Question 1 Adjusting the contractual service margin

Transcription

1 Question 1 Adjusting the contractual service margin Do you agree that financial statements would provide relevant information that faithfully represents the entity s financial position and performance if differences between the current and previous estimates of the present value of future cash flows if: (a) differences between the current and previous estimates of the present value of future cash flows related to future coverage and other future services are added to, or deducted from, the contractual service margin, subject to the condition that the contractual service margin should not be negative; and (b) differences between the current and previous estimates of the present value of future cash flows that do not relate to future coverage and other future services are recognised immediately in profit or loss? Why or why not? If not, what would you recommend and why? Response 1. Paragraph 30 states, The remaining amount of the contractual service margin at the end of the reporting period is the carrying amount at the start of the reporting period: a. Plus the interest accreted on the carrying amount of the contractual service margin (CSM) during the reporting period to reflect the time value of the money. b. Minus the amount in accordance with paragraph 32 for services provided in the period c. Plus a favourable difference between the current and previous estimates of the present value of the cash flows, if those future cash flows relate to future coverage and other future services. 2. Given the existence of the CSM, we consider issues arising from its proposed treatment. a. A consequence of the proposed approach is that any downward change in the expected future profit, beyond the absorbency provided of the contractual service margin, is recognised immediately, whereas upward changes are deferred so as to be recognised as the experience emerges. These effects are demonstrated by Example 6, paragraph IE9 et seq., in the document Illustrative Examples on Exposure Draft Insurance Contracts. b. The principal choice to be made in the treatment of the CSM is whether to unlock it for changes in economic assumptions as well as for changes in noneconomic assumptions. We note that interest measured at historical rates may have no relevance when reported on the current valuation date. If however the CSM were unlocked for interest rate movements, its capacity to absorb movements would be limited because of the floor of zero. The consequent asymmetry in its behaviour would make it difficult, if not impossible, to adopt an investment strategy designed to stabilise the P&L. In fact a strategy that on an economic basis matched the liability would not achieve this end, even if changes to assets were taken at fair value through P&L and liability movements that resulted from changes in interest rates were recognised in the P&L account. c. We therefore concur that the CSM should not be unlocked to reflect interest rate changes. We refer the reader to our response to Question 4 for further discussion of the treatment of interest rate volatility.

2 d. We agree however that it should be unlocked to reflect non-economic assumption changes. These certainly affect the estimate of future profits and so should be reflected in the CSM. We also agree that cash flows that cannot be absorbed by the CSM should be recognised immediately in the profit and loss account. We suggest however that paragraph 30(c) requires revision, in that it suggests that any reduction in the fulfilment cashflows immediately gives rise to a CSM. We suggest instead that earlier losses should be recovered before a CSM can be created. 2

3 Question 2 Contracts that require the entity to hold underlying items and specify a link to returns on those underlying items If a contract requires an entity to hold underlying items and specifies a link between the payments to the policyholder and the returns on those underlying items, do you agree that financial statements would provide relevant information that faithfully represents the entity s financial position and performance if the entity: (a) measures the fulfilment cash flows that are expected to vary directly with returns on underlying items by reference to the carrying amount of the underlying items? (b) measures the fulfilment cash flows that are not expected to vary directly with returns on underlying items, for example, fixed payments specified by the contract, options embedded in the insurance contract that are not separated and guarantees of minimum payments that are embedded in the contract and that are not separated, in accordance with the other requirements of the [draft] Standard (i.e. using the expected value of the full range of possible outcomes to measure insurance contracts and taking into account risk and the time value of money)? (c) recognises changes in the fulfilment cash flows as follows: (i) changes in the fulfilment cash flows that are expected to vary directly with returns on the underlying items would be recognised in profit or loss or other comprehensive income on the same basis as the recognition of changes in the value of those underlying items; (ii) changes in the fulfilment cash flows that are expected to vary indirectly with the returns on the underlying items would be recognised in profit or loss; and (iii) changes in the fulfilment cash flows that are not expected to vary with the returns on the underlying items, including those that are expected to vary with other factors (for example, with mortality rates) and those that are fixed (for example, fixed death benefits), would be recognised in profit or loss and in other comprehensive income in accordance with the general requirements of the [draft] Standard? Why or why not? If not, what would you recommend and why? Response 1. Paragraph 33 states that paragraph 34 applies if the contract: (a) requires the entity to hold underlying items such as specified assets and liabilities, an underlying pool of insurance contracts, or if the underlying item specified in the contract is the assets and liabilities of the entity as a whole; and (b) specifies a link between the payments to the policyholder and the returns on those underlying items. The entity shall determine whether the contract specifies a link to returns on underlying items by considering all of the substantive terms of the contract, whether they arise from a contract, the law or regulation. Paragraph B84 states, by way of clarification, The criteria in paragraph 33 would not be met if either of the following apply: (a) the payments arising from the contract reflect the returns on identifiable assets or liabilities only because the entity chooses to make payments on that basis. In that case, the entity may choose to avoid economic mismatches by 3

