getting to grips with the grips with the shake-up · pdf file · 2015-06-03it forms...

Getting to grips with the shake-up

www.pwc.com/insurance

ni/moc.cwp.www

cenarusn

itteG

og tni

kehass wiprgitteG

ppuup-kehh ttis w

og tni

e h

eveo ds trrs treusnw iollakorwemarS f frRFFRd I IFnacnevlog Snigrrgeme eht

s beigrrgenye s syhe tlihW

pooplel lis w

Iy I IIcy n eewtes b

etsyg s synitorpt re epceffefffaaflis wihw tos hsesso at

d sns akorwemaro f frwtn teewtes beitiralimis

d ns aecnreeffefffiife dhtimaxe eon witacilbup

s ihn t. Isecnreeffefffiifdt nacfiiifingie some so btore bre aeh, tmorfforttfalp

g nitorpon re epmoma ceveo ds trrs treusnw iolla

, sm

l lt ratd s

e hn t

eni

t d nuo

poople

010r 2ebotcO

numomt cekrad mnauatlavetenemgnaam

yg ypffff

.onitaci

niouat,

Foreword 1

Introduction: A critical juncture 2

First five steps to integration 4

Contract liabilities 8

Assets and other liabilities 12

Disclosures 14

Group reporting 15

Appendices 16Appendix A – Insurance contracts 17Appendix B – Investment contracts 25Appendix C – Assets and other liabilities 27Appendix D – Group reporting 32

Contacts 34

Contents

PwCGetting to grips with the shake-up

The parallels between Solvency II and theplanned changes to IFRS open upvaluable synergies in areas such as datamanagement and model development.However, there are also crucialdifferences between the two regimes.Insurers need to understand how thesedifferences will affect the ‘numbers’ andhow they can be reconciled and properlyexplained. Otherwise, firms could findthemselves facing some challengingquestions from analysts.

This publication is designed to helpinsurers identify the key differencesbetween the two proposed regimes,and start to assess the implications forreporting systems and investor relations.It forms part of a series of guidance andresearch studies examining the strategicand implementation issues surroundingSolvency II and IFRS.

If you would like to discuss any of thepoints raised in this paper or any otheraspect of Solvency II and IFRS, you arevery welcome to contact me (detailsbelow) or one of the contacts listed onpage 34.

Paul ClarkePartner +44 (20) 7804 [email protected]

Foreword

PwCGetting to grips with the shake-up 1

The move to Solvency II and the new IFRS for insurance contracts will havecritical implications for the way insurers measure capital and financialperformance and how they are judged by the financial markets andregulators. Implementation and operation of the reporting frameworksalso present considerable logistical challenges.

QIS5 is one of the last chances forEuropean insurers to road-test andinfluence the new Solvency II regime.The consultation over the IFRS InsuranceContracts Exposure Draft (ED) is the bestopportunity for the industry to influencethe increasingly imminent newaccounting standard. Insurers also faceextensive changes to the classification andmeasurement requirements for financialinstruments (the IASB is developingInternational Financial ReportingStandards (IFRS) 9, which will replacethe current International AccountingStandard (IAS) 39) and to the principlesgoverning revenue recognition throughthe Revenue from Contracts withCustomers ED. Finally, the developmentof a single accounting standard to definefair value is important for insurers thatmeasure assets or liabilities at fair value.

As Figure 1 highlights, 2011 will be adecisive year with the expectedfinalisation of the Solvency II ‘Level 2’implementing measures and the expectedpublication of the new IFRS standards forinsurance contracts, financial instruments

and revenue recognition all due at thistime. There is still a degree of uncertaintyabout the effective date of all theimplementing measures and standards.The latest statement from the EuropeanCommission indicates that Solvency IIwill be implemented from the end of2012, and this proposal should beconfirmed once the draft Omnibus IIDirective is published later in 2010.The IASB plans to consult separately onthe proposed effective date of theStandards it is publishing in 2011.

Insurers face significant challenges indelivering the scale of change,understanding the implications,embedding the results into all aspectsof the business and, communicating thisinternally and externally. At the sametime, there is an opportunity to achievesynergies and to create frameworks fordisclosure that better reflect the valuebeing created within the business andhow the business is being run bymanagement.

This publication begins withconsideration of the first steps inimplementing Solvency II and thechanges to IFRS, primarily the proposedinsurance contracts standard, in parallel.It then examines the key similarities anddifferences between IFRS and Solvency IIin the areas of contract liabilities, assetsand other liabilities, disclosures andgroup reporting. The appendices providea more detailed point-by-point technicalcomparison.

The publication is based on IFRS andSolvency II proposals up to 30 September2010, many of which are in a consultationphase. The final requirements of bothIFRS and Solvency II may still evolvesignificantly up to their effective datesand, therefore, may differ from those setout in this publication.

Introduction:A critical juncture

2 PwCGetting to grips with the shake-up

The overhaul of accounting and solvency regulations in the Europeaninsurance industry has reached a critical juncture with the EuropeanCommission’s publication of the technical specifications for SolvencyII’s Fifth Quantitative Impact Study (QIS5) and the InternationalAccounting Standards Board’s (IASB) long-awaited InsuranceContracts Exposure Draft.


Figure 1: Current timelines for the Solvency II and IFRS exposure drafts and final standards

Sol

venc

y II

Insu

ranc

e co

ntra

cts

Fina

ncia

l ins

trum

ents

(IFR

S 9

rep

laci

ng IA

S39

)

IFR

S

2009

Level 1 Text in Official Journal

Level 2 Implementing measures

Techincal guidance

Effective date

(To be confirmedin Omnibus IIDirective)Level 3

Phase IIExposureDraft

Possible effective date of 1 January 2013(or later) depending on:

• Feedback from the Exposure Draft• Endorsement process by the EU• Transition project by the IASB across all

IFRS developments

Expected finalstandard

Fair value measurement

ED Fair valuemeasurement

ED Measurment uncertaintyanalysis disclosure for fair value measurements


Hedge accounting and

offsetting

Expected ED’s on hedging accountingand offsetting

ImpairmentED on amortisedcost andimpairment

Classification and measurement -financial liabilities

ED on fair value option

Expected final standards


ED Revenuefor contacts withcustomers


Mandatory effective date for financial assets of 1 January 2013 with other components also expected to be effective from this date.

Effective date depends on endorsement process by the EU and transition project by the IASBacross all IFRS developments.

IASB has indicated that transition date for insurers may be delayed to coincide with the effective date of the Insurance Contracts standard.

Subject to EU endorsement and IASB transition project, the expected effective date is no earlier than 1 January 2013

Subject to EU endorsement and IASB transition project,the expected effective date is 1 January 2013

Classificationand measurement -

financial assets

Final standard

Revenue recognition(replacing IAS 18)

Quantitative Impact Study

QIS5

201220112010 2013-2015

Expected draftOmnibus IIDirective

The timeline is based on information published at 30 September 2010 and may be subject to change.

Source: PwC analysis

PwC has created a five-step plan toprepare to integrate the new IFRSrequirement with Solvency IIpreparations (see Figure 2) and describeseach step in more detail here.

1 Understand the keyrequirementsAs we outline in this publication, themarket consistent measurement basis forinsurance contracts under IFRS has strongsimilarities with Solvency II. However, itis important to understand the nature andimplications of the differences describedin subsequent sections as they will have acrucial bearing on the ability to integrateIFRS with Solvency II. At this stage, thereare significantly more uncertaintiessurrounding IFRS than Solvency II, as theinsurance contracts standard is only at theexposure draft stage.

It would therefore be useful to carry outa gap analysis to assess similarities anddifferences in the requirements (see

Figure 3) – and how these specificallyimpact your business – though thefindings may be subject to change as bothIFRS and Solvency II evolve up to finalisation. The degree of uncertaintysurrounding certain IFRS proposalsshould be included in the gap analysis asit will be an important factor in assessingthe immediate priorities and avoidwasting scarce time and resources. Theoutput from the gap analysis forms thebasis for an implementation plan forexternal reporting from 2012 and beyond.

There are timing as well as technicalissues to consider at this stage. Inparticular, there is a risk that the variousIFRS standards may come on stream atdifferent times resulting in multipletransitions and restatements; and the riskthat Solvency II may be effective beforethe new IFRS developments. The timingissues present a range of practicalchallenges and considerations,not least as the current IFRS reportingrequirements for insurance contracts areoften based on Solvency I or US GenerallyAccepted Accounting Principles (GAAP)methods. Insurers will have a number ofpotential options for IFRS reporting forinsurance contracts in the interim period,if Solvency II is applicable prior to thenew IFRS standard, including:

• Maintain current approach. Thiswould require the parallel runningof current models and processes

First five stepsto integration

If you’re already preparing for the implementation of Solvency II, there isan opportunity to integrate the changes that will be required by IFRS.Given the size and complexity of Solvency II implementation projects,particularly for multinational insurers, this will be a significant challenge.However, the alternative of a separate reporting project is likely to be bothrisky and costly, and will miss the opportunity to address the majorcriticisms of insurers in recent years: the failure to communicate the capitalmanagement and value creation story effectively.


in addition to those required bySolvency II, which is likely to be adrain on costs and resources.

• Adopt Solvency II (or a modifiedversion). This would require a carefulassessment of the current IFRS 4 andIAS 8 requirements to check whethersuch an approach is permitted. Afurther change would then be requiredto adopt the insurance contractsstandard, once it becomes mandatory.

• Adopt the requirements of theinsurance contract standard.Insurers might adopt the requirementsof the insurance contract standard,expected to be published in 2011,either through early implementationof the standard itself (subject to itsendorsement in Europe) or by takingon board some of its requirements asa way of improving existing accountingpolicies under IFRS 4 (subject toconfirming whether such an approachis permitted).

The uncertainty in approach over theinterim period may resolve itself over thecoming years as a standard industryposition emerges. Most insurers will notwant regular transitions betweendifferent approaches, not least to avoidthe requirement for regular restatementsand potential volatility in earnings. Formost insurers, a key first step should be toassess the financial impacts of thepotential options.

2 Develop the operatingmodel and processes toanticipate the newreporting requirements,while allowing for potentialfurther changeIt is likely that insurers will look to usetheir existing Solvency II projects as astarting point for the implementation ofthe changes to IFRS and to assess howthey can integrate these reportingrequirements. For many insurers,Solvency II has seen the development of a‘target operating model’ to articulate theirgovernance, operational, structural and

capital priorities. Insurers will need toconsider what changes IFRS will bringand how to incorporate these changesinto their operating model and processes.

Effective operation will require closerintegration of risk and finance functions’operational and technical capabilities.Figure 4 illustrates how this alignmentof risk and finance may be structuredin practice.

3 Understand and preparefor new data requirementsSolvency II is leading to a fundamentalchange in the management andgovernance of data, which will requireexacting data quality thresholds and thedevelopment of a rigorous controlenvironment. It is important forcompanies to make sure that any IFRSspecific requirements that are now on thehorizon are captured. For example, thecalculation of the residual margin forinsurance contracts under IFRS, asoutlined later in this publication, is

required at a granular level – by portfolioof contracts, similar inception date andsimilar term – and as a result the bestestimate liability and risk adjustment willbe needed at this level. The split of datarequired is likely to be finer than manyinsurers are currently planning in theirSolvency II model developments.Technical challenges include theallocation of diversification benefits in therisk adjustment within a portfolio.

There has been some debate on thetransitional arrangements set out in theinsurance contracts ED, which will notpermit a residual margin on existingbusiness. If the final insurance contractsstandard allows or requires the inclusionof a residual margin on existing business –which is by no means clear – this wouldresult in significant data and resourcerequirements. Insurers would need toreturn to day one of its contracts at alower level of granularity than theportfolio, to calculate the residual marginand then amortise it to the reporting date.


Figure 2: A five-step plan to prepare to integrate the new IFRS requirementswith Solvency II preparations

The practical steps are not necessarily sequential and will depend on the specific circumstances ofeach insurer.


