1. Application of IAS/IFRS to Life Insurance – Some practical issues
Jan Kamieniecki
Lisbon, 7 July 2004

2. Agenda Background to IAS Implementation Topics for discussion:
Some current implementation issues
Managing a life business in an IAS world

3. State of Play of Insurance Project
EU committed to implement IAS from 2005 for quoted companies in consolidated accounts
Subsidiarity for non-consolidated accounts and for unquoted companies
Requires an opening balance sheet as at 1/1/2004
And reconciliation to local GAAP
Insurance standard is just one of many
IAS have taken pragmatic 2-phase approach to insurance
Implies a transitional period
More difficult to pilot result without certainty as to endgame
Need to make a strategic choice

4. Many other IASs Driving Insurance Accounting include
IFRS 1 – First Time Adoption of IFRS
IAS 8 – Accounting Policies
IAS 18 – Revenue
IAS 19 – Pensions
IAS 32 – Financial Instruments: Disclosure & Presentation
IAS 37 – Provisions, Contingent Liabilities and Assets
IAS 39 – Financial Instruments: Recognition and Measurement
IAS – Real Estate
Many subtle issues arise that are non-specific to insurance

5. IFRS 4: Insurance Contracts (Phase I)
Pragmatic approach to meeting the 2005 EU deadline
Provides specific and uniform definition of insurance
=> Classification of products as “insurance” or “financial”
This IFRS allows insurers to use of local GAAP for:
“insurance” contracts
savings contracts with discretionary profit sharing (WP)
Liability Adequacy Test is required
Equalisation and catastrophe reserves are not permitted
Unallocated surplus not allowed; either equity or liability
Some guidance on implementing IAS 32 and 39 for products classified as financial instruments
Presentation and disclosure requirements
No details on assets given in the presentation
Can use local GAAP or different accounting, as long as “more relevant and reliable”
All with profit dispensed from FV until Phase II

6. Phase II of the Insurance Project
Exposure Draft expected in 2005
Comprehensive standard on recognition and measurement for “insurance contracts”
Based on fair values
Replaces temporary dispensations and interim standards from Phase I
Implement final standard by 2007???

7. Definition of “insurance contract”
As per Appendix A of IFRS 4:
“A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder.”
Test is to be done contract by contract, splitting maybe by:
Contract type
SAR
Technical rate
Duration
Age

8. Definition of “significant insurance risk”
As per Appendix B of IFRS 4:
“If and only if, an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance.”
“This condition is met even if the insured event is extremely unlikely.”
rule of thumb for risk contracts – does the DB exceed surrender or maturity value just after the initial premium is paid?
It may be reasonable to say:
Risk is significant if sum at risk >= x% of reserves
Similar rules for survivorship contracts

9. Insurance versus Financial Risk
“Financial risk” is defined:
“Risk of a possible future change in one or more of a specified interest rate, security price, commodity price, exchange rate, index or similar variable”
A contract classified as financial, can become insurance (e.g. deferred annuity)
“Insurance risk” is defined:
“Risk other than financial risk”
A contract classified as insurance at inception remains insurance throughout
“A contract that exposes the issuer to financial risk without significant insurance risk is not an insurance contract”
As per Appendix B

10. Examples of Classification
insurance contracts:
Term Assurance
Life contingent annuities and pensions
Deferred annuity with rate guaranteed at issue
Disability and medical cover
Waiver of premium rider
Pure endowments
financial instruments:
Savings contract with no profit sharing
Accumulation phase of non-guaranteed deferred annuity
Simple unit linked products
Financial guarantees where holder not exposed to loss
Pure endowment is savings unless there is significant probability of death before specified date.
Also depend on DB (ROP, fund, ?)

11. Liability Adequacy Test (LAT)
Shall carry out a LAT at each reporting date if no test meeting IFRS 4 minimum requirements already in place
Uses current estimates of insurance contracts’ future cash flows
Any deficiency in liabilities to be recognised immediately in profit and loss account
LAT required for what is not accounted for at FV:
IAS 39 contracts valued at amortised cost
Insurance contracts products not at FV
Contracts with a DPF not at FV
LAT may be an issue if:
High guaranteed interest rates are not matchable by assets
Deterioration in anticipated experience from technical basis
Allowance for expenses in technical basis not adequate
Deferred acquisition costs not all recoverable
For insurers with a current requirement to test for loss recognition, then there may be no need to amend practice, provided the test is carried out using the most up to date information and is at least as prudent as the test set out in the ED.

