Managing the Transition SLFRS – 4. © 2010 EYGM Limited Managing The Transition Slide 2 Managing...

Managing the Transition

SLFRS – 4

© 2010 EYGM Limited Managing The TransitionSlide 2

Managing The Transition

1) Identification of an Insurance Contract

- Product Classification

- Embedded Derivatives

2) Contemporary Issues

- Unbundling of Deposit Component

- Liability Adequacy Test

- Shadow Accounting

3) Change In Accounting Policies

4) Business Consideration


Insurance Liabilities – Phase I

Investments equitiesfixed interest mortgagesloans

Other assetsOther liabilities

Equity

Insurance contracts and investment contracts with DPF

Investmentcontract liabilities

Investmentcontract DAC

Property

LKAS 39

LKAS (16) 40

LKAS 18

Insurance DAC

SLFRS 4

PVIF SLFRS 4

Various

SLFRS 4

LKAS 39

Various

LKAS 19 and others

Key standards for insurers

Identification of an Insurance Contract



Insurance Contract:

► 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 future event (the insured event) adversely affects the policyholder.

► Insurer as per SLFRS 4 is any entity that issues insurance contract, irrespective of whether the entity is considered an insurer for legal/ regulatory purposes.

► All reference in this SLFRS to insurance contracts also apply to reinsurance contracts.


Once insurance – always insurance!

InvestmentContract

InsuranceContractX


Deposit accounting

► Deposit is not an insurance liability► Financial instrument

► ‘Premiums’ are not revenue► Changes in deposits (balance sheet)

► Claims are not expenses► Repayment of deposit (balance sheet)

► Movements in deposits not in P&L


Discretionary Participation FeatureA contractual right to receive, as a supplement to guaranteed benefits, additional benefits:(a) that are likely to be a significant portion of the total contractual benefits;(b) whose amount or timing is contractually at the discretion of the issuer; and(c) that are contractually based on:

(i) the performance of a specified pool of contracts or a specified type of contract;(ii) realised and/or unrealised investment returns on a specified pool of assets held by the issuer; or(iii) the profit or loss of the company, fund or other entity that issues the contract.

Guaranteed benefits- Payments or other benefits to which a particular Policyholder or investor has an unconditional right that is not subject to the contractual discretion of the issuer.


Product Classification

Embedded Derivatives


Product classification

► Product classification determines the accounting treatment for contracts during phase 1.

► Product Classification► A major exercise for insurance companies► A hot topic for the future as product complexity increases► Solutions developed to address complex classification

issues


*Subject to certain modifications**Possibly with separate

accounting for service component

Product classification is very important as it defines the accounting treatment for the issued contracts by an insurer. The following chart provides an overview of the accounting treatment for different types of contracts as a result of product classification.

Amortised Cost-or-

Fair Value**

Amortised Cost-or-

Fair Value**

ExistingAccounting*

ExistingAccounting*

SLFRS 4SLFRS 4

Insurancecontracts

LKAS 32/39Recognition and

Measurement

LKAS 32/39Recognition and

Measurement

ExistingAccounting*

ExistingAccounting*

SLFRS 7 for DisclosureSLFRS 7 for Disclosure

Discretionary Participation Investment contracts

Investment contracts



Impact On The Financial Statements

If Contract qualify as Insurance Contract

GWP Insurance Liability

Deposit Liability

GWP Investment Liability

If Contract qualify as Investment Contract


Flowchart of Product Classification

Is there significantinsurance risk present

in the contract?

Is there adeposit component to the

contract? If so, is the deposit componentindependent of the insurance

cash flows?

Are any elements ofthe benefit driven by discretionary

participation

Insurancefeatures present

in contract

Classified as aninvestment contract

Deposit component

Yes

No

Insurance and depositcomponents of contract must,

if not recognised, be unbundled and valued

separately

Yes

No

Insurancecomponent

Product is an InvestmentContract without discretionary

participation features

Product is anInsurance Contract

Product is an InvestmentContract with discretionary

participation features

Yes

No

SLFRS 4

SLFRS 4

LKAS 39


Based on the definition of an insurance contract, an insurance contract must have all of the following three characteristics:


1. Uncertain future events (Insured event)

2. Transfers significant insurance risk from the policyholder to the insurer

3. Adverse effect on the policyholder


Insurance product Analysis- scenario 01

Unit Link Product

Maturity Value/Surrender value

Unit value/Fund value

Death Benefit 100.1% of the unit value

Conclusion

If the insured event affect adversely to the policyholder, Mortality risk is 0.1% of the unit value which is not significant means that contract does not transfers significant insurance risk from the policyholder to the insurer.

This contract can be considered as an Investment Contract



Unit Link ProductMaturity Value/Surrender Value

Unit value/Fund value

Death Benefit greater of:(a) unit value of an investment fund (equal to the amount payable on surrender or maturity); and(b) guaranteed minimum

ConclusionExcess of guaranteed minimum over unit value is a death benefitThis meets the definition of an insurance contract (unless the life-contingent payments are insignificant) .



► bb

Single Premium ContractMaturity Value/Surrender Value

Fund value

Death Benefit 5 times of the initial premium

ConclusionInsurer could suffer a significant loss on an individual contract if the policyholder dies early.

This meets the definition of an insurance contract.



