IFRS4
1. Background information
The International Accounting Standard Board's (IASB) paper "Preliminary Views on Insurance Contracts", published on 3 May 2007 ("the Discussion Paper") puts forward a current-exit-value approach to setting technical provisions. In principle, the current exit value should represent the amount the insurer has to pay at the reporting date in order to transfer immediately its remaining contractual rights and obligations to a third party of equivalent credit standing.Official Journal of the European Union
2. Definitions
The approach follows that set out in the draft Framework Directive, but with a slightly weaker requirement to value the constructive liability for future policyholder dividends/bonuses.The main proposition in the Discussion Paper(DP) is that all insurance liabilities (including life, non-life, direct insurance and reinsurance) should be measured at current exit value (CEV) using the following three building blocks:
I. Current estimates: explicit, unbiased, market-consistent, probability weighted and current estimates of the contractual cash flows;
II. Time value of money: current market discount rates that adjust the estimated future cash flows for the time value of money; and
III. Margins: an explicit and unbiased estimate of the margin that market participants require for bearing risk (risk margin) and for providing other services, if any (service margin).
CEV is defined as the amount an insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another entity. Typically, the CEV of an insurance liability is not observable so it must be estimated using the three building blocks described above. The purpose of this measurement attribute is to provide useful information that will help users make economic decisions.
I. Current estimates:
The Board's view is that estimates of future cash flows used to measure insurance liabilities should:
Explicit:
The use of explicit estimates would provide a more accurate representation of the insurer's obligations to policyholders. The information resulting from using explicit estimates would make it easier for users to understand and compare with other liabilities, such as "provisions" and "employee benefits", which are accounted for using other IFRSs.
Unbiased:
The measurement should start with an estimate of the expected present value(PV) of the cash flows generated by the contract. Furthermore, when estimating the PV using all the possible scenarios, each of these should be neutral, i.e. the estimates and their probability should not include a margin for prudence or optimism.
Consistency with observed market prices:
More relevant and reliable measurements will result from using inputs consistent with observed market prices. Examples of such observable inputs are interest rates and mortality rates for which industry standard tables are used across companies. In developing estimates that are observable from market transactions, insurers will need to consider all available data, external and internal, ensuring the resulting assumptions do not contradict current market variables. This is achievable for estimates of variables which are clearly observable in the market. However, this may be difficult to demonstrate where there is no readily observable market such as obtaining a "market value" for service margins.
Current estimates:
The approach to estimate cash flows for claims liabilities should use all currently available information as opposed to using a "lock in" approach. The view is that it gives more faithful representation of the insurer's contractual obligations and rights, and provides more useful information about the amounts, timing and uncertainty of the cash flows generated by the contract. Using current estimates avoids the need for a separate liability adequacy test and may also reduce the need to separate embedded derivatives. Another advantage noted by the Board is the improved consistency with other IFRSs that use current estimates of future cash flows, such as IAS37 and IAS39.
Entity-specific cash flows:
The measurement of an insurance liability should reflect the cash flows generated by that liability, without taking into account those generated by other assets and liabilities or resulting from internal synergies. Two different insurers reserving for an identical contract should arrive at the same measurement of the liability borne from the obligations of that contract. "Entity-specific" should not be confused with "portfoliospecific". For example, estimated mortality related cash flows are portfolio specific and may differ from one company to another for an otherwise identical contract, simply because the insured population characteristics differ between the companies.
II. Time value:
Cash flows measured on the basis that reflects the time value of money means they are discounted. The DP raises two questions under this heading: whether the carrying amount of insurance liabilities should reflect the time value of money and if it does, how should the discount rate be determined. Life insurers are used to the concept of discounted liabilities. On the other hand, non-life insurers do not generally use discounting when valuing their claims liabilities, with the exception of a few countries or a limited range of liabilities, particularly where there is an extended settlement period.The Board's view is that discounting should be used for all insurance liabilities, including non-life claims liabilities. Although it recognizes it may cause some increase in both subjectivity and cost, the Board feels the increase in relevance resulting from discounting is greater than the drawbacks. The DP however points out that IAS8 (Accounting Policies, Changes in Accounting Estimates and Errors) would allow cash flows not to be discounted when the effect of discounting is immaterial.
When reflecting the time value of money, the discount rate should adjust estimated future cash flows in a way that captures the characteristics of the liability, not those of the assets backing the liabilities. It is the Board's view that the discount rate should therefore be consistent with observable current market prices for cash flows whose characteristics match those of the insurance liability. Whichever assets are held to back the insurance obligations, the value of those liabilities bears no relationship to these assets and therefore, it would be inappropriate to base the discount rate on the expected returns on the backing assets.
III. A. Risk margin:
It is the Board's view that the measurement of liabilities needs to include margins that reflect the extent of the uncertainty inherent in insurance cash flows. Its views are as follows:The purpose of a risk margin is that it measures the compensation that entities demand for bearing risk, adjusting the margin at each reporting date by assessing how much risk remains in the liabilities. The risk margin that would be demanded by market participants cannot be observed in the absence of a market and will need to be estimated both at inception and subsequently by the insurer, based on market data and internal information on the liabilities. When calibrating the risk margin, the premium paid at inception is an important reasonableness check on the initial measurement of the insurance liability. However, it should not override an unbiased estimate of the margin that market participants require for bearing risk. The risk margin should provide relevant information about the uncertainty associated with future cash flows and for that to be the case, the risk margin should be an explicit and unbiased estimate of the margin market participants require for bearing risk.
III B. Service margin
As well as bearing risk, insurance contracts generally require an insurer to provide other services, such as investment management services in participating type contracts or claims handling costs, for which adequate compensation should be paid. Therefore, when measuring its liability, an insurer should include a service margin that market participants typically require for such services. The Board's view is that the measurement of an insurance liability should incorporate, in addition to the margin for the service of bearing risk, an unbiased estimate of the margin, if any, that market participants would require for rendering other services. The DP notes that the CEV approach to service margin is significantly different to the IAS18 model. Under the CEV, profit may be recognized at inception and subsequent recognition of service margin is based on the margin market participants would require not the service margin implicit or explicit in the contract. The CEV principle of excluding entityspecific cash flows means that, in measuring its insurance liability, an insurer should in theory use servicing costs that market participants would incur as opposed to its own. However, in practice, it is expected that an insurer would use its own cash flows unless there is clear evidence that it is significantly more or less efficient than other market participants, in which case the insurer would use the market's assumption.Insurance Market Update June 2007 (PDF)
3. Differences in approach:
| Solvency II | IASB Discussion Paper | MCEV |
|---|---|---|
|
Basic Measurement Approach Pure exit value with best estimate liability assessed as the mean of policyholder liability cash flows Form of risk margins prescribed. |
Exit value but with profit margins for service elements. Best estimate liability assessed as the mean of policyholder liability cash flows Guidance on criteria for risk margins supplied. |
Settlement value with best estimate liability assessed from the mean of shareholder cash flows |
| Allowance for own credit risk No |
Yes | Not in practice |
|
Treatment of investment contract No special treatment |
Value using IAS 39 and IAS 18 | No special treatment |
|
Allowance for expenses Entity-specific |
Market related | Entity-specific |
|
Future premiums Full allowance |
Restricted allowance | Full allowance |
|
Participating business Allowance required for future bonus |
Future bonuses must satisfy normal rules for constructive liability | Allowance required for future bonus and policyholder share of orphan assets incorporating shareholder burn-through cost |