International Accounting Standards for Life Insurance Companies Michael Ross 17 July 2003

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Contents What is the background? In particular, what is the history, scope and reactions What is the approach to calculating the reserves under the proposed standard for a life insurer? What are the implications of the new approach for life insurers? 2

Contents What is the background? In particular, what is the history, scope and reactions What is the approach to calculating the reserves under the proposed standard for a life insurer? What are the implications of the new approach for life insurers? 3

The need for consistent global standards No-one now questions the need for more effective, more economical and standardised financial reporting worldwide Historic reporting based on historic cost has often failed to reflect important changes in trading or financial conditions Several types of transactions utilise deferral and matching or ‘smoothing’ approaches e.g. revenue accounting and ‘premium basis’ reserving Many practices also non-transparent with little disclosure

However the global standards now being introduced are intended to present reality from a more consistent but also more volatile market-value-based perspective 4

Towards a global standard The common and agreed goal - consistent global accounting standards; getting agreement as to ‘how’ is not always so easily achieved The drive for these latest developments has come primarily from the EU and from stock exchanges around the world Resistance has come especially from the financial services One of the biggest hurdles is also US GAAP – itself a widely used standard for international groups, but still imperfect

Historically regulators, fiscal authorities and other bodies have also usually based their own requirements on annual audited company accounts (with variations) – will they also in future? 5

Who is involved – international bodies (1) l

The International Organisation of Securities Commissions (IOSCO) - established in 1974, comprises all the major Security Exchange Regulators

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The International Association of Insurance Supervisors (IAIS) founded in 1994 - includes Hong Kong and all other major market regulators from 120 countries

l

The International Actuarial Association (IAA) - established in 1895 for individual actuaries, but now re-formed national associations

6

Who is involved International Accounting Standards Board ("IASB") Formed in 1973 with the objective …. "To produce a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements"

l l l l

l Independent and privately-funded Insurance project (1997) l 41paper International Issues (Nov 1999) Accounting Standards (“IAS”) or International Financial reporting Standards (“IFRS”) so far Comments (May 2000) Draft Statementadopted of Principles l Already in (Dec some countries as domestic standard 2001 – Jul 2002)

and often accepted on stock markets for foreign listed companies

l

The Board co-operates with national accounting standard setters to achieve convergence in accounting standards 7

Global position June June2002: 2002: proposal proposaltoto allow allowIAS IASfor forforeign foreignlisted listed companies in 2005 without companies in 2005 without reconciliation reconciliationtotoCanadian CanadianGAAP GAAP

June June 2002: 2002: EU EU listed listed companies companies reporting reporting under under IAS IAS in in 2005 2005

China China –– IAS IAS ifif listed listed July July2002: 2002:FASB FASB Agreement Agreementto tohave have USGAAP USGAAPand andIAS IASto to resolve resolvedifferences differences

Hong Hong Kong Kong -IFRS IFRS permitted permitted June June2002: 2002: adoption adoptionof of IAS IASfor for domestic domesticentities entitiesinin2005 2005 8

IASB Insurance project l

Development of IFRS for insurance contracts

The story so far…… l l

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Insurance project (1997) Issues paper (Nov 1999)

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Comments (May 2000) Draft Statement of Principles (Jul 2002)

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IASB discussion (Jul 2002 - now)

May 2002: interim solution proposed for IFRS : Ø Phase I 2005 (?): temporary recognition existing GAAP for insurance Ø Phase 2 2007 (?) onwards – new IFRS All exiting IAS/IFRS apply

9

Key aspects of Phase 1 l

Any contracts that fall within the definition of an insurance contract (except for those covered by other IFRS’s) shall be subject to Phase I

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Local measurement standards will in general be permitted under Phase I . There are certain exceptions.

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Continuation of existing practices will be permitted including deferral of acquisition cost and the use of embedded values

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Disclosures will be required that identifies and explains the reporting of insurance-contract-related amounts, helps understand the estimated amounts and fair value of insurance liabilities as at 31 December 2006

10

IAS treatment assets and liabilities Assets

Liabilities

IAS 39

Is it an insurance contract? Yes Phase 1: Local Current GAAP GAAP

2005 fair value/ amortised cost

actuarial reserves

Yes Phase 2: Insurance Insurance IFRS IAS

No IAS IAS39 39

2007? fair value

fair value/ amortised cost

11

What is an insurance contract? “contract under which one party (The insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event ) adversely affects the policyholder or other beneficiary” Risk is significant if “ a reasonable possibility exists that an event affecting the policyholder will cause a significant change in the present value of the insurer’s net cash flows …” Ø

