CAIR/CARTAC/World Bank Workshop and ConferenceRose Hall Resort and Spa, 1-5 December 2008
Accounting for Insurance ContractsAccounting for Insurance ContractsThe Long Winding RoadThe Long Winding Road
5 December 20085 December 2008
Ashley PatelAshley Patel
2PRESENTATION STRUCTURE
Objectives and overview of IFRS 4 (Phase I)
Phase II – IASB Discussion Paper
Comments and Key Contentious Areas
A High Level Comparison with Solvency II
Practical Implications
This presentation is structured as follows:
3IFRS 4 – PHASE I
Interim standard - focused primarily on disclosures and classification of insurance contracts.
Introduced a definition for an insurance contract based on the contract containing significant insurance risk.
Required only limited changes to existing accounting practices for insurance contracts and extensive disclosures.
Elimination of equalisation and catastrophe reserves utilized in some countries.
A principles-based framework that allows a high degree of discretion.
4IFRS 4 – PHASE I – KEY PROBLEMS
The key achievement of IFRS 4 (Phase I) was a standard definition of insurance contracts. It did not prescribe accounting for insurance contracts; hence, there is great diversity in insurance accounting among jurisdictions
Accounting mismatch between assets (which are reported at fair value) and liabilities (which are not)
No consistency or transparency in the level of conservatism in estimates - Phase I merely prohibited further increasing the level of conservatism in reserving, but did not require that a “best estimate” approach
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INSURANCE ACCOUNTING – ANALYSTS’ COMMENTS
Between May and October 2007, PricewaterhouseCoopers carried out in-depth interviews with 39 dedicated insurance analysts from the US, Europe, Asia and Australia.
‘As it stands, financial reporting for life insurance companies is not useful to investors. The fundamentals of the business are not visible. Analysts cannot do any basic analysis and they have to resort to alternative bases.’
‘Non-life business is not transparent because companies manage the level of reserves as the cycle swings up and down.’
6PHASE II – STATUS OF THE PROJECT
Phase II work begun
- Jul 04
Discussion Paper
published - May 07
Comment period ends
- Nov 07
Phase II Draft IFRS
published – Late 09?
Phase II IFRS
published – Late 2010?
Phase II IFRS
effective 2012?
We are here
Current situation for accounting for insurance contracts is a mixed model
Resulted in too much diversity, less relevance and reliability, and inconsistency
The IASB started with a clean slate to develop Phase II
Modified joint project with FASB (US GAAP convergence)
7IASB DISCUSSION PAPER
Published on 3 May 2007
149 pages plus 83 pages of appendices
21 specific questions for comment by 16 November 2007
161 responses received from individuals, life and non-life companies, industry groups, accounting and actuarial firms, analysts, and regulators.
Responses came from all parts of the world underlining the global nature of the debate
IASB Discussion Paper“Preliminary Views on Insurance Contracts”
8SCOPE OF THE DISCUSSION PAPER
9ACCOUNTING MODEL
Single accounting model
• Discounting for non-life business• Strong opposition from US industry
Exit value model• Controversial (inside and outside IASB)• Day one gains
Entry vs. Exit Value Illustration:
• 10 year single premium policy sold by insurer X for $1,000• Expected to realise a profit for insurer X of $250 on average• Insurer Y prepared to purchase policy from X for $900 (after allowing for risk)
Entry value liability = $1,000 Initial profit is $nilExit value liability = $900 Initial profit is $100
10THE MODEL AT A GLANCE
Life of the contractC
laims
Receive premiums to stand ready
Stand ready to pay claims
Probabilityweighted
Probabilityweighted
The contract can be an asset or liability
11CURRENT EXIT VALUE MODEL
The amount the insurer would expect to pay to another entity if it transferred all its remaining obligations and
contractual rights to that entity
Time value of money Discount
rate
Current unbiased probability weighted estimates of future cash
flows
Current estimates
Risk Margin
Service Margin Margins
The Three Building Blocks
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ESTIMATES OF FUTURE CONTRACTUAL CASH FLOWS
Explicit
Unbiased
Market-consistent
Probability-weighted
Current
Exclude entity specific
13WHICH CASH FLOWS?
