professie en praktijk By Teus Mourik AN ACTUARIAL APPROACH FOR IFRS 4 PHASE II The International Accounting Standards Board (‘IASB’) has received numerous comments on its recent Exposure Draft (‘ED’) for IFRS 4 Phase II about the future valuation of insurance liabilities; see IASB (2013, 2014), Van der Veen (2013). The European insurance industry organisations CFO Forum and Insurance Europe responded jointly by announcing that they will develop an alternative ‘industry proposal’; see Harlin (2013). This is currently still work in progress. This article proposes and discusses a set of five principles that could serve as the basics of an alternative actuarial approach for Life insurance. Key differences with the ED and the industry proposal (so far, following the industry’s comments on the ED) are discussed in separate blocks. I conclude by summarising the merits of my alternative approach. Proposal for key principles of IFRS 4 Phase II I propose to apply the following key principles for IFRS 4 Phase II: Drs. T.J. Mourik AAG is a senior actuary at AEGON Corporate Center. This article reflects his personal opinions. 1 – Because of principles 3-5 below, I ignore reinsurance assets, assets at amortised cost in the balance sheet and DAC and VOBA for this adjustment. There are generally no other (material) items that are not FV-d through P&L in the insurer’s IFRS balance sheet. 2 – This ‘adjustment for accounting mismatch’ is also prescribed by Dutch law for the Dutch regulatory Liability Adequacy Test (‘TRT’); see Besluit prudentiële regels Wft, article 121, paragraph 3. 50 de actuaris september 2014 1.The liability values for future recognition in P&L are set equal to the maximum of (I) either the PV of future insurance liability cash flows based on ‘locked-in’ assumptions that underlie the tariffs (for non-participating traditional insurance and all participating products without an account balance), per policy set to nil when negative, or the account balance if there were one (UL business and all participating products with an account balance); and (II) the PV of cash flows based on current assumptions plus a risk margin (‘RM’), but adjusted for the revaluation reserve (‘RR’) of underlying assets that are classified as ‘available for sale’ under IAS39, i.e. as ‘Fair Value through Other Comprehensive Income’ (‘FVOCI’)1. The ‘locked-in PV’ under (I) can either be based on discount rates A. which are locked-in at inception (for nonparticipating traditional insurance) or equal to the expected future book returns, including those from future reinvestments, of the assets that are held to cover the liabilities (for participating business without account balances); or B. which are ‘current’; some call this the ‘Fair Value through P&L’ (‘FVPL’) option’. Option B can be selected when the liabilities are covered by FVPL assets. The ED does not distinguish products with an account balance, but suggests a ‘mirroring’ approach for participating products that is rather complex – different discount rates for expected future policyholder benefits and expense cash flows – and subject to conditions on the underlying assets that are very restrictive. The industry, therefore, objected against the possible resulting accounting mismatches for participating products. My approach only distinguishes products with an account balance – making value (I) above easy to determine for such products – and proposes asset-dependent discount rates for valuing participating products without an account balance; conditions for applying the latter should not depend on the ownership of the underlying assets. The ‘current PV’ plus RM under (II) is preferably market consistent, i.e. discounted by current riskfree interest rates (option C). However, in special circumstances it should be discounted by the same rates as the locked-in PV under (I) (option D); see the last paragraph of principle 4 below. The assumed reinvestment rates for participating contracts, for both PVs under (I) and (II), must always be current and risk-free. Changes in the maximum of (I) and (II) minus RR are recognised in P&L, with the difference between (I) and (II) minus RR defined as the risk group’s ‘contractual service margin’ (‘CSM’). Therefore, expected future profits, after updating current estimates, RM and discount rates and after adjusting for the actual amount of RR (that is included in the CSM!)2, are deferred. When CSM < 0 we apply loss recognition in P&L. professie en praktijk This definition of the CSM differs fundamentally from the one in paragraphs 28-32 of the ED (which is also adopted in the industry proposal so far). In particular, the ED defines the CSM as the PV of expected future profits discounted at locked-in discount rates. It is determined at initial recognition of the corresponding policies but must be unlocked for subsequent changes in current estimates (and probably RM, as