2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Contract Classification under IFRS Johanne Papillon September 25, 2008

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Presentation Outline Background IFRS Contract Classification Embedded Derivatives Overview of IAS 39 Observations and Conclusion Background IFRS Contract Classification Embedded Derivatives Overview of IAS 39 Observations and Conclusion

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Background Conversion to IFRS: Jan 1, 2011 Insurance contracts: IFRS 4; keep current basis of accounting until Phase II (effective 2012 or 2013) Investment contracts: IAS 39 Financial Instruments Service contracts: IAS 18 Revenue (similar to CGAAP)  Most significant impact: Investment contracts, and potentially Embedded Derivatives Conversion to IFRS: Jan 1, 2011 Insurance contracts: IFRS 4; keep current basis of accounting until Phase II (effective 2012 or 2013) Investment contracts: IAS 39 Financial Instruments Service contracts: IAS 18 Revenue (similar to CGAAP)  Most significant impact: Investment contracts, and potentially Embedded Derivatives

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 IFRS: Double conversion for Insurers Insurance Contracts: CALM Insurance and Investment Contracts: Actuarial Liabilities Investment Contracts: IAS 39 Phase I January 1, 2011: Phase II January 1, 2012, (or later): Insurance Contracts: new IFRS standards (Discussion Paper) Current CGAAP: Embedded Derivatives : IAS 39 Fair Value option

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Contract classification under IFRS IFRS definition of Insurance Contract: ‘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.’ Three key criteria: 1) Insured event must adversely affect policyholder 2) Insured benefits must be significant 3) Insurance risk must be non-financial: mortality, longevity, morbidity, P&C risks IFRS definition of Insurance Contract: ‘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.’ Three key criteria: 1) Insured event must adversely affect policyholder 2) Insured benefits must be significant 3) Insurance risk must be non-financial: mortality, longevity, morbidity, P&C risks

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Contract classification (cont’d) Significance of 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 Probability of insured event is not considered when assessing significance of risk Company determines what it considers as being significant: 5%-10% additional benefits? Risks that are created by the contract (lapse, expense) do not constitute Insurance Risk (i.e. risk must be pre-existing) Significance of 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 Probability of insured event is not considered when assessing significance of risk Company determines what it considers as being significant: 5%-10% additional benefits? Risks that are created by the contract (lapse, expense) do not constitute Insurance Risk (i.e. risk must be pre-existing)

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Tools: Decision Tree Does the insured event adversely affect the insured? No The contract is not an insurance contract; consider Investment or Service contract Yes Identify scenario A, in which insured event occurs: Example: Death of Policyholder before end of insurance coverage period Insured event: Example: Death of policyholder

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Decision tree (cont’d) Determine the benefit payable by the insurer under Scenario A: Example: Face Amount of $100,000 Identify scenario B, in which insured event does not occur: Example: Survival of policyholder to the end of the coverage period Determine the benefit available to policyholder under Scenario B: Example: Surrender Value

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Is benefit payable under Scenario A significantly greater than benefit available under Scenario B? Compare benefits in Scenario A versus benefits in Scenario B (ratio) No Yes The contract is an insurance contract: IFRS 4 applies. The contract is not an insurance contract; consider Investment or Service contract Decision tree (cont’d)

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Other considerations Once Insurance, always Insurance Assessment is made at contract inception Contract is assessed as a whole: If significant insurance risk is present in the contract, then the whole contract is classified as Insurance.  Then, determine if contract contains: Embedded derivative (separate fair value measurement under IAS 39) Deposit component (option to unbundle) Discretionary participation feature Once Insurance, always Insurance Assessment is made at contract inception Contract is assessed as a whole: If significant insurance risk is present in the contract, then the whole contract is classified as Insurance.  Then, determine if contract contains: Embedded derivative (separate fair value measurement under IAS 39) Deposit component (option to unbundle) Discretionary participation feature

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Can assess at segment level for blocks that have “relatively homogeneous risk profiles” Lapse/expense risks do not constitute insurance risk to the direct insurer, but do constitute insurance risk to reinsurer assuming the risk  Lapse/expense risk is “pre-existing” to the reinsurance arrangement, and would adversely affect the direct writer Legal entity versus consolidated:  Situations may exist for related-party reinsurance arrangements, where a contract will be classified differently at legal entity level versus consolidated Can assess at segment level for blocks that have “relatively homogeneous risk profiles” Lapse/expense risks do not constitute insurance risk to the direct insurer, but do constitute insurance risk to reinsurer assuming the risk  Lapse/expense risk is “pre-existing” to the reinsurance arrangement, and would adversely affect the direct writer Legal entity versus consolidated:  Situations may exist for related-party reinsurance arrangements, where a contract will be classified differently at legal entity level versus consolidated Other considerations (cont’d)

