INVESTMENT AND COMPANY REPORTING Accounting and financial reporting

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1 EUROPEAN COMMISSION Directorate General Financial Stability, Financial Services and Capital Markets INVESTMENT AND COMPANY REPORTING Accounting and financial reporting Endorsement of Amendments to International Financial Reporting Standard 4, Applying IFRS 9 Financial Instruments with IFRs 4 Insurance Contracts Introduction, background and conclusions Attachment 1: Endorsement advice prepared by EFRAG Commission européenne/europese Commissie, 1049 Bruxelles/Brussel, BELGIQUE/BELGIË - Tel

2 INTRODUCTION European Commission services and the European Financial Reporting Advisory Group (EFRAG) analyse the effects of new accounting standards and interpretations before they are endorsed by the European Union. This paper sets out an explanation of the accounting areas covered by the Amendments to IFRS 4, "Insurance Contracts"; the process of stakeholder consultations involved in the development of the Amendments to the Standard, and an analysis of the effects of using the new accounting requirements in the EU. EFRAG's endorsement advice has been developed and adopted by the EFRAG Board taking into account the input from the observers to the Board: the European Central Bank (ECB), the European Securities Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA). EFRAG's endorsement advice to the European Commission on the Amendments to IFRS 4 assessed whether they meet the endorsement criteria in Regulation (EC) no 1606/2002 of the European Parliament and Council for the adoption of international accounting standards into EU law and whether their overall benefits outweigh costs. EFRAG s endorsement advice is included in attachment BACKGROUND The IASB published the Amendments to IFRS 4 on 12 September 2016 following a faster than usual development and consultation process. The Amendments address concerns arising from the different effective dates of IFRS 9, "Financial Instruments", and the forthcoming insurance contracts Standard Reasons for the Amendments IFRS 9 was published by the IASB in July 2014 and endorsed in the EU in November The standard is effective for financial years beginning on or after 1 January During the endorsement process of IFRS 9, the Commission stated that, notwithstanding, its decision to endorse this standard, the issue of the non-alignment of the effective dates of IFRS 9 and the forthcoming insurance contracts Standard, IFRS 17, should be addressed in a satisfactory manner. This position is reflected in Recital 5 of the Regulation endorsing IFRS 9: "The adoption of international accounting standards by the Commission has to be done in a timely manner so as not to undermine investor understanding and confidence. Nevertheless, while endorsing IFRS 9, the need for an optional deferral of its application for the insurance sector is recognised". The recital acknowledged that the IASB was developing a solution to the problem. The Commission services undertook to monitor, with EFRAG's input, the progress of the IASB's solutions for the insurance industry and noted that a deferral: should be optional given that part of the insurance industry is willing to apply IFRS 9 as of 2018, and 2

3 should be limited in time (until 2021) so that the insurance industry adopts IFRS 9 and the new insurance contracts standard as soon as possible. The problem of the non-alignment of effective dates of the two standards stems from the way in which insurance companies manage their business. They generally operate a business model in which they invest in financial assets in order to generate income and capital gains to cover liabilities arising from the insurance contracts they have written. The accounting for their financial assets will be determined by IFRS 9, which requires that certain financial assets are measured at fair value, while the accounting for insurance liabilities is currently covered by IFRS 4 which effectively permits insurance companies to continue using their national Generally Accepted Accounting Principles (GAAP). Hence, some insurance companies in Europe use a cost-based measurement to measure their liabilities from insurance contracts while others use a value based on more up-todate information. IFRS 4 is currently being substantively changed by the IASB and will be replaced by IFRS 17. The new standard will require that liabilities arising from insurance contracts are measured on a consistent basis using relevant current assumptions. It has been developed so that insurance companies can reflect their business model as far as possible. Thus, if IFRS 9 and IFRS 17 had been finalised by the IASB at about the same time, their effective dates could have been aligned which would have meant that, in implementing them, the insurance industry could more appropriately reflect in their financial statements their business model of managing financial assets and insurance contract liabilities together. The IASB is expected to finalise IFRS 17 in the first half of 2017 with an effective date of 1 January In its endorsement advice on IFRS 9, EFRAG assessed the effects on the insurance industry of the non-alignment of the effective dates between IFRS 9 and the future IFRS 17. EFRAG noted that this non-alignment would create disruptions in the financial reporting of many entities undertaking insurance activities during the period until IFRS 17 is applied. Such disruptions include accounting mismatches (for example, arising from financial assets reported at fair value while the liabilities relating to these assets are reported at cost) and volatility arising from market-driven fluctuations in fair values of financial assets measured at fair value. In some cases, these issues already arise under the existing accounting for financial assets (under IAS 39). However, the application of IFRS 9 before the forthcoming insurance contracts Standard may move some accounting mismatches and volatility from Other Comprehensive Income (OCI) to profit or loss making the issues more prominent as well as introducing some additional mismatches and volatility beyond that which already exist. EFRAG noted that the extent of the difficulties created by the non-alignment of the effective dates of the two standards varies between companies. These disruptions could make financial reporting less understandable for users while potentially increasing costs for preparers who would have to explain their results to their investors and may also incur additional costs in relation to their accounting choices under IFRS 9. During the endorsement process of IFRS 9, the IASB also acknowledged that the nonalignment of dates of the effective dates of IFRS 9 and the future IFRS 17 posed particular problems for insurance entities. The IASB developed two approaches to resolve the problems. Both are optional given that the accounting rules applying to liabilities from insurance contracts vary across jurisdictions. 3

