Society of Actuaries’
Liability Modeling Project
IASB’s Insurance Contracts
Exposure Draft: Where are we now?
Where are we going?
R. Thomas Herget, FSA, MAAA, CERA
President, RiskLighthouse
October/November, 2010

Contents
 Brief History of the Insurance Contracts
Project
 Impact of Preliminary Views (PV)comments on Exposure Draft (ED) ED Highlights
 Earnings patterns from the Society ofActuaries study for life, annuity and healthproducts
 What others think – preliminary feedback Next steps

2

Brief History3History of Project - IASB
 International Accounting Standards Board• London-based, 14 members from 9 countries• Dedicated staff• Insurance Working Group (IWG)• Worked with FASB (U.S. Financial AccountingStandards Board) (2008-2010)• Pronouncements:
IAS (International Accounting Standards)
 IFRS (International Financial Reporting Standards)
 These are identical – IAS was published before IFRS

4History of Project - Influencers• Those providing significant input:
 CFO Forum (European insurers)
 GNAIE – Group of North American Insurance
Enterprises
 Insurers from Japan
 IAA (International Actuarial Association)
 IAIS (International Association of
Insurance Supervisors) European Union (EU) – they mandate the IASB
make the standards, but each country must adopt

5History of Project - Objectives
 To provide information to users offinancial statements that is relevant
for economic decision-making
 To eliminate inconsistencies andweaknesses in existing practices
 To provide comparability acrossentities, jurisdictions and capital
markets
6

History of Project – Phase 1
 Phase 1 started in 1997
 2001 Draft Statement of Principles
 2004 - Phase 1 ended with IFRS4• Defined insurance• Revised IAS 39, guidance for investment
products• Existing local GAAP with additional disclosureand loss recognition was permitted• Still allowed diverse practices

 Applies to insurance contracts, notinsurance companies
7

History of Project – Phase 2
 Phase 2 started mid-2004• IASB, IASB staff and IWG worked on a
discussion paper called “Preliminary Views” or“Discussion Paper,” released in May 2007
• Main text – 150 pages; Appendices – 80
pages
• Over 160 Comments letters• Had something appealing and something
offending to everybody

8Impact of Preliminary Views(PV), also called Discussion
Paper (DP), Comments on
Exposure Draft

9Impact of PV Comments # 1
 Unwarranted profits at issue• For products without heavy investment
component• Discounting all cash flows coupled withsmaller risk margin (now called Risk
Adjustment) They listened, and we get• Residual Margin, an unearned profit reserve
calibrated so no profits appear at issue10Impact of PV Comments # 2
 Unwarranted losses at issue• For savings-oriented products• Use of risk-free rate as discount rate caused
heavy losses at issue They listened, and we get• A higher discount rate, the risk-free rate plus
an illiquidity adjustment11

Impact of PV Comments # 3
 Use of “Exit Value” concept• Hypothetical; not enough transactions• Should reflect own viewpoint, not someone
else’s• Can’t determine market assumptions

 They listened, and we get• Fulfillment value

Based on what you think it takes to fulfill thecontract12Impact of PV Comments # 4
 Loss of comparability due to lack of
specificity on Risk Margins• Cited 8 methods• No limitations on range of assumptions

 They listened, and we get• Three methods eligible for Risk Margins• Coupled with constraints (lower limits) on
results13

Impact of PV Comments # 5
 Limitation on cash flows• Contractual – future premiums notnecessarily mandatory• Contractual – future dividends andinterest credits not mandatory

 They listened, and we get• All relevant cash flows included
14

Impact of PV Comments # 6
 Service Margin• What exactly is this?
• Why would we need this?

