1 International Financial Reporting Standard 4 (HKFRS4): Insurance Contracts The future of insurance reporting for now Presented by: David Campbell November 2005
2 Setting the Scene 1 This This is the first IFRS to deal with insurance contracts 2 Effective Effective for annual periods beginning on or after 1 January 2005 in Hong Kong
3 Insurance Analysts Perspectives on the Move to IFRS
4 Attitudes of Analysts How would you rank European insurers external financial reporting in terms of adequacy? 1 Very Poor 2 Poor 3 Average 4 Good 0% 5 Very Good 0% 14% 33% 53%
5 Attitudes of Analysts Do you think that as a result of the introduction of the Phase II proposals the financial management of insurance companies will 1 improve 94% 2 stay the same 6% 3 deteriorate 0%
6 Survey of 20 insurers in Asia in June 2005: Do you think you are ready to prepare financial statements that comply with IFRS 4 requirements now? 100% Yes No
7 Survey of 20 insurers in Asia in June 2005: Has your company performed a detailed review of all existing products to ensure they meet the new definition of an insurance contract? 95% Yes No
8 Survey of 20 insurers in Asia in June 2005: The survey reveals the following issues they face in adopting the new Standard: Lack of trained resources Time constraints The ability to fully comprehend the requirements of IFRS 4 The ability to obtain quality IFRS data from regional subsidiaries and branches
9 Beyond the hurdles, the opportunities The move to IFRS 4 is the most fundamental shift in accounting practices ever faced by insurance companies. It will impact: The viability and design of products Data and information system requirements The way the company manages its balance sheet and earnings The way the company is judged by investors and rating agencies
10 Agenda Walking through IFRS 4 Everything started with a definition Separation of deposit components and embedded derivatives Accounting for insurance liabilities and reinsurance assets Interaction of IFRS 4 with IAS 39 and other standards IFRS 4 disclosures
11 Implementing IFRS 4 - Areas Posing the Greatest Challenge IMPACT Interpreting Practicalities of implementing Embedding process Product classification Phase I Disclosure Accounting Phase II Colour importance High Medium Low Size of = Degree of anticipated difficulty Dotted line is the FUTURE?
12 IFRS 4 Objectives Interim standard - focuses primarily on disclosures and classification of insurance contracts. Introduces a definition for an insurance contract based on the contract containing significant insurance risk. This standard however exempts insurers from changing their accounting policies to comply with the IFRS Hierarchy subject to limited required changes to existing accounting practices for insurance contracts and extensive disclosures. A principles-based framework that allows a high degree of discretion, even experimentation, in how it is presented.
13 Everything started with a definition IFRS 4 Appendix A defines an insurance contract as contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.
14 Is it an insurance contract? Do cash flows under the contract depend on an uncertain future event? Yes Is the policyholder adversely affected by the uncertain event? Yes Is it a pre-existing uncertain event, i.e. the event is not created by the contract itself? Yes Does the loss event have commercial substance in the context of the contract? Yes Does the insured event cause the insurer to pay significant additional benefits in any scenario with commercial substance? No No No No No Not an insurance contract under IFRS 4 Yes Insurance contract under IFRS 4
15 Product Classification Yes Does Does contract contract contain contain significant significant insurance insurance risk risk?? No Insurance Insurance features features present present Investment Investment features features only only present present No Does Does the the contract contract need need to to be be unbundled unbundled?? Yes Are Are any any discretionary discretionary participation participation features features present present?? No Yes Insurance Insurance Component Component Deposit Deposit Component Component Insurance Insurance Contract Contract Investment Investment Investment Investment Contract Contract Contract with Contract with discretionary discretionary participation participation features features
16 Product classification Product classification What is significant insurance risk? Additional benefits include: claims handling and claims assessment costs. Exclude: loss of the ability to charge future fees; surrender penalties and market value adjusters; possible reinsurance recoveries. Commercial substance: pricing; marketing. No guidance on amount of insurance risk provided.
17 Product classification Product classification What is significant insurance risk? Insurance risk evaluated at inception of contract. Changes in level of risk e.g., Universal life contracts. Survival risk is an insured risk. Annuity options: not insurance contact if insurer price at annuity current rates when option is exercised; insurance if annuity rates guaranteed at inception if there is a reasonable expectation that the option will be exercised. Once insurance always insurance.