4 1.2. Content of the Amendments The IASB's two approaches are now reflected in the Amendments to IFRS 4. First, the deferral approach, allows reporting entities with predominant insurance activities to defer the application of IFRS 9 between 1 January 2018 and 31 December 2020.The scope of the IASB deferral solution will exclude some significant insurance companies in Europe that are part of bank-led financial conglomerates. This matter is covered in further detail in Section 4. Secondly, the "overlay approach", could be used by insurance entities that would not qualify for a deferral of IFRS 9 or which choose to adopt IFRS 9. The overlay approach would allow for increased volatility reported in profit in loss as a result of applying IFRS 9 to be removed from profit or loss to the Statement of Other Comprehensive Income (OCI) IASB Deferral Approach The conditions for applying the deferral approach are that the reporting entity has not previously applied any version of IFRS 9 and that its activities are predominantly linked with insurance at its reporting date immediately preceding 1 April 2016 (this can be subject to a reassessment where there has been a significant change in activities). The predominance test is in two parts: (i) the proportion of liabilities falling under IFRS compared to total liabilities should be significant and (ii) the total amount of liabilities connected with insurance activities compared to total liabilities should be greater than 90% 1. The IASB considered that a reporting entity meeting the above criteria would provide more understandable and useful information by accounting for its financial assets and financial liabilities applying either IFRS 9 or IAS 39. Thus the Board decided that the temporary exemption from IFRS 9 should be available only if the entity as a whole qualifies by considering all of its activities in order to avoid having the use of two different accounting standards within the consolidated financial statements of a group. Nevertheless, this decision means that some sizeable insurance companies in Europe that are part of bank-led financial conglomerates would not be able to take advantage of the temporary exemption from applying IFRS 9 and would have to apply it from 1 January 2018 onwards. The IASB considered that groups that do not meet the predominance test could as an alternative use the overlay approach. This scope issue is covered further in Section 4 below. The Amendments contain provisions for disclosure to address the lack of comparability between entities that will use IFRS 9 and those that will opt to defer its application and remain using IAS 39. Given that IFRS 9 introduces significant improvements over IAS 39, in particular, in the area of recognition of expected credit losses, the disclosures include some improved credit risk information for certain financial assets. There are also disclosure requirements of fair value information separated into groups similar to those in IFRS 9. 1 If less than or equal to 90% but greater than 80%, the insurer should not engage in significant activities unconnected with insurance. 4

5 The Overlay Approach The overlay approach is available for all companies and groups that have financial assets connected to liabilities for insurance contracts accounted for under IFRS 4 and can be applied until the time the future insurance contracts Standard is first applied (which is expected to be on 1 January 2021). Under this approach, an insurer applies IFRS 9 and adjusts profit or loss so that it reports the same overall amount of profit or loss that it would have reported under IAS 39. This adjustment to profit or loss can only be made for certain financial assets (the so-called "designated" financial assets as defined by the Amendments) however, within those designated assets an insurer has the option to apply the overlay to all, none or some of the assets. The approach allows insurers reporting under IFRS 9 to address accounting mismatches and volatility in profit or loss that may arise from reporting under IFRS 9 before applying the forthcoming insurance contracts Standard, IFRS 17. The Amendments include presentation and disclosure requirements to make the effects of the overlay transparent. In complying with the presentation and disclosure requirements for the overlay approach, an insurer will provide information under IFRS 9 and also on the application of the overlay, for example, explaining how the adjustment is calculated and its effect upon the financial statements IASB due process and EFRAG consultations During the development of the Amendments to IFRS 4 The IASB finalised IFRS 9 in However, in late 2015, although the IASB considered it was at an advanced stage of developing IFRS 17, it concluded that the effective date of the replacement standard would be after that of IFRS 9. Recognising that this misalignment of dates could give rise to undesirable accounting effects such as mismatches and volatility when IFRS 9 is applied with the existing IFRS 4, the Board agreed these issues should be addressed. An Exposure Draft was published on 9 December 2015 with a 60-day comment period, which ended on 8 February Ninety six comment letters were received. IASB staff also conducted an extensive outreach with affected preparers and held discussions with 70 users. EFRAG consulted on the IASB proposals by publishing a draft comment letter on the proposals on 24 December EFRAG received twenty comment letters and finalised its comment letter on the proposals on 14 March Following the publication of the standard Following the publication of the IASB Amendments to IFRS 4 in September 2016, Commission services wrote to EFRAG on 13 October 2016 asking for an opinion on whether the standard meets the criteria set out in Regulation (EC) no 1606/2002 of the European Parliament and Council for the adoption of international accounting standards into EU law. 5