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Examples of insurance contracts Insurance contracts: Term plans, T100 Par Life, Whole life Universal Life Endowment products / Pure endowments Critical Illness/Health/Disability contracts Long Term Care Group Life and Health insurance (excluding ASO contracts) Reinsurance treaties with “significant” risk transfer Payout immediate/deferred annuities (life contingent) Insurance contracts: Term plans, T100 Par Life, Whole life Universal Life Endowment products / Pure endowments Critical Illness/Health/Disability contracts Long Term Care Group Life and Health insurance (excluding ASO contracts) Reinsurance treaties with “significant” risk transfer Payout immediate/deferred annuities (life contingent)

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Insurance contracts (cont’d) Insurance contracts: Seg fund/VA products with GMDB / GMIB / ”For-life” GMWB  GMDB, GMIB or “for life” GMWB constitute significant insurance risk Accumulation products/deferred annuities with contractual guaranteed annuitization rates  Guaranteed annuitization rates, even if rarely exercised, constitute significant insurance risk Accumulation products/deferred annuities with Book Value Death Benefit in deferral period  If MVA surrender charge is waived on death and/or disability, this constitutes significant insurance risk Insurance contracts: Seg fund/VA products with GMDB / GMIB / ”For-life” GMWB  GMDB, GMIB or “for life” GMWB constitute significant insurance risk Accumulation products/deferred annuities with contractual guaranteed annuitization rates  Guaranteed annuitization rates, even if rarely exercised, constitute significant insurance risk Accumulation products/deferred annuities with Book Value Death Benefit in deferral period  If MVA surrender charge is waived on death and/or disability, this constitutes significant insurance risk

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Examples of Investment contracts: Investment contracts: Term certain contingent annuities Fixed accummulation annuities which do not contain guaranteed annuitization rates Seg funds with no guaranteed minimum returns Group contracts with strong “hold harmless” provisions (terminal/deficit accounting) Mutual funds / banking products IAS 39 applies:  Potential asset segmentation issues if commingled with assets backing Insurance segments Investment contracts: Term certain contingent annuities Fixed accummulation annuities which do not contain guaranteed annuitization rates Seg funds with no guaranteed minimum returns Group contracts with strong “hold harmless” provisions (terminal/deficit accounting) Mutual funds / banking products IAS 39 applies:  Potential asset segmentation issues if commingled with assets backing Insurance segments

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Examples of Service contracts Service contracts: Group ASO Financial Reinsurance with very limited risk transfers Potentially: mutual funds where company acts as “conduit” / does not have ability to choose/replace investment managers Widely expected that IFRS treatment will be similar to existing CGAAP DAC implications for service components embedded in investment contracts Service contracts: Group ASO Financial Reinsurance with very limited risk transfers Potentially: mutual funds where company acts as “conduit” / does not have ability to choose/replace investment managers Widely expected that IFRS treatment will be similar to existing CGAAP DAC implications for service components embedded in investment contracts

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives Embedded derivatives (EDs) within insurance or investment contracts must be separately measured at fair value if such ED is:  not itself considered insurance, and  not closely related to the host insurance or investment contract EDs within Investment contracts do not need to be separately fair valued if the whole contract is measured at fair value Embedded derivatives (EDs) within insurance or investment contracts must be separately measured at fair value if such ED is:  not itself considered insurance, and  not closely related to the host insurance or investment contract EDs within Investment contracts do not need to be separately fair valued if the whole contract is measured at fair value

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives: Definitions IAS 39.9: “A derivative is a financial instrument with all three of the following characteristics: –its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided that the variable is not specific to a party to the contract (sometimes called the “underlying”); –it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and –it is settled at a future date.” IAS 39.9: “A derivative is a financial instrument with all three of the following characteristics: –its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided that the variable is not specific to a party to the contract (sometimes called the “underlying”); –it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and –it is settled at a future date.”

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives (cont’d) An embedded derivative is defined in IAS as follows: –is a part of a combined (hybrid) contract, which also contains non-derivative components –combined contract includes an identifiable condition to modify the cash flows otherwise payable; and –modification of cash flows is in response to a market factor or non-financial variable that is not specific to a party to the contract An embedded derivative is defined in IAS as follows: –is a part of a combined (hybrid) contract, which also contains non-derivative components –combined contract includes an identifiable condition to modify the cash flows otherwise payable; and –modification of cash flows is in response to a market factor or non-financial variable that is not specific to a party to the contract

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives (cont’d) ED that is itself Insurance: – If cashflows affected by the ED are only paid on a insured/contingent event, then ED itself meets the definition of an insurance contract;  IFRS 4 applies; exempt from separate Fair Value measurement Examples: – Seg fund GMDB, GMIB, “for-life” GMWB – Seg fund GMAB, “term certain” GMWB? – CPI-indexing feature in disability contracts ED that is itself Insurance: – If cashflows affected by the ED are only paid on a insured/contingent event, then ED itself meets the definition of an insurance contract;  IFRS 4 applies; exempt from separate Fair Value measurement Examples: – Seg fund GMDB, GMIB, “for-life” GMWB – Seg fund GMAB, “term certain” GMWB? – CPI-indexing feature in disability contracts

