SESSION/SÉANCE: IFRS 4, Phase II Update on new standards for insurance contracts CIA Appointed Actuaries Seminar Toronto, September 20, 2012

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2 SESSION/SÉANCE: IFRS 4, Phase II Update on new standards for insurance contracts CIA Appointed Actuaries Seminar Toronto, September 20, 2012 SPEAKER(S)/CONFÉRENCIER(S): Jacqueline Friedland, FCIA, FCAS, MAAA Partner & P&C Actuarial Practice Leader Page 1

3 Our agenda 1. Refresher 2. Key decisions since Exposure Draft (ED) 3. Outlook for convergence of IASB and FASB 4. Some nitty-gritty details 5. Re-exposure and effective date 6. Are we ready? Page 2

4 Refresher IASB Project to Replace IFRS 4 Progress to Date Project Phases IASB Discussion paper Preliminary Views on Insurance Contracts (May 2007) Current Exit Value Approach FASB invitation to Comment wrapping IASB paper (August 2007) FASB joins IASB project (October 2008) IASB Exposure Draft (July 2010) FASB Discussion Paper (September 2010) Final IFRS re-exposure draft is not expected before late in 2012 FASB Exposure Draft also targeted for late 2012 but being reconsidered First time application to be established (Boards intent was to align effective date with IFRS 9 Financial Instruments 2015? 2016?) Page 3

5 Insurance Contracts Key Decisions of IASB Since ED Issue Reconfirmation of key aspects of the model 4 building blocks model Measurement at portfolio (vs. contract) level Premium allocation approach (unearned premium) approximates building blocks model Discount rate No linkage between assets actually held and the discount rate used for liabilities This has been the most controversial issue for Canadian life insurers, less so for P&C insurers Volatility No linkage between assets and liabilities can lead to unrealistic short term volatility Tentative decisions to date Separately determined risk margins Acquisition costs at portfolio level Use of premium allocation approach permitted for short term business, but is not required Allow either a top down approach, starting with an asset rate, or a bottom up approach starting with a yield curve IASB has tried to address some industry concerns, but largely confirmed its positions Two sided OCI interest rate changes in liability measurement to be recorded in other comprehensive income (OCI) as would FV changes in certain assets The above requires changes in IFRS 9 to reintroduce something similar to the old AFS Page 4

6 IFRS and US GAAP The Outlook for (Non) Convergence June 5 and 7 statements by FASB Chair Leslie Seidman seem to rule out converged standards in the near future: Despite attempts to reach agreement with IASB on several issues, FASB has been unable to do so areas cited in particular: Separately determined risk margins in the IASB model Treatment of certain policy acquisition costs Timing and classification of changes in liability assumptions FASB will issue an ED but it won t look like IASB s proposals FASB is not dropping the project, and will continue to work with IASB Page 5

7 Some Nitty-Gritty Details Measurement model 3 or 4 building blocks? Fulfilment cash flows Identification and treatment of acquisition costs Time value of money Use of OCI to address discount rate volatility Risk adjustment Residual margin Relative size of the risk adjustment and residual margin (Robert Micollis) FASB single margin Premium allocation approach Page 6

8 IASB Stage II Insurance Contracts Update Measurement Model 3 or 4 Building Blocks? Four Building Blocks IASB Preference (modified to exclude day one gains) Expected future cash flows explicit, unbiased and probability-weighted estimates of future cash outflows less future cash inflows Time value of money discounted using current rates to reflect the time value of money Risk adjustment to adjust for the effects of uncertainty about the amount and timing of future cash flows Residual margin to remove any profit at inception and release over time Three Building Blocks FASB Preference (modified to exclude day one gains) Expected future cash flows explicit, unbiased and probability-weighted estimates of future cash outflows less future cash inflows Time value of money discounted using current rates to reflect the time value of money Composite margin to remove any profit at inception and release over time Page 7

9 Building Block 1 Fulfilment Cash Flows Recap Explicit, unbiased mean of both outflows and inflows clarifications indicate that it is not intended that stochastic methods are implied or required Include all costs directly attributable to the portfolio (acquisition and maintenance) but therefore not all company costs acquisition and maintenance expenses will typically fall short of total company expenses acquisition expenses excluded constitute loss on sale Page 8

