Participating Contracts Insurance IFRS Seminar December 2, 2016 Eric Lu Session 27
Overview
Product Classification Direct participating contracts Indirect participating contracts Non-participating contracts Contracts with asset-dependent cash flows Other Insurance contracts, investment contracts with DPF and reinsurance contracts held 3
Contract with Asset Dependency Asset dependency is acknowledged in IFRS 17 as the situation when the amount, timing or uncertainty of the cash flows that arise from an insurance contract depends wholly or partly on the returns on underlying items. The difference from those contracts that do not have this dependency is based on a number of key requirements: Discount rates must take into account the dependency with the underlying items; and Future cash flows must include all payments arising from existing contracts that provide policyholders with a share in the returns on underlying items, regardless of whether those payments are made to current or future policyholders. Generally speaking the asset-dependent contracts depend on assets. But these contracts should expand the participation to other types of underlying items (e.g. entity s profit). For simplicity, we will still refer the contracts as asset-dependent contracts. 4
Contract with Asset Dependency Products with asset-dependent cash flows = insurance products providing payments to policyholders that vary with the returns on underlying items. Underlying items (held directly by the entity or used as a reference assets), refers to: Specified assets of investments Groups of assets or liabilities or the profits of an entity Combinations of mortality experience, expenses and investment returns Examples of products with asset-dependent cash flows: Unit Linked products Universal Life products 5
Measurement Model VFA approach The Variable Fee Approach ( VFA ) is applicable to Insurance Contracts with Direct Participating Features (DPF, or direct par) where: 1. The contractual terms specify, or there is a constructive obligation that the policyholder participates in share of a clearly identified pool of underlying items; 2. The entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items; and 3. A substantial proportion of the cash flows that the entity expects to pay to the policyholder should be expected to vary with the cash flows from the underlying items. BBA approach modified to account for discretion For asset-dependent contracts NOT eligible for VFA (Indirect Par), the Building Block Approach (BBA) will be applied. Per the May 2015 IASB Staff Paper 2D, such contracts: Have cash flows that vary with the returns on assets, but the contract does not create an obligation to pay to the policyholder an amount equal to underlying items less a variable fee for service. Direct participation contracts expand the participation to other types of items (including underlying items, entity s profit, etc.) For all insurance contracts with participating features, an entity should recognise the CSM in P&L on the basis of the passage of time. 6
Indirect Participating Contracts
The Effect of Discretion Background The effect of discretion applies to participating contracts which do not meet the definition of direct participating contracts. (to which the variable fee approach should be applied) A change in discretionary cash flows is regarded as relating to future service, and accordingly adjusts the CSM. 8
Discretionary Cash Flows Specification To determine how to identify discretionary cash flows, an entity shall specify at the inception of the contract: What basis it regards as its commitment under the contract for the payments that it expects to continue with regardless of changes in assumptions that give rise to financial risk and What it regards as discretionary Use the definition above to determine if changes in assumptions give rise to financial risk, (do not adjust CSM), or discretionary changes (adjust CSM) If the entity cannot specify the above, it shall regard its commitment to be the return implicit in the estimate of the fulfilment cash flows at the inception of the contract, updated to reflect current assumptions that give rise to financial risk 9
Interpretation For indirect participating contracts the IASB decision is more closely aligned to the variable fee approach, because the changes related to discretion (indirect profit sharing) are adjusted through CSM. The discretion is effectively the basis the entities will use to set the asset dependant cash flows. For example, an insurer may give 95% of an investment to its policyholders as a target return. Another example could be the insurer targeting a spread on the return from assets. The presence of guaranteed returns complicates the definition of discretion. However, Deloitte believes that setting a guaranteed return is not part of discretion. Changes in the BEL related to cash flows for such guarantees are considered as changes related to market variables. 10
Market Variables vs. Discretion The approach for indirect participating contracts will provide further information due to the required split between market variables and discretion. Given that the effect of market variables on discretion will flow to P&L, the accounting volatility between the assets and the indirect insurance contracts will be reduced. For example, consider a universal life contract with a minimum guaranteed rate of return: Changes on the expected levels of discretionary bonuses will adjust the CSM while all other changes caused by market variables will be accounted for in P&L or OCI in line with the presentation of the effects of the discount rate. If the investment returns drop below the minimum guaranteed rate of return, the CSM is reduced to zero; and discretion is no longer applicable for the insurer. 11
Indirect Par - BBA At initial recognition, Indirect Par adopts the Building Block Approach, which is same as Non-Par except for the compliance with the guidance on discount rates for contracts with asset-dependent cash flows: Discount Rate: Estimates of discount rates shall be consistent with other estimates used to measure the insurance contract to avoid double counting or omissions The discount rates are consistent with observable current market prices for financial instruments with cash flow whose characteristics are consistent with those of the insurance contract Accordingly for participating products, Cash flows that depend on the returns on any underlying items shall be discounted using rates that reflect the extent of that dependence. Source: May 2015 2D Para.5-6 2013 ED Para. 26 CSM Risk Adjustment Expected Future Cash Flows Time Value of Money CSM: An amount that is equal and opposite to the sum of BEL and RA. Discretion is specified at inception. RA: Reflects all non-financial risks associated with the insurance contract BEL: Current, unbiased estimate of the cash flows expected to fulfil the insurance contract Includes all the cash inflows and outflows that relate directly to the fulfilment of the insurance contract 12
