Joint Regional Seminar 2006

Financial Reporting Development

U.S. GAAP and SOX 404

Joint Regional Seminar 2006

Financial Reporting Development

U.S. GAAP and SOX 404

Actuarial Services

Jonathan Zhao, FSA, Bruce Moore, FSA

June 22 – 30, 2006

Jonathan Zhao, FSA, Bruce Moore, FSA

June 22 – 30, 2006

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AgendaU.S. GAAP Reporting• General Introduction

• Latest Development of US GAAP– SOP 03-1

– SOP 05-1

• Implementation Consideration for US GAAP

• U.S. GAAP Valuation – Experience within Asia

SOX 404• General Introduction

• Roles of Actuaries – “What do I have to do”– Actuarial Roles

– Actuarial Responsibilities

– Actuarial Implementation

• Experience within Asia

U.S. GAAP ReportingU.S. GAAP Reporting

Actuarial Services

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U.S. GAAP Principles

• Emphasis on income recognition (matching of revenue and expenses)

• Based on earnings rather than on solvency and balance sheet

• Most acquisition expenses charged against earnings over the life of the product rather than against earnings as incurred (DAC Amortization)

• More realistic reserves than the conservative statutory reserves

• Smoother pattern of earnings

• Requires significant management judgment with respect to accounting and reporting framework

• Best estimate assumptions with (FAS 60) and without (FAS 97) PAD

• Required for U.S. listed insurers

• Used by some Asian insurers, even if not listed in U.S., for credibility with investors

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Key U.S GAAP Phrases You Should Know

• SEC / FASB / AICPA / EITF

• 10-Q, 10-K

• PADs

• DAC Amortization and Capitalization

• Prospective Assumption True-up

• Unlock the DAC

• K-factors

• Loss Recognition

• Recoverability

• Gross profits

• Deferrable Expenses

• Available for sale

• Shadow DAC

• Net GAAP Liability

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U.S GAAP Accounting History

• 1982 - FASB 60 (Traditional Products)

• 1987 - FASB 97 and FASB 97 Limited Pay (Interest Sensitive Products)

• 1992 - FASB 113 (Reinsurance)

• 1993 - FASB 115, (Shadow Accounting)

• 1995 - FASB 120, (Mutual Company & Participating Policies)

• 1998 - FASB 133, (Derivative Instruments and Hedging Activities)

• 2001 - FASB 141/FASB 142 (Business Combination & Goodwill Impairment)

• 2003 – SOP 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts

• 2005 – SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contract

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Condensed GAAP Balance Sheet and Income StatementDecember 31, 2005

Income StatementIncome Statement

Balance SheetBalance Sheet

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Latest Development of US GAAPLatest Development of US GAAP

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Statement of Position 03-1Provides guidance on accounting and reporting by insurance

enterprises for certain nontraditional long-duration contracts and for separate accounts.

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SOP 03-1• Statement of Position (SOP) 03-1: Most significant GAAP pronouncement in years,

effective for fiscal years beginning after December 15, 2003

• Addressed product features not adequately addressed by FASB 60 and FASB 97, such as GMDB, persistency bonus, annuitization guarantees, and reinsurance.

• Major SOP 03-1 Implications

– Separate Account: Assets and liabilities should be reported as general account (GA) items if four criteria are not met

– Valuation of Liabilities: AV w/o surrender and MVA adjustment for FAS97 contracts

– Contracts with Death or Other Insurance Benefit Features: Defined “insurance contract” using “benefit ratio”. Need to establish a liability in additional to AV for VA/VUL with GMDB, UL with no lapse guarantee, and any benefits that are expected to have “gains follow by losses”

– Annuitization Benefits: Needs to establish a liability for annuitization guarantees if PV annuitization payments at time of annuitization would exceed accumulated balance

– Sales Inducements: Persistency bonus, bonus interest; Amortize similar to DAC and need to be identified separately from DAC

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Statement of Position 05-1Accounting by Insurance Enterprises for Deferred Acquisition Costs in

Connection With Modifications or Exchanges of Insurance Contracts

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SOP 05-1• Provides guidance on accounting on treatment of DAC, Unearned revenue liability or Sales

Inducement Asset on internal replacements of insurance and investment contracts.

