IFRS Insurance Reporting - Beyond Transition E Q. Suggestions for improvements to industry presentation and disclosures

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1 Assurance and Advisory Business Services International Financial Reporting Standards E Q IFRS Insurance Reporting - Beyond Transition Suggestions for improvements to industry presentation and disclosures

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3 c o n t e n t s Contents Section Topic Page Introduction and summary 2 The impact of IFRS on insurance accounting 3 Financial statement presentation 0 Enhancing disclosures Closing observations 33 Appendices A Some accounting features specific to the insurance industry 35 B Sensitivity disclosures 3 C Companies included in the analysis 3 D Glossary of terms 0 E Ernst & Young insurance contacts 2 Ernst & Young believes the insurance industry should be signalling to standard setters the presentation and disclosures it believes would improve users understanding of insurance activities

4 I n t r o d u c t i o n and summary 1 Introduction and summary Investors, shareholders and other users of insurers financial statements need more understandable, comparable and relevant information. Dr Helmut Perlet, Chief Financial Officer of Allianz Group, June 2006 Source: CFO Forum This publication presents the results of an analysis of the 2005 financial statements of 18 insurance companies reporting under International Financial Reporting Standards (IFRS). It makes some presentation and disclosure recommendations that we believe will improve the overall comparability and decision-usefulness of insurers financial reporting. For many insurers, 2005 was the first year of reporting under IFRS. It was clear from our analysis that a large amount of time and effort went into the preparation of these financial statements. Complying with all the new requirements in time to meet reporting deadlines was, in our view, an outstanding achievement. However, all this effort resulted in documents which, by their size and complexity, are difficult to understand. Moving forward, we expect insurance companies to focus their attention on providing information that will enable readers to compare insurance companies more effectively. Unfortunately the introduction of IFRS has not reduced the complexity inherent in insurance accounting. Acknowledging that the development and adoption of a comprehensive financial reporting standard for insurance contracts is a long way off, we believe that insurers who will be reporting under IFRS in the next couple of years could make some relatively straightforward changes to their presentation and disclosures that, in our view, would go some way to reducing the divergence in current reporting practice. Insurance accounting is not well understood, even by many professional analysts. The insurance accounting process is regarded by many as a black box because financial statements have generally not provided information of an appropriate nature, or in an appropriate form, to enable users of financial statements to readily identify the drivers of value in the business. In addition to the inherent complexity of the products underlying the insurance operations that are reflected in financial statements, difficulties in extracting decision-useful information from the financial statements of international insurance groups have historically been compounded by the industry practice of aggregating insurance liabilities measured according to different local regulatory requirements and/or local practices. This has not changed with the introduction of IFRS 4 Insurance Contracts since insurers are permitted to continue previous accounting policies for insurance liabilities. Indeed, as we discuss in this publication, the use of certain accounting options introduced by IFRS 4 has made insurance contract accounting even more complicated. In a complex accounting environment, where there is little consistency in recognition and measurement practices, we believe comprehensive and consistent presentation and disclosure becomes particularly important. The International Accounting Standards Board (IASB) effectively recognised this when they developed the extensive implementation guidance to IFRS 4 which contains many disclosure suggestions to support the guidance in IAS 1 Presentation of Financial Statements. Since the IASB in Phase II does not intend to address presentation and disclosure requirements until important decisions on recognition and measurement have been made, users of financial statements will not be well served for some time to come. We do not believe it makes sense to wait this long to achieve improved presentation and disclosure so that investors can better understand the nature of the risks