4 making payments that are expected to vary directly with returns on underlying items, but it is not required to do so. However the entity is not required to avoid the economic mismatches that would arise if it held other assets or liabilities. (b) the entity could choose to hold the underlying items and so could avoid the economic mismatches, but is not required to hold those underlying items. 2. We consider below certain issues arising from the proposed approach to mirroring : a. We note that if our proposals in response to Question 4 are adopted, there will be no need for any provisions concerning mirroring. The remainder of this response would then be redundant. b. In case of with profits business, it would typically be the case that the benefit payable to the policyholder reflects the surplus in the with profits fund. Thus B84(b) would not apply since the insurance company must hold the underlying item of the with profits fund. The basis of allocation of emerging surpluses between different classes of policyholder, however, would typically be a matter of choice for the Company, although its discretion may be limited by considerations such as policyholders reasonable expectations. It should be clarified that this element of choice would not render business with discretionary participation features ineligible under Paragraph B84(b) for the treatment permitted in Paragraph 34. c. The method of decomposition of cashflows between those expected to vary with underlying items and those that are not is specified in Paragraph B85 and an example is given in Paragraph B86. However since all the decompositions are arithmetically identical, as they must be, to establish any one decomposition as correct appears arbitrary. Indeed, as noted in BC 130, any decomposition of cash flows is, to some extent, arbitrary. The different ways in which an entity might identify which of the cash flows that are expected to vary directly with returns on underlying items would result in different amounts being recognised in profit or loss and other. Since the decomposition is arbitrary, and the recognition of movements in the P&L and OCI depends on the decomposition, it follows that the P&L will also be, to the same extent, arbitrary. This appears unsatisfactory. We understand that for embedded derivatives in contracts that fall under paragraphs 33 and 34, paragraph 66(b) requires that changes in the fulfilment cash flows that are expected to vary indirectly with those returns on underlying items be recognised in profit or loss. However, for embedded derivatives that are not in contracts that fall under paragraphs 33 and 34, the movement in the embedded derivative from a change in economic assumptions would be recognised in OCI. We do not believe there is any adequate rationale for this differentiation. d. We note also that the distinction between a fixed cash flow and one that varies with underlying items may not be clear in business with discretionary participation features, since the extent to which future bonus or dividend rates may be varied could be a matter a judgement. e. We suggest that the accounting split between mirrored and non-mirrored cash flows could be quite artificial in that it may not represent how the business is actually managed. 4

5 3. To avoid these problems to some extent, we propose that where the extent of mirroring is significant, all the fulfilment cash flows should be valued by reference to a valuation rate that reflects the carrying value of the backing assets, with due allowance for expected reinvestment rates. Any change in liability as a result of change in interest rates would then mirror the treatment of the change in value of the backing assets. We note however that in respect of the assets categorised as HTM, changes in value may be split between OCI and P&L: unrealised gains would reside in the former and realised gains would reside in the latter. It is difficult to see in the proposed structure how the change in the value of a mirrored liability may be reflected so as to eliminate accounting mismatch. 4. We note a further inconsistency, as highlighted in BC127(b). this Exposure Draft would recognize changes in the value of some options embedded in insurance contracts wholly in profit or loss if the contract requires the entity to hold underlying items and specifies a link to those underlying items. Thus, there would be an inconsistent presentation of changes in the value of options and guarantees embedded in insurance contracts, depending on whether the options and guarantees are embedded in a contract that requires the entity to hold underlying items and specifies a link to returns on those underlying items. This too appears unsatisfactory. Our proposal in response to Question 4 below addresses this issue. 5

