Session 4B, Transformation in Hedging Strategy Under the New Report Standards: IFRS 17, IFRS 9 and Future Drivatives Standard

Presenters: Keumcheol Shin, CPA

Taik-ki Lee, FSA

SOA Antitrust Disclaimer SOA Presentation Disclaimer

Transformation in hedging strategyunder the new reporting standards

24 May 2018

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This paper has been prepared for discussion at an annual symposium held on 24 May 2018 bySociety of Actuaries and does not represent the views of organization that presenters belongto. Anyone who receives a copy of this presentation pack should note that we shall not haveany responsibility to anyone in respect of the information contained in this document.

Disclaimer

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FV Fair ValueFVPL Fair Value through Profit and LossFVOCI Fair Value through Other Comprehensive IncomeAC Amortized costHTM Held To MaturityAFS Available For SaleK-ICS Korea Insurance Capital StandardGM General ModelVFA Variable Fee ApproachInv InvestmentRiskPrem Risk PremiumDRM Dynamic Risk ManagementPRA Portfolio Revaluation Approach

Acronyms

I. Current practice

4

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Required capital is measured based on the durations preset by the solvency regulation. The preset durations are shorterthan real durations. This causes interest rate risk to be underestimated resulting in creating an illusion that hedge is notrequired for interest rate risk.

Source: annual reports of 2017, Insurance industry association

Duration

Duration

Note1 Sensitivity: proposed by the regulator despite the actual sensitivity

Deposits

FVPL

AFS

HTM

Loans

Sum

16.3

1.0

379.6

184.6

184.1

31.2

4.0

2,985.4

1,912.2

771.7

765.6 5,704.5

exposure Sensitivity1categories

Interest sensitive assets

exposure Sensitivity1categories

Interest sensitive liabilities

209.1

494.1

431.2

703.2

2,600.4

2,977.6

Not disclosed

5,578.0

Liability with fixedinterest rate

Liability with floatingcredited rate

Minimum interestrate guaranteed

Sum

7.9 years

7.5 years

Regulator preset interest rate sensitivities are applied to all insurers on a factor basis.→ Interest rate risk is underestimated

Actual duration estimated to increase by 5 to 10 years ascompared to duration under Regulation. Required capitalexpected to significantly increase given that actual sensitivity isapplied to insurance contracts.

(Unit: US$ bil)

I. Current practice1. Underestimated interest risk

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Evolution of regulatory requirements

~2011 ~2021

New capital requirements force insurers to manage their risks in a more sophisticated manner than ever.

Guarantee risk notfactored

Do not measureguarantee options.

Guarantee reserve set aside for variable products• In scope risks: GMDB, GMAB, GMWB, GLWB• Guarantee reserveü Hedged items : guarantee risk claims less guarantee feesü Measuring changes in fair value of combined position of hedged

items and hedging instruments using risk-neutral method

Reflecting hedging activitiesin solvency requirement

• Hedging effect reducesrequired capital

~2017

K-ICSeffective in2021≒Solvency II

Voluntarymanagement

Introduction of newrequirements Stabilisation Enhanced

regulation

Stricter capital requirements and underwriting of products with complex features require morerobust risk management of financial risks than ever.

504 604801 626

1,013

Annualised fees of variable products

2013 2014 2015 2016 2017

(Unit: US$ mil)

2. Reform in regulatory requirementsI. Current practice

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Under current GAAPs, there exist constraints for insurers to perform dynamic risk management. Locally there has beenless incentive for Korean insurers to enhance their hedging strategy and method as insurance contracts were required tobe measured on a historic cost basis.

Globallimitation:

under IAS39 orIFRS9

Local limitation:

Specific to Koreaninsurers

Current cost basis accounting for insurancecontracts.

GAAP requirements Constraints

Lack of incentive to apply hedging to riskyproducts. No economic hedging results inincrease in volatility of equity.

Static portfolio of insurance contractsassumed.

Insurance contracts constituting a portfoliochanges due to policy holders’ behavioralfeatures such as lapse and renewal.

One to one designation of a hedgingrelationship between a hedged item and ahedging instrument in contrast to norm ofinsurers’ risk management.

