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International Financial Reporting Standard
Actuarial Services
IFRS 4 and its Implication to HKand China’s Insurance IndustryRaymond Li, FSA MAAA
AA Symposium17 November 2004
2AA Symposium 2004
Agenda
• Introduction• Key Principles of IFRS 4• Challenges to HK and PRC Insurance Industry• Questions to CEO?
3
Introduction
4AA Symposium 2004
Why IFRS 4?
• Diversity of practices internationally• Existing standards do not address specific insurance
issues and not necessarily reflect the trueperformance of the business
• Need to distinguish between insurance contracts andfinancial instruments
• Regulatory driven (e.g. in HK, Singapore and Europeancountries)
• Lack of transparency – inadequate disclosures undersome local rules
5AA Symposium 2004
Important changes in accounting andreporting
• Implementation of IFRS will lead to increased transparency andcomparability of performances
• Less options• More data requirements• Complex (fair value) measurements• Insight in sensitivity assumptions• Increased enforcement• Greater insight in performance• Increased volatility in results
IFRS 4 – objectives for phase 1• Limited improvements• Increased disclosure
6AA Symposium 2004
Development of IFRS
31/12/02 31/12/0731/12/03 31/12/04
Opening IFRS 4balance sheet in
Europe
ED forphase 1
31/12/0631/12/05
Period coveredin first IFRS 4
financialstatements
Phase 2?First IFRS 4financialstatements
IFRS 4
Cumulative effect of IFRS 4recognised in the openingbalance sheet at 1/1/2005
Fair valuedisclosurespertaining to
insurance liabilities
ED for phase 2?
A first time adopter need notrestate the comparative
information in respect of IFRS 4,IAS32 & IAS 39 (together)
Expectedimplementation of
HKFRS 4 in HK
7
Key Principles of IFRS 4
8AA Symposium 2004
Key Principles of IFRS 4
• Definition of insurance contract• Unbundling• Embedded Derivatives• Change in Accounting Policies• Asset Liability Matching• Liability Adequacy Test• Discretionary Participating Contracts• Extensive Disclosure Requirements
9AA Symposium 2004
Definition of Insurance Contract
• A contract under which one party (the insurer) acceptssignificant insurance risk from another party (thepolicyholder) by agreeing to compensate thepolicyholder if a specified uncertain future event (theinsured event) adversely affects the policyholder.
10AA Symposium 2004
Why does definition of insurance risk matter?
Financialrisk
Insurancerisk
Insurance contract(phases 1 & 2)
Financial instrument(IAS 39)
Traditional life
Endowment
Universal life
Deferred annuity
Unit linked
11AA Symposium 2004
Changes in the level of insurance riskChanges in the level of insurance risk
Significant insurance risk
Significant insurance risk
Life of the (insurance) contract
Term life insurance: risk remains significant throughout the contract
Endowment policy : amount at risk in case of death reduces as valueof investment component increases
Deferred annuity : no insurance risk during savings phase, insurancerisk in annuity phase; overall is insurance contract since opting forannuity is an event of commercial substance
Significant insurance risk
12AA Symposium 2004
“Unbundling” of an insurance contract
• Unbundling of a deposit component is permitted if• the deposit component can be measured separately.
• Unbundling of a deposit component is required if• the deposit component can be measured separately;
and the resulting rights and obligations are nototherwise recognized under the insurer’s accountingpolicies.
• Unbundling of a deposit component is prohibited if• an insurer cannot measure the deposit component
separately.
13AA Symposium 2004
Embedded derivatives in insurance contracts
• IAS39 requires derivatives embedded in an insurancecontract to be separated and marked-to-market whenits economics are not closely related to the hostcontract
• IFRS 4 provides three exceptions to this principle, inthat the following three provisions need not beseparated from its host contract
• Option such as a life-contingent annuity,• A fixed-price or interest rate linked surrender options, or• Liabilities under unit-linked contracts may be measured
at unit values.