6 As noted above, a company or a group of companies whose predominant activities are insurance activities would be allowed to defer the application date of IFRS 9 from 2018 until 1 January However, insurance entities within bank-led financial conglomerates are excluded from the scope of the IASB deferral. In some Member States these insurance entities have very significant amounts of liabilities arising from their insurance contracts and hold financial assets to match them. Accordingly, the Commission's letter asked EFRAG to consider whether from an economic perspective the scope of the IASB amendments could give rise to any competition issues within the EU for financial services companies reporting under IFRS and to explain the extent to which the amendment to IFRS 4 would contribute to a level playing field among European businesses carrying out significant insurance activities. EFRAG issued its draft endorsement advice on 15 November 2016 for consultation until 13 December 2016 and 23 comment letters were received. EFRAG provided the Commission with its endorsement advice on the new standard on 13 January This advice provides detailed analysis of the Amendments to the Standard against the endorsement criteria and includes analysis in respect of the issues raised in the Commission services' letter. 2. EFFECTS STUDY This effects study is based on the EFRAG endorsement advice which took into consideration the views expressed by the ECB and the ESAs in their role as observers to the EFRAG Board. It covers both the temporary deferral of IFRS 9 and the overlay approach. It is a general feature of the application of IFRS that it is difficult to arrive at a quantification of its benefits such as those identified by EFRAG for preparers and users of the financial statements Impact on financial statements - assessment against technical endorsement criteria EFRAG considered the impact of the Amendments on the quality of financial statements by assessing whether they are not contrary to the principle of true and fair view and whether they meet the criteria of understandability, relevance, reliability and comparability 2. EFRAG concluded that these criteria were met Impact on European public good Effect on the quality of financial reporting EFRAG concludes that the Amendments are a necessary solution to the very specific short term problem of the misalignment of the effective dates of IFRS 9 and the 2 Regulation (EC) No 1606/2002 of the European Parliament and of the Council of 19 July 2002 on the application of international accounting standards (OJ L 243, , p. 1). 6

7 forthcoming insurance contracts Standard. Thus EFRAG considers that the Amendments will serve to improve the quality of financial reporting in comparison to a situation without any remedies for insurers to reduce the impact of the misalignment Cost-benefit analysis EFRAG considered to what extent implementing the Amendments might result in increased costs for preparers and / or users and whether those costs are likely to be exceeded by the benefits to be derived from its adoption. Costs for Preparers Depending on their circumstances, preparers will have the ability to apply IFRS 9 from 1 January 2018; to defer application of IFRS 9 until 1 January 2021; and / or to use the overlay approach. If preparers defer the application of IFRS 9, they are likely to incur some incremental costs in explaining and providing users with relevant information about the deferral. However, preparers that defer IFRS 9 may benefit from cost savings in implementing IFRS 9 and IFRS 17 simultaneously as opposed to consecutively in 2018 and 2021 respectively. This is because some accounting choices made in applying IFRS 9 in 2018 would have to be reconsidered and possibly changed in 2021 when IFRS 17 is first applied. In addition, having more complete information about the forthcoming insurance contracts Standard when first implementing IFRS 9 could lead to costs savings. Preparers using the overlay approach will incur costs in applying IFRS 9 and also some incremental costs in applying the overlay relating to tracking and reporting information about the designated assets under both IFRS 9 and IAS 39. The disclosures relating to the overlay approach will also cause some additional costs. However, the extent of the incremental costs of applying the overlay approach will vary between organisations. Overall, EFRAG concludes that preparers would incur some incremental costs under either option. However, the deferral may give rise to cost savings in implementing IFRS 9 that might exceed the additional costs. Costs for Users EFRAG draws a distinction between specialised and non-specialised users. If preparers defer the application of IFRS 9, they will continue to report under IAS 39 and therefore EFRAG considers that specialised users would not incur additional costs other than in understanding the basis for application of the deferral. By contrast, EFRAG notes that non-specialised users have concerns that they will incur higher costs from the continued use of IAS 39 which will create difficulties in comparing insurers with noninsurers. However, EFRAG considers that the majority of users of insurance financial statements are specialised. In respect of the overlay approach, EFRAG considers that users will incur costs in understanding the adjustment and additional costs if there are changes in the designated assets to which the adjustment relates. 7

