The New Insurance Contracts Accounting Standard:History in the makingIABA Conference, August 7, 2010Tara Hansen and Gareth Kennedy
Agenda • Introduction and project background • The proposed models • Income emergence • Conclusion
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
Insurance contracts project timeline Run US GAAP and new insurance standard parallel 2012 and 2013 statements filed under US GAAP Implementation Development of the new standard End of comment period End of comment periods (IASB and FASB) IASB and FASB meetings to develop accounting standards FASB Exposure Draft or Discussion Paper IASB — discussion paper issued IASB Exposure Draft IFRS 4 Insurance Contracts Implementation date Final standard FASB — Joined the project FASB — invitation to comment August May November Aug. October July January June Jan. 2009 thru July 2010 Nov. January 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 First year of new standard 2014 Restate openingbalance sheet Potential Transition Fiscal2012 Fiscal2013 Fiscal2014 Fiscal2011 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.
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
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
FASB/IASB proposed insurance contracts measurement model FASB IASB Current estimate of future cash flows Current estimate of future cash flows • 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) • 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 Discount Discount Composite margin Risk adjustment Residual margin
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
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)
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.
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.
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.”
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
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
Insurance contracts considerations – P&CComparison of baseline profit emergence
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.
Insurance contracts considerations – lifeExample – Product Features
Insurance contracts considerations – lifeExample – FASB/IASB Insurance Contracts Approach
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
Insurance contracts considerations – life Comparison of profit emergence by investment strategy
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
Increased actuarial involvement • Discounting and risk adjustment calculations • Capital modeling • Asset-liability modeling • Attribution analysis