FASB provides preliminary views on insurance accounting

Transcription

1 17 September 2010 Insurance Accounting Alert Special edition Contents Background... 1 Definition of an insurance contract... 2 Scope... 2 Unbundling... 2 Recognition... 3 Contract boundaries... 3 Policyholder behavior... 3 Measurement model... 3 Average of future cash flows... 3 Time value of money (discount rate)... 4 Composite margins... 4 IASB measurement approach... 4 Risk adjustment... 4 Residual margins... 5 IASB Topics... 5 Modified model... 5 Reinsurance... 6 Performance statement... 6 Statement of financial position... 6 Statement of comprehensive income... 6 Disclosures... 6 Comparison of current US GAAP, the IASB s ED and the FASB s Preliminary Views... 6 FASB provides preliminary views on insurance accounting What you need to know If the FASB preliminary views are adopted, they will have a significant effect on the measurement and reporting of insurance contracts. Some of the significant changes that would occur are as follows: Entity-based accounting guidance would be replaced by contract-based guidance. Several measurement models would be replaced with one single measurement model. Depending on the measurement model, traditional line items in the income statement (e.g., premium revenue and claims expense) would be eliminated. Companies should be aware that comments received on discussion papers can influence the FASB in their deliberations and, therefore, could affect the proposals that are included in a subsequent exposure draft. So, we strongly encourage interested parties to comment on the discussion paper and participate in the FASB deliberation process. Background The Financial Accounting Standards Board (FASB) released a Discussion Paper 1 (DP) on the accounting for insurance contracts. The release of the DP is a result of a joint project with the International Accounting Standards Board (IASB). On 30 July 2010, the IASB issued its Exposure Draft 2 (ED) on the accounting for insurance contracts. The DP summarizes key aspects of the ED and compares those proposals to alternative preliminary views of the FASB. For example, the IASB proposed a measurement model based on a two-margin approach (i.e., risk adjustment and residual margin) while the 1 Discussion Paper, Preliminary Views on Insurance Contracts 2 Exposure Draft, Insurance Contracts

2 measurement model proposed by the FASB is based on a composite margin approach. In addition, the DP compares the IASB s proposed approach and FASB s preliminary views to current guidance in Accounting Standards Codification Topic 944, Financial Services Insurance (ASC 944). The comment period ends on 15 December The ED, if adopted, will replace International Financial Reporting Standard No. 4, Insurance Contracts (IFRS 4), which is the interim standard. The new standard will result in a single consistent recognition and measurement standard for insurance contracts internationally. The IASB has invited comments to be submitted by 30 November This publication provides a high-level summary of the key components of the DP. For a more comprehensive summary of the ED please see our Special Edition Insurance Accounting Alert issued on 30 July Definition of an insurance contract ASC 944 provides accounting guidance for insurance entities. Therefore, contracts that are similar to insurance contracts are not subject to the same accounting if not issued by an insurer. When the FASB joined 4 the IASB s project on insurance contracts, one of the FASB s desired improvements to ASC 944 was to develop a standard where contracts with identical or similar economic characteristics would be accounted for similarly regardless of the issuing entity. For this reason, the FASB and the IASB decided to propose the following definition of an insurance contract: A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by 3 The FASB and IASB plan to hold several public roundtable meetings in December Those entities interested in participating in the roundtables must submit comments on the DP and ED by 30 November The FASB joined the IASB s project on insurance contracts in the fourth quarter of agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. Based on this definition, a contract is an insurance contract only if it transfers significant insurance risk. Insurance risk refers to the risk, other than financial risk, transferred from the holder of a contract to the issuer, and is significant if, and only if, an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance. An insurance contract does not transfer insurance risk if there is no scenario in which the present value of net cash outflows can exceed the present value of cash inflows. The DP would eliminate the notion that only contracts issued by an insurance company should follow the insurance contracts accounting in ASC 944. We would expect that a number of noninsurers may have contracts that are similar to those issued by an insurance company that meet the definition of an insurance contract. For example, third party warranty contracts and health care contracts that are not accounted for under ASC 944 would meet the proposed definition of an insurance contract. Scope The scope of the DP includes contracts that meet the definition of insurance that an insurer issues and reinsurance contracts that an insurer holds. The DP proposes to exclude from the scope of the proposed guidance the following contracts: Product warranties issued by a manufacturer, dealer or retailer Employer s assets and liabilities under employee benefit plans Contractual rights and obligations that are contingent on the future use of, or right to use, a non-financial item Residual value guarantees in a lease or provided by a manufacturer, dealer or retailer Fixed-fee service contracts unless issued by an insurer Contingent consideration payable or receivable in a business combination Direct insurance contracts in which the entity is the policyholder One notable scope difference between the DP and the ED is that the FASB decided to exclude from the scope of the insurance contracts standard financial instruments that contain discretionary participation features. Discretionary participating features provide the issuer of contracts with flexibility on the amount and timing of supplement benefits above guaranteed benefits. This feature is more common in European financial instrument products. Unbundling Insurance contracts may include multipleelements, such as insurance coverage, investment (or financial) components and embedded derivatives. A key question in measuring insurance contracts is whether and how to separately identify and measure the components of the contract. The DP proposes that entities unbundle certain components of a contract that are not closely related to the insurance coverage specified in the contract. Examples included in the DP of components that should be unbundled are: Investment components that reflect an account balance that is credited with an explicit return and the crediting rate is based on the investment performance of the underlying investments Embedded derivatives that are required to be separated from its host contract in 2 Insurance Accounting Alert, 17 September 2010

