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Laying the foundations for the future of insurance reporting

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As your business reflects on both the changing shape of the Solvency II timetable and the eventual move to a new IFRS standard for insurance contracts, how can you build a durable platform for regulatory and financial reporting in the future?

November 2012

PwC Laying the foundations for the future of insurance reporting

03 Foreword

04 Overview

08 Mind the gap!

10 Gearing up for an efficient transition

12 Overcoming the technical challenges

24 Appendices

43 Addressing the practicalities

Contents

This is a follow up to our 2010 publication,‘Getting to grips with the shake-up’, whichlooked at how to take advantage of theparallels between Solvency II and IFRSPhase II to reduce the cost and burden ofimplementation, while identifying theimportant differences and assessing theirimplications.

Since then, the timetables for both havebeen put back. Solvency II looks virtuallycertain to be delayed from the plannedJanuary 2014 launch date. Further time isneeded to run an impact assessment onthe proposals for the treatment of long-term guarantees and to reach a politicalconsensus on the way forward. In turn,consultations on a second exposure draftsetting out final proposals for IFRS PhaseII won’t begin until first half of 2013,which would mean that the changes areunlikely to be mandatory until 2017or 2018.

Some insurers will see the continueddelays in Solvency II and IFRS Phase IIas a chance to put preparations on thebackburner. But as we examine in this

publication, smarter organisations will usethe extra time to smooth the way toimplementation and future-proof thebusiness for further changes ahead. Thisincludes building Solvency II into businessas usual now and making sure systems canbe easily adapted for the demands of IFRSPhase II.

With the potential for early adoption ofIFRS Phase II and the likely delay toSolvency II, the opportunity for reportingprojects to once again be consideredtogether re-emerges. It will start tobecome clearer over the next few monthswhether a real option exists to early adoptIFRS Phase II when Solvency II islaunched, providing an opportunity todevelop a single communication strategyand to clear out legacy issues in one go.

We hope you find the publication useful.If you would like to discuss any of thepoints raised or any other aspect ofSolvency II and IFRS, you are verywelcome to contact us (details below) orone of the contacts listed on page 43.

PwC Laying the foundations for the future of insurance reporting 3

Foreword

Welcome to ‘Laying the foundations for the future of insurance reporting’.This publication looks at how your business can prepare for the plannednew IFRS for insurance contracts (IFRS Phase II) in the most efficient way,including making the most out of your investment in Solvency II for IFRSpurposes.

Paul ClarkePartner, PwC (UK)Global Solvency II Leader+44 20 7804 [email protected]

Brian PurvesPartner, PwC (UK)Insurance Market Reporting Leader+44 20 7212 [email protected]

Failure to agree leadsto delay

Solvency IIThe text for the Solvency II Directive islargely known, with much of the detaillikely to remain unchanged from draftsalready in circulation. However, theCouncil of the European Union(representing national governmentsaround the European Union), theEuropean Commission and the EuropeanParliament (the ‘trialogue parties’) havefailed to agree on measures to addressproducts with long term guarantees(a consensus is necessary for the Directiveto go through). Subsequently, theEuropean Parliament has amended theindicative date for the vote on theDirective, which will allow the trialogueparties more time to reach an agreementand will also make it virtually impossiblefor the Directive to go live on 1 January2014 (due to the procedures required inthe legislative process). At the time ofpublication, the exact delay is unclearhowever we understand that one to twoyears from 2014 is being considered.

The most contentious issue is how to dealwith volatility in credit spreads in thevaluation of products with long-termguarantees. An impact assessment by theEuropean Insurance and OccupationalPensions Authority (EIOPA) on thecurrent proposals is expected this year.Due to uncertainties about what theresults will show and how policymakerswill react, it may be mid-2013 before theresults are finalised and the implicationscan be assessed.

IFRSThe International Accounting StandardsBoard (IASB) is planning to publish asecond exposure draft (‘re-exposure’)setting out its final proposals for IFRSPhase II in the first half of 2013. Since thefirst exposure draft in 2010, the IASB hasmade significant revisions to address theperceived ‘artificial’ earnings volatility inthe original model. It has also attemptedto achieve convergence with the USaccounting standard setter, but this is nowunlikely due to the divergence in views.

The re-exposure represents what maybe the final opportunity for the industryto influence the new accounting standardand it is expected to be limited to five keyareas:

• Treatment of unearned profit incontracts (‘unlocking’ the residualmargin)

• Treatment of participating contracts

• Presentation of premiums in theincome statement

• Presentation of the effect of changes inthe discount rate in othercomprehensive income

• Transition by retrospective application

Insurers also face changes to theclassification and measurementrequirements for financial instruments(the IASB is developing IFRS 9 which willreplace the current IAS 39). IFRS 9 isexpected to be effective from 1 January2015, subject to a further exposure draftand subsequent endorsement for use inthe European Union. This means therewill now be a staggered adoption of thisstandard and the new insurance contractsstandard.

Figure 1 sets out the current knowntimeline for both Solvency II and IFRS.

4 PwC Laying the foundations for the future of insurance reporting

Overview

Making the most of thebreathing space

Solvency IIWhilst the expected delay in Solvency IIcreates further uncertainty over the finaltimeframe, the bulk of the framework isestablished creating an opportunity tofocus on embedding Solvency IIprogrammes into ‘business as usual’.

Sustaining the momentum of Solvency IIpreparations will allow your business toprepare in good time and embed theframework, avoiding undue inefficiencyand disruption. You would also benefitearlier from the payback on any plannedrestructuring, strategic realignment andinvestment in new information systemsahead of slower moving competitors.

Some contingency planning for theremaining issues will be necessary,including gauging the impact of differentoutcomes from the long-term guaranteesassessment. But the system requirements,organisational considerations and other‘heavy lifting’ won’t change. Givinggreater focus to the practical challengesarising from the public and privatedisclosure requirements may also bebeneficial as currently this is a commonarea of under investment in Solvency IIpreparations.

IFRS Phase IIGiven the delay, it will be important to usethis time to fully understand recentdevelopments and respond to the re-exposure draft. You can then look tobegin more significant implementation

planning activities in the second half of2013 when the final requirements will beclearer. This should include a detailedimpact assessment to understand thefinancial and operational impacts of therevised requirements on your business.

An important consideration in your impactassessment will be how to deal with thedifferent timelines in IFRS and Solvency II,as we explore later in this publication (inthe ‘Mind the gap’ section). There is a realopportunity to ‘future-proof’ Solvency IIactuarial and reporting models for IFRS.With the potential for early adoption ofIFRS Phase II and the likely delay toSolvency II, the possibility of acoordinated one time transition toSolvency II and the new IFRS standardsre-emerges.

Figure 1: Current known timeline for Solvency II and IFRS

Effective date of 1 January 2014 appears unlikely

As of publishing, a delay of 1 to 2 years is beingconsidered

Final standard?

Mandatory effectivedate 2017/2018?

Effective date of 1January 2015

Issued and effective 1 January 2013 (relevant when other standards refer)

The timeline is based on information to October 2012 and may be subject to change.

Source: PwC analysis based on our understanding of the evolving frameworks

Solvency II

2012 2013 2014 2015 onwards

IFRS (subject to EU endorsement)

Insurance contracts

Level 1

Level 2

Level 3

Classification &measurement

Impairment

Hedgeaccounting

Macrohedging

Fair valuemeasurement

Revenuerecognition

IFRS 9 published2009 & 2010

Financial instruments

Revisedexposuredraft

Exposure drafton modifications

Consultation period, IASB re-deliberationand issuance of final standard?

Consultation period, IASB re-deliberation and issuance offinal standard?

Furtherexposure draft

Review draft

Discussion paper Exposure draft, issuance of final standard and effective date areto be confirmed

Consult & publish?

Consult & publish?Ongoing pre-consultation by EIOPA?


IASB re-deliberation and issuance of furtherexposure draft

Consultation period, IASB re-deliberationand issuance of final standard?

Trialogue and final legal process?

Finalisation by EC/EIOPA?

Transpose to nationallaw?

Expected effective date no earlier than 1 January 2015

Bringing it all togetherThe breathing space provides a valuableopportunity to put the foundations inplace for a finance function which iscapable of meeting these new demandsand providing the insights that will giveyour business an edge in the newcommercial landscape.

Key priorities include closer collaborationbetween the risk, actuarial and financefunctions and making sure that theunderlying risk and capital models beingdeveloped for Solvency II are flexibleenough to be adapted for IFRS Phase II,given the similarities.

However, there will be some significantdifferences in the detailed requirementsbetween the Solvency II and IFRS Phase IIframeworks. Your business will thus needto reconcile, or at least explain, thesevariations. Otherwise you may faceawkward questions from analysts andinvestors.

You may also feel that Solvency II and thenew IFRS basis will not fully explain thetrue performance and potential of yourbusiness, and the strategic rationalethat underlies this. You should considerhow to approach any supplementaryreporting, such as embedded value(or equivalent) and cash generationdisclosures, that may be needed in thenew reporting world.

The box opposite sets out key questionsfor your organisation to consider in thecoming months when planning for futureIFRS Phase II implementation.

Outline of thispublicationThis publication sets out the challenges inimplementing the changes to IFRS,focusing on the proposed insurancecontracts standard, in view of thesignificant Solvency II projects insurersare currently undertaking and considersthe impact of the different expectedimplementation dates. It then examinesthe various technical challenges and keysimilarities and differences between IFRSand Solvency II in the areas of contractliabilities, disclosure and presentation,assets and other liabilities and groupreporting. The appendices provide a moredetailed point-by-point technicalcomparison.

The publication is based on ourunderstanding of IFRS and Solvency IIproposals as of October 2012, elementsof which are in different phases ofdiscussion and consultation. The finalrequirements of both IFRS and Solvency IImay still evolve significantly up to theireffective dates and, therefore, may differfrom those set out in this publication.Given the recent challenges in finalisingthe requirements of the two regimes,it is also possible that the expectedimplementation timelines will changeagain in the future.



• Are concerns over ‘artificial’ earnings volatility being adequately addressed inthe revised IFRS Phase II proposals?

• How much impact is the implementation of IFRS Phase II going to have onyour organisation from a strategic and operational perspective?

• How can you make sure you secure the right resources for futureimplementation?

• Would there be any benefits from changing your current accounting approachbefore mandatory IFRS Phase II implementation?

• How can you take advantage of the parallels between Solvency II and IFRSPhase II and develop ‘future-proof’ actuarial and reporting models capable ofdealing with both sets of demands?

• Should the impact of new IFRS on your financial results affect your currentdecision making?

What you should be considering on IFRS

There is a likelihood that the various newIFRS standards may come on stream atdifferent times, resulting in multipletransitions and re-statements. Even withthe expected delays, it still appears likelythat Solvency II will be effective beforeIFRS Phase II.

The timing issues present a range ofpractical challenges and considerations,not least because the current IFRSreporting requirement for insurancecontracts are often based on the currentregulatory framework (Solvency I). IfSolvency II does go live before IFRS PhaseII, your business will have a number ofpotential options for IFRS reporting forinsurance contracts in the interim (‘gap’)period. Effective stakeholdercommunication and explanation duringthis period of transition and uncertaintywill be crucial.

A standard industry position may emergeover the coming years. Most insurerswon’t want multiple transitions betweendifferent approaches, not least to avoidthe requirement for re-statements andpotential artificial volatility in earnings.Other important considerations inassessing the options include the reportedfinancial impact, actual cash cost (suchas running two separate models), impacton distributable profit, ease ofpreparation, future proofing, ‘first mover’risk and the future role and approach tosupplementary reporting. The impact onyour current tax position and future taxplanning will also be important as inmany countries tax regulations are basedon accounting profit. Understandinginvestor preference for the basis of yourreporting may help you to decide on yourapproach and to identify gaps wherefurther effort will be required in yourcommunication strategy.

The options to consider include:

(1) Maintain currentapproachIn this option, existing IFRS reportingwould be maintained during the gapperiod. This would require the parallelrunning of current models and processes,in addition to those required bySolvency II, which is likely to be a drainon costs and resources. While theapproach provides stability andconsistency in reporting as Solvency II isintroduced, many of the currentcommunication challenges faced byinsurers will remain. Some of thesechallenges could be addressed byenhancing external disclosure on matterssuch as the drivers of IFRS operatingearnings and the change in free capitalover the reporting period. The wider thegap between the effective date ofSolvency II and IFRS Phase II, the moreimportant the decision to continue toincur the costs of running two modelswill become.


The timelines for Solvency II and IFRS Phase II are not aligned and you willneed to consider your options for reporting in this gap period. How canyour business limit the cost and disruption of running separate systems?Which reporting options are feasible in the gap period and how will they beperceived and understood by investors?

Mind the gap!

(2) Adopt Solvency II(or a modified version) Existing IFRS 4 permits changes to theaccounting policies in respect of themeasurement of contract liabilities if theymeet certain criteria for improving‘relevance and reliability’. An option forIFRS reporting during the gap period maybe to adopt Solvency II or a modifiedversion as the basis of financial reportingfor insurance contracts, subject tomeeting the requirements of existingIFRS 4. Potential challenges in adoptingthis option would include:

• How does the approach compare tothe expected IFRS Phase II model?IFRS Phase II will give context forjudgements about whether the‘relevance and reliability’ criteria ofIFRS 4 are met.

• Does the approach introduceadditional prudence? IFRS 4 prohibitschanges in accounting policies whichintroduce additional prudence in themeasurement of insurance contractswhere there is already sufficientprudence.