6 Question 3 Presentation of insurance contract revenue and expenses Do you agree that financial statements would provide relevant information that faithfully represents the entity s financial performance if, for all insurance contracts, an entity presents, in profit or loss, insurance contract revenue and expenses, rather than information about the changes in the components of the insurance contracts? Why or why not? If not, what would you recommend and why? 1. Paragraphs 56 to 59 state: 56 An entity shall present revenue relating to the insurance contracts it issues in the statement of profit or loss and other comprehensive income. Insurance contract revenue shall depict the transfer of promised services arising from the insurance contract in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those services. Paragraphs B88 B91 specify how an entity measures insurance contract revenue. 57 An entity shall present incurred claims and other expenses relating to an insurance contract it issues in the statement of profit or loss and other comprehensive income. 58 Insurance contract revenue and incurred claims presented in the statement of profit or loss and other comprehensive income shall exclude any investment components that, in accordance with paragraph 10(b), have not been separated. 59 An entity shall present the expense of purchasing reinsurance contracts held, excluding any investment components, in profit or loss as the entity receives reinsurance coverage and other services over the coverage period. 2. We make the following observations: a. A gross representation of revenue and expenditure items seems more useful than the net margin approach as this will help a user identify all drivers of the net result and thereby better enable him or her to project the performance of an entity. b. The revenue as defined in the ED is a significant departure from the current practice of premium being represented as revenue. However, we believe IASB s rationale for its proposals to be logical in that the proposed method is consistent with the concept of revenue in other industries, notably banking. c. The current proposal also seeks to address concerns on the complete absence of premium in the financial results by asking for a reconciliation to be provided between premium and revenue. d. Nevertheless, there will need to be considerable efforts made on educating the users on the new concept of revenue compared to the old concept. 3. We note that IASB has already acknowledged the complexity of the approach, for example in paragraph BC99. We can only endorse this opinion. It appears to us however that significant simplifications would arise if paragraph 58 were deleted. (See response to question 6, below.) We suggest that if it is deemed of sufficient importance, disclosure on the basis proposed may be included in the notes to accounts. In that case, at least, the complexity would not be forced on the user. 6

7 4. Conceptually, too, we have concerns over paragraph 58. a. We believe that it would be better not to strip out the investment component for the following reasons: i. if we are not unbundling under paragraph 10(b), there is no reason to treat the investment component separately. The proposal smacks of unbundling through the back door, so to speak. We note that in any case the proposed treatment would not affect the bottom line; and ii. it appears that consistency with the standard on revenue recognition may require the treatment proposed by the ED. We suggest however that an inconsistency with that standard may be intrinsic to insurance, and that it is precisely such considerations that have led to a standard specific to insurance. b. We suggest that preparer of the accounts would need to apply judgment on what constitutes an investment component. For example, it does not appear clear to us how to unbundle deposit components in the following contracts: i. Maturity benefit in an endowment contract ii. Survival benefits under an anticipated endowment contract iii. Survival benefits in a life annuity iv. Benefits under a life annuity with return of purchase price on death. 7

8 Question 4 Interest expense in profit or loss Do you agree that financial statements would provide relevant information that faithfully represents the entity s financial performance if an entity is required to segregate the effects of the underwriting performance from the effects of the changes in the discount rates by: (a) recognising, in profit or loss, the interest expense determined using the discount rates that applied at the date that the contract was initially recognised. For cash flows that are expected to vary directly with returns on underlying items, the entity shall update those discount rates when the entity expects any changes in those returns to affect the amount of those cash flows; and (b) recognising, in other comprehensive income, the difference between: (i) the carrying amount of the insurance contract measured using the discount rates that applied at the reporting date; and (ii) the carrying amount of the insurance contract measured using the discount rates that applied at the date that the contract was initially recognised. For cash flows that are expected to vary directly with returns on underlying items, the entity shall update those discount rates when the entity expects any changes in those returns to affect the amount of those cash flows? Why or why not? If not, what would you recommend and why? 1. Paragraphs 60, 64 and 66 propose that an entity should recognise: a. in profit or loss interest expense determined on an amortised cost basis; and b. in other comprehensive income the difference between the carrying amount of the insurance contract measured using the discount rates that were used to determine that interest expense, and the carrying amount of the insurance contract measured using the current discount rates. These proposals are intended to segregate the effects of the underwriting performance from the effects of the changes in the discount rates that unwind over time. These proposals revise the conclusion in the 2010 Exposure Draft that the effects of changes in discount rates should always be presented in profit or loss. The rationale for the changes is given in the Basis for Conclusions. BC118 states, in the responses to the 2010 Exposure Draft, many preparers expressed the concern that the requirement to use a current value measurement for insurance liabilities, specifically to remeasure insurance contract liabilities for changes in interest rates, would mean that entities would be forced to exercise the fair value option for financial assets in order to avoid the accounting mismatches that would arise between assets measured at amortised cost and insurance contract liabilities. They noted that the IASB has indicated that amortised cost is an appropriate measure for financial assets in some circumstances and that IFRS would generally require an entity to measure financial liabilities at amortised cost. Accordingly, they believe that the volatility in profit or loss that would result from a current value measurement of insurance contracts would not result in a faithful representation of their economic performance and would not provide comparability across entities without significant insurance contract liabilities. BC119 states, The IASB is unconvinced that entities that issue insurance contracts would be disadvantaged if insurance contracts were to be measured at current value. 8

