1. The World Bank The Advanced Program in Accounting and Auditing Regulation A new era of prudential rules and financial reporting for insurance Catherine Guttmann 16 May 2006

2. 2 GDNL Program –Module 25 (2) © 2006 Deloitte Outline of presentation In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital What are the main features of IFRS for insurance companies (as of today, Phase I) IFRS 4 – Phase II – A common valuation of insurance liabilities for accounting and solvency purposes ?

3. 3 GDNL Program –Module 25 (2) © 2006 Deloitte In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level Solvency II as a consequence of insufficient efficiency of Solvency I  85 insurance companies have been under regulator’s close scrutiny, in the last five years in Europe, because of capital inadequacy under Solvency I, of which 20 have ultimately disappeared : – Administrative sanction – bankrupcy Main Reasons :  Inadequacy of the pricing of the contracts  Under estimate of insurance liabilities, including embedded options granted to policy holders  Inadequate asset/liability management – Duration – Liquidity – …  Inadequate reinsurance coverage linked with insufficient insurance risk diversification  Inadequate corporate governance and internal control

4. 4 GDNL Program –Module 25 (2) © 2006 Deloitte In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level Solvency II as a convergence between insurance and banking sector  More and more similar products e.g. :  Catastroph bond versus insurance contract  Saving contracts  Climatic derivatives In line with IAIS thinking :  more prospective assessment and control of the risks :  Insurance  Financial  Operational  … both on management and supervisor’s side

5. 5 GDNL Program –Module 25 (2) © 2006 Deloitte Fev 2007 : Final Directive Jui 2007 : Adoption 2008 : Elaboration of detailled implementation guidances 2009-2010 : Transposition of the directive by each Member State 2010 : Application Solvency II Removal of 19 Directives EU in existence In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level – The Calendar May 01 jan 03 jun 04 dec 04 may 05 apr 06 oct 06 dec 06 feb 07 jun 2007 2008 2009 2010 Inventory on Solvency I Assessment of the relevance / adaptation of banking rules to insurance Considerations into the form of a future system of prudential control Study leads by european insurance supervisors on Solvency I and recommendations on the Solvency II project Project of Directive proposed for adoption Preparatory works 1999 Phase IPhase II Project of DirectiveDirective Solvency II June 2004 : 1 st wave of calls for advice (Pillar II) Dec. 2004 : 2 nd wave of calls for advice (Pillar I) May 2005 : 3 rd wave of calls for advice (Pillar III) June 2005 : Amended Framework for consultation Sept 2005 : 1 st quantitative impact study (QIS 1) April 2006 : 2 nd quantitative impact study (QIS 2) Oct 2006 : 1 st draft of Directive Dec 2006 : 2 nd draft of Directive

6. 6 GDNL Program –Module 25 (2) © 2006 Deloitte In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level SOLVENCY II March 06 CEIOPS answer – 3 rd wave of calls for advice Oct 06 1 st draft of Directive July 07Feb 07 Final Directive Directive proposed for adoption Results QIS 1 Starting QIS 2 on MCR & SCR) Feb 06April 06Sept 06 Results QIS 2 2 rd draft of Directive Dec 06 Key phases of short term development

7. 7 GDNL Program –Module 25 (2) © 2006 Deloitte In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level 3 pillars structure Capital Adequacy Value based approach - Solvency Capital Requirement (SCR) - Min. Capital Requirement (MCR) Insurance Liabilities Risks linked to the asset more specifically integrated Capital Adequacy Value based approach - Solvency Capital Requirement (SCR) - Min. Capital Requirement (MCR) Insurance Liabilities Risks linked to the asset more specifically integrated Supervisory Review Corporate Governance Asset/Liability Management Efficiency of internal control Investment policy Reinsurance program Process of prudential supervision Supervisory Review Corporate Governance Asset/Liability Management Efficiency of internal control Investment policy Reinsurance program Process of prudential supervision Market Regulation Information for public and control Transparency principle Information requirements (disclosures) Financial communication Market Regulation Information for public and control Transparency principle Information requirements (disclosures) Financial communication Pillar I Pillar II Pillar III Solvency II

8. 8 GDNL Program –Module 25 (2) © 2006 Deloitte MCR/SCR (CFA n°9, 10, 11, 13, 14) 2 levels of solvency requirement : MCR and SCR Insurance Liabilities MCR Min. Capital Requirement SCR Solvency Capital Requirement Level 0: Mortality risk Level 1: floor Level 2: capital target Surplus Prudential graduated intervention Risk considered as unacceptable by policy holders In line with IAIS work, new risk-based solvency requirements (Solvency II) are underway at the EU level - Internal models - Standard approach

9. 9 GDNL Program –Module 25 (2) © 2006 Deloitte Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital Relevant information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming or correcting their past evaluations Prospective approach Unlocking of the assumptions Completeness : no omission As far as possible, all items valued in the balance sheet e.g. : guarantees, options

10. 10 GDNL Program –Module 25 (2) © 2006 Deloitte Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital Common : – Same definitions (substance over form) Definition of financial assets and liabilities Definition of insurance contract Definition of financial risk, or insurance risk,... – Same accounting rules Convergence between countries Convergence between insurance and banking