• Does the approach introduce non-uniform accounting policies acrossinsurance groups? IFRS 4 prohibitsincreasing the diversity in accountingpolicies across insurance groups.

Adopting a pure Solvency II approach tomeasure the contract liability would allowthe recognition of a profit at inception of acontract and this is also permitted in somecurrent GAAPs. However, in IFRS Phase IIsuch a profit is spread over the period ofcoverage by the inclusion of a ‘residualmargin’ within the liability. In this option,as a modification to Solvency II, aninsurer may seek to include a residualmargin depending on its circumstances.Practices for the calculation andamortisation of the residual marginwould then be required.

Specific considerations will also berequired for non-life insurers as theoption to adopt the simplified model forshort duration contracts in IFRS Phase IIis not an option in Solvency II.

The option to adopt Solvency II (or amodified version) may remove therequirement to maintain two differentmodels, though a further change wouldthen be required to adopt IFRS Phase II.As a result, two sets of re-statements(with comparatives) would be required.This approach is likely to be confusing toanalysts and investors if not handledcarefully.

(3) Early adoptionof the requirements ofIFRS Phase IIIn this option, the requirements of IFRSPhase II would be adopted in advance ofthe mandatory date. Either through earlyimplementation of the standard itself(as expected to be permitted in IFRS, butsubject to its endorsement in Europe) orby taking on board some of its keyrequirements as a way of improvingexisting accounting policies under IFRS 4.

Early adoption may be attractive as partof a co-ordinated ‘big bang’ exercise thatbrings together Solvency II and thetransition to IFRS Phase II, IFRS 9 andother new IFRS standards. A big bangwould limit the number of re-statements.It would also provide an opportunity todevelop a single communication strategyand to resolve any legacy issues in one go.However, the complexities of a combinedtransition could introduce greaterdelivery risk to both Solvency II and IFRSprojects. As with any early adoption, thereare advantages and risks to being the ‘firstmover’ including the risk of subsequentrevisions to the accounting requirements.


“With the potential for early adoption of IFRS Phase II and the likely delay to Solvency II,the opportunity for a coordinated ‘big-bang’ exercise has re-emerged.”

There are clear advantages anddisadvantages to each of theseoptions. Time spent assessing theoptions now, to identify the bestapproach for your organisation,will not be wasted as the likelyfuture path will become clearerover time.

Figure 2 sets out an indicative plan for theimplementation and phasing-in of IFRSPhase II. This is under the workingassumptions that IFRS Phase II ismandatory from 1 January 2018,Solvency II is effective from 1 January2016 and that during the ‘gap’ period theexisting approach to IFRS reporting forinsurance contracts is maintained.Inplanning to implement IFRS Phase IIinitial considerations include:

• Size of project: Investigate thepotential size of the project at an earlystage (especially if your businesscurrently reports under a mixture ofGAAPs) so that budget requirementscan be estimated in advance andsufficient time can be built in to secureresources.

• Leveraging Solvency II: It is likely thatthe starting point for implementingIFRS Phase II will be the Solvency IImodels which insurers have recentlydeveloped. Understanding thedifferences between the twoframeworks and whether yourSolvency II models are flexible enoughto be adapted for IFRS Phase II will beimportant.

• Priority areas: It will be important atan early stage to scope the most criticalareas of the project. This includes thepractical complexities such as fullretrospective transition, so that yourapproach can be tailored to allowsufficient focus on these areas.

• Scenario planning: Investigate thedifferent scenarios that could applyand understand the practical impact ofeach scenario as changes may beexpected following the IASB re-exposure and as industry practicedevelops.

• Disclosure and communication:Don’t underestimate the time neededto prepare and industrialise disclosurerequirements and the importance ofexternal communication. Experiencefrom IFRS conversions in 2005demonstrates the importance of earlystakeholder management. Theimplementation of IFRS Phase II andSolvency II will lead to fundamentalchanges in how insurers evaluate andcommunicate performance, risk andcapital both internally and externally.Investors will also value insurers andassess financial and capital flexibilitydifferently. These changes represent aone-time opportunity for a ‘root andbranch’ reform of reporting to addressa number of the externalcommunication challenges theindustry has faced in recent years.The challenges for insurers will includebridging between the new and oldmetrics in a coherent manner. All thevalue gained from implementationcould be lost during this phase.


The move to IFRS Phase II presents significant implementationand investor relations challenges. How can your business ensure anefficient transition?

Gearing up for anefficient transition


Figure 2: Indicative implementation plan for moving into IFRS Phase II

Source: PwC analysis based on our understanding of the evolving frameworks and PwC assumption

* For foreign private issuer (FPI) registrant companies, an additional year of IFRS comparative information may be required

2013

Q1 Q2 Q3 Q4

2014

Q1 Q2 Q3 Q4

2015

Q1 Q2 Q3 Q4

2016

Q1 Q2 Q3 Q4

2017

Q1 Q2 Q3 Q4

2018

Q1 Q2 Q3 Q4

2019

Q1 Q2 Q3 Q4

Solvency II milestones

Comparativebalance sheet*

Opening balancesheet

IFRS Phase II live IFRS Phase IIfirst annualreport

IFRS Phase II milestones

IFRS Phase II Im

plementation

Solvency II Live

Solo Quantitative reportingtemplates live

First Solvency and Financial ConditionReport/Regular Supervisory Report

Group Quantitative reportingtemplates live

Final standardissued

Monitoring ongoing IFRSPhase II developments

Stage 1: Change readiness Stage 2: IFRS design,implementation and build

Stage 3:Comparativesand testing

IFRS Phase II live

IFRS Phase II impactassessment and sizing

Reporting strategy forgap period

Lay foundations forSolvency II

and IFRS reporting

Assess Solvency II synergies

Develop detailedimplementation

plan

Establish accounting policies,guidance

and resolve issues

Testing of newsystems, processes

and controls

Preparecomparativesand analyseresults

Organisational change roll-out(e.g. product design, remunerationand bonuses...etc.) and embedding

within the business

Systems change and data management

Controls designDesign revised financialreporting processes

Comparative half year

First IFRS Phase II halfyear report (includingopening and comparativebalance sheet)

Revised exposuredraft issued

Review, analyse and explain differences in reporting bases

OverviewAs a prudential regulatory regime, thefocus of Solvency II reporting is on thefinancial strength (capital resources) ofthe insurer as opposed to its performanceduring the year. As such, the Solvency IIbalance sheet is intended to reflect aneconomic valuation of all assets andliabilities at the balance sheet date. As afinancial reporting regime, IFRS isfocused not only on reporting financialposition at the balance sheet date but alsoon reporting performance in the period.This gives rise to some of the differencesbetween reporting under Solvency II andIFRS; in particular:

• Under IFRS Phase II the recognition ofthe profit arising from an insurancecontract is spread over the period ofcoverage – this is achieved by theinclusion of a ‘residual margin’ liabilitywhich is not present under Solvency II.The valuation of insurance contractliabilities under IFRS Phase II andSolvency II is discussed in the ‘ContractLiabilities’ section with Appendix Aproviding a comparison by component.

• Solvency II applies a consistentvaluation approach to all contractsissued by insurers. Under IFRS'investment contracts' issued byinsurers which do not transfersignificant insurance risk (and that donot contain a discretionaryparticipation feature) are accountedfor as financial instruments, notinsurance contracts (see Appendix B).

• The focus on reporting of performanceunder IFRS leads to changes in thevalue of insurance liabilities (andcertain financial assets) resulting fromchanges in interest rates not beingreported within profit or loss (asdiscussed in the ‘Contract Liabilities’section).

• IFRS contains specific requirementsregarding the reporting of volumemeasures in the income statement andthere will be differences between thedisclosures required under Solvency IIand IFRS (as discussed in the ‘ExternalReporting: Presentation andDisclosure’ section).

• Under Solvency II all assets and otherliabilities will be reported at economic(fair) value. Where the IFRS valuationis also based on fair value the valuationbases will be aligned. However, insome areas Solvency II introducesdifferent valuation bases where IFRS isnot viewed as representing aneconomic valuation (as discussed inthe ‘Assets and Other Liabilities’section, with Appendix C providing acomparison by component).

• In both Solvency II and IFRS, reportingis required at the level of the group aswell as at the level of the individualinsurer. However, there are differencesin the scope and approach to groupreporting (as discussed in the ‘GroupReporting’ section, with Appendix Dproviding a comparison bycomponent).


Both Solvency II and IFRS Phase II include significant departures fromcurrent reporting. A number of issues are also yet to be resolved. Furtherchallenges come from the differences in approach between the twoframeworks. How can you assess the potential synergies and the practicalchallenges that IFRS Phase II will bring?

Overcoming thetechnical challenges

A key aspect of the Solvency II regime isthe requirement for an insurer to havesufficient financial strength to absorbfuture adverse developments. This isachieved through the requirement forinsurers to hold a solvency capitalrequirement (SCR). There is noequivalent concept to the SCR withinIFRS, and this paper does not considerSolvency II’s requirements aroundcalculating and reporting the SCR.

Contract liabilities

Measurement modelBoth Solvency II and IFRS Phase II basethe measurement of insurance contractliabilities on the concepts of a probability-weighted estimate of future cash flows,the time value of money and anadditional allowance for risk.

In IFRS Phase II, an additional contractliability known as the residual margin isincluded to eliminate a gain on day one(while all day-one losses are recognised asincurred). There is no equivalent conceptto the residual margin in Solvency II or inmany current GAAPs. For short durationinsurance contracts, which make up themajority of non-life contracts, a simplifiedunearned premium approach is permittedbut not required under certaincircumstances for pre-claims contractliabilities in IFRS. There is no equivalentconcept in Solvency II.

In addition, there is a requirement tounbundle certain components ofcontracts and measure them underdifferent IFRS standards, though thesesituations in practice are expected tobe limited.

In IFRS, the measurement of contractsdepends on their classification aseither insurance or investment, whileSolvency II makes no such distinction.

The IFRS classification depends on thelevel of insurance risk transferred to theinsurer and this definition is expected tobe largely unchanged from IFRS 4.In addition, investment contracts witha discretionary participating feature(participating investment contracts),where issued by an insurer, are expectedto be in the scope of the new insurancecontracts standard.

Non-participating investment contracts,for example, a pure unit-linked savingscontract, are similar in nature toinstruments found in other markets andsectors and, as a result, are subject to theIFRS financial instruments and revenuestandards. The contract liability istypically measured at fair value or atamortised cost.

Figure 3 illustrates a comparison of theSolvency II and IFRS requirements formeasuring contract liabilities.


Figure 3: Solvency II versus IFRS requirements for measuring contract liabilities

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 (limited expectedapplication).

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

• Risk adjustment = Compensation theinsurer requires for bearing the uncertaintyinherent in the cash flows that arise as theinsurer fulfils the contract.

• Replicating portfolio methods are allowablewith constraints (limited expectedapplication).

• Residual margin is set to avoid aday-one gain.

• Acquisition cost are included in thefulfilment cash flows resulting in implicitdeferral of these costs.

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

• Initial measurement is at fair value.Subsequent measurement is at fair valueor at amortised cost depending onclassification.

• Model contains deferral of acquisition costsand upfront fees.

Free assetsEquity Equity

Residual marginSolvency capital requirement

Replicating portfolio value

Replicating portfolio value

Fair value or amortised cost liability

Risk margin Risk adjustment

Discountedprobability-weighted

estimate offulfilmentcash flows

Discountedprobability-weighted

estimate offuture cashflows

ContractLiability

The relative size of the diagram is purely for illustration purposes only and could differ significantly by product and company. A number of simplifying assumptions havebeen made. Asset valuations may differ between Solvency II and IFRS, resulting in differences in free assets and equity respectively. For insurance contracts, it assumesthat there is no unbundling requirement and does not consider specific short duration contract treatment.


ContractLiability(TechnicalProvisions)

Figure 4: At a glance, a summary comparison of the main differences between IFRS Phase II and Solvency IIcontract liabilities

ObservationsTopic

Definition andscope

Recognition

Unbundling

Insurance andparticipatinginvestment contracts

Date coverage begins(plus onerous contracttest for period beforecoverage begins)

Distinct investmentcomponents, embeddedderivatives and certaingoods and services

All contracts

Date party to contract

No

• The measurement of investment contracts in IFRSmay be significantly different from Solvency II.

• The level of difference will depend on the onerouscontract test in IFRS. For many contracts therecognition will be the same.

• It is expected that the scope of unbundling is limitedso this difference may not be significant.

• Revenue items are not presented on the IFRS incomestatement for non-distinct investment components(known as ‘disaggregation’).

Contractboundary

No longer required toprovide coverage orcontract does not conferany substantive rights topolicyholder

Amend terms to‘fully reflect risk’

No projection of premiumsfor savings contracts

• The contract boundary definition could be differentbetween Solvency II and IFRS.

• In Solvency II (unlike IFRS) there is a requirement toseparate contracts into components, where thecontract boundary differs between components.

Cash flows(excluding acquisitioncosts)

Incurred directly to fulfilportfolio of contracts

Prescribed • There is a risk of differences in the cash flowsincluded in the two frameworks. For example, thetreatment of certain overhead expenses.

Acquisition costs Directly attributable atportfolio level

Expensed as incurred • In IFRS, there is ‘implicit’ deferral of acquisitionexpenses. There is no equivalent concept in Solvency II.

