2010 Valuation Actuary Symposium
Sept. 20- 21, 2010
Session # 37 PD: Convergence of Accounting
Approaches – (U.S. GAAP and IFRS)
Rowen B. Bell, FSA, MAAA
William C. Hines, FSA, MAAA
Marc Slutzky, FSA, MAAA, CERA
Moderator:
Marc Slutzky, FSA, MAAA, CERA
9/7/2010
Convergence of IFRS and
US GAAP
Marc Slutzky, FSA, MAAA, CERA
SOA Valuation Actuary Symposium
Session 37PD
Chicago, IL
September 21, 2010
Update
U
d t on IFRS and
d US GAAP for
f
Life Insurance and Health Insurance
1
9/7/2010
Contents
1. The IFRS 4 project and the new Exposure Draft
2. What are the characteristics of the ED for Life and Health
3. Other IASB projects
4. Accounting convergence
3
The long and winding road of IFRS 4 (so far)
 1997: IASC sets up Steering Committee
 2002: Project split into two phases
 2004: IFRS 4 – the first phase of the project is completed
 2006: IASB and FASB agree roadmap for convergence
between IFRSs and US GAAP - MoU
 May 2007: Discussion Paper: Preliminary Views on Insurance
Contracts
 Nov. 2007: policyholder accounting topic
 Feb. 2008: review of responses to the discussion paper
 Oct. 2008, the FASB decided to participate in this project, so
this is now a joint project (but not part of MoU).
 Nov. 2008: Working Group provides input for a number of topics
 2009: Ongoing IASB Board meetings – discussion of insurance
project
 2010 The Exposure Draft is Here!!
4
2
9/7/2010
The road is even longer
Field test
August November
2009
Exposure Draft
3Q
2010
Final Standard
Effective Date
June
2011
2013
IASB meetings
•Discount rates
•Margins
•OCI
•Disclosures
•Participating
•Linked business
•(De)Recognition
5
5
Contents
1. The IFRS 4 project and the new Exposure Draft
2. What are the characteristics of the ED for Life and Health
William Hines - Life
Rowen Bell - Health
6
3
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Accounting Convergence
7
Global Context - Convergence
Risk Management Approach
Pricing & Valuation
European CFO Forum
decided to MCEV from 2010.
EarningsEarnings
based
Embedded
Value
Currently, many insurers
disclosing EVs.
Market –
MarketConsistent
consistent
EV
Economic
Capital
Model
New
Environment
Accounting
IAS /
IFRS44
IFRS
Phase I1
Historic
Cost
Accounting
8
Asset
Risk
Models
Solvency regulation
Fair Value (discounting at
market rates)
IFRS 4Phase II
IFRS4-Phase
2
PBA (U.S.)
(US)
Deterministic
Actuarial
Valuations
Internal
Model
A
Approach
h
Stochastic Model
• UK ICA
• EU Solvency II
• Swiss Solvency Model
Risk-factor
Risk-Factor
Solvency
Simple
Solvency
Margins
Factor-based
Factor
based model
• U.S.
US NAIC
NAICRBC
RBC
• UK ICA
• EU Solvency II
• Swiss Solvency Model
IFRS Practical Implications An Actuarial Perspective
8
4
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Estimated Use of IFRS by Insurance Premium
Premium is for 2008 life and pension coverage on direct basis.
Source: Swiss Re sigma 3/2009
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September 7, 2010
Convergence with US GAAP
 SEC Work Plan
 SEC Roadmap
 Memorandum of Understanding
 Insurance project
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September 7, 2010
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SEC Work Plan
 SEC Roadmap was Issued November 2008, comment period
extended to April, 2009
 Proposal to replace US GAAP with IFRS
 Updated with SEC Work Plan in February 2010
 Will assist in the SEC ‘s decision whether and how
to move forward slated for 2011
– Six areas for staff to study and evaluate
 Potential
P t ti l full
f ll adoption
d ti in
i 2014
 Proposed early adoption by certain large companies
 Timeline may change given SEC’s focus on other priorities
11
September 7, 2010
FASB/IASB Joint Efforts
 2002 - Norwalk agreement
 2006 - Memorandum of Understanding (MOU)
 2008 – Revised MOU
–
–
–
Achieve limited convergence
Jointly develop new standards
Do not diverge further
 2009 – Statement reaffirming objective of convergence
 2010 – IASB issued exposure Draft of IFRS 4. SEC will issue as a
discussion paper
 2011 – Revised strategies and work plan set targeted completion
dates of June 2011or earlier for priority projects believed to bring
about significant improvement and convergence of IFRS and US
GAAP.