 They listened, and we get• No Service Margin in the ED

15

Impact of PV Comments # 7
 Non-performance Risk
• Including the risk that the insurer will not
perform in establishing the discount rate
for cash flows• This results in lower liabilities for riskier
companies They listened, and we get• No non-performance risk in ED
16

Course Changes during 2010
 Acquisition costs – headed towards
no recognition• Significant input by interested parties put
these issues back on track Unbundling• Some clarity needed• Introduced in June just before release ofED
17

The Lesson Learned
 Express your opinion…
• During the remaining Comment Period(ends November 30)• During final deliberations

 They are listening Offer solutions
18

ED Highlights(as they relate to this presentation)

19

ED Highlights
 Four Building Blocks• Current Estimates of Future Cash Flows• Time Value of Money• Risk Adjustment• Residual Margin

 Contract Classification
 Unbundling Other20Current Estimates of Future Cash Flows 1 of 2
 Explicit, unbiased and probability-weighted estimate of
future cash flows
 Includes all incremental cash flows that will arise as theinsurer fulfils the insurance contract• Premiums and cash flows that arise from thosepremiums,• Claims and benefits paid to policyholders, plus
associated costs,• Cash flows resulting from options and guarantees,• Incremental costs of selling underwriting and inititiating
the contract, and• Policy administration and maintenance costs.
21

Current Estimates of Future Cash Flows 2 of 2
 Cash flows included if they arise within the contract
boundary• Boundary is a point at which insurer can terminate orre-underwrite a contract, and• Future premiums, claims and expenses are related tothose premiums.
 Cash flows are re-assessed at each reporting period
 Stochastic modeling may be required
 Estimates of market variables are to be consistent withobservable market prices

22

Time Value of Money Adjusts first building block for time value of money
 The discount rate is based on the characteristics of theinsurance liability: currency, duration and liquidity
 Measurement reflects characteristics of the assetsbacking the insurance liability only if the amount, timing
or uncertainy of contract cash flows depend on
performance of assets
 Discount rate is a market consistent “risk free rate”
adjusted for illiquidity characteristics of liability cash flows
 No further guidance on what is a “risk free rate” or how to
calculate the illiquidity premium

23

Risk Adjustment (RA) 1 of 4
 A liability to reflect uncertainty in the estimate of future cash flows
 Included in the measurement explicitly
 Defined as “the maximum amount an insurer would rationally pay tobe relieved of the risk that the ultimate fulfillment cash flows exceed
those expected.” Re-measured at each reporting period
 Estimated at level of portfolio of insurance contracts
 Effects of diversification between portfolios of insurance is notallowed Allow one of three techniques• Confidence Interval (CI)• Conditional Tail Expectation (CTE)• Cost of Capital

24

Risk Adjustment (RA) 2 of 4
 Confidence Interval• Likelihood that the actual outcome will
be within a specified interval• Sometimes called Value at Risk (VaR)• Easy to communicate and calculate• Not as useful for distributions that are
not statistically normal

25

Risk Adjustment (RA) 3 of 4
 Conditional Tail Expectation• Better reflection of extreme losses• Focuses on the tail of the probability
distribution• Judgment needed to determine bandand may need to change in the future• Tail VaR is similar

26

Risk Adjustment (RA) 4 of 4
 Cost of Capital• Often used in pricing, valuations andregulatory reporting (such as Solvency
II)• Estimates cost of holding required
capital to meet obligations with highconfidence• Need to determine capital rate thatreflects risk relevant to liability
27

Residual Margin (RM) Eliminates any gain at inception of contract
 May not be negative; arises when Present Value (PV) of future cash
inflows exceeds sum of PV of future cash outflows plus the Risk
Adjustment
 Estimated at portfolio level, split by cohort (contracts with same
inception date and similar coverage duration)
 Measured at initial recognition only
 Amortized over coverage period based on expected claims
 Cannot be negative as a loss must be recognized immediately
 Interest accretes using the discount rate locked-in at inception

28

Contract Classification (simplified) Does contract have significant
insurance risk?
• No – measure as investment contract(IAS 39)• Yes – does contract need to be
unbundled?
If yes, value deposit component under
IAS39
 If no, value insurance component under
Insurance Contracts29