18 Walking through IFRS 4 Applying the insurance definition Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Identify the insured event (IFRS 4 B2-B4) Establish that the insured event affects the insured adversely (IFRS 4 B13) Identify a scenario in which the insured event occurs (IFRS 4 B23) Test that the scenario in Step 3 has commercial substance (IFRS 4 B23) Determine the amount payable by the insurer (IFRS 4 B23-B24) Determine another scenario in which the insured event does not happen (IFRS 4 B24) (continued next page)
19 Walking through IFRS 4 Applying the insurance definition Step 7 Step 8 Step 9 Step 10 Establish that Step 6 also has commercial substance (IFRS 4 B23) Determine the benefit under Step 6 (IFRS 4 B24) Compare Step 5 and 8. If necessary, allow for time value i.e. compare actuarial and financial equivalents (IFRS 4 B23) Establish if Step 5 is significantly more than Step 8 (IFRS 4 B23) If YES, then the contract is insurance Check with the examples in IFRS 4
20 Product classification Product classification Examples of insurance contracts General insurance contracts such as insurance against theft, product liability. Life insurance and prepaid funeral plans. Life-contingent annuities and pensions. Disability and medical cover. Surety bonds. Credit insurance (pending exposure draft). Deferred annuity: policyholder will receive, or can elect to receive, a life contingent annuity at rates guaranteed at inception. Reinsurance policy with regards to lapse risk on life insurance policies/ investment policies.
21 Product classification Product classification Examples of contracts that are not insurance Investment contracts that have the legal form of an insurance contract but do not expose the insurer to significant insurance risk. Contracts that have the legal form of insurance, but pass all significant insurance risk back to the policyholder through mechanisms that adjust future payments by the policyholder as a direct result of insured losses. Self-insurance, such as captive reinsurance. Financial guarantee providing for payments in response to changes in specified interest rate, security price etc.
22 Examples of insurance contracts A Group healthcare contract where the initial premium paid is subject to further increase or rebate at the end of the cover period to reflect actual claims experience (after taking into account the time value of money and administration expenses). No As the premium is always adjusting in line with claims experience there are no additional benefits under the contract. What if same as above but with any additional premium payable being subject to an upper limit? Maybe The upper limit on the additional premium is effectively a stop-loss insurance. For the contract to be one of insurance, it will need to be demonstrated that this creates insurance risk that is significant. For example if the upper limit was set at such a high level that, in practice, it was never likely to be reached then this may be viewed as not of commercial substance.
23 Examples of insurance contracts A contract, otherwise an investment contract, that pays significant additional benefits if the policyholder survives to age 98. No The scenario of survival to the age of 98 is one that lacks commercial substance. Participation in a guarantee fund (such as the Motor Insurance Bureau) established by law. No The commitment of participants is established by law so there is no contract present. If the fund was established by contract it would be an insurance contract.
24 Examples of insurance contracts Fully re-insured risk Yes An insurance risk that is 100% re-insured is still insurance.
25 Discretionary Participation Feature ( DPF ) A contractual right to receive, as a supplement to guaranteed benefits, additional benefits: a) that are likely to be a significant portion of the total contractual benefits; b) whose amount or timing is contractually at the discretion of the issuer; and c) that are contractually based on: i. the performance of a specified pool of contracts or a specified type of contract; ii. iii. realised and/or unrealised investment returns on a specified pool of assets held by the issuer; or the profit or loss of the company, fund or other entity that issues the contract. (IFRS 4 Appendix A)
26 Unbundling Deposit Components and Separating Embedded Derivatives
27 Unbundling The Decision Tree Is the contract an insurance contract? No Accounting is under IAS 39 Yes Is the deposit component reliably measurable? No Unbundling is prohibited (IFRS 4.10 (c)) Yes Do the insurer s accounting policies recognise all obligations and rights from the deposit component? No Yes Unbundling is required (IFRS 4.10 (a)) Unbundling is permitted (IFRS 4.10 (b))
28 Embedded Derivatives - An Overview of Identification Is the contract carried at fair value through earnings? No Will it be a derivative if it was free standing? Yes Is it closely related to the host contract or interdepen dent or an insurance contract in itself? Yes No Yes Yes Yes No Is it an option to surrender at fixed amount / fixed amount plus interest? Do Not Separate and Fair Value No Is the surrender option at a value which equals fair value of investments after surrender charges? No Separate and Fair Value
29 When to separate embedded derivatives? In summary the embedded derivative that is most commonly separated is a surrender option that varies in response to change in equity or commodity price or index and entire contract is not at fair value through income Surrender options in a DPF investment contract have received the same exemptions from separations as those embedded in insurance contracts
30 Do we need to separate and fair value the embedded derivative? 1 Unit linked insurance contract The contract pays benefits that are measured in terms of number of units multiplied by the current value of linked unit trusts. Answer: Unit denominated payments can be measured in terms of units, avoiding the need to separate out an embedded derivative from the host contract. NO!
