The IASB Insurance Contracts Project by pengxuebo


									Insurance news
December 2010

                 The IASB Insurance
                 Contracts Project
Management Summary
The IASB published an exposure draft on insurance contracts in July 2010. The goal of
this exposure draft is to improve financial reporting and provide guidance for consistent
accounting of insurance contracts.

This new standard will have a significant impact on financial statements, the measurement
of insurance contracts, the business processes and IT systems of insurance companies.
The proposed margin-based income statement presentation is a fundamental change
from the current standard. Practical implementation, understanding and analysing the
results of the financial statements as well as dealing with the many uncertainties of the
new IFRS standard are the main challenges for insurance companies.

In many instances the implementation of the new accounting framework will go alongside
the Solvency II and IFRS 9 transition programmes. The Solvency II and IFRS frameworks
will allow insurers to develop a common reporting platform. There are considerable
similarities between Solvency II and IFRS requirements, which create synergies by
combining the implementation programmes. However, there are a number of differences
where IFRS goes beyond the scope of Solvency II.

The timeline for implementing the new IFRS 4 phase II is not definitive, but it can be
assumed that the effective application date will be not before 2014.

In this paper, we highlight the key changes of IFRS 4 phase II, explore the similarities and
differences with Solvency II and identify the key focus areas where insurance companies
need to get prepared.

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                                                      Exposure   Final                                   Effective
Phase II:           Discussion Paper                  Draft      standard ?                              date?
The exposure draft Insurance Contracts (“the ED”), the planned replacement
for IFRS 4, was published on 30 July 2010. Its content proposes fundamental
changes to the way in which insurance contracts are accounted for. In this
technical bulletin, we will explore some of the key questions the ED raises:

What is it?                                    What is yet to be decided …
                                               In addition to insurance contracts, both IFRS
The ED is part of the IASB’s long-running
                                               4 and the draft standard apply to financial
project to develop a comprehensive
                                               instruments with discretionary participation
accounting framework for insurance
                                               features (“DPF”), albeit that the definition of
contracts. The first phase of this project
                                               a DPF has been tightened by introducing the
resulted in IFRS 4 which was always
                                               new requirement that there must also exist
intended only as an interim standard. The
                                               insurance contracts with similar contractual
ED is an important step towards the issue
of a new standard which will replace IFRS 4    rights to participate in the same benefits. It
and complete the project.                      should be noted however that the IASB has
                                               specifically asked for feedback on whether these
The ED contains far-reaching proposals for     contracts should be “in scope” or accounted
the recognition, measurement, presentation
                                               for under financial instrument standards.
and disclosure of insurance contracts.

What does it apply to?                         Who has to apply it?
                                               Entities that issue insurance contracts or
If the ED were to become a standard, it
                                               financial instruments with DPF within the
would apply to all contracts meeting the
                                               scope of the draft standard will have to apply
definition of an insurance contract and
                                               it. This is the case whether or not the entity
falling within the scope of the standard.
                                               in question is regulated by a supervisor.
IFRS 4 already contains a definition of an     Policyholders will not have to apply the
insurance contract and scoping parameters      standard. The only exceptions to this are
and by and large the proposed new standard     insurers who will have to apply the standard
will not make any major changes to these.
                                               to the outwards reinsurance contracts they
However, there will be some relatively         hold.
minor “tweaks” to the definition and some
changes to the types of contract that are in
or out of scope:                               When does it apply?
                                               The IASB plans to issue its new Insurance
What’s in the scope …
                                               Contracts standard in 2011 and if this
IFRS 4 contains a scope exemption that
                                               timetable is met, the standard will be one
enables financial guarantee contracts to
                                               of several expected to be issued that year.
be accounted for as financial instruments
                                               The IASB has announced its intention to
under IAS 39; the ED proposes to remove
                                               consult separately on the effective dates and
this exemption.
                                               transition for these standards.
What’s outside the scope …                     However, the effective date of the new
Conversely the ED specifically excludes from   standard has been explicitly linked to that for
its scope fixed fee service contracts (e.g.    IFRS 9 Financial Instruments – this means
certain maintenance contracts or roadside      that the Board will delay the effective date of
assistance contracts) whereas they are “in     this standard beyond 2013 if the Insurance
scope” under IFRS 4.                           Contracts standard is not ready by then.
IFRS - Phase I                  IFRS - Phase II

  Life      Non-life              Life and Non-life                          }   Non-incremental
                                                                                 acquisition costs

 Shadow                                               Margin
  PHB          UPR


                                                                   Premium        Insurance
                               flows    Discounted   Discounted
              Loss                       expected     expected
             Reserve                      future       future
  Math                                      cash         cash
 Reserve                                   flows        flows

