Embedded Derivatives in Insurance Contracts

Embedded Derivativesin Insurance Contracts Draft International Actuarial Standard of Practice Stefan Engeländer

Formal Basis • IFRS 4.7: Apply IAS 39 to embedded derivatives • IAS 39.2 (e): Scope includes such derivatives • IAS 39.9: Definition of a derivative • IAS 39.10: Definition of an embedded derivative • IAS 39.11: Guidance for embedded derivatives • IAA Draft International Actuarial Standard of Practice „Embedded Derivatives“

International Actuarial Standards of Practice • Issued by the IAA • Drafted and proposed by the International Actuarial Standards Subcommittee • Subsidiary to national standards • Member organizations of IAA obliged to transform in own standards • “Embedded Derivative” will be Class IV, merely educational

Concept of Derivatives • Concentration of financial risk inherent in normal investments by trading it separately • Significantly subject to changes in market views of values • Causes an unusual risk exposure, therefore special consideration required • Best measurement at market value • In some cases derivatives artificially combined with other features causing a non-derivative contract • If actually artificial (not closely-related) separation required to identify concentrated risk properly

Critical Consideration of Concept • Derivative refers only to a very specific risk • There are many significant risks, especially options and guarantees, not covered by that concept • Especially in insurance business very exotic form of risk • Accounting concentration on that exotic risk might distract from more relevant risks • Actually relevant only in case of traded risks, insurance business often based on non-traded factors (natural disasters, longevity)

Identification of a Derivative • Financial instrument • No insurance contract • Value changes in response to changes of a specified market factor • Initial net investment significantly smaller than for comparable primary investment • Settled at future date • Time up to settlement date exposes to changes of market factors

Market Factor • Market factor defined by IAS 39.9 (a) (as amended by IFRS 4.C6) as:“interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract” • Insurance risk is a non-financial variable specific to the policyholder transferred to the insurer • Market factors are therefore: • All financial variables • All non-financial variables not specific to a party

Market Factor • IFRS 4 changed the definition of a market factor, by limiting the general reference to “other variable” • Otherwise as well any insurance would be a derivative, since as well the occurrence of a claim can be seen as “other variable” • Therefore, the definition was limited to actual market relevant variables, rather than variables specific to a party

Market Factor • Market factors are variables applicable for all market participants • Examples of market factors • Market interest rates • Market price of a bond • Market assessment of credit standing of an entity • Price index • Market assessment of commodities • Longevity of population • Weather conditions • Index of natural disasters

Specific Non-Financial Variables • Specific non-financial variables are variables relevant only for the parties of the contract • Examples of specific non-financial variables • Occurrences affecting the condition of a good • Life expectation of a party • Health condition of a party (guaranteed insurability) • Employment situation of a party • Claims development of a portfolio of a party • Cost situation of a party • Individual investment policy of a party • Actual insolvency of a party • Any deliberate action of a party

Specified Market Facor • The market factor has to be specified to qualify a derivative • Cash flows under the contract are directly determined based on a market factor specified in the contract • Actions of the parties influencing the cash flows of the contract are subject to the development of specified market factors, not necessarily written in the contract but obvious at outset of the contract, eg development of market prices for alternative investments • Not qualifying: During the contract duration appears a new aspect causing that future cash flows are subject to a market factor

Effect of the market factor • Value of contract changes in response to changes of market factor • Basis fair value of the contract, not book value, considering all uncertainties in measurement • Significant impact required, as well in comparison with all other impacting risks • Right to exchange one right with another right at fair value has always the fair value zero, ie value of that right does not change • Obligation to settle in future at cost, as well on a portfolio level, to be seen as value zero, except if at outset clear, that ability to settle below market • Short term initial advantages in long term contracts to be ignored

Effect of the market factor • Value of contract changes in response to changes of market factor • The fair value of the contract need to change in response to changes of market factor- effects to individual cash flows under the contract do not necessarily affect the value of the contract! • Example: Unit linked contracts, the benefit changes in response to unit price, but the value of the entire contract is ideally always zero since any cash flow is exchanged at market value in units

Effect of the market factor • Examples of such effects • External factors determine the amount of cash flows • Index-linked benefits • Interest linked to indices, eg weather conditions • Annuity conversion rate linked to population longevity • External factors determine the occurrence of cash flows • Cancellation of a fixed-interest investment in dependence from current market interest rates • Payment due if a specific event occurs which is not specific to a party • In those cases it has to be checked, whether the effect of the market factor impacts significantly the fair value of the contract

Comparison with Alternative Investment • IAS understands a derivative as concentrated risk from normal (primary) investments • A derivative is not a primary investment • The payment is merely a risk price rather than an investment • A derivative has therefore a lower net initial payment than that primary investment from which the derivative risk origins • That difference in initial net payment is a defining characteristic of a derivative

Comparison with Alternative Investment • Derivatives and insurance similar • Both contain cash flows subject to variables • Both cover concentrated risk • Both charge a risk premium rather than being an investment used for commercial processes • Difference between derivative and insurance • Definition: Only financial instruments in the scope of IAS 39 can be derivatives • Derivatives cover mainly market risks (ie the assessment of market participants of future economic use of items), while insurance cover actual risks endangering the economic position of the policyholder directly • Insurance risks are usually stochastic risks and can be usually mitigated by the Central Limit Theorem since large number of identical distributed and independent risks are available • Derivatives are subject to inpredictible market behavior