Current portfolio hedge accounting is notpracticable because of strict criteria: Costoutweighs benefits.

Limited to a interest rate risk as a risk inscope of hedging under the currentportfolio hedge.

Other risks such as equity, currency, lapseand expense risks not in scope.

3. Constraints under current accounting standardI. Current practice

II. Hedging under newstandards

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Hedge accounting has been improved to more faithfully represent a financial institution’s risk management activities.

IAS 39(2004)

IFRS9(2018)

IFRS17(2021)

Dynamic RiskManagement

• Under GM, accounting choicegiven to presentation ofmovement in insurance liabilitiesdue to financial risks on the basisof portfolio (PL vs PL & OCI)

• Under VFA, movement ininsurance liabilities due tofinancial risks allowed torecognise in PL instead of CSMto avoid accounting mismatch

• Hedging on an openportfolio basis allowed

• Net risk position of assetsand liabilities designatedas hedged items

• Continuous rebalancingneeded

• Allowed designatingmore items as hedgedones

• More instrumentsdesignated as hedginginstruments

• No 80 to 120 % rulerequired.

• Limitation indesignating hedgeditems and hedginginstruments.

• Strict effectivenessrequirement(eg 80 to 120% rule)

II. Hedging under new standards > 1. Evolution of hedge accountingFaithfully represent real world practice

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If hedged items and hedging instruments were recognised on a different measurement basis, or changes in value ofhedged items or hedging instruments were differently presented, accounting mismatch would take place even in a caseof economically perfect hedging. Hedge accounting needed to eliminate the accounting mismatch in such a case.

Note. Hedge of net investment in a foreign operation is available in addition to fair value hedge and cash flows hedge

Aligning measurement basis and presentation of hedged items to those of hedging instruments► Measuring hedged items on a fair value basis regardless of measurement basis required if hedge accounting

were not applied to the hedged items► Recognising in PL changes in fair value of hedged items would reduce accounting mismatch.

Fair valuehedge

concept100

hedging instrmnts

0

hedged items

100

PL

100

hedging instrmnts

-100

hedged items

0

PL

00

Aligning presentation of hedging instruments to hedged items► Deferring gains or losses arising from hedged items in OCI► OCI recycled to PL as hedged cash flows arising from hedged items affect PLCash flows

hedgeconcept

100hedging instrmnts

0

hedged items

100PL

0

hedging instrmnts

0

hedged items

0

PL

000 0

Concept of hedge accountingII. Hedging under new standards > 2. IFRS9

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For insurance contracts required to apply VFA, hedge accounting is allowed if those contracts are economically hedgedagainst a particular financial risk and required hedge documentation is in place.

Notes1. Allowed choosing to recognise change in value of insurance liabilities due to financial risks in either PL or OCINotes2. Assumed no economic mismatch between assets and liabilities for simplicity

(ie Underlying assets have the same duration and exposure as liabilities)

Linkage(Investmentreturn from

underlying itemsvs benefits to

policy holders)

Accountingmodel

Accounting policies selected to mitigate accounting mismatchesespecially for insurance liabilities 1 Hedge

accountingneeded?

General modelAccounting

choices1. PL or2. disaggregation

between PL &OCI

VFAChanges in valuesdue to financialrisks are treated

as CSM

Accountingmismatch

in PL2

NoIncome from

assets≒

expense fromliability

Yes

Notsubstantial

Substantial

Insurance liabilities

Measurementbasis Effect on PL

FV

Nil(OCI)

Nil(OCI)

PL

FV

Nil(CSM)

Nil(CSM)

Nil(CSM)

No

Yes

Underlying assets

Measurementbasis Effect on PL

AC Nil

FV Nil(OCI)

FV PL

AC Nil

FV Nil(OCI)

FV PL

Classification

AC

FVOCI

FVPL

AC

FVOCI

FVPL

Allowed recognizing insurance liabilitiesmovement due to financial risks in PLinstead of CSM

Hedge under each accounting model (GM vs VFA)II. Hedging under new standards > 3. IFRS17

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VFA is required for insurance contracts from which policyholders’ benefits substantially vary with investment return onthe underlying assets.

