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

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

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

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 40 – Real Estate Many subtle issues arise that are non-specific to insurance

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

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???

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

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

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

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, ?)

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.

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

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

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

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.”

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

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

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

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”

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

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.”

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

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

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

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?

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

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

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

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

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

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

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

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?

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?

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