DevelopmentsDevelopments inin InternationalInternational AccountingAccounting StandardsStandards forfor InsuranceInsurance CompaniesCompanies

DavidDavid CongramCongram

September 6, 2007

1 AgendaAgenda

•• BackgroundBackground •• TimeTime tabletable •• PhasePhase 11 •• PhasePhase 22 – Measurement Attribute – Building blocks •• ItemsItems notnot addressedaddressed •• RelatedRelated projectsprojects

2 WhyWhy isis thethe InsuranceInsurance ProjectProject aa TopTop Priority?Priority? •• IndustryIndustry historicallyhistorically mutualmutual inin formform •• FinancialFinancial reportingreporting largelylargely dictateddictated byby nationalnational regulatorsregulators (solvency(solvency driven);driven); financialfinancial reportingreporting modelsmodels quitequite differentdifferent aroundaround thethe worldworld •• IndustryIndustry nownow demutualized;demutualized; raisingraising capitalcapital acrossacross bordersborders •• NoNo commoncommon regulationregulation // capitalcapital formulaformula withoutwithout aa commoncommon financialfinancial reportingreporting basisbasis •• IfIf thethe insurersinsurers adoptadopt fairfair valuevalue standard,standard, thenthen banksbanks mightmight asas wellwell

3 TheThe PlayersPlayers

•• InternationalInternational AccountingAccounting StandardsStandards BoardBoard (IASB)(IASB) •• InternationalInternational ActuarialActuarial AssociationAssociation (IAA)(IAA) •• InternationalInternational OrganizationOrganization ofof SecuritiesSecurities CommissionsCommissions (IOSCO)(IOSCO) •• InternationalInternational AssociationAssociation ofof InsuranceInsurance SupervisorsSupervisors (IAIS)(IAIS) •• NationalNational StandardStandard SettersSetters –– Convergence?Convergence? 4 WhyWhy InternationalInternational FinancialFinancial ReportingReporting Standards?Standards? •• IFRSIFRS isis becomingbecoming thethe basisbasis ofof GAAPGAAP inin mostmost majormajor jurisdictionsjurisdictions outsideoutside NorthNorth AmericaAmerica •• IFRSIFRS areare principlesprinciples--basedbased standards,standards, asas opposedopposed toto rulesrules--basedbased standardsstandards (e.g..(e.g.. USUS GAAP)GAAP) •• ManyMany companies,companies, includingincluding insurers,insurers, alreadyalready reportreport upstreamupstream onon thisthis basisbasis

5 IFRSIFRS –– MovingMoving TowardsTowards aa GlobalGlobal StandardStandard

Fixed deadlines for IFRS implementation US-GAAP - Convergence intended Convergence plans No intent to converge with IFRS

6 Source KPMG InternationalInternational convergenceconvergence –– USUS FASBFASB andand IASBIASB •• MemorandumMemorandum ofof UnderstandingUnderstanding –– FASBFASB andand IASBIASB pledgedpledged toto useuse theirtheir bestbest effortsefforts to:to: •• make existing financial reporting standards fully compatible as soon as is practicable; and •• coordinate future work programs to ensure that compatibility is maintained.

7 InternationalInternational ConvergenceConvergence ProjectProject –– USUS SECSEC

SECSEC ChairmanChairman ChristopherChristopher CoxCox ––JulyJuly 2525 20072007 ““HavingHaving aa setset ofof globallyglobally acceptedaccepted accountingaccounting standardsstandards isis criticalcritical toto thethe rapidlyrapidly acceleratingaccelerating globalglobal integrationintegration ofof thethe worldworld capitalcapital marketsmarkets”” –– ConceptConcept ReleaseRelease forfor publicpublic commentcomment –– AllowingAllowing USUS IssuersIssuers prepareprepare onon IFRSIFRS forfor SECSEC purposespurposes

ThisThis followsfollows thethe JuneJune 20072007 proposalproposal –– ProposalProposal toto eliminateeliminate thethe requirementrequirement onon foreignforeign privateprivate issuersissuers usingusing IFRSIFRS toto reconcilereconcile toto USUS GAAPGAAP

8 InsuranceInsurance ProjectProject TimeTime tabletable IASC IASB

Insurance Project Steering Advisory Insurance Committee Committee Working Group

Phase I Phase II Issues IFRS 4 Start Paper DSOP ED 5 IFRS 4 Phase II

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Split Discussion ED X Application of Project Paper Discussion Source KPMG With FASB 9 IFRSIFRS PhasePhase II ------>>> PhasePhase IIII

Assets Liabilities

All Insurance Other Investment Contracts and Investment Contracts and All Contracts with Discretionary Service Contracts Participation Features

Phase I IFRS 4 (2005) IAS 39 and IAS 39 for Status Quo some Invested aspects in IAS 32 and IAS 18 Phase II Phase II (20??)