                                                                                 (fig. 1)

What are the main                                level and are to include both inflows and
                                                 outflows expected to arise from existing
proposals?                                       contracts. The cash flows are to be
                                                 incremental, which means that general
What will change?                                overheads are not to be included, and they
                                                 are not restricted to contractual obligations.
The central proposal of the ED is the
                                                 Expected bonus payments to policyholders
introduction of a new measurement model
                                                 on with profits business should be taken
for insurance contracts. Four different
                                                 into account. Indeed the draft application
“building blocks” are to be fitted together to
                                                 guidance in this particular area actually
arrive at the carrying value of the insurance
                                                 states that payments to future (as well as
liability and the focus is on a current
                                                 existing) policyholders should be taken
assessment of the amount, timing and
                                                 into account. This would have significant
uncertainty of future cash flows.
                                                 implications for both the inherited estates
                                                 of life insurers and the capital resources
The four building blocks (see fig. 1) are:
                                                 of mutuals. The treatment of policy loans
• Current unbiased probability weighted
                                                 under the ED is unclear - are they separate
  estimates of future cash flows;
                                                 financial instruments? or are they just
• An adjustment for the time value of            additional expected cash flows from an
  money;                                         existing insurance contract?
• A risk adjustment; and
                                                 The inclusion of incremental cash flows
• A residual margin.                             applies to acquisition costs (at a contract
                                                 rather than a portfolio level) and this
Future cash flows                                means the end to any separately recognised
                                                 asset for deferred acquisition costs. It will
The cash flows to be estimated are at a          also mean an increase in non-incremental
portfolio (rather than individual contract)      acquisition costs being expensed as
incurred. Firms may want to re-consider              any illiquidity premium is to be calculated
their cost structures and find ways of making        and in practice firms will probably use the
more expenses “incremental”.                         discount rates they use for their Solvency
In considering future cash flows, it is the          II calculations, unless there is a particularly
perspective of the entity itself that should be      strong argument for another rate.
reflected. The IASB has moved away from              A variety of discount rates will have to be
the concept of “current exit value” proposed         used to match the different durations of
in its earlier Discussion Paper. The idea was        the insurance liabilities and entities may
to estimate a market consistent value at             have to upgrade their modelling capability
which the entity could transfer its insurance        to deliver the requirements of the ED on a
liabilities; now it is to estimate how much          timely basis.
it will cost the entity to fulfil its outstanding
obligations under the contracts it has
written (“the fulfilment value”).                    Risk adjustment
The future cash flows are “probability               This adjustment is an explicit measure
weighted”- it will no longer be sufficient           of the uncertainty of the estimated future
for an insurer to produce a single point             cash flows. It is defined in the ED as “the
estimate of its liabilities. Instead, it will have   maximum amount the insurer would
to consider the range of possible outcomes           rationally pay to be relieved of the risk that
and assign probabilities to them.                    the ultimate fulfilment cash flows exceed
This may require the use of sophisticated            those expected”.
stochastic modelling techniques - but not            The ED mandates the use of one of three
necessarily so.                                      techniques to calculate the risk adjustment:
Since the future cash flows are restricted to        • confidence level (Value at Risk);
those of existing contracts, the boundary
                                                     • conditional tail expectation (Tail Value at
between existing and future contracts
                                                       Risk); or
becomes an important concept. The ED
defines the boundary as the point at which           • cost of capital.
“an insurer either                                   These techniques will not be appropriate
                                                     in every situation but the cost of capital
• is no longer required to provide coverage;
                                                     approach should be familiar to insurers
                                                     from the Solvency II project.
• has the right or the practical ability
  to reassess the risk of the particular             The actual calculation will, however, typically
  policyholder and, as a result, can set a           be different for financial reporting purposes
  price that fully reflects that risk.”              compared to that for solvency purposes.
                                                     Firms will have to consider their own
                                                     tailored cost of capital rate and the level of
Time value of money                                  capital adequacy they are targeting.
(Discounting)                                        The adjustment is to be calculated at the
                                                     level of the portfolio and as a consequence
Under the draft standard the future cash
                                                     no credit is given for any diversification
flows will have to be adjusted for the time
                                                     benefits between portfolios.
value of money. The discount rates to be used
should be consistent with the characteristics        A portfolio is a collection of insurance
of the insurance contract liabilities in             contracts that are “subject to broadly
terms of, for example, timing, currency and          similar risks and managed together as a
liquidity. Unless the liability cash flows are       single pool”. In view of the flexibility of this
linked to supporting assets, the rates used          definition and the importance of the portfolio
