Embedded Derivatives
in Insurance Contracts
Draft International Actuarial Standard of Practice
Stefan Engeländer
Formal Basis
 IFRS 4.7:
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Apply IAS 39 to embedded
derivatives
IAS 39.2 (e):Scope includes such derivatives
IAS 39.9:
Definition of a derivative
IAS 39.10: Definition of an embedded
derivative
IAS 39.11: Guidance for embedded
derivatives
IAA Draft International Actuarial Standard of
Practice „Embedded Derivatives“
International Actuarial Standards of Practice
 Issued by the IAA
 Drafted and proposed by the International
Actuarial Standards Subcommittee
 Subsidiary to national standards
 Member organizations of IAA obliged to
transform in own standards
 “Embedded Derivative” will be Class IV,
merely educational
Concept of Derivatives
 Concentration of financial risk inherent in
normal investments by trading it separately
 Significantly subject to changes in market
views of values
 Causes an unusual risk exposure, therefore
special consideration required
 Best measurement at market value
 In some cases derivatives artificially
combined with other features causing a nonderivative contract
 If actually artificial (not closely-related) separation
required to identify concentrated risk properly
Critical Consideration of Concept
 Derivative refers only to a very specific risk
 There are many significant risks, especially
options and guarantees, not covered by that
concept
 Especially in insurance business very exotic
form of risk
 Accounting concentration on that exotic risk
might distract from more relevant risks
 Actually relevant only in case of traded risks,
insurance business often based on nontraded factors (natural disasters, longevity)
Identification of a Derivative
 Financial instrument
 No insurance contract
 Value changes in response to changes of a
specified market factor
 Initial net investment significantly smaller
than for comparable primary investment
 Settled at future date
 Time up to settlement date exposes to changes of
market factors
Market Factor
 Market factor defined by IAS 39.9 (a) (as
amended by IFRS 4.C6) as:
“interest rate, financial instrument price,
commodity price, foreign exchange rate, index
of prices or rates, credit rating or credit index,
or other variable, provided in the case of a nonfinancial variable that the variable is not specific
to a party to the contract”
 Insurance risk is a non-financial variable
specific to the policyholder transferred to the
insurer
 Market factors are therefore:
 All financial variables
 All non-financial variables not specific to a party
Market Factor
 IFRS 4 changed the definition of a market
factor, by limiting the general reference to
“other variable”
 Otherwise as well any insurance would be a
derivative, since as well the occurrence of a
claim can be seen as “other variable”
 Therefore, the definition was limited to actual
market relevant variables, rather than
variables specific to a party
Market Factor
 Market factors are variables applicable for all
market participants
 Examples of market factors
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Market interest rates
Market price of a bond
Market assessment of credit standing of an entity
Price index
Market assessment of commodities
Longevity of population
Weather conditions
Index of natural disasters
Specific Non-Financial Variables
 Specific non-financial variables are variables
relevant only for the parties of the contract
 Examples of specific non-financial variables
 Occurrences affecting the condition of a good
 Life expectation of a party
 Health condition of a party (guaranteed
insurability)
 Employment situation of a party
 Claims development of a portfolio of a party
 Cost situation of a party
 Individual investment policy of a party
 Actual insolvency of a party
 Any deliberate action of a party
Specified Market Facor
 The market factor has to be specified to
qualify a derivative
 Cash flows under the contract are directly
determined based on a market factor specified in
the contract
 Actions of the parties influencing the cash flows of
the contract are subject to the development of
specified market factors, not necessarily written in
the contract but obvious at outset of the contract,
eg development of market prices for alternative
investments
 Not qualifying: During the contract duration
appears a new aspect causing that future
cash flows are subject to a market factor
Effect of the market factor
 Value of contract changes in response to
changes of market factor
 Basis fair value of the contract, not book value,
considering all uncertainties in measurement
 Significant impact required, as well in comparison
with all other impacting risks
 Right to exchange one right with another right at
fair value has always the fair value zero, ie value
of that right does not change
 Obligation to settle in future at cost, as well on a
portfolio level, to be seen as value zero, except if
at outset clear, that ability to settle below market
 Short term initial advantages in long term
contracts to be ignored
Effect of the market factor
 Value of contract changes in response to
changes of market factor
 The fair value of the contract need to change in
response to changes of market factor
- effects to individual cash flows under the
contract do not necessarily affect the value of the
contract!
