IFRS 4 Phase II updates

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1 IFRS 4 Phase II updates Mike Wong, Ernest Yip, Steve Cheung 10 June 2015

2 Agenda 1 Overview 2 Insurance contracts standard: non-par contract 3 Current discussion: par contract Page 1

3 Section 1 Overview Page 2

4 IFRS 4 IFRS 9 Overview IFRS 4 Insurance contracts & IFRS 9 Financial instruments timeline IFRS 9 final standard IFRS 9 effective date 1 Jan 2018 IFRS 9 first financial statements IFRS 9 deferred effective date for Insurers? IFRS 9 start of comparative period IFRS 4 phase II start of comparative period? IFRS 4 phase II re-exposure draft IFRS 4 phase II final standard? IFRS 4 phase II effective date? IFRS 4 phase II first financial statements? Ongoing IASB deliberations Implementation period Reporting Page 3

5 Overview A Standard that better meets the needs of users The goal of new standard is to improve the quality of financial reporting by providing more transparent and comparable information. Provides up-to-date market consistent information of obligation including value of options & guarantees Single accounting approach Treats services provided by underwriting activity as revenue and expenses in comparable way to other non-insurance business Reflects time value of money Reflects the characteristics of the insurance contract rather than the risk related to asset/ investment activity Provides separate information about the investment and underwriting performance Page 4

6 Section 2 Insurance contracts standard: Non-par contract Page 5

7 Building block approach overview Contractual service margin Risk adjustment Time value of money Fulfilment cash flows The unearned profit that the entity recognizes as it provides services The compensation that an entity requires for bearing the uncertainties about the amount and timing of the cash flows Discount rate that reflects the characteristics of the liabilities An explicit, unbiased and probabilityweighted estimate of future net cash flows that will arise as the entity fulfils the insurance obligations Overview Use of current market rate Explicit estimate of the effect of uncertainty about amount and timing of cash flows Eliminate Day 1 gain Profits earned over coverage period Acquisition cost deferral Reflect the impact of discount rate change through P/L or OCI Spread the impact of changes in estimate of future cash flows over contract period Page 6

8 Building block approach - contractual service margin Contractual service margin Represent the unearned profit that the entity will systematically recognize as it provides services under the contract Risk adjustment Time value of money At initial recognition: CSM is recognized as an amount opposite to the sum of: The amount of the fulfilment cash flows for the insurance contract at initial recognition and Example: At inception of the policy, BEL(0) = RA(0) = 20 Any pre-coverage cash flows Future cash flows Eliminate any day 1 gains CSM shall not be negative. If the contract is onerous, all loss should be recognized in profit or loss Hence, CSM(0) = - BEL(0) RA(0) = 80 Page 7

9 Building block approach - contractual service margin Contractual service margin Represent the unearned profit that the entity recognizes as it provides services under the contract Risk adjustment At subsequent measurement: Example: CSM(0) = 80 Time value of money CSM at the end of the period equals to: CSM at the start of the period Interest rate = 5% Amortization = 20% per year Plus accretion of interest using locked rate at the inception of the contracts No change in future estimates of BEL and RA Future cash flows Minus the amount recognized for services that were provided in the period Unlock for the difference between current and previous estimate of BEL and RA CSM(1) = CSM(0) x (1 + 5%) x 80% = 80 x (1 + 5%) x 80% = 67.2 Page 8

10 Building block approach - contractual service margin Contractual service margin Risk adjustment Time value of money Discount rate: Use locked-in rate at the inception of the contract for accreting interest on the CSM and for calculating the change in PV of future CFs that offset the margin Significant impact to system and data storage RA = 30 Change in future estimates RA = 20 Future cash flows 2005 cohort 2006 cohort 2008 cohort 2009 cohort Locked-in rates BEL = 80 BEL = 50 Locked-in rates 2007 cohort 2010 cohort Previous noneconomic assumptions Latest noneconomic assumptions Page 9

11 Building block approach - contractual service margin Contractual service margin Risk adjustment Unlocking of CSM: Unlock CSM for changes in estimate of BEL and RA that relate to future services or coverages Base Scenario 1 Scenario 2 Before Assumption Change Favorable Assumption Change Unfavorable Assumption Change No change in the total liability Time value of money CSM = 20 RA = 80 CSM = 40 RA = 70 RA = 100 No P/L impact CSM is exhausted Future cash flows P/L impact = - 20 BEL = 100 BEL = 90 BEL = 120 Page 10