Discount rate

Risk adjustment/margin

Residual margin

Participatingcontracts

Short durationcontracts

Top-down or bottom-up(current and locked-infor OCI purposes)

No prescribed method

Eliminate day-one gain(update for certainsubsequent changes)

Cash flows fromparticipating featureincluded (consistentwith asset valuationand presentation)

Unearned premium modelfor pre-claims liability whilecash flow projection forclaims liability

Prescribed based onswaps + (matchingadjustment or counter-cyclical premium)

Prescribed 6% cost ofcapital

No

Cash flows fromparticipating featureincluded (exceptfor ‘approvedsurplus funds’)

As for other contracts

• The discount rate is the most significant area ofuncertainty in Solvency II. It is unclear how theSolvency II discount rate will compare to the principle-based approach in IFRS.

• Two sets of discount rates (current and at inception)are required for IFRS income statement presentation.

• The Solvency II risk margin is highly prescribed, whilethe IFRS risk adjustment is principle-based. It is likelythat there will be differences in the two approaches.

• In IFRS, there will be retrospective application of thestandard. The residual margin on transition will be thekey area of complexity.

• The linkage of the cash flows in IFRS to the assetmeasurement and presentation is a significantdifference from Solvency II if assets are not at fairvalue through profit or loss.

• The treatment of residual participating fund assets andthe allocation between liability and equity will dependon the specific nature of the contracts and theapproved national law. The comparison between IFRSand Solvency II is currently unclear.

• In IFRS, the unearned premium model is optional.A cash flow approach can be adopted as inSolvency II.

IFRS Phase II Solvency II Significance



Figure 4 presents a summary of the main differences between IFRS Phase II and Solvency II contract liabilities based on ourunderstanding of the evolving frameworks.

Addressing volatilitySince the original IASB exposure draft in2010, significant revisions have beenmade to the IFRS Phase II measurementmodel. A number of these changes gosome way to address the concern ofstakeholders on what is perceived to bethe ‘artificial’ earnings volatility in theoriginal model (see Figure 5). Thechanges include:

• Requiring the residual margin toabsorb certain changes in estimates offuture cash flows.

• Clarifying that a ‘top-down’ approachcan be adopted to determine thediscount rate.

• Requiring that the effect of changesin the discount rate be presented inOther Comprehensive Income (OCI)to address the interaction with thepresentation and measurement ofassets (when at fair value throughOCI or amortised cost).

• Reflecting the contractual linksbetween assets and liabilities in themeasurement of participatingcontracts.

The benefits of these refinements areaccompanied by increased operationalcomplexities that are not mirrored inSolvency II due to its focus on balancesheet strength. It is also unclear whetherthe proposed changes will fully addressall stakeholders’ concerns.

The following subsections of thispublication explore in more detail themain difference between IFRS Phase IIand Solvency II contract liabilities and theproposals to address the perceived‘artificial’ earnings volatility in IFRS.

Figure 5: Addressing volatility in IFRS 4 Phase II



Presentation of discount rate changes in OCI

Addressingvolatility

Permitting use of ‘top-down’ discount rate approach

Unlock residual margin to absorb changes

in future cash flow estimates

Reflecting contractual linkage b

etween assets and

liabilities for p

articipating contracts

Cash flowsThe use of estimated future cash flows isthe foundation for the measurementmodel for Solvency II and IFRS Phase II.However, there are some differenceswhich may present practical difficulties,necessitating either separate models orgreater flexibility within a single model.We highlight three specific areas:

Scope of cash flowsIn both Solvency II and IFRS Phase II,there is expected to be explicit guidanceas to which cash flows are to be includedin the measurement of the liabilities.Many of the cash flows will be the same inthe two models, such as premiums andclaims. However, not all the cash flowsare expected to be fully aligned. Forexample, the inclusion of certainoverheads costs may be different. Thismay trigger changes in your expenseallocation process and lead to two sets ofexpense assumptions.

Acquisition costsIn IFRS Phase II, the cash flow modelincludes directly attributable acquisitionexpenses and so there is ‘implicit’ deferralof these expenses through a reduction inthe residual margin. Many current GAAPspermit an explicit deferral of acquisitioncosts as an asset on the balance sheet, sowhile the exact definition of acquisitioncosts permitted to be deferred may bedifferent you may well have the systemsalready in place to capture this data.For non-participating investmentcontracts in IFRS, there is explicit deferralof acquisition costs as an asset on thebalance sheet, but with a narrowerdefinition of the costs permitted to bedeferred compared to insurance contracts(broadly costs that are incremental atthe contract rather than portfolio level).There is no equivalent concept ofdeferring revenue or costs over the lifeof the contract in Solvency II.

Boundary of a contractThe boundary of a contract represents thepoint beyond which any cash flowsrelating to a contract are no longerrecognised in the measurement of theliability. The boundary will be the same inthe two frameworks for many contractshowever there is a risk that somedifferences may exist. For example, thereis a requirement in Solvency II to separatecontracts into components, where thecontract boundary differs betweencomponents. There is no equivalentrequirement in IFRS.

In Solvency II, there is a separate contractboundary for those contracts whichwould typically be non-participatinginvestment contracts in IFRS. Theboundary is defined so that no futurepremiums are included in the cash flows,and as a consequence, embedded profitsarising from these future premiums arenot included on the balance sheet. InIFRS, as these contracts are often unitlinked, there is no estimation of futurecash flows and the liability is measured atfair value or amortised cost which isusually the unit balance.

Insurers will require data and cash flowmodel developments to deal with theseimplications.

Discount rate For insurers writing long-term savingsproducts, the valuation of contractliabilities and resulting solvency ratiosand accounting profit are highly sensitiveto the selection of the discount rate.

There remains considerable uncertaintyover the discount rate in Solvency IIpending the proposed long-termguarantees impact assessment. It isexpected that the discount rate to be usedwill be determined by the regulator basedon the swap curve plus either a matchingadjustment (applicable to certaincontracts) or a counter-cyclical premium(only applicable in certain extrememarket conditions). These adjustments to

the swap curve are designed to addressthe impact of volatility in credit spreadson the solvency balance sheet. Thematching adjustment is designed toreflect the possibility that there may be no(or limited) exposure to spread risk(excluding default risk) due to thecharacteristics of the liabilities and theasset-liability matching strategiesadopted. The scope of liabilities to whichthe matching adjustment is applied(narrow versus wider) and the calibrationof the adjustment remain uncertain. Thecounter-cyclical premium is designed,when triggered (by the regulator), toprovide short-term relief during periodsof ‘excess’ spread widening in sovereignand corporate bond markets. Thecalibration of the premium and thecriteria as to when the premium ispermitted remain uncertain.

In IFRS Phase II, the approach to thediscount rate is principle-based and itmust reflect the characteristics of theliabilities. You can use a ‘top-down’approach, starting with the yield on thesupporting or reference assets withdeductions for default and mismatch risk(to adjust for differences in the timing ofasset and liability cash flows), or a‘bottom-up’ approach starting with therisk-free reference rate plus an illiquiditypremium. A top-down approach is likelyto be applied for ‘spread-based’ insurancecontracts, notably annuities in payment.

In IFRS Phase II, it is proposed that theimpact of all changes in the discount rateover time are to be presented in OCIrather than through profit or loss. There isno equivalent concept in Solvency II. Theapproach will require the contract liabilityto be measured based on both the currentand ‘locked-in’ (at inception) rates.This will introduce additional data andsystem requirements and will result in anaccounting mismatch in the incomestatement for those contracts withsupporting assets measured at fair valuethrough profit or loss. However, wherecontacts are backed by debt securitiesmeasured at fair value through OCI the


“The use of estimated future cash flows is the foundation ofboth frameworks. However, there are some potentialdifferences which will present practical difficulties.”

presentation of the discount rate willreduce accounting mismatch in theincome statement.

Figure 6 illustrates the different approachin Solvency II compared to IFRS andraises a number of questions, includingwhether a wider application of thematching adjustment would be equivalentto a top-down approach in IFRS. Theanswers won’t be known until Solvency IIis finalised. Conceptually, there aresimilarities between the matchingadjustment and the top-down approach.However, to include the counter-cyclicalpremium (triggered by a regulator’sassessment of market events) in IFRS

would appear challenging given therequirement to reflect the characteristicsof the liabilities, which are typicallyindependent of market events.

In addition, there is the possibility that atransitional arrangement on the discountrate may exist in Solvency II. For example,use of Solvency I rules may be allowed orphased out gradually over a period oftime for existing contracts onimplementation of Solvency II. This couldresult in liabilities with the samecharacteristics having different discountrates in Solvency II, which would bechallenging to justify in IFRS.

Where there are differences between thediscount rate in Solvency II and IFRS,including the requirement for two rates inIFRS, this will introduce a number ofoperational challenges, including dualassumption and valuation processes,potentially different asset datarequirements, multiple economic scenariocalibrations and additionalreconciliations.

For short duration insurance contracts,the issue of discounting is less significantfor the pre-claims liability. However, it isimportant to be aware of the implicationsfor the liability for incurred claims (post-claims) particularly long tailed claimsliabilities, notably, periodic paymentorders and latent claims (such asasbestosis).


Figure 6: Illustrative discount rate comparison – Solvency II versus IFRS Phase II

or or

The relative size of the diagram is purely for illustration purposes only and could differ significantly by product line and company.


Scope of products: To all products not in the scope of thematching adjustment

Calibration:When the counter-cyclical premium is nottriggered, the discount rate is the risk free rate. Whentriggered, the counter-cyclical premium represents the‘excess’ spread on reference sovereign and corporate bonds

Scope of products:Narrow versus wideapplication?

Calibration: Matchingadjustment represents theasset rate less an allowancefor default risk (withrestrictions on the calibration)

For products in thescope of the matchingadjustment, could IFRS =Solvency II? It will dependon the calibration of thecomponents

Top-down = bottom-up?It will depend on thecalibration of thecomponents and thecomponents of assetyields not relating to creditor illiquidity

Two discount rates required:Locked-in (OCI) and current rates

IFRS (‘top-down’)Solvency II – developing proposals IFRS (‘bottom-up’)

Transitional provisions: Could Solvency I discount rates be permitted inSolvency II for a period of time?

Expecteddefault

Unexpecteddefault

Mismatchadjustment

Discountrate

Risk-freerate

Illiquiditypremium

Risk-freerate

Risk-freerate

Matchingadjustment

Risk-freerate

Counter-cyclicalpremium

“There remains considerable uncertainty over the discountrate in Solvency II. Differences in approach betweenSolvency II and IFRS, including the requirement for currentand locked-in rates in IFRS, introduce a number ofoperational challenges.”

Allowance for risk The concept of an explicit adjustment forrisk is fundamental to both Solvency IIand IFRS Phase II. In Solvency II, theallowance for risk is determined followinga ‘cost of capital’ approach with aprescribed calibration, for example, a 6%assumed cost. In IFRS Phase II there is noprescribed method and the calibrationmust conform to a principle: ‘thecompensation the insurer requires forbearing the uncertainty inherent in thecash flows that arise as the insurer fulfilsthe contract’. If you are governed bySolvency II, it is likely that you will wantto make use of the models you havedeveloped for this purpose and aretherefore likely to adopt a cost of capitalapproach under IFRS. However, there isthe potential in IFRS to have a differentcost of capital calibration from that usedin Solvency II. For example differencescould exist in respect of the assumed costrate, the level of diversification benefitand the treatment of tax losses in thecapital assessment. There are alsopractical considerations, including

whether the Solvency II models can beadapted, model run times and how anydifferences will be reconciled andcommunicated to stakeholders.

As the results from the Solvency II FifthQuantitative Study (QIS 5) highlighted,the risk margin in Solvency II is expectedto be a relatively small percentage of thetechnical provisions (see Figure 7), so anydifferences in the calibration for IFRSPhase II may not be that significant.

At inception of a contract, a difference inthe calibration of the allowance for riskbetween IFRS and Solvency II does notimpact IFRS profit or loss as it is offsetby the calculation of the residual margin(to the extent that there is a gain atinception). However, the difference willimpact the future recognition of profitdue to the different patterns of releasingthe risk adjustment and residual marginto profit or loss.

Residual margin As the residual margin is a concept withno direct comparison in Solvency II andmany current GAAPs, you will need todevelop a new model or separate systemto determine this element of the liabilityand its release to profit or loss during thelifetime of the contracts.

The residual margin is determined ata ‘portfolio level’. The release of theresidual margin is to the period in whichthe service is provided and there is noprescribed level (unit of account). It isunclear how this will be interpreted inpractice by insurers.

In addition, the margin is increased forinterest at each reporting period at thelocked-in rate (as considered in thediscount rate section). Changes inestimates of future cash flows are notrecorded in profit or loss, but are offset inthe residual margin (‘unlocking’), subjectto the residual margin not becomingnegative. You will still need to monitor anegative residual margin as changes inthe estimates of future cash flows couldresult in the residual margin becoming

Figure 7: Risk Margin as a percentage of Technical Provisions in QIS 5

Source: EIOPA Report on the Fifth Quantitative Impact Study (QIS 5) for Solvency II (March 2011)

8%

7%

6%

5%

4%

3%

2%

1%

0%Total life Total non-life

n Solo n Group


positive in future periods and presentedas a liability on the balance sheet.Changes in the valuation of options andguarantees, discount rate and riskadjustment are not offset by the residualmargin. The requirement to unlock theresidual margin and charge interestintroduces greater complexity and moregranular data requirements.

