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W W W . W A T S O N W Y A T T . C O M
International Accounting Standards for Life Insurance CompaniesMichael Ross17 July 2003
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Contents
What is the background? In particular, what is the history, scope and reactions
What is the approach to calculating the reserves under the proposed standard for a life insurer?
What are the implications of the new approach for life insurers?
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Contents
What is the background? In particular, what is the history, scope and reactions
What is the approach to calculating the reserves under the proposed standard for a life insurer?
What are the implications of the new approach for life insurers?
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The need for consistent global standards
No-one now questions the need for more effective, more economical and standardised financial reporting worldwide
Historic reporting based on historic cost has often failed to reflect important changes in trading or financial conditionsSeveral types of transactions utilise deferral and matching or ‘smoothing’ approaches e.g. revenue accounting and ‘premium basis’ reserving Many practices also non-transparent with little disclosure
However the global standards now being introduced are intended to present reality from a more consistent but also more volatile market-value-based perspective
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Towards a global standardThe common and agreed goal - consistent global accounting standards; getting agreement as to ‘how’ is not always so easily achievedThe drive for these latest developments has come primarily from the EU and from stock exchanges around the world
Resistance has come especially from the financial servicesOne of the biggest hurdles is also US GAAP – itself a widely used standard for international groups, but still imperfect
Historically regulators, fiscal authorities and other bodies have also usually based their own requirements on annual audited company accounts (with variations) –will they also in future?
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Who is involved – international bodies (1)
l The International Organisation of Securities Commissions(IOSCO) - established in 1974, comprises all the major Security Exchange Regulators
l The International Association of Insurance Supervisors (IAIS) founded in 1994 - includes Hong Kong and all other major market regulators from 120 countries
l The International Actuarial Association (IAA) - established in 1895 for individual actuaries, but now re-formed national associations
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Who is involved International Accounting Standards Board ("IASB")
"To produce a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements"
l Insurance project (1997)l Issues paper (Nov 1999)l Comments (May 2000)l Draft Statement of Principles (Dec
2001 – Jul 2002)
Formed in 1973 with the objective ….
l Independent and privately-fundedl 41 International Accounting Standards (“IAS”) or
International Financial reporting Standards (“IFRS”) so farl Already adopted in some countries as domestic standard
and often accepted on stock markets for foreign listed companies
l The Board co-operates with national accounting standard setters to achieve convergence in accounting standards
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Global positionJune 2002: proposal to allow IAS for foreign listed
companies in 2005 without reconciliation to Canadian GAAP
June 2002: proposal to allow IAS for foreign listed
companies in 2005 without reconciliation to Canadian GAAP
July 2002: FASBAgreement to have
USGAAP and IAS to resolve differences
July 2002: FASBAgreement to have
USGAAP and IAS to resolve differences
June 2002: EU listed companies reporting under IAS in 2005
June 2002: EU listed companies reporting under IAS in 2005
June 2002: adoption of IAS for
domestic entities in 2005
June 2002: adoption of IAS for
domestic entities in 2005
Hong Kong -IFRS permittedHong Kong -IFRS permitted
China – IAS if listedChina – IAS if listed
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IASB Insurance project
l Insurance project (1997)
l Issues paper (Nov 1999)
The story so far……l Development of IFRS for insurance contracts
l Comments (May 2000)
l Draft Statement ofPrinciples (Jul 2002)
l May 2002: interim solution proposed for IFRS :Ø Phase I 2005 (?):
temporary recognition existing GAAP for insuranceØ Phase 2 2007 (?) onwards – new IFRS
l All exiting IAS/IFRS apply
l IASB discussion (Jul 2002 - now)
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Key aspects of Phase 1l Any contracts that fall within the definition of an insurance contract
(except for those covered by other IFRS’s) shall be subject to Phase I
l Local measurement standards will in general be permitted under Phase I . There are certain exceptions.
l Continuation of existing practices will be permitted including deferral of acquisition cost and the use of embedded values
l Disclosures will be required that identifies and explains the reporting of insurance-contract-related amounts, helps understand the estimated amounts and fair value of insurance liabilities as at 31 December 2006
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IAS treatment assets and liabilities
2005
Is it an insurance contract?
Liabilities
IAS 39IAS 39
No
Local GAAP
Phase 1: Current GAAP
Yes
Insurance IAS
Phase 2:Insurance IFRS
Yes
IAS 39
Assets
2007?
actuarial reserves fair value fair value/
amortised cost
fair value/amortised cost
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What is an insurance contract?
