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Accounting for Insurance Contracts
IFRS 4 and US-GAAP
5th April 2018
Thorsten Wagner
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Agenda
1 IFRS 4
→ Scope and Definition
→ General principles
→ Special issues regarding profit sharing
2US-GAAP for Insurance Contracts:
The principle of “deferral and matching”
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IFRS 4: Introduction
Start of „insurance project“ in the second half of the „90‘s“
31st July 2003: Publication ED 5 (exposure draft)
31st March 2004: IFRS 4 Phase I
First Quarter 2006:
Accounts per 31st December 2005 according IFRS 4 (Phase I)
May 2007: Discussion Paper for Phase II
June 2010: Exposure Draft
June 2013: Re-Exposure
Actual standard Mai 2017 with first time application from 2021
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IFRS 4: Introduction
IFRS 4 is a temporary standard!
Main statement:
“If you fulfill some basic conditions, you are allowed to account for insurance contracts in
the same way as you have accounted for them before the issuance of IFRS 4.”
What are “insurance contracts”?
What are those “basic conditions”?
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IFRS 4: Introduction
But first of all:
What does it mean - for example for an international insurance company … ?
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IFRS 4: Introduction
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IFRS with several
GAAP-Figures for
reserving,
profit participation etc.
Italian GAAP Austrian GAAP German GAAP
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IFRS 4: Scope
Basically will be unchanged in Phase II
(Re-) Insurance contracts (Re: activ and ceded)
financial instruments with a DPF:
“discretionary participation feature“
IFRS 4 shall not be applied for:
insurance companies in general
financial guarantees
accounting for the policyholder (except ceded re-insurance)
product warranties issued directly (manufacturer, dealer,…)
employee benefit plans (IAS 19 / IAS 26)
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IFRS 4: Definition
Definition “Insurance Contract“
significant insurance risk
compensation in case of a specified uncertain future event (insured event)
insured event has to affect the policyholder adversely
insured event may only occur in future periods
(e.g. not in the first five years but afterwards)
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IFRS 4: Definition
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Insurance Contract
A contract under which one party (the insurer) accepts significant insurance risk from another party
(the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event
(the insured event) adversely affects the policyholder.
Uncertain future eventSignificantInsurance risk
Uncertainty concerning:
Whether or not
When
How much to pay if such an
future event occurs
The insured event must
have a commercial
substance.
The insurer has to pay
significant additional
benefits if such an insured
event occurs.
“Additional”
= “loss for the insurer”
in case of an insured event
Risk other than financial risk.
Financial risk:
interest rates
Equity
Commodities
Foreign Exchange
Price-Index
Credit risk
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IFRS 4: Classification
Especially for life insurance:
Insurance contract under IFRS 4 vs Investment contract under IAS 39?
Example from “Guidance on Implementing” (IG 1.3) referred to “significant insurance
risk”:
death benefit = 101 % of the surrender value in case of lapse
=> does not qualify as “insurance contract”
“Classic” death coverage (IG 1.2) or “endowment” (IG 1.4, IG 1.6) are also “insurance
contracts“
Even “pure endowment“ are (in most cases) “insurance contracts“
However, deferred annuities without any fixed guarantees do not qualify as “insurance
contract
=> in “scope” of IFRS 4 through “discretionary participation feature” (DPF)
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IFRS 4: Classification
„Insurance Contract“: yes or no?
Deferred annuity without any insurance risk within the deferral period (i.e. in case of death or
surrender the benefits are equal to the account value); annuity conversion rates will be fixed at the
end of the deferral period
If insurance risk does not exist at issue of the contract but may occur afterwards:
If a guarantee exists at issue for insurance risk which may occur in the future:
Insurance contract according IFRS 4
If not, e.g. the insurance company may have the right to alter insurance conditions :
Not an insurance contract according IFRS 4, but in scope of IFRS 4 through DPF
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IFRS 4: “Accounting Policies”
Accounting in accordance with existing „accounting policies“
Existing accounting according to IFRS with US-GAAP -> US-GAAP
Initial implementation of IFRS: local GAAP for technical insurance accounting
Decisive limitations:
Claim equalization provision not permitted according to IFRS 4
„Liability adequacy test“ to be performed – Control of sufficient reserving
Permission for „Change in Accounting Policies“ for some circumstances – primarily in
accordance with IAS 8:
„Relevance and reliability“
No introduction of additional prudence
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IFRS 4: Unbundling
For contracts with an insurance and a deposit component
“Unbundling” required if
the insurer can measure the deposit component separately
AND
the insurer’s accounting policies do not otherwise require it to recognize all obligations / rights from
the deposit component
Accounting after unbundling: Deposit component: IAS 39
Insurance component: IFRS 4
“Unbundling“ permitted if the deposit component can be measured separately.
