IAA Phase 2 Issue Discussion Paper June 2005 Contract Liability

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1 1. Description of issue and background The liability held for insurance contracts ( contract liability ) is fundamental to the recognition of revenue and the pattern of earnings resulting from these contracts. The contract liability refers to the net of the technical reserve held for the contract and any related assets or liabilities (eg deferred acquisition cost and value of business acquired assets, deferred income liabilities, claim reserves, etc). It is possible that some of the related assets or liabilities should be dealt with separately (eg claims reserves separate from policy reserves). Accounting regimes in use today can generally be categorized as either following the deferral-and-matching or the asset-liability approaches. In the deferral-and-matching approach, the contract liability can be viewed as the consequential result designed to achieve a specific pattern of revenue that matches the pattern of expenses and benefits paid. In the asset-liability approach, the pattern of revenue is the consequential result of the chosen liability method. This discussion paper focuses on two potential implementations of the asset-liability approach: The entry value (or business-to-consumer) model The exit value (or business to-business) model The contract liability in both models can be viewed as the present value of future cash flows arising from the contract. Subsequent to inception, the liabilities in both models would likely take into account current estimates of future cash flows, plus risk margins. The risk margins in the models would likely differ. The models differ in the following respects: gain or loss at inception the entry value model would be calibrated such that no gain or loss would be recognized at inception. The exit value model would allow recognition of a gain or loss at inception to the extent the estimated secondary market price differs from the price (or premium) charged to the policyholder. margin at inception the entry value model would have a margin at inception that reflects the transaction price. This would likely be in addition to any risk margins already required in the liability. The margin at inception in the exit value model would have to be estimated based on estimated margins required in the secondary market, possibly in addition to any risk margins already required. margins after inception the entry value model maintains the margin at inception less the portion no longer necessary. The exit value model requires estimation of the margin market participants would require. In addition to the points discussed above, the fair value hierarchy in IFRS also has bearing on the measurement of the contract liability. The guidance on fair value in IFRS and the proposed FASB standard on fair value are attached as appendices. References (attached): 1

2 IASB Agenda paper 8A for the Insurance Working Group meeting in April 2005 the entry and exit value models are identified in this paper as Approaches C and D respectively IAA Paper Insurance liabilities valuation and capital requirements general overview of a possible approach IAIS comments on Phase II IAA comments on the IAIS comments on Phase II 2. Other issues and IASB projects related to contract liability IFRS 4 currently requires insurance liabilities to be accounted for using existing accounting policies. Other IASB projects and guidance that relate to the definition of the contract liability are as follows: Revenue recognition project this is a project that is concurrent with Insurance Contracts Phase 2. Tentative conclusions from the project appear in line with an exit value model. IAS 18 sets a precedent for deferral of origination costs on investment management service contracts IAS 39 s amortized cost approach defers transaction costs IAS 39 defines transaction costs IAS 39 defines a fair value hierarchy IAS 37 s guidance on provisions are in line with the exit value model AcSB Measurement Bases for Financial Accounting: Measurement on Initial Recognition (a research project being led by the Canadian Institute of Chartered Accountants) may provide guidance on measurement of the contract liability. The issue of risk margins, which is the subject of a separate discussion paper, would impact the contract liability. 3. Alternative approaches that might be considered With the above discussion and references as background, the issues that would be appropriate for the IAA to discuss and recommend include the following: 1. Calibration to market prices should the business-to-consumer or business-to-business price be used? a. Are business-to-business prices observable? b. Could entry prices be inappropriate due to competitive reasons? c. If entry prices are inappropriate, could this be addressed via a suitable liability adequacy test? d. Could the definition be that transactions prices are the best indication of fair value unless observable market data prove otherwise? 2. Is a third method feasible calibrating to transaction price at issue and transitioning to exit value at subsequent measurement? If so, how? 3. How does the recommended model fit within the fair value hierarchy? 4. Should the cash flows in the liability be based on expected or contractual cash flows? 5. Should estimates of future cash flows be based on market-based inputs? Would entity-specific assumptions be appropriate, and if so, when? 2