• Effective for fiscal years beginning after Dec 15, 2006; early adoption is allowed, but no retrospective application.

• “Internal Replacement”– modification in product benefits, features, rights or coverages that occurs by the legal

extinguishment of one contract and the issuance of another contract, or by amendment, endorsement, or rider to a contract, or by the election of a benefit feature, right or coverage within a contract

– Modifications that result from the election of a benefit within the original contract are not internal replacements as long as all of the following conditions are met:

Terms are fixed or specified within narrow range

Election of the benefit is not subject to underwriting

Insurance enterprise cannot decline to provide the coverage or adjust the pricing of the benefit

Feature has been accounted for since the inception of the contract or the existence of the benefit was contemplated in original contract classification

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SOP 05-1Modification

Internal ReplacementNot Internal Replacement

SOP does not applyExample: New life policy subject to U/W

Integrated ModificationOr Exchange

Example: Add GMDB, GMAB to VA

Non-Integrated ModificationTreat as if separate contract

Example: Add an LTC rider to a VA

Substantially ChangedExtinguishment of original contract

Example: SPDA to EIA

Substantially UnchangedContinuation of original contract

Example: Fixed annuity exchange with nochanges to credited rate, guarantee or CSV

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“Substantially Unchanged”Insured event of the contract has not changed

Nature of investment return rights (e.g., formulaic, pass-through, discretionary) has not changed

No additional deposit, premium, or charge is required to effect the transaction

No net reduction in the contract holder’s account value or CSV if no account value

No change in the participation or dividend features of the contract

No change to the amortization method or revenue classification of the contract

If substantially unchanged:Replacement contract is considered a continuation of the original contract

Unamortized DAC, deferred revenue liability, deferred sales inducement asset, and unearned premium associated with the original contract continue to be deferred in connection with the replacement contract

– FAS 60 contracts: “prospective revision” – preserves lock-in– FAS 97 contracts: revision of future EGPs/EGMs of the original contract

Costs incurred in connection with the internal replacement are maintenance-type costs/expenses

If substantially changed:Accounted for as an extinguishment of the initial contract

Unamortized DAC, deferred revenue, and deferred sales inducement asset from the original contract are not deferred in connection with the replacement contract

Acquisition costs incurred in connection with the internal replacement are evaluated for deferral in accordance with the provisions of FAS 60 and 97

Integrated Modification or Exchange SOP 05-1 Impact

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Implementation Consideration of U.S. GAAP Accounting

Implementation Consideration of U.S. GAAP Accounting

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U.S. GAAP Conversion & Implementation Considerations• Planning and Conceptual Definition

– U.S. GAAP training and reference materials gathering– Develop work plans, timeline, and resources– Define near, interim and long-term goals– Analyze accounting and system requirements, software selection, alternatives and implications

• Execution– Product Classification– Setting GAAP assumption and unlocking processes (e.g. best estimate assumptions, PAD)– Analyze expenses and set expense deferral guidelines– Developing GAAP valuation process and procedures (e.g. formal GAAP policy & procedure manual) – Building GAAP models (e.g. benefit reserve, DAC, etc.)– Developing GAAP analytical tools and documentation (DAC/AV roll-forwards, SOX 404) – Prepare GAAP financial statements and ensure close coordination with finance & IT departments

• Follow Up– Streamline GAAP reporting process– Supplemental management report (e.g. quarterly reporting process, GAAP earning by source, link

with pricing, business planning)

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U.S. GAAP Conversion & Implementation Challenges• Setting Assumptions and Expense Deferral Policy Challenges

– Lack of reliable experiences studies

– No detailed expenses breakdown by sources

• Financial Reporting Challenges– Developing GAAP general ledger system / financial reporting process

– Developing line of business reporting and internal control structure

• Implementation Challenges– Building the appropriate model for numerous plans (e.g., seriatim vs. product grouping)

