Life Insurance (Prudential Rules) Determination No. 6 of 2005: Prudential Rules No. 49 Applying To Life Companies Including Friendly Societies
Explanatory Statement
This statement is issued by the authority of the Australian Prudential Regulation Authority (‘APRA’) under:
- Life Insurance Act 1995, subsection 252(1)
Legislative background
Under subsection 252(1) of the Life Insurance Act 1995 (‘the Act’), APRA has the power to determine (in writing) prudential rules prescribing all matters required or permitted by the Act that must be complied with by all life companies registered under the Act. Such prudential rules are ‘legislative instruments’ within the meaning of the Legislative Instruments Act 2003.
Subsection 82(1) of the Act requires every life company to give APRA financial statements as at the end of each financial year of the company. Paragraphs 82(5)(a) and (b) of the Act provide that these financial statements must be in the form prescribed, and signed, in accordance with the Prudential Rules made under subsection 252(1) of the Act.
Section 244 of the Act provides that APRA must collect such statistics as are prescribed by the prudential rules, in the time and manner prescribed by the rules. Section 117 of the Act provides that life companies must prepare an additional annual statistical return relating to policy liabilities at the end of the financial year and policy movements during the financial year in respect of each statutory fund of the company.
Prudential Rules No. 49 (PR 49) deal with how contracts are classified where required for all of these purposes.
Although sections 82, 117 and 244 do not appear in some published editions of the Act, they will continue to form part of the Act until repealed by Items 48, 57, 72 and 75 of Schedule 2 to the Financial Sector (Collection of Data – Consequential and Transitional Provisions) Act 2001. The repeal will not occur until APRA makes a reporting standard in relation to life insurers under section 13 of the Financial Sector (Collection of Data) Act 2001 and, under section 15 of that Act, the reporting standard begins to apply to life insurers. Accordingly, sections 82, 117 and 244 remain in effect.)
The Determination
The purpose of Life Insurance (Prudential Rules) Determination No. 6 of 2005 (‘the Determination’) is to make the new PR 49 for the purposes of subsection 82(5), paragraph 117(2)(d) and subsections 117(3), 244(1) and 244(2) of the Act. The Determination will take effect upon registration on the Federal Register of Legislative Instruments.
PR 49 stipulate the basis on which contracts written by life companies are to be classified for the purpose of regulatory reporting in accordance with the prudential rules, and for the valuation of contracts in accordance with the Actuarial Standards
In particular, the rules:
- Distinguish between those contracts that meet the definition of a life insurance contract under Australian Accounting Standard AASB 1038 life insurance contracts and those that do not;
- Identify key components of contracts written by life companies (insurance component, financial instrument, service component, discretionary participation feature and embedded derivatives); and
- Stipulate the circumstances in which such components must be unbundled for regulatory reporting purposes, and for the valuation of contracts in accordance with the Valuation Standard.
Background to the Requirements
Australian reporting entities are adopting Australian equivalents of International Financial Reporting Standards (IFRS) for reporting periods commencing on or after 1 January 2005. The accounting standards are available from the Australian Accounting Standards Board (AASB) website (www.aasb.com.au).
For general purpose reporting under Australian Accounting Standards, life insurance companies (including friendly societies) have some discretion in the way that contracts are classified. These prudential rules constrain, for regulatory reporting purposes, the extent to which that discretion may be exercised in order to achieve uniformity in regulatory reporting.
Summary of Key Requirements
The key requirements of these prudential rules are that, for regulatory reporting purposes:
- The definitions of life insurance contract, life investment contract, Insurance Contract and Discretionary Participation Feature are the same as the definitions applying under AASB 1038.
2. Criteria set out in Prudential Rules No. 22 (PR 22), for defining certain benefits as non-participating under the Act, may also be of assistance in establishing whether the additional benefits payable under a contract are significant for the purpose of assessing whether the contract contains a discretionary participation feature.