will be risk-free and may include an illiquidity     to the risk margin and the determination of
premium. The ED gives no guidance on how             incremental future costs, firms will no doubt
be giving careful consideration to the exact       model for all insurance contracts, in
composition of their portfolios.                   practice it makes a distinction between
                                                   certain short duration contracts and other
                                                   contracts. A modified approach has to be
Residual margin                                    applied to contracts with a coverage period
                                                   of approximately one year or less which
This building block eliminates any day
                                                   have no option or derivative elements that
one gain on the initial recognition of the
                                                   would “significantly affect the variability of
insurance contract. If, on initial recognition,
                                                   cash flows”.
the present value of the total fulfilment
cash flows (i.e. the total value of the three      For these contracts the insurer has to
previous building blocks including the initial     separately calculate a pre-claims liability
premium) is positive, the residual margin          and a claims liability. The pre-claims
reduces this value to zero. Effectively the        amount is the present value of the premium
residual margin is the profit that the insurer     expected to be received under the contract
expects to earn over the coverage period. If       less incremental acquisition costs. This
the initial fulfilment value is negative, this     figure is subject to an onerous contract test
day one loss is recognised immediately i.e.        and is compared to the present value of the
the residual margin can never be negative.         fulfilment cash flows. If the fulfilment cash
                                                   flows are higher, an additional liability is
The residual margin is amortised in a              recognised.
systematic way over the coverage period
and the basis will normally be the passage         The initial pre-claims obligation is reduced
of time, unless the pattern of claims and          in a systematic way over the coverage
benefits is significantly different.               period on a “passage of time” basis (or on
                                                   the basis of the expected timing of claims
Unlike the other building blocks, the residual     and benefits, if significantly different).
margin is not subsequently re-measured
using current estimates. The only change to        This approach to short duration contracts
it, once it has been recognised, is the periodic   may seem familiar. It is not totally dissimilar
amortisation.                                      to the calculations of unearned premiums
                                                   and unexpired risk provisions that are
For its latter stages, the Insurance Contracts     already routinely performed by most general
Project has been a Joint Project with FASB         insurers. Not totally dissimilar but not
(the US Financial Accounting Standards             exactly the same - every insurer will have
Board). There remain differences between           to make some changes to comply with the
the IASB and FASB on certain key proposals         draft standard.
in the ED. One of the main differences is in
the need for a separate residual margin. FASB
currently favour a single composite margin         Outwards reinsurance
instead of the residual margin and a risk
                                                   Outwards reinsurance under the draft
adjustment. This composite margin would
                                                   standard will be accounted for using
be amortised over both the coverage period
                                                   the same building blocks as for inwards
and claims handling period in accordance
                                                   business. Unlike inwards business, it will
with a prescribed formula. Depending on the
                                                   be possible in certain circumstances for
responses it receives to the ED, the IASB may
                                                   an entity to record a day one gain on initial
adopt the composite margin approach.
                                                   recognition of a reinsurance contract. If the
                                                   expected present value of future cash inflows
Short duration                                     and the risk adjustment exceeds that of the
                                                   future cash outflows, the difference can be
contracts                                          recognised as a gain through profit or loss.
Although the new draft standard in theory          It is not entirely clear from the draft standard
introduces a comprehensive accounting              whether the alternative approach for short
duration contracts applies to outwards
reinsurance and there are issues both
                                                 Presentation and
inwards and outwards as to the duration of       disclosure
reinsurance contracts - e.g. those providing
                                                 Under the draft standard the Statement
reinsurance on a risk attaching basis or
                                                 of Comprehensive Income will look very
quota share contracts that are continuous.
                                                 different (see fig. 2).
One notable change in the draft standard
                                                 The focus will be on the drivers of
compared to IFRS 4 is that irrecoverable
                                                 performance i.e.
reinsurance is to be assessed on an
“expected” basis rather than on an “incurred”    • release from risk;
basis. However this change may be of more        • earnings from providing insurance services;
theoretical than practical importance as         • investment returns;
in practice many insurers already seem to
                                                 • differences between expected and actual
provide on an “expected” basis.
                                                   cash flows; and
Foreign exchange                                 • changes in estimates and the discount rate.
All insurance balances under the draft           Premiums and claims will be deposit
standard will be monetary items and this         accounted through the balance sheet.
will remove one source of “accounting
                                                 The approach will be similar for the
mismatch” in the financial statements
                                                 alternative short duration contract approach
of some insurers due to foreign currency
                                                 but the underwriting margin has to be
unearned premiums being treated as non-
                                                 analysed either on the face of the statement
monetary items and being translated for
                                                 or in the notes into:
balance sheet purposes at their original
transaction rate rather than the closing rate.   • premium revnue,

