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International Financial Reporting Standard
Actuarial Services
IFRS 4 and its Implication to HKand China’s Insurance IndustryRaymond Li, FSA MAAA
AA Symposium17 November 2004
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2AA Symposium 2004
Agenda
• Introduction• Key Principles of IFRS 4• Challenges to HK and PRC Insurance Industry• Questions to CEO?
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3
Introduction
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4AA Symposium 2004
Why IFRS 4?
• Diversity of practices internationally• Existing standards do not address specific insurance
issues and not necessarily reflect the trueperformance of the business
• Need to distinguish between insurance contracts andfinancial instruments
• Regulatory driven (e.g. in HK, Singapore and Europeancountries)
• Lack of transparency – inadequate disclosures undersome local rules
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5AA Symposium 2004
Important changes in accounting andreporting
• Implementation of IFRS will lead to increased transparency andcomparability of performances
• Less options• More data requirements• Complex (fair value) measurements• Insight in sensitivity assumptions• Increased enforcement• Greater insight in performance• Increased volatility in results
IFRS 4 – objectives for phase 1• Limited improvements• Increased disclosure
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6AA Symposium 2004
Development of IFRS
31/12/02 31/12/0731/12/03 31/12/04
Opening IFRS 4balance sheet in
Europe
ED forphase 1
31/12/0631/12/05
Period coveredin first IFRS 4
financialstatements
Phase 2?First IFRS 4financialstatements
IFRS 4
Cumulative effect of IFRS 4recognised in the openingbalance sheet at 1/1/2005
Fair valuedisclosurespertaining to
insurance liabilities
ED for phase 2?
A first time adopter need notrestate the comparative
information in respect of IFRS 4,IAS32 & IAS 39 (together)
Expectedimplementation of
HKFRS 4 in HK
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7
Key Principles of IFRS 4
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8AA Symposium 2004
Key Principles of IFRS 4
• Definition of insurance contract• Unbundling• Embedded Derivatives• Change in Accounting Policies• Asset Liability Matching• Liability Adequacy Test• Discretionary Participating Contracts• Extensive Disclosure Requirements
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9AA Symposium 2004
Definition of Insurance Contract
• A contract under which one party (the insurer) acceptssignificant insurance risk from another party (thepolicyholder) by agreeing to compensate thepolicyholder if a specified uncertain future event (theinsured event) adversely affects the policyholder.
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10AA Symposium 2004
Why does definition of insurance risk matter?
Financialrisk
Insurancerisk
Insurance contract(phases 1 & 2)
Financial instrument(IAS 39)
Traditional life
Endowment
Universal life
Deferred annuity
Unit linked
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11AA Symposium 2004
Changes in the level of insurance riskChanges in the level of insurance risk
Significant insurance risk
Significant insurance risk
Life of the (insurance) contract
Term life insurance: risk remains significant throughout the contract
Endowment policy : amount at risk in case of death reduces as valueof investment component increases
Deferred annuity : no insurance risk during savings phase, insurancerisk in annuity phase; overall is insurance contract since opting forannuity is an event of commercial substance
Significant insurance risk
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12AA Symposium 2004
“Unbundling” of an insurance contract
• Unbundling of a deposit component is permitted if• the deposit component can be measured separately.
• Unbundling of a deposit component is required if• the deposit component can be measured separately;
and the resulting rights and obligations are nototherwise recognized under the insurer’s accountingpolicies.
• Unbundling of a deposit component is prohibited if• an insurer cannot measure the deposit component
separately.
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13AA Symposium 2004
Embedded derivatives in insurance contracts
• IAS39 requires derivatives embedded in an insurancecontract to be separated and marked-to-market whenits economics are not closely related to the hostcontract
• IFRS 4 provides three exceptions to this principle, inthat the following three provisions need not beseparated from its host contract
• Option such as a life-contingent annuity,• A fixed-price or interest rate linked surrender options, or• Liabilities under unit-linked contracts may be measured
at unit values.
