metrics, e.g. loss ratios.
• Respondents with multiple lines supported one format for both short and long duration.
slide 33
Disclosures
• More detailed disclosure than IFRS 4 including qualitative and quantitative information about:– amounts recognised in financial statements– the nature and extent of risks– reconciliations of opening to closing account balances– methods and inputs to estimate risk adjustments and discount rates– measurement uncertainty analysis
• 70% of respondents agreed in principle.• Concerns about
– significant changes to actuarial and accounting systems needed– some information may be proprietary
slide 34
Transition
• Proposal: on transition the liability for existing contracts would be the PV of fulfilment cash flows with no residual margin. De-recognition of DAC and other intangibles associated with existing contracts.
• 93% of respondents disagreed with this proposal.• Reasons cited were
– lack of residual margin would depress profits after transition– non-sensible profit outcome for many long-term life products– possible losses subsequent to transition on profitable business– inconsistent reporting of same product depending whether it was
written before or after transition date• General agreement a residual margin is required on existing
business, either through retrospective calculations or other methods.
slide 35
Effective date
• The ED did not include an effective date• Respondents indicated that a transition period of at least 3
years would be required.
slide 36
Solvency II and IFRS Phase II Comparison
slide 37
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
• All contracts sold by an insurer are in scope.• Unbundling is required between life & non-life
and by line of business.• The measurement approach is the same.
• All contracts which comply with the definition of an insurance contract are within scope.
• Unbundling is mandatory if a component is not closely related to the insurance coverage.( i.e., account driven contracts, such as unit-linked contracts and embedded derivatives).
• For that component a different measurement approach is required (generally IAS39).
• Contracts which primary purpose is the provision of services could comply with the definition of insurance contract but are scoped out and need to be unbundled.
Unbundling & scope of insurance risk
• Insurers will need to develop their systems to facilitate a robust reporting process to track & measure the different components of the Solvency II and Phase II balance sheets.
slide 38
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
• Best estimate is determined using homogenous risk groups;
• Insurance liabilities are split into homogeneous risk groups or by line of business;
• Distinction made between life and non-life lines of business based on the nature of the underlying risk;
• Best estimate should be determined at the level of a portfolio of insurance contracts;
• Insurance contracts that are subject to broadly similar risks are managed together as a single pool.
Cashflows slide 39
Solvency II & IFRS 4-IIOverhead Expenses
• . Solvency II IFRS 4 Phase II
• Overhead expenses allocated according to professional judgment & realistic assumptions .
• Overhead expenses represent the cost of running the business;
• Overheads are expected to be covered by profits as they emerge in the future;
• Only requires costs related to managing insurance contracts included in TP’s
slide 40
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
All expenses are allocated and are part of the calculation of the technical provisions.
Only the costs related to managing the insurance contracts to be included in the calculation of the technical provisions.
Acquisition costsslide 41
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
Insurer has:• The right to cancel the contract;• The right to reject the premium; or• The ability to amend the premium or the benefits.
Insurer is:• No longer required to provide coverage, or• Has the practical ability to reassess the risk
of the individual policyholder and set a price that fully reflects the risk.
Boundaries of the contractslide 42
Solvency II & IFRS 4-II
Solvency II (QIS5) IFRS 4 Phase II
• The discount rate is defined by EIOPA. QIS5 used swap rates (with adjustment of 10 bps) which were considered to be a benchmark for credit risk-free rates
• The illiquidity premium is set by EIOPA.• Depending on the characteristics of the
insurance contract the discount rate may contain an illiquidity premium of 0%, 50%, 75% or 100%
• EIOPA define which illiquidity premium should be applied
• The discount rate should be determined by the company & should reflect the characteristics of the liability
• If future cash flows are not related to the performance of specific assets, then risk free rate should be used with an adjustment for illiquidity
• If cash flows depend wholly or partly on the performance of specific assets, then discount rate should reflect that dependence replicating portfolio should be used;
• The illiquidity premium is set by the company and reflects the differences in liquidity characteristics between the assets underlying the rate observed and the insurance contract
Discount rate & liquidity premiumslide 43
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
• Risk Margin is determined for legal entity and translated to line of business or homogeneous risk group
• Only one technique is allowed - Cost of capital
• Confidence intervals, horizons, risk types & cost of capital rates are defined
• Risk Adjustment is determined within a portfolio of insurance contracts
• Three methods for risk adjustment calculation are allowed
• Confidence level• Conditional Tail Expectation• Cost of capital
• Confidence intervals, horizons, risk types to be included in the CoC calculation, cost of capital rates are not determined. Fully open to the industry
• No diversification across portfolios can be considered in setting the risk adjustment per portfolio
Risk Marginslide 44
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
• Part of available capital. • Defer and amortise any gain at inception of the contract over the coverage period of the contract;
Residual Margin
• Determined at a portfolio level for insurance contracts (not at contract level);
• Contracts with similar dates of inception should be grouped;
• Contracts with similar coverage periods should be grouped;
• Allow for acquisition expenses – this will reduce the level of the residual margin;
• Need to measure the residual margin at inception & track changes at a cohort level;
slide 45
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
• Expected gains and losses on reinsurance are part of available capital
• The risk margin is determined for the insurance contract on a net basis
• A residual margin has to be determined based on the reinsurance premium to be paid
• The risk adjustment is determined for the reinsurance asset ´stand alone´;
Reinsurance
• Need to ensure that systems can accommodate the new data requirements;
slide 46
Solvency II & IFRS 4-II
Solvency II IFRS 4 Phase II
• Primary focus on balance sheets;• RTS and SFCR cover the reporting
requirements;
• Focused on both balance sheet & income statement;
• Relates specifically to insurance contracts;
Disclosureslide 47
Questionsslide 48
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