14AA Symposium 2004
Change in Accounting Policies
• Changing accounting policies is allowed, if changesmake the financial statements
– more relevant for the user's economic decision-making needs and no less reliable
OR
– more reliable and no less relevant to those needs
15AA Symposium 2004
Asset Liability Matching
• Assets might be classified as available-for-sale (“AFS”) or tradingwhich are at fair or market value)
• Liabilities might be on different basis e.g. amortised cost
• IFRS 4 and IAS 39 suggested the following:
• An insurer is permitted, but not required, to change its accountingpolicies so that it re-measures designated insurance liabilities toreflect current market interest rates
• Shadow adjustment – amortise DAC and the value of businessacquired through equity in order to offset unrealised capital gains ofAFS investment
16AA Symposium 2004
Liability Adequacy Test
• Must assess at each reporting date whetherrecognised insurance liabilities are adequate based oncurrent estimates of future cash flows under insurancecontracts.
• IFRS 4 only specifies minimum requirements:• The assessment must use current assumptions and
consider all contractual cash flows, including:– Claims handling costs; and– Cash flows from options and guarantees.
17AA Symposium 2004
Discretionary Participating Feature (DPF)
• IFRS 4 does not require a specific accountingtreatment for the discretionary component of theinsurance contract
• DPF may be recognized 1) as part of benefit reserve or2) separately as Liability or Equity
• If recognized separately, the annual surplus is splitbetween policyholders’ share and stockholders’ share.The policyholders’ share is either recognized as aspecial liability (e.g. deferred bonus liability) or as aseparate component of equity.
• BUT the basis used should be applied consistently
18AA Symposium 2004
Extensive Disclosure Requirement
• An insurer should disclose :• Amounts arising from insurance contracts
- Process used to determine significant assumptions- Effects of changes in assumptions- Material changes in insurance liabilities, reinsurance asset and
DAC
• Amount, Timing & Uncertainties of future cash flows- Risk management objectives and policies- Details of insurance contracts with significant cash flow impact- Information about insurance risk- Information about interest risk and credit risk- Sensitivity of ‘embedded derivatives’ to interest risk & credit
risk
19AA Symposium 2004
Disclosure Issues
• Degree of disaggregation of information• Which assumptions need to be disclosed• Commercially sensitive information• Systems implications/data collection
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Challenges to HK and PRCInsurance Industry
21AA Symposium 2004
There will be a number of challenges to HKand PRC insurance companies
• Product Classification• Disclosure• Liability Adequacy Test• Asset Liability Mismatch• Reserves• Embedded Values Reporting• Comparison with US GAAP
22AA Symposium 2004
Some of insurance premium may no longerbe recognized as premium income
• Short Term Single Premium Endowment type ofproduct is very popular, with large premium income, inrecent HK and PRC market
• Heavy investment elements• If these are considered as investment products premium
received NOT recognised under IFRS• Significant impact to companies’ financials
• Implementation guidance from IFRS 4 containspractical examples
• BUT mainly focus on European/ American insurancemarkets
• Local regulators may want to provide examples whichare applicable to the local markets
23AA Symposium 2004
Greater disclosure requirement means morework
• Greater disclosure will be required on Sensitivity ofchange in assumptions and Concentration ofinsurance risk
• HK and PRC insurers require:
• Competent actuaries and accountants who are familiarwith IFRS regulations and able to set up the system inaccordance to the disclosure requirement
• Software which can provide information for IFRSreporting need to be tailor-made
24AA Symposium 2004
Disclosure will lead to higher transparency
• System enhancement will improve the quality ofinternal management reporting
• Greater understanding of existing business condition
• Increase responsiveness to changes in insurancemarket
• Enhance transparency of insurance industry• Policyholders, shareholders and analyst will have a
better understanding of financial situation and riskprofiles of the company
25AA Symposium 2004
Liability Adequacy Test
• No such requirement under both HK and PRC accountingstandard
• Liability Adequacy Test is similar to Loss Recognition Test(“LRT”) under US GAAP basis
• Insurers who already report under US GAAP basis may base ontheir LRT and related reporting capabilities to meet IFRS 4requirement
• Level of aggregation: portfolio of contracts that are subject tobroadly similar risks and managed together as a single portfolio
• Impact on solvency of insurers
• Need to reconsider the investment strategy and dividend payingstrategy
26AA Symposium 2004
Liability Adequacy Test
• PRC Insurer’s concern:• Valuation mortality and interest are prescribed by CIRC; so adverse
experience variance (e.g. negative interest spread) might result innot passing the test
• Products with high guaranteed interest rates may need to increasereserve as a result of negative interest spread for older businessesissued in PRC
• Need to evaluate the adequacy of IBNR which is currentlydetermined as 4% of claim; premium deficiency reserve may berequired as a result
• For HK insurers:• The valuation assumptions are primarily determined based on
prudent rates, with reference to company’s experience (e.g. actualportfolio investment yield).
