The New Insurance Contracts Accounting Standard: History in the making IABA Conference, August 7, 2010 Tara Hansen and Gareth Kennedy

Page 1 Agenda ► Introduction and project background ► The proposed models ► Income emergence ► Conclusion

Introduction and project background

Page 3 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

Page 4 IASB — discussion paper issued Insurance contracts project timeline FASB — invitation to comment June May November August End of comment periods (IASB and FASB) IASB Exposure Draft Final standard Implementation date Implementation FASB — Joined the project October IFRS 4 Insurance Contracts January IASB and FASB meetings to develop accounting standards Jan thru July 2010 July Aug and 2013 statements filed under US GAAP Fiscal 2012 Fiscal 2013 Fiscal 2014 Potential Transition Restate opening balance sheet Fiscal 2011 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 Quarterly information required as of March 31, 2014 with balance sheet comparative to Dec. 31, 2013 and income statement to March 31, First year of new standard 2014 Development of the new standard Nov. End of comment period FASB Exposure Draft or Discussion Paper

Page 5 Project considerations Conceptual 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

Page 6 Project considerations Revenue recognition Key ConceptImplication 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

Page 7 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

Page 9 FASBIASB 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

Page 10 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

Page 11 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)

Page 12 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.

Page 13 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.

Page 14 Presentation of the performance statement Summarized MarginYear 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 MarginYear 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

Page 15 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.”

Page 16 Comparison of proposed models to Solvency II AttributeProposed FASBProposed IASBSolvency II ScopeAll companies reporting under US GAAP All IFRS listed companies EU insurance companies MeasurementCurrent assessment of the obligations Market consistent with entity parameters Risk Margin/ Adjustment Method Not applicableNot yet prescribedCoC (Directive) and rate prescribed (QIS5) with 1-year VaR capital standard Own Credit Standing Possibly includedExcluded DisclosuresTo be defined but more than current US GAAP Similar to current IFRSSolvency & Financial Condition report Discount rateRisk-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

Page 18 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

Page 19 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

Page 20 Comparison of income emergence Current US GAAP income Current US GAAP Time = Written Premiums 1, Unearned Premiums 1, Earned Premiums Claims Expense - (400) Discount Risk Adjustment Acquisition costs - (100) Underwriting Income Investment Return Income

Page 21 Comparison of income emergence Proposed IFRS income Proposed IFRS Time = Written Premiums 1, Unearned Premiums Earned Premiums 1, Claims Expense (800) Discount 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 Unwind of Residual Margin Income After Unwind - (3) (2) (1) (0) 0 Investment Return Income

Page 22 Comparison of income emergence Proposed US GAAP income Proposed US GAAP Time = Written Premiums 1, Unearned Premiums Earned Premiums 1, Claims Expense (800) Discount Composite Margin (70) Acquisition costs (200) Underwriting Income Unwind of Discount on Claims Reserves - (11) (10) (9) (8) (7) (6) Unwind of Composite Margin Income After Unwind (6) (4) (3) Investment Return Income

Page 23 Insurance contracts considerations – P&C Comparison of baseline profit emergence

Page 24 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.

Page 25 Insurance contracts considerations – life Example – Product Features Product FeaturesAssumptions Universal Life Block ► Heavily funded universal life with no secondary guarantees ► One year of new business ► 45-year old nonsmoker male with total face amount equal to 250m Credited interest and Bonus ► Guaranteed minimum credited rate: 3% ► Target spread: 1.85% ► Interest bonus: 75bps beginning in year 10 Product Charges ► Policy loads (% of premium): 19%, 7% ► Surrender charges (% face amount): 50%, 30%, 28%, 18.6%, 12.9%, 9.2%, 6.6%, 5.0%, 3.9%, 3.0%, 2.2%, 1.6%, 1.2%, 0.7%, 0.3%, 0% Commissions and Expenses ► Commissions (% of premium): 60%, 6%, 6%, 6%, 3% ► Acquisition expense: 112 per policy ► Maintenance expense: 33 per year ► Inflation: 1.5% ► Premium tax: 2.5% ► All commissions in excess of ultimate rate are deferrable for GAAP; 90% of non-commission acquisition expense is deferrable for GAAP Termination Rates ► Lapse: 4.9%, 4.2%, 3.5% ► Mortality: 60% of nonsmoker SoA table ► Premium persistency: 125%, 100%, 100%, 100%, 100%, 100%, 100%, 38%

Page 26 Insurance contracts considerations – life Example – FASB/IASB Insurance Contracts Approach Risk-free forward rate Projected book yield less provision for default (assumed equal to credit default swap rate on underlying assets) less pricing spread, subject to guaranteed interest rates Risk adjustment considers time value of money Residual margin is run off in proportion to risk adjustment IASB Risk adjustment – explicit assumption with 5% expected mortality and 10% reduction in lapse plus a residual margin FASB composite margin Margins Re- measurement Approach Discount RateCredited Rate

Page 27 Sample Results – UL New Business Projection Pre-tax Net Income * Investment Income based on Invested assets = U.S. statutory reserves + 350% RBC

Page 28 Insurance contracts considerations – life Comparison of profit emergence by investment strategy

Conclusion

Page 30 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

Page 31 Increased actuarial involvement ► Discounting and risk adjustment calculations ► Capital modeling ► Asset-liability modeling ► Attribution analysis