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e
IFRS 4 Training
August 2009
Agenda
Background
Product Classification
Embedded Derivatives
Insurance Contract Accounting
Investment Contract Liability Measurement
Disclosure Requirements
2
Aug 2009
Key standards for insurers
Investments: Equity Various
Equities
Insurance
Fixed interest IAS 39 Liabilities &
Mortgages
investment
Loans
contracts
with IFRS 4
Property IAS 40 discretionary
Investment participation
Contract IAS 18 features
DAC
Investment
Insurance Insurance Liabilities
Insurance Assets – Phase I
IFRS 4 contract
– Phase I IAS 39
DAC
liabilities
PVIF IFRS 4 Other
Other assets Various liabilities Various
3
Aug 2009
Phased approach for insurance
There is now a phased approach to insurance contracts.
Phase I – Implement by 2005
IFRS
INSURANCE
PROJECT
Phase II – Implement Fair
Value by 2010 / 11 (?)
The Board‟s objective for Phase I is to implement some
components of the insurance project by 2005, without
delay to Phase II
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Aug 2009
e
Product Classification
Product classification
- Why is it important?
Product Classification defines accounting treatment
Discretionary
Phase I Participation Investment
contracts
Insurance contracts Investment contracts
Existing
Accounting* Amortised Cost
Existing
-or-
Accounting*
Fair Value
*Subject to certain modifications
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Aug 2009
Classification flowchart
Are any elements of Product is an Investment
Classified as an
the benefit driven by discretionary Yes Contract with discretionary
investment contract
participation participation features
No
No Deposit component Product is an Investment
Contract without discretionary
participation features
Insurance and deposit
Is there significant
components of contract must, if
insurance risk present
not recognised, be unbundled
in the contract?
and valued separately
Insurance
Yes component
Yes
Is there a
Insurance deposit component to the
Product is an
features present contract? If so, is the deposit component No
Insurance Contract
in contract independent of the insurance
cash flows?
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Aug 2009
Insurance risk
Are any elements of Product is an Investment
Classified as an
the benefit driven by discretionary Yes Contract with discretionary
investment contract
participation participation features
No
No Deposit component Product is an Investment
Contract without discretionary
participation features
Insurance and deposit
Is there significant
components of contract must, if
insurance risk present
not recognised, be unbundled
in the contract?
and valued separately
Insurance
Yes component
Yes
Is there a
Insurance deposit component to the
Product is an
features present contract? If so, is the deposit component No
Insurance Contract
in contract independent of the insurance
cash flows?
8
Aug 2009
Definition of insurance
“A contract under which one party (the insurer) accepts
significant insurance risk from another party (the
policyholder) by agreeing to compensate the
policyholder if a specified uncertain future event (the
insured event) adversely affects the policyholder.”
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Aug 2009
Insurance versus financial risk
Financial risk is the risk of a possible future change in one or
more of a specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index or other variable, provided in the
case of a non-financial variable that the variable is not specific to
a party to the contract.
Insurance risk is risk, other than financial risk, transferred from
the holder of a contract to the issuers
If both financial risk and significant insurance risk are present,
contract is classified as insurance.
Example: Lapse risk is not an insurance risk
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Aug 2009
Significant insurance risk
„Significant if, and only if, an insured event could cause an
insurer to pay significant additional benefits in any scenario,
excluding scenarios that lack commercial substance.‟
Additional benefits must be for pre-existing risk and do not
include:
Charges that would be made on cancellation or surrender
Loss of ability to charge policyholder for future services
Possible reinsurance recoveries (these are classified separately)
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Aug 2009
Significant insurance risk
Additional benefits include timing risk
Whole life contract (payment known, timing unknown) has additional
benefits
Contract where death benefit is equivalent to maturity benefit (i.e.
maturity benefit adjusted for time value of money) does not have
additional benefits
Classification on a contract by contract basis
Contracts entered into simultaneously with the same policyholder count as
one contract
Products may be classified homogeneously on materiality grounds
12
Aug 2009
Quantitative measures
No quantitative guidance given.
