Consultation Paper: Insurance Solvency Standards and NZ IFRS 16 Leases

Ref #7548363 Consultation Paper: Insurance Solvency Standards and NZ IFRS 16 Leases July 2018

2 Ref #7548363 v4.0 Reserve Bank of New Zealand

3 Ref #7548363 v4.0 Reserve Bank of New Zealand The Reserve Bank welcomes your written feedback on this Consultation Paper by 5 pm, Friday 24 August 2018. Please note the information on the publication of responses below. Address responses and enquiries to: Richard Johnson, Senior Adviser Prudential Supervision Department Reserve Bank of New Zealand PO Box 2498 Wellington 6140 Email: InsuranceLeasesConsultation@rbnz.govt.nz Publication of responses All information in written responses will be made public unless you indicate you would like all or part of your response to remain confidential. Responders who would like part of their response to remain confidential should provide both a confidential and public version of their response. Apart from redactions of the information to be withheld (i.e. blacking out of text) the two versions should be identical. Responders who request that all or part of their response be treated as confidential should provide reasons why this information should be withheld if a request is made for it under the Official Information Act 1982 (OIA). These reasons should refer to section 135 of the Insurance (Prudential) Supervision Act 2010 or the grounds for withholding information under the OIA. If an OIA request for redacted information is made the Reserve Bank will make its own assessment of what must be released taking into account the responder’s views. The Reserve Bank may also publish an anonymised summary of the responses received on this consultation.

4 Ref #7548363 v4.0 Reserve Bank of New Zealand Table of Contents Publication of responses ................................................................................................... 3 Table of Contents................................................................................................................ 4 Part 1. Request for information and feedback................................................................ 5 Part 2. Proposed changes to the Solvency Standards................................................... 6 Part 3. The accounting changes...................................................................................... 7 3.1 Rationale for, and summary of, accounting changes............................................... 7 3.1.1 Current accounting arrangements differ by classification as an operating or finance lease..7 3.1.2 Current accounting for leases has been criticised on a number of grounds...........................8 3.1.3 NZ IFRS 16 requirements.........................................................................................................8 3.1.4 Transition to NZ IFRS 16 ........................................................................................................11 Part 4. NZ IFRS 16 and the solvency standards ........................................................... 13 4.1 Risks associated with the new assets and liabilities .............................................. 13 4.2 Proposed approach to the Solvency Standards .................................................... 17 4.3 Approach to IFRS 16 from other regulators........................................................... 18

5 Ref #7548363 v4.0 Reserve Bank of New Zealand Part 1. Request for information and feedback

1. NZ IFRS 16 Leases is a new accounting standard for lease contracts.1 NZ IFRS 16 will apply for financial reporting periods beginning on or after 1 January 2019 although earlier adoption is permitted.
2. NZ IFRS 16 will result in new assets and liabilities on the balance sheet for lease contracts.
3. The new “right-of-use” assets and “lease liabilities” are not explicitly addressed in the current RBNZ insurance sector Solvency Standards.2
4. The Reserve Bank:  Seeks your views on some proposed changes to the insurance sector Solvency Standards for the right-of-use assets and lease liabilities.  Requests that licensed insurers use their best endeavours to provide responses to the survey set out in Appendix A. This survey aims to improve the Reserve Bank’s understanding of the current use of lease arrangements, the impact of the accounting changes, and the effect of the proposed changes to the insurance solvency standards.
5. We welcome your feedback on the proposals by 5 pm Friday 24 August 2018 to: InsuranceLeasesConsultation@rbnz.govt.nz
6. Once we have considered your feedback and the results of the survey, the Reserve Bank will aim to finalise the proposed changes and amend the current solvency standards so they can take effect from 1 January 2019. Structure of the paper
7. Part 2 sets out the proposed changes to the Solvency Standards.
8. Part 3 provides further information on the accounting changes.
9. Part 4 sets out matters considered by the Reserve Bank in developing the proposed changes.
10. The Appendices are: A The survey questions. B Draft text of the proposed solvency standard changes. C Numerical calculations for Figure 1 and 2. D Alternative changes to the solvency standard considered by the Reserve Bank.

1 https://www.xrb.govt.nz/accounting-standards/for-profit-entities/nz-ifrs-16/ 2 In this paper “Solvency Standards” refers to all current solvency standards, including the Solvency Standard for Life Insurance Business December 2014 and the Solvency Standard for Non-life Insurance Business December 2014. Where a distinction between different standards is required, this is made clear.