Unbundling 1 of 2
 Unbundling is required fo all components that are
not “closely related” to the insurance coverage The ED provides 3 examples of this principle:• Account balances – a deposit component with certain
characteristics• Embedded derivatives• Service components

 Any unbundled component is separated without
any of the related fees or charges, which areaccounted for with the insurance contract30

Unbundling 2 of 2
 The more serious implication of theserequirements is the separation of theaccount balance The characteristics that need to be met toqualify for the requirements:• The deposit must be an explicit accountbalance with the policyholder• The account balance must receive interest
based on a crediting rate that is “based on theinvestment performance of the underlying
investments.”• The crediting rate is not capped31Significant ED items outside of study scope Presentation
 Disclosures Portfolio / unit of account Short term contracts
 Contract boundaries
 Transition
 Implementation issues
 Conflict between RA objective and RA
options IAS39/IFRS9 Financial Instruments32Society of Actuaries Study

33

SOA Study – Overview
 Requested by American Academyof Actuaries for their response to IASB Sponsored by Financial Reporting Section toprovide valuable research to its members
 To be completed November 2010
 8 companies
 15 submissions
 100 page report To be available on SOA website:www.soa.org/research/research-projects/lifeinsurance/default.aspx

34

SOA Study – Process Project Manager, PricewaterhouseCoopers(PwC)
 Actuarial Task Forces (ATF) Explicit Instructions
 Spreadsheet Template Conference Calls for Instructions and Questions
 Calculations by ATFs
 Review by PwC
 Overview by Section’s Project Oversight Group Preparation of draft then final report Webcast
35

Particpating ATFs
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

Deloitte
Manulife
AFLAC
Ernst & Young
PolySystems
New York Life
Jackson National
AIG
Great American
Lincoln National
And others

36

SOA Study – Products Traditional Life (Term)
 Traditional Life (Participating) Universal Life (UL), with and w/o Guarantees
 Single Premium Fixed Deferred Annuity (SPDA) Variable Deferred Annuity with and w/o Guar’s Single Premium Immediate Annuity (SPIA) Long-term Care (LTC) Supplemental Health (Medical)
 Equity Indexed Annuity

37

SOA Study – Deliverables
 New Business Only (one year’s issues)
 US GAAP – Balance Sheet and Income
Statement
 IFRS – Balance Sheet and Income
Statement
 Alternative Scenarios
 Observations – why results are what theyare
 Observations – areas where new or more
research is needed38

Variations Requested
 Include/exclude acquisition costs
 Composite margin
 Investment / Discount rate
 Change in estimate after issue Change in experience after issue
 Alternative levels of RA (200% of CofC)

 Alternative RA methods
39

Discount Rates
 Risk-Free Rates
 Illiquidity Premium Par WL, variable annuity use
investment earned rate
 No adjustment for own credit risk

40

Risk-Free Discount Rates
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
1

2

3

4

5

6

7

8

9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Spot Rate

1yr forward

June 30 2009 one year forward rates were smoothed to remove
anomalous pattern

41

Illiquidity Adjustment to Discount Rates

 .73 basis points for SPIA
 .37 basis points for all other products Based on May 2010 study by Groupe
Consultatif in Europe
 Not an adjustment for “own credit risk”
or “non-performance”

42

Risk Adjustment Choices
 Confidence Interval (CI) Conditional Tail Expectation (CTE) Cost of Capital (C of C) We used C of C

43

Risk Adjustment – Cost of Capital Calculation

Risk Adjustment liability equals
Present Value of
Cost of Capital rate × capital needed in year t
Where
PV uses discount rate from the scenario,
Cost of capital rate is 6%, andCapital need in year t comes from factors on next slide

44

Risk Adjustment Capital Factors
Fixed Annuity and Immediate Annuity: 2.3% of AccountValue plus 6.16% of premium
Par WL and UL: 2.3% of claims plus 1.8% of face amountplus 6.16% of premium
Term life: 1.8% of face plus 6.16% of premium
Supplemental Health: 10% of claims plus 8.54% ofpremiumLong Term Care: 15.4% of Claims plus 47.74% ofpremiums