Rules of thumb currently being adopted for internal
consistency
Benefit paid on death exceeds benefits payable on survival by more than
x% (term assurance)
Plausible scenario exists under which the death benefit exceeds the
survival benefit by x% or more at any time during the policy term
(guaranteed minimum death benefit in unit-linked contract)
Benefit payable on survival exceeds the benefit payable on death by more
than x% (Pure Endowment, life contingent annuity)
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Aug 2009
Testing for significant
insurance risk
Feature Significant
Significant additional benefits payable on insured event
Costly and feasible event in scenario of commercial substance
even if it is extremely unlikely
Waiver of surrender charges on death
Loss of ability to charge for future services
Unfeasible event in any scenario
Contingent amount is insignificant in all scenarios of
commercial substance
14
Aug 2009
Quiz – Insurance risk
Contract Type Is it insurance?
Term insurance plan Yes
Whole life contract Yes
Life annuity in payment Yes
Non-linked life endowment product Yes
Non-participating health product Yes
Endowment pension product Probably
Regular premium UL savings contract No
(101% DB)
Contract with rider benefits Yes – assuming they are significant
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Aug 2009
Classification of products
in the Indian context
Indian insurance companies will need to categorize/classify their products
into insurance/investment products based on the guidance on classification
in IFRS 4
Riders attached to the base products need not to be independently
classified and accounted. Its accounting treatment would be similar to that
of the base product
However, for the purpose of having a uniform practice in the industry,
IRDA has proposed that a contract would be an insurance contract if the
benefit payable on death is higher by:
at least 5% of the fund value at any time during the life on the contract for unit linked
products, or
at least 5% of the premium at any time during the life on the contract for other than unit
linked products
That said, in the Indian context, most contracts are likely to be classifiable
as insurance contracts
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Aug 2009
Product Classification –
IRDA Perspective
Product Features IFRS Classification Product Class Participating Insurance Risk
"Participating – non Significant Insurance Insurance "Participating Yes
linked products - Life - Risk Discretionary"
endowment products&
anticipated endowment
products"
"Participating - Insurance or Investment Insurance or Investment "Participating "Risk depends on the
endowment pension Risk depending on the Contract depending on Discretionary" extent of SA"
products" SA opted the SA opted
"Non participating - Significant Insurance Insurance Non-Participating Yes
Mortgage / Credit Term Risk
Assurance"
"Non participating - Significant Insurance Insurance Non-Participating Yes
Term Insurance Plan" Risk
"Non participating - Significant Insurance Insurance Non-Participating Yes
Health product" Risk
"Non participating - Insurance/Investment Insurance/Investment Non-Participating Yes
single premium Product product depending on
investment products" the extent of SA opted
Linked products Significant Insurance Insurance Non-Participating Yes
Risk
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Aug 2009
Change in level of
insurance risk
Once insurance, always insurance, but can go from investment to
insurance
Investment may change to insurance through:
Changes in regulation, law
Switch between funds, first fund has no insurance risk – second fund has insurance risk.
Previously underestimated risks in investment contracts
INVESTMENT INSURANCE
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Aug 2009
Unbundling
Are any elements of Product is an Investment
Classified as an
the benefit driven by discretionary Yes Contract with discretionary
investment contract
participation participation features
No
No Deposit component Product is an Investment
Contract without discretionary
participation features
Insurance and deposit
Is there significant
components of contract must, if
insurance risk present
not recognised, be unbundled
in the contract?
and valued separately
Insurance
Yes component
Yes
Is there a
Insurance deposit component to the
Product is an
features present contract? If so, is the deposit component No
Insurance Contract
in contract independent of the insurance
cash flows?
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Aug 2009
When do you unbundle?
