Measure by measure. Synchronising IFRS 9 and IFRS 4 Phase II for Insurers

Transcription

1 Measure by measure Synchronising IFRS 9 and IFRS 4 Phase II for Insurers

2 Executive summary The development of a new standard to replace IFRS 4 Insurance Contracts and the publication of IFRS 9 Financial Instruments by the International Accounting Standards Board (IASB) will profoundly change accounting by insurers both for the insurance contracts that they issue and for investments held. The changes will have a considerable impact on processes and systems used to produce financial information and may even drive changes to current business models 1. This publication specifically focuses on the expected impact of IFRS 9 Classification and Measurement for insurers taking into consideration types of financial assets held currently, the expected impact of the proposals under IFRS 4 Phase II and the considerations for any potential difference in the timing of adoption of the standards. It is important that insurers understand the impact of IFRS 9, and acto now to make sure that they are prepared for the potential impact. Insurers usually aim to manage their assets and liabilities in a way that seeks to match cash outflows to existing policyholders with inflows from investments and from new policyholders. However, such matching is not always attained, either because assets of sufficient duration are not available, or because insurers intentionally decide to accept a duration mismatch in an effort to enhance investment returns. 1 Business models under IFRS 9 Financial Instruments: Classification and Measurement From an accounting perspective where an insurer s assets and liabilities are economically matched, gains and losses on the respective components should largely offset. 2 However, if different measurement bases are applied to assets and liabilities then this offsetting impact may not be reflected in the financial statements. When identical economic impacts affect assets and liabilities in different ways, this is often referred to as an accounting mismatch. An example of such a mismatch arises if investments are reflected at fair value through profit or loss while liabilities are measured on an amortised cost-like basis. In this case, a change in the market interest rate would change the fair value of the investments (with a corresponding impact on income statement), but with no offsetting impact resulting from re-measurement of the liability at amortised cost. Under existing accounting models for insurance contracts, various techniques have been developed to reduce or remove the impact of accounting mismatches in profit. Such techniques include a combination of designation of asset portfolios as available for sale (with unrealised market movements being reported directly in equity and outside of profit or loss) and shadow accounting. In the proposed IFRS accounting regime, insurers should prevent or mitigate accounting mismatches and seek to 2 This publication does not discuss asset-liability duration matching any further. It is assumed that the insurers would have considered duration matching before making a decision on the classification of the investment under IFRS 9. minimise the volatility of reported profit within and between reporting periods. As part of its project to replace the existing insurance standard, IFRS 4 Phase II, the IASB issued an Exposure Draft (ED) in July 2010 containing proposals for a new recognition and measurement model for insurance contracts. One of the features of the proposed model is that, in each reporting period, an insurer would be required to reflect current assumptions in the measurement of insurance contract liabilities. Therefore the present value of expected future cash flows, the discount rate and risk adjustment of insurance liabilities would be updated at each reporting period with any changes being reported in profit or loss for the period. The use of this current value for insurance contract liabilities has led to the assumption that insurers will choose to designate investments supporting the insurance business as at fair value through profit or loss to minimise accounting mismatches. However, the proposed insurance liabilities measurement model will result in certain aspects of the liabilities not being updated for current assumptions at each reporting period, so amortised cost may be the better choice for some investments. Examples of such instances are the residual margin and the pre-claims liability for short duration contracts. In addition, insurers also hold investments in excess of the value of their insurance liabilities to support other financial liabilities and the remaining net shareholders equity in the company. Insurers may wish to minimise profit 2

3 or loss volatility by holding assets that qualify for amortised cost treatment to support these items. Classification of financial instruments will generally be retained for the entire period the financial instrument is held. Insurers need to carefully evaluate the classification choices to select the most appropriate classification for each investment. As part of that evaluation, insurers should consider performing an assessment of the impact of IFRS 9 to determine if it is possible to achieve the newly defined amortised cost measurement. This should be performed well before implementation of IFRS 9 to allow time for any optimisation activities to be undertaken. When assessing and determining the ultimate impact of the applying IFRS 9, insurers should take into account the results of the IASB s recent and upcoming discussions around the use of other comprehensive income (OCI) for reporting the movements in insurance liabilities due to changes in the discount rate and the unlocking of the residual margin. The outcomes of these discussions have consequences on whether, or to what extent, an insurer should hold investments at amortised cost. Measure by measure Synchronising IFRS 9 & IFRS 4 Phase II for Insurers 3

