PowerPoint-Pr

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III International Conference Insurance and
Pension Funds Practical Implications of IFRS 4
An Actuarial Perspective Stefan Engeländer
Lisboa, July, 7th 2004
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Agenda

• International Actuarial Standards of Practice
• Contract Classification
• Unbundling
• Embedded Derivatives
• Discretionary Participation Feature

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Agenda

• International Actuarial Standards of Practice
• Contract Classification
• Unbundling
• Embedded Derivatives
• Discretionary Participation Feature

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IAA and IASB

• Close cooperation of IASB and International
  Actuarial Association (IAA) in developing IFRS
  for insurance contracts
• No intend of IASB to provide technical details in
  IFRSs
• Interpretation required since IFRS 4 often based
  on simplified examples applicable only in very
  narrow circumstances
• Hence, IASB staff clarified in IASB Observer
  Notes January 200492. (d) Some argued that the
  Board (or IFRIC) should set up an interpretation
  panel to address questions that will arise in
  phase I. The staff notes that a sub-committee of
  the International Actuarial Association (IAA) has
  begun developing guidance for actuaries.

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IAA and IASB

• No official role of IAA in interpreting IFRSs
• No official role of actuaries in establishing
  accounting policies or financial statements
• But
• IAA ensures a professional interpretation and
  comparable application of IFRS 4 world-wide
• Actuaries to be involved in establishing
  accounting policies and financial statements
• Consequence of responsibility of preparers rather
  than explicit rule

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IAA Subcommittee

• IAA established International Actuarial Standards
  Subcommittee to
• propose International Actuarial Standard of
  Practice (IASP) regarding actuarial work under
  IFRSs
• develop educational material accompanying such
  IASP
• support IAA member associations in implementing
  and applying those IASP
• Subcommittee established Drafting Team, preparing
  draft papers

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IASP

• The IASP is to be adopted by all member
  organizations either
• by making it binding for members directly or
• by introducing an own standard, at least
  equivalent in binding force and content
• Classification of IASP in preparation
• Class 4 Practice Guideline
• Examples of adequate behavior, merely
  educational,
• any alternative, assumed to be suitable by the
  actuary, is allowed

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Due Process

• Drafting Team prepares currently exposure drafts
  to be exposed by the president of the IAA in due
  course
• Comment period to Washington meeting in autumn
• After approval by Council, ballot vote of member
  organizations

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Planned IASP

• Actuarial Practiceregulation of actuarial
  behavior in agreeing, proceeding and reporting
  work
• Contract Classificationinterpretation of
  definition of insurance contracts, investment and
  service contracts
• Liability Adequacy Testminimal requirement,
  interpretation of IAS 37
• Discretionary Participation Feature
• Embedded Derivatives
• Reinsurance
• Disclosure
• Measurement issues for investment contracts
• Changes in Accounting Policyinterpretation of
  guidance provided in IFRS 4

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Agenda

• International Actuarial Standards of Practice
• Contract Classification
• Unbundling
• Embedded Derivatives
• Discretionary Participation Feature

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Insurance Characteristics

• Classification of most contracts in mass business
  trivial
• Main features causing trouble
• What is significant insurance risk?
• Life insurance with large investment component
  and negligible insurance coverage
• What are the borders of one contract?
• Group contract or group of contracts?
• Sequence of contracts or one contract?
• How to ensure that all contract features are
  adequately considered?
• Complex reinsurance constructions

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Significant Insurance Risk

• Events of commercial substance
• Normally clear, anything
• where market participants are willing to pay for
• Premiums charged explicitly for that risk
• where market participants take effort to
  avoid/reduce risk
• Effective risk examination at outset
• Taking (re-)insurance for protection