5 I n t r o d u c t i o n and summary and opportunities faced by insurance companies and are better able to evaluate their relative performance and financial positions. Anecdotal evidence indicates that non-gaap sources of information, such as embedded value (EV) reports, are viewed by many readers as more informative than the IFRS-based financial statements themselves. This is a sad indictment of the decision-usefulness of the financial statements currently being issued. We believe that some features of these EV reports hold the key to improving users understanding of what is happening within an insurance company. This publication makes some recommendations along these lines. We believe there is considerable scope for standardising the presentation of various components of insurance company balance sheets and income statements. We also believe the insurance industry should explain to the IASB why certain presentation formats are more useful than others, and demonstrate their support for greater consistency and comparability by reflecting them in the IFRS financial statements they prepare. Our suggestions for improved disclosures stem from a similar thought process. We see three areas where straightforward, but significant enhancements can be made. All of them are based on realigning information and formats found in the 2005 IFRS-based financial statements we reviewed, and when appropriate, linking them with other information that is often published by insurance companies, such as EV reports. The three areas of disclosure on which we would like to see the industry build consensus are: Insurance risk disclosures. These disclosures are vitally important because they provide information to users about the business of an insurer, and how well it manages the risks that it assumes. The main disclosures in this area are insurance sensitivities and the maturities of assets and liabilities. An analysis of the maturity dates of financial assets and liabilities helps users to understand the risks associated with asset and liability settlement and therefore the uncertainties surrounding the amount and timing of the insurers future cash flows. Our analysis indicated that sensitivity disclosures vital to insurance are found in different places throughout financial statements, as well as in the management discussion of results for the year and in EV reports. We believe it would be helpful if sensitivity disclosures vital to insurance were to be combined and presented together so that the effects of changes in assumptions on liabilities, equity and income can more easily be seen. We also recommend that insurers should provide consistent analyses of both asset and liability maturities. Liability roll-forward schedules. Roll-forward schedules are a key source of information about the factors influencing the measurement of an insurer s obligations to policyholders. Insurance liabilities are among the most material items on insurance company balance sheets and thus information about the development of insurance liabilities is important in evaluating the amounts, timing and uncertainty of future cash flows. Since the measurement of these liabilities involves significant estimation and uncertainty as well as a variety of different measurement bases, we believe that users should be given more information about the sources of change during the period. We recommend that insurers take a more structured approach to the presentation of their liability roll-forward schedules, explaining the elements of movements in liabilities due to cash flows, experience adjustments and changes in assumptions. Claims development tables. These tables provide information about variances between management s previous estimates and the final cost of settling the claims. As such, they provide an indication of the reliability of these (often highly complex) estimates. Claims development tables convey valuable information about how accurate management s prior estimates were, and the extent to which insurance contract liabilities are subject to variation.

6 I n t r o d u c t i o n and summary Our recommendation is that insurance companies should provide more narrative discussion to explain the amounts presented in their claims development tables, especially in cases where the tables show large differences between estimates made and the ultimate cost of settling claims. We also recommend that insurers consider presenting separate tables for their long- and short-tail businesses. Improving financial reporting in the insurance industry is challenging because a transparent picture for the user must be built while the requirements of IFRS and regulators are taken into account. For example, if risk-based disclosures are based on EV rather than IFRS information it is necessary to consider how best to present the information. It is also important to ensure that the improvements made align with other significant reporting developments. There are currently three important dimensions to consider: the adoption of IFRS 7 Financial Instruments: Disclosures (effective for years beginning 1 January 2007); regulatory developments (especially Solvency II public disclosure requirements in Europe); and the development of a new international insurance standard to replace IFRS 4 under Phase II of the IASB s insurance accounting project. In conclusion, we observe that more disclosure on its own does not necessarily result in the provision of better information that is useful in making economic decisions. Based on what we have seen in 2005 financial statements, if insurance companies were to place more emphasis on identifying the areas which are subject to assumptions and significant management judgement, explaining the basis for these assumptions, and discussing how actual performance has deviated from expectations, we believe there would be a significant improvement in the decision-usefulness of the financial statements produced by the industry.

7 T h e impa c t of IFRS on insurance a c c o u n t i n g 2 The impact of IFRS on insurance accounting 2.1 Background IFRS 4 was one of the last standards to be issued by the IASB in creating its so-called stable platform of standards for Recognising the difficulty inherent in formulating a high quality global standard for insurance contracts, the IASB split the insurance accounting project in two phases. Phase I made limited improvements to current accounting and resulted in an interim standard. A Discussion Paper containing the current views of the IASB regarding Phase II, and items open to discussion, is due to be published in the first quarter of The IASB s intention is that the Discussion Paper will lead to an Exposure Draft in 2008 and, eventually, to a new insurance accounting standard that is expected to be effective from about One of the most persuasive arguments for the adoption of IFRS throughout the world was that it would improve comparability between different reporting entities. To date this has not been the case for insurance companies. Indeed, the adoption of IFRS has heightened awareness of the lack of comparability and consistency of financial statements within the industry. This is largely because IFRS 4 still allows companies to continue to apply their previous GAAP accounting policies for the recognition and measurement of insurance contract assets and liabilities. This means that the accounting policies used by an insurance company under IFRS are influenced heavily by the requirements of its previous GAAP. In addition, when an international insurance group reports a particular insurance contract line item (eg deferred acquisition costs) in its balance sheet, different recognition and measurement bases may have been used to determine the amount reported because IFRS 4 permits the consolidation of amounts determined under different previous GAAPs. 2.2 Insurance accounting today Insurance accounting is complex. Indeed the complexity that surrounds the compilation of financial statements of insurers has resulted in the industry s accounting practices being regarded as a black box to be worked around rather than worked with. This perception has forced investors and analysts to look for other sources of information to understand the financial performance and position of insurers. This point is well illustrated by the following recent comment reported in the British press. On the 24th of July 2006, the Financial Times (FT) reported an interesting exchange at the 2006 Prudential annual general meeting. A shareholder asked Chairman Sir David Clementi if there was any difference between the hypothetical future accounting employed by Enron and accounting for insurance contracts. The FT quotes Sir David s response as I have to say I very much regret your reference in the context of the Prudential AGM, however he acknowledged that there was a serious question about the accounting system we use. Source: Financial Times, 24 July 2006 While the implication in the shareholder s question was unfair to Prudential, it does highlight the fact that insurance accounting is extremely complex and very often not understood. This complexity and lack of understanding comes at a price, with industry executives believing that investors and analysts apply an accounting discount to the