12 Building block approach - contractual service margin Contractual service margin Previously recognized losses: Keep track of the previously recognized losses Allow for accretion of interests and amortization of the balance going forward Risk adjustment Time value of money Future cash flows Page 11

13 Building block approach - contractual service margin Contractual service margin Previously recognized losses: Recognize favorable changes in estimates in P/L to the extent that they reverse the previously recognized losses Risk adjustment Time value of money Favorable change = 200 Future cash flows Favorable change in future estimates Reverse previously recognized losses Recognize profit in P/L Page 12

14 Building block approach - contractual service margin Contractual service margin Previously recognized losses: Re-establish CSM when all previous losses are reversed Risk adjustment Re-establish positive CSM of 150 Time value of money Continue to reverse previously recogized losses and recogize profit of 250 in P/L Favorable change = 400 Future cash flows Another favorable change in future estimates Page 13

15 Building block approach - contractual service margin Contractual service margin Profit recognition: Risk adjustment Recognize the remaining CSM in P/L over the coverage period in a systematic way that best reflects the remaining transfer of the services Time value of money The service represented by the CSM is insurance coverage that is provided: on the basis of passage of time and reflects the expected number of contracts in force Future cash flows Page 14

16 Building block approach - contractual service margin Contractual service margin Level of aggregation: Risk adjustment Objective of the standard is to provide principles for the measurement of an individual insurance contract. In applying the standard, an entity could aggregate insurance contracts provided that it meets the objective; and Time value of money At initial recognition, onerous contracts should not be aggregated with profit-making contracts Future cash flows Despite the clarity provided by the IASB, the industry is still concerned about the level of aggregation for determining CSM because it may not be in line with how they manage their business Page 15

17 Interest expenses and accounting option for the effect of discount rate change Statement of comprehensive income Insurance contract revenue Total revenue Claims & expenses incurred Non-attributable expenses Losses at initial recognition of contracts Minus: reverse of previously recognized losses Total expense Investment result = Investment income on the underlying assets Interest expense on insurance liability An entity can choose to present the effect of discount rate change in either P/L or OCI as its accounting policy Underwriting result Investment income on the underlying assets Interest expense Present the effect of discount rate change through P/L OCI Investment result Other profit and loss Profit or loss before tax Income tax expense Profit or loss net of tax Other comprehensive income Total comprehensive income net of tax Interest expense Other comprehensive income Current rate - Locked-in rate Difference in interest expense calculated using current rate and locked-in rate Page 16

18 Subsequent measurement recap Changes in the measurement of the insurance contracts would flow through different line items of the financial statements, depending on the sources of the changes. Change in estimates relating to future services Contractual service margin (Expected contract profit) Fulfilment cash flows Future cash flows Release of CSM Change in CFs related to past and current services Release of RA related to past and current services Profit or loss: Underwriting result Profit or loss: Investment result Risk adjustment Discounting Interest expense at locked in discount rate Effect of changes in discount rates Other comprehensive income Page 17

19 Simplified approach - premium allocation approach Start of coverage period Valuation date Insurance liability is extinguished Liability for remaining coverage An entity may simplify the measurement using the PAA when: The coverage period at initial recognition is one year or less; or PAA produces a reasonable approximation of BBA Acquisition costs Premiums received (plus any additional onerous contract liability) Liability for remaining coverage Page 18

20 Simplified approach - premium allocation approach Start of coverage period Valuation date Insurance liability is extinguished Recognition of insurance contract revenue in profit or loss On the basis of passage of time; but Liability for remaining coverage An entity may simplify the measurement using the PAA when: The coverage period at initial recognition is one year or less; or PAA produces a reasonable approximation of BBA If the expected pattern of release of risk differs significantly from the passage of time, then on the basis of expected timing of incurred claims and benefits Acquisition costs Premiums received (plus any additional onerous contract liability) Insurance contract revenue Liability for remaining coverage Page 19

21 Simplified approach - premium allocation approach Start of coverage period Valuation date Insurance liability is extinguished Liability for incurred claims Liability for remaining coverage Measured using BBA An entity may simplify the measurement using the PAA when: The coverage period at initial recognition is one year or less; or PAA produces a reasonable approximation of BBA Risk adjustment Acquisition costs Present value of expected cash flows Premiums received (plus any additional onerous contract liability) Insurance contract revenue Liability for remaining coverage Page 20