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Significant Insurance Risk

• Significant additional benefits More difficult
• Significant
• Rebuttable presumption above 10 significant
• Judgment required, but significance doubtful 5
  - 10
• Up to prove of contrary unacceptable below 5
• Comparison value
• Normally surrender value plus surrender charge at
  death date
• Surrender value or surrender charge might be
  artificial and economically meaningless
• Theoretically Comparison of value of contract
  from policyholders view point in case of
  occurrence of insured event with the value in
  case of any other event of commercial substance.
• If maximal difference is significant, there is a
  significant additional benefit

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Borders of the contract

• Major question in case of group policies
• Is the group one contract?
• Is each risk covered in the group one contract,
  just grouped for administrative purposes?
• Important, if
• risk equalization effect in the group is so
  significant
• premium adjustment clauses apply
• that insurance risk on group level is not
  significant
• Terms of group agreement need to be investigated,
  whether
• each individual risk ort
• the entire group
• comply with the definition of a contract in IAS
  32.13

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Borders of the contract
Life of the (insurance) contract
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Significant insurance risk
2
Significant insurance risk
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Significant insurance risk

1. Term life insurance Risk remains significant
   throughout the contract
2. Endowment policy amount at risk in case of
   death reduces as value of investment component
   increases
3. Deferred annuity no insurance risk during
   savings phase, insurance risk in annuity phase
   overall insurance since opting for annuity is an
   event of commercial substance, except if annuity
   factor is bilaterally negotiated, enabling to
   determine prohibitive factors.

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Consideration of all Features

• Traditional problem in reinsurance How to ensure
  that all contractual
• features are adequately considered and properly
  reflected?
• Fantasy of reinsurance actuaries to style
  reinsurance treaties unlimited, hiding financing
  features reinsurance no mass business
• If a financing feature is fully hidden,
  unbundling is no threaten and it is not possible
  to measure the significance of the existing
  insurance risk properly
• But Reinsures should be able to link each
  financing agreement with at least significant
  insurance coverage
• IFRS 4 less strict than US-GAAP

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Agenda

• International Actuarial Standards of Practice
• Contract Classification
• Unbundling
• Embedded Derivatives
• Discretionary Participation Feature

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Unbundling

• IFRS 4.10 prohibits unbundling of a deposit
  component if
• not measurable separable, ie without
  consideration of the insurance component
• and allows it in all other cases.
• IFRS 4.10 requires unbundling of a deposit
  component if
• it is allowed
• recognition of all rights and obligation under
  the deposit component is not required by
  existing accounting policy

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Unbundling

• EU Directive 2002/83/EC (Life Insurance
  Directive) Article 20 1. A. (i)
• As provisões técnicas de seguro de vida devem
  ser calculadas segundo um método actuarial
  prospectivo suficientemente prudente que tome em
  conta todas as obrigações futuras de acordo com
  as condições fixadas para cada contrato em
  curso, ...
• In Europe, in applying the directive, all
  obligations considered
• Normally existing accounting policies require
  recognition of all rights
• Relevant is recognition (ie consideration in
  actuarial formula), disregarded of measurement
• Complex contract constructions might cause that
  rights or obligations are not noticed, causing
  non-recognition but no unbundling

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Agenda

• International Actuarial Standards of Practice
• Contract Classification
• Unbundling
• Embedded Derivatives
• Discretionary Participation Feature

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Derivatives and Embedded Derivatives

• Embedded derivatives are not derivatives embedded
  in other contracts
• Derivative
• Stand-alone contract
• subject to IAS 39 (ie not subject to IFRS 4)
• with specific features as defined in IAS 39.9
• especially reflecting concentrated market risk
• Embedded derivatives (IAS 39.10)
• Component of another contract (need not to be
  stand-alone a derivative, ie it can include
  insurance risk)
• Explicit clause modifying cash flows of contract
  payable otherwise
• Varying in response to market factors

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Derivatives Embedded in Insurance Contracts

