IASB Exposure Draft Insurance Contracts 23 September 2010 KUALA LUMPUR
IASB Exposure Draft Insurance Contracts Jeremy Hoon 23 September 2010 KPMG LLP, SINGAPORE
OECD Bank Negara Malaysia OECD-Asia Regional Seminar: Enhancing transparency and monitoring of insurance markets 23-24 September 2010 Kuala Lumpur, Malaysia (sponsored by the Government of Japan) 2
Challenges and issues in insurance statistics and insurance sector monitoring Implications of Exposure Draft Insurance Contracts (issued by the IASB on 30 July 2010) 3
Components of an insurance contract Historical diversity of contract types across geographies, resulting in accounting diversity - but tends to follow regulatory requirements Basic insurance concept small premiums contributed by many to an insurance pool are used to pay large losses of a few Contract coverage: Insurance risks (life and non-life); handling claims and servicing contracts Can include: financial risks services (asset management, custody, pension administration) guarantees and options supply of goods Can be a combination of the above 4
So what are we really accounting for? Insurance contract IAS 18 or Revenue Proposals Service component Financial component Discretionary participation feature Insurance component Financial Instrument Supply of goods IAS 39 or IFRS 9 Embedded derivative Insurance Proposals 5 5
Background Insurance Contracts Project Joint project between IASB and FASB 1997 Insurance contracts project initially started in 1997 Project phases 2007 Discussion paper (Current Exit Value Approach) 2010 IASB Exposure Draft July 2010 (Fulfilment Approach) 2010 FASB Discussion Paper (September 2010?) 2011/2012 IASB standard expected by June 2011; (Final FASB standard expected in 2012?) 2013? First time application to be established (Boards intent is to align effective date with IFRS 9 Financial Instruments - 2013?) Comment deadline on ED ends 30 November 2010 6
Insurance Project Scope Insurance and reinsurance contracts issued Reinsurance contracts held Investment contracts containing a discretionary participation feature (DPF) provided that there also exist insurance contracts that provide similar contractual rights to participate in the performance of the same pool or entity Financial guarantee contracts issued by an entity (and financial guarantee reinsurance contracts held) that meet the definition of an insurance contract. 7
Scope Exemptions Product warranties issued directly by a manufacturer, dealer or retailer Fixed fee service contracts that have as their primary purpose the provision of services, but that expose the service provider to risk because the level of service depends on an uncertain event Policyholder accounting (other than reinsurance held) Others 8
Definition of an Insurance Contract a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. Consistent with existing definition, but with minor changes to guidance 9
Significant insurance risk Insurance risk is significant if, and only if, an insured event could cause an insurer to: pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance 10
Recognition An insurance contract liability or asset is recognised at the earlier of: (1) the date when the insurer is bound by the terms of the contract; and (2) the date when the insurer is first exposed to risk under the contract. This is when the insurer can no longer withdraw from its obligation to provide coverage and no longer has the right to reassess the risk of the policyholder and as a result can no longer change the price to fully reflect that risk. 11
Derecognition An insurance contract liability (or a part thereof) is derecognised from the statement of financial position when, and only when, it is extinguished, i.e. when the obligation specified in the insurance contract is discharged or cancelled or expires. At that point, the insurer is no longer at risk and is therefore no longer required to transfer economic resources to satisfy the insurance obligation. The purchase of reinsurance does not trigger derecognition of an insurance liability unless it is extinguished. 12
The Measurement Model Measurement model is based on a principle that insurance contracts create a bundle of rights and obligations that work together to create a package of cash inflows (premiums) and outflows (benefits, claims and costs). The model uses certain building blocks in measuring that package of cash flows. Incremental Cash Inflows Incremental Cash Outflows Claims handling and costs to service Guarantees and options Premiums Insurance Contract Claim benefits/payments Acquisition costs Participating benefits paid Contract Margins Discounting 13
Proposed Measurement Models The 4 IASB (or 3 FASB) building blocks IASB Preference (modified to exclude day one gains) Cash Flows - Explicit, unbiased and probability-weighted estimates of future cash outflows less future cash inflows * Discount Rates - Discounted using current rates to reflect the time value of money * FASB Preference (modified to exclude day one gains) Cash Flows - Explicit, unbiased and probability-weighted estimates of future cash outflows less future cash inflows * Discount Rates - Discounted using current rates to reflect the time value of money * Risk Adjustment - To adjust for the effects of uncertainty about the amount and timing of future cash flows * Residual margin (to remove any profit at inception and released over time) Composite margin Contract liability measurement * Re-measured subsequent to inception through profit or loss (to remove any profit at inception and released over time) The sum of the first three building blocks in the IASB model (discounted cash flows with risk adjustment) is referred to as the present value of fulfilment cash flows 14
