Introduction. Agenda. Financial Instruments. Ian Manktelow Senior Manager Ernst & Young LLP. Canadian Institute of Actuaries November 10, 2005

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1 ASSURANCE AND ADVISORY BUSINESS SERVICES Financial Instruments Canadian Institute of Actuaries November 10, 2005 Introduction Ian Manktelow Senior Manager Ernst & Young LLP Agenda The context surrounding the creation of the new financial instrument rules Overview of the new rules and the importance to Canadian life insurers Classification of investments and the impact on life company volatility Derivatives and hedge accounting Deferred tax implications 1

2 A Change in the Direction of Canadian Standard Setting Part of trend toward global/us GAAP convergence and fair value accounting Draft plan Accounting Standards Board Plan is for Canadian GAAP to converge with IFRS by 2011 for public companies Canada will continue to maintain its standard setting authority though it will evolve to match proposed strategies The new financial instruments rules move Canadian GAAP closer to both US GAAP and IFRS The new rules are similar (but not the same) to FAS 115 and FAS 133 in the US and IAS 39 Internationally Financial Instruments - Overview Financial instruments scoped out of CICA 4210 which is renamed CICA 4211 New standards include: S. 3855, Financial Instruments Recognition and Measurement S. 3865, Hedges S. 1530, Comprehensive Income Numerous consequential amendments to other standards Effective for annual and interim periods in fiscal years beginning on or after October 1, 2006 Financial Instruments - Overview Covers all types of financial instruments and certain contracts to buy or sell non-financial items Applies to all derivatives, including embedded derivatives Excludes: Equity accounted or consolidated investments Equity instruments issued by entity Intended to harmonize with SFAS 115 and SFAS 133 (as amended) while permitting alternatives not available under US GAAP Also intended to harmonize with IAS 39 2

3 Significant Changes from Existing Canadian GAAP Canadian life insurers no longer have special investment accounting rules Classification of all financial assets and liabilities into prescribed categories All derivatives on balance sheet New Statement of Comprehensive Income Hedge ineffectiveness recorded in P&L Importance to Canadian Life Insurers Abandonment of move-to-market and deferred realized gain accounting for bonds, stocks and mortgages No change for real estate Increased volatility in the surplus segment Volatility in the liability segment will depend on asset classification CALM will minimize for assets classified as trading, receivables and held-to-maturity Regardless - More line item volatility Financial Instruments - Categories Financial assets to be classified as Held for trading Held to maturity Loans and receivables, or Available for sale Financial liabilities Held for trading Other 3

4 Held for Trading (1) Can be in trading if the asset is not a loan or receivable and is: Acquired or incurred principally for the purpose of selling or repurchasing it in the near term; Part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking OR A derivative (except derivatives that are designated and effective hedging instruments) (2) Designated by the entity upon initial recognition as held for trading Any financial instruments within the scope of s.3855 may be designated when initially recognized as held for trading, except for: Financial instruments whose fair value cannot be reliably measured; and Financial instruments transferred in a related party transaction that were not classified as trading before the transaction Held for Trading Reclassification of a financial instrument into or out of trading category while it is held or issued is not permitted Carry at fair value on balance sheet with unrealized gains and losses included in Works well with CALM Availability of market values limits use Held to Maturity Investments Non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has Positive intention and Ability to hold to maturity Carry at amortized cost using the effective interest method 4

5 Held to Maturity Investments Works well with CALM Limitation on ability to sell/transfer these assets An entity cannot classify any financial assets as HTM when during the current year or during the 2 preceding years, it has sold or reclassified more than an insignificant amount of HTM investments before maturity US GAAP differs tainting cannot be cured and no exception for insignificant sales Risk of tainting entire HTM portfolio and requirement to reclassify HTM portfolio to AFS Loans and Receivables Non-derivative financial assets resulting from the delivery of cash or other assets by a lender to a borrower in return for a promise to repay on a specified date or dates, or on demand, usually with interest Could include mortgages Does not include debt securities and loans and receivables designated as trading or AFS Carry at amortized cost using effective interest method Available for Sale Catch-All Category Debt or equity securities Carry at fair value on balance sheet with unrealized gains and losses included in equity (OCI), net of tax Realized gains and losses reclassified from equity (OCI) to Equity instruments that do not have a quoted market price in an active market are measured at cost even if classified as AFS Problematic under CALM 5

