aa seminar 08 presentation-ps 6 handouts.ppt

8/22/2019 AA Seminar 08 Presentation-PS 6 Handouts.ppt

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2008 Seminar for the Appointed Actuary

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Contract Classification

under IFRS

Johanne Papillon

September 25, 2008


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Presentation Outline

Background IFRS Contract Classification

Embedded Derivatives

Overview of IAS 39 Observations and Conclusion


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Background

Conversion to IFRS: Jan 1, 2011

Insurance contracts: IFRS 4; keep current basisof accounting until Phase II (effective 2012 or2013)

Investment contracts: IAS 39 FinancialInstruments

Service contracts: IAS 18 Revenue (similar toCGAAP)

Most signi f icant impact:

I nvestment contracts, and potentially

Embedded Derivatives


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InsuranceContracts: CALM

Insurance and InvestmentContracts: Actuarial Liabilities

InvestmentContracts: IAS 39

Phase IJanuary 1, 2011:

Phase IIJanuary 1, 2012,(or later):

Insurance Contracts:

new IFRS standards

(Discussion Paper)

Current CGAAP:

Embedded

Derivatives: IAS 39Fair Value option


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Contract classification under IFRS

IFRS definition of Insurance Contract:

contract under which one party (the insurer) accepts

signif icant insurance riskfrom another party (the

policyholder) by agreeing to compensate the

policyholder if a specified uncertain future event (theinsured event) adversely affects the policyholder.

Three key criteria:

1) Insured event must adversely affect policyholder2) Insured benefits must be significant

3) Insurance risk must be non-financial: mortality,

longevity, morbidity, P&C risks


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Contract classification (contd) Significance of insurance risk:

Insurance risk is significant if, and only if, an insuredevent could cause an insurer to pay significant additionalbenefits in any scenario, excluding scenarios that lackcommercial substance

Probability of insured event is not considered whenassessing significance of risk

Company determines what it considers as beingsignificant: 5%-10% additional benefits?

Risks that are created by the contract (lapse,expense) do not constitute Insurance Risk (i.e. riskmust be pre-existing)


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Does the insured event adversely affect the insured?

NoThe contract is not an

insurance contract; consider

Investment or Service contractYesIdentify scenario A, in which insured event

occurs: Example: Death of Pol icyholder

before end of insurance cov erage period

Insured event: Example:Death of po l icyho lder


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Decision tree (contd)

Determine the benefit payable by the insurer underScenario A: Example: Face Am ount o f $100,000

Identify scenario B, in which insured event does notoccur: Example: Surv ival of pol icyholder to the

end of th e coverage period

Determine the benefit available to policyholder

under Scenario B: Example: Surrender Value


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Is benefit payable under Scenario A significantly

greater than benefit available under Scenario B?

Compare benefits in Scenario A versus benefitsin Scenario B (ratio)

NoYesThe contract is aninsurance contract:

IFRS 4 applies.The contract is not aninsurance contract;

consider Investment

or Service contract

Decision tree (contd)


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Once Insurance, always Insurance

Assessment is made at contract inception

Contract is assessed as a whole: If significant

insurance risk is present in the contract, then thewhole contract is classified as Insurance.

Then, determine if contract contains:

Embedded derivative (separate fair valuemeasurement under IAS 39)

Deposit component (option to unbundle)

Discretionary participation feature


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Can assess at segment level for blocks that have

relatively homogeneous risk profiles

Lapse/expense risks do not constitute insurance risk

to the direct insurer, but do constitute insurance risk

to reinsurer assuming the risk Lapse/expense risk is pre-existing to the reinsurance

arrangement, and would adversely affect the direct

writer

Legal entity versus consolidated: Situations may exist for related-party reinsurance

arrangements, where a contract will be classified

differently at legal entity level versus consolidated

Other considerations (contd)


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Examples of insurance contracts

Insurance contracts:

Term plans, T100

Par Life, Whole life

Universal Life

Endowment products / Pure endowmentsCritical Illness/Health/Disability contracts

Long Term Care

Group Life and Health insurance (excluding ASO

contracts)

Reinsurance treaties with significant risk transfer

Payout immediate/deferred annuities (life contingent)


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2008 Insurance contracts (contd)

Insurance contracts:Seg fund/VA products with GMDB / GMIB /

For-life GMWB

GMDB, GMIB or for life GMWB constitute significant

insurance risk

Accumulation products/deferred annuities with

contractual guaranteed annuitization rates

Guaranteed annuitization rates, even if rarely exercised,

constitute significant insurance risk

Accumulation products/deferred annuities with BookValue Death Benefit in deferral period

If MVA surrender charge is waived on death and/or

disability, this constitutes significant insurance risk


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Examples of Investment contracts:

Investment contracts:Term certain contingent annuities

Fixed accummulation annuities which do not contain

guaranteed annuitization rates

Seg funds with no guaranteed minimum returnsGroup contracts with strong hold harmless

provisions (terminal/deficit accounting)

Mutual funds / banking products

IAS 39 applies:

Potential asset segmentation issues if commingled

with assets backing Insurance segments


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Examples of Service contracts

Service contracts:Group ASO

Financial Reinsurance with very limited risk transfers

Potentially: mutual funds where company acts asconduit / does not have ability to choose/replaceinvestment managers

Widely expected that IFRS treatment will besimilar to existing CGAAP

DAC implications for service componentsembedded in investment contracts


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2008 Embedded Derivatives

Embedded derivatives (EDs) withininsurance or investment contracts must be

separately measured at fair value if such

ED is:

not itself considered insurance, and

not closely related to the host insurance or

investment contract

EDs within Investment contracts do notneed to be separately fair valued if the

whole contract is measured at fair value


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2008 Embedded Derivatives: Definitions

IAS 39.9: A derivative is a financial instrumentwith all three of the following characteristics:

its value changes in response to the change in aspecified interest rate, financial instrument price,commodity price, foreign exchange rate, index of

prices or rates, credit rating or credit index, or othervariable, provided that the variable is not specific to a

party to the contract (sometimes called theunderlying);

it requires no initial net investment or an initial netinvestment that is smaller than would be required forother types of contracts; and

it is settled at a future date.


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2008 Embedded Derivatives (contd)

An embedded derivative is defined in IAS39.10 as follows:

is a part of a combined (hybrid) contract, which

also contains non-derivative components

combined contract includes an identifiable

condition to modify the cash flows otherwise

payable; and

modification of cash flows is in response to a

market factor or non-financial variable that is not

specific to a party to the contract


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ED that is itself Insurance:

If cashflows affected by the ED are only paid on a

insured/contingent event, then ED itself meets the

definition of an insurance contract;

IFRS 4 applies; exempt from separate FairValue measurement

Examples:

Seg fund GMDB, GMIB, for-life GMWB Seg fund GMAB, term certain GMWB?

CPI-indexing feature in disability contracts


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Definition of closely related: An ED is closely related to its host contract

if the risks inherent in the ED and the host

contract are similar

An ED is considered closely related if ED and

host contract are so inter-dependent that the

ED cannot be measured without considering

the host contract


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Examples closely related EDs: Unit-linked deposit components (where

policyholder AV is expressed in terms ofunits of underlying fund) are explicitly

listed in IFRS literature as being closelyrelated

Equity-linked UL deposit account?

UL account minimum return guarantees?

Refer to IAS 39 Appendix Aparagraphs AG30 and AG33


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Other Embedded Derivatives at risk ofrequiring separate fair value

measurement:

Ceded / assumed GMIB: depending on specifics

of the contract, and whether actual reinsurance

recoveries can be viewed as being payable on

an insured event

Credit derivatives/ModCo Reinsurance treaties

(USGAAP DIG B36)

Surrender values based on external index or a

pool of equity investments


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Embedded Derivatives:

Measurement implications

For non-exempt EDs: ED is separately measured at Fair Value under IAS 39

similar to US GAAP FAS 133; change in value of ED

flows through earnings each quarter

Host contract is measured under IFRS 4 (Insurance), IAS

39 (Investment)

Insurance: CGAAP/CIA Standards require all

cashflows to be reflected in valuation (SoP 2130)

May argue that total measurement under IFRS =CALM, and ED separate measurement simply

affects where amounts are reported (ie. geography

issue, not earnings issue)


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High Level Overview of IAS 39:

Financial Instruments

CICA 3855 is based on IAS 39: liabilities wereexplicitly excluded from 3855

Elect either Amortized Cost or Fair Value option

Amortized cost: Effective rate of interest that exactly discounts future

cashflows to initial fair value;

must go back to contract inception; operationally

complex assets would have to be reclassified as AFS; issue if

some a given asset is partially allocated to Insurancesegment


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2008 Overview of IAS 39 (contd)

Fair value option: Similar to USGAAP fair value;

Maximum use of market inputs, margin forbearing risk, risk free rate + adjustment for owncredit and liquidity

DAC implications: No such concept under IAS 39

If service component embedded in contract, can

capitalize certain transaction costs only, providedthey are direct and incremental to contractissuance

Different rules will likely result in difference inwhat can be capitalized, and opening retained

earnings adjustment


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2008 Observations and Conclusions

Contract Classification exercise: Broad definition of insurance

Unlikely to have material amounts of InvestmentContracts;

For Investment contracts: need to understand

implications of IAS 39; potential asset segmentation issues

DAC differences

Embedded derivatives:

may find that most are exempt as either insurance orclosely related

Service contracts:

identify, but no significant accounting changes expected

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