6 Ref #7548363 v4.0 Reserve Bank of New Zealand Part 2. Proposed changes to the Solvency Standards 11. The following table sets out the Reserve Bank’s proposed changes to the Solvency Standards for the new right-of-use assets and lease liabilities arising under NZ IFRS 16 for leases entered into as a lessee. 12. The table sets out the objective of the proposed change. Appendix B contains proposed implementing text for the Solvency Standards. Proposed requirement Objective of requirement A right-of-use asset is not deducted from capital where the underlying asset is tangible. Clarifies when right-of-use assets are to be deducted from capital. Asset risk capital charge of 100% ( value of right-of-use asset – value of corresponding lease liability) with a minimum of $0. Allows the right-of-use asset to support the lease liability, but recognises that the asset may be of limited value to support other liabilities. The right-of-use asset value may also include amounts for acquisition costs and similar items that are of limited value for solvency purposes. Offsetting the asset and liability recognises the close linkage between them. Right-of-use assets are excluded from the asset concentration risk charge. Clarifies the application of the concentration risk charge. The nature of the right-of-use asset and the close linkage with the lease liability make the concentration of counterparty of less concern. Right-of-use assets and corresponding lease liabilities are subject to the Foreign Exchange Risk Capital Charge and the Interest Rate Risk Capital Charge where appropriate. Recognises that right-of-use assets and lease liabilities may be subject to interest rate and foreign exchange rate risks in some circumstances. A right-of-use asset is not subject to a 100% charge due to the counterparty being a related party, provided the lease contract is on a prudent commercial arm’s length basis. Clarification of when related party leasing arrangements may require a capital charge.

7 Ref #7548363 v4.0 Reserve Bank of New Zealand Part 3. The accounting changes 13. This section provides a summary of the lease accounting changes. 14. A lease is an agreement where a person obtains the right to use an asset (the “underlying asset”) for a period of time in exchange for payment. The person that provides the right-of-use is the lessor and the person that obtains the right-of-use is the lessee. 15. Lease arrangements are commonly used to obtain the right-of-use of: premises, such as head office space or retail/branch offices; motor vehicles for staff or sales representatives; and information technology and office equipment. 3 Lease arrangements can provide an alternative means to finance an asset and reduce exposure to the risks associated with asset ownership. 16. Financial obligations under lease arrangements can be relatively significant components of an entity’s operating expenses and the value of future lease obligations can be material relative to the current balance sheet.4 3.1 Rationale for, and summary of, accounting changes 3.1.1 Current accounting arrangements differ by classification as an operating or finance lease 17. Under the current accounting standards, a lease is classified as a ‘finance lease’, if substantially all the risks and rewards incidental to ownership of the underlying asset are transferred to the lessee (but not necessarily with a transfer of title). All other leases are ‘operating leases’. 18. We expect the majority of lease contracts in use by licensed insurers to be classified as operating leases. The survey seeks information about this. 19. The accounting treatment is different for a lessee and a lessor. 20. We expect the majority of licensed insurers to enter into lease contracts as a lessee although some may act as lessor. The survey seeks information about this. 21. A lessee accounts:  For a finance lease, by initially recognising an asset and a liability equal to the fair value of the leased property (or, if lower, the value of minimum lease payments). The asset may be increased for acquisition costs. Over time, the asset is subject to depreciation and the minimum lease payments apportioned between a finance

3 The use of lease arrangements varies from industry to industry. The listed areas are those commonly seen in the financial services sector. 4 An informal survey of recent annual financial statements indicates the significance of lease arrangements varies by entity. Operating lease costs can be in the order of 10% or more of disclosed operating expenses. The value of future lease obligations can be around 5% or more of total assets and may exceed current reported solvency margins in some cases.

8 Ref #7548363 v4.0 Reserve Bank of New Zealand charge and a reduction in the liability. This approach reflects the view that, under a finance lease, the risks and rewards of ownership are largely transferred to the lessee.  For an operating lease, by recognising the lease payments as an expense, typically on a straight-line basis over time. There is no asset or liability on the balance sheet. 22. A lessor accounts:  For a finance lease, by recognising an asset equal to the value of lease payments receivable under the lease.  For an operating lease, by recognising the underlying asset in the balance sheet and the income received, typically on a straight-line basis.5 This reflects the view that under an operating lease, the risks and rewards of ownership remain with the lessor. 23. The current accounting standards also require a range of disclosures in the notes to the financial statements. 3.1.2 Current accounting for leases has been criticised on a number of grounds 24. The current accounting methods have been criticised, 6 particularly for lessees, on the grounds that:  the two different accounting approaches (i.e. the distinction between operating and finance lease) may mean that economically very similar leases could be accounted for very differently; and,  that the information presented and disclosed lacked transparency and failed to meet the needs of users. 25. NZ IFRS 16 aims to address these concerns by changing the approach to lease accounting by lessees. 3.1.3 NZ IFRS 16 requirements 26. Under NZ IFRS 16 there continues to be a different treatment for lessees and lessors. 27. We focus on the changes for leases entered into as a lessee and currently classified as operating leases. The approach for lessors is largely unchanged from the current approach summarised above. 28. For lessees, there will no longer be a distinction between finance and operating leases. The majority of leases will be represented by an asset (a “right-of-use asset” or RoU asset) and liability related to the lease. This reflects the view that a lessee obtains the right to use the underlying asset and incurs a liability to make one or more lease