The box above poses key questions toconsider for developing a model todetermine and manage the residualmargin.

Participating contractsThe basic definition of a participatingfeature is similar in Solvency II and IFRSPhase II. All participating contracts issuedby an insurer are expected to be in thescope of IFRS Phase II. In bothframeworks, certain 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.

In IFRS, the cash flows relating to thepolicyholder’s participation are measuredand presented mirroring the underlyingassets in which the policyholderparticipates, so at cost or fair value

(through OCI or profit or loss); whileoptions and guarantees are measuredat their current value. There is noequivalent concept of mirroring inSolvency II as all assets are at economic(fair) value.

In IFRS, all expected payments to currentor future policyholders are treated as aliability, even when at the insurer’sdiscretion. In Solvency II, there is nodirectly equivalent concept, however,no liability is required for ‘surplus funds’where this has been authorised undernational law. The implications of theseapproaches will depend on the specificnature of the participating contracts andthe approved national law.

The treatment of participating contractsin IFRS Phase II, including the practicalapplication, remains an area ofuncertainty as the IASB continues itsdeliberations. In comparison to manycurrent GAAPs, it is expected that IFRSPhase II may introduce greaterinvestment volatility in IFRS earnings.

TransitionBoth Solvency II and IFRS Phase II requireretrospective application on transition.This represents a significant change forIFRS compared to the exposure draft in

2010, where it was assumed that noresidual margin would be allowed onexisting contracts, effectively writingoff this future profit to equity on adoptionof the new standard. In Solvency IItransitional provisions (such aspotentially for the discount rate discussedearlier) may remove in certain respectsthe requirement for a retrospectiveapplication.

As Solvency II is a full prospectivemeasure there is limited additionalcomplexity from retrospectiveapplication. However, it will bechallenging under IFRS, as the residualmargin on transition will require anassessment of contract profitability atoutset which is then reassessed to thecurrent date, a period of over 20 years onsome contracts. The importance of thisassessment cannot be understated giventhe significant impact the margin willhave on IFRS earnings followingimplementation.

For IFRS Phase II, transition is effectivelyon a ‘best endeavours’ basis, as estimationmethods will be permitted to determinethe residual margin on transition whenthere is insufficient objective data forcertain years. Examples of estimatemethods could include adjustingembedded value new business margins


1. What is the definition of your portfolios and do your existing cash flow models provide the required information atthis level?

2. How will you release the residual margin to profit or loss, including both pattern and unit of account?3. Can you identify in your models the impact from changes in estimates of future cash flows to unlock the residual margin? 4. What are the system options for modelling the residual margin?5. A reconciliation of the residual margin between each reporting period has to be disclosed. How will you prepare

this analysis?6. Once established, the residual margin will be a significant component of profit in each period. How will you explain

and analyse this internally?

The answers to these questions (among others) will help to determine the model requirements for managing the residualmargin process following transition.

Key questions to be considered in developing a residual margin model:

“Full retrospective application will be challenging underIFRS as the residual margin on transition will require anassessment of contract profitability at outset and thenreassessed to the current date, a period of over 20 years onsome contracts.”

for differences to IFRS or adapting otherlegacy reporting metrics. There is addeddata complexity from the unlocking of theresidual margin and the requirement for adiscount rate at inception. Gathering datain the right format and at the right level ofgranularity is likely to be a substantialexercise, which should not beunderestimated. An assessment on aproduct by product basis will help tailorthe approach to those products where themost significant profit margins haveexisted. For some products, the marginmay be clearly zero (or negative) due toage or adverse demographic assumptionchanges in the past. Whichever approachis adopted, it will need to be robust andcapable of being audited.

Insurers are expected to adopt a similarapproach to disclosing the impact oftransition as was adopted for theimplementation of IFRS 4 in 2005.

The residual margin on transition has thepotential to create some surprisingresults, which will need to be explained,particularly for products written back inpast decades when the market conditionsand underwriting practices were differentfrom those of today.

External reporting:presentation anddisclosure

DisclosuresThe IFRS Phase II package of disclosuresis largely known, and includes a numberof additional requirements beyond thosecurrently required for IFRS 4. Insurersmay find the requirements onerous, suchas detailed opening to closing balancesheet reconciliations and the confidencelevel disclosures for the risk adjustment.Solvency II also creates a significantnumber of private and public reportingand disclosure requirements. In bothframeworks, the required level of detail isexpected to be more onerous than currentaccounting and regulatory requirements.In Solvency II, there is also increasedfrequency of reporting.

Given the status of the disclosurepackages, it should be possible to carryout an initial comparison of therequirements and judge what could bebrought together. For example, couldthe Solvency II analysis of change intechnical provisions and claimsdevelopment tables be used for equivalentIFRS disclosures? Automating theproduction will reduce reporting timeframes and save on related costs. Inaddition, with separate accounting andregulatory reporting requirements, it willbe important to explain and reconcile thetwo balance sheets.

Presentation of the incomestatement IFRS Phase II will prescribe the approachto income statement presentation. In achange from the original exposure draft,it will include premium, claim andexpense information (‘volume measures’)on the face of the income statement.An ‘earned premium’ method is to befollowed, where premiums are allocatedto each period in proportion to therelative value of the insurance coverageand other services expected to beprovided in that period. In addition, the

measurement of premiums, claims andbenefits presented in the incomestatement excludes receipts and paymentsfrom certain investment componentswithin contracts (typically expected to bemany policyholder account balances).These changes represent substantialdifference to many current GAAPs forinsurers who write long-durationbusiness, and so will impact significantlydata and system requirements. How thevolume measures are explained tostakeholders will need to be considered.

There are no equivalent concepts inSolvency II due to its focus on the balancesheet strength rather than performancereporting.

Assets and otherliabilitiesThe valuation of assets and otherliabilities under Solvency II is, wherepossible, intended to be consistent withIFRS as endorsed by the European Union.It is therefore likely that there will besignificant overlap between the twoapproaches, although there will be somemeasurement differences where IFRS isnot considered to provide a suitablevaluation for regulatory purposes.

Financial assets andfinancial liabilitiesUnder IAS 39 and its replacement IFRS 9,financial assets are valued either atamortised cost or at fair value (either inOCI or through profit or loss). Wherevalued at amortised cost, insurers willneed to convert them to fair value forSolvency II. Under IFRS, financialliabilities are valued at either fair value oramortised cost. Solvency II requires thatfinancial liabilities should be valued inconformity with IFRS upon initialrecognition however subsequentadjustments are made for changes in therisk-free rate. This deviates from a fairvalue valuation because changes arisingfrom changes in the insurer’s owncredit standing are excluded from theSolvency II valuation.


Participations(subsidiaries, associates,joint ventures and specialpurpose vehicles)Under IFRS in solo financial statements,investments in participations are valuedat either cost or fair value. This may differfor Solvency II, where listed participationsare valued using quoted market prices,unlisted subsidiaries on an ‘adjustedequity method’ (being the share of netassets valued in accordance withSolvency II valuation principles or, whenSolvency II valuation is not practicable,valued based on IFRS excludingintangibles and goodwill) and otherundertakings (not subsidiaries) on anadjusted equity method (with an optionto mark to model if an adjusted equityvaluation is not possible).

Property plant andequipment (PPE)Solvency II proposes that PPE (excludinginvestment property) should be at fairvalue where these items are not otherwisemeasured at economic value. Therevaluation model in IFRS is consideredas a reasonable proxy for fair value.However IFRS also allows a morecommonly used alternative method ofvaluing PPE at cost less depreciation. Theshift to economic valuation in Solvency IIis likely to be a change for most.

Goodwill and intangiblesUnder IFRS goodwill is recognised as aspecific asset when an acquisition takesplace and there is a positive differencebetween the purchase consideration paidand the fair value of the net assetsacquired. Solvency II proposes that novalue be ascribed to acquired goodwill.

Under IFRS intangible assets that qualifyfor recognition are measured under eithera cost model or, where there is an activemarket for the asset, a revaluation model.Solvency II proposes that intangible assetsare assigned a value only when they canbe sold separately and a valuation can bederived from a quoted market price in anactive market for the same or similarintangible. In practice most intangibleassets of insurers are not traded in activemarkets and so no value will be assignedunder Solvency II.

LeasesUnder Solvency II, finance lease assets aremeasured at fair value. This differs fromthe present value of the minimum leasepayment under IAS 17, which isconsidered inconsistent with Solvency IIvaluation principles.

Contingent liabilitiesUnder Solvency II material contingentliabilities are recognised as liabilities inthe balance sheet and they are valuedbased on the discounted expected presentvalue of the cash flows needed to settlethe liability. Under IFRS, contingentliabilities are disclosed but not recognisedon the balance sheet (except when arisingupon an acquisition).

Employee and terminationbenefitsFollowing the recent amendment toIAS 19, the treatment of employee andtermination benefits under Solvency IIand IFRS are closely aligned. Under QIS 5it was possible for insurers to apply theirown internal model to the valuation ofemployee benefits. Under most recenttechnical specifications from EIOPApublished in October 2012, this approachis not mentioned. It is not clear whetherthis means the use of an internal modelfor the valuation of defined benefitpension obligations will no longer bepermitted under the Solvency II regime.


Group reportingBoth Solvency II and IFRS requirereporting at group as well as at the entitylevel. For Solvency II, group reportingallows the insurer to make an assessmentof its group capital position, and underIFRS consolidated accounts are preparedto present a single picture of the results ofthe group. Reflecting these differentpurposes, the scope, level and method ofconsolidation differs between IFRS andSolvency II, and the results prepared foreach purpose may therefore besignificantly different.

Level at which groupreporting appliesIFRS requires group reporting at the levelof the top company (the ultimate parentcompany) of the group, regardless of theactivities of the entities within the group.In addition consolidation may be requiredat a sub-group level either by IFRS (forexample, where an intermediate parenthas listed debt) or by requirements ofnational law.

Under Solvency II group reporting is onlyapplicable at the level of an insurancegroup which could be a subset of a largergroup also conducting significant non-insurance activities. The level at whichSolvency II group supervision appliesdepends on the location of the ultimateinsurance parent and whether itsregulatory regime is deemed equivalentto Solvency II:

• Where the ultimate insurance parent ofthe group is within the EuropeanEconomic Area (EEA), Solvency IIgroup reporting will be at this level.

• Where the ultimate insurance parent isoutside the EEA, the group is subject toSolvency II group supervision at theultimate EEA insurance parent level(that is at the sub-group level) and therequirement for any additionalsupervision will depend on whetherthe regulatory regime of the ultimateparent entity is deemed equivalent toSolvency II. If the regulatory regime of

the ultimate parent is deemed to benon-equivalent it is possible that theultimate group parent will also besubject to Solvency II groupsupervision.

The level of Solvency II group reportingmay therefore differ from IFRS eitherbecause Solvency II reporting is requiredat an EEA level where IFRS reporting maynot be; or because the insurance groupsubject to Solvency II group reporting is asub-group of a larger group subject toIFRS group reporting.

Scope of consolidationAnother potential source of differencesbetween Solvency II and IFRS groupreporting lies in the definition of thegroup and as a result, which entities willbe part of a group. Under IFRS a group iscomprised of subsidiaries, joint venturesand associates. Under Solvency II thegroup is defined as the parent, itssubsidiaries and participations. Thedefinition of the entities comprising theSolvency II group is based on definitionscontained in EU Accounting Directives;although these definitions are broadlyconsistent with IFRS, there are somedifferences that could potentially lead to adifferent scope of consolidation. Inaddition, supervisors are able to includeother entities in the scope of Solvency IIgroup supervision where they concludethat dominant or significant influenceis exercised.

Method of consolidationIFRS requires a single approach toconsolidation, which involves combiningall the results of the parent and itssubsidiaries in the group on an individualline item basis, then applyingconsolidation adjustments, for example toeliminate inconsistencies in accountingpolicies and intra-group transactions.Associated undertakings are accountedfor using the equity method ofaccounting.

Solvency II has two methods by which thegroup results may be prepared. Thedefault approach under Solvency II is the‘accounting consolidation-based method’,using the consolidated accounts as astarting point. Although it is called theaccounting consolidation method, inreality the mechanism of consolidationdepends on the type of entities beingconsolidated. For example, insurancesubsidiaries are consolidated on a full lineby line basis; other financial institutionswithin the group are incorporated on thebasis of the proportional share of theirown funds; and non financial sectorunlisted subsidiaries will be incorporatedon an adjusted equity method. As a result,although there may be opportunities forsynergies where a group prepares IFRSconsolidated accounts at the same level asthe Solvency II group calculation, it isclear that the Solvency II consolidationmechanism is quite different to IFRS.Alternatively under Solvency II, the‘deduction and aggregation’ method maybe used at the discretion of the groupsupervisor, which calculates groupsolvency based on the aggregation of theindividual entities in the group on aSolvency II or equivalent basis.


Appendix A: Insurance contracts

Appendix B: Investment contracts

Appendix C: Assets and other liabilities

Appendix D: Group reporting


AppendicesDetailed technicalcomparison of Solvency IIand IFRS



Solvency II

1. Relevant standards / sources of information

• QIS 5 technical specification (where relevant)

• Solvency II Level 1 Directive (where relevant)

• Proposals on the Omnibus II Directive issued by the EuropeanCommission in January 2011, the Council of the EuropeanUnion in September 2011 and the European Parliament inMarch 2012

• EIOPA Technical Specifications for the Solvency II valuationand Solvency Capital Requirements calculations (Part I)published in October 2012

In addition, other public consultations and our currentunderstanding of the evolving framework are included.

