CAIR/CARTAC/World Bank Workshop and ConferenceRose Hall Resort and Spa, 1-5 December 2008

Accounting for Insurance ContractsAccounting for Insurance ContractsThe Long Winding RoadThe Long Winding Road

5 December 20085 December 2008

Ashley PatelAshley Patel

2PRESENTATION STRUCTURE

Objectives and overview of IFRS 4 (Phase I)

Phase II – IASB Discussion Paper

Comments and Key Contentious Areas

A High Level Comparison with Solvency II

Practical Implications

This presentation is structured as follows:

3IFRS 4 – PHASE I

Interim standard - focused primarily on disclosures and classification of insurance contracts.

Introduced a definition for an insurance contract based on the contract containing significant insurance risk.

Required only limited changes to existing accounting practices for insurance contracts and extensive disclosures.

Elimination of equalisation and catastrophe reserves utilized in some countries.

A principles-based framework that allows a high degree of discretion.

4IFRS 4 – PHASE I – KEY PROBLEMS

The key achievement of IFRS 4 (Phase I) was a standard definition of insurance contracts. It did not prescribe accounting for insurance contracts; hence, there is great diversity in insurance accounting among jurisdictions

Accounting mismatch between assets (which are reported at fair value) and liabilities (which are not)

No consistency or transparency in the level of conservatism in estimates - Phase I merely prohibited further increasing the level of conservatism in reserving, but did not require that a “best estimate” approach

5

INSURANCE ACCOUNTING – ANALYSTS’ COMMENTS

Between May and October 2007, PricewaterhouseCoopers carried out in-depth interviews with 39 dedicated insurance analysts from the US, Europe, Asia and Australia.

‘As it stands, financial reporting for life insurance companies is not useful to investors. The fundamentals of the business are not visible. Analysts cannot do any basic analysis and they have to resort to alternative bases.’

‘Non-life business is not transparent because companies manage the level of reserves as the cycle swings up and down.’

6PHASE II – STATUS OF THE PROJECT

Phase II work begun

- Jul 04

Discussion Paper

published - May 07

Comment period ends

- Nov 07

Phase II Draft IFRS

published – Late 09?

Phase II IFRS

published – Late 2010?

Phase II IFRS

effective 2012?

We are here

Current situation for accounting for insurance contracts is a mixed model

Resulted in too much diversity, less relevance and reliability, and inconsistency

The IASB started with a clean slate to develop Phase II

Modified joint project with FASB (US GAAP convergence)

7IASB DISCUSSION PAPER

Published on 3 May 2007

149 pages plus 83 pages of appendices

21 specific questions for comment by 16 November 2007

161 responses received from individuals, life and non-life companies, industry groups, accounting and actuarial firms, analysts, and regulators.

Responses came from all parts of the world underlining the global nature of the debate

IASB Discussion Paper“Preliminary Views on Insurance Contracts”

8SCOPE OF THE DISCUSSION PAPER

9ACCOUNTING MODEL

Single accounting model

• Discounting for non-life business• Strong opposition from US industry

Exit value model• Controversial (inside and outside IASB)• Day one gains

Entry vs. Exit Value Illustration:

• 10 year single premium policy sold by insurer X for $1,000• Expected to realise a profit for insurer X of $250 on average• Insurer Y prepared to purchase policy from X for $900 (after allowing for risk)

Entry value liability = $1,000 Initial profit is $nilExit value liability = $900 Initial profit is $100

10THE MODEL AT A GLANCE

Life of the contractC

laims

Receive premiums to stand ready

Stand ready to pay claims

Probabilityweighted

Probabilityweighted

The contract can be an asset or liability

11CURRENT EXIT VALUE MODEL

The amount the insurer would expect to pay to another entity if it transferred all its remaining obligations and

contractual rights to that entity

Time value of money Discount

rate

Current unbiased probability weighted estimates of future cash

flows

Current estimates

Risk Margin

Service Margin Margins

The Three Building Blocks

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ESTIMATES OF FUTURE CONTRACTUAL CASH FLOWS

Explicit

Unbiased

Market-consistent

Probability-weighted

Current

Exclude entity specific

13WHICH CASH FLOWS?