Source E&Y 10 PrimaryPrimary ProvisionsProvisions ofof IFRSIFRS 44

•• IFRS 4 defines insurance contracts: “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 affect the policyholder” •• IFRS 4 allows insurance contracts to be accounted under local GAAP, with certain restrictions •• Liability adequacy tests required •• Certain existing practices may continue in Phase 1 • Requires a wide range of disclosures on insurance contracts: – Risk selection and risk concentrations – Sensitivity analysis 11 IASIAS 32&3932&39 –– FinancialFinancial InstrumentsInstruments

•• Covers measurement of side of the balance sheet •• Covers financial instrument component of investment contracts – GICs, term certain annuities •• Election as “held for trading” or not •• Held for trading measured at fair value; others measured at amortized cost – Any embedded derivatives at fair value – Amortized cost based on effective interest rate – DAC prohibited

12 IASIAS 1818 –– ServiceService ContractsContracts

•• Covers contracts service component of investment contracts and other contracts that are not financial instruments – ASO contracts etc •• Matching of revenue and expense •• DAC allowed but more restrictive definition than US GAAP

13 IAAIAA InsuranceInsurance ActuarialActuarial PracticePractice GuidelinesGuidelines • IASP 2 Actuarial Practice • IASP 3 Classification of Contracts • IASP 4 Measurement • IASP 5 Current Estimates • IASP 6 Liability Adequacy Testing • IASP 7 Discretionary Participation Features • IASP 8 Changes in Policies Introduced July 25, 2005 • IASP 9 Accounting for Reinsurance Contracts • IASP 10 Embedded Derivatives and Derivatives

Introduced June 11, 2007 14 ReviewReview IAAIAA ExposureExposure DraftsDrafts ClassificationClassification PaperPaper IAS 18 Significant Create financial Service Contract insurance risk assets or liabilities? No No Measurement Yes Yes Service Element IFRS 4 Contains Insurance Yes Discretionary No Contains Participation service elements Tests Feature? Financial Embedded Instrument Derivative Test Tests IAS 39 Financial Instrument Deposit Component Financial Instrument Measurement

15 ReviewReview IAAIAA ExposureExposure DraftsDrafts MeasurementMeasurement •• MeasurementMeasurement approachesapproaches addressedaddressed •• Amortised Cost model •• Fair Value model •• Stage of completion •• StructureStructure •• Approach •• Models and assumptions •• Updating •• Accounting Constraints

16 IFRSIFRS PhasePhase II ------>>> PhasePhase IIII

Assets Liabilities

All Insurance Other Investment Contracts and Investment Contracts and All Contracts with Discretionary Service Contracts Participation Features

Phase I IFRS 4 IAS 39 and (2005) Status Quo IAS 39 for some Invested aspects in Assets IAS 32 and IAS 18 Phase II Phase II (20??)

Source E&Y 17 PhasePhase IIII DiscussionDiscussion PaperPaper

• Issued May 2007; comment period November 16, 2007 • Presents tentative decisions to date by IASB • Has considered input by a number of interest groups, such as IAA, CFO Forum, GNAIE, and IAIS • Process will lead to final standard, replacing IFRS 4 Insurance Contracts

18 PhasePhase IIII DiscussionDiscussion PaperPaper -- ObjectivesObjectives

• Insurance to be subject to the same general principles as other financial services firms • Principles-based approach with additional guidance • Consistency of treatment between insurance, investment management and banking products

19 FeaturesFeatures ofof IASBIASB’’ss proposedproposed measurementmeasurement modelmodel •• SingleSingle measurementmeasurement modelmodel:: LifeLife insuranceinsurance andand nonnon--lifelife insuranceinsurance

•• ProspectiveProspective valuation:valuation: ValueValue ofof insuranceinsurance contractcontract == PVPV (all(all futurefuture cashcash flows)flows) •• CurrentCurrent exitexit valuevalue:: TheThe amountamount thethe insurerinsurer wouldwould expectexpect toto paypay toto anotheranother entityentity ifif itit transferredtransferred allall itsits remainingremaining contractualcontractual rightsrights andand obligationsobligations immediatelyimmediately 20 PreliminaryPreliminary viewsviews ofof thethe IASBIASB expressedexpressed inin thethe discussiondiscussion paperpaper