Fulfillment cashflows divided into

(+)Premium

(+)Inv return(Policy holder’s share)

(-)Variable fee(GMxB fees,

Risk Premium,Loadings) Expenses PremiumFixed benefits

GMxB claims

Underlying items

Criterion 3Criterion 2

Criterion 1

Criterion 3

Criterion 2

IFRS17 requirements

Underlying items should be clearly identified incontracts terms

Substantial share of fair value returns onunderlying items should be paid to policyholders

Substantial proportion of any changes inamounts to be paid to policy holders varieswith changes in fair value of underlying items

Underlying assets should be separately managed and recorded

The following should constitute a smaller part:ü Entity’s variable fee charged for the service

The following non-varying cash flows should not account forsignificant proportion:ü GMxB claimsü fixed benefitsü expenses

Practical considerations

Cash flows should be analysed to assessif insurance contracts meet criteria for

VFA.

Assessing criteria for VFAII. Hedging under new standards > 3. IFRS17 (Cont’d)

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PL

CSM

③ Variable fee= ① - ②

B104.b

② Fulfillment cash flowsthat do not vary withunderlying items

B104.b.ii

① Fair value of underlyingitems

B104.aPL or OCI

CSM

In scope ofhedge accounting

An adjustment of CSM due to changes in financial risks on the entity’s share of underlying items or fulfillment cash flowsis an object of hedge accounting under IFRS17.

Presentation

Experience adjustment(premiums,investment components)

Changes in estimates of cashflows in liability for remainingclaims

Changes in risk adjustments

û

Disaggregatingcash

flows

Obligation to pay policyholders

B111

GMxB claims

B113

Components

Fixed benefits

Expense

Investment fees

B112 to B113

Risk premium

GMxB fees

Experience adjustment(claims, expenses)

Changes in financial risks andtime value of money

Changes in estimates of cashflows in liability for incurredclaims

û

Identifying items to be hedged under VFAII. Hedging under new standards > 3. IFRS17 (Cont’d)

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Accounting mismatch between hedged items and hedging instruments is eliminated by applying hedge accounting.

§ Designating as hedged items GMxB claims that do not vary with underlying items§ Derivatives (eg interest rate swaps) used to hedge GMxB claims against interest rate risk

Fact Pattern

Hedgeaccountingnot applied

Hedgeaccounting

applied

Accountingmismatcheliminated

Gains

100 100

Hedginginstrum

ents

Hedgeditems

Neteffecton PL

0

Losses

& (+)

100 100

Hedginginstrum

ents

Hedgeditems

Netimpacton PL

0

(-)

&Profits and Losses Balance Sheet

100

100

Gains

100

Hedginginstrum

ents

Hedgeditems

Netimpacton PL

Losses

& (+)

100

Hedginginstrum

ents

Hedgeditems

Netimpacton PL

(-)

&Profits and Losses Balance Sheet

1001000 0

Eliminated accounting mismatchby recognizing changes in fulfillmentcash flows in PL instead of adjusting CSM

Accountingmismatcheliminated

Accountingmismatchoccurred

Illustrative example of hedge accountig under VFAII. Hedging under new standards > 3. IFRS17 (Cont’d)

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IASB proposed a new model (Core model) in November 2017 in response to constituents’ feed back on PortfolioRevaluation approach(PRA) issued in 2014. The new model is conceptually similar to cash flow hedge whereas theprevious model, PRA, is similar to fair value hedge.

Purpose

Progress

• To provide hedging principles to faithfully represent entities’ actual risk management activities

• Managing risks on a portfolio basis• Net risk position of assets and liabilities hedged

• Continuous rebalancing of hedging instruments• Dynamic nature of assets and liabilities considered

Features ofDRM

Discussion paper“Portfolio Revaluation Approach”

Feedback from constituentsincluding EFRAG’s outreach

Staff’s proposed approach– “Core model”

2nd discussion paperto be released

►Conceptually similar to current cash flowshedge

►Phased approach- Core model developed first for major

issues,- Then extension for further issues

DRM

OverviewII. Hedging under new standards > 4.Dynamic Risk Management (DRM)

►Under PRA, assets or liabilities that donot meet criteria for recognitionrecognised in financial statements.è Not consistent with conceptual

framework of financial reporting.

