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Peter Clark Project Manager International Accounting Standards Board 30 Cannon Street London EC4M 6XH 15 November 2007

Dear Sir, Re: Comments on Discussion Paper on Insurance Contracts I would hereby like to submit comments on the discussion paper on insurance contracts, which I hope will be of some value. This submission is done in my personal capacity. Yours Faithfully Johan van Zyl Smit

Accounting for Insurance There are a few aspects to life insurance accounting that differentiate it from accounting of most other industries. Some of these are the long term nature of liabilities, the need for long-term matching of liabilities with assets, the intricacy of each contract with each different customer and the nature of the relationship with the customer. These are not unique to life insurance, but as a whole makes for quite a distinct style of reporting. The long-term nature of liabilities also brings with it increased risk (any single transaction has consequences lasting years if not decades, matching risk on long-term liabilities is exaggerated), problematic recognition of profits, and an inherent lack of transparency. The fact that insurance accounting is so distinctive does not imply that arbitrary rules should be devised to cater for it. The approach should rather be to determine how the existing accounting principles can be fashioned and applied so that they are sufficiently general in their scope to include both life insurance and other industries. Insurance contracts are simply contracts that need to be analysed to a suitable level of detail for the general accounting principles to be applied in an appropriate manner. (In this manner one could also take learnings from the exercise into other industries that have aspects in common with insurance.) A critical requirement in fitting the general principles to these contracts is therefore to avoid arbitrary rule-making, and it is the intention of this submission to minimise any arbitrariness in slightly broadening the existing general rules to include insurance. This submission also subscribes to the ratchet-style of historical accounting where prudence is seen as paramount for reporting purposes, generally leading to more robust (and conservative) treatment of income and expenses: for items where more of a true and fair view is required, that can be reported separately in e.g. the embedded value or as supplementary notes to the accounts. Life insurance contracts are typically either or a mixture of insurance and investment contracts. Investment contracts and the investment portion of mixed contracts should effectively be seen as deposits and therefore as trust moneys. That implies that premiums should not be seen as income nor claims as expenses. Rather, the bulk of premiums and claims are deposits received and paid, whereas charges and expenses constitute income and outgo for the company. For (insurance) risk contracts or the (insurance) risk element of mixed contracts, there is not such a question of trusteeship of investment monies, so that risk premiums and claims can be regarded as income and expense. It is admittedly not always clear exactly where risk ends and investment starts for any single contract, but I would propose that each life insurance contract is separable into its investment and insurance elements for reporting purposes; and that this can be done to quite a high degree of accuracy.

For this purpose, the starting point for any policy is a generalised model of a mixed contract with the insurance element taken as a risk premium. The long-term nature of the liabilities is (generally) critical in determining profit for not only the current year, but also for future years. That is, the action of setting a liability has a very long-term impact, and inappropriate assumptions have a geared effect on future profitability, as have secular changes affecting the assumptions underlying the liability. Setting the liability requires a position to be taken as to all future revenue accounts in respect of the existing liabilities. This is unlike most other industries, although it has parallels in for instance long-term construction projects. Although setting the liability is clearly (one of) the most significant elements of accounting for long term liabilities, currently very little presentation is required in respect of it. I would propose that the projected revenue account in respect of each future year should be made an explicit item in the accounts. This ensures that the liability is presented in a transparent way in the accounts. This projected revenue account exercise includes investment income (from matching assets, as described later), but also assumptions in respect of the other revenue items. Although the use of forward-looking assumptions initially seems unique to life insurance accounting, bear in mind that providing for depreciation and bad debtors also require some appropriate assumptions to be made about the future. This principle of presenting projected future revenue accounts for existing long-term insurance contracts would clearly also be very useful for long-term liabilities in any industry, for instance for long-term engineering contracts. If projected revenue accounts were required for any existing long-term liabilities in all industries (as seems sensible), the proposal would not simply be a rule arbitrarily made up for insurance. It is very difficult to evaluate objectively the appropriateness of assumptions used in the liability setting (projected revenue account) exercise. This is where an analysis of surplus is especially useful, as it compares each assumption made in respect of the current year with the actual item, and provides some information to assess the reliability of those assumptions for the projected revenue accounts. Reporting on profits and losses should therefore be performed on an analysis of surplus basis rather than the traditional method of lumping premiums in as income and claims as expenses. The analysis of surplus approach is in fact a more natural accounting fit for investment contracts, as each revenue item (risk premium, charge, expense, surrender profit, mortality profit, investment surplus etc.) is an event or transaction from which one would expect a profit or loss to emanate. In contrast (as in traditional life reporting), one would not expect a profit or loss to emanate simply from a premium being deposited with the insurer. Note the deliberate use of the word deposit! Any assumption used, for instance those in respect of mortality, surrender and expenses, should be substantiated by past experience or other suitable evidence or motivation.

