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					CIA Appointed Actuary Seminar

David Thomson, Partner
KPMG LLP

September 21, 2006
FINANCIAL SERVICES - INSURANCE
Today’s Agenda

  Background
  What Are The Changes
  Practical Application Issues
  Impact On Financial Reporting




                                  2
Background


  Global trend towards international financial reporting
  standards (“IFRS”)
  Canadian AcSB has announced a plan to move to
  IFRS within 5 years
      No more Canadian GAAP
      Convergence underway
  IFRS accounting model is a fair value measurement
  model
      Most relevant measure




                                                           3
What Are The Changes

 3 new accounting standards
     S.3855     Financial Instruments – Recognition and
                Measurement
     S.3865     Hedges
     S.1530     Comprehensive Income

 Consequential amendments
    S.4211      Replaces S.4210 – Life Insurance
                Enterprises
    AcG9        Financial Reporting by Life Insurance
                Enterprises



                                                          4
What Are The Changes

    Applies to all entities
    Affects the life insurance industry in a unique way
    due to linkage between asset and liability
    measurement
         Extensive lobbying for an exemption for life
         insurers however CICA unconvinced
         The Train Has Left The Station!!
    Will significantly change the measurement of
    financial instruments and their presentation and
    disclosure of the financial statements.




                                                          5
What Are The Changes

 Timing

   Applies to fiscal years beginning on or after October
   1, 2006 for publicly accountable enterprises
      Q1 2007 for most life insurers




                                                           6
What Are The Changes

 Transition

   No restatement of prior periods
   Designate all assets/liabilities at beginning of first
   period
      Generally January 1, 2007
   Restate the opening balance sheet
      To recognize assets/liabilities at fair value
      To write-off previously deferred gains/losses
      Adjust opening equity as a result of the above



                                                            7
What Are The Changes

 Application

   All financial assets and liabilities that meet the
   definition
   Insurance contract liabilities meet the definition
   however, they are specifically exempted therefore
   4210/4211 measurement basis continues i.e. CALM
   Results in a “Hybrid” or mixed measurement model




                                                        8
CICA 3865 - Hedges

    Combines existing guidance in AcG-13 on when an
    entity can apply hedge accounting with guidance on
    how to apply hedge accounting
    Introduces to Canadian GAAP three types of
    hedges: Fair value hedge, cash flow hedge and
    hedge of a net investment in a self sustaining
    foreign operation and provides guidance on how to
    account for each
    New requirement that any ineffectiveness in a
    hedging relationship be recorded immediately in
    income
    Significant disclosure requirements


                                                         9
Hedge Accounting S.3865

  Current GAAP
      Hedge is measured on the same basis as the
      hedged item
      Otherwise derivatives are measured as equities
      → moving to market
  GAAP in 2007
      Derivatives measured at fair value
      Unrealized gains/losses to income for fair value
      hedges
      For cash flow or net investment hedges,
      effective portion of unrealized gains/losses is
      reported in other comprehensive income and
      the ineffective portion in income

                                                         10
Comprehensive Income – S.1530

   Comprehensive income
     ..change in equity of an enterprise during a period
     from transactions and other events and
     circumstances from non-owner sources. It
     includes all changes in equity except those
     resulting from investments by owners and
     distributions to owners
   Other comprehensive income (OCI)
     ..revenue, expenses, gains or losses that are
     included in comprehensive income, but excluded
     from net income



                                                           11
Comprehensive Income - S.1530

   Statement of comprehensive income must be
   displayed with same prominence as other financial
   statements
   OCI is a temporary “parking lot” for certain gains and
   losses arising from certain hedges, translation of self-
   sustaining foreign operations and available for sale
   financial assets
   OCI items are also tax-effected
   Amounts in OCI reclassified to net income when
   required by GAAP




