IASB Exposure Draft Insurance Contracts

2. IASB Exposure DraftInsurance Contracts Actuarial Society Life Insurance Seminar September 2010 Peter Withey

3. 3 Agenda Content of the Exposure Draft Issues and implications for South Africa DISCLAIMER: The views expressed are my own and do not necessary reflect the view of my employer or the Actuarial Society of SA.

4. 4 Background IFRS4 Phase I issued March 2004 Insurance Contracts Project (Joint IASB and FASB) IASB Discussion Paper � Preliminary Views on Insurance Contracts (May 2007) � Current Exit Value Approach FASB Invitation to Comment wrapping IASB paper (August 2007) FASB joins IASB project (October 2008) IASB Exposure Draft (July 2010) FASB Discussion Paper (Aug/Sept 2010) Final IASB standard expected by June 2011; Final FASB standard expected in 2012 First time application to be established (Boards� intent is to align effective date with IFRS 9 Financial Instruments- 2013?) Comment deadline on ED ends 30 November 2010

5. 5 Insurance Project Scope

6. 6 Insurance Contract Definition

7. 7 The Measurement Model Measurement model is based on a principle that insurance contracts create a bundle of rights and obligations that work together to create a package of cash inflows (premiums) and outflows (benefits, claims and costs). The model uses certain �building blocks� in measuring that package of cash flows. Fulfillment principle

8. 8 Contract Boundary

9. 9 Proposed Measurement Models

10. 10 Level of measurement An insurer would measure the present value of the fulfilment cash flows (includes risk adjustment) at a portfolio level of aggregation for insurance contracts. A portfolio of contracts are contracts that are subject to broadly similar risks and managed together as a single pool. The definition is consistent with IFRS 4. The residual margin should be determined by grouping insurance contracts by portfolio and, within the same portfolio, by similar date of inception of the contract and by similar coverage period.

11. 11 Future cash flows Estimates of cash flows for a portfolio of insurance contracts should include all incremental cash inflows and outflows arising from that portfolio and shall: Be explicit (i.e. separate from estimates of discount rates that adjust for the time value of money and the risk adjustment) Reflect the perspective of the insurer (market variables are consistent with observable market prices) Reflect all available information that relates to the cash flows of the contract (including policyholder behaviour � e.g. lapses) Be current and consistent with market prices, i.e. use of estimates of financial market variables such as interest rates Include only cash flows arising from existing contracts within the contracts� boundaries Cash flow estimates are required to be updated each reporting period and changes are recognised in profit or loss

12. 12 Expected present value approach Estimates of cash flows start with a range of scenarios that reflects a full range of possible outcomes. Each scenario specifies the amount and timing of cash flows for a particular outcome and the estimated probability of that outcome. The aim is not necessarily to identify every possible scenario but rather to incorporate all relevant information and not to ignore data or information that is difficult to obtain. In some cases, the cash flows may be driven by complex underlying factors and respond in a highly non-linear fashion to changes in economic conditions, for example if the cash flows reflect a series of inter-related implicit or explicit options. In such cases, more sophisticated stochastic modelling is likely to be needed

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14. 14 Current estimates and future events Insurer should use all available current information in estimating the probability of each cash flow scenario relating to non-market variables Insurer should consider estimates made at the end of the previous reporting period and update if previous estimates are no longer valid May not be identical to recent experience An insurer investigates changes in experience and develops new probability weighted estimates for possible outcomes Estimates of non-market variables should consider trends, future inflation rates, and future events that might affect the cash flows without changing the nature of the obligation

15. 15 Premiums Claims and benefits paid to policyholders (Includes IBNR and Benefits in kind and salvage and subrogation) Costs of claims Costs of servicing the contract (excluding overheads) Transaction based taxes Options & Guarantees Incremental costs of selling, underwriting, and initiating an insurance contract (acquisition costs) but only for contracts issued Payments to current or future policyholders as a result of a contractual participation feature