3 accordance with existing bifurcation guidance Goods and services not closely related to the insurance coverage The DP indicates that entities would be prohibited from unbundling if not required to do so. Recognition The DP proposes an entity recognize an insurance obligation when it becomes a party to the contract, which occurs at the earlier of when the insurer: Is bound by the terms of the contract or Becomes exposed to risk under the contract (i.e., the insurer can no longer withdraw from its obligation and no longer has the right to reassess the risk of the particular policyholder) The initial recognition of an insurance contract does not necessarily occur at the beginning of the coverage period. Therefore, an insurance contract may be recognized prior to the start of the coverage period. Contract boundaries Contract boundaries are the key consideration in determining whether multiple-period insurance coverage might represent one or many insurance contract(s). The DP defines contract boundaries as the point at which the insurer either: Is no longer required to provide coverage Or Has the right or practical ability to reassess the risk of the particular policyholder and, as a result, can set a price that fully reflects that risk The measurement of an insurance contract would include premiums and other cash flows resulting from those premiums if, and only if, either the insurer can compel the policyholder to pay the premium or the premiums are within the boundary of the contract. The DP indicates that the boundary principle should be applied at the individual contract level. In determining the contract boundary for a group contract, the specific contractual terms and conditions need to be considered to establish whether the unit of account is an individual contract with a single policyholder or the entire group. Policyholder behavior Certain contractual features permit a policyholder to take actions that change the cash flows resulting from an insurance contract, such as an option that allows the policyholder to suspend or terminate the payment of premiums under the policy. The DP proposes that policyholder options, forwards and guarantees related to existing coverage should be measured on a lookthrough basis using the expected value of future cash flows (to the extent that they are within the boundary of the existing contract). No deposit floor (e.g., surrender value) should be applied. Policyholder options, forwards and guarantees that do not relate to the existing insurance coverage should be excluded from the measurement of the contract. Measurement model The DP proposes that an insurer measure insurance liabilities using a building block approach that would provide a current depiction of an insurance contract as well as information about the main drivers of profitability in the current period. The measurement model is made up of the following building blocks: An unbiased, probability-weighted average of future cash flows expected to arise as the insurer fulfills the obligation Incorporation of time value of money A composite margin Average of future cash flows The first building block in valuing insurance contracts as discussed in the DP is the unbiased, probability-weighted average of future cash flows. The DP indicates that the future cash flows should represent the net rights and obligations present in the contract as opposed to separately identifying the gross obligations and presenting separate gross assets and liabilities. One of the principles in the DP for estimating future cash flows is that they should be explicit, meaning those cash flows directly related to the insurance contract should be used. The future cash flows should reflect the manner in which the insurer expects to fulfill the contract. The DP proposes that an entity incorporate, in an unbiased way, all available information about the amount, timing and uncertainty of all cash flows that will arise as the insurer fulfills the insurance contract. Available information includes, but is not limited to, industry data, historical company data and market inputs when those inputs are relevant to the measurement of the contract. To the extent that the inputs used to calculate the estimated cash flows relate to observable market variables, the DP proposes that these be consistent with current observed market prices. However, for most insurance contracts, many significant variables (e.g., mortality and specific expenses) will not be observable in the market. The FASB and IASB recognize that for these assumptions insurers will usually use internal data for estimation. Many entities may not have the capabilities today to model all possible outcomes. Therefore, insurers may have to change their internal processes to include all future cash flows and to perform probability-weighted scenarios. This change would have a significant effect on the information systems that an insurer uses to maintain data. Insurance Accounting Alert, 17 September