Unbundling is required when:
The insurer‟s existing accounting policies do not require recognition of the
deposit component
The insurer can independently measure the deposit component from the
insurance component
Unbundling is allowed when the insurer can independently measure
the deposit component from the insurance component
Consistent treatment of unit-linked products where some contracts have
rider benefits
IRDA has suggested that unbundling would be prohibited in India
20
Aug 2009
Discretionary participation
Features (DPF)
Are any elements of Product is an Investment
Classified as an
the benefit driven by discretionary Yes Contract with discretionary
investment contract
participation participation features
No
No Deposit component Product is an Investment
Contract without discretionary
participation features
Insurance and deposit
Is there significant
components of contract must, if
insurance risk present
not recognised, be unbundled
in the contract?
and valued separately
Insurance
Yes component
Yes
Is there a
Insurance deposit component to the
Product is an
features present contract? If so, is the deposit component No
Insurance Contract
in contract independent of the insurance
cash flows?
21
Aug 2009
Definition of DPF
Contractual right to additional payments as a supplement to
guaranteed minimum payments
Likely to be a significant portion of the total contractual payments.
Amount or timing is contractually at the discretion of the issuer
Contractually based on
Performance of a specified pool of contracts or a specified type of contract
Realised and / or unrealised investment returns on a specified pool of assets
held by the issuer
Profit or loss of the company, fund or other entity that issues the contract
22
Aug 2009
Measurement of discretionary
participation features
Investment contracts with discretionary participation
features are measured under IFRS 4
Probably subject to IAS 39 in Phase II of the insurance contract project
Investment contracts without discretionary participation
features are measured under IAS 39
Service elements may need to be separated and valued under IAS 18
All contracts subject to IAS 32 disclosures
Fair value disclosure will be an issue for contracts with discretionary
participation features
23
Aug 2009
Key learning points
Product classification will affect measurement basis, profit emergence
and disclosures
Contracts with significant insurance risk will be insurance
Contracts without significant insurance risk will be investment
Definition of insurance contract: “A contract under which one party
(the insurer) accepts significant insurance risk from another party
(the policyholder) by agreeing to compensate the policyholder if a
specified uncertain future event (the insured event) adversely
affects the policyholder.”
Contracts may need to be unbundled, with the deposit features valued
under IAS 39
Contracts with discretionary participation features are exempt from
IAS 39 during Phase I but not from IAS 32 disclosures
24
Aug 2009
e
Embedded Derivatives
Definition of a derivative
Value changes in response to the change in a specified
interest rate, financial instrument price, commodity price,
foreign exchange rate, index of prices or rates, credit rating
or credit index, or other variable, provided in the case of a
non-financial variable that the variable is not specific to a
party to the contract (underlying).
No initial investment or initial investment is lower than
required for another contracts that behaves similarly.
It is settled at a future date.
26
Aug 2009
Embedded Derivative
Flowchart
Is there an embedded feature
that may be an embedded
derivative?
Yes
Yes
Is the host contract at fair Do not separate
value through income?
No
Does the feature meet the Yes
definition of an insurance Do not separate
contract?
27
Aug 2009
Embedded Derivative
Flowchart
No
Does the feature meet the
Do not separate
definition of a derivative?
Yes
Is the derivative closely Yes
Do not separate
related to the host contract?
No
Separate and value at
Fair Value
28
Aug 2009
Measurement of embedded
derivatives
Certain embedded derivatives have to be separated from
insurance contracts, investment contracts with DPF and
investment contracts without DPF
If separated, measured under IAS 39:
Fair value
Changes in fair value through profit and loss
29
Aug 2009
Definition of closely related
Economic characteristics of derivative are similar to those of the host
contract, the derivative is closely related
Mainly defined by use of examples
Unit-linked contract measured at fair value of underlying units
Surrender option is closely related if surrender value is similar to carrying
value of liability
If so interrelated to insurance host contract that cannot be measured
separately
30
Aug 2009
Contract at fair value
If the whole contract is at fair value with movements in the
fair value flowing through the income statement, there is no
requirement to separate the contract as embedded derivative
already measured
Unlikely to apply to insurance contracts as not at fair value
If embedded derivative is already at fair value, then no requirement to
separate
31
Aug 2009
Meets definition of insurance
contract
If a derivative meets the definition of an insurance contract then
it does not need to be separated in Phase I. Examples include:
Occurs only on Insurance Event Guaranteed minimum death
benefit
Guaranteed minimum maturity
value
Form of an insurance contract Guaranteed annuity option
The presence of an embedded derivative with insurance risk
may cause the contract to be classified as insurance.
