Financial Reporting Framework for Insurers, the potential impact of IFRS 4 and future direction for insurance accounting

1. Financial Reporting Framework for Insurers, the potential impact of IFRS 4 and future direction for insurance accounting in Pakistan Pakistan Society of Actuaries Karachi, 12 March 2010

2. Contents of This Presentation Recent History of Changes in Accounting Regulations Financial Reporting in Pakistan today, the need for change and likely future direction The IFRS framework and future direction IFRS 4 – Brief Overview Likely impact of IFRS 4 – Phase 1

3. Recent History of Insurance Accounting in Pakistan The introduction of the Insurance Ordinance 2000 followed by the SEC (Insurance) Rules 2002 and a number of circulars have brought in a significant strengthening of insurance regulation in Pakistan included financial reporting by insurance companies which underwent a significant change in December 2002 with the introduction of the accounting regulations for insurance companies which form a part of the 2002 Rules The regulations were developed by an insurance sub-committee of ICAP’s Accounting and Auditing Standards Committee consisting of representatives from accounting firms, insurance companies and the actuarial profession. The committee also had sessions with representatives of the Insurance Association of Pakistan and individual life insurers (who were not a part of IAP until that time) The regulations significantly enhanced the quality of and standardization of financial statements However, especially in the case of life insurers, many felt that the regulations had gone overboard in terms of detail

4. Recent History of Insurance Accounting in Pakistan In 2004 the International Accounting Standards Board introduced a new financial reporting standard for Insurance Contracts (IFRS 4), effective for insurance periods beginning on or after 1 January 2005. The insurance sub-committee of ICAP was re-convened but came to the conclusion that, given that insurance companies were still adapting to the major change brought about in end 2002, and also that IFRS 4 would not bring about any drastic changes in the measurement of reported figures, this be deferred for the time being. In March 2007 the Insurance Committee was reconvened and, in August 2007, recommended the adoption of IFSR 4 but deferring some disclosure requirements for two years as it was felt that many insurers would find it difficult to comply with these. ICAP was, however, working towards full compliance of the IFRS framework and therefore recommended, to the SECP to implement the IFRS without modification. After some deliberation the SECP notified, in February 2009, the IFRS for adoption for accounting periods beginning 1 January 2009. At the request of the IAP the SECP deferred certain paragraphs of the IFRS for the first three quarters and in January 2010 issued guidelines for their implementation for the annual accounts for 2009

5. Financial Reporting Framework for Insurance Companies in Pakistan The current framework for financial reporting by insurance companies in Pakistan is governed by: The Insurance Ordinance 2000 and SEC (Insurance) Rules 2002 In particular the appendices dealing with Accounting The Companies Ordinance 1984 The International Financial Reporting Framework (as applicable in Pakistan) Barring some specific exceptions Listing Regulations of the Stock Exchanges

6. Insurance & Companies Ordinances The Insurance Ordinance requires insurers to submit to the commission: Annual statutory accounts – covered by S46 which also defines the types of financial statements to be submitted Accounts prepared under the Companies Ordinance (S47) The Companies Ordinance contains disclosure requirements relating to financial statements to be submitted by companies – these do not, however, specifically address insurance companies Section 52 allows the SECP to prescribe the form of financial statements required under the Companies Ordinance. Although strictly this provision is for life insurers it has been extended to non-life insurers

7. Current Accounting Regulations The SEC (Insurance) Rules contain detailed guidance on the treatment of various elements of insurance company financial statements and also contain detailed formats Currently these are common for both reporting to shareholders under the Companies Ordinance (termed as “Published Financial Statements” in the regulations) and reporting to the regulator (called “Regulatory Returns” in the regulations) The accounting profession is widely of the view that the current formats do not comply with IAS 1 for life insurers The formats currently prescribe a Revenue Account and a Profit and Loss Account (as prescribed in S46 of the Insurance Ordinance) whereas the IAS only talks about a single income statement The insurance industry at large is also of the view that the accounting formats need to be simplified for Companies Ordinance purposes. The current regulations also exempt insurance companies from certain accounting standards, most notably IAS 39.