Determined on contract by contract basis Ø

Ø

Insurance if significant loss possible in one foreseeable scenario One way classification: once insurance always insurance

Main issues Definition of “significant” and “reasonable possibility” l

l

Ensure consistency in local markets

Application of IAS 39 to investment contracts l

12

Insurance contracts and scope Insurance (significant risk) Ø Ø Ø Ø Ø Ø Ø Ø

Whole of life Endowments Annuities Term insurance Disability Health Credit insurance Reinsurance

Insurance but outside scope Ø

Ø

Ø

Financial guarantees (under discussion) (IAS 37,39) Product warranties issued directly by a manufacturer or others (IAS 18,37) Retirement benefit obligations and related assets (IAS 19,26)

Not insurance Ø

Insurance contracts that have little insurance risk

Ø

Financial reinsurance

Ø

Group contracts where all risks are passed on

Ø

Self-insurance

Ø

Gambling

Ø

Financial derivatives 13

Phase 1: companies still face a number of issues despite use of local GAAP Mismatch A&L Asset Management Fees

Participating features

Unbundling

Embedded derivatives Amortised cost/ Fair value

DAC Loss recognition

Reinsurance Disclosure 14

Phase 2 l l

l

Based on the DSOP’s Identify and measure directly individual assets and liabilities rather than creating deferrals of inflows and outflows Implemented in 2006

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DSOP contents Chapter

Title

Chapter

Title

1

Scope

8

Reinsurance

2

Overall Approach, Recognition and Derecognition

9

Measurement of direct insurance contracts by policyholders

3

Measurement: Overall Issues

10

Other assets and liabilities

4

Estimating the Amount and Timing of Cash Flows

11

Reporting entity and consolidation

5

Adjustments for risk and uncertainty

12

Interim Financial Reports

6

Discount Rates

13

Presentation

7

Performance-linked insurance contracts

14

Disclosure

(Note) Titles in blue have not yet been published as at April 2003 16

Phase 2: Fair value accounting Insurance Supervision

Required amount

IAS

Expected value of liability

Fair value liability

MVM Required solvency Net free asset

Shareholder equity

Main elements l Best estimate cash flows plus ‘service margin’ l Discount rate derived from market : ‘risk free’ plus own credit risk allowance l Allowance for future premiums restricted l Profit at inception only if “market evidence”

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Methods of evaluation l l l

All cash flows, including embedded options, required to be modelled and discounted at a risk-free rate 1.15 In many cases, deterministic projections may 1.1 give reasonably reliable answers But stochastic modelling needed for: Ø Ø Ø Ø

l l

Embedded options and guarantees; Benefits that correlate to economic performance Discretionary bonuses related to company profits Other situations where deterministic projections are not sufficient

1.05

1

0.95 0

0.2

0.4

0.6

0.8

1

Many scenarios (1,000 – 10,000) needed with associated projections using market-consistent economic models Fair value now fully replaces the earlier concept of entity-specific value, which has been dropped for this IFRS 18

Risk, uncertainty and discount rates l

l

l

l

Addition of margins to all assumptions for risk and uncertainty that reflect market’s risk preferences (hereinafter “RSA”s – previously “MVM”s) RSAs should always reflect not only undiversifiable risk (systematic risk) but also diversifiable (non-systematic) risk different to asset pricing theories such as CAPM and APT Pre-tax risk free discount rates to be used - consistent with modern financial theory but different to normal practice for embedded values Also the credit rating of the company should be included – however this produces a counter-intuitive and contrary answer for liabilities in that it implies reserves should reduce as the risk of bankruptcy increases. 19

Reactions from the world industry (1) US (Life), German, Austrian, Japanese (Life) /RAA letter: l

Latest joint letter from the above associations submitted February 2003: Ø

Ø

Phase 1 - opposing several of the major changes in Phase 1 l

Scope of Phase 1 and application of IAS 39 should be restricted

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Oppose separation of built in derivatives and use of lossrecognition tests

Phase 2 – comment that l

the study is hasty and premature

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the associations support deferral and matching method and most support deferral of acquisition expenses

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the associations oppose reflection of credit risks 20

Reactions from the world industry (2) October 2002 : 20 world major life insurers’ joint opposition letter l l l l l l

