Neil Coulson

13 January 2011

Insurance contracts - IFRS

Insurance contracts accounting

Contents (compare with current UK GAAP/IFRS and highlight feedback to ED)

• Background

• Recognition

• Measurement

• Short-duration contracts

• Reinsurance

• Presentation

• Disclosure

• Transition

Insurance contracts accountingCurrently - UK GAAP

• Non-listed UK companies and Lloyd’s syndicates– The Large and Medium-sized Companies and Groups (Accounts and

Reports) Regulations 2008 - Schedule 3 Insurance Companies– ABI SORP – Accounting for Insurance Business

Currently - IFRS• Listed European companies

– Phase I: IFRS 4 – Insurance Contracts Issued 2004– Interim standard permits many different existing practices – few differences

to UK GAAP for general insurersFuture

• UK GAAP proposed transfer to IFRS • Implementation - Periods ending after 1 July 2013 at earliest – early adoption

permitted

Insurance contracts IFRS

Timetable

Phase I - started 1997

• IFRS 4 – issued 2004

Phase II

• Discussion paper – May 2007

• Exposure draft issued – July 2010 – 87 pages & 95 pages of explanatory

• Comments deadline - 30 November 2010 – improvements but 248 comments

• New standard – mid 2011?

• Implementation – periods commencing 1 January 2013? (plus comparatives)

Will it coincide with IFRS changes, end of UK GAAP & start of Solvency II?

What is an insurance contract for this Standard?

“A contract under which the insurer accepts significant insurance risk from the policyholder by agreeing to compensate policyholder if a specified uncertain future event adversely affects the policyholder.”

• Mostly similar to IFRS4

• Different to UK GAAP where policies with only financial risk may be allowed

Includes: - Financial guarantee contracts – previously excluded by IFRS4 –(may change)

Excludes: - Product warranties & fixed-fee service contracts

- Employer’s pension scheme assets & liabilities

- Direct insurance contracts held as a policyholder

- Certain specific types of financial contract

When is a contract recognised?

Recognise - provided can compel policyholder to pay premium at earlier of:

– When the insurer is bound by the terms, and

– When the insurer is first exposed to risk.

• Potentially different to current position under UK GAAP & IFRS

• Need to identify risks bound before inception – not currently recognised

Boundary - policies exposed until:

– No longer required to provide coverage (liability extinguished), or

– Has the ability to reassess and re-price to reflect risk.

• Need to include policies with unalterable renewal terms

Unbundle - separate components not closely related to insurance coverage

– Mostly impacts life

Measurement (many differences to IFRS4 & UK GAAP)

Present value of fulfilment cash flows - (3 building blocks)

• Explicit unbiased and probability weighted-estimate of future cash flows (in & out)

• Discount rate that adjusts those cash flows for time value of money

• Explicit estimate of effects of uncertainty about amount & timing of cash flows

Residual margin

• To eliminate any gain at inception of above cash flows

• Release over coverage period based on passage of time (or risk)

Acquisition costs

• Include incremental costs in above cash flows

– Only costs that would not be incurred if no policy issued

• Recognise all other costs as expenses when incurred – worsen day 1 result

Building blocks

Reserves

0

20

40

60

80

100

120

Best Estimate Less Discount Add Margin Add Residual

Cash flows – probability weighted best estimate

Inflows and outflows for a portfolio of contracts – net effect

• Exclude discount & risk adjustment

• From perspective of entity but consistent with market observables

• Unbiased incorporation of amounts, timing & uncertainty

• Current information

• Only contracts within boundary

Discounting

Time value of money

• Consistent with observable current market prices for instruments with:

– Similar timing, currency, liquidity to the liability

• Exclude any factors present in instruments not in the liability

– Risk free yield curve – (not linked to assets held)

– Adjust for illiquidity of contracts if applicable

– Reflect any dependence of contract cash flows upon specific assets

– Cash flows internally consistent with inflation effects

Risk margin

Risk adjustment

• Maximum amount insurer would rationally pay to relieve risk of cash flows exceeding expectation

• Estimate at portfolio level – not diversify between portfolios

• No adjustment for non-performance of insurer

• Only 3 techniques for estimating permitted:

– Confidence level

– Conditional tail

– Cost of capital

• Must disclose confidence level selected

Feedback to ED suggesting more flexibility in techniques – FASB composite margin

Short-duration contracts – mandatory treatmentCoverage period of contracts approximately one year or less

• Biggest difference is presentation

– Will include most general insurance contracts – (binding authorities?)

