IFRS4 Insurance Contracts Phase I

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IFRS4 Insurance ContractsPhase I

• Topical Actuarial Issues, 1.4.2004, Prague
• Jirí Fialka

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Agenda

• Reasons for issuing the standard
• Approach
• Difficulties
• Scope of IFRS4
• Solutions for Phase I
• Changes from ED5 to IFRS4
• Outlook

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Reasons for issuing the standard

• No IFRS on insurance contracts
• Diverse current practices
• IFRS intended to form EU accounting basis from
  2005

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Approach

• Fair value approach proposed in DSOP, but
• because not feasible for the IASB to complete
  its insurance project .. in 2005
• IASB decided to
• Make limited improvements to accounting practices
• without requiring major changes that may need to
  be reversed, and
• require detailed disclosure.

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Difficulties What is fair value?

• No observable market evidence about fair value of
  insurance liabilities
• Existing practices contradictory to other IFRS
  standards and even framework
• To get calculated fair value, number of
  theoretical and implementational issues need to
  be resolved
• Market value margins, Embedded derivatives,
  Market/Entity specific data

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Difficulties Who is against fair value?

• Powerful lobby against the new standard
• North American Insurers
• But Canadian and Mexican insurers did not join
  the initiative
• Is US GAAP the accumulated wisdom?
• European insurers
• Japanese insurers
• Number of them might be virtually insolvent, if
  realistic valuation introduced

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Difficulties IFRS4/IAS39 mismatch

• Most commentators criticised the inconsistencies
  between the measurement of assets (IAS39) and
  liabilities (existing insurance accounting)
  mismatch
• Various solutions considered
• Relax tainting rules on HTM assets
• Create new asset category
• Adjust measurement of liabilities
• Shadow accounting

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Scope of IFRS4

• IFRS4 is applicable to
• Issued (re)insurance contracts and held
  reinsurance contracts
• Issued financial instruments with a discretionary
  participation feature (!)
• IFRS4 is not applicable to
• Product warranties issued directly by a
  manufacturer, dealer or retailer
• Direct insurance contracts that the entity holds
  (policyholder accounting)

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Scope definition of insurance contract

• An insurance contract is a contract under which
  one party (the insurer) accepts significant
  insurance risk from another party (the
  policyholder) by agreeing to compensate the
  policyholder or other beneficiary if a specified
  uncertain event (the insured event) adversely
  affects the policyholder or other beneficiary.

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Solutions for Phase I

• To classify products as insurance or investment
• To use current accounting practice for insurance
  contracts
• To eliminate extreme features contradicting
  framework
• To allow some improvements
• To prevent divergence from framework
• To introduce Liability adequacy test
• To require disclosure

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Solutions To classify products as insurance or
investment

• 3 groups of products
• Insurance products subject to IFRS4
• Investment contracts with discretionary
  participating features subject to IFRS4,
  subject to minimum calculated by IAS39
• Other investment contracts subject to IAS39
• IAS39 Demand Deposit Floor, limited DAC
• Discretionary participating features (DPF)
• Contractual right to receive additional payments
• Likely to be significant portion of total
  payments,
• Amount or timing at the discretion of the
  insurer, and
• Based on performance of the company (assets
  return or other criteria)

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Solutions To use current accounting practice for
insurance contracts

• What are current accounting practices?
• Local or consolidation?
• Could different accounting policies be
  consolidated?
• Are all CEE practices compliant?

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Solutions To eliminate extreme features
contradicting framework

• Catastrophe and equalization provisions are not
  liabilities
• If currently recognized liabilities are not
  adequate, additional liability should be provided
  for
• No offset of insurance liabilities and
  reinsurance assets

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Solutions To allow some improvements

• Accounting policies for insurance contracts may
  be changed if, and only if, the change makes the
  financial statements more relevant and reliable,
  judged by the criteria in IAS 8
• The change need not be sufficient to achieve full
  compliance with all those criteria
• When changes in the accounting policies for
  insurance liabilities are made, some or all
  financial assets may be reclassified into the
  category measured at fair value with all
  movements in the profit and loss account

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Solutions To prevent divergence from framework

• An insurer may continue to apply, but not change
  to
• Non-discounting insurance liabilities
• Do not introduce additional prudence in insurance
  liabilities
• Including future investment margins in insurance
  liabilities
• Measuring contractual rights to future investment
  management fees
• Using non-uniform accounting policies for the
  insurance liabilities and related DAC of
  subsidiaries
• Recognition of future investment margins

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Solutions To introduce Liability adequacy test

• If there is an existing liability adequacy test
  using current estimates of future cash flows,
  resulting in the recognition of any potential
  inadequacy, IFRS4 does not impose further
  requirements
• If no LAT required, IAS37 should be used

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Solutions To require disclosure 1