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Generally unbundling is obligatory for selected reinsurance contracts only
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IFRS 4: Embedded Derivatives in insurance contracts
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Fair Value for the whole contract?
Feature = Derivative?
Close relation to the host contract?
Feature = insurance contract?
Surrender option in
“traditional” insurance contracts?
Separate measurement
Separate measurement
according to IAS 39 (fair value)
no
yes
yes
yes
yes
Separate measurement
Separate measurement
Separate measurement
Separate measurement
IAS 39
IFRS 4
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IFRS 4: Liability adequacy test (LAT)
The LAT shall ensure that the recognized insurance liabilities are adequate – because up
to now:
Different and non-uniform accounting policies are possible
LAT is therefore a kind of “minimum requirement” for insurance liabilities
Requirements for the LAT:
Current estimates of all future contractual cash flows
Including claim handling costs and embedded options and guarantees
If the LAT shows some inadequate liabilities, the entire deficiency is recognized at once
in profit and loss.
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IFRS 4: Discretionary participation feature (DPF)
Application for insurance and investment contracts
Applicable for contracts that contain guaranteed benefits and grant also additional
benefits. As DPF qualifies:
contractual right to receive additional benefits
with a significant portion of the total contractual benefits
with contractually discretion of the issuer concerning amount and/or timing
contractually based on performance of a pool of contracts, investment returns, or profit/loss of the
issuing company
The question is: How to present the contract (i.e. guaranteed element and DPF) within
the balance sheet?
Separation of guaranteed element is possible, but not required
If DPF is separated: classification either as liability or a separate component of the equity; splitting
is also allowed.
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IFRS 4: Discretionary participation feature (DPF)
“Best practice” example
Life insurance portefeuille of traditional with-profit contracts
Local requirement: minimum profit participation of 90% of investment earnings
(according to local GAAP)
Local GAAP earnings: the principle of “lower of cost or market”
What to do with unrealized gains from “available-for-sale”?
Suppose: Local GAAP assets = 1.000
Afs assets = 1.400
Best practice: 90% of GAAP difference – i.e. 360 – should be recognized as “DPF
reserve” (liability)
The remaining 40: equity (OCI) – and also tax (“deferred tax”)
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IFRS 4: Disclosure
Extensive disclosures as compensation for
non-uniform accounting policies
less strict accounting policies
no exact and uniform LA test
Two blocks of disclosure requirements
Explanation of recognized amounts
Nature and extent of risk arising from insurance contracts
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IFRS 4: Disclosure
Explanation of recognized amounts
Accounting policies
Gains and losses arising on buying reinsurance including information on amortization (only if gains or losses are deferred and amortized)
Information about the process of deriving assumptions with the greatest effect on the measurement (also quantification if practicable)
Sensitivities on assumptions with material effect
Reconciliation of changes (liabilities, reinsurance assets, deferred acquisition costs): Analysis of change
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IFRS 4: Disclosure
Nature and extent of risk arising from insurance contracts
Risk management
Insurance risk
sensitivities – either sensitivity analysis (quantitative), e.g. by Embedded Value figures or
qualitative information
risk concentration
claim development
credit, liquidity, market risk according to IFRS 7
Reference to Embedded Value Analysis
Exposure to market risk for Embedded Derivatives in insurance contracts if not
separated
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Agenda
1 IFRS 4
→ Scope and Definition
→ General principles
→ Special issues regarding profit sharing
2US-GAAP for Insurance Contracts:
The principle of “deferral and matching”
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US-GAAP: Deferral and matching
Expenses will be recognized according to profit-recognition of the corresponding asset
acquired.
Revenue will be recognized according to the benefit provided.