►Financial institutions do not fair valuetheir assets just to apply DRM.

►Similar to current fairvalue hedge in concept

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Mechanics

Under Core model, net risk position of an open portfolio is a target of risk management. New conceptual terms such asasset profile, target profile and performance measurement were introduced in the model.

IFRS9 hedge accounting Proposed DRM model

Hedged item Asset portfolio

Risk management objective Target profile

Hedging instrument DRM derivative instrument

Effectiveness requirements Performance assessment

Criteria for designating arelationship

Criteria for designating arelationship

Disclosure Wider disclosure

Asset:Interest income

from Loans

Liabilities:Interest expense

from deposits

Net risk position:Net interest income

A portfolio of 5 year maturity loans with fixed interest rate

7 year fixed cash flows based on a behavioral analysis of coredeposits,

Two swaps that create 7 year fixed cash flows

Comparing hedged result to Target profile

Hedging instruments respond to hedged items in oppositedirections with similar sensitivity.

Provide an entity’s risk management objective, strategy andhedging outcome

• Deferring changes in derivatives in OCI and recognising the OCI in PL as cash flows of asset profile affect PL→ Net interest income will be stabilised and recognised in PL as desired in Target profile.

Linkage to current principles

Analogous to current cash flows hedge

Example

Key concept of Core modelII. Hedging under new standards > 4.Dynamic Risk Management(Cont’d)

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A Target profile is derived from modeling an entity’s funding structure. DRM derivative instruments are combined withthe entity’s asset profile to create cash flows similar in amount and timing to the Target profile.

Objective • To stabilise entity’s net interest income for 7 years

Hedging

Outcome receive fix(6%)Loans 600 receive fix(6%)• NII stabilised at the interest rate of 6%

for the target period

AS-IS: Asset profile-Loans

Balance 1,000

Maturity (Yrs) 5

Yield Fixed 5%

TO-BE: Target profile

Balance 400 600

Maturity (Yrs) 5 7

Yield Fixed 5% Fixed 6%

DRM derivatives

?5 Yr (Loan) 7 Yr (Target)

Assetprofile

receive fix(5%)Loans 600 receive floating

• No further action required for balance of 400• For 600, fixed 5% of interests received for

5 Yrs. For the subsequent 2 Yrs up to 7th

Yr, floating rate interests received.

DRMderivativeinstrument

pay fix (5%)receive floatingSwap 1 600

receive fix(6%)pay floating

receive fix(6%)pay floating

• Pay leg: Fixed 5% interest arising from 5Yr loan is paid with receipt of floating

• Receive leg: fixed 6% interest receivedfor the target period of 7 Yrs.

Swap 2 600

0

Illustrative example of Core modelII. Hedging under new standards > 4.Dynamic Risk Management(Cont’d)

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Implications

§ More flexibility in selecting items to be hedged (eg a percentage of asset portfolio can be designated ashedged items

§ Behavioral characteristics of a portfolio of liabilities and underlying assets should be considered whenmodeling

§ ALM results can be presented and disclosed in financial statements§ Analysis of cost and benefit of hedging should be performed to determine size and frequency of rebalancing

By linking Core model to insurers’ risk management practice, we can derive the following implications:

Asset profileLoans

Debt securities

Insurance liabilitiesFixed

FloatingTarget profile

DRM instrumentsSwap

ForwardsOptions

Modelling behaviorism for aportfolio of insurance contractsneeded for• Duration• Lapse• Highly probable new business

Behavioralassumptions neededfor• Prepayment• Maturities• Highly probable new

loans

Continuous rebalancingfor a open portfolio

Mitigating rather thaneliminating a particular risk(eg stabilising net interestincome arising frominsurance liabilities andunderlying assets)

What does Core model mean for insurers?II. Hedging under new standards > 4.Dynamic Risk Management(Cont’d)

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IASB takes a phased approach where major issues are addressed in the Core model and then remaining issues are to befurther discussed in the Extended model prior to finalising the 2nd discussion paper.

