Preparing for PrinciplesBased Financial Reporting
and Solvency Standards
A. David Pelletier FCIA, FSA
Executive Vice President
RGA Reinsurance Company
Institute of Actuaries of JapanTokyo, June 2009

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What we’ll coverI.

IFRS – an update

II.

Solvency standards – an update

III. Impact on a company’s assets,liabilities, products, ...
IV. Impact on the actuary’s work,
training, and systems
V.

Possible outcomes in Japan
2I.

IFRS – an update• Why global standards• Framework• Phase I• Phase II and where it’s heading

3

A global set of accounting
standards - why• Given that companies operate, and raise capital,
increasingly more globally• To enhance transparency and comparability of companies
in same industry across different countries• To reduce cost of capital via better access to capital
markets• Will in many countries result in an improvement overcurrent standards• Hopefully will ultimately lead to a single basis forgeneral purpose and statutory reporting
4

IFRS reporting framework
AssetsLiabilities
Insurance Contracts

Phase I(2005)

Phase II(20XX ?)Investment Contracts

IFRS 4
IAS 39 for
Invested
AssetsIAS 39andIAS 18
Phase II5

Insurance contracts - Phase I• IFRS 4 as temporary solution – “Keep doing what
you’re doing, mostly!”• Liability adequacy test
• Elimination of equalization/cat reserves• Reporting of reinsurance• Reinsurance ceded moved to the asset side of the balance
sheet• Reinsurance premiums to be reported as an expense, notoffset against premium income• Some “unbundling” and separate accounting of“embedded derivatives”• More extensive disclosure requirements• Management, concentration and mitigation of risks• Assumptions and sensitivity analysis
6Phase II timeline highlights• 1999 – Issues Paper on Insurance producedby the IASB’s predecessor IASC
• 2001 – Draft Statement of Principles• 2005 – IFRS 4 as temporary measure(Phase I)• 2007 – Discussion Paper• Oct 2008 – FASB formally joins project• April 2010 ? – Exposure Draft• July 2011 ?? – Final standard• 2013 ??? – Effective date
7

The old approach ...
• The liabilities Ax+t – Px äx+t

• based on frozen assumptions, potentially irrelevant later• using a premium that wasn’t the one actually being paid
• ignoring various contingencies (lapse!) and benefits (cashvalues)• ignoring specific reinsurance treaty features• erroneously considered to be automatically conservative(and along came “negative spread”)• eventually suggesting “cashflow testing” to see if the resultsof all these old-fashioned calculations made any sense• And then compared to assets not held at what they
were worth, and/or not at values consistent with themeasurement of the liabilities• Unfortunately, not so old ...
8

Getting (slowly!) to the newway• Best estimate assumptions, and process fordeveloping them
• Explicit margins, and process for developing them
• Ongoing revision of assumptions• All significant benefits, risks picked up, including
actual features of reinsurance treaties• Measurement of assets and liabilities on aconsistent basis• Potentially simpler to explain and understand, butmore complex to carry out
9What we’ll see in IFRS 4 Phase II• Liability will be a discounted cashflow
approach• Present value of probability-weighted cash flows,
using up-to-date assumptions and observable
market inputs where they exist• Insurers must consider embedded options,guarantees, policyholder cancellation options,and participation rights• Practical translation• Net liability will be what you’re going to pay out,
less what you’re going to take in, measured
realistically on an up-to-date basis, with a risk
margin• But the process of getting there will be more
complex, and the results will be more volatile10Some issues••••

Exit value vs fulfillment value vs IAS 37 model
Use of risk-free rates for discounting (and impact whereproducts priced using expected asset returns)
Use of own credit standing
Approaches towards the risk margin• “Provision for Adverse Deviation”, vs• Cost of capital• Not a “shock absorber”••••

Unbundling (bifurcation) for contracts that include deposit andinsurance elements
Gain at issue (“Day one difference”).
Possible (unfortunate?) impact of separate “revenue
recognition project”.
Consideration of renewal premiums

Will they get to the right answers???
11Various candidate approaches
Exit value 1

Fulfillment
IAS 37 model Fulfillment
value 2(discarded) updated
value 4

Definition

Amount totransferobligations

PV of cost to
fulfillobligations

Margincomponents

Market risk +servicemargins

Risk margin

Marginremeasurement in future

Yes

Day 1
difference
Liability
adequacy test
Own credit
standing

Rational am’t torelieve oblig’ns,
plus additional
marginCost margin +add’l margin
based on Day 1
differenceSame, but with“composite”
marginYes

