The New Insurance Contracts
Accounting Standard:
History in the making
IABA Conference, August 7, 2010
Tara Hansen and Gareth Kennedy
Agenda
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Page 1
Introduction and project background
The proposed models
Income emergence
Conclusion
Introduction and project
background
Why is this important to me?
►FASB
►
joined the insurance project in October 2008
Project will now impact US GAAP even if SEC doesn’t
require IFRS
►SEC
work plan
► Plan to make a decision in 2011 on requiring adoption of
IFRS by US companies
►NAIC
►
►
Page 3
Solvency Modernization Initiative
Monitoring developments from the IASB and Solvency II
Insurance Accounting Standards Working Group asked to
propose solution by end of 2011
Insurance contracts project timeline
Implementation
Development of the new standard
End of comment periods
(IASB and FASB)
IASB and FASB meetings
to develop accounting
standards
IASB —
discussion paper
issued
IFRS 4 Insurance
Contracts
May
January
2006
Potential
Transition
August November
2007
IASB
Exposure
Draft
FASB —
Joined the
project
FASB — invitation
to comment
2005
October
2008
Jan. 2009 thru July 2010
2009
Final standard
Nov.
Implementation
date
June
2011
January
2012
2013
2014
First year of new
standard 2014
Restate opening
balance sheet
Fiscal
2011
July Aug.
2010
Fiscal
2012
Fiscal
2013
2012 and 2013 statements
filed under US GAAP
Run US GAAP and new
insurance standard parallel
Page 4
End of comment
period
FASB Exposure
Draft or Discussion
Paper
Fiscal
2014
Form 10-K are produced for year ended December 31,
2014 with comparatives for fiscal years 2013 and 2012.
Quarterly information required as of March 31, 2014
with balance sheet comparative to Dec. 31, 2013 and
income statement to March 31, 2013.
Project considerations
Conceptual accounting framework
► An
exposure draft on the Conceptual Accounting Framework
Project indicated that relevance and faithful representation are the
fundamental qualitative characteristics of financial information
► Relevant - information that has predictive value or confirmatory
value
► Faithful representation - complete, free from material error, and
neutral
► Also
the draft indicated comparability, verifiability, timeliness, and
understandability are enhancing qualitative characteristics
►Materiality
Page 5
and cost are pervasive constraints
Project considerations
Revenue recognition
Key Concept
Implication
Performance obligation
►
Satisfaction of
performance obligation
►
Revenue recognition
►
The promise in a contract to transfer economic resources to a
customer
Goods – when enforceable rights or access to goods transfer to
customer
► Services – when a service or access to a service is provided
Revenue is recognized when contract asset increases or contract
liability decreases.
Revenue can be recognized at two occasions:
► when the contract is obtained (if a contract asset is recognised)
► when a performance obligation is satisfied
Page 6
Project considerations
Financial instruments project
► Recently
published IFRS 9 will require investments to
be recorded at fair value with changes in value flowing
through profit and loss
► Exceptions are provided for:
►Debt
instruments with only basic loan features and the
asset is held to collect the cash flows under the
company’s business model, amortized cost can be used
►Equity instruments not held for trading through an
irrevocable election, with dividends through profit or loss
and changes in fair value through OCI
►FASB
Page 7
has published separate exposure draft
The proposed models
FASB/IASB proposed insurance contracts
measurement model
FASB
IASB
Current estimate of future cash flows
Current estimate of future cash flows
Discount
Discount
Risk adjustment
Composite margin
Residual margin
►
The unbiased, probability-weighted average of
future cash flows expected to arise as the
insurer fulfils the obligation
►
The unbiased, probability-weighted average of
future cash flows expected to arise as the
insurer fulfils the obligation
►
The time value of money
►
The time value of money
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An amount that eliminates any gain at inception
of the contract minus an amount equal to the
incremental acquisition cost(composite margin)
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A risk adjustment for the insurer’s view of the
uncertainty (amount and timing) associated
with the future cash flows
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An amount that eliminates any gain at inception
of the contract minus an amount equal to the
incremental acquisition cost
Page 9
UPR simplification
►IASB
has tentatively decided that unearned premium
will be used during the pre-claims period for short
duration contracts as a simplification to the four
building block approach. This would eliminate the need
for a residual margin to eliminate day 1 profits
► FASB
is currently debating this approach and recently
discussed it in an education session
Page 10
Discount rates
►The
Boards tentatively decided that the discount rate
should reflect the characteristics of the liabilities, rather
than the characteristics of assets held to back the
contracts, unless the contracts share those
characteristics
►The
Boards have indicated that the discount rate could
consist of:
►The
risk-free rate
►A liquidity premium
►An adjustment for non-performance risk/own credit
standing (not to be included in the measurement)
Page 11
Acquisition costs
►The
IASB tentatively decided to exclude from the initial
measurement of the residual margin an amount equal
to the incremental acquisition costs
► The
FASB recently changed their tentative decision to
include acquisition cost related to a contract in the
cash flows used to measure the contract value at
inception.