31 Do we need to separate and fair value the embedded derivative? 2 Guaranteed annuity option An option to receive an annuity at a future date with rates (in terms of mortality and interest) guaranteed at inception of the contract. Answer: It s an insurance contract on a stand alone basis if guarantee apply to payments that are life contingent. NO!
32 Do we need to separate and fair value the embedded derivative? 3 Index linked bond This contract offers benefits that are equal to 100% of the increment of the FTSE 100 during the term of the contract. Answer: The embedded derivative is not an insurance contract. It s not closely related to the host insurance contract. Separate embedded derivative and fair value it. YES!
33 Accounting for Insurance Liabilities and Reinsurance Assets
34 Liability Adequacy Test Liability adequacy test (IFRS 4 paras 15-19) Current estimates of future (contractual) cash flows; Compare to liability less related DAC and other intangible; Recognise deficiency immediately in profit or loss. If current policy meets requirements continue to use it; If not use IFRS 4 para 17 with test based on IAS 37. Level of aggregation for liability adequacy test (IFRS 4 para 18): managed together AND similar risks
35 Reinsurance Assets Impairment Reinsurance purchased is subject to the same exemptions as insurance contracts (IFRS 4 para13(b)) Existing accounting policies may continue subject to IFRS 4 para 14 requirements IFRS 4 para 14(e) specifies a requirement to consider impairment of reinsurance assets (IFRS 4 para 20): Is there objective evidence of impairment (trigger event)? Can the impact of the trigger event be measured reliably? Yes to both questions reduce carrying amount with impairment loss in profit and loss
36 And do not forget No liabilities for future claims arising from future insurance contracts (for example, catastrophe provisions and equalisation reserve). No offset of reinsurance assets against related insurance liabilities; or income or expense from reinsurance contracts against the expense or income from the related insurance contracts. De-recognition of insurance liabilities from its balance sheet when, and only when, it is extinguished (i.e. obligation is discharged or cancelled or expired).
37 Accounting Policies What can you do? Continue with undiscounted liabilities Continue with excessive prudence Continue to use non-uniform accounting policies in group accounts Continue to measure rights to future investment management fees at a value higher than their fair value
38 Accounting Policies What can you change? Changes must make the accounts more relevant and no less reliable or more reliable and no less relevant Measure designated liabilities using current market interest rates Introduce a measurement that reflect future investment margins subject to rebuttable presumption Move to a comprehensive investor oriented basis of accounting Introduce shadow accounting
39 Optional considerations Shadow accounting Permitted, but not required, to use shadow accounting. Unrealized gains/losses on available for sale securities are recorded in equity along with other effects that would have been recorded has those gains/losses been realized. Additional guidance on shadow accounting effects for discretionary participation features Change of market interest rates Permitted but not required, to move interest rates used to calculate policyholder liabilities on insurance contracts to current rates: not required for all liabilities: key concession from IAS 8; no guidance on what are current interest rates will allow estimation techniques. May also update other assumptions
40 A Chinese life company Most investment contract under US GAAP basis were found to be insurance contracts under IFRS 4; Annuity products with lump sum benefits are to be treated as financial instruments under IAS 39. US GAAP FAS FAS 60/97 60/97 LP LP (35%) (35%) FAS FAS 97UL 97UL and and IC IC (65%) (65%) IFRS4 IFRS4 Insurance contract IAS IAS Insurance (EX- (EX-FAS (EX (EX FAS 60) 60) (EX FAS 97) 97IC) 97IC)
41 A Chinese life company IFRS4 IFRS4 Insurance contract IAS IAS Insurance (EX- (EX-FAS (EX (EX FAS 60) 60) (EX FAS 97) 97IC) 97IC) Loss recognition Continually using the existing grouping and deficiency testing and no further requirement at the level of a portfolio of contracts that are subject to broadly similar risks and managed together as a single portfolio. risk free rate
