The New Insurance Contracts Accounting Standard: History in the making

IABA Conference, August 7, 2010

Tara Hansen and Gareth Kennedy

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Agenda

► Introduction and project background ► The proposed models► Income emergence► Conclusion

Introduction and project background

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Why is this important to me?

►FASB joined the insurance project in October 2008► Project will now impact US GAAP even if SEC doesn’t

require IFRS

►SEC work plan► Plan to make a decision in 2011 on requiring adoption of

IFRS by US companies

►NAIC Solvency Modernization Initiative► Monitoring developments from the IASB and Solvency II► Insurance Accounting Standards Working Group asked to

propose solution by end of 2011

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IASB — discussion paper

issued

Insurance contracts project timeline

FASB — invitation to comment

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

JuneMay November

August

End of comment periods (IASB and FASB)

IASBExposure

Draft Final standardImplementation

date

Implementation

FASB — Joined the

project

October

IFRS 4 Insurance Contracts

JanuaryJanuary

IASB and FASB meetings to develop accounting

standards

Jan. 2009 thru July 2010 July Aug.

2012 and 2013 statements filed under US GAAP

Fiscal2012

Fiscal2013

Fiscal2014

PotentialTransition

Restate openingbalance sheet

Fiscal2011

Run US GAAP and new insurance standard parallel

Form 10-K are produced for year ended December 31, 2014 with comparatives for fiscal years 2013 and 2012.

Quarterly information required as of March 31, 2014 with balance sheet comparative to Dec. 31, 2013 and

income statement to March 31, 2013.

First year of new standard 2014

Development of the new standard

Nov.

End of comment period

FASB Exposure Draft or Discussion

Paper

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Project considerationsConceptual accounting framework

►An exposure draft on the Conceptual Accounting Framework Project indicated that relevance and faithful representation are the fundamental qualitative characteristics of financial information

►Relevant - information that has predictive value or confirmatory value

►Faithful representation - complete, free from material error, and neutral

►Also the draft indicated comparability, verifiability, timeliness, and understandability are enhancing qualitative characteristics

►Materiality and cost are pervasive constraints

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Project considerations Revenue recognition

Key Concept Implication

Performance obligation ► The promise in a contract to transfer economic resources to a customer

Satisfaction of performance obligation

► Goods – when enforceable rights or access to goods transfer to customer► Services – when a service or access to a service is provided

Revenue recognition ► Revenue is recognized when contract asset increases or contract liability decreases.

Revenue can be recognized at two occasions:► when the contract is obtained (if a contract asset is recognised)► when a performance obligation is satisfied

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Project considerations Financial instruments project

► Recently published IFRS 9 will require investments to be recorded at fair value with changes in value flowing through profit and loss

► Exceptions are provided for:►Debt instruments with only basic loan features and the

asset is held to collect the cash flows under the company’s business model, amortized cost can be used

►Equity instruments not held for trading through an irrevocable election, with dividends through profit or loss and changes in fair value through OCI

► FASB has published separate exposure draft

The proposed models

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FASB IASB

FASB/IASB proposed insurance contracts measurement model

► The unbiased, probability-weighted average of future cash flows expected to arise as the insurer fulfils the obligation

► The time value of money

► An amount that eliminates any gain at inception of the contract minus an amount equal to the incremental acquisition cost(composite margin)

Current estimate of future cash flows

Discount

Composite margin

Current estimate of future cash flows

Discount

Risk adjustment

Residual margin

► The unbiased, probability-weighted average of future cash flows expected to arise as the insurer fulfils the obligation

► The time value of money

► A risk adjustment for the insurer’s view of the uncertainty (amount and timing) associated with the future cash flows

► An amount that eliminates any gain at inception of the contract minus an amount equal to the incremental acquisition cost

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UPR simplification

►IASB has tentatively decided that unearned premium will be used during the pre-claims period for short duration contracts as a simplification to the four building block approach. This would eliminate the need for a residual margin to eliminate day 1 profits

►FASB is currently debating this approach and recently discussed it in an education session

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Discount rates

►The Boards tentatively decided that the discount rate should reflect the characteristics of the liabilities, rather than the characteristics of assets held to back the contracts, unless the contracts share those characteristics

►The Boards have indicated that the discount rate could consist of:

►The risk-free rate►A liquidity premium►An adjustment for non-performance risk/own credit

standing (not to be included in the measurement)

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Acquisition costs

►The IASB tentatively decided to exclude from the initial measurement of the residual margin an amount equal to the incremental acquisition costs

►The FASB recently changed their tentative decision to include acquisition cost related to a contract in the cash flows used to measure the contract value at inception.

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Recognition

►The IASB has agreed in principle and the FASB has tentatively decided that the insurer should recognize the rights and obligations arising from an insurance contract on the earlier of:

►The insurer being on risk to provide coverage to the policyholder for insured events; and

►The signing of the insurance contract.

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Presentation of the performance statement

Summarized Margin Year 1

Year 2

Risk adjustment *

Residual Margin *

*(FASB – one composite margin)

Insurance Margin

Experience adjustment

Changes in estimates

Investment income

Interest on insurance liability

Net interest and investment

Profit

Expanded Margin Year 1

Year 2

Revenue

Policyholder benefits

Expenses

Release of benefit and expense accrued in

previous period

Insurance Margin

Experience Adjustment

Changes in estimates

Investment income

Interest on insurance liability

Net interest and investment

Profit

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Level of aggregation

►Boards tentatively decided:►“That an entity should measure any risk adjustment at a

portfolio level of aggregation; to retain the definition of portfolio of contracts in the existing IFRS 4 as Contracts that are subject to broadly similar risks and managed together as a single portfolio; and

►That residual or composite margins should be determined at a cohort level of aggregation, by grouping insurance contracts by portfolio and, within the same portfolio, by date of inception of the contract and by length (or life) of the contract.”

