International Financial Reporting Standard IFRS 4 and its Implication to HK and China s Insurance Industry Raymond Li, FSA MAAA Actuarial Services AA Symposium 17 November 2004
Agenda Introduction Key Principles of IFRS 4 Challenges to HK and PRC Insurance Industry Questions to CEO? 2
Introduction 3
Why IFRS 4? Diversity of practices internationally Existing standards do not address specific insurance issues and not necessarily reflect the true performance of the business Need to distinguish between insurance contracts and financial instruments Regulatory driven (e.g. in HK, Singapore and European countries) Lack of transparency inadequate disclosures under some local rules 4
Important changes in accounting and reporting Implementation of IFRS will lead to increased transparency and comparability of performances Less options More data requirements Complex (fair value) measurements Insight in sensitivity assumptions Increased enforcement Greater insight in performance Increased volatility in results IFRS 4 objectives for phase 1 Limited improvements Increased disclosure 5
Development of IFRS ED for phase 1 IFRS 4 ED for phase 2? Fair value disclosures pertaining to insurance liabilities Opening IFRS 4 balance sheet in Europe Expected implementation of HKFRS 4 in HK First IFRS 4 financial statements Phase 2? 31/12/02 31/12/03 31/12/04 31/12/05 31/12/06 31/12/07 Cumulative effect of IFRS 4 recognised in the opening balance sheet at 1/1/2005 Period covered in first IFRS 4 financial statements A first time adopter need not restate the comparative information in respect of IFRS 4, IAS32 & IAS 39 (together) 6
Key Principles of IFRS 4 7
Key Principles of IFRS 4 Definition of insurance contract Unbundling Embedded Derivatives Change in Accounting Policies Asset Liability Matching Liability Adequacy Test Discretionary Participating Contracts Extensive Disclosure Requirements 8
Definition of 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. 9
Why does definition of insurance risk matter? Insurance risk Traditional life Insurance contract (phases 1 & 2) Endowment Universal life Financial instrument (IAS 39) Deferred annuity Unit linked Financial risk 10
Changes in the level of insurance risk Life of the (insurance) contract Term life insurance: risk remains significant throughout the contract Significant insurance risk Endowment policy : amount at risk in case of death reduces as value of investment component increases Significant insurance risk Deferred annuity : no insurance risk during savings phase, insurance risk in annuity phase; overall is insurance contract since opting for annuity is an event of commercial substance Significant insurance risk 11
Unbundling of an insurance contract Unbundling of a deposit component is permitted if the deposit component can be measured separately. Unbundling of a deposit component is required if the deposit component can be measured separately; and the resulting rights and obligations are not otherwise recognized under the insurer s accounting policies. Unbundling of a deposit component is prohibited if an insurer cannot measure the deposit component separately. 12
Embedded derivatives in insurance contracts IAS39 requires derivatives embedded in an insurance contract to be separated and marked-to-market when its economics are not closely related to the host contract IFRS 4 provides three exceptions to this principle, in that the following three provisions need not be separated from its host contract Option such as a life-contingent annuity, A fixed-price or interest rate linked surrender options, or Liabilities under unit-linked contracts may be measured at unit values. 13
Change in Accounting Policies Changing accounting policies is allowed, if changes make the financial statements more relevant for the user's economic decisionmaking needs and no less reliable OR more reliable and no less relevant to those needs 14
Asset Liability Matching Assets might be classified as available-for-sale ( AFS ) or trading which are at fair or market value) Liabilities might be on different basis e.g. amortised cost IFRS 4 and IAS 39 suggested the following: An insurer is permitted, but not required, to change its accounting policies so that it re-measures designated insurance liabilities to reflect current market interest rates Shadow adjustment amortise DAC and the value of business acquired through equity in order to offset unrealised capital gains of AFS investment 15
Liability Adequacy Test Must assess at each reporting date whether recognised insurance liabilities are adequate based on current estimates of future cash flows under insurance contracts. IFRS 4 only specifies minimum requirements: The assessment must use current assumptions and consider all contractual cash flows, including: Claims handling costs; and Cash flows from options and guarantees. 16
Discretionary Participating Feature (DPF) IFRS 4 does not require a specific accounting treatment for the discretionary component of the insurance contract DPF may be recognized 1) as part of benefit reserve or 2) separately as Liability or Equity If recognized separately, the annual surplus is split between policyholders share and stockholders share. The policyholders share is either recognized as a special liability (e.g. deferred bonus liability) or as a separate component of equity. BUT the basis used should be applied consistently 17
Extensive Disclosure Requirement An insurer should disclose : Amounts arising from insurance contracts - Process used to determine significant assumptions - Effects of changes in assumptions - Material changes in insurance liabilities, reinsurance asset and DAC Amount, Timing & Uncertainties of future cash flows - Risk management objectives and policies - Details of insurance contracts with significant cash flow impact - Information about insurance risk - Information about interest risk and credit risk - Sensitivity of embedded derivatives to interest risk & credit risk 18
Disclosure Issues Degree of disaggregation of information Which assumptions need to be disclosed Commercially sensitive information Systems implications/data collection 19