5 NZ IAS 17 49,50 6 IFRS 16 Basis for Conclusions BC3- BC4.

9 Ref #7548363 v4.0 Reserve Bank of New Zealand payments in exchange, a lease liability. The assets and liabilities will be subject to depreciation and interest charges respectively. 29. Table 1 (page 12) provides more detail on the accounting under NZ IFRS 16. The figures below provide an illustrative example for a 10 year lease (Appendix C contains further detail on the example). Figure 1 Example of Right-of-Use Assets and Lease Liability Evolution 30. Figure 1, illustrates how the value of the right-of-use asset (RoU, blue columns) and lease liability (orange columns) may change over the term of the lease assuming the lease continues to expiry with no change. Some observations include:  The right-of-use asset at commencement may be higher than the lease liability due to the inclusion of the value of initial expenses and pre-paid lease payments or other adjustments. Such prepaid expenses may result in reduced values in other asset classes on the balance sheet (such as cash held) so the impact on net assets may be nil initially.  The right-of-use asset reduces over time with depreciation (straight-line in this case).  The lease liability increases with interest (unwinding of discount rate) and reduces with payments made. In this example, the lease liability value first increases in value before decreasing.  In this example, the lease liability generally exceeds the value of the right-of-use asset.

10 Ref #7548363 v4.0 Reserve Bank of New Zealand Figure 2 Example of lease expenses under current and new accounting approaches (for a lessee and a lease classified as an operating lease under current standards) 31. Figure 2 illustrates the lease related expenses under the current approach (yellow line) and under NZ IFRS 16 (grey line). Some observations include:  The current approach allocates lease costs evenly over the term of the lease as an operating expense.7  Under NZ IFRS 16, the liability increases with interest (unwinding of discount rates). The interest is greatest in the early periods of the lease (blue columns). The right-of-use asset reduces with depreciation (here on a straight-line basis, orange column). The net effect are reported lease expenses that are more “front loaded” than under the current approach (the grey line is higher than the yellow line initially and reduces over time). The depreciation and interest expenses are presented separately to operating expenses.  The total profit or loss reported over the term of the lease is the same, however the timing, amount and presentation of the accounting values each year are different. In either approach, the lease related expenses may differ in amount and timing from the lease payment cash flows.

7 Alternative allocation of lease expenses may be used where they are more representative of the pattern of the user’s benefit.

11 Ref #7548363 v4.0 Reserve Bank of New Zealand 32. NZ IFRS 16 also includes provisions for specific transactions such as sale and leaseback arrangements. At this stage, we do not believe that such arrangements require addressing in the Solvency Standards, but we welcome feedback on this position. 3.1.4 Transition to NZ IFRS 16 33. NZ IFRS 16 includes a range of transition options entities may use when first applying NZ IFRS 16 to existing lease contracts. 34. Depending on the transition choices made, the transition to NZ IFRS 16 may alter the reported financial position of the entity. The survey in Appendix A provides an opportunity to indicate the expected impact on your firm. 35. This paper does not address the various transition options available to insurers, as our intention is to allow insurers to select the transition approach they prefer. Our proposals focus on the steady-state treatment of leases under the solvency standards (i.e. post implementation of NZ IFRS 16 rather than the transition). This is because we do not expect that specific transition provisions will be required in the Solvency Standards. Please provide feedback on this point if NZ IFRS 16, along with the proposed changes to the Solvency Standards, is expected to be of particular difficulty for your firm. Is the description of the accounting approaches discussed in Part 3 consistent with your understanding of the current and new accounting approaches for lease contracts? If not, please provide an explanation of the differences. Are there any requirements of NZ IFRS 16 that you consider the Reserve Bank needs to make specific provision for in the Solvency Standard in addition to or instead of those set out in Part 2? Are there any elements of NZ IFRS 16 transition proposals that you consider the Reserve Bank needs to consider? Are there any other specific lease related transactions that the Reserve Bank should consider from a Solvency Standard perspective?

12 Ref #7548363 v4.0 Reserve Bank of New Zealand Table 1 Requirements of NZ IFRS 16 for Lessees

8 NZ IFRS 16, 34, 35 require a fair value method if the lease qualifies as investment property and fair value is used for the entity’s other investment property under NZ IAS 40. A revaluation method (fair value estimate) may be used for lease of property plant and equipment where that class of property is valued using a revaluation method under other accounting standards. 9 NZ IFRS 16, 36 Scope Balance Sheet Profit or Loss Classification Not required. All leases except short￾term leases or leases of low value items. A ‘right-of-use asset’ and a ‘lease liability’ are recognised in the balance sheet. The liability is initially equal to the present value of the future minimum lease payments (including fixed payments, payments determined by reference to a rate or index at the value at commencement, residual value guarantees and costs of purchase options or termination fees consistent with the assessed lease term). The value of the right-of-use asset is initially equal to:

• the initial value of the liability; plus,
• any initial directly attributable expenses; plus,
• any lease payments made at or before the commencement date less any lease incentives received; plus,
• an estimate of make-good provisions. In future periods the value of the right-of-use asset is subject to depreciation and impairment testing. Alternative valuation methods for the right-of-use asset are permitted or required for some items. 8 The value of the asset may be adjusted for specified changes in the lease liability. The value of the liability is increased by interest (at a rate used in discounting the payments) and reduced by lease payments made. The value of the liability is re￾assessed under certain circumstances with any changes matched by changes in the value of the right-of-use asset. 9 Expense of depreciation on the asset. Expense of interest on the liability.