• Insurance Contracts exposure draft (where relevant –July 2010)

• IASB Detailed Progress Report (October 2012)

• IASB Staff Paper: Effect of the Board decisions (October 2012)

• IASB Working draft papers (December 2011, July 2012)

• Tentative decisions made by the IASB to October 2012

2. Scope

• Solvency II applies to all insurance and reinsurance contractswritten by insurers in the European Economic Area (EEA) andits group supervision requirements apply to insurance groupscontaining EEA insurers. In addition certain of Solvency II’srequirements apply to contracts written by non-EEA insurersthrough branches in the EEA.

• There is no distinction between insurance and investmentcontracts except for determining the cash flows that are withinthe boundary of a contract as discussed in a subsequentsection.

• 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 are primarily a provision of services;and financial guarantee contracts that the issuer has notpreviously asserted that it regards as insurance contracts(under IFRS 4)); or

– Do not transfer significant insurance risk, but are investmentcontracts with discretionary participation features thatare issued by an insurer.

• The definition of significant insurance risk is largelyunchanged from IFRS 4, with the exception that a contractdoes not transfer insurance risk if there is no scenario that hascommercial substance in which the insurer can suffer a loss (ona present value basis). Special provisions allow certainreinsurance contracts that do not suffer an overall loss tocontinue to be within the scope of the insurance standard.

• Distinct investment components (e.g. certain policyholderaccount balances), embedded derivatives and distinct goodsand services contained in insurance contracts are unbundledand measured under the applicable IFRS standards.

• There is no directly equivalent concept of unbundling andalternative measurement under Solvency II. The consequencesof unbundling in IFRS, may in some circumstances, result in asignificant difference from Solvency II, as the treatment ofinvestment contracts and revenue differ between the twoframeworks.

• It is likely that many investment components will not be distinctdue to interactions with the insurance component. As aconsequence, it is expected that there will be limitedunbundling for measurement in IFRS.

IFRS


Solvency II

3. 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 forclaims outstanding and premium provisions is carried outseparately.

• The claims provisions relate to claim events already incurredat the valuation date (including incurred but not reported) andcomprise all future benefits, expenses and premiums relatingto those events.

• For premium provisions, the cash-flow projections relate toclaims events, falling within the boundary of the contract, thatoccur after the valuation date. Cash flows include future claimpayments in relation to claims that occur after the valuationdate (that is, unexpired risks), future premiums and associatedexpenses. As cash inflows could exceed the cash outflows, thepremium provision can be negative and hence expected futureprofit is recognised at day one.

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

Liability for remaining coverage (‘pre-claims’ liability)

• A modified measurement model, the Premium AllocationApproach (PAA), is permitted (but not required) where either:

– the period of cover is one year or less; or

– the approach would produce measurements that are areasonable approximation of those that would be producedby the building block model.

This is expected to relate to the majority of non-life contractsand certain short-term life contracts. There is no equivalentoption in Solvency II.

• In the PAA model, the liability is measured using the premiumreceivable at inception less eligible acquisition costs. Theliability is spread evenly over the contract period or based onthe expected timing of incurred claims and benefits, if thatpattern differs significantly (for example a portfolio with a highlevel of US hurricane exposure).

• In addition, in relation to the PAA model:

– If the insurer elects, the acquisition costs can be expensedas incurred if the coverage period is one year or less.

– The time value of money (discounting and interest accretion)should be reflected in the liability, using the locked-indiscount rate at inception of the contract, if the contract hasa significant financing component. As a practical expedient,discounting and interest accretion is not required if the periodbetween premium receipt and the end of the coverage is oneyear or less.

• When the facts and circumstances indicate that a portfolio ofcontracts is or is likely to become onerous an additional liabilityis set up. The onerous contract test is an active assessment ateach valuation date.

Liability for incurred claims (‘post-claims’ liability)

• The liability (incurred whether reported or not) is measured,similarly to Solvency II and the building block model, as thediscounted probability-weighted future claim cash flows (with arisk adjustment) related to claim events having occurred before,or at the point of valuation (this is discussed further, in thesubsequent sections).

• Claims and interest expense reported in profit or loss aredetermined using the locked-in discount rate at inception of thecontract. The difference from the current rate used to measurethe liability is reported in Other Comprehensive Income (OCI).

• However, unlike Solvency II, discounting is not required if theclaims are expected to be paid within 12 months.

IFRS



Solvency II

4. Future cash flows

Probability-weighted future cash flows

• In 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 maybe more appropriate. For example, in respect of the valuationof non-life liabilities, deterministic methods (for example chain-ladder methods) will usually be appropriate, providing these arecalibrated (or else adjustments made) to target a best estimate.Alternatively, for life insurance liabilities the outcomes forcertain risk variables are sufficiently symmetric that adeterministic valuation will suffice.

• 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. For example, for non-life liabilities or more generallywhere stochastic methods are adopted.

• There is no deposit floor and negative liabilities are permitted.For example, the total liability for a unit linked contract can bebelow the account balance (unit fund).

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

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 as the point where the insurer canunilaterally terminate the contract, refuse to accept apremium; or amend the benefit or premium without limit (tofully reflect the risks, so there is no scenario under which thebenefits and expenses payable exceed the premium).

• The ability to amend (or re-price) to reflect risk is at thelevel of a portfolio of obligations except for certain lifeinsurance obligations where it is at the contract level (this isin the case where an individual risk assessment was carried outat the inception of the contract and the assessment cannot berepeated before amending the premiums or benefits).

• If there is no material transfer of insurance risk or financialguarantees in the contract, then any obligations that do notrelate to premiums which have already been paid do not belongto the contract, unless the insurer can compel the policyholderto pay the future premium. So effectively, these contracts aretreated as being ‘paid-up’ and embedded profit from futurepremium is not included on the Solvency II balance sheet. It isnot immediately clear that the ‘significant’ insurance risktest in IFRS is the same as this boundary definition inSolvency II.

• There is a requirement to unbundle contracts into componentswhere the contract boundary definition would differ betweenparts. This is a different concept to the unbundlingrequirements in IFRS.

Probability-weighted future cash flows

• In IFRS, the contract liability is measured on the basis of anexplicit, unbiased and probability weighted estimate of thefuture cash outflows less the future cash inflows that will ariseas the insurer fulfils the contracts. It is the expected value.The considerations regarding the valuation techniques tobe used are likely to be similar to Solvency II. However, IFRSprovides less explicit guidance on the technique to be appliedthan Solvency II.

• The considerations over grouping and approximations applyequally under IFRS.

• A gain is not permitted at inception and would beeliminated by the residual margin.

• A minimum level of segmentation is defined by the requirementto determine the residual margin at a portfolio level (where aportfolio comprises contracts (a) subject to similar risksand priced similarly relative to the risk taken; and (b)managed together as a single pool).

Contract boundary

• The boundary is at the point where the contract no longerconfers substantive rights on the policyholder.

• For insurance contracts, this is considered to be either when:

– the insurer is no longer required to provide coverage; or

– the insurer is able to fully reassess and re-price the riskattaching to an individual policyholder.

There are additional conditions that apply where thereassessment and re-pricing of risk is at the portfolio level.

• For investment contract with a discretionary participationfeature (DPF), this is considered to be either when:

– the policyholder no longer has a contractual right to receivebenefits arising from the DPF; or

– premiums charged confer upon the policyholder substantiallythe same benefit as those that are available, on the sameterms, to those who are not yet policyholders.

• There is a risk that the contract boundary for Solvency IIand IFRS for insurance contracts may diverge. Bothdefinitions permit, under certain conditions, a boundarybased on a re-pricing assessment at the contract andportfolio level. Insurers will need to look closely at the twodefinitions across their full range of contracts to assesswhether the revised definition will change the existing contractboundary.

IFRS



Solvency II

4. Future cash flows continued

Recognition and derecognition

• A contract is initially recognised at the earlier of the date whenthe insurer or reinsurer becomes party to the contract and thedate when the cover begins.

• For binder business, the contract between the insurer and thebinding authority is not an insurance contract, andconsequently the underlying insurance contracts arerecognised as per the previous paragraph.

• A contract is derecognised when the contractual obligationsare extinguished, discharged, cancelled or expired.

Assumptions underlying the best estimate

For economic assumptions, there is expected to be guidance asto what constitutes active, deep, liquid and transparent financialmarket data to be used unadjusted in the valuation, and wheredata does not have these characteristics, how the data should betreated. This is important:

• Where insurance liabilities are longer dated than availablemarket data and extrapolation is required, such as in respect ofeconomic assumptions for the risk-free rate and equity impliedvolatilities; or

• Where current or historic average data could be applied, suchas in respect of equity and swaption implied volatilityassumptions; or

• Where there is no current market data, such as for assetcorrelation assumptions.

The derivation of the risk-free rate, including the use of marketdata, is expected to be provided by EIOPA on a frequent basis.

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 must beincluded.

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).

Recognition and derecognition

• Insurance contracts are initially recognised when the coverageperiod begins. If facts and circumstances indicate that thecontract is onerous, a liability is recognised earlier.

• Investment contracts with a DPF are recognised when theinsurer becomes a party to the contractual provisions of theinstrument (as applied in IFRS 9).

• The IFRS requirements regarding the point of recognitionare different from Solvency II.

• Similar to Solvency II, a contract is derecognised when thecontractual obligations are extinguished, discharged, cancelledor expired.

• An insurer is required to derecognise an existing contract andrecognise a new contract as a result of certain modifications,including if the modification changes whether the contract is inscope of the insurance standard or whether the contract canapply the PAA.

Assumptions underlying the best estimate

• The approach to market variables in IFRS is similar toSolvency II. In particular, IFRS specifically states that suchvariables ‘shall be consistent with observable market prices’.There is less practical guidance in IFRS than in Solvency II,and therefore there is potential for a wider range ofinterpretations. However, insurers would have to considerhow to justify different interpretations where the twoframeworks are similar in principle.

• Similar to Solvency II, an entity-specific approach is requiredfor non-economic assumptions, and management actions andpolicyholder behaviour are required to be included in theexpected cash flows.

Scope of cash flows

• All cash flows that the insurer will incur directly as it fulfilsthe contracts in a portfolio are included. Consistent withSolvency II, the cash flows are on a going concern basis andthere is no allowance for own credit risk.

• For participating contracts, both guaranteed and discretionarycash flows are included, regardless of whether they are paid tocurrent or future policyholders.

• Many of the cash flows are the same as in Solvency II, forexample, regular premiums and benefits. However, thereare potential differences relating to expense cash flows, asillustrated in the following section. The treatment of taxespaid on behalf of policyholders remains an outstandingtopic to be discussed by the IASB and could be a potentialdifference with Solvency II.

IFRS



Solvency II

4. Future cash flows continued

Expense cash flows

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

• Overhead expenses include salaries to general managers,auditing costs and regular day-to-day costs (e.g. office rent).They also include expenses related to the development ofnew insurance and reinsurance business, advertising andimprovements to internal processes (e.g. buying new ITsystems). Both future expected cost increases and reductionsmay be included, but any expected cost reductions should berealistic, objective and based on verifiable data andinformation.

• Expense assumptions should consider the availability andrelevance of any available market data representative of theportfolio.

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, the selectionof the investment return in a stochastic calculation is commonlythe ‘risk-free’ rate (‘risk neutral’ projection) or an expectedasset growth rate (‘real world’/‘deflator’ projection). Theselection of the investment return is consistent with thediscount rate to provide a ‘market consistent’ style method.

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 that arise directly fromexisting contracts or can be attributed to the contracts on areasonable and consistent basis are included.

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

Expense cash flows

• All expenses that relate directly to the fulfilment of the portfolioof insurance contracts are included. Examples of suchexpenses are claims handling costs, policy administration andmaintenance (including recurring commission) costs, costs ofdirectly engaged personnel and costs incurred in providingcontractual benefits in kind. Some costs such as salaries willcover more than one portfolio, but directly relate to insurancecontracts or contract activities. Such costs are allocated toportfolios on a rational and consistent basis.

• A systematic allocation of directly attributable fixed and variableoverheads is also included. Costs that do not relate directly tothe contract or contract activities (such as indirect overheadslike staff training costs or advertising costs) are excluded.

• Costs arising from abnormal amounts of wasted labour orabnormal amounts of other resources are excluded from thecash flows.

• Directly attributable acquisition expenses in acquiring a portfolioof contracts are included in the cash flows and serve to reducenew business strain (implicit deferral through the residual margin).Acquisition costs incurred before a contract is recognised arerecorded as part of the contract liability for the portfolio.

• The scope of expense cash flows is different fromSolvency II, specifically acquisition costs and certainnon-direct overhead expenses.

Investment return cash flows

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

• When policyholder benefits do depend on investment returncash flows, this dependency is reflected in the measurement ofthe contracts. Techniques include replicating portfolios or astochastic method (to capture potential asymmetries) usingactual investment cash flows consistent with the discount rateand the measurement of the underlying assets.

• The use of replicating portfolios is considered in a subsequentsection. It is likely that the most common approach will be astochastic method similar to Solvency II; however, thelinkage to the IFRS asset valuation will cause a differencewhere the underlying assets are not at economic (fair)value (required for Solvency II), as is commonly the case forContinental European participating contracts.

