WHAT IS EXPECTED IN ROMANIAN INSURANCE MARKET AFTER IFRS 4 PHASE2

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1 WHAT IS EXPECTED IN ROMANIAN INSURANCE MARKET AFTER IFRS 4 PHASE2 Camelia Stefan PhD. Student Academy of Economic Studies Bucharest, Romania Luciana Rabu PhD. Student Academy of Economic Studies Bucharest, Romania Abstract: Romanian Insurance Sector will enter in a new stage of reform in the near future if IFRS 4 Phase 2 will be implemented. According to the current status of searching and development, some changes regarding evaluation and reporting of financial instruments are expected. Also, considering that Romania is part of European Union, local authorities have initiated an international strategy to improve the financial reporting. According to the current status, IASB recomanded and local autoritys showed their intention to ask for a double reporting maner (local accoding to the current principles and reporting according to IFRS 4 Pahese 2 reporting principles). Our research inteds to analyse the impact of this change for Romanian Insurance Companies. JEL classification: M41, M48 Key words: IFRS, insurance contracts, valuation of financial instruments 1. LITERATURE REVIEW: In 1997 IASB thought that a dedicated standard for insurance contracts was considered to be prepared. Based on that idea, a first result was. In 2002 it was decided to split this standard for insurance companies in 2 phases. Starting with January 2005, IFRS 4 Phase 1 has been required in European Union. This was an important change for the insurance industry. Even though, according to the first stage, many local accounting policies were accepted and not so many limitations of classify or valuate the assets or liabilities were imposed. The result of not having limited reporting rules was that Financial Statements were not easy to be compared. For IFRS4 Phase 2, a second step was done in September 2004 when IASB started to work for continue what was already done by IFRS4 Phase 1. In 2007 was published Preliminary Views on Insurance and an updated version was published in In 2010 IASB made public a request for comments and proposals from insurance market s actors. Year 2011 was expected for having in place IFRS 4 Phase 2, but, according to the current status of set up, there is not any chance to expect this change earlier than This qualification as: high impacts expected, can be easily sustaind by the lack of previous experiences considering that never before it was passed a comparable change in the insurance accounting and reporting world. Also, there has been no chance

2 to empirically evaluate the hypotheses presented. Dickinson and Liedtke 1 (2004) did a comprehensive survey of insurance business leaders to ascertain their opinions about this problem. Local preparation for implementation of IFRS 4 updated are related to the following area.: o According to KPMG s analysis 2, 3-5 years of prepares are estimated by the countries, so the expectation for starting to work with the new version is From the countries there is a feedback that 86% already started the preparations: tracings for the employees from Finance, Controlling, Actuarial and Risk, meeting with audit o commissions, progress status presentations. At that moment, only 29% from the countries started already the modeling the impact of the proposals. The motivation was based on the requirements of Solvency 2 that is asking for the same profiles (actuaries, finance people) and for this case the deadline for go live is much closer. This period used for the analysis is taking place at the same time when changes are expected for IAS 18, IAS 37, IAS 39, IFRS 7 There also expectations regarding the impact of other changes: o valuation of financial instruments (IFRS 9, IAS 32, IAS 37); o effort to combine Solvency 2 requirements with IFRS 4 Phase 2 requirements in order to minimize the costs. 2. OBJECTIVES The article presented by us is based on the fact that we consider important to analyze the consequences of introducing IFRS Phase 1 in Romanian Insurance Comanies in order to extrapolate this impact for IFRS Phase 2 implementation. We see this implementation as a serious challenge for the insurance industry. According to the current status of implementing IFRS in Romanian: Banks are using IFRS starting with January 2012; Listed companies are starting the implementation in 2012 and they must prepare Financial Statements at 31 December 2012 according to IFRS; according to the current legal requirements IFRS 1 is not applicable in this case; Insurance companies are starting preparation for the transition to IFRS: o 01 January 2012 will be considered as transition date and opening balances for 2012 will be retreated according to IFRS; o IFRS 1 will be applicable. o Financial Statements at 31 st of December 2012 will contain a limited number of reports; a complete set of Financial Statements will be prepared at 31 st of December The regulator of Insurance Industry (Insurance Supervisory Commission) has decided to apply a pilot for a limited number of companies from the industry: 10 companies with foreign capital and 1 Romanian insurance company are in scope for thin implementation. Local transition to IFRS means a complex exercise for alignment that requites efforts from many areas than financial department and accounting activities.

