The World Bank The Advanced Program in Accounting and Auditing Regulation

1
The World Bank The Advanced Program in
Accounting and Auditing Regulation

• A new era of prudential rules and financial
  reporting for insurance
• Catherine Guttmann
• 16 May 2006

2
Outline of presentation

• In line with IAIS work, new risk-based solvency
  requirements (Solvency II) are underway at the EU
  level
• Complete, prudent, relevant, common accounting
  principles as a pre requisite for assessing
  insurers capital requirements and enhancing the
  ability of insurers to call for capital
• What are the main features of IFRS for insurance
  companies (as of today, Phase I)
• IFRS 4 Phase II A common valuation of
  insurance liabilities for accounting and solvency
  purposes ?

3
In line with IAIS work, new risk-based solvency
requirements (Solvency II) are underway at the EU
level

• Solvency II as a consequence of insufficient
  efficiency of Solvency I
• 85 insurance companies have been under
  regulators close scrutiny, in the last five
  years in Europe, because of capital inadequacy
  under Solvency I, of which 20 have ultimately
  disappeared
• Administrative sanction
• bankrupcy
• Main Reasons
• Inadequacy of the pricing of the contracts
• Under estimate of insurance liabilities,
  including embedded options granted to policy
  holders
• Inadequate asset/liability management
• Duration
• Liquidity
• Inadequate reinsurance coverage linked with
  insufficient insurance risk diversification
• Inadequate corporate governance and internal
  control

4
In line with IAIS work, new risk-based solvency
requirements (Solvency II) are underway at the EU
level

• Solvency II as a convergence between insurance
  and banking sector
• More and more similar products
• e.g.
• Catastroph bond versus insurance contract
• Saving contracts
• Climatic derivatives
• In line with IAIS thinking
• more prospective assessment and control of the
  risks
• Insurance
• Financial
• Operational
• both on management and supervisors side

5
In line with IAIS work, new risk-based solvency
requirements (Solvency II) are underway at the EU
level The Calendar
Project of Directive proposed for adoption
Phase I
Phase II
May 01 jan 03 jun 04 dec
04 may 05 apr 06 oct 06 dec 06 feb
07 jun 2007 2008 2009 2010
1999

Preparatory works
Project of Directive
Directive Solvency II
Fev 2007 Final Directive Jui 2007
Adoption 2008 Elaboration of detailled
implementation guidances 2009-2010
Transposition of the directive by each Member
State 2010 Application Solvency II Removal
of 19 Directives EU in existence
June 2004 1st wave of calls for advice
(Pillar II) Dec. 2004 2nd wave of calls for
advice (Pillar I) May 2005 3rd wave of calls
for advice (Pillar III) June 2005 Amended
Framework for consultation Sept 2005 1st
quantitative impact study (QIS 1) April 2006
2nd quantitative impact study (QIS 2) Oct 2006
1st draft of Directive Dec 2006 2nd draft of
Directive

• Inventory on Solvency I
• Assessment of the relevance / adaptation of
  banking rules to insurance
• Considerations into the form of a future system
  of prudential control
• Study leads by european insurance supervisors on
  Solvency I and recommendations on the Solvency II
  project

6
In line with IAIS work, new risk-based solvency
requirements (Solvency II) are underway at the EU
level
Key phases of short term development
SOLVENCY II
March 06
Oct 06
July 07
Feb 07
Feb 06
April 06
Sept 06
Dec 06
CEIOPS answer 3rd wave of calls for advice
Results QIS 1
Starting QIS 2 on MCR SCR)
Results QIS 2
1st draft of Directive
Directive proposed for adoption
2rd draft of Directive
Final Directive
7
In line with IAIS work, new risk-based solvency
requirements (Solvency II) are underway at the EU
level

• 3 pillars structure

Solvency II
Pillar I
Pillar II
Pillar III
Capital Adequacy Value based approach -
Solvency Capital Requirement (SCR) - Min. Capital
Requirement (MCR) Insurance Liabilities Risks
linked to the asset more specifically
integrated
Supervisory Review Corporate
Governance Asset/Liability Management Efficiency
of internal control Investment
policy Reinsurance program Process of
prudential supervision
Market Regulation Information for public and
control Transparency principle Information
requirements (disclosures) Financial
communication
8
In line with IAIS work, new risk-based solvency
requirements (Solvency II) are underway at the EU
level

• MCR/SCR (CFA n9, 10, 11, 13, 14)
• 2 levels of solvency requirement MCR and SCR

Level 2 capital target
Surplus
Prudential graduated intervention

• Internal models
• Standard approach

SCR Solvency CapitalRequirement
Level 1 floor
MCR Min. Capital Requirement
Risk considered as unacceptableby policy holders
Insurance Liabilities
Level 0 Mortality risk
9
Complete, prudent, relevant, common accounting
principles as a pre requisite for assessing
insurers capital requirements and enhancing the
ability of insurers to call for capital

• Relevant information has the quality of relevance
  when it influences the economic decisions of
  users by helping them evaluate past, present or
  future events or confirming or correcting their
  past evaluations
• Prospective approach
• Unlocking of the assumptions
• Completeness no omission
• As far as possible, all items valued in the
  balance sheet
• e.g. guarantees, options

10
Complete, prudent, relevant, common accounting
principles as a pre requisite for assessing
insurers capital requirements and enhancing the
ability of insurers to call for capital