Level of measurement Measure present value of the fulfilment cash flows (includes risk adjustment) at a portfolio level of aggregation for insurance contracts. A portfolio of contracts are contracts that are subject to broadly similar risks and managed together as a single pool. The definition is consistent with IFRS 4. The residual margin should be determined by grouping insurance contracts by portfolio and, within the same portfolio, grouping contracts by similar date of inception by similar coverage period 15
Building Block 1: What inputs are considered? Market variables Consistent with observable market prices at the end of reporting period e.g. Equity prices and interest rates Reflect risk preferences of market participants Fair value of replicating assets Non-market variables Reflect all available evidence, both external and internal Historical data on costs including frequency and severity of claims and mortality Current price information for reinsurance contracts and other instruments covering risks Views on future trends and inflation rates Industry data 16
Building Block 1: Using current estimates and future events Use all available current information in estimating the probability of each cash flow scenario relating to non-market variables Consider estimates made at the end of the previous reporting period and update if previous estimates are no longer valid May not be identical to recent experience Investigate changes in experience and develop new probability weighted estimates for possible outcomes Consider trends, future inflation rates, and future events that might affect the cash flows without changing the nature of the obligation 17
Building Block 1: Which contractual cash flows? Incremental cash flows within boundary of a contract that are incremental at portfolio level Claims and benefits paid to + policyholders (including IBNR) Claims handling costs + Premiums - Salvage and subrogation - Costs of servicing the contract (policy administration and maintenance) + Transaction-based taxes and levies + Contractual benefits paid in kind + Payments to current or future policyholders as a result of a contractual participation feature + Incremental* costs of selling, underwriting, and initiating an insurance contract (acquisition costs) but only for contracts issued + Options or guarantees + + Indicates an obligation * Incremental at contract rather than portfolio level Indicates a right 18
Acquisition Costs Incremental acquisition costs Should be recognised in the present value of the estimated fulfilment cash flows at initial recognition. Excluded from the residual margin. Identified at individual contract level. Not recognised in profit or loss under summarised margin approach. Non incremental acquisition costs An insurer should recognise all acquisition costs as an expense when incurred. 19
Building Block 2: Discounting What discount rate should be used in measurement? If the amount, timing or uncertainty of cash flows for the insurance contracts depends on the performance of specific assets measurement shall reflect that fact Should be consistent with observable current market prices for instruments whose characteristics reflect the insurance liability (e.g. timing, currency and liquidity) Discount rate is yield curve with no or negligible credit risk, adjusted for differences in liquidity, if cash flows are not dependent on specific assets Should not include own credit risk Should not include factors not relevant (i.e. risks not present in liability but present in the instrument with observable market price) Should not capture characteristics of assets actually held to back the insurance liability, unless the contract shares those characteristics Should not include any risk that is included in other parts of measurement 20
Building Block 3: Risk Adjustment Risk Adjustment: The maximum amount that the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows may exceed those expected." An insurer shall use only the following techniques for estimating the risk adjustment: Confidence level Conditional Tail Expectation (CTE) Cost of Capital (CoC) 21
Building Block 3: Composite Margin 4: Residual Margin Residual Margin Composite Margin Arises when the present value of the fulfilment cash flows* is less than zero If the present value of fulfilment cash flows is greater than zero, this amount should be recognised in profit or loss at inception (i.e. a day one loss) Systematic release over coverage period based on the passage of time If an insurer expects to incur benefits and claims in a pattern that differs significantly from passage of time the residual margin should be released on the basis of the expected benefits and claims to be incurred Classified as part of the insurance liability Interest accretion using locked in rate Arises when the present value of future cash outflows less the present value of future cash inflows is less than zero. If the present value of future cash outflows less the present value of future cash inflows is greater than zero, this amount should be recognised in profit or loss at inception (i.e. a day one loss) Release over both the coverage period and the claims handling period (during which the insurer is expected to pay claims) Percentage of completion amortisation reflecting the decline of risk based on actual and expected cash flows Classified as part of the insurance liability No interest accretion Unit of account at cohort level grouping insurance contracts by portfolio and within the same portfolio, by similar date of inception of the contract and by similar coverage period. * defined as the expected present value of the future outflows plus risk adjustment less cash inflows 22