Understand the key requirements

Develop the operating model and process to anticipate the new reporting requirements

Understand and prepare for new data requirements

Develop the modelling and reporting capability

Develop the external reporting strategy

Gap analysis to assess similarities and differences between the latest IFRS and Solvency II requirements; and how these specifically impact your business.

Develop a market communication strategy. Reviewscope of current Solvency II Pillar 3 projects to assessfeasibility to extend project to include disclosuresrequired by IFRS.

Target Operating Model to include requirements of IFRS. Identify processes that can be used for bothIFRS and Solvency II and assess where streamliningof existing processes is necessary.

Initial assessment of modelling requirements andhow this ties in with existing modelling strategy. Timetable modelling developments to fit with current Solvency II projects.

Identify any additional data requirements from IFRS.Assess current data system capabilities and plan forany required developments.

1

2

3

4

5

Area of focus Practical steps to take now

There are precedents in IFRS for fullretrospective adoption of standards.For example, in the first phase ofinsurance accounting under IFRS, thedefinition of acquisition costs permittedto be deferred in respect of investmentcontracts was changed in many countries.However, the scale of calculating theresidual margin on existing businesswould be much more significant.This is an example of a potential datarequirement, which is not in the scope ofSolvency II, where forward-thinkinginsurers may now be starting to factor thisinto current Solvency II data projects.

4 Develop the modellingand reporting capabilityBuilding an actuarial cash-flow modelthat is fit for purpose for both Solvency IIand IFRS is a challenge. The move to amarket consistent approach presents a

number of implementation hurdles.For life insurers, this includes the need forsophisticated stochastic modellingcapabilities, as those insurers that haveembarked on Market ConsistentEmbedded Value (MCEV) in recent yearsunderstand. Many international groupsalso face the prospect of moving frommultiple local GAAPs, which may nothave required a market consistentvaluation, to a single harmonisedfinancial reporting standard. Developingthe capability to a standard that stands upto independent scrutiny requires asignificant investment, as alreadyreflected in the Solvency II programmesof many insurers. Adding IFRS to thisinvestment is important to avoidduplication and unnecessary additionalcost. It is important to capture the subtledifferences between Solvency II and IFRS,as illustrated later in this publication.

5 Develop the externalreporting strategyMoving to an economic framework forreporting is an opportunity to enhancethe quality, depth and transparency ofinsurance reporting, addressing once andfor all the criticism that insurers fail tocommunicate their value creationactivities effectively and consistently.The ultimate aim is being able to convey asingle view of the business that moreclosely reflects its risks and the way it isrun. The differences in measurementbetween IFRS and Solvency II mean thatinsurers will need to explain the disparityin disclosure between the differentapproaches. Designing and presentingthat message coherently – and bridgingthe story from IFRS 4 and Solvency I –will be challenging, but is more importantthan ever for insurers to get this right.

If the final insurance contracts standard allows or requiresthe inclusion of a residual margin on existing business –which is by no means clear – this would result in significantdata and resource requirements.

Figure 3: At a glance, a summary comparison of the main differences between the IFRS Insurance Contracts ED andSolvency II technical provisions

Solvency IIArea IFRS Significance Observation

Definition andscope

All contracts Insurance plussome participatinginvestment contracts

• The measurement of investment contracts in IFRS is likely to be significantly• different to Solvency II.

• In IFRS, participating contracts are not automatically in the insurance standard.

Recognition Party to contract Party to contract • Similar requirements.

Unbundling No Not ‘closely related’(3 examples)

• The scope of unbundling in IFRS is not clear. However, requirements to • unbundle will have significant systems, data and process implications • for some insurers.

Cash flows Prescribed Incremental atportfolio level

• There is the potential for certain cash flows, for example overhead expenses• and tax to be different between Solvency II and IFRS.

Discount rate Risk-free plusilliquidity premium

Risk-free plus illiquidity premium

• Potential grandfathering arrangements in Solvency II would significantly • differ from IFRS.

• The discount rate is prescribed in Solvency II. It is likely that the Solvency II discount • rate will be used as the starting point for determining the IFRS discount rate.

Risk adjustment Prescribed 6%cost of capital

One of threemethods

• IFRS permits one of three methods, while Solvency II prescribes a 6% cost• of capital approach. More diversification benefits will be permitted in Solvency II.

Residual margin No Eliminate day-one gain

• Significant difference. The level of granularity required for the residual margin• will impact modelling and data requirements.

Acquisition costs Expensed as incurred

Contractualcash flows

• For IFRS, incremental acquisition costs are included in contractual cash flows. • Additional data and modelling required compared to Solvency II.

Short duration contracts

No difference Unearned Premium Reserve

• For IFRS, the Unearned Premium Reserve (UPR) model is mandatory for• pre-claim liabilities with an onerous contract test at the portfolio level • (by similar date of inception). There is no equivalent concept in Solvency II.



Many insurers have started to developplans for Solvency II disclosure reporting(Pillar 3) and it is sensible to integrate theIFRS requirements to the extent there issufficient certainty in the proposals. Aspart of this integration, the vision forexternal reporting from 2012 and beyondwill need to be developed.

The key disclosures to start consideringnow are:

• Capital disclosures between existingand future reporting particularly at thetransitional stage;

• Reconciliation from key Solvency IImeasures to their IFRS equivalent;

• Measures that explain how value iscreated while allowing for theassociated risk, for example, a profitand loss attribution at a granularproduct level; and

• Cash-flow measures that show howcapital turns into cash.

The IASB insurance contracts standardshould also support the concept of aneconomic balance sheet as a key reportingmeasure outside the European EconomicArea (EEA). This is important as it maynot be long before their regulatoryrequirements move closer to Solvency II.

Figure 4: Example of future state with alignment of risk and finance

Bus A

Bus B

Bus C

Finance Partnersin the Business

Bus A

Bus B

Bus C

Risk and Finance Partnersin the Business

Market Risk

Credit Risk

Underwriting Risk

Risk Governance and Policy Centres

of Excellence

Capital Strategy, Allocations and Planning

FinancialReporting

and Control

CFO CRO

CFO CRO

Risk Monitoringand Escaltion inthe Business*

Bus A

Bus B

Bus C

Tax Planningand

Compliance

Finance Data, Assumptions, Systems, and Controls –Offshored or Outsourced Shared Services

Risk Data, Assumptions, Systems, and Controls –in-House Developed Tools and Teams

* Credit, Market, Liquidity and Operational Risk

Financial Planning,Budgeting Strategy

and Analysis

InvestorRelations

Treasuryand ALM

Oversight, Policyand Model

Development

Financial andCapital Strategy,

Planning andAnalysis

Treasury andBalance SheetManagement

Oversight, Policyand Model

Development

RiskCommittees

Tax Planningand

Compliance

RiskCommittees

Risk,Reporting

and Control

External Relations

Intergrated Financial andRisk Reporting and Control

Finance and risk data assumptions, systems and controls make use of consisent data, with supporting application across finance, risk, tax and regulatory reporting and shared services

M&AChange

Management

Operational Risk/Control

Aligned future risk and finance structure

‘Typical’ current risk and finance structure



Solvency II ushers in a singlemeasurement model for all insurance andreinsurance contracts as the current costto transfer obligations immediately toanother undertaking. The liability ismeasured as the discounted probabilityweighted estimate of future cash flowsplus a risk margin. In the limited caseswhere a complete replicating portfolioexists for contracts (for example, certainguaranteed equity bonds), the liability isdefined as the value of the replicatingportfolio.

In IFRS, the measurement of the contractliability depends on the classification ofcontracts as insurance or investment.The classification depends on whethersignificant insurance risk is transferred tothe insurer. In addition, investmentcontracts with a discretionaryparticipating feature (DPF) are treated asinsurance contracts if they participate inthe same performance pool as otherinsurance contracts.

Figure 5 illustrates the comparison of theSolvency II and IFRS measurement ofcontract liabilities.

For insurance contracts in IFRS (forexample, a term assurance), the liability is

measured as the amount required to fulfilthe contractual obligations over thelifetime of the contract. This is calculatedas the discounted probability weightedestimate of the fulfilment cash flows plusa risk adjustment. As for Solvency II,where a complete replicating portfolioexists, the contract liability is defined asthe value of the replicating portfolio. Inboth cases in IFRS, there is an additionalcomponent to the liability – the residualmargin – set to eliminate any day onegains, while any losses are immediatelyrecognised. For short duration insurancecontracts (where the period of cover isapproximately one year or less (forexample, the majority of non-lifecontracts), a simplified UnearnedPremium Reserve (UPR) model isrequired for the pre-claims liability.

Investment contracts (for example, a pureunit-linked savings contract) do notcontain significant insurance risk and soare similar in nature to instruments foundin other markets and sectors. As a result,they are subject to the IFRS financialinstruments and revenue standards.The contract liability is typically measuredat fair value or amortised cost.

For insurance contracts, it will benecessary to unbundle components of thecontracts that are not ‘closely related’ tothe insurance coverage. The purpose ofunbundling is to introduce comparabilitybetween insurers and other industrieswhere similar components exist. Theinsurance contract ED does not definethe term ‘closely related’ and so this ispotentially open to interpretation.However, the ED does specifically notethat certain policyholder accountbalances (for example, the unit balanceof a unit-linked contract), embeddedderivatives, and goods and services needto be unbundled and then measuredunder the relevant IFRS standard,principally financial instruments andrevenue standards. The remainingcomponents, excluding all unbundledcash flows, follow the insurance contractstandard. The requirement to unbundlecomponents will have a significant effect

Contract liabilities


Solvency II and the IFRS insurance contracts ED establish a marketconsistent valuation for measuring insurance contract liabilities, based onthe concepts of a probability weighted estimate of future cash flows, thetime value of money and an additional risk margin or adjustment. UnlikeSolvency II, IFRS will not permit the recognition of a gain on the inceptionof an insurance contract.

on the emergence of profit due to thedifferent measurement models appliedto each component. Further, it introducessignificant technical and practicalchallenges to insurers. For example, theidentification of components not closelyrelated to the insurance coverage, theseparate reporting of unbundledcomponents under relevant standardsand the challenge of allocating acquisitionand other costs between the componentsof the contract, and more generallythrough increased complexity inprocesses and controls. There is noequivalent concept of unbundling inSolvency II.

In the remainder of this section of thepublication, we compare the technicaldifferences between Solvency II and IFRSfor the measurement of insurance andinvestment contracts. Appendices A and Bprovide a more detailed comparison.

Discount rateBoth Solvency II and IFRS for insurancecontracts require that the discount rate isdefined as a risk-free rate allowing for theinclusion of an ‘illiquidity premium’,where a higher discount rate may be usedfor more illiquid liabilities. Thisrepresents a significant departure fromcurrent practice for non-life business,where discounting is uncommon and forlife business where an asset-backeddiscount rate is used in many countries.

The selection of the discount rate,specifically the method of determiningthe risk-free interest rate and the extent ofinclusion of an illiquidity premium,continues to be an area of significantdebate across the insurance industry.The inclusion of an illiquidity premium isof fundamental importance to ‘spread’based life insurance contracts (forexample, annuities in payment) wherethe pricing of such contracts takes intoaccount the additional investment returnsthat may be obtained, from investing inassets with similar illiquid characteristicsto those of the liability.

Solvency II is more prescriptive than IFRSwith, for example, QIS5 prescribing boththe risk-free rate interest rate and theilliquidity premium to be applied to allliabilities. There is uncertainty in respectof Solvency II, as a number of technicalaspects are being road-tested throughQIS5 for the first time, includingextrapolation of the risk-free rate and thecalibration of the illiquidity premium.For many European insurers, it is likelythat the Solvency II discount rate will beused as the starting point for determiningthe IFRS discount rate.