8 t h e impa c t of ifrs on insurance A c c o u n t i n g insurance industry which increases its cost of capital. the insurance industry is one of the few industries still applying a patchwork of different and unsatisfactory accounting principles. These result in financial statements that are a hindrance rather than a help to comparing financial positions with companies in other sectors and even between two insurers. This ultimately penalises consumers by limiting insurers ability to compete and requiring them to pay a higher price for capital than would be the case with better financial reporting. Press release from the CFO Forum 1 22 June 2006 on the cost of capital disadvantages facing insurers The insurance industry focuses on managing assets and liabilities on an economic basis, something which its accounting practices often do not reflect. The application of IFRS can result in a significant accounting mismatch between assets and liabilities when there is little or no economic mismatch (see Section 4.2.4). Conversely, a significant economic mismatch, for example between the duration of assets and liabilities, might exist that is not apparent from the financial statements due to the accounting policies selected by an insurance company. The accounting mismatch mentioned above arises when, partly for regulatory reasons, large insurance liabilities are measured at cost, while the related investments are measured at fair value. The IASB provided in IFRS 4 a number of ways for insurers to mitigate the effects of this mismatch. Two of these concessions are the ability to re-measure some designated insurance contracts at current interest rates and the ability to use shadow accounting 2. In 2005 insurers made only limited use of the first option. Only three companies in our sample disclosed they had changed their accounting policies to remeasure certain liabilities at current rates. However, most companies in our sample group did apply shadow accounting. 2.3 Some options for the future Unfortunately, until Phase II is completed, little can be done to improve consistency in recognition and measurement within the industry. In our view, the only way forward in the foreseeable future is to improve disclosures in the financial statements. This was noted by the Geneva Association: ii. The way forward [... ] flexibility in reporting would not undermine the ability of the main users of financial statements to make consistent comparisons between insurance companies, providing there is adequate disclosure of relevant information in the notes to the accounts or in supplementary financial statements. The search for an international accounting standard for insurance - The Geneva Association 3 February 2003, page 13 The IASB s Guidance on implementing IFRS 4 has helped to promote greater consistency in financial statement presentation and disclosure within the insurance industry. It contains 1 The CFO Forum was formed in 2002 as a high level discussion group made up of the Chief Financial Officers of 20 major European insurers. Members of the CFO Forum are: AEGON, Allianz, Generali, AA, Aviva, CHP, Fortis, Skandia, Hannover Re, ING, Legal & General, Munich Re, Old Mutual, Prudential, Scottish Widows, Standard Life, Swiss Re, Winterthur and Zurich. See their website: 2 Both are explained in more detail in Appendix A Some accounting features specific to the insurance industry. 3 The Geneva Association researches the economic importance of insurance activities in major sectors of the global economy. Membership includes some 80 Chief Executive Officers of the major insurance companies around the world. 8

9 T h e impa c t of IFRS on insurance a c c o u n t i n g sections on the explanation of accounting policies, (changes in) recognised amounts, (changes in) assumptions and estimation uncertainty, as well as suggestions for disclosures on the nature and extent of risks arising from insurance contracts. In the following sections we comment briefly on the approaches to presentation and disclosure applied by our sample of companies in their 2005 financial statements. Based on these observations, we offer some suggestions to improve the decision-usefulness of the information that might be presented and disclosed in future financial statements. Financial reporting involves a trade-off between the level of detail and amount of information provided on the one hand, and clarity of communication on the other. Clear and concise reports do not necessarily score highly on technical detail and discussion and this was borne out in our analysis results. However, the approaches used by some of the companies in our sample were particularly informative and, in our view, should be more widely applied. Some of them are reproduced below as illustrations of good practice, while others are reflected in the presentation and disclosure recommendations we have developed. Our view is that because there is such inconsistency in recognition and measurement among companies, insurers need to provide more information on the following three elements: the assumptions used to generate the amounts presented; the sensitivity of reported amounts to changes in those assumptions; the extent to which actual experience differs from expectations, and why.

