IFRS 17 Forum 2018 Exploring Challenges with Reinsurance Sections - - PowerPoint PPT Presentation

November 2018

IFRS 17 Forum 2018 Exploring Challenges with Reinsurance

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Sections

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1 Important Concepts for Reinsurance Contracts 2 Case Studies

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IFRS 17 – Important Concepts for Reinsurance Contracts

— Reinsurance contracts held must be accounted separately from the underlying insurance contracts issued by the cedent. — Unlike IFRS 4, the concept of “netting contractual obligations” is no longer applicable based on the principle that policyholders’ obligations are not extinguished simply because the underlying contracts are reinsured. — Reinsurance contracts are generally treated as an asset (rather than a liability) and represent a net cost (negative CSM). — Reinsurance costs can be deferred over the lifetime of the contract in cases claims relates to future events, otherwise a loss needs to be recognized at inception. — Initial recognition of insurance contracts and reinsurance contracts may differ depending on whether the risk transfer is proportional or non-proportional. — For proportional treaties, the initial recognition would be set a the later of (1) the beginning of the coverage period or (2) inception date of the underlying insurance contracts. For non-proportional treaties, as the losses refer to a group of aggregate contracts, the recognition would generally be set at the beginning of the coverage period. — The boundaries of a reinsurance contract can differ from the underlying insurance contract leading to potential use of different measurement approaches (Premium Allocation Approach vs Building Block Approach) or timing of profits recognition. Cedent Reinsurer Policyholders Insurance Contracts Issued Reinsurance Contracts Held

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Building Blocks Approach – Insurance

q Future cash flows within the boundary of an insurance contract include: § Premiums § Claims § Direct acquisition costs § Claims handling costs § Administration and maintenance costs q Future cash flows are discounted at rates “consistent with observable market prices” q Choice of appropriate discount rates to use q The risk adjustment or risk margin is to reflect the uncertainty of future cash flows q There are different potential ways to calculate this, e.g. using CoC approach. q The expected profit over the life of the transaction q This is deferred on day 1 and spread over time, subject to subsequent measurement on each reporting date

Time value

• f money

Risk adjustment Contractual service margin

Fulfilment cash flows Best Estimate Liability

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Building Blocks Approach - Reinsurance

q Future cash flows within the boundary of a reinsurance contract include: § Ceded Premiums § Ceded Claims § Ceded Commissions (treated as reduction in premiums if payment is not contingent on claims, otherwise negative expenses) § Profit commissions (treated as a reduction to claims). *Credit risk of reinsurer to be adjusted in cash flows. *A mismatch in maturities between contracts is reflected in the boundary of the contract. q Use the same discount rates as for the underlying insurance contracts q Risk adjustment can be allocated to risk being transferred by the cedent. q e.g. Mortality reinsurance would cede mortality risk capital but not the investment risk capital. q Reinsurance contract resulting in a net cost is not necessarily recognized immediately in profit or loss recognition but can be deferred over the lifetime of the contract q Reinsurance can be recognized as a net loss (debit CSM) or net gain (credit CSM)

Time value

• f money

Risk adjustment Contractual service margin

Future Cash Flows Best Estimate Ceded Liability

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CSM for Insurance Contract Issued vs Reinsurance Contract Held

CSM Risk Adjustment Future Cash Flows Discounting Insurance Contract Issued (Liability)

+

• =

CSM Risk Adjustment Future Cash Flows Discounting Reinsurance Contract Held (Asset)

• +

+ =

— The CSM on a group of reinsurance contracts equals the inverse of the future cash flows on insurance contracts issued adjusted for their own respective contract boundaries and risk adjustments. − Reinsurance held is treated as an asset on the cedent’s balance sheet. − Net cost from reinsurance is treated as an asset (i.e. negative CSM).

CSM > 0 (liability) CSM < 0 (loss recognition at inception)

• CSM > 0 (reinsurance cost)
• CSM < 0 (reinsurance gain)

Need to take the negative amount as this would be recognized as an asset.

