Update on IFRS 4, Phase 2 IFRS 4, phase 2 is a forthcoming update to the financial reporting standards of re/insurance. This update may impact re/insurers in different ways, including to how insurance is defined, the accounting impact of reinsurance transactions and a dramatic change to how income statements and balance sheets look for re/insurers. This paper looks at highlights of the phase 2 proposals and outlines key considerations and next steps for re/insurers.

Background The International Financial Reporting Standard (IFRS) aims to bring a consistent approach to financial reporting across varied regions, while reducing the inherent inconsistencies of local GAAP accounting principles. The International Accounting Standards Board (IASB) has been the leading governing body behind IFRS, with supporting opinions, dialogue and input from other accounting authorities such as the Financial Accounting Standards Board (FASB) in the US.

IFRS is a series of statements and pronouncements for accounting principles. IFRS 4 is one of those statements, and was the first attempt at consolidated guidance for accounting for insurance contracts. The initial guidance for IFRS 4 was released in 2004 Phase I (P1). Although limited direction was provided with P1, key highlights include:

1. Entities issuing insurance contracts to disclose information about those contracts

2. A definition of insurance is provided. Some traditional insurance is accounted for separately from other financial instruments captured in International Accounting Standard 39 – Financial Instruments: Recognition and Measurement

3. End of equalization reserve / catastrophe liability provision accounts

4. Guidance on accounting mismatch (the inconsistent response to economic changes of insurance liabilities and assets aligned with those liabilities)

In July 2010 an Exposure Draft for Phase 2 (P2) was released for comment by the IASB. P2 is meant to ensure a more consistent and comprehensive reporting standard for insurance contracts than what was reflected in P1. It is an attempt at a principles-based approach to recognize the economic nature of insurance contracts, as opposed to a prescriptive accrual approach. The final standard is expected in the middle of 2011.

Core Principle Proposed According to IFRS.org: “insurance contracts create a bundle of rights and obligations that work together to generate a package of cash inflows (premiums) and outflows (benefits and claims).” Generally, there are four building blocks used to measure and account for these cash flows under P2 (figure 1). These blocks are applicable to insurance policies over a 12 month term. Policies of a year or less, like most non-life insurance, are subject to a modified version of the building block approach.

The four building blocks collectively determine the insurance liability

Building Block 3

Building Block 2

Building Block 4

Building Block 1

Risk Adjustment

Discount Rate

Residual Margin

Estimated Future Cash Flows

Prohibits a day-1 profit

View of uncertainty

Time value of money

Expected payouts and collections

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Table 1: Summary of Key Selected Topics

Proposal Highlight Takeaways

Refined Definition of Insurance

Significant underwriting or timing risk must be transferred from the insured to the insurer due to a specified future insured event

There must be at least one (economically sensible) scenario where the present value of cash outflows exceeds cash inflows

Building Block 1: Estimating future cash flows

Probability weighting of explicit future cash outflows (less inflows) expected over the fulfilment of the insurance contract, and is updated each reporting period

Cash flows include premiums, claims, incremental policy admin costs, recoveries, incremental acquisition costs

Reinsurance impacting cash flows of a cedant are excluded as these are valued separately

Building Block 2: Discount rate

Reflects the nature of the liability. Uses a risk free rate that appropriately reflects timing, currency and liquidity characteristics of the insurance contract cash flows, and is updated each reporting period

Does not reflect the company’s own current or future credit risk, local sovereign risk or other similar future cash flow influences

Building Block 3: Explicit risk adjustment

Reflects the insurer’s view of uncertainty of the amount and timing of cash flows, and is updated each reporting period

Three methods allowed to estimate: cost of capital, conditional tail expectation (CTE), confidence levels

Similar insurance contracts should be grouped and measured by collectively as portfolios. No diversification among portfolios

Declines over time as insurance risk diminishes

Limited direction of what constitutes a portfolio. There are multiple ways to use the allowed methods of calculation, making for inconsistencies (e.g., unspecified confidence level acceptance)

Building Block 4: Residual margin

Profit from the contract, used at policy inception to prevent reporting a gain at the insurance policy’s inception

Amount is fixed at inception, amortized over time, and becomes zero once the coverage period is over

If the building blocks result in an initial loss, that loss would be recognized on day one. The FASB proposed an alternative approach which combines Building Blocks 3 and 4 into one composite margin

Acquisition costs Incremental insurance policy acquisition costs are included in the Building Block 1 cash flows at inception

All other acquisition costs expensed as incurred

Prevents the accrual of a deferred acquisition cost asset

Short-term contracts (i.e., 12 months or less)

A modified measurement alternative applies. An unearned premium (UEP) approach is required instead of building block method for pre-claim liabilities

Building block method needs to be applied in the testing of whether an insurance contract is not onerous (i.e., roughly speaking tests that that the outflows (claims and expenses) do not exceed the inflows (premiums)