12. Liability Adequacy Test - Methodology
Projection of all insurance cashflows on a best-estimate basis, discounting using risk-free yield curve
Result compared to liability, net of any DAC asset
Any loss is immediately recognised in revenue account
Loss to recognise =
max(0, LAT Liability – Current Liability net of DAC)
Aggregation must be at least at portfolio level or for funds managed together.
=> impact on loss recognised
Options and guarantees can be valued at intrinsic value i.e. current best estimate scenario

13. Unbundling
Some insurance contracts contain an insurance component and a deposit component
Unbundling is required if both these conditions are met:
can measure deposit component separately
current accounting policies do not require to otherwise recognise all obligations and rights arising from the deposit component
To unbundle a contract, an insurer shall:
apply IFRS 4 to the insurance component
apply IAS 39 to the deposit component
Some forms of Universal Life may be affected
Financial reinsurance may be affected

14. Embedded Derivatives Is hybrid Split & Apply IAS 39 Is the embedded
If the derivative is not insurance itself apply decision tree in deciding whether to split:
Is hybrid
marked to fair
value through
earnings?
Is the embedded
a stand-alone
derivative?
Is it
closely related? No
Yes No
Split & Apply IAS 39
Yes No
Yes
Do Not Split Embedded

15. Embedded Derivatives
Embedded Derivatives:
Exception to IAS 39:
An insurer need not separate a policyholder’s option to surrender an insurance contract for a fixed amount (or for an amount based on a fixed amount and an interest rate) even if the exercise price differs from the carrying amount of the host Insurance Liability
However, an insurer shall separate a put option or cash surrender option embedded in an insurance contract if the surrender value varies based on the change in an equity or commodity price or index
“a derivative is a financial instrument with all three of the following characteristics:
Its value changes in response to the change in a specified interest rate, index,…
It requires little initial net investment … and
It is settled at a future date.”

16. Fair Value FV is defined in IAS 39 as Hierarchy of valuation:
‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument: [IAS 39 Appendix A, paragraphs AG69-82]’
Hierarchy of valuation:
Published prices in an active market
Recent transactions where no active market
Other valuation techniques where neither available

17. Fair Value Liability Best estimate assumptions for projection
Pre-tax risk free rates for discounting
Market consistent calculations:
Independent of asset performance
No investment returns included in cash flows
If policyholders’ benefits dependent on management decision and/or investment returns
=> stochastic approach required

18. Fair Value Calculations for IAS 39
FV(t) = max(PVrfr(best estimate policy CFs)+ VoG(t), SV(t))
Where:
PVrfr = Present Value at the risk free rate
CFs = Cash Flows
VoG = Value of Guarantee (e.g. Return of Premium => use Black Scholes)
SV = Surrender Value
Where, for a SP Unit Linked contract:
PVrfr(Policy CFs) = Fund Value(t) + PV(expenses – charges)
– PV(surrender penalties) + PV(DB in excess of fund)…
Fair value limited to deposit floor

19. Fair Value Amendment
IASB have asked for comments on a proposed FV amendment
FV limited to contracts where one of these conditions applies:
Embedded derivative is contained
Contractually linked to performance of specified assets
Changes in FV substantially offset by changes in FV of another instrument
FV must be “verifiable”

20. Amortised Cost Method
AC(0) = initial premium received – initial external costs
AC(t) = {AC(t-1) + Premiums – Benefits paid} rolled up at EIR
Where:
EIR = Effective Interest Rate
calculated at issue and locked-in, using best estimate at inception
EIR = IRR(best estimate of future policy cash flows)
Policy cash flows are:
Those exchanged between policyholder and insurer
Include surrenders
Exclude expenses and commissions

21. What Does it Mean for Reinsurance?
No change in basis of underlying insurance and no offsetting
Unbundling separable deposit components of financial reinsurance
Future uncertain event can be quantum of loss: retrospective (re) insurance allowed.
Net accounting - if positive difference between cost and ceded liability at outset then “recognised on systematic and rational basis over the underlying period of risk exposure.”