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Sections

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1 Important Concepts for Reinsurance Contracts 2 Case Studies

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IFRS 17 – Case Studies of Reinsurance

— Case studies on accounting for reinsurance contracts under IFRS 17 — Case Study 1: Yearly Renewable Term Insurance (YRT) — Case Study 2: Excess of Loss (XOL) — Case Study 3: Traditional Coinsurance — Case Study 4: Reinsurance Commission Financing — Case Study 5: Loss Portfolio Transfer

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Case Study 1 - Quota Share YRT

— Under a Quota Share Yearly Renewable Term (QS YRT) treaty: − 50% Quota Share = Reinsurer pays 50% of any claims − Reinsurance premium on a specified schedule depending on the year − Reinsurance profit commission of 50% of profits after expense charge of 10% of insurance premium Cedent Reinsurer

Reinsurance premium Claims Profit commission Insurance premium Claims Insurance Premium 200.0 Claims

• 90.0

Net result 110.0 YRT reinsurance Premium

• 70.0

Profit commission 22.5 Net Premium

• 47.5

50% claims 45.0 Net result

• 2.5

Technical Result = 110 – 2.5 = 107.5

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Case Study 1 - Quota Share YRT

— Under IFRS 17 the pool of insurance contracts and the reinsurance contract are valued as two items under the Building Blocks Approach – here assuming cash flows for 20 years.

• 300.0
• 100.0

100.0 300.0 500.0 2011 2014 2017 2020 2023 2026 2029

Insurance cash flows

Premium Claims

• 300.0
• 100.0

100.0 300.0 500.0 2011 2014 2017 2020 2023 2026 2029

YRT Reinsurance cash flows

Net Premium 50% claims

• 168

3,264 3,820

• 388

Fulfilment cash flows Time value

• f money

Risk adjustment Contractual service margin

Insurance

• 87

84 6 9

Reinsurance

As 50% of the risk is ceded, the risk adjustment is quite material relative to the profitability to the reinsurer in part due to the 50% profit commission. Since reinsurance is viewed as an assets a positive amount correspond to a profit.

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Case Study 1 - Quota Share YRT

— Under IFRS 17, the results are presented in a different manner, but over a 1 year horizon with no changes in interest rates or other assumptions, this should be in line with IFRS 4. — The major change is the split between underwriting result and investment income. — This level of detail would be presented in the notes to the accounts, with the totals presented in the overall statement

• f profit or loss.

Statement of profit or loss and

• ther comprehensive income

Insurance

Reinsurance Total

Release of contractual service margin 74.6

0.1 74.7

Release of risk margin 3.8

1.9

• 1.9

Expected claims 90.0

45.0

• 45.0

Recoverable of acquisition costs

• Insurance contracts revenue

168.4 46.8

• 121.6

Claims and expenses current period 90.0

• 45.0

45.0

• Acquisition costs
• Insurance service expenses

90.0

• 45.0

45.0

• Insurance service result

78.4 1.8

• 76.6

Investment income

30.9

Insurance finance expenses

• Net finance result

30.9

Profit or loss

107.5 Corresponds to the unwind of the time value of money of the future cash flows.

31.6

• 0.7

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Claims

Case Study 2 – Excess Of Loss Reinsurance

— Under an Excess Of Loss (XOL) catastrophe cover treaty: − The treaty lasts for only 1 year − No ceding commission − Reinsurance pays for claims for a single event with a loss over 30 millions Cedent Reinsurer

Reinsurance premium Claim if XOL threshold reached Insurance premium

Premium 0.5 Claims Net result 0.5 Probability 99% Premium 0.5 Claims

• 10.0

Net result

• 9.5

Probability 1%

No claims A claim of 40 mio

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Case Study 2 – Excess Of Loss Reinsurance

