1. Participating Contracts
Insurance IFRS Seminar
December 2, 2016
Eric Lu
Session 27

2. Overview

3. Product Classification
Insurance contracts, investment contracts with DPF and reinsurance contracts held
Contracts with asset-dependent cash flows
Direct participating contracts
Indirect participating contracts
Other
Non-participating contracts

4. Contract with Asset Dependency
Asset dependency is acknowledged in IFRS 17 as the situation when the amount, timing or uncertainty of the cash flows that arise from an insurance contract depends wholly or partly on the returns on underlying items.
The difference from those contracts that do not have this dependency is based on a number of key requirements:
Discount rates – must take into account the dependency with the underlying items; and
Future cash flows – must include all payments arising from existing contracts that provide policyholders with a share in the returns on underlying items, regardless of whether those payments are made to current or future policyholders.
Generally speaking the asset-dependent contracts depend on assets. But these contracts should expand the participation to other types of underlying items (e.g. entity’s profit). For simplicity, we will still refer the contracts as asset-dependent contracts.

5. Contract with Asset Dependency
Products with asset-dependent cash flows = insurance products providing payments to policyholders that vary with the returns on underlying items.
Underlying items (held directly by the entity or used as a reference assets), refers to:
Specified assets of investments
Groups of assets or liabilities or the profits of an entity
Combinations of mortality experience, expenses and investment returns
Examples of products with asset-dependent cash flows:
Unit Linked products
Universal Life products

6. Measurement Model BBA approach – modified to account for discretion
VFA approach
The Variable Fee Approach (“VFA”) is applicable to Insurance Contracts with Direct Participating Features (DPF, or direct par) where:
The contractual terms specify, or there is a constructive obligation that the policyholder participates in share of a clearly identified pool of underlying items;
The entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items; and
A substantial proportion of the cash flows that the entity expects to pay to the policyholder should be expected to vary with the cash flows from the underlying items.
BBA approach – modified to account for discretion
For asset-dependent contracts NOT eligible for VFA (Indirect Par), the Building Block Approach (BBA) will be applied. Per the “May 2015 IASB Staff Paper 2D”, such contracts:
Have cash flows that vary with the returns on assets, but the contract does not create an obligation to pay to the policyholder an amount equal to underlying items less a variable fee for service.
Direct participation contracts expand the participation to other types of items (including underlying items, entity’s profit, etc.)
For all insurance contracts with participating features, an entity should recognise the CSM in P&L on the basis of the passage of time.

7. Indirect Participating Contracts

8. The Effect of Discretion
Background
The effect of discretion applies to participating contracts which do not meet the definition of direct participating contracts. (to which the variable fee approach should be applied)
A change in discretionary cash flows is regarded as relating to future service, and accordingly adjusts the CSM.

9. Discretionary Cash Flows Specification
To determine how to identify discretionary cash flows, an entity shall specify at the inception of the contract:
What basis it regards as its commitment under the contract for the payments that it expects to continue with regardless of changes in assumptions that give rise to financial risk and
What it regards as discretionary
Use the definition above to determine if changes in assumptions give rise to financial risk, (do not adjust CSM), or discretionary changes (adjust CSM)
If the entity cannot specify the above, it shall regard its commitment to be the return implicit in the estimate of the fulfilment cash flows at the inception of the contract, updated to reflect current assumptions that give rise to financial risk

10. Interpretation
For indirect participating contracts the IASB decision is more closely aligned to the variable fee approach, because the changes related to discretion (indirect profit sharing) are adjusted through CSM.
The discretion is effectively the basis the entities will use to set the asset dependant cash flows. For example, an insurer may give 95% of an investment to its policyholders as a target return. Another example could be the insurer targeting a spread on the return from assets.
The presence of guaranteed returns complicates the definition of discretion. However, Deloitte believes that setting a guaranteed return is not part of discretion. Changes in the BEL related to cash flows for such guarantees are considered as “changes related to market variables”.

11. Market Variables vs. Discretion
The approach for indirect participating contracts will provide further information due to the required split between market variables and discretion.
Given that the effect of market variables on discretion will flow to P&L, the accounting volatility between the assets and the indirect insurance contracts will be reduced.
For example, consider a universal life contract with a minimum guaranteed rate of return:
Changes on the expected levels of discretionary bonuses will adjust the CSM while all other changes caused by market variables will be accounted for in P&L or OCI in line with the presentation of the effects of the discount rate.
If the investment returns drop below the minimum guaranteed rate of return, the CSM is reduced to zero; and discretion is no longer applicable for the insurer.

12. Expected Future Cash Flows
Indirect Par - BBA
At initial recognition, Indirect Par adopts the Building Block Approach, which is same as Non-Par except for the compliance with the guidance on discount rates for contracts with asset-dependent cash flows:
BEL:
Current, unbiased estimate of the cash flows expected to fulfil the insurance contract
Includes all the cash inflows and outflows that relate directly to the fulfilment of the insurance contract
Discount Rate:
Estimates of discount rates shall be consistent with other estimates used to measure the insurance contract to avoid double counting or omissions
The discount rates are consistent with observable current market prices for financial instruments with cash flow whose characteristics are consistent with those of the insurance contract
Accordingly for participating products, Cash flows that depend on the returns on any underlying items shall be discounted using rates that reflect the extent of that dependence.
RA:
Reflects all non-financial risks associated with the insurance contract
CSM:
An amount that is equal and opposite to the sum of BEL and RA. Discretion is specified at inception.
Expected Future Cash Flows
Risk Adjustment
CSM
Time Value of Money
Source: May D Para ED Para. 26