13 Ref #7548363 v4.0 Reserve Bank of New Zealand Part 4. NZ IFRS 16 and the solvency standards 36. The Solvency Standards do not currently require operating lease obligations of a lessee to be factored into the minimum capital requirements. 37. We expect that licensed insurers take account of the costs and risks associated with lease arrangements within current business planning and risk management practices including in the assessment of the adequacy of current and future capital needs. 4.1 Risks associated with the new assets and liabilities 38. Underlying economic risks are not directly impacted by accounting methodologies. 39. Accounting methodology changes can alter reported financial performance measures, reported financial position and regulatory capital, either when first applied or over time. Such changes can lead to changes in the economic risks faced by firms as business practices change in order to optimise the entity’s chosen performance and capital measures. 40. As a result, consideration of prudential capital requirements needs to consider both underlying economic risks and matters that are introduced to the reported financial position and performance by accounting methodologies. 41. Table 2 (page 14) sets out a summary of the risks identified by the Reserve Bank in respect of lease contracts and the accounting methodology, focusing on the position of a lessee. Do you consider that the nature of the potential risks of lease contracts and the accounting treatment of NZ IFRS 16 set out in Table 2 are reasonable? Are there any risks that have been ignored or inappropriately characterised?

14 Ref #7548363 v4.0 Reserve Bank of New Zealand Table 2 Potential Risks of Lease Contracts - Lessees Risk Comment Capital Issues Credit Risk i.e. risk of counterparty default Credit risk appears limited as there is little or no cash flow to the lessee. The right-of-use asset and lease liability are not recognised until the underlying asset is made available for use (the key lessor obligation), unless the contract is onerous. Credit risk is an element of the current asset risk charges. Credit risk does not appear to be relevant to a right-of-use asset after recognition. Market Risk i.e. risk that value of assets and liabilities vary adversely with market variables The value of the lease liability may increase or decrease. These changes may be market related e.g. CPI levels, market rent reviews, or may arise from changes to the lease contracts or the expectations about whether a lease will be renewed or terminated. These changes are largely matched by corresponding changes to the right￾of-use asset. The value of the right-of-use asset may move independently of the lease liability if:

• The asset is subject to impairment losses.
• Where the accounting choice is made to value the asset using the revaluation model for property plant and equipment or for leases of investment property. The value of the asset and liability may change to different degrees in response to interest rate risks or foreign exchange rate changes in some circumstances. Current asset risk charges allow for market risks. NZ IFRS 16 appears to result in a largely matched asset and liability position in response to changes in the value of the lease liability. Some specific classes of right-of-use asset may be on a fair value basis under NZ IFRS 16 which may lead to more volatile value for the asset:
• Leases of investment property if the fair value method is applied to an entity’s other investment property.
• Leases of property plant and equipment may be determined on a revaluation model if the lessee applies the revaluation model to that class of underlying asset. Right-of-use asset may not be realisable or maybe an intangible asset A lease contract may be terminated in accordance with its terms (may involve payment of termination costs) or under certain breaches of contract (limited by Property Law Act in some cases). In such cases the lease liability and lease asset would reduce and be adjusted for termination costs. If a firm is wound up, it would seem likely that lease contracts could be re-negotiated or Intangible assets are currently deducted from capital, as they are regarded as unlikely to be of full value in distress situations. Accounting items such as capitalised expenses and deferred acquisition costs are normally limited

15 Ref #7548363 v4.0 Reserve Bank of New Zealand terms of leases may automatically cancel the lease on insolvency. On-going lease costs will need to be funded. The right-of-use asset, although the value is largely dependent on the entity continuing as a going-concern, may be realisable to an extent through sub leasing or as part of a business sale. The right-of-use asset includes amounts related to pre-payments and direct acquisition costs (if any). These are items where the cash has already been spent and the accounting entry is primarily a reporting tool to spread the reported cost over time. NZ IFRS 16 requires leases of certain items to be accounted for as intangible assets (e.g. leases of licenses, manuscripts) and permits but does not require leases of other intangible items to be accounted for under either NZ IFRS 16 or as intangible assets. under the Solvency Standards as they do not represent fully realisable items or are dependent on future profitability. Concentrated exposure Leases of significant property assets may result in relatively large right-of-use assets and lease liabilities to single counterparties. Concentration risk capital charges largely encourage diversification of investments, and so reduce risks to a firm of single counterparty failure. For lease arrangements, lease liabilities and right￾of-use assets are closely linked (i.e. failure of the landlord is likely to result in both asset and liability being derecognised). Liability value understated The lease liability represents the value of the fixed leases payments in line with the firm’s expectations of the lease term and the take up of any options of renewal or termination under the contracts. There are a number of factors that may mean the lease liability is understated in the accounts and uncertain: Understatement of the value of liabilities overstates a firm’s financial position. Approaches to deal with liability understatement or uncertainty could include a more conservative estimate of the liability cost.

