U.S.

GAAP, From Basic Application to Current

Topics Seminar
August 31 September 1, 2009
11A: IFRS for Insurance Contracts; IFRS 4
(Intermediate)
Mark Freedman

IFRS 4, Insurance Contracts

Mark Freedman
Ernst & Young
August 31 September 1, 2009
Society of Actuaries GAAP Seminar

Agenda

Background
Product classification
Insurance contract measurement

Page 2

IFRS guidance for an insurance company balance sheet

Investments:
Equities,
fixed interest,
loans

IAS 39

Property

IAS 40

Investment
contract DAC

IAS 18

Insurance DAC

IFRS 4

PVIF

IFRS 4
Various

Other assets

Equity
Insurance
liabilities and
investment
contracts with
discretionary
participation
features

Various

IFRS 4

Investment
Insurance
Liabilities
Phase
contract
I

IAS 39

Other liabilities

Various

liabilities

Page 3

Phased approach for insurance

There is a phased approach to insurance contracts.

Phase I Implemented 2005

IFRS
INSURANCE
PROJECT
Phase II
Uniform, likely new, insurance
measurement standard

Page 4

Exemption from IAS 8

Absent a specific relevant standard, reporting entities look to IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors for
guidance on adopting accounting policies.
IFRS 4 exempts insurance and investment contracts with
discretionary participation features, but not other investment
contracts, from IAS 8, effectively allowing insurers to continue existing
accounting policies, with certain limitations and modifications.
Insurers are also given relief from the strict requirements of IAS 8 if
they wish to change accounting policies for insurance contracts,
either at the time of adopting IFRS or later. They can make a change
to a policy that is more relevant but not less reliable or more reliable
but not less relevant than the current policy.

Page 5

Key requirements under IFRS 4

Changes in IFRS 4 accounting policies
An insurer may change its accounting policies for insurance contracts if, and only if, the
change makes the financial statements:

more relevant and no less reliable, or

more reliable and no less relevant
An insurer shall judge relevance and reliability by the criteria in IAS 8.
Relevance economic decision-making needs of users
Reliability

represent faithfully the financial positions, financial performance and cash flows of the
entity

reflect the economic substance of transactions, other events and conditions, and not
merely the legal form

are neutral, ie free from bias

are prudent; and

are complete in all material respect

Page 6

Agenda

Background
Product classification
Insurance contract measurement

Page 7

Product classification - Why is it important?

Product Classification defines accounting treatment

Phase I
Insurance contracts
Existing
Existing
Accounting*
Accounting*

Discretionary Participation
Investment contracts
Investment contracts
Existing
Existing
Accounting*
Accounting*

*Subject to certain modifications

Amortised
Amortised Cost
Cost
-or-orFair
Fair Value**
Value**

**Possibly with separate accounting

for service component
Page 8

Classification flowchart

Classified as an
investment contract

Are any elements of

the benefit driven by discretionary
participation

No

Deposit component

Product is an Investment
Contract with discretionary
participation features

Yes

No
Product is an Investment
Contract without discretionary
participation features

Insurance and deposit

components of contract must, if
not recognised, be unbundled
and valued separately

Is there significant
insurance risk present
in the contract?

Yes

Insurance
features present
in contract

Yes

Is there a
deposit component to the
contract? If so, is the deposit component
independent of the insurance
cash flows?

Insurance
component

No

Product is an
Insurance Contract

Page 9

Definition of insurance

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.
IFRS 4.Appendix A

The same definition and tests apply to reinsurance.

Page 10

Insurance versus financial risk

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 nonfinancial variable that the variable is not specific to a party to the
contract.
Insurance risk is risk, other than financial risk, transferred from the
holder of a contract to the issuers
If both financial risk and significant insurance risk are present,
contract is classified as insurance.

IFRS 4.Appendix A

Considered over life of the contract including option periods

Page 11

Significant insurance risk

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.
Additional benefits must be for pre-existing risk and do not
include:

Charges that would be made on cancellation or surrender

Loss of ability to charge policyholder for future services (e.g., if a
contract terminates on death)
Possible reinsurance recoveries as these are classified separately

IFRS 4.Appendix B22 - B28

Page 12

Significant insurance risk

Additional benefits include timing risk

Whole life contract (payment known, timing unknown) has additional

benefits
Contract where death benefit is equivalent to maturity benefit (i.e.,
maturity benefit adjusted for time value of money) does not have
additional benefits

Classification on a contract by contract basis

Contracts entered into simultaneously with the same policyholder count as

one contract
Products may be classified homogeneously on materiality grounds

IFRS 4.Appendix B22 - B28

Page 13

Quantitative measures

No quantitative guidance given.

Rules of thumb currently being adopted for internal consistency

Benefit paid on death exceeds benefits payable on survival by more than

x% (term assurance)
Plausible scenario exists under which the death benefit exceeds the
survival benefit by x% or more at any time during the policy term
(guaranteed minimum death benefit in unit-linked contract)
Benefit payable on survival exceeds the benefit payable on death by more
than x% (pure endowment, life contingent annuity)
The ultimate result on reinsurance may exceed x% of premium earned by
reinsurer.

