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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

  4
Aug 2009
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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


  6
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?



     7
  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.”




  9
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
  10
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)


  11
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)

  13
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
  15
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

  16
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

  17
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



  18
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?



     19
  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

  39
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

				
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