Issue IASB preliminary view Measurement attribute Current exit value - single approach for all insurance Discount rate Observable market rates for similar cash flows Unit of account Risk margins determined on portfolio basis Initial measurement Day one profits may be recognised Subsequent measurement All changes in estimates recognised immediately Policyholder behaviour Recognise future premiums only if certain tests are met Acquisition costs Acquisition costs are expensed as incurred Unbundling Unbundle deposit and service components unless interdependent Participating contracts Par component is a liability if a legal or constructive obligation exists Own credit risk Included in the liability measurement 21 FeaturesFeatures ofof IASBIASB’’ss proposedproposed measurementmeasurement modelmodel AnAn insurerinsurer shouldshould useuse thethe followingfollowing inputsinputs toto measuremeasure itsits insuranceinsurance liabilitiesliabilities

– Current unbiased probability-weighted estimates of future cash flows (ie an expected value approach) – Current market discount rates that adjust the estimated future cash flows for the time value of money – An explicit unbiased estimate of the margin that market participants require for • Bearing risk (a risk margin); and • Providing other services (a service margin)

22 ObjectiveObjective ofof IASBIASB’’ss proposedproposed measurementmeasurement modelmodel

•• CurrentCurrent exitexit valuevalue:: TheThe amountamount thethe insurerinsurer wouldwould expectexpect toto paypay toto anotheranother entityentity ifif itit transferredtransferred allall itsits remainingremaining contractualcontractual rightsrights andand obligationsobligations immediatelyimmediately

23 ComparisonComparison ofof MeasurementMeasurement AttributesAttributes

Criteria Current Exit B Current Exit A Value in Fair Value Embedded Settlement Value Relevance Market prices Pricing Run Off Market Prices Management

Comparability

Reference Market Mixed Reporting Market Reporting Entity Parcicipant Entity Parcicipant Entity Assumptions Market Mixed Entity Specific Market Entity Specific Parcicipant Parcicipant Reliability

Adequacy Test No - implicit Required Required No - implicit Required

Profit at Issue Potentially No Potentially Potentially Potentially

Embedded Not expected Expected Expected Not expected Expected derviatives Earnings Emergence Changes in Market Partial Market Entity Specific Market Management estimates Changes Changes Changes Changes Changes

24 EstimatesEstimates ofof FutureFuture CashCash FlowsFlows

• These should: – Be explicit – Be consistent with observed market prices – Be current

– Exclude – entity-specific cash flows – Non – enforceable premiums – Income Tax – Transaction costs – Investment revenues

25 DeterminationDetermination ofof thethe LiabilityLiability

•• ConsiderationConsideration ofof allall informationinformation availableavailable atat thethe reportingreporting datedate •• DeterminationDetermination requiresrequires – Identification of all possible scenarios – Calculation of the present value of all cash flows under each scenario – Unbiased neutral estimate of the probability of each scenario

26 ServicingServicing costcost

•• Principle: Those cost, which would be considered by market participants •• Estimate considering – Characteristics of contracts to be measured – Service level – Claims management •• Pragmatic solution of Discussion Paper: Use estimates of own servicing costs, unless there is clear evidence that the insurer is significantly more or less efficient than other market participants

27 DiscountDiscount RateRate

•• All insurance assets and liabilities to be discounted including claims liabilities •• Discounting exclusively for consideration of “time value of money“ discount rate should be consistent with observable current market prices for cash flows whose characteristics match those of the insurance liability, in terms of, for example, timing, currency and liquidity

Discounting based on all possible due dates, weighted with the probability of the due date

28 RiskRisk MarginMargin

• Convey uncertainty associated with cash flows • Should be market consistent • IASB has given high level guidance, leaving details to industry • Acceptable approaches include: – Cost of capital – Percentile – A multiple of standard deviation – Confidence level – Tail Value at Risk – Explicit margin within a specified range – Methods based on CAPM or other asset-pricing models – Adjusted discount rates (only if it can be shown the risk is proportional to cash flows and duration)

29 ServiceService MarginMargin

•• Service margin = Unbiased estimate of the margin, if any, that market participants would require for rendering other services (in addition to cost included in the current estimate) •• Measurement of insurance liabilities should include an explicit service margin, if other services than insurance converage are provied, e.g. administrative or investment management services •• Conceptual difference between Current Exit Value and Embedded Value

30 RiskRisk MarginMargin –– SpecialSpecial CasesCases

•• No explicit margins if market prices are applied for measurements, since they include already margins implicitly •• Existence of a “replicating asset“ equal to the obligation regarding amount, timing and uncertainty makes estimate superfloous

No need to determine separately current estimate and margin!

