an actuarial perspective stefan engeländer lisboa, july, 7 th 2004

An Actuarial Perspective

Stefan Engeländer Lisboa, July, 7th 2004

III International Conference Insurance and Pension Funds

Practical Implications of IFRS 4

© 2004 KPMG — Stefan Engeländer – III International Conference Insurance and Pension Funds — 2

Agenda

International Actuarial Standards of Practice Contract Classification Unbundling Embedded Derivatives Discretionary Participation Feature


Agenda



IAA and IASB

Close cooperation of IASB and International Actuarial Association (IAA) in developing IFRS for insurance contracts

No intend of IASB to provide technical details in IFRSs Interpretation required since IFRS 4 often based on simplified

examples applicable only in very narrow circumstances

Hence, IASB staff clarified in IASB Observer Notes January 2004:

92. (d) Some argued that the Board (or IFRIC) should set up an interpretation panel to address questions that will arise in phase I. The staff notes that a sub-committee of the International Actuarial Association (IAA) has begun developing guidance for actuaries.


IAA and IASB

No official role of IAA in interpreting IFRSs No official role of actuaries in establishing accounting policies or

financial statements

But: IAA ensures a professional interpretation and comparable

application of IFRS 4 world-wide Actuaries to be involved in establishing accounting policies and

financial statements Consequence of responsibility of preparers rather than explicit rule


IAA Subcommittee

IAA established International Actuarial Standards Subcommittee to

propose International Actuarial Standard of Practice (IASP) regarding actuarial work under IFRSs

develop educational material accompanying such IASP support IAA member associations in implementing and applying

those IASP

Subcommittee established Drafting Team, preparing draft papers


IASP

The IASP is to be adopted by all member organizations either

by making it binding for members directly or by introducing an own standard, at least equivalent in binding force

and content

Classification of IASP in preparation:

Class 4 Practice Guideline

Examples of adequate behavior, merely educational,

any alternative, assumed to be suitable by the actuary, is allowed


Due Process

Drafting Team prepares currently exposure drafts to be exposed by the president of the IAA in due course

Comment period to Washington meeting in autumn After approval by Council, ballot vote of member organizations


Planned IASP

Actuarial Practiceregulation of actuarial behavior in agreeing, proceeding and reporting work

Contract Classificationinterpretation of definition of insurance contracts, investment and service contracts

Liability Adequacy Testminimal requirement, interpretation of IAS 37

Discretionary Participation Feature Embedded Derivatives Reinsurance Disclosure Measurement issues for investment contracts Changes in Accounting Policy

interpretation of guidance provided in IFRS 4


Agenda



Insurance Characteristics

Classification of most contracts in mass business trivial

Main features causing trouble

What is significant insurance risk? Life insurance with large investment component and negligible

insurance coverage

What are the borders of one contract? Group contract or group of contracts? Sequence of contracts or one contract?

How to ensure that all contract features are adequately considered? Complex reinsurance constructions


Significant Insurance Risk

Events of commercial substance:

Normally clear, anything

where market participants are willing to pay for Premiums charged explicitly for that risk

where market participants take effort to avoid/reduce risk Effective risk examination at outset Taking (re-)insurance for protection


Significant Insurance Risk

Significant additional benefits: More difficult Significant

Rebuttable presumption: above 10 % significant Judgment required, but significance doubtful: 5 %- 10 % Up to prove of contrary unacceptable: below 5 %

Comparison value: Normally surrender value plus surrender charge at death date Surrender value or surrender charge might be artificial and

economically meaningless Theoretically: Comparison of value of contract from policyholders

view point in case of occurrence of insured event with the value in case of any other event of commercial substance.

If maximal difference is significant, there is a significant additional benefit


Borders of the contract

Major question in case of group policies: Is the group one contract? Is each risk covered in the group one contract, just grouped for

administrative purposes?

Important, if risk equalization effect in the group is so significant premium adjustment clauses apply

that insurance risk on group level is not significant

Terms of group agreement need to be investigated, whether each individual risk ort the entire group

comply with the definition of a contract in IAS 32.13


Significant insurance risk


Life of the (insurance) contract

1

2

3

1. Term life insurance: Risk remains significant throughout the contract

2. Endowment policy – amount at risk in case of death reduces as value of investment component increases

3. Deferred annuity – no insurance risk during savings phase, insurance risk in annuity phase; overall insurance since opting for annuity is an event of commercial substance, except if annuity factor is bilaterally negotiated, enabling to determine prohibitive factors.


Borders of the contract


Consideration of all Features

Traditional problem in reinsurance: How to ensure that all contractual

features are adequately considered and properly reflected?

Fantasy of reinsurance actuaries to style reinsurance treaties unlimited, hiding financing features – reinsurance no mass business

If a financing feature is fully hidden, unbundling is no threaten and it is not possible to measure the significance of the existing insurance risk properly

But: Reinsures should be able to link each financing agreement with at least significant insurance coverage

IFRS 4 less strict than US-GAAP


Agenda



Unbundling

IFRS 4.10 prohibits unbundling of a deposit component if

not measurable separable, ie without consideration of the insurance component

and allows it in all other cases.