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives (cont’d) Definition of “closely related”: – An ED is “closely related” to its host contract if the risks inherent in the ED and the host contract are “similar” – An ED is considered closely related if ED and host contract are so inter-dependent that the ED cannot be measured without considering the host contract Definition of “closely related”: – An ED is “closely related” to its host contract if the risks inherent in the ED and the host contract are “similar” – An ED is considered closely related if ED and host contract are so inter-dependent that the ED cannot be measured without considering the host contract

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives (cont’d) Examples “closely related” EDs:  Unit-linked deposit components (where policyholder AV is expressed in terms of units of underlying fund) are explicitly listed in IFRS literature as being “closely related”  Equity-linked UL deposit account?  UL account minimum return guarantees? Refer to IAS 39 Appendix A paragraphs AG30 and AG33 Examples “closely related” EDs:  Unit-linked deposit components (where policyholder AV is expressed in terms of units of underlying fund) are explicitly listed in IFRS literature as being “closely related”  Equity-linked UL deposit account?  UL account minimum return guarantees? Refer to IAS 39 Appendix A paragraphs AG30 and AG33

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives (cont’d) Other Embedded Derivatives at risk of requiring separate fair value measurement:  Ceded / assumed GMIB: depending on specifics of the contract, and whether actual reinsurance recoveries can be viewed as being “payable on an insured event”  Credit derivatives/ModCo Reinsurance treaties (USGAAP DIG B36)  Surrender values based on external index or a pool of equity investments Other Embedded Derivatives at risk of requiring separate fair value measurement:  Ceded / assumed GMIB: depending on specifics of the contract, and whether actual reinsurance recoveries can be viewed as being “payable on an insured event”  Credit derivatives/ModCo Reinsurance treaties (USGAAP DIG B36)  Surrender values based on external index or a pool of equity investments

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Embedded Derivatives: Measurement implications For non-exempt EDs: – ED is separately measured at Fair Value under IAS 39 – similar to US GAAP FAS 133; change in value of ED flows through earnings each quarter – Host contract is measured under IFRS 4 (Insurance), IAS 39 (Investment) Insurance: CGAAP/CIA Standards require all cashflows to be reflected in valuation (SoP 2130) May argue that total measurement under IFRS = CALM, and ED separate measurement simply affects where amounts are reported (ie. geography issue, not earnings issue) For non-exempt EDs: – ED is separately measured at Fair Value under IAS 39 – similar to US GAAP FAS 133; change in value of ED flows through earnings each quarter – Host contract is measured under IFRS 4 (Insurance), IAS 39 (Investment) Insurance: CGAAP/CIA Standards require all cashflows to be reflected in valuation (SoP 2130) May argue that total measurement under IFRS = CALM, and ED separate measurement simply affects where amounts are reported (ie. geography issue, not earnings issue)

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 High Level Overview of IAS 39: Financial Instruments CICA 3855 is based on IAS 39: liabilities were explicitly excluded from 3855 Elect either Amortized Cost or Fair Value option Amortized cost: – Effective rate of interest that exactly discounts future cashflows to initial fair value; – must go back to contract inception; operationally complex – assets would have to be reclassified as AFS; issue if some a given asset is partially allocated to Insurance segment CICA 3855 is based on IAS 39: liabilities were explicitly excluded from 3855 Elect either Amortized Cost or Fair Value option Amortized cost: – Effective rate of interest that exactly discounts future cashflows to initial fair value; – must go back to contract inception; operationally complex – assets would have to be reclassified as AFS; issue if some a given asset is partially allocated to Insurance segment

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Overview of IAS 39 (cont’d) Fair value option: – Similar to USGAAP fair value; – Maximum use of market inputs, margin for bearing risk, risk free rate + adjustment for own credit and liquidity DAC implications: – No such concept under IAS 39 – If service component embedded in contract, can capitalize certain transaction costs only, provided they are “direct and incremental” to contract issuance – Different rules will likely result in difference in what can be capitalized, and opening retained earnings adjustment Fair value option: – Similar to USGAAP fair value; – Maximum use of market inputs, margin for bearing risk, risk free rate + adjustment for own credit and liquidity DAC implications: – No such concept under IAS 39 – If service component embedded in contract, can capitalize certain transaction costs only, provided they are “direct and incremental” to contract issuance – Different rules will likely result in difference in what can be capitalized, and opening retained earnings adjustment

2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008 Observations and Conclusions Contract Classification exercise:  Broad definition of “insurance”  Unlikely to have material amounts of Investment Contracts; For Investment contracts: need to understand implications of IAS 39;  potential asset segmentation issues  DAC differences Embedded derivatives:  may find that most are exempt as either “insurance” or “closely related” Service contracts:  identify, but no significant accounting changes expected Contract Classification exercise:  Broad definition of “insurance”  Unlikely to have material amounts of Investment Contracts; For Investment contracts: need to understand implications of IAS 39;  potential asset segmentation issues  DAC differences Embedded derivatives:  may find that most are exempt as either “insurance” or “closely related” Service contracts:  identify, but no significant accounting changes expected