Implications of Exposure Draft IFRS 4 Phase II and its Implementation

Transcription

1 Implications of Exposure Draft IFRS 4 Phase II and its Implementation Institute of Actuaries of India Conference 17 October 2011 Gautam Kakar

2 Agenda Definition and scope of contracts Measurement Model High level overview Individual building blocks Short duration contracts Contract Boundary Unbundling Recognition / derecognition of contracts Participating contracts Reinsurance Presentation of results Disclosures Transition 2

3 Insurance industry performance The insurance market has underperformed the market FTSE100 Insurance companies in FTSE Dec-06 Source: Datastream Dec-07 Dec-08 Dec-09 Dec-10 3

4 Definition and scope of contracts Exposure Draft Definition A contract under which one party accepts significant insurance risk from another party by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder Insurance risk is defined as any risk other than financial risk Significant risk implies a scenario with commercial substance where the present value of cash outflows can exceed the present value of the premium 4

5 Definition and scope of contracts Exposure Draft Scope Some contracts are excluded from the scope of the definition including: Product warranties issued by a manufacturer, dealer or retailer Residual value guaranteed provided by a manufacturer, dealer or retailer as well as a lessee s residual value guarantee embedded in a financial lease Contingent consideration payable in a business combination Employers assets and liabilities under employee benefit plans Insurance contracts that the entity holds as a policyholder (this excludes reinsurance contracts) Financial guarantee contracts can no longer be treated as financial instruments if they meet the insurance definition Fixed fee service contracts, where the primary purpose is the provision of services are excluded from the scope. Financial instruments containing discretionary participating features are included in the scope (assuming the contract itself falls under scope) 5

6 Definition and scope of contracts Implementation aspects Observations The definition of an insurance contract is largely unchanged from IFRS 4 but guidance is more prescriptive The discretion in the treatment of financial guarantees may allow inconsistent interpretation by companies Implementation: The standard applies to all entities, i.e. not just insurers Some contracts may no longer meet the insurance definition Non-clarity: The ED wording is such that it will not always be clear whether a fixed fee service contract is in or out of scope 6

7 Definition and scope of contracts Update Feedback Pressure to return to the original IFRS 4 definition because: It is well understood It has not generated any issues in practice Some reinsurance contracts covering an entire pool of risks, may not meet the definition criteria because the chance of a loss might be extremely remote, even though individual contracts would typically have significant insurance risk IASB Update Rejected proposal to revert to current IFRS 4 definition to ensure only insurance contracts receive insurance accounting Clarified that a risk transfer is deemed significant if the reinsurance contract transfers substantially all of the risks in the underlying contracts Option to account financial guarantees under IFRS 9 7

8 Measurement model high level overview Exposure Draft Guidelines A single measurement model is developed to calculate the present value of the fulfilment cash flows using the following building blocks: Eliminates day 1 gain Residual margin Risk adjustment Present value of fulfilment cash flows Time value of money Current unbiased probability weighted estimate of future cash flows 8

9 Measurement model high level overview Implementation aspects Observations IFRS 4 currently defers largely to local GAAP, which reduces comparability Exit value notion as compared to that of a fulfilment value Liabilities are presented as a single item on the balance sheet The use of IAS 21 for overseas liabilities avoids some of the current mismatches, particularly for property and casualty insurers Implementation: The measurement model (except for the debate on residual margin component), is a current model and hence requires updating at each reporting period The model prohibits a day 1 gain, but losses are recognised immediately The FASB model uses a composite margin instead of the separate risk adjustment and residual margin approach meaning the IASB model may recognise more losses 9

10 Measurement model cash flows Exposure Draft Guidelines Included if they are incremental at the portfolio level and upto the boundary of the contract Need to arise in the fulfilment of the existing contract Acquisition costs need to be directly attributable to the sale of a policy Should be an explicit, unbiased and probability weighted estimate Based on current estimates that reflect the perspective of the entity Market variables should be consistent with observable market prices Reflect policyholder behaviour including contract features which allow a change in amount, timing or the nature of benefits 10