3 6. Should embedded options and guarantees be valued using marketconsistent assumptions? 7. Should acquisition costs be deferred either implicitly or explicitly? 8. Should policy reserves and claims liabilities be treated separately? Additionally, the IAA could discuss and recommend the following: 1. Should the change in the contract liability all flow through the profit or loss account, or should there be a liability category similar to the availablefor-sale asset category? 2. Should there be any changes in the categories of assets backing insurance contracts? 4. Recommendation and basis for recommendation (to be determined later) 3

4 Appendix I Extracts from fair value guidance in IAS 39 IAS 39.9 Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. IAS39.49 The fair value of a financial liability with a demand feature (eg a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. IAS39.AG69 Underlying the definition of fair value is a presumption that an entity is a going concern without any intention or need to liquidate However, fair value reflects the credit quality of the instrument. No Active Market: Valuation Technique IAS39.AG74 If the market for a financial instrument is not active, an entity establishes fair value by using a valuation technique. Valuation techniques include using recent arm s length market transaction between knowledgeable, willing parties, if available, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis and option pricing models. If there is a valuation technique commonly used by market participants to price the instrument and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the entity uses that technique. IAS39.AG75 Fair value is estimated on the basis of the results of a valuation technique that makes maximum sue of market inputs, and relies as little as possible on entity-specific inputs. A valuation technique would be expected to arrive at a realistic estimate of the fair value if (a) it reasonably reflects how the market could be expected to price the instrument and (b) the inputs to the valuation technique reasonably represent market expectations and measures of the risk-return factors inherent in the financial instrument, IAS39.AG76 Therefore, a valuation technique (a) incorporates all factors that market participants would consider in setting a price and (b) is consistent with accepted economic methodologies for pricing financial instruments. The best evidence of the fair value of a financial instrument at initial recognition is the transaction price (ie the fair value of the consideration given or received) unless the fair value of that instrument is evidenced by comparison with other observable current market transactions in the same instrument (ie without modification or repackaging) or based on a valuation technique whose variables include only data from observable markets. IAS39.AG76A 4

5 The subsequent measurement of the financial asset or financial liability and the subsequent recognition of gains and losses shall be consistent with the requirements of this Standard. The application of paragraph AG76 may result in no gain or loss being recognized on the initial recognition of a financial asset or financial liability. In such a case, IAS 39 requires that a gain or loss shall be recognized after initial recognition only to the extent that it arises from a change in a factor (including time) that market participants would consider in setting a price. IAS39.AG78 The same information may not be available at each measurement date. It would be reasonable to assume, in the absence of evidence to the contrary, that no changes have taken place in the spread that existed at the date the loan was made. However, the entity would be expected to make reasonable efforts to determine whether there is evidence that there has been a change in such factors. When evidence of a change exists, the entity would consider the effects of the change in determining the fair value of the financial instrument. IAS39.AG82 An appropriate technique for estimating the fair value of a particular financial instrument would incorporate observable market data about the market conditions and other factors that are likely to affect the instrument s fair value. The fair value of a financial instrument will be based on one or more of the following factors (and perhaps others). (a) The time value of money (ie interest at the basic or risk-free rate). (b) Credit risk. (c) Foreign currency exchange prices. (d) Commodity prices. (e) Equity prices. (f) Volatility (ie magnitude of future changes in price of the financial instrument or other item). (g) Prepayment risk and surrender risk. (h) Servicing costs for a financial asset or a financial liability. 5