10 Building Block 1 Identification and Treatment of Acquisition Costs Identification IASB tentative decision is that acquisitions costs are to be identified on a portfolio basis allows inclusion of variable but indirect costs of selling and originating new business (decision confirmed in May 2012) US FASB implemented a change in US GAAP to a narrower definition of acquisition costs effective 2012, and has voted against the IASB approach Limits acquisition costs to those directly identifiable with the sale of a specific policy, and only for successful efforts (EITF 07-G) Given the recent change in US GAAP, it is hard for FASB to reverse themselves and align with IASB New US GAAP change aligns with non-insurance IFRS approach to revenue recognition and acquisition costs Treatment Acquisition costs are part of fulfilment cash flows, and not an asset In the building blocks model, acquisition costs reduce the residual margin required In the premium allocation approach, acquisition costs reduce the preclaims liability (unearned premium) Page 9

11 Building Block 2 Time Value of Money In principle, not a change in Canada, for either life or P&C insurance. However, discounting is the exception for P&C insurers outside of Canada and Australia. Existing IFRS 4 Permits but does not require discounting - but does not allow a change from discounting to undiscounted insurance liabilities Permits but does not require the continued use of a discount rate including future investment margins but does not allow moving to adopt such a rate The original ED proposals had two points of controversy for Canadian insurers: Breaking the linkage between the discount rate used for liabilities, and the return expected from the investments held resulting in unrealistic volatility in income (and capital) Proposing the use of low or no-risk discount rates, typically well below the rates built into life insurance product pricing resulting in unrealistic profit recognition and liability valuation Page 10

12 Building Block 2 Discount Rate Alternative Approaches Asset rate > Liquidity premium Risk- free rate ED: Bottom up approach? Top down alternative Credit risk Tentative decisions of the IASB: Reflect the characteristics of the liability No linkage to assets No locking in of the rate Allow a top down approach as an alternative, starting with an asset rate The top down alternative Deduct risks not present in the liability IASB: bottom up and top down should get to the same place but in practice? Might reduce but not eliminate problems of volatility and losses at inception What asset rate can you use as a starting point? IASB prefers debt securities only Page 11

13 Building Block 2 Discount Rate Applying the Top Down Approach Asset rate > Liquidity premium Risk- free rate ED: Bottom up approach? Top down alternative Credit risk Deducting credit risk Expected and unexpected credit defaults can be determined using the insurer s own methodology, not market credit spreads Why would there be a gap between bottom up and top down in practice? Market yields tend to include premiums related to sentiment, inefficiencies, frictional costs Methods for long durations? Need other approaches where insurance contracts have durations beyond those that are reliable and observable Page 12

14 Building Block 2 Use of OCI to Address Discount Rate Volatility May 2012 decision by IASB to introduce a 2-sided OCI approach to keep some short-term volatilities and mis-matches out of the income statement The Boards made the following tentative decisions: Interest expense is recognised in profit or loss by discounting current estimates of future cash flows at a locked-in discount rate determined at inception. Changes in the insurance liability arising from changes in discount rates (other than the unwind of the locked-in discount rate presented in profit or loss) would be presented in OCI. All other changes in the insurance liability, unless they are recognised as an adjustment to the residual margin, are recognised in profit or loss. Require changes in the insurance liability arising from changes in discount rates to be recognised in OCI regardless of classification and measurement applied to insurer s underlying assets Approach would reduce P&L volatility from interest rate changes but not necessarily in capital Approach would not eliminate mis-matches in many circumstances (e.g., where an insurer uses non-financial instruments as backing assets) Page 13

15 Building Block 3 Risk Adjustment Tentative decisions the risk adjustment: Should be the compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfils the insurance contract Would be determined at the level of a portfolio of insurance contracts Would be re-measured each reporting period and changes in measurement of the risk adjustment would be recognised in profit or loss Is not limited to determination by any prescribed method Disclosures would require information about the implied confidence level Page 14