8 Overall, EFRAG's assessment is that users will incur some additional costs under both options as they will need to understand the reasons for and the impact of the approach used by the preparers. Furthermore some generalist users will incur additional costs in comparing entities undertaking insurance activities with other entities. Benefits for preparers and users The temporary exemption from IFRS 9 (deferral) will allow preparers to avoid recognising volatility in profit or loss and accounting mismatches arising from applying IFRS 9 before the forthcoming insurance contracts Standard. Users will be able to continue using their existing models until The overlay approach will allow preparers to remove the volatility resulting from the misalignment of the effective dates of IFRS 9 and the forthcoming insurance contracts Standard. Users will benefit from this removal of the volatility as well as from the relevant and transparent information under IFRS 9 and complementary information in order to understand the effects of the overlay adjustment. Overall, EFRAG concludes that the benefits arising from the Amendments for both preparers and users are likely to exceed the costs relating to their application Conclusion EFRAG considers that the Amendments will generally bring improved financial reporting when compared to the mandatory application of IFRS 9 from 1 January 2018 with an acceptable cost-benefit trade off. EFRAG has not identified that the Amendments would hinder European economic development or endanger financial stability. EFRAG has not identified any other factors that would mean adoption is not conducive to the European public good. Therefore, EFRAG concludes that adopting the Amendments is conducive to the European public good. While arriving at the conclusions stated above, EFRAG notes that the Amendments do not address the cost concerns of many insurance companies that are not predominant insurers. EFRAG cannot exclude that the Amendments could create a competition issue. However, EFRAG is not in a position to conclude on whether such an issue could be material from an economic perspective. This topic is considered further in Section 4 below. 3. CONCLUSION ON THE ENDORSEMENT OF THE AMENDMENTS TO IFRS 4 As stated above, EFRAG's endorsement advice takes into consideration the views provided by the ECB and the ESAs in their role as observers to the EFRAG Board. The ECB and the ESAs all support the endorsement of Amendments to IFRS 4. On the basis of EFRAG endorsement advice, the Commission services conclude that the Amendments to IFRS 4: 8

9 are not contrary to the principle 3 set out in Article 4(3) of Directive 2013 /34 EU [the "Accounting Directive"] and are conducive to the European public good, and meet the criteria of understandability, relevance, reliability and comparability required of financial information needed for making economic decisions and assessing the stewardship of management. While recommending the endorsement of the Amendments to IFRS 4, the Commission services have further assessed whether the scope of the IASB deferral could give rise to any competition issues taking into account EFRAG's endorsement advice. This assessment is covered in the following section. 4. COMMISSION ASSESSMENT OF THE SCOPE OF THE IASB'S DEFERRAL SOLUTION 4.1. Scope of the deferral Background The IASB's Amendments permit a company or a group of companies whose predominant activities are insurance activities to defer the application date of IFRS 9 from 2018 until 1 January Most of the biggest European insurance companies (19 out of 20 insurance companies in EFRAG's analysis) could elect for this deferral. However, entities with both significant insurance and significant non-insurance activities such as bank-led financial conglomerates would fail the predominance test and be excluded from the scope of the IASB deferral. EFRAG reviewed the 2015 consolidated financial statements of 50 European groups that conduct significant insurance activities and based on disclosed insurance liabilities, EFRAG estimated that entities representing approximately 20 25% of the total insurance activity within the sample would not be eligible to use the temporary exemption. These entities include bank-led groups with significant insurance activities so that the percentage varies between jurisdictions as the bancassurance model is not equally used across Europe IASB Position The IASB decided that the temporary exemption from IFRS 9 should be available only if the entity as a whole, by considering all of its activities, has predominant insurance activities (see section above). Thus the assessment is made at reporting entity level taking into account all the activities such as insurance, banking and asset management within a group. The rationale was that the group would provide more understandable and useful information to investors by reporting under the same accounting standard (IFRS 9 or IAS 39). By contrast, the use of two different accounting standards within the financial statements of a group (IAS 39 for the insurance entities and IFRS 9 for the banking and other entities) would make financial statements more complex. Moreover the IASB was 3 Article 4(3) states that the annual financial statements shall give a true and fair view of the undertaking's assets, liabilities, financial position and profit or loss. 9