This exemption also applies if it meets the definition of DPF.
32
Aug 2009
Surrender option exemption
Some surrender options do not require separation.
Surrender options in insurance contracts or contracts with
discretionary participation features are exempt if:
Surrender value is a fixed amount
Surrender value is a fixed amount and reduced by a specified
interest rate
Exemption does not apply if the surrender value is based on
financial variable (equity prices or index)
33
Aug 2009
How many do we expect?
Most contracts contain significant numbers of guarantees
and options
These tend to only be payable on insured events
Guaranteed minimum death benefits
Guaranteed minimum maturity values
Therefore very few do not meet the definition of insurance
and are exempt from separation
Specific disclosure are therefore required
34
Aug 2009
Key learning points
Guarantee must meet the definition of a derivative to be an
embedded derivative.
If an embedded derivative is closely related to the host
contract it does not need to be separated.
If the host contract is at fair value, there is no requirement
to separate any embedded derivatives.
Some surrender values on insurance contracts, and
embedded derivatives that meet the definition of insurance
do not require be separation.
35
Aug 2009
e
Actuarial Liability Management
Agenda
Liability adequacy testing
Current situation on estimation of liabilities in India
37
Aug 2009
Liability adequacy testing
38
Aug 2009
Liability Adequacy Testing
IFRS 4 provides guidance on liability adequacy testing for:
insurance contracts
investment contracts with discretionary participation features
What is Liability Adequacy Testing?
The objective of such tests is to assess whether the liability held makes
adequate provision for the obligation of the contract
Basic principle being that the probable future losses must be anticipated.
Present value of future profits may not be negative
Future losses on undervalued liabilities should be recognised in the period
in which they are identified
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Aug 2009
Liability Adequacy Testing
Timing: Testing must be performed at each reporting date
Recognition — If the net carrying amount is deficient, the entire
deficiency is recognised in profit or loss.
Judgment is needed as to what defines a block of business to be tested:
entire block or groups of issue years
effect of new business written
Otherwise Liability Adequacy Test under IAS 37
Fair value like calculations
LAT should take account of guarantees and options in the contract
40
Aug 2009
Current situation on estimation of liabilities
in India
41
Aug 2009
Current situation on estimation
of liabilities in India
The approach to the determination of life insurance policy
liabilities is defined in IRDA Regulations and supplemented by
Guidance Notes issued by the Institute of Actuaries of India
Policy liabilities are incorporated into financial statements which
are submitted to the IRDA as well as various reports and forms as
part of the prudential supervision of life insurers
The general expectation in India is that policy liabilities are
determined on a prudent basis, as opposed to being a realistic or
best estimate assessment of amounts needed to meet liabilities to
policyholders with a modest bias towards prudence
42
Aug 2009
Current situation on estimation
of liabilities in India
The degree of prudence arises out of the Regulatory requirement to
incorporate Margins for Adverse Deviations (MADs) when
determining the level of each valuation parameter
Guidance Note 7 provides guidance for Appointed Actuaries on
this matter
In addition there are restrictions on reserves being less than zero.
For e.g., no reserves can be less than zero, not less than a policy‟s
surrender value and, in the case of linked contracts, that the
separate unit and non unit reserves shall each be not less than zero
constitute additional implicit margins – referred to as the current
reserve „Floors‟
43
Aug 2009
Determination of policy liabilities
under IFRS 4 – Suggestions by IRDA
Option I Option II Option III
Carry forward the existing Reduce the liabilities as currently Amend the existing approaches for
approaches for insurance contracts determined by the amt rep by the insurance contracts to reduce the
into implementation of Indian IFRS MADs within the liabilities degree of prudential bias & to have
and then await the outcome of IFRS together with the adj arising out of regard to IFRS phase 2 as well
Phase 2 the Floors
Would minimize implementation A situation of overstating current Would require reserving principles
effort and would also minimize the financial performance could arise. to be addressed. Revision to the
effort needed to realign the The current Required Solvency current RSM regime
Required Solvency Margin regime Margin would need to be increased
Simplest to implement but does Relatively straightforward to Best in terms of improving quality
least to improve the quality of implement, & would improve but implementation effort would be
general purpose financial quality – i.e., nearer to where the significant
statements results should be - but on the wrong
side of prudence
These options still need to be deliberated upon by the Actuarial Profession who will then adopt a
suitable approach for the industry.