9 However, the IASB was persuaded that entities should segregate the effects of changes in the discount rate that are expected to unwind over time from other gains and losses, so that users of financial statements could better assess the underwriting and investing performance of an entity that issues insurance contracts. 2. The effect of the (draft) Standard appears to be that the profit and loss (P&L), would operate rather as though US GAAP s FAS 60 had been overlaid on a market consistent base. The balance sheet meanwhile would, broadly speaking, be based on a market consistent valuation (with an additional liability in respect of the CSM). Other comprehensive income (OCI) would be left to provide a reconciliation between the two. We suggest such a combination of radically different approaches could prove to be confusing. 3. We also suggest that both expected investment earnings and expected underwriting performance are assumptions, and the reason for splitting the effects of changes in these assumptions, allocating economic assumptions to OCI and non-economic changes to the P&L, is far from clear. Indeed, where interest rate risk is intrinsic to the business, as it often is for life insurance companies, it would appear somewhat misleading to isolate the P&L from the effects of changes in prospective yields. 4. Paragraph BC127(c) highlights the degree of complexity, not only in preparing the accounts, but also in interpreting them. In particular, it would appear quite difficult, if not impossible, to interpret the effects of interest rates in OCI, since they will combine the effects of movements in interest rates in the reporting period with the effects on unwinds at different rates arising from movements in past reporting periods. (Mr Cooper also raises this problem in paragraph AV5.) In particular, it is important for the user to be able to segregate expected items in the income statement from unexpected items, which may be the result of short-term volatility, in order to be able to make projections of earnings. We suggest that the disaggregation proposed is inadequate for this purpose. 5. We note that some level of disaggregation of profits is helpful in interpreting financial results. We also note that in supplementary information currently reported by European companies under EEV and MCEV Principles, the effect of investment income is segregated between the expected income and the rest, which is reported as an investment variance. (We take this to be analogous to the proposed split between P&L and OCI.) However, the expected income is not specified by reference to the discount rate applicable at initial recognition, but by reference to that at the valuation date. Such an approach would appear more relevant and provide a more transparent representation of the entity s performance. 6. Section (b) (ii) of the question addresses cash flows that are expected to vary directly with returns on underlying items. We have considerable sympathy with the Alternative View of Mr Stephen Cooper, which states, in paragraph AV2, in the context of the disaggregation of earnings between P&L and OCI, that IASB has spent many years developing a current-value based measurement approach for insurance contract liabilities The IASB has done so on the basis that only an approach that uses updated estimates can provide relevant information. If this principle were applied consistently to assets, they would all be measured at fair value and the difficulties of accounting mismatches, where no economic mismatch can arise, that are addressed by paragraphs 33 and 34 would not arise. It appears that the issues that paragraphs 33 and 34 address and the complexities so generated are of IASB s own making and result from its departure from the principle of reporting assets (and liabilities) at fair value. 9

10 7. We note also that the treatment of the assets proposed in IFRS 9, taken in conjunction with this (draft) Standard could lend itself to manipulation of the profit and loss account, e.g. if assets are categorized as HTM, realized gains would go through the profit and loss account. However, whether to realize gains may be a matter of choice. We note that changes in the value of liability on account of interest rate changes would go through OCI, except in case of mirrored liabilities. 8. We propose that the Standard mandate that any change in liability on account of interest rates go through the profit and loss account, if the backing assets are also taken at fair value through profit and loss account 1. The primary reason given in the BC118 for the departure from the model of current value measurement proposed in 2010 is that it would effectively force companies to value assets at fair value through P&L, and this would be counter to IASB s other standards which indicate that, for example, amortised costs could be an appropriate basis of recognition. We suggest however that if a company is able to value its assets at fair value through P&L, it should recognise the effect of interest rate changes on the present value of its fulfilment cash flows in the P&L. Then, the P&L would disclose the effect of economic matches (and mismatches) between its assets and liabilities, which would be transparent. Not to allow this would effectively consign all assets to either an amortised cost basis or fair value through OCI. We note that this too would preclude use of a category, fair value through P&L, that IASB has deemed appropriate in its other accounting standards, specifically in IFRS We note also that in the context of recognition of changes in the risk margin, BC37(b) states, Changes in risk relating to future coverage periods or changes in risk relating to incurred claims would arise when there are unexpected changes in circumstances. Changes in estimates of risks assumed in an insurance contract are critical to the measurement of the performance of commitments that are already underwritten. Recognising in profit or loss such changes in risk would provide more transparent information about those changes in circumstances. We suggest that what applies to the risk inherent in the fulfilment cashflows must apply equally to the present value of those fulfilment cashflows, and hence that a change in that present value, whether on account interest rates or on account of changes to the estimated cashflows themselves, should be recognised in the P&L. 10. If such a mandate is deemed inappropriate, an option to adopt this treatment should be provided. IASB considered in BC144 an approach similar to the existing option in IFRS 9 that permits an entity to measure a financial asset at fair value through profit or loss (the fair value option ) if it reduces or eliminates accounting mismatches. IASB s offers two objections: (a) applying such an option to an individual insurance contract is the best way to fully eliminate accounting mismatches. It is also consistent with the 1 We suggest that IFRS 9 be considered in the context of the ability of insurance companies to categorise assets at fair value through P&L where investment risk is intrinsic to their business. 10