Amortization over the term of risk acceptance in relation to expected “margins”:
There are several margin concepts in place
=> different amortization pattern for different kind of contracts
Aim: smooth and steady profit and loss recognition
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US-GAAP: Deferral and matching
Example
Acquisition expenses (at issue): 600
Term of contract: 20 years
Expected “margins”:
80 in each year for the first 10 years
160 in each year for the second 10 years
Amortization of the acquisition expenses
according to the margins:
during first 10 years: 3,33% p.a.
during second 10 years: 6,67% p.a.
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0
100
200
300
400
500
600
700
0 2 4 6 8 10 12 14 16 18 20
DAC
Margin
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US-GAAP: Deferral and matching
Which expenses and revenues will be amortized with such a margin concept?
Expenses:
acquisition costs => deferred acquisition cost: DAC
terminal dividends => liability for terminal dividend: LTD
present value of future profits (PVFP) of acquired insurance contracts
Revenue:
unearned revenue => unearned revenue reserve: URR
Deferral and matching is only applicable for a small part of expenses and revenue
We will also have to consider other matters, e.g. calculation of claim reserves, life insurance
liabilities, premium recognition etc.
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US-GAAP: Classification
Classification is crucial for the margin concept which is different for FAS
traditional life insurance products -> FAS 120:
endowment, term, annuity, disability etc.
participating contracts according to the contribution principle
very seldom, but possible: FAS 60 Long Duration
Non-traditional life insurance products -> FAS 97:
unit- and index-linked products
hybrid products (with a traditional and a unit-linked component)
Participating investment products -> FAS 97
non participating: “Investment Contract“ according IAS 39
Non-Life and Health -> FAS 60
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US-GAAP: FAS 60
Health: FAS 60 long duration
premium recognition when due from policyholder
at the same time: accrual of liability for future policyholder benefits
Non-Life: FAS 60 short duration
premium are recognized and earned in relation to insurance protection
Principle of margin for FAS 60:
The margin will be measured in relation to the premium
Locked in for the term of contract, therefore only calculated at issue
Calculated for a block of business, i.e. all new car-insurance policies within one year
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US-GAAP: FAS 60
Example
Deferred acquisition cost (DAC) = 300
Present Value of premiums = 6.000
=> DAC / PV(premium) = 5%
premium at beginning of year:
for the first year: 2.000
for the second year (due to lapse etc): 1.600
5 years term assumed
Interest rate to be adopted = 4%
=> DAC after 1st year = (1 + 4%) x (300 – 5% x 2.000) = 208
=> DAC after 2nd year = (1 + 4%) x (208 – 5% x 1.600) = 133
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US-GAAP: FAS 60
Example
How to reflect differences in premiums from actual to expected?
LESS premium received (e.g. due to more lapse)
slower than planned amortization
at the end of amortization period: additional amortization of the residuum (refer to loss recognition
later on)
MORE premiums received (lower lapse):
faster amortization
Please have in mind: There are
quite many methods in use
which are slightly different.
However, the main approach
is the same!
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0
50
100
150
200
250
300
350
1 2 3 4 5 6
Planned
Faster
Slower
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US-GAAP: FAS 60
Reserving:
Best estimate assumptions
With PAD: Provision for adverse deviation
Inclusion of premium deferrals
Especially for non-life claim reserves: Actuarial valuation
Especially for Health insurance calculated similar to Life:
“prospective unlocking”, i.e.
reserving will be actualized in cases of premium adjustments
interest rates, lapse, claim amount per risk etc.
in the same way: unlocking of the DAC
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US-GAAP: FAS 120 and FAS 97
Deferral and matching similar for FAS 120 and FAS 97
Before we will deal with the deferral and matching items
let’s see how the other balance sheet items are dealt with
…….
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US-GAAP: FAS 120
FAS 120 for traditional life insurance business
Reserving: Net level premium reserve (NLPR)
Including deferred premiums (sometimes called unearned premium reserve) and LTD (liability for
terminal dividends)
Based on assumptions (especially interest rates) used to determine surrender value
Best practice: same assumptions as under local GAAP
BUT: Zillmerization not allowed
(because of the possibility to book the DAC as an asset)
Therefore: Adaption of local reserve by only taking into account the Zillmer part and therefore
increase the reserve
Claim reserves: more or less equal to local GAAP (best estimate with small PADs)
Policyholders’ bonus fund (“RfB”)
Extraction of terminal dividends (will be shown within the NLPR)
Additional allocation of valuation differences between IFRS/US-GAAP and local GAAP with the
policyholders’ legal or contractual proportion (“Latenz” and “Shadow”)
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US-GAAP: FAS 97
Reserving: market values for funds (unit-linked business) – i.e. same as local GAAP
For hybrid products (i.e. that have a unit-linked as well as a traditional “with profit”
component with interest guarantee)
Funds with market value as under local GAAP
Traditional part: reserving as under FAS 120, i.e. without Zillmerization but beside this as under
local GAAP
But now: Deferral and matching again…..
here are … the margins!