Unbundling                                       • claims incurred,
                                                 • expenses incurred, and
Where components of an insurance
contract are not “closely related” to the        • amortisation of incremental acquisition
insurance coverage provided, they are to           costs.
be “unbundled”, a concept already in IFRS        The disclosure requirements build on those
4. There is no application guidance in the       already contained in IFRS 4 and IFRS 7.
ED, however, and no definition of “closely       The main new requirements relate to items
related”. Consequently this area lacks           arising from the new measurement model.
clarity, although three common examples
of components not closely related to the
insurance coverage are provided:                 Transition
• an investment component reflecting             The main issue under the proposed
  an account balance meeting certain             transition arrangements is the exclusion
  conditions;                                    of any residual margin from the insurance
• an embedded derivative separable from          liabilities included in the earliest balance
  its host in accordance with IAS 39; and        sheet presented on adoption.
• contractual terms relating to goods            For some insurers this could mean some
  and services that have been included           insurance earnings never being reported
  for reasons that have “no commercial           through profit or loss.
Balance sheet

Liability at
of the year

    100               -25
                                                                                  Liability at
                                                                                  end of year
                 cash flows            -15                               +10
                                                   -5           +5    Interest
                                      in risk                            on
                                                Release of
                                     adjust-               Unexpected liability
                                       ment                cash flows

                                                Items in profit & loss

Presentation under the ED (fig. 2)
Profit & Loss
 Underwriting margin                                                           20
 Change in risk adjustment                                                      15
 Release of residual margin                                                     5

 Gains and losses at initial recognition                                       -2
 Non-incremental acquisition costs                                            -10

 Experience adjustments and changes in estimates                                -5
 Changes in estimates of cash flows and changes in discount rates               0
 Differences between actual cash flows and previous estimates                   -5

 Interest on insurance contract liabilities                                   -10

 Summarised margin                                                             -7

 Non – P&L changes                             Changes that go through profit
                                               or loss
 Expected cash flows
                                               Change in risk adjustment
 Actual cash receipts and payments that
 were expected                                 Changes in the uncertainty about the
                                               amount of future cash flows
                                               Release of residual margin
                                               The reduction in the residual margin
                                               during the current period
                                               Interest on liability
                                               Interest on the liability in the current
                                               Unexpected cash flows
                                               Actual cash receipts or payments that were
                                               not expected, as well as changes in the
                                               estimate of future cash flows
Differences and similarities of IFRS 4 phase II
with Solvency II

Solvency II and IFRS 4 phase II share similar      • Discount rates: both Solvency II and IFRS
concepts but have different goals: Solvency          4 allow illiquidity adjustments. Therefore,
II measures solvency while IFRS 4 measures           entities could use Solvency II rate curves
performance.                                         for IFRS. Since current P&C reserves are
                                                     undiscounted, entities need to implement
Therefore some significant differences will
                                                     a discounting solution for both Solvency II
remain. For instance, IFRS 4 provisions
                                                     and IFRS 4.
on the residual margin are clearly not
compatible with the Solvency II framework.         • Risk adjustment: the concept is very
                                                     similar between Solvency II and IFRS 4
Still, entities should be able to leverage their
                                                     but its implementations differ, making
Solvency II efforts when implementing IFRS
                                                     synergies hard to achieve. It may be
4 phase 2. Indeed, there are many potential
                                                     worth waiting until the final standard is
overlaps between Solvency II and phase 2 of
                                                     published before implementing new risk
the insurance contracts project.
                                                     adjustment models.
Changes being made now in readiness for            • Portfolio segmentation: the concept of a
Solvency II should also be looked at from            portfolio in the sense of IFRS 4 should be
the perspective of phase 2 – does this               incorporated in the entity’s management
change to the accounting system also work            and reporting tools.
for the ED? If it does not, it is simpler to
“tweak” it now rather than trying to make
changes to the Solvency II system once it is
up and running.                                                          Liabilities
When making this analysis, one should bear
in mind that some provisions of the ED                  IFRS Phase II                    Solvency II
may be amended following the consultation
phase. Consequently, it is important to                                                   Surplus
“guess” which provisions are most likely                   Equity                  Solvency Capital
to remain unchanged and focus on these                                              Requirement
areas in priority.
                                                                                  Minimum Capital
                                                       Residual margin
Expected future cash flows: the two                                                Requirement
frameworks are quite similar since they both           Risk adjustment                  Risk margin
refer to fulfillment cash flows and a have a
similar definition of the contract boundary.
(Difference: incremental acquisition costs).           Expected future                 Expected future
The value of options and guarantees                      cash flows                      cash flows
calculated for Solvency II should also be
usable for IFRS 4.
                   Mazars helps you to implement the upcoming
                   standard in the following focus areas:
Added Value

