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Business Model Draft For Meeting 20110111
 

Business Model Draft For Meeting 20110111

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    Business Model Draft For Meeting 20110111 Business Model Draft For Meeting 20110111 Document Transcript

    • Measurement and Presentation of Insurance Contracts Based on the Insurer’s Business Model Proposed principle – Measurement and presentation of insurance contracts should be based on the insurer’s business model for managing its insurance liabilities, with additional disclosure to meet the needs of investors and other financial statement users. (Note. Corresponds to classification and measurement principle in IFRS 9 (paragraph 4.1) – “Unless paragraph 4.5 applies, an entity shall classify financial assets as subsequently measured at either amortized cost or fair value on the basis of both: a) the entity’s business model for managing financial assets; and b) the contractual cash flow characteristics of the financial asset.” Paragraph 4.5 allows measurement at fair value through profit or loss to reduce accounting mismatch.) What is meant by “the insurer’s business model”? (Note. According to Application Guidance in Appendix B of IFRS 9 (paragraph B4.1), “Paragraph 4.1(a) requires an entity to classify financial assets as subsequently measured at amortized cost or fair value on the basis of the entity’s business model for managing the financial assets. An entity assesses whether its financial assets meet this condition on the basis of the objective of the business model as determined by the entity’s key management personnel (as defined in IAS 24 Related Party Disclosures.)”. “Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.”) - The business model is determined from how the insurer manages its business and analyzes its performance (planning, directing, controlling) - How it reports to management, shareholders if any, and other stakeholders - How it manages risks inherent in the business - How it establishes the prices it charges to customers The two most basic business models for managing insurance contracts are: - The asset liability management (ALM) business model – This model is focused on all cash flows of the business including investment income on all assets, to minimize the risk of cash flow mismatches, considering the risks of both favorable and unfavorable variations in those cash flows. This business model is typical of long duration insurance contracts in which the insurer accumulates significant asset portfolios at times over the life of the contracts. Additional information will be found in papers on cost option, discount rates, and presentation (being prepared by the ACLI); and on the cost option (how it would work and how it could be combined with an OCI solution) (being prepared by Allianz) - The underwriting business model (“UBM”) - The UBM is focused on underwriting results, which include premiums from policyholders, benefits paid for covered claims and related claims expenses, and expenses incurred; all on an undiscounted (i.e., ultimate) basis and without explicit risk adjustments. This is 1
    • consistent with how property-casualty insurers underwrite, manage, and evaluate the performance of their insurance business. Investment income, while important, is a secondary consideration and not a component of underwriting income. The UBM is typical for most short duration property-casualty insurance contracts, for which success is heavily dependent on close monitoring of underwriting results. Attachment 1 to this paper is a diagram of the business model paradigm for insurance contracts, which aligns insurance contract attributes with the business models. Attachment 2 provides additional information on the UBM. (Should other models, or subsets of the basic models, be described? Should additional considerations be described for reinsurance or for particular types of direct contracts?) ALM Business Model This business model is consistent with a building blocks measurement approach (discounted, mean expected cash flows, with margin(s)). It is based on matching asset and liability cash flows over the life of insurance contracts. Accounting volatility caused by inconsistent measurement of assets and liabilities does not provide an accurate representation of the performance of the business and is not predictive of future results. The interaction of the accounting models for insurance liabilities and invested assets should be coordinated to produce a meaningful reflection of the insurer’s performance. The rate(s) used to discount expected cash flows in the measurement models should be consistent with the business model. Discount rates based on how insurance contracts are priced and managed will be more reflective of the characteristics of the liabilities than adjusting risk free rates for illiquidity. In the absence of evidence to the contrary, the interest rate explicit (or implicit) in pricing should be considered to reflect the characteristics of the insurance contract liabilities at the time of sale. Measurement alternatives Current rate bases (alternatives based on rates as of the reporting date) - Discount cash flows based on current rates inherent in how contracts are priced (i.e., update discount rates based on current pricing for identical or similar products). - Consider the mechanics and assumptions used in the pricing process (in effect as of the reporting date). - If there is not a current pricing benchmark, use the most recent pricing point that would be relevant, and update it to reflect current market data (e.g., changes in market benchmark rates). - Project future portfolio earnings rates based on current portfolio yields and projected future investment rates, consistent with current yield curves. All yield rates are net of expected defaults and investment expenses. - Current asset earned rate (net of deductions for defaults and investment expenses). 2
