CAIR/CARTAC/World Bank Workshop and Conference
Rose Hall Resort and Spa, 1-5 December 2008
Accounting for Insurance Contracts
The Long Winding Road
5 December 2008
Alok Jain
PRESENTATION STRUCTURE
This presentation is structured as follows:
 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
1
IFRS 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.
2
IFRS 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
3
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.’
4
PHASE II – STATUS OF THE PROJECT
5
 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)
Phase II
work begun
- Jul 04
Discussion
Paper
published
- May 07
Comment
period ends
- Nov 07
Phase II
Phase II
IFRS
Draft IFRS
published – published –
Late 2010?
Late 09?
We are here
Phase II
IFRS
effective
2012?
IASB DISCUSSION PAPER
IASB Discussion Paper
“Preliminary Views on Insurance Contracts”
 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
6
SCOPE OF THE DISCUSSION PAPER
7
ACCOUNTING 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 $nil
Exit value liability = $900 Initial profit is $100
8
THE MODEL AT A GLANCE
9
Life of the contract
Claims
Stand ready
to pay claims
Probability
weighted
Probability
weighted
Receive premiums to stand ready
The contract can be an asset or liability
CURRENT EXIT VALUE MODEL
The Three
Building Blocks
Service
Margin
10
Margins
Risk Margin
Time value of money
Current unbiased probability
weighted estimates of future cash
flows
Discount
rate
Current
estimates
The amount the insurer would expect to pay to another
entity if it transferred all its remaining obligations and
contractual rights to that entity
ESTIMATES OF FUTURE CONTRACTUAL CASH
FLOWS
 Explicit
 Unbiased
 Market-consistent
 Probability-weighted
 Current
 Exclude entity specific
11
WHICH CASH FLOWS?
INCLUDE
 Policyholder claims
 Claims handling and
maintenance expenses
 Direct and indirect costs of
benefits in kind
 Option and guarantees
 Unfavourable policyholder
behaviour
12
EXCLUDE
 Investment returns
 Reinsurance
 Income tax
 Entity specific
 Non-guaranteed insurability
premiums
DISCOUNT 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
13
HOW 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
14
THE 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
15
THE SERVICE MARGIN
16
Day One Gain
If margins are
higher or lower
than those
required by market
participants?
Day One Loss
=
No Day One Gain/Loss
PARTICIPATING 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
17
UNBUNDLING
Interdependent resulting in
arbitrary measurement
Phase II for
whole contract
18
Interdependent but not resulting
in arbitrary measurement
Phase II for
whole contract,
but IAS 39 for
deposit
Not
interdependent
IAS 39 for
deposit, Phase II
for insurance
COMMENTS 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
19
COMMENTS 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
20
INTERACTION 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.
21
COMPARISON WITH SOLVENCY II
Similarities with Solvency II
INCLUDE
Technical
Disclosure
 Best estimate
 Discounted
 Risk margin
 Transparency
 Qualitative as well as
quantitative
 Risk management focus
 Sensitivity testing
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
22
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
23
PRACTICAL 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
24
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Questions?