The World Bank The Advanced Program in Accounting and Auditing Regulation

1. The World Bank The Advanced Program in Accounting and Auditing Regulation A new era of prudential rules and financial reporting for insurance Catherine Guttmann 16 May 2006

2. Outline of presentation • In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level • Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital • What are the main features of IFRS for insurance companies (as of today, Phase I) • IFRS 4 – Phase II – A common valuation of insurance liabilities for accounting and solvency purposes ?

3. In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level • Solvency II as a consequence of insufficient efficiency of Solvency I • 85 insurance companies have been under regulator’s close scrutiny, in the last five years in Europe, because of capital inadequacy under Solvency I, of which 20 have ultimately disappeared : • Administrative sanction • bankrupcy Main Reasons : • Inadequacy of the pricing of the contracts • Under estimate of insurance liabilities, including embedded options granted to policy holders • Inadequate asset/liability management • Duration • Liquidity • … • Inadequate reinsurance coverage linked with insufficient insurance risk diversification • Inadequate corporate governance and internal control

4. In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level • Solvency II as a convergence between insurance and banking sector • More and more similar products e.g. : • Catastroph bond versus insurance contract • Saving contracts • Climatic derivatives In line with IAIS thinking : • more prospective assessment and control of the risks : • Insurance • Financial • Operational • … both on management and supervisor’s side

5. In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level – The Calendar Project of Directive proposed for adoption Phase I Phase II 1999 May 01 jan 03 jun 04 dec 04 may 05 apr 06 oct 06 dec 06 feb 07 jun 2007 2008 2009 2010 Preparatory works Project of Directive Directive Solvency II June 2004 : 1st wave of calls for advice (Pillar II) Dec. 2004 : 2nd wave of calls for advice (Pillar I) May 2005 : 3rd wave of calls for advice (Pillar III) June 2005 : Amended Framework for consultation Sept 2005 : 1st quantitative impact study (QIS 1) April 2006 : 2nd quantitative impact study (QIS 2) Oct 2006 : 1st draft of Directive Dec 2006 : 2nd draft of Directive Fev 2007 : Final Directive Jui 2007 : Adoption 2008 : Elaboration of detailled implementation guidances 2009-2010 : Transposition of the directive by each Member State 2010 : Application Solvency II Removal of 19 Directives EU in existence • Inventory on Solvency I • Assessment of the relevance / adaptation of banking rules to insurance • Considerations into the form of a future system of prudential control • Study leads by european insurance supervisors on Solvency I and recommendations on the Solvency II project

6. In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level Key phases of short term development SOLVENCY II Feb 06 March 06 April 06 Sept 06 Oct 06 Dec 06 Feb 07 July 07 Results QIS 1 CEIOPS answer – 3rd wave of calls for advice Starting QIS 2 on MCR & SCR) Results QIS 2 1st draft of Directive 2rd draft of Directive Directive proposed for adoption Final Directive

7. In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level 3 pillars structure Solvency II Pillar I Pillar II Pillar III Capital Adequacy Value based approach - Solvency Capital Requirement (SCR) - Min. Capital Requirement (MCR) Insurance Liabilities Risks linked to the asset more specifically integrated Supervisory Review Corporate Governance Asset/Liability Management Efficiency of internal control Investment policy Reinsurance program Process of prudential supervision • Market Regulation • Information for public and control • Transparency principle • Information requirements (disclosures) • Financial communication

8. In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level • MCR/SCR (CFA n°9, 10, 11, 13, 14) • 2 levels of solvency requirement : MCR and SCR Level 2: capital target Surplus • Internal models • Standard approach Prudential graduated intervention SCR Solvency CapitalRequirement Level 1: floor MCR Min. Capital Requirement Risk considered as unacceptableby policy holders Insurance Liabilities Level 0: Mortality risk

9. Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital • Relevant information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or futureevents or confirming or correcting their past evaluations Prospective approach Unlocking of the assumptions • Completeness : no omission As far as possible, all items valued in the balance sheet e.g. : guarantees, options

10. Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital • Common : • Same definitions (substance over form) Definition of financial assets and liabilities Definition of insurance contract Definition of financial risk, or insurance risk, ... • Same accounting rules Convergence between countries Convergence between insurance and banking

11. Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital • Prudent : • Valuations have to contend with the uncertainties • Those uncertainties are to be recognised and valued • However, the exercise of prudence doesn’t allow deliberate overstatement of liabilities No double counting with solvency capital requirement Conclusion : a prerequisite, a priori, in coherence with IFRS framework

12. What are the main features of IFRS for insurance companies (as of today, Phase I) • The IFRS on insurance contracts applies to all insurance contracts (including reinsurance contracts) and only to insurance contracts Financial assets and liabilities of insurers are treated by IAS 39 • All IFRS standards apply to insurance companies • « Insurance contract » definition is a definition in substance and not a legal one : • The standard on insurance contracts should then be used for example in the banking industry

13. What are the main features of IFRS for insurance companies (as of today, Phase I) Definition of an insurance contract • An insurance contract is a contract : • « under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain futur event (the insured event) adversely affects the policyholder » • The « policyholder » is defined as : « a party that has a right to compensation under an insurance contract if an insured event occurs »

14. What are the main features of IFRS for insurance companies (as of today, Phase I) Definition of financial and insurance risks • An insurance risk is a « risk , other that financial risk, transferred from the holder of a contract to the issuer » • A financial risk is « the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract »

15. What are the main features of IFRS for insurance companies (as of today, Phase I) Examples of insurance contracts

16. Major changes with fair value orientation Local GAAP Consequence : an insurer balance sheet

17. Major changes with fair value orientation Local GAAP

18. Juillet 2005 2009/2010 2006 2008 IFRS 4 – Phase II – A common valuation of insurance liabilities for accounting and solvency purposes ? • Agenda • A Working Paper should be published by the Working Group Phase II before year end 2006 • An Exposure Draft should be published in 2008 • Final standard could be published before year end 2008 Endorsement of phase II standard Working paper published ED published Working Group meetings

19. Main issues : valuation approaches under consideration • Approach A – Current Entry Value • Principles : Approach A measures the insurance liability at the amount that the insurer would charge to a policyholder today for entering into a contract with the same remaining rights and obligations as the existing contract. • Initial measurement : • Discounting of future projected cash flows using current yield curve (best estimate value) • A margin for risk and uncertainty • • Valuation of an implicit margin, equal to the difference between premiums and the best estimate value • Next measurements • Best estimate value is calculated on current assumptions (economic and non economic) • The initial margin is amortised among the duration of the contract with the release of the risk

20. Main issues : valuation approaches under consideration • Approach B – Current Exit Value (Transfer Value) • Principles : Approach B measures the insurance liability at the amount that the insurer would expect to have to pay today to another entity if it transferred all its remaining contractual rights and obligations immediately to that entity. • Because there is no secondary market for most insurance liabilities, that amount would need to be estimated. • Specifically, approach B : • Measures the insurance liability as the present value of future cash flows arising from the contract (Uses a current risk-free discount rate). • Does not defer acquisition costs as a separate asset. • The measurement of the liability includes the margin that market participants would require for contractually assuming risks and providing services : • Margin for risks and uncertainty AND • Margin for the servicing part included in the insurance contract (servicing margin) • Profit at inception is limited : • by the level of the MRI and • by the level of the Servicing margin

21. Main issues : valuation approaches under consideration Approach A – "Business to Customers” Approach B – "Business to Business” Asset Net equity Asset Net equity No gain at inception Some gain at inception but limited by the SM and the MRI Global Margin Servicing margin • Separation and valuation of the 3 parts of the contracts : • exit value "best estimate" • Margin for risks • Servicing margin MRU Global margin = Premiums – Exit Value best estimate Exit Value best-estimate Exit Value best-estimate

22. Main issues : valuation approaches under consideration • IAIS is working on a similar model so that the same valuation for liabilities could be taken for solvency purposes and accounting • Questions still to be solved : • Definition of the MRU (level of confidence ; Cost of capital), pattern of amortisation • Definition and level of the servicing margin (market reference ?) • Policyholder behaviour ? Surrenders, futur premiums, renewals … • IAS 39 for investment contracts ? 39 to be amended ? • Own credit risk • Discretionary participating features : liability or equity or separate component of equity ?