6 Appendix II IAA Phase 2 Issue Discussion Paper June 2005 Fair Value Hierarchy in FASB s Fair Value Measurements proposed statement (extracts from staff update on the FASB s Fair Value project March 8, 2005) GENERAL MEASUREMENT PRINCIPLE Paragraph 9 of the FVM ED incorporates the general principle that all valuation techniques (approaches) used to estimate fair value should maximize market inputs that represent the assumptions and data that marketplace participants would use in their estimates of fair value. In general, the more market inputs the more reliable the estimate. Thus, an entity should use as many market inputs as are available and about which there is a consensus in order to replicate an exchange (settlement) price for the asset (or liability) being measured. FAIR VALUE HIERARCHY (VALUATION INPUTS) As a basis for applying that general measurement principle, the FVM ED establishes a fair value hierarchy, which groups into three broad levels the inputs to valuation techniques used to estimate fair value. The hierarchy ranks those inputs, giving the highest priority to market inputs that represent quoted prices in active markets and the lowest priority to entity inputs that represent an entity s own assumptions. The emphasis on quoted prices in active markets is consistent with the Board s conclusion in other pronouncements that those prices provide the most reliable estimate of fair value and should be used whenever they are available. Respondents comments on the fair value hierarchy varied. However, many respondents indicated a need to revise the hierarchy so that it more clearly conveys a continuum of inputs, distinguishing estimates that are objectively determined from other estimates that are subjectively determined, requiring significant judgment and estimation. Hierarchy Objective As a basis for considering related comments, the Board clarified that the hierarchy objective is to rank the inputs to valuation techniques used to estimate fair value to provide a framework for assessing the relative reliability of the estimates. Although the extent to which market inputs are available and the ranking of those inputs within the hierarchy will affect the selection of the valuation technique used to estimate fair value, the hierarchy objective is not to rank or otherwise specify those valuation techniques, per se. The Board agreed that the ranking of inputs is important and that the hierarchy provides a useful construct for assessing the relative reliability of the estimates. While the emphasis on market inputs would not necessarily improve reliability of the estimates, it would improve consistency and comparability of those estimates. Accordingly, the Board decided to retain but clarify the hierarchy. Level 1 Estimates 6

7 Paragraph 15 of the FVM ED refers to the use of quoted prices for identical assets or liabilities in the active reference market the entity has the ability to currently access for the asset or liability being measured as-is. Ability to Access In the FVM ED, the Board agreed that the ability to currently access the reference market used for a Level 1 estimate is important because within Level 1 a quoted price for an identical asset or liability ( as-is ) represents the sole market input used for the estimate. In particular, it limits discretion in selecting the price used for the estimate. In its redeliberations, the Board affirmed that decision. Readily Available and Representative of Fair Value Paragraph 15 of the FVM ED emphasizes that a quoted price in an active market used for a Level 1 estimate should not be adjusted. Some respondents narrowly interpreted the Level 1 guidance as requiring the use of a quoted price in an active market whenever it is observable, without regard to whether it is readily available and (or) representative of fair value; in other words, as precluding adjustments to a quoted price in an active market in those situations. In that regard, some respondents referred to possible conflicts with ASR 118, which requires adjustments to a quoted price in an active market in those situations. The Board clarified that was not its intent, as indicated by the guidance contained elsewhere within the FVM ED. To more clearly convey its intent, the Board revised the guidance within Level 1 to refer to quoted prices for identical assets or liabilities in active markets that are readily available and representative of fair value. Examples of limited situations in which those prices might not be readily available and representative of fair value and, thus, should be adjusted (within a lower level of the hierarchy) include the following: The market for the particular asset or liability being measured is thin, that is, where there are few transactions or market-makers in the security, the spread between the bid and asked prices is large, or price quotations vary substantially either over time or among individual market makers. Similar guidance is referred to in paragraph 10 of the FVM ED, which states, In determining whether a market is active, the emphasis is on the level of activity for a particular asset or liability. Marketplace participants would not currently transact at those prices. That might be the case if significant events (for example, principal-to-principal or brokered trades or significant announcements) occur after the close of the market but before the end of the reporting period, as indicated in paragraph 18 of the FVM ED. Readily Obtainable A few respondents also referred to limited situations in which quoted prices for identical assets or liabilities in active markets are readily available and representative of fair value, but not readily obtainable (from financial reporting services or 7