44
Aug 2009
General Approach for
Implementation
As per IFRS 4 phase I, an entity may continue to measure insurance
liabilities with excessive prudence but must not introduce such a
practice at the time of implementation
Initially, if a prevailing national approach is adopted, then the
scope to vary the approach is limited
An entity may change its accounting policies for insurance
contracts if, as a result, its financial statements are more relevant
and no less reliable, or more reliable and no less relevant
45
Aug 2009
General Approach for
Implementation
In light of the IFRS principles and Indian prescribed interpretation
of IFRS for Indian reporting, IRDA concludes that:
The existing basis for determining actuarial liabilities for life
insurance contracts be carried forward into the initial
implementation of IFRS in India. An exception, however, needs to
be made for contracts classified as investment contracts
46
Aug 2009
Investment Contracts
International Actuarial Standards of Practice (IASPs) have been
issued by the International Actuarial Association specifically:
IASP 4 – Measurement of investment contracts and service contracts
IASP 5 - Selection of current estimates for the measurement of
investment contracts, service contracts and certain embedded
derivatives
IASP 10 - Embedded derivatives incorporated within Insurance
Contracts, Investment Contracts and Service Contracts and separately
issued Derivatives of a Reporting Entity
As per IRDA‟s suggestion provided in the recent report, Institute of
Actuaries of India may be required to review these IASPs to adopt
as Recommended Practice or Practice Standard in India
47
Aug 2009
Participating Contracts
There are two ways in which an insurer may chose to recognize the
guaranteed element and the DPF:
Recognize the guaranteed element and the DPF together. The whole
contract can then be classified as a liability.
Recognize them separately. In which case, the guaranteed element is
classified as a liability but the discretionary participation can be classified
either as a liability or a separate component of equity.
Current practice amongst Indian insurers is that both the guaranteed and
discretionary participation features are recognized as liabilities. Given
this established practice, IRDA suggests that the most straightforward
approach would be to continue with this practice.
48
Aug 2009
Global Reserves
Currently, in India, life insurers may maintain global reserves related
to generic risks such as AIDS, Catastrophes, Resilience,
Reinstatement, Closure to New Business and Data Deficiencies.
These are provided for from a prudential perspective.
IFRS prohibits recognition of possible future claims under insurance
contracts that are not in existence at the reporting date as a liability.
This would impact the current treatment of global reserves unless
Appointed Actuaries exercise their discretion to apportion such
global reserves to individual policies.
IRDA will provide a direction regarding global reserves for IFRS
implementation
49
Aug 2009
Actuarial Issues
There are other issues arising under IFRS where IASP‟s have been
issued and which are therefore matters of actuarial interest. For e.g.
IASP 9 deals with specific classification, recognition, and
measurement issues arising for reinsurance contracts
The implications of all the standards have not been considered by
IRDA but it seems probable that in near future Guidance notes to
actuaries are issued on these
50
Aug 2009
Key Learning Points
IFRS 4 requires a liability adequacy test to determine adequacy of
liability provision based on actuarial input
The existing methods bases for determining actuarial liabilities for
life insurance contracts may be carried forward into the initial
implementation of IFRS in India
The liabilities for contracts classified as investment contracts cannot
be determined using the existing approach and Guidance by
Actuaries is required
IFRS4 eliminates provision of catastrophe and other global reserves
Guidance for actuaries will be required to act upon certain areas
relating to estimation of actuarial liability
51
Aug 2009