42 Interaction of IFRS 4 with Other Standards
43 Interaction of IFRS 4 with other standards Accounting for investment contracts basic concepts Within the scope of IAS 39 and IAS 18 Financial liability at fair value or amortised cost (IAS 39) Service revenue based on stage of completion with capitalisation of costs incurred to secure rights (IAS 18)
44 Amortised Cost Measurement Investment Contracts Investment Management Contracts Financial Liabilities Effective Interest Method with floating rate + embedded derivative (service component is separated) Effective Interest Method + embedded derivative Insurance Contract Insurance Contract Existing GAAP (IFRS 4 para 13)
45 Fair Value Measurement Investment Contracts Investment Management Contracts Financial Liabilities Valuation technique (for example use the unit value of the assets) Valuation technique (for example: DCF at market rates) Insurance Contract Insurance Contract Wait until Phase II
46 Accounting for Transaction Costs Investment Contracts Investment Management Contracts Financial Liabilities IAS 18 An asset is recognised representing the right to receive future investment management fees IAS 39 There are no contractual rights to receive service fees = part of amortised cost or expensed in FV Insurance Contracts Insurance Contracts IFRS 4 Existing GAAP (DAC)
47 Revenue Recognition for Services Rendered Issuers often charge customers upfront for services Is this revenue on day 1? Yes, if a specific and separable service is rendered Examples Fund management services Advisory service Sale service Origination fee No day 1 revenue No day 1 revenue No day 1 revenue Day 1 revenue if the financial liability is fair valued
48 IFRS 4 Disclosures
49 Disclosures IFRS 4 and Other Standards Primary statement formats (IAS 1) Segmental analysis (IAS 14) Accounting policies (remember the reference to existing accounting policies ) (IFRS 4) Financial instruments disclosures (IAS 32 and IFRS 4) Amount, timing and uncertainty of insurance cash flows (IFRS 4)
50 Disclosure Principle 1 Accounting polices must be explained in detail (IFRS 4 para 37(a)) Assets, liabilities, income and expenses must be identifiable in the notes (IFRS 4 para 37(b)) including full reconciliation of movements of all balance sheet items (IFRS 4 para 37(e)) Key assumptions used with quantitative disclosure where possible (IFRS 4 para 37(c)) Change in assumptions with explanation of material effects (IFRS 4 para 37(d))
51 Illustration: Accounting Policies IFRS 4 Para 37(a)
52 Illustration: Key Assumptions Used IFRS 4 Para 37(c)
53 Illustration: Change in Assumptions IFRS 4 Para 37(d)
54 Disclosure of Assumptions Changes in assumptions and impact of those changes that have a material impact on assets, liabilities, income and expense: How to disclose qualitatively? Start with change in estimates Identify sources of change Describe the underlying changes in assumptions in terms of, example: Length of term to settlement Severity of claims Frequency of claims
55 Disclosure of Assumptions Assumptions Quantitative disclosure Disclose values of assumptions that have a material impact on estimates in balance sheet and income statement For example: Discount rates Effect of legislative changes, if any Mortality and morbidity tables and specific adjustments Lapse ratios
56 Disclosure Principle 2 Focus on disclosure in absence of fair value measurement Mirrors the requirements of IAS 32 Risk management approach (IFRS 4 para 39(a)) Terms and conditions (IFRS 4 para 39(b)) Requires extensive disclosures on insurance risk Sensitivity (IFRS 4 para 39(c)(i)) Concentration (IFRS 4 para 39(c)(ii)) Loss development tables (IFRS 4 para 39(c)(iiii))
57 Illustration: Risk Management Approach IFRS 4 Para 39(a)
58 Illustration: Sensitivity IFRS 4 Para 39(c)(i)
59 Illustration: Concentration IFRS 4 Para 39(c)(ii)
60 Illustration: Loss Development Tables IFRS 4 Para 39(c)(iii)
61 Principle 2 links back to Principle 1 Set out assumptions (principle 1) Describe change in assumptions (principle 1) Explain sensitivity to variables (principle 2)
62 Questions and Answers