Page 14

Examples of significant insurance risks

Insured Event Occurrence and Cost

Significant Insurance Risk?

Significant additional benefits payable under insured event

YES

Costly and feasible event in scenario of commercial substance

even if it is extremely unlikely

YES

Waiver on death of surrender charges

NO

Loss of ability to charge for future services

NO

Unfeasible event in any scenario of commercial substance

NO

Contingent amount to be paid is insignificant in all scenarios of

commercial substance

NO

Page 15

Comparison to US GAAP

US GAAP classification

IFRS classification

SFAS
SFAS 60,
60, SFAS
SFAS 97
97 Limited
Limited
Payment,
SFAS
Payment, SFAS 120
120

Insurance
Insurance

SFAS
SFAS 97
97 Universal
Universal Life
Life

Generally
Generally Insurance
Insurance

SFAS
SFAS 91,
91, SFAS
SFAS 97
97 Investment
Investment

Insurance
Insurance or
or Investment
Investment

(depending
(depending on
on significance
significance of
of insurance
insurance risk)
risk)

Page 16

Examples of insurance and financial risks

Insurance - significant insurance risk

Most property/casualty insurance contracts
Term assurance and pure endowment assurance
Life contingent annuities
Whole life contracts
Variable annuities with significant death benefit
Fixed or variable (unit-linked) with significant life contingent annuity
guarantee
Most reinsurance contracts
Financial guarantees of specific third party debts

Page 17

Examples of insurance and financial risks

Investment - insignificant insurance risk

Reinsurance contracts that do not transfer any significant reinsurance

risks
Short-term endowment contracts
Variable or unit-linked without significant death benefit (e.g. 101% value
of units)
Pension accumulation contracts without significant death benefits
Contract exposed to lapse or expense risk only
Financial derivatives
Deferred annuity with no life contingency or insurance guarantee
Guaranteed investment contract or bond
Product warranties issued directly by manufacturer
Reinsurance catastrophe bonds with triggers not directly related to the
issuers losses
Financial guarantees linked to credit index

Page 18

Examples of insurance and financial risks

Classification unclear
Pensions with return of premiums on death
Property/casualty with experience payments/rating mechanisms
Experience-rated group business, with premium deficit recoverable
or significant premium stabilization reserve
Waiver of surrender charge on death
Products with rider options

Page 19

Change in level of insurance risk

Once insurance, always insurance, but can go from investment to

insurance
Investment may change to insurance through:

Switch between funds, first fund has no insurance risk second fund has insurance
risk
Take up of option to increase insurance risk
IFRS 4.Appendix B.29-30

INVESTMENT

INSURANCE

Page 20

Unbundling
*Likely none in North America
Classified as an
investment contract

Are any elements of

the benefit driven by discretionary
participation

No

Deposit component

Yes

Product is an Investment
Contract with discretionary
participation features.*

No
Product is an Investment
Contract without discretionary
participation features

Insurance and deposit

components of contract must, if
not recognised, be unbundled
and valued separately

Is there significant
insurance risk present
in the contract?

Yes

Insurance
features present
in contract

Yes

Is there a
deposit component to the
contract? If so, is the deposit component
independent of the insurance
cash flows?

Insurance
component

No

Product is an
Insurance Contract

Page 21

When do you unbundle?

Unbundling seperate presentation and measurement of insurance and investment

component.
Some insurance contracts contain both an insurance component and a deposit component.
In some cases, an insurer is required or permitted to unbundle those components:

Unbundling is required when:

The insurers 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 when the insurer can independently measure the

deposit component from the insurance component

IFRS 4.10 12

Unbundling is intended to require recognition of deposit elements of contracts

that in some accounting regimes were not reflected, such as in some
catastrophic reinsurance arrangements. Given the requirements of US GAAP,
this will have little effect on US insurers.

Page 22

Unbundling examples
Traditional
insurance
contracts

Insurance

cash flows are integrated with deposit cash flows and contract should not
be unbundled
Where term assurance is attached and premium is recorded for joint contract and
practicably inseparable, then contract will not be unbundled.
Where term assurance is attached and premium is recorded separately, then
contract will be unbundled.

Unit-linked
contracts

Cost of life cover made through charges to fund. Unbundling is complex and
therefore would not be required
Where separate risk premium for fixed death benefit, then unbundling required.

Rider
benefits

Some riders interact with underlying contract. Some riders do not.

Rule of thumb:
If premium is from fund do not unbundle
If separate premium unbundle - really treat as separate contracts
If the rider benefit is insurance and the underlying contract is insurance, then there is
no need to unbundle.

Page 23

Discretionary participation features (DPF)

Classified as an
investment contract

Are any elements of

the benefit driven by discretionary
participation

No

Deposit component

Yes

Product is an Investment
Contract with discretionary
participation features

No
Product is an Investment
Contract without discretionary
participation features

Insurance and deposit

components of contract must, if
not recognised, be unbundled
and valued separately

Is there significant
insurance risk present
in the contract?