 Example: Unit linked contracts, the benefit changes in
response to unit price, but the value of the entire
contract is ideally always zero since any cash flow is
exchanged at market value in units
Effect of the market factor
 Examples of such effects
 External factors determine the amount of cash
flows
 Index-linked benefits
 Interest linked to indices, eg weather conditions
 Annuity conversion rate linked to population longevity
 External factors determine the occurrence of cash
flows
 Cancellation of a fixed-interest investment in dependence
from current market interest rates
 Payment due if a specific event occurs which is not
specific to a party
 In those cases it has to be checked, whether
the effect of the market factor impacts
significantly the fair value of the contract
Comparison with Alternative Investment
 IAS understands a derivative as concentrated
risk from normal (primary) investments
 A derivative is not a primary investment
 The payment is merely a risk price rather
than an investment
 A derivative has therefore a lower net initial
payment than that primary investment from
which the derivative risk origins
 That difference in initial net payment is a
defining characteristic of a derivative
Comparison with Alternative Investment
 Derivatives and insurance similar
 Both contain cash flows subject to variables
 Both cover concentrated risk
 Both charge a risk premium rather than being an investment
used for commercial processes
 Difference between derivative and insurance
 Definition: Only financial instruments in the scope of IAS 39
can be derivatives
 Derivatives cover mainly market risks (ie the assessment of
market participants of future economic use of items), while
insurance cover actual risks endangering the economic
position of the policyholder directly
 Insurance risks are usually stochastic risks and can be usually
mitigated by the Central Limit Theorem since large number of
identical distributed and independent risks are available
 Derivatives are subject to inpredictible market behavior
Alternative Primary Investment
 For qualifying as derivative, there needs to
be an alternative primary investment subject
to the same market factor
 A primary investment is a funding of a
commercial process subject to commercial
risks and chances
 Especially difficult in case of non-financial
market factors like
 Longevity of a population
 Weather conditions
 Index of natural disasters
Alternative Primary Investment
 Examples for alternative primary investments
subject to such non-financial market factors
 Cost of living in case of longevity of a population
equivalent to a life-contingent annuity
 Investment in weather dependant activities like
agriculture, tourism or open air events
 Investment in buildings in an area of increased
geotectonic activity
Initial Net Investment
 Price paid for achieving the rights
 Not just the initial contribution in case of
regular payment contracts
 To be modified for
 Modified for risk exposure in comparison to
alternative investment by modifying the risk price
without changing the funding component
 Included servicing cost is servicing is no part of
alternative investment
Comparison of Initial Net Investments
 Initial net investment needs to be so
significantly lower than for alternative
investment that
 it is clear, that it is merely concentrated risk rather
than investment (even onerous by intention)
 it outweighs the differences between different
available alternative investments and different
prices charged in markets for those
 It is significant as well considering whether the
relationship between funding component and risk
price in the alternative investment is large or
small
Example
 Right to get an life-contingent annuity at a
future date at a price reflecting longevity of
the population at that date and at market
interest rate
 Specified non-financial market factor longevity of
population and financial market factor market
interest rate
 Value of right always zero
 Alternative investments
 Fixed interest instrument
 Life-contingent annuity
 Both no difference in initial net investment
Example
 How to style a derivative based on longevity
of a population?