– Refine the models to match actual experiences

– Lack of resources and GAAP expertise

• Investment Accounting Challenges– Shadow accounting

– Realized and unrealized gains/losses

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U.S. GAAP Valuation –Experience within AsiaU.S. GAAP Valuation –Experience within Asia

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U.S. GAAP Issues Found In Asian Companies

• True U.S. GAAP vs. In reference to U.S. GAAP

• Issues and short cuts found in the U.S. GAAP valuation – No DAC and URR being established for FAS 97 business, assuming they offset

each other – No true-up of actual gross margins– Inclusion of non-deferrable acquisition expense in the DPL calculation for FAS 97 LP– No separation for maintenance expense reserve and DAC for FAS 60– Changing of PAD vs. Changing of Best Estimate Assumptions– Loss Recognition: Gross Premium Valuation vs. DAC Loss Recognition/

Recoverability Test– Shadow Accounting (Shadow DAC/Shadow URR/Shadow Loss Recognition)– Lack of clear expense deferral policies / Unlocking does not follow experience trends– Lack of detailed DAC roll-forward analysis– Lack of experience studies– Materiality????

Sarbanes-Oxley 404 – Actuarial ProcessesSarbanes-Oxley 404 – Actuarial Processes

Actuarial Services

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Overview

• Background– Purpose and Timing of SOX 404

– PCAOB and Audit Standard No. 2

– Basic Framework of SOX 404 Requirements

• Roles of Actuaries – “What do I have to do”– Actuarial Roles

– Actuarial Responsibilities

– Actuarial Implementation

• Experience within Asia

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Purpose of SOX 404• Sarbanes-Oxley Act was passed in July 2002

– Restore public confidence and renew investors’ trust in corporate executives and financial reports

– Protection of public investors; enhancing and formalizing governmental oversight; and restructure governance over auditors.

• Section 404 Requirements

– Management must assert as to the effectiveness of financial reporting internal controls (FRIC)

– External auditor must separately attest and report on management’s assessment, and on the effectiveness of internal control over financial reporting

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Compli

ance

Opera

tions

Control Environment

Risk Assessment

Control Activities

Information and Communications

Monitoring

FUNCTIONS

BUS

UNITS

Finan

cial

Repo

rting

• Internal Control is a process:

1) effected by an entity’s board of directors, management and other personnel,

2) designed to provide reasonable assurance regarding the achievement of objectives in the following categories:

(a) reliability of financial reporting

(b) effectiveness and efficiency of operations, and

(c) compliance with applicable laws and regulations.

Internal Control covered by SOX 404 focus on “Financial Reporting”Internal Control Defined by Committee of Sponsoring Organizations (“COSO”):

Financial Reporting Internal ControlFinancial Reporting Internal Control

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SOX 404 Compliance Time Tables

• December 31, 2004 – All companies that file U.S. GAAP financial statements with the SEC or “accelerated” SEC filers (Primarily U.S. domiciled filers)

• December 31, 2006 – Non-accelerated SEC filers, primarily consisting of non-U.S. domiciled organizations including several large insurance companies with large U.S. operations

• December 31, 2009 – Proposed NAIC revisions to the Model Audit Rule to possibly include internal control assessments comparable to SOX 404. Potentially applicable to all U.S. insurance legal entities filing statutory financial statements.

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PCAOB

• Public Company Accounting Oversight Board (PCAOB) is a private-sector, non-profit corporation, created by SOX

• Oversees the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports

• Principal Activities

– Registration of accounting firms who audit SEC registrants

– Establish professional standards

– Inspections of accounting firms

– Conduct investigations and disciplinary proceedings for accounting firms

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Audit Standard No. 2 • PCAOB adopted on March 9, 2004 Auditing Standard No. 2, “An Audit of

Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements”

• Key Areas

– Management’s responsibilities

– Performing an audit of internal control over financial reporting

– Using the work of management and others

– Internal control deficiencies

– Evaluating the results of the testing of controls

– Reporting and communication

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Basic Framework of SOX 404 Requirements• Scoping - Identify and document significant accounts and related processes

• Identify risks – the “what could go wrong”

• Identify mitigating risk controls that serve to prevent or detect and correct errors of importance or fraud

• Select and test key risk controls

• Evaluate and communicate findings

– Including Remediation of Deficiencies

SignificantAccounts

ManagementAssertions

?