11. 11 GDNL Program –Module 25 (2) © 2006 Deloitte Complete, prudent, relevant, common accounting principles as a pre requisite for assessing insurer’s capital requirements and enhancing the ability of insurers to call for capital Prudent : – Valuations have to contend with the uncertainties – Those uncertainties are to be recognised and valued – However, the exercise of prudence doesn’t allow deliberate overstatement of liabilities No double counting with solvency capital requirement Conclusion : a prerequisite, a priori, in coherence with IFRS framework

12. 12 GDNL Program –Module 25 (2) © 2006 Deloitte What are the main features of IFRS for insurance companies (as of today, Phase I) The IFRS on insurance contracts applies to all insurance contracts (including reinsurance contracts) and only to insurance contracts Financial assets and liabilities of insurers are treated by IAS 39 All IFRS standards apply to insurance companies « Insurance contract » definition is a definition in substance and not a legal one :  The standard on insurance contracts should then be used for example in the banking industry

13. 13 GDNL Program –Module 25 (2) © 2006 Deloitte What are the main features of IFRS for insurance companies (as of today, Phase I) Definition of an insurance contract An insurance contract is 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 futur event (the insured event) adversely affects the policyholder »  The « policyholder » is defined as : « a party that has a right to compensation under an insurance contract if an insured event occurs »

14. 14 GDNL Program –Module 25 (2) © 2006 Deloitte What are the main features of IFRS for insurance companies (as of today, Phase I) Definition of financial and insurance risks An insurance risk is a « risk, other that financial risk, transferred from the holder of a contract to the issuer » A financial risk is « the risk of a possible future change in one or more of 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 in the case of a non-financial variable that the variable is not specific to a party to the contract »

15. 15 GDNL Program –Module 25 (2) © 2006 Deloitte What are the main features of IFRS for insurance companies (as of today, Phase I) Examples of insurance contracts Are insurance contracts:Are not insurance contracts: - Insurance against theft or damage to property - Insurance against product liability, professional liability, civil liability - Disability and medical cover - Life contingent annuities - Death benefit -Catastrophe bond if the triggering event includes a condition that the issuer of the bond suffered a specified loss -Financial contracts which don’t expose the insurer to significant insurance risk (investment contracts, financial reinsurance) -Fronting -Own insurance :  for example : product warranty is issued directly by a manufacturer dealer or retailer -Catastrophe bond triggered by an external event for which the issuer doesn’t incure a specific loss

16. 16 GDNL Program –Module 25 (2) © 2006 Deloitte Consequence : an insurer balance sheet Major changes with fair value orientation Local GAAP

17. 17 GDNL Program –Module 25 (2) © 2006 Deloitte Major changes with fair value orientation Local GAAP

18. 18 GDNL Program –Module 25 (2) © 2006 Deloitte IFRS 4 – Phase II – A common valuation of insurance liabilities for accounting and solvency purposes ? Agenda – A Working Paper should be published by the Working Group Phase II before year end 2006 – An Exposure Draft should be published in 2008 – Final standard could be published before year end 2008 Juillet 2005200620082009/2010 Working Group meetings Working paper published ED published Endorsement of phase II standard

19. 19 GDNL Program –Module 25 (2) © 2006 Deloitte Approach A – Current Entry Value Principles : Approach A measures the insurance liability at the amount that the insurer would charge to a policyholder today for entering into a contract with the same remaining rights and obligations as the existing contract. Initial measurement : Discounting of future projected cash flows using current yield curve (best estimate value) A margin for risk and uncertainty Valuation of an implicit margin, equal to the difference between premiums and the best estimate value Next measurements Best estimate value is calculated on current assumptions (economic and non economic) The initial margin is amortised among the duration of the contract with the release of the risk Main issues : valuation approaches under consideration

20. 20 GDNL Program –Module 25 (2) © 2006 Deloitte Approach B – Current Exit Value (Transfer Value) Principles : Approach B measures the insurance liability at the amount that the insurer would expect to have to pay today to another entity if it transferred all its remaining contractual rights and obligations immediately to that entity. Because there is no secondary market for most insurance liabilities, that amount would need to be estimated. Specifically, approach B : Measures the insurance liability as the present value of future cash flows arising from the contract (Uses a current risk-free discount rate). Does not defer acquisition costs as a separate asset. The measurement of the liability includes the margin that market participants would require for contractually assuming risks and providing services : Margin for risks and uncertainty AND Margin for the servicing part included in the insurance contract (servicing margin) Profit at inception is limited : by the level of the MRI and by the level of the Servicing margin Main issues : valuation approaches under consideration

21. 21 GDNL Program –Module 25 (2) © 2006 Deloitte Main issues : valuation approaches under consideration Asset Approach B – "Business to Business” Asset Approach A – "Business to Customers” Global margin = Premiums – Exit Value best estimate Net equity Servicing margin MRU Exit Value best- estimate Net equity Global Margin Exit Value best- estimate Some gain at inception but limited by the SM and the MRI No gain at inception Separation and valuation of the 3 parts of the contracts : - exit value "best estimate" - Margin for risks - Servicing margin

22. 22 GDNL Program –Module 25 (2) © 2006 Deloitte IAIS is working on a similar model so that the same valuation for liabilities could be taken for solvency purposes and accounting Questions still to be solved : Definition of the MRU (level of confidence ; Cost of capital), pattern of amortisation Definition and level of the servicing margin (market reference ?) Policyholder behaviour ? Surrenders, futur premiums, renewals … IAS 39 for investment contracts ? 39 to be amended ? Own credit risk Discretionary participating features : liability or equity or separate component of equity ? Main issues : valuation approaches under consideration