EULER

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INSURING CREDIT RISK
London December 15, 2004
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Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
3
Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
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Representing credit insurance and surety industry
since 1928
Group Members


Coface Group

Euler
Hermes Group

Atradius
Group


Reinsurance Members


Converium
-
Swit
zerland

Switzerland
-
Partner Ré
-

Hannover Re
-
Germany

Munich Re
-
Germany


Swiss Re

Switzerland
ICISA members insure annually trade receivables
in excess of 1,000 billion euros
-


De Montfort Insurance - UK

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Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
6
What is credit insurance

• Credit insurance has expanded in the early 1920s
  because the development of intercompany credit
  made the former one-to-one risk management
  techniques outdated and called for insurance to
  manage the not knowable credit risk.
• Hence, credit insurance offers to the seller
  protection against the default of his clients by
  insurance diversification techniques
• as well as collection and claims management
  services.
• This industry plays an essential role in
  enhancing and securing trade for SMEs.

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What is credit insurance
BALANCE SHEET
Credit insurers protect 30 of companies
property
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What is credit insurance
CREDIT INSURER
CLIENT
. INSURANCE BROKER
A SME needs a coverage for its overall assets and
asks its insurance broker
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What is credit insurance
REINSURERS
CREDIT INSURER
CLIENT
. INSURANCE BROKER
. As credit insurers manage risk through
insurance techniques, their only way
to externalise part of it is to resort to
reinsurers as they share these techniques
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What is credit insurance
REINSURERS
CREDIT INSURER
CLIENT
DEBTOR
?
. INSURANCE BROKER
?
Credit insurance is priced on the basis of the
statistical combination of the occurrence of the
adverse event and of the probability it leads to
a loss

• as property insurers are not aware of all the
  premises of their clients, credit insurers are
  not aware of the identity of all the debtors of
  their clients
• where banks usually provide guarantees if the
  risk is fully measured on a single basis, credit
  insurers do only if the risks are on the whole
  statistically non correlated
• where banks know their exposure on each debtor,
  credit insurers are not aware of the exposures of
  their clients

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Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
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Insuring credit risk
Client 3
Client 1
Credit insurer
Client 2
Client 4
Pooling mutualised risks (not individual risk) in
a portfolio
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Insuring credit risk
Insured turnover fluctuation Y (Raw material)
Z GDP t
Claims cost Y GDP t
Building a portfolio with the countrys economy
as a benchmark
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Insuring credit risk
Diluting the risk through insurance techniques
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Insuring credit risk

• Faced to a classical insurance situation of
  asymetrical information on the covered
• asset, credit insurers resort to various
  insurance techniques in order to mitigate
• the risk and uncertainties of their business and
  avoid moral hazard and adverse
• selection
• whole turnover policy (no selection by the
  insured)
• co-insurance with the client (individual and/or
  aggregate deductibles)
• subrogation on the receivable and waiting period
  prior indemnification
• conditionality of the guarantee (delivery,
  dispute, ownership of asset andany subject of
  insurance fraud)
• potential cancellation of the policy after any
  one loss
• maximum liability the aggregate amount of
  claims payable cannot exceed  x  times the
  premiums

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Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
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Accounting under current practices and IFRS 4

• Ultimate technical margin is estimated at
  inception (hence a liability is recognised at
  inception) and spread over the life of the
  contract (including deferred acquisition costs)
• Ultimate margin is re-estimated for subsequent
  measurement and liability adequacy test meets the
  specified minimum requirements of IFRS 4
• Adequacy of measurement between liabilities and
  the reinsurers shares in those liabilities
• Two existing types of policies underwriting
  year basis and accident year basis (simplified
  example next page)

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Accounting under current practices and IFRS 4
Simplified example for reinsurance and other
insurance features see VI. Implications of the ED
on Financial guarantee and credit insurance
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Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
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Operating similarities and differenceswith
financial guarantees
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Operating similarities and differenceswith
financial guarantees
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Operating similarities and differenceswith
financial guarantees
. Financial guarantees are very close to loan
commitments whereascredit insurance contract are
insurance contracts
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Summary
I. Who are we ? II. What credit insurance is
about ? III. Insuring credit risk IV. Accounting
under current practices and IFRS 4 V. Operating
similarities and differences with financial
guarantees VI. Implications of the ED on
Financial guarantee and credit insurance
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Implications of the ED on Financial guarantee and
credit insurance