    • - Reference portfolio - Use discount rates linked to realistically investable assets representing a typical portfolio, with appropriate adjustments for defaults and expenses. - A single market reference rate (e.g., a high grade corporate bond rate). - Use of a single reference rate could lead to unnatural demand for that particular asset class, potentially creating market distortions. - A part of the Canadian proposal, with presentation as described below. Cost rate bases (alternatives based on rates at inception of an insurance contract) - Project future portfolio earnings rates based on current portfolio book yields and projected future investment rates, consistent with current yield curves. All yield curves are net of expected defaults and investment expenses. - Permit use of discount rates established at inception for the entire duration of the contract (locked in rate) if the cash flows are not interest rate dependent. - Liability values would be determined from current estimates of cash flows, to which the locked in discount rates would be applied. - It would require a “business model test” similar to that in IFRS 9 and a liability adequacy/onerous contract test. Elements other than the discount rates could also be considered for better alignment of measurement with the business model. - Remeasure the margin (residual, composite) to reflect effects of changes in assumptions not observable in financial markets (with differences between current estimates and actual experience recognized in profit or loss). - Option to unbundle (account balance) components and allow them to be measured at amortized cost under IFRS 9 (if this is consistent with how the contracts are managed). - Develop a macro hedge accounting approach that is capable of reflecting an insurer’s asset-liability management under the IASB’s proposed hedge accounting amendments to IFRS 9. - As an illustrative example, cash flows from interest rate guarantees in insurance liabilities are hedged by insurers using fixed rate assets. This could be considered to create a macro cash flow hedge relationship. Because the objective of macro hedge accounting is to remove the volatility from profit when a hedging relationship is in place, insurers should be entitled under the future IFRS 9, in the same way as banks, to seek solutions to the volatility issue that would be common across the financial services sector and not industry specific. The macro hedge accounting debate offers this opportunity. 3
    • Presentation alternatives Other comprehensive income - Elements of changes in value of insurance liabilities directly due to changes in financial assumptions are taken into OCI rather than reflecting all such changes in net income, on a basis that is consistent with treatment of unrealized gains and losses on assets. - Such a solution may involve reopening IFRS 9 (aligned with an available for sale asset category). - Alternatively, an OCI model could be considered that doesn’t require reopening IFRS 9, by developing a basis for presentation with underlying operating performance shown in net income separately from short term market movements related to both assets and liabilities that are not representative of long-term performance. - Recycling to capture timing differences caused by an unmatched measurement model. Canadian proposal - In profit or loss, discount at the long-term rate the insurer expects to earn on its investments (i.e., a rate determined based on a probability-weighted estimate of the net cash inflows that the insurer expects to earn on its investments, net of expected defaults/losses and including a risk adjustment). - In OCI, the insurer would report the change in the difference between discounting the liability using a current market observable rate (i.e., a high quality corporate rate, or a rate derived from a reference portfolio of realistically investible assets) and the long-term expected rate of return on investments (the rate used in profit or loss)). - Reflects the insurer’s business model in profit or loss, and provides transparent and comparable measurement on the balance sheet. The basis of presentation should be consistent with the insurer’s business model, could be based on premiums or margins, and should be supplemented by disclosure to meet the needs of investors and other financial statement users. Underwriting Business Model (see attachment for further information descriptive of this model) The UBM is the predominate measurement model employed consistently throughout most of the world by property-casualty insurers. The UBM is based on undiscounted (i.e., ultimate) values for premiums, claims, claims expenses, and other expenses; and does not incorporate explicit risk adjustments. The UBM is understandable to investors and other financial statement users, comparable, and has proven reliable over time throughout a variety of business environments, business cycles, and across diverse geographies. The importance of the UBM is that it allows property-casualty insurers to measure and report their business activities in a manner consistent with how they underwrite, manage, and evaluate the performance of their business. 4
    • Implications for measurement and presentation applying the traditional UBM include: - No discounting or explicit risk adjustments in pre-claim or post-claim periods; - All revenue is earned over the policy coverage period which coincides with the period over which insurance protection is provided; there is no insurance protection risk beyond the coverage provided, only adverse claim development risk; - Presentation of claim experience through claims development tables; - Operating performance presented through the underwriting income or loss metric; as opposed to a margin presentation, which is not consistent with this business model. Notwithstanding the existence of the traditional UBM utilized throughout most of the world, several countries utilize both discounting and explicit risk adjustments in measurement and presentation of their property-casualty insurance business. The objective of the Conceptual Framework for Financial Reporting is to provide relevant, representationally