QIS5 is also road-testing a transitionalarrangement to ‘grandfather’ the existingSolvency I asset-backed discount raterules, though it is not clear at this stagewhat businesses and over what period

such provisions would apply.Grandfathering arrangements wouldrepresent a significant divergence fromIFRS, where an asset-backed discount rateis prohibited.

Risk margin or adjustmentAlthough the concept of an adjustmentfor risk is fundamental to both Solvency IIand IFRS for insurance contracts, thecalculation methods and calibrations maydiffer as will the magnitude of theresulting adjustment:

• IFRS permits three measurementtechniques, with disclosurerequirements to provide comparability,while Solvency II permits only a costof capital approach that is highlyprescribed (for example, a cost ofcapital rate of 6% for the purposes ofQIS5); and

• Diversification benefits are currentlyset at the entity level for Solvency IIand at the portfolio level for IFRS andso are expected to be greater inSolvency II.

For QIS5, many insurers are likely toadopt simplified risk margin calculations,with plans for more sophisticatedapproaches for full Solvency IIimplementation. In developing theseplans, insurers will want to consider therequirements of IFRS.


Figure 5: Solvency II versus IFRS requirements

The relative size of the diagram is purely for illustration purposes only and could differ significantly by product line and company. A number of simplifying assumptionshave been used. Asset valuations may differ between Solvency II and IFRS resulting in differences in free assets and equity respectively. For insurance contracts, itassumes that there are no unbundling requirements and does not consider specific short duration contract treatment.


Solvency II IFRS Insurance Contracts IFRS Investment Contracts

• Risk margin = Sets the technical provisionsas the expected amount required to takeover and meet the obligations.

• Replicating portfolio methods are allowablewith constraints.

• As a regulatory regime, there are capitalrequirements.The Solvency CapitalRequirement (SCR) is calibrated to ensureadequacy to withstand a 1 in 200 event.

• Risk adjustment = Maximum amountinsurer would rationally pay to be relievedof the risk that the ultimate fulfilment cashflows exceed those expected.

• Replicating portfolio methods are allowablewith constraints.

• Residual margin is set to avoid a dayone gain.

• All financial liabilities are classified asfair value through profit and loss oramortised cost.

• Initial measurement is at fair value(which will generally equate to thetransaction price so that no initial gainarises). Subsequent measurement is at fairvalue (subject to a ‘deposit floor’) or atamortised cost depending on classification.

Free AssetsEquity Equity

Residual MarginSolvency Capital Requirement

Replicating portfolio value

Replicating portfolio value

Fair Value or Amortised Cost liability

Risk Margin Risk Adjustment

Discountedprobabilityweightedestimate of

fulfilment cashflows

Discountedprobabilityweightedestimate offuture cashflows

TechnicalProvisions

ContractLiabilities

For short duration contracts accountedfor using the UPR model, the riskadjustment is only relevant for thecalculation of the outstanding claimsliability. Further, there is no explicitconcept of risk adjustment for investmentcontracts under IFRS, although it may berelevant when determining a fair valueusing a model rather than by directobservation from the market.

Cash flowsThe cash flows included in themeasurement model for Solvency II andIFRS for insurance contracts arefundamental to actuarial modelling, themagnitude of the contract liability and theresulting profit emergence. There isexplicit guidance in Solvency II as towhich cash flows are to be included, whilein IFRS for insurance contracts, cashflows which are incremental at the levelof a portfolio of insurance contracts areincluded (the ‘fulfilment’ cash flows).Many of the cash flows will be the same inthe two models, for example, regularpremiums and benefits. However, thereare a number of potential differences thatinsurers should consider. Overheadexpenses that can be allocated on aneconomic basis are included in Solvency II,while in IFRS, general overheads areexcluded. The treatment of ‘policyholder’tax cash flows in IFRS follows therequirements of the relevant accountingstandard (IAS 12 – Income Taxes), whichmay be different to an economicinterpretation in Solvency II. The taxregimes across the EEA vary significantly,so insurers will need to consider eachterritory separately. Further, there aresome cash-flow items in IFRS whichare open to potentially significantjudgement – for example, cash flowsarising from ‘abnormal’ amounts ofwasted labour or ‘abnormal’ amounts ofother resources used to fulfil the contractare excluded.

Acquisition expenses For insurance contracts in IFRS, directlyincremental acquisition expensesidentified at the individual contract levelare implicitly deferred as a reduction tothe liability (as opposed to being explicitlydeferred as an asset). This is achieved byincluding such expenses as a contractualcash flow and so reducing the initialmeasurement of the residual margin. Theresulting smaller residual margin issubsequently amortised in the incomestatement over the period of insurancecoverage. The definition of acquisitionexpenses, though similar to that currentlyadopted for investment contracts in IFRS,is narrower than in many existinginsurance accounting frameworks.Insurers that perform direct marketing orhave a salaried in-house sales force arelikely to have lower acquisition costs,which are considered incremental to aspecific insurance contract, compared tothose that use external agents. As a result,they will have a larger residual margin fora contract that is recognised over thecoverage period and will expense most oftheir acquisition costs immediately givingrise to an initial loss.

For investment contracts in IFRS, the‘Revenue from Contracts with CustomersED’ requires that all acquisition costs areexpensed to the income statement whenincurred. This represents a major changefrom current accounting and will result insignificantly increased day-one lossesfrom writing such new business.Moreover, it is proposed that all deferredacquisition cost (DAC) assets on thebalance sheet relating to such existingbusiness are eliminated to shareholderequity on transition to the new standard.

The economic-based Solvency II regimetakes a prospective view on risk – there isno concept of deferring revenue or costsover the life of the contract.

Participating businessThe basic definition of a participatingfeature is the same in Solvency II andIFRS. Under IFRS, participating contractswithin the scope of the insurancestandard contain either significantinsurance risk or are investment contractsthat participate in the same performancepool as other insurance contracts.

In Solvency II and IFRS for insurancecontracts, the treatment of participatingcontracts is similar with the exception ofthe residual margin. All cash flows arisingfrom the participating feature areincluded in the same way as any othercontractual cash flows, that is, on anexpected present value basis with a riskadjustment.

The requirements regarding the ‘contractboundary’ discussed below wouldpreclude any cash flows expected tobecome payable to future policyholdersfrom the measurement of the contractualliability. Some might argue, however, thatif investment returns earned on assetsbacking existing contracts are expected tobe paid to future policyholders then thosecash flows could be considered to arisefrom the existing contracts. In particular,the insurance contracts ED makes explicitreference to including cash flows relatingto future policyholders within the


The economic-basedSolvency II regimetakes a prospectiveview on risk – there isno concept of deferringrevenue or costs overthe life of the contract.

measurement of the contract. However, itis unclear how the ‘estate’ within aproprietary or mutual entity will beallocated between equity and the contractliability. While there is no equivalentreference to future policyholders in thedraft Solvency II guidance, this is an areawhere further clarification of theproposed treatment is needed under bothSolvency II and IFRS.

For participating investment contracts notwithin the scope of the IFRS insurancecontracts standard, the financialinstruments standards will apply. Thiswill require careful application as up untilnow participating features have not beenconsidered in the context of thesestandards. In particular, companies willneed to:

• Identify the liability and equity part ofthe instrument (under IAS 32) andconsider the accounting treatment ofany equity elements, which may causeaccounting mismatches in the incomestatement;

• Decide whether a fair value oramortised cost approach is adopted tomeasure the liability; and

• Consider the treatment of anyembedded derivatives and themeasurement of assets backing theliability to avoid accountingmismatches.

The treatment of participating investmentcontracts under IFRS therefore has thepotential to be at odds with Solvency II.

Contract boundaryThe contract boundary distinguishesbetween future cash flows on existingcontracts and those that relate to futurecontracts. Within the boundary period,both contractual premiums and benefitsarising from policyholder options toamend, renew or extend their policy aretaken into account on a probabilityweighted basis. QIS5 sets the boundary asthe point where the insurer canunilaterally terminate the contract, refuseto accept a premium or amend thebenefits or premiums without limit. Any

premiums received after that date do notbelong to the existing contract and shouldtherefore be excluded. For insurancecontracts, excluding participatinginvestment contracts that participate inthe same performance pool as otherinsurance contracts, IFRS sets theboundary as the point where the insureris no longer required to provide coverageor has the right or practical ability toreassess the risk of the particularpolicyholder and, as a result, can set aprice that fully reflects that risk.

There has been recent market comment,primarily due to the practical examples inthe Annex to the QIS5 technicalspecifications that these two definitionscould diverge in practice. A differenceobserved is whether the ability to repricecontracts at the portfolio level is theboundary in Solvency II compared to thecontract level in IFRS. Insurers will needto look closely at the two definitionsacross their full range of insurancecontracts.

Transitional arrangementsUnder IFRS (for both insurance andinvestment contracts) and underSolvency II, there is retrospectiveapplication of the new requirements.Crucially, the measurement approachfor existing insurance contracts in IFRSexcludes a residual margin at the point oftransition. The changes in measurementfor insurance contracts arising ontransition to the new IFRS will berecognised in shareholder equity and notin the income statement. As a result, theremay be a negative impact on futureearnings compared to existing accountingframeworks for insurance contractsunder IFRS.

Profit recognition In Solvency II, the measurement based onfuture cash flows with an allowance forrisk is in some respects similar to theprofit emergence observed in currentMCEV reporting; in particular, under bothSolvency II and MCEV, gains can berecognised on the inception of insurancecontracts. This contrasts with the positionunder IFRS for both insurance and

investment contracts, where all day-onegains are eliminated, while losses areimmediately recognised.

For insurance contracts in IFRS, theelimination of a day-one gain is throughthe residual margin, which issubsequently released over the coverageperiod, either on the basis of passage oftime or on the basis of expected claims orassets under management (depending onthe product). All changes in subsequentestimates (financial and non-financial)are recognised as incurred.

For non-participating investmentcontracts in IFRS, a day-one loss is likely,as acquisition costs would no longer bedeferred under the Revenue RecognitionED. Subsequently, deferred upfront feesare earned, either over the expected termof the contract or as the services areprovided. Regular fees, for example,administration and fund-related fees, arerecognised as the services are provided.

There is little precedent in accountingunder IFRS for participating investmentcontracts not within the scope of theinsurance contracts standard (as suchcontracts currently fall within the scope ofIFRS 4). In addition, the terms of suchcontracts tend to vary from country tocountry. The accounting treatment thatwill be applicable to such contracts,including the pattern of profitrecognition, is therefore likely to dependon the specific contractual terms and theoutcome of the IASB’s current ‘financialinstruments with characteristics ofequity’ project.


A difference observed is whether the ability to repricecontracts at the portfolio level is the boundary in SolvencyII compared to the contract level in IFRS. Insurers willneed to look closely at the two definitions across their fullrange of insurance contracts.

Solvency II requires assets and liabilitiesto be valued on a basis that reflects theirfair value (described as an ‘economicvaluation’), with the exception thatliabilities should not be adjusted to takeaccount of an insurer’s own creditstanding. Many IFRS standards are alsobased on the fair value measurementprinciple, which means that a significantdegree of convergence will exist.However, some adjustment will berequired for those standards not based onthe fair value concept or where differentoptions are permitted.

The Solvency II valuation requirements,based on the most recent iteration inQIS5, give clear guidance on where IFRSis not considered to provide a suitableeconomic valuation for use underSolvency II, so the differences betweenSolvency II and IFRS are likelyto be relatively clear. These differencesare explained in detail in Appendix C,and the most significant of which arehighlighted below.

The development of further new andrevised IFRS standards will introducechanges to the valuation adjustmentsfrom those that insurers will applyfor QIS5.

Financial assetsUnder IAS 39 and its proposedreplacement IFRS 9, financial assets arevalued either at amortised cost or atfair value. Valuation at fair value underIFRS is considered to provide a reasonableproxy for economic value underSolvency II. However, where financialassets are valued at amortised cost foraccounting purposes, insurers will need toconvert them to fair value for Solvency II.