Alternative Primary Investment • For qualifying as derivative, there needs to be an alternative primary investment subject to the same market factor • A primary investment is a funding of a commercial process subject to commercial risks and chances • Especially difficult in case of non-financial market factors like • Longevity of a population • Weather conditions • Index of natural disasters

Alternative Primary Investment • Examples for alternative primary investments subject to such non-financial market factors • Cost of living in case of longevity of a populationequivalent to a life-contingent annuity • Investment in weather dependant activities like agriculture, tourism or open air events • Investment in buildings in an area of increased geotectonic activity

Initial Net Investment • Price paid for achieving the rights • Not just the initial contribution in case of regular payment contracts • To be modified for • Modified for risk exposure in comparison to alternative investment by modifying the risk price without changing the funding component • Included servicing cost is servicing is no part of alternative investment

Comparison of Initial Net Investments • Initial net investment needs to be so significantly lower than for alternative investment that • it is clear, that it is merely concentrated risk rather than investment (even onerous by intention) • it outweighs the differences between different available alternative investments and different prices charged in markets for those • It is significant as well considering whether the relationship between funding component and risk price in the alternative investment is large or small

Example • Right to get an life-contingent annuity at a future date at a price reflecting longevity of the population at that date and at market interest rate • Specified non-financial market factor longevity of population and financial market factor market interest rate • Value of right always zero • Alternative investments • Fixed interest instrument • Life-contingent annuity • Both no difference in initial net investment

Example • How to style a derivative based on longevity of a population? • Right to receive the difference between the price of a life-contingent annuity today and the price of that at future longevity of a population

Embedded Derivatives • An embedded derivative is a component of a non-derivative contract, that would be a derivative if it was seen as a stand-alone contract • Component of a contract • Basis is an identifiable feature of a contract, which can be isolated without any artificial split • The component containing that feature is the sum of all parts of the contract related to that feature to enable to be a reasonable contract if it were a stand-alone feature • Such related features are especially prices charged and other economically required features • Such related features may need artificial splits of contractual features, eg if one single price is charged for the entire contract • Notional split of prices in the contract shall not be considered except that split reflects economic reality

Embedded Derivative Cash Flows • Embedded derivative cash flows are cash flows under the contract that change in respond to changes of a specified market factor • For identifying embedded derivative cash flows contractual cash flows shall not be artificially split • No split of a risk-free cash flow in two negatively correlated cash flows • No split of a cash flow changing in respond to a specified market factor in a cash flow responding to a non-specified factor, eg a non-specified interest rate, and the deviation of that factor to the specified market factor

Double Trigger • An insurance contract is no derivative by definition • A component including significant insurance risk (measured in comparison to the component only) is therefore no embedded derivative • A cash flow double triggered by insurance risk and derivative risk is therefore no embedded derivative cash flow • A benefit payable in case of occurrence of an insured event but amount market factor triggered • An option, whose execution is triggered by market factor as well by eg health condition under coverage of guaranteed insurability

Behavior of Parties • Options are contract features allowing parties to influence cash flows unilaterally • Behavior in executing options might be triggered by • specific circumstances of parties (health condition, financial situation eg in case of unemployment, legal situation eg in relation to state social security) • If creating significant insurance risk, the component is no embedded derivative • market considerations considering alternative instruments available in the market • Might cause that cash flow is subject to a specified market factor

Guaranteed Insurability • Guaranteed insurability is a feature of contracts • guaranteeing that in future insurance coverage is provided and that at normal terms • disregarded of individual development of insurability, ie without risk examination • In case of a significant chance of a significant impairment of insurability, that feature is qualified as insurance contract if considered stand-alone • A component containing such a qualified feature is no embedded derivative

Separation Requirements • IAS 39.11 requires an embedded derivative to be separated and measured at fair value if • it is not closely related to the host contract • Closely related means that the economic risks and characteristics of the component, especially those qualifying as derivative, are not the same as in the host contract • It is not possible to style the component reasonably in a manner that those economic risks and characteristics appear only in the component • and the entire contract is not already measured at fair value with changes through P&L • An embedded derivative only treated as such if reflecting economic reality of the reporting entity (no intend to make use of the derivative option)

Examples of Closely Related Risks • Fixed interest rates in component closely related to (assumingly) fixed interest rate inherent in insurance pricing • Limited prolongation, prepayment or surrender rights, cancellable current premium payment at fixed terms are closely related • Unlimited prolongation rights of a deposit component extent of insurance component at predetermined terms not closely related • Modification of fixed interest by market factors in a range of 0-2*i is closely related • Any embedded derivative not measurable separated from the insurance contract is to be seen as closely related

Entire Contract at Fair value • No separation required if entire contract already measured at fair value with changes through P&L • It is sufficient that the component containing the embedded derivative, eg the deposit component, is measured at fair value and contained with that value in the insurance liability • Typical example unit-linked contracts, where assets and liabilities are reported consistently at fair value

Fair Value of the Embedded Derivative • Fair value measurement required in accordance to guidance by IAS 39 • Major difficulties can be expected in case of embedded derivatives in insurance contracts, especially for non-specific non-financial variables • Measurement approaches will require an extended degree of assumptions mainly based on judgment rather than on observable data

Measurement of the Host Contract • Application of existing accounting policy to the host contract may cause significant difficulties • Assuming that initial recognition of the host contract reflects fair value, initial measurement equals amount of existing accounting policy for entire contract minus fair value of embedded derivative • Subsequent measurement should be the measurement of existing accounting policy for the entire contract minus subsequent measurement of embedded derivative according existing accounting policy

Embedded Derivatives in Insurance Contracts