11 Measurement model cash flows Implementation aspects Observations Single point estimates will no longer be sufficient The definition of acquisition expenses may be narrower than local GAAP Exclusion of general overheads will understate liabilities Implementation: Significant changes to models and systems will be required Expense allocation systems may need adjusting for the narrower definition Method of selling contracts, i.e. direct sales or third party, would impact results Non-clarity: Limited guidance on determining which costs are incremental at the contract or portfolio level, e.g. non-commission acquisition costs, and which to exclude Policy loans secured against insurance contracts may be either included in cash flows or separately assessed under IFRS 9 11

12 Measurement model cash flows Update Feedback IASB Update Move to a fulfilment value notion generally well received Many felt the definition of acquisition costs was too narrow, with particular pressure to move to a portfolio level Pressure to also include overhead costs because they are included in pricing models Concern over the level of stochastic modelling expected, in particular for low frequency but high severity events Agreed to move to a portfolio definition for acquisition costs Tentative agreement to include costs for both successful and unsuccessful acquisition efforts to avoid penalising insurers with predominantly direct sales Agreed direct overheads could be included in the cash flows Clarification that expected value refers to the mean value Clarification that it is not necessary to quantify all possible scenarios in all circumstances 12

13 Measurement model discount rate Exposure Draft Guidelines The discount rate is used to adjust the cash flows for the time value of money They should be consistent with observable market prices for instruments with cash flows whose characteristics match those of the liabilities in terms of timing, currency and liquidity Where contract cash flows depend on the performance of specific assets, their measurement shall reflect that dependence Calculated as risk-free rate plus an adjustment for illiquidity, i.e. bottomup approach Should not reflect the risk of non-performance of the insurer 13

14 Measurement model discount rate Implementation aspects Observations Discount rates will not be based on the actual assets backing the liabilities Multiple curves might be required for contracts with different benefits Accounting mismatch as change in price of credit risk would affect value of assets but liability measurement excludes some of this market movement Could lead to more volatile profits Potential day 1 losses because discount rate is lower than in premium setting Implementation: Complexities arising from using a curve and determining rates at extreme durations Potential for accounting mismatches Insurers might not be able to capture the asset illiquidity premia in practice Non-clarity: Determining which liabilities ought to have a discount rate adjusted for illiquidity Determining how to calculate the illiquidity adjustment itself 14

15 Measurement model discount rate Update Feedback Life insurers concerned that fluctuations caused by the discount rate are not reflective of their business Concerns over the feasibility, objectivity and comparability of the illiquidity adjustment Some opposition to the prescription of a bottom-up rate IASB Update Confirmed that government bonds are not always risk free Agreed to revoke the prescription of a bottom-up rate and allow a top down approach to be used Rejected proposal to use pricing assumptions Confirmed a practical expedient would not be provided In favour of not discounting cash flows with insignificant financing requirements, e.g. non-life pre-claims liabilities 15

16 Measurement model risk adjustment Exposure Draft Guidelines The definition of the risk adjustment initially proposed: the maximum amount the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows exceed those expected Recent update compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfils the insurance contract There are 3 permitted techniques to calculate it: Confidence level, i.e. value at risk Conditional tail expectation, i.e. tail value at risk Cost of capital Must disclose the confidence level the risk adjustment corresponds to, even if the conditional tail expectation or cost of capital techniques are used The proposals require the adjustment to be measured at the portfolio level 16

17 Measurement model risk adjustment Implementation aspects Observations Move to an explicit margin is a major change from current implicit models Cost of capital approach may differ from other applications e.g. pricing Diversification benefits from different portfolios are not allowed Profit emergence will differ depending on the technique used Implementation: Calculating probability distributions which bear the scrutiny of market disclosures Selecting the calculation technique to use Selecting the confidence level at which to set the risk adjustment Care needs to be taken to ensure risks are not duplicated Non-clarity: The intended meaning of maximum and exceed in the definition Specification of the 3 techniques would appear to rule out a future, better method 17