45

Risk Adjustment Calibration
 The Base Line used 200% of CAL (Company
Action Level) of U.S. RBC which represents anestimate of a component of economic capital For perspective,• Most companies are at 300 to 750%
• An A company is 300%
• Company Action is required at 100%

 But remember, we don’t incorporate economic
cost of investments and financial risk (credit risk
and ALM), which regulatory capital does include
 Remeasured each period
46

Residual Margin
 Amount needed to avoid profit at issue Is a “plug” based on level of Current
Estimate plus Risk Adjustment
 Cannot be negative
 Amortized by ratio of PV expected benefits
at time t divided by PV expected benefits
at issue Accretes with interest, using the discountrates in effect at issue47

Composite Margin Not for IASB but for FASB Equates to Risk Adjustment plus
Residual Margin
 Amortization without interest accretion
 Amortization based on premiums andclaims48

Other Basic Assumptions
 Investment Income – Based on GAAP Net
Assets No reflection of volatility due to asset fairvalue valuation
 Investment Earned Rate – based on ATF
pricing assumptions
 Pre-tax
 Earnings paid out as Shareholder Dividend
Annually Base studies – actual experience equals
expected
49

Term Life Product 20 Year Level Term with ART Rates
Starting Year 21
 One year’s issues
 No reinsurance50Term Life – Cash Flows51

Term Life – Liability Components

52

Term Life Liabilities – 3 Models
To ensurereceipt of
our emails,

1,400,000
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0(200,000)

Term Life Model
Total Liabilities

1

3

5

7

9

11 13 15 17 19 21 23 25 27 29

GAAP Reserve less DAC

ED (A)53

FASB (B)Term Life Liability Components

54

Term Life Liability Components

55

Term Life Income Comparison

56

Term Life – Impact of Discount Rates
Term Model
IFRS income at different yields
90,000

Impact of discount ratemagnifies yr 10 change
due to CE. If constantyield, smooth results

80,00070,000Axis Title

60,00050,00040,00030,00020,00010,000(10,000)

1

2

3

4

5

6

7

8

initial9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
0%

4%

5%

57

6%

10%

Term Life IFRS Margins vs. Income

Term Model
Margins vs Income
80,00070,00060,00050,00040,00030,00020,00010,000(10,000)

1

3

5

7

9

11 13 15 17 19 21 23 25 27 29 31

Change in Margins

58

IncomeTerm Life – Results Verification
Solid – Margin change only;

Box – earned rate is discount rate; assets equal IFRS liability

Term Model
Income without investment earnings
80,00060,00040,00020,000(20,000)

1

3

5

7

9

11

13

15

17

19

(40,000)(60,000)
IFRS

Poly IFRS

59

21

23

25

27

29

31

Term Life IFRS income components

60

Single Premium Income Annuity
 Six cells: male, female; 65, 75 & 85
 All life only

61

SPIA Cash Flows

62

SPIA Liability Comparison

63

SPIA Liability Components
time zero is one second before issue64

SPIA Liability Components
time zero is one second after issue

600,000
500,000
400,000
300,000
200,000
100,000
00
Current Estimate

5

10
Risk Adjustment

65

15

20

Residual Margin

SPIA Income Comparison

66

Long Term Care (LTC) Product Features

 A health type policy, paying anannuity-type benefit based on poor
health Premiums to age 100
 Benefits to age 115
 Issue ages 45, 55 and 65

67

LTC Contract Cash Flows68

LTC Comparative Liability Levels

69

LTC Total Liabilities

70

LTC Elements of GAAP Income71

LTC Components of IFRS Income72

LTC Income Comparison

73

LTC IFRS Income, Margins

74

1 of 2

LTC IFRS Income, Margins

75

2 of 2

LTC components of IFRS liability

76

LTC Sensitivity Test

1 of 2

 Experience is positive; morbidity is
85% of expected, starting day one
 This observation is reflected in
Current Estimate in year 3