31 RiskRisk MarginMargin -- ImplicationsImplications

•• Different “release from risk“ for risk from estimation error, risk from furture changes in circumstances and random deviation risk •• Anticipation of future gains at inception not in compliance with insurance business model to provide services over time •• No expectation, that there will be often initial gains: Lacking reliability of estimate requires calibration to premiums

32 UnitUnit ofof AccountAccount

• Liability (including the setting of risk margins) should be determined on a portfolio basis • Determining risk margins on portfolio basis excludes benefits of diversification between portfolios.

33 FutureFuture PremiumsPremiums andand policyholderpolicyholder behaviourbehaviour

• Future premiums are included in the projected cash flows to the extent that either: – The insurer has an unconditional contractual obligation to accept premiums whose value is less than the value of the resulting additional benefit payments – They are required for the policyholder to continue to receive guaranteed insurability at a price that is contractually constrained

Issue: Should gains from future beneficial policyholders‘ behavior (especially payment of future profitable premiums) be anticipated or not?

34 CalibrationCalibration ofof riskrisk marginsmargins –– IASBIASB modelmodel • A small majority of IASB members believe that a net gain may be recognised on inception if there is a difference between the price charged to policyholders and the price that would be paid to another insurer to accept the risk • A small minority of IASB members believe that the margin should be “calibrated” to the observed price for the transaction with a policyholder, with no net gain on inception. • The IASB do not intend to attempt to define how margins should be determined but will suggest criteria an insurer should consider in selecting an approach to risk margins 35 DeferredDeferred AcquisitionAcquisition CostsCosts

• There is to be no separate asset (DAC) to account for the investment the insurer makes in the customer relationship – acquisition costs are to be expensed when incurred • Acquisition costs play no direct role in determining current exit value

36 DiscretionaryDiscretionary ParticipatingParticipating FeaturesFeatures andand UniversalUniversal LifeLife ContractsContracts

–– LiabilityLiability oror equity?equity?

•• PolicyholderPolicyholder participationparticipation rightsrights createcreate aa liabilityliability onlyonly whenwhen thethe insurerinsurer hashas aa legallegal oror constructiveconstructive obligationobligation toto paypay dividendsdividends toto policyholderspolicyholders •• InIn assessingassessing whetherwhether anan insurerinsurer hashas aa constructiveconstructive obligationobligation thethe BoardBoard willwill relyrely onon definitionsdefinitions inin itsits currentcurrent literatureliterature

37 ReinsuranceReinsurance

PrinciplesPrinciples •• MeasurementMeasurement ofof insuranceinsurance liabilitiesliabilities fromfrom reinsurancereinsurance equivalentequivalent toto measurementmeasurement ofof directdirect insuranceinsurance CurrentCurrent ExitExit ValueValue measurementmeasurement attributeattribute •• PrinciplesPrinciples ofof IFRSIFRS 44 remainremain inin forceforce – No derecognition until all obligations are expired – No off-setting of • Reinsurance assets and ceded insurance liabilities • Earnings/expenses under reinsurance contracts with ceded earnings/expenses 38 OwnOwn CreditCredit StandingStanding

• Measurement of liabilities should include the effects, if any, of the credit characteristics of the liability • Must disclose impact of this item • Quite controversial, although IASB does not think impact should be large

39 UnearnedUnearned PremiumPremium ReserveReserve

• For contracts in which claims have yet to be incurred, liabilities will have to be determined by projecting future cash flows • Many existing accounting systems use UPR (less acquisition costs) as a proxy for this item • IASB notes the unearned premium “may sometimes provide an approximation”

40 StillStill OutstandingOutstanding

• Definition of Insurance Contract • Securitizations • Deferred Tax • Interim Reporting • Presentation and Disclosure • Measurement by Policyholders • Transition / Effective Date

41 RelatedRelated IASBIASB ProjectsProjects

• Conceptual Framework • Revenue Recognition • Fair Value Measurement • Revisions to “Provisions, Contingent Liabilities and Contingent Assets” (IAS 37) • Presentation • Financial Instruments

42 ToTo LearnLearn MoreMore

•• www.iasb.org.ukwww.iasb.org.uk •• www.actuaries.orgwww.actuaries.org •• [email protected]@sympatico.ca

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