16 Ref #7548363 v4.0 Reserve Bank of New Zealand

• rental costs based on variable underlying drivers e.g. sales volumes, are not required to be estimated,
• rental costs based on an index or rate e.g. CPI, are not altered until the payments change as a result of a change in the index or rate
• termination costs are not required to be held until a firm expects under the circumstances not to renew;
• the initial value of the lease liability may be based on discounted cash flows using an entity’s marginal borrowing rate. These rates may be relatively high, lowering the value of the liability, for entities in a weaker financial position. Accounting exemptions may apply for short-term leases (being those of 12 months or less) or for leases of assets of “low value”. Low value is not defined in NZ IFRS 16. The supporting guidance suggests that lease contracts where the underlying asset has a value under USD5000 would be of low value. These exemptions result in no asset or liability being recognised even where, in aggregate, the potential liability could be material. The solvency standards do not currently require non-insurance related liabilities to be valued on a more conservative basis than required by the accounting standards (with the exception of contingent liabilities and some other “off balance” sheet credit exposures). Developing a more prudent valuation approach may be relatively complex and may be more appropriately considered in a wider context. Mismatch of asset and liability value The default amortization and depreciation requirements generally result in the assets and liabilities not fully offsetting each other. Changes in the value of the lease liability (other than changes due to the application of finance charges and lease payments made) are generally offset by corresponding changes to the value of the right-of-use asset. The right-of-use asset may increase or decrease in value in some circumstances without a corresponding change in the lease liability e.g. impairment losses or where fair value methods are used. A mismatched asset and liability position may result in the reported financial position weakening in response to changes in asset and liability values arising from common underlying drivers (e.g. typically interest rates). Operational As a contractual arrangement, there are associated operational and compliance risks associated with the contracts. In general, breach of contractual terms can result in lease cancellation (limited by Property Law Act) and normal contractual remedies. Operational risks are not currently quantified within the Insurance sector Solvency Standards.

17 Ref #7548363 v4.0 Reserve Bank of New Zealand 4.2 Proposed approach to the Solvency Standards 42. In view of the risks identified in Table 2, the Reserve Bank considers that it is necessary to:  clarify when a right-of-use asset is to be deemed intangible for the purposes of deductions from capital;  recognise the close linkage between the value of the right-ofuse asset and lease liability by enabling the value to be offset when considering appropriate capital charges; and,  recognise that, after offsetting the value of the right-of-use asset and lease liability, the net position may: i. reflect the value of items currently restricted under the solvency standards (e.g. acquisition costs): or, ii. be exposed to a degree of market risks such as from changes in market interest rates or foreign exchange rate variations, or otherwise; or, iii. not always be fully realisable in a form that can support other liabilities. 43. In addition, in developing the proposed changes we have aimed to  not deviate too far from the current methodologies within the Solvency Standards to support a relatively straight forward implementation given the time until applying NZ IFRS 16 is mandatory; and,  limit attention to NZ IFRS 16 specific issues. For example, the risks identified in Table 2 include potential risks around the use of discount rates that may reflect an entity’s financial strength. Such issues may arise in other contexts and may need to be considered, in due course, more broadly than in response to NZ IFRS 16. 44. Part 2 sets out the preferred changes developed with the above points in mind. The Reserve Bank expects that the proposed approach will result in neither a material increase nor decrease in reported solvency margins in most cases. 45. Appendix B includes draft text that aims to implement the proposals set out in Part 2. 46. Appendix D sets out a range of alternative options for change the Reserve Bank has considered and the reasons why these are not preferred. Do you consider that the proposed approach appropriately addresses the key risks identified in Table 2? If not, please provide an explanation and recommend an alternative approach. Do you consider that the draft text set out in Appendix B, would effectively implement the proposed changes?

18 Ref #7548363 v4.0 Reserve Bank of New Zealand Do you have any further points about NZ IFRS 16 Leases you would like to bring to the Reserve Bank’s attention? 4.3 Approach to IFRS 16 from other regulators 47. In developing the proposals for change the Reserve Bank has considered how other regulators’ capital requirements have been altered or proposed to be altered by the implementation of the international equivalents to NZ IFRS 16. 48. The response by international regulators is mixed. Table 3 provides a summary of the approach taken to IFRS 16 in other jurisdictions. 49. The Reserve Bank’s view is that the proposed changes to the Solvency Standards are not expected to apply in an unreasonable manner to New Zealand incorporated insurers relative to that which may apply in other jurisdictions. Table 3 Summary of changes to other jurisdiction’s capital framework in response to NZ IFRS 16 equivalents

10 https://eur-lex.europa.eu/legal￾content/EN/TXT/?uri=uriserv:OJ.L_.2017.291.01.0001.01.ENG&toc=OJ:L:2017:291:FULL Jurisdiction Summary of Changes RBNZ Comment Australia In a letter to industry dated 31 May 2018 the Australian Prudential Regulation Authority (APRA) have indicated that, for the insurance sector:  Where the leased asset is tangible the right￾of-use asset be considered tangible.  The right-of-use asset and corresponding lease liability be subject to the real interest rate stress, expected inflation stress and foreign exchange stress where relevant.  The credit spread stress is not required.  The Asset Concentration Risk Charge is not necessary. Although APRA’s prudential standards on capital requirements are not directly comparable to New Zealand’s framework, APRA’s approach appears broadly consistent with the assessment of the risks outlined in this paper. The treatment of intangible assets, recognition of the exposure to interest, foreign exchange rate and concentration risks appear consistent. European Union The European Commission has accepted IFRS 16 as a recognised valuation method for the purposes of Solvency II. 10 This means the right-of-use assets and liabilities are recognised on the Solvency II balance sheet. The Balance sheet as a whole would then be subject to the Solvency II stress scenarios for the determination of required capital. Solvency II is not directly comparable to the New Zealand framework. Recognition of the right-of-use assets and lease liabilities on the regulatory balance sheet may result in changes to regulatory capital as an outcome of the Solvency II stress tests.