77

LTC Sensitivity Test78

2 of 2

Participating Whole Life – Product Features

 Whole Life – to age 100
 Policyholder dividends every year Interest element of dividend is basedon actual investment returns
 No earning restrictions toshareholders
 Discounted at asset earned rate

79

Participating Whole Life – Cash Flows80

Par WL – Liability elements 1 of 2

81

Par WL – Liability elements 2 of 2

82

Par WL – Income Comparison

83

Par WL – longer income comparison

84

Par WL – Size of Margins

85

Par WL - Components of IFRS liabilities

86

Accident Product Premiums, benefits to age 65
 Notice, claim costs are higher atyounger ages

87

Accident – Cash Flows88

Accident – Liability Comparison

89

Accident – IFRS liability components

90

Accident – Income Comparison

91

Bundled vs. Unbundled Product Universal Life with secondary guarantee (SGUL) As long as a minimum level of premiums arepaid, the policy will not lapse
 Coverage to age 100, premiums to age 100,
Cost of insurance charges, expense loads andexcess interest credited to the account Discount rate is risk-free plus illiquidity
 The unbundled CE is PV Death Claims (NAR
only) plus PV Expenses less PV of policy
charges (COI’s, loads and surrender charges)

92

UL cash flows

93

UL Bundled Liabilities

94

UL Bundled Liabilities

95

UL Bundled Income Comparison

96

UL Unbundled Liabilities

97

UL Unbundled Liabilities

98

UL Unbundled Income Comparison99What Others Think
Preliminary
Feedback

100

Investors – PwC survey 1 of 2
 Interviewed 40 investment
professionals
 Their concerns:• They don’t want bigger, blacker box• Lack of transparency is leading toundervaluing of insurers• Want pragmatism over theory101

Investors – PwC survey 2 of 2
 Investors’ desires:• Reflect the underlying economic reality• Utilize the company’s business model• Match revenues and expenses• Insurers can have their own accounting
model• Release no profits at issue• Establish explicit risk margin102

International Actuarial Association (IAA) Key issues likely to be emphasized:
 RA stated objective should be redefined. The statedmethod doesn’t imply the three methods described Discount rate – in general agrees
 RM remeasurement – re-assess the propriety ofamortizing based on claims and benefits
 Transition – need a RM on existing business Acquisition costs should be incremental at the portfolio
level, not the contract level Unbundling – make it clear that unit-linked and universal
life contracts are not to be unbundled103

UK actuarial profession
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These are “best estimate” positions and unofficial
Positive:• Fulfillment is much better than exit value• Contract boundaries are fine
• Participating provisions are fine
Neutral:• No objection to de-linking asset and liabilities (unlike Canada and US)• Not enthusiastic about risk free + illiquidity premium for discount rate but
less worry than other countries
Negative:• Restrictions on extent of acquisition costs that can be taken into account• Attempt to restrict RA techniques• Residual Margin – it is OK to show day one profits• If there must be a RM, then remeasure it every period as the RA is• Unbundling is too complicated and does not reflect reality of contracts

104

CFO Forum 1 of 2
 Agrees that discount rate should not reflect own credit risk andshould include the effect of liquidity
 Does risk-free mean swap rates as used in Market Consistent
Embedded Value and Solvency II?
 Support the explicit Risk Adjustment (RA) Supports the Cost of Capital method for calculating RAs but doesn’t
believe methods should be restricted to the three in the ED
 Concerned about limiting benefit of diversification in calculation ofrisk margin to the portfolio level Concerned that Residual Margin is not subsequently re-measured,leading to income statement volatility