 However changes at FASB may cause delays
12
September 7, 2010
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Short Term Convergence Projects
 Completed
– Fair value option
p
– Business combinations
– Borrowing costs
– Segment reporting
 In progress
– Joint ventures
– Income taxes
– Reporting on subsequent events
13
Longer Term Joint Projects
 Revisions to Business Combinations
 Financial Instruments
 Financial statement presentation
 Intangible assets
 Leases
 Liabilities and Equity
 Revenue Recognition
 Consolidations
 Derecognition
 Fair value measurement
 Post-employment benefits (including pensions)
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September 7, 2010
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9/7/2010
US GAAP Implementation Issues
 Classification of contracts under IFRS 4 is different from US GAAP
– US GAAP classifies based on issuing
g company
p y ((insurer vs. bank))
– IFRS classifies based on contract economics
– How will products not classified as insurance be accounted?
 Will FASB follow IASB’s lead for Financial Instruments?
– Available for sale assets
– Tainting rules for held to maturity class
– Bifurcation of embedded derivatives
 Communication to stakeholders
 Changes at FASB
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September 7, 2010
When will it impact your employer or your
clients?
 Of the approximately 8,400 SOA members that work for companies
1,300 + (16%) are in companies already reporting IFRS
 In 2011, Canadian companies will move to IFRS affecting thousands
more.
 2013 will be here sooner than you think!
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September 7, 2010
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9/7/2010
Convergence of Accounting Approaches (US GAAP and IFRS)
Session 37
William Hines, FSA, MAAA
Willi
Hi
FSA MAAA
Milliman, Inc.
The ED is Here!
 Project started in 1997
 Exposure draft in 2010
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Agenda
 Contract classification under IFRS
 Measurement model
 Expected cash flows
 Risk adjustment
 Residual margin
 Profit emergence
 Presentation
Contract Classification
Investment
Contracts
Investment Investment
Contracts with DPF
Insurance
Contracts
Service
Contracts
Yes
No
Significant Insurance Risk
No
No
Financial Risk
Yes
Yes
Yes or No
No
Participation Feature
No
Yes
Yes or No
No
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Insurance Contract
Measurement
 Short duration contract pre-claims liabilities
 Unearned premium approach
 All other contracts and liabilities
 Current fulfillment value
Current Fulfillment Value
For existing contracts
t t
For newly issued contracts
t t
Residual margin
To eliminate any gain at inception of contract
Total Insurance
Liability
Total Insurance
Liability
Risk adjustment
For risk of ultimate cash flows exceeding expected
Expected PV of future net cash flows
Amount insurer expects to pay out less take in
Amount insurer expects to pay out less take in estimated as of the valuation date
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9/7/2010
Expected Cash Flows
Include:
 Premiums
P
i
 Payments to policyholders for claims, benefits
 Payments from guarantees and options if not unbundled
 Incremental acquisition costs
g premium
p
billing,
g handling
g
 Policyy administration costs ((e.g.,
changes, recurring commissions)
 Transaction-based taxes
 Participation payments
Expected Cash Flows
Do Not Include:
 Investment
I
t
t returns
t
 Payments to/from reinsurers
 Cash flows from future contracts
 Acquisition costs other than incremental
 Costs that do not relate directlyy to the contract, such as
general overhead
 Income tax payments
 Cash flows from unbundled contract components
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9/7/2010
Expected Cash Flow Issues
 Expected values are needed
 Need to consider all possible scenarios
 Stochastic analysis or known distributions
 Discount rates
 Reflect liability currency, timing and liquidity
 Risk free plus illiquidity adjustment
 Incremental acquisition expense
 Likely different from deferrable expense
Risk Adjustment
The maximum amount the insurer would
rationally pay to be relieved of the risk that
the ultimate fulfillment cash flows exceed
those expected.
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9/7/2010
Risk Adjustment
 Do not reflect risks that do not arise from the contract
such as
 Investment risks – except as they affect payments to
policyholders
 Asset/liability mismatch risk
 General operational risk relating to future transactions
 To be estimated at the portfolio level so as to reflect
diversification within the portfolio.