Page 12
Recognition
►The
IASB has agreed in principle and the FASB has
tentatively decided that the insurer should recognize
the rights and obligations arising from an insurance
contract on the earlier of:
►The
insurer being on risk to provide coverage to the
policyholder for insured events; and
►The signing of the insurance contract.
Page 13
Presentation of the performance statement
Summarized Margin
Year
1
Year 2
Expanded Margin
Risk adjustment *
Revenue
Residual Margin *
Policyholder benefits
*(FASB – one composite
margin)
Expenses
Insurance Margin
Insurance Margin
Experience adjustment
Experience Adjustment
Changes in estimates
Changes in estimates
Investment income
Investment income
Interest on insurance
liability
Interest on insurance
liability
Net interest and
investment
Page 14
Release of benefit and
expense accrued in
previous period
Net interest and
investment
Year
1
Year 2
Level of aggregation
►Boards
tentatively decided:
►“That
an entity should measure any risk adjustment at a
portfolio level of aggregation; to retain the definition of
portfolio of contracts in the existing IFRS 4 as Contracts
that are subject to broadly similar risks and managed
together as a single portfolio; and
►That
residual or composite margins should be
determined at a cohort level of aggregation, by
grouping insurance contracts by portfolio and, within
the same portfolio, by date of inception of the
contract and by length (or life) of the contract.”
Page 15
Comparison of proposed models to Solvency II
Attribute
Proposed FASB
Proposed IASB
Solvency II
Scope
All companies reporting
under US GAAP
All IFRS listed
companies
EU insurance
companies
Measurement
Current assessment of
the obligations
Current assessment of
the obligations
Market consistent
with entity
parameters
Risk Margin/
Adjustment
Method
Not applicable
Not yet prescribed
CoC (Directive) and
rate prescribed
(QIS5) with 1-year
VaR capital standard
Own Credit
Standing
Possibly included
Excluded
Excluded
Disclosures
To be defined but more
than current US GAAP
Similar to current IFRS
Solvency & Financial
Condition report
Discount rate
Risk-free plus an
adjustment for illiquidity
and possible for OCS
Risk-free plus an
adjustment for illiquidity
Risk-free plus 50%
of the illiquidity
adjustment (QIS5)
Page 16
Income emergence
Income emergence – assumptions
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$1,000 of premium is written at time zero for one year of
coverage with expected losses of $800
Incremental acquisition costs are $200, losses include
ALAE and ULAE, and there are no other expenses
A risk free yield curve is used to discount the liabilities
Return on invested cash is 3.0% per annum
There is no tax or reinsurance
Actual reserve development does not differ from expected
Payments are made just prior to the end of each time
period
Page 18
Income emergence – assumptions
►
►
►
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The risk adjustment for the proposed IASB model is
estimated using a “Cost of capital” approach with return
on capital set such that it equals the amount of discount
The amortization of the composite margin uses a formula
as tentatively decided by the FASB
Investment income is on available cash only
Losses are paid out over 10 years
The UPR simplification is ignored
Page 19
Comparison of income emergence
Current US GAAP income
Current US GAAP
Time =
0
0.5
1
1.5
2
2.5
3
Written Premiums
1,000
-
-
-
-
-
-
Unearned Premiums
1,000
-
-
-
-
-
-
Earned Premiums
-
500
500
-
-
-
-
Claims Expense
-
(400)
(400)
-
-
-
-
Discount
-
-
-
-
-
-
-
Risk Adjustment
-
-
-
-
-
-
-
Acquisition costs
-
(100)
(100)
-
-
-
-
Underwriting Income
-
-
-
-
-
-
-
Investment Return
-
12
12
11
10
9
8
Income
-
12
12
11
10
9
8
Page 20
Comparison of income emergence
Proposed IFRS income
Proposed IFRS
Time =
0
0.5
1
1.5
2
2.5
3
Written Premiums
Unearned Premiums
Earned Premiums
1,000
1,000
-
-
-
-
-
-
Claims Expense
Discount
Risk Adjustment
Residual Margin
(800)
70
(70)
-
-
-
-
-
-
-
Acquisition costs
(200)
-
-
-
-
-
-
Underwriting Income
-
-
-
-
-
-
-
Unwind of Discount on Claims
Reserves
Unwind of Risk Adjustment
Unwind of Residual Margin
-
(11)
8
-
(10)
8
-
(9)
8
-
(8)
7
-
(7)
6
-
(6)
6
-
Income After Unwind
-
(3)
(2)
(1)
(0)
(0)
0
Investment Return
-
12
12
11
10
9
8
Income
-
9
10
10
10
9
8
Page 21