10 SF ei nc at ni oc n i aor l stat Chapter e m e n t Tpresentat i t l e i o n 3 Financial Heading statement Ut wisi ad minim veniam, quis nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip ex ea commodo consequat. Duis autem vel eum iriure dolor in hendrerit in vulputate velit esse molestie consequat, vel illum dolore eu feugiat nulla facilisis at vero eros et accumsan et iusto odio dignissim qui blandit praesent luptatum zzril Source presentation Sub Heading Lorem ipsum dolor sit amet, consectetuer adipiscing elit, sed diam nonummy nibh euismod tincidunt ut laoreet dolore magna aliquam erat volutpat. Ut wisi enim ad minim veniam, quis nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip ex ea consequat. Lorem The observations ipsum dolor and sit suggestions amet, consectetuer in this publication adipisvolutpat. are based Ut wisi on enim a review ad minim of the veniam, 2005 quis annual nostrud financial exerci statements tation ullamcorper of 18 insurers suscipit reporting lobortis under nisl IFRS. ut aliquip This ex sample ea consequat. included Lorem three bancassurers, ipsvolutpat. Ut two wisi reinsurance enim ad minim entities veniam, and thirteen quis nostrud life and exerci non-life tation insurers. ullamcorper Of the suscipit entities lobortis included, nisl five ut were aliquip based ex ea in consequat. the UK, eleven Lorem in ipsvolutpat. Continental Ut Europe, wisi enim one in ad South minim veniam, Africa 4 quis and one ud exerci in Australia. tation ullamcorper Only publicly suscipit available lobortis information nisl ut aliquip was used ex ea in consequat. the survey. Lorem A list of ipsum the 18 dolor companies sit amet, making consectetuer up our adipisvolutpat. sample can be Ut found wisi in enim Appendix ad minim C. veniam, quis nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip ex ea consequat. Lorem ipsvolutpat. Ut wisi enim ad minim veniam, quis nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip ex ea consequat. Lorem ipsvolutpat. Ut wisi enim ad minim 3.1 The bigger picture veniam, quis nostrud exerci A significant observation from our analysis of 2005 financial statements is that very Lorem few insurance ipsum dolor groups sit fundamentally amet, consectetuer re-engineered adipiscing their elit, financial sed diam statements nonummy when nibh euismod they tincidunt transitioned ut laoreet to IFRS. dolore Consistent magna with aliquam other erat industries, volutpat. a strong Ut wisi national enim ad GAAP minim heritage veniam, quis remains nostrud in the presentation of their primary financial statements (ie formats of balance sheets and income statements) and in the order that their note disclosures were made. There was a notable increase in the extent of narrative disclosures and, as predicted, a number of new disclosures were made in compliance with IFRS requirements. However, some of them appear to have been drafted simply with a view to meeting the minimum Sub disclosure Heading requirements under IFRS, rather than providing useful insight as to where value in their insurance business was being created and how the risks were being managed. Lorem ipsum dolor sit amet, consectetuer adipiscing elit, sed diam nonummy nibh euismod tincidunt A number ut of laoreet insurers dolore also provided magna aliquam disclosures erat that volutpat. were not Ut wisi based enim on IFRS ad minim measures veniam, but on quis other nostrud measurement exerci bases tation such ullamcorper as embedded suscipit value lobortis (EV). nisl However, ut aliquip there ex was ea consequat. little consistency Lorem between ipsum the different dolor sit sets amet, of EV consectetuer information adipisvolutpat. that were provided Ut wisi in the enim annual ad minim reports. veniam, quis nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip ex ea consequat. Lorem The manner ipsvolutpat. in which Ut the wisi balance enim ad sheet minim and veniam, income statement quis nostrud were exerci presented, tation ullamcorper and also the suscipit measurement lobortis bases nisl applied, ut aliquip tended ex ea to consequat. vary depending Lorem on ipsvolutpat. the country Ut in wisi which enim the ad insurer minim veniam, is headquartered. quis ud exerci We noted tation a distinct ullamcorper split suscipit in our sample lobortis between nisl ut UK, aliquip Australian ex ea consequat. and Lorem South African ipsum dolor insurers sit amet, on the consectetuer one hand, and adipisvolutpat. those from Continental Ut wisi enim Europe ad minim on the veniam, other. quis There nostrud were marked exerci tation differences ullamcorper between suscipit the two lobortis groups. nisl This ut meant aliquip that ex ea someone consequat. from a Lorem Continental ipsvolutpat. European Ut country wisi enim would ad minim potentially veniam, be able quis to nostrud interpret exerci the tation financial ullamcorper statements suscipit of an insurer lobortis from nisl another ut aliquip Continental ex ea consequat. European Lorem country ipsvolutpat. far more easily Ut wisi than enim someone ad minim veniam, from the quis UK, nostrud Australia exerci or South Africa. The differences we observed extended not only to disclosure and presentation, but also to the historical measurement bases which IFRS 4 Lorem allows companies ipsum dolor to sit carry amet, over consectetuer into their IFRS adipiscing financial elit, statements. sed diam nonummy nibh euismod tincidunt ut laoreet dolore magna aliquam erat volutpat. Ut wisi enim ad minim veniam, quis nostrud 4 Old Mutual has, for the purpose of this analysis, been classified as an insurer based in the United Kingdom. 10