Risk margin
portion onlyNo Composite
margin fixed

Recognized

RecognizedNo Day 1 profit

No Day 1 profit;
Loss if onerous

Not required

Not required

Not required

Reflected

Not reflected

Not reflected

Required onlyat inception
Not reflected

Composite
margincalibrated topremium

Source: IASB Agenda Papers 10E of Feb 2009 and 10A, B, D of June 200912

II. Solvency standards –an update• Early solvency requirements• Solvency II in Europe• A view from Canada

13Early Solvency Requirements• Accounting Rules• EU Solvency I• Canadian MCCSR• US RBC• Australia, Japan, and many more

14

Early solvency measurement
shortcomings• Looked only at liabilities• Didn’t differentiate by risk
• Didn’t cover all the risks• Didn’t recognize guarantees• Didn’t keep pace with product evolution

15

Solvency II – Three-pillar
approach1
Three-pillar approach(and reflecting Basel II approach)

Pillar 1:
Quantitative
capital requirements Technical provisions
 Minimum capitalrequirement (MCR) Solvency Capital
Requirement (SCR) Eligible capitalMarket-consistentvaluation of assets andliabilities
Validation of internalmodels
1.
2.

Pillar 2:

Pillar 3:

Qualitative
supervisory review
process
 Principles for internal
control and risk
management
 Own risk and solvency
assessment (ORSA)
 Capital add-ons?

Disclosures
 Enhance market discipline
through public disclosures
 Provide additional (nonpublic) information to thesupervisors

New focus for supervisor
Level of harmonisation
Group supervision2

More pressure from
capital markets and rating
agencies

Source: CEIOPS
Aspects of group supervision deleted from current draft directive

16

Pillar 1 – Key Features• Solvency Capital Requirement – 99.5% VaRover 1 year
• Scenarios instead of factors• Correlation assumptions• Standard formula or internal models• Utilizes calculation of market-consistentvalues of assets and liabilities

17

The SCR Standard Approach
SCR

Non-LifeMarket

Basic SCR

Operationalrisk

HealthDefault

Correlation
Factorbased
LifePremium
reserve

Currency

ExpenseCatastrophe

Property

ClaimsLapse

Longevity

Interest
rate

Epidemic

ExpenseCatastrophe

Disability

Revision

Concentration

EquityMortality

Scenario
based
Adjustment for
Risk-mitigating
effect of future
profit-sharing

SpreadSource: CEIOPS

18

Sample covariance matrix(Life risk)

Source: European Commission, QIS 4 Technical Specifications19

A view from Canada• Unlike the US, Canada has preferred tohave principles-based “statutory” and“Canadian GAAP” one and the same
• A separate solvency calculation MCCSR on
top of the liabilities• But now, the regulator OSFI losing influence
over Canadian GAAP as it moves to IFRS
• Simple solution: Total Asset Requirement

20

Total Asset Requirement• Traditional approach: add solvency
requirement on top of policy liabilities• What Canada will do instead: determine
total assets required for financial strengthand then subtract policy liabilities todetermine required capital• Hence:• can maintain same total asset requirement asliability accounting standards change• can automatically adjust for features of IFRS thatare “unacceptable” to OSFI
21

III. Impact on a company’s
assets, liabilities, products ...
• Of emerging solvency requirements• Of IFRS• Examples of profit stream• Illustration of volatility

Source: CEIOPS-SEC-107/08 19 March 200922

Impact of emerging solvency
requirements• Will drive greater focus on assetliability management:• Finding/generating longer assets, or• Reducing duration of products?

• May lead to greater risk diversification
by insurers• May lead to greater use of reinsurance• Will require good communication skills
on part of actuaries, so not a “blackbox”
23

Impact of IFRS (includingPhase II)• In many countries on many products:• Life insurance liabilities will tend to drop relative
to past statutory results, as undue
conservatism stripped away
• Investment contract liabilities may tend to rise,due to use of risk-free discount rates• On some products in some countries (eg,where negative spread exists), a potentiallysignificant increase in liabilities• Relative to US GAAP, see Society ofActuaries’ Research Report at:
http://www.soa.org/files/pdf/research-2008-ifrs-report.pdf
24IFRS exit value approach vs US
GAAP: Term New Business Profit
25000000
20000000
15000000
IFRS

10000000US GAAP

5000000

0369111171-5000000

40Source: Society of Actuaries Research Report, 2008.01.29
25IFRS exit value approach vs US
GAAP: LTC New Business Profit
5000000

0369111171-5000000

40-10000000

IFRS-15000000

US GAAP-20000000-25000000-30000000

Source: Society of Actuaries Research Report, 2008.01.29
26

Volatility: Actual example of life
product under IFRS-like approach
1. Pricing, hence
before issue•

Change of 1% ineither assumed
lapse or interest
rate would drive
premium up byaround 10-12%

2. Valuation, after
issue:•

Change of 1% ineither assumed
lapse or interest
rate would drive
reserves up byaround 50%•Note: premiums
now fixed, so muchgreater impact on
PV of benefits thanPV of premiums!
27