16. 16 Discounting What discount rate should be used in measurement? Should not capture characteristics of assets actually held to back the insurance liability, unless the contract shares those characteristics Should be consistent with observable current market prices for instruments whose characteristics reflect the insurance liability (e.g. timing, currency and liquidity) Discount rate is yield curve with no or negligible credit risk, adjusted for differences in liquidity, if cash flows are not dependent on specific assets Should not include own credit risk Should not include factors not relevant (i.e. risks not present in liability but present in the instrument with observable market price) If the amount, timing or uncertainty of cash flows for the insurance contracts depends on the performance of specific assets measurement shall reflect that fact Should not include any risk that is included in other parts of measurement

17. 17 Risk Adjustment Risk Adjustment: �The maximum amount that the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows may exceed those expected." An insurer shall use only the following techniques for estimating the risk adjustment: Confidence level Conditional Tail Expectation (CTE) Cost of Capital (CoC) The proposals in the ED do not mandate a specific confidence level or CTE band for calibrating the risk adjustment. An insurer discloses the confidence level and, if applicable, CTE bands used in estimating the risk adjustment. Should be estimated at a portfolio basis to reflect diversification of risks within a portfolio, but not diversification between different portfolios Re-measured each reporting period and changes are recognised in profit or loss Although the risk adjustment must be explicit, this requirement is not intended to preclude a �replicating portfolio� approach

18. 18 Composite or Residual Margin Arises when the present value of the fulfilment cash flows is less than zero If the present value of fulfilment cash flows is greater than zero, this amount should be recognised in profit or loss at inception (i.e. a day one loss) Systematic release over coverage period based on the passage of time If an insurer expects to incur benefits and claims in a pattern that differs significantly from passage of time the residual margin should be released on the basis of the expected benefits and claims to be incurred Classified as part of the insurance liability Interest accretion using �locked in� rate Arises when the present value of future cash outflows less the present value of future cash inflows is less than zero. If the present value of future cash outflows less the present value of future cash inflows is greater than zero, this amount should be recognised in profit or loss at inception (i.e. a day one loss) Release over both the coverage period and the claims handling period (during which the insurer is expected to pay claims) Percentage of completion amortisation reflecting the decline of risk based on actual and expected cash flows Classified as part of the insurance liability No interest accretion

19. 19 Short duration contracts The modified approach is required for pre-claim liabilities for contracts that meet both of the following definitions: The coverage period is approximately 12 months or less The contract does not contain embedded options or other derivatives that significantly affect the variability of cash flows �Premium Allocation Model� Not unlike UPR approach If a contract is onerous on the general measurement model for a portfolio with similar inception dates, the excess of the present value of the fulfilment cash flows over the carrying amount of the pre-claims obligation is recognised as an additional liability and expense. Liabilities for claims incurred are using the general measurement model. Consistent with the general measurement model, a current market discount rate would be used in discounting the pre-claims obligation and claims liability.

20. 20 Reinsurance Reinsurer should use the same recognition and measurement approach for reinsurance contracts it issues as all other insurers use for the insurance contracts they have issued. A cedant shall measure a reinsurance contract it holds in the same manner as the corresponding part of the present value of fulfilment cash flows for the underlying insurance. The residual margin eliminates any loss at inception of the contract but cannot be negative. (i.e can recognise a gain at inception) The cedant estimates the present value of fulfilment cash flows after remeasuring the underlying insurance contract on initial recognition of the reinsurance contract. The cedant takes the risk of non-performance by the reinsurer into consideration in the calculation Any ceding commissions a cedant receives should be recognised as a reduction of the premium ceded to the reinsurer.

21. 21 Unbundling Investment and service components of an insurance contract should be unbundled and accounted for separately if the components are not closely related to the insurance coverage specified in the contract. The following are the most common examples of unbundling applying this principle: An investment component reflecting an account balance that is credited with an explicit return at a rate based on the investment performance of a pool of underlying investments (e.g. unit-linked contracts; index-linked contracts; and universal life contracts). The rate should pass on all investment performance but may be subject to a minimum guarantee. An embedded derivative that is separated under existing bifurcation guidance in IAS 39. and Goods and services that are not closely related to the insurance coverage, but have been combined in a contract with the insurance coverage for reasons that have no commercial substance. Unbundling is not permitted unless�required.

22. 22 Statement of financial position The ED proposes that an insurer present each portfolio of insurance contracts as a single item within insurance contract assets or insurance contract liabilities. It also proposes that an insurer present a pool of assets underlying unit-linked contracts as a single line item separate from the insurer�s other assets and that the portion of the liabilities linked to the pool be presented as a single line item separate from the insurer�s other liabilities. Reinsurance assets are not offset against insurance contract liabilities.

