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Draft for discussion at ICAEW IISC meeting, 20th June 2005 - page 37 / 51





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to release profit by one or more ‘service drivers’. ‘The measure of liabilities should be chosen such that the corresponding profit signature matches the desired emergence of profit.’ Different patterns are illustrated in Appendix B. The principle of profit recognition ought to be explicable to a layman. EV regards a policy as a financial instrument where the profit emerges up-front as the PVFP at the outset, and subsequently each year as a percentage (equal to RAD minus the investment rate) of the opening PVFP. This gives a declining profit signature (so not consistent with e.g. fund management service view), with a redemption yield achieved equal to RAD. (If RAD equals the investment rate earned, all profit is upfront.) [The illustrations in Appendix B are for 0 investment rate: but they show a larger up front PVFP and first year profit the lower the RAD (i.e. closer to 0). So with RAD = 0 the PVFP in year 1 is equal to the whole of the future profit margins, and profit in the first year is the whole lifetime profit, while profits in subsequent years are 0.] [***need to recheck example: why is PVFP 60 when total profit only 15?****]

In conclusion the authors argue that while there should be a disproportionate amount of profit upfront, how much this should be is debatable.

Both authors favour a realistic PRE measure of with-profits liabilities recognising the correlation between ‘C’ and ‘i’. For other liabilities, one author favours EV (i.e. treat the policy as a financial instrument), though certain pensions unit-linked savings contracts should be wholly service contracts. Unit-linked whole of life are in between, so treat as financial instruments. FV should reflect capital tied up in statutory provisions and solvency margins. Change in FV = profit. Increasing liabilities by profit margins is not consistent with IASC Framework concept of ‘prudence’.

The other author favours ‘gross premium value on best estimate basis with a profit margin’. For unit-linked apply to the sterling cash flows and add unit value. Changes in assumptions should be on a prospective basis. Insurance contracts are part financial instrument, part service contract. The EV profit-signature is too manipulable via the discount rate, and a declining profit signature is unrealistic for the services provided in later years. Do not need to take into account capital tied up in regulatory provisions.

So there is still much room for debate and it is important that the actuarial profession contributes to the development of international GAAP.

In the subsequent discussion of the paper, there was some support for the ABI’s guidance on ‘achieved profits’ as broad enough to accommodate different factors, market conditions etc. Frequent concern was expressed about how to educate people with respect to greater P&L volatility, with support for reporting a ‘trend’ operating profit as in SORP. For FV, there was a suggestion to look to second-hand policy market for intermediate fair values of policy liabilities (which would be greater than surrender values).

A former analyst emphasised that the whole point of so-called upfront profit recognition is to identify how profitable ‘new business’ is.

Questions were raised as to how big the differences would be in practice: and it was observed that FV needs to be experimented with in practice (e.g. by reporting EV) if IASC are to be persuaded to adopt it. ‘It would be helpful if those individuals in a decision making and advisory capacity could become better informed about how EVs work in practice before drawing their conclusions. The profession has a key role to play in assisting them with this duty.’

There was a question whether EV will signal the end of mutuals (as appeared to have happened under the Australian ‘Margin on Services’ regime where the ‘estate’ had to be identified by the regulator before the new accounting (also used for


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