International Financial Reporting Standards and the Captive Insurance Industry

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International Financial Reporting Standards and
the Captive Insurance Industry
GSCCA
Presented by Peter Miller Linda Johnson Rob
Fletcher
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International Financial Reporting Standards and
the Captive Insurance Industry
GSCCA
Working party members
Aon Deloitte Ernst Young GFSC KPMG
Marsh Prism PwC Thomas Miller Willis
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IFRS 4 - Overview

• Objectives and definitions Peter Miller
• Disclosure requirements Linda Johnson
• Potential boundary issues Rob Fletcher

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Agenda

• Background
• IFRS 4 Insurance Contracts

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Background

• IFRS to apply to consolidated accounts of all
  listed EU companies for periods beginning on or
  after 1 January 2005
• IFRS 4 (Phase 1) applies to periods beginning
  on or after 1 January 2005
• IASB Insurance project (Phase 2) Expected 2007/8

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Objectives of IFRS 4

• To require entities issuing insurance contracts
  to disclose information about those contracts
  that helps users understand the amount, timing
  and uncertainty of future cash flows from the
  contracts.
• Phase one aims to make limited improvements to
  accounting practices for insurance contracts,
  until the Board completes the second phase of its
  project on insurance contracts.

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What is insurance, as defined by IFRS 4?

• A contract under which one party (the insurer)
  accepts significant insurance risk from another
  party (the policyholder) by agreeing to
  compensate the policyholder if a specified
  uncertain future event (the insured event)
  adversely affects the policyholder.
• (See Appendix B of IFRS 4 for guidance on this
  definition)

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Significant insurance risk

• Appendix B22 A contract is an insurance contract
  only if it transfers significant insurance risk.
• Appendix B23 Insurance risk is significant, if,
  and only if, an insured event could cause an
  insurer to pay significant additional benefits.
• Appendix B24 The additional benefits described in
  paragraph B23 refer to amounts that exceed those
  that would be payable if no insured event
  occurred. Those additional amounts include claims
  handling and claims assessment costs.
• Appendix B25 An insurer shall assess the
  significance of insurance risk contract by
  contract, rather than and not by reference to
  materiality to the financial statements.

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Distinction between insurance risk and other risks

• Appendix B8 The definition of an insurance
  contract refers to insurance risk, which this
  IFRS defines as risk, other than financial risk,
  transferred from the holder of a contract to the
  issuer. A contract that exposes the issuer to
  financial risk without significant insurance risk
  is not an insurance contract and should be
  accounted for under IAS39.

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Financial Risk

• The risk of a possible future change in one or
  more of a specified interest rate, financial
  instrument price, commodity price, foreign
  exchange rate, index of prices or rates, credit
  rating or credit index or other variable,
  provided in the case of a non-financial variable
  that the variable is not specific to a party to
  the contract.

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Uncertain future event

• Appendix B2 Uncertainty (or risk) is the essence
  of an insurance contract. Accordingly, at least
  one of the following is uncertain at the
  inception of an insurance contract -
• (a) whether an insured event will occur
• (b) when it will occur or
• (c) how much the insurer will need to pay if it
  occurs.

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Examples of non-insurance contracts

• Investment contracts that are legally insurance
  but do not transfer significant insurance risk.
• Contracts that pass all significant insurance
  risk back to policyholder through non-cancellable
  and enforceable mechanisms that adjust future
  payments by the policyholder as a direct result
  of insured losses (some financial reinsurance and
  group contracts).
• Unit linked life insurance contracts.

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Specific aspects of IFRS 4
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Disallowed claims provisions

• No recognition allowed within liabilities of
  possible future claims from insurance contracts
  not entered into at the reporting date.
• Catastrophe, equalisation and other statutory
  provisions are specifically prohibited as
  insurance liabilities.

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Acceptable claims provisions

• IBNR Reserve.
• Unexpired Risk Reserve.
• Will need to be justified as they are under UK
  GAAP.
• Follow the provisions of the ABI SORP when
  including such reserves.
• No real change here until Phase II.

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Liability adequacy test

• A captive should assess annually at the balance
  sheet date whether its recognised insurance
  liabilities are adequate, using current estimates
  of future cash flows under its insurance
  contracts.
• Any deficiency to be recognised through the
  income statement.

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Impairment of reinsurance assets

• If a captives reinsurance asset is impaired, the
  captive shall reduce its carrying value
  accordingly and recognise the impairment in the
  income statement.
• Asset can only be impaired if there is objective
  evidence of an impairment event and that event
  has a reliably measurable impact on the
  recoverable amounts.
• No real change from current practice.