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14AA Symposium 2004
Change in Accounting Policies
• Changing accounting policies is allowed, if changesmake the financial statements
– more relevant for the user's economic decision-making needs and no less reliable
OR
– more reliable and no less relevant to those needs
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15AA Symposium 2004
Asset Liability Matching
• Assets might be classified as available-for-sale (“AFS”) or tradingwhich are at fair or market value)
• Liabilities might be on different basis e.g. amortised cost
• IFRS 4 and IAS 39 suggested the following:
• An insurer is permitted, but not required, to change its accountingpolicies so that it re-measures designated insurance liabilities toreflect current market interest rates
• Shadow adjustment – amortise DAC and the value of businessacquired through equity in order to offset unrealised capital gains ofAFS investment
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16AA Symposium 2004
Liability Adequacy Test
• Must assess at each reporting date whetherrecognised insurance liabilities are adequate based oncurrent estimates of future cash flows under insurancecontracts.
• IFRS 4 only specifies minimum requirements:• The assessment must use current assumptions and
consider all contractual cash flows, including:– Claims handling costs; and– Cash flows from options and guarantees.
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17AA Symposium 2004
Discretionary Participating Feature (DPF)
• IFRS 4 does not require a specific accountingtreatment for the discretionary component of theinsurance contract
• DPF may be recognized 1) as part of benefit reserve or2) separately as Liability or Equity
• If recognized separately, the annual surplus is splitbetween policyholders’ share and stockholders’ share.The policyholders’ share is either recognized as aspecial liability (e.g. deferred bonus liability) or as aseparate component of equity.
• BUT the basis used should be applied consistently
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18AA Symposium 2004
Extensive Disclosure Requirement
• An insurer should disclose :• Amounts arising from insurance contracts
- Process used to determine significant assumptions- Effects of changes in assumptions- Material changes in insurance liabilities, reinsurance asset and
DAC
• Amount, Timing & Uncertainties of future cash flows- Risk management objectives and policies- Details of insurance contracts with significant cash flow impact- Information about insurance risk- Information about interest risk and credit risk- Sensitivity of ‘embedded derivatives’ to interest risk & credit
risk
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19AA Symposium 2004
Disclosure Issues
• Degree of disaggregation of information• Which assumptions need to be disclosed• Commercially sensitive information• Systems implications/data collection
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20
Challenges to HK and PRCInsurance Industry
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21AA Symposium 2004
There will be a number of challenges to HKand PRC insurance companies
• Product Classification• Disclosure• Liability Adequacy Test• Asset Liability Mismatch• Reserves• Embedded Values Reporting• Comparison with US GAAP
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22AA Symposium 2004
Some of insurance premium may no longerbe recognized as premium income
• Short Term Single Premium Endowment type ofproduct is very popular, with large premium income, inrecent HK and PRC market
• Heavy investment elements• If these are considered as investment products premium
received NOT recognised under IFRS• Significant impact to companies’ financials
• Implementation guidance from IFRS 4 containspractical examples
• BUT mainly focus on European/ American insurancemarkets
• Local regulators may want to provide examples whichare applicable to the local markets
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23AA Symposium 2004
Greater disclosure requirement means morework
• Greater disclosure will be required on Sensitivity ofchange in assumptions and Concentration ofinsurance risk
• HK and PRC insurers require:
• Competent actuaries and accountants who are familiarwith IFRS regulations and able to set up the system inaccordance to the disclosure requirement
• Software which can provide information for IFRSreporting need to be tailor-made
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24AA Symposium 2004
Disclosure will lead to higher transparency
• System enhancement will improve the quality ofinternal management reporting
• Greater understanding of existing business condition
• Increase responsiveness to changes in insurancemarket
• Enhance transparency of insurance industry• Policyholders, shareholders and analyst will have a
better understanding of financial situation and riskprofiles of the company
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25AA Symposium 2004
Liability Adequacy Test
• No such requirement under both HK and PRC accountingstandard
• Liability Adequacy Test is similar to Loss Recognition Test(“LRT”) under US GAAP basis
• Insurers who already report under US GAAP basis may base ontheir LRT and related reporting capabilities to meet IFRS 4requirement
• Level of aggregation: portfolio of contracts that are subject tobroadly similar risks and managed together as a single portfolio
• Impact on solvency of insurers
• Need to reconsider the investment strategy and dividend payingstrategy
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26AA Symposium 2004
Liability Adequacy Test
• PRC Insurer’s concern:• Valuation mortality and interest are prescribed by CIRC; so adverse
experience variance (e.g. negative interest spread) might result innot passing the test
• Products with high guaranteed interest rates may need to increasereserve as a result of negative interest spread for older businessesissued in PRC
• Need to evaluate the adequacy of IBNR which is currentlydetermined as 4% of claim; premium deficiency reserve may berequired as a result
• For HK insurers:• The valuation assumptions are primarily determined based on
prudent rates, with reference to company’s experience (e.g. actualportfolio investment yield).