• Derivative embedded in an insurance contract
• component of the contract (ie forming separated
  an economically reasonable contract which
  includes earnings and expenses)
• stand-alone in compliance with the definition of
  a derivative (especially not containing
  significant insurance risk)
• Needs to comply with all requirements in IAS 39.9
• Value provable responses to changes of specified
  market factor
• Initial net investment lower than for alternative
  investment

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Derivatives Embedded in Insurance Contracts

• A derivative embedded in an insurance contract is
  subject to IAS 39 and to be separated if and only
  if IAS 39.11 determines that, except if exempted
  by IFRS 4.8
• An embedded derivative, not qualified as a
  derivative embedded in the contract, is not
  subject to IAS 39, except if separated in cases
  allowed by IFRS 4 and the separated component is
  not in the scope of IFRS 4
• Any embedded derivative subject to disclosure
  requirements of IFRS 4.39 (e) if not reported at
  fair value

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Separation of Derivatives

• Embedded derivative is no derivative and
  therefore never separated if
• Containing significant insurance risk (in
  relation to the component)
• guaranteed insurability
• double trigger
• No alternative investment with lower initial
  investment available
• Annuity option
• Other non-traded factors (eg claim indices)
• Derivative embedded in an insurance contract is
  not separated if
• closely related
• not measured already at fair value
• not a traditional surrender option or something
  equivalent

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Agenda

• International Actuarial Standards of Practice
• Contract Classification
• Unbundling
• Embedded Derivatives
• Discretionary Participation Feature

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Discretionary Participation Feature

• Definition of DPF focused on UK situation
• Contract grants insurer discretion to decide for
  the entire surplus
• Continental European situation is deviating
• Contract grants insurer discretion regarding
  timing of recognition of surplus and allocation
  to individual policyholders
• Amount is a contractually fixed share of surplus
• Insurers have the ability to over-perform
  voluntarily obligations and pay for competitive
  reasons amounts in addition to obligatory amount,
  but not granted by contract

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Discretionary Participation Feature

• Most relevant features of definition of DPF
• Additional benefit is contractual right (no
  constructive obligation)
• Discretion is granted explicitly by contract
• Additional benefits based contractually on
  surplus
• Consequences
• Universal-life interest no DPF, since additional
  benefit not based contractually on surplus
• Voluntary payments no DPF, since discretion not
  granted explicitly by contract

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Discretionary Participation Feature

• Typical Continental European example
• Basis of participation statutory surplus
• Timing of realization or distibutability of
  investment gains at the discretion of the insurer
• Policyholders share in surplus is a
  contractually fixed percentage
• Insurer may pay voluntarily additional amounts
  based on competitive pressure
• Application of DPF-Definition
• Timing of realization or distributability
  qualifies as discretion
• Percentage share of policyholders in surplus
  qualifies as connection to surplus
• ? Contract contains DPF

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Discretionary Participation Feature

• DPF comprises
• those additional benefits paid under the
  contractual right
• not the entire additional benefit, if reflecting
  competitive pressure rather than share in surplus
• Voluntary payment in addition to legal share is
  not part of DPF, since
• is not paid based on a contractual right of
  policyholders
• the discretion to pay that amount is not granted
  by the contract and not contractually based on
  surplus
• the amount is not determined based on surplus but
  on competitive needs irrespective surplus (no
  incremental relation to surplus)
• ? No need to report any amount paid voluntarily
  in future as liability before a legal or
  constructive obligation is established

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Discretionary Participation Feature

• Consequence
• Entire DPF is classified as liability, if the
  insurer classifies as liability
• any amount already legally allocated to
  policyholders
• the contractual percentage of any surplus
• reported under statutory accounting but not
  ultimately allocated to policyholders since
  subject to future performance (policyholders have
  no right to get more, but might get less)
• reported under IFRSs but not yet reported under
  statutory accounting
• ? Future voluntary payments are not anticipated
  but expensed and to be reasoned to the owners
  when the legal binding decision is made, there
  is in difference to the situation in UK no
  contractual constraint earlier