Comparison of income emergence
Proposed US GAAP income
Proposed US GAAP
Time =
0
0.5
1
1.5
2
2.5
3
Written Premiums
Unearned Premiums
Earned Premiums
1,000
1,000
-
-
-
-
-
-
Claims Expense
Discount
Composite Margin
(800)
70
(70)
-
-
-
-
-
-
Acquisition costs
(200)
-
-
-
-
-
-
Underwriting Income
-
-
-
-
-
-
-
Unwind of Discount on Claims
Reserves
Unwind of Composite Margin
-
(11)
20
(10)
20
(9)
3
(8)
3
(7)
3
(6)
3
Income After Unwind
-
9
11
(6)
(4)
(3)
(3)
Investment Return
-
12
12
11
10
9
8
Income
-
21
22
5
6
6
5
Page 22
Insurance contracts considerations – P&C
Comparison of baseline profit emergence
Income emergence - baseline example
25
Income ($)
20
15
10
5
0
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
6.5
7
7.5
Time (yrs)
Current US GAAP
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Proposed US GAAP
Proposed IFRS
8
8.5
9
9.5
10
Insurance contracts considerations – P&C
Discount rate change scenario at t=2
Income emergence at t=2
20
18
16
14
12
10
8
6
4
2
Current US GAAP
Baseline
Proposed US GAAP
Proposed IFRS
After IR change
A 50 basis point increase in the interest rate at t=2, causes a significant increase in the
expected income at t=2 for the proposed US GAAP and IFRS models.
Page 24
Insurance contracts considerations – life
Example – Product Features
Product Features
Assumptions
Universal Life Block
►
Credited interest and Bonus
►
Product Charges
Heavily funded universal life with no secondary guarantees
► One year of new business
► 45-year old nonsmoker male with total face amount equal to 250m
Guaranteed minimum credited rate: 3%
► Target spread: 1.85%
► Interest bonus: 75bps beginning in year 10
Policy loads (% of premium): 19%, 7%
Surrender charges (% face amount): 50%, 30%, 28%, 18.6%, 12.9%, 9.2%,
6.6%, 5.0%, 3.9%, 3.0%, 2.2%, 1.6%, 1.2%, 0.7%, 0.3%, 0%
►
►
Commissions (% of premium): 60%, 6%, 6%, 6%, 3%
► Acquisition expense: 112 per policy
► Maintenance expense: 33 per year
► Inflation: 1.5%
► Premium tax: 2.5%
► All commissions in excess of ultimate rate are deferrable for GAAP; 90% of
non-commission acquisition expense is deferrable for GAAP
Commissions and Expenses
►
Termination Rates
►
Page 25
Lapse: 4.9%, 4.2%, 3.5%
► Mortality: 60% of nonsmoker SoA 75-80 table
► Premium persistency: 125%, 100%, 100%, 100%, 100%, 100%, 100%, 38%
Insurance contracts considerations – life
Example – FASB/IASB Insurance Contracts Approach
•IASB Risk adjustment
– explicit assumption
with 5% expected
mortality and 10%
reduction in lapse plus
a residual margin
•FASB composite
margin
•Projected book yield less
provision for default
(assumed equal to credit
default swap rate on
underlying assets) less
pricing spread, subject to
guaranteed interest rates
Page 26
• Risk adjustment
considers time
value of money
• Residual margin is
run off in
proportion to risk
adjustment
Margins
Remeasurement
Approach
Credited Rate
Discount Rate
• Risk-free forward
rate
Sample Results – UL New Business Projection
Pre-tax Net Income
* Investment
* Investment
Income
Income
based
based
on on
Invested
Invested
assets
assets
= U.S.
= U.S.
statutory
statutory
reserves
reserves
+ 350%
+ 350%
RBC
RBC
Page 27
Insurance contracts considerations – life
Comparison of profit emergence by investment strategy
Income by Investment Strategy
Surplus by Investment Strategy
100.0
100.0
80.0
60.0
50.0
40.0
20.0
Duration Mismatch
0.0
-20.0
Duration Match
-40.0
KRD Match
-60.0
CF Match
-80.0
Duration Mismatch
0.0
Duration Match
KRD Match
-50.0
CF Match
-100.0
-100.0
-120.0
1
2
3
4
5
6
7
-150.0
1
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2
3
4
5
6
7
8
Conclusion
Key effects that will interest management
►
Transparency
►
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Investors will get a much greater insight into insurance companies
Companies who efficiently use capital and make adequate risk
adjusted returns will find it easier to raise capital
Income volatility
►
►
Page 30
Income from insurance liabilities will be subject to interest rate
fluctuation
Asset-liability management will become more critical for P&C
companies who’s management wish to minimize the effect of
interest rate changes on income
Increased actuarial involvement
►
Discounting and risk adjustment calculations
►
Capital modeling
►
Asset-liability modeling
►
Attribution analysis
Page 31