To the extent that forward-looking assumptions change from year to year, the effect of each change in assumption on revenue should be demonstrated explicitly. This, together with the yearly comparison of each revenue item with that expected by the liability basis, obviates the need for locked-in assumptions. Stating projected future revenue accounts also means that comparisons between companies are made much easier. This does marry well with the principle that we should not be devising special rules for life insurance, as it simply presents the components of liabilities and change in these components of liabilities as they would appear naturally in the accounts in future years; rather than simply stating an untransparent blob of liability in the Balance Sheet and change in this object in the Income Statement. The question of whether insurance liabilities should be discounted is important for both life and general insurance. The principle should be that under prudence one should not anticipate profit (i.e. investment income), but where there is an asset that precisely matches the liability, the liability should be able to benefit from the fact that the asset will provide income and capital proceeds that will be able to extinguish the liability. The same argument cannot be made to the same extent for badly matched liabilities, where there can be a significant risk that the type of income from the asset will not match the progression of the liability. Some decent scenario testing or statistical modelling might provide the answer to that question of capital requirement. I would propose that in conjunction with the projected revenue accounts, there should also be a robust projected illustration of matching between assets and liabilities. The continuance of premiums and surrender of policies are examples of future assumptions at the option of the client. It might be most in line with the general accounting principles to assume the most onerous option in respect of these items, so the policyholder is assumed to make the policy paid-up if it is more onerous to the insurer, and to surrender if the surrender value is higher than the value of the policy to the insurer. Premiums under traditional insurance contracts are not enforceable in the general sense as the reality is that insurers do not summons policyholders in order to extract unpaid premiums. In fact, surrendering a policy or making it paid-up usually does not penalise the policyholder to any great extent. So premiums are not a contractually enforceable income after all. Where recognising future premiums leads to a profit, they should therefore be ignored and the consequences for the associated liability realistically incorporated. Conversely, where a continuing premiums is more onerous for the insurer, that is the situation that should be presented in the accounts, as the policyholder does have a right to insist on continuing the policy. One could argue that an unbiased estimate would allow some allowance for future premiums even though they are not enforceable. This is quite a strong argument,

although that perhaps opens the door for a retailer to claim profit margins on unbiased estimates of future sales as current income. Instead, for a retailer at least, future superprofits on expected sales is goodwill. That should be no different for an insurer. Initial expenses is an item where prudence should have precedence above matching of income and expense; here it is the permanence of the insurance contract that is in question, as future premiums are generally not contractually enforceable. Ignoring future premiums and deferred acquisition cost completely are an outcome of prudence and might be viewed as opposing going concern and as precluding a true and fair view. To the extent that reasonable assumptions in respect of the continuation of premiums and spreading initial expenses are appropriate, those can be presented as additional information, in the mode of the Embedded Value rather than as part of the main accounting presentation. The distinction made regarding guaranteed insurability is appropriate as it supports not recognising future premiums when discontinuance of premium payments is the better option for the policyholder, and therefore not recognising the premium is the more prudent for the insurer.

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