 Do not reflect diversification across portfolios
Risk Adjustment Techniques
 Allowable methods are limited to:
 Confidence
C fid
level
l
l (Value
(V l att Risk
Ri k or VaR)
V R)
 Conditional tail expectation (CTE)
 Cost of capital
 Technique must be implementable at a reasonable
cost, in a reasonable time and be auditable
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9/7/2010
Risk Adjustment Issues
 Shape of distribution
 Assignment of probabilities to scenarios
 Assessing only risks related to liability
 Determining level of confidence to calculate the
measure
 D
Determining
t
i i costt off capital
it l rate
t that
th t reflects
fl t only
l
risks of liability
Residual Margin Calibration
Non-incremental
acquisition costs
New business loss at issue
Residual margin
Risk margin
PV of Premiums
PV of cash outflows
•
Existing
Business
Liability
For new business issued after implementation of IFRS 4 Phase II, a loss
at issue equal to the non-incremental acquisition costs will be incurred.
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9/7/2010
Price On Fully Allocated Basis
Premium covers:
 Benefits, including guarantees and options
 Expected payments from non-guaranteed elements
 Incremental acquisition costs
 Non-incremental acquisition costs
 Maintenance costs
 Contribution to overhead costs
 Cost of holding reserves and capital




Risk charge for insurance risks
Risk charge for asset risks
Risk charge for asset/liability mismatch risk
Profit
Current Fulfillment Value
Expected present value of CFs and risk margin covers:
 Benefits, including guarantees and options
 Expected payments from non-guaranteed elements
 Incremental acquisition costs
Non-incremental acquisition costs
 Maintenance costs
Contribution to overhead costs
 Cost of holding reserves and capital
 Risk charge for insurance risks
Risk charge for asset risks
Risk charge for asset/liability mismatch risk
Profit
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9/7/2010
Residual Margin
Conceptually equal to premium margin for:
 Non-incremental
N i
t l acquisition
i iti costs
t
 Contribution to overhead costs
 Cost of holding reserves and capital
 Risk charge for asset risks
 Risk charge for asset/liability mismatch risk
 Profit
Residual Margin Issues
 Aggregation level at which to determine
margin
i
 Maintenance of separate amortization
stream
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9/7/2010
Profit Emergence
Fixed Premium Products
 Under US GAAP, profit emerges as
 A level percent of premium
 Release of PADs
 Actual less expected experience
 Under CFV, profit will emerge as
 Residual margin is amortized (proportion to
claims)
 Release of risk adjustment
 Actual less expected experience
Profit Emergence
Flexible Premium Products
 Under US GAAP profits emerge as:
 Le
Level
el percent of e
expected
pected gross profits
 Actual less expected experience
 Under CFV profits will emerge as:
 Residual margin is amortized (proportion to
claims)
 Release of risk adjustment
 Actual less expected experience
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9/7/2010
Presentation – Income Statement
Required Elements
Change in risk adjustment
Release of residual margin
Underwriting margin
Gains and losses at initial recognition
Non‐incremental acquisition costs
Difference between actual and expected cash flows
Changes in estimates
Experience adjustments & change in estimates
Interest on insurance liability
Profit & Loss
Presentation Issues
 Producing actual margin information
 Development of margin information in
projection systems
 Education of management and
stakeholders
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9/7/2010
Summary – Big Changes
 Systems issues are significant
 Mindset
Mi d t change
h
from
f
considering
id i d
deterministic
t
i i ti tto
multiple scenarios
 Risk adjustment methodologies will require
research and judgment
 Reported profit drivers will change
 Significant education is needed
12
9/7/2010
SOA Valuation Actuary Symposium
Session 37PD
Chicago, IL
September 21, 2010
US Health Insurance
 Hard to fit into a “life” vs. “nonlife” paradigm
H d fi i “lif ” “
lif ” di
 Two different main types of US health insurance products:
 “Medical” (but also drug, dental, vision, etc.)
 “Non‐medical” (i.e., LTC, disability income, critical illness etc )
illness, etc.)