16 Building Block 4 Residual Margin IASB confirmed the proposal in the ED that a residual margin would arise at inception when the present value of the fulfilment cash flows is less than zero The residual margin would be determined on initial recognition at a portfolio level for contracts with a similar inception date and coverage period Tentative decision by the IASB that the residual margin should not be locked in at inception Other tentative decisions of the IASB are that an insurer should: Adjust the residual margin for favourable and unfavourable changes in the estimates of future cash flows used to measure the insurance liability, with experience adjustments recognised in profit or loss Not limit increases in the residual margin Recognise changes in the risk adjustment in profit or loss in the period of the change Make any adjustments to the residual margin prospectively Insurers should allocate the residual margin over the coverage period on a systematic basis that is consistent with the pattern of transfer of services provided under the contract Page 15

17 Relative Size of the Risk Adjustment and Residual Margin (Robert Micollis) 1. The size of the risk adjustment relative to the residual margin is likely to be substantially different for different types of insurance products, different portfolios of such products, and different maturities of such portfolios. 2. The risk adjustment is a function of the knowledge of the underlying cost elements costs to fulfill the contract(s) and an assessment of the risk and uncertainty associated with the estimates of those costs. 3. The risk adjustment is not a direct function of estimated profit at issue, but residual margin is. 4. The risk adjustment is reflective of the compensation required by the insurer for risk. 5. The residual margin is reflective of the compensation that the insurer was able to achieve in the marketplace, in excess of the expected value of the costs (NPV) to fulfill the contract(s) and the compensation required by the insurer for risk and uncertainty related to the estimates of expected costs. 6. Consequently, the range of the relative size of risk adjustment to residual margin could be quite wide Page 16

18 FASB Single Margin FASB has tentatively decided: An insurance contract measurement model should use a single margin approach. An insurer satisfies its performance obligation as it is released from exposure to risk as evidenced by a reduction in the variability of cash outflows. An insurer should not re-measure or recalibrate the single margin to recapture previously recognised margin. The FASB tentatively decided that an insurer is released from risk for the purpose of recognising the single margin in profit as follows: If the variability of the cash flows of a specified uncertain future event is primarily due to the timing of that event, then an insurer is released from risk on the basis of reduced uncertainty in the timing of the specified event. If the variability of the cash flows of a specified uncertain future event is primarily due to the frequency and severity of that event, then an insurer is released from risk as variability in the cash flows is reduced as information about expected cash flows becomes more known throughout the life cycle of the contract. A significant difference between the IASB and FASB: re-measurement (IASB) vs. locked-in (FASB) FASB s decision did not address specific methods for how an insurer would determine when it is released from its exposure to risk Page 17

19 Premium Allocation Approach IASB considers the Premium Allocation Approach (PAA) to be a short cut or simplification of the four building blocks model not a different model (FASB sees as a separate model) The approach uses an unearned premium calculation to establish a pre claim liability Eligibility of contracts for the PAA: Insurance contracts with a coverage period of approximately 12 months or less, if there are no embedded options or derivatives that significantly affect cash flows If a reasonable approximation of the building block approach results IASB would permit but not require use of PAA Page 18

20 Premium Allocation Approach Measurement Details Pre-claims liability Unearned premium, pro rata calculation Reduced by acquisition costs and no deferred acquisition cost asset Discounting may be required practical expedient to ignore discounting of pre-claims liability if coverage period after premium is paid is one year or less Onerous contract test similar to premium deficiency test today Claims liabilities Discounted cash flows, with an express risk margin similar to current practice Outlook PAA will be available and will likely be selected for most P&C insurance; it could be used for some life insurance business, but is not mandatory Page 19

21 Effective Date Current Outlook? Little or no formal guidance, but IASB board members have indicated not before 2015 Expect IASB to issue a re-exposure draft of the standard in late 2012 and final standard sometime in 2013 Other indicator timing of IFRS 9 Financial Instruments IASB has consistently expressed desire for IFRS 9 and the new Insurance Contracts standard to be available at the same time Postponement of mandatory effective date from 2013 to 2015 Targeted improvements in IFRS 9 are to be considered to address interactions with the insurance project Prognosis: effective date in 2015 is still technically possible, but 2016 (or later) is far more likely Page 20

22 Are we ready? Recent survey findings: The big problem is uncertainty Insurers fear political meddling Insurers want a global framework Companies are stuck in a wait and see mode Boards have little awareness of change Insurers doubt the benefits Page 21

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