11 application of the fair value option for financial assets. However, applying such an option at an individual insurance contract level may be operationally complex and may not provide useful information. This is because insurance contracts and associated assets are typically managed at a more aggregated level. Nonetheless, it would be difficult to achieve the objective of reducing or eliminating accounting mismatches through the use of a fair value option for insurance contracts because accounting mismatches would not be eliminated overall if an entity applied an option to recognise in profit or loss all changes in the value of insurance contracts at: (i) an entity level, because an entity may have different portfolios that it manages in different ways. (ii) a portfolio level, because an entity may hold assets that are measured using a mix of measurement attributes (for example, at fair value through profit or loss, amortised cost or fair value through other comprehensive income) and the mix of measurement attributes in the portfolio may change over time. Accounting mismatches would be reduced only if the entity exercises the option to measure all the assets at fair value through profit or loss. We suggest that operational complexity appears inevitable and is certainly a consequence of the (draft) Standard; that companies are well used to such complexity as arises from a policy-by-policy measurement of liabilities coupled with portfolio level management; and that so long as companies have the choice to recognise assets at fair value through P&L, this approach would eliminate accounting mismatch. (b) it would be necessary to specify whether an entity should be permitted or required to invoke or revoke any such option, and in what circumstances. For financial assets, the application of the fair value option in IFRS 9 is available only at initial recognition and is irrevocable. This ensures that entities do not invoke or revoke the fair value option in a particular period to achieve a particular accounting result for that period. However, an irrevocable option would not necessarily reduce or eliminate accounting mismatches if the duration of insurance contracts and the assets backing the insurance contracts differed. An entity would only be able to assess whether the accounting mismatches would be reduced or eliminated when the duration of either the insurance contract or the backing assets ended. While the exercise of the option might reduce accounting mismatches in the short term, it could exacerbate those accounting mismatches in later periods. This would be especially of concern because of the extent of the duration mismatches that might arise between assets and liabilities. We confess to being somewhat puzzled by IASB s argument. We suggest that where the duration of the assets and liabilities differ, there is an economic mismatch, not an accounting mismatch, and it would be the function of a true and fair accounting system to disclose the economic mismatch. We suggest also that the choice of categorisation of liabilities would, all other things being equal, be such as to avoid accounting mismatches. Since the categorisation of assets is defined in IFRS 9, we would expect that of liabilities to follow that of the assets. In these circumstances, there would be no need for any prescription on the part of IASB. 11

12 Question 5 Effective date and transition Do you agree that the proposed approach to transition appropriately balances comparability with verifiability? Why or why not? If not, what do you suggest and why? Response 2. Paragraph C3 states: At the beginning of the earliest period presented, an entity shall, with a corresponding adjustment to retained earnings, (d) measure each portfolio of insurance contracts at the sum of: (i) the fulfilment cash flows; and (ii) a contractual service margin, determined in accordance with paragraphs C4 C6. (e) recognise, in a separate component of equity, the cumulative effect of the difference between the expected present values of the cash flows at the beginning of the earliest period presented, discounted using: (i) current discount rates, as determined in accordance with paragraph 25; and (ii) the discount rates that were applied when the portfolios were initially recognised, determined in accordance with paragraph C6. Paragraph C4 specifies that this (draft) Reporting Standard should be applied retrospectively in accordance with IAS 8 to existing business. We note that BC162 sets out the requirements of IAS8: retrospective application of a new accounting policy except when it would be impracticable. We also note that, in view of the difficulties adumbrated in BC165, IASB has concluded in BC166: retrospective application of this Exposure Draft would often be impracticable, as defined in IAS8. Therefore, IASB has proposed an alternative approach which is described in paragraphs C5 and C6. Paragraph C5 states, an entity shall, at the beginning of the earliest period presented: (a) measure the insurance contract at the sum of: (i) the fulfilment cash flows in accordance with this [draft] Standard; and (ii) an estimate of the remaining contractual service margin, using the information about the entity s expectations at initial recognition of the contract that were determined in accordance with paragraph C6. (b) estimate, for the purpose of measuring insurance contract revenue after the beginning of the earliest period presented, in accordance with paragraph C6, the carrying amount of the liability for the remaining coverage, excluding: (i) any losses on the date of initial recognition; and (ii) any subsequent changes in the estimates between the date of initial recognition and the beginning of the earliest period presented that were immediately recognised in profit or loss. 12