10 concerned that the use of two different accounting standards could create incentives to transfer assets around the group to benefit from a more favourable accounting treatment and lead to further complexities in reporting. This means that the IASB rejected the possibility for groups such as bank-led financial conglomerates to defer the application of IFRS 9 for their insurance entities. Their position is in line with the long established and fundamental accounting principle that consolidated financial statements should be prepared using consistent accounting policies. However, IFRS 4 itself departs from this principle in respect of measurement of liabilities arising from insurance contracts. Finally, the IASB observed that if a group fails to qualify for the temporary exemption then it could choose to use the overlay approach Commission request for advice to EFRAG The Commission services were concerned that the IASB's decision not to allow the deferral approach to insurance subsidiaries of a financial conglomerate could introduce discrimination vis-a-vis stand-alone predominant insurance groups that will be able to benefit from deferring IFRS 9. Furthermore, there could be a risk that the difference in treatment between these insurers could affect the competitiveness of the bank-led insurers. Accordingly, Commission services asked EFRAG, in delivering its endorsement advice on the amendments, to consider whether from an economic perspective, the scope of the IASB's amendments could give rise to any competition issues within the EU for financial services companies reporting under IFRS EFRAG's Opinion EFRAG received comments concerning a number of potential competition issues that could arise from the scope of the IASB's deferral solution. Broadly, these comments related to three main areas: investment strategy; financial performance reporting and costs. Investment Strategy Some bank-led financial conglomerates argue that an inability to defer IFRS 9 for their insurance activities could have an adverse effect on their investment strategies, such as moving from investments in equities to less volatile instruments such as bonds although these would provide a lower return. This change in behaviour would arise because IFRS 9 does not allow "recycling" of profits on equity instruments held at fair value through other comprehensive income upon disposal. The category equity instruments measured at fair value through other comprehensive income means that fair value changes are not reflected in profit or loss as usual for equity instruments but in the category other comprehensive income. The use of this category allows long-term investors to avoid reporting short-term volatility in profit or loss. However, the gains (or losses) from equity investments may not be recognised in profit or loss when they are realised (ie when the shares are sold). This is referred to as the prohibition on "recycling" and it is a change in treatment in IFRS 9 compared to the existing treatment in IAS 39 which requires that gains and losses on sale of equities are 10

11 recognised in profit or loss. Some entities argue that this prohibition would prevent them from fairly reporting their performance in profit or loss which they also consider is a more important performance measure for investors than total comprehensive income. In respect of the "no-recycling" provision, EFRAG concluded in its endorsement advice on IFRS 9 that, for long-term investors, the "broader economic considerations such as the need to obtain a yield on their asset portfolio sufficient to meet their obligations to policy holders are likely to outweigh any accounting concerns in deciding whether or not to invest in equity investments." Some entities raised a further concern that the ban on "recycling". Predominant insurers using the temporary exemption will have until 2021 to sell and realise gains on some of their equity investments and report them as profit in profit or loss. By contrast, insurance entities that cannot use the deferral would only have until 2018 initial application of IFRS 9 to realise and report such gains in the same way. Thereafter, unrealised gains on equity instruments would be "frozen" in retained earnings. Financial Performance Reporting Since the recycling of gains (or losses) upon disposal of equity instruments held at fair value through the OCI would be prohibited, an insurer reporting under IFRS 9 would either: reclassify the equity to fair value through profit or loss in which case the results would be affected by short-term price fluctuations; or maintain the equity instrument at fair value through OCI in which case gains or losses on sale would not be reported in profit or loss. In either of these situations, there is a distortion of reported results which would have to be explained to investors. Costs All entities that undertake insurance activities will in due course be required to implement IFRS 9 and will incur costs in so doing. However, in the absence of a temporary deferral, entities would have to revise some of the accounting choices made when first applying IFRS 9 in 2018 and again when they first apply the new insurance standard in Such revision could lead to material incremental implementation costs. However, EFRAG notes that implementing IFRS 9 throughout an entire group at the same time could give rise to cost synergies (for example, in introducing an expected credit loss model) as certain aspects of the implementation are centrally managed in some groups. 11

12 4.2. The overlay approach EFRAG's Opinion The IASB considered that the overlay approach can be used by entities that are not predominant insurers. EFRAG notes that this approach can substantially mitigate the accounting mismatches and volatility in profit or loss that would arise from applying IFRS 9 before the forthcoming insurance contracts Standard. However, EFRAG recognises that it does not address all the effects of applying IFRS 9. Some assets will be at fair value through profit or loss under IFRS 9 that would have been at amortised cost under IAS 39 and for such assets there is additional volatility that the overlay approach does not remove from the balance sheet but only moves from profit or loss to Other Comprehensive Income. However, only a small proportion of insurers' assets should be affected in this way. The overlay approach can also be used to address the restrictions on recycling in IFRS 9, except for new investments. Furthermore, EFRAG notes that the overlay approach does not allow an entity to eliminate the effects of the application of the expected credit loss model introduced by IFRS 9. Entities that are not predominant insurers will have to apply the expected loss model in 2018 while predominant insurers will be able to defer it until However, EFRAG assesses this as a positive feature of the approach since the new model should bring improvements in financial reporting. EFRAG notes that insurers' holdings in debttype instruments are typically concentrated in investment grade assets and hence the effect of IFRS 9 is not expected to be significant in most cases. The main drawback to the overlay approach is that some bancassurers consider its costs of implementation too high to make it a viable option Conclusion EFRAG's overall assessment is that the overlay approach substantially addresses the concerns of bank-led groups that undertake insurance activities relating to accounting mismatches and volatility in profit or loss. However the use of the overlay would result in additional implementation costs. As a result EFRAG cannot exclude that the scope of the IASB deferral could create a competition issue. However, EFRAG was unable to conclude on whether this is material from an economic perspective. 12