3 The impact of change the accounting standards applied as local standards (replacement of Romanian Local Standards by IFRS) will have an impact for the following areas: quality and flexibility of reporting, complexity/ structure of the organization. Considering the high impact expected by this change, each and every company that will be in scope for this implementation should consider some changes to be done: identify and apply different treatments and accounting principles and asses from the beginning the impact on financial results; identify and asses the fiscal impact of recalculate the results; change of reporting requirements prepared by the companies are expected to be considerably much detailed presented ; assess the impact of changes related to processes, systems, data bases and the implementation of new reports; change management: a communication strategy and learning period is required in order to train the people affected by the new rules. 3. METHODOLOGY Transition date for IFRS will be considered the beginning of the first period when the company prepares a complete set of Financial Statements according to IFRS by preparing and presenting an opening IFRS statement of financial position at transition date. 1 st January st December st December 2013 IFRS Transition date Comparative Financial Financial Statements Statements according to IFRS Statement of Financial position Statement of Financial position Statement of Financial position Transition disclosure Statement pf comprehensiv income Statement pf comprehensiv income Statement of changes in equity Statement of changes in equity Statement of chash flows at 31st of Dec 2012 Statement of chash flows at 31st of Dec 2013 Disclosures Disclosures Steps to be performed: 1. Update of the accounting policies according to IFRS rules Considering that the opening balances of Financial Statements at transition date must prove that all the standards have been applied, considering the exceptions from IFRS 1: o Use IFRS standards at transition date; o Settle the applicable standards; o Settle the exemptions 2. Prepare of opening balances of Financial Statements considering all the adjustments required by the alignment: o Recognition of assets and liabilities according to IFRS rules and derecognition of assets and liabilities which don t respect IFRS rules; o Reclassification of assets and liabilities according to IFRS rules; o Revaluation of assets and liabilities according to IFRS rules;

4 o Consider the awareness that retrospectively calculation of estimations and classifications of financial instruments is not accepted. 3. Establish the list of applicable and not applicable rules according to IFRS 1 exceptions An entity that applies for the first time IFRS rules must consider the requirements presented by IFRS 1 First-time Adoption of International Financial Reporting Standards. The objective of this IFRS is to ensure that an entity s first IFRS financial statements, and its interim financial reports for part of the period covered by those financial statements, contain high quality information that: (a) is transparent for users and comparable over all periods presented; (b)provides a suitable starting point for accounting in accordance with International Financial Reporting Standards (IFRSs); and (c) can be generated at a cost that does not exceed the benefits [IFRS1 1]. Considering the main rule that all the assets and liabilities must be adjusted as if they had been applied IFRS rules from the set up of the company, IFRS 1 accepts exceptions to the retrospective application of IFRS rules: o De-recognition of financial assets and financial liabilities o Business combinations o Share-based payment transactions o Insurance contracts o Deemed cost o Leases o Cumulative transaction differences o Investment in subsidiaries, joint ventures and associates o Compound financial instruments o Designation of previously recognized financial instruments o Fair value measurement of financial assets or financial liabilities at initial recognition o Decommissioning liabilities included in the cost of property, plant and equipment o Financial assets or intangible assets accounted in accordance with IFRIC 12 o Borrowing costs o Transfer of assets to customers o Extinguishing financial liabilities with equity instruments o Severe hyperinflation o Joint arrangements [IFRS1 1] Explain transition s effects by reconciliation The following checklist can be considered when Financial Statements are prepared: 1st Jan st Dec st Dec Statement of Financial Position x x x Statement pf Comprehensiv x x

5 Income Statement of changes in Equity x x Statement of Cash Flows x x Reconciliation of Equity x x Reconciliation of Comprehensive Income x 4. ANALYSIS Differences IFRS- local GAP During the current period, according to the legislation in force, insurance companies must apply the requirements presented by Order no. 3129/ to approve accounting regulations in line with insurance-specific European Union directives. Description Definition of insurance contracts Structure of Statement of Comprehensive Income Gross written premiums 2005 Order no. 3129/ Is not presented Structured into 2 parts: technical and non-technical Statement Revenues from insurance contracts related to reporting period IFRS 4 Is presented and the differences are clear presented Statement of Comprehensive Income New business Is not presented Assets and liabilities related to insurance contracts are registered by using the Fair Value Liabilities Ask to compute and register technical reserves; Shadow accounting is not mentioned; Liability adequacy test- is not presented; Discretionary participation features in insurance contracts- clasified as liability. IAS/ IFRS Not defined yet Is not define clearly which type of technical reserves are mandatory; Shadow accounting is mentioned; Liability adequacy test- is required at each reporting date; Discretionary participation features in insurance contractsclasified as equity or liability. Deferred acquisition cost (DAC) Consists in directly attributable expenses and indirect expenses Reinsurance There is not required any test to measure the reinsurance assets deprreciation. This type of expenses is not presented by IFRS as a deferred expense and also there is not presented a depreciation method. Reinsurance assets must be tasted for depreciation. Financial classification assets Long investments: term in IAS32: financial instruments at ;

