Intensive Actuarial Training for Bulgaria

January 2007

Lecture 8International Accounting Standard

For Insurance Companiesby Michael Sze, PhD, FSA, CFA

Introduction

• More emphasis on corporate governance– Prompted by recent corporate scandals

• Risk based approach– Enterprise risk management (ERM) and risk

based supervision• Global trends on consolidation

– Basel I and II for banking sectors– Solvency I and II for insurance

Global Harmonization on Insurance Accounting

• Common more meaningful reporting• International Accounting Standard Board (IASB)

– IFRS 4 • International Association of Insurance Supervisors

(IAIS) – Cornerstones paper• International Actuarial Association (IAA) –

Solvency I and Solvency II• EU Commission – Solvency I and Solvency II

Direction of New Accounting Rules

• Integrated supervision– Harmonization with other disciplines– International supervisory cooperation– Increased cooperation with insurance professionals

• Emphases– Solvency of insurance companies– Insurer capital requirements– Market discipline (management/supervisory oversight)– Risk sensitivity testing (principle base, less rule base)– Communication (disclosure, transparency)

International Financial Reporting Standards (IFRS) 4

• Issued in March 2004• Applicable for fiscal on or after 1/1/2005• Transitional framework for Phase I• More fundamental changes under Phase II• More than just a technical issue• Fundamental changes to insurance industry

– The way the industry does business– Communicates value to analysts, investors, and other

stakeholders

Historic Background• 1997, International Accounting Standards Committee

(IASC) Board established Steering Committee (SC) on Insurance

• 1999, SC published Draft Statement of Principles (DSOP), public discussions

• 2001, IASC replaced by IASB, reissued DSOP• 2002, IASB split project into 2 phases

– Phase I, effective 1/1/2005, transition– Phase II, effective after 1/1/2007, final

• July 2003, IASB issued Exposure Draft (ED) 5, public discussions, comments, changes

• March 2004, IASB issued IFRS 4, final for Phase I

Major Provisions of IFRS 4• New definition of insurance contract

– Exemption from IFRSs• Liability adequacy test

• Changes to accounting practice• Financial reporting issues

– Intangible assets • Acquired insurance contracts

– Unbundling deposit components – Discretionary participation features– Sensitivity analysis– Reinsurance, and impairment– Initial compliance

New Definition of Insurance Contract

A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder

Implications of the Definition

• Emphases on– Significant– Insurance risk– Uncertainty

• Significance: based on commercial substance• Policies transferring financial risk covered under

IAS 39• Contract providing service to policyholder

covered under IAS 18

Significant Risk• Assessed at inception of the contract• Company need to develop internal quantitative

guidance: consistent application• Pre-existing risk to policyholder

– Not arisen from terms of the contract• Excludes lapse, persistency, expense risks• Excludes loss of future earnings when insurance

contract is terminated by death or disability• Excludes waiver of early retirement penalties in

mortgages on death• Includes pure endowment contracts with early payment

upon death or disability

Uncertainty in Determining Insurance Risk

• Uncertainty may arise over:– Occurance of the insured event

• And may happen during or after the contract period– Timing of the insured event

• In whole life insurance, occurrence is certain, timing is not– Magnitude of the effect of insured event

• In some cases, event has already occurred, effect is not certain

• Survival risk with uncertain cost of living qualifies as insurance risk

• Fixed fee contract appliance maintenance or car roadside assistance qualifies as insurance

Definition of Financial Risk

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

Examples of Non-financial Variables Not Specific to a Party

• Weather or catastrophe indices• Mortality rates of a population• Claims indices of an insurance market• Changes in fair value of non-financial asset

based on general market price changes

Examples of Non-financial Variables Specific to a Party

• Claim index, cost or lapse rate of that party• State of health of the party• Change in the condition of an asset that the

party owns

Insurance vs Financial ContractsInsurance• Motor• Travel• Life• Annuity• Medical• Property• Reinsurance• Professional indemnity• Catastrophe bonds related to

insured future events

Financial• Bonds• Equities• Other investment assets• Financial liabilities

– Pension– Options– Guarantees with

insignificant insurance risk

Impact of Insurance Definition• Insurance contracts covered under IAS 32

– Liabilities measured under amortized cost• Financial contracts covered under IAS 39