4 Observations An overview of IFRS 9 IFRS 9 will replace IAS 39 in its entirety through a three-phased approach: classification and measurement; impairment of financial assets; and hedge accounting. The first phase of IFRS 9 has now been finalised; it covers the classification and measurement of both financial assets and financial liabilities. IFRS 9 replaces the four measurement categories for financial assets under IAS 39 with three categories: fair value through profit or loss, fair value through OCI and amortised cost. The requirements for financial liabilities remain largely unchanged with respect to classification. Under IFRS 9, the classification and measurement of financial assets depends on whether the asset is a derivative, a debt instrument or an equity investment: All derivatives are measured at fair value through profit or loss. Debt instruments are recorded at amortised cost, if they are not held for trading and meet the business model and characteristics of financial asset tests under IFRS 9. Otherwise they are measured at fair value through profit or loss. Equity investments that are held for trading must be measured at fair value through profit or loss. Other equity investments are measured at fair value through profit or loss or at fair value through OCI. In the latter case, there is no recycling of the change in fair value to profit or loss if the investment is subsequently derecognised, but dividend income is recognised in profit or loss. Although IFRS 9 has a mandatory adoption date of 1 January 2013, the IASB has initiated discussions on the topic of aligning the effective dates of a number of new standards and it is therefore likely that the mandatory implementation date will be deferred. IFRS 9 is not yet endorsed by the EU. Insurance accounting and the impact of IFRS 9 in moving to IFRS 4 Phase II Insurance companies follow asset liability management policies to match the investments held in support of a line of business to the nature of the underlying liabilities. This is tailored to consider: Local regulatory requirements The measurement model for the insurance liabilities A suitable portfolio mix in line with the investment strategy and risk appetite of management 4

5 A desire to generate greater investment returns Current accounting under IFRS 4 Phase I Under the current IFRS 4 framework, insurers apply the accounting policies that they were using when they first implemented IFRS to account for insurance contracts. Usually these policies represent their previously applied generally accepted accounting principles (local GAAP). The current standard also allows the application of non-uniform accounting policies for different parts of a group within a single set of consolidated financial statements. Under some forms of local GAAP in continental Europe, Japan, and the US, insurance liabilities are measured on a locked-in basis. Liabilities for insurance contracts are established at inception using discounted future cash flows and provisions for possible deviation from expectations, but these liabilities are not subsequently updated for changes in market interest rates or other assumptions, unless the obligations become onerous. As a result, changes in market interest rates typically do not impact the liabilities. In these jurisdictions, insurance entities tend to hold large amounts of debt instruments, which are classified as available for sale under current IFRS in accordance with IAS 39. These insurers have an incentive to designate the debt instruments that support their insurance liabilities at amortised cost. Under some other local jurisdictions (e.g., UK, Australia, Canada and South Africa), insurance liabilities are measured using current interest rates and current assumptions. Also, some insurers in other jurisdictions make use of the option in IFRS 4 to choose current interest to measure insurance liabilities for their portfolio. These insurers tend to designate their investments at fair value with fair value changes recognised in profit or loss under IAS 39. Expected impact of IFRS 4 Phase II The ED on IFRS 4 Phase II seeks to establish a consistent recognition and measurement model for all insurance contracts issued by entities reporting under IFRS. In the ED, the IASB proposes that insurers measure insurance liabilities using a model based on the present value of the fulfilment cash flows, plus a residual margin that eliminates profit at initial recognition. Losses at inception are recognised immediately and profits are recognised over time. The components of the present value of the fulfilment cash flows, i.e., the expected future cash flows, discount rate and the risk adjustment will be updated for current assumptions at each reporting Figure 1 Illustration of the building blocks of the insurance liability Premium Residual margin Discounting Risk adjustment Modified pre-claims liability for short duration contracts Expected future cash flows Present value of the fulfillment cash flows Measure by measure Synchronising IFRS 9 and IFRS 4 Phase II for Insurers 5