The insurance contract ED contains anoption on implementation to redesignatea financial asset to fair value fromamortised cost, but not vice versa.The restriction over the redesignation toamortised cost could result in accountingmismatches, given unbundlingrequirements and changes in the scopeof contracts included in the financialinstruments standard. However, IFRS 9allows assets to be redesignated into, andfrom, fair value through profit or loss ontransition, so insurers may resolve suchdifficulties if the standards are adoptedsimultaneously.

Financial liabilitiesUnder both current IFRS and theproposals to be incorporated into IFRS 9,financial liabilities are valued initially atfair value and, subsequently, at either fairvalue or amortised cost. Where financialliabilities are included at fair value, thisvaluation will reflect the credit risk of theliability and therefore take account ofthe insurer's own credit standing.

Solvency II requires that financialliabilities should be valued in conformitywith IFRS upon initial recognition.No subsequent adjustments are made totake account of the change in own creditstanding; however, adjustments forchanges in the risk-free rate have to beaccounted for.

Assets and otherliabilities


The valuation of assets and other liabilities under Solvency II is, wherepossible, intended to be consistent with IFRS as endorsed by the EuropeanUnion. It is therefore likely that there will be significant overlap betweenthe two approaches, although there will be some measurement differenceswhere IFRS is not considered to provide a suitable economic valuation.

Participations(subsidiaries, associates,joint ventures and specialpurpose vehicles)Under IFRS, from the perspective of theinvestor’s entity accounts, investments inparticipations are valued, either at cost orat fair value. In QIS5, participations areclassified into three classes for valuation:

• Listed companies should be valuedusing quoted market prices in activemarkets;

• Unlisted subsidiaries should be valuedon an ‘adjusted equity method’ (beingthe parent’s share of the excess of theassets over the liabilities of thesubsidiary valued in accordance withSolvency II valuation principles); and

• All other undertakings (notsubsidiaries) should wherever possibleuse an adjusted equity method with anoption to mark to model if the adjustedequity method is not possible.

However, notwithstanding the above,if an insurer invests in a ‘financialinstitution’, defined as either a bank oran investment firm, the participationmust effectively be valued at nil forsolvency purposes.

Property plant andequipmentSolvency II proposes that property(excluding investment property), plantand equipment should be at fair valuewhere these items are not otherwisemeasured at economic value. For thispurpose the revaluation model in IFRS isconsidered as a reasonable proxy for fairvalue. This model requires that valuationsshall be made ‘with sufficient regularity toensure that the carrying amount does notdiffer materially from that which wouldbe determined using fair value’. SolvencyII specifies that external valuations ofproperty shall be undertaken at leastevery three years (and more frequentlywhere significant changes occur in thereal estate market).

IFRS also allows an alternative methodof valuing property, plant and equipmentat cost less depreciation. This method ismore commonly used by insurers inpractice and the shift to economicvaluation in Solvency II is likely to be achange for most.

Goodwill and intangiblesIFRS allows goodwill to be recognisedas a specific asset when an acquisitiontakes place and there is a positivedifference between the purchaseconsideration paid and the fair value ofthe net assets acquired. Solvency IIproposes that no value be ascribed toacquired goodwill, given that goodwill isnot considered to be an identifiable andseparable asset in the marketplace.

Solvency II proposes that intangible assetsare assigned a value, only where theymay be fair valued under IFRS. Onlythose intangible assets that are traded inan active market are permitted to beaccounted for at fair value under IFRS.It is unlikely, in practice, that manyintangible assets of insurers will be tradedin active markets and so assigneda value under Solvency II.


Many IFRS standards are based on the fair valuemeasurement principle, which means that a significantdegree of convergence with Solvency II will exist. However,adjustments will be required where the fair value concept isnot required or where different options are permitted in IFRS.

Solvency II will introduce extensivedisclosure requirements in the form of anannual public Solvency FinancialCondition Report (SFCR), a privateReport to Supervisors (RTS) (required infull periodically with changes reported insubsequent years) together with quarterlyquantitative reporting. The SFCR and RTSinclude qualitative information coveringthe areas of: business and performance,system of governance, risk profile,regulatory balance sheet, capitalmanagement and information on theinternal model if applicable. The SFCRand RTS must also include an Annexcontaining detailed and granularquantitative information disclosed onprescribed templates, which also form thebasis of the quarterly quantitativereporting.

In addition to quantitative financialreporting, IFRS currently requiresextensive risk management and capitaldisclosures within the annual financialstatements – these will develop furtherunder the proposed new IFRS standards.In some countries, insurers are alsorequired by law to include qualitativeinformation in their annual report beyondthat required by IFRS, for examplenarrative commentary on theperformance of the business.

There are clear opportunities forsynergies between the various disclosuresmade in the IFRS financial statementsand those made under Solvency II. Forexample, there is significant alignmentbetween IFRS risk and capital disclosures,the risk profile and capital managementsections of the SFCR and RTS, and it islikely that the information disclosed inthe business-focused sections of theannual report could be leveraged for thebusiness and performance section of theSFCR and RTS.

However, Solvency II will also requireinsurers to disclose a significant amountof information that goes beyond theannual financial statements. Thequantitative disclosures proposed underSolvency II are significantly more detailedand are at a much more granular levelthan the current regulatory reporting inmost countries and those reported underIFRS. Solvency II quantitative disclosuresare also based on the ‘Solvency II balancesheet’ used to calculate own funds – this isnot in keeping with IFRS valuations in allrespects, as we outline in this publication,and so will introduce valuationdifferences that insurers will need toexplain in their Solvency II reporting.

Some of the qualitative informationproposed in the SFCR and RTS is alsosignificantly in excess of that included inthe annual financial statements under therequirements of IFRS and otherlegislation. For example the informationrequired in respect of the insurer’sbusiness and external environment,which includes the main trends andfactors that have contributed to thedevelopment, performance and positionof the insurer over the year; and in respectof the insurer’s system of governance,which includes a description of theadequacy of the system of governance,a statement of its adequacy and anoverview of any material changes thathave taken place in the governancestructure during the year.

The disclosure requirements underSolvency II are subject to the Level 2implementing measures to be adopted bythe European Commission and the Level 3guidance and binding technical standardsdue to be published by EuropeanInsurance & Occupational PensionsAuthority (EIOPA) in 2011. The IFRSdisclosure requirements proposed in theinsurance contracts ED may be subject tochange in the final standard. The mostsignificant challenges for insurersdeveloping their reporting will be toensure that both sets of disclosuresconvey consistent messages to the market,regulators and rating agencies, and thatthey communicate their value generatingactivities effectively and consistently,while making the most of opportunitiesfor synergies and efficiency in producingthe various disclosures.

For more information on how to tacklethe reporting logistics in Solvency IIplease see the PwC publication: ‘Up tospeed with reporting’.

Both Solvency II and IFRS have complex and extensive requirements forexternal reporting and disclosure. While there are clear synergies in someareas, including risk and capital reporting, insurers will have to generate asignificant volume of information to meet both sets of requirements.

Disclosures


The differences are explained in detail inAppendix D and the most significant areexplained below.

Solvency II is concerned with thesupervision of insurance groups only.For the group reporting requirements ofSolvency II to apply, therefore, the groupmust contain at least one insurancecompany that must either hold aparticipation in another insurancecompany or must be owned by aninsurance holding company. Once a grouphas been established, the scope is alsolimited to the participations held by thehighest insurer or insurance holdingcompany in the group, which may not bethe highest entity in the group. Incontrast, IFRS requires consolidatedgroup reporting to be prepared coveringthe entire group, regardless of activities.

The basis of determination of entitieswithin the group is similar underSolvency II and under IFRS. Bothframeworks have consistent definitionsof subsidiaries, which must be included inthe group reporting, and the definitionof an associate under IFRS is similar to thedefinition of a ‘participation’ underSolvency II. However, Solvency II also

gives a group’s supervisor the power torequire the inclusion of any other entitywhich would not otherwise be includedwithin the scope of group supervision.To the extent to which it is used inpractice this power may introducedifferences between the entities includedin the group for IFRS and Solvency IIpurposes.

Both Solvency II and IFRS require groupreporting at the level of the top companyin the group (albeit these may be differentas described above). However, where theultimate insurance parent of the group isoutside the EEA, Solvency II also requiresgroup reporting at the level of the top EEAinsurance holding company. In addition,national supervisors may, where theydeem it necessary, also require groupreporting at EEA subgroup level.

IFRS requires a single approach toconsolidation, which involves combiningall the results of the companies in thegroup on an individual line item basis,then applying consolidation adjustments,for example to eliminate inconsistenciesin accounting policies and intra-grouptransactions. The default approachunder Solvency II is the ‘accountingconsolidation-based method’, which takesthe consolidated accounts as a startingpoint, which will provide synergies wherea group is required to prepare IFRSconsolidated accounts at the same level asthe Solvency II group calculation isperformed. Solvency II also describes analternative ‘deduction and aggregation’method to be used at the discretion of thegroup supervisor, which calculates groupresults as the aggregation of theindividual results of the entities in thegroup prepared on a Solvency II orequivalent basis. Both of the methods arebased on a single set of principles,including Solvency II valuation principlesand the elimination of intra-groupcreations of capital.

Under both Solvency II and IFRS, groupreporting will include the prescribedqualitative and quantitative disclosures asexplained in the Disclosures section ofthis publication.

Group reporting


Both Solvency II and IFRS require reporting at group as well as at the entitylevel. For Solvency II, group reporting allows the insurer to make anassessment of its group capital position, and under IFRS consolidatedaccounts are prepared to present a single picture of the results of the group.Reflecting these different purposes, the scope, level and method ofconsolidation differs between IFRS and Solvency II, and the resultsprepared for each purpose may therefore be significantly different.


Appendices


Solvency II IFRS

Relevant standards

• QIS5 technical specification

• Solvency II Level 1 Directive.

• Insurance Contracts ED.

Scope

• Solvency II applies to all insurance and reinsurance contractswritten by the issuer in the EEA or branches of EEA-basedinsurers outside the EEA. There is no distinction betweeninsurance and investment contracts.

• There are scope exclusions for certain undertakings by virtue oftheir size, legal status nature or specific services they offer.

• IFRS for insurance contracts applies to all contracts which:

– Transfer significant insurance risk, except for those explicitlyexempted such as certain product warranties and fixed-feeservice contracts that have as their primary purpose theprovision of services; or

– Do not transfer significant insurance risk, but have aparticipating feature and participate in the same performancepool as other insurance contracts.

• There is no requirement for such contracts to be written by aninsurance or reinsurance undertaking.

• Certain policyholder account balances, embedded derivativesand certain goods and services contained in insurancecontracts are unbundled and measured under the alternativeIFRS standards, principally financial liabilities (IAS 39/IFRS 9) orrevenue (IAS 18/Revenue from Contracts with Customers ED).The requirement to unbundle other components outside ofthese three examples is not fully clear. There is no directlyequivalent concept of unbundling and alternativemeasurement under Solvency II.

• The consequences of unbundling in IFRS may in somecircumstances result in a significant difference to Solvency II,as the treatment of investment contracts and revenue differbetween the two frameworks. Conversely, in othercircumstances, the differences may be less, for example, a unitbalance. The requirement to unbundle, will introducesignificant technical and practical challenges to insurers.For example, the identification of components not closelyrelated to the insurance coverage, the separate reportingof unbundled components under relevant standards andthe challenge of allocating acquisition and other costsbetween the contract’s components, and more generallythrough increased complexity in processes and controls.

Non-life insurance and other short duration contracts

• The fundamental building blocks of the probability weightedaverage of future cash flows, discounting and the risk marginapply as discussed in the subsequent sections.

• For non-life insurance obligations, the best estimate for claimsoutstanding and premium provisions is carried out separately.

