IFRS Seminar for Regulators Accounting and Regulatory Issues Insurance Sector

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REPARIS A REGIONAL PROGRAM IFRS Seminar for Regulators Accounting and Regulatory Issues Insurance Sector Session 2: Implications for regulators of

1 REPARIS A REGIONAL PROGRAM IFRS Seminar for Regulators Accounting and Regulatory Issues Insurance Sector Session 2: Implications for regulators of IFRS4 Phase I versus Phase II Teddy Nyahasha May 31, 2011 THE ROAD TO EUROPE: PROGRAM OF ACCOUNTING REFORM AND INSTITUTIONAL STRENGTHENING (REPARIS)

2 Outline Introduction Phase I - Headlines Phase II - Headlines Provision for Outstanding Claims Phase I vs. Phase II Key changes Wider Implications 2

3 Introduction Technical provisions represent the most significant liability item in an insurance company s financial statements In most countries in Europe there is a general requirement that technical provisions for regulatory purposes should follow generally accepted accounting principles applied to such provisions included in the financial statements The calculation of the technical provisions, can be an extremely subjective area due to inherent uncertainty understatement of outstanding claims provisions is one of the major factors in insolvencies of insurance companies The presentation will focus on non-life insurance technical provisions; and we will consider the key valuation principles and methodologies for determining non-life outstanding claims provisions in Europe under phase I and the changes under phase II 3

4 Phase I - Headlines IFRS 4 applies to virtually all insurance contracts (including reinsurance contracts) that an entity issues and to reinsurance contracts that it holds The standard effectively allows insurers to maintain whatever accounting policies they had for the measurement and recognition of insurance contracts prior to adopting IFRS 4. However it: prohibits provisions for possible claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions) requires (i) a test for the adequacy of recognised insurance liabilities and (ii) an impairment test for reinsurance assets requires an insurer to keep insurance liabilities in its balance sheet until they are discharged or cancelled, or expire, and prohibits offsetting insurance liabilities against related reinsurance assets and income or expense from reinsurance contracts against the expense or income from the related insurance contract 4

5 Phase I Headlines (cont) In the context of the EU, the European Insurance Accounts Directive (IAD) prescribes the format for disclosure of non-life technical provisions as follows: Provision for unearned premiums; Claims outstanding (including claims handling expenses); Provisions for bonuses and rebates (significant for life insurers but not non-life); Equalisation provision; Other provisions (including provision for unexpired risks) An important requirement in the IAD states the amount of technical provisions must at all times be such than an undertaking can meet any liabilities arising out of insurance contracts as far as can reasonably be foreseen. What does this mean in practice? Two main approaches, and interpretations, have emerged in Europe: Provisioning based on a best estimate basis (i.e. 50% confidence level); and Provision based on prudent level to ensure adverse run-off 5

6 Phase II Headlines FASB and IASB joint project A measurement approach for insurance contracts conceptually should: Make use of 4 building blocks Use estimates of financial market variables that are as consistent as possible with observable market prices No recognition of revenue on day 1 to offset acquisition expenses Unearned Premium Reserve (UPR) being adopted for short duration contracts There are a number of areas where the FASB and IASB have taken different approaches creating uncertainty around the standard and timetable 6

7 Provision for Outstanding Claims Case provision for notified outstanding claims (agreed and not yet agreed) Incurred but not reported (IBNR) provision = Notified claims to date (agreed and not yet agreed) less paid claims to date = Ultimate claims costs less notified claims to date Total provision = Case provision plus IBNR provision It should be noted that whilst the provision for outstanding claims can, and is, usually analysed between reported claims outstanding (based on case estimates) and the IBNR provision, it is total provision, and not the analysis between the two elements which is important for financial statements and regulatory purposes. Many estimation techniques project total claims incurred for a particular class of business from which claims paid and reported claims are deducted to determine the IBNR provision. Reported claims R + = IBNR Total Provisions 1 March 2010 Page 11 7

8 Provision for Outstanding Claims (cont) Regardless of the complexity of the technique that is used to estimate provisions, there are a number of underlying uncertainties, which mean there will always be an element of estimation It is therefore key that a user of financial statements no only understands the current methodologies used but any changes and the impact of those changes The following is a list of some of the common factors that contribute to the complexity and uncertainty of the calculation: Delays in the reporting or processing of claims (some of the delays could be due to delay in brokers submitting data); Determining whether the insurer is liable ; Impact of inflation; Large or unusual claims (e.g. Catastrophe claims); Discount rates (where applied) 8

9 Phase I vs. Phase II: Key Changes The total profit over the years is unchanged from phase I to phase II, the timing of the profit recognition can be significantly affected as a result of a move to phase II proposals Premiums must be reported in the year that the policy is incepted under phase II, resulting in profits (or losses) usually being higher than under existing practice in Year 1, but lower in Year 2 The addition of the risk margin under IFRS phase II has the effect of smoothing the probability, reducing profit in early years and increasing profit in the later years as the risk margin is released Acquisition costs cannot be deferred under IFRS Phase II Setting higher risk margins (through higher capital cost or requirements) does not change the total profit. They lead to reduced profits in earlier years balanced by higher profits in later years. 9

10 Phase I vs. Phase II Key Key Changes Unearned Premium Reserve (UPR) For contracts under which claims have yet been incurred, liabilities will have to be determined by projecting expected future cash flows Existing models use UPR (less acquisition cost) as a proxy for this liability. The IASB state: unearned premium may sometimes provide reasonable approximation to current value if contract is not likely to be highly profitable/unprofitable and circumstances have not changed since inception. Recognition Rights and obligations are recognised when insurer becomes party to the contract, not at the inception date of the contract This, together with the removal of Deferred Acquisition Costs (DAC), will lead to recognition on an underwriting year basis 10

11 Wider implications Phase II will result in greater use of statistical methods and these could vary from one insurer to the other. It is therefore important that the regulator understands the basis of determining provisions Statistical techniques produces results that are only as good as the quality of the underlying data; in assessing the quality of data used, the supervisor should consider the way claims are subdivided by the insurer Expect greater available capital volatility; due to movements in discount rates; and assumptions such as payment patterns However, also expect greater consistency between companies over time 11

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