13 (c) determine, for the purpose of measuring the interest expense to be recognised in profit or loss, the discount rates that applied when the contracts in a portfolio were initially recognised in accordance with paragraph C6. Paragraph C6 states that certain simplifying procedures may be adopted. In respect of C5(a) quoted above, an entity may, estimate the expected cash flows at the date of initial recognition at the amount of the expected cash flows at the beginning of the earliest period presented, adjusted by the cash flows that are known to have occurred between the date of initial recognition and the beginning of the earliest. In respect of the risk adjustment, an entity may, estimate the risk adjustment at the date of initial recognition at the same amount of the risk adjustment that is measured at the beginning of the earliest period presented. The entity shall not adjust that risk adjustment to reflect any changes in risk between the date of initial recognition and the beginning of the earliest period presented. In respect of discount rates, an entity may either use the observable yield curve that applied at the time of initial recognition or, if such a yield curve does not exist, construct a yield curve by combining an observable yield curve with an average spread. 3. The following problems with proposals appear to be significant: a. BC 169 states that IASB has been persuaded that its proposals of 2010 would lead to a lack of comparability between business written after adoption of the new Standard and that written before. We suggest however that the bigger problem with its proposals of 2010 was the likely one-off emergence of surplus on transition, and consequently the depressed level of the profits thereafter. While this (draft) Standard is an improvement on the previous proposal, we suggest that this remains a problem. b. The proposed approach could lead to a significant change in the reserves, relative to existing local GAAP. This then would lead to a disjuncture in the emergence of surplus from the assets backing the liabilities and hence the recognition of profit on the business in force at the date of transition. This in turn would be counter to shareholders requirements of the business, and could also could lead to a disjuncture in the year-on-year tax liability in jurisdictions where financial statements are the basis of the tax computation. c. In the procedures outlined in paragraphs C5 and C6, the intention is either to apply the (draft) Standard retrospectively, or to approximate its retrospective application based on current data. We note firstly that the discount rates that applied at the point of initial recognition of the in-force business may have very little economic relevance at the date of transition. Secondly, the purpose of this retrospective calculation appears to be to enable a current estimate of the two liability building blocks on the discount rates which would have applied on initial recognition of the liabilities. Then, they may continue to accrete interest at these rates in the P&L account in future, with any residual amount of interest to be recognised in the OCI. Whether this would eliminate accounting mismatches would depend on the treatment of the existing assets, but since accounting mismatches are unlikely to be eliminated prospectively under this (draft) 13

14 Standard, they are equally unlikely to be eliminated by either a fully retrospective application or by the approach set out in Paragraph C5. d. We note that the complexity arising from a fully retrospective approach is recognised, for example in BC164. However, we suggest that even the modified approach set out in Paragraph C5 may be challenging. In particular, for older contracts, to adjust the expected cash flows from initial recognition by those that have actually occurred could be an onerous activity. 4. We therefore propose the following: a. We note that the contractual service margin s purpose appears to be to defer the emergence of expected profits in the P&L account. Since it is a component of the liability in addition to an estimate of its fair value, we also note that, no matter what its value, it must inevitably be an estimate of the future profit, subject to a floor of zero, that is expected to emerge from the assets backing the liabilities. b. We propose that at transition, an option be given (to local accounting authorities) to define the CSM such that no surplus emerges as a consequence of transition. We further propose that this option may be exercised only if previous GAAP was based on a prospective method. Note that deficits would be permitted to emerge at point of transition, if the existing reserves were relatively weak. Given our comments in paragraph 3.a above, we believe that the CSM s purpose would not be compromised by this method of computation. The potential disjuncture in the emergence of profit discussed in paragraph 2.d would however be avoided. 5. We note that IASB does consider in BC 171 whether the CSM may be defined at transition as the difference between the fulfilment cash flows and the carrying amount under previous GAAP. Three arguments are presented against this proposal: a. It would not provide comparability between contracts in force at date of transition and those recognised initially after date of transition. However, we believe that this drawback this may be outweighed by the smoother emergence of profit. Our proposed approach to the CSM is analogous to that adopted for new business: no change in net worth is generated on first application of the standard to a portfolio. In respect of new business, the CSM prevents the immediate recognition of any change to net worth even for a profitable portfolio. Our proposal would have a similar effect on first application of the Standard to the existing business. b. It would not provide information that is needed to measure contract revenue. We understand the issue to relate to the subsequent contribution to profit and loss account from the existing business at date of transfer, but we do not believe this to be insurmountable, at least where previous GAAP adopts a prospective approach. The elements of the income statements are specified in Paragraph 60 of the (draft) Standard). These include, in particular, i. Changes in estimates of future cash flows; ii. Difference between actual and expected cash flows; and iii. Changes in the risk adjustment. All these should be readily accessible where previous GAAP requires a prospective calculation of the liabilities. Where no explicit risk adjustment was held, the change would of course be zero. Our proposal does not appear to give rise to any complications in respect of the other items in the income statements. c. It would still require IASB to specify simplifications. We note that the (draft) Standard itself proposes simplifications since the impracticability of a full 14

