the world bank the advanced program in accounting and auditing regulation a new era of prudential...

The World Bank The Advanced Program in Accounting and Auditing RegulationA new era of prudential rules and financial reporting for insurance

Catherine Guttmann

16 May 2006

2GDNL Program –Module 25 (2) © 2006 Deloitte

Outline of presentation

• In line with IAIS work, new risk-based solvency requirements (Solvency II) are

underway at the EU level

• Complete, prudent, relevant, common accounting principles as a pre

requisite for assessing insurer’s capital requirements and enhancing the

ability of insurers to call for capital

• What are the main features of IFRS for insurance companies (as of today,

Phase I)

• IFRS 4 – Phase II – A common valuation of insurance liabilities for accounting

and solvency purposes ?


In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level

• Solvency II as a consequence of insufficient efficiency of Solvency I 85 insurance companies have been under regulator’s close scrutiny, in the last five

years in Europe, because of capital inadequacy under Solvency I, of which 20 have ultimately disappeared :– Administrative sanction

– bankrupcy

Main Reasons : Inadequacy of the pricing of the contracts Under estimate of insurance liabilities, including embedded options granted to policy

holders Inadequate asset/liability management

– Duration

– Liquidity

– …

Inadequate reinsurance coverage linked with insufficient insurance risk diversification Inadequate corporate governance and internal control



• Solvency II as a convergence between insurance and banking sector More and more similar products

e.g. : Catastroph bond versus insurance contract Saving contracts Climatic derivatives

In line with IAIS thinking : more prospective assessment and control of the risks :

Insurance Financial Operational …

both on management and supervisor’s side


Fev 2007 : Final Directive

Jui 2007 : Adoption

2008 : Elaboration of detailled implementation guidances

2009-2010 : Transposition of the directive by each Member State

2010 : Application Solvency II

Removal of 19 Directives EU in existence

In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level – The Calendar

May 01 jan 03 jun 04 dec 04 may 05 apr 06 oct 06 dec 06 feb 07 jun 2007 2008 2009 2010May 01 jan 03 jun 04 dec 04 may 05 apr 06 oct 06 dec 06 feb 07 jun 2007 2008 2009 2010

• Inventory on Solvency I

• Assessment of the relevance / adaptation of banking rules to insurance

•Considerations into the form of a future system of prudential control

•Study leads by european insurance supervisors on Solvency I and recommendations on the Solvency II project

Project of Directive proposed for adoption

Preparatory works

19991999

Phase I Phase II

Project of Directive Directive Solvency II

June 2004 : 1st wave of calls for advice (Pillar II)

Dec. 2004 : 2nd wave of calls for advice (Pillar I)

May 2005 : 3rd wave of calls for advice (Pillar III)

June 2005 : Amended Framework for consultation

Sept 2005 : 1st quantitative impact study (QIS 1)

April 2006 : 2nd quantitative impact study (QIS 2)

Oct 2006 : 1st draft of Directive

Dec 2006 : 2nd draft of Directive



SOLVENCY II

March 06

CEIOPS answer – 3rd wave of calls for advice

Oct 06

1st draft of Directive

July 07 Feb 07

Final Directive Directive proposed for adoption

Results QIS 1

Starting QIS 2 on MCR & SCR)

Feb 06 April 06 Sept 06

Results QIS 2

2rd draft of Directive

Dec 06

Key phases of short term development



3 pillars structure

Capital Adequacy

Value based approach- Solvency Capital Requirement (SCR)- Min. Capital Requirement (MCR)

Insurance Liabilities

Risks linked to the asset more specifically integrated

Capital Adequacy

Value based approach- Solvency Capital Requirement (SCR)- Min. Capital Requirement (MCR)


Risks linked to the asset more specifically integrated

Supervisory Review

Corporate Governance

Asset/Liability Management

Efficiency of internal control

Investment policy

Reinsurance program

Process of prudential supervision

Supervisory Review

Corporate Governance

Asset/Liability Management

Efficiency of internal control

Investment policy

Reinsurance program

Process of prudential supervision

Market Regulation

Information for public and control

Transparency principle

Information requirements (disclosures)