— Under an Excess Of Loss (XOL) treaty, we look at the probability weighted cash flows of the contract: — As the treaty is only for 1 year, there is no issue of contract boundaries. — The result under the BBA will be very close to the Premium Allocation Approach (PAA). — The PAA is a simplified liability measurement approach based on earned premium and can be used as long as the eligibility criteria are met(1). — As the premium is so low, any Risk Adjustment and CSM calculated will be very low. Premium 0.5 Claims

• 0.1

Net cost 0.4

(1) Eligibility criteria for PAA includes: reinsurance contract must be less than 1 year and no variability in the fulfilment cash flows.

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Case Study 3 – Coinsurance

— Under a coinsurance agreement, the cedent shares a proportional risk of expected future premiums, claims, expenses and broker’s commissions. — All claims reserves are also shared proportionally between parties where the reinsurer is responsible for holding its own share

• f the reserves.

— Claims are adjusted by default probability of reinsurers. — This type of risk transfer solution is effective in sharing the acquisition costs of insurers wanting to enter a new market or new product line while leveraging from the UW expertise and balance sheet capacity of the reinsurer. Reinsurance cash flows Cedent Reinsurer

Reinsurance premiums Claims + Reinsurance Commissions Insurance premium Claims + Commission Y0 Y1 Y2 Y3 Y4 Y5 Reinsurance Premiums

• 100,000,000
• 50,000,000
• 25,000,000
• 12,500,000
• 6,250,000

Reinsurance Claims 21,000,000 28,000,000 28,000,000 24,500,000 19,250,000 14,875,000 Expected default

• 105,000
• 140,000
• 140,000
• 122,500
• 96,250
• 74,375

BoY Claim reserves

• 49,000,000
• 56,000,000
• 45,500,000
• 29,750,000
• 14,875,000

EoY Claim reserves 49,000,000 56,000,000 45,500,000 29,750,000 14,875,000 Reinsurance commission 40,000,000 7,500,000 3,750,000 1,875,000 937,500 Technical result 9,895,000

• 7,640,000
• 3,890,000
• 1,997,500
• 1,033,750
• 74,375

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Case Study 3 – Coinsurance

— The following graphs provides a comparison of IFRS 4 vs IFRS 17 pre-tax profits from the cedent and reinsurer’s perspectives. — Unlike IFRS 4, under IFRS 17 the emergence of future profits is smoothed over the lifetime of the reinsurance contract. — A coinsurance treaty ensures a more symmetric distribution of profits between the cedent and the reinsurer.

• 15,000,000
• 10,000,000
• 5,000,000

5,000,000 10,000,000

Y0 Y1 Y2 Y3 Y4

P&L pre tax - Reinsurer

IFRS 4 IFRS 17

• 10,000,000
• 5,000,000

5,000,000 10,000,000 15,000,000

Y0 Y1 Y2 Y3 Y4

P&L pre tax - Cedent

IFRS 4 IFRS 17

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Case Study 4 - Reinsurance Commission Financing

— A cedent writes annual medical insurance, and the policies have a high upfront sales commission. However, the policies also have a high annual renewal rate so the cedent expects to make profits in future years. — To reduce the cash strain, it enters into a multi-year quota share retrocession treaty with a reinsurer, and receives an initial ceding commission. Cedent Reinsurer

Reinsurance premium Claims Initial ceding commission – Reinsurance Fees Insurance premium Claims

Forecast 2021 2022 2023 Premium 100 100 100 Claims

• 70
• 70
• 70

Expenses

• 40
• 10
• 5

Net result

• 10

20 25 Reinsurance 2021 2022 2023 Premium

• 85
• 85
• 85

Claims 70 70 70 Commission 25 Net result 10

• 15
• 15

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Case Study 4 - Reinsurance Commission Financing

— The cost of reinsurance is spread

• ver the 3-year term of the

contract, including the cash flow from the initial commission

• payment. There is no upfront profit

recognised under IFRS 17. — There is a difference in contract boundaries between the underlying insurance policy (1 year) and the reinsurance contract (3 years). — Furthermore, in 2021 the underlying insurance policies will be onerous policies.

