110309 ifrs phase ii - society of actuaries in ireland · slide 5. definition of an insurance...

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



• 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



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



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 (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



• 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



• 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



• 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



• 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

110309 ifrs phase ii - society of actuaries in ireland · slide 5. definition of an insurance...

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