Financial communication

Market Regulation

Information for public and control

Transparency principle

Information requirements (disclosures)

Financial communication

Pillar IPillar I Pillar IIPillar II Pillar IIIPillar III

Solvency II


• MCR/SCR (CFA n°9, 10, 11, 13, 14)

• 2 levels of solvency requirement : MCR and SCR


MCRMin. Capital Requirement

SCRSolvency Capital

Requirement

Level 0: Mortality risk

Level 1: floor

Level 2: capital target Surplus

Prudential graduated intervention

Risk considered as unacceptableby policy holders


- Internal models

- Standard approach


Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital

• Relevant information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming or correcting their past evaluations

Prospective approach

Unlocking of the assumptions

• Completeness : no omission

As far as possible, all items valued in the balance sheet

e.g. : guarantees, options



• Common :

– Same definitions (substance over form)

Definition of financial assets and liabilities

Definition of insurance contract

Definition of financial risk, or insurance risk, ...

– Same accounting rules

Convergence between countries

Convergence between insurance and banking



• Prudent : – Valuations have to contend with the uncertainties

– Those uncertainties are to be recognised and valued

– However, the exercise of prudence doesn’t allow deliberate overstatement of liabilities

No double counting with solvency capital requirement

Conclusion : a prerequisite, a priori, in coherence with IFRS framework


What are the main features of IFRS for insurance companies (as of today, Phase I)

• The IFRS on insurance contracts applies to all insurance contracts (including reinsurance contracts) and only to insurance contracts

Financial assets and liabilities of insurers are treated by IAS 39

• All IFRS standards apply to insurance companies

• « Insurance contract » definition is a definition in substance and not a legal one : The standard on insurance contracts should then be used for example in the banking

industry



Definition of an insurance contract

• An insurance contract is 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 futur event (the insured event) adversely affects the policyholder »

The « policyholder » is defined as : « a party that has a right to compensation under an insurance contract if an insured event occurs »



Definition of financial and insurance risks

• An insurance risk is a « risk , other that financial risk, transferred from the holder of a contract to the issuer »

• A financial risk is « the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract »



Examples of insurance contracts

Are insurance contracts: Are not insurance contracts:

- Insurance against theft or damage to property

- Insurance against product liability, professional liability, civil liability

- Disability and medical cover

- Life contingent annuities

- Death benefit

- Catastrophe bond if the triggering event includes a condition that the issuer of the bond suffered a specified loss

- Financial contracts which don’t expose the insurer to significant insurance risk (investment contracts, financial reinsurance)

- Fronting

- Own insurance : for example : product warranty is issued directly by a manufacturer dealer or retailer

- Catastrophe bond triggered by an external event for which the issuer doesn’t incure a specific loss


ASSET IFRS

Goodwill IFRS 3, IAS 36 Value business in force for insurance contracts IFRS 4 Value business in force for financial contracts IAS 39 Differed acquisition costs for insurance contracts and financial contracts with discretionary participating feature

Local GAAP / IFRS 4 / IAS 39

Differed acquisition costs for financial contracts IAS 39 Intangibles assets – Impairment IAS 38, IAS 36 Tangible assets - Impairment IAS 16, IAS 36 Differed tax assets and current tax IAS 12 Leases IAS 17 Financial assets IAS 39 Derivatives (including embedded derivatives) IAS 39 Loans IAS 39 Investment property IAS 40 Investments in Associates and joint ventures

o Equity method IAS 28, IAS 36

o Investment IAS 39 Other financial assets IAS 39

Cash and cash equivalent IAS 7, IAS 39 Reinsurance assets IAS 39

Reinsurance ceded IFRS 4 Financial reinsurance ceded IFRS 4, IAS 39

Consequence : an insurer balance sheet

Major changes with fair value orientation

Local GAAP


LIABILITY IFRS

Equity :