Risk is significant if “ a reasonable possibility exists that an event affecting the policyholder will cause a significant change in the present value of the insurer’s net cash flows …”
Ø Determined on contract by contract basisØ Insurance if significant loss
possible in one foreseeable scenario
Ø One way classification: once insurance always insurance
Main issuesl Definition of “significant” and “reasonable possibility”
l Ensure consistency in local markets
l Application of IAS 39 to investment contracts
“contract under which one party (The insurer) accepts significantinsurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event ) adversely affects the policyholder or other beneficiary”
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Insurance contracts and scopeInsurance (significant risk)
Insurance but outside scope
Not insurance
Ø Whole of lifeØ EndowmentsØ AnnuitiesØ Term insuranceØ DisabilityØ HealthØ Credit insuranceØ Reinsurance
Ø Financial guarantees(under discussion) (IAS 37,39)
Ø Product warranties issued directly by a manufacturer or others (IAS 18,37)
Ø Retirement benefit obligations and related assets (IAS 19,26)
Ø Insurance contracts that have little insurance risk
Ø Financial reinsurance
Ø Group contracts where all risks are passed on
Ø Self-insuranceØ GamblingØ Financial
derivatives
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Phase 1: companies still face a number of issues despite use of local GAAP
Mismatch A&L
UnbundlingAsset
ManagementFees
Embedded derivatives
Participating features
DAC
Disclosure
ReinsuranceLoss
recognition
Amortised cost/
Fair value
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Phase 2
l Based on the DSOP’s l Identify and measure directly individual assets and
liabilities rather than creating deferrals of inflows and outflows
l Implemented in 2006
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Presentation13Discount Rates6
Disclosure14Performance-linked insurance contracts
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Interim Financial Reports12Adjustments for risk and uncertainty
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Reporting entity and consolidation11Estimating the Amount and Timing of Cash Flows
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Other assets and liabilities10Measurement: Overall Issues3
Measurement of direct insurance contracts by policyholders
9Overall Approach, Recognition and Derecognition
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Reinsurance8Scope1
TitleChapterTitleChapter
DSOP contents
(Note) Titles in blue have not yet been published as at April 2003
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Phase 2: Fair value accounting
Main elementsl Best estimate cash flows plus
‘service margin’ l Discount rate derived from
market : ‘risk free’ plus own credit risk allowance
l Allowance for future premiums restricted
l Profit at inception only if “market evidence”
Required solvency
MVM
Expected value of liability Fair value
liability
Net free asset
Shareholder equity
Required amount
Insurance Supervision
IAS
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l All cash flows, including embedded options, required to be modelled and discounted at a risk-free rate
l In many cases, deterministic projections may give reasonably reliable answers
l But stochastic modelling needed for:Ø Embedded options and guarantees;Ø Benefits that correlate to economic performanceØ Discretionary bonuses related to company profitsØ Other situations where deterministic projections
are not sufficientl Many scenarios (1,000 – 10,000) needed with associated projections
using market-consistent economic models l Fair value now fully replaces the earlier concept of entity-specific
value, which has been dropped for this IFRS
0.95
1
1.05
1.1
1.15
0 0.2 0.4 0.6 0.8 1
Methods of evaluation
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Risk, uncertainty and discount rates
l Addition of margins to all assumptions for risk and uncertainty that reflect market’s risk preferences (hereinafter “RSA”s – previously “MVM”s)
l RSAs should always reflect not only undiversifiable risk (systematic risk) but also diversifiable (non-systematic) risk -different to asset pricing theories such as CAPM and APT
l Pre-tax risk free discount rates to be used - consistent with modern financial theory but different to normal practice for embedded values
l Also the credit rating of the company should be included –however this produces a counter-intuitive and contrary answer for liabilities in that it implies reserves should reduce as the risk of bankruptcy increases.
