Articles - Are your financial models ready for future IFRS?

 By Alastair Black, Consultant with Towers Watson

 As part of Solvency II one major area of work has been to prepare financial cash flow models that deliver results in accordance with the Directive. But companies also need to prepare models for the coming Phase II International Financial Reporting Standard (IFRS) for insurance contracts says Alastair Black.
 Flexibility is key in financial model development these days. To survive in the new evolving world, companies will need to:
 • Ensure financial cash flow models, including any stochastic models, are up to the task of meeting both IFRS and Solvency II requirements.
 • Produce information for IFRS to be presented on the balance sheet, in the income statement and through additional disclosures.
 • Determine IFRS-required residual margins and release them in an appropriate manner over time.
 • Identify, quantify, and explain differences between IFRS, Solvency II and other financial measures they report, and to explain how those measures change over time.

  

 IFRS Exposure Drafts
 After the International Accounting Standards Board (IASB) Exposure Draft ED/2010/8, published in July 2010, a further exposure draft or review draft is now expected in early 2012, with the final standard expected in late 2012 at the earliest. The objectives of the IFRS are to standardise and improve financial reporting disclosures and provide guidelines for consistent treatment of insurance contacts.

 
 Changes proposed since the Exposure Draft have included:
 1. The residual margin should not be locked in at inception. However, IASB has not yet decided whether changes in discount rate should be recognised as an adjustment to the residual margin or in profit or loss in the period of the change to the extent that these changes create an accounting mismatch.
 2. IASB has tentatively decided that the residual margin should not be negative and that insurers should allocate the residual margin over the coverage period on a systematic basis that is consistent with the pattern of transfer of services in the contract.
 3. The board has tentatively decided that acquisition costs should only include the direct costs that the insurer will incur in acquiring the contracts in the portfolio. Furthermore, no distinction should be made between successful acquisition efforts and unsuccessful ones for the purpose of insurance contract cash flows.

 
 Modelling implications
 Cash flow model
 Even in cases where a company is starting with a well-established model with appropriate controls, a number of questions need to be asked, including:
 • Are the projection periods consistent with the IFRS definition of the contract boundary?
 • Are the cash flows those that are incremental at a portfolio level? In particular, general overhead expenses will need to be excluded. In practice, it may be possible to achieve this by adjusting assumptions rather than by changes to model code.
 • Are the contract groupings appropriate? The definition of a portfolio of insurance contracts
 may imply different grouping to that which companies currently consider. This may particularly be the case if the primary purpose of existing models is different from determining contract liabilities.
 • Do benefits that are currently projected in combination need to be unbundled? For example, contract components, such as investment and service components, that are not closely related to the insurance coverage should be unbundled and measured according to other relevant non-insurance IFRS.
 • Does the model utilise investment return and discount rate assumptions that are constant over time?
 • Are there contractual minimum guarantees which will result in asymmetric sharing of risk between
 shareholders and policyholders? The impact of guarantees on future cash flows will need to be considered within the model.

  

 Risk adjustment
 The measurement model for long-term contracts (and the post-claims obligation of short-term contracts) includes a risk adjustment to be determined by one of three prescribed techniques: confidence level, conditional tail expectation or cost of capital. Given Solvency II requirements in this area, many companies may opt to utilise a cost of capital methodology to evaluate the IFRS risk adjustment. However, unlike under Solvency II, the level of capital and cost of capital for the risk adjustment will not be mandated.

 
 Residual margin

 To most companies, the concept of the residual margin will be new. Its purpose is to eliminate day one gains (losses would be recognised immediately), and to release the product margins (over and above the risk adjustment) in a logical way over the life of the insurance contracts. The residual margin will act as a ‘shock-absorber’ as it will be recalibrated for changes in assumptions that impact estimates of future cash flows .

 The major complexity will be tracking separate residual margins for contracts with similar contract inception dates and coverage periods within each insurance portfolio, should this be a requirement of the final standard.

 
 Presentation and disclosure
 Particular consideration will need to be given to experience adjustments, which capture the difference between actual cash flows and previous estimates of the cash flows.

 
 Other considerations
 Measurement of insurance contract liabilities is a core function for any insurance company. A successful and robust outcome for a financial model will require there to be appropriate linkages to policy administration and accounting systems, rather than over-reliance on manual processes.

 
 Making preparations
 At a minimum, it is essential − while implementing Solvency II requirements − to bear in mind that model system architecture should be able to accommodate IFRS functionality at a later time. Otherwise, much of the significant investment in Solvency II modelling will need to be repeated, and new sleek, efficient and well-documented Solvency II systems may end up clogged with messy coding changes and manual ad-hoc adjustments.