6 affiliates/subsidiaries, borrowings and receivables from affiliats/ subsiadiaries. Short term investments ; Listed/ nonlisted Shares; Investments in mutual funds; Deposits; Investments related to insurance contracs; Receivables. Fair Value through P&L (assets classified by nature); Loans and receivables; Held to maturity- classified at acquisition date; Held for trading; Derivatives Not presented Presented as instrument with dedicated recognition, de-recognition and valuation method. Amortized cost, effective yield IAS 32 Financial Instruments; IAS 32 Financial Instruments; IAS 32 Financial Instruments; IAS 39 Financial Instruments Not presented Presented IAS 39 Financial Instruments IFRS 4 Phase 1 brings also a very important classification that should be considered by insurance companies before implementation (during preparation period) and of course after the implementation: the difference between insurance risk and other risks. Life insurance contracts which guarantee a minimum rate of return to policyholders and also a benefit in case of realized claim (death of the beneficiary). Financial risk is related to possible underling financial instruments price, foreign exchange rates, index of prices fluctuations. The contracts that are not registered as insurance contracts should be registered as investment contracts. In May 2007 IASB launched the public consultation on the proposed version of Accounting Standard for Insurance. IFRS 4 Phase2 intents to touch the following areas: measurement, presentation, reorganization and derecognizing. At this moment, IFRS 4 is only an interim standard and permits a wide variety of accounting practices for insurance contracts. Many of these practices make it difficult to understand insurers financial statements and differ from those used in other sectors. The paper proposes that an insurer should measure its insurance liabilities using the following three building blocks: o explicit, unbiased, market-consistent, probability-weighted and current estimates of the contractual cash flows; o current market discount rates that adjust the estimated future cash flows o for the time value of money; an explicit and unbiased estimate of the margin that market participants require for bearing risk (a risk margin) and for providing other services, if any (a service margin). According to the proposed version: it is proposed that the valuation of the insurance contracts is made by using current exist value. This value is defined as the amount the insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another entity. Regarding the valuation method, there are 2 proposals: using IFRS 7 or to use current fulfillment value 4. The analysis related to the definition of current

7 fulfillment value showed that this term should be able to offer a clear described measurement attribute that provides a coherent framework to resolve new and emerging issues. When it was chosen this combination of words for the phrase, it was recommended to use some expected worlds as follows: value, present. As current value was not considered precise enough they think to add also fulfillment. Considering or not the valuation method, insurance company should take care of the following elements: o to prepare a forecast for cash flow ; o to calculate the actual value for the future receivables; o to have available a calculation for the margins: risk margin, margin for o other services if necessary; none of the valuation methods is not taking into consideration to recognize any future revenues, so all the revenues should be correlated with the premiums settlement. International Standards Accounting Board (IASB) intends by IFRS 4 Phase 2 to establish in the public interest, a single set of high quality, global accounting standards that require transparent and comparable information in general purpose financial statements (IASB, 2007a, p. 3). So, the main aim of the new version of IFRS 4 is to bring a consistent approach in Financial Reporting trought the entire country and also through the entire area that applyes these rules. 4.1 Critical IAS 39 will be replaced starting January 2013 with IFRS 9. Considering the changes announced from IFRS 9, it is expected that only 2 valuation methods will be used: o amortized cost for the financial instruments which are registered based o on the expected yield; fair value for all the other assets that doesn t belong to the first category. The rules from IFRS 9 are already adopted and they will be used for the financial statements from In order to apply the requirements for Solvency 2 it is expected that the assets will exceed the liabilities in order to cover the risks. In addition, the credit risk and operational risk will require to be offset. As a first impact, it is expected that the cost of additional risks, mandatory to be registered, will need additional capital. From here, it is very easy to remark that any risk will be analyzed based on the capital cost. According to IFRS 4, the adequacy test means that for each moment the insurer should compare the debs with the present value of future incomes. Any negative difference will be reported as realized loss. 5. CONCLUSIONS Considering the activities required by IFRS implementation but also the interdependencies with other changes in insurance industry we conclude that is not an easy process the impact will be high. IFRS will increase transparency due tomore, or better, comparable information across companies and countries.

8 REFERENCES 1. Dickinson, G., and P. M. Liedtke, Impact of a Fair Value Financial Reporting System on Insurance Companies: A Survey, The Geneva Paperson Risk and nsurance: Issues and Practice, 29: , *** kpmg.com/ifrs THE NEW WORLD FOR INSURANCE, Preparation and readiness for accounting change- an industry survey 3. *** INFORMATION FOR OBSERVERS, Board Meeting: 18 September 2008, London, Project: Insurance, Subject: Fulfillment value 4. *** Order no. 3129/2005 to approve 5. accounting regulations in line with insurance-specific European Union directives (Published in the Official Gazette, Part I no of 29 December 2005) 6. *** IFRS 4; 7. *** IFRS 9; 8. *** IFRS 1;