3. A non-participating benefit that is deemed for general purpose reporting to contain a discretionary participation feature is to be treated under the Valuation Standard as a non-participating benefit, with allowance made within the policy liabilities for the value of future discretionary additions, including any additions in respect of the current reporting period.
4. A participating benefit is deemed to satisfy the definition of a life insurance contract, even if it is classified as a life investment contract for general purpose reporting. In such circumstances a life company may, under subsection 15(4) of the Act, request that APRA declare the benefit to be non-participating, to allow the regulatory reporting treatment and the general purpose reporting treatment to be aligned.
5. For regulatory reporting purposes, reinsurance contracts and participating contracts with insurance riders must not be unbundled.
6. Otherwise, a contract must be unbundled if it can be split for the purpose of recognising premium revenue and claims expense under section 5 of AASB 1038.
7. Where a contract contains both investment linked and discretionary investment options, they must be unbundled as separate deposit components, with the associated service components apportioned between them.
8. An option to make future investments into a discretionary investment option should not taint the classification of the existing deposit components.
Explanation of Requirements
Although the contract definitions for regulatory reporting purposes and general purpose financial reporting may be able to be aligned, there are additional considerations that allow companies some scope to choose how business is categorised under general purpose reporting. This relates to the unbundling of deposit components.
Some contracts contain elements of both insurance contracts and deposits (i.e. investment contracts, with or without a discretionary participation feature).
In addition to one or more deposit elements (i.e. financial instruments that are not derivatives), an investment contract may also include other features and benefits, including:
- Other financial instruments (including embedded derivatives, options and performance guarantees);
- The provision of management services, (which may include investment management itself as well as financial planning, advice and contract administration); or
- A discretionary participation feature (which, in conjunction with all other components with which it remains bundled, is treated as a life insurance contract under AASB 1038).
In accordance with Section 14 of AASB 1038, the financial instrument element(s) of a life investment contract is (are) accounted for under AASB 139 Financial Instruments: Recognition and Measurement, while the management services element is accounted for under AASB 118 Revenue. AASB 118 deals specifically with revenue under service contracts and also notes that the requirements of AASB 111 Construction Contracts are generally applicable to the recognition of revenue and the associated expenses for a transaction involving the rendering of services.
Sections 2.3.2 and 2.3.3 of AASB 1038 permit contracts containing elements of both insurance contracts and deposits to be unbundled into separate insurance contracts and deposit components if (and only if) the deposit component can be measured separately. However, the life company is not required to unbundle, and may therefore treat the entire contract as a life insurance contract if it so wishes.
This discretion not to unbundle has the potential to give rise to diverse treatments across the Australian life insurance industry for otherwise like contracts. APRA seeks certainty that life companies across the industry will consistently classify their products and that any scope for “classification arbitrage” is limited.
It should be noted that unbundling is a separate, although related, concept from the “splitting” of premiums and claims into their revenue, expense and deposit components which is required under section 5 of AASB 1038. Premium and claim splitting is a presentational issue that does not affect the quantification of profit. Unbundling relates to the entire accounting treatment. The criteria for premium and claim splitting are given in section 5.2 of AASB 1038, and are linked to the criteria for unbundling, with the exception that there is no choice – if the deposit component can be separately measured then the premiums and claims must be split.
There are three potential areas where divergent unbundling treatments might arise. These are:
- Contemporary (i.e. non-traditional) products such as investment linked or investment account with risk riders;
2. Hybrid products offering both investment linked and discretionary investment options, where the existence of balances under both sets of options may be used to justify the treatment of the whole contract as one with a discretionary participation feature; and
3. Hybrid products where the mere option to make future investments into a discretionary investment option may be used to justify the treatment of the whole contract as one with a discretionary participation feature.
The requirements, which are intended to ensure consistent treatment of such contracts for regulatory reporting purposes, are to:
- unbundle where the contract can be split for the purpose of recognising premium revenue and claims expense;
2. unbundle investment linked and discretionary investments under a hybrid contract as separate deposit components; or
3. unbundle as an embedded derivative an option to make future deposits into a discretionary investment.