– Assets based on market values• Mismatch causes potential earnings volatility, and

may affect– Product design– Acquisition strategies– Basis for performance incentives– Communication of new numbers to stakeholders

Asset Provisions under IAS 39• Most of insurer’s investments are under IAS 39• IAS 39 classifies financial instruments into 4

categories:– Financial assets at fair value through profit/loss– Loans and receivables– Held-to-maturity investments– Available-for-sale financial assets

• For non-life insurance, most assets are in categories 1 and 4: measured at fair value

• For life insurance, most assets are in fixed income, which normally would be in category 3

Measure Assets in Categories

• Cat 1 are either purchased for trading or irrevocably designated as such: fair value

• Cat 2 not quoted in market: amortized value• Cat 3 are listed bonds, not traded: amortized value

– Tainting rules: trading Cat 3 forbid using Cat 3 for 2 years

• Cat 4 are residual assets measure at fair value, with changes deferred in separate reserve account

Managing Asset-Liability Mismatch• Short to medium term by appropriate investments• Long term matching is difficult because

– No corresponding investment instrument – Long duration liability with much volatility– IFRS 4 requires fair value measure for assets, but

• Allows amortized value for liabilities– Life insurance assets are mostly in bonds, which need to be traded:

measured in fair value• But liabilities are measured in amortized values

• Matching technique– IFRS 4 allows designated insurance contracts to be discounted at

market interest rates– Shadow accounting for Cat 4 assets

• Non-life insurance: timing and claim liabilities are uncertain and volatile: matching is difficult

Exemption from IAS 8• IAS 8 requires applying same accounting principles to all

categories of insurance– By exemption, IFRS 4 allows continued use of current accounting

practice, except:

• May not recognize provisions for future claims for events not in existence at reporting date– No catastrophe and equalization provisions

• Carry out liability adequacy test• Remove insurance liability only when extinguished• No offset of reinsurance assets or income• Consider reinsurance assets impairment

Liability Adequacy Test

• Minimum test– Compares reported liabilities including DAC– Against estimated future cash flows including

embedded options and guarantees– Record deficiency in profit and loss– Current level of aggregation may be used

• Companies meeting minimum requirements need not conduct onerous test in IFRS 4 and IAS 37

Liability Adequacy Test of IFRS 4

• Determine carrying value of insurance liability less carrying amount of– Deferred acquisition costs and intangible assets

• Determine liabilities under IAS 37, – which prescribes using market-related margins for risk

and uncertainty• Carrying value deficiency is fully recognized in

profit/loss:– Decrease carrying amount of DAC and IA, or– Increase carrying value of insurance liability

Accounting Policy Changes

• IFRS allows companies to change accounting policy as long as

• The change makes the financial statements:• More relevant to economic decisions needs, and

no less reliable, or• More reliable and no less relevant to those needs• May use different methods for different types of

contracts

Rebuttable Presumption

• IFRS 4 allows companies to adjust their liabilities to reflect future investment margins only if– Switch is widely used– Comprehensive investor orientated basis of accounting– Improve relevance and reliability of financial statement

• Pure asset-based discount rate unacceptable• Phase II may not allow this

Shadow Accounting

• Particularly useful when assets are in available-for-sale category

• Assets may have unrealized gains or losses• Adjust corresponding liabilities by amount

of unrealized gains or losses• Thus assets and liabilities are brought in

line with each other

Designation of Assets to Cat 1

• IFRS 4 allows companies to designate assets as for trading

• Such assets are measured at fair value• Designate assets supporting liabilities

linked to the fair value of these properties• Leave other investments unchanged

Intangible Assets

• Acquisition of insurance contracts through business combination or portfolio transfer– Difference between fair value and book value of

insurance liabilities– For non-life insurance, if insurer’s accounting policies

do not discount claims• Future investment management fees to offset

incremental transaction costs– Incurred to secure investment contract

Reason for Unbundling• Example of contract with deposit and insurance

components– Profit sharing reinsurance contract, where– Cedant guaranteed a minimum repayment of its

premium• Unbundling to ensure rights and obligations are

recorded on balance sheet, and not as expenses and revenues– Not necessary if rights are recognized– E.g. maturity or surrender benefits in life insurance