6 Comprehensive Income Covered by new handbook section S Special equity account that rolls and accumulates similar to retained earnings Statement of Comprehensive Income to have the same prominence as other financial statements in both annual and interim financial statements Temporary location for gains and losses on: Available for sale financial assets Cash flow hedges Unrealized gains and losses for other accounting items Financial Instruments Category Insert Initial table Subsequent ASSETS LIABILITIES Loans and receivables Available-forsale Held-tomaturity investment Held for trading Other measureme nt Fair value Fair value Fair value measurement Amortized cost using the effective interest method Fair value Fair value Amortized cost using the effective interest method Gains and losses in net when the asset is derecognized; impairment write-downs and foreign exchange translation adjustments recognized immediately in net in other comprehensive ; transferred to net when the asset is derecognized. Impairment writedowns recognized immediately in net immediately in net in net when the liability is derecognized. Foreign exchange translation adjustments recognized immediately in net Bonds Comparison to Section 4210 Trading 4210 Available For Sale Held-to- Maturity Carrying Value Realized Gains & Amortized Cost Deferred & Amortized in in Amortized Cost in Unrealized Gains and Interest Not recognized unless loss is other than of discount or premium in of discount or premium in OCI unless loss is other than of discount or premium Not recognized unless other than of discount or premium 6

7 Mortgages Comparison to Section 4210 Trading 4210 Carrying Value Realized Gains & Unrealized Gains and Interest Amortized Cost Deferred & Amortized Not recognized unless loss is other than of discount or premium of discount or premium Available For Sale in OCI unless loss is other than of discount or premium Loans and Receivables Amortized Cost in Not recognized unless impaired of discount or premium Stocks Comparison to Section 4210 Trading 4210 Carrying Value Realized Gains & Unrealize d Gains and Dividend Adjusted cost (moved to market) Deferred & Amortized at 5% per quarter Move-tomarket at 5% per quarter. Available For Sale in OCI unless loss is other than Held-to- Maturity N/A N/A N/A N/A Financial Instruments Other Aspects of Measurement Financial assets not recorded at fair value are reviewed for impairment Other than impairment concept for bonds and stock classified as AFS and bonds classified as HTM Loan loss provision rules for loans and receivables Investment in equity instruments that are not classified as held for trading and do not have a quoted market price are measured at cost Financial liabilities not held for trading are measured at amortized cost 7

8 Derivatives and Hedge Accounting Derivatives must now always be carried at fair value on the balance sheet regardless of whether or not they are in a hedging relationship Embedded derivatives must generally be bifurcated from the host Change in derivative fair value goes through unless the strict hedge documentation requirements are met in which case one of three hedge accounting regimes applies Hedge accounting is still optional and essentially the same guidance as current GAAP applies as to the hedge documentation required to obtain hedge accounting No hedge documentation = no hedge accounting There is now prescriptive guidance on how hedge accounting is performed depending on the type of hedging relationships: Fair value hedge Cash flow hedge Hedge of net investment in self-sustaining foreign operation Hedges A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Key aspects: Hedged item is exposed to price risk Changes in fair value of hedged item and hedging instrument (derivative) are recorded in earnings Basis of hedged item is adjusted by the change in value Cash Flow Hedges A cash flow hedge is a hedging relationship where the variability of the hedged item s cash flows is offset by the cash flows of the hedging instrument. Key aspects: Hedged item is a forecasted transaction or balance sheet item with variable cash flows Effective gain or loss of hedged item (derivative) reported in OCI Earnings recognition matches hedged transaction Ineffective gain or loss recorded in earnings 8

9 Hedges Yes Is instrument a stand alone or embedded derivative? Record at fair value in balance sheet No Hedging Standard does not apply Fair value hedge Cash flow hedge Hedge of a net investment in a foreign operation All other situations To Earnings Hedge item marked to fair value through earnings for changes caused by hedged risk To Other Comprehensive Income to extent of hedge effectiveness OCI balance reclassified to earnings at same time as hedged item To OCI To extent of hedge effectiveness To Earnings Derivatives (if in hedging relationship) Comparison to CICA 4210 and AcG- CICA 3855 & 3865 Current GAAP 13 (Old) (New) Carrying Value No specific guidance Requirement to establish hedge effectiveness Onerous documentation requirements Onerous documentation requirements Unrealized Gains & Realized Gains & No specific guidance No specific guidance (fair value hedge) or OCI to the extent effective (cash flow hedge) Derivatives (if NOT in hedging relationship) Comparison to Current GAAP CICA 4210 and AcG-13 CICA 3855 & 3865 Carrying Value / Adjusted Cost (move-to-market) Unrealized Gains & Market to Market / Move-to-market at 5% per quarter Realized Gains & Market to Market / Move-to-market at 5% per quarter 9

10 General Criteria for Hedge Accounting Generally no different from current Canadian GAAP or US GAAP At the inception, all of the following conditions must be satisfied Identify and designate the hedging relationship Formal documentation of details of the hedging relationship Reasonable assurance that the relationship is effective Reasonable assurance that the relationship is effective throughout the term. Quarterly testing may be required in some cases. Differences from US GAAP Mortgages can be classified as trading or available for sale under the new Canadian rules Held-to-maturity investment tainting can be cured and there are exceptions for insignificant sales Deferred taxes Fair value adjustments may represent timing differences for which undiscounted deferred taxes are recognized on the balance sheet The change in the deferred tax balances from period flow through either or comprehensive depending on the classification of the invested assets to which they relate The discounting of the deferred taxes remains in the actuarial reserves 10

11 Questions? 11