IFRS4 Insurance Contracts Phase I

IFRS4 Insurance ContractsPhase I Topical Actuarial Issues, 1.4.2004, Prague Jiří Fialka

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

Reasons for issuing the standard • No IFRS on insurance contracts • Diverse current practices • IFRS intended to form EU accounting basis from 2005

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.

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

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

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

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)

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.”

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

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)

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?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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“

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 31/12/03 31/12/02 31/12/04 31/12/05 31/12/06 Period covered in first IAS financial statements Period covered in first IAS financial statements SUNSET CLAUSE

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

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

IFRS4 Insurance Contracts Phase I