22. Closely related and/or Insurance? Embedded option?
Is significant
Insurance Risk
transferred?
Financial Product
IAS 39 No
Yes
Insurance Product
(with or without DPF)
DPF?
Embedded option?
Unbundling required? No
Yes
AC or if possible
FV? AC
Yes No
Yes
Fair value
Closely related and/or Insurance?
Embedded option? No
Yes
Closely related and/or Insurance? No
Yes
Yes No
Separate and FV
Embedded Option.
Host uses local GAAP or better + LAT
Phase II: FV
Phase I: Current method or better + LAT
Separate and FV option. Host contract valued at AC
Entire contract Valued at AC
Financial Component (IAS39) at AC or FV

23. Disclosure Requirements
Objective is to better understand risk exposure
Describe business through management’s eyes
What is required for disclosure:
Quantitative and qualitative measures
Management, concentration and mitigation of risks
Assumptions and sensitivity analysis
Extensive claim development information
Embedded derivatives for which it is not required to measure at fair value:
Disclose information about exposures to interest rate risk or market risk
Need to explain items on BS, IS and CF stmt
Disclosure required on:
Insurance risk management policy
Sensitivity, key variables and risk concentrations
Insurance contracts with significant impact on future cash flows;
Interest risk, credit risk and market risk exposures

24. Some Current Issues Classification Choice of AC vs FV
Treatment of non-allocated surplus
Treatment of DAC
Auditability

25. Classification Generally unproblematic but:
Absence of definition of materiality
Requirement for substance over form
Note need for materiality in profit-sharing & discretion
Some contracts may be insurance for one type of policyholder, and a financial instrument for another … need to look at policyholder profile
Do clients take up switching etc options?
Does existence of any survivorship benefit make the contract insurance?

26. Choice of AC vs FV Will FV amendment apply?
What does “substantially offset” in FV amendment mean?
Generally aim is to manage balance-sheet and revenue account impact
Need to look at matching assets as well as insurance liabilities
Use of AC limits flexibility in asset management
FV may create extra volatility where there are closely related options, or matching is poor
Historic data for assumptions at time of issue for FV

27. Treatment of non-allocated surplus
Where assets are at FV this may include “unrealised” capital gains
Standards require classification of all items as equity or liability
This may require an explicit formulation of future bonus policy, and consequently an appropriate allocation of items into each category
Future changes in bonus policy may have a (geared ?) impact on the bottom line

28. Treatment of DAC DAC not consistent with a FV approach
Possible approach to unbundle administration component of contract and to value under IAS 18.
Split into acquisition and maintenance expenses a significant factor
Amortisation based in proportion to run-off of expense margins
Only relevant if surrender penalties exist

29. Auditability
FV, LAT require best estimate projections, not dissimilar to existing Embedded Value Approach
Embedded Values have often been documented to a lower standard than audit information
Experience analyses
Documented choice of assumptions
Systems for fair values
Auditing stochastic valuations introduces new complications
This may require a significant investment in new processes and systems

30. Some other implementation issues
1st time application
Restatements and/or comparatives
FX implications
System limitations
Forecast / planning implications
Ability to provide data for disclosure information
Extent of disclosure – competitive information considerations

31. Managing a life business in an IAS world
Key performance indicators
Investment Strategy
Profit-sharing strategy
All this may lead to changes in contract design

32. Key Performance Indicators
Premium income and reserves superseded
Provide comparatives
League tables may change
Need to restate corporate targets/ review strategy
Potential need to review incentive plans

33. Investment Strategy IAS may highlight a mis-match
Or may introduce greater volatility
Possible solutions include
Strategic asset re-allocation
Tactical hedging
Strategic framework may need to be disclosed
Will this create a competitive disadvantage?

34. Profit-sharing strategy
Will need to be formulated more explicitly
For FV calculations
For attribution of un-allocated surplus
Likely to need to be disclosed
Will this create competitive issues?
Will disclosure affect strategy?

35. A member firm of
Deloitte Touche Tohmatsu
Deloitte & Touche LLP is authorised and regulated by the Financial Services Authority.