Tax cash flows

• Income tax payments and receipts are recognised andmeasured under IAS 12 (Income Taxes). In some territoriespolicyholder benefits are dependent on future net of taxinvestment returns (and expenses) and the proposals may notpermit these future tax flows to be reflected in themeasurement of the liability if they meet the definition of anincome tax under IAS 12. The treatment of taxes paid onbehalf of policyholders remains an outstanding topic to bediscussed by the IASB. The outcome of this discussionmay differ from Solvency II.

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

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

IFRS



Solvency II

5. Discount rate

The discount rate is defined as the current risk-free interest rateterm structure for each currency. The risk-free rate is defined as:

• Swap curve (as the starting point in developed financialmarkets) less a deduction for credit default and basis risk.

• Plus an additional counter-cyclical premium (‘adaption to therate’) or matching adjustment to the term structure depending onthe characteristics of the liabilities and current financial markets.

There remains considerable uncertainty at the date of thispublication over the determination of the risk-free interestrate term structure, including potential transitionalarrangements (as discussed in a subsequent section). However,given the importance of the risk-free rate to Solvency II, themethod of calculation is expected to be heavily prescribed andthe rates that insurers must use will be published regularly byEIOPA. In this section we set out our current understanding of thedevelopments and potential options under investigation:

Swap curve

• The key areas of debate on the swap curve are: (i) approachto extrapolation (entry point, period of transition and ultimatelong term target); and (ii) how an allowance for credit and basisrisk should be made.

• In certain less developed financial markets, the startingpoint may be the local government bond curve rather than theswap curve.

Counter-cyclical premium (CCP)

• The CCP is designed to adjust the swap curve for ‘excessspread’ in government and corporate bond markets.

• There are a number of uncertainties over the CCP, including:(i) when it would apply (the ‘trigger’); and (ii) its calibration(‘quantum’), for example, the selection of asset portfolio todetermine the CCP and which risks in corporate andgovernment bond yields are excluded.

• The CCP cannot be applied to products using a matchingadjustment, but the interaction between the two is not fullyclear.

Matching adjustment (MA)

• The MA is designed to reflect the stable characteristics ofcertain liabilities which permits insurers to be long-terminvestors and reduce or eliminate exposure to short termspread movements in assets (while default risk does remain).

• There are two approaches currently under discussion:

1. A narrow application to certain products meeting strictcriteria (risks exposed to, assets held and matching ofcash flows), typically, this would be certain immediateannuity-style contracts.

2. A wider application reflecting that a portion of liability cashflows for a wide variety of contracts is stable due toproduct features (e.g. surrender penalties) and associatedpolicyholder behaviour (e.g. lapses). There are practicalchallenges to a wider application, including the interactionwith the SCR Standard Formula.

• The MA is calibrated as the yield on the matching assets(actually held) less an allowance for credit default. It is expectedthat minimum assumptions will be prescribed to be used in thecomponents forming the credit default risk allowance.

• The discount rate is defined to be consistent with the currentobservable market prices for instruments with cash flows whichreflect the characteristics of the liability (timing, currency andliquidity).

• Unlike the requirements in Solvency II, there is noprescribed method in IFRS for the determination of thediscount rate. It can be determined using:

– A ‘bottom-up’ approach, adjusting a risk-free yield curve(typically for an illiquidity premium reflecting the differentliquidity characteristics between assets and insuranceliabilities); or

– A ‘top-down’ approach, adjusting a yield curve that reflectscurrent market returns on either the actual portfolio of assetsheld or a reference asset portfolio. Adjustments would bemade for credit default risk and an allowance for cash flowmismatches between the assets (actual or reference) and theliabilities. Calibration of expected and unexpected creditdefault risk will be an area of focus in the approach.

• It is unlikely that a top down and bottom up approach willprovide the same yield curve in all circumstances.

• It is also not clear whether the prescribed Solvency II yieldcurves would be appropriate in IFRS. For example, whethera wider application of the matching adjustment could beequivalent to a top-down approach.

• In IFRS, for contracts where the liability depends on theperformance of specific assets (e.g. participating and unit-linked products) the valuation should reflect the dependence.As noted previously, this is likely to be a stochastic methodsimilar to Solvency II; however, the linkage to the IFRSasset valuation will cause a difference where the underlyingassets are not at economic (fair) value (required forSolvency II).

• For IFRS and Solvency II, the contract liabilities are measuredusing a current discount rate. In IFRS, changes in the currentdiscount rate (from that at inception) are presented in OtherComprehensive Income (OCI) rather than in profit or loss.Consequently, several discount rate assumption sets will berequired to measure contract liabilities. There is no equivalentconcept in Solvency II.

IFRS



Solvency II

6. Allowance for risk (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 marginis required where the technical provision has been determinedas a whole using a replicating portfolio. 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.

• The capital requirement is designed to cover a confidence levelof 99.5% over a one-year time horizon and capturesunderwriting risk, residual market risk (other than interest rate),operational risk and certain counterparty default risk. Thecapital requirements are based on an approved internal modelcalibration otherwise the Standard Formula is adopted.

• An unadjusted risk-free discount rate is used, excluding anyallowance for matching adjustment or counter-cyclicalpremium.

• The risk margin reflects the level of diversification of the insurer(‘entity level’ diversification) and so reflects diversificationbetween lines of business.

• No allowance is made for the loss-absorbing capacity ofdeferred tax.

• 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 compensation theinsurer requires for bearing the uncertainty inherent in the cashflows that arise as the insurer fulfils the insurance contracts.

• There is no prescribed technique or limit on the range oftechniques, however application guidance will describe threeexample techniques: confidence level, conditional tailexpectation and cost of capital. In view of Solvency II, weexpect most European-based insurers will adopt a cost ofcapital approach in IFRS, albeit with a potentially differentcalibration.

• Two key components of the cost-of-capital method are theassumed cost rate and the capital amount (that is theconfidence level and the capital projection method). UnlikeSolvency II, there is the potential to set different confidencelevels and costs for different types of contracts.

• The risk adjustment reflects all risks associated with theinsurance contract. The range of risks in scope is potentiallynarrower than under Solvency II. There is no risk adjustmentassociated with reinsurer default (non-performance of thereinsurer is considered elsewhere in the model), investment risk(except where it affects the amount to policyholders, such ason participating business) and general operational risk relatingto future transactions.

• No unit of account is prescribed for the calculation of the riskadjustment, resulting in the potential for similar or morediversification benefits compared to Solvency II.

• Unlike Solvency II, there is no explicit prohibition on taking intoaccount the loss-absorbing capacity of deferred tax.

• The risk adjustment is a current measure, as for Solvency II,which is revised each period and runs off in line with the riskexposure. Changes in the risk adjustment are recognised inprofit and loss in the period of change. Unlike Solvency II,there are two risk adjustments relating to the gross ofreinsurance and reinsurance positions.

• There is a separate requirement to disclose the confidencelevel to which the risk margin corresponds, even if analternative technique is adopted. This will introduceadditional complexity and valuation runs compared toSolvency II.

IFRS



Solvency II

7. Residual margin

No concept of a residual margin, so day one gains can exist. • The residual margin is calibrated at inception to an amount thatavoids recognising a gain when an insurer enters into theinsurance contract. A loss at inception is immediatelyrecognised.

• The residual margin is determined at a ‘portfolio level’. Therelease of the residual margin is to the period in which the serviceis provided and there is no prescribed level (unit of account). It isunclear how this will be interpreted in practice by insurers.

• The residual margin cannot be negative (i.e. it cannot be anasset) and interest is accreted using the discount ratedetermined at inception (the ‘locked-in’ rate).

• Favourable and unfavourable changes in estimates of futurecash flows are offset prospectively in the residual margin(‘unlocking’). However, changes in experience or in the riskadjustment cannot be offset. In practical terms, the impactof changes in demographic (e.g. mortality and morbidity)and expense assumptions is absorbed by the residualmargin rather than being directly reflected in the incomestatement. Adverse mortality experience in a certain yearand all changes in the risk adjustment are reflected directlyin the income statement.

• There will be significant data requirements for thedetermination, release and unlocking of the residual margin.A negative residual margin will need to be monitored aschanges in estimates of a future cash flows could result in theresidual margin becoming positive and presented as a liabilityon the balance sheet in future periods.

8. Discretionary participating business

Future discretionary benefits (‘participating feature’) are benefits,excluding index-linked and unit-linked benefits, with one of thefollowing characteristics:

• The amount or timing is at the discretion of the insurer; or

• The benefits are legally or contractually based on one or moreof the following results: (i) the performance of a specified groupof contracts or a specified type of contract or a single contract;(ii) realised or unrealised investment returns on a specified poolof assets held by the insurer; or (iii) the profit or loss of theinsurer or fund that issued the contract.

The best estimate includes all future discretionary benefit cashflows, except those relating to surplus funds where this hasbeen authorised under national law (which possess thecharacteristics of Tier 1 basic own funds).

A stochastic valuation is likely in most cases to value options andguarantees due to the dependency of the policyholder benefitson future investment return through the participating feature.Management actions and policyholder behaviour are included inthe assessment.

• The definition of a discretionary participating feature isexpected to be unchanged from IFRS 4 (Insurance Contracts).Participating investment contracts issued by insurers are alsoincluded in the scope of the insurance standard.

• The measurement of the participating cash flows should mirrorthe measurement of the underlying items in the financialstatements (‘mirroring’). The direct linkage to the assetvaluation may cause a difference from Solvency II when theIFRS asset valuation is not economic (fair) value (requiredin Solvency II), as is commonly the case for ContinentalEuropean participating contracts. In addition, changes in theliability are presented in either the income statement or OCIconsistent with the presentation of the linked asset. Themirroring takes precedence over the OCI treatment for changesin the discount rate.

• All options and guarantees are measured at a current valuethrough profit or loss. As for Solvency II, it is likely that astochastic valuation will be required.

• As for all contracts, where there is no replicating portfolio, a riskadjustment and residual margin is required.

• The measurement of the liability should include all paymentsthat result from the contract, including expected futureparticipations whether they are paid to current or futurepolicyholders. There is no equivalent reference in Solvency II.

• The treatment of participating contracts in IFRS remains adeveloping area.

IFRS



Solvency II

9. 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 reliably the uncertainty in amount andtiming of the liability cash flows in all possible scenarios.Cash flows depending on underwriting risk cannot be reliablyreplicated. Furthermore, the financial instruments should betraded in active markets that are deep, liquid and transparent.Where the criteria are met and unbundling is feasible, then thereplicating portfolio is used for those cash flows and a bestestimate and risk margin method is used for the remainingcash flows.

• The primary example provided is the unit balance on a pureunit-linked contract. There are likely to be limited other caseswhere a replicating portfolio approach is permitted.

• 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 for theuse of replicating portfolios. It is expected that the use ofreplicating portfolios will be limited in IFRS 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 additional risk adjustment is required. For theremaining cash flows, the probability-weighted cash flows andrisk adjustment 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.

10. Reinsurance

• Reinsurance recoveries are in general recognised andmeasured as for the gross cash flows and then presented asa separate asset on the balance sheet. Depending on thenature of the risks transferred in a reinsurance arrangement,there is a possibility that the measurement could be differentfrom the gross cash flows such as the contract boundary(if there is no insurance risk transferred as an illustration) or theMatching Adjustment in the discount rate (if a wider applicationmethod is adopted).

• The reinsurance-related cash flows include the risk of expectedreinsurer counterparty default. Cash flows are based on anassessment of the probability of default of the counterparty andthe resulting average 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 are calculated on anexpected present value basis of the future cash inflows,plus a risk adjustment (which represents the risk being removedthrough reinsurance).

• Non-performance by the reinsurer is captured by applying thefinancial instruments impairment model when determiningrecoverability.

• Instead of recognising a day one gain on entering into areinsurance contract, it is deferred and amortised througha reinsurance residual margin. In the case of a loss it is eitherrecognised immediately (if the contract is for past events) orspread over the coverage period (if it relates to future events).

11. Business combinations and portfolio transfers

• There is no concept in Solvency II of business combinationsor portfolio transfers. All contracts are treated as if writtenwithin the current entity and follow the same recognition,measurement and presentation approach.

• Business combination matters are yet to be re-deliberated bythe IASB. It is unclear as to whether proposals within theInsurance Contracts Exposure Draft (2010) will change in thisarea.

• The Exposure Draft proposed that for insurance contractsassumed in a portfolio transfer or acquisition, the residualmargin of the insurance contract is calibrated to be the excessof the consideration received (portfolio transfer) or fair value(business combination) over the best estimate plus riskadjustment. If best estimate plus risk adjustment is greater thanthe consideration received or fair value, then a loss isrecognised or goodwill is increased respectively.

IFRS



12. Transitional arrangements

• There is the possibility that a transitional arrangement mayexist over the discount rate. For example, a period of time overwhich Solvency II requirements are phased in for Solvency Irequirements for those liabilities under the Consolidated LifeDirective. It is not clear how a ‘phased-in’ approach wouldinteract with the counter-cyclical premium and matchingadjustment.

• In addition, there is the possibility that:

– The discount rate or one of its components (such as thematching adjustment) may have a defined reviewarrangement after the implementation date of Solvency II.

– Other transitional arrangement for technical provisions mayexist in the final Solvency II framework.

• Unlike the proposed set up for Solvency II, there is nograndfathering of existing rules for the discount rate.The use of Solvency I discount rates for a period of timeunder Solvency II may represent a significant differencefrom IFRS (depending on the liabilities underconsideration).