15 retrospective application in line with IAS 8 is acknowledged. Our proposal would not therefore appear to impose any additional burden. 15

16 Question 6 The likely effects of a Standard for insurance contracts Considering the proposed Standard as a whole, do you think that the costs of complying with the proposed requirements are justified by the benefits that the information will provide? How are those costs and benefits affected by the proposals in Questions 1 5? How do the costs and benefits compare with any alternative approach that you propose and with the proposals in the 2010 Exposure Draft? Please describe the likely effect of the proposed Standard as a whole on: (a) the transparency in the financial statements of the effects of insurance contracts and the comparability between financial statements of different entities that issue insurance contracts; and (b) the compliance costs for preparers and the costs for users of financial statements to understand the information produced, both on initial application and on an ongoing basis. Response While it has not yet been possible to conduct a cost-benefit analysis of the proposals as a whole, we have noted certain areas of particular complexity where we think the benefits are unlikely to be proportionate. We take this opportunity to draw IASB s attention to these areas: 1. Paragraph 58 states: Insurance contract revenue and incurred claims presented in the statement of profit or loss and other comprehensive income shall exclude any investment components that, in accordance with paragraph 10(b), have not been separated. This will inevitably introduce considerable complexity into the reporting and into the interpretation of the results. 2. Paragraphs 33 and 34 require a differentiated treatment of fulfilment cash flows that are linked to underlying assets. We submit that the splitting of cash flows within a single contract would introduce considerable cost and complexity but may not reflect, in certain cases, how these liabilities are managed. Hence, there would be little or no benefit by way of addition to transparency. 16

17 Question 7 Clarity of drafting Do you agree that the proposals are drafted clearly and reflect the decisions made by the IASB? If not, please describe any proposal that is not clear. How would you clarify it? Response 1. Nothing appears to be specified in the main body of the (draft) Standard in respect of the treatment of the inherited estate of a with profits fund, though there is some discussion in the Basis for Conclusions. We note that BCA62 states, Some insurance contracts that specify payments to policyholders based on underlying items are issued by mutual entities, while others are issued by investor-owned entities. The IASB has identified no reason to adopt different treatments for these contracts on the basis of the legal form of the issuer. This means that, if the contract provides policyholders with the right to participate in the whole of any surplus of the issuing entity, there would be no equity remaining and no profit reported in any accounting period. In the FASB s approach, a mutual entity treats as equity an amount of surplus that the entity does not have the obligation or intention to pay out in fulfilling the insurance contract obligations. The FASB believes that this approach is consistent with its treatment of the cash flows resulting from any other entity s discretionary participation features (that is, to include only cash outflows that an entity will incur to directly fulfil its obligation to the policyholders). In addition, the FASB believes that presenting the amounts the entity is obligated and intends to pay its policyholders as a liability, and this notional surplus that it is not obligated and does not intend to pay to policyholders as equity, would provide more useful information to users of the financial statements of mutual entities and would be more comparable to other entities that issue similar insurance contracts. BCA63 continues, Some have asked whether the IASB intends to provide specific guidance on amounts that have accumulated over many decades in participating funds and whose ownership may not be attributable definitively between shareholders and policyholders. The IASB does not propose such guidance. In principle, the proposals would require an entity to estimate the cash flows in each scenario. If that requires difficult judgements or gives rise to unusual levels of uncertainty, an entity would consider those matters in deciding what disclosures it must provide to satisfy the proposed disclosure objective. On the one hand, in the absence of any intention to distribute the estate, it appears inappropriate to present it as funding fulfilment cash flows. On the other, in respect of a with profits fund from which distributions to the shareholders fund are limited by, for example, a 90:10 gate, while the estate represents capital, it is not fungible and hence a representation as shareholders net worth may also be inappropriate. Alternative treatments can have profound effects on the emergence of profit in the shareholders profit and loss account and we suggest that, in order to achieve a consistent outcome, some guidance should be given. We note IASB s view that for a mutual, if the contract provides policyholders with the right to participate in the whole of any surplus of the issuing entity, there would be no equity remaining. This presumably depends on the premise that the fulfilment cash flows would be such as to exhaust the inherited estate. Based on the same premise, 17