22 Reinsurance overview cedent s perspective CSM Risk adjustment Consistent assumptions as the underlying direct contract Risk adjustment CSM CSM Separated from the direct contracts Measurement for reinsurance held Any net cost or net gain -> recognise as a CSM except there is net cost on the coverage relates to event that occurred before the purchase of the reinsurance Time value of money Time value of money Positive/ negative CSM To avoid asymmetric treatment between reinsurance and direct contracts Expected future cash flows Reinsured part of cedent s liability Expected future cash flows Cedent s reinsurance asset Reflect the nonperformance risk After inception, if there are changes in future estimate of direct contract that would impact P/L, entity should also recognise in P/L the corresponding impact from the reinsurance contract Page 21

23 Presentation - insurance contract revenue An entity should: Present insurance contract revenue (ICR) and expenses in the statement of comprehensive income Be prohibited from presenting premium information Present value of premium income at inception of the contract Performance obligations Non-distinct investment component Non-distinct investment components are excluded from the definition of ICR and claims & expenses incurred Contractual service margin Risk adjustment Bearing the risk Expected claims and expense, and the part of the premium allocated to the recovery of directly attributable acquisition cost Provision of coverage and services Page 22

24 Presentation - insurance contract revenue 1. Release in CSM 2. Release of RA relating to past coverage 3. Expected claims and expenses and 4. The part of the premium allocated to the recovery of directly attributable acquisition costs Present value of premium income at inception of the contract Insurance contract revenue Non-distinct investment component Allocate total revenue over the coverage period of the contract Interest Contractual service margin Risk adjustment Expected claims and expense, and the part of the premium allocated to the recovery of directly attributable acquisition cost Year Page 23

25 Presentation statement of comprehensive income Statement of comprehensive income Insurance contract revenue Total revenue Claims & expenses incurred Non-attributable expenses Losses at initial recognition of contracts Minus: reverse of previously recognized losses Total expense Underwriting result Investment income on the underlying assets Interest expense Investment result Other profit and loss Profit or loss before tax Income tax expense Profit or loss net of tax Other comprehensive income Total comprehensive income net of tax Page 24

26 Transition Three approaches for transition are proposed: Approach Conditions Full retrospective approach When historical data exists and hindsight is not required Simplified retrospective approach When not all historical information is available but information about historical cash flows is available or can be constructed Fair value approach When no historical information about cash flows is available to determine the CSM Page 25

27 Transition Re-designation of financial assets The IASB tentatively decided to consider providing further transition relief to permit or require an entity to reassess the business model for financial assets at the date of initial application of the new insurance contracts standard. The European Financial Reporting Advisory Group (EFRAG) had advised the European Commission to ask the IASB to defer the effective date of IFRS 9 for insurance businesses and to align it with the effective date of the new insurance contracts standard. Page 26

28 Numerical example: Non-par contract Page 27

29 Numerical example Background A non-par product 10 year limited pay, whole life coverage Issued in 1998 Sum assured upon death Cash value upon surrender IFRS 4 Phase I valuation: net-level premium approach Locked-in valuation assumptions (discount rate = 7%) IFRS 4 Phase II valuation: building block approach Transition date: YE 2014 Page 28

30 Numerical example Overview of results step by step Initial measurement Transition Subsequent measurement Phase II result = < Phase I result = (Unit in mil) CSM = 10.7 RA = 2.5 CSM = 3.8 RA = 4.8 CSM = 10.7 RA = 2.5 BEL = 51.5 BEL = 46.9 BEL = 95.6 CSM = 6.3 RA = 4.7 BEL = (11.0) Valuation date Non-economic assumption Prudent Discount rate % Page 29

31 Numerical example Profit & loss (Unit in mil) Profit & loss IFRS 4 Phase II investment result IFRS 4 Phase II underwriting result IFRS 4 Phase II profit & loss IFRS 4 Phase I profit & loss In this example, on P&L: Phase I P&L ( black line): more profit is released at later period 1.5 Phase II P&L ( red line): profit is accelerated Mainly due to underwriting result ( color) Investment result ( color), can become negative under low interest rate environment -0.5 Calendar year Page 30

32 Section 3 Current discussion: Par contracts Page 31

33 Current discussion Participating contracts Exposure Draft Mirroring approach in 2013 Exposure Draft: Applies when (i) the contract requires holding underlying items, and (ii) specifies a link between the payments to the policyholder and the returns on those underlying items. When applicable, measure the fulfilment cash flows that are expected to vary directly with returns on underlying items by reference to the carrying amount of the underlying items. Behaviour of cash flows Vary directly Vary indirectly Do not vary Measurement By reference to underlying items Building block approach Presentation of measurement changes Consistent with underlying items Profit or loss Profit or loss or OCI, following general requirements Page 32