                                                              12
CICA 4211 – Life Insurance Enterprises

    Replaces the existing CICA 4210, effective
    immediately with the implementation of CICA 3855,
    to conform to the latter
    Deletes the old “move to market” accounting for
    assets that are financial instruments but retains it for
    “life insurance investments”, defined as:
      “ investments held by life insurance enterprises, other than:
      (a) investments in subsidiaries, joint ventures, partnerships or
           companies that are subject to significant influence by the
           investor; and
      (b) financial instruments and non-financial derivatives”



       What does this leave on a move to market basis? Most
       common example is investment real estate

                                                                         13
Classification

    All financial instruments must be classified

         Hold To Maturity
                                                   •    Once and for all
         Held For Trading                              designation at inception


         Available For Sale                        •   Based on
                                                       management’s intention
         Loans and receivables




                                                                                  14
Classification


       Category        Accounting Treatment                 Issues

  Held To Maturity     Amortized Cost             Portfolio Tainting Rules
                                                  - Difficult to maintain
                                                    Requires reclassification to
                                                    AFS
  Held For Trading     Fair value with gains and Can elect HFT for any
                       losses included in income financial instrument at
                                                  inception (The Fair Value
                                                  Option)
  Available For Sale   Fair value with unrealized Mismatch for assets
                       gains and losses included backing liabilities
                       in Other Comprehensive
                       Income. Amortization of
                       premiums/discounts
                       included in income.
  Loans and            Amortized cost
  receivables
                                                                                   15
Classification

                                               $

    Net income                                 X

    Other comprehensive income                 X

    Total comprehensive income                 X




→    Income will be accounted for differently depending on the classification
→    OCI is a separate category within equity on the balance sheet

WILL LIKELY CHANGE THE FOCAL POINT FOR INVESTORS AND ANALYSTS



                                                                                16
Classification


                                     Net Income            Other
                                                       Comprehensive
                                                          Income
             Hold To Maturity     Amortized Cost      Nil

Investment   Held For Trading     Change in fair      Nil
Portfolio                         value
             Available for Sale   Amortized cost      Change in fair
                                  plus realized gains value




                                                                       17
Classification


            Net Income         Other     Actuarial Liabilities
                           Comprehensive   Discount Rate
                              Income
Held to     Amortization   Nil              Book                 Matched
Maturity
Held for    Change in      Nil              Market               Matched
Trading     fair value
Available   Amortization   Change in fair   Market               Mismatched
for Sale                   value




                                                                              18
Applying Financial Instruments to Life Insurers –
impact on policy liability measurement

   Under CALM, policy liabilities would reflect the
   carrying value of assets used to support liabilities
   If available for sale (AFS) assets support liabilities, a
   mis-match arises since:
        unrealized gains are held in other comprehensive
        income (OCI), while
        the corresponding increase in policy liabilities are
        expensed
   Hold to maturity classification ordinarily won’t be
   sustainable for investment portfolios



                                                               19
Applying Financial Instruments to Life Insurers –
impact on policy liability measurement

   This leaves the “fair value option”, ie. as held for
   trading:
     Avoids mis-matches as all investment gains,
        realized and unrealized, would be recognized in
        income in the same period as changes in policy
        liabilities
     Assets supporting surplus can be either on an AFS
        basis (probably the most common approach) or at
        market
     This will likely be the preferred option for most life
        insurers



                                                           20
Practical Application

   Designation as trading/use of fair value option for asset
   backing liabilities
     Theoretical matching with CALM liability model
     Eliminated income statement volatility
   However, there are significant practical application
   challenges
     Controls and procedures within the actuarial
       valuation prices
     AuG-43 compliance
     Difficulty with rollforward techniques when CALM
       valuation is done pre-period end
     Will require new controls and procedures


                                                           21
Applying Financial Instruments to Life
Insurers – Determining Fair Value


Active market valuation        Published prices
Non-active market              Valuation models/techniques
                               External evidence vs. internal analysis



