Managing the Transition
SLFRS – 4
© 2010 EYGM Limited Managing The TransitionSlide 2
Managing The Transition
1) Identification of an Insurance Contract
- Product Classification
- Embedded Derivatives
2) Contemporary Issues
- Unbundling of Deposit Component
- Liability Adequacy Test
- Shadow Accounting
3) Change In Accounting Policies
4) Business Consideration
© 2010 EYGM Limited Managing The TransitionSlide 3
Insurance Liabilities – Phase I
Investments equitiesfixed interest mortgagesloans
Other assetsOther liabilities
Equity
Insurance contracts and investment contracts with DPF
Investmentcontract liabilities
Investmentcontract DAC
Property
LKAS 39
LKAS (16) 40
LKAS 18
Insurance DAC
SLFRS 4
PVIF SLFRS 4
Various
SLFRS 4
LKAS 39
Various
LKAS 19 and others
Key standards for insurers
Identification of an Insurance Contract
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© 2010 EYGM Limited Managing The TransitionSlide 5
Identification of an Insurance Contract
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.
► Insurer as per SLFRS 4 is any entity that issues insurance contract, irrespective of whether the entity is considered an insurer for legal/ regulatory purposes.
► All reference in this SLFRS to insurance contracts also apply to reinsurance contracts.
© 2010 EYGM Limited Managing The TransitionSlide 6
Once insurance – always insurance!
InvestmentContract
InsuranceContractX
© 2010 EYGM Limited Managing The TransitionSlide 7
Deposit accounting
► Deposit is not an insurance liability► Financial instrument
► ‘Premiums’ are not revenue► Changes in deposits (balance sheet)
► Claims are not expenses► Repayment of deposit (balance sheet)
► Movements in deposits not in P&L
© 2010 EYGM Limited Managing The TransitionSlide 8
Discretionary Participation FeatureA contractual right to receive, as a supplement to guaranteed benefits, additional benefits:(a) that are likely to be a significant portion of the total contractual benefits;(b) whose amount or timing is contractually at the discretion of the issuer; and(c) that are contractually based on:
(i) the performance of a specified pool of contracts or a specified type of contract;(ii) realised and/or unrealised investment returns on a specified pool of assets held by the issuer; or(iii) the profit or loss of the company, fund or other entity that issues the contract.
Guaranteed benefits- Payments or other benefits to which a particular Policyholder or investor has an unconditional right that is not subject to the contractual discretion of the issuer.
Identification of an Insurance Contract
Product Classification
Embedded Derivatives
© 2010 EYGM Limited Managing The TransitionSlide 10
Product classification
► Product classification determines the accounting treatment for contracts during phase 1.
► Product Classification► A major exercise for insurance companies► A hot topic for the future as product complexity increases► Solutions developed to address complex classification
issues
© 2010 EYGM Limited Managing The TransitionSlide 11
*Subject to certain modifications**Possibly with separate
accounting for service component
Product classification is very important as it defines the accounting treatment for the issued contracts by an insurer. The following chart provides an overview of the accounting treatment for different types of contracts as a result of product classification.
Amortised Cost-or-
Fair Value**
Amortised Cost-or-
Fair Value**
ExistingAccounting*
ExistingAccounting*
SLFRS 4SLFRS 4
Insurancecontracts
LKAS 32/39Recognition and
Measurement
LKAS 32/39Recognition and
Measurement
ExistingAccounting*
ExistingAccounting*
SLFRS 7 for DisclosureSLFRS 7 for Disclosure
Discretionary Participation Investment contracts
Investment contracts
Product classification
© 2010 EYGM Limited Managing The TransitionSlide 12
Impact On The Financial Statements
If Contract qualify as Insurance Contract
GWP Insurance Liability
Deposit Liability
GWP Investment Liability
If Contract qualify as Investment Contract
© 2010 EYGM Limited Managing The TransitionSlide 13
Flowchart of Product Classification
Is there significantinsurance risk present
in the contract?
Is there adeposit component to the
contract? If so, is the deposit componentindependent of the insurance
cash flows?