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US-GAAP: FAS 120 / FAS 97
FAS 120: EGM = estimated gross margins
FAS 97: EGP = estimated gross profits
Both calculated for each period (i.e. per year) and for each Block of Business (e.g.
endowment policies issued in 2008)
Assumption basis for calculation: “best estimate”
Consideration of portfolio development over the years
death, lapse, maturity (different maturities in one Block of Business) also with best estimate
assumptions
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US-GAAP: FAS 120
„P&L“ like are the EGM for FAS 120
Expected gross premiums
+ Expected investment returns on NLPR (and bonus account)
- Expected change in NLPR
- Expected benefits to be paid
- Expected maintenance expenses
- Expected annual policyholder dividends
+/- Other (e.g. re-insurance result)
-----------------------------------------------------------------------------
Estimated Gross Margin
NLPR: Net Level Premium Reserve
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US-GAAP: FAS 97
„Analysis of results“ like are the EGP for FAS 97
Risk result
+ Expense result (without acquisition expense result!)
+ If applicable: investment results (e.g. kick-backs)
+ Other (e.g. in case of surrender deductions)
___________________________________________
Estimated Gross Profit
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US-GAAP: FAS 120 / FAS 97
What to do during the term of a block of business?
EGM will become “AGM”: actual gross margins
expected figures will be replaced by actual figures
process is called “true-up”: calculation right from the start including all past AGM and future EGM
i.e. the last value, e.g. of DAC, has no influence on the actual value of DAC
same for EGP
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US-GAAP: FAS 120 / FAS 97
DAC(0) = “initial DAC“
PV(X; t) = Present value of X over the whole term, calculated at t
PV(X; s; t) = PV of X but only from year s on, calculated at t, i.e.
= X_s / (1 + i_s) + X_(s+1) / (1 + i_(s+1))^2 + ….
X may be EGM, EGP, terminal dividends (TD) paid (for LTD) or unearned revenue (UR) received
(for URR)
To calculate PV(X; t): for years including and before t use “actual” figures (e.g. AGM), for up-
coming years v (with v > t) use “estimated” (e.g. EGM)
AV(X; t) = until t accumulated value of X_s (s=1..t)
DAC(t) = PV(EGM; t+1; t) x DAC(0) / PV(EGM; t) (equal to EGP)
URR(t) = PV(EGP; t+1; t) x PV(UR; t) / PV(EGP; t)
LTD(t) = AV(EGM; t) x PV(TD; t) / PV(EGM; t) – AV(TD; t)
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US-GAAP: FAS 120 / FAS 97
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0
500
1.000
1.500
2.000
2.500
3.000
3.500
4.000
1 3 5 7 9 11 13 15 17 19 21 23 25
Years
DA
C / E
GM
DAC-Verlauf
EGM-Vektor
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US-GAAP: True-up according to FAS 120 / FAS 97
True-up: EGM / EGP update
Hence, change within the depending amounts: DAC, PVFP, URR, TBR
Change impacts often unpredictable, because of model complexity
Interaction of substantial assumptions:
Interest surplus participation of the policyholder
Return on capital investments
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US-GAAP: FAS 120 / FAS 97
Example: “True-up” of DAC for traditional life insurance
Initial DAC: DAC(0) = 1.000
EGM, calculated at t = 0: constant over whole term (20 years) = 100 p.a.
Discount rate = 0%, i.e. linear amortization of DAC planned at issue
AGM of first 10 years equal to EGM: 100 p.a.
=> DAC after 10 years BEFORE True-up: 500
True-up of future EGM (i.e. for the second ten years):
Case A: 50 p.a.
Case B: 200 p.a.