Yes

Insurance
features present
in contract

Yes

Is there a
deposit component to the
contract? If so, is the deposit component
independent of the insurance
cash flows?

Insurance
component

No

Product is an
Insurance Contract

Page 24

Definition of DPF

Contractual

right to additional payments as a supplement to

guaranteed minimum payments

Likely to be a significant portion of the total contractual payments.

Amount or timing is contractually at the discretion of the issuer
Contractually based on

Performance of a specified pool of contracts or a specified type of contract

Realised and / or unrealised investment returns on a specified pool of
assets held by the issuer
Profit or loss of the company, fund or other entity that issues the contract
IFRS 4.Appendix A

Page 25

Measurement of DPF

Investment contracts with discretionary participation features are

measured under IFRS 4
Investment contracts without discretionary participation features
are measured under IAS 39

Investment management services separated and measured under IAS 18

IFRS 4.2

Page 26

Agenda

Background
Product classification
Insurance contract measurement

Page 27

Insurance contract measurement

During Phase I, existing accounting policies apply with certain

modifications

Prohibited certain accounting policies are prohibited as they do not meet

the IFRS framework
Mandated certain accounting policies must be implemented if they are not
already in the existing accounting policies
Allowed to continue, but not start certain accounting policies that do not
meet the IFRS framework can continue, but cannot be implemented.
Can be started certain accounting policies can be introduced.

Page 28

Prohibited policies

The following accounting policies are prohibited

Amounts for catastrophe provisions for potential claims beyond the term
of existing contracts
Amounts for claims equalisation provisions
Offsetting of reinsurance assets and direct liabilities

IFRS 4.14

This is no different from US GAAP.

Page 29

Mandated policies

The following accounting policies are mandated if they are not

already present

Liability adequacy testing

Impairment of reinsurance assets

IFRS 4.14

Page 30

Mandated Policies:
Liability adequacy test

Current liability adequacy test applies if

Test at each reporting date using current estimates of future cash flows
(including guarantees and options)
If these are greater than current liability, liability is increased and
deficiency flows through profit and loss

Otherwise Liability Adequacy Test under IAS 37 Provisions,

Contingent Assets and Contingent Liabilities

Fair value like calculations

IFRS 4.15-19

US companies may have to change loss recognition policies for

deferred annuities that are insurance contracts under IFRS but
investment contracts under US GAAP to avoid having them fall under
IAS 37.

Page 31

Mandated Policies:
Impairment of reinsurance assets

Reinsurance asset is reduced and reduction flows through income

statement if it is impaired
Reinsurance asset is impaired if:

Objective evidence of an event after initial inception that the cedant may
not receive all amounts due to it
The impact of the event can be reliably measured

Impairment may be reversed

IFRS 4.20

This guidance is similar to US GAAP.

Page 32

Policies that may continue

The following accounting policies may continue but companies

may not switch to these where they are not already applied

Using an undiscounted liability basis

Measuring future investment management fees at a value greater than the
acquisition costs
Using non-uniform accounting policies for subsidiaries
Using excessive prudence in the valuation of liabilities

IFRS 4.25

Page 33

Policies that may be started

The following accounting policies can be started subject to certain

restrictions

Use of current market discount rates and use of other current variables for
selected liabilities
Use of shadow accounting
Use of asset based discount rates
Only if part of a comprehensive accounting policy which makes
financial statements more relevant and reliable

An example is the adoption of FAS 60 for the

measurement of liabilities for traditional policies. If FAS
60 is more relevant or more reliable than the existing
accounting policy, then discounting at asset yields is
acceptable.
Page 34

Current market interest rates

Measure liabilities using current market interest rates

Current market interest rates

Can include investment spreads only if already included

Otherwise presumably risk free rates

Can move to using current assumptions for other variables at the same
time
Can be performed for any designated liabilities
All changes in liabilities must flow through income statement

IFRS 4.24

The ability to use current assumptions for variables that are locked in
under current accounting policies is intended to allow for movement
in liabilities that is more consistent with movement in investments, as
assets are generally measured at fair value.

Page 35

Shadow accounting

Shadow accounting

Quantify impact of realising gains on liability and related assets

If unrealised gains flow through P&L the effect on the measurement of
liabilities and related assets flows through P&L
If unrealised gains flow through equity as OCI the effect on the
measurement of liabilities and related assets flows through equity as OCI

IFRS 4.30
The use of shadow accounting is new to many companies not using US GAAP. The point
that the treatment of shadow movement follows the treatment of unrealized gains and
losses (ie, through P&L or in OCI) is the common application of the guidance in IFRS 4.

Page 36

Insurance contracts with DPF

Distributable surplus must be classified as liability or equity

Disclosure of movement in statement of equity if any distributable surplus

classified as equity
Distributable surplus classified as liability taken into account in liability
adequacy test

IFRS 4.34

This means, for example, that a PDO associated with a closed block
of contracts from a demutualized company could be reported as a
component of equity rather than as a liability. Few insurers in Europe
took the alternative to classify distributable surplus as equity and it is
doubtful that US insurers will find this attractive.

Page 37