• The claims provisions relate to claim events having occurredbefore, or at, the valuation date (including incurred but notreported) and associated expenses.

• For premium provisions, the cash-flow projections relate toclaims events occurring after the valuation date and during theremaining in-force period of the contract. Cash flows includefuture claim payments in relation to claims that occur after thevaluation date (that is unexpired risks), future premiums andassociated expenses. As cash inflows could exceed the cashoutflows, the premium provision can be negative and henceexpected future profit is recognised at day one.

• In IFRS, a modified measurement model applies to shortduration contracts where the period of cover is approximatelyone year or less and where there are no embedded derivativessignificantly affecting the variability of cash flows. This isexpected to relate to the majority of non-life contracts andshort-term life contracts.

• Post-claims liabilities are measured, similarly to Solvency II andother insurance contracts in IFRS, as the discounted probabilityweighted future cash flows (with a risk adjustment) related toclaim events having occurred before, or at the point ofvaluation. This is discussed further, in the subsequent sections.

Appendix A: Insurance contracts

Appendix A


Solvency II IFRS

Non-life insurance and other short duration contracts continued

• A risk margin is required for both the premium and claimsprovisions.

• For pre-claims liabilities, a simplified approach is mandatedrather than the full model for other insurance contracts.The simplified approach is the UPR, including implicit spreadingof incremental acquisition costs as these reduce the initialpremium. The premium is assumed to be earned evenly overthe contract period or based on the expected incurred claimsand benefits, if that pattern differs significantly (for example aportfolio with a high level of US hurricane exposure). Interestis credited on the carrying amount of pre-claims liability. Thereis no day one profit which differs from the Solvency IItreatment of premium provision.

• If the insurance contract, at a portfolio level with a similarinception date, is onerous an additional liability is set, similar tothe current Additional Unexpired Risk Reserve concept.

Future cash flows

Probability weighted future cash flows

• Under Solvency II, the best estimate corresponds to the‘probability weighted average of future cash flows takingaccount of the time value of money’. This requires all futurescenarios to be considered, which in some circumstances maynecessitate the use of stochastic methods, for example whenvaluing the future discretionary benefits of participatingcontracts or other contracts with embedded options andguarantees. Conversely, for non-life liabilities and for other lifeinsurance liabilities, the use of stochastic techniques may notbe necessary and deterministic or analytical techniques may bemore appropriate. For example, in respect of the valuation ofnon-life liabilities, deterministic methods (for example chain-ladder methods) are common, reflecting the nature of suchliabilities and the availability of data.

• The calculations are on a policy-by-policy basis though, forpractical reasons, grouping and approximations are likely tooccur where these can be demonstrated as being materiallythe same.

• There is no deposit floor and negative liabilities are permitted.

• There is a minimum level of segmentation required whencalculating the technical provisions and contracts containinglife and non-life features are required to be split.

Probability weighted future cash flows

• Under IFRS, this represents an explicit, unbiased andprobability weighted estimate of the future cash outflows lessthe future cash inflows that will arise as the insurer fulfils thecontracts. The considerations regarding the valuationtechniques to be used are likely to be similar to Solvency II.However, IFRS provides less explicit guidance on the techniqueto be applied than Solvency II.

• The considerations over grouping and approximations applyequally under IFRS.

• A negative liability (i.e. gain) is not permitted at inceptionand would be eliminated by the residual margin.

• A minimum level of segmentation is defined by the requirementto determine the residual margin at a portfolio level (where aportfolio is defined as a contract subject to broadly similar risksand managed together as a single pool), and within a portfolioby similar date of inception and similar coverage period.

Contract boundary

• The contract boundary sets the point at which obligations canbe recognised on existing business. Within the boundaryperiod, both contractual premiums and benefits arising frompolicyholder options to review or extend their policy are takeninto account on a best estimate basis. The boundary is set asthe point where the insurer can unilaterally terminate thecontract, refuse to accept a premium; or amend the benefit orpremium without limit.

Contract boundary

• The boundary is at the point where the insurer is no longerrequired to provide coverage, or has right or practical ability toreassess the risk of the particular policyholder and, as a result,can set a price that fully reflects that risk.

• There has been recent market comment, primarily due tothe practical examples in the Annex to the QIS5 technicalspecifications that these two definitions could diverge inpractice. The difference observed is whether the ability toreprice contracts at the portfolio level is the boundary inSolvency II compared to the contract level in IFRS. Insurerwill need to look closely at the two definitions across their fullrange of insurance contracts.

Appendix A: Insurance contracts continued


Solvency II IFRS

Future cash flows continued

Recognition and derecognition

• A contract is initially recognised at the point when the insurer orreinsurer is party to the contract and at the latest when thecover begins. A contract is derecognised when the obligationsare discharged, cancelled or expired.

Recognition and derecognition

• The requirements regarding recognising and derecognisingcontracts are similar to Solvency II. In both cases, there is arequirement to recognise contracts that have not commenced,but the insurer is bound to issue or accept them at aconstrained prices. Whether an insurer is bound by aninsurance contract will depend on the legal requirements in theterritory in which it operates.

Assumptions underlying the best estimate

• For economic assumptions, a market consistent approach isrequired. There is guidance as to what constitutes deep, liquidand transparent financial market data to be used unadjusted inthe valuation and where data does not have thesecharacteristics, how the data should be treated. This isimportant where insurance liabilities are longer dated thanavailable market data and extrapolation is required, such as inrespect of economic assumptions for the risk-free rate andequity implied volatilities.

• For non-economic assumptions, an entity specific approach isrequired, but with reference to external data sources where thisis relevant.

• The interaction between economic and non-economic variable(for example persistency dependent on economic conditions),management actions and policyholder behaviour are requiredto be included.

Assumptions underlying the best estimate

• The approach to economic variables in IFRS is similar toSolvency II. In particular, IFRS specifically states that suchvariables ‘shall be consistent with observable market pricesat the end of the reporting period’. There is less practicalguidance in IFRS than Solvency II, and therefore thepotential for a wider range of interpretations. However,insurers would have to consider how to justify differentinterpretations where the two frameworks are similarin principle.

• Similar to Solvency II an entity specific approach is required fornon-economic assumptions.

• Similar to Solvency II, management actions and policyholderbehaviour are required to be included in the expected cashflows.

Scope of cash flows

• There is explicit guidance over which premiums, benefits,expenses and tax cash flows should be incorporated.

• The cash flows are on a going concern basis and there is noallowance for the risk of non-performance by the insurer (owncredit risk).

Scope of cash flows

• All cash flows that are incremental at the level of a portfolio ofinsurance contracts are included and no other. There areexplicit details of which cash flows are and are not in scope.

• Consistent with Solvency II, the cash flows are on a goingconcern basis and there is no allowance for own credit risk.

• Many of the cash flows are the same, for example, regularpremiums, benefits, etc. However, there are potentialdifferences relating to expense and taxation cash flows asillustrated below.

Expense cash flows

• All expenses that will be incurred in servicing all obligationsover the lifetime of the contracts including both overheadexpenses and expenses that are directly assignable toindividual claims, policies or transactions (for exampleadministration, investment management, claims management,claims handling and acquisition expenses includingcommission expected to be incurred in the future) are included.

• Overhead expenses include general management and servicedepartment costs that are not directly involved in policymaintenance or new business and are insensitive to volumes(new business and in-force).

• Future expected cost increases are included. Expected costreductions can be included provided they are realistic, objectiveand based on verifiable data and information.

Expense cash flows

• All expenses incremental at the level of a portfolio of insurancecontracts are included. Examples of such expenses are claimshandling costs, policy administration and maintenance(including recurring commission) costs, and costs incurred inproviding contractual benefits in kind. Some costs such assalaries will cover more than one portfolio, but directly relate toinsurance contracts or contract activities. Such costs areallocated to portfolios on a rational and consistent basis.

• Costs that do not relate directly to the contract or contractactivities, such as general overheads are excluded.

• Cash flows arising from abnormal amounts of wasted labour orabnormal amounts of other resources used to fulfil the contractare excluded.



Solvency II IFRS

Future cash flows continued

• Incremental acquisition expenses identified at the individualcontract level (not portfolio level) are included, i.e. only thosecosts that would not have been incurred if the sale had nottaken place.

• The scope of expense cash flows is different to Solvency II,specifically acquisition expenses and general overheadexpenses.

Investment return cash flows

• Investment return cash flows are not taken into account unlessthe liability to the policyholder depends on the cash flows, forexample participating and certain unit-linked contracts.

• When investment return cash flows are required, then a marketconsistent approach is followed. Commonly, the selection ofthe investment return in a stochastic calculation is the risk-freerate (‘risk neutral’ projection) or an expected asset growthrate (‘real world’/‘deflator’ projection). The selection of theinvestment return is linked to the discount rate to ensurea market consistent approach.

Investment return cash flows

• Consistent with Solvency II, investment return cash flows arenot included when the policyholder benefits do not dependon them.

• When investment return cash flows are required, IFRS refersto reflecting this dependency in the measurement of thecontracts, and that replicating portfolio techniques may be anappropriate method to capture this linkage. There is noexplicit reference to commonly used market consistentstochastic techniques as in Solvency II. Further, Solvency IIexplicitly recognises limitations of replicating portfolios forinsurance risk. However, as IFRS does refer to the use ofobservable market prices at the reporting date in settingeconomic assumptions it maybe that Solvency IItechniques are applied.

• The use of replicating portfolios is considered further in asubsequent section.

Tax cash flows

• Only tax payments that are charged to policyholders, or thatwould be required to be made by the undertaking to settle theobligations are included. All other tax payments are includedelsewhere on the balance sheet.

• Transaction based taxes and levies are included.

• Where changes to tax requirements are substantially enacted,the change is reflected in the best estimate.

Tax cash flows

• Income tax payments and receipts are recognised andmeasured under IAS 12. In some territories policyholderbenefits are dependent on future net of tax investment returnsand the proposals will not permit these future tax flows to bereflected in the measurement of the liability if they meet thedefinition of an income tax under IAS 12. This is expected tobe different to Solvency II.

• As for Solvency II, transaction-based taxes and levies areincluded.

• Under IFRS, specifically IAS 12, there is a comparable conceptof ‘substantively’ enacted.


Discount rate

• The discount rate is defined as the current risk-free interest rateterm structure for each currency. The risk-free rate is defined asthe swap curve less a deduction for credit default risk (c10bps)plus an illiquidity premium depending on the characteristics ofthe liability. Most discount rate curves are specified (over 30 inQIS5) including the extrapolation from the last liquid observabledata point. It is expected that the discount rate curve for eachmajor currency will be specified when Solvency II becomeseffective.

• All contracts can allow for some illiquidity premium. Theilliquidity premium is set at 100%, 75% or 50% of the currentmarket illiquidity premium. Contracts where the onlyunderwriting risk is longevity and expense and there are noincoming cash flows, apply 100%. Participating contracts notfulfilling the previous criteria can apply 75%. All other contractsapply 50%. The assessment is performed at the contract level.

• The discount rate is defined to be consistent with the currentmarket prices for instruments, which reflect the characteristicsof the liability (timing, currency and liquidity).

• For contracts where the liability does not depend on theperformance of specific assets (for example general insurance,conventional non-profit life and savings products), the discountrate would be represented as a risk-free yield curve with anadjustment for an illiquidity premium. There is no furtherguidance on the calibration of the discount rate, thoughthe overall framework is consistent with Solvency II. Thechallenge for insurers will be to determine when it isappropriate to apply an adjustment for illiquidity and byhow much. As a result, this is an area where Solvency IIand IFRS may differ.


Solvency II IFRS

Discount rate continued

• Illiquidity premium is added to the credit adjusted spot swapcurve up to the point where the curve enters extrapolation.

• QIS5 is road-testing a transitional provision whereby discountrates based on the yield on the backing assets (minus aprudent margin) may continue to be used for those liabilitieswhere such an approach has been followed under theConsolidated Life Directive.