• 9.5
• 10

0.5

• 9.5

Fulfilment cash flows Time value

• f money

Risk adjustment Contractual service margin Transfer to Profit & Loss

Insurance

• 20

3.5

• 15

1.5

Reinsurance 2021 2021 - 2023

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Case Study 4 - Reinsurance Commission Financing

— Under IFRS 4, the reinsurance commission can be recognized as an upfront profit by the cedent to offset acquisition expenses from writing new insurance contracts. This effectively ensures the emergence of future IFRS earnings are smoothed over the economic life of the contracts (rather than the legal contract boundary). — Under IFRS 17, the asymmetry created in contract boundaries between the insurance and reinsurance contracts will prevent this essential offset from happening as the reinsurance contract held will have to be recognized over a longer contract boundary life than the underlying insurance contract issued. — The following solution might be available to preserve a similar profitability profile to IFRS 4 under IFRS 17. It is however too early to tell if it can be implemented.

Explanation of Solution

• Step 1: Shorten the contract

boundary of the reinsurance contract to be the same as the underlying insurance contract

• The boundary of the reinsurance contract will be deemed short if the reinsurer includes a

clause with the right to reprice the existing coverage prospectively after 1 year.

• This enables the cedent to achieve perfect symmetry in contract boundaries

between the insurance issued and reinsurance contract held.

• IFRS outcome: Cedent is able to completely offset its acquisition expenses against the

reinsurance commission provided by the reinsurer.

• Step 2: Introducing

accounting asymmetry between parties

• The reinsurer recognizes the contract under IFRS 9 while the cedent recognizes the

contract under IFRS 17 due to different interpretation on the risk transfer test by their respective auditors.

• The P&L of the reinsurer would be impacted with a day-one loss under IFRS 17 due to the

short contract boundary but not under IFRS 9 as only fees would be recognized on its P&L.

• IFRS outcome: The reinsurer’s P&L is not impacted by the day-1 commission as the

reinsurance contract issued is accounted under IFRS 9.

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Case Study 5 - Loss Portfolio Transfer

— A cedent has a large inforce portfolio of claims in-payment. No future premiums are expected from policyholders, hence the expression “Loss Portfolio” transfer. — An insurer cedes 50% of the liability via a quota-share with an initial transfer of assets in order to reduce its future claims volatility. — The reinsurer is able to obtain a more capital efficient allocation with a more aggressive view of best estimates assumptions resulting in a transfer price (commission paid by the cedent) that is less then the reserves. Cedent Reinsurer

Commission (via transfer of assets) Claims Claims Y0 Y1 Y2 Y3 Y4 Y5 Premiums Claims 2,500,000 2,000,000 1,500,000 1,000,000 Expected default

• 12,500
• 10,000
• 7,500
• 5,000

BoY Claim reserves

• 7,000,000
• 4,500,000
• 2,500,000
• 1,000,000

EoY Claim reserves 7,000,000 4,500,000 2,500,000 1,000,000 Transfert asset

• 6,860,000

Technical result 140,000

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Case Study 5 - Loss Portfolio Transfer

— The claims in-payment portfolio is deemed an onerous contract by the cedent due to higher capital requirements and conservatism in the reserves. — The loss portfolio transfer creates generates a gain (held as a CSM). The future releases of the CSM will enable the cedent to mitigate future claims volatility. — The contract maturity is the same under both contracts.

• 350,000
• 300,000
• 250,000
• 200,000
• 150,000
• 100,000
• 50,000

50,000 100,000 150,000

Y0 Y1 Y2 Y3 Y4

P&L pre tax - IFRS 17

Insurance Contract Issued Reinsurance Contract Held

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Disclaimer

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