• If credit insurance remains in the scope of IFRS
  4, credit insurers will account for their
  contracts with their existing practices which are
  comparable because they are compliant with EEC
  Directive of 1991
• ? If credit insurance is scoped in IAS 39 / 37,
  1) credit insurers would have to develop
  accounting practices until phase II is completed
  for some of their insurance features2) a
  contract which meets the definition of an
  insurance contract will not be accounted for
  under the Insurance Contract Standard,
  potentially opening the way to inconsistencies or
  arbitrage accounting

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Implications of the ED on Financial guarantee and
credit insurance

• Potential issue could come out of the followings
  
• Reinsurance to be booked or not ?? Credit
  insurance contracts are insurance contracts.
  Hence, the reinsurance of credit insurance is
  within the scope of IFRS 4 IFRS 4-2-a  An
  entity shall apply this IFRS to insurance
  contracts (including reinsurance contracts) that
  it issues and reinsurance contracts that it
  holds ? Reinsurance cannot be measured by IAS
  32 and 39, if reinsurance accounting is viewed as
  policyholder accounting IFRS 4 BC 73 (d)  A
  policyholders rights and obligations under
  insurance contracts are outside the scope of IAS
  32 and IAS 39  ? Only financial reinsurance is
  in the scope of IAS 39 QA 1-3-a (August 29/30,
  2000)  A reinsurance contract is excluded from
  the scope of IAS 39 if it principally transfers
  insurance risk. In contrast, a reinsurance
  contract is within the scope of IAS 39 if it
  principally involves the transfer of financial
  risks (a financial reinsurance contract) ?
  There would therefore no longer be any adequacy
  of measurement between liabilities and the
  reinsurers shares in those liabilities for
  credit insurers. In addition, as the receivable
  from the reinsurer are not virtually certain
  until the claims are paid, there should never be
  any reinsurance accounting under IAS 37.

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Implications of the ED on Financial guarantee and
credit insurance

• Salvage subrogation possible Phase I /
  impossible IAS 37? Salvage subrogation
  represent amounts to be recovered out of pending
  claims. They are anticipated at inception
  together with the claims cost (see simplified
  example). They represent 15 of paid
  indemnities. ? IFRS 4-BC-120  Some insurance
  contracts permit the insurer to sell (usually
  damaged) property acquired in settling the claim
  (ie salvage). The insurer may also have the right
  to pursue third parties for payment of some or
  all costs (ie subrogation) The Board will
  consider salvage and subrogation in phase II ?
  Anticipated salvage subrogation being estimates
  of potential future recoveries might not meet the
  IAS 37 recognition criteria (conflicting
  interpretations currently between auditors).
• Risk and uncertainties Phase II applicable to
  credit insurance? Insurance liabilities are
  uncertain. This gives rise to measurement
  questions. How should the amount of uncertainty
  be assessed ? Should it be reflected by the risk
  premium that marketplace participants would
  demand ? Should it be reflected using provision
  for risk of adverse deviation ? (IFRS 4-BC-6)?
  Credit insurance contracts are faced to the same
  uncertainties, hence they will be required to
  apply in substance Phase II conclusions whether
  scoped in IFRS 4 or not.

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Implications of the ED on Financial guarantee and
credit insurance

•  Uncertain  performance features (no claim
  bonus)? Some policies include performance
  features which lead to the retrocession of a part
  of the profit to the insured if the technical
  result of his policy overpasses a specified
  amount. In the existing accounting policies, this
  liability is estimated and booked at inception
  even though it depends on the final result of the
  policy at the end of a specified period (mostly
  three years).? This liability is potentially
  uncertain as it is mostly based on the
  anticipation of GDP for the three coming years
  and as it is only payable to the insured if he is
  still client at the time he is entitled to ask
  for the computation (see below renewal options).
  Will this liability meet the IAS 37 recognition
  criteria ?
• Renewals, cancellation and continuation options?
  Credit insurance contracts are cancellable at the
  option of the policyholder (three month
  notice).? Cancellation or continuation can be
  predicted all along the economic cycle (hence the
  no claim bonus above to keep the client).? As a
  result, should the closed book of insurance
  contracts include future premiums, claims and
  other cash flows once past the three month notice
  or when the cancellation or continuation be
  predicted ?

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Implications of the ED on Financial guarantee and
credit insurance

• Deferred acquisition costs? When cancellation or
  continuation are predictable (see before), should
  costs incurred to acquire new insurance contracts
  be capitalised and amortised ?? Moreover how
  should the Exposure Draft (BC-23-c) be
  interpreted when there is no such thing as
  interest expense for a credit insurance contract
   Instead of being recognised as an expense,
  those transaction cost would result in additional
  interest expense over the life of the contract 
• Discounting of reserves ? IAS 37 considers the
  time value of money when setting up a reserve. ?
  IFRS 4 BC-126 reads  However, because the
  Board will not address discount rates and the
  basis for risk adjustment until Phase II, the
  Board concluded that it could not require
  discounting in Phase I ? What do credit
  insurance reserves have in special that enables
  to address discount rates in Phase I ?  