faithful, comparable information to investors and other financial statement users. To achieve this objective, reporting entities should measure and present their business and business results in a manner consistent with how they underwrite, manage, and evaluate performance. Accordingly, the final standard should allow these companies and their respective countries to measure and present their insurance business on a discounted basis and incorporating risk adjustments, consistent with their business model. Other considerations (applicable to both models) - Reclassification between business models would be very rare, but would be allowed (with transparent disclosure) when, and only when, the insurer’s business model changes. - No gain at inception (in both models, no gain is recognized before insurance services are provided). - Unbundling would be allowed only if (and to the extent that) it is consistent with the insurer’s business model. - The level of aggregation in measurement and presentation should be consistent with the insurer’s business model. - Diversification benefits (and costs) could be recognized across portfolios, if based on the insurer’s business model, and if the insurer is legally and practically able to realize such benefits (and costs). - The basis of presentation should be consistent with the business model, and should be supplemented by disclosure to meet the needs of investors and other financial statement users. 5
    • Attachment 1 Business Model Paradigm for Insurance Contracts (see attached document) 6
    • Attachment 2 The Underwriting Business Model Short duration 1 property-casualty insurance contracts typically utilize an underwriting business model (“UBM”). The UBM is characterized by the following attributes: Premiums typically single and fixed; Claims typically emerge quickly and latent exposures not subject to reliable estimation; Dollar amount of insurance risk variable up to policy limits; Insurance risks typically re-underwritten and re-priced annually or more frequently due to dynamics of underlying risks; Contracts are cancellable during the coverage period with mandatory pro-rata refunds; Primary performance metrics: o Written and Earned Premiums o Claims and Claims Expense o Operating Expenses o Underwriting Income or (Loss) Primary performance analytical tool o Claim Development Tables The short coverage period is by design as the covered risks are very dynamic; this requires the insurer to maintain the ability to re-underwrite and re-price covered risks on a very frequent basis. That is, as claims tend to emerge quickly, if profitability issues arise, they must be addressed through underwriting and pricing as opposed to investment strategies. Consistent with the secondary importance of investment income, the UBM focuses on underwriting income or loss (the components of which are premiums, claims, claims expenses, and operating expenses); all measured on an ultimate (i.e., undiscounted) basis. This measurement basis has been in place for decades throughout most of the world and has worked well for most non-life insurance contracts. This measurement methodology has the benefit of being time tested through a variety of economic environments, business cycles, and across diverse geographic environments. The most critical metric for investors and other users of property-casualty insurer financial statements is the adequacy of claim and claim expense reserves. Over time, 1 : Insurance contracts shall be classified as short of long-duration contracts depending on whether they are expected to remain in force for an extended period. Factors considered in determining whether a particular contract can be expected to remain in force for an extended are as follows for a short-duration contract: a. The contract provides insurance protection for a fixed period of short-duration. b. The contract enables the insurer to cancel the contract or to adjust the provisions of the contract at the end of any contract period, such as adjusting the amount of premiums charged or coverage provided. Factors considered in determining whether a particular contract can be expected to remain in force for an extended period are as follows for a long-duration contract: a. The contract is generally not subject to unilateral changes, such as a non-cancellable or guaranteed renewable contract. b. The contract requires performance of various functions and services (including insurance protection) for an extended period. 7
    • the adequacy of claim and claim expense reserves has been the principal determinant of the failure of property-casualty insurers. The adequacy of claim and claim expense reserves is most clearly supported by an UBM, the most prominent element of which is claim and claim expense reserves on an undiscounted basis. Presenting claim and claim expense data on an ultimate basis allows investors and other financial statement users to most effectively evaluate the adequacy of claim and claim expense reserves though reconciliation with paid and incurred statutory claim data presented on an accident year basis. The measurements required by the ED for property-casualty insurance contracts are fundamentally inconsistent with the UBM. As a result, the information would not be effective for use by management to underwrite, manage, or evaluate the results of its property-casualty insurance business. More specifically, existing practice for most property-casualty insurers is to develop case reserves on a local/specific claim basis and to aggregate local estimates centrally. These aggregated estimates are supplemented based on an evaluation of historical and expected future trends developed using time-tested statistical and non-statistical methods and models applied by trained actuaries. Under the proposal, discounting and risk adjustments would be developed centrally and it would likely not be possible to allocate the adjustments down to a local/specific claim level in a manner that would allow the information to be useful in managing or evaluating the performance of the business. 8