• There is full retrospective application of the insurancestandard which includes the calculation of the residualmargin. Insurers are required to determine the residual marginon transition using a full retrospective adoption as far backas practicable.

• A practical expedient applies for estimating the residual marginfor those periods when full retrospective determination of theresidual margin cannot be performed (because the estimate ofthe residual margin would not be based solely on objectiveinformation).

• In addition, if it is not practicable to apply the standardretrospectively for any other reason (for example, the datacannot be recreated in a suitable form) the residual margin isdetermined by reference to the carrying amount of the liabilitybefore transition (so the existing GAAP basis).

• It is assumed that all changes in cash flow estimates betweencontract inception and the date of transition are known at initialrecognition and hence unlocked within the residual marginon transition.

• To present changes in the discount rate through OCI, discountrates at inception for the historic business will be required.A practical expedient is proposed whereby an insurer can usea suitable observable rate for historical periods beyond threeyears prior to the date of transition.

• On transition to the insurance standard, insurers will continueto apply IFRS 9 asset classifications. However, some additionalprovisions will specifically apply on transition for designatingassets under the fair value option (or revoking previousdesignations) and elections to use fair value through OCImeasurement for equity instruments.

• There will be minimum disclosure requirements for transition.

Solvency II IFRS



Solvency II

1. Relevant standards / sources of information

• As for Appendix A – Insurance contracts • IAS 32 – Financial Instruments: Presentation

• IFRS 13 – Fair Value Measurement

• IFRS 9 – Financial Instruments (2010)

• IAS 39 – Financial Instruments: Recognition and Measurement

• IAS 18 – Revenue

• IASB IFRS 9 Classification and Measurement Project

• Revenue from Contracts with Customers Exposure Draft(‘Revenue Recognition ED’)

• Matters as for insurance contracts (in defining the scope ofinsurance contracts and therefore implicitly the scope ofinvestment contracts)

• There remains uncertainty as to the treatment of investmentcontracts in IFRS due to the range of new developingstandards

2. Scope

• Solvency II applies to all insurance and reinsurance contractswritten by EEA insurers and its group supervision requirementsapply to insurance groups containing EEA insurers. In addition,certain of Solvency II’s requirements apply to contracts writtenby non-EEA insurers through branches in the EEA. There is nodistinction between insurance and investment contracts exceptfor determining the cash flows that are within the boundary of acontract as discussed in Appendix A.

• 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.

• Investment contracts are usually separated into an investmentmanagement service component (measured in accordancewith IAS 18) and a financial instrument component (measuredin accordance with IAS 39 or IFRS 9). Distinct investmentcomponents and embedded derivatives unbundled frominsurance contracts are also measured in accordance withIAS 39 or IFRS 9 (and IAS 18 where relevant).

• Investment contracts issued by insurers containing adiscretionary participation feature are within the scope of theInsurance Contracts Standard.

3. 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 as forinsurance contracts.

• It is likely that most investment contracts will be treated asbeing premium paid up as a result of the contract boundarydefinition.

• There is no deposit floor. For example, the total liabilityfor a unit linked contract can be below the account balance(unit fund).

• 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 andnon-participating investment contracts).

• For those contracts measured at fair value there is a depositfloor (a surrender value). A deposit floor means that the fairvalue of a financial liability with a demand feature is not lessthan the net present value of the amount payable on demand.

• For contracts measured at fair value, currently the bid valueof units is used for typical unit-linked contracts. IFRS 13 onfair value measurement does not preclude the use ofmid-market pricing or other pricing conventions used bymarket participants as a practical expedient for fair valuemeasurements within a bid-ask spread.

• For contracts measured at amortised cost, any embeddedderivatives are separated and valued at fair value if theseparate instrument meets the definition of a derivative and thecharacteristics are not closely related to the host contract.

IFRS



Solvency II

4. Profit recognition

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

Under IAS 39 (or IFRS 9) any gain or loss on initial recognition ofthe financial instrument component can only be recognised wherethe fair value is determined based upon observable market data.

For the investment management service component, profit isrecognised as services are provided:

Deferral of acquisition costs

• The Revenue Recognition ED requires an entity to recognise anasset for the incremental costs of obtaining a contract with acustomer if it expects to recover those costs. The asset isamortised on a systematic basis consistent with the pattern oftransfer of the goods and services. The treatment of acquisitioncosts is expected to be the same as IAS 18 (Revenue), thecurrent standard. However, the definition of deferrableacquisition costs for investment contracts is narrower thanfor insurance contracts and consequently results in higherexpected new business strain for these contracts, all elsebeing equal. The extent to which there is unbundling ofinvestment management service components for insurancecontracts is important given the different levels of deferral.

• In addition, compared to the proposed method for insurancecontracts, the deferral for investment contracts is as an explicitasset rather than ‘implicit’ deferral through the residual margin.

Deferral of origination fees

• The Revenue Recognition ED proposes additional paragraphsto be included within IAS 39 application guidance. These clarifythat an entity should continue to distinguish fees and costs thatare an integral part of the effective interest rate for the financialliability from origination fees and transaction costs relating tothe right to provide services, such as investment managementservices. The proposals therefore suggest that origination feesrelating to investment management services should continue tobe accounted for within the revenue recognition standard. Assuch, fees are deferred and earned as services are provided,for example, over the expected term of the policy.

5. Other matters

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

The following other matters are noted:

• Where investment contract liabilities are held at fair value underIAS 39, the change in fair value (including changes relating toown credit risk) is recognised in profit or loss. In IFRS 9, if afinancial liability is designated at fair value (via the fair valueoption), the portion of the change in fair value due to changesin own credit is recorded in Other Comprehensive Income.This is expected to be relevant only in a limited number ofcases (certain non-linked investment contracts and embeddedderivatives).

• For unit-linked insurance contracts, an insurer may recognisetreasury shares and owner-occupied property at fair valuethrough profit or loss to eliminate an accounting mismatch.It remains unclear whether this change will also apply to unit-linked investment contracts.

IFRS



Solvency IIItem

1. Assets

• As for Appendix A – Insurance contractsRelevant standards/sources of information

• IFRS standards in existence as ofpublication date

• IASB IFRS 9 Classification andMeasurement Project

• IASB Leases Project

• Assets and liabilities other than technicalprovisions are expected to be valued ateconomic value under Solvency II. Unlessotherwise specified, there is a presumption thateconomic value equates to IFRS under mostcircumstances. However, the regulator retainsa measure of discretion to determine situationswhere this is no longer the case; for example,in cases of extreme market disruption.

General

• Goodwill is not considered an identifiable andseparable asset in the marketplace. Theeconomic value of goodwill for solvencypurposes is nil.

• Intangible assets are ascribed value only whenthey can be sold separately and a valuation canbe derived from a quoted market price in anactive market for the same or similar intangible.

• In practice, there will be very few caseswhere intangible assets meet the criteria tobe ascribed value under Solvency II.

Goodwill on acquisition • Initial measurement at cost (the excess of thefair value of consideration transferred over theacquirer's interest in the net fair value of theidentifiable assets, liabilities and contingentliabilities). Subsequent measurement is at costless any impairment loss.

Intangible assets • An acquired intangible asset is recognised whenit is probable that the expected future economicbenefits will flow to the entity and the cost of theassets can be measured reliably.

• Initial measurement is at cost. Subsequentmeasurement is at either (i) cost model: cost lessany accumulated depreciation and impairmentloss; or (ii) revaluation model: fair value at dateof revaluation less any subsequent accumulateddepreciation or impairment where fair value isdetermined by reference to an active market.

• PPE should be measured at economic value forsolvency purposes.

• PPE valued at cost in financial statements mustbe re-measured at fair value (equivalent toeconomic value) for solvency purposes.

• The revaluation model under the IFRS on PPEis considered to be a reasonable proxy foreconomic value.

Property plant andEquipment (‘PPE’)

• PPE includes owner-occupied property.Initial measurement is at cost. Subsequentmeasurement is using either the cost or therevaluation model described in the entry forintangible assets above.

IFRS



Solvency IIItem

1. Assets continued

• Finance lease assets and liabilities are measuredat fair value. Lessor accounting for financeleases is consistent with IAS 17. However, lesseeaccounting needs adjustments as lessees haveto fair value all lease assets – the present valueof the minimum lease payment under IAS 17 isnot considered consistent with Solvency IIvaluation principles.

• Operating leases are measured consistentlywith IAS17.

Leases • Finance leases are measured initially at the lowerof fair value and the present value of theminimum lease payment under IAS 17. Operatingleases are not capitalised on the balance sheet,with lease payments generally recognised as anexpense straight-line over the lease term.

• In 2010, an exposure draft was releasedproposing amendments to IAS 17, which,coupled with further decisions since 2010,would significantly alter lease accounting asset out below.

• Lessee accounting – Leases of more than 12months are recognised on-balance-sheet witha liability for the present value of the leasepayments and a ‘right-of-use’ asset at inception.

• Lessor accounting – There are two potentialapproaches for lessors. The receivable andresidual approach requires lessors toderecognise the leased asset and insteadrecognise both a lease receivable and a grossresidual asset. Otherwise, the underlying assetremains on the lessors balance sheet andincome is recognised straight-line, similar totoday’s operating lease accounting.

2. Investments

• Investment property is measured at economicvalue. Investment properties that are measuredat cost in the financial statements must beremeasured at fair value for solvency purposes.The fair value model under the IFRS onInvestment Property is considered a goodproxy for economic value for Solvency II.

Investment property • Measurement is initially at cost. Subsequentmeasurement is using either the cost (as per PPEabove) or the fair value model.

• Related undertakings are classified into threeclasses for valuation:

– Listed companies, valued using quoted marketprices in active markets;

– Unlisted subsidiaries, valued on an ‘adjustedequity method’ (parent’s share of subsidiary’snet assets); and

– All other related undertakings (not subsidiaries)should, wherever possible, use the ‘adjustedequity method’ with an option to mark tomodel if the adjusted equity method is notpossible.

• The ‘adjusted equity method’ default approach isthat valuation must be in accordance withSolvency II valuation rules. For relatedundertakings that are not insurers, wherevaluation under Solvency II is not practicable, itcan be based on IFRS with deduction ofgoodwill and intangibles that would be valued atzero under the Solvency II rules.

Participations / relatedundertakings insubsidiaries, associatesand joint ventures

• Participations in subsidiaries are valued underIAS 27 in the parent company’s separatefinancial statements, either at cost or at fairvalue under IAS 39 (see the entry in respect offinancial assets).

• If a participation is purchased purely with a viewto sell, it is valued under IFRS 5 at the lower ofcarrying amount and fair value less costs to sell,unless the participation has previously beenvalued at fair value under IAS 39, in which case itcontinues to be measured at fair value.

IFRS



Solvency IIItem

2. Investments continued

• Financial assets should be measured at fairvalue for solvency purposes, even when theyare measured at amortised cost in an IFRSbalance sheet. The fair value measurementapproach in IAS 39 is considered a good proxyfor economic value under Solvency II.

Financial assets • Under existing IFRS 9 the following assetmeasurement categories are set out: -– Amortised cost: Debt instruments giving riseon specified dates to cash flows that are solelypayments of principal and interest; where thebusiness model is to hold assets in order tocollect contractual cash flows; and where thefair value option is not used to eliminate anaccounting mismatch.

– Fair value through profit or loss (FVPL): Allother financial assets (except when an entityhas elected for equity instruments to be heldat fair value through OCI).

• As part of the limited modifications to IFRS 9 theIASB has introduced a third fair value throughother comprehensive income (FVOCI) categorywhere (i) the business model is to both collectcontractual cash flows and sell financial assets;and (ii) debt instrument cash flows are solelypayment of principal and interest.

• FVPL options exist under both existing andmodified IFRS 9 for accounting mismatches andthe FVOCI option for equity instruments remainsunchanged.

3. Other assets

• These types of asset must be re-allocated toother asset categories depending on their natureand re-valued accordingly.

Non-current assets heldfor sale or discontinuedoperations

• Deferred tax is calculated in accordance withthe method used under IFRS based on thevaluations in the Solvency II balance sheet.

Deferred tax assets

• Non-current assets are held at the lower ofcarrying amount and fair value less costs to sell.

• Deferred tax assets should be valued as thetemporary difference between the IFRS value ofan asset or liability and its tax base multiplied bythe tax rate that will be applicable when thedifference reverses. Deferred tax assets shouldbe offset with deferred tax liabilities if and only ifthe entity has a legal right of set-off, whichrequires inter alia both the asset and the liabilityto relate to the same taxation authority, and if theentity intends either to settle net or to realise theasset and settle the liability simultaneously.Deferred tax assets are not discounted.

• Deferred tax assets should be recognised onlywhere it is probable that the entity will earnsufficient taxable profits in the future againstwhich it can make the tax deductions.

• Current tax assets are valued at the amountexpected to be recovered.

Current tax assets • Current tax assets are valued at the amountexpected to be recovered.

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

Cash and cashequivalents

• Cash is a financial asset and is therefore valuedunder IFRS 9 / IAS 39 as described above.

• All assets where there are no specificvaluation rules are valued in accordancewith IFRS, provided that this is consistentwith an economic valuation. When applying aneconomic valuation of assets insurers shouldrefer to a three level valuation hierarchy. The useof quoted prices is the default method ofvaluation. Where this is not possible, insurersshould use quoted prices of similar assets.Where no quoted prices can be used, the insurercan develop an alternative valuation methodthat makes maximum use of market inputs.