preferred by the industry), and must be amortised in a way that ‘best reflects the remaining transfer of services’. This means that portfolio-specific variables must be selected (e.g. premiums, benefits, sum at risk, expenses) that could serve as best indicators for this ‘transfer of services’. The amortisations of the CSM should ‘mirror’ the pattern of these indicators. In my opinion, such an approach can only produce rather arbitrary, and therefore disputable outcomes for the periodical P&L results. In my actuarial proposal, the CSM is always calculated prospectively because (I) and (II) are calculated prospectively. It will also absorb changes in RR, current discount rates and, for participating business without account balances, expected future asset book yields from underlying asset mixes and current reinvestment rates. This CSM therefore reflects a market consistent estimate of the value of expected future profits that is embedded in value (I). Its recognition in P&L, i.e. the ’amortisation’ of this (pre-tax) ‘Market Consistent Value in Force’, corresponds with the release of the expected (market consistent) profit for the reporting period. 2.Embedded derivatives are valued at FV, i.e. including their Time Value (‘TVOG’)3. However, we will have the following choice for recognising changes of the TVOG in P&L: A. the TVOG is added to the current PV + RM above, i.e. value (II); or B.it is bifurcated and fully recognised in P&L, i.e. as if it were a common FVPL derivative. 3 – Time Values of embedded derivatives linked with participating business (non-UL) or products that are covered by assets at amortised cost must be calculated by combining (fixed) asset book yields from current assets and stochastic future riskfree returns from reinvestments. Intrinsic Values are always included in both (I) and (II). Option A allows for absorbing changes of the TVOG in the CSM as long as the CSM is positive. This option will be appropriate in case the embedded derivatives are not hedged. When they are hedged (by FVPL derivatives), option B will be preferable. There is no more need for assessing whether embedded derivatives are closely related to the host contracts or not. However, when they are not life contingent, only option B should be allowed. The ED and industry proposal (so far) are unclear about the treatment of embedded derivatives (like minimum investment return guarantees), particularly for participating products. However, there are signals that key parties do not want to support valuing embedded derivatives at FV for P&L recognition when the host contract is valued at (I) instead of (II). Disallowing this would result in an accounting mismatch in P&L when these derivatives are hedged by real derivatives (IAS 39 requires these to be FV-d in the P&L). Instead, allowing for a choice between 2A and 2B for TVOGs, irrespective of the character of the embedded derivative and the way the host contract is valued, will prevent such a disincentive for proper risk management. 3.Reinsurance assets are measured and recognised similar to insurance liabilities, apart from the fact that the reinsurer’s credit standing must be accounted for in its related current PV + RM (+ TVOG unless 2B is selected). We always apply loss recognition net of reinsurance. This agrees with the industry’s preferred treatment of reinsurance contracts on an individual loss basis. However, for reinsurance contracts on an aggregate loss basis both IASB and industry prefer (so far) deferring both gains and losses at inception – so their CSM (different from my definition) within the reinsurance asset can be positive and negative –, including unlocking for changes in estimates (and RM). The ED proposes the same for reinsurance contracts on an individual loss basis. It is unclear why it is deemed acceptable to refrain from loss recognition (/’impairing’) when it is expected that the reinsurance asset (industry: on an aggregate loss basis only) will ‘eat’ more than all the expected future profits arising from the underlying direct insurance contracts (industry: net of reinsurance on an individual loss basis). Companies should be allowed to reclassify underlying FVOCI assets as FVPL (P&L and equity neutral) or to strengthen the locked-in assumptions that are causing a negative CSM (through P&L). 