An Insurance Contract IFRS Is Coming

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1 An Insurance Contract IFRS Is Coming Are Your Financial Models Ready? By John Nicholls and Ana Escudero Efforts to develop new international accounting standards are moving apace, as the joint IASB FASB Insurance Contracts project illustrates. Insurers should consider this IFRS work when they start financial modeling projects. The new financial reporting changes will not only impact the primary financial figures of insurers, but will also prescribe new disclosures and have a significant impact on financial models. You may be building a new Ferrari model for your insurance liabilities, or you may be driving your existing reliable family car model, but in either case you need to be watching out for future International Financial Reporting Standards (IFRS). The new financial reporting changes will not only impact the primary financial figures of insurers, but will also prescribe new disclosures and have a significant impact on financial models. We recommend keeping an eye on the rearview mirror if you don t want your models to be overtaken by the IFRS developments. Many companies are focusing on getting ready for Solvency II or other risk-based capital regulatory standards, as is the case in Mexico. A major part of this preparation is development of financial cash flow models that meet regulatory requirements. Immediately after this work, companies will need to prepare themselves for changes to the accounting requirements for insurance contracts. This article focuses on financial modeling considerations you need to watch if you want to be ready for the coming Phase II IFRS for insurance contracts. Any financial model development, whether for Solvency II, economic capital evaluation or other purposes, should facilitate implementation of the IFRS for insurance contracts. Financial modeling projects need to deliver financial models that remain sufficiently flexible to consider both IFRS developments and allow for changes in Solvency II Pillar 1 details. To survive in this evolving world, companies will need to do the following: Ensure financial cash flow models, including any stochastic models, are up to the task of producing results and aiding the preparation of reports in line with both IFRS and Solvency II requirements. IFRS compliance will require production of information to be presented on the balance sheet, in the income statement and through additional disclosures. Have processes in place to determine IFRS-required residual margins and to release the residual margins in an appropriate manner over time. Have processes in place to identify, quantify and explain differences between IFRS, Solvency II and other reported financial measures, and to explain how those measures change over time. 6 towerswatson.com

2 Measurement of an insurance contract under the proposed building-block approach The discussion in this article takes into consideration tentative decisions made by the International Accounting Standards Board (IASB) through September 2011, with a focus on the potential impact on accounting for long-term contracts. Further IASB deliberations may result in decisions that change the current picture considerably. The discussion in this article is of relevance to preparers of U.S. GAAP information for insurance contracts because the Insurance Contracts project is being undertaken jointly with the IASB and the Financial Accounting Standards Board (FASB). Many aspects of the IASB proposals may be mirrored in future U.S. GAAP requirements for insurance contracts. While this is the case, there is also a real possibility that the U.S. will retain the existing U.S. GAAP rule-based approach (subject to some modification), at least for the foreseeable future. Present value of the fulfillment cash flows Residual margin Risk adjustment Discounted future cash flows Eliminates any gain at inception (cannot be negative) Estimate of the effects of uncertainty on the amount and timing of cash flows Estimate of future cash flows, adjusted for the time value of money Relevant Background Knowledge IASB Insurance Contracts Exposure Draft On July 30, 2010, the IASB published its Exposure Draft ED/2010/8 Insurance Contracts (ED) and accompanying Basis for Conclusions. This comprehensive standard for the measurement of insurance contracts represented a significant milestone of the IASB FASB project. A further exposure draft or review draft is expected to be published in the first half of 2012, meaning there will be a lot more to take in and prepare for before the new standard takes effect, quite possibly starting January 1, The IFRS objectives are to standardize and improve financial reporting disclosures and provide guidelines for consistent treatment of insurance contacts. We refer the reader to our October 2010 Insights: IASB s Insurance Contracts Exposure Draft A Big Step Forward, but Could It Be Improved? for a summary and detailed analysis of the ED proposals. The figure illustrates the core building blocks of the proposed measurement model for long-term contracts. Key Developments Since the ED s Publication Since publication of the ED, the IASB has continued its discussion of insurance contracts. At press time, the main topics considered are: The residual margin should not be locked in at inception. In order to unlock the residual margin, the IASB tentatively decided that an insurer should: Adjust the residual margin for favorable and unfavorable changes in the estimates of future cash flows used to measure the insurance liability, with experience adjustments recognized in profit or loss Not limit increases in the residual margin Recognize changes in the risk adjustment in profit or loss in the period of the change Make any adjustments to the residual margin prospectively It has not been decided yet whether changes in discount rate should be recognized as an adjustment to the residual margin, or in profit or loss in the period of the change to the extent that these changes create an accounting mismatch. Regarding the allocation methods for the residual margin, the IASB tentatively decided that the residual margin should not be negative and that insurers should allocate the residual margin over Emphasis 2011/4 7