- Variation of fair value for available for sale financial instruments

- Cash flow hedges (effective hedge)

- Actuarial gains and losses (option)

- Discretionary participating features classifed as equity

IAS 32, IAS 1

IAS 39

IAS 39

IAS 19

IFRS 4

Minority interests IAS 27, IAS 1

Total Equity Insurance and reinsurance contracts qualified as financial instruments

IAS 39

Discretionary participating features classified as liability IFRS 4 / Shadow accounting

Insurance and reinsurance contracts non qualified as financial instruments, financial contracts with discretionary participating features

IFRS 4 / IAS 39

Derivatives (including embedded derivatives) IAS 39

Financial liabilities (option) IAS 32, IAS 39

Differed tax liabilities IAS 12

Contingent liabilities and provisions IAS 37

Current taxes IAS 12

Employee benefits IAS 19

Short term liabilities IAS 39

Reinsurers liabilities IAS 39

Leases IAS 17

Banking deposits IAS 7, IAS 39

Total Liabilities

Major changes with fair value orientation

Local GAAP


IFRS 4 – Phase II – A common valuation of insurance liabilities for accounting and solvency purposes ?

• Agenda– A Working Paper should be published by the Working Group Phase II before year end 2006

– An Exposure Draft should be published in 2008

– Final standard could be published before year end 2008

Juillet 2005 2006 2008 2009/2010

Working Group meetings

Working paper published

ED published Endorsement of phase II standard


• Approach A – Current Entry Value

Principles : Approach A measures the insurance liability at the amount that the insurer would charge to a policyholder today for entering into a contract with the same remaining rights and obligations as the existing contract.

• Initial measurement :• Discounting of future projected cash flows using current yield curve (best estimate value)• A margin for risk and uncertainty• Valuation of an implicit margin, equal to the difference between premiums and the best estimate value

• Next measurements• Best estimate value is calculated on current assumptions (economic and non economic)• The initial margin is amortised among the duration of the contract with the release of the risk

Main issues : valuation approaches under consideration


• Approach B – Current Exit Value (Transfer Value)

Principles : Approach B measures the insurance liability at the amount that the insurer would expect to have to pay today to another entity if it transferred all its remaining contractual rights and obligations immediately to that entity.Because there is no secondary market for most insurance liabilities, that amount would need to be estimated.

Specifically, approach B :• Measures the insurance liability as the present value of future cash flows arising from the contract (Uses a current risk-free discount rate).• Does not defer acquisition costs as a separate asset.• The measurement of the liability includes the margin that market participants would require for contractually assuming risks and providing services :

• Margin for risks and uncertainty AND• Margin for the servicing part included in the insurance contract (servicing margin)

• Profit at inception is limited :• by the level of the MRI and• by the level of the Servicing margin




Asset

Approach B – "Business to Business”

Asset

Approach A – "Business to Customers”

Global margin = Premiums – Exit Value best estimate

Net equity

Servicing margin

MRU

Exit Value best-

estimate

Net equity

Global Margin

Exit Value best-

estimate

Some gain at inception but limited by the SM and the MRI

No gain at inception

Separation and valuation of the 3 parts of the contracts :- exit value "best estimate"- Margin for risks- Servicing margin


• IAIS is working on a similar model so that the same valuation for liabilities could be taken for solvency purposes and accounting

Questions still to be solved :

• Definition of the MRU (level of confidence ; Cost of capital), pattern of amortisation• Definition and level of the servicing margin (market reference ?)• Policyholder behaviour ? Surrenders, futur premiums, renewals …•IAS 39 for investment contracts ? 39 to be amended ?•Own credit risk•Discretionary participating features : liability or equity or separate component of equity ?


the world bank the advanced program in accounting and auditing regulation a new era of prudential...

Documents

application solvency

solvency purposes

eu level solvency

insurance companies

insurance contract

insurance considerations

european insurance supervisors

iais work