13 4.3. Commission Services Opinion The bancassurers account for a significant market share of the EU insurance industry. Their insurance activities in Europe are so sizeable that some of them rank alongside the biggest global insurance groups. As noted above, EFRAG has found that in a sample of 50 European-based groups that conduct significant insurance activities, approximately 20-25% of the total insurance activity within the sample would not be able to use the IASB's temporary exemption. This significant proportion is largely made up of bancassurers. For insurance entities within bancassurers, the Commission services consider that there is a potential risk that the competiveness of their insurance businesses might be damaged if they could not benefit from the deferral option available to other European insurance groups that meet the predominance criterion for two main reasons: Changes in investment strategy There is a risk that strategic investment decisions could be affected as a result of the change in accounting requirements. In particular, the prohibition on recycling gains or losses on equity reported at fair value through other comprehensive income may lead to sales of equity instruments; also investments in other instruments may change to avoid reporting fair value changes through profit or loss. While the overlay approach could mitigate these risks, the costs associated with it would be so significant according to some financial conglomerates that it would not be a viable option for them. Higher implementation costs: The insurance entities unable to defer the application of IFRS 9 until the implementation of forthcoming insurance contracts Standard would face higher costs in implementing IFRS 9 in 2018 and revisiting the accounting choices made when implementing IFRS 17 in In other words, predominant insurers that are eligible to use the temporary exemption from IFRS 9 will be able to make use of certain cost mitigations that are not available to other entities. In order to remedy this potential competition issue, the Commission has extended the scope of the IASB deferral to include the insurance entities of bank-led financial conglomerates. This extension of scope is consistent with the IASB's deferral in that it is optional and only a temporary measure from 1 January 2018 until The effect of introducing such an option means that the financial conglomerate could opt for its insurance entities to continue reporting under IAS 39 until 2021 while the rest of the group, including the banking entities, would report under IFRS 9 from 1 January Insurance entities within bank-led financial conglomerates wanting to defer the application of IFRS 9 until 1 January 2021 will have to satisfy strict criteria designed to address concerns arising from the application of non-uniform accounting policies across a group. These concerns primarily relate to risk of "earnings management" and complexity for investors. Accordingly, two types of safeguards are included: 13

14 A temporary ban on transfer of financial assets to prevent the group moving financial instruments from the banking part to the insurance part in order to benefit from a more favourable accounting treatment (so called "earnings management") and to protect the level playing field between banks and banking entities of bancassurers. This ban applies from the date of entry into force of the Regulation. Additional disclosure requirements to facilitate the understanding of the financial statements by investors. The ban on transfers provides a safeguard against earnings management and it also helps minimise any complexity that could be caused by moving financial instruments around the group such that they would be measured on one basis under IAS 39 and another under IFRS 9; loans and advances provide a good example as the measurement of impairment is different under the two standards. For this reason, the ban does not apply to instruments that are measured at fair value through profit or loss under both IAS 39 and IFRS 9 as no earnings management could be achieved by moving these instruments around a group. The ban also excludes instruments such as debt and equity shares that one part of the group has issued and another part holds as an investment because such intra-group holdings are dealt with on consolidation. The additional disclosure requirements that should be made are described in the regulation. Their objective is to show the extent to which IAS 39 has continued to be applied in the group as a result of the deferral. The IASB Amendments contain further disclosure requirements for insurance entities that defer IFRS 9 and these also apply to a financial conglomerate that chooses to defer IFRS 9 as these disclosures aim to provide some comparability between groups that defer IFRS 9 and groups that apply it. 5. OVERALL CONCLUSION On the basis of EFRAG s endorsement advice, Commission services have considered the main costs and benefits of endorsing the above mentioned amendments to IFRS 4. Commission services agree with EFRAG that the benefit of the amendments outweigh the associated costs and therefore considers that the EU should endorse them. Moreover, the Regulation adopting the Amendments to IFRS 4 into EU law includes provisions to extend the scope of entities eligible to use the deferral under the Amendments. Specifically, the Regulation permits the entities within the insurance sector within a financial conglomerate as defined under the Financial Conglomerates Directive (FICOD) to defer IFRS 9 until 2021 provided that the Financial Conglomerates meet certain criteria. 14