What CanGo Wrong?

ControlsSignificantProcesses

Inherent andKey Business

Risks

2003FinancialStatements

2003FinancialStatements

FinancialStatements

ManagementReport onInternalControl

ReportEvaluate/Monitor

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SOX 404 Process Documentation• For each identified significant account and related process, the following

materials are generally assembled:

– Narrative

– Flow Chart

– Risk Control Matrix (“RCM”)

– Control Documentation Sheet

– Documentation on Testing of Design Effectiveness

– Documentation on Testing of Operating Effectiveness

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Actuarial Department Staffing Roles• SOX 404 documentation requires identification of individuals involved in the

actuarial valuation processes

• Each individual is responsible for validating the documentation pertaining to their area of responsibility

• Sample hierarchy of those involved:

– Account owner(s): Performs the work (Junior Staff)

– Process owner(s): Reviews the work (Senior Staff)

– Business owner: Signs off on the work (Lead Actuary)

• For foreign registrants, both the primary accounting basis (e.g., IFRS) and the U.S. GAAP basis (and all financial statement disclosures as well) are in scope, and the people working on those should be involved.

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Actuarial Staff Responsibilities • Overall, documentation requirements for actuarial-related processes will be the

same as for other departments

• Identification of the resulting risks and the related controls are important for financial reporting

• SOX 404 addresses internal controls around the process of establishing financial statement balances but is not an audit of those balances

• Nature of actuarial processes and associated balances necessitates procedural, if not technical, knowledge in certain areas

– Assumption development

– Methodological approaches

– Modeling and projections (in support of financial statement balances)

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Collaboration with Other Departments

• Effective documentation and testing of SOX 404 controls requires collaboration and integration with many groups outside of the Actuarial Department:

– Internal Audit Department

– External Auditor

– Information Technology Department

– Controllers Department

– CFO/Senior Management

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Actuarial Processes Affected

• Most actuarial processes will be considered significant and subject to documentation under SOX 404 due to the magnitude and complexity of their associated balances

• Some sub processes (e.g. the reserving process for a specific product) may be considered immaterial, and thus deemed outside the scope of documentation and testing requirements

• Significant Actuarial Processes (need to identify both risks and controls)

– Reserve process (e.g. factor setting, methodology/assumption, system/data flows, analytics)

– DAC/VOBA/URR (e.g., loss recognition/recoverability, methodology/assumption, unlocking, model projection, system/data flows)

– Reinsurance operation (e.g., treaty accounting, reinsurance reserve, system/data flows)

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Actuarial Documentation Controls• Generally, documentation is sufficient when it addresses the following and

provides evidence that appropriate controls have been established and are effectively designed to prevent or detect errors:

– Specifies “what can go wrong” in the processing stream and indicates where controls are needed;

– Describes in good detail the relevant controls and how they are performed;

– States who (by title) performs the controls;

– States the data reports, files or other materials used in performing the control; and,

– States what physical evidence and sign-off, if any, is produced as a result of performing the control.

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Experiences in Asia - Common SOX 404 Deficiencies Identified• Too much reliance on “one” person to perform calculations and/or valuations

with no contingency plans• Insufficient security controls around “software packages” (e.g., Excel, Prophet,

Access, etc.)• Too much reliance on “black box” processes with no or inadequate validations

of output for these processes• Too much reliance on “outdated” assumptions with insufficient periodic review

of assumptions• Insufficient documentation or explanation of actuarial assumptions and

methodologies as to compliance with GAAP accounting requirements• Lack of management review/sign-off on reconciliations or other key analytic

controls• Insufficiency of control on outsourced processes (or components of

processes). • Inadequate documentation in methodology, process and so on.

Actuarial Services

For additional details, please contact:

Jonathan Zhao, FSA, jonathan.zhao@hk.ey.com, (852) 2846-9023

Bruce Moore, FSA, bruce.moore@cn.ey.com, (8610) 5815-3364

E&Y Financial Reporting Developments on:

SOP 03-1

and

SOP 05-1