• So less likely to fail the test as a result of negative experiencevariance
27AA Symposium 2004
Asset Liability Mismatch
• IFRS 4 allows fair value accounting for insurancecontracts to match with the fair value reporting oninvestment portfolio
• For example:• Re-measure reserve using current estimates and
assumptions• Shadow adjustment
28AA Symposium 2004
Reserves
• Actuarial reserves are allowed to be calculated usingexisting basis under local GAAP
• Need not eliminate excessive prudence but for aninsurer which already measures its insurance contractwith sufficient prudence, it should not introduceadditional prudence
• May re-measure designated insurance liabilities toreflect current market interest rates (and other currentassumptions)
• Claim reserves are only permissible to the extent theyrelate to actual liabilities – end to equalisation andcatastrophe reserves
• Liability adequacy test
29AA Symposium 2004
Embedded Value reporting
Advantages
• Increasingly adopted as performance measurement tool by the multinationals• Provides a useful platform for risk analysis using sensitivity tests and stochastic
analysis• Focuses on a long time horizon which matches the nature of insurance products• Highlights where value is being created and destroyed• Early recognition of profits / values when compared to SAP and GAAP
Major uses
• Commonly used in evaluating mergers and acquisition• Management of in-force business
• New incentive program for distributors• Interest crediting and investment strategies• Impact of expense control• Impact of persistency control
• Provides a rigorous means to quantify the value of business written in the previousyear
30AA Symposium 2004
Embedded Value reporting
• Phase 1 allows embedded value measurement if it provides relevant andreliable financial statements
• Current embedded value approaches reflect future investment margins, inthat the discount rate is based on estimated return
• Less relevant and reliable financial statement• Guidance will be given on Risk Discount Rate in Phase 2
• Also, current practise only use single best estimate basis• Unable to reflect full range of possible outcome• Need to keep an eye on phase 2 requirement
31AA Symposium 2004
Comparison with US GAAP
• Similarity exists in DAC, Liability Adequacy Test (LRT under USGAAP)
• Allow Shadow Accounting, in order to address potential asset-liabilitymismatches in phase 1
• DAC does not meet the IFRS framework definition of an asset so likelywill be removed in phase 2
• UPR does not meet the IFRS framework definition of an liability solikely will be removed in phase 2
• Phase 2 is expected to require discounting of liability which is generallynot permitted under USGAAP for claim reserving. This leads topossible advantage for European insurers, particularly on long tailedbusinesses
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Questions for CEOs
33AA Symposium 2004
Questions for CEOs
• Should and how product mix and design be changed?
• Do we need to improve our asset-liability matching?
• Should and how investment strategy be changed?
• Are existing IT and accounting systems capable of trackinginformation resulting from a change in the contract definition andproduct classification?
• How will the insurance regulators and the Tax Departmentinterpret the new definition of insurance contracts?