INCLUDE

Policyholder claims

Claims handling and maintenance expenses

Direct and indirect costs of benefits in kind

Option and guarantees

Unfavourable policyholder behaviour

EXCLUDE

Investment returns

Reinsurance

Income tax

Entity specific

Non-guaranteed insurability premiums

14DISCOUNT RATES

“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”

Own Credit Characteristics

15HOW TO CALCULATE THE RISK MARGIN

No prescribed technique

Compensation for bearing risk

Reference to what a market participant would require

Not a ‘Shock-absorber”

Unit of account is the portfolio

16THE SERVICE MARGIN

Compensation for providing other services

Investment management services

What else?

Based on market price demanded by another party to assume the service obligation

Different from IAS 18

Could have day one profit or loss

Stage of completion is not the only driver to revenue -reference to market prices must be taken into account

17THE SERVICE MARGIN

Day One Loss

No Day One Gain/Loss

Day One Gain

If margins are higher or lower

than those required by market

participants?

=

18PARTICIPATING CONTRACTS

Is there a present obligation?

IAS 37

Legal obligation

Constructive obligation

IASB’s view: Participating rights only create a liability when the insurer has an unconditional requirement to provide economic benefits

19UNBUNDLING

Interdependent resulting in arbitrary measurement

Interdependent but not resulting in arbitrary measurement

Not interdependent

Phase II for whole contract

Phase II for whole contract, but IAS 39 for

deposit

IAS 39 for deposit, Phase II

for insurance

20COMMENTS ON DP - KEY CONTENTIOUS AREAS

Day One profit is unpopular – “nothing is earned yet”

Opposition to “current exit value” as it:

Has questionable relevance as insurers generally expect to settle the liabilities by paying benefits rather than transferring to a third party

Excludes entity-specific cash flows

Greater clarity required around the nature of and basis for calculation of risk and service margins

Use of a discount rate reflecting characteristics of the liability (including own credit rating) rather than an asset-based rate

Use of discounting and risk margins for non-life insurance contracts

21COMMENTS ON DP - KEY CONTENTIOUS AREAS

The IAS 37 Liabilities Project may narrow the definition of a constructive obligation and therefore limit the ability to recognise all expected payments to participating contract policyholders

22INTERACTION WITH EU SOLVENCY II

EU insurance companies are preparing for Solvency II with implementation due by 2012

Solvency II rules for valuation of assets and liabilities are expected to be compatible with IFRS Phase II

While Solvency II is a European initiative, it is likely that other regulators globally will adopt solvency regimes with varying degrees of similarity to Solvency II

The timings and underlying principles of Solvency II and IFRS Phase II are moving ever closer, opening up valuable opportunities for synergies in systems, organisation and market communications.

23COMPARISON WITH SOLVENCY II

INCLUDE Differences from Solvency II

Definition of insurance contract Profit / service margins Customer relationship asset /

future premiums Own credit standing

Categories of assets and liabilities

Audit materiality versus relevance to supervisor

Segmentation analysis

Best estimate Discounted Risk margin

Transparency Qualitative as well as

quantitative Risk management focus Sensitivity testing

Similarities with Solvency II

Technical

Disclosure

24

PRACTICAL IMPLICATIONS – FINANCIAL REPORTING

Earnings volatility Revaluing insurance liabilities will create potential earnings volatility

Potential day one profit or loss

Using current exit values could lead to reported profit or loss at contract inception

Impact on revenue The question of whether certain premiums should be treated as income or deposits is left open and could affect “top line” revenue

Impact on equity Discretionary policy dividends qualify as liabilities only if there is a ‘constructive obligation’ to pay them

25PRACTICAL IMPLICATIONS – OPERATIONAL

Systems impact Forecasting future cash flows based on probability-weighted scenarios will require significant upgrade of modelling capabilities

Organisational impact

Use of risk margins and cash flow analyses in accounting will require closer integration among finance, regulatory, actuarial and risk management functions.

Resource impact Need for more qualified actuarial as well as finance and IT personnel

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Questions?