• For contracts where the liability does depend on theperformance of specific assets (e.g. participating and unit-linked products) then the valuation should reflect thedependence. The approach to be followed is not fully clear,however, it may be that market consistent stochastic assetmodelling techniques, as for Solvency II, are applied.

• There are no transitional provisions in respect of the discountrate under IFRS. The use of an asset-backed rate for aperiod of time under Solvency II would represent asignificant difference between frameworks.

Risk margin/adjustment

• Risk margin is calibrated to ensure that the technical provisionsare equivalent to the expected amount required by anotherinsurer to take over and meet the obligations. No risk margin isrequired where the technical provision has been determined asa whole using replicating portfolios. The use of replicatingportfolios is considered further in a subsequent section.

• The methodology and calibration of the risk margin isprescribed under Solvency II. A cost–of-capital approach isrequired with a cost-of-capital rate of 6% specified for thepurposes of QIS5.

• The capital requirement is designed to cover a confidence levelof 99.5% over a 1-year time horizon and captures underwritingrisk, unavoidable market risk (assumed to be zero for all butlong-time life obligations), operational risk and credit risk withrespect to reinsurance contracts and special purpose vehicles.The capital requirement is measured by applying a series ofprescribed stresses (the standard formula) or an insurers’designed internal model. A pure liquid discount rate is used.

• Level of diversification is at the entity level between linesof business.

• There is a specific prohibition of taking into account theloss-absorbing capacity of deferred tax in the calculation.

• The risk margin is a current measure, which is revised eachperiod and run off in line with the risk exposure. A single net ofreinsurance risk margin is determined.

• The risk adjustment is calibrated as the maximum amount theinsurer would rationally pay to be relieved of the risk that theultimate fulfilment cash flows exceed those expected.Consistent with Solvency II, no risk adjustment is required forthe components valued using a replicating portfolio approach.The use of replicating portfolios is considered further in asubsequent section.

• There is no single prescribed technique for calculating the riskadjustment. There are three permitted techniques: confidencelevel, conditional tail expectation and cost of capital. There is arequirement to disclose the confidence level to which the riskmargin corresponds, even if an alternative method is adopted.There is no detailed calibration of the confidence level forthe capital amount or the cost of capital rate when applyingthe cost of capital approach. Additionally, unlike Solvency II,there is no explicit prohibition on taking into account the loss-absorbing capacity of deferred tax.

• For the cost of capital approach, the capital amount is set at asufficiently high level that it captures almost the entire tail of thedistribution. It is intended to provide a high degree of certaintythat an insurer can fulfil its obligations. The cost rate is set toreflect the risks that are relevant to the liability. There is theoption to set different confidence levels and costs fordifferent types of contracts.

• The risk adjustment reflects all risks associated with theinsurance contract. The range of risks in scope is narrowerthan under Solvency II. There is no risk adjustment associatedwith reinsurer default (non-performance of the reinsurer),investment risk (except where it affects the amount topolicyholders such as on participating business) and generaloperational risk relating to future transactions.

• The risk adjustment is calculated at the level of a portfolio ofcontracts resulting in less diversification benefit than inSolvency II.

• The risk adjustment is a current measure, as for Solvency II,which is revised each period and runs off in line with the riskexposure. Unlike Solvency II, a separate risk adjustment isrequired for the gross of reinsurance and reinsurance cashflows.



Solvency II IFRS

Residual margin

• No concept of a residual margin. • The residual margin is calibrated at inception to an amountthat avoids recognising a gain when an insurer enters into theinsurance contract. A loss at inception is immediatelyrecognised.

• The residual margin is calculated within a portfolio by similardate of inception and by similar period of coverage. The levelof granularity in the residual margin will need to bemanaged from a data perspective.

• The residual margin is recognised over the coverage periodin a systematic way that reflects the exposure from providinginsurance coverage. This is on the basis of passage of time oron the basis of the timing of expected claims and benefits (orfair value of assets under management for certain participatingbusiness), if this pattern differs significantly from the basis ofpassage of time.

• There is no adjustment for changes in estimates of bothfinancial variables (such as discount rates and equity prices)and other estimates (such as expenses and lapses).All variances flow directly through to profit or loss.

Participating business

• A Discretionary Participating Feature is a contractual right toreceive additional benefits:

– Whose amount or timing is contractually at the discretion ofthe insurer; and

– Which are contractually based on: (i) the performance of aspecified pool of contracts or a specified type of contract ora single contract; (ii) realised or unrealised investment returnson a specified pool of assets held by the insurer; or (iii) theprofit or loss of the insurer or fund that issued the contract.

• There is no distinction between the treatment of contracts withparticipating features and those without. The best estimateincludes all future discretionary benefit cash flows, exceptthose relating to surplus funds where this has been authorisedunder national law. The only countries where significantamounts of surplus funds were identified at the QIS4 stagewere Germany, Denmark and Sweden. Management actionsand policyholder behaviour are included in the assessment.

• The basic definition of a participating feature is the same asSolvency II. The treatment of a participating contract underIFRS depends on whether the contract falls within the scope ofthe insurance contracts standard. Participating contracts areclassified within the scope of the insurance contracts standardif either they transfer significant insurance risk or they areinvestment contracts which participate in the sameperformance pool as insurance contracts.

• For participating contracts in the scope of the insurancestandard, the measurement model is the same as for otherinsurance contracts. All payments arising from the participatingfeature are included in the same way as any other contractualcash flows, that is on an expected present value basis includingmanagement actions and policyholder behaviour. There is noconcept of surplus funds in IFRS.

• The requirements regarding the ‘contract boundary’ discussedbelow would preclude any cash flows expected to becomepayable to future policyholders from the measurement of thecontractual liability. Some might argue, however, that ifinvestment returns earned on assets backing existing contractsare expected to be paid to future policyholders then those cashflows could be considered to arise from the existing contracts.In particular, the insurance contracts ED makes explicitreference to including cash flows relating to future policyholderswithin the measurement of the contract. However, it is unclearhow the ‘estate’ within a proprietary or mutual entity will beallocated between equity and the contract liability. While thereis no equivalent reference to future policyholders in the draftSolvency II guidance, this is an area where further clarificationof the proposed treatment is needed under both Solvency IIand IFRS.



Solvency II IFRS

Participating business Continued

• The boundary of a participating contract depends whether ittransfers significant insurance risk or whether there is justpooling with other insurance contracts:

– Where there is significant insurance risk, the boundary is asfor other insurance contacts discussed previously.

– Where there is pooling with other insurance contracts and nosignificant insurance risk transfer, the boundary of thecontract is the point where the policyholder no longer has acontractual right to receive the participating benefits.

In Solvency II, there is no distinction in the contract boundarybetween participating and non-participating contracts.

Replicating portfolios

• Where a replicating portfolio of financial instruments exists andmeets certain criteria it is used to value the technical provisionsas a whole. There is no additional risk margin.

• Criteria for permitting the use of replicating portfolios arerestrictive. The cash flows of the financial instruments arerequired to replicate the uncertainty in amount and timing of theliability cash flows in all possible scenarios. Cash flowsdepending on underwriting risk cannot be reliability replicated.Furthermore, the financial instruments should be traded inactive markets that are deep, liquid and transparent. Where thecriteria are met and unbundling is feasible, then the replicatingportfolio is used for those cash flows and a best estimate andrisk margin method is used for the remaining cash flows.

• The primary example provided is the unit balance on a pureunit-linked contract.

• Replicating portfolios are a permitted technique for contractswhere the policyholder liability depends on the performance ofa specified pool of assets. A replicating portfolio is one whosecash flows exactly match those contractual cash flows inamount, timing and uncertainty. There is no prescription in theuse of replicating portfolios. However, the term ‘exactly’ mayresult in a similar level of restriction in the use of replicatingportfolios as for Solvency II.

• As for Solvency II, cash flows can be split between those thatcan be replicated and the remaining ones. For the replicatedcash flows, no risk adjustment is required. For the remainingcash flows, the probability weighted cash flows and riskadjustment model is followed.

• There is no requirement to use a replicating portfolio. However,where they are available and an alternative method is followed,then the methods should produce materially the same answer.

Reinsurance

• Reinsurance recoveries are in general recognised andmeasured as for the gross cash flows and then presented as aseparate asset on the balance sheet.

• The reinsurance related cash flows include the risk of expectedreinsurer default. Cash flows are based on an assessment ofthe probability of default of the counterparty and the resultingaverage loss (‘loss-given-default’ approach).

• There is only a single net of reinsurance risk margin on thebalance sheet, which includes reinsurer credit risk.

• There is no concept of a residual margin.

• As for Solvency II, reinsurance recoveries are recognised,measured and presented separately.

• The reinsurance related cash flows include the risk of non-performance by the reinsurer, which is included on an expectedvalue basis when estimating the fulfilment cash flows of thereinsurance asset.

• There is an explicit reinsurance risk adjustment, which excludesreinsurer credit risk.

• There is an explicit residual margin calibrated to the reinsurancepremium and set to avoid a loss at inception. However, if thenet cost of the reinsurance is less than the expected value ofthe recovery (including a risk adjustment), then this isrecognised as an immediate gain.

• The reinsurance-related residual margin is released usingthe same method as the residual margin relating to the grosscash flows.



Solvency II IFRS

Business combinations and portfolio transfers

• There is no concept in Solvency II of business combinations orportfolio transfers. All contracts are treated as organic, andfollow the same recognition, measurement and presentationapproach.

• For insurance contracts assumed in a portfolio transfer oracquisition, the residual margin of the insurance contract iscalibrated to be the excess of the consideration received(portfolio transfer) or fair value (business combination) over thebest estimate plus risk adjustment. If best estimate plus riskadjustment is greater than the consideration received or fairvalue, then a loss is recognised or goodwill is increasedrespectively.

Transitional arrangements

• A transitional arrangement to grandfather existing rulesover the discount rate is being tested under QIS5, as previouslydiscussed. Currently, there are no other transitionalarrangements proposed for the measurement of contractliabilities under Solvency II.

• There is full retrospective application of the insurance standard,except that there is no recreation of the residual margin. Thereis no grandfathering of existing rules.

• On implementing the new insurance contracts standard, eachportfolio of insurance contracts is measured as the bestestimate plus risk adjustment, excluding the residual margin.Any existing intangible assets or liabilities (e.g. DAC) arederecognised (excluding customer relationships that relate tofuture contracts). The change in measurement is presented inshareholder equity and is not recognised in the incomestatement. The proposal to exclude the residual marginmay negatively impact future profit emergence comparedto existing accounting frameworks.



Solvency II IFRS

Relevant standards

• QIS5 Technical Specification

• Solvency II Level 1 Directive

• IAS 32 – Financial Instruments: Presentation

• Fair Value Measurement ED

• IFRS 9 – Fair Value Option for Financial Liabilities ED

• IFRS 9 – Amortised Cost and Impairment ED

• IAS 39 – Financial Instruments: Recognition and Measurement(in relation to financial liabilities where not replaced by theabove-mentioned IFRS 9 ED)

• IAS 18 – Revenue

• Revenue from Contracts with Customers ED

• Insurance Contracts ED (in defining the scope of insurancecontracts and therefore implicitly the scope of investmentcontracts)

There is considerable uncertainty as to treatment of investmentcontracts in IFRS due to the range of EDs currently underconsultation.

Scope

• Solvency II applies to all insurance and reinsurance contractswritten by the issuer in the EEA or branches of EEA basedinsurers outside the EEA. There is no distinction betweeninsurance and investment contracts.

• There are scope exclusions for certain undertakings by virtue oftheir size, legal status nature or specific services they offer.

• Contracts not transferring significant insurance risk arecommonly known as investment contracts. Investmentcontracts (other than participating contracts that participate inthe same performance pool as other insurance contracts) areaccounted for as financial instruments under IFRS.