11 F i n a n c i a l stat e m e n t presentat i o n 3.2 Presentation in the balance sheet and income statement Insurers in Europe were generally required under their previous GAAP reporting regimes to prepare their financial statements, and in particular their balance sheets and income statements, in accordance with prescribed formats. These formats are generally no longer used for IFRS reporting (except in France and Italy where regulatory presentational requirements do currently extend to the financial statements). This meant that companies were more or less free to create their own formats for reporting within the guidelines of IFRS. Many insurers retained previous formats as far as possible with adjustments only being made to comply with specific IFRS reporting requirements. The general freedom provided by IFRS resulted in significant variations in the appearance of IFRS balance sheets and income statements. The tables that follow show different descriptions adopted for financial assets, and insurance and investment liabilities on the face of the balance sheet. Table 1 shows the variety of approaches adopted to the presentation of financial assets on the face of the balance sheets of the sample group. Insurers may choose between presenting their investments based on the measurement categories of IAS 39 Financial Instruments: Recognition and Measurement, according to the type of investment, or in one single line. There were also variations within each of these options. FINANCIAL ASSETS PRESENTATION Allianz ING Fortis AA Swiss Life L&G Old Mutual Generali Zurich SCOR AEGON RSA Aviva AMP Prudential KBC MUNICH RE SANLAM IAS 39 CATEGORIES Financial assets at fair value through P&L Trading assets Financial assets held to maturity Financial assets available for sale Loans and receivables TYPE OF FINANCIAL ASSET Debt securities Equity securities Property securities Deposits/ short term securities Derivatives Non-trading derivatives Financial assets pledged as collateral Other investments/ financial assets UNIT-LINKED Investments for account of policyholders Unit-linked investments Assets backing contracts where financial risk is borne by policyholders PRESENTED AS TOTALS ON B/S Investments Financial investments/ assets Table 1 - Different captions used for presentation of financial assets In constructing Table 1 we reduced the apparent diversity somewhat by grouping items with different names together when it was clear that they were describing the same thing. This has made the differences appear less pronounced than they actually are, but it was necessary to make the table readable because there were almost as many different names for the same line item as there were companies in our sample. The order in which companies are listed in the table was adopted in an attempt to group similar presentations together to make it easier to analyse the choices made. 11

12 F i n a n c i a l stat e m e n t presentat i o n Table 2 looks at the presentational choices made for investment and insurance contract liabilities on the face of the balance sheet. Again, the divergence in practice among the 18 companies is apparent. Three insurers disclosed investment and insurance liabilities in a single line on the face of the balance sheet. Others split contracts into investment and insurance liabilities and made a distinction between those with, and those without, discretionary participation features. Again, for clarity of presentation, we had to simplify the actual picture somewhat. INSURANCE AND INVESTMENT CONTRACT LIABILITIES Allianz ING Fortis AA Swiss Life L&G Old Mutual Generali Zurich SCOR AEGON RSA Aviva AMP Prudential KBC MUNICH RE SANLAM INSURANCE AND INVESTMENT LIABILITIES Outstanding claims liabilities (non-life) Life insurance contract liabilities Liability for insurance contracts Liability for investment contracts Provision for future policy benefits Liabilities fair valued through the income statement (including investment contract liabilities) DPF WITHIN INSURANCE AND INVESTMENT LIABILITIES Insurance contract liabilities with DPF Insurance contract liabilities without DPF Investment contracts with DPF Non participating investment contracts Discretionary participation feature (DPF) liabilities Unallocated surplus UNIT-LINKED LIABILITIES Liabilities arising from insurance contracts where financial risk is borne by policyholders Liabilities arising from investment contracts where financial risk is borne by policyholders External unit-holder's liabilities NO BREAKDOWN ON FACE OF B/S Liabilities arising from insurance and investment contracts Table 2 - Different captions used for presentation of insurance and investment contract liabilities There were other choices reflected in the balance sheets of the insurance companies we reviewed. Some of these are listed in Table 3. The results suggest to us that it may be possible to achieve consensus within the industry on a preferred presentation. Reporting items Presentation Percentage 5 Deferred Acquisition Costs (DAC) Investment contracts with DPF Comparatives DAC shown as part of Other Assets on face of B/S DAC shown as a separate line item on face of B/S DAC shown as part of Intangible assets on face of B/S Investment contracts with DPF shown as a liability Investment contracts with DPF shown as partly equity/partly liability Comparatives restated for IFRS 4/IAS 39 Comparatives not restated for IFRS 4/IAS 39 Table 3 Balance sheet presentation options used by companies in our sample 13% 68% 19% 82% 18% 83% 17% 5 5 Where a category was not applicable to all the 18 companies in our sample, companies to which that category did not apply were excluded in calculating the percentage presented. 12