• Explanation of reported amounts
• Accounting policies
• Material amounts of assets, liabilities, income
  and expenses
• Process used to determine significant assumptions
  and, when practicable, quantified disclosure of
  assumptions
• Effects of changes in assumptions, showing
  separately effect of each change with material
  effect on financial statements
• Changes in insurance liabilities, reinsurance
  assets and DAC

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Solutions To require disclosure 2

• Amount, timing and uncertainty of cash flows
• Objectives in managing risks and its policies to
  mitigate risk
• Terms and conditions of insurance contracts which
  have a significant impact on cash flows
• Information about insurance risk including
  sensitivity to key variables, concentrations of
  insurance risk, details of actual claims compared
  with previous estimates (10 year maximum)
• Information about interest risk and credit risk
• Sensitivity of embedded derivatives to interest
  risk and credit risk

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Changes from ED5 to IFRS4

• Clarified definition
• Permission to remeasure some insurance
  liabilities for changes in interest rates
• Exemptions
• Liability adequacy test
• Changes in accounting policies
• Reinsurance accounting
• Disclosure
• Discussed solutions of AL mismatch

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Changes from ED5 to IFRS4 - Clarified definition

• Improved wording on the definition of significant
  insurance risk
• Plausible scenario ? Scenario with commercial
  substance
• Trivial ? Insignificant
• Surrender charges waived on death not sufficient
  for insurance product classification
• Pure endowment is insurance, unless risk transfer
  is insignificant, portfolio approach
• Investment contracts with DPF closer treatment
  to insurance contracts than in ED5

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Changes from ED5 to IFRS4 - Permission to
remeasure some insurance liabilities for changes
in interest rates

• Permitted but not required
• Might be applied to some liabilities, but not to
  all similar liabilities as IAS8 would otherwise
  require
• Assumed use of simplified models that give
  reasonable effect of interest rate changes

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Changes from ED5 to IFRS4 - Exemptions

• Exemptions confirmed, which resulted in some
  board members dissenting from IFRS4
• Deleted sunset clause that would have made the
  exemption expire in 2007
• New exemption allowing different accounting
  policy for some insurance liabilities

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Changes from ED5 to IFRS4 - Liability adequacy
test

• ALL contractual cash flows should be considered
  (incl. expenses and cash flow from embedded
  options and guarantees)
• Premature to specify how to treat embedded
  options and guarantees

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Changes from ED5 to IFRS4 - Changes in accounting
policies

• More general approach replaced strict individual
  rules guidance, what is more, and what is less
  relevant and reliable
• Changed wording to excessive prudence paragraph
  do not introduce additional prudence
• Rebuttable presumption that introducing future
  investment margins will result in less relevant
  and reliable financial statements

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Changes from ED5 to IFRS4 - Reinsurance accounting

• Restriction of the profit or loss recognised at
  inception of the reinsurance contract was removed
• Instead, requirement for cedant to disclose
  extent to which profit or loss include gains that
  arose at inception of reinsurance contracts

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Changes from ED5 to IFRS4 - Disclosure

• Insurer has to make judgement calls on emphasis
  and aggregation
• Insurer should disclose a sensitivity analysis
  for all variables that have material effect,
  including observable market prices and rates
• Disclosure includes material changes in insurance
  liabilities, reinsurance assets and DAC as
  reconciliation

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Changes from ED5 to IFRS4 - Discussed solutions
of AL mismatch

• Shadow accounting
• Recognised but unrealised gain or loss on asset
  may affect the measurement of insurance
  liabilities in the same way that a realised gain
  or loss does through equity
• Permission to remeasure some insurance
  liabilities for changes in interest rates
• Rejected assets solutions
• Relaxing tainting rules for Held-to-maturity
  portfolio
• Creating new category of Assets Held to Back
  Insurance Liabilities

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Outlook - Timetable
ED for phase 2?
Fair value disclosures
Opening IAS balance sheet
First IAS financial statements
ED for phase 1
Interim reporting?
Phase II?
31/12/07
31/12/02
31/12/03
31/12/04
31/12/06
31/12/05
Period covered in first IAS financial statements
Period covered in first IAS financial statements
SUNSET CLAUSE
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Outlook Phase II

• Board decisions November 2003
• Phase II should be a high priority project
• On restarting the Board should return to a study
  of the basics
• Round discussions and field visits should be
  conducted during exposure draft phase
• Specialised task forces should be established to
  assist staff
• Insurance Advisory Committee should be retained
  as forum for staff to discuss higher-level issues
  and as convenient means of obtaining feedback on
  progress
• Working group of staff experts from national
  standard setters should assist staff
• Selected industry participants should make
  presentations to Board on problematic issues
• Project should restart in May 2004
• Board should aim to complete exposure draft by
  June 2005
• Board should encourage non insurance parties to
  become more actively involved

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Discussion

• How would IFRS4 influence CEE insurance markets?
• Only accounting rules, or change in the business
  management?
• Thank you for your attention!
• Contact jfialka_at_kpmg.cz