23. 23 Statement of comprehensive income The ED proposes a summarised margin presentation for the statement of comprehensive income. This presentation approach treats all premiums as deposits and all claims and benefits as repayments to the policyholder; those elements are treated as movements in the insurance liability. This presentation is supplemented by disclosures of premiums and expenses (as part of the reconciliation of opening and closing contract balances). Exception: For short-duration contracts that are eligible for the modified measurement approach, the underwriting margin is disaggregated in the statement of comprehensive income into premium revenue (release of gross pre-claims obligation plus accreted interest), claims incurred, expenses incurred, and amortisation of incremental acquisition costs included in the pre-claims obligation plus changes in additional liabilities for onerous contracts

24. 24 Summarised Margin Presentation

25. 25 Disclosures Under the proposals, an insurer is required to disclose quantitative and qualitative information in respect of: the amounts arising from insurance contracts recognised in the financial statements; and the nature and extent of risks arising from insurance contracts. The IASB used the disclosure requirements in IFRS 4 (including the disclosures about financial risks in insurance contracts incorporated in IFRS 4 by cross reference to IFRS 7) as a basis for its proposals Aggregation principle Useful information should not be obscured by either the inclusion of a large amount of insignificant details or the aggregation of items that have different characteristics Required disclosures include: reconciliation of contract balances; methods and inputs used to develop the measurements, including a measurement uncertainty analysis; the nature and extent of risks arising from insurance contracts; a risk sensitivity analysis; and claims development information. Additional disclosure requirements from IFRS 4 were retained

26. 26 Transition For each portfolio of insurance contracts that exist on the transition date, the insurer needs to measure the remaining cash inflows and outflows plus a risk adjustment. Measurement both at transition and subsequently does not include a residual margin. The effect of not recognising a residual margin for contracts in existence at transition would be to depress the net income reported for those contracts in periods post-transition compared to a full retrospective application. The transition adjustment is calculated at the beginning of the earliest period presented and adjusted to retained earnings. Proposals do not contain effective date as Board wants to align with other proposals and standards (e.g. IFRS 9 Financial Instruments).

27. 27 Other considerations Measurement in the context of portfolio transfers and business combinations apply general measurement model with the residual margin being determined relative to the purchase price. The proposals introduce a requirement to measure property owned and occupied by the insurer that is part of a pool of assets underlying unit-linked contracts at fair value through profit or loss to the extent the changes in the property relate to the interest of unit-linked contract holders in a pool of assets. The proposals also require that for insurer�s own shares underlying unit-linked contracts, an insurer recognise the shares as assets and measure the shares at fair value through profit or loss to the extent those changes relate to the interest of unit-linked contract holders in the pool of assets. An entity should recognize an insurance contract liability or asset at the earlier of (1) the date when the insurer is bound by the terms of the contract; and (2) the date when the insurer is first exposed to risk under the contract. This is when the insurer can no longer withdraw from its obligation to provide coverage and no longer has the right to reassess the risk of the policyholder and as a result can no longer change the price to fully reflect that risk.

28. 28 Agenda Content of the Exposure Draft Issues and implications for South Africa

29. 29 Insurance Definition Definition essentially the same as IFRS4 but introduces 2 additional features. Significant additional benefits assessed on a discounted basis Must be a scenario with economic substance where the PV of benefits must exceed the PV of premiums Implication/Impact Will need to revisit the insurance contract classifications made under IFRS4 May result in some borderline contracts being reclassified

30. 30 Discretionary Participation Scope includes Investment contracts containing a discretionary participation feature (DPF) provided that there also exist insurance contracts that provide similar contractual rights to participate in the performance of the same pool of assets. Implication/Impact: Likely that many parts of the business already currently under IFRS4 and valued under PGN104 will fall into IAS39/IFRS9 Potential impact on valuation of these which may bring BSR�s (in particular negative BSR�s) onto the balance sheet. Contracts that remain in scope but are currently valued on a retrospective basis may need to be valued on a prospective basis under the general measurement model.