Pre-claim liability (different basis to post-claim liability)

• Present value of premium less incremental acquisition costs

• Increase liability if onerous and present value exceeds above

– Evaluate by portfolio & similar inception

Release

• Evenly over policy period - unless expected claims timing different

• Accrete interest on liability at relevant discount rate

Feedback to ED suggest

• Optional, not strict 12 months, still complicated

Reinsurance (many differences to IFRS4 & UK GAAP)

Apply same principals as for insurance contracts

• Value ceded cash flows in same manner as underlying contracts

– Use short-duration approach if approximately one year

• Do consider risk of non-performance by reinsurer when estimating values

• Do not de-recognise underlying liabilities until extinguished (same as now)

• If present value of cash inflows to cedant exceed outflows

– Immediately recognise gain

• If present value of cash outflows from cedant exceed inflows

– Treat as residual margin and release over policy period (or risk)

Presentation (many differences to IFRS4 & UK GAAP)

IFRS4 had only fairly general guidance on presentation

UK GAAP – detailed guidance on presentation from Sch 3 & SORP

Proposed presentation difficult to visualise

Statement of financial position ( = Balance sheet)

• Each portfolio of contracts as single net item within insurance contract assets or liabilities

– Net asset/liability of future premiums less future claims and incremental acquisition costs cash flows

• No offset of reinsurance assets against insurance liabilities

• All foreign currency cash flows from insurance contracts are monetary amounts

– Including residual margins (NB: there are no unearned premiums)

Presentation

Statement of Comprehensive Income (= Profit & loss)

• Include all income & expenses from insurance contracts

• Not offset income/expense from reinsurance contracts with income/expense from insurance contracts

• Generally treat as deposits/repayments and do not present the following within statement of income as line items:

– Premiums, claims and incremental acquisition costs

• Except short –duration contracts where present – underwriting margin split by:– Premium revenue - being the release of pre-claim obligation– Claims incurred– Expenses– Amortisation of incremental acquisition costs– Change in additional liabilities for onerous contracts

PresentationStatement of Comprehensive Income (= Profit & Loss)

Line disclosures & notes

• Underwriting margin (if not short-duration) – showing:

– change in risk adjustment, release of residual margin

• Gains & losses at initial recognition – showing:

– losses acquired on portfolio transfer, gains on reinsurance ceded, losses on initial recognition of contract

• Acquisition costs (those not incremental at individual policy level)

• Experience adjustments & changes in estimate – showing:

– difference between actual & estimated cash flows, change in estimated cash flows & discount rates, reinsurance impairment, interest on contracts

– highlight changes in discounts and interest rates with investment returns of assets backing liabilities

Disclosure

General disclosures regarding insurance contracts

• Qualitative & quantitative disclosure of amounts recognised

• The nature & extent of risks arising

• Sufficient information to reconcile line items

• Do not aggregate different reportable segments under IFRS8

– Appropriate aggregations – type of contract or geographic

• Explanation of recognised amounts & uncertainties of future insurance cash flows

– Reconciliation of opening & closing aggregate balances

– Methods & inputs used for measurement

Disclosure

Balance Sheet Items

Insurance assets, insurance liabilities and reinsurance assets – (shown separately)– Disclose for the above separately: risk adjustments & residual margins– Impairment losses on reinsurance assets

Show the following for each of the above reconciled to the Statement of Income:– Opening and closing carrying values– New contracts recognised in period & premiums received– Claims, expenses, incremental acquisition costs - also disclose amounts

incurred in period– Other cash paid & other cash received– Currency translation differences– For short duration contracts – claims liabilities, pre-claims liabilities, onerous

liabilities

Disclosure

Methodology & risk disclosures

Methods & inputs for key measurements – including risk adjustment & discount rate