UEP is roughly a pre-claims liability that is released over the policy term

Incremental acquisition costs are deferred over the covera

lies

ge period

Spirit of the building block approach otherwise app

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No equalization reserve

As under the current IFRS 4, insurers ought not to recognize any asset or liability resulting from possible claims on future contracts

Likely to increase volatility in earnings for those companies that adopt IFRS 4 with significant catastrophe risk or that maintains meaningful equalization reserve or provisions. We are aware of six countries that currently allow for some sort of equilization reserve provisions: 1. China (no plans to adopt IFRS; exception being companies listed on the Hong Kong stock exchange) 2. India (converging with IFRS over a period beginning April 1, 2011) 3. Japan (plans to adopt IFRS) 4. Philippines (has a variation of IFRS) 5. Taiwan (plans to adopt a variation of IFRS) 6. Vietnam (no plans to adopt IFRS) For Philippines and Taiwan, they haven't made a final decision on negating the use of catastrophe / contingency reserves in their versions of IFRS.

Reinsurance Same refined definition of insurance applies to reinsurance liability or asset

Same building block approach (or modified approach for short-term contracts) for insurance applies for a reinsurance liability or asset. However, the determination of a reinsurance asset includes counterparty default risk in the risk margin

Reinsurance assets use separate building blocks to an insurer’s liabilities, they are not netted against specific insurance liabilities in financial statements

Uncertainty if a risks-attaching policy or a multi-year contract qualifies as short-term or long-term

Expanded insurance risk disclosure

Required to disclose nature of and exposure to insurance risks, the related risk management processes and any changes period to period

Effect of regulatory requirements, such as minimum capital requirements for particular products

Gross and net insurance positions, and pre and post risk mitigation including the impact of reinsurance, and including profit / loss / equity sensitivities, concentrations, and claims development

Examples of items where P2 is not applicable or are not considered insurance contracts

Product warranties issued by manufacturers, dealers, or retailers

Residual value guarantees issued by manufacturers, dealers, or retailers

Certain derivatives securities

Other proposals under consideration

A revised (and less intuitive) format for income statements and statements of financial position (see table 2 below)

Expanded disclosure requirements

Unbundling, and accounting for separately, non-insurance components of a contract (e.g., embedded derivatives)

A few points relating to Solvency 2 (S2)

IFRS is targeting a global audience, whereas S2 is targeting a Europe audience

S2 follows a similar building block methodology, but without the residual margin. So with S2 profit can be recognized on day one

Difference in guidance related to allowable methods for calculation of risk margin and granularity for calculation

IFRS proposes the UEP method for short-duration contracts while S2 does not distinguish between short-term and long-term contracts

IFRS requires expanded disclosure on risk exposures and risk management similar to pillar 3 of S2

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Going Forward The changes will likely create a degree of short-term angst for the sake of long-term improved financial reporting, or at least that is a hope. Certain questions and clarifications still need to be addressed and as expected there are divergent views on aspects of P2, including from FASB in the U.S.

The P2 proposals present new considerations for the insurance industry. Re/insurers will face:

Operational risks given changes in accounting systems and infrastructure that may be necessary to measure and report figures appropriately for IFRS 4

Additional costs for training and development to assure the necessary acumen on IFRS standards

Some variances in methodology between P2 and Solvency II

A new way to report income and financial position that may present difficulties in the beginning for observers, including rating agencies, regulators and investors, to gauge and compare financial performance or to estimate value

Aon Benfield maintains extensive thought leadership on regulatory and accounting matters. We are available to share that insight with clients as they consider the various implications of P2, particularly as it relates to reinsurance decision-making, capital management and strategic planning.

Table 2: Illustrative & Simplified Example of Potential Profit & Loss Statement Under P2

Margin RevenueRisk adjustment margin 70 Net earned premium 750 Residual margin 20 Net investment income 150

Total margin 90 Total revenues 900

Investments & Interest ExpensesNet investment income 150 Claims and loss expense 655- Interest on insurance liabilities 15- Deferred acquisiton cost 20-

Total investments and interest 135 Other expenses 25- Total expenses 700-

Adjustments & ExpensesAdjustments in prior estimates 5- Profit (ignoring taxes) 200 Non-incremental acquisition costs 11- Other expenses and adjustments 9-

Total adjustments 25-

Profit (ignoring taxes) 200

Margin Approach Traditional Approach

Contact Information Christopher R. Myers, CFA, FRM +44.20.7522.3906 christopher.myers@aonbenfield.com Kelly Superczynski, CPA +1.312.381.5351 kelly.superczynski@aonbenfield.com Sources for this article: Aon research, estandardsforum.org, iasplus.org, icaew.com, IFRS.org, IFRS Insurance Contracts Exposure Draft, July 2010. Copyright 2011 Aon Benfield Inc.