3 John Nicholls Specializes in life insurance risk consulting and software. Towers Watson, Melbourne Ana Escudero Specializes in life insurance risk consulting and software. Towers Watson, Madrid the coverage period on a systematic basis that is consistent with the pattern of transfer of services provided under the contract. The IASB has tentatively decided to change the objective of the risk adjustment from the previous exit-value approach to the compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfills the insurance contract. The board tentatively decided that the acquisition costs included in the initial measurement of a portfolio of insurance contracts should be all the direct costs that the insurer will incur acquiring the contracts in the portfolio. These should exclude indirect costs such as software dedicated to contract acquisition, equipment maintenance and depreciation, agent and sales staff recruiting and training, administration, rent and occupancy, utilities, advertising and other general overhead. In addition, no distinction should be made between successful and unsuccessful acquisition efforts when determining acquisition costs to be included in insurance contract cash flows. The IASB tentatively decided that insurers should consider the right to adjust premiums at both an individual contract level and portfolio level in determining the contract boundary. A consequence of this IASB tentative decision is that blocks of unit-linked business and annual renewable term insurance business, for example, could be measured at much shorter durations than the expected lifetime of the contracts because of insurers ability to vary risk premiums according to the experience of the portfolio as a whole. The IASB tentatively decided that the measurement of the fulfillment cash flows of participating contracts should be based on the measurement in the IFRS financial statements of the underlying items in which the policyholder participates. Such items could be assets and liabilities, the performance of an underlying pool of insurance contracts or the performance of the entity (some of which could, for example, be valued at amortized cost). A number of significant aspects of the ED proposals are yet to be reexamined. One area certain to come under heavy scrutiny is the ED proposal that the residual margin for business existing at the time of transition to the IFRS for insurance contracts be effectively set to nil. The ED proposal in this area, which is out of line with more typical retrospective transition arrangements, would likely lead to unwarranted volatility in the results reported by insurance companies. Financial Modeling Implications Phase II IFRS for insurance contracts is expected to have major implications for financial models. This section includes a brief discussion of just a few key considerations. Cash flow model The core of any financial model for measurement of insurance contracts will be a model for projecting the insurance contract cash flows. Most companies already have such a model in place, whether for local statutory reporting or for evaluation of internal or external capital requirements (for example, for Solvency II purposes). Even in cases where a company is starting with a well-established model with appropriate controls, a number of questions must be asked of the existing model, including: Are the projection periods consistent with the IFRS definition of the contract boundary (where the existing contract is assumed to end)? Are the cash flows incremental at a portfolio level? In particular, general overhead expenses will need to be excluded. In practice, it may be possible to achieve this by adjusting assumptions rather than by changes to the model code. An associated question is whether the contract groupings are appropriate. The definition of a portfolio of insurance contracts (contracts that are subject to broadly similar risks and managed together) may imply different groupings from what companies currently use. This may be particularly true if the primary purpose of existing models differs from determining contract liabilities. So if the primary purpose is asset/liability management, aggregation of results might be based on which asset portfolio backs the insurance liabilities (for 8 towerswatson.com