• Common
• Same definitions (substance over form)
• Definition of financial assets and liabilities
• Definition of insurance contract
• Definition of financial risk, or insurance risk,
  ...
• Same accounting rules
• Convergence between countries
• Convergence between insurance and banking

11
Complete, prudent, relevant, common accounting
principles as a pre requisite for assessing
insurers capital requirements and enhancing the
ability of insurers to call for capital

• Prudent
• Valuations have to contend with the uncertainties
• Those uncertainties are to be recognised and
  valued
• However, the exercise of prudence doesnt allow
  deliberate overstatement of liabilities
• No double counting with solvency capital
  requirement
• Conclusion a prerequisite, a priori, in
  coherence with IFRS framework

12
What are the main features of IFRS for insurance
companies (as of today, Phase I)

• The IFRS on insurance contracts applies to all
  insurance contracts (including reinsurance
  contracts) and only to insurance contracts
• Financial assets and liabilities of insurers
• are treated by IAS 39
• All IFRS standards apply to insurance companies
•  Insurance contract  definition is a definition
  in substance and not a legal one
• The standard on insurance contracts should then
  be used for example in the banking industry

13
What are the main features of IFRS for insurance
companies (as of today, Phase I)

• Definition of an insurance contract
• An insurance contract is 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 futur event
  (the insured event) adversely affects the
  policyholder 
• The  policyholder  is defined as  a party
  that has a right to compensation under an
  insurance contract if an insured event occurs 

14
What are the main features of IFRS for insurance
companies (as of today, Phase I)

• Definition of financial and insurance risks
• An insurance risk is a  risk , other that
  financial risk, transferred from the holder of a
  contract to the issuer 
• A financial risk is  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 

15
What are the main features of IFRS for insurance
companies (as of today, Phase I)

• Examples of insurance contracts

Are insurance contracts Are not insurance contracts
Insurance against theft or damage to property Insurance against product liability, professional liability, civil liability Disability and medical cover Life contingent annuities Death benefit Catastrophe bond if the triggering event includes a condition that the issuer of the bond suffered a specified loss Financial contracts which dont expose the insurer to significant insurance risk (investment contracts, financial reinsurance) Fronting Own insurance for example product warranty is issued directly by a manufacturer dealer or retailer Catastrophe bond triggered by an external event for which the issuer doesnt incure a specific loss
16
Consequence an insurer balance sheet
17
(No Transcript)
18
IFRS 4 Phase II A common valuation of
insurance liabilities for accounting and solvency
purposes ?

• Agenda
• A Working Paper should be published by the
  Working Group Phase II before year end 2006
• An Exposure Draft should be published in 2008
• Final standard could be published before year end
  2008

Endorsement of phase II standard
Working paper published
ED published
Working Group meetings
19
Main issues valuation approaches under
consideration

• Approach A Current Entry Value

• Principles Approach A measures the insurance
  liability at the amount that the insurer would
  charge to a policyholder today for entering into
  a contract with the same remaining rights and
  obligations as the existing contract.
• Initial measurement
• Discounting of future projected cash flows
  using current yield curve (best estimate value)
• A margin for risk and uncertainty
• Valuation of an implicit margin, equal to the
  difference between premiums and the best
  estimate value
• Next measurements
• Best estimate value is calculated on current
  assumptions (economic and non economic)
• The initial margin is amortised among the
  duration of the contract with the release of the
  risk

20
Main issues valuation approaches under
consideration

• Approach B Current Exit Value (Transfer Value)

• Principles Approach B measures the insurance
  liability at the amount that the insurer would
  expect to have to pay today to another entity if
  it transferred all its remaining contractual
  rights and obligations immediately to that
  entity.
• Because there is no secondary market for most
  insurance liabilities, that amount would need to
  be estimated.
• Specifically, approach B
• Measures the insurance liability as the present
  value of future cash flows arising from the
  contract (Uses a current risk-free discount
  rate).
• Does not defer acquisition costs as a separate
  asset.
• The measurement of the liability includes the
  margin that market participants would require for
  contractually assuming risks and providing
  services
• Margin for risks and uncertainty AND
• Margin for the servicing part included in the
  insurance contract (servicing margin)
• Profit at inception is limited
• by the level of the MRI and
• by the level of the Servicing margin

21
Main issues valuation approaches under
consideration
Approach A "Business to Customers
Approach B "Business to Business
Asset
Asset
Net equity
Net equity
No gain at inception
Some gain at inception but limited by the SM and
the MRI
Global Margin
Servicing margin

• Separation and valuation of the 3 parts of the
  contracts
• exit value "best estimate"
• Margin for risks
• Servicing margin

MRU
Global margin Premiums Exit Value best
estimate
Exit Value best-estimate
Exit Value best-estimate
22
Main issues valuation approaches under
consideration

• IAIS is working on a similar model so that the
  same valuation for liabilities could be taken for
  solvency purposes and accounting

• Questions still to be solved
• Definition of the MRU (level of confidence
  Cost of capital), pattern of amortisation
• Definition and level of the servicing margin
  (market reference ?)
• Policyholder behaviour ? Surrenders, futur
  premiums, renewals
• IAS 39 for investment contracts ? 39 to be
  amended ?
• Own credit risk
• Discretionary participating features liability
  or equity or separate component of equity ?