6 period. Conversely, the residual margin is locked-in at the inception date of the contract and amortised over the contract coverage period. For insurance contracts that are regarded as short-duration contracts, liabilities from incurred claims will be measured at the present value of the fulfilment cash flows. However, the liability for the preclaims period will be locked in upon initial recognition and released over the coverage period on a straight-line basis or in line with the expected timing of incurred claims and benefits, if this pattern differs significantly. Figure 1 (page 5) illustrates the proposed building blocks for insurance liability measurement. Implementing IFRS 9 and IFRS 4 Phase II simultaneously The proposals contained in the ED have some elements that may be impacted differently by changes in market interest rates and other variables. The following are examples of the impact of the treatment of insurance liabilities under IFRS 4 Phase II that may drive the desired classification under IFRS 9 (at amortised cost or at fair value), in order to minimise accounting mismatches and earnings volatility. Some insurance liabilities will be measured at the present value of the fulfilment cash flows plus a residual margin. The remeasurement of the present value of the fulfilment cash flows at each reporting period to reflect current market variables, such as interest rates, means that a change in market interest rates will affect the value of the insurance liabilities. In this instance, insurers may seek to match the relevant portion of insurance liabilities with investments carried at fair value through profit or loss. As a result, movements in the investment values will largely offset movements in the insurance liabilities as a result of changing financial inputs. A perfect match would rarely arise as the assets and liabilities are unlikely to be of exactly equal duration. The impact of this economic duration mismatch can be substantial. A further mismatch may arise due to other factors, e.g., changes in the price of credit risk that affect the measurement of the assets but not the measurement of the insurance liabilities. The residual margin will not be updated for current assumptions under the ED and could be characterised as being akin to an amortised cost item. Because the value is locked in on day one, interest is accrued based on an interest rate curve locked in at inception, and the residual margin is recognised in income over the period of the contract. In this instance, insurers may consider matching this part of the liability with investments carried at amortised cost. For short-duration liabilities, the preclaims liability will be established at inception as an unearned premium amount and subsequently released to profit or loss over the coverage period (generally 12 months or less). This part of the insurance liability will be measured on a basis that resembles amortised cost. In this case insurers may consider matching their asset portfolio to the claims liability expected to arise from the pre-claims liability. Insurers should hold investments carried at amortised cost and at fair value in order to address the issue of pre- and post claims liability. Any impact from changes in interest rates is unlikely to be significant for a liability with a duration of 12 months or less. An insurer s balance sheet contains a number of other items as part of liabilities and equity, which balance against total assets that are not insurance liabilities. These include items such as subordinated debt, preference share capital, bank loans, accounts payable and accruals, as well as equity items like share capital and retained earnings which are all recorded at historical or amortised cost. Therefore, the assets which are in effect backing such liabilities and residual equity are likely candidates for being measured at amortised cost. The implications quantified In order to emphasise the potential issues faced by the insurance industry when adopting IFRS 9, Ernst & Young performed a survey based on the current classification of financial assets employed under IAS 39 by insurers reporting under IFRS across Europe, South Africa, Asia and Australia. This survey is based on the information published in the 2010 financial statements. The analysis focused on investments other than those specifically identified in the financial statements as being held on account of unit-linked policyholders. Below are the results of the survey and our view of the impact. In line with our expectation, insurers who are predominantly active in continental Europe and the US market classify over 60% of their investments as available for sale AFS. These AFS investments are generally held by their subsidiaries backing insurance liabilities measured on a locked-in basis. Designating investments as AFS results in unrealised fair value changes being reported directly in equity rather than 6