Modified Approach : Premium Allocation Model The modified approach is required for pre-claim liabilities for contracts that meet both of the following definitions: The coverage period is approximately 12 months or less The contract does not contain embedded options or other derivatives that significantly affect the variability of cash flows 23
Reinsurance Ceded At initial recognition of a reinsurance contract, a cedant measures the reinsurance asset under the building block approach, taking account of the risk of non-performance by the reinsurer. Negative Difference Positive Difference Reinsurance premium paid Input Measurement Input Measurement (Expected present value of premiums ceded to reinsurer) (100) Reinsurance premium paid (Expected present value of premiums ceded to reinsurer) Reinsurance commission received 7 Reinsurance commission received 10 Expected present value of reinsurance recoverable cash inflows (after allowance for expected credit losses) 80 Expected present value of reinsurance recoverable cash inflows (after allowance for expected credit losses) Risk adjustment 15 Risk adjustment 15 Gain at inception 2 Residual margin (5) If the cash inflows under the building block measurement approach is greater than the cash outflows (consideration paid by the cedant), the cedant recognises that difference as a gain in profit or loss at initial recognition of the reinsurance contract. If the cash inflows under the building block measurement approach is less than the cash outflows (consideration paid by the cedant), the cedant treats that negative amount as the residual margin at initial measurement. (110) 80 24
Unbundling Investment and service components of an insurance contract should be unbundled and accounted for separately if the components are not closely related to the insurance coverage specified in the contract. The following are the most common examples of unbundling applying this principle: An investment component reflecting an account balance that is credited with an explicit return at a rate based on the investment performance of a pool of underlying investments (e.g. unit-linked contracts; index-linked contracts; and universal life contracts). The rate should pass on all investment performance but may be subject to a minimum guarantee. An embedded derivative that is separated under existing bifurcation guidance in IAS 39. and Goods and services that are not closely related to the insurance coverage, but have been combined in a contract with the insurance coverage for reasons that have no commercial substance. Unbundling is not permitted unless required. 25
Unbundling Insurance contract IAS 18 or Revenue Proposals Service component Financial component Discretionary participation feature Insurance component Financial Instrument Supply of goods IAS 39 or IFRS 9 Embedded derivative Insurance Proposals 26 26
Other matters: Embedded Derivatives IAS 39 applies to an embedded derivative in an insurance contract unless the embedded derivative is itself an insurance contract. If the economic characteristics and risks of the embedded derivative are not closely related to those of the host insurance contract, the insurer is required to separate the embedded derivative and measure it at fair value with recognition of changes in fair value in profit or loss. Surrendering an insurance contract generally leads to cancellation of the entire contract (and therefore is often interdependent with other components). An insurer would need to determine whether the surrender option is closely related to the host contract in applying the guidance in paragraph AG33(h) of IAS 39. This application guidance clarifies that an embedded derivative in an insurance contract is closely related to the host contract if the embedded derivative and host contract are so interdependent that an entity cannot measure the embedded derivative separately. 27
Investment Contracts with a Discretionary Participation Feature (DPF) Investment contracts with discretionary participation features (DPF) are within scope of standard, provided there also exists insurance contracts that provide similar contractual rights to participate in the performance of the same insurance contracts, the same pool of assets or the profit or loss of the same company, fund or other entity. Investment contracts with DPF not part of shared pool are financial instruments in scope of financial instruments standard. 28
Presentation: Statement of financial position The ED proposes that an insurer present each portfolio of insurance contracts as a single item within insurance contract assets or insurance contract liabilities. It also proposes that an insurer present a pool of assets underlying unit-linked contracts as a single line item separate from the insurer s other assets and that the portion of the liabilities linked to the pool be presented as a single line item separate from the insurer s other liabilities. Reinsurance assets are not offset against insurance contract liabilities. 29