                 Performance                                              Reporting &
                 Measurement                                               Disclosure

              • Adjust key performance indicators                    • Update accounting manuals and policies, charts of
              • Reset planning, budgeting and forcecasting             accounts in general ledgers on group and entity level
                figures and reports                                  • Implement additional reporting requirements
              • Update the models for evaluating potential             which need to be aligned with statutory, Solvency
                investments and acquisitions                           II & Embedded value
              • Usage of different metrics in management             • Prepare of margin-based income statement
                compensations                                        • Align reporting with Solvency II reporting
                                                                     • Ensure parallel reporting during transition phase

                                                                       Systems & Data

              • Identify immediate priorities taking into account    • Update actuarial systems to provide regular,
                the uncertainties of IFRS4 phase II                    updated cash flow projections
              • Assess of capabilities of current financial          • Upgrade systems for stochastic modelling
                reporting architecture                               • Update cost allocation systems to provide
              • Review segmentation on portfolio and cohort level      incremental acquisition costs at contract level
              • Assess whether appropriate (stochastic) models       • Design a system that allows discounting
                are in place to measure options and guarantees         cash-flows in the Non-Life area
                and to provide reserve distributions
              • Assess of data availability, quality and readiness

              Governance, processes
                & internal control

              • Review accounting, reporting and actuarial           • Provide training to key employees on the new
                processes and internal controls                        standard features alongside with Solvency II and
              • Create new policies for setting discount rates         IFRS 9 trainings
                and risk margins                                     • Inform and educate of external stakeholders,
              • Standardise policies on insurance liabilities          including analyst community, rating agencies and
                across international insurance groups                  investors
              • Ensure auditability and quality of documentation     • Keep up to date with current IFRS standard
                                                                                                                               Tailor-made services


                                                                     Business Strategy &
              Project Management
                                                                     product development

              • Set up a transition project with an                  • Analyse the impacts on your investment strategy
                implementation plan based on the performed             to adopt IFRS 9 and define hedging strategy to
                gap analysis                                           mitigate volatility
              • Handling of critical resource situations and the     • Manage volatility of financial profits with new
                need for experienced finance staff to support the      market-consistent measurement approach
                transition process                                   • Consider the implications of discounting in
                                                                       product development
Gilles Magnan
Head of International Insurance
Tel: +33 1 49 97 64 62

Your contacts in Europe:
Austria:                              Ireland:                           Russia:
Peter Ernst                           Mark Kennedy                       Anne Belveze
Email:          Email:          Email:
Tel: +43 1 367 16 67 12               Tel: +39 02 58 20 13 96
                                                                         Tel: +7 495 792 52 47
Belgium:                              Italy:
Philippe de Harlez                    Antonia di Bella
                                      Email:   Mickael Compagnon
                                      Tel: +39 02 58 20 13 96            Email:
Tel: +32 27 79 02 02
Czech Republic:
                                      Laurent Decaen                     Tel: +421 2 59 20 47 00
Milan Prokopius
Email:      Email:    Spain:
                                      Tel: +352 29 94 94 240             Enrique Sanchéz
Tel: +420 2 24 83 57 30
                                      The Netherlands:                   Email:

                                                                                                          Layout: Mazars, Communication - DEP 122 EN - 12/10 - credits: Getty images
                                      Kees Harteveld                     Tel: +34 6 49 81 12 91
Jesper Pedersen
Email:                                                     Sweden:
                                      Tel: +31 1 02 77 15 76
Tel: +45 35 26 52 22                                                     Bengt Fromell
France:                                                                  Email:
                                      Monika Kaczorek
Maxime Simoen                         Email:        Tel: +46 8 796 37 00
Email:        Tel: +48 2 23 45 52 00             Switzerland / Liechtenstein:
Tel: +33 1 49 97 67 85
                                      Portugal:                          Lionel Cazali
Germany:                              Leonel Vicente                     Email:
Amand Rufin                           Email:          Tel: +41 44 384 84 37
Email:          Tel: +351217222571
Tel: +49 69 96 76 5 11 01                                                United Kingdom:
Hungary:                                                                 Andrew Heffron
                                      Jean-Pierre Vigroux
Philippe Michalak                     Email:                             Email:
Tel: +36 14 29 30 10                  Tel: +40 31 229 2600               Tel: +44 20 70 63 44 55

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