4 Related Developments for Users of U.S. GAAP example, for managing interest rate guarantees and profit sharing), rather than on the nature of the insurance liabilities. Do benefits that are currently projected in combination need to be unbundled? Contract components, such as investment and service components, that are not closely related to the insurance coverage should be unbundled and measured according to other relevant noninsurance-contract IFRS standards. Account balances that are credited with an explicit return that is based on the account balance should be unbundled and measured under IAS 39 Financial Instruments: Recognition and Measurement, or its successor, IFRS 9 Financial Instruments. The financial modeling requirements for those contracts or contract components that are subject to standards other than the future insurance contract IFRS could potentially be burdensome and are not reflected further in this article. Does the model use investment return and discount rate assumptions that are constant over time? Relevant assumptions for measurement of insurance contracts will be time-dependent, which should be reflected in the financial models. Are there contractual minimum guarantees that will result in asymmetric sharing of risk between shareholders and policyholders? The impact of guarantees on future cash flows will need to be considered. Stochastic modeling may be necessary to ensure that the insurance contracts measure a probability-weighted estimate of the present value of future cash flows. Risk adjustment The measurement model for long-term contracts (and the post-claim obligation of short-term contracts) includes a risk adjustment to compensate the insurer for the uncertainty in the contract cash flows. The IASB tentatively decided not to limit the range of available techniques for its calculation (and will give as guidance examples of the confidence level, conditional tail expectation and cost-of-capital methods). Although the range of techniques available for the calculation of the risk adjustment may not be limited, current expectations are that it will be necessary to disclose the confidence level implied by the risk adjustment that is determined, which may create practical and communication challenges. The Insurance Contracts project is a joint IASB FASB effort. Although it may be a joint project, tentative decisions made by the two boards differ significantly in some instances: The FASB favors a single-margin model, rather than the two-margin (risk adjustment and residual margin) approach proposed by the IASB. The FASB has tentatively decided that only a successful acquisition is included under incremental acquisition costs, while the IASB has tentatively decided that no distinction need be made between successful and unsuccessful acquisition efforts. The claim liability for short-duration contracts would consist of the discounted future cash flows and risk adjustment under the IASB proposals, while the FASB has tentatively decided that the liability for incurred claims should not include any margin. It is a significant accomplishment that the tentative decisions reached by the IASB and FASB are well aligned in many aspects. It will be unfortunate for the users of financial information if, as appears likely, the IASB and FASB are unable to eliminate the remaining areas of difference, some of which are basic elements of the proposals, such as differences in the building blocks used, particularly the single-margin versus twomargin approach. The idea of an explicit risk adjustment should be familiar to companies that are implementing Solvency II. Solvency II requirements may encourage many companies to use a cost-of-capital methodology to evaluate the IFRS risk adjustment. However, unlike Solvency II, the level and cost of capital for the risk adjustment will not be mandated. Residual margin To most companies, the concept of the residual margin will be a new one. The purpose of the residual margin is to eliminate day-one gains (losses would be recognized immediately) and to release product margins (over and above the risk adjustment) in a logical way over the life of the insurance contract. Tentative IASB residual margin decisions indicate that the residual margin is to be released (through profit and loss) over time on a basis consistent with the pattern of transfer of services under the contract. The residual margin will act as a shock absorber because it will be recalibrated for changes in assumptions that impact estimates of future cash flows. The residual margin must be calculated separately for each portfolio of insurance contracts, and within each portfolio, by contracts of similar inception date and coverage period (with the level of aggregation subject to change). Many companies are focusing on getting ready for Solvency II. A major part of this preparation is financial cash flow models that meet the regulation s requirements. Emphasis 2011/4 9

5 In principle, the calculations should be reasonably straightforward, even though a number of details of the approach are not yet fi nalized (e.g., how to treat the impact of changes in discount rates). The major complexity for treating residual margin will be tracking separate residual margins for contracts with similar contract inception dates and coverage periods within each insurance portfolio, should this be a requirement of the fi nal standard. The rebalancing of the residual margin will in effect require two valuation runs to be performed for the present value of future cash fl ows, one using assumptions from the prior valuation, and one using current-period assumptions. The fi nal residual margin (for a particular segment of business) may then be determined as: Expected fi nal residual margin based on prior (noneconomic) valuation assumptions, plus Present value of future cash fl ows based on prior (noneconomic) valuation assumptions, less Present value of future cash fl ows based on current (noneconomic) valuation assumptions The result would be subject to the restriction that the residual margin may not be negative. Presentation and disclosure The key function of a fi nancial model will be to produce measurement results applicable at a given point in time. However, in order to satisfy the presentation and disclosure requirements, it will be equally important for systems and processes to be in place to analyze the movement over time of recognized amounts. The IASB has tentatively decided that the effect of each change on inputs and methods must be disclosed separately, along it is essential while implementing new regulatory requirements to bear in mind that system architecture should have the flexibility to easily add ifrs functionality. with an explanation of the reason for the change. Particular consideration will need to be given to experience adjustments, which capture the difference between actual cash fl ows and previous estimates of the cash fl ows. Other considerations Measurement of insurance contract liabilities is a core function for any insurance company. A successful and robust outcome for a fi nancial model will require appropriate linkages to policy administration and accounting systems, rather than overreliance on manual processes. Any additional valuation runs necessary to produce required information disclosures will need to be performed to audit standards. Strong processes and controls will be needed for future system developments and implementation, coupled with adequate testing and verifi cation of system changes. Conclusion There will be a large number of modeling and system implications with the introduction of the future IFRS standard for insurance contracts. It will be a challenge to keep up with the deadlines and shifting requirements of Solvency II. However, IFRS should be considered when undertaking Solvency II (or other fi nancial modeling) projects. At a minimum, it is essential while implementing new regulatory requirements to bear in mind that system architecture should have the fl exibility to easily add IFRS functionality. Otherwise, much of the signifi cant modeling investment will need to be repeated, and new, sleek, effi cient and well-documented Solvency II systems may end up clogged with messy coding changes and manual, ad hoc adjustments. This will lead to ineffi cient use of time, money and resources, and ultimately systems that are hard to use, and output that will be hard to interpret and audit. For comments or questions, call or John Nicholls at , john.nicholls@towerswatson.com; or Ana Escudero at , ana.escudero@towerswatson.com. 10 towerswatson.com