Product Classification and DPFs Session 6 Insurance IFRS Seminar December 1, 2016 Michael Lockerman Session 6

Agenda IFRS 4 Scope Current IFRS 4 Product Classification Insurance Contracts Discretionary Participating Features Phase 2 proposals

IFRS 4 SCOPE

IFRS 4 Scope Insurance contracts, including reinsurance contracts, issued by an entity Reinsurance contracts held by an entity Investment contracts with discretionary participating features (DPF’s) Therefore the first step in applying IFRS 4 is to determine the appropriate product classification

Current IFRS 4 Product Classification

Product Classification Date Product Classification

IFRS 4 - Insurance Contracts Definition of an Insurance Contract (IFRS 4, Appendix B)

IFRS 4 - Insurance Contract Definition A single definition of insurance contracts “a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.” “A reinsurance contract is a type of insurance contract.” Insurer Entity separate from policyholder  Uncertain future event Uncertainty (risk) present at inception of contract as to at least one of Whether event occurs When it will occur or How much will it cost

Insurance Risk Distinction between insurance risk and other risks Financial risk: Change in interest rate, security price, commodity price, etc.: NOT insurance risk Lapse, persistency or expense risk: NOT insurance risk in direct contract Contracts including both financial risk and significant insurance risk have insurance risk Must relate to uncertain future event that adversely affects the policyholder Must be a pre-existing risk vs. risk created by the contract ( US GAAP requires that the policyholder have an insurable interest. IASB did not propose a similar criterion as it found it difficult to define insurable interest. Instead, IFRS requires an adverse effect on the policyholder as a precondition for payment. Also, IFRS criterion is that the risk insured must be a preexisting risk to the policyholder; it cannot be a risk created by the contract. Thus, a direct contract that exposes the issuer to lapse risk, persistency risk, or expense risk is not an insurance contract unless it also exposes issuer to insurance risk. Lapse and persistency risk are not insurance risks because they are risks created by the contract and do not have adverse impact on policyholder. However, under B16, if the issuer of a contract that has only lapse, persistency and expense risk mitigates that risk by using a second contract to transfer part of that risk to another party, the second contract is insurance because it protects the direct insurer against adverse financial impacts of experience different than expected for those risks. This differs from US GAAP, where lapse and persistency risk alone are not considered insurance risk, even when reinsured.

Insurance Risk Insurance risk evaluated at inception of contract A contract that initially does not meet the definition of insurance may subsequently do so. Example: Annuity options Once insurance always insurance until all rights and obligations extinguished EG Annuity options: not insurance contract at inception if insurer can price annuity at current rates when option is exercised; insurance if annuity rates guaranteed at inception if there is a reasonable expectation that the option will be exercised.

Significant Insurance Risk What is a significant insurance risk? “Insurance risk is significant if, and only if, an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance (ie have no discernible effect on the economics of the transaction). If significant additional benefits would be payable in scenarios that have commercial substance, the condition in the previous sentence may be met even if the insured event is extremely unlikely or even if the expected (ie probability-weighted) present value of contingent cash flows is a small proportion of the expected present value of all the remaining contractual cash flows.”

Significant Insurance Risk Significance test: Compare: (1) Cash flows that would be paid if the insured event occurred Versus (2) Cash flows that would be paid if no insured event occurred Are cash flows under (1) > (2)? Are additional benefits significant? Does the scenario have commercial substance? Evaluated on a contract-by-contract basis Reinsurance contract exception

Determining Insurance Risk Simplified Example of 7 year endowment product. Death benefit equals the endowment benefit. Scenario 1 Policyholder dies in first policy month and received 134k Scenario 2 Policyholder survives to endowment and receives 134k, PV = 90k

IFRS 4 - Insurance Contracts Insurance Risk Lapse risk Not a pre-existing risk for the insurer Becomes an insurance risk if transferred to a reinsurer Financial guarantees Either under IFRS 4 or under IAS 39 Mortgage guarantees EG Annuity options: not insurance contract at inception if insurer can price annuity at current rates when option is exercised; insurance if annuity rates guaranteed at inception if there is a reasonable expectation that the option will be exercised.

Compensation for Loss The contract must compensate the policyholder for a loss. The risk must be pre-existing. Gambling contracts are not insurance Catastrophe bonds are not insurance, but a policy that pays for losses suffered in a hurricane is an insurance contract. US GAAP requires that the policyholder have an insurable interest. IASB did not propose a similar criterion as it found it difficult to define insurable interest. Instead, IFRS requires an adverse effect on the policyholder as a precondition for payment. Also, IFRS criterion is that the risk insured must be a preexisting risk to the policyholder; it cannot be a risk created by the contract. Thus, a direct contract that exposes the issuer to lapse risk, persistency risk, or expense risk is not an insurance contract unless it also exposes issuer to insurance risk. Lapse and persistency risk are not insurance risks because they are risks created by the contract and do not have adverse impact on policyholder. However, under B16, if the issuer of a contract that has only lapse, persistency and expense risk mitigates that risk by using a second contract to transfer part of that risk to another party, the second contract is insurance because it protects the direct insurer against adverse financial impacts of experience different than expected for those risks. This differs from US GAAP, where lapse and persistency risk alone are not considered insurance risk, even when reinsured.

Key classification differences Date Key classification differences IFRS USGAAP Single definition of an insurance contract? Yes No Required probability of significant insurance loss Any possibility with commercial substance Reasonable possibility; requirement for underwriting and timing risk Requirement for underwriting and timing risk? Significant loss required? Scope limited to insurance companies? Separate contract for accumulation phase versus payout phase? This should just be a summary of what we said/wrote in the prior slides

IFRS 4 Product Classification Date IFRS 4 Product Classification

Discretionary Participation Features A contractual right to receive, as a supplement to guaranteed benefits, additional benefits: that are likely to be a significant portion of the total contractual benefits; whose amount or timing is contractually at the discretion of the issuer; and that are contractually based on: the performance of a specified pool of contracts or a specified type of contract; realised and/or unrealised investment returns on a specified pool of assets held by the issuer; or the profit or loss of the company, fund or other entity that issues the contract.

Discretionary Participation Features May, but need not, report the fixed element separately from the discretionary participation feature Should classify unallocated surplus arising from discretionary participation features as either a liability or equity (not as an intermediate category that is neither liability nor equity). Consider possible separation of embedded derivatives (apply IAS 39 to in-scope embedded derivatives with specific exemption for DPF surrender options). Should, in all respects not described above, continue its existing accounting policies for such contracts, unless it demonstrates that a change in those accounting policies would result in more understandable, relevant, reliable and comparable financial statements.

Phase II Proposals

Insurance Contracts Retain IFRS 4 definition ‘A contract under which one party (the issuer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder’ Significance measured using present values Underwriting or timing risk but additional guidance that timing delays may reduce uncertainty Requires a scenario in which present value of cash outflows exceeds present value of premiums. Evaluated on a contract by contract basis. Thus insurance risk can be significant even if the chance of losses on the portfolio is remote Reinsurance exception: If a reinsurance contract transfer substantially all of the insurance risk of the reinsured portions of the underlying contracts, then it is an insurance contract Financial guarantee contracts generally excluded from the scope (included in 2010 version)

Discretionary Participating Features Definition of DPF is the same as in current IFRS 4 Investment contracts with DPF are included in the scope if the entity also issues insurance contracts. Guidance is basically the same for investment contracts with DPF as for insurance contracts. Modification of some guidance to reflect that there is no insurance risk contract boundary, coverage period)

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