4.Insurance and reinsurance values that include a positive CSM are always revalued through OCI by replacing the outcome of (I) by the outcome of (II) (including TVOG unless 2B is selected) in the balance sheet (‘BS’). So, like in Solvency II (and the Dutch TRT, de actuaris september 2014 51 professie en praktijk after approval by DNB), positive CSMs are recognised in equity (/available capital). Paragraph 64 of the ED only addresses revaluing by moving to current discount rates through OCI. This suggests that the (ED’s) CSM should remain unchanged and added to this ‘new’ PV. However, the treatment of the CSM in the alternative approach is just a logical extension of the current IFRS treatment of the revaluation reserve of underlying assets, which is part of this CSM, namely as part of equity. Not only the unrealised gains/losses on assets (RR), relative to their market values, but also the total amount of expected future gains on insurance liabilities (from a ‘fulfilment’ perspective), i.e. CSM minus RR when positive, should be recognised in equity. However, the future IFRS 9 may still require that specific financial instruments, e.g. mortgages, be measured at amortised cost in the BS. It should therefore be allowed for the BS to continue discounting cash flows of policies which are covered by such assets by locked-in discount rates (or asset book yields when participating)4. Loss recognition for these groups should also be based on the discount rates that are used in (I). 5.As CSMs are recognised in equity, and financial instruments are (generally) valued at FV in the BS, there is no more room for intangibles like DAC, VOBA and Deferred cost of reinsurance in the BS (again, like in Solvency II). I, therefore, propose recognising acquisition expenses in OCI (together with the CSM of new business as at the end of the reporting period), instead of deferring them. By doing so these expenses will still not create P&L volatility. However, in that case, we must also recognise subsequent premium margins to cover these acquisitions costs in OCI. Principles 1-3 cover two ‘old’ principles: 1. profits are only recognised in P&L when they are realised (including no gains at inception) and 2. expected future losses (CSM < 0) are recognised immediately. By selecting the right options we can avoid P&L volatility due to accounting mismatches. This also allows for correctly reflecting the effectiveness of risk mitigation (hedging, reinsurance) in P&L. and with more freedom for defining units of account, current discount rates and RMs). Actually, several Dutch (life) insurers also apply the basics of this approach for their financial (IFRS) reporting since then. This approach, which is fully prospective – making transition relatively easy –, is fully symmetrical to current (and expected future) IFRS measurement and recognition of financial instruments. Subject to the options chosen, we can get a stable P&L as long as the individual product groups are profitable (CSM > 0). The corresponding balance sheet is economically sound because the balance of expected future profits from insurance and expected future losses from reinsurance, if positive, and acquisition expenses are no longer hidden but recognised in equity through OCI. Consequently, this way we would get an IFRS balance sheet that is closely aligned with the Solvency II balance sheet. It is impossible to obtain this large set of benefits, resulting in a consistent framework for insurance accounting (no accounting mismatches) with a smooth P&L and a ‘fair’ balance sheet, by using the ED’s definition of the CSM (and not recognising positive CSMs as equity). Not prescribing the superior alternative definition under IFRS will therefore imply missing an excellent opportunity for improving transparency for (IFRS) insurers’ shareholders worldwide. Furthermore, prescribing the ED’s approach would definitely create much more operational burden for Dutch insurers. References: Besluit prudentiële regels Wft, 2007. G. Harlin, Comments on Exposure Draft 2013/7 on behalf of CFO Forum and Insurance Europe, 25 October 2013. International Accounting Standards Board, Exposure Draft 2013/7, Insurance Contracts, June 2013. International Accounting Standards Board, Outreach and comment letter analysis, January 2014. H.W. van der Veen, ‘Het herziene IASB-voorstel voor verzekeringscontracten’, Het Verzekerings-Archief 2013/3, pp 144-151. @ Reacties op dit artikel graag naar [email protected] Summary and conclusions 4 – This option (ID) shows some resemblance with the Matching Adjustment under Solvency II. 52 de actuaris september 2014 This alternative actuarial approach for IFRS 4 Phase II is basically a logical elaboration of current IFRS 4 Phase I, because its key principles are defined much more concretely. In particular, it proposes requiring a nonnegative CSM (including RR = revaluation reserve of FVOCI assets) that is identical to the outcome of a Liability Adequacy Test equal to the market consistent TRT as applied by Dutch insurers since 2007 for regulatory reporting (aside from the surrender value floor that is ignored now, all FVOCI assets being considered available for covering insurance liabilities, Wilt u meer over dit onderwerp weten schrijf u dan in voor de ontbijtsessie “Laatste ontwikkelingen IFRS 4 fase II” op 2 oktober van 8.00 tot 10.00 uur, waar o.a. Teus Mourik optreedt als spreker. Voor meer informatie zie pagina 61 van dit magazine of ga naar de website van het AG&AI.