            Major Concern for OSFI is reliability




                                                                          22
OSFI guideline D-10 limits use of the “fair
value option”
 Only if the result is “more relevant financial
 information”, where it:
    Eliminates or significantly reduces            Assets backing policy
    measurement or recognition                      liabilities would meet
    inconsistencies (“accounting mismatch”)         this criterion – but not
    Group of financial assets and/or                surplus assets
    liabilities managed and performance            Not clear whether this
    evaluated on a fair value basis                 would have application
 General requirements:                              for most insurers
    Both of the above requires documented
    risk management strategy
    FV option should not be used for any
    assets for which fair values cannot be
    reliably estimated
    FV option should not be used for loans
    and mortgages to individuals, or to
    companies with revenue under $62.5M

                                                                               23
Applying Financial Instruments to Life
Insurers – use of the “fair value option”


 Note for those with US reporting            However, proposals were
 requirements - the “fair value option” is   released recently to
 available under both Canadian GAAP          change US GAAP to
 and International Financial Reporting       allow the fair value
 Standards (IFRS), but not under current     option
 US GAAP




                                                                       24
Applying Financial Instruments to Life Insurers

Asset/Liability                        Expected accounting basis
Investments -        Backing policy    Held for trading
financial            liabilities
Investments -        Backing surplus   Available for sale
financial
Investments – real                     Amortize to market (current
estate                                 basis)
Loans and                              Amortized cost
receivables
Policy liabilities                     Exempt from CICA 3855; CALM
                                       valuation
Deferred realized                      No longer applicable to financial
investment gains                       instruments – realized gains
                                       included in income
Other liabilities                      Amortized cost
                                                                       25
Implementation issues – systems and
processes
  Continue to amortize purchase premiums and discounts
  for fixed income securities (constant yield method)
     Need this in particular for AFS securities, otherwise
     premiums and discounts would not be “realized” until
     sale or maturity, distorting income
  New rules call for use of bid prices rather than “last
  trade” prices as market values




                                                             26
Implementation Issues – Treatment for Tax
Purposes

 Mark to market property (for tax) includes:
    An SDO (Specified Debt Obligation) which is carried at
    market in the books and
    Has been carried at market since the time it was
    purchased
 Appears that all SDO’s currently held (at Dec 31, 2006) will
 not be MTM property for tax purposes
 Many investments will eventually become MTM properties
 (AFS and HTM classifications)




                                                                27
Implementation Issues – Treatment for Tax
Purposes

 Tax Reserves
   P&C reserves – Will change due to change in book
   reserves
   Life reserves Pre-96 – No change as a result of change
   in book reserves
   Life reserves Post-95 – Will change due to change in
   book reserves
   Question: How direct is the relationship to FV
   increase?




                                                            28
Implementation Issues – Treatment for Tax
Purposes

   Result: There will be a change in book and tax
   reserves (except life pre-96 tax)
   The related change in SDO’s currently owned will not
   trigger a taxable income inclusion
   Finance will not like a one time increase in reserves
   with no immediate income inclusion on SDO’s
   Transitional rule for reserve increase?
   Over what period?
   Impact on Future Tax discount adjustment included in
   actuarial reserves




                                                           29
Implementation issues – systems and
processes, cont’d
  Investments will need to be “tagged” for different
  categories
  For AFS assets, will need both fair value and cost (to
  calculate realized gains, and to relieve OCI)
  Assess how the fair value of any financial instruments for
  which a quoted market price is not available will be
  accurately determined for reporting purposes




                                                               30
Implementation issues – reporting timetables

  Without the “asset value smoothing” in the old CICA
  4210, asset carrying values will be much more volatile
  Actuarial liability calculations will have to reflect asset
  value movements right up to year end, to avoid mis-
  matches

      Re-run or run actuarial calculations only after year
       end?
      Develop methods for bulk adjustments to liabilities
       based on late-in-year asset movements?




                                                                31
Impact on financial reporting


  Earnings
     Volatility should not change
     much for assets backing
     insurance liabilities…
     … but will increase sharply for
     assets backing surplus
     Some loss of comparability
     with pre-2006 results
  Higher book values                   Asset carrying values
     Higher asset values               should be more easily
     Higher total surplus - will       understood by readers …
     mean lower ROEs                   but policy liabilities will be
                                       just as opaque as ever

                                                                        32