7 Movements in the investment values will largely offset movements in the insurance liabilities as a result of changing financial inputs. profit or loss. Measuring insurance liabilities with locked-in assumptions, together with the use of shadow accounting, limits the profit or loss volatility arising from movements in interest rates. With the elimination of the AFS category upon the introduction of IFRS 9, insurers will need to consider whether they are able to classify investments at amortised cost or must classify and measure them at fair value through profit or loss. Insurers who have principal insurance subsidiaries in the UK, South Africa and Australia designate more than 60% of their investments at fair value through profit or loss. These insurers will likely continue with that classification to a large extent under the current IFRS 4 but might consider holding some investments at amortised cost. It is useful to note that some of these insurers also have a portion of their investments designated as AFS investments to support the insurance liabilities of their US or continental European subsidiaries. Due to the differing current investment classification in these locations, these insurers would likely conduct separate classification exercises under IFRS 9 for the businesses based in these countries upon the adoption of the financial instrument accounting standard. As IFRS 9 prohibits reclassification from fair value through profit or loss to amortised cost after initial designation, insurers should diligently and strategically redesignate their investments prior to transition to IFRS 9. To bring to light the specific challenges that insurers will face in implementing IFRS 9, we focused our analysis on the composition of the AFS category of financial investments. We found that debt securities make up more than 60% of the insurers AFS portfolio. This is particularly relevant because it is likely that only some debt instruments will qualify for classification as amortised cost under IFRS 9. Even though a majority of investments classified as available for sale are debt instruments, these would not necessarily meet the characteristics of the asset test under IFRS 9. Hence, a further analysis is required to ensure that these investments are eligible to be measured at amortised cost under the new accounting standard for financial instruments. Measure by measure Synchronising IFRS 9 and IFRS 4 Phase II for Insurers 7

8 Conclusion Concluding points and recent IASB discussions The IASB expects to issue the new IFRS 4 standard by the end of We anticipate and hope that the effective dates of both IFRS 9 and IFRS 4 will be aligned. If they are not, insurers will need to undergo two separate asset classification exercises once for the implementation of IFRS 9, and then another when the new IFRS 4 is implemented. This is because insurers, especially those with large portfolios in continental Europe, the US and Japan, are likely to favour different investment classifications under the different regimes as they seek to minimise profit and loss volatility and accounting mismatches. Under IFRS 4 Phase II, insurance liabilities measured at the present value of fulfilment cash flows will have all changes in estimates reported in profit or loss. In order to achieve consistent measurement on the asset side, insurers may be inclined to value much of their financial investments at fair value through profit and loss. Different conclusions may be reached for the residual margin, pre-claims liability for short-duration contracts, shareholders equity and other liabilities. For assets backing those items, fair value would introduce an accounting mismatch and earnings volatility not currently experienced. As a result, those assets might be better held at amortised cost. If an insurer applies amortised cost, those instruments need to pass the two IFRS 9 tests (business model and characteristic of the financial asset). A thorough investigation into the specific types of investments is merited before an insurer concludes that amortised cost may be applied. Concerns surrounding earnings volatility have surfaced in response to the IFRS 4 Phase II Exposure Draft especially in light of the severe market circumstances experienced during the recent financial crisis. While it is fair to say that the greater part of earnings volatility following the measurement model proposed in the ED will come from duration mismatches between investment assets and insurance liabilities, fluctuation in spreads that are embedded in market interest rates will also be a notable issue. Following the comments from the constituents on the ED, the IASB discussed proposals that might reduce the volatility in profit or loss upon the adoption of IFRS 9 and IFRS 4 Phase II. The first proposal relates to the use of a locked-in discount rate for discounting the expected future cash flows of the insurance contract when it aligns with the way insurance contracts are managed as part of the insurer s business model. The second proposal relates to the possibility of using OCI to report movement of insurance liabilities caused by changes in discount rates. The IASB subsequently affirmed their tentative decision that the discount rate should be current rate that is updated each reporting period. They concluded that the current rate is an important aspect of providing useful information about insurance contracts and therefore it should not be locked-in. In a recent meeting, the IASB also tentatively decided to adjust the residual margin subsequently for changes in estimates of future cash flows but has not yet taken a decision on how to treat changes in discount rates under the model. Therefore the IASB will continue to discuss how the potential for earnings volatility, including from financial assumption changes, can best be addressed. The IASB is considering the use of OCI for some or all assumption changes and is also elaborating on a measurement model for participating contracts that somewhat differs from the building block approach. The discussions will need to be held together with the Financial Accounting Standards Board (FASB, and together with the IASB, the Boards) because the insurance contracts project is a joint project of the Boards. The resolution for the earnings volatility issue embodies a critical milestone for the insurance model that is inextricably linked with the accounting for financial instruments. The outcome of those discussions will be a very important consideration for assessing whether and to what extent an insurer should hold investments at amortised cost. 8