8 individual broker-dealers) for each individual asset or liability to be measured at fair value due to practical operational constraints (in particular, the volume of assets or liabilities to be measured at fair value and the timing of financial reporting). They indicated that in those situations, the fair value hierarchy should allow the use of an alternative pricing method as a practical expedient. The Board agreed that the hierarchy should not preclude practical considerations and trade-offs in selecting the valuation technique to estimate fair value. The Board decided to revise the guidance within Level 1 to clarify that in limited situations in which quoted prices for identical assets or liabilities in active markets are readily available and representative of fair value but not readily obtainable, an alternative pricing method (for example, a data aggregation method such as matrix pricing) that is commonly used (accepted) in the market and demonstrated to provide reliable pricing information may be used as a practical expedient within Level 1. In reaching that decision, the Board emphasized that the use of an alternative pricing method within Level 1 is a pure practical expedient, where (1) individual price quotes in active markets could be obtained for all of the assets or liabilities to be measured but, for practical reasons, are not and (2) there is evidentiary basis for concluding that the pricing method provides reliable pricing information and results in an estimate that would approximate the estimate that would have resulted had individual price quotes in active markets been used. The Board clarified that burden of proof is on the measurer. If that burden of proof is met, the estimate is a Level 1 estimate. Otherwise, the estimate is a lower level estimate. The Board further clarified that in all cases where individual price quotes in active markets could be obtained for some, but not all, of the assets or liabilities to be measured, the requisite adjustments render the estimate a lower level estimate. Level 1 Bid/Asked Spread Estimates Pricing Method(s) Paragraph 17 of the FVM ED prescribes the use of bid prices for long positions (assets) and asked prices for short positions (liabilities) when bid and asked prices in active (dealer) markets (that is, firm offers to buy and sell) are used to estimate fair value. In the FVM ED, the Board observed that some existing pronouncements that require fair value estimates using bid and asked prices do not provide guidance on how to use those prices in developing the estimates (for example, Statement 115). The Board acknowledged that related guidance is included in ASR 118. However, that guidance provides entities with flexibility in selecting the method used to estimate fair value within a bid/asked spread. To maximize consistency and comparability, the Board decided to prescribe the bid/asked spread pricing method within Level 1 (in active markets) at the standards level, considering information provided by broker-dealer constituents that buy at or near the bid price and sell at or near the asked price. With respect to bid/asked spread pricing within other levels of the fair value hierarchy (in less active markets), the Board decided that other methods within the bid-asked spread should be considered. 8

9 Some respondents (in particular, broker-dealers) agreed with the bid/asked spread pricing method, noting that method is currently used by many entities in that industry. However, many more respondents disagreed. Some respondents (in particular, investment companies) referred to conflicts with ASR 118. They said that a single pricing method would maximize consistency and comparability, but that the resulting estimates would not necessarily be relevant. In that regard, they explained that bid and asked prices are appropriate in some but not all situations because different marketplace participants transact at different levels. Some respondents also indicated that for those entities that do not currently use the prescribed bid/asked pricing method, its use would create operational difficulties and entail significant additional cost, particularly with respect to obtaining the necessary information and making systems changes necessary to capture that information. Respondents also referred to the interaction between that prescribed method and hedging activities under Statement 133. They said that method could have unintended consequences in achieving hedge effectiveness under Statement 133. Other respondents indicated that the level of specificity (mandating a bid/asked pricing method) is inconsistent with an objectives-based approach to financial reporting. They added that it is paradoxical that the Board would mandate that pricing method for the relatively narrow spreads in active markets but not the relatively wider spreads in other (less active) markets. In response, the Board reconsidered its decision to prescribe that pricing method within Level 1. Instead, the Board decided to emphasize the valuation objective and allow judgment in achieving that objective, requiring an estimate within the bid/asked spread that best approximates an exchange-equivalent price in the circumstances, provided that the method used for the estimate is consistently applied, similar to the guidance in ASR 118. The same guidance would apply whenever bid and asked prices are used to estimate fair value, whether in active dealer markets or not. Thus, when using bid and asked prices in active (dealer) markets to estimate fair value, the use of bid prices for assets (long positions) and asked prices for liabilities (short positions) is permitted but not required. Offsetting Positions Paragraph 17 of the FVM ED specifies that for offsetting positions, mid-market prices should be used for the matched portion. Bid and asked prices should be used for the net open position, as appropriate. In the FVM ED, the Board decided to include detailed guidance for pricing offsetting positions to preclude recognition of artificial gains or losses when using bid and asked prices to estimate fair value. In its redeliberations, the Board agreed that absent the requirement to use bid prices for assets (long positions) and asked prices for liabilities (short positions), the FVM Statement should not provide detailed guidance for pricing offsetting positions. Instead, in the relatively limited situations in which that bid/asked pricing method is used, the Board decided that the FVM Statement should include general guidance requiring consistent pricing for offsetting positions (in the same instrument). 9