18 Measurement model risk adjustment Update Feedback Generally positive comment outside USA because the explicit adjustment is a current and transparent measure Some opposition because of concerns the information is subjective, costly, open to manipulation and inconsistent with the fulfilment value notion Usefulness of a confidence level equivalent questioned Requests for differ to replace exceed in the definition of the risk adjustment Proposal for changes in the risk adjustment to be recognised in income and not in the residual margin IASB Update Decision to eliminate the limitation of 3 permitted techniques to measure risk adjustment Tentative agreement to recognise changes in the risk adjustment in income rather than in the residual margin 18

19 Measurement model residual margin Exposure Draft Guidelines A residual margin arises when: PV of future inflows > PV future outflow + risk adjustment Determined within a portfolio by date of inception and length of contract The amortisation basis is defined as follows: on the basis of the passage of time, but on the basis of the expected timing of incurred claims and benefits, if that pattern differs significantly from the passage of time i.e. in a systematic way that represents the insurance coverage Assumptions are locked in, i.e. the residual margin is not re-measured Set to zero if a contract terminates or lapses Accretes interest at the discount rate used at inception 19

20 Measurement model residual margin Implementation aspects Observations Increases likelihood and potential level of day 1 losses A favourable change in assumptions on day 2 is a recognisable gain Represents future shareholder profits plus the general overheads and nonincremental acquisition costs allocated to the contract Amortisation done without reference to profit emergence Implementation: Tracking the residual margin and its release will be complex and require system development Certain products will have a back-ended amortisation pattern inconsistent with the provision of services Non-clarity: Unclear whether the amortisation pattern can change 20

21 Measurement model residual margin Update Feedback Most insurers complained that locking in the margin is inconsistent with the rest of the current value model If the margin is locked in then insurers want to use it as a shock absorber for non financial estimate changes Complaints that the amortisation methods are inconsistent with the economies of the contracts IASB Update Use of the residual margin as a shock absorber rejected Agreed to unlock the residual margin for estimate changes Adjusted for both favourable and unfavourable changes No limit to the change (cannot be negative) Should only be made prospectively Amortisation pattern should be consistent with transfer of services under the contract Decisions were very tentative!!! 21

22 Measurement model short duration contracts Exposure Draft Guidelines A simplified measurement model mandated for contracts of approximately one year or less which do not contain embedded derivatives or options Two components to the simplified model: a) Pre-claims liability, i.e. unearned premium reserve b) Liability adequacy test, i.e. onerous contracts test Pre-claims liability is measured as: Initial premium + future expected premiums incremental acquisition costs Pre-claims liability is amortised in a similar way to the residual margin The liability adequacy test checks whether the present value of the fulfilment cash flows exceeds the pre-claims liability and if so expenses the excess Observation Property and casualty insurers might have to apply two different calculation methods to contracts where only the contract term differs 22

23 Measurement model short duration contracts Implementation aspects & update Implementation: Requirement to use two measurement models for short duration contracts is an added complexity and unlikely to reduce workload Requirement to amortise the pre-claims liability in a way which reflects the seasonality of claims might be a new approach Liability adequacy test could be at a lower level than current accounting practice Non-clarity: Unclear whether an insurer would be allowed/required to release any pre-claims liability in the event that a claim curtails coverage Unclear if the amortisation pattern can change in response to changes in the pattern of expected claim and benefit payments IASB Debate Approximation to the full model Less restrictive interpretation of approximately one year Simplified model should be permitted rather than mandated 23

24 Measurement model contract boundary Exposure Draft, implementation aspects & update The boundary of an insurance contract is the point at which: Guidelines IASB Update the insurer is no longer required to provide coverage, or has the right or the practical ability to reassess the risk of the particular policyholder and, as a result, can set a price that fully reflects that risk. Implementation: May impact the treatment of certain contracts, e.g. health contracts, where the regulator imposes constraints on re-pricing for individual policyholders Duration of some contracts might be reduced under the new definition, which may result in the insurer recognising a loss Tentative agreement to modify the definition of the contract boundary such that the ability to re-price risk now rests at the portfolio level 24