9 How can Ernst & Young help? Issues and steps Gain a general understanding of the new or proposed accounting standards Perform a preliminary assessment of the impact of the proposal on the company s financial statements and regulatory capital Benchmark the company against peers and others in the industry Assess processes for data collection, internal controls, IT systems Assess tax positions relating to the new or proposed accounting standards Plan for ultimate implementation of the new or proposed standards Advise management during the implementation Communicate effect of implementation to stakeholders analysts, regulators, shareholders How Ernst & Young can help Design and deliver a training session for company personnel on the accounting implications of the new or proposed standards Share insights of IASB views, including interpretations Advise and provide input into: Gathering necessary scoping information to implement the new or proposed standards Calculating the income statement impact of implementing the new or proposed standards Assessing impact on key financial ratios and performance measures Identifying shortfalls in available information to implement the new or proposed standards Assessing impact on regulatory capital For non-audit clients, Ernst & Young can provide support, through the use of an automated tool, to determine the characteristics of financial assets for IFRS 9 classification. This tool is able to run queries through large data sets and identify features to help determine fair value classification using information from external data vendors. The use of this tool can reduce the time needed to analyze instruments that would require fair value classification based on characteristics of the instrument. This automated approach is also available for use on contractually linked instruments. For audit clients, Ernst & Young can use the tool to evaluate assessments made independently by company management. Provide observations of how others are approaching the new or proposed standards, problems they are identifying and solutions developed Assist in the evaluation of peers, competitors, industry disclosures and the expected impact on the financial statements Provide observations and insights based on leading practices regarding ways the company could design its business processes, IT systems, and internal controls to capture information necessary to apply new or proposed standards Perform an impact assessment of IFRS 4 phase II on company s business processes and systems by using Ernst & Young s web-based Gap Analyser tool Provide criteria to consider in selecting IT packages, and assist in the selection process Assist in analyzing tax positions arising from adopting the new or proposed standards, reducing tax exposure, and determining tax effects of any accounting changes Advise on the implementation of the new or proposed standards using an established methodology Advise regarding your project maintenance and planning, including timeline, tasks, and resource allocation Advise where the new or proposed standards require careful use of judgment Assist in reviewing and providing input into accounting manuals and policies selected by management Assist in providing coordinated support with Ernst & Young subject matter resources (regulatory, tax, finance transformation, etc.) on a global basis Provide assistance in developing a communication plan and drafting communications Measure by measure Synchronising IFRS 9 and IFRS 4 Phase II for Insurers 9

10 Contacts Tara Kengla EMEIA Financial Services Financial Accounting and Advisory Services Leader Michiel van der Lof EMEIA Financial Services IFRS Leader Country leaders Belgium Sylvie Goethals sylvie.goethals@be.ey.com Peter Telders peter.telders@be.ey.com Channel Islands Chris Matthews cmatthews@uk.ey.com France Amaury de la Bouillerie amaury.de.la.bouillerie@fr.ey.com Loic Moan loic.moan@fr.ey.com Germany Edgar Loew edgar.loew@de.ey.com Martin Gehringer martin.gehringer@de.ey.com Ireland Vincent Bergin vincent.bergin@ie.ey.com Italy Wassim Abou Said wassim.abou-said@it.ey.com Ambrogio Virgilio ambrogio.virgilio@it.ey.com Luxembourg Aida Jerbi aida.jerbi@lu.ey.com Netherlands Peter Laan peter.laan@nl.ey.com Christine Holmes christine.holmes@nl.ey.com Spain Manuel Martinez Pedraza manuel.martinezpedraza@es.ey.com Jose Carlos Hernandez Barrasus josecarlos.hernandezbarrasus@es.ey.com Switzerland Stefan Schmid stefan.schmid@ch.ey.com John Alton john.alton@ch.ey.com United Kingdom Sarah Williams swilliams10@uk.ey.com Tony Clifford aclifford@uk.ey.com Kevin Griffith kgriffith@uk.ey.com 10

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12 Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 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 their potential. Ernst & Young 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 clients. For more information about our organization, please visit About Ernst & Young s Global Insurance Center Insurers must increasingly address more complex and converging regulatory issues that challenge their risk management approaches, operations and financial reporting practices. Ernst & Young s Global Insurance Center brings together a worldwide team of professionals to help you achieve your potential a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant industry issues. Ultimately it enables us to help you meet your goals and compete more effectively. It s how Ernst & Young makes a difference EYGM Limited. All Rights Reserved. EYG No. AU NY This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.