Liability (ignoring reinsurance):• Sum of PV of:• Less sum of PV of:• death benefits• actual premiums• surrender benefits• any other policyrelated income• dividends• commissions andexpenses• any otherdisbursements

28

Impact of assumption change(say i from 5% to 2%)• Before change: V = Ax+t – Px äx+t @ 5%
• After change: V = Ax+t – Px äx+t @ 2%?????
29

Impact of assumption change(say i from 5% to 2%)• Before change: V = Ax+t – Px äx+t @ 5%
• After change: V = Ax+t – Px äx+t @ 2%5%
• After change: V = Ax+t – Px
äx+t @ 2%30

Numerical illustration
Impact of Actuarial Assumption Strengthening

BeforeAssets1100

Liabilities. PV Benefits. PV Premiums. Difference

10000
9000
1000

Surplus100

Earnings

2031

Numerical illustration (cont’d)
Impact of Actuarial Assumption Strengthening

BeforeAfter

ChangeAssets

1100

1100

0%

Liabilities. PV Benefits. PV Premiums. Difference

10000
9000
1000

10500
9270

5%
3%

Surplus100

Earnings2032

Numerical illustration (cont’d)
Impact of Actuarial Assumption Strengthening

BeforeAfterChange

Assets

1100

1100

0%

Liabilities. PV Benefits. PV Premiums. Difference

10000
9000
1000

10500
9270
1230

5%
3%
23%

Surplus

100Earnings

2033

Numerical illustration (cont’d)
Impact of Actuarial Assumption Strengthening

BeforeAfterChangeAssets

1100

1100

0%

Liabilities. PV Benefits. PV Premiums. Difference

10000
9000
1000

10500
9270
1230

5%
3%
23%

Surplus100-130-230%

Earnings

20-210-1150%
34

IV. Impact on the actuary’s work,
training, and systems• Principles• Judgement and impact• Future focus on measuring andmanaging risk

35

An opening perspective• Post-Enron, a widely-sharedperspective that “principles-based”
rather than “rules-based” approaches
preferable
BUT

36

An opening perspective• Post-Enron, a widely-sharedperspective that “principles-based”
rather than “rules-based” approaches
preferable
BUT• Principles-based approaches work only
• if the principles make sense, and• with people who have them, and canmake sound judgements accordingly
37

The role, and training, of theactuary• Ability to manipulate commutation columns
doesn’t matter any more
• Assumption-setting• Huge impact on financial statements• No longer a question of meekly following the rules
from the regulator• Understanding both sides of the balance
sheet, and what can go wrong• Judgement on trends, impact, whistleblowing, ...
38

Assumption Setting Process* at
Sun Life Financial
SLF Chief Actuary

BG Chief Actuary
BG Valuation
Practice Leader

BG Pricing
Practice Leader

BG Req’d
Assumptions

BG Req’d
Assumptions

BU Valuation
Actuaries

Experience
StudiesSOE

BU Pricing
Actuaries

Plan Economic
Assumptions

Investment
Assumptions*Quarterly(!!) for some, annually for others

39Possible support for the actuary in
his/her professional role
• Standard-setting• Techniques• Expected assumptions• Margins• Possibly, given lessons
learned from financial
crisis, dynamic
solvency testing(stress-testing rather
than mere models)• Software???

• Possibly, given impactof actuary’s work, peer
review• Assumptions/methods• Procedures/verification• Quality/clarity ofcommunication• Reasonableness• Materiality• Discipline

40

The skill that will be needed: an example

Source: Price Waterhouse Coopers Insurance Digest41

V. Possible outcomes inJapan• IFRS: When and which?
• Solvency standards – bringing it in linewith other developed countries

42

IFRS: when and which?
• When will Japan adopt IFRS? Before orafter IFRS 4 is amended by Phase II?
• If it’s before Phase II is implemented(unlikely), a double conversion??
• Will the FSA require IFRS for all insurancecompanies (à la Canada) or just listed ones?
• What will Phase II finally look like?
• What will the impact of negative spread be?
• How much volatility will it introduce?

43

Solvency standards• A Solvency II approach?
• A Total Asset Requirement approach?
• Importance of both the numerator and thedenominator• Regardless, eventually full recognition ofasset-liability mismatch

44

For both IFRS and solvency
reporting• Lots of work for the actuaries (good)• But a lot of work in standard-setting,software development, and technicaland professional training to get there

45

Sources for reference• www.iasb.org - International AccountingStandards Board• www.iaisweb.org - International Association of
Insurance Supervisors• www.actuaries.org - International ActuarialAssociation• www.cfoforum.nl - CFO Forum• www.croforum.org - CFO Forum46