• Effect of material changes to inputs

• An analysis of measurement uncertainty

Nature of risks – qualitative & quantitative details highlighting changes

• Insurance risk, credit risk, liquidity risk, market risk, other risks

• Exposures & concentrations, risk management policies, mitigation & reinsurance, sensitivities

Up to 10 years claims development history

The above disclosures are similar to IFRS4 with some overlap with UK GAAP

Transition

Need not disclose previously unpublished claims data that is more than 5 years before transition

At beginning of earliest period presented under transition

• Measure each portfolio at present value of cash flows

• Ignore any residual margin – potential large one-off profit

• Derecognise existing deferred acquisition cost balances b/f

At transition may re-designate financial assets to fair value

Results may become more volatile

• Asset & liability valuation & discount mismatch – mostly for life

What next?

• Standard due in mid 2011

• Significant feedback on ED

• Struggling to converge with FASB

• May be delayed

Philip Alexander

13 January 2011

Comparative analysis: IFRS v Solvency II

Comparative analysis: IFRS v Solvency II

• Insurance liabilities measurement

– Overview / structure of the balance sheet

– Discounted cash flows

– Risk margins and risk allowances

– Residual margin

– Expenses

• Asset measurement – a ‘canter through’

Liability measurement: An overview

• Solvency II

– A single measurement for all insurance and reinsurance contracts

– Liabilities measured at discounted cash flows plus a risk margin

– Current cost to transfer obligations immediately to another undertaking

• IFRS

– Liabilities measured as the amount required to fulfil the contractual obligations over the lifetime of a contract

– Measured at discounted fulfilment cash flows plus a risk adjustment

– Maximum amount an insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows exceed those expected

– Additional component – the residual margin to eliminate day 1 profits

Liability measurement: Structure of the balance sheet

Discounted probabilityweighted

estimate offuture cash

flows

Free assets

Solvency capitalrequirement

Risk margin

Solvency II Balance Sheet IFRS

Balance Sheet

Risk allowance

Residual margin

Equity

Discounted probabilityweighted

estimate offulfilmentcash flows

Margin set to prevent a day one

gain

Maximum amount an insurer would

rationally pay to be relieved of the risk that the ultimate fulfilment

cash flows exceed those expected

Sets the technical provisions as the expected amount

required to take over and meet obligations

Regulatory capital requirement calibrated

at a 1 in 200 event

Technical provisions

Liability measurement: Discounted future cash flows

Solvency II IFRS Impact

Liability measurement The expected or mean valu e (probability weighted average) of the present value of future cash flows for current obligations, projected over the contract’s run-off period, taking into account all up-to-date financial market and actuarial information.

The expected present value of the future cash flows less future cash inflows that will arise as the insurer fulfils the insurance contract, adjusted for the effects of uncertainty about the amount and timing of those cash flows

Discount rate • Risk free rate plus an allowance for an ‘illiquidity’ premium.

• Both the risk free rate and the ‘illiquidity premium’ were prescribed within in QIS 5

• Require use of rates that are consistent with current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability.

• Equates to the risk free rate plus an allowance for an ‘illiquidity’ premium

Liability measurement: Expense cash flows

Solvency II IFRS Impact

General rule Includes all expenses that will be incurred over the lifetime of contracts, including overheads

Includes incremental expenses only

Includes • Acquisition costs, including any commissions due in the future

• Administration costs, including general management overheads and costs not directly attributable to policy maintenance

• Claims management costs

• Claims handling fees

• Can build in inflation

• Policy administration costs including commissions payable in the future

• Costs that do not relate directly to the contract, such as general overheads, are excluded – but onerous administration costs are!

• Claims management costs

• Claims handling fees

Liability measurement: Risk adjustmentsSolvency II Risk margin

IFRSRisk adjustment

Impact

Similar concepts -measure of uncertainty about the amounts and timing of future cash flows

Calculation methodology

Only allows for the cost of capital methodology – heavily prescribed

Allows three measurement techniques:

• confidence level

• conditional tail

• cost of capital

Cost of capital Cost-of-Capital rate should be consistent with the Value-at- Risk-assumption corresponding to a confidence level of 99.5 per cent over the stipulated one-year time horizon – 6% in QIS 5.