13 F i n a n c i a l stat e m e n t presentat i o n Table 4 illustrates divergence in industry specific disclosures appearing in the income statements of insurance companies we sampled. The percentages noted provide a broad indication of the extent to which a particular presentation option was favoured by insurers, and as we noted above with the balance sheets of insurers, it seems to us that it may be possible to build some consensus within the industry as how best to choose between alternatives. Reporting items Presentation 5 Percentage Outward reinsurance Reinsurance outward shown as negative revenue 67% premiums Reinsurance outward shown as expense 33% Comparatives Comparatives restated for IFRS 4/IAS 39 Comparatives not restated for IFRS 4/IAS 39 Table 4 Income statement presentation options used by companies in our sample 3.3 Some suggestions We believe that in order to enhance the ability of users from different parts of the world to understand and compare IFRS-based financial statements, insurers should make greater use of peer group comparison, and should co-operate in efforts to reduce the divergence in presentation. This might start with key players in the industry that have adopted IFRS agreeing informally to use a common set of terms and formats in their financial statements. Outlined below are some quick win changes that we believe insurers could make, without too much time and effort, to improve the decision-usefulness of their financial statements Improve navigation We saw some helpful techniques being used by insurers to assist users in finding their way around the financial statements. Based on examples found in our analysis, we would make the following suggestions: A detailed index at the front of the annual report is helpful. The index should list every note to the financial statements together with any non-gaap sources of information referred to in the financial statements such as EV reports. Prior to the introduction of IFRS, cross-referencing from the primary financial statements was generally a straightforward matter. However, some of the notes are now so long we believe they need to be broken up into subsections, with page numbers added, to help readers find the information in a complex set of financial statements more easily Terminology and abbreviations We found that insurers frequently use different terminology in their financial statements to describe the same item. This adds unnecessary complication and sometimes causes confusion. One of the most noticeable examples is the present value of acquired insurance business profits. This item is variously described as: value of business acquired (VOBA), present value of in-force business (PVIF), acquired value of in-force business (AVIF), present value of future profits (PVFP), value of purchased business in-force (VIF), value of business in-force (VBI), present value profits (PVP), purchased interest in long term business and intangible insurance asset. Some of these terms are also used in different contexts (eg PVFP is also used to designate a component of embedded value). We believe it would help a wider group of users if consistent insurance terminology were to be used by all insurers. 83% 17% 5 Where a category was not applicable to all the 18 companies in our sample, companies to which that category did not apply were excluded in calculating the percentage presented. 13

14 F i n a n c i a l stat e m e n t presentat i o n A number of companies use the term reserve when they refer to insurance contract liabilities. The term reserve is not used in IFRS to describe liabilities and we believe it would make sense for insurers reporting under IFRS to use the term liabilities rather than reserve. Making this change would then help avoid any confusion when reference was made to movements in equity reserves. The use of abbreviations and specialised technical terms is not limited to the insurance industry. However, they are used extensively in insurance company financial statements and this does add to the confusion some users must experience. Some terms might be wellknown locally by the insurance industry, but internationally this is not necessarily the case. Companies may wish to consider setting aside the terminology they have historically used in the interest of improved understanding and comparability. The inclusion of a glossary of terms is also helpful. 3.4 Next steps European insurers are already working together on accounting issues through the CFO Forum, enabling them to engage with the IASB in a more effective way. Our suggestion is that this body now works with other international insurance organisations to help develop and promote a more consistent approach to the presentation of information in primary financial statements and to adopt, to the greatest extent possible, common terminology. We suggest that a recommended format for the balance sheet and income statement for insurers be developed through discussion at industry roundtables and the like. If a sufficient number of insurers were to reach consensus on a favoured presentation basis that is in line with the recognition and measurement principles of IFRS, this should influence the IASB s consideration of the disclosures required in Phase II. 14