18 in a proprietary company, given a 90:10 gate, 10% of the estate would be treated as equity and the rest as a liability to policyholders. However, we suggest that the premise itself requires reconsideration, as there may be no intention to distribute the estate and hence no such distribution should be a part of the fulfilment cash flows. We note that the Exposure Draft issued by FASB dated June 27, 2013, lists the treatment of the fulfilment cashflows of participating business as an area of difference with the IASB s proposals. In particular, FASB proposes: Noncontractual or discretionary participation features should be included in the measurement of the fulfillment cash flows based on expected cash flows from these features. We suggest that FASB s proposals present a more accurate reflection of reality. We propose that the fulfilment cash flows should reflect expected claim amounts, in accordance with paragraph 22, on a going concern basis. For a proprietary company with a participating fund whose surplus is not fully fungible, a liability equal to the estate could be identified on the balance sheet, separately from shareholders equity. The income statement would recognise only the appropriation made to the shareholder account from the participating fund, net of any injection. This arrangement would be transparent, in that the amount of estate would be apparent, and it would not introduce a specious element of volatility into the income statement. We also suggest that it would be consistent with the principle adopted of holding a reserve in respect of future profits. The estate represents a fund for future appropriations (or profits) and it is consistent for this to be represented as a liability that is run down as the profits are appropriated from the fund. 2. The level of aggregation for the calculation of the CSM is not specified except to say that it should be at the level of the portfolio (paragraph 28 of (draft) Standard). This term is defined in Appendix A, but we question whether it is sufficiently precise. If there is flexibility around the level of aggregation, it can lead to wide variations and to results that are not comparable. 3. Paragraph 34 states, When paragraph 33 applies, the entity shall, at initial recognition and subsequently: (a) measure the fulfilment cash flows that are expected to vary directly with returns on underlying items by reference to the carrying amount of the underlying items (meaning that paragraphs do not apply); This would suggest that concepts such as the time value of money, described in paragraph 25, would not apply. Is this the intention or is it rather that a prospective valuation of fulfilment cash flows may still be made but that the valuation yield should be related to the carrying value of the backing assets? 4. We find paragraph B68 somewhat confusing, in particular as section (e) appears to contradict section (d). 5. We find paragraph B89(a) a little confusing. Directly attributable acquisition costs, under paragraph B66(c), form part of the fulfilment cash flows. The pre-coverage costs, we presume, will have been recognised in the profit and loss account at the time of incidence under paragraph 60(e), while post-coverage costs will be valued as a part of the fulfilment cash flows. The former, therefore, will in effect be explicitly deducted from the CSM, under paragraph 28(b); the latter will be deducted under paragraph 28(a). Thus, the liability of the CSM is already net of these costs, at least 18

19 to the extent they are expected. It appears therefore that, setting details in the definition of what is allowable aside, the CSM consists of a deferred profit liability minus a deferred acquisition cost, subject to a floor of zero. However, we see little that clearly indicates that the (negative) component in respect of deferred acquisition costs may be treated differently from the rest of the CSM, as appears to be suggested in paragraph 89(b). Is it proposed that instead of recognising the post-coverage acquisition costs as they are incurred, they may somehow be recognised over the premium payment term solely for the purpose of amortising the CSM? We note that BC95 states, To be consistent with those proposals, and to avoid recognising insurance contract revenue before any coverage has been provided, this Exposure Draft proposes that entities should, for presentation purposes, present the insurance contract revenue and expenses associated with such costs over the coverage period in line with the pattern of services provided under the contract, rather than when the costs are incurred. Because this allocation approach applies only to the premium charged to cover such costs, and affects only the amount of insurance contract revenue and expenses that is grossed up from the margin, there is no recognition of an asset representing the acquisition of the insurance contract. However, if an expense is being recognised in any manner that is not consistent with when the expense is incurred, presumably the income statement would not provide a reconciliation successive balance sheets. We suggest that this may be clarified. 19