INCLUDE
Policyholder claims
Claims handling and maintenance expenses
Direct and indirect costs of benefits in kind
Option and guarantees
Unfavourable policyholder behaviour
EXCLUDE
Investment returns
Reinsurance
Income tax
Entity specific
Non-guaranteed insurability premiums
14DISCOUNT RATES
“Consistent with observable current market prices for cash flows whose characteristics match those of the insurance liability, in terms of, for example, timing, currency and liquidity”
Own Credit Characteristics
15HOW TO CALCULATE THE RISK MARGIN
No prescribed technique
Compensation for bearing risk
Reference to what a market participant would require
Not a ‘Shock-absorber”
Unit of account is the portfolio
16THE SERVICE MARGIN
Compensation for providing other services
Investment management services
What else?
Based on market price demanded by another party to assume the service obligation
Different from IAS 18
Could have day one profit or loss
Stage of completion is not the only driver to revenue -reference to market prices must be taken into account
17THE SERVICE MARGIN
Day One Loss
No Day One Gain/Loss
Day One Gain
If margins are higher or lower
than those required by market
participants?
=
18PARTICIPATING CONTRACTS
Is there a present obligation?
IAS 37
Legal obligation
Constructive obligation
IASB’s view: Participating rights only create a liability when the insurer has an unconditional requirement to provide economic benefits
19UNBUNDLING
Interdependent resulting in arbitrary measurement
Interdependent but not resulting in arbitrary measurement
Not interdependent
Phase II for whole contract
Phase II for whole contract, but IAS 39 for
deposit
IAS 39 for deposit, Phase II
for insurance
20COMMENTS ON DP - KEY CONTENTIOUS AREAS
Day One profit is unpopular – “nothing is earned yet”
Opposition to “current exit value” as it:
Has questionable relevance as insurers generally expect to settle the liabilities by paying benefits rather than transferring to a third party
Excludes entity-specific cash flows
Greater clarity required around the nature of and basis for calculation of risk and service margins
Use of a discount rate reflecting characteristics of the liability (including own credit rating) rather than an asset-based rate
Use of discounting and risk margins for non-life insurance contracts
21COMMENTS ON DP - KEY CONTENTIOUS AREAS
The IAS 37 Liabilities Project may narrow the definition of a constructive obligation and therefore limit the ability to recognise all expected payments to participating contract policyholders
22INTERACTION WITH EU SOLVENCY II
EU insurance companies are preparing for Solvency II with implementation due by 2012
Solvency II rules for valuation of assets and liabilities are expected to be compatible with IFRS Phase II
While Solvency II is a European initiative, it is likely that other regulators globally will adopt solvency regimes with varying degrees of similarity to Solvency II
The timings and underlying principles of Solvency II and IFRS Phase II are moving ever closer, opening up valuable opportunities for synergies in systems, organisation and market communications.
23COMPARISON WITH SOLVENCY II
INCLUDE Differences from Solvency II
Definition of insurance contract Profit / service margins Customer relationship asset /
future premiums Own credit standing
Categories of assets and liabilities
Audit materiality versus relevance to supervisor
Segmentation analysis
Best estimate Discounted Risk margin
Transparency Qualitative as well as
quantitative Risk management focus Sensitivity testing
Similarities with Solvency II
Technical
Disclosure
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PRACTICAL IMPLICATIONS – FINANCIAL REPORTING
Earnings volatility Revaluing insurance liabilities will create potential earnings volatility
Potential day one profit or loss
Using current exit values could lead to reported profit or loss at contract inception
Impact on revenue The question of whether certain premiums should be treated as income or deposits is left open and could affect “top line” revenue
Impact on equity Discretionary policy dividends qualify as liabilities only if there is a ‘constructive obligation’ to pay them
25PRACTICAL IMPLICATIONS – OPERATIONAL
Systems impact Forecasting future cash flows based on probability-weighted scenarios will require significant upgrade of modelling capabilities
Organisational impact
Use of risk margins and cash flow analyses in accounting will require closer integration among finance, regulatory, actuarial and risk management functions.
Resource impact Need for more qualified actuarial as well as finance and IT personnel
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Questions?