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The Actuary The magazine of the Institute & Faculty of Actuaries

Insurance: Out with the old…

In 2004, the International Accounting Standards Board (IASB) started Phase II of a project to implement International Financial Reporting Standards (IFRS) for insurance contracts. It aims to address investors’ needs for more reliable and relevant information about profit drivers and business risks.

Proposed timeline
IFRS Phase II began in July 2004 with the setting up of an Insurance Working Group. The IASB published its preliminary views in a discussion paper in May 2007 that launched a public consultation process. Respondents were invited to provide comments on the discussion paper by 16 November 2007. The Board has been analysing the responses to the discussion paper, with an exposure draft expected in 2009. A final standard is not expected until 2011 with implementation likely to be in 2012/2013. This article discusses the likely changes to measuring liabilities for general insurers.

Much of the detail may well change between now and the implementation of IFRS Phase II. However, the change to a valuation of insurance contracts based on current estimates of future cash flows should be considered by management of general insurance companies and actuaries sooner rather than later, both to aid a smooth transition period into the new IFRS world and to assess the impact of the proposals.

Features of the IASB proposal
The IASB proposals are designed to provide a more relevant method of valuing insurance contracts and to use market assessments of expected risks and rewards. The features are:
>> A single measurement model for all insurance and reinsurance contracts
>> Prospective valuation based on estimating the present value of all expected future cash flows
>> A Current Exit Value (CEV) based on the price to transfer the liabilities to another entity.

The CEV is defined as ’the amount the insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another entity’. Typically, the CEV of an insurance liability is not observable, so the Board’s view is that an insurer should measure its insurance liabilities using the following three building blocks:
1. Current estimates. Explicit, unbiased, market-consistent, probability-weighted and current estimates of the contractual cash flows
2. Time value of money. Current market discount rates that adjust the estimated future cash flows for the time value of money
3. Margins. An explicit and unbiased estimate of the margin that market participants require for bearing risk margin and other services, if any – for example, service margin.

Margins: what do they mean in practice?
The building block that poses the most challenging practical concerns is what should be included within the risk and service margins and how they should be determined. The IASB’s view is that the risk margin encompasses the compensation that entities demand for bearing risk. Its objective is to convey decision-useful information about the uncertainty associated with future cash flows. A few approaches to determining a suitable risk margin have been suggested:
>> Confidence interval. There are established techniques – bootstrapping, for example – but further guidance is required to achieve consistency between insurers
>> Cost of capital. There are difficulties in calculating the capital required to support the reserves over time and the associated cost of holding that capital, but this approach is in line with current Solvency II proposals
>> Assumptions-based. For example, proportion of current estimate. This is a simple approach but it fails to meet the IASB’s proposed criteria for a risk margin.

Diversification between portfolios cannot be taken into account when estimating risk margins, although what this means in practice is still under discussion and many practitioners are looking forward to clarification from the IASB.

The service margin covers the compensation that entities demand for providing services other than bearing of risk. In practice, any such margin is likely to be estimated using an insurer’s own costs unless there is a clear indication that they differ from the market norm. Distinguishing a risk margin separately from a service margin may be inapplicable in practice within the current guidance. The margins may contain an element of profit but it is unclear how any additional profit will be treated:
>> If the risk margin is not calibrated to the premium less acquisition costs then there could be a profit on day one
>> Consideration should be given to how profit is recognised over the life of the risk margin.

For insurance markets, market data is often unavailable causing difficulties in ensuring the consistency between the current estimate cash flows and the discount rate.

The discount rate should be consistent with observable current market prices for cash flows whose characteristics match those of the insurance liability, not the characteristics of the assets backing those liabilities. A risk-free rate is required. There is no guidance yet on whether a single discount rate or a yield curve is to be used in discounting the future cash flows.

Responses to the IASB’s proposals
Generally, there was strong support in favour of developing an international standard although there were mixed views on the detailed proposals.

Respondents were broadly in support of the building block approach but many disagreed with the exit value concept. A concept based on an ultimate settlement value was often quoted as an alternative. Nearly all respondents had concerns with details underlying the building blocks. In particular there was a need for more clarity on the margins and most respondents did not understand the rationale for a service margin. There were varied comments on the use of expenses which were market-consistent rather than entity-specific.

Some general insurers opposed the requirement to discount liabilities and argued for the retention of the unearned premium and undiscounted models. Nearly all respondents disagreed with reflecting credit characteristics in its carrying value. The recognition of ’day one‘ profit also generated comment. Clearly there is still some way to go before a consensus is reached.

There is disquiet in the US about having to discount liabilities. The IASB will seek the US Financial Accounting Standards Board’s views before the IASB’s exposure draft is issued.

How will things change for general insurers?
The implementation of IFRS Phase II will affect general insurers in the following ways:
>> There could be a day one profit at the inception of a contract or a deferral of profit depending on how the margins are unwound over the period of the risk
>> There could be changes in the mix of sales by line of business or product design as insurers move into classes with favourable treatment and away from those with less favourable treatment
>> The supply of investors’ capital may change due to potential increased comparability with other companies and markets
>> Reporting of earnings may become more volatile to take account of movements in the market at each reporting date
>> Modelling may become more sophisticated when estimating liabilities such as the increased use of stochastic reserving methods. This is already happening due to the use of capital models by insurers
>> There may be increased pressure on actuaries’ best estimates (building block 1) from senior management as the estimation of risk margins (building block 3) becomes more explicit. Currently, management and the board of insurance companies often influence the booked reserves via margins
>> The data required for modelling may need to be more extensive
>> The costs of reporting may increase, however, the additional information available could be embedded in the management processes of companies.

How does Solvency II fit into all this?
There are common principles and features between IFRS Phase II and Solvency II. The three building blocks and a market-consistent valuation basis underpin Solvency II as well. As always, the devil is in the detail.

A fundamental difference is that Solvency II uses a cost-of-capital approach for estimation of a risk margin whereas IFRS does not specify a particular approach. There is no separate service margin under Solvency II. It is unclear whether diversification credit will be permissible between portfolios under IFRS, unlike Solvency II which allows for a limited level of diversification.

Solvency II proposals are at a more advanced stage than IFRS. Will Solvency II lead and IFRS follow? Will the two projects converge? There will certainly be pressure for convergence.

There is more to be done
The IASB discussion paper raises a number of technical concerns and introduces questions relating to how the measurement of general insurance liabilities will change under IFRS Phase II. Although the period to comment on the discussion paper has now ended, there will be further opportunities to influence the standard following the publication of the exposure draft. As a profession, these opportunities need to be taken to ensure the new reporting standards are robust, practical and interact with other developments such as Solvency II.

Building Block 1: Current estimate of cash flows
>> Explicit and consistent with observable market prices
>> Probability-weighted
>> Unbiased information about amounts, timings and uncertainties
>> Current and corresponds to conditions at the end of the reporting period
>> Not entity-specific

Building Block 2: Explicitly discount all cash flows
>> Time value of money should be taken into account
>> Not influenced by assets held to match liabilities unless there is a contractual link
>> Observable market rates for cash flows that match in terms of timing, currency and liquidity

Building Block 3: Risk and service margins to reflect uncertainty
Risk Margin should:
>> Reflect the market rate for bearing risk
>> Be estimated at inception and subsequently by using market data and internal information •
>> Not be a shock absorber
>> Be updated at each reporting date
>> Be explicit and unbiased

Shreyas Shah is a director in the Actuarial & Insurance Solutions practice of Deloitte