15 Regarding Endorsement of Applying IFRS 9 Financial Instruments with IFRS 4 Insurance Contracts: Amendments to IFRS 4 Olivier Guersent Director General, Financial Stability, Financial Services and Capital Markets Union European Commission 1049 Brussels 13 January 2017 Dear Mr Guersent, Adoption of Applying IFRS 9 Financial Instruments with IFRS 4 Insurance Contracts: Amendments to IFRS 4 Based on the requirements of the Regulation (EC) No 1606/2002 of the European Parliament and of the Council on the application of international accounting standards, EFRAG is pleased to provide its opinion on the Applying IFRS 9 Financial Instruments with IFRS 4 Insurance Contracts: Amendments to IFRS 4 (the Amendments), which was issued by the IASB on 12 September An Exposure Draft of the Amendments was issued on 9 December EFRAG provided its comment letter on that Exposure Draft on 15 February The objective of the Amendments is to address concerns arising from the different effective dates of IFRS 9 Financial Instruments and the forthcoming insurance contracts Standard. The Amendments aim to meet this objective by providing two alternative, optional accounting treatments that an entity can select subject to specified eligibility criteria. The Amendments become effective for annual periods beginning on or after 1 January 2018 for the temporary exemption or upon first applying IFRS 9 for the overlay approach. A description of the Amendments is included in Appendix 1 to this letter. In order to provide our endorsement advice as you have requested, we have first assessed whether the Amendments meet the technical criteria for endorsement, in other words whether the Amendments would provide relevant, reliable, comparable and understandable information required to support economic decisions and the assessment of stewardship, lead to prudent accounting and are not contrary to the true and fair view principle. We have then assessed whether the Amendments would be conducive to the European public good. We provide our conclusions below. Do the Amendments meet the IAS Regulation technical endorsement criteria? EFRAG has concluded that, in the specific circumstances arising from the misalignment of effective dates referred to above, the Amendments meet the qualitative characteristics of relevance, reliability, comparability and understandability required to support economic decisions and the assessment of stewardship and lead to sufficiently prudent accounting. Page 1 of 37

16 EFRAG has also assessed that the Amendments do not create any distortion in their interaction with other IFRS, especially in that they were developed to address concerns arising from the misalignment of effective dates and that these concerns were raised in EFRAG s endorsement advice on IFRS 9. EFRAG has also concluded that all necessary disclosures are required. Therefore EFRAG has concluded that the Amendments are not contrary to the true and fair view principle. EFRAG s reasoning is explained in Appendix 2 to this letter. Are the Amendments conducive to the European public good? EFRAG has assessed that the Amendments would serve to reduce the negative financial reporting and cost consequences that would otherwise arise from implementing IFRS 9 before the forthcoming insurance contracts Standard and would reach an acceptable costbenefit trade-off. EFRAG s analysis is that the Amendments address the main concerns of entities whose activities are predominantly related to insurance ( predominant insurers ). EFRAG further notes that predominant insurers are the most significantly affected by the issues arising from the misalignment of the effective dates of IFRS 9 and the forthcoming insurance contracts Standard. On that basis, EFRAG assesses that adopting the Amendments would be conducive to the European public good. EFRAG s reasoning is explained in Appendix 3 to this letter, which includes certain elements of an impact analysis. Other issues raised in your request for endorsement advice Your request for endorsement advice specifically noted that: The amendments to IFRS 4 arise from the interaction between requirements for accounting for liabilities arising on insurance contracts with the requirements for accounting for financial instruments under IFRS 9. Your endorsement advice on IFRS 9 commented on this interaction and your advice on these amendments should take into consideration your previous comments. In particular, we should be grateful if you would consider whether, from an economic perspective, the scope of the IASB's amendments could give rise to any competition issues within the EU for financial services companies reporting under IFRS and explain the extent to which the amendments to IFRS 4 would contribute to a level playing field among European businesses carrying out significant insurance activities. EFRAG s conclusion on whether endorsement of IFRS 9 would be conducive to the European public good was positive, except for the impact on the insurance industry of the misalignment of effective dates referred to above. EFRAG s endorsement advice on IFRS 9 stated: EFRAG has confirmed its preliminary view that the benefits to users of consistent financial reporting until IFRS 9 and the future insurance contracts standard are both applied, together with the cost savings for preparers and users, made a strong case for having the IASB defer the effective date of IFRS 9, so as to align it with the effective date of the future insurance contracts standard, albeit only for entities undertaking insurance activities and as an option. Furthermore, in the absence of uniform accounting policies for insurance liabilities, and considering that some insurance activities are conducted in the context of conglomerates, the impact of the non-alignment of the effective dates of IFRS 9 and the future insurance contracts standard varies from one company to the other. Therefore any remedy provided to mitigate the negative impact of the non-alignment of effective dates should be granted on an optional basis. Page 2 of 37