Are any elements ofthe benefit driven by discretionary
participation
Insurancefeatures present
in contract
Classified as aninvestment contract
Deposit component
Yes
No
Insurance and depositcomponents of contract must,
if not recognised, be unbundled and valued
separately
Yes
No
Insurancecomponent
Product is an InvestmentContract without discretionary
participation features
Product is anInsurance Contract
Product is an InvestmentContract with discretionary
participation features
Yes
No
SLFRS 4
SLFRS 4
LKAS 39
© 2010 EYGM Limited Managing The TransitionSlide 14
Based on the definition of an insurance contract, an insurance contract must have all of the following three characteristics:
Product classification
1. Uncertain future events (Insured event)
2. Transfers significant insurance risk from the policyholder to the insurer
3. Adverse effect on the policyholder
© 2010 EYGM Limited Managing The TransitionSlide 15
Insurance product Analysis- scenario 01
Unit Link Product
Maturity Value/Surrender value
Unit value/Fund value
Death Benefit 100.1% of the unit value
Conclusion
If the insured event affect adversely to the policyholder, Mortality risk is 0.1% of the unit value which is not significant means that contract does not transfers significant insurance risk from the policyholder to the insurer.
This contract can be considered as an Investment Contract
© 2010 EYGM Limited Managing The TransitionSlide 16
Insurance product Analysis- scenario 02
Unit Link ProductMaturity Value/Surrender Value
Unit value/Fund value
Death Benefit greater of:(a) unit value of an investment fund (equal to the amount payable on surrender or maturity); and(b) guaranteed minimum
ConclusionExcess of guaranteed minimum over unit value is a death benefitThis meets the definition of an insurance contract (unless the life-contingent payments are insignificant) .
© 2010 EYGM Limited Managing The TransitionSlide 17
Insurance product Analysis- scenario 03
► bb
Single Premium ContractMaturity Value/Surrender Value
Fund value
Death Benefit 5 times of the initial premium
ConclusionInsurer could suffer a significant loss on an individual contract if the policyholder dies early.
This meets the definition of an insurance contract.
© 2010 EYGM Limited Managing The TransitionSlide 18
Insurance product Analysis- scenario 04
► bb
Single Premium ContractMaturity Value/Surrender Value Initial Premium + 12% Interest per Annum
Death Benefit Initial Premium + 12% per interest Annum + 2 times of the initial premium
ConclusionInsurer could suffer a significant loss on an individual contract if the policyholder dies early.
This meets the definition of an insurance contract.
© 2010 EYGM Limited Managing The TransitionSlide 19
Insurance product Analysis- scenario 05
► bb
Single Premium ContractMaturity Value/Surrender Value No
Death Benefit 20 times of the initial premium
ConclusionInsurer could suffer a significant loss on an individual contract if the policyholder dies early.
This meets the definition of an insurance contract.
© 2010 EYGM Limited Managing The TransitionSlide 20
Embedded Derivatives
► LKAS 39 require an entity to separate some embedded derivatives from their host contract, measure at fair value and include the changes in FV in the P&L.
► An insurer need not account for an embedded derivative separately at fair value if the embedded derivative meets the definition of an insurance contract.
► LKAS 39 will apply to all other instances- embedded derivative and are not closely related to the host contract need to be measured at fair value.
Embedded Derivative
A component of a hybrid instrument that includes both a derivative and a host contract – with the effect that some of the cash flows of the combined instrument vary in a similar way to a stand-alone derivative.
© 2010 EYGM Limited Managing The TransitionSlide 21
IFRS 4 embedded derivative flow chart
Yes
No
No
Yes
YesDo not separate
Does the feature meet the definition of Insurance
Contract?
NoDo not separate
Does the feature meet the definition of a derivative?
Yes
Do not separateclosely related?
Separate and value at Fair Value
No
Host contract at FVTPL?
Do not separateYes
Does it look and feel like an embedded derivative?
No actionNo
© 2010 EYGM Limited Managing The TransitionSlide 22
Embedded derivatives – examples
Separate and fair value
Examples:► Equity index feature
in fixed principles savings plan
► Guaranteed accumulation value in unit linked plan payable on death as well as maturity
Fair value treatment not required
Is it insurance? or
fixed/cash surrender
Examples:► Unit-linked guaranteed
minimum income benefits
► Guaranteed minimum death benefits (e.g., Ratchets)
► Guaranteed annuity options
Yes
Yes
1. Is it an embedded derivative
► Value changes with underlying► Little or no net investment► Settled at future date
2. Is it ‘not closely related’ to host
► Such as an equity index-link on a debt host instrument
► Create interest-rate risk and is leveraged
3. Is it not already at fair value
► Contract is at a mortised cost or accounted at measure other than fair value
Examples:► Interest rate floor in fixed interest rate contract► Option to renew contract
Se
pa
rati
on
cri
teri
a
No
No
Contemporary Issues
© 2010 EYGM Limited Managing The TransitionSlide 24
Unbundling of deposit component
So when do you unbundle?Unbundling is required only if both the following conditions are met :
► The insurer’s existing accounting policies do not require recognition of the deposit component and
► The insurer can independently measure the deposit component from the insurance component
Unbundling is allowed but not required when the insurer only meets the second condition that the insurer can independently measure the deposit component from the insurance component.