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Comparison of proposed models to Solvency II

Attribute Proposed FASB Proposed IASB Solvency II

Scope All companies reporting under US GAAP

All IFRS listed companies

EU insurance companies

Measurement Current assessment of the obligations

Current assessment of the obligations

Market consistent with entity parameters

Risk Margin/

Adjustment

Method

Not applicable Not yet prescribed CoC (Directive) and rate prescribed (QIS5) with 1-year VaR capital standard

Own Credit Standing

Possibly included Excluded Excluded

Disclosures To be defined but more than current US GAAP

Similar to current IFRS Solvency & Financial Condition report

Discount rate Risk-free plus an adjustment for illiquidity and possible for OCS

Risk-free plus an adjustment for illiquidity

Risk-free plus 50% of the illiquidity adjustment (QIS5)

Income emergence

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Income emergence – assumptions

► $1,000 of premium is written at time zero for one year of coverage with expected losses of $800

► Incremental acquisition costs are $200, losses include ALAE and ULAE, and there are no other expenses

► A risk free yield curve is used to discount the liabilities► Return on invested cash is 3.0% per annum► There is no tax or reinsurance► Actual reserve development does not differ from expected► Payments are made just prior to the end of each time

period

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Income emergence – assumptions

► The risk adjustment for the proposed IASB model is estimated using a “Cost of capital” approach with return on capital set such that it equals the amount of discount

► The amortization of the composite margin uses a formula as tentatively decided by the FASB

► Investment income is on available cash only ► Losses are paid out over 10 years► The UPR simplification is ignored

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Comparison of income emergenceCurrent US GAAP incomeCurrent US GAAP

Time = 0 0.5 1 1.5 2 2.5 3

Written Premiums 1,000 - - - - - -

Unearned Premiums 1,000 - - - - - -

Earned Premiums - 500 500 - - - -

Claims Expense -

(400)

(400) - - - -

Discount - - - - - - -

Risk Adjustment - - - - - - -

Acquisition costs -

(100)

(100) - - - -

     

Underwriting Income - - - - - - -

Investment Return - 12 12 11 10 9 8

Income - 12 12 11 10 9 8

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Comparison of income emergence Proposed IFRS income

Proposed IFRSTime = 0 0.5 1 1.5 2 2.5 3

Written Premiums 1,000 - - - - - - Unearned Premiums - - - - - - - Earned Premiums 1,000 - - - - - -

Claims Expense (800) - - - - - -

Discount 70 - - - - - - Risk Adjustment (70) - - - - - - Residual Margin - - - - - - -

Acquisition costs (200) - - - - - -

     Underwriting Income - - - - - - -

Unwind of Discount on Claims Reserves - (11) (10)

(9)

(8)

(7)

(6)

Unwind of Risk Adjustment - 8 8 8 7 6 6 Unwind of Residual Margin - - - - - - -

Income After Unwind - (3) (2)

(1)

(0)

(0) 0

Investment Return - 12 12 11 10 9 8

Income - 9 10 10 10 9 8

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Comparison of income emergence Proposed US GAAP incomeProposed US GAAPTime = 0 0.5 1 1.5 2 2.5 3

Written Premiums 1,000 - - - - - - Unearned Premiums - - - - - - - Earned Premiums 1,000 - - - - - -

Claims Expense (800) - - - - - -

Discount 70 - - - - - - Composite Margin (70) - - - - - -

Acquisition costs (200) - - - - - -

     Underwriting Income - - - - - - -

Unwind of Discount on Claims Reserves - (11) (10) (9)

(8)

(7)

(6)

Unwind of Composite Margin - 20 20 3 3 3 3

Income After Unwind - 9 11 (6)

(4)

(3)

(3)

Investment Return - 12 12 11 10 9 8

Income - 21 22 5 6 6 5

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Insurance contracts considerations – P&CComparison of baseline profit emergence

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Insurance contracts considerations – P&C Discount rate change scenario at t=2

A 50 basis point increase in the interest rate at t=2, causes a significant increase in the expected income at t=2 for the proposed US GAAP and IFRS models.

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Insurance contracts considerations – lifeExample – Product Features

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Insurance contracts considerations – lifeExample – FASB/IASB Insurance Contracts Approach

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Sample Results – UL New Business ProjectionPre-tax Net Income

* Investment Income based on Invested assets = U.S. statutory reserves + 350% RBC* Investment Income based on Invested assets = U.S. statutory reserves + 350% RBC

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Insurance contracts considerations – life Comparison of profit emergence by investment strategy

Conclusion

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Key effects that will interest management

► Transparency► Investors will get a much greater insight into insurance companies► Companies who efficiently use capital and make adequate risk

adjusted returns will find it easier to raise capital

► Income volatility► Income from insurance liabilities will be subject to interest rate

fluctuation► Asset-liability management will become more critical for P&C

companies who’s management wish to minimize the effect of interest rate changes on income

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Increased actuarial involvement

► Discounting and risk adjustment calculations

► Capital modeling

► Asset-liability modeling

► Attribution analysis