15 E n h a n c i n g disclosures 4 Enhancing disclosures 4.1 Drivers of value The notes to the financial statements can play a very important role in signalling where value is created within an organisation. In the case of the insurance industry, the importance of the note disclosures is further increased by the diversity of accounting policies that are currently being applied in the industry. As mentioned in section 2, we believe that there are three key elements which assist comparison and analysis: the assumptions used to generate the numbers presented; the sensitivity of reported amounts to changes in those assumptions; the extent to which actual experience differs from expectations, and why. In this section we comment on the way insurers in our sample reported on each of these key elements and we provide some presentation and disclosure recommendations. Section 4.2 focuses on the first two elements. The third element is addressed in section 4.3 for life insurance (liability roll-forward schedules) and also in section 4.4 for non-life insurance (claims development tables). 4.2 Insurance risk disclosures The adoption of IFRS has increased the requirement for insurers to disclose risk management information not only in respect of insurance contracts, but across their entire business. The disclosure requirements in IFRS 4 regarding insurance risk are extensive, although expressed in broad terms. As a result, a wide range of information was provided in the 2005 reports we sampled, both in the management discussion section of the annual report, and in the financial statements themselves. Some insurance groups provided detailed risk information at a product level, including quantitative information, while others provided only qualitative information at a group level. With the implementation of IFRS 7 acting as a catalyst, we anticipate that risk management disclosures will evolve and converge over time. In considering how information should be disclosed to enable financial statement users to evaluate the nature and extent of risks arising from insurance contracts, we emphasise in the following sections: the importance of having some common sensitivity analysis parameters (section 4.2.1); the need to ensure that the relationship between EV and IFRS is clearly understood (section 4.2.2); the need for proper disclosure of significant potential costs relating to financial options and guarantees (section 4.2.3); and the need to highlight mismatches through appropriate asset and liability maturity schedules (section 4.2.4). 15

16 e n h A n c i n g disclosures Reporting sensitivities under IFRS IFRS 4 requires insurers to disclose the sensitivity of reported profit or loss and equity to changes in variables that have a material effect on them 6. This information can be qualitative, but should preferably also include quantitative disclosures. IFRS 7, which will come into effect for all insurers for annual periods beginning on or after 1 January 2007, will require reporting entities to disclose risk information and sensitivities to market risk as seen through the eyes of management. The amendments made to IFRS 4 as a consequence of IFRS 7 explicitly allow insurers to disclose sensitivity using EV information, if management uses that information to manage risk. For this reason we expect that more sensitivity information (currently provided in management s discussion on the operating results for the year and in EV reports) will be included in 2007 financial statements 7. We believe that the insurance industry needs to explain carefully its embedded value disclosures so that the similarities and differences of sensitivity parameters for IFRS and EV amounts can be better understood. IFRS 7 requires entities to disclose information about their exposure to risks that is based on the information provided internally to key management personnel. As a consequence of IFRS 7, IFRS 4 was amended. The main changes are: Maturity analyses for recognised insurance liabilities can be based on the estimated timing of net cash outflows (previously required a contractual timing basis) IFRS 4.39(d)(i). Sensitivity analyses, including insurance risk sensitivities, can be based on EV (or alternative methods such as economic capital), as long as the objectives, assumptions, parameters and limitations of the approach are disclosed, along with an explanation of the method used IFRS 4.39(c) and 4.39A(a). Entities have the option of presenting qualitative insurance risk sensitivity analyses rather than the quantitative analyses referred to above, provided that information is disclosed about the terms and conditions of insurance contracts that have a material effect on the amount, timing and uncertainty of future cash flows IFRS 4.39A(b). In our sample we noted that the sensitivity information presented related mostly to life insurance business. There was very little disclosure about the sensitivities relating to nonlife business. Life insurance does have a larger number of variables that impact the amount, timing and uncertainty of future cash flows. However, as the following extracts from Aviva and Legal & General show, it is also possible to present quantitative sensitivities for nonlife (or general) insurance business. 6 Paragraph 39A of IFRS 4. 7 Sensitivities are complex and presenting the outcome of a test in the form of a number does not necessarily provide optimal information. A few of the companies in our analysis stressed the limitations of sensitivity testing as part of their disclosures.

17 e n h A n c i n g disclosures The sensitivity to a 5% increase in gross loss ratios is the same both net and gross of reinsurance because this increase does not result in any material excess of loss reinsurance limits being reached. For general insurance, the impact of the expense sensitivity on profit also includes the increase in on-going administration expenses, in addition to the increase in the claims handling expense provision. Illustration of a quantitative sensitivity analysis relating to non life insurance Aviva, 2005, Note 50, page 187 Illustration of a quantitative sensitivity analysis relating to non life business Legal & General, 2005, Note 3, page 73 Sensitivity information was disclosed in many different ways in 2005 annual reports with no two companies being directly comparable in every respect. Some insurers in our sample provided EV sensitivity information in their management discussion of the activities for the year while others did so in their financial statements. When EV information was presented outside the financial statements, it was rarely audited 8. Going forward it will be interesting to see how and where EV information will be presented in financial statements, especially when IFRS 7 becomes effective. Our view is that it would be helpful if all the sensitivity information provided by an insurer were to be combined and presented together. Disclosing the information in this way would make it far easier for the reader to see the effects of changes in those factors which impact liabilities, equity and income. As part of our survey, we looked to compare the quantitative sensitivity analyses provided by seven insurers in their financial statements, management discussion or EV reports 9. From our analysis of quantitative sensitivity information we note the following: Every company made some sensitivity disclosures that were not made by any of the other companies in our sample. 8 We note however that EV information presented by UK insurers is usually published as part of the report containing the financial statements. This information is subject to audit, but a separate auditors opinion is issued on the supplementary EV information. 9 As shown in Appendix B, the companies whose Embedded Value reports we studied were AEGON, Allianz, Aviva, AA, ING, Prudential and Zurich.