34 Current discussion Participating contracts - industry concerns on 2013 Exposure Draft The mirroring approach proposed in the 2013 ED was considered by many respondents as being overly complex and not fit for purpose. In November 2014, the IASB held an education session in which representatives of the European CFO Forum presented their alternative proposal for the accounting for contracts with participation features. Key principles of the alternative proposal: 1. Applicable to all types of participating contracts 2. One measurement basis for all insurance contracts 3. Fully unlocked CSM 4. CSM is released in P/L in a way that best reflects the transfer of services under the contract 5. Current portfolio book yield used to determine interest expense in P/L 6. The insurer elects to present the effect of changes in the discount rate in OCI or P/L as an accounting policy choice Page 33

35 Current discussion Participating contracts educational sessions by the IASB The IASB held two educational sessions in 2015 to discuss the possible adaptions to the general model for contracts with participation features. No tentative decisions have been made so far. The staff proposed two possible views on the entity s interest in such underlying items: View of entity s economic interest Measurement model Indirect participation contract As a share of economic returns from the underlying items General model approach Direct participation contract Promise to pay an amount equal to the value of underlying items less a variable fee for services Variable fee approach Page 34

36 Current discussion Participating contracts educational sessions by the IASB Three criteria for variable fee approach: 1 The contract specifies a participation in clearly identifiable underlying pools of assets (or other underlying items). 2 The entity expects that a substantial proportion of the cash flow from the contract will vary with underlying items. 3 The entity expects that the policyholder will receive a substantial share of the returns. Page 35

37 Current discussion Participating contracts educational sessions by the IASB Key differences between indirect and direct participation contract: Indirect participation contracts [General model approach] Direct participation contracts [Variable fee approach] Unlocking of CSM due to change in underlying item The CSM would not be unlocked: The changes in estimates that arise because of changes in financial assumptions (change in discount rate) would be recognized in P/L or OCI The CSM would be unlocked for changes in: The expected present value of variable fee for service and The expected present value of the cost of guarantees Discount rate for accretion of CSM and unlocking View 1: Follow the general model approach Locked-in rate View 2: Follow the variable fee approach Current rate No need to accrete interest on the CSM as the measurement of the value of the underlying items already reflects the time value of money in the obligation Unlock the CSM using the current liability rate at reporting date Page 36

38 Current discussion Participating contracts educational sessions by the IASB Key differences between indirect and direct participation contract Assuming that the OCI option is permitted: Indirect participation contracts [General model approach] Direct participation contracts [Variable fee approach] Interest expenses The entity may choose as its accounting policy to determine the interest expense in P/L using the current discount rate or an effective yield approach When the entity has not held the assets in each reporting period: the entity may choose as its accounting policy to determine interest expense in P/L using the current discount rate or an effective yield approach. When the entity expected at inception to hold the assets and has held the assets in each reporting period. the entity may choose as its accounting policy to determine interest expense in P/L using either the current discount rate, an effective yield approach or a current period book yield approach Page 37

39 Current discussion Participating contracts educational sessions by the IASB Current period book yield approach In scope of variable fee approach; and The underlying items are held by the entity to ensure an exact match between the items underlying the obligation and the obligation itself exists Investment income Year 1 Year 2 Year 3 Year 4 Year The interest expense would be equal and opposite to investment income on the underlying items. Interest expense (70.0) (164.7) (61.7) (64.8) (68.1) Investment results Other comprehensive income (9) (20) The difference between the interest expense in profit or loss and the interest expense determined based on current rates would be reported in OCI for both the underlying items and the insurance liability. Page 38

40 Major open discussion points in IFRS 4 Key items to be resolved Participating contracts Level of aggregation Participating contracts Variable fee approach? Approach for universal life contracts? Re-open debate on the general model? Allocation of CSM over coverage period? Interest expense? Presentation of changes in discount rates? Transition No decisions taken Level of aggregation Objective of IASB: measure CSM at individual contract level No compensation between onerous and profitable contracts Mutualisation in participating contracts Implications for non-participating contracts Significant impact Page 39

41 Thank you

42 EY Assurance Tax Transactions Advisory About EY Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our over 200,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve potential. For more information, please visit EY refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to their clients Ernst & Young All Rights Reserved. Page 41

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