Challenges to HK and PRC Insurance Industry 20
There will be a number of challenges to HK and PRC insurance companies Product Classification Disclosure Liability Adequacy Test Asset Liability Mismatch Reserves Embedded Values Reporting Comparison with US GAAP 21
Some of insurance premium may no longer be recognized as premium income Short Term Single Premium Endowment type of product is very popular, with large premium income, in recent HK and PRC market Heavy investment elements If these are considered as investment products premium received NOT recognised under IFRS Significant impact to companies financials Implementation guidance from IFRS 4 contains practical examples BUT mainly focus on European/ American insurance markets Local regulators may want to provide examples which are applicable to the local markets 22
Greater disclosure requirement means more work Greater disclosure will be required on Sensitivity of change in assumptions and Concentration of insurance risk HK and PRC insurers require: Competent actuaries and accountants who are familiar with IFRS regulations and able to set up the system in accordance to the disclosure requirement Software which can provide information for IFRS reporting need to be tailor-made 23
Disclosure will lead to higher transparency System enhancement will improve the quality of internal management reporting Greater understanding of existing business condition Increase responsiveness to changes in insurance market Enhance transparency of insurance industry Policyholders, shareholders and analyst will have a better understanding of financial situation and risk profiles of the company 24
Liability Adequacy Test No such requirement under both HK and PRC accounting standard Liability Adequacy Test is similar to Loss Recognition Test ( LRT ) under US GAAP basis Insurers who already report under US GAAP basis may base on their LRT and related reporting capabilities to meet IFRS 4 requirement Level of aggregation: portfolio of contracts that are subject to broadly similar risks and managed together as a single portfolio Impact on solvency of insurers Need to reconsider the investment strategy and dividend paying strategy 25
Liability Adequacy Test PRC Insurer s concern: Valuation mortality and interest are prescribed by CIRC; so adverse experience variance (e.g. negative interest spread) might result in not passing the test Products with high guaranteed interest rates may need to increase reserve as a result of negative interest spread for older businesses issued in PRC Need to evaluate the adequacy of IBNR which is currently determined as 4% of claim; premium deficiency reserve may be required as a result For HK insurers: The valuation assumptions are primarily determined based on prudent rates, with reference to company s experience (e.g. actual portfolio investment yield). So less likely to fail the test as a result of negative experience variance 26
Asset Liability Mismatch IFRS 4 allows fair value accounting for insurance contracts to match with the fair value reporting on investment portfolio For example: Re-measure reserve using current estimates and assumptions Shadow adjustment 27
Reserves Actuarial reserves are allowed to be calculated using existing basis under local GAAP Need not eliminate excessive prudence but for an insurer which already measures its insurance contract with sufficient prudence, it should not introduce additional prudence May re-measure designated insurance liabilities to reflect current market interest rates (and other current assumptions) Claim reserves are only permissible to the extent they relate to actual liabilities end to equalisation and catastrophe reserves Liability adequacy test 28
Embedded Value reporting Advantages Increasingly adopted as performance measurement tool by the multinationals Provides a useful platform for risk analysis using sensitivity tests and stochastic analysis Focuses on a long time horizon which matches the nature of insurance products Highlights where value is being created and destroyed Early recognition of profits / values when compared to SAP and GAAP Major uses Commonly used in evaluating mergers and acquisition Management of in-force business New incentive program for distributors Interest crediting and investment strategies Impact of expense control Impact of persistency control Provides a rigorous means to quantify the value of business written in the previous year 29
Embedded Value reporting Phase 1 allows embedded value measurement if it provides relevant and reliable financial statements Current embedded value approaches reflect future investment margins, in that the discount rate is based on estimated return Less relevant and reliable financial statement Guidance will be given on Risk Discount Rate in Phase 2 Also, current practise only use single best estimate basis Unable to reflect full range of possible outcome Need to keep an eye on phase 2 requirement 30
Comparison with US GAAP Similarity exists in DAC, Liability Adequacy Test (LRT under US GAAP) Allow Shadow Accounting, in order to address potential asset-liability mismatches in phase 1 DAC does not meet the IFRS framework definition of an asset so likely will be removed in phase 2 UPR does not meet the IFRS framework definition of an liability so likely will be removed in phase 2 Phase 2 is expected to require discounting of liability which is generally not permitted under USGAAP for claim reserving. This leads to possible advantage for European insurers, particularly on long tailed businesses 31
Questions for CEOs 32
Questions for CEOs Should and how product mix and design be changed? Do we need to improve our asset-liability matching? Should and how investment strategy be changed? Are existing IT and accounting systems capable of tracking information resulting from a change in the contract definition and product classification? How will the insurance regulators and the Tax Department interpret the new definition of insurance contracts? 33
Presenter s contact details Raymond Li KPMG (852) 2143 8820 raymond.li@kpmg.com.hk www.kpmg.com 34