31. 31 Unbundling Specific example of a contract requiring unbundling appears to require unbundling of �universal life� type contracts. Seems to be in conflict with the �closely related� aspect of the definition Implication/Impact May not be too much of an issue for the balance sheet Potentially significant implications for the flow elements involved

32. 32 Contract boundary Boundary of the contract is defined as the point at which the insurer either is no longer required to provide coverage or has the right to reassess the risk of the particular policyholder and, as a result, can set a price that fully reflects that risk. Implication/Impact: On initial look a repricing right in a �universal life� type contact may require the contract boundary to be when the right to reprice triggers. Some whole life risk products may have similar features. However, the key element is related to the �particular policyholder� and unless the right is to re-underwrite then the boundary remains the full contract.

33. 33 Measurement model Present Value of fulfilment cash flows Generally support the approach in principle Implications/Impact Some implications in respect of each of the 3 building blocks that make this up Residual margin Artificial construct to prevent any form of profit at issue Implications/Impact Massive practical implications

34. 34 Cash flows Initial Expenses: only incremental expenses directly related to the issued policy may be included in cash flows, all other expenses must be expensed Implication/impact No inclusion of underwriting department costs � only direct costs (e.g. medicals for issued policies) Potential significant increase in New Business Strain Business models with direct written business and salaried agents will be hard hit Accounting model may dictate business model Renewal expenses: may only include direct costs of administration not allocations (e.g. CEO and other central cost may be excluded) Implication/impact Will likely reduce best estimate liabilities and increase residual margin

35. 35 Discount rate Cannot use asset driven discount rates. Rates must reflect risk free market rates at time of reporting Implications/Impact Annuity portfolios matched with corporate bonds on a buy and hold strategy will show a balance sheet loss. What is the risk free rate? What about markets where there is no real risk free market of suitable term?

36. 36 Risk adjustment May only use the following techniques for estimating the risk adjustment: Confidence level Conditional Tail Expectation (CTE) Cost of Capital (CoC) No specific confidence level or CTE band set for calibrating the risk adjustment. But disclosure required Implication/Impact Other potential methodologies that may emerge will have to be accommodated by a change in the standard. There is likely to be a lack of comparability What level of capital calibration and what rate should be used for the Cost of capital approach?

37. 37 Residual margin Created at inception based on a �cohort� of policies grouped by portfolio and within the same portfolio, by similar date of inception of the contract and by similar coverage period. Systematic release over coverage period based on the passage of time Interest credited at �locked in� rate Not remeasured unless the portfolio reduces below the expected size Implications/Impact How many �cohorts�? Is a policy at the start of a year preculded from releasing profit over the balance of the year if it is grouped with policies written at the end of the year? How is it managed � multiple spreadsheets drive a key piece of your accounts. Need to test for adjustment in each cell each year.

38. 38 Short duration contracts Modified approach is intended to simplify calculations since it is similar to the currently used UPR approach Must be applied to all contracts of approximately 1 year or less Required to perform an onerous contract test Implications/Impact May result in a book being split into 2 parts treated differently (e.g. credit life book with durations between 6 and 18 months) Must do the onerous contract test using the general model anyway so is it any simpler?

39. 39 Transition No residual margin to be determined on transition Implications/Impact Computationally simpler than trying to recreate estimates of remaining residual margin for existing business All �profit� in excess of the present value of the fulfilment cash flows (allowing for risk margin) will fall into surplus at transition date. Some existing discretionary margin likely to be released No allowance for future overhead costs

40. 40 Presentation & Disclosure Results presented using a summarised margin approach Significant detailed supporting disclosure required Implication/Impact In principle should not be an issue as to some extent it is similar to Analysis of Embedded value information Most likely that there will be more information that needs to be presented than currently in the SA accounts Premiums and claims will not be in income statement.

41. 41 Initial recognition � old vs new

42. 42 SA Current vs Phase II

43. 43 Closing remarks The proposals are extensive and will require a lot of work to implement. The administration of the Residual margin over time will grow in complexity. It is likely that there will be a divergence between different forms of reporting � IFRS vs Regulatory vs Tax The disclosures will provide a lot more information to users � whether it is more meaningful or more useful remains to be seen Embedded Values will most likely continue to play a role and will probably still be seen by analysts as the primary information