► bb

Single Premium ContractMaturity Value/Surrender Value Initial Premium + 12% Interest per Annum

Death Benefit Initial Premium + 12% per interest Annum + 2 times of the initial premium





► bb

Single Premium ContractMaturity Value/Surrender Value No

Death Benefit 20 times of the initial premium




Embedded Derivatives

► LKAS 39 require an entity to separate some embedded derivatives from their host contract, measure at fair value and include the changes in FV in the P&L.

► An insurer need not account for an embedded derivative separately at fair value if the embedded derivative meets the definition of an insurance contract.

► LKAS 39 will apply to all other instances- embedded derivative and are not closely related to the host contract need to be measured at fair value.

Embedded Derivative

A component of a hybrid instrument that includes both a derivative and a host contract – with the effect that some of the cash flows of the combined instrument vary in a similar way to a stand-alone derivative.


IFRS 4 embedded derivative flow chart

Yes

No

No

Yes

YesDo not separate

Does the feature meet the definition of Insurance

Contract?

NoDo not separate

Does the feature meet the definition of a derivative?

Yes

Do not separateclosely related?

Separate and value at Fair Value

No

Host contract at FVTPL?

Do not separateYes

Does it look and feel like an embedded derivative?

No actionNo


Embedded derivatives – examples

Separate and fair value

Examples:► Equity index feature

in fixed principles savings plan

► Guaranteed accumulation value in unit linked plan payable on death as well as maturity

Fair value treatment not required

Is it insurance? or

fixed/cash surrender

Examples:► Unit-linked guaranteed

minimum income benefits

► Guaranteed minimum death benefits (e.g., Ratchets)

► Guaranteed annuity options

Yes

Yes

1. Is it an embedded derivative

► Value changes with underlying► Little or no net investment► Settled at future date

2. Is it ‘not closely related’ to host

► Such as an equity index-link on a debt host instrument

► Create interest-rate risk and is leveraged

3. Is it not already at fair value

► Contract is at a mortised cost or accounted at measure other than fair value

Examples:► Interest rate floor in fixed interest rate contract► Option to renew contract

Se

pa

rati

on

cri

teri

a

No

No

Contemporary Issues


Unbundling of deposit component

So when do you unbundle?Unbundling is required only if both the following conditions are met :

► The insurer’s existing accounting policies do not require recognition of the deposit component and

► The insurer can independently measure the deposit component from the insurance component

Unbundling is allowed but not required when the insurer only meets the second condition that the insurer can independently measure the deposit component from the insurance component.

It means unbundling may be required when insurance benefit cash flows do not affect the deposit-like cash flows at all. If any grey areas exist, or if there are difficulties in unbundling, then do not unbundle.

Unbundle- Account for the components of a contract as if they were separate contracts


Unbundling of deposit component

Impact On The Financial Statements

If Unbundled If not Unbundled


Deposit Liability



Liability Adequacy Testing

► Recognition of future losses required► A deficiency is indicated when future cash flows exceed the net

carrying amount► For insurance contracts, existing liability adequacy tests apply unless

they fail to meet the IFRS 4 minimum requirements, in which case an SLAS 36- Provisions, contingent assets and contingent liabilities measure apply

Liability Adequacy Test- An assessment of whether the carrying amount of an insurance liability needs to be increased (or the carrying amount of related deferred acquisition costs or related intangible assets decreased), based on a review of future cash flows.


Liability Adequacy Test - LAT

► Temporary First-Aid bandage► In some countries the local tests might not be adequate► Inverse impairment test

► Two routes► Local test if SLFRS 4 minimum criteria are met:

► Use current estimates of all cash flows► Current estimate is not discounting

► ‘Consider’ options and guarantees► ‘consider’ is not measuring ► time value? What about New Money?

► Use LKAS 37 rules

► Discounting: what yield curve?► Relation to local regulatory test


In some accounting models, realised gains or losses on an insurer's assets have a direct effect on the measurement of some or all of

its insurance liabilities, related deferred acquisition costs and related intangible assets,

An insurer is permitted, but not required, to change its accounting policies so that a recognised but unrealised gain or loss on an asset affects those measurements in the same way that a realised gain or loss does. The related adjustment to the insurance liability (or deferred acquisition costs or intangible assets) shall be recognised in other comprehensive income if, and only if, the unrealised gains or losses are recognised in other comprehensive income. This practice is sometimes described as 'shadow accounting'.

Shadow accounting


‘Shadow accounting’ – Example at transition date, AXA

Source: AXA

Changes in Accounting Policies.


Changes in Accounting Policies

► An insurer may change its accounting policies for insurance contracts if, and only if, the change makes the financial statements more relevant to the economic decision-making needs of users and no less reliable, or more reliable and no less relevant to those needs. An insurer shall judge relevance and reliability by the criteria in LKAS 8


Prohibited in Phase I

► Phase 1► No catastrophe/equalisation reserves► No Netting of reinsurance against gross numbers► No change to less relevant/reliable

► So – DO NOT► Stop discounting► Introduce extra prudence► Start to recognise future investment margins► Start to use less uniform accounting in consolidation

Business Consideration


Business considerations

► Additional complexity in Finance processes and system calculations

► Better communication and alignment between the Investment function and Finance is required – the business activity should reflect the accounting classification and vice versa

► Certain funding instruments less attractive► Greater balance sheet and potentially greater P&L volatility► Actuaries and accountants need to work closer to source and

calculate additional risk related disclosures► Product development teams need to be aware of changes, in

particular for product classification and guarantees

Thank You.

Managing the Transition SLFRS – 4. © 2010 EYGM Limited Managing The Transition Slide 2 Managing...

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