19 Ref #7548363 v4.0 Reserve Bank of New Zealand If your firm is an overseas licensed insurer under the Insurance (Prudential Supervision) Act, please indicate, if known, how the home regulator has or is expected to respond to the introduction of IFRS 16 for regulatory capital purposes.

11 https://www.bis.org/press/p170406a.htm United States The United States requires regulatory capital to be determined under a set of regulatory capital accounting standards established by the National Association of Insurance Commissioners (NAIC) known as the US Statutory Basis. The Statutory Basis differs from US GAAP used for general￾purpose financial statements. It is proposed that the US Statutory Basis will retain the current treatment of lease contracts and so will not recognise the right-of-use assets or lease liabilities for capital purposes, even though US GAAP is being altered in a similar manner to the requirements of IFRS 16. The proposals are still to be finalised. The NAIC’s view is that right-of￾use assets are not appropriate for the satisfaction of policyholder claims Basel Committee on Banking Supervision (BCSB) A press release11 by the BCSB, that sets the international guidelines for Banking sector capital requirements, states:  Right-of-use assets should not be deducted from capital so long as the underlying asset is a tangible asset;  A risk weight of 100% applies to the right-of-use asset.  The right-of-use assets contribute to key capital and leverage ratios. This approach is largely the default treatment for assets not otherwise given specific treatment in the Banking sector capital framework. It results in additional minimum capital for right-of-use assets of around 8% of the face value of the right-of-use asset with no offset of the lease liability. The increase in capital is not expected to be material relative to current balance sheets in the Banking sector.

20 Ref #7548363 v4.0 Reserve Bank of New Zealand Appendix A. Survey for completion on a best endeavours basis Where possible it would be helpful to the Reserve Bank if your entity can provide further information in response to the following questions. Information on a best endeavours basis is acceptable. The Reserve Bank recognises that the information may change as your entity’s financial reporting policies under NZ IFRS 16 develop.

1. Please provide a description of the nature of current and proposed lease arrangements in use by your firm and how they have been classified and accounted for in the financial statements and the solvency calculations currently (e.g. as at your last annual reporting date).
2. Does your firm plan on taking advantage of the ‘practical expedient’ for low value items and short-term leases (less than 12 months)? Please estimate the total amount of such leases and describe the nature of the underlying assets.
3. What types/ categories of right-of-use assets will come on to your Balance Sheet as a result of NZ IFRS 16? Has your firm identified any right-of-use assets that have not been included in the financial commitments notes to the financial statements? If yes, please identify the type/ category of assets and the amount.
4. Will any of the right-of-use assets be valued using other measurement models under NZ IFRS 16? e.g. right-of-use assets that may qualify as investment property under NZ IAS 40 or the revaluation method under NZ IAS 16?

21 Ref #7548363 v4.0 Reserve Bank of New Zealand 5. Please quantify the expected impact of NZ IFRS 16 adoption on the balance sheet and capital position by completing the table below on a best endeavours basis. For life insurance companies please complete the table for each life fund and for the total life entity. Please determine values under the Proposals set out in Part 2, and under your best estimate of how you would have applied the current solvency standard. Values may be estimated relative to your last annual reporting date. Change in Total Assets Change in Total Liabilities Change in Net Assets Change in Actual Solvency Capital For non-life insurers

• Impact on Asset Risk Capital Charge, by component
• Impact on Foreign Currency Risk Charge (if applicable)
• Impact on Interest Rate Capital Charge (if applicable)
• Impact on Concentration Risk Capital Charge Impact on minimum capital required, solvency margin and solvency ratio. For Life Insurers,
• Impact on Asset Risk Capital Charge by component
• Impact on minimum capital required, solvency margin and solvency ratio

22 Ref #7548363 v4.0 Reserve Bank of New Zealand 6. Does the right-of-use asset exceed the Asset Concentration Risk Charge limits prescribed in the Solvency Standards (assuming these are determined taking the right￾of-use assets as a component of Total Assets)? If ‘Yes’, please quantify the amount of the right-of-use asset/exposure and the asset concentration limit that has been breached. 7. Describe the approach to transition your firm intends to adopt and the expected impact on the balance sheet?

