Treatment of future profits
There are a number of ways in which expectations about future profits may be measured. One measure is Value In Force (“VIF”). Generally, VIF has no asset value for regulatory purposes. This is set to continue under Solvency II. However, CEIOPS’s advice (expressed in DOC-25/09, following Consultation Paper 30) is that certain future cash in-flows relating to in-force business can be taken into account in valuing technical provisions, meaning that some elements of VIF may be used to reduce liabilities. Specifically, future premiums may be brought into account in relation to “existing contracts”. The concept of an “existing contract” places tight limits around the extent to which future premiums can be used to reduce liabilities. A contract is not an “existing contract” (and future premiums cannot be recognised) if the (re)insurer has the ability to reject future premiums, can unilaterally cancel the contract or has an unlimited right to vary future premiums or benefits. Also, policyholder renewals relating to options or guarantees can only be taken into account to increase the best estimate of the liability.
The effect of the above advice is that future premiums will to some extent be excluded from both the asset and liability side of many UK insurers’ regulatory balance sheets. Accordingly, there is likely to be continued interest in monetisation transactions, such as contingent loans.
How will contingent loans work?
Currently in the UK a contingent loan is an effective means of converting a future profit stream which does not count as an asset under the admissibility rules into a current asset for those purposes. This is achieved by an insurer borrowing money from another company and only making principal and interest repayments from surplus (or profit) as it accumulates in the insurer’s accounts, or in a defined book of business held by the insurer. In this way, loan repayments are contingent on the emergence of future surpluses and the insurer is able to ignore that contingent repayment obligation in valuing its liabilities. There are now specific rules in INSPRU to that effect. Thus, the insurer receives an asset (i.e., the loan proceeds, upon drawdown) without an offsetting liability. As repayments are made, the run-off of the asset consisting in the loan proceeds is offset by the accumulation of surpluses.
CEIOPS’s final advice on asset and “other liability” valuations is that contingent liabilities should be recognised in accordance with existing accounting standards (specifically, IAS 37). The effect is that contingent liabilities will need to be recognised when they become “probable” and capable of reliable estimation, rather than simply being ignored until actually due. The question thus becomes – at what point do repayment obligations under contingent loans become “probable” (they will almost always be able to be reliably estimated). A related question is whether the degree of probability is to be reflected in the valuation of the liability itself (i.e., should a 60% probability of a liability of 100 be valued at 60?).
What is “probable”?
CEIOPS’s advice (expressed in DOC-31/09, following Consultation Paper 35) is that contingent liabilities should not be recognised whilst they remain “contingent” (within the meaning of IAS 37), but should be reported to supervisors and “subject to continuous assessment”. However, if a liability ceases to be “contingent” within the meaning of IAS 37, a provision must be raised. IAS 37 states that a liability ceases to be “contingent” (and must therefore be recognised) where:
- there is a present obligation based on a past event (including a “constructive” event);
- payment is probable – meaning more likely than not; and
- the amount can be estimated reliably.
The first element (i.e., the requirement for a present obligation) should not be taken to mean that repayments need to be presently due and payable. Otherwise, the second element is redundant (as there would always be a 100% - or near 100% - probability of a debt that is presently due and payable giving rise to an actual payment). Thus, it is presumably not necessary for surplus to have emerged (and for the contingency to therefore have been met) in order for the first element to be satisfied. The existence of a current contingent (but non-discretionary) repayment obligation would likely suffice. If so, virtually every contingent loan will meet the first element. Similarly, the third element is likely to be readily satisfied on the basis that contingent loan repayment obligations have a transparent value (assuming the satisfaction of the contingency, or applying a defined probability to that contingency).
The second element is likely to cause the greatest difficulties. Contingent loans are generally made in the expectation of future surpluses from which repayments will be made. If there was no such expectation of future surpluses, the lending company may struggle to show that it is acting in its own bests interests and on an arms-length basis from the borrower – points that may be relevant from tax and corporate governance perspectives. This expectation may mean that there is a greater than even chance that the contingent loan will be fully repaid (i.e., that the payment of the liability is “probable” and therefore not “contingent” under IAS 37).
Valuing the “probability”
There may still be capital benefit in contingent loans if the value of the repayment obligation can be discounted to reflect the level of uncertainty regarding future surpluses. An example would be if a 60% probability of having to pay 100 over a given period were to be valued at 60% of the present value of the payments (i.e., something less than 60). The threshold question is whether this will be permitted. Regrettably, there is no clear answer on this point from CEIOPS. Several submissions were made to CEIOPS suggesting that such discounting should be permitted and also pointing out that IAS 37 is currently under review. The Association of British Insurers has noted that such discounting would be consistent with the changes that are currently proposed in relation to IAS 37. It remains to be seen how CEIOPS will deal with any amendments to IAS 37; for now CEIOPS has indicated that it will keep IAS 37 under review for the purposes of developing Level 3 guidance.
If discounting of the type discussed above is indeed permitted, the next question is how does one determine the discount factor? Put another way, what is the probability of the relevant insurer (or defined book of business) being sufficiently profitable over the anticipated course of the loan? There will surely be as much art as science in answering this question. For the sake of simplicity, the hope is that accounting valuations performed in relation to the same loans can be carried across to the regulatory treatment. If the Solvency II rules are intended to reflect the accounting treatment in this regard, there is no reason why such a carry-across should not occur.
For further information, please contact:
Duncan Barber (duncan.barber@linklaters.com, (+44) 20 7456 3356);
Victoria Sander (victoria.sander@linklaters.com, (+44) 20 7456 3395).
