1. Session 8 IFRS and Solvency Requirements Regional Training Seminar IAIS-ASSAL-FIDES 25 November 2009, Lima Peru Takao Miyamoto, IAIS Secretariat

2. 1 Agenda 1.Background –Accounting and Solvency –IASB Insurance Contracts Project Overview 2.IASB and IAIS Views on Main Issues –Measurement Approaches –Building Blocks –Margins –Day One Difference –Acquisition Costs –Own Credit Risk

3. 2 Two Uses of Financial Reporting General purpose financial reporting Regulatory purpose reporting & requirements –Many resources (e.g. audit) were already used for accuracy & reliability –Widely accepted –Often in conservative direction –IAIS seeks to minimise (Starting point) : Efficiency (Prudential filter) : Adjustment for different purposes Should reflect economics of businesses Should serve to protect policyholders

4. 3 Key Principle The IAIS believes that it is most desirable that the methodologies for calculating items in general purpose financial reports can be used for, or are substantially consistent with, the methodologies used for regulatory reporting purposes, with as few changes as possible to satisfy regulatory requirements.

5. 4 IASB Project Schedule 2004 1997 Q2 2010 –Insurance Contracts Project start New IFRS May 2007–Discussion Paper “Preliminary Views on Insurance Contracts” (DP) Mid 2011 –Exposure Draft IFRS 4 Phase II Phase I

6. 5 Agenda 1.Background –Accounting and Solvency –IASB Insurance Contracts Project Overview 2.IASB and IAIS Views on Main Issues –Measurement Approaches –Building Blocks –Margins –Day One Difference –Acquisition Costs –Own Credit Risk

7. 6 Measurement Approaches – IASB “Current Exit Value” Amount insurer would expect to pay at reporting date to transfer remaining contractual rights and obligations immediately to another entity “Current Fulfillment Value” Expected present value of cost of fulfilling obligations to policyholder over time “Updated IAS 37” Amount entity would rationally pay at end of reporting period to be relieved of present obligations –Given absence of active market for insurance contracts, this may be close to fulfillment notion

8. 7 Measurement Approaches – IAIS Insurers generally do not transfer liabilities, given no active market for insurance contracts Insurers generally fulfill/settle obligations to policyholders over time Any transfer notion would be strongly influenced by settlement of obligations that transferee would undertake –Transfers would need to be made to entity capable of accepting transfer –It implies that transferee would also need to be regulated and capable of settling obligations to claimant/beneficiary

9. 8 Building Blocks – IASB Three building blocks Current estimate of expected (i.e. probability weighted) present value of future cash flows Time value of money (i.e. discounting) Explicit margin Rationale Markets for trading insurance contract rarely exist So, its value is rarely observable (i.e. Level 3 financial product) So, its value has to be estimated somehow

10. 9 Comparison IASBIAIS Measurement Approaches Current Exit Value - Could work with any of views - Devil is in details Updated IAS 37 Current Fulfillment Value Building Blocks - Current estimate of expected present value of CF - Time value of money - Explicit margin - Agree with building blocks approach - Easy to say but difficult to implement… - Details to be developed

11. 10 Unearned Premium Approach Exception Pre-claims short-duration liabilities only Permitted (not required) to use “Unearned Premium” approach –Provide decision-useful information –Cost vs. Benefit Measurement method As insurer is released from risk, related part of premium is earned and recognised as revenue Unearned part of premium is recognised as liability –Lock-in: allocate original price (premium) over periods –No explicit margin

12. 11 Agenda 1.Background –Accounting and Solvency –IASB Insurance Contracts Project Overview 2.IASB and IAIS Views on Main Issues –Measurement Approaches –Building Blocks –Margins –Day One Difference –Acquisition Costs –Own Credit Risk

13. 12 Margins – IASB Types of margins Risk: compensation required for bearing risks Service: compensation for assuming services other than risk margin Residual: remaining margin (calibrated to actual premium) Composite: inclusive of above three (calibrated to actual premium)

14. 13 Comparison IASBIAIS Margins Current Exit Value - Risk, Service, Residual - Support explicit margins regardless whether/how they are classified - Initial measurement calibrated to zero profit on inception is supportable - Challenge is how to measure margins in subsequent periods Updated IAS 37 - Risk, Service, Residual Current Fulfillment Value - Composite

15. 14 Agenda 1.Background –Accounting and Solvency –IASB Insurance Contracts Project Overview 2.IASB and IAIS Views on Main Issues –Measurement Approaches –Building Blocks –Margins –Day One Difference –Acquisition Costs –Own Credit Risk

16. 15 Day One Difference What is “Day One Difference”? When using exit price (whether transfer or fulfillment) instead of entry price, day one difference could arise at inception It could be both positive (gain) or negative (loss) Simple examples –Insurance Company A enters into one-year term non-life contract. Premium for contract is 1,000 and is received at inception. Expected present value of future cash outflow is 800. –What if expected present value of future cash outflow is 1,200?

17. 16 Day One Difference – IASB Recognition No profit at inception should be recognised in profit/loss –Margin (either residual or composite) is recognised as liabilities –They are calibrated to actual premiums Loss at inception should be recognised in profit/loss – onerous contracts –Asymmetry exists

18. 17 Acquisition Costs – IASB Issues Insurance companies incur initial acquisition costs –Significant amount especially for long term contracts Are they expensed or deferred? How about matching revenue? IASB position All acquisition costs should be expensed when incurred No revenue can be recognised to offset acquisition costs expensed – October 2009 position –Day one loss on long term contracts (e.g. life insurance)

19. 18 Comparison IASBIAIS Day One Difference No profit at inception Fine (except for below) Loss at inception – onerous contracts Acquisition Costs All acquisition costs should be expensed when incurred No recognition of revenue to offset acquisition costs - It does not reflect economics (profitable business may incur losses at inception) - It would be disincentive for entering into profitable business

20. 19 Agenda 1.Background –Accounting and Solvency –IASB Insurance Contracts Project Overview 2.IASB and IAIS Views on Main Issues –Measurement Approaches –Building Blocks –Margins –Day One Difference –Acquisition Costs –Own Credit Risk

21. 20 Own Credit Risk Whether to include insurer’s own credit risk in valuation of insurance liabilities If included, decrease in liabilities for worsening of insurer’s credit standing Liabilities Assets Surplus AAA Insurer Liabilities Assets Surplus BBB Insurer

22. 21 Comparison IASBIAIS Own Credit Risk Current Exit Value - Include own credit risk in technical provision - Initial premium, agreed between relevant parties, may be presumed to incorporate own credit risk - However, remeasurement should never incorporate changes in credit risk (insurance contracts are not publicly traded) Updated IAS 37 - To be discussed (arguably implicit in residual margin at inception) Current Fulfillment Value - To be discussed (arguably implicit in residual margin at inception)

23. 22 Questions and Answers Thank you very much! www.iaisweb.org takao.miyamoto@bis.org