© 2004 Deloitte

Application of IAS/IFRS to Life Insurance – Some practical issues

Jan Kamieniecki

Lisbon, 7 July 2004

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Agenda

Background to IAS Implementation

Topics for discussion:

Some current implementation issues

Managing a life business in an IAS world

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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

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• 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

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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

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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???

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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.”

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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

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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”

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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

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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

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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

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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

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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

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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.”

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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

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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

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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

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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”

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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

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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

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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

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Some Current Issues

Classification

Choice of AC vs FV

Treatment of non-allocated surplus

Treatment of DAC

Auditability

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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?

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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

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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

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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

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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

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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

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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

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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

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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?

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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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