International Financial Reporting Standards Applied to Property and Casualty Insurance presented to OCCA by Jim Christie November 2004 - PowerPoint PPT Presentation


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International Financial Reporting Standards Applied to Property and Casualty Insurance presented to OCCA by Jim Christie November 2004


Title: IFRS Insurance Training Author: Ernst & Young Last modified by: Jim Christie Created Date: 3/13/2002 9:09:59 PM Document presentation format – PowerPoint PPT presentation

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Title: International Financial Reporting Standards Applied to Property and Casualty Insurance presented to OCCA by Jim Christie November 2004

International Financial Reporting
Standards Applied to Property and Casualty
Insurance presented to OCCA by Jim Christie
November 2004
  • Cross-border capital flows highlight the need for
    consistent, understandable financial information
    BUT insurance accounting has significant local
  • The International Accounting Standards Board
    (IASB) is developing a single set of global
    accounting standards
  • Many countries committed to the objective of
    global harmonisation
  • Drivers for new approach
  • Historical cost accounting models lack relevance
  • Solvency-based approaches do not provide an
    accurate picture of financial performance
  • Convergence of banking and insurance industries

Phased approach for insurance
  • A phased approach to insurance contracts.
  • Objective for Phase I is to implement some
    components of the insurance project by 2005,
    without delay to Phase II.

Phase I Implement by 2005
Phase II Implement Fair Value by 2007 / 8 (?)
Property Casualty Phase 1
  • Key Phase I Issues
  • Defining Insurance
  • Accounting for insurance contracts
  • Disclosures

Definition of Insurance
  • A contract under which the insurer accepts
    significant insurance risk by agreeing to
    compensate the beneficiary if the insured event
    adversely affects the policyholder
  • (Insurance Contracts (Phase I) paraphrased with
    emphasis added)
  • Significant means at least one scenario with
    payment of commercial substance with an amount
    that is not trivial

Insurance vs Financial Risk
  • Financial risk is risk of possible future change
    in specified interest rate, security price,
    commodity price, foreign exchange rate, index of
    prices or rates, a credit rating or credit index
    or similar variable
  • Insurance risk is risk from contingent events
    other than financial risk
  • If both financial risk and significant insurance
    risk are present, contract classified as insurance

Insurance Contract Accounting
  • During Phase I, existing accounting policies
    apply with certain modifications
  • Prohibited certain accounting policies are
    prohibited as they do not meet the IFRS framework
  • Mandated certain accounting policies must be
    implemented if they are not already in the
    existing accounting policies
  • Allowed to continue, but not start certain
    accounting policies that do not meet the IFRS
    framework can continue, but cannot be
  • Can be started certain accounting policies can
    be introduced.
  • Existing accounting policies are those in the
    primary financial statements

PROHIBITED accounting policies
  • The following policies are prohibited
  • Catastrophe provisions
  • Claim equalisation provisions
  • Offsetting of reinsurance assets and direct

MANDATED accounting policies
  • The following policies are mandated if not
    already present
  • Liability adequacy testing
  • Impairment of reinsurance assets

Liability Adequacy Test
  • Current liability adequacy test applies IF
  • Test at each reporting date using current
    estimates of future cash flows, AND
  • If these are greater than current liability,
    liability is increased and deficiency flows
    through profit and loss

IMPAIRMENT of reinsurance assets
  • Reinsurance asset is reduced and reduction flows
    through income statement if it is impaired
  • Reinsurance asset is impaired if
  • Objective evidence of an event after initial
    inception that the cedant may not receive all
    amounts due
  • The impact of the event can be reliably measured
  • Impairment may be reversed

Accounting policies that may CONTINUE
  • The following policies may continue but companies
    may not switch to these if they are not already
    in use
  • Undiscounted liability basis
  • Deliberate overstatement of liabilities
  • Deferred acquisition costs approach

Accounting policies that may be STARTED
  • The following accounting policies may be started,
    subject to certain restrictions
  • Use of current market discount rates
  • Use of shadow accounting
  • Use of asset based discount rates

Phase I Insurance disclosure requirements
  • IFRS 4 has two high level principles

Principle 1 Explanation of recognised amounts
Principle 2 Amount, timing and uncertainty of
cash flows
Fair Value Disclosure for insurance contract
assets and liabilities
  • Implementation guidance - runs to 61 paragraphs
    but does not create additional requirements!

Principle 1 - EXPLAIN
  • Accounting policies
  • Amounts
  • Assumptions
  • Changes in liabilities
  • Gain or loss on buying reinsurance

Principle 2 CASH FLOWS
  • Terms and conditions
  • Segment information
  • Risk management policies objectives
  • Insurance risks covered
  • Run off triangles (claim development)
  • Other risks

  • PHASE 2 (in 2007?)