25 Measurement model unbundling Exposure Draft, implementation aspects & update Guidelines IASB Update Insurers are required to unbundle components which are not closely related, e.g. embedded derivatives When unbundling an account balance the charges and fees are not considered part of the investment component Implementation: Measurement approach will depend on whether a contract is unbundled and which components are unbundled Different interpretations could lead to different earnings profiles Approach to unbundling could incur significant costs Non-clarity: Terms such as closely related open to interpretation Unclear how the account charges would be allocated between the different components of the contract Embedded derivatives unbundled when not closely related Goods and services unbundled when revenue recognition project one performance obligation criteria met Account balances unbundled when credited with an explicit return 25

26 Measurement model recognition & derecognition Exposure Draft, implementation aspects & update Guidelines IASB Update Contracts are recognised at the earlier of when bound by the contract or exposed to the risk under the contract Contracts are derecognised when the obligations are discharged, cancelled or expire Implementation: Contracts will be recognised before they commence which may create reporting and systems difficulties The recognition definition is different from the contract commencement date currently used Legal requirements in local territories may mean contracts are recognised at different times Non-clarity: No guidance on when a substantial modification to a contract should be accounted for as an extinguishment of the contract Agreed to recognise contracts at the start of the coverage period An onerous contracts test will still be required to avoid material misstatement in the accounts 26

27 Measurement model participating contracts Exposure Draft, implementation aspects & update Guidelines IASB Update Contracts measured in the same way as any other contractual cash flow Investment contracts can also be under scope Contract boundary for investment contracts is the point at which they no longer have a contractual right to participate Implementation: How to decide on a dividing line where the pool consists of a limited/immaterial amount of participating insurance contracts How to treat contracts which can choose to switch between unit linked funds and funds with discretionary participating features Non-clarity: Unclear how future contracts would be within the boundary of existing contracts and the implications of this on inherited estates Agreed for the policyholder participation to be measured on the same basis as the underlying assets 27

28 Measurement model reinsurance contracts Exposure Draft, implementation aspects & update Guidelines Observation Measured in the same way as for other insurance contracts Where the net cost exceeds the expected value of the recovery a residual margin is set up in the reinsurance asset If the net cost is less than the expected value of the recovery then an immediate gain is recognised Risk of non-performance should be included on an expected value basis when estimating the fulfilment cash flows of the reinsurance asset Reinsurance balances should not offset contract balances Insurance liability and reinsurance asset not necessarily the same value IASB Update Reinsurance gains may now be deferred by setting up a residual margin and recognised over the coverage period 28

29 Presentation Exposure Draft Guidelines The Statement of Comprehensive Income (SoCI) must show as a minimum: Underwriting margin Gains/losses at initial recognition Non incremental acquisition costs Experience adjustments and changes in estimates Interest on insurance liabilities For the pre-claim liability of short duration contracts insurers should show: Underwriting margin Changes in liability for onerous contracts Premiums, claim and other expenses are treated as deposit receipts/payments and are not presented on the SoCI, except for short duration contracts 29

30 Presentation Implementation aspects Observations All lines on the SoCI link back to the building blocks All items from insurance contracts are shown in the income section of the SoCI Other Comprehensive Income not used Represents a significant change from the cash flow revenue account presentation insurers currently use to present results Asset/liability mismatches will be shown in the SoCI Implementation: Insurers who do not report embedded value will find the new format more difficult than those that do Conglomerate groups will need to consider how to present their combined result, e.g. with respect to premium income Changes will be needed to general ledgers and accounting systems Management, analysts and investors will need to be educated Non-clarity: A number of areas lack detail, e.g. where to present ceded reinsurance items or interest on the residual margin 30

31 Disclosures Exposure Draft Guidelines Overarching principle: To help users understand the amount, timing and uncertainty of future cash flows arising from insurance contracts Quantitative and qualitative information about the amounts recognised in the financial statements and the nature and extent of risks is required Reconciliations are required from the opening to the closing aggregate insurance and reinsurance balances for a number of items Specific minimum line items are specified for these reconciliations Methods used and the processes for determining the inputs Measurement uncertainty analysis of inputs that have a material effect on the measurement Claims development tables required initially for 5 years, but rising to 10 Different reporting segments are not permitted to be aggregated 31