4 The DP proposes that the cash flows be remeasured each reporting period. Therefore, the information used to estimate the future cash flows should be current and correspond to conditions at the end of the reporting period. Any changes in the liability as a result of re-measurement should be recorded in earnings. Acquisition costs Acquisition costs are expenses insurers incur to secure contracts with policyholders. The DP proposes an insurer include in the future cash flows only those acquisition costs that are incremental at the individual contract level. Incremental acquisition costs are those costs of selling, underwriting and initiating an insurance contract that the insurer would not have incurred if it had not issued that particular insurance contract. The incremental acquisition costs increase the future cash outflows. The DP indicates that all non-incremental costs should be expensed when the insurer incurs them. The EITF recently finalized their proposed revisions to ASC 944 for the types of acquisition costs that should be deferred when acquiring or renewing insurance contracts (EITF 09-G 5 ). We will issue a separate document on the effects that those changes will have on insurers once they are approved by the FASB. 5 EITF issue No. 09-G, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. Under current US GAAP, many entities capitalize acquisition costs as an asset on the balance sheet and expense them in the income statement over the period of the insurance contract to which they relate. The DP proposes a significant change to the accounting for acquisition costs under US GAAP because only incremental acquisition costs would be included in the future cash outflows. This proposal would increase the amount of acquisition costs that are expensed as incurred for life insurers. Time value of money (discount rate) The second building block is the discount rate used to discount the probabilityweighted cash flows. The DP proposes that the discount rate be based on a risk-free rate that is consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability. The discount rate should exclude any factors that influence the observed rates but are not relevant to the insurance contract liability. Also, the DP notes that the discount rate should reflect the yield curve in the appropriate currency for instruments that expose the holder to no or negligible credit risk, with an adjustment for illiquidity. Composite margins The DP indicates that the measurement of an insurance contract should include one single composite margin. This composite margin eliminates any day excess of the expected present value of cash inflows over the expected present value of cash outflows. However, if the present value of expected cash outflows are greater, the resulting negative day-one difference must be recognized immediately in earnings. The composite margin is to be released to earnings over the coverage period (during which the insurer provides insurance coverage) and the claims handling period (during which the insurer pays claims) to reflect the insurer s exposure to uncertainties to the amount and timing of future cash outflows. The DP indicates that the composite margin would be released in earnings based on the following ratio: (Premium allocated to date + claims and benefits paid to date) / (Total expected premium + total expected claims and benefits) The ratio would be updated each reporting period so the composite margin recognized in earnings each period reflects current estimates and experience. Notwithstanding the fact that the ratio is updated each reporting period, the DP indicates that an insurer should not adjust the composite margin measured at initial recognition in subsequent reporting periods for changes in cash flow estimates. Therefore, the composite margin is only adjusted for amortization. The DP indicates that the release of the composite margin should not include the accretion of interest. IASB measurement approach As previously mentioned, the FASB proposes a measurement model based on a composite margin while the IASB s approach introduces a two-margin approach (risk adjustment and residual margin). Although the margins are different, both the IASB and FASB propose that the measurement of an insurance liability should include the expected present value of future cash flows. Risk adjustment The risk adjustment is an adjustment to capture the effects of uncertainty associated with the probability-weighted cash flows arising from the contract. The risk adjustment should be the maximum amount that the insurer would rationally pay to be relieved of 4 Insurance Accounting Alert, 17 September 2010

5 the risk that the ultimate fulfillment cash flows may exceed those expected. The IASB has limited the number of permitted techniques used to estimate the risk adjustment. The permitted techniques are: Confidence level Conditional tail expectation Cost of capital While the ED does not require the use of any one of these techniques for a specific situation, the application guidance includes a discussion of which technique the IASB believes would be most suitable in specified circumstances. The ED indicates that a considerable amount of judgment will be necessary to determine which technique is most appropriate for their business. The ED requires that the risk adjustment be determined for a portfolio of insurance contracts without any credit for diversification or negative correlation between portfolios. The risk adjustment should be re-measured each reporting period, and any changes in the liability as a result of re-measurement should be recorded in earnings. Residual margins The ED requires that the measurement of an insurance contract include a residual margin that eliminates any gain at inception of the contract. The residual margin eliminates the excess of a) the expected present value of cash inflows over b) the expected present value of cash outflows plus a risk adjustment. If the expected claims, benefits and claims handling expenses and incremental acquisition costs results in a negative day-one difference, the insurer must recognize that difference immediately in earnings. The residual margin is to be released over the coverage period (during which the insurer provides insurance coverage