• Account balances and embedded derivatives unbundled frominsurance contracts are within the same financial instrumentsstandards.

Measurement approach

• The same recognition and measurement principles apply forinsurance and investment contracts in Solvency II.

• Unless full replication is possible, the technical provisions arethe probability weighted average of future cash flows takingaccount of the time value of money plus a risk margin,calibrated to ensure that the technical provisions are equivalentto the expected amount required by another insurer to takeover and meet the obligations.

• There is no deposit floor.

• The recognition, measurement and presentation of investmentcontracts are initially governed by IAS 32. This is particularlyrelevant for participating contracts (not in the scope of theInsurance Contracts ED) as it will determine how suchcontracts are split between liability and equity components.The treatment of participating investment contracts isuntested in the financial instruments standards. This is anarea where market practice will develop over the comingperiod. However, it is clear that the approach is likely todiverge from Solvency II.

• All financial liabilities are measured initially at fair value.Subsequent measurement is either at fair value (typically forunit-linked contracts) or amortised cost using the effectiveinterest method (typically for guaranteed non-linked and non-participating investment contracts).

• Further, for those contracts measured at fair value there is adeposit floor. A deposit floor means that the fair value of afinancial liability with a demand feature is not less than the netpresent value of the amount payable on demand.

• For contracts measured at fair value, currently the bid valueof units for typical unit-linked contracts, the implications ofthe Fair Value Measurement ED will need to be considered.The current staff draft of a proposed IFRS on fair valuemeasurement does not preclude the use of mid-marketpricing or other pricing conventions used by marketparticipants as a practical expedient for fair valuemeasurements within a bid-ask spread.

Appendix B: Investment contracts

Appendix B


Solvency II IFRS

Measurement approach continued

• For contracts measured at amortised cost, any embeddedderivatives are separated and valued at fair value if the separateinstrument meets the definition of a derivative and thecharacteristics are not closely related to the host contract. It isnot expected that the effective interest rate method for financialliabilities at amortised cost will change significantly as a resultof the Amortised Cost and Impairment ED, but there may besome minor changes.

Profit recognition

• There is no concept of deferring revenue to match the provisionof services. Any day-one gain or loss is recognised at inception.

• All day-one gains are eliminated (if not observable in themarket) while losses are immediately recognised.

Deferral of origination costs

• Under the Revenue from Contracts with Customers ED, there isno deferral of incremental acquisition costs. All such costs areexpensed as incurred. Further, any existing deferred assets ontransition are eliminated to shareholder equity. This representsa significant change compared to the current treatment ofinvestment contracts where deferral of such incrementalcosts is permitted under IAS 18. Consequently, there will bea day-one loss from writing such business and a different profitprofile for the existing book at transition. It also contrastswith the Insurance Contracts ED where implicit deferralof such costs is achieved through the reduction in theresidual margin.

• In light of the above, the unbundling of investmentmanagement related components under the Insurance ContractED will be important because acquisition costs cannot bedeferred for such an unbundled component.

Deferral of origination fees

• Origination fees relating to investment management servicesare deferred. The fees are earned as services are provided, forexample, over the expected term of the policy.

Other matters

• There is no allowance for the risk of non-performance by theinsurer (own credit risk).

• Where investment contract liabilities are held at fair value, thechange in fair value (including changes relating to own creditrisk) is recognised in profit or loss. Under the financial liabilitiesED, if a financial liability is designated at fair value the portionof the change in fair value due to changes in own credit isrecorded in Other Comprehensive Income (“OCI”).

• For unit-linked insurance contracts, it is proposed that entitiesrecognise treasury shares and owner occupied property atfair value through profit or loss to the extent those changesrelate to the interest of unit-linked contract holders in the poolof assets. It is unclear whether this change will also apply tounit-linked investment contracts.

Appendix B: Investment contracts continued


Item Solvency II IFRS

Assets

Goodwill is not considered an identifiable andseparable asset in the market place. The economicvalue of goodwill for solvency purposes is nil.

Initial measurement at cost (the excess of the cost ofthe business combination over the acquirer's interestin the net fair value of the identifiable assets, liabilitiesand contingent liabilities). Subsequent measurement isat cost less any impairment loss.

Goodwill onacquisition

Intangible assets should be measured at fair valueonly when they are separable and where there isevidence of exchange transactions of the same orsimilar assets indicating that they are saleable in themarketplace. Where these criteria are met, which isunlikely in practice, the valuation under IFRS maybe used for Solvency II. Where the criteria are notmet, intangible assets must be valued at nil.

An asset is recognised when it is probable that theexpected future economic benefits will flow to theentity and the cost of the assets can be measuredreliably.

Initial measurement is at cost. Subsequentmeasurement is at either (i) cost model: cost less anyaccumulated depreciation and impairment loss; or(ii) revaluation model: fair value at date of revaluationless any subsequent accumulated depreciation orimpairment.

Intangible assets

PPE should be measured at fair value for solvencypurposes. The revaluation model under the IFRSon PPE is considered to be a reasonable proxy forfair value.

Initial measurement is at cost. Subsequentmeasurement is using either the cost or the revaluationmodel described in the entry for intangible assets,above.

Property plant andEquipment (“PPE”)

Finance leases are measured at fair value. Finance leases are measured initially at the lower offair value and the present value of the minimum leasepayment under IAS 17. An ED proposingamendments to IAS 17 has been published, whichwould significantly alter the accounting treatmentfor leases including the valuation of assets andliabilities arising under leases currently classified asfinance leases. Under the proposals, an entity wouldbe required to set up a liability for the present value ofthe lease payments, which should subsequently beamortised using the effective interest method, andreassessed where facts or circumstances indicate thatthe liability may have changed since the previousreporting period. The entity should also establish a‘right-of-use’ asset at inception at the value of theliability to make lease payments plus initial directcosts, which should subsequently be measured atamortised cost.

Finance leases

Investment property is measured at fair value. The fairvalue model under the IFRS on Investment Propertyis considered a good proxy for economic value forSolvency II.

Measurement is initially at cost. Subsequentmeasurement is using either the cost or the revaluationmodel described in the entry for intangible assets,above.

Investmentproperty

Appendix C: Assets and other liabilities

Investments

Appendix C


Item Solvency II IFRS

Investments continued

Other assets

Under QIS5, participations are classified into threeclasses for valuation:

• Listed companies, which should be valued usingquoted market prices in active markets;

• Unlisted subsidiaries, which should be valued on anadjusted equity method (being the parent’s share ofthe excess of the assets over the liabilities of thesubsidiary valued in accordance with Solvency IIvaluation principles); and

• All other undertakings (not subsidiaries), whichshould wherever possible use an adjusted equitymethod with an option to mark to model if theadjusted equity method is not possible.

Notwithstanding the above, where an insurer invests ina financial institution (being banks or investment firms)these must be valued at nil for solvency purposes.

Participations are valued under IAS 27 in the parentcompany’s separate financial statements either at costor at fair value under IAS 39 (see the entry in respect offinancial assets below).

If a participation is purchased purely with a view to sell,it is valued under IFRS 5 at the lower of carryingamount and fair value less costs to sell, unless theparticipation has previously been valued at fair valueunder IAS 39, in which case it continues to bemeasured at fair value.

Participations insubsidiaries,associates andjoint ventures

Financial assets should be measured at fair valuefor solvency purposes, even when they are measuredat amortised cost in an IFRS balance sheet.

Under IFRS9 the following asset measurementcategories are set out: -

• Amortised cost: Debt instruments giving rise onspecified dates to cash flows that are solelypayments of principal and interest; where thebusiness model is to hold assets in order to collectcontractual cash flows; and where the asset has notbeen designated at fair value through profit and lossto eliminate an accounting mismatch.

• Fair value through OCI: Equity instruments where ithas been elected that gains and losses arepresented in OCI.

• Fair value through profit and loss: All other financialassets.

The Insurance Contract ED contains an option onimplementation to redesignate a financial asset to fairvalue from amortised cost, but not vice versa. Therestriction over the redesignation to amortised costmay result in accounting mismatches given unbundlingrequirements and changes in the scope of contractsincluded in the financial instruments standard.However, IFRS 9 allows assets to be redesignated into,and from, fair value through profit or loss on transition,which may resolve such difficulties if the standards areadopted simultaneously.

Financial assets

Non-current assets are measured at fair value lesscost to sell.

Non-current assets are held at lower of carryingamount and fair value less costs to sell.

Non-current assetsheld for sale ordiscontinuedoperations

Appendix C: Assets and other continued


IFRSItem Solvency II

Other assets continued

Deferred tax is calculated in accordance with themethod used under IFRS based on the valuations inthe Solvency II balance sheet.

Deferred tax assets should be valued as the temporarydifference between the IFRS value of an asset orliability and its tax base multiplied by the tax rate thatwill be applicable when the difference reverses.Deferred tax assets should be offset with deferred taxliabilities if and only if the entity has a legal right of set-off, which requires inter alia both the asset and liabilityto relate to the same taxation authority, and if the entityintends either to settle net or to realise the asset andsettle the liability simultaneously. Deferred tax assetsare not discounted.

Deferred tax assets should be recognised only where itis probable that the entity will earn sufficient taxableprofits in the future against which it can make the taxdeductions. There are limited exceptions removing therequirement to recognise deferred tax assets in certainsituations.

Deferred taxassets

Current tax assets are valued at the amount expectedto be recovered.

Current tax assets are valued at the amount expectedto be recovered.

Current taxassets

Cash is valued at an amount not less than theamount payable on demand.

Cash is a financial asset and is therefore valued underIAS 39 as described above.

Cash and cashequivalents

Under QIS5, all assets where there are no specificvaluation rules are valued in accordance with IFRS.

An entity may have other assets, for exampleprepayments or accrued income, which are subject tospecific accounting rules under IFRS.

Other assets

Subject to supervisory approval, certain items of off-balance-sheet financing (for example, letters ofcredit) may be recognised as ancillary own fundsunder Solvency II. Consistent with Solvency IIvaluation principles, valuation should be at economicvalue at either an amount or using a method approvedby the supervisor.

By definition, items of off-balance-sheet financing arenot recognised on the IFRS balance sheet.

Off-balance-sheetfinancing


Liabilities

Financial liabilities should be valued at fair value inconformity with IFRS upon initial recognition.Subsequent measurement should take account ofdifferences in the risk-free rate but not the insurer’sown credit standing.

Subordinated liabilities which satisfy the relevantrequirements for recognition may be treated as ownfunds on the Solvency II balance sheet rather than asliabilities on the IFRS balance sheet.

Financial liabilities should be valued under IFRS ateither fair value or at amortised cost.

Where financial liabilities are included at fair value, thisvaluation will reflect the credit risk of the liability andtherefore take account of the insurer's own creditstanding.

As noted in Appendix B, under the financial liabilitiesED it is proposed that changes in the valuation offinancial liabilities designated at fair value (using thefair value option), relating to changes in the liability’sown credit risk should be reported in OCI rather thanprofit and loss.

Subordinated liabilities are recognised as financialliabilities under IFRS.

Financial liabilities



Liabilities continued

Provisions other than technical provisions should bevalued in accordance with IFRS.

Provisions other than those relating to insurancecontracts should be recognised under IAS 37 where itis probable that an outflow of economic resources willbe necessary to settle a present obligation of an entitythat can be reliably measured. Provisions should bevalued at a best estimate of the amount required tosettle the obligation at the balance-sheet date, beingthe amount that the entity would rationally pay to settlethe obligation.

An ED has been published proposing amendments toIAS 37. The ED clarifies that the best estimate shouldbe valued at the lower of the present value of theresources required to settle the obligation taking intoaccount the time value of money and the risk that theactual resources required may differ from thoseexpected, or the amount that the entity would actuallyhave to pay to settle or transfer the obligation.