23 Ref #7548363 v4.0 Reserve Bank of New Zealand Appendix B. Draft text of proposed changes to the Solvency Standards The following table contains the draft text of the proposed changes to the Solvency Standards Solvency Standard for Non-life Insurance Business 2014 Section Proposed Text (new text in red) 2.5 Intangible Asset Deductions new paragraph 28A A right-of-use asset arising from lease contracts accounted for under NZ IFRS 16 where the underlying asset is tangible shall not be deducted from capital. 3.3 Risk Weighted Exposures Charge New paragraph 62A Right-of-use assets arising from NZ IFRS 16 Leases are excluded from the calculation in 62. The Risk Weighted Exposure Charge under paragraph 62 is increased in respect of right-of-use assets and lease liabilities under NZ IFRS 16 by: 100% *(Value of the right-of-use asset less the value of the corresponding lease liability) subject to a minimum of zero. OR (as an alternative if stakeholders consider this clearer) 100% of the excess of the value of the right-of-use asset over the corresponding lease liability, if any. Amend Table 2 class 14 Assets incurring a full capital charge Loans to directors or associated parties of the licensed insurer Unsecured loans to employees or agents of the licensed insurer in excess of $1,000 Assets under a fixed or floating charge Obligations of a related party (except as provided in Exposure Class 7 and right-of-use assets under NZ IFRS 16 where the lease is entered in to on prudent commercial terms on an arm’s length basis) Unpaid premiums (including premium funding receivables) that are twelve months or more past the contractual due date for payment to the licensed insurer 3.3 (c) Asset Concentration Risk Charge: Amend paragraph 72 72. In order to determine the Asset Concentration Risk Charge, the licensed insurer must first calculate the total value of its exposures to any single entity or group of related entities (counterparty). For the purposes of the Asset Concentration Risk Charge the exposures must include assets (excluding right-of-use assets arising from lease contracts accounted for under NZ IFRS 16), Contingent Liabilities included in the Risk Weighted Exposures Charge and the gross balance sheet asset in respect of derivatives with that counterparty (“asset derivative position”) or, where there is a legally binding netting agreement with that counterparty, the net asset derivative position with that counterparty.

24 Ref #7548363 v4.0 Reserve Bank of New Zealand Exclude right-of-use assets from concentration limits: Amend Table 3, heading of 2nd column Limit (% of total assets of the licensed insurer excluding any reinsurance recovery assets and right-of-use assets arising from lease contracts accounted for under NZ IFRS 16) Solvency Standard for Life Insurance Business 2014 Section Proposed Text (new text in red) 2.5 Intangible Asset Deductions new paragraph 32A A right-of-use asset arising from lease contracts accounted for under NZ IFRS 16 where the underlying asset is tangible shall not be deducted from capital. 3.3 (a)(i) Risk Weighted Exposures Charge New paragraph 66A Right-of-use assets arising from NZ IFRS 16 Leases are excluded from the calculation in 66. The Risk Weighted Exposure Charge under paragraph 66 is increased in respect of right-of-use assets and lease liabilities under NZ IFRS 16 by: 100% *(Value of the right-of-use asset less the value of the corresponding lease liability) subject to a minimum of zero. OR (as an alternative if stakeholders consider this clearer) 100% of the excess of the value of the right-of-use asset over the corresponding lease liability, if any. Note: it is then anticipated that the resulting CEP Capital Charge be treated in the current manner. Amend Table 1 Class 11 Assets incurring a full capital charge Loans to directors or associated parties of the licensed insurer Unsecured loans to employees or agents of the licensed insurer in excess of $1,000 Assets under a fixed or floating charge Obligations of a related party (except as provided in Exposure Class 5 and right-of-use assets arising from lease contracts accounted for under NZ IFRS 16 where the lease is entered in to on prudent commercial terms on an arm’s length basis ) Unpaid premiums that are twelve months or more past the contractual due date for payment to the licensed insurer (except as provided in Exposure Class 14 below)

25 Ref #7548363 v4.0 Reserve Bank of New Zealand 3.3 (b) Asset Concentration Risk Charge: Amend paragraph 90 90. In order to determine the Asset Concentration Risk Charge, the licensed insurer must first calculate the exposures of each Life Fund to any single entity or group of related entities (counterparty). For the purposes of the Asset Concentration Risk Charge the exposures must include assets (excluding right-of-use assets arising from lease contracts accounted for under NZ IFRS 16), Contingent Liabilities included in the Risk Weighted Exposures Charge and the gross balance sheet asset in respect of derivatives with that counterparty (“asset derivative position”) or, where there is a legally binding netting agreement with that counterparty, the net asset derivative position with that counterparty. Exclude right-of-use assets from concentration limits: Amend Table 3, heading of 2nd column Limit (% of total assets of the licensed insurer excluding any reinsurance recovery assets and right-of-use assets arising from lease contracts accounted for under NZ IFRS 16) Other Standards Other standards refer directly to, or to the principles of, the Solvency Standards above. We do not consider that any specific changes are required but please provide feedback on this point.