13. Subsequent Measurement
The CSM is adjusted as follows:
Favourable and unfavourable differences between current and previous estimates of the fulfilment cash flows that relate to future coverage and changes in discretion (determined using the locked-in rate) are absorbed in the CSM, subject to the CSM not being negative.
An allocation of the CSM is recognised in P&L as the entity provides service under the insurance contract. The IASB has concluded that the service in a contract without participation features is the provision of insurance coverage, which is provided on the basis of the passage of time.
Interest is accreted on the CSM, using the rate locked in at inception of the contract. The entity is required to specify its discretion under the contract and to use that specification to distinguish between the effect of changes in market variables and changes in discretion. Changes related to market variables are adjusted against the P&L/OCI. 1 3 2
Source: June A Para.6 and Deloitte interpretation of IASB January 2016 decision

14. Direct Participating Contracts
Variable Fee Approach (VFA)

15. Eligibility(1)
The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items.
Includes any contract which creates a contractual obligation linked to underlying items.
Explicit contractual terms
Includes regulatory requirements
However, measurement based on expected cash flows (not contractually-specified cash flows)
Not dependent on holding of underlying assets, e.g. could be related to an indexed fund.
Obligation need not be to current generation of policyholders
*The IASB intends to clarify this criterion and to explain that non-contractual or non-statutory terms could be sufficient to qualify a contract under such criterion if they constitute a “constructive obligation”. (Jan 2016)
Examples
Remarks
Unit Linked Products
Choices of funds are transparent and clearly identified to policyholders
Universal Life Products
No clearly identified underlying items
Singapore Participating Products
Regulatory requires a 90/10 split from policyholder fund’s surplus
Some HK Participating Products
No defined share of pool of underlying items*

16. Eligibility(2)
The entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items
Unit Linked products: 100% of fund return
Participating products: E.g. 90% policyholder fund’s surplus
A substantial proportion of the cash flows the entity expects to pay to the policyholder should be expected to vary with the cash flows from the underlying items.
Unit Linked products: Death benefit = Max(Fund Value, Sum Assured)
Participating products: Reversionary Bonus, Terminal Bonus

17. Different Underlying Business Model
In the general measurement model (BBA approach), the net gains and losses that the entity retains from invested premiums are treated as if they were a share of economic returns from the investment portfolio.
In the variable fee approach, the returns to the entity arising from participating contract is viewed as part of the compensation that the entity charges the policyholder for service provided by the insurance contract, rather than as a share of returns from a stand-alone investment.
The entity’s interest in the investment portfolio is not the equivalent of a direct holding in assets, but is equivalent to a variable fee that the entity charges the policyholder, expressed as a share of returns.
General Measurement Model
Assets
Liab
Surplus PH SH x%
100 - x%
Changes will go to P&L or OCI
Variable Fee Approach
Assets
Liab
Surplus PH
100% SH
A variable fee that entity charges policyholder
Changes will go to CSM

18. Changes in asset-dependent CF due to financial components
General Measurement model
Changes in estimate relating to future service are recognised as an adjustment to the CSM and affect P&L in the period in which the future service is provided.
Changes in estimates relating to the financial component (e.g. changes in discount rate) are recognised in P&L or OCI in the period in which the change occurs.
Similar to products with no participating features:
Source: June A
12/2015
New assump
Inceptn disc rate
CSM
New disc rate
Change in assumptions
Changes in discount rate
Expect PV of Future Cash Flows
Expect PV of Future Cash Flows (new asset return)
Lower CSM means less Profit from CSM release in the future
Expect PV of Future Cash Flows
Old assump
Change in FCF due to change in underlying items
(new asset return)
CSM is not changed for change in FCF due to underlying items
CSM is not changed for change in discount rate

19. Changes in asset-dependent CF due to financial components
Variable fee model
Changes in estimate of the obligation to pay to the policyholder an amount equal to the fair value of the underlying items would be recognised in P&L or OCI, in the same way as changes in the fair value of the underlying items.
Changes in estimate of the variable fee for future services would be accounted for in a way consistent with the changes in estimate relating to future service. Such change would be adjusted in CSM.
Similar to products with no participating features:
Source: June B
12/2015
New assump
Inceptn disc rate
CSM
New disc rate
Change in assumptions
Changes in discount rate
Expect PV of Future Cash Flows
Expect PV of Future Cash Flows (new asset return)
Lower CSM means less Profit from CSM release in the future
Old assump
Change in FCF due to change in underlying items
CSM is changed for change in FCF due to underlying items
CSM is changed for change in discount rate

20. Discount rates used to determine CSM adjustments
After initial recognition, the CSM is adjusted for changes in estimates in relation to non- financial assumptions (e.g. mortality)
General measurement model:
The discount rates used in the BEL and RA calculations to determine CSM adjustments are locked in at inception of the contract.
Variable fee approach
The discount rates used in the BEL and RA calculations to determine CSM adjustments are implicitly the current interest rate.

21. Discount rates used to determine CSM adjustments
At inception, the CSM is determined as a discounted amount. Over time, the effect of that discounting should be reversed. The unwinding of the discounting recognised at inception is referred to as accretion.
General measurement model:
The interest is accreted using the rate locked in at inception of the contract.
Variable fee approach
Although the CSM is not a cash flow in itself, and the IASB has concluded that it cannot be remeasured, the interest is implicitly accreted in the change of the variable fee thus using the current interest rate.

22. Risk Mitigation
An entity is permitted to recognize in P&L changes in value of guarantee (i.e. as in the general model) if:
Entity holds derivative instruments
Derivatives are held in line with the entity’s risk management strategy;
Economic offset exists between guarantee and derivative, and
Credit risk does not dominate the economic offset
The entity is required to:
Document its risk management objective and strategy
Discontinue prospectively when economic offset ceases
Disclose the effect of changes in the value of the guarantee in the profit or loss for the period

23. Thank You