 Right to receive the difference between the price
of a life-contingent annuity today and the price of
that at future longevity of a population
Embedded Derivatives
 An embedded derivative is a component of a
non-derivative contract, that would be a
derivative if it was seen as a stand-alone
contract
 Component of a contract
 Basis is an identifiable feature of a contract, which can be
isolated without any artificial split
 The component containing that feature is the sum of all
parts of the contract related to that feature to enable to
be a reasonable contract if it were a stand-alone feature
 Such related features are especially prices charged and
other economically required features
 Such related features may need artificial splits of
contractual features, eg if one single price is charged for the
entire contract
 Notional split of prices in the contract shall not be
considered except that split reflects economic reality
Embedded Derivative Cash Flows
 Embedded derivative cash flows are cash
flows under the contract that change in
respond to changes of a specified market
factor
 For identifying embedded derivative cash
flows contractual cash flows shall not be
artificially split
 No split of a risk-free cash flow in two negatively
correlated cash flows
 No split of a cash flow changing in respond to a
specified market factor in a cash flow responding
to a non-specified factor, eg a non-specified
interest rate, and the deviation of that factor to
the specified market factor
Double Trigger
 An insurance contract is no derivative by
definition
 A component including significant insurance
risk (measured in comparison to the
component only) is therefore no embedded
derivative
 A cash flow double triggered by insurance
risk and derivative risk is therefore no
embedded derivative cash flow
 A benefit payable in case of occurrence of an
insured event but amount market factor triggered
 An option, whose execution is triggered by market
factor as well by eg health condition under
coverage of guaranteed insurability
Behavior of Parties
 Options are contract features allowing parties
to influence cash flows unilaterally
 Behavior in executing options might be
triggered by
 specific circumstances of parties (health condition,
financial situation eg in case of unemployment,
legal situation eg in relation to state social
security)
 If creating significant insurance risk, the component is no
embedded derivative
 market considerations considering alternative
instruments available in the market
 Might cause that cash flow is subject to a specified
market factor
Guaranteed Insurability
 Guaranteed insurability is a feature of
contracts
 guaranteeing that in future insurance coverage is
provided and that at normal terms
 disregarded of individual development of
insurability, ie without risk examination
 In case of a significant chance of a significant
impairment of insurability, that feature is
qualified as insurance contract if considered
stand-alone
 A component containing such a qualified
feature is no embedded derivative
Separation Requirements
 IAS 39.11 requires an embedded derivative to be
separated and measured at fair value if
 it is not closely related to the host contract
 Closely related means that the economic risks and
characteristics of the component, especially those qualifying as
derivative, are not the same as in the host contract
 It is not possible to style the component reasonably in a
manner that those economic risks and characteristics appear
only in the component
 and the entire contract is not already measured at fair value
with changes through P&L
 An embedded derivative only treated as such if
reflecting economic reality of the reporting entity (no
intend to make use of the derivative option)
Examples of Closely Related Risks
 Fixed interest rates in component closely related to
(assumingly) fixed interest rate inherent in insurance
pricing
 Limited prolongation, prepayment or surrender rights,
cancellable current premium payment at fixed terms are
closely related
 Unlimited prolongation rights of a deposit component
extent of insurance component at predetermined
terms not closely related
 Modification of fixed interest by market factors in a
range of 0-2*i is closely related
 Any embedded derivative not measurable separated
from the insurance contract is to be seen as closely
related
Entire Contract at Fair value
 No separation required if entire contract
already measured at fair value with changes
through P&L
 It is sufficient that the component containing the
embedded derivative, eg the deposit component,
is measured at fair value and contained with that
value in the insurance liability
 Typical example unit-linked contracts, where
assets and liabilities are reported consistently at
fair value
Fair Value of the Embedded Derivative
 Fair value measurement required in
accordance to guidance by IAS 39
 Major difficulties can be expected in case of
embedded derivatives in insurance contracts,
especially for non-specific non-financial
variables
 Measurement approaches will require an
extended degree of assumptions mainly
based on judgment rather than on
observable data
Measurement of the Host Contract
 Application of existing accounting policy to
the host contract may cause significant
difficulties
 Assuming that initial recognition of the host
contract reflects fair value, initial
measurement equals amount of existing
accounting policy for entire contract minus
fair value of embedded derivative
 Subsequent measurement should be the
measurement of existing accounting policy
for the entire contract minus subsequent
measurement of embedded derivative
according existing accounting policy