Presentation: Statement of comprehensive income (SOCI) The ED proposes a summarised margin presentation for the statement of comprehensive income. This presentation approach treats all premiums as deposits and all claims and benefits as repayments to the policyholder; those elements are treated as movements in the insurance liability. This presentation is supplemented by disclosures of premiums and expenses (as part of the reconciliation of opening and closing contract balances). Exception: For short-duration contracts that are eligible for the modified measurement approach, the underwriting margin is disaggregated in the statement of comprehensive income into: Premium revenue (release of gross pre-claims obligation plus accreted interest) Claims incurred Expenses incurred Amortisation of incremental acquisition costs included in the pre-claims obligation plus changes in additional liabilities for onerous contracts 30
Summarised Margin Presentation Statement of comprehensive income Underwriting margin Change in risk adjustments Release of residual margins Gains and losses at initial recognition Losses on insurance contracts acquired in a portfolio transfer Gains on reinsurance contracts bought by a cedant Losses at initial recognition of an insurance contract Acquisition costs that are not incremental at individual contract level Experience adjustments and changes in estimates Differences between actual cash flows and previous estimates Changes in estimates of fulfilment cash flows and discount rates Impairment losses on reinsurance contracts Interest on insurance liabilities Standard model on face of SOCI yes disaggregation could be included In notes yes disaggregation could be included In notes yes yes disaggregation could be included In notes yes 31
Disclosures Under the proposals, an insurer is required to disclose quantitative and qualitative information in respect of: the amounts arising from insurance contracts recognised in the financial statements; and the nature and extent of risks arising from insurance contracts. The IASB used the disclosure requirements in IFRS 4 (including the disclosures about financial risks in insurance contracts incorporated in IFRS 4 by cross reference to IFRS 7) as a basis for its proposals Aggregation principle Useful information should not be obscured by either the inclusion of a large amount of insignificant details or the aggregation of items that have different characteristics Required disclosures include: reconciliation of contract balances; methods and inputs used to develop the measurements, including a measurement uncertainty analysis; the nature and extent of risks arising from insurance contracts; a risk sensitivity analysis; and claims development information. Additional disclosure requirements from IFRS 4 were retained 32
Transition calculation For each portfolio of insurance contracts that exist on the transition date, the insurer needs to measure the remaining cash inflows and outflows plus a risk adjustment. Measurement both at transition and subsequently does not include a residual margin. The effect of not recognising a residual margin for contracts in existence at transition would be to depress the net income reported for those contracts in periods post-transition compared to a full retrospective application. Transition Calculation (at beginning of the earliest period presented) Previously recognised liability balances at transition 90 Previously recognised deferred acquisition costs at transition <5> Previously recognised intangible assets arising from business combination at transition 1 <1> Present value of fulfilment cash flows of insurance liabilities 2 <80> Transition adjustment (increase to retained earnings) 3 4 1 Does not include intangible assets such as customer relationships and customer lists which relate to future contracts 2 Calculated at a portfolio level and subsequently re-measured 3 Both positive and negative differences are recorded in retained earnings 33
Other transition considerations The transition adjustment is calculated at the beginning of the earliest period presented and adjusted to retained earnings. Proposals do not contain effective date as Board wants to align with other proposals and standards (e.g. IFRS 9 Financial Instruments). An insurer is permitted, but not required, to redesignate a financial asset as measured at fair value through profit or loss at the start of the earliest period presented when it adopts the proposals if doing so would reduce a measurement or recognition inconsistency. The reclassification is a change in accounting policy in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. The insurer should recognise the cumulative effect of that redesignation as an adjustment to opening retained earnings of the earliest period presented and remove any balances from accumulated other comprehensive income. Additionally, an insurer is exempt from disclosing previously unpublished information about claims development that occurred earlier than five years before the end of the first financial year in which it applies the proposals. An insurer is required to disclose if it is impracticable to prepare information about claims development that occurred before the beginning of the earliest period presented. The transition requirements apply both to a first-time adopter of IFRS and to an insurer currently reporting under IFRS. 34
Contact details: Jeremy Hoon Tel: +(65) 6213 2608 www.kpmg.com.sg