Sessional research event Anthony Coughlan and Kamran Foroughi

Sessional research event Anthony Coughlan and Kamran Foroughi, on behalf of the IFRS Working Party Insurance accounting: A new era? London, 11 April 2011 © 2011 The Actuarial Profession www. actuaries. org. uk

Working Party background and introductions • Set up in May/June 2010, following request from Life PEC • Purpose to: – – • Describe Insurance Contracts ED and other recent IASB developments Set out key issues for life insurers (much also relevant to non-life insurers) Compare Proposed IFRS measurement model with Solvency II and MCEV Consider possible future role of supplementary reporting Link to working party paper: https: //www. actuaries. org. uk/sites/all/files/documents/pdf/110411110511 combined. pdf Working party members Chris Barnard Raymond Bennett Darren Clay Edward Conway Steve Corfield Anthony Coughlan Kamran Foroughi (Chair) James Harrison Gary Hibbett Irina Kendix Marylène Lanari-Boisclair Chris O’Brien Jeremy Straker © 2011 The Actuarial Profession www. actuaries. org. uk 1

Agenda • Existing and proposed IFRS • Exposure Draft: Review of measurement model and issues arising • Conclusions and future role of supplementary reporting • Comments and questions © 2011 The Actuarial Profession www. actuaries. org. uk 2

Existing IFRS IAS 18: Revenue IFRS 4: Insurance Contracts Intangibles / DAC Property Equity Other Liabilities Debt IAS 39: Financial Instruments Recognition and measurement IAS 32: Financial Instruments Presentation Financial Instruments IFRS 7: Financial Instruments Disclosures Assets Contract Liabilities IAS 12: Income Taxes IAS 19: Employee Benefits IAS 39: Financial Instruments Recognition and measurement IFRS 4: Insurance Contracts IAS 39: Financial Instruments Recognition and measurement Investment Contracts Liabilities = standard undergoing major review with implications for insurers • Other IASB projects also impact insurers, for example: – Fair value measurement framework – Disclosures, in particular to the Statement of Comprehensive Income © 2011 The Actuarial Profession www. actuaries. org. uk 3

Proposed IFRS – key developments Insurance contracts ED (to replace IFRS 4) IFRS 9: Financial instruments (to replace IAS 39) • Classification and measurement of financial assets - Fair value or Amortised cost only • Liability deposit floor retained; affects business classified as “investment contracts” Revenue recognition ED (to replace IAS 18) • Affects business classified as “investment contracts” • Exposure draft removed deferral of acquisition costs • 2 February Board meeting considered permitting retention of DAC incremental at contract level Fair value measurement ED (new standard defining how to fair value) • “. . . the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date” • The fair value of a liability should reflect the effect of non-performance risk (i. e. own credit risk) © 2011 The Actuarial Profession www. actuaries. org. uk 4

Exposure Draft: The building block approach Probability weighted best estimate cash flows Contract liability Residual Margin Risk Adjustment • Current and entity specific assumptions for non-market variables • No deposit floor Allowance for time value of money • Consistent with observable market prices for instruments with cash flows whose characteristics reflect the liability (includes an illiquidity premium) Risk adjustment Discounted probability weighted estimate of fulfilment cash flows • “the maximum amount the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows exceed those expected” • Only three permitted methods and “portfolio level” diversification Residual margin • Separate risk and residual margin (no composite margin) • Set to eliminate gain at inception. Day one loss recognised immediately • Estimated at cohort level – similar inception date and coverage period • Earned over coverage period with no subsequent re-measurement © 2011 The Actuarial Profession www. actuaries. org. uk 5

Exposure Draft: Review of measurement model Measurement approach • Spectrum of insurance accounting models: elements of deferral-and-matching and economic value approaches • ED model is a hybrid between the two approaches, for example: – Expected value using current estimates – Residual margin eliminates day 1 profit and is earned over the coverage period – Restricted diversification benefit in the risk adjustment Volatility and discount rates • Accounting versus economic mismatches • Alternatives proposed by industry: – Subsequent re-measurement of the residual margin? – Locked-in liability discount rate where assets measured at amortised cost? – Presentation – Use of OCI rather than taking all changes to net income? • Recent Board meeting: “top down” vs. “bottom-up” discount rate approaches © 2011 The Actuarial Profession www. actuaries. org. uk 6