26 Ref #7548363 v4.0 Reserve Bank of New Zealand Appendix C. Numerical example of a lease under NZ IFRS 16 This example represents a 10-year lease, with payments of 50,000 annually, payable in advance, contractually increasing at 5% per annum. A discount rate of 4.5% per annum is determined. Taxation is ignored. No directly attributable expenses or other adjustments are made. Under current accounting approaches, we understand the estimated total lease cost of $628,895 could be allocated evenly through profit or loss at $62,889.5 per annum. Cashflows and Assumptions Year 1 2 3 4 5 6 7 8 9 10 TOTAL Payments (in advance) 50000 52,500 55,125 57,881 60,775 63,814 67,005 70,355 73,873 77,566 628,895 Discount 4.5% Initial Costs - Payment escalation 5% Initial RoU Asset PV future Lease Payments 460,904 Net Present Value of future lease payments, at discount rates inherent in lease or marginal borrowing cost Lease Payments made at or before start 50,000 Lease payments made at or before commencement (assumed to occur at commencement here) Initial direct costs - Any directly attibutable costs of lease (assumed to occur at commencement here) Initial RoU Asset 510,904 Evolution of Lease Asset - straight line depreciation 1 2 3 4 5 6 7 8 9 10 RoU asset at start 510,904 459,814 408,723 357,633 306,542 255,452 204,362 153,271 102,181 51,090 Depreciation (51,090) (51,090) (51,090) (51,090) (51,090) (51,090) (51,090) (51,090) (51,090) (51,090) RoU asset at the end 459,814 408,723 357,633 306,542 255,452 204,362 153,271 102,181 51,090 0 Evolution of Lease Liability - interest accrued less payments made 1 2 3 4 5 6 7 8 9 10 Lease liability at the start 460,904 481,645 448,456 411,031 369,042 322,138 269,949 212,077 148,099 77,566 Less amounts paid (52,500) (55,125) (57,881) (60,775) (63,814) (67,005) (70,355) (73,873) (77,566) Interest 20,741 19,312 17,700 15,892 13,872 11,625 9,132 6,377 3,340 0 Lease liability at the end 481,645 448,456 411,031 369,042 322,138 269,949 212,077 148,099 77,566 0 Under NZ IFRS 16 Period Commencment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Income Statement Interest expense 20,741 19,312 17,700 15,892 13,872 11,625 9,132 6,377 3,340 0 117,991 Depreciation 51,090 510,904 Rental Expenses Total Lease expense 71,831 70,402 68,790 66,982 64,962 62,715 60,223 57,468 54,431 51,090 628,895 Balance Sheet RoU Asset 510,904 459,814 408,723 357,633 306,542 255,452 204,362 153,271 102,181 51,090 0 Cash (50,000) (50,000) (102,500) (157,625) (215,506) (276,282) (340,096) (407,100) (477,455) (551,328) (628,895) Lease Liability 460,904 481,645 448,456 411,031 369,042 322,138 269,949 212,077 148,099 77,566 0.0000 Net Assets - (71,831) (142,233) (211,023) (278,005) (342,968) (405,683) (465,906) (523,374) (577,804) (628,895) Retained earnings (71,831) (142,233) (211,023) (278,005) (342,968) (405,683) (465,906) (523,374) (577,804) (628,895)

27 Ref #7548363 v4.0 Reserve Bank of New Zealand Appendix D. Alternative approaches to the asset risk charge The following table sets out a number of alternative approaches the Reserve Bank considered in formulating the proposed Asset Risk charge: Alternative Asset Risk Charge Comment X * right-of-use asset This is the usual calculation method under the Solvency Standards. X is a factor that varies by asset class and counterparty reflecting past volatility in asset values / credit risk etc. These factors are listed in the solvency standards. Factors vary for example from 0.5% for cash, 25% for owned property, or 100% for assets with related counterparties. The default value of X for assets not explicitly listed is 40%. This appears high for assets where credit and market related risks appear relatively low. The approach does not reflect the close linkage with the lease liability. Where there is a close linkage or where assets and liability values vary in response to common underlying drivers, the solvency standards generally consider the net position (e.g. in the capital charges for Foreign Currency, Interest Rates and for Life Insurers, some insurance risks). This method does not prevent the right-of-use asset potentially enhancing reported capital if there are large acquisition cost components for example. X * (right-of-use asset – lease liability) Recommended approach with X = 100. This approach recognises the close linkage between the right-of-use asset and lease liability whilst limiting acquisition costs and other enhancements to the right-of-use asset value increasing reported capital. A floor of zero is necessary to ensure there is no offset to the reduction in capital when the values of lease liabilities exceed the value of the right-of-use asset. A value of X under 100 would permit the right￾of-use assets appearing to support other liabilities of the firm. Right-of-use assets in excess of lease liabilities do not appear to be

28 Ref #7548363 v4.0 Reserve Bank of New Zealand readily realisable and may reflect adjustments aimed at managing reported profit or loss (e.g. capitalised expenses). Require the lease liability to be assessed more prudently, and increase minimum capital required by the difference from the book value of the liability Lease Liability (more prudent estimate) – Lease Liability (accounting estimate). A more prudent (higher) valuation of the liability could include allowance for  Future lease payments dependent on variable items (sales, mileage)  Minimum termination fees if any (required under NZ IFRS 16 only where the termination is probable under the circumstances).  Assuming that all renewal options are utilised (only required under accounting if it is probable that a renewal would be exercised).  The liability could be subject to a floor e.g. of any termination cost expected. Although there are risks around understatement of the lease liabilities, the approach would be a significant departure from the current standards. The solvency standards have not required non-insurance liabilities to be valued on a more prudent basis than accounting standards with the exception of some off-balance sheet credit related exposures (guarantees, etc.). The method is likely to be quite complex to implement.