18 E n h a n c i n g disclosures Some of the sensitivity descriptions appeared to be similar, but from the explanation given they could mean different things. For example, is a parallel shift in risk-free interest the same as a shift in risk-free yield curve ; or are changes in mortality and morbidity and worsening demography similar? Different sets and different levels of sensitivity are being provided by companies. Three of the seven companies we reviewed in our EV survey made some quantitative sensitivity disclosures in their financial statements that were not included in either their EV reports or management discussion. Appendix B provides a more detailed analysis of similarities and differences we found in sensitivity information reported for a number of areas specific to insurance Clearly indicating the relationship between EV and amounts reported in financial statements Embedded value is recognised as being the present value of the future cash flows, arising from existing insurance contracts, that will be distributable to shareholders. It is our impression that certain users of insurers financial information, especially financial analysts, consider EV information to be more relevant than accounting-based information. Insurance companies are responding to this by publishing separate EV reports, but also by including EV numbers in their financial statements and/or their management discussion. Detailed information about the development of EV is useful to the users of financial statements as it provides insights into the aspects of the business that affect its overall value. EV consists of various components. A typical analysis of EV would recognise the following three elements: 1. A Free Surplus 10 allocated to the Covered Business 11, together with a Required Capital 12 amount to support the Covered Business, the total of the two being referred to as the Adjusted Net Asset Value (ANAV) or a similar name The present value of future shareholder cash flows from in-force covered business. (The Value of In Force or VIF). 3. A deduction for the cost of holding Required Capital. The Value of In Force represents, in practical terms, the insurer s inventory of future profits that are embedded in the current portfolio of insurance contracts. On the other hand, Adjusted Net Asset Value (ANAV), the first element of EV mentioned above, represents profits that have already emerged. As such, ANAV is the element of EV most closely linked to IFRS equity because it relates to that part of EV that has been recognised in the financial statements. Future profits (VIF) will not have been recognised in the financial statements, unless these were paid for when acquiring a portfolio. (See the discussion of the Value Of Business Acquired (VOBA) below). Insurers regard it as appropriate to provide explanations of how the EV information aligns with IFRS information reported in the financial statements. The reconciliations are sometimes complex, but as illustrated below, we believe some insurers do this quite well. 10 Free Surplus is the amount of any capital and surplus allocated, but not required, to support the in-force business. 11 Covered Business relates to the insurer s business that is included in the embedded value estimate. In most cases, this is the life business. The European Embedded Value Principles (CFO Forum) require that covered business is clearly identified so that what is included in the EV reports and what is not, is clearly understood. 12 Required Capital is the amount of assets, over and above the value placed on liabilities in respect of covered business, whose distribution to shareholders is restricted. 13 A commonly used term is net worth. 18

19 E n h a n c i n g disclosures Differences between IFRS equity and ANAV arise from the different bases for recognition and measurement. Two frequently occurring differences between ANAV and IFRS equity are adjustments for deferred acquisition costs (DAC) and the value of business acquired (VOBA). This is because in calculating EV; DAC and VOBA are part of the second element mentioned, the present value of future cash flows. In our sample we noted differences in the way companies presented their reconciliations of EV to IFRS, as well as the IFRS balances to which the embedded values were reconciled. The extract below shows the reconciliation that was presented by Aviva. It distinguishes life business from non-life and describes the allocation of EEV to the various stakeholders in the business. Principles for a common measure of EV were published by the CFO Forum in May The common measure is referred to as European Embedded Value (EEV). This has been adopted and disclosed by many insurers. llustration of the relationship between IFRS Equity and EEV - Aviva, 2005 EEV report, page 203 (2004 amounts and note 3 on pension scheme deleted for clarity) 19

20 e n h A n c i n g disclosures The reconciliation presented by Prudential is also, in our view, helpful to readers, although the different forms of presentation used by Aviva and Prudential illustrate the diversity of disclosure practice in the industry. IFRS equity versus European embedded value (EEV) Prudential, 2005 EEV report, Note 14, page 224 The table above links Statutory IFRS basis shareholders funds to EEV-basis shareholders funds with the difference being described as Additional retained profit on an EEV basis. It also shows the split of EEV into five components with the value of inforce business of 6,751 million identified in Note 15 below being grossed up to 7,811 million so that the cost of capital ( 848 million) and cost associated with the time value of guarantees ( 212 million) can be shown separately. Prudential then provides the following analysis of the movement in the components of embedded value (ie net worth and value of in-force business): IFRS equity versus European embedded value (EEV) Prudential, 2005 EEV report, Note 15, page

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