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International Financial Reporting Standards
Applied to Property and Casualty Insurance
presented to OCCA by Jim Christie
November 2004
Background
 Cross-border capital flows highlight the need for
consistent, understandable financial information BUT
insurance accounting has significant local variations
 The International Accounting Standards Board (“IASB”) is
developing a single set of global accounting standards
 Many countries committed to the objective of global
“harmonisation”
 Drivers for new approach
 Historical cost accounting models lack relevance
 Solvency-based approaches do not provide an accurate picture of
financial performance
 Convergence of banking and insurance industries
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Phased approach
for insurance
 A phased approach to insurance contracts.
Phase I – Implement by 2005
IAS
INSURANCE
PROJECT
Phase II – Implement Fair
Value by 2007 / 8 (?)
 Objective for Phase I is to implement some components of
the insurance project by 2005, without delay to Phase II.
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Property & Casualty – Phase 1
Key Phase I Issues
Defining Insurance
Accounting for insurance contracts
Disclosures
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Definition of Insurance
 A contract under which the insurer accepts
significant insurance risk by agreeing to
compensate the beneficiary if the insured event
adversely affects the policyholder
(Insurance Contracts (Phase I) paraphrased with emphasis added)
 Significant means at least one scenario with payment
of commercial substance with an amount that is not
trivial
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Insurance vs Financial Risk
 Financial risk is risk of possible future change in
specified interest rate, security price, commodity
price, foreign exchange rate, index of prices or rates,
a credit rating or credit index or similar variable
 Insurance risk is risk from contingent events other
than financial risk
If both financial risk and significant insurance
risk are present, contract classified as insurance
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Insurance Contract
Accounting
 During Phase I, existing accounting policies apply with
certain modifications
 Prohibited – certain accounting policies are prohibited as they do not
meet the IFRS framework
 Mandated – certain accounting policies must be implemented if they are
not already in the existing accounting policies
 Allowed to continue, but not start – certain accounting policies that do
not meet the IFRS framework can continue, but cannot be implemented.
 Can be started – certain accounting policies can be introduced.
 Existing accounting policies are those in the primary
financial statements
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PROHIBITED
accounting policies
The following policies are prohibited
 Catastrophe provisions
 Claim equalisation provisions
 Offsetting of reinsurance assets and
direct liabilities
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MANDATED
accounting policies
The following policies are mandated
if not already present
 Liability adequacy testing
 Impairment of reinsurance assets
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Liability Adequacy Test
 Current liability adequacy test applies IF
1. Test at each reporting date using current
estimates of future cash flows, AND
2. If these are greater than current liability,
liability is increased and deficiency flows
through profit and loss
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IMPAIRMENT of
reinsurance assets
 Reinsurance asset is reduced and reduction
flows through income statement if it is impaired
 Reinsurance asset is impaired if:
 Objective evidence of an event after initial inception
that the cedant may not receive all amounts due
 The impact of the event can be reliably measured
Impairment may be reversed
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Accounting policies that
may CONTINUE
The following policies may continue but
companies may not switch to these if they
are not already in use
 Undiscounted liability basis
 Deliberate overstatement of liabilities
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 Deferred acquisition costs approach
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Accounting policies that
may be STARTED
The following accounting policies may be
started, subject to certain restrictions
 Use of current market discount rates
 Use of shadow accounting
 Use of asset based discount rates
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Phase I Insurance
disclosure requirements
IFRS 4 has two high level principles:
Principle 1 – Explanation of recognised amounts
Principle 2 –Amount, timing and uncertainty of cash flows
Fair Value Disclosure for insurance contract assets and liabilities
 Implementation guidance - runs to 61 paragraphs – but
does not create additional requirements!
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Principle 1 - EXPLAIN
 Accounting policies
 Amounts
 Assumptions
 Changes in liabilities
 Gain or loss on buying reinsurance
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Principle 2 – CASH FLOWS
 Terms and conditions
 Segment information
 Risk management policies & objectives
 Insurance risks covered
 Run off triangles (claim development)
 Other risks
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PHASE 2
 PHASE 2 (in 2007?)
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Phase 2
 Scope – all insurance contracts
 Based on asset/liability model, rejecting
current deferral/matching model
 Where liabilities are independent of asset
returns, unless
 Policyholder benefits directly related to
asset returns; e.g, linked products
 Intended to be consistent with IAS 39
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Accounting Basis
 Proposed
 Move to “underwriting year” accounting, thus no smoothing of results
with UPR and DAC
 Liabilities measured at Fair Value
 Issues
 Extra volatility of the insurance result
 Potential changes to the IT systems
 Loss ratios for new products to be estimated from day one
 Re-engineering of claim reserving process
 Reserves for expenses
 Gain or loss at issue
 Renewals/Future Premiums
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Discounting
 Proposed
 Discounting of reserves will become mandatory
 Discounting at risk free rate, plus a spread for credit, and MVM’s
 Valuing options and guarantees
 Impact
 Projection of expected cash flows
 Selection of suitable economic assumptions consistent with market data
 Need to consider all future events including legislation and technology
 Re-engineering of the actuarial reserving process
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Market Value Margins
 Proposed
 Reserves will require a market value margin consistent with observed
market risk preferences
 Market value margin incorporated either
 by adjusting discount rates OR
 By adjusting cashflows
 Consider both diversifiable and non diversifiable risks
 Impact
 Need to develop suitable approach and discounting assumptions
 Need for enhanced disclosures
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Other Fair Value Issues
 Future premiums only included where
 Uncancelable continuation or renewal rights constraining
insurer’s ability to re-price; and
 Rights lapse if the policyholder ceases premiums
 No net gain at inception (ignoring indirect costs) unless
market evidence
 Same derecognition rules used for financial assets and
liabilities will apply to insurance
 Reflect all guarantees and options
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Types of Estimation Risk
1) Model Risk
 the risk that the wrong model was used to estimate the insurer’s liabilities
2) Parameter Risk
 the risk of misestimating the parameters for the model used to estimate the
insurer’s claim liabilities
3) Process Risk
 the risk that remains due to random variation, even if the correct model and the
correct parameters are used to estimate the insurer’s claim liabilities
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What of risks does MVM include?
 IAS Draft Statement of Principle 5.4:

“The entity-specific value or fair value of an insurance
liability or insurance asset should always reflect both
diversifiable and non-diversifiable risk.”
 This implies that model risk, parameter risk,
and process risk should be modeled.
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However …
 IAS Draft Statement of Principle, Section 5.10:

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while it is “conceptually preferable” to
reflect parameter risk and model risk, “it
is appropriate to exclude such adjustments
unless there is persuasive evidence that
enables an insurer to [quantify] them by
reference to observable market data.”
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What is the market’s
risk preference?
The Fair Value of policy liabilities reflects the risk
preferences of the insurance market.
What is the insurance market’s risk preference?
The 60th percentile of the distribution?
The 75th percentile?
The 95th percentile?
IAS Draft Standard of Principles: the risk preference
is “inevitably subjective” (Section 5.29)
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Some practical techniques
to model the MVM
1) Canadian Provision for Adverse Deviation
 Includes Parameter Risk & Model Risk
2) Initial Expected Profit Margin
 Process Risk, Parameter Risk, & Model Risk
3) Poisson Frequency / Lognormal Severity Simulation
 Process Risk
4) Mack’s Approach
 Process Risk, Parameter Risk, & potentially Model Risk
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Canadian Provision for
Adverse Deviation (PFAD)

Three components to Provision for Adverse Deviation:
1. Claims Development (2.5% to 15% of discounted gross liabilities)
2. Discount Rate (50 to 200 basis points on interest rate)
3. Reinsurance Recovery (0% to 15% of discounted ceded claim liabilities)

The MVM could be set equal to the claims development PFAD.

The PFAD does not attempt to model process risk (i.e. size of the
company is not considered when determining the PFAD).
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Initial Expected Profit Margin
 If insurance markets are efficient, the DSOP
suggests there should be no gain at issue
 Consequently if a profit is indicated at issue, any
theoretical MVM should be scaled so that the result is
simply breakeven
 Are P&C insurance markets efficient?
 Are there situations where a gain at issue would be
permitted?
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Frequency / Severity
Simulation
 Determine the distribution of loss reserves using a Monte
Carlo approach
 Frequency often assumed to be Poisson distributed
 Severity often assumed to be lognormally distributed
 Data requirements:
 Pending counts (ultimate counts – closed counts)
 Unpaid Claims (case + IBNR)
 Coefficient of Variation for severity (can be based on historical or
industry data)
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Mack Method
Mack Method can be applied to:
 Paid Losses
 Incurred Losses
 Historical Recorded Ultimate Losses
Source: Measuring the Variability of Chain Ladder Estimates by
Thomas Mack
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Conclusions on MVM
 Many judgments required under IFRS 4 requirements:
1) Should one include parameter & model risk in MVM?
2) How should the risk preference of the market be
measured?
3) What approach should be used to model the MVM?
4) Given that you have selected an approach, how
should you select your MVM?
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Questions
Jim.K.Christie@ca.ey.com
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