A mandatory exception is made for reinsurance contracts and riders attached to participating contracts.
Most reinsurance contracts contain some financing element, although the cashflows associated with the financing cannot be readily identified and the recovery of acquisition costs paid by the reinsurer will ultimately depend on the experience of the insurance components of the reinsured business. Unbundling such reinsurance arrangements would present practical difficulties, and might lead to inconsistent treatment between life companies as different interpretations of the degree of financing are made for otherwise similar contracts. They are therefore not to be unbundled for regulatory reporting purposes.
The profits on insurance riders attached to a participating contract may in many cases be deemed to be in respect of participating business and so allocated between policyholders and shareholders. In the interests of policyholder equity it is important in such circumstances for the entire contract to be treated as participating business, rather than for the riders to be unbundled and treated as non-participating business.
Otherwise mandating that contracts be unbundled if the deposit component can be measured separately provides the best possible balance of consistency, certainty and practicality. It allows companies to comply with the requirements of regulatory financial reporting without necessarily requiring dual reporting (unless they decide not to unbundle for the purpose of general purpose financial reporting).
Assuming that the contract is appropriately managed, an option to make future investments into a discretionary investment option is unlikely to have material value. However, to ensure that it does not taint the classification of the existing deposit components it should be regarded as having been unbundled.
Where a hybrid contract is unbundled into several deposit components some of which contain a discretionary participation feature, there is an additional issue of how to allocate the associated management services element between those components, or whether to unbundle it and treat it separately.
Where a contract contains both investment linked and discretionary investment options, they must be unbundled as separate deposit components, with the associated service components apportioned between them. This ensures that the profits associated with that part of the service component associated with a participating investment option are appropriately identified as relating to participating business and so allocated accordingly. If the service component were instead treated wholly under AASB 118 then participating policyholders would potentially lose the benefit of profits arising in respect of that part of the service component associated with the participating investment option.
Switching between one investment option and the other will result in the extinguishment of deferred acquisition costs (‘DAC’) or acquisition expense recovery components (‘AERC’) under one component and the (possible) creation of DAC or AERC in respect of the new component (to the extent that the new investment generates a change in the value of the underlying carrier, in relation to AERC, or to the extent that further incremental expenses are incurred in the case of DAC).
Finally, PR 49 acknowledge that the definition of a discretionary participation feature for general purpose reporting is not necessarily the same as the definition of a participating policy under the Act. It is therefore conceivable that a participating policy may not be classified as a life insurance contract if it is not considered to contain a discretionary participation feature (and so valued as a participating benefit under the Valuation Standard) or conversely that a non-participating policy may still contain a discretionary participating feature.
The rules firstly attempt to narrow these potential differences by referring to the criteria under PR 22 as possibly providing a basis for assessing whether a discretionary participation feature exists which would at least be consistent with the categorisation as participating under the Act.
To the extent that differences remain, the rules:
- identify the basis under which a non-participating contract with a discretionary participation feature is to be valued in accordance with the Valuation Standard; and
2. stipulate that, for regulatory reporting purposes, a participating benefit is to be deemed to be a life insurance contract, even though it may not be regarded as having a discretionary participation feature for general purpose reporting.
The rules then note that the ability exists for APRA to declare policies to be participating or non-participating under the Act, and that, if necessary, such declaration might enable the classification to be aligned.
Implementation
These new prudential rules will apply for reporting periods in respect of life companies that are not friendly societies ending on or after 31 December 2005, i.e. corresponding to the first full financial reporting periods for which IFRS applies. This corresponds to the application of changes to PR 35, PR 26 and the new Actuarial Standards which PR 49 supports.
These new prudential rules will apply for reporting periods in respect of friendly societies ending on or after 31 May 2006, i.e. corresponding to the application of the new Actuarial Standard AS 1.04 Valuation of Policy Liabilities to friendly societies.