Session 8 IFRS and Solvency Requirements

1. Session 8IFRS and Solvency Requirements Regional Training Seminar IAIS-ASSAL-FIDES 25 November 2009, Lima Peru Takao Miyamoto, IAIS Secretariat

2. Agenda • Background • Accounting and Solvency • IASB Insurance Contracts Project Overview • IASB and IAIS Views on Main Issues • Measurement Approaches • Building Blocks • Margins • Day One Difference • Acquisition Costs • Own Credit Risk

3. Two Uses of Financial Reporting General purpose financial reporting Should reflect economics of businesses (Starting point) : Efficiency • Many resources (e.g. audit) were already used for accuracy & reliability • Widely accepted (Prudential filter) : Adjustment for different purposes • Often in conservative direction • IAIS seeks to minimise Regulatory purpose reporting & requirements Should serve to protect policyholders

4. Key Principle The IAIS believes that it is most desirable that the methodologies for calculating items in general purpose financial reportscan be used for, or are substantially consistent with, the methodologies used for regulatory reporting purposes, with as few changes as possible to satisfy regulatory requirements.

5. IASB Project Schedule 1997 • Insurance Contracts Project start Phase I IFRS 4 2004 Phase II May 2007 • Discussion Paper “Preliminary Views on Insurance Contracts” (DP) Q2 2010 • Exposure Draft New IFRS Mid 2011

6. Agenda Background Accounting and Solvency IASB Insurance Contracts Project Overview IASB and IAIS Views on Main Issues Measurement Approaches Building Blocks Margins Day One Difference Acquisition Costs Own Credit Risk 5

7. Measurement Approaches – IASB • “Current Exit Value” • Amount insurer would expect to pay at reporting date to transfer remaining contractual rights and obligations immediately to another entity • “Current Fulfillment Value” • Expected present value of cost of fulfilling obligations to policyholder over time • “Updated IAS 37” • Amount entity would rationally pay at end of reporting period to be relieved of present obligations • Given absence of active market for insurance contracts, this may be close to fulfillment notion 6

8. Measurement Approaches – IAIS • Insurers generally do not transfer liabilities, given no active market for insurance contracts • Insurers generally fulfill/settle obligations to policyholders over time • Any transfer notion would be strongly influenced by settlement of obligations that transferee would undertake • Transfers would need to be made to entity capable of accepting transfer • It implies that transferee would also need to be regulated and capable of settling obligations to claimant/beneficiary 7

9. Building Blocks – IASB • Three building blocks • Current estimate of expected (i.e. probability weighted) present value of future cash flows • Time value of money (i.e. discounting) • Explicit margin • Rationale • Markets for trading insurance contract rarely exist • So, its value is rarely observable (i.e. Level 3 financial product) • So, its value has to be estimated somehow

10. Comparison 9

11. Unearned Premium Approach • Exception • Pre-claims short-duration liabilities only • Permitted (not required) to use “Unearned Premium” approach • Provide decision-useful information • Cost vs. Benefit • Measurement method • As insurer is released from risk, related part of premium is earned and recognised as revenue • Unearned part of premium is recognised as liability • Lock-in: allocate original price (premium) over periods • No explicit margin 10

12. Agenda Background Accounting and Solvency IASB Insurance Contracts Project Overview IASB and IAIS Views on Main Issues Measurement Approaches Building Blocks Margins Day One Difference Acquisition Costs Own Credit Risk 11

13. Margins – IASB • Types of margins • Risk: compensation required for bearing risks • Service: compensation for assuming services other than risk margin • Residual: remaining margin (calibrated to actual premium) • Composite: inclusive of above three (calibrated to actual premium) 12

14. Comparison 13

15. Agenda Background Accounting and Solvency IASB Insurance Contracts Project Overview IASB and IAIS Views on Main Issues Measurement Approaches Building Blocks Margins Day One Difference Acquisition Costs Own Credit Risk 14

16. Day One Difference • What is “Day One Difference”? • When using exit price (whether transfer or fulfillment) instead of entry price, day one difference could arise at inception • It could be both positive (gain) or negative (loss) • Simple examples • Insurance Company A enters into one-year term non-life contract. Premium for contract is 1,000 and is received at inception. Expected present value of future cash outflow is 800. • What if expected present value of future cash outflow is 1,200?

17. Day One Difference – IASB • Recognition • No profit at inception should be recognised in profit/loss • Margin (either residual or composite) is recognised as liabilities • They are calibrated to actual premiums • Loss at inception should be recognised in profit/loss – onerous contracts • Asymmetry exists 16

18. Acquisition Costs – IASB • Issues • Insurance companies incur initial acquisition costs • Significant amount especially for long term contracts • Are they expensed or deferred? • How about matching revenue? • IASB position • All acquisition costs should be expensed when incurred • No revenue can be recognised to offset acquisition costs expensed – October 2009 position • Day one loss on long term contracts (e.g. life insurance) 17

19. Comparison 18

20. Agenda Background Accounting and Solvency IASB Insurance Contracts Project Overview IASB and IAIS Views on Main Issues Measurement Approaches Building Blocks Margins Day One Difference Acquisition Costs Own Credit Risk 19

21. Own Credit Risk • Whether to include insurer’s own credit risk in valuation of insurance liabilities • If included, decrease in liabilities for worsening of insurer’s credit standing

22. Comparison 21

23. Questions and Answers Thank you very much! www.iaisweb.org takao.miyamoto@bis.org