It means unbundling may be required when insurance benefit cash flows do not affect the deposit-like cash flows at all. If any grey areas exist, or if there are difficulties in unbundling, then do not unbundle.
Unbundle- Account for the components of a contract as if they were separate contracts
© 2010 EYGM Limited Managing The TransitionSlide 25
Unbundling of deposit component
Impact On The Financial Statements
If Unbundled If not Unbundled
GWP Insurance Liability
Deposit Liability
GWP Insurance Liability
© 2010 EYGM Limited Managing The TransitionSlide 26
Liability Adequacy Testing
► Recognition of future losses required► A deficiency is indicated when future cash flows exceed the net
carrying amount► For insurance contracts, existing liability adequacy tests apply unless
they fail to meet the IFRS 4 minimum requirements, in which case an SLAS 36- Provisions, contingent assets and contingent liabilities measure apply
Liability Adequacy Test- An assessment of whether the carrying amount of an insurance liability needs to be increased (or the carrying amount of related deferred acquisition costs or related intangible assets decreased), based on a review of future cash flows.
© 2010 EYGM Limited Managing The TransitionSlide 27
Liability Adequacy Test - LAT
► Temporary First-Aid bandage► In some countries the local tests might not be adequate► Inverse impairment test
► Two routes► Local test if SLFRS 4 minimum criteria are met:
► Use current estimates of all cash flows► Current estimate is not discounting
► ‘Consider’ options and guarantees► ‘consider’ is not measuring ► time value? What about New Money?
► Use LKAS 37 rules
► Discounting: what yield curve?► Relation to local regulatory test
© 2010 EYGM Limited Managing The TransitionSlide 28
In some accounting models, realised gains or losses on an insurer's assets have a direct effect on the measurement of some or all of
its insurance liabilities, related deferred acquisition costs and related intangible assets,
An insurer is permitted, but not required, to change its accounting policies so that a recognised but unrealised gain or loss on an asset affects those measurements in the same way that a realised gain or loss does. The related adjustment to the insurance liability (or deferred acquisition costs or intangible assets) shall be recognised in other comprehensive income if, and only if, the unrealised gains or losses are recognised in other comprehensive income. This practice is sometimes described as 'shadow accounting'.
Shadow accounting
© 2010 EYGM Limited Managing The TransitionSlide 29
‘Shadow accounting’ – Example at transition date, AXA
Source: AXA
Changes in Accounting Policies.
© 2010 EYGM Limited Managing The TransitionSlide 31
Changes in Accounting Policies
► An insurer may change its accounting policies for insurance contracts if, and only if, the change makes the financial statements more relevant to the economic decision-making needs of users and no less reliable, or more reliable and no less relevant to those needs. An insurer shall judge relevance and reliability by the criteria in LKAS 8
© 2010 EYGM Limited Managing The TransitionSlide 32
Prohibited in Phase I
► Phase 1► No catastrophe/equalisation reserves► No Netting of reinsurance against gross numbers► No change to less relevant/reliable
► So – DO NOT► Stop discounting► Introduce extra prudence► Start to recognise future investment margins► Start to use less uniform accounting in consolidation
Business Consideration
© 2010 EYGM Limited Managing The TransitionSlide 34
Business considerations
► Additional complexity in Finance processes and system calculations
► Better communication and alignment between the Investment function and Finance is required – the business activity should reflect the accounting classification and vice versa
► Certain funding instruments less attractive► Greater balance sheet and potentially greater P&L volatility► Actuaries and accountants need to work closer to source and
calculate additional risk related disclosures► Product development teams need to be aware of changes, in
particular for product classification and guarantees
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Q&A
Thank You.
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