105

CFO Forum 2 of 2
 Reflection of incremental acquisition costs is better than the PV
position, but differing distribution models will result in different
amounts of expenses included in the initial liability
 Unearned Premium Reserve approach for short duration contracts
should be optional and is inconsistent with Solvency II Does not support unbundling. The contract should be recognized asa whole, reflecting the basis on which the company manages.
Unbundling would be less transparent to users. Unbundling would
be costly to implement
 Supports proposed presentation
 Concerned about income statement volatility A challenge to implement
 Concerns regarding consistency with Solvency II

106

Canadian Life & Health Insurance Association

 Supports:• Fulfillment objective• Building blocks approach• Risk Adjustment & Residual Margins

 Concerns:• Discount rate – results will be unreliable, irrelevant and difficult to explain• Discount rate – will lead to unintended consequences to consumers andthe economy• Risk adjustment methodology limitations• Transition• Unbundling• Wants a second Exposure Draft with a Qualitative Impact Studies• Basically, it is unusable as a measurement basis for investors

107

American Academy of Actuaries (AAA) Include all acquisition costs and overhead in Current Estimate
 Discount rate for each CE scenario should be consistent with theeconomic assumptions used to generate the cash flows
 Don’t limit RA methods to three Concerns over link between objective of RA to the methods
articulated
 Agree there should be no gain at issue
 In general, supports unbundling Transition – do not agree with no RM on existing business The insurance contracts ED and IFRS 9 (Financial Instruments) need
to be aligned so that assets and liabilities are accounted forconsistently

108

Group of North American Insurance Enterprises (GNAIE) Need separate models for short-term and long-term business All measurement should be based on fulfillment value, not based on
an amount an insurer would rationally pay to be relieved of its
obligations
 Since performance of life and annuity contracts are inextricably
linked to earnings on assets; ignoring their impact will be disruptive,
causing distorted earnings and withdrawal of products Approach for short term products doesn’t add value and shouldn’t
have to use interest discounting Wants Composite Margin, not the Risk Adjustment plus Residual
Margin If Risk Adjustment is used, allow more than three methods
 At transition, do allow Residual Margins on existing business Retain key indicators (premium, claims) in income statement
 No unbundling109

International Association of Insurance
Supervisors (IAIS) Discount rate - why differ from IAS19 (pensions, whichuses a high quality corporate bond rate) Discount rate – not comfortable with risk free plus
illiquidity
 Objective for RA doesn’t match with fulfillment value Need more than just 3 sanctioned methods fordetermining RA
 Incremental Acquisition Costs are acceptable if done at
the portfolio, not contract, level At transition, don’t put future profits on existing business
into shareholders’ equity
 Most other issues – much diversity in opinions
110

Life Reinsurer in Sixty Countries

 ED needs significant enhancements
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Discount rate – using (lower) rates not linked to policyholder pricing will lead to productwithdrawal
Discount rate – use of current curves with amortized cost assets will lead to volatility inearnings
Discount rate – too much inconsistency in selection of illiquidity adjustment. 2008MCEV disclosures showed companies varied illiquidity premiums from 0 to 300 basis
pointsSupports Risk Adjustment plus Residual Margin
The maximum amount an insurer would pay to be relieved of risk is somewhat
nebulous
Unbundling – not well-defined; costly to account; little value to users
Presentation – wants premiums, claims
Disclosures – complexity and extensiveness reduces usefulness. Readers will beoverwhelmed with these disclosures. Disclosures will be expensive to prepare.
Should pare back.
At transition, need Residual Margin on all business. Otherwise inconsistent results willappear for many years

111

Next Steps112

Next Steps Comment Period Ends November 30
 IWG Meeting in London November 11–12
 Further Outreach (for example, earlyNovember staff road trip to USA) Field Testing Board Deliberations
 Standard Issued July 2011
 Implementation…2 – 3 Years Later
 SEC decision on convergence – late 2011113

Questions & Answers
R. Thomas Herget, FSA, MAAA, CERA
Thomas.Herget@RiskLighthouse.com
Opinions expressed are those of the
speaker and not of the Society ofActuaries or its members