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Insurance contracts

Date recorded:

Explicit risk adjustment (education session)

The FASB and IASB observed two educational session presentations on explicit risk adjustments.

Presentation 1: Tony Coleman, Director, AMP Life Ltd & Chairman of Audit Committee

Mr. Coleman presented on Accounting for Insurance in Australia. He discussed a number of key features of the Australian standards and the insurance industry overall, with significant points summarised as follows:

Key features of the standard on non-life insurance include:

  • Use of unearned premium for pre-claim liabilities
  • Discount insurance liabilities at risk-free interest rates
  • Risk margins mandatory for outstanding claim liabilities
  • Liability Adequacy Test applies with risk margins
  • Mandatory disclose of Probability of Adequacy (PoA) of insurance liabilities with risk margins
  • Mandatory disclosure of sensitivity of insurance liabilities to key assumptions e.g. inflation, claims severity, claim frequency
  • Mandatory disclosure of claims development table
  • All assets valued at market value, through Profit & Loss

Key Features for Life Insurance accounting include:

  • Unbiased probability weighted expected cost of settling claims incurred
  • Discounting for time value of money (at risk free rate with an allowance for illiquidity) to obtain present value
  • Does not require explicit risk margins
  • Uses residual margins with unlocked assumptions
  • Difference between previously expected and current actual in year (including discount rate changes) flow through to P&L with residual margin adjusted for changes in non-financial market estimates/assumptions
  • Residual margin can never be negative
  • All assets valued at market, through Profit & loss

Risks within the risk margin include:

  • Internal systemic — Risks internal to the liability valuation — whether the model is a good representation
  • External systemic — Outside of insurer's control (judicial interpretations, economic risks, event risk, latent claim risk, recovery risk, claims management process risk, expense risk)
  • Independent Risk — Inherent in the insurance process due to random statistical fluctuation

Since adopting the new standards, consistency and disclosure have improved. Market analysts (users) are very interested in liability disclosures and claim development tables.

Examples of required disclosures include:

  • Change in value of insurance liabilities if:
    • Inflation rate assumed increases/(decreases) by 10%
    • Interest rate used increases/(decreases) by 1.0% per annum
    • Average claims severity increases by 10%
    • Average claims frequency increases/(decreases) by 10%
    • Average term to maturity of outstanding claims increases/(decreases) by 10%
    • Mr. Coleman also notes that various models that the FASB and IASB have been discussing should be reconcilable to the Australian model; however, disclosure is key.

Presentation 2: Mark Swallow and Leopoldo Camara, Swiss Re

Mr. Swallow and Mr. Camara discussed the Risk Adjustment in the context of their internal economic accounting framework called Economic Value Management (EVM). EVM is used by Swiss Re for: pricing of reinsurance/insurance business; asset liability management; internal/external performance reporting for all business; regulatory reporting under the Swiss Solvency Test. The EVM framework uses the cost of capital approach to calculate required returns. For underwriting activities, this includes an estimate of the frictional cost of the capital held for taking re/insurance risk.

The EVM framework:

  • Splits performance of fund raising activities (underwriting) and fund investment activities (asset management)
  • Recognises all profits on new business at inception, changes in estimates as they occur, and excludes future new business
  • Values assets and liabilities on a market consistent basis
  • Reflects best estimates
  • Measures performance after capital costs (i.e., cost to shareholders for taking risk- the risk adjustment)
  • Profit (after capital costs) is recognised upfront. Over the lifetime of the contract, frictional capital costs are released and recognised as income, as liabilities run off.
  • Group capital costs consist of:
    • Risk free return on capital representing shareholders base cost of capital
    • Market risk premium (MRP) representing the shareholder's expected excess returns on market risk exposure, applicable to all business activities that generate systematic market risk
    • Frictional capital costs (FCC) representing shareholders required compensation for agency costs, costs of potential financial distress and regulatory/illiquidity costs (required return on underwriting risk only)
  • EVM Capital takes into account internal risk, regulatory, and rating capital requirements.

Mr. Swallow also stressed the importance of disclosure, noting there has to be flexibility in order for a company to run its business as it chooses (a more highly rated entity may pay less for capital; different insurers will adopt different risk appetites, which drives their risk capital).

Mr. Swallow also noted that under the EVM framework, profits are taken on Day 1 (acquisition costs are fully expensed upfront). Mr. Coleman noted the opposite is true in Australia where there is no upfront profit.

Contract boundary

The Boards also re-deliberated certain criteria around setting the contract boundary. The Staff noted that most respondents agreed with the contract boundary provisions within the IASB's exposure draft and the FASB's discussion paper. However, some questioned whether the proposed contract boundary was "drawn in the right place" as it may affect the contract's eligibility for the modified approach for short-duration contracts. These concerns primarily stemmed from the health insurance sector but may extend to other sectors as well.

The discussion focused on:

  • Whether a contract renewal should be treated as a new contract when the existing contract does not confer on the policyholder any substantive rights
  • Whether this assessment should be made at the particular policy holder level or at the portfolio level (when pricing of the premiums does not include risks relating to future periods).

The Staff noted a distinction between those contracts that are priced for future risk (for example, a 10 year life insurance contract where the insured party pays $100/year, even though the actual cost may be $70 in year 1 versus $115 in year 10) and those that can be re-priced each year, even though it may be done at the portfolio level.

Some board members expressed concerns over unintended consequences not yet identified in providing a practical expedient, noting it may put too much business in the short-term bucket. Other board members supported the portfolio view, noting that if the insurer can re-price the contract, they can "get out of" the contract. Ultimately, both boards voted for the following:

  • A contract renewal should be treated as a new contract when the existing contract does not confer on the policyholder any substantive rights
  • This assessment should be made at the portfolio level but only if the pricing does not include risks related to future periods
  • All renewal rights should be considered in determining the contract boundary, whether arising from contract, law, or regulation.

 

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