DSOP ignores the unique characteristics of the insurance industry, thus making a change in the business model inevitable This will result in a disadvantageous position of the insurance industry in competition with others for capital resources This could force insurance enterprises to deviate from a longterm and equity-oriented investment strategy Deferral & matching approach plus lock-in necessary for main accounts Fair values, assumptions and sensitivities could be disclosed in notes to the accounts Discounting of outstanding claims also supported 21

Insurance supervisors’ comments l l

l l l

l

IAIS submitted their comments to IASB in June 2002 Insurance supervisors are key stakeholders in an insurance accounting standard, and the standard should take account of a company’s ability to meet its obligations Separation of financial accounting and supervisory accounting should be avoided More conservative measurement methods should be used. Current proposal has practical difficulties – stochastic assessment is difficult, and risk margins cannot be determined by reference to the market. Own credit risks should not be included. Detailed field tests should be implemented – hasty decisions avoided 22

IAA’s reaction l l l

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IAA in general favours proposals in DSOP A sub-group is now developing 23 actuarial standards for Phase 1 Recent discussions on drafting international actuarial practice standards for Phase 2 based on DSOP have not progressed very fast Another sub-group is exploring various methodologies and worked examples – however there remains strong potential for internal disagreement – as with previous alternative approaches to measurement and control of emergence of profitability

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Contents What is the background? In particular, what is the history, scope and reactions What is the approach to calculating the reserves under the proposed standard for a life insurer? What are the implications of the new approach for life insurers? 24

Calculation of fair value liabilities Cash flow items

Approach l

Market value, for deep and liquid markets

l

Must be supportable

l

Professional assessment, otherwise

l

Ø

l

Ø Ø

Must be consistent with current market prices Must be consistent with budgets and forecasts

l

l

Assumptions l

Method l l l

Discounted future cash flows Similar contracts grouped Reinsurance separate

Claims Surrenders Loans Administration and maintenance expenses Premiums

l l

Must be explicit Current and not locked in Cover all future events Ø Ø

l

options legislative changes

Best estimates plus RSA’s 25

Market Risk Preferences (“RSA’s”) l l

Cover all risks, including operational and default Risk types Ø Ø

l

Non-diversifiable, systematic, parameter / model mis-estimation risks Diversifiable, unsystematic, randomness / volatility risks

Market data reflects some non-diversifiable

Two approaches to RSA’s l

Cash flow adjustment Ø

l

Adjust the cash flows to reflect the risk. E.g. increase the mortality charge

Risk discount rate adjustment Ø

Lower the discount rate to reflect the risk 26

Two approaches to discounting Two main methods l

l

Replicating portfolio Ø Market value of a replicating asset portfolio. Stochastic Techniques Ø Mean of the deflated cash flow

Which one? l Use the simplest method allowed for l Product likely to decide

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Two approaches to discounting Replicating portfolio l l

l l

l

Market value of a replicating asset portfolio. Examples Ø

Annuities

Ø

Non-par products

Ø

products with uncomplicated charging structures

Simple to understand, non-stochastic and fast Arbitrage- free pricing Ø

Black-Scholes for equity and option pricing

Ø

Government bonds for risk free rates

Assumptions Ø

portfolio of traded asset cash flows match adjusted liability cash flows

Ø

no investor preference or asset pricing

Ø

Perfect market assumption 28

Example 1 - non linked annuity Replicating portfolio

5,200 5,000

l

4,800 4,600 4,400 4,200

l

4,000 3,800 1

2

3

4

5

Expected cashflow

Year

1 2 3 4 5 6 7 8 9 10

6

7

8

9

Series of risk free (government issued ) zero coupon bonds precisely matching the liability outflow. Sum the market values of the matching zero coupon bonds

10

Risk Adjusted Cash flow

Expected cashflow

Adjusted for risk

4,957 4,909 4,856 4,796 4,729 4,654 4,571 4,479 4,378 4,267 46,596

10 20 31 55 59 75 93 112 132 154 741

Risk Adjusted Cash flow 4,967 4,929 4,887 4,851 4,788 4,729 4,664 4,591 4,510 4,421 47,337

Investment

1 year zero 2 year zero 3 year zero 4 year zero 5 year zero 6 year zero 7 year zero 8 year zero 9 year zero 10 year zero

Market value of investment 4,730 4,471 4,222 3,991 3,752 3,529 3,315 3,107 2,907 2,714 36,738