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Changes in accounting policies

• May change accounting policies for insurance
  contracts if, and only if, the changes make the
  financial statements more relevant and no less
  reliable, or more reliable and no less relevant.
• May continue doing, but may not change to -
• Measuring liabilities on undiscounted basis
• Measuring rights to future investment fees at an
  amount in excess of fair value (embedded value)
• Need not eliminate excessive prudence but if
  liabilities already sufficiently prudent, shall
  not introduce additional prudence.
• Fund accounting is not permitted where companies
  have adopted the 2003 ABI SORP.

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Disclosure - Introduction

• For Phase I much of the work in relation to
  insurance is based around providing additional
  disclosures
• Principles based approach, giving companies
  flexibility as to how they present the required
  disclosures
• Disclosure requirements are extensive
• It is probable that system/reports will need
  amendments in order to provide the appropriate
  information

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Disclosure - IFRS 4 adoption disclosures

• When adopting IFRS 4 do not present more than 5
  years data
• Following adoption, IFRS 4 requires that an
  insurer discloses back to the period in which the
  earliest material claim still outstanding arose,
  but no more than 10 years.
• If impracticable to disclose particular
  comparative information required by IFRS 4, this
  is to be disclosed.

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Disclosure - Principles based approach to
disclosure

• The two main principles are
• Principle 1 An insurer shall disclose
  information that identifies and explains the
  insurance-contract-related amounts reported in
  the balance sheet, income statement and cash flow
  statement.
• Principle 2 An insurer shall disclose
  information that helps users understand the
  estimated amount, timing and uncertainty of
  future cash flows from insurance contracts,
  (extensive risk management disclosure).

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Disclosure - Extensive disclosure requirements

• Cash inflows and outflows
• An insurer would need to disclose the estimated
  net cash inflows and outflows under existing
  insurance contracts for each of the following
  periods after the balance sheet date

Later than 1 year
Not later than 1 year
More detailed analysis by time periods can be
given
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Disclosure - Extensive disclosure requirements

• More extensive disclosures will be required in
  Captive accounts to fully comply with IFRS. Under
  IFRS 4 key disclosure requirements include
• Explanations of recognised amounts and
• Amount, timing and uncertainty of cash flows.
• These can be categorised further as follows
• 1. Quantitative and qualitative disclosures
• 2. Amounts of assets, liabilities, income and
  expenses
• 3. Assumptions
• 4. Risk management

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Disclosure - Extensive disclosure requirements

• 1. Quantitative and qualitative disclosures
• How to disclose quantitatively?
• Disclose values of assumptions that have a
  material impact on estimates in balance sheet and
  income statement
• For example
• discount rates
• effect of legislative changes
• overriding estimates such as IBNR / OSLR ratios
  applied

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Disclosure - Extensive disclosure requirements

• 1. Quantitative and qualitative disclosures
  (cont)
• How to disclose qualitatively?
• Start with change in estimates
• Identify sources of change
• Describe the underlying changes in assumptions
• For example
• length of term to settlement
• severity of claims
• frequency of claims

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Disclosure - Extensive disclosure requirements

• 2. Amounts of assets, liabilities, income and
  expenses
• Disclose recognised assets, liabilities, income
  expense and cash flows arising from insurance
  contracts, and how significant measurement
  assumptions are determined
• Gains and losses recognised, or deferred, on
  buying reinsurance
• Reconciliation of opening to closing balances of
  insurance contract assets, liabilities and
  deferred acquisition costs

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Disclosure - Extensive disclosure requirements

• 2. Amounts of assets, liabilities, income and
  expenses (continued)
• To satisfy disclosure requirements, an insurer
  would typically need to separately disclose for
  each insurance contract liability details, such
  as
• The carrying amount at the beginning of the
  period
• Additional insurance liabilities incurred during
  the period
• Cash paid
• Income and expenses included in the income
  statement
• Liabilities acquired from, or transferred to,
  other insurers
• Foreign exchange translation differences

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Disclosure - Extensive disclosure requirements

• 3. Changes in insurance liabilities example

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Disclosure - Extensive disclosure requirements

• 3. Assumptions
• Disclose the process used to determine
  assumptions that have a significant effect on
  recognised amounts and where practical, make
  quantified disclosures of those assumptions.
• May not be practical if too many - more important
  to describe process
• Process used to determine assumptions might
  include
• Objective (e.g. best estimates / level of
  assurance)
• Source of data
• Consistency with market
• Past experience
• Allowance for future trends
• Identifying correlations
• Significant uncertainties

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Disclosure - Extensive disclosure requirements

• 3. Assumptions (continued)
• Consistent with IAS 8 must disclose the nature
  and effect of a change in an accounting estimate
  that has a material effect in the current period
  or is expected to have a material effect in a
  subsequent period.
• Example disclosure

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Disclosure - Extensive disclosure requirements

• 4. Risk management disclosures
• Include information about insurance risk
  including
• Objectives and policies for accepting insurance
  risks
• Terms and conditions
• Methods used to assess and monitor risks
• Sensitivity of profit/loss/equity to change in
  key variables
• Asset and liability management techniques
• Policies and use of reinsurance
• Concentrations of insurance risk
• Interest rate risk and credit risk (IAS 32)
• Actual claims compared with previous estimates

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Disclosure potential impact

• Greater transparency will intensify the spotlight
  on risk management with sensitivity to risk
  likely to emerge as key differentiator between
  insurance entities
• Flaws will be highlighted by the need to compare
  actual claims to expected claims
• Data collection and system considerations
• Generally a lot more work!