• So less likely to fail the test as a result of negative experiencevariance
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27AA Symposium 2004
Asset Liability Mismatch
• IFRS 4 allows fair value accounting for insurancecontracts to match with the fair value reporting oninvestment portfolio
• For example:• Re-measure reserve using current estimates and
assumptions• Shadow adjustment
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28AA Symposium 2004
Reserves
• Actuarial reserves are allowed to be calculated usingexisting basis under local GAAP
• Need not eliminate excessive prudence but for aninsurer which already measures its insurance contractwith sufficient prudence, it should not introduceadditional prudence
• May re-measure designated insurance liabilities toreflect current market interest rates (and other currentassumptions)
• Claim reserves are only permissible to the extent theyrelate to actual liabilities – end to equalisation andcatastrophe reserves
• Liability adequacy test
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29AA Symposium 2004
Embedded Value reporting
Advantages
• Increasingly adopted as performance measurement tool by the multinationals• Provides a useful platform for risk analysis using sensitivity tests and stochastic
analysis• Focuses on a long time horizon which matches the nature of insurance products• Highlights where value is being created and destroyed• Early recognition of profits / values when compared to SAP and GAAP
Major uses
• Commonly used in evaluating mergers and acquisition• Management of in-force business
• New incentive program for distributors• Interest crediting and investment strategies• Impact of expense control• Impact of persistency control
• Provides a rigorous means to quantify the value of business written in the previousyear
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30AA Symposium 2004
Embedded Value reporting
• Phase 1 allows embedded value measurement if it provides relevant andreliable financial statements
• Current embedded value approaches reflect future investment margins, inthat the discount rate is based on estimated return
• Less relevant and reliable financial statement• Guidance will be given on Risk Discount Rate in Phase 2
• Also, current practise only use single best estimate basis• Unable to reflect full range of possible outcome• Need to keep an eye on phase 2 requirement
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31AA Symposium 2004
Comparison with US GAAP
• Similarity exists in DAC, Liability Adequacy Test (LRT under USGAAP)
• Allow Shadow Accounting, in order to address potential asset-liabilitymismatches in phase 1
• DAC does not meet the IFRS framework definition of an asset so likelywill be removed in phase 2
• UPR does not meet the IFRS framework definition of an liability solikely will be removed in phase 2
• Phase 2 is expected to require discounting of liability which is generallynot permitted under USGAAP for claim reserving. This leads topossible advantage for European insurers, particularly on long tailedbusinesses
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32
Questions for CEOs
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33AA Symposium 2004
Questions for CEOs
• Should and how product mix and design be changed?
• Do we need to improve our asset-liability matching?
• Should and how investment strategy be changed?
• Are existing IT and accounting systems capable of trackinginformation resulting from a change in the contract definition andproduct classification?
• How will the insurance regulators and the Tax Departmentinterpret the new definition of insurance contracts?