 Under US GAAP, medical products typically use short‐
duration accounting, and non‐medical products long‐
duration accounting; but, some exceptions
2
1
9/7/2010
IASB ED: Two Accounting Models
 Main CFV model (as described in William’s slides)
M i CFV d l ( d
ib d i Willi ’ lid )
 Modified model:
 Separation of pre‐claims liability from claims liability
 Measurement of claims liability follows main model
 Measurement of pre‐claims liability is based on allocating premiums over coverage period not on allocating premiums over coverage period, not on explicit cash flow projections
 Presentation is also different for contracts measured under the modified model
3
IASB ED: Two Accounting Models
 Modified model only applies to contracts where the M difi d d l l li h h coverage period is approximately one year or less
 But, how do you determine the coverage period? When does the current insurance contract stop?
 ED defines concept of boundaries of the insurance contract
 In main model, used to determine which cash flows to include
 Also appears to drive eligibility for modified model
4
2
9/7/2010
Boundaries of the Contract
“The boundary of an insurance contract
“Th
b
d f i
t t is the point at i th i t t which an insurer either:
(a) is no longer required to provide coverage, or
(b) has the right or the practical ability to reassess the risk of the particular policyholder and, as a result, can set a price that fully reflects that risk.”
What if the insurer must renew the contract, but is prevented by rate regulation from setting a renewal price that fully reflects risk at the contract (as opposed to portfolio) level?
5
Boundaries of the Contract
What is the boundary of the contract for:
Wh
t i th b
d f th t t f
 Large group medical?
 Small group medical?
 Individual medical (pre‐2014)?
 Individual medical (2014+ / guaranteed issue)?
 Individual disability
 Group disability
 Long‐term care
6
3
9/7/2010
Boundaries of the Contract
 Moral: There is not necessarily a clear mapping M l Th i il l i between
 US health contracts that today apply short‐duration US GAAP accounting; and
 US health contracts that would qualify to apply the modified model under the IASB ED
 Does the IASB ED give the “right answer” for all types health contracts, with respect to which of the two models to use? (Is the boundaries definition “right”?)
7
Applying the Modified Model
 Even for US health contracts that clearly get to use the E f US h l h h l l h modified model (e.g., large group medical), the resulting accounting may be very different from current US GAAP
 Pre‐claims liability resembles a “P&C‐style” unearned premium reserve
p
 Here the accounting considers the entire expected premium for the contract at outset
 Whereas, today’s “health‐style” unearned premium accounting considers only the current modal premium
8
4
9/7/2010
Applying the Modified Model
 Pre‐claims liability is amortized into revenue “on the P
l i li bili i i d i “ h basis of the expected timing of incurred claims and benefits, if that pattern differs significantly from the passage of time”
 Fix the expected timing at start of contract? Or, can it be “unlocked” during the contract?
 This seems like a useful improvement from US GAAP with respect to seasonality of health insurer earnings
 Downside: Administrative complexity
9
Claims Liabilities
 Manner in which ED suggests liabilities are to be M
i hi h ED t li biliti t b calculated differs significantly from current practice:
 Scenarios specifying amount & timing of cash flows
 Probability‐weighting across scenarios, and discounting, to provide expected present value
 Risk adjustment, using one of three specified families of methods (confidence interval CTE CoC)
methods (confidence interval, CTE, CoC)
 Are our current methods & approaches (e.g., development, tabular) salvageable?
 Do we need to think about new methods?
10
5
9/7/2010
Onerous Contracts
 “Additional liability for onerous contracts” is the ED “Addi i
l li bili f ” i h ED language for premium deficiency reserves
 Calculation is not contract‐by‐contract, but aggregated by portfolio “and, within a portfolio, by similar date of inception”
 Portfolio defined as a set of defined as a set of “insurance contracts that are insurance contracts that are subject to broadly similar risks and managed together as a single pool”
 How granular are a health insurer’s portfolios?
 Calculation excludes some cash flows (e.g., overhead)
11
Closing Thoughts
 Steep learning curve for most US health insurers S
l
i f US h l h i
relative to accounting model(s) laid out in IASB ED
 Resulting accounting could be an improvement for some US health products (e.g., revenue recognition timing more in line with expected claims timing for medical products); could be problematic for others p
);
p
(e.g., discount rates for longer‐tailed lines like LTC)
 Health insurer valuation function likely to be more complex in future, if accounting evolves in this direction
12
6