IFRS 4.10 requires unbundling of a deposit component if

it is allowed recognition of all rights and obligation under the deposit component

is not required by existing accounting policy


Unbundling

EU Directive 2002/83/EC (Life Insurance Directive) Article 20 1. A. (i):

As provisões técnicas de seguro de vida devem ser calculadas segundo um método actuarial prospectivo suficientemente prudente que tome em conta todas as obrigações futuras de acordo com as condições fixadas para cada contrato em curso, ...

In Europe, in applying the directive, all obligations considered Normally existing accounting policies require recognition of all

rights Relevant is recognition (ie consideration in actuarial formula),

disregarded of measurement Complex contract constructions might cause that rights or

obligations are not noticed, causing non-recognition but no unbundling


Agenda



Derivatives and Embedded Derivatives

Embedded derivatives are not derivatives embedded in other contracts

Derivative: Stand-alone contract subject to IAS 39 (ie not subject to IFRS 4) with specific features as defined in IAS 39.9

especially reflecting concentrated market risk

Embedded derivatives (IAS 39.10): Component of another contract (need not to be stand-alone a

derivative, ie it can include insurance risk) Explicit clause modifying cash flows of contract payable otherwise Varying in response to market factors


Derivatives Embedded in Insurance Contracts

Derivative embedded in an insurance contract:

component of the contract (ie forming separated an economically reasonable contract which includes earnings and expenses)

stand-alone in compliance with the definition of a derivative (especially not containing significant insurance risk)

Needs to comply with all requirements in IAS 39.9 Value provable responses to changes of specified market factor Initial net investment lower than for alternative investment


Derivatives Embedded in Insurance Contracts

A derivative embedded in an insurance contract is subject to IAS 39 and to be separated if and only if IAS 39.11 determines that, except if exempted by IFRS 4.8

An embedded derivative, not qualified as a derivative embedded in the contract, is not subject to IAS 39, except if separated in cases allowed by IFRS 4 and the separated component is not in the scope of IFRS 4

Any embedded derivative subject to disclosure requirements of IFRS 4.39 (e) if not reported at fair value


Separation of Derivatives

Embedded derivative is no derivative and therefore never separated if Containing significant insurance risk (in relation to the component)

guaranteed insurability double trigger

No alternative investment with lower initial investment available Annuity option Other non-traded factors (eg claim indices)

Derivative embedded in an insurance contract is not separated if closely related not measured already at fair value not a traditional surrender option or something equivalent


Agenda



Discretionary Participation Feature

Definition of DPF focused on UK situation: Contract grants insurer discretion to decide for the entire surplus

Continental European situation is deviating: Contract grants insurer discretion regarding timing of recognition of

surplus and allocation to individual policyholders Amount is a contractually fixed share of surplus Insurers have the ability to over-perform voluntarily obligations and

pay for competitive reasons amounts in addition to obligatory amount, but not granted by contract



Most relevant features of definition of DPF

Additional benefit is contractual right (no constructive obligation) Discretion is granted explicitly by contract Additional benefits based contractually on surplus

Consequences:

Universal-life interest no DPF, since additional benefit not based contractually on surplus

Voluntary payments no DPF, since discretion not granted explicitly by contract



Typical Continental European example Basis of participation statutory surplus Timing of realization or distibutability of investment gains at the

discretion of the insurer Policyholders’ share in surplus is a contractually fixed percentage Insurer may pay voluntarily additional amounts based on competitive

pressure

Application of DPF-Definition: Timing of realization or distributability qualifies as discretion Percentage share of policyholders in surplus qualifies as connection

to surplus

Contract contains DPF



DPF comprises those additional benefits paid under the contractual right not the entire additional benefit, if reflecting competitive pressure

rather than share in surplus

Voluntary payment in addition to legal share is not part of DPF, since is not paid based on a contractual right of policyholders the discretion to pay that amount is not granted by the contract and

not contractually based on surplus the amount is not determined based on surplus but on competitive

needs irrespective surplus (no incremental relation to surplus)

No need to report any amount paid voluntarily in future as liability before a legal or constructive obligation is established



Consequence:

Entire DPF is classified as liability, if the insurer classifies as liability any amount already legally allocated to policyholders the contractual percentage of any surplus

reported under statutory accounting but not ultimately allocated to policyholders since subject to future performance (policyholders have no right to get more, but might get less)

reported under IFRSs but not yet reported under statutory accounting

Future voluntary payments are not anticipated but expensed and to be reasoned to the owners when the legal binding decision is

made, there is – in difference to the situation in UK – no contractual constraint earlier

an actuarial perspective stefan engeländer lisboa, july, 7 th 2004

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