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Reactions from the world industry (1)
US (Life), German, Austrian, Japanese (Life) /RAA letter:l Latest joint letter from the above associations submitted February
2003:Ø Phase 1 - opposing several of the major changes in Phase 1
l Scope of Phase 1 and application of IAS 39 should be restrictedl Oppose separation of built in derivatives and use of loss-
recognition tests
Ø Phase 2 – comment thatl the study is hasty and prematurel the associations support deferral and matching method and
most support deferral of acquisition expenses
l the associations oppose reflection of credit risks
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Reactions from the world industry (2)
October 2002 : 20 world major life insurers’ joint opposition letter
l DSOP ignores the unique characteristics of the insurance industry, thus making a change in the business model inevitable
l This will result in a disadvantageous position of the insurance industry in competition with others for capital resources
l This could force insurance enterprises to deviate from a long-term and equity-oriented investment strategy
l Deferral & matching approach plus lock-in necessary for main accounts
l Fair values, assumptions and sensitivities could be disclosed innotes to the accounts
l Discounting of outstanding claims also supported
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Insurance supervisors’comments
l IAIS submitted their comments to IASB in June 2002l Insurance supervisors are key stakeholders in an
insurance accounting standard, and the standard should take account of a company’s ability to meet its obligations
l Separation of financial accounting and supervisory accounting should be avoided
l More conservative measurement methods should be used.l Current proposal has practical difficulties – stochastic
assessment is difficult, and risk margins cannot be determined by reference to the market. Own credit risks should not be included.
l Detailed field tests should be implemented – hasty decisions avoided
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IAA’s reaction
l IAA in general favours proposals in DSOPl A sub-group is now developing 23 actuarial standards for
Phase 1l Recent discussions on drafting international actuarial practice
standards for Phase 2 based on DSOP have not progressed very fast
l Another sub-group is exploring various methodologies and worked examples – however there remains strong potential for internal disagreement – as with previous alternative approaches to measurement and control of emergence of profitability
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Contents
What is the background? In particular, what is the history, scope and reactions
What is the approach to calculating the reserves under the proposed standard for a life insurer?
What are the implications of the new approach for life insurers?
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Calculation of fair value liabilities
l Market value, for deep and liquid marketsØ Must be supportable
l Professional assessment, otherwiseØ Must be consistent with
current market pricesØ Must be consistent with
budgets and forecasts
l Discounted future cash flows
l Similar contracts groupedl Reinsurance separate
Approach
Method
l Claimsl Surrendersl Loansl Administration and
maintenance expensesl Premiums
Cash flow items
l Must be explicitl Current and not locked inl Cover all future events
Ø optionsØ legislative changes
l Best estimates plus RSA’s
Assumptions
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Market Risk Preferences (“RSA’s”)
l Cover all risks, including operational and defaultl Risk types
Ø Non-diversifiable, systematic, parameter / model mis-estimation risksØ Diversifiable, unsystematic, randomness / volatility risks
l Market data reflects some non-diversifiable
Two approaches to RSA’sl Cash flow adjustment
Ø Adjust the cash flows to reflect the risk. E.g. increase the mortality charge
l Risk discount rate adjustmentØ Lower the discount rate to reflect the risk
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Two approaches to discounting
Two main methodsl Replicating portfolio
Ø Market value of a replicating asset portfolio.l Stochastic Techniques
Ø Mean of the deflated cash flow
Which one?l Use the simplest method allowed forl Product likely to decide
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Replicating portfoliol Market value of a replicating asset portfolio.l Examples
Ø AnnuitiesØ Non-par products Ø products with uncomplicated charging structures
l Simple to understand, non-stochastic and fastl Arbitrage- free pricing
Ø Black-Scholes for equity and option pricingØ Government bonds for risk free rates
l AssumptionsØ portfolio of traded asset cash flows match adjusted liability cash flowsØ no investor preference or asset pricingØ Perfect market assumption
Two approaches to discounting
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Example 1 - non linked annuityReplicating portfoliol Series of risk free
(government issued ) zero coupon bonds precisely matching the liability outflow.
l Sum the market values of the matching zero coupon bonds3,800
4,000
4,200
4,400
4,600
4,800
5,000
5,200
1 2 3 4 5 6 7 8 9 10
Expected cashflow Risk Adjusted Cash flow
Year Expected cashflow
Adjusted for risk
Risk Adjusted Cash flow
Investment Market value of
investment1 4,957 10 4,967 1 year zero 4,730 2 4,909 20 4,929 2 year zero 4,471 3 4,856 31 4,887 3 year zero 4,222 4 4,796 55 4,851 4 year zero 3,991 5 4,729 59 4,788 5 year zero 3,752 6 4,654 75 4,729 6 year zero 3,529 7 4,571 93 4,664 7 year zero 3,315 8 4,479 112 4,591 8 year zero 3,107 9 4,378 132 4,510 9 year zero 2,907 10 4,267 154 4,421 10 year zero 2,714
46,596 741 47,337 36,738
Assumptionsl Assume a risk free rate of
5%l Flat yield curvel All cash flows at end of year
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Replicating portfolio
l a zero coupon bond l a purchased call option, which on
maturity of the bond, gives the insurer the option to buy the FTSE index at the level at which it stood at policy inception
l Market value of zero coupon easily obtained and if risk free no further adjustment for risk would be required
l Price of the call option may not be risk free thus an adjustment for risk would be required
Guaranteed Equity Bond Payoff Profile
-
4,000
8,000
12,000
16,000
20,000
0% 20% 40% 60% 80% 100% 120% 140% 160% 180%
FTSE as a % of Initial level
Polic
yhol
der b
enef
it ($
)Example 2 - Guaranteed Equity Bond
Product descriptionl The product is an index-linked
single premium guaranteed equity bond.