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Potential boundary issues

• Experience accounts
• Contingent capital
• Full funding
• Full reinsurance (fronting)
• Adjusting premiums
• Examples summary

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Experience accounts

• An Experience Account is a fund accounted for by
  the insurer. It comprises the premiums paid plus
  any investment income earned on the premiums
  received.
• The insurers exposure is reduced by the balance
  of the experience account being used to fund
  claims on the policy.
• The insurers exposure is eliminated entirely
  where the aggregate loss is restricted to the
  balance on the experience account.
• The insurer usually receives a fee for providing
  such a facility.

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Experience accounts Example 1

• Based on an actual policy document
• An Experience Account will be maintained by the
  insurer that shall be equal to the premium paid,
  less paid losses, plus interest credit until
  there is a complete and final release of all of
  the insurers obligations.
• Upon commutation of this agreement the insurer
  shall pay to the reinsured any positive value on
  the experience account.
• In this case the aggregate liability of the
  insurer is restricted to the balance of the
  experience account.
• Is this an insurance contract under IFRS 4 or not?

û
No significant risk
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Experience accounts Example 2

• The second case has similar wording but the
  experience account balance will always be less
  than the aggregate exposure and so there is some
  risk transfer.
• Is this an insurance contract under IFRS 4 or not
  ?

?
Not enough detail
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Experience accounts Conclusion

• Experience accounts are generally used as a
  funding mechanism.
• Experience accounts can preclude risk transfer,
  in which case the policy would not constitute an
  insurance contract as defined by IFRS 4.
• If the experience account is significantly less
  than the aggregate exposure, however remote, then
  there would be significant risk transfer.

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Contingent Capital

• Some captive programmes can be funded by part
  paid capital.
• Consider the following Example
• Policy type Property protection
• Cover 500k aggregate
• Premium 100k pa for a two year policy
• Risk gap 400k pa
• Funded by 300k paid share capital and 100k
  unpaid on the issued shares
• Is this an insurance contract under IFRS 4?

ü
Share capital not part of contract
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Full Funding

• Many captive insurance programmes are fully
  funded by share capital or retained reserves.
• Consider the following example
• Policy type professional indemnity deductible
  (single policy structure)
• Cover 450k annual aggregate
• Premium 250k pa
• Risk gap 200k pa
• Funded by 275k share capital and retained
  reserves
• Is this an insurance contract under IFRS 4?

ü
Equity reserves not part of contract
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Full Reinsurance (Fronting)

• Some captive programme risk gaps are covered by
  reinsurance.
• Consider the following example
• Policy type Public liability
• Cover 5m annual aggregate
• Premium 2.5m pa
• Risk gap 2.5m
• Reinsurance cover 4m xs 1m aggregate for
  1.25m premium gives net nil risk gap.
• Is this an insurance contract under IFRS 4?

ü
Reinsurance not part of contract
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Adjusting Premiums

• Some captive programme risk gaps are covered by
  adjusting premiums.
• Policy type Professional indemnity deductible
  (single policy structure)
• Cover 450k pa
• Premium 250k minimum and deposit premium
  125k adjusting premium triggered by claims
• Risk gap on minimum and deposit premium is 200k
• Risk gap on adjusted premium is 75k, which is
  covered by 75k share capital and therefore fully
  funded.
• Is this an insurance contract under IFRS 4?

ü
Share capital not part of contract
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Examples summary

• We consider that in all the examples above there
  is significant risk transfer to the insurer,
  which happens to be a fully funded captive
  vehicle or to have eliminated its risk gap by
  some method.
• Note that IFRS 4 relates to insurance contracts
  and states that significance should be considered
  on a contract by contract basis (para B25 - and
  not by reference to audit materiality) and the
  funding of the captive is not relevant.
• The IFRS is not entitled insurance programmes
  nor captive insurance vehicles and structures.

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Summary

• IFRS 4 includes definition of insurance contract
• Limited guidance on reserving aspects. Additional
  guidance expected in phase 2
• Extensive disclosure requirements which may
  require data collection and system changes
• Number of potential boundary issues

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Next weeks presentation
GSCCA

• Session Two
• Impact of other International Financial Reporting
  Standards on captive insurance companies
• Presented by David Becker
• Evelyn Brady
• Monday, 13th December 2004 12.30 13.30
• La Seigneurie, St Pierre Park Hotel
• The lecture is free