Exposure Draft: Review of measurement model (continued) Paper discusses following possible mismatches: • FV “orderly transaction” principle vs. ED calibration to observable market prices • Non-performance or own credit risk • Illiquidity premium and viability of investment strategies in extreme market conditions • Inconsistency between the IAS 12 tax measurement and ED measurement model Risk adjustment • Appears to introduce exit value concept from the insurer’s own perspective • 21 March Board meeting principle changed to: “compensation the insurer requires to bear the risk that the ultimate fulfilment cash flows exceed those expected. ” • Diversification benefit Residual margin • Unit of measurement increases likelihood and potential level of day one losses • Amortisation pattern © 2011 The Actuarial Profession www. actuaries. org. uk 7

Timeline 2010 2011 IFRS (1) Insurance contracts Financial instruments Final standard Solvency II Revenue Recognition Draft Omnibus II Directive Level 2 Implementing measures Level 3 Technical guidance • (1) The Possible effective date of 1 January 2015 Expected effective date of 1 January 2013 Final standard Level 1 2013 -2015 Effective date of 1 January 2013? Final standard Fair value measurement 2012 Expected effective date no earlier than 1 January 2013 Effective date of 1 January 2013 effective date of all IFRS standards is subject to EU endorsement and the IASB transition project © 2011 The Actuarial Profession www. actuaries. org. uk 8

Other Insurance Contract ED issues arising for UK life insurers Topic Exposure Draft position Why is this an issue? Transitional arrangements Change from the Existing IFRS liability to Proposed IFRS liability (defined to exclude residual margin) released to shareholder equity • Combined with excluded cash flows, creates future losses on in force books • Conservative risk adjustment? • IASB has indicated that this aspect of ED will change, but to what? Excluded expense cash flows General overheads and all acquisition costs not incremental at contract level excluded from PV of the fulfilment cash flows • Narrower definition than Existing IFRS resulting in increased new business strain • Recent IASB Board meeting (2 February) considered permitting acquisition costs incremental at the portfolio level Unbundling required where components not “closely related” to the insurance coverage. • “Closely related” not defined and so could be subject to different interpretation • Fundamental to the measurement of the liabilities and recognition of profit • Practical challenges © 2011 The Actuarial Profession www. actuaries. org. uk 9

Other Insurance Contract ED issues arising for UK life insurers (continued) Topic Exposure Draft position Why is this an issue? Contract boundaries • Contract boundary triggered by pricing reassessment at “policyholder” level • Generally preferred to QIS 5 definition, but some unintended consequences • Recent IASB Board meeting (21 -22 March) considered a “contract renewal” definition Participating business • Para. B 61(j): include liabilities for future policyholders • Contradicted elsewhere • Clarification of the treatment of surplus assets in a with-profits fund required • Estate is a main source of capital for a mutual Presentation and disclosures • Summarised margin presentation • Focus on liability side of the balance sheet rather than capturing the full interactions • Reconciliation of contract balances • Mixes an analysis by source of surplus and by source of cash flow • Risk adjustment confidence level disclosure • Significant additional work for European insurers for little or no benefit © 2011 The Actuarial Profession www. actuaries. org. uk 10

Implications for new business earnings Illustrative pre-tax earnings profile for an immediate annuity • No day 1 profit due to residual margin. Possibility for day one loss given potential differences between the ED discount rate and the pricing discount rate • Non-incremental acquisition costs expensed at inception • Profits deferred and released with the residual margin over the life of the contract © 2011 The Actuarial Profession www. actuaries. org. uk 11

Conclusions We welcome many aspects of the Exposure Draft including: • Development of single accounting practice and measurement model • Inclusion of expected cash flows and explicit risk adjustment • Current estimates based on observable prices for market variables and entity specific assumptions for non-market variables • Potential for fewer accounting mismatches However, we have identified a number of issues with the measurement model: • Challenges in understanding hybrid nature of model • Significant volatility may arise • May be hard to distinguish between accounting and economic mismatches • Risk adjustment and residual margin proposals raise number of concerns © 2011 The Actuarial Profession www. actuaries. org. uk 12

Future role of supplementary information? Shift in reporting emphasis in recent years. . . • Greater focus on IFRS earnings as a headline earnings metric • Increased focus on the amount and timing of expected cash flows Will Proposed IFRS and Solvency II meet investors’ needs? • Proposed IFRS – Hybrid approach – negative value of new business, volatility – Limitations in minimum presentation standards – No information on free surplus or cash flows • Solvency II QIS 5 – Is this an economic approach? – Focus on capital ratios, what about equity and performance statement? – No information on free surplus or cash flows © 2011 The Actuarial Profession www. actuaries. org. uk 13

Questions or comments? Expressions of individual views by members of The Actuarial Profession and its staff are encouraged. The views expressed in this presentation are those of the presenters. © 2011 The Actuarial Profession www. actuaries. org. uk 14