Remaining topics

Transparency How to present and disclose entities’ DRM purpose, strategy and hedging outcome under new standard?

Eligibility Criteria for designating Asset profile and governing principles for setting Target profile

Dynamic nature How to reflect dynamic natures of asset profile and target profile under new standard?

Performance measurement How to assess performance as a result of hedge?

Extension of Core model

Items to be hedged Loans measured at amortized cost FVOCI

Risks to be hedged Interest rate risk Other risks such as equity, commodities and FX

Hedging instruments Focus on interest rate swaps Other derivatives such as option and futures

Funding source Deposits driven Equity funding

Topics Core model Extended model

Items Key issues

Further issues and Extended modelII. Hedging under new standards > 4.Dynamic Risk Management(Cont’d)

III. Impact analysis

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> Two major types or variable products in Korea:- VA (GMAB/GLWB), VUWL (NLG)

> Fees / Loadings are deducted as a % of AV- Risk Premium, Investment Management Fee, GMxB Fee, Loadings

AccountValue

FixedDeath Benefit

AccountValue

(+ No LapseGtee)

GMAB/GMDB

Fixed Death Benefit

PayoutPhase

< Variable Annuity > < Variable Universal Whole Life>

Typical design of variable products in KoreaIII.1 Product Design

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[Equity shock: –25%]

[Equity Volatility Reduction through Hedging]

> Liability for variable product = AV + Gtee Reserve- Bifurcated Approach

> Change in Reserve is offset by change in hedging asset

III.2 Hedging StrategyUnder current accounting standard

GteeReserve($3,000)

AccountValue

($10,000)

GeneralAccount

Asset($3,000)

Underlying(SeparateAccount)

Assets($10,000)

Hedging Asset($2,500) Gtee

Reserve($5,500)

AccountValue

($7,500)

GeneralAccount

Asset($3,000)

Underlying(SeparateAccount)

Assets($7,500)

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[Hedging Credit for Required Capital]

[Equity –12%]

Req. Capital($5,000)

[Interest- 90bp]

Loss from

Prescribed

Shock

($30,000)

Hedging

Asset

Recovery

($25,000)

FV Reserve($10,000)

Shocked

Gtee Reserve

($40,000)

Reduction in RC

Post-HedgingRC

Pre-HedgingRC

> Under prescribed shock scenarios, increase in reserve is calculatedand that amount is the required capital (RC)

> RC is offset by the amount of asset movement (hedging credit)

Under current accounting standard (Cont’d)III.2 Hedging Strategy

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> BEL can be rearranged as follows:BEL = Death Benefit + Surrender Benefit + Annuity Benefit + Expense – Premium

= AV0 + ∑PV[GMxB Claims(t) + Add’tl DB(t) + InvRet(t) – Fees(t) + Exp(t)]

Expense Premium

100%

AV0 Premium Fees, RiskPrem,LoadingsInv Return ∑AVt

BEL

Rearranging cash flowsIII.3 Hedging Strategy under IFRS17 VFA

DeathBenefit

∑AVt

FixedBenefit

GMDBclaim

Prob[Death]Surrender

BenefitAnnuityBenefit

∑AVt

GMABclaim

∑AVt

Prob[Surrender] Prob[Survival]

VaryingCFs

non-varyingCFs

Rearrange AVt

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How to assess whether VFA criteria is met or not:- B101(b) The entity expects to pay to the policyholder an amount equal to a substantial share of the fair

value returns on the underlying item

VFA requirement (criterion 2)III.3 Hedging Strategy under IFRS17 VFA

Fair Value return

PMT DeathBenefit

SurrenderBenefit

AnnuityBenefit

∑AVtFixed

BenefitGMxBclaim

AV0 Premium Fees, RiskPrem,Loadings

FutureNet Inv Return

FixedBenefit

GMxBclaim

ΔAV

ΔPMT Increase in the amt to be paid to PHRatio of‘Payment to PH’ to‘Fair Value Return’

Need to beSubstantial

Equity+35%

• Higher Fees would reduce the ratio• Deep ITM would reduce the ratio

B104 (a): Obligation to pay the policyholder an amount equal tothe fair value of the underlying items

