The document discusses two business models for managing insurance contracts:
1) The asset liability management (ALM) business model, which focuses on matching asset and liability cash flows over the life of insurance contracts. Measurement should be based on discounted expected cash flows.
2) The underwriting business model (UBM), which is focused on underwriting results like premiums, claims, and expenses on an undiscounted basis. This model is typical for short-duration property/casualty contracts.
The document argues that measurement and presentation of insurance contracts should be based on the insurer's business model to provide a meaningful reflection of performance.
1. 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
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2. 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).
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3. - 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.
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4. 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.
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5. 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.
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6. Attachment 1
Business Model Paradigm for Insurance Contracts
(see attached document)
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7. 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,
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: 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.
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8. 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.
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