Assumptions l Assume a risk free rate of 5% l Flat yield curve l All cash flows at end of year

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Example 2 - Guaranteed Equity Bond Product description

Replicating portfolio

The product is an index-linked single premium guaranteed equity bond. The benefit at the end is a return of the initial investment plus any increase in the level of the FTSE 100 index over the period.

l

l

l l

20,000 16,000

l

12,000 8,000

l

4,000 0%

20%

40%

60%

80%

100%

120%

FTSE as a % of Initial level

a zero coupon bond a purchased call option, which on maturity of the bond, gives the insurer the option to buy the FTSE index at the level at which it stood at policy inception

Prices for these can be obtained from the market

Guaranteed Equity Bond Payoff Profile

Policyholder benefit ($)

Replicating portfolio can be constructed as a combination of:

140%

160%

180%

Market value of zero coupon easily obtained and if risk free no further adjustment for risk would be required Price of the call option may not be risk free thus an adjustment for risk would be required 30

Stochastic methods l l

If the liability cash flow is too complex to be able to determine the replicating portfolio, stochastic methods need to be employed. Examples Ø Ø Ø Ø

l

products with complex guarantees such as with-profit policies policies with embedded options Assumptions correlated to economic environment e.g. lapses No market data for RSA’s

The stochastic model is Black Scholes consistent

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Stochastic methods l l

Most commonly discussed stochastic method is the “State Price Deflator method” Deflators can be best described as stochastic discount rates and can be used to calculate fair value of liabilities as follows Ø Ø Ø

Ø

a stochastic asset model is run, the output from which will include a deflator for each time period of each scenario The liability cash flows are projected and adjusted for non-financial risk for each simulation the deflator is applied to the relevant cash flow at each point in time and the values are summed across all projection steps to obtain a deflated value the fair value of the liability is the mean value of the deflated cash flows.

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Example 3 - non-linked annuity Example 1 but using state price deflators instead of the deterministic method Year 1 2 3 4 5 6 7 8 9 10 Deflated Value

l

l

Riskadjusted 4,967 4,929 4,887 4,851 4,788 4,729 4,664 4,591 4,510 4,421

Run 1 0.9867 0.8613 0.8022 0.8126 0.7215 0.6579 0.6279 0.6347 0.5854 0.5007 34,270

Run 2 0.9124 0.9410 0.9097 0.8085 0.8197 0.8094 0.7635 0.6799 0.6637 0.6986 38,054

Deflators Run 3 0.8993 0.8248 0.7677 0.7423 0.6831 0.6663 0.6288 0.5552 0.5506 0.5236 32,586

Run 4 1.0011 0.9826 0.9504 0.8850 0.8658 0.7991 0.7623 0.7773 0.7057 0.6680 39,938

Run 5 0.9433 0.9468 0.9470 0.8527 0.8534 0.7864 0.7493 0.7299 0.6700 0.6824

Number of simulations 5 100 500 1000 5000 Deterministic

Fair value 36,731 36,755 36,744 36,733 36,739 36,737

38,806

The average over the five runs equals 36,731 compared to the deterministic value of 36,737. Ø Reflecting the random statistical error resulting from such a small number of simulations Results converge as the number of stochastic simulations increases

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Contents What is the background? In particular, what is the history, scope and reactions What is the approach to calculating the reserves under the proposed standard for a life insurer? What are the implications of the new approach for life insurers? 34

Getting to grips with fair value l

Implementation

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Communication

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Management

l l

Other uses

High level audit of products Assessment of financial impact Methodology and assumptions Data capture Systems Stochastic modelling Market consistent asset model

35

Getting to grips with fair value Implementation

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Communication Management

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Day-one impact and volatility Enhanced disclosure Can we explain results to our board, customers, shareholders and analysts?

Other uses 36

Getting to grips with fair value l

Implementation l

Communication

l l

Management Other uses

l l

What are the unacceptable risks? Should we change the asset allocation? Should we modify the bonus policy? Should we transfer risk? Should we change the product mix/design? How should we modify corporate governance? 37

Getting to grips with fair value Implementation

Communication Management

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Other uses

l

Regulatory capital? Capital allocation? Internal performance measure? 38

Summary l

IAS is coming and planning will be required before 2005

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Complex issues to address for with-profits

l

Attitude to risks may change

l

Wider applications than just the accounts

l

Impact on day 1 results will depend on nature of the business

l

Volatility of profits is likely to increase 39

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