Calculation including the whole term yields:
Amortization of initial DAC during the first 10 years:
Case A: 2/3 = (10 * 100) / (10 * 100 + 10 * 50) of initial DAC
Case B: 1/3 = (10 * 100) / (10 * 100 + 10 * 200) of initial DAC
DAC after True-up: Case A = 333 vs. Case B = 667
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US-GAAP: FAS 120 / FAS 97
Loss Recognition Test (LRT):
a test to clarify if reserving is sufficient
based on actual “best estimate”
in practice based on EGM / EGP margins for FAS 120 / FAS 97
under FAS 60: compared to lock-in assumptions
Principle of LRT:
need for action only after the exhaustion of all safety margins
DAC and – if applicable – URR and LTD have to be included in calculation
in practice: in case of action needed – first decrease DAC, than increase reserving
under IFRS 4 the LRT qualifies as LAT
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US-GAAP: FAS 120 / FAS 97
Loss Recognition Test (LRT):
example for Life insurance, FAS 120:
example for Life insurance, FAS 97:
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PV [EGM]
- DAC
- PV [terminal dividends]
PV [“result before taxation”]
PV [EGP]
- DAC
+ URR
PV [“result before taxation”]
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US-GAAP: FAS 97
FAS 97: Different approach to recognize premiums in P&L
idea / opinion: savings premiums which are invested in a fund are not under risk and responsibility
of the insurance company
therefore, that’s a “pass-through premium”
which should not be recognized as income!
Big difference to many local GAAP in which the whole premium will be recognized as
income
Consequently under FAS 97:
increase of the reserve due to saving premiums are not shown as expense
benefits are only shown as expense if exceeding the fund value (again: pass-through feature!)
decrease of the reserve due to benefits are not shown as income
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US-GAAP: Accounting for differences between IFRS/US-GAAP and local
GAAP
There may occur many differences between local GAAP and IFRS/US-GAAP figures
DAC, reserving, LTD, URR
IAS 39: accounting for assets (“available for sale” etc…)
Others like e.g. IAS 19, pension obligation
However, for with-profit business (“discretionary participation” under IFRS 4) the profit
participation will be linked (in most cases) to local GAAP figures
Consequently, there is a problem to be solved:
Which part of the differences between local GAAP and IFRS/US-GAAP should be
accounted for as
Equity (and corresponding deferred taxes)?
Policyholder bonus reserve?
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US-GAAP: Accounting for differences between IFRS/US-GAAP and local
GAAP
Which part of the differences between local GAAP and IFRS/US-GAAP should be
accounted for as
Equity (and corresponding deferred taxes)?
Policyholder bonus reserve?
In general: Build up a policyholder bonus reserve for GAAP differences to the amount of
that portion on which the policyholders have a right to receive a participation
Often “best practice”: approximations as e.g. “90%”
What to do if GAAP difference sum up to a negative amount – i.e. a charge to
policyholder bonus reserve?
“Best practice”: permitted up to the amount of the non-allocated (“free”) part of the statutory
policyholder bonus reserve
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US-GAAP: Accounting for differences between IFRS/US-GAAP and local
GAAP
Example:
Consider the following insurance company which offers only traditional with-profit
contracts with an obligation of a participation rate of 90% on all results based on
statutory GAAP.
local reserve = 18.500
=> no Zillmerization under US-GAAP => NLPR = 19.500
statutory assets related to acquisition costs = 300 (“Zillmer”-asset) => DAC = 1.500
local reserve for terminal dividends = 560
(e.g. the so-called “SÜAF” in Germany which is part of the whole policyholder bonus reserve,
called RfB)
=> LTD = 1.000
unearned premium reserve (under both GAAP) = 140
local book value of assets = 21.000
=> all classified as “available for sale” under IAS 39 => 22.000
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US-GAAP: Accounting for differences between IFRS/US-GAAP and local
GAAP
Example:
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Balance sheets: Statutory IFRS with US-GAAP
Invested assets 22.000 Equity 500
DAC 1.500 OCI equity 76
NLPR 20.640
thereof UPR 140
therefore LTD 1.000
RfB 1.600
IFRS RfB add on 684
S Assets 23.500 S Liabilities 23.500
Assets Liabilities
Invested assets 21.000 Equity 500
Acq. cost assets 300
unearn. prem. res. 140
Statutory reserve 18.500
RfB 2.160
therefore SÜAF 560
S Assets 21.300 S Liabilities 21.300
Assets Liabilities