Other assets • An entity may have other assets, for exampleprepayments or accrued income, which aresubject to specific accounting rules under IFRS.

IFRS



Solvency IIItem

4. Liabilities

3. Other assets continued

• Financial liabilities should be valued at fairvalue in conformity with IFRS upon initialrecognition. Subsequent measurement shouldtake account of differences in the risk-free ratebut not the insurer’s own credit standing.

• Financial liabilities that are valued atamortised cost basis according to IAS 39 orIFRS 9 must be valued at fair value forsolvency purposes.

• Subordinated liabilities which satisfy the relevantrequirements for recognition may be treated asown funds on the Solvency II balance sheetrather than as liabilities under IFRS.

Financial liabilities • Financial liabilities should be valued under IFRS 9either at fair value or at amortised cost.

• Where financial liabilities are included at fair value,this valuation will reflect the credit risk of theliability and therefore take account of the insurer'sown credit standing.

• For the valuation of financial liabilities designatedat fair value (via the fair value option) includingsubordinated liabilities, changes in the liability’sown credit risk should be reported in OCI ratherthan profit and loss.

• Both the recognition criteria and themeasurement approach in IAS 37 for provisions(other than technical provisions) are consideredto be consistent with Solvency II regulations.

• As a result, provisions other than technicalprovisions are valued in accordance with IFRS.

Provisions other thantechnical provisions

• Provisions other than those relating to insurancecontracts should be recognised under IAS 37where it is probable that an outflow of economicresources will be necessary to settle a presentobligation of an entity that can be reliablymeasured. Provisions should be valued at a bestestimate of the amount required to settle theobligation at the balance-sheet date, being theamount that the entity would rationally pay tosettle the obligation.

• Material contingent liabilities, as defined underIFRS, should be recognised as liabilities forSolvency II. Valuation should be based on theexpected present value of future cash flowsrequired to settle the contingent liability,discounted at the basic risk-free interest rateterm structure.

Contingent liabilities • Contingent liabilities should not be recognisedunder IAS 37, but should be disclosed andcontinuously assessed. Under IFRS, contingentliabilities are off balance sheet (unless onacquisition); however, these will berecognised on balance sheet under theapproach proposed for Solvency II.

• Deferred tax liabilities should be valued inaccordance with IFRS (undiscounted) based onthe Solvency II balance sheet. Whilst themethodology for calculating deferred tax balancesis consistent with IFRS, as it is determined byreference to the Solvency II balance sheet, othermeasurement differences within the Solvency IIbalance sheet may cause the Solvency IIdeferred tax balance to differ from IFRS.

Deferred tax liabilities • Deferred tax liabilities should be valued asdescribed above for deferred tax assets.

• With limited exceptions, all deferred tax liabilitiesshould be recognised, even where the entityexpects to have future tax losses that couldrelieve the liability.

• Current tax liabilities should be valued at theamount expected to be paid.

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

• Liabilities for employee and termination benefitsshould be valued in accordance with IFRS.Following the recent amendment to IAS 19where the use of the corridor approach wasremoved, IAS 19 is now considered consistentwith Solvency II. Under QIS 5 there was anoption for insurers to use their own internalmodel method in valuing their pension assets /liabilities. In the October 2012 technicalspecifications from EIOPA this options wasremoved. However, it remains to be seenwhether this was done solely to achieveconsistency in the next impact study or whetherthis represents a change in policy.

Employee benefits andtermination benefits

• Recent amendments to IAS 19 have removedthe corridor approach and altered thepresentation of gains and losses, meaning thatall changes in defined benefit obligations and inthe fair value of plan assets are recognisedimmediately in OCI with other costs recognisedimmediately in the profit and loss account.This change makes the treatment ofemployee and termination benefits closer tothe treatment under Solvency II, which doesnot allow the corridor approach to be used.In addition, instead of calculating a separateinterest expense and expected return on assetsas part of the annual pension cost calculation,one amount is calculated based on the discountrate multiplied by the net pension surplus ordeficit amount.

IFRS

• Subject to supervisory approval, certain items ofoff-balance-sheet financing (for example,letters of credit) may be recognised as ancillaryown funds under Solvency II. Consistent withSolvency II valuation principles, valuation shouldbe at economic value at either an amount orusing a method approved by the supervisor.

Off-balance-sheetfinancing

• By definition, items of off-balance-sheetfinancing are not recognised on the IFRSbalance sheet.



A group consists of a participating undertaking, its subsidiariesand the entities in which it and its subsidiaries hold aparticipation, in addition to any other undertaking which ismanaged on a unified basis. A group may also be based on theexistence of strong and sustainable financial relationshipsbetween undertakings.

The scope of group supervision under Solvency II isrestricted to insurance groups, limited to subsidiaries orparticipations of an insurance company or an ‘insurance holdingcompany’ (any company whose main business is to acquire andhold participations in insurers or reinsurers).

For the purposes of assessing the scope of the group, thedefinitions of ‘parent’ and ‘subsidiary’ are based on EUDirectives. In most cases the definition of parent andsubsidiary will be consistent with those used under IFRS,but might differ in very particular scenarios. A ‘participation’exists whenever one entity controls more than 20% of thecapital/voting rights of another undertaking (this could beextended to cases where the supervisor is of the opinion thatsignificant influence is exerted over an entity where voting rightsare below the 20% mark), and is similar in concept to anassociate under IFRS. However, both of these definitions maybe extended or restricted by the group’s supervisor toinclude or exclude any entity from within the scope of thegroup which may result in a difference under Solvency IIand IFRS.

The scope of consolidation under IAS 27 is based on theprinciple that the accounts should include the results of theparent company and all of its subsidiaries. A subsidiary is anyentity that is controlled by the parent company, either throughownership of more than half of the voting rights of that entity,or through any other circumstance which enables the parentcompany to control the subsidiary in practice. The scope ofconsolidation under IAS 27 takes into account all subsidiaries ofa parent, regardless of whether their business activities differfrom the activities of other entities in the group.

IFRS 10 revises the definition of control. Consolidation is requiredonly if the investor possesses power over the investee, hasexposure to variable returns from its involvement with theinvestee and has the ability to use its power over the investeeto affect its returns. IFRS 10 does not provide ‘bright lines’ andrequires consideration of many factors. The new standardwill change how insurance groups that also own assetmanagement entities assess the investment funds theymanage for consolidation purposes and may change thenumber of funds that are consolidated.

Under Solvency II, the level at which a group is required toprepare consolidated results depends on the structure ofthe group and where the ultimate insurance parent companyof the group is situated:

• If within the EEA, group reporting is at the level of the ultimateinsurance parent. However, Member State supervisorsare able to require additional group reporting at a limitednumber of lower levels where it is considered necessary.

• If outside the EEA and deemed equivalent with Solvency II,then there is no requirement for group reporting underSolvency II at the level of the ultimate insurance parent.However, to gain equivalence, one of the criteria is that asolvency assessment based on the group (in accordancewith local regulation) is required.

• If in a non-equivalent non-EEA territory, consolidationmay be required at whatever level the EEA groupsupervisor considers appropriate.

Where a group with an ultimate parent based in a non-EEAterritory has subgroups within the EEA, then, in addition to anyrequirements to report at the level of the ultimate insuranceparent, the requirement for group reporting under SolvencyII applies at the level of the group headed by the ultimateEEA insurance parent.

The ultimate parent company of a group is required toprepare consolidated accounts under IFRS.

Under IAS 27 and IFRS 10, an intermediate parent (i.e. one that isitself a subsidiary) is exempt from preparing consolidatedfinancial statements where the following conditions apply:

• The company’s owners have been informed and do not objectto not preparing consolidated accounts;

• The company has not issued publicly traded debt or equity;

• The company does not file its accounts with a securitiescommission or other regulatory body for the purpose of issuingany class of instruments in a public market; and

• The company’s ultimate parent (or any intermediate parentabove the company in the group) prepares consolidatedfinancial statements in accordance with IFRS which areavailable to the public.


Solvency II

2. Scope of group reporting

• As for Appendix A – Insurance contracts. • IAS 27 – Consolidated and Separate Financial Statements

• IFRS 10 – Consolidated Financial Statements

1. Relevant standards/sources of information

3. Level of group reporting

IFRS


Groups are required to prepare group reporting to assess thecapital adequacy of the group, taking into account theSolvency Capital Requirement (‘SCR’) and own funds calculatedat group level.

The group results must be based on Solvency II principles,including: balance-sheet valuation principles; proportionalrecognition of participations of less than 100%; elimination ofintra-group creation or double use of own funds; andadjustments to reflect group own funds restricted in their abilityto absorb group losses.

Solvency II has two methods by which the group results maybe prepared:

• The default accounting consolidation-based method usesthe group’s consolidated accounts as a starting point inthe calculation of group SCR and group own funds. As thesemust be prepared based on Solvency II principles it may differfrom the IFRS accounts. Calculation of group own funds isbased on the full consolidated balance sheet (unless thereare differences in the scope of the group under consolidationfor Solvency II purposes); however, only insurance-relatedsubsidiaries are considered on a consolidated basis whencalculating SCR. Contribution of other group members toSCR are aggregated on an entity-by-entity basis (and do notreflect diversification benefits);

• The deduction and aggregation method, which groups mayapply subject to supervisor permission, calculates the groupresults as the aggregation of the results and SCRs of eachentity within the scope of the group.Where the participationis less than 100%, only the group’s proportion of that entity’sresults and SCR are included, unless the entity is in deficit, inwhich case the full amount is included. The individual resultsmust be based on Solvency II principles (unless based in anon-EEA territory deemed equivalent with Solvency II) andadjustments made to eliminate any capital charge on intra-group transactions.

Participations are included in the group’s results as investmentsof the entities holding them, subject to certain exceptions, asdetailed in the section of this document on assets and liabilitiesnot related to technical provisions.

A consolidation performed under IFRS presents all the resultsof the entities in the group combined to form a single set ofresults. The method of consolidation is to add together all theindividual results of the entities in the group, then makeadjustments to:

• Eliminate the investment in each subsidiary and the parent’sportion of equity of each subsidiary;

• Adjust accounting policies to be consistent with the group;

• Eliminate pre-acquisition reserves and the results of intra-grouptransactions;

• Recognise material adjusting post-balance-sheet events;

• Adjust subsidiary results where not coterminous with the parentcompany; and

• Recognise the ‘minority interest’/‘non-controlling interest’ of theother shareholders, for subsidiaries not owned 100% by thegroup (which forms part of the equity of the parent).

Under the equity method, the interest in associates are initiallymeasured at cost and subsequently adjusted for the investor’sshare of post-acquisition profits or losses.


Solvency II

4. Method of group reporting

IFRS

GlobalPaul ClarkeGlobal Solvency II leaderPartner, PwC (UK)[email protected] +44 20 7804 4469

David LawGlobal Insurance LeaderPartner, PwC (UK)[email protected] +44 7710 173 556

Gail TuckerGlobal Financial Instruments LeaderPartner, PwC (UK)[email protected]+44 117 923 4230

UKBrian PurvesInsurance Market Reporting leaderPartner, PwC (UK)[email protected]+44 20 7212 3902

Alex FinnPartner, PwC (UK)[email protected]+44 20 7212 4791

Kirsty WardPartner, PwC (UK)[email protected]+44 20 7804 2999

James QuinPartner, PwC (UK)[email protected]+44 20 7212 5173

Anthony CoughlanDirector, PwC (UK)[email protected]+44 20 7804 2084

Mike VickeryDirector, PwC (UK)[email protected]+44 117 923 4222

EuropeAlexander HofmannPartner, PwC (Germany)[email protected]+49 21 1981 7408

Julia UnkelPartner, PwC (Germany)[email protected]+49 69 9585 2667

Eric DupontPartner, PwC (France)[email protected]+33 15 657 8039

Emile RondhoutPartner, PwC (Netherlands)[email protected]+31 88 792 51 67

Bas van de PasPartner, PwC (Netherlands)[email protected]+31 88 792 6989

Michel AbbinkPartner, PwC (UK/Europe)[email protected]+44 20 7804 0919

USDenise CutronePartner, PwC (US)[email protected] +1 678 419 1990

David ScheinermanPartner, PwC (US)[email protected]+1 860 241 7129

AsiaDominic NixonAsia Insurance LeaderPartner, PwC (Singapore)[email protected] +65 62 36 31 88

Michael LockermanDirector, PwC (Hong Kong)[email protected]+852 2289 1177

We are grateful for the efforts of partnersand staff that assisted in the productionof this publication. In particular, wewould like to thank Danielle Atherton,Joanne Clarke, Kareline Daguer,Ainsley Normand, Elizabeth Oakley,Rebecca Pratley and Natalie Timberlake.


PwC is helping a range of insurers to assess the implications and address the practical challenges of preparingfor Solvency II and IFRS Phase II. If you would like to discuss any of the issues raised in this paper or other aspectsof the frameworks, please speak to your regular PwC contact or one of the following:

Addressing thepracticalities

www.pwc.com/insuranceThis publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the informationcontained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completenessof the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers does not accept or assume any liability, responsibility or dutyof 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 any decision based on it.

© 2012 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 asagent of PwCIL 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 memberfirms nor can it 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 othermember firm nor can it control the exercise of another member firm’s professional judgment or bind another member firm or PwCIL in any way.

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