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Implications of the ED on Financial guarantee and
credit insurance

• Accounting by policyholders? The Exposure Draft
  (BC 4) does not deal with the treatment of
  financial guarantee contracts by the holder.? In
  February 2002, the Board agreed tentatively to
  create a simplified measurement model for
  policyholders based on paragraph 9.6 of the
  DSOP.? We wiew as prejudicial to our insured
  1) the current impossibility to refer to any
  Standard for policyholder accounting2) the
  exclusion from the potential benefit of using a
  simplified model (the great majority of our
  client being SMEs) and/or the obligation to
  account for one of their insurance contract
  differently from their other ones (which could
  cause confusion).
• Disclosures? Reporting under IAS 39/37, credit
  insurers would have to disclose under IAS 32.?
  Although the high level principles that drive
  IFRS 4 requirements share the same spirit as
  those of IAS 32, they are supplemented by
  specified disclosures (reinsurance, claims
  development, ) The lack of these specified
  disclosures in the IAS 32 requirements might lead
  to 1) a reduction in the level of information
  provided to external party2) depending on the
  shared interpretation of the new requirements
  among credit insurers, to incomplete,
  inconsistent and uncomparable information.

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Implications of the ED on Financial guarantee and
credit insurance

• Insurance contracts acquired in a business
  combination? When an insurer acquires a block of
  insurance contracts in a portfolio transfer, the
  fair value of the block of contracts may exceed
  the amount received from the transferor. The
  Board agreed in February 2002 that the insurer
  would recognise that excess not as an expense but
  as an intangible asset not submitted to IAS 36
  and 38? Under IAS 39/37 this option will not be
  open. Why single out unfairly credit insurance
  contracts ?

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As a conclusion

• The Exposure Draft puts pressure on the credit
  insurance industry to justify why it should be
  accounted for according to IFRS 4. In our mind,
  it should rather be justified why an insurance
  contract should not be accounted for under the
  Insurance Contract Standard.
• The absence of an arbitrage market between credit
  insurance and financial guarantees is a clear
  evidence that the two products are different, do
  not meet the same needs, are not interchangeable.
• Financial guarantees deal with currency risk,
  interest rate risk, market risk, credit risk,
  liquidity risk and cash flow risk. They never
  transfer significant insurance risk and as such
  are naturally in the scope of IAS 39.
• Credit insurance insures credit risk. Accounting
  for credit insurance under IAS 39/37 might mean
  in the future that property insurers should apply
  IAS 40 when insuring buildings

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As a conclusion

• We think that the current Exposure Draft is
  unnecessary, because
• the existing requirements in IFRS 4 already
  provide appropriate requirements for credit
  insurance contracts (a liability is already
  recognised at inception)
• the proposed measurement would bring no real
  improvement to the existing practice in IFRS 4
  for credit insurance contracts
• to the contrary, the proposed requirements would
  be less relevant for credit insurance contracts
  than the existing accounting standards
• the proposed requirements would also reduce
  (instead of increasing) the comparability between
  entities
• the proposed measurement of financial guarantees
  could be easily achieved through amendment to the
  existing IFRSs other than IFRS 4
• the proposed requirements will not allow a
  consistent measurement of financial guarantees
  and credit insurance
• the proposed effective date will make credit
  insurers accounts less comparable and
  understandable as they will change in 2005
  (investment equalisation reserve), 2006 (IAS
  39/37), Phase II (risk and uncertainty, salvage
  and subrogation, )

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As a conclusion

• We therefore agree that all insurance contracts
  should be accounted for under the Standard for
  Insurance Contracts (IFRS 4). The proposed
  exception for credit insurance contracts is
  neither logical nor relevant to the accounts.
• The publication of the Exposure Draft was based
  (BC 22) on the fact that To counter the view
  that IFRSs (and specifically IAS 37) do not
  require an entity to recognise a liability when
  it issues a financial guarantee contract, the
  Board concluded that it should publish this
  Exposure Draft now and not wait for further work
  on phase II of the Insurance project
• We think that if the wording of IAS 37 seems
  ambiguous to some respondent than the amendment
  should be made to IAS 37, not IFRS 4.

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INSURING CREDIT RISK
London December 15, 2004