8. Takaful In 2005 the SECP issued the Takaful Rules and since then two family takaful and three general takaful operators have started operations The Takaful Rules did not, however, address the specific (and different) financial reporting requirements of takaful operators. As a result each company was left to fend for themselves. Guidance was obviously provided by different accounting firms (in their capacity as auditors) under the IFRS framework but there is still a need for some standardization of practice. The Takaful Rules are being revised which may also have some implications on financial reporting.

9. Revision of Accounting Regulations Given the concerns mentioned earlier, as well as exemption given to insurance companies under the Accounting Regulations from the provisions of some International Accounting Standards (which need to be reversed), the ICAP sub-committee is working to review the Accounting Regulations and make recommendations to the SECP for their modification. Major modifications are likely to be: Simplification of the main financial statements (income statement and balance sheet) and relegation of details (eg., statutory fund-wise accounts) to the notes. The need to adopt standards currently not adopted (IAS 39 and IAS 40). This is likely to come about later in 2010.

10. International Standards International Financial Reporting Standards are set by the International Accounting Standards Board which is the independent standard-setting body of the International Accounting Standards Committee Foundation. The mission of the IASB is to develop, in the public interest, a single set of high quality, understandable and international financial reporting standards (IFRSs) for general purpose financial statements.

11. The Insurance Project The IASB decided to develop an IFRS on insurance contracts because there was no IFRS on insurance contracts, and insurance contracts were excluded from the scope of other relevant IFRSs (eg IFRSs on provisions, financial instruments and intangible assets). Furthermore, accounting practices for insurance contracts were diverse, and also often differed from practices in other sectors. The insurance project addresses accounting by both insurers and policyholders. The objective of the joint IASB/FASB insurance contracts project is to develop a common, high-quality standard that will address recognition, measurement, presentation, and disclosure requirements for insurance contacts. Specifically, this project is intended to: Improve and simplify the financial reporting requirements for insurance contracts. Eliminate numerous pieces of current U.S. accounting literature that add to the complexity of accounting for insurance contracts. Provide investors with more decision useful information. The Board split the project into two phases: Phase I of this project resulted in IFRS 4 Insurance Contracts, an interim standard that permits a wide variety of accounting practices for insurance contracts. Many of these practices differ from those used in other sectors and make it difficult to understand insurers’ financial statements. In phase II, the Board intends to develop a standard that will replace the interim standard and that will provide a basis for consistent accounting for insurance contracts on the longer term.

12. Progress on Phase II In May 2007, the Board published a discussion paper, Preliminary Views on Insurance Contracts. The discussion paper proposed that insurers should measure insurance contracts at their current exit value, estimated using three blocks: an estimate of future cash flows the effect of the time value of money a margin. In February 2008, the Board started its review of responses to the discussion paper. The 11th meeting was held in June 2009. The Board aims to publish an Exposure Draft in May 2010 and a final standard in 2011.

13. Accounting Standards in Pakistan The process followed for the adoption of any IAS/IFRS in Pakistan is that the Institute of Chartered Accountants of Pakistan (ICAP) considers and recommends each IAS/IFRS and recommends to the SECP for adoption. The IAS/IFRS are applicable to all companies in Pakistan. SECP and ICAP have agreed, in principle, to take urgent necessary steps so as to ensure full compliance with IFRS, as far as the financial statements of the listed companies are concerned. The notification of IFRS 4 is a step in this direction. For insurance companies, however, other than the concern wrt IAS 1, IAS 39 and IAS 40 (dealing with accounting for investments and investment properties) are also not currently applicable The background is that capital gains of non-life insurers were treated differently to other companies until last year. However, as this aspect has been clarified there is no longer any justification for the non-applicability of these standards. However, in order for them to be applicable, there needs to be a change in the Accounting Regulations by the SECP.