Unbundling Deposit Component• Unbundling required if

– Deposit and insured components can be measured separately– Insurer’s accounting policies do not require it to recognize

obligations from deposit component

• Unbundling permitted, but not required– Deposit and insured components can be measured separately– Insurer’s accounting policies requires it to recognize obligations

from deposit component

• Unbundling prohibited– Deposit and insured components cannot be measured separately

Discretionary Participation Features (DPF)

• Guaranteed element: contractual obligation to pay guaranteed benefits

• DPF is contractual right to additional benefits:– Likely to be substantial– Amount and timing at discretion of issuer– Contractually based on

• Performance of contracts,• Investment returns, or• Profit/loss of the Company

Accounting for DPF

• Guaranteed element separately recognized as minimum liability

• If DPF is not recognized separately, whole contract classified as liability

• If DPF is recognized separately, may be recognized as– Liability: liability adequacy test on whole contract– Equity: liability recognized for entire contract >

minimum liability for guaranteed element

Special Issues

• Weather or catastrophe bonds: not insurance– Does not require insurable interest

• Equalisation provisions: not recognized– Liabilities for future claims not initially insured

• Insurance risk may change: deferred annuity– Long deferment period: no insurance risk– Annuity period: significant insurance risk,

• Even though PV annuity cash flow risk small

Options

• If execution of option introduces insurance risk to contract: must be considered

• Example: Investment contract with annuitization option– Case 1: If option factors are determined at

execution: not insurance– Case 2: If option factors fixed at inception, or

severely constraint: insurance

Embedded Derivatives• Definition according to IAS 39• Derivative is a financial instrument which:

– Changes value in response to external index– Small initial investment– Settled at a future date

• Derivative may be embedded in financial or insurance host

• Changes the cash flows of the host• May be able to separately determine the values of

the host and the embedded derivative

Separate Identification of Embedded Derivatives

• Embedded derivative is separated only if– Risks for host and derivative not closely related– Embedded component meets definition of derivative– Combined instrument is not measured at fair value

• Insurance contract with financial derivative: – Separate unless closely related

• Financial instrument with discretionary participation features: – Separate unless closely related

• Financial instrument with financial derivative: – No separation

Examples of Embedded Derivative• Unit-linking feature embedded in insurance

contracts with unit-denominated payments: – Not separated

• Surrender options in insurance contract:– According to specified schedule– Based on principal amount plus interest– Based on fair value of pool of equity equal to value of

host– Not separated

• Surrender value based on changes of financial index: – Separated

Embedded Derivatives with Insurance Risk

• Not required to be measured at fair value• Option to take life-contingent annuity at

guaranteed rate: not separated• Death benefit at greater of unit value of

investment or guaranteed minimum: not separated• Death benefit linked to equity price or index

payable on death or annuitization: not separated

Embedded Derivatives in Insurance Contract requiring Separation

• Guarantee minimum interest rates used to determine surrender or maturity values

• Maturity and surrender values leveraged on interest or inflation rates

• Equity or commodity indexed benefit payments not contingent on insured event

• Persistency bonus paid at maturity in cash

Reinsurance and Impairment

• IFRS prohibit offsetting of assets and liabilities and income and expenses by corresponding amounts from reinsurance

• Gains/losses from reinsurance purchase must be disclosed

• Consider whether reinsurance assets are impaired at each valuation date– Objective evidence cedant may not receive all amounts

due– Reliably measurable impact on cedant

Enhanced Disclosure under IFRS 4• Help users understand insurance contract’s

– Estimated amount, timing, uncertainty of cash flow– Accounting policies and assumptions– Reconciliation of changes in liabilities, reinsurance assets, and

deferred acquisition costs– Gains/losses from purchased reinsurance contracts

• Sensitivity analysis to disclose risks due to– Risk concentration– Market variables and assumption changes

• Principle based– Considerable flexibility for companies– Greater transparency– Companies needs to develop effective communication

First Time Adoption of IFRS 4

• Need not restate comparative figures– Except for disclosure of material amounts– Requires companies to explain why not

practicable to apply recognition and measurement section of IFRS

– Anticipate only liability adequacy test may be impracticable

• Most companies expect to restate the 2004 accounts under IAS 32/39