More flexible approach based on:

• estimation of CF distribution

• set confidence level

• set cost of capital

• set discount factor

Diversification Diversification credit set at entity level

Diversification credit set at the portfolio level

Liability measurement: SCR v Residual margin

SCR – A regulatory rather than financial reporting concept.

Residual margin - not a concept for Solvency II – for IFRS the margin is calibrated at inception to an amount that avoids recognising a gain when an insurer enters into an insurance contract. A loss is recognised on inception.

Asset measurement: An overview

• Generally a lot easier than for insurance liabilities

• Solvency II tends to follow ‘fair value’ accounting

• ‘Fair value’ often, but not always, equivalent to the IFRS treatment

Asset measurementSolvency II IFRS Impact

Goodwill on acquisition No value - goodwill is not considered an identifiable and separable asset that can be sold in the market place

Initial measurement at cos t. Subsequently, cost less any impairment

Intangible assets • Carry at fair value if the asset is identifiable and separable and there is an observed market

• Very high hurdle – in practice likely to be £nil.

• Initial measurement at cost.

• Subsequently, cost less accumulated depreciation (cost model); or

• Fair value at revaluation date less depreciation or impairment (revaluation model)

• Plant, property and equipment

• Investment properties

• Carry at fair value

• Revaluation model under IFRS is a proxy for fair value

• Initial measurement at cost.

• Subsequently, cost less accumulated depreciation (cost model); or

• Fair value at revaluation date less depreciation or impairment (revaluation model)

Asset measurementSolvency II IFRS Impact

Finance leases Finance leases are measured at fair value

Initial measurement at the lower of fair value and the pv of the minimum lease payments.

Financial assets • Carry at fair value in the solvency balance sheet

• Any investments carried at amortised cost need to be marked- to-market and carried at fair value

• Amortised cost – Debt instruments giving rise to payments of interest and principal on specified dates. Asset cannot have been designated FV through the profit and loss account.

• Fair value through ‘Other Comprehensive Income’

• Fair value through the profit and loss account.

• Watch IFRS 9

Non-current assets • Carry at fair value less cost to sell • Carry at lower of carrying amount or fair value less cost to sell

Asset measurementSolvency II IFRS Impact

Deferred tax assets and current tax assets

• Value in accordance with IFRS • Deferred tax asset – recognise only when probable that an entity will earn sufficient taxable profits to utilise the asset.

• Current tax asset at the amount expected to be recovered i.e. Fair value

Cash • Cash carried at an amount not less than the amount payable on demand – effectively fair value

• Treated as a financial asset – effectively fair value.

Other assets • Value in accordance with IFRS • Generally - carry at fair value

Philip Alexander

13 January 2011

UK GAAP and IFRS

The changing reporting landscape

• At present three accounting bases:

– IFRS

– UK GAAP

– FRSSE

• In looking at Solvency II we looked at IFRS – why?

– UK GAAP convergence with IFRS

– Three bases:• Full IFRS

• IFRS for medium sized companies – FRSME

• Smallest companies continue with FRSSE

– Planned that will be effective from 1 July 2013

• Likely that any insurer going down the own model route – full IFRS

Impact of moving to IFRS

• First time adoption

• y/e 31 December 2013 – Full IFRS accounts required

• y/e 31 December 2012 – Comparatives under IFRS required

– Reconciliation of UK GAAP profit and equity to UK GAAP

– Amended cash flow statement

• As at 1 January 2012 – Transition balance sheet

First year adoptionComparative year

31/12/131/1/12 31/12/12

Impact of moving to IFRS

• Format of the financial statements

– Not Companies Act format

– No SORP

– Balance sheet - total assets = total liabilities + equity

– Income statement – replaces the profit and loss account

– Statement of comprehensive income – replaces the STRGL

– Increased disclosures

• Format set out in IAS 1

• It is coming and as well as Solvency II, companies need to start thinking about IFRS

• New standards – move towards fair value

• Likely to be a topic of a future seminar

Questions

This guide is prepared as a general guide. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author or publisher. Always seek professional advice before acting .

© Littlejohn