14. IFRS 4 IFRS4 is not entity specific but transaction specific It relates to accounting for insurance contracts and not all transactions which an insurer undertakes Other accounting standards will, therefore, also need to be followed. What may change is the method in which insurance contracts are to be accounted for and disclosure relating to such contracts An Insurance Contract is defined as : “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 future event (the insured event) adversely affects the policyholder.” There is an appendix which deals with the definition in greater detail, giving examples as to what constitutes an insurance contract or not. For most insurers, however, the definition is fairly clear.

15. Retention of Accounting Policies As allowed under IFRS 4 Insurance Contracts Phase I, an insurance company is permitted to grandfather its accounting policies adopted for its insurance contracts, within its IFRS accounting framework. The requirement will continue until Insurance Contracts Phase 2 is completed, which will then regulate the recognition and measurement of all insurance contracts on a consistent basis. Hence there is no immediate mandatory impact on financial reporting by existing insurers who are likely to continue to follow existing accounting policies.

16. Provisions Relevant to Pakistan Accounting policies Unbundling of deposit component Exemption from some IFRS’s Liability Adequacy Test Discounting of liabilities Disclosure Explanation of Recognized Amounts Nature and Extent of Risk Arising from Insurance Contracts

17. Unbundling This essentially means that for contracts which “contain a deposit component”, the deposit part is not recognized as premiums but directly credited to the liability in the balance sheet For example, assume a unit linked policy premium of Rs. 10,000 from which Rs. 8,000 is allocated for investment after deducting Rs. 2,000 for expenses and mortality Currently the whole Rs.10,000 is declared as premiums and (ignoring the mortality reserve and any variation in investment value) the reserves would increase by Rs. 8,000, both elements appearing in the revenue account. In the unbundled concept, only Rs. 2,000 would be treated as premium and the Rs. 8,000 would be directly credited to deposits (essentially policy liabilities) without going through the revenue account or P&L Adopting IFRS4 would result in the unbundling treatment being allowed. It would not, however, be mandatory as there is a provision (para 10(b)) which does not make it mandatory if the insurer is, under its existing accounting policy, recognizing the deposit component as a liability (which all life insurers in Pakistan are).

18. Temporary Exemption from Other IFRS’s The IFRS exempts an insurer temporarily (until completion of Phase II of the Insurance Project) from some requirements of other IFRSs, including the requirement to consider the IASB's Framework in selecting accounting policies for insurance contracts. However, the IFRS: Prohibits provisions for possible claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions). Requires a test for the adequacy of recognised insurance liabilities and an impairment test for reinsurance assets. Requires an insurer to keep insurance liabilities in its balance sheet until they are discharged or cancelled, or expire, and prohibits offsetting insurance liabilities against related reinsurance assets. The first of these would mean that provisions for contingencies would no longer be permissible.

19. Liability Adequacy Test This provision essentially requires insurers to ensure that provisions in its financial statements ensure that liabilities under existing contracts are adequately provided for. This includes measuring all future costs associated with settling claims This should not be an issue in Pakistan as the Insurance Ordinance already requires insurers to provide for premium deficiency reserves if it is felt that the Unearned Premium Reserves would not be adequate to cover future claims and related costs.

20. Discounting of Liabilities IFRS4 requires insurance liabilities to be measured on a discounted basis. Existing insurers can continue to measure these on an undiscounted basis (under paragraph 25) but new insurers would need to take the present expected value as the basis of recognizing liabilities.

21. Explanation of Recognized Amounts (a) Accounting policies for insurance contracts and related assets, liabilities, income and expense. (b) The recognized assets, liabilities, income and expense (and, if it presents its cash flow statement using the direct method, cash flow) arising from insurance contracts. Furthermore, if the insurer is a cedant, it shall disclose: gains and losses recognized in profit or loss on buying reinsurance; and if the cedant defers and amortises gains and losses arising on buying reinsurance, the amortization for the period and the amounts remain unamortized at the beginning and end of the period. (c) The process used to determine the assumptions that have the greatest effect on the measurement of the recognized amounts described in (b). When practicable, an insurer shall also give quantified disclosure of those assumptions. (d) The effect of changes in assumptions used to measure insurance assets and insurance liabilities, showing separately the effect of each change that has a material effect on the financial statements. (e) Reconciliation of changes in insurance liabilities, reinsurance assets and, if any, related deferred acquisition costs.