Provisions otherthan technicalprovisions

Material contingent liabilities, as defined under IFRS,should be recognised as liabilities for Solvency II.Valuation should be based on the probability weightedaverage of future cash flows required to settle thecontingent liability, discounted at the relevant risk-freeinterest rate term structure.

Contingent liabilities should not be recognised underIAS 37, but should be disclosed and continuouslyassessed. An ED has been published proposingamendments to IAS 37, which aims to align therequirement for recognition of liabilities with other IFRSstandards. This would remove the requirement for anoutflow of economic resources to be ‘probable’ (i.e.having a probability of greater than 50%) for theliability to be recognised, so would require contingentliabilities to be recognised in a manner consistent withthe requirements for provisions explained above.The ED proposals would take the treatment ofcontingent liabilities much closer to the approachproposed for Solvency II.

Contingentliabilities

Deferred taxes liabilities should be valued inaccordance with IFRS (undiscounted) based on theSolvency II balance sheet.

Deferred tax liabilities should be valued as thetemporary difference between the IFRS value of anasset or liability and its tax base multiplied by thetax rate that will be applicable when the differencereverses. Deferred tax liabilities should be offset withdeferred tax assets if, and only if, the entity has alegal right of set-off, which requires inter alia boththe liability and asset to relate to the same taxationauthority, and if the entity intends either to settle netor to settle the liability and realise the assetsimultaneously. Deferred tax liabilities are notdiscounted.

With limited exceptions, all deferred tax liabilitiesshould be recognised, even where the entity expectsto have future tax losses that could relieve the liability.

Deferred taxliabilities




Liabilities continued

Current tax liabilities should be valued at the amountexpected to be paid.

Current tax liabilities are measured at the amountexpected to be paid.

Current taxliabilities

Liabilities for employee and termination benefits shouldbe valued either in accordance with IFRS but with theimpact of smoothing eliminated, or in accordance withan internal economic model reflecting Solvency IIvaluation principles.

Under IAS 19, the fair value of defined benefit plans byreference to a market yield is the net of:

• the present value of a reliable actuarial estimate ofthe benefit employees have earned in current andprior periods;

• the total amount of actuarial gains and losses to berecognised;

• current service costs; and

• the fair value of the plan assets recognised.

IAS 19 requires an entity to recognise, as a minimum,a specified portion of the actuarial gains and lossesthat fall outside the range (‘or corridor’) of bestestimate plus or minus 10%.

Two EDs have been published proposing amendmentsto IAS 19. The proposals remove the corridor approachand alter the presentation of gains and losses,meaning that all changes in defined benefit obligationsand in the fair value of plan assets would berecognised immediately in OCI with other costsrecognised immediately in the profit and loss account.This change would make the treatment ofemployee and termination benefits closer to thetreatment under Solvency II, which does not allowthe corridor approach to be used. The EDs alsopropose the deletion of the current requirement to usemarket yields on government bonds where deepmarkets for high-quality corporate bonds are notavailable, and therefore to use high-quality corporatebond rates at all times, in order to eliminate the currentpotential for companies to use different rates forreporting similar obligations.

Employee benefitsand terminationbenefits




A group consists of a participating undertaking, itssubsidiaries and the entities in which it and itssubsidiaries hold a participation, in addition to anyother undertaking which is managed on a unifiedbasis. A group may also be based on the existence ofstrong and sustainable financial relationships betweenundertakings.

The scope of group supervision under Solvency II isrestricted to insurance groups, so the scope of thegroup is limited to those entities that are subsidiariesor participations of an insurance company or an‘insurance holding company’, which is any companywhose main business is to acquire and holdparticipations in insurers or reinsurers.

Entities may be excluded by the group supervisorfrom the scope of group supervision where they aresituated in non-EEA countries where there are legalimpediments to the transfer of the necessaryinformation (in this case the book value of the entitymust be deducted from group own funds), where theyare of negligible interest for group supervision, bothindividually and in aggregate, or where their inclusionin group supervision would be inappropriate given theobjectives of group supervision.

For the purposes of assessing the scope of the group,the definitions of ‘parent’ and ‘subsidiary’ areconsistent with those used under IFRS.Furthermore, a ‘participation’ relationship is consideredto exist whenever one entity controls more than 20%of the capital or voting rights of another undertaking,and is similar in concept to an Associate underIFRS. However, both of these definitions may beextended or restricted by the group’s supervisor toinclude or exclude any entity from within the scopeof the group which may result in a difference underSolvency II and IFRS.

The scope of consolidation under IFRS is based on theprinciple that the accounts should include the resultsof the parent company and all of its subsidiaries.A subsidiary is considered to be any entity that iscontrolled by the parent company, either through director indirect ownership of more than half of the votingrights of that entity, or through any other circumstancewhich enables the parent company to control thesubsidiary in practice. The scope of consolidationunder IAS 27 takes into account all subsidiaries of aparent, regardless of whether their businessactivities differ from the activities of other entitiesin the group.

Holdings in associates, being entities over which thegroup has significant influence, but which are notcontrolled by the group, are generally included in theconsolidated accounts under the equity method(unless the associate is classified as held for sale).However, where the investor is a venture capitalorganisation, mutual fund, unit trust or similar entity(such as investment linked insurance fund) it does notuse the equity method where the investment in theassociate has been designated at fair value throughprofit or loss or is classified as held for trading.

Scope of groupreporting

Under Solvency II, the level at which a group isrequired to prepare consolidated results dependson the structure of the group.

Where the ultimate insurance parent company of thegroup is within the EEA, group reporting is required bydefault only at the level of the ultimate insuranceparent. However, Member State supervisors are ableto require additional group reporting at a limitednumber of lower levels where it is considerednecessary.

If the ultimate insurance parent is based in a territoryoutside the EEA, which has been deemed equivalentwith Solvency II, then there is no requirement forgroup reporting under Solvency II at the level of theultimate insurance parent. However, in order for theultimate parent’s territory to be assessed as‘equivalent’, one of the criteria that must be met is thata solvency assessment based on the group isperformed. Therefore group reporting will need to beperformed at the level of the ultimate parent inaccordance with local regulation.

The ultimate parent company of a group is requiredto prepare consolidated accounts under IFRS.

Under IAS 27, an intermediate parent (i.e. one that isitself a subsidiary) is exempt from preparingconsolidated financial statements where the followingconditions apply:

• The company’s owners have been informed aboutand do not object to its not preparing consolidatedfinancial statements;

• The company has not issued debt or equityinstruments that are traded in a public market;

• The company does not file its financial statementswith a securities commission or other regulatorybody for the purpose of issuing any class ofinstruments in a public market; and

• The company’s ultimate parent (or any intermediateparent above the company in the group) preparesconsolidated financial statements in accordancewith IFRS which are available to the public.

Level of groupreporting

Appendix D: Group reporting

Appendix D



If the ultimate insurance parent company is based in anon-equivalent non-EEA territory, consolidation maybe required at whatever level the EEA group supervisorconsiders appropriate.Where a group with an ultimate parent based in anon-EEA territory has subgroups within the EEA, then,in addition to any requirements to report at thelevel of the ultimate insurance parent, therequirement for group reporting under Solvency IIapplies at the level of the group headed by theultimate EEA insurance parent.

Level of groupreportingcontinued

Under Solvency II, groups are required to preparegroup reporting to allow an assessment to beperformed of the capital adequacy of the group,taking into account the Solvency Capital Requirement(“SCR”) and own funds calculated at the level ofthe group.The group results with which the assessment isperformed, must be based on Solvency II principles,including Solvency II balance-sheet valuationprinciples, proportional recognition of participations ofless than 100%, the elimination of intra-group creationor double use of own funds and adjustments to reflectgroup own funds that are restricted in their ability toabsorb losses elsewhere in the group. Solvency II hastwo methods by which the group results may beprepared: the accounting consolidation-basedmethod, which is the default method that groups mustnormally apply, and the deduction and aggregationmethod, which groups may apply subject topermission from their supervisor:• The accounting consolidation based method usesthe group’s consolidated accounts as a startingpoint in the calculation of group SCR and group ownfunds. However, these must be prepared, based onthe Solvency II principles outlined above, so maydiffer from the IFRS consolidated accounts.The calculation of group own funds is based on thefull consolidated balance sheet. However, whencalculating the SCR only, the insurance-relatedsubsidiaries are considered on a consolidated basis.The contribution of other members of the group tothe SCR are aggregated on an entity-by-entity basis(and so do not reflect any benefits of diversification);

• The deduction and aggregation method calculatesthe group’s results as the aggregation of the resultsand SCRs of each entity within the scope of thegroup.Where the group has a participation in anentity of less than 100%, only the group’s proportionof that entity’s results and SCR are brought into thecalculation, unless the entity is in deficit, in whichcase the full amount is included. The individualresults must be based on Solvency II principles,unless an entity is based in a non-EEA territory thathas been deemed equivalent with Solvency II for thispurpose, and adjustments are necessary to eliminateany capital charge on intra-group transactions forindividual entities within the group.

Participations are included in the group’s results asinvestments of the entities holding them, subject tocertain exceptions, as detailed in the section of thisdocument on assets and liabilities not related totechnical provisions.

A consolidation performed under IFRS presents allthe results of the entities in the group combined toform a single set of results. The method ofconsolidation is to add together all the individualresults of the entities in the group, then to applyconsolidation adjustments to:• Adjust individual accounting policies to beconsistent with the accounting policies of the group;

• Eliminate pre-acquisition reserves;• Recognise material adjusting post-balance-sheetevents occurring between the time subsidiaryaccounts were signed and the finalisation of theconsolidated financial statements;

• Adjust subsidiary results where the subsidiary’syear-end is not coterminous with that of the parentcompany; and

• Eliminate intra-group balances, transactions, incomeand expenses, for example those relating to intra-group trading.

Where a subsidiary is not owned 100% by the group,an adjustment is also required to recognise the‘minority interest’/‘non-controlling interest’ of the othershareholders in the company, which forms part of theequity of the parent.Where associates are valued in the consolidatedaccounts under the equity method, the interest inthe associate is initially measured at cost and issubsequently adjusted for the investor’s share ofpost-acquisition profits or losses.

Method of groupreporting

Appendix D: Group reporting continued

We are grateful for the efforts ofpartners and staff that assisted inthe production of this publication.In particular, we would like tothank: Anthony Coughlan (writinglead), Chris Hancorn, ClaireWoolley, David Mbatha, ElizabethLynn, Henry Jupe, Kareline Daguer,Marian Williams and Mike Vickery.

Paul [email protected] +44 (0) 207 804 4469

Alex [email protected]+44 (0) 207 212 4791

Alexander [email protected]+49 21 1981 7408

Stéphane [email protected]+33 1 56 57 1283

Brian [email protected]+44 (0) 207 212 3902

Julia Schü[email protected]+49 69 9585 2667

Gail [email protected]+44 (0) 117 923 4230

Kirsty [email protected]+44 (0) 207 804 2999

Jimmy [email protected]+33 1 56 57 7213

Contacts


If you would like to discuss any of the issues raised in this paper, please speak to yourregular PwC contact or one of the following:

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon theinformation contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy orcompleteness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers does not accept or assume any liability,responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for anydecision based on it.

www.pwc.com/insurance© 2010 PwC. All rights reserved. Not for further distribution without the permission of PwC. “PwC” refers to the network of member firms of PricewaterhouseCoopersInternational Limited (PwCIL), or, as the context requires, individual member firms of the PwC network. Each member firm is a separate legal entity and does not act as agent ofPwCIL or any other member firm. PwCIL does not provide any services to clients. PwCIL is not responsible or liable for the acts or omissions of any of its member firms nor canit control the exercise of their professional judgment or bind them in any way. No member firm is responsible or liable for the acts or omissions of any other member firm nor canit control the exercise of another member firm’s professional judgment or bind another member firm or PwCIL in any way.

getting to grips with the grips with the shake-up · pdf file · 2015-06-03it forms...

Documents