A Way Forward for Participating or Discretionary Benefits
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1 IAA Life Section April, 19 th 2007 A Way Forward for Participating or Discretionary Benefits Stefan Engeländer DAV 1
2 Agenda I. Varying Features II. IFRS and Solvency III. Recognition IV. Measurement 2
3 Agenda I. Varying Features II. IFRS and Solvency III. Recognition IV. Measurement 3
4 Varying Features Features allowing insurers to vary premiums or benefits are typical for long term life insurance but exist as well in many other products Features affect significantly insurers profitability and solvency Features shaped significantly by national legal environment and local tradition Many forms: unit, investment, index, performance linked, participating, premium or benefit adjustment, variable benefits 4
5 Range of Features Full guarantees, potentially matched or reinsured (no varying feature) Guarantees expressed in a currency Guarantees expressed in another, external index Obligation refers to specified amounts, but adjustable Premium/benefit adjustment clauses Adjustable dividend scales Obligation refers to a share in performance, with limitations Performance linkage with guaranteed minimum benefit or maximum premium (often with proportional share for insurer) Performance linkage with minimum profit for insurer Full Performance linkage = no risk born by insurer Insurance at cost (cattle guilds) Partial: Investment linkage 5
6 Possible Classification Obligations referring to specified amounts expected to be payable in the normal course of events (potentially adjustable in unexpected situations) = adjustable obligations Obligations referring directly to a share in performance, payable in the normal course of events (potentially a fixed amount applies in unexpected situations) = performance oriented obligations 6
7 Obligating Features? Legal constraints Regulatory constraints Presumed regulatory constraints Market practices (protection of entity s reputation) Fiduciary position (protection of management s reputation) Economic compulsion (protection of intangible assets) Pure discretion (improvement of business) 7
8 Agenda I. Varying Features II. IFRS and Solvency III. Recognition IV. Measurement 8
9 Aims of Reporting IFRS: Describing stockholders profitability in the normal course of events, possibility of deviations considered in margins Solvency: Describing resource needs for a defined horizon under emergency circumstances, allowing a fresh start of the portfolio afterwards 9
10 Resulting Issues IFRS: How does the feature affect profitability in the normal course of events? Solvency:How does the feature affect net resources in emergency situations? 10
11 Agenda I. Varying Features II. IFRS and Solvency III. Recognition IV. Measurement 11
12 Recognition of a Liability Liability for future effects of varying features? IAS 37 requirement: Enforceable obligation Many varying features: Resulting financial reports not useful Framework definition refers as well to: business practice custom good business relations equitable manner Only economic compulsion and pure discretion no liability 12
13 Economic Compulsion Economic compulsion: Protection of earnings by achieving future customers contracts and persistency of existing contracts Purpose: Securing current economy of scales protection against anti selection intangible assets 13
14 Economic Compulsion Incomplete financial report recognizing current economy of scales recognizing current avoidance of anti selection ignoring self generated intangible assets (customer relationship, persistency) Recognition of self generated intangible assets as well key for recognition of economic compulsion 14
15 Economic Compulsion Investigation needed: What is the economic consequence from payments under economic compulsion? When is that consequence recognized? To be useful: Consistent recognition required! Economy of scales Avoidance of anti selection Consideration of future persistency under guaranteed insurability 15
16 Pure Discretion Future effects of varying feature at the discretion of the insurer (or under economic compulsion related to unrecognized consequences) No liability today although expected never to be distributed to stockholders Part of the profitability of current contracts expected to be used for profitable future business decisions = attract new business or achieve (unrecognized) future persistency 16
17 Agenda I. Varying Features II. IFRS and Solvency III. Recognition IV. Measurement 17
18 Measurement Two approaches exist: Consideration of expected cash flows under the varying feature together with other contractual cash flows (cash flow approach) Measurement of guarantees and reporting policyholders share in resulting surplus to be recognized as liability on top (share approach) Possibly modification of overall risk margin applied considering effect on risk pattern 18
19 Cash Flow Approach Ideal in case of adjustable obligations: Current estimate: Estimation of the expected cash flows under each scenario including corresponding adjustments to premiums/benefits (consistent with discount rate) Risk margin: Determined considering the variation for each scenario risk margin reduced, if adjustable benefits are reduced in case of losses risk margin increased, if adjustable benefits are increased in case of advantageous development 19
20 Cash Flow Approach Application of fair value requirements to discount rate: No anticipation of future investment earnings in excess of current market interest rate consider explicitly investment income offsetting adjustable amounts, annual results discounted with current market interest rate or applying an increased discount rate providing for the adjustable benefit 20
21 Share Approach Ideal in case of performance oriented obligations Determination of fictive exit value of the guaranteed element (1) Together with all other IFRS surplus subject to the performancelinkage resulting in an IFRS pre refund surplus per period Determination of obligatory share of policyholders in that pre refund surplus (2) Determination of risk margin (considering already included risk margins in exit value of the guaranteed element) on potential future losses to be born by the insurer and compensation by future shares in surplus (price of the guarantee, that policyholders share only in surplus) (3) Insurance liability equals sum of (1), (2) and (3) 21
22 Share Approach Is share approach fair value? Not fair value of future cash flows, but fair value of current right to share in recognized surplus Cash flow approach would result in less useful information, if the financial report is not entirely at fair value! Target of financial reporting is not fair value, but a useful information! Differences Share in current surplus to be allocated to future policyholders under current obligations Policyholders share in difference between fair value of insurer and recognized value 22
23 Share Approach Position of the IASB from scratch on: Modifications of fair value approach if obligations depend on performance of the insurer If obligation is a share in recognized surplus, the liability equals that share in recognized IFRS surplus plus a risk margin for the inability to forward future losses to policyholders (Agenda Paper 7B March 2006 Case A) 23
24 Risk Margin Complexity of adjustable amounts and shares in performance risk margins will often cause release from risk recognition of profit close to statutory profit pattern, without initial gains or losses Losses very rare under a participation approach risk margins rarely determinable based on cost of capital, risk margins reflect the variation of profit Risk margins will contain cost of regulatory imposed capital requirements, if not included in the current estimate Except that, risk margins will cause relatively stable profits, considering the smoothing impact of varying features 24
25 Emergency Situations Is there an ability to cover current losses in emergency situations by reducing unallocated past surplus or even future participating benefits from future surplus expected otherwise to be paid to policyholders in the normal course of events? Or is past surplus irrevocably allocated to policyholders? future surplus to be forwarded to policyholders irrespective losses occurred in the past? 25
26 Solvency Measurement Fair value at end of coming year: Based on the future obligation of any transferee after an emergency situation of the current insurer Capital requirement: Based on risk after variation of benefits or premiums in case of emergency situation. IFRS liabilities established for policyholders share in past surplus are capital, if allowed to be used to cover losses Future distributable surplus only anticipated, if current losses release transferee from payment to policyholders 26
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