32 Disclosures Implementation aspects Observations The disclosures are more detailed than currently required Comparability of the risk adjustment may not work Additional supplementary reporting information still likely to be required focusing on shareholder value and the amounts and timings of expected distributable earnings Implementation: The sheer volume of information will be onerous to produce Systems might need to be developed to produce the reconciliations Data capture and management may require modifying to ensure all the requirements can be met Analysts will require additional shareholder cash flow information Non-clarity: Reconciliation of contract balances mixes two distinct analysis approaches and its interpretation is unclear for some cash flows Limited guidance on how to determine explanatory items in the reconciliation and in what order 32

33 Disclosures IASB Updates Aggregation level IASB agreed on Principles based aggregation levels and decided not to retain ED s minimum disaggregation level Measurement Uncertainty ED s proposed requirement to disclose a measurement uncertainty analysis has been deleted. However disclosure of effect of each change in inputs and methods on measurement of insurance liabilities is still required, along with explanation of the reasons for the change Liquidity Risk Maturity analysis to be based on expected maturities and the option to use remaining contractual maturities has been removed 33

34 Transition Exposure Draft Guidelines Full retrospective application for in-force contracts with no grandfathering of past practices Each portfolio of insurance contracts measured as the present value of the fulfilment cash flows which will exclude any residual margin Existing deferred acquisition costs will be written off Other intangible assets arising from insurance contracts assumed in previous business combinations will be written off Insurers can redesignate an asset currently measured at amortised cost to fair value through profit and loss, but not vice-versa Early adoption is permitted but this must be disclosed 34

35 Transition Implementation aspects Observations The extent of the opening retained earnings adjustment will depend on past accounting practices and contract profitability In-force contracts will have less future profit than new business because of the lack of a residual margin Estimation of a proper risk adjustment for the in-force contracts at transition is crucial because it will be the primary source of future accounting profit Implementation: For long-term insurers, profit that would have been recognised in future periods will now be recognised in equity Determining assumptions to use to calculate the risk adjustment at transition and the implications this has on future periods Deciding whether or not to value assets at fair value Cannot revalue assets currently at fair value at amortised cost Careful communication of the impact the transition has had on current and future accounting will be needed 35

36 Insurance project still some way to go Exposure draft Definition and scope Fulfilment cash flows, including acquisition costs Discount rate Risk adjustment Residual margin Participating contracts Modified/UPR approach Unbundling Reinsurance Performance statement Transition/disclosure Re-deliberations No significant change from ED - except financial guarantees Some change from ED Some change from ED Some change from ED; re-deliberations ongoing Potentially significant change; re-deliberations ongoing Potentially significant change; re-deliberations on-going Re-deliberations ongoing Some change from ED Some change from ED; re-deliberations on-going Re-deliberations ongoing Not yet re-deliberated 36

37 Summary Key challenges Ensuring data is captured at a sufficient level of granularity Updating systems, accounting and actuarial models to be able to report under the new guidelines Agreeing which contracts fall under scope and the degree of unbundling required Deciding the level of prudence to include in the risk adjustment Determining the amortisation pattern for the residual margin Interpreting the areas of uncertainty in a manner which does not disadvantage the company compared to its peers Ensuring staff and management understand the new requirements Uncertainty around when to implement the standard Communicating the impact the new guidelines have on key metrics and being able to successfully explain the effect transition has on profit 37

38 Thank you Gautam Kakar Principal Consultant, UK + 44 (0) gautam.kakar@uk.pwc.com All rights reserved. Not for further distribution without the permission of. "" refers to the network of member firms of PricewaterhouseCoopers International Limited (IL), or, as the context requires, individual member firms of the network. Each member firm is a separate legal entity and does not act as agent of IL or any other member firm. IL does not provide any services to clients. IL is not responsible or liable for the acts or omissions of any of its member firms nor can it control the exercise of their professional judgment or bind them in any way. No member firm is responsible or liable for the acts or omissions of any other member firm nor can it control the exercise of another member firm's professional judgment or bind another member firm or IL in any way.