B104 (b): Variable Fee= Entity’s Share less FCF that do not vary with underlying

B104:Entity’sobligation to thepolicyholder

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[Appendix] Criterion b101(b) for different blocks

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How to assess whether VFA criteria is met or not:- B101(c) The entity expects a substantial proportion of any change in the amounts to be paid to the

policyholder to vary with the change in fair value of the underlying items

VFA requirement (criterion 3)III.3 Hedging Strategy under IFRS17 VFA

Total Payment to PH

PMT DeathBenefit

SurrenderBenefit

AnnuityBenefit

∑AVtFixed

BenefitGMxBclaim

PMT

∑AVt Varying Portion of Payment to PHRatio of‘Varying Payments’ to

‘Total Payments’

Need to beSubstantial

• Higher Fixed Benefit not varying with AVwould reduce the ratio

• Deep ITM would reduce the ratio

Varying Non-Varying

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[Appendix2] Criterion b101(c) for different blocks

98% 93%

72%

36%

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Market changes affect BEL through (assume RA=0) :a) Changes in obligation to pay an amount equal to the fair value of the underlying items -> by B111:

does not adjust CSM, reflected in P&L or OCIb) Changes in the entity’s share of the fair value of the underlying items

-> by B112: adjust CSM, can be reflected in P&Lc) Changes in FCFs that do not vary based on the returns on underlying items

-> B113(b): effect of the TVM and financial risks not arising from underlying items-> Adjust CSM, can be reflected in P&L

AV0

Net Inv Return

a)Fixed

Death Benefit

GMxBclaims

Expense

c)

P&L orOCI

CSM or P&L CSM or P&L

Inv Mgmt FeesRiskPrem,Loadingsb)

GMxB Fees

Not hedging target-Changes in AV is offset by

underlying asset

New Hedging Targetunder IFRS17

Hedging Target undercurrent accounting standard

Changing hedging targetIII.3 Hedging Strategy under IFRS17 VFA

Legend

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Hedging before the transition date could increase equity volatility- Change in Hedging Asset is absorbed by CSM if Fair Value Method is used for CSM calculation- Although net cash flows are effectively hedged, CSM existence can cause accounting mismatch

GMxB claim3,200

Entity Share(8,500)

BEL(10,000)

AV0(10,300)

Inv Return(1,100)

Expense(3,900)

Hedging Asset(700)

Equity(700)

CSM (300)

GMxB claim(2,200)

Entity Share(8,000)

BEL(9,000)AV0

(10,000)

Inv Return(1,000)

Expense(3,800)

Equity = 0

CSM (1000)

LiabilityAsse

t Asse

t Liability

Interest Rate-0.90%

*Note: FVL – BEL = CSM, Assuming FVL = AV

Hedging target (before)3,800+1,000+2,200-8,000= -1,000

Hedging target (after)3,900+1,100+3,200-8,500= -300

Hedging before transition dateIII.3 Hedging Strategy under IFRS17 VFA

IV. Conclusion

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VFACriteria

Cannot lock in accounting equity at transition through hedging for the profitableblock (with positive CSM)ü Economically, hedging still makes sense since it protects CSM at transition

ü It might make more sense to start hedging onerous block with negative CSM to avoid thisaccounting mismatch

Hedging under VFA gives more flexibility, but need to satisfy the requirement evenfor variable productsü Cash flows need to be rearranged to assess the qualification

ü ‘In the money’ block might not satisfy the criteria as the liability does not move as much asmarket changes

Fundamentals of hedging have not changed much, but need toü consider cash flows other than guarantee related

ü think of entire balance sheet, not just liability

HedgingunderIFRS17

Hedgingbefore

Transition

4. Insight into new hedgingIV. Conclusion

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Any Questions?

1st Presenter: KeumCheol Shin, CPAPartner, EY Koreakeum-cheol.shin@kr.ey.com

2nd Presenter : Taik-Ki Lee, FSAKyobo Life Insurancetklee1@kyobo.com

Facilitator: DaeEun Kang, ASA, CPAManager, EY Koreadaeeun.kang@kr.ey.com