22. Nature and Extent of Risk Arising from Insurance Contracts (a) Objectives, policies and processes for managing risks arising from insurance contracts and the methods used to manage those risks. (b) {deleted} (c) Information about insurance risk (both before and after risk mitigation by reinsurance), including information about: sensitivity to insurance risk (see paragraph 39A). concentrations of insurance risk, including a depreciation of how management determines concentrations and a description of the shared characteristic that identifies each concentration (eg type of insured event, geographical area, or currency). Actual claims compared with previous estimates (ie claims development). The disclosure about claims development shall go back to the period when the earliest material claim arose for which there is still uncertainty about the amount and timing of the claims payments, need not go back more than ten years. An insurer need not disclose this information for claims for which uncertainty about the amount and timing of claims payments is typically resolved within one year. Information about credit risk, liquidity risk and market risk. Information about market risk arising from embedded derivatives.

23. Nature and Extent of Risk Arising from Insurance Contracts (contd) 39A To comply with paragraph 39(c)(i), an insurer shall disclose either (a) or (b) as follows: a sensitivity analysis that shows how profit or loss and equity would have been effected had changes in the relevant risk variable that were reasonably possible at the balance sheet date occurred; the methods and assumptions used in preparing the sensitivity analysis; and any changes from the previous period in the methods and assumptions used. However, if an insurer uses an alternative method to manage sensitivity to market conditions, such as an embedded value analysis, it may meet this requirement by disclosing that alternative sensitivity analysis and the disclosure required by paragraph 41 of IFRS 7. Qualitative information about sensitivity and information about those terms and conditions of insurance contracts that have a material effect on the amount, timing and uncertainty of the insurer’s future cash flows.

24. Likely Impact of IFRS 4 Although IFRS 4 may not force companies to change the way they account for transactions, there are significant impacts likely from two provisions: There is a significant amount of additional disclosure relating to The basis used for recognizing insurance related assets and liabilities as well as greater details of the amounts The risks which the company faces under insurance contracts and how it manages those risks The basis on which provisions for liabilities under insurance contracts are made and their sensitivity to various assumptions made. This includes an analysis of claims development patterns. Equalization reserves and provisions for catastrophic losses (used often to absorb exceptional losses) will no longer be required Recommend the reading of a Swiss Re publication relating to the impact of IFRS 4 – Sigma Vol 7/2004 (available on Swiss Re’s site)

25. Why Will Disclosures be an Issue ? The disclosures required would not really be onerous if companies are managed on a scientific basis and determine the provisions they make on their financial statements using scientific methods The IFRS simply requires disclosure of the company’s policies, methods and bases used along with some sensitivity analysis The vast majority of companies in Pakistan, however, especially on the non-life side, do not follow any formal risk management / measurement processes, nor are provisions made using any statistical methods. Hence the difficulty It is strongly recommended that, in addition to trying to comply with IFRS 4, companies take this opportunity to review the way they do business and try and introduce formal risk management processes.

26. Impact of Not Allowing Equalization/ Catastrophe Provisions Reserves of this nature were often used by life insurers for various reasons: Not least to provide against possible losses resulting from a mis-match of assets and liabilities Contingency reserves Theoretically these are of more use on the non-life side where insurance risks are subject to greater volatility As companies will no longer be able to provide for these it is likely that reported results will be subject to greater volatility

27. The Need to Respond to Change As indicated earlier, there will be significant changes in the accounting regulations later this year apart from changes caused by the recently published solvency rules There are other significant changes on the horizon Solvency II – capital requirements to be based on a more comprehensive assessment of risk Phase II of IFRS 4 There is a need for the insurance industry to play a pro-active role in trying to anticipate these changes and in developing strategies to respond to these changes Both the actuarial and accounting professions would be extremely supportive of any such initiative taken by the IAP

28. Thank You