Phase 2
  • Scope all insurance contracts
  • Based on asset/liability model, rejecting current
    deferral/matching model
  • Where liabilities are independent of asset
    returns, unless
  • Policyholder benefits directly related to asset
    returns e.g, linked products
  • Intended to be consistent with IAS 39

Accounting Basis
  • Proposed
  • Move to underwriting year accounting, thus no
    smoothing of results with UPR and DAC
  • Liabilities measured at Fair Value
  • Issues
  • Extra volatility of the insurance result
  • Potential changes to the IT systems
  • Loss ratios for new products to be estimated from
    day one
  • Re-engineering of claim reserving process
  • Reserves for expenses
  • Gain or loss at issue
  • Renewals/Future Premiums

  • Proposed
  • Discounting of reserves will become mandatory
  • Discounting at risk free rate, plus a spread for
    credit, and MVMs
  • Valuing options and guarantees
  • Impact
  • Projection of expected cash flows
  • Selection of suitable economic assumptions
    consistent with market data
  • Need to consider all future events including
    legislation and technology
  • Re-engineering of the actuarial reserving process

Market Value Margins
  • Proposed
  • Reserves will require a market value margin
    consistent with observed market risk preferences
  • Market value margin incorporated either
  • by adjusting discount rates OR
  • By adjusting cashflows
  • Consider both diversifiable and non diversifiable
  • Impact
  • Need to develop suitable approach and discounting
  • Need for enhanced disclosures

Other Fair Value Issues
  • Future premiums only included where
  • Uncancelable continuation or renewal rights
    constraining insurers ability to re-price and
  • Rights lapse if the policyholder ceases premiums
  • No net gain at inception (ignoring indirect
    costs) unless market evidence
  • Same derecognition rules used for financial
    assets and liabilities will apply to insurance
  • Reflect all guarantees and options

Types of Estimation Risk
  • Model Risk
  • the risk that the wrong model was used to
    estimate the insurers liabilities
  • Parameter Risk
  • the risk of misestimating the parameters for the
    model used to estimate the insurers claim
  • Process Risk
  • the risk that remains due to random variation,
    even if the correct model and the correct
    parameters are used to estimate the insurers
    claim liabilities

What of risks does MVM include?
  • IAS Draft Statement of Principle 5.4
  • The entity-specific value or fair value of an
    insurance liability or insurance asset should
    always reflect both diversifiable and
    non-diversifiable risk.
  • This implies that model risk, parameter risk, and
    process risk should be modeled.

  • IAS Draft Statement of Principle, Section 5.10
  • while it is conceptually preferable to reflect
    parameter risk and model risk, it is appropriate
    to exclude such adjustments unless there is
    persuasive evidence that enables an insurer to
    quantify them by reference to observable market

What is the markets risk preference?
  • The Fair Value of policy liabilities reflects the
    risk preferences of the insurance market.
  • What is the insurance markets risk preference?
  • The 60th percentile of the distribution?
  • The 75th percentile?
  • The 95th percentile?
  • IAS Draft Standard of Principles the risk
    preference is inevitably subjective (Section

Some practical techniques to model the MVM
  • Canadian Provision for Adverse Deviation
  • Includes Parameter Risk Model Risk
  • Initial Expected Profit Margin
  • Process Risk, Parameter Risk, Model Risk
  • Poisson Frequency / Lognormal Severity Simulation
  • Process Risk
  • Macks Approach
  • Process Risk, Parameter Risk, potentially Model

Canadian Provision for Adverse Deviation (PFAD)
  • Three components to Provision for Adverse
  • Claims Development (2.5 to 15 of discounted
    gross liabilities)
  • Discount Rate (50 to 200 basis points on interest
  • Reinsurance Recovery (0 to 15 of discounted
    ceded claim liabilities)
  • The MVM could be set equal to the claims
    development PFAD.
  • The PFAD does not attempt to model process risk
    (i.e. size of the company is not considered when
    determining the PFAD).

Initial Expected Profit Margin
  • If insurance markets are efficient, the DSOP
    suggests there should be no gain at issue
  • Consequently if a profit is indicated at issue,
    any theoretical MVM should be scaled so that the
    result is simply breakeven
  • Are PC insurance markets efficient?
  • Are there situations where a gain at issue would
    be permitted?

Frequency / Severity Simulation
  • Determine the distribution of loss reserves using
    a Monte Carlo approach
  • Frequency often assumed to be Poisson distributed
  • Severity often assumed to be lognormally
  • Data requirements
  • Pending counts (ultimate counts closed counts)
  • Unpaid Claims (case IBNR)
  • Coefficient of Variation for severity (can be
    based on historical or industry data)

Mack Method
  • Mack Method can be applied to
  • Paid Losses
  • Incurred Losses
  • Historical Recorded Ultimate Losses
  • Source Measuring the Variability of Chain Ladder
    Estimates by Thomas Mack

Conclusions on MVM
  • Many judgments required under IFRS 4
  • Should one include parameter model risk in MVM?
  • How should the risk preference of the market be
  • What approach should be used to model the MVM?
  • Given that you have selected an approach, how
    should you select your MVM?