Subsequent Measurement The CSM is adjusted as follows: 1 Favourable and unfavourable differences between current and previous estimates of the fulfilment cash flows that relate to future coverage and changes in discretion (determined using the locked-in rate) are absorbed in the CSM, subject to the CSM not being negative. 2 An allocation of the CSM is recognised in P&L as the entity provides service under the insurance contract. The IASB has concluded that the service in a contract without participation features is the provision of insurance coverage, which is provided on the basis of the passage of time. 3 Interest is accreted on the CSM, using the rate locked in at inception of the contract. The entity is required to specify its discretion under the contract and to use that specification to distinguish between the effect of changes in market variables and changes in discretion. Changes related to market variables are adjusted against the P&L/OCI. Source: June 2015 2A Para.6 and Deloitte interpretation of IASB January 2016 decision 13
Direct Participating Contracts Variable Fee Approach (VFA)
Eligibility(1) 1. The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items. Includes any contract which creates a contractual obligation linked to underlying items.» Explicit contractual terms» Includes regulatory requirements However, measurement based on expected cash flows (not contractually-specified cash flows) Not dependent on holding of underlying assets, e.g. could be related to an indexed fund. Obligation need not be to current generation of policyholders Examples Unit Linked Products Universal Life Products Singapore Participating Products Some HK Participating Products Remarks Choices of funds are transparent and clearly identified to policyholders No clearly identified underlying items Regulatory requires a 90/10 split from policyholder fund s surplus No defined share of pool of underlying items* *The IASB intends to clarify this criterion and to explain that non-contractual or non-statutory terms could be sufficient to qualify a contract under such criterion if they constitute a constructive obligation. (Jan 2016) 15
Eligibility(2) 2. The entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items Unit Linked products: 100% of fund return Participating products: E.g. 90% policyholder fund s surplus 3. A substantial proportion of the cash flows the entity expects to pay to the policyholder should be expected to vary with the cash flows from the underlying items. Unit Linked products: Death benefit = Max(Fund Value, Sum Assured) Participating products: Reversionary Bonus, Terminal Bonus 16
Different Underlying Business Model In the general measurement model (BBA approach), the net gains and losses that the entity retains from invested premiums are treated as if they were a share of economic returns from the investment portfolio. In the variable fee approach, the returns to the entity arising from participating contract is viewed as part of the compensation that the entity charges the policyholder for service provided by the insurance contract, rather than as a share of returns from a stand-alone investment. The entity s interest in the investment portfolio is not the equivalent of a direct holding in assets, but is equivalent to a variable fee that the entity charges the policyholder, expressed as a share of returns. General Measurement Model x% PH Variable Fee Approach 100% PH Surplus Surplus Assets Liab 100 - x% SH Assets Liab A variable fee that entity charges policyholder SH Changes will go to P&L or OCI Changes will go to CSM 17
Changes in asset-dependent CF due to financial components General Measurement model Changes in estimate relating to future service are recognised as an adjustment to the CSM and affect P&L in the period in which the future service is provided. Changes in estimates relating to the financial component (e.g. changes in discount rate) are recognised in P&L or OCI in the period in which the change occurs. Similar to products with no participating features: Source: June 2015 2A CSM Expect PV of Future Cash Flows Lower CSM means less Profit from CSM release in the future CSM Expect PV of Future Cash Flows CSM Expect PV of Future Cash Flows (new asset return) CSM is not changed for change in FCF due to underlying items CSM Expect PV of Future Cash Flows (new asset return) CSM is not changed for change in discount rate Old assump Inceptn disc rate New assump Inceptn disc rate New assump Inceptn disc rate New assump New disc rate 12/2015 Change in assumptions Change in FCF due to change in underlying items Changes in discount rate 18
Changes in asset-dependent CF due to financial components Variable fee model Changes in estimate of the obligation to pay to the policyholder an amount equal to the fair value of the underlying items would be recognised in P&L or OCI, in the same way as changes in the fair value of the underlying items. Changes in estimate of the variable fee for future services would be accounted for in a way consistent with the changes in estimate relating to future service. Such change would be adjusted in CSM. Similar to products with no participating features: Source: June 2015 2B Lower CSM means less Profit from CSM release in the future CSM CSM is changed for change in FCF due to underlying items CSM is changed for change in discount rate CSM Old assump Inceptn disc rate Expect PV of Future Cash Flows CSM Expect PV of Future Cash Flows New assump Inceptn disc rate Expect PV of Future Cash Flows (new asset return) New assump Inceptn disc rate CSM Expect PV of Future Cash Flows (new asset return) New assump New disc rate 12/2015 Change in assumptions Change in FCF due to change in underlying items Changes in discount rate 19
Discount rates used to determine CSM adjustments After initial recognition, the CSM is adjusted for changes in estimates in relation to nonfinancial assumptions (e.g. mortality) General measurement model: - The discount rates used in the BEL and RA calculations to determine CSM adjustments are locked in at inception of the contract. Variable fee approach - The discount rates used in the BEL and RA calculations to determine CSM adjustments are implicitly the current interest rate. 20
Discount rates used to determine CSM adjustments At inception, the CSM is determined as a discounted amount. Over time, the effect of that discounting should be reversed. The unwinding of the discounting recognised at inception is referred to as accretion. General measurement model: - The interest is accreted using the rate locked in at inception of the contract. Variable fee approach - Although the CSM is not a cash flow in itself, and the IASB has concluded that it cannot be remeasured, the interest is implicitly accreted in the change of the variable fee thus using the current interest rate. 21
Risk Mitigation An entity is permitted to recognize in P&L changes in value of guarantee (i.e. as in the general model) if: Entity holds derivative instruments Derivatives are held in line with the entity s risk management strategy; Economic offset exists between guarantee and derivative, and Credit risk does not dominate the economic offset The entity is required to: Document its risk management objective and strategy Discontinue prospectively when economic offset ceases Disclose the effect of changes in the value of the guarantee in the profit or loss for the period 22
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