17 EFRAG assesses that the Amendments address many of the concerns raised in its endorsement advice on IFRS 9. In particular, the Amendments provide an optional, temporary exemption from the application of IFRS 9 for predominant insurers. However, this option is not available to entities undertaking insurance activities that are not predominant insurers. The Amendments also provide an alternative approach (the overlay approach) that would be available to all entities undertaking insurance activities and which can substantially mitigate the financial reporting-related concerns arising from the misalignment of effective dates referred to above. The main drawback of the overlay approach is that it would not provide the cost savings referred to in our endorsement advice on IFRS 9 and would in fact increase costs for entities compared to implementing IFRS 9 in the normal way. Accordingly, EFRAG considers that the Amendments would not result in a completely level playing field among entities undertaking insurance activities. In making these observations, EFRAG notes that the misalignment of effective dates is a unique and short-term situation. This situation gives rise to a complex set of concerns, the impact of which varies from one entity to another. There is unlikely to be any single, perfect solution to these concerns (especially given the short time available to develop one) and any solution put forward would inevitably reflect certain trade-offs between competing factors. For these reasons EFRAG considers that the Amendments address many of the concerns in our endorsement advice on IFRS 9 but do not address the cost concerns of many entities undertaking insurance activities that are not predominant insurers. EFRAG could not exclude that the Amendments could create a competition issue. However, we are not in a position to conclude on whether this is material from an economic perspective. EFRAG s reasoning is further explained in Appendix 3. Our advice to the European Commission As explained above, we have concluded that the Amendments meet the qualitative characteristics of relevance, reliability, comparability and understandability required to support economic decisions and the assessment of stewardship, raise no issues regarding prudent accounting, and are not contrary to the true and fair view principle. We have also concluded that the Amendments are conducive to the European public good for the period for which they are needed. Therefore, we recommend the Amendments for endorsement. Without qualifying our advice, we note that the Amendments address many of the concerns raised in our endorsement advice on IFRS 9 but do not address the cost concerns of many entities undertaking insurance activities that are not predominant insurers. EFRAG could not exclude that the Amendments could create a competition issue. However, we are not in a position to conclude on whether this is material from an economic perspective. On behalf of EFRAG, I would be happy to discuss our advice with you, other officials of the European Commission and the Accounting Regulatory Committee as you may wish. Yours sincerely, Jean-Paul Gauzès President of the EFRAG Board Page 3 of 37

18 Contents Applying IFRS 9 Financial Instruments with IFRS 4 Insurance Contracts Appendix 1: Understanding the changes brought by Applying IFRS 9 Financial Instruments with IFRS 4 Insurance Contracts: Amendments to IFRS Temporary exemption from IFRS Overlay approach... 9 Appendix 2: EFRAG s technical assessment on Applying IFRS 9 Financial Instruments with IFRS 4 Insurance Contracts: Amendments to IFRS Does the accounting that results from the application of the Amendments meet the technical criteria for endorsement in the European Union? Relevance Providing two options the overlay approach and the temporary exemption from IFRS The temporary exemption from IFRS Scope and eligibility criteria Reassessment of eligibility for the temporary exemption from IFRS Disclosures Temporary exemption from specific requirements in IAS 28 and for first-time adopters Effect of the application of the temporary exemption The overlay approach Scope and eligibility criteria Presentation Conclusion on relevance Reliability The temporary exemption from IFRS Scope and eligibility criteria Reassessment of eligibility for the temporary exemption from IFRS Disclosures The overlay approach Scope and eligibility criteria Conclusion on reliability Comparability Introducing two options the overlay approach and the temporary exemption from IFRS The temporary exemption from IFRS Predominance ratio Disclosures Effect of the application of the temporary exemption The overlay approach Page 4 of 37

19 Difference between de-designation of specific financial assets or ceasing to use the overlay approach Applicability of the overlay approach and the temporary exemption from IFRS 9 to firsttime adopters of IFRS Conclusion on comparability Understandability Temporary exemption from IFRS The overlay approach Applying IFRS 9 Financial Instruments Conclusion on understandability Prudence Temporary exemption from IFRS Eligibility criteria The overlay approach Eligibility criteria Conclusion on prudence True and Fair View Principle Conclusion Appendix 3: Assessing whether the Amendments are conducive to the European public good Introduction Whether the Amendments are likely to improve the quality of financial reporting Costs and benefits of the Amendments Costs for preparers Temporary exemption from IFRS Overlay approach Conclusion cost for preparers Costs for users Temporary exemption from IFRS Overlay approach Conclusion cost for users Benefits for preparers and users Temporary exemption from IFRS Overlay approach Conclusion benefits for preparers and users Potential competition issues within the EU Temporary exemption from IFRS Adverse effect on investment strategies Less relevant information on performance Page 5 of 37

20 Cost mitigations available to predominant insurers Overlay approach Conclusion on European public good Page 6 of 37