Practical measurement of risk adjustment liabilities (papers 3B and 3C - education session)
The Boards received a third education session on Tuesday delivered by Joachim Oechslin, Chief Risk Officer at Munich Re. This session presented the case for a risk adjustment liability and illustrated the practical implications for its inclusion in an IFRS. Mr Oechslin explained the use of market-consistent valuation of insurance liabilities developed at Munich Re and the use that the company has made of these measures for a number of purposes including external market disclosure.
Mr. Oechslin explained the basis for Munich Re's calculation is a replicating portfolio that models the insurance liabilities cash flows. This calculation includes a risk margin that is determined using a cost of capital technique. The presentation highlighted that for this technique the key components that need to be defined for its consistent application are the level of confidence that the technique has to achieve (e.g. a 99.5 percentile confidence level); the time horizon over which the confidence level applies (e.g. the next twelve months) and the cost of capital rate.
A second education session on the same subject is planned for next week on 22 March.
A discount rate for participating contracts - the "Asset Liability Rate" (ALR) (papers 3E and 3H - education session)
A fourth and final education session for the Boards was delivered by Jean-Michel Pinton and Baptiste Brechot respectively Group Accounting Director and Actuary at CNP Assurances. Messrs. Pinton and Brechot co-presented with Eric Meistermann, a Deloitte partner who advised CNP Assurances in the development and testing of the results presented to the Boards. The ALR is a proposal to determine a discount rate for participating contracts. These are insurance and investment contracts where the benefits payable to the holder are dependent on the value of the assets backing the contracts' cash flows.
The ALR method determines the discount rate using a yield curve derived from the expected return of the assets held in the participating funds backing the insurance participating liabilities being measured.
The yield curve is not necessarily market consistent; instead it uses the same basis selected for accounting purposes for each of the asset classes that form the participating fund. The yield curve determined with reference to these assets accounting values is then adjusted with the deduction of a credit spread (in a "risk neutral" environment) and the addition of a liquidity premium to arrive at the ALR curve.
The presentation explained that the ALR method would give full account of the cash flows on options and guarantees and use a forward market consistent risk free rate to discount cash flows in excess of the asset durations.
Discount rate for participating contracts (paper 3F)
The Boards reached two important decisions on the discount rate for participating contracts:
- To align the objectives for discount rates on participating contracts to those tentatively agreed last month for non-participating contracts; and
- To include guidance in the final IFRS that explains how an insurer should reflect the dependency on asset values of participating contract cash flows
In reaching these unanimous decisions the Boards made reference to a Staff paper that was released in November 2010 where the cash flows of participating contracts were analysed across three sets of cash flows that:
- directly reflect asset values where the measure of the liability can be effectively and fully replicated by the use of the asset values;
- are independent of asset values thus identical to those in non-participating contracts; and
- indirectly reflect asset values as a result of being cash flows from embedded options and guarantees.
The Boards noted that this paper could be a valid basis for the development of the mandatory application guidance that would be included in the final IFRS.
Timing of initial recognition of an insurance contract (paper 3I)
The Staff presented two alternative proposals
- to reaffirm the principles in the ED and emphasise that insurers need not recognise insurance contracts before the start of coverage where the effect on the financial statements would not be material
- that insurance contract assets and liabilities should initially be recognised when the coverage period begins, but to require the recognition of an onerous contract portfolio liability in the pre-coverage period if management becomes aware of an event that would cause a portfolio of contracts to become onerous in the pre-coverage period
Both Staff alternatives would require recognition of a liability for a contract portfolio that becomes onerous after an insurer becomes a party to the contracts but before the start of coverage. Some members in both Boards were not comfortable with the proposed emphasis on materiality in the first alternative and the complex processes that would be required for many insurers to monitor contracts prior to the start of the coverage period. One Board member questioned whether the alternative view would affect the contract boundary principle set out in the ED. The general view was that the contract boundary principle would not be affected. This point is expected to be considered further by the Staff.
The Boards decided tentatively that insurance contract assets and liabilities should initially be recognised when the coverage period begins, but to require the recognition of an onerous contract portfolio liability in the pre-coverage period if management becomes aware of an event that would cause a portfolio of contracts to become onerous in the pre-coverage period.
FASB members voted unanimously for this decision with a large majority of IASB members reaching the same decision.
Definition of an insurance contract (paper 3D)
The Exposure Draft proposes that a contract is not an insurance contract if it does not transfer significant insurance risk. This is in line with the current text of IFRS 4.
The Staff presented two alternative proposals
- to reaffirm the additional conditions included in the Exposure Draft and not in the current text of IFRS 4 (consideration of time value of money in determining cash flows and the significance of additional benefits payable in certain scenarios and whether there is a possibility of loss by the insurer) to assess whether there is a significant transfer of insurance risk
- to withdraw those additional conditions in assessing whether there is a significant transfer of insurance risk.
The Boards decided tentatively to confirm the following additional conditions not in IFRS 4 as proposed in the Exposure Draft that:
- In determining whether it will pay significant additional benefits in a particular scenario, the insurer takes into effect of the time value of money; and
- A contract does not transfer significant insurance risk if there is no scenario that has commercial substance in which the present value of the net cash outflows paid by the insure can exceed the present value of the premiums.
However, it was noted the Staff should draft additional guidance to address the situations where a reinsurer accepts substantially all the insurance risk inherent in the underlying policies but there may be only very limited likelihood that the reinsurer may suffer a loss as defined above on that reinsured portfolio of business.
FASB members voted unanimously for this decision with a large majority of IASB members voting for this decision.