l The benefit at the end is a return of the initial investment plus any increase in the level of the FTSE 100 index over the period.
Replicating portfolio can be constructed as a combination of:
Prices for these can be obtained from the market
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Stochastic methodsl If the liability cash flow is too complex to be able to determine the
replicating portfolio, stochastic methods need to be employed.l Examples
Ø products with complex guarantees such as with-profit policiesØ policies with embedded optionsØ Assumptions correlated to economic environment e.g. lapsesØ No market data for RSA’s
l The stochastic model is Black Scholes consistent
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Stochastic methodsl Most commonly discussed stochastic method is the “State Price
Deflator method”l Deflators can be best described as stochastic discount rates and
can be used to calculate fair value of liabilities as followsØ a stochastic asset model is run, the output from which will include a
deflator for each time period of each scenarioØ The liability cash flows are projected and adjusted for non-financial riskØ for each simulation the deflator is applied to the relevant cash flow at
each point in time and the values are summed across all projection steps to obtain a deflated value
Ø the fair value of the liability is the mean value of the deflated cash flows.
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Example 3 - non-linked annuityExample 1 but using state price deflators instead of the deterministic method
YearRun 1 Run 2 Run 3 Run 4 Run 5
1 4,967 0.9867 0.9124 0.8993 1.0011 0.94332 4,929 0.8613 0.9410 0.8248 0.9826 0.94683 4,887 0.8022 0.9097 0.7677 0.9504 0.94704 4,851 0.8126 0.8085 0.7423 0.8850 0.85275 4,788 0.7215 0.8197 0.6831 0.8658 0.85346 4,729 0.6579 0.8094 0.6663 0.7991 0.78647 4,664 0.6279 0.7635 0.6288 0.7623 0.74938 4,591 0.6347 0.6799 0.5552 0.7773 0.72999 4,510 0.5854 0.6637 0.5506 0.7057 0.670010 4,421 0.5007 0.6986 0.5236 0.6680 0.6824
Deflated Value 34,270 38,054 32,586 39,938 38,806
Risk-adjusted
Deflators
Number of simulations Fair value5 36,731
100 36,755500 36,744 1000 36,733 5000 36,739
Deterministic 36,737
l The average over the five runs equals 36,731 compared to the deterministic value of 36,737.Ø Reflecting the random statistical error resulting from such a
small number of simulationsl Results converge as the number of stochastic simulations
increases
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Contents
What is the background? In particular, what is the history, scope and reactions
What is the approach to calculating the reserves under the proposed standard for a life insurer?
What are the implications of the new approach for life insurers?
35
Getting to grips with fair valuel High level audit of productsl Assessment of financial
impactl Methodology and
assumptionsl Data capturel Systemsl Stochastic modellingl Market consistent asset
model
Implementation
Communication
Management
Other uses
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Getting to grips with fair value
Implementation
Communication
l Day-one impact and volatility
l Enhanced disclosurel Can we explain results to
our board, customers, shareholders and analysts?
Management
Other uses
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Getting to grips with fair value
Implementation
Communication
Management
l What are the unacceptable risks?
l Should we change the asset allocation?
l Should we modify the bonus policy?
l Should we transfer risk?l Should we change the
product mix/design?l How should we modify
corporate governance?Other uses
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Getting to grips with fair value
Implementation
Communication
Management l Regulatory capital?l Capital allocation?l Internal performance
measure?Other uses
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Summaryl IAS is coming and planning will be required before
2005
l Complex issues to address for with-profits
l Attitude to risks may change
l Wider applications than just the accounts
l Impact on day 1 results will depend on nature of the business
l Volatility of profits is likely to increase