10 Accordingly, the same price should be used to value both the long and short position, consistent with current practice where the long position would be delivered to settle the short position and a gain or loss measured as the difference between fair value and original cost would be realized. Level 2 Estimates Paragraphs 19 and 20 of the FVM ED refer to the use of quoted prices for similar assets or liabilities in active (reference) markets, adjusted for differences between the asset or liability being measured and other similar assets or liabilities that are objectively determinable, If the differences are not objectively determinable, the estimate defaults to Level 3. In the FVM ED, the Board acknowledged that assessments of differences that are objectively determinable require judgment. However, the Board chose to narrowly define Level 2, largely to emphasize that whenever prices for similar assets or liabilities can be observed in the marketplace, an entity should make the necessary assessments (of differences) before defaulting to pricing methods that rely on other information (including entity inputs). Several respondents expressed concerns about the objectively determinable criterion for adjustments within Level 2. They indicated that because all adjustments involve at least some level of subjective judgment and estimation, Level 2 would rarely, if ever, be used, forcing many of the estimates currently required in GAAP into Level 3, including those that are relatively reliable, and, thus, do not fit the Board s description of Level 3. Moreover, the objectively-determinable criterion likely would not be consistently applied. To more clearly convey a continuum of inputs, the Board decided to revise the guidance within Level 2 to eliminate the objectively determinable criterion, thereby broadening its use. Accordingly, quoted prices for similar assets or liabilities in active markets should be adjusted for differences. Further, the adjustments should be based on observable market inputs (within the fair value hierarchy) so that they reflect the adjustments that marketplace participants would make. In the absence of observable market inputs, the estimate is a lower level estimate. Level 3 Estimates Paragraph 21 of the FVM ED refers to the use of multiple valuation techniques (approaches) and other market inputs that are available without undue cost and effort. In its redeliberations: The Board revised that guidance to refer to other market inputs that are used, either directly or indirectly, by marketplace participants in making pricing decisions rather than valuation techniques (approaches). The Board reconsidered the undue cost and effort criterion for other market inputs. Specifically, the Board decided that undue cost and effort is inappropriate as a basis for excluding from estimates of fair value market inputs that are otherwise available and relevant to the asset or liability being 10

11 measured. Accordingly, market inputs should be used to estimate fair value whenever they are available. Level 4 Estimates Paragraph 24 of the FVM ED refers to the use of entity inputs within Level 3 that represent an entity s own internal estimates and assumptions as a practical expedient where market inputs are not available, subject to the requirements of other pronouncements. In its redeliberations, the Board acknowledged, as it did in the FVM ED, that the use of significant entity inputs requires more estimation and assumptions to, in effect, replicate market prices in the absence of observable markets and (or) market inputs. To some Board members, that hypothetical construct raises practical concerns about the relevance and reliability of the estimates. However, the Board affirmed that hypothetical construct, noting that for valuation purposes, a hypothetical construct is essential as a basis for replicating a market price. Similarly, in paragraph 28 of Concepts Statement 7 the Board concluded that, The use of an entity s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating that marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information. The Board decided to retain that hypothetical construct within the fair value hierarchy and consider issues of relevance and reliability as it relates to the selection of possible measurement attributes in its conceptual framework project. Many respondents said that because Level 3 encompasses estimates that use both market and entity inputs, it would be overly broad, especially when used for disclosure purposes. In that regard, respondents indicated that a three-level hierarchy is not as effective as it could be in conveying the relative reliability of the estimates. To more clearly convey a continuum of inputs, the Board added a new Level 4 to separately refer to the use of entity inputs. The Board affirmed that regardless of whether market inputs or entity inputs are used for a fair value estimate, the measurement objective remains the same fair value. Accordingly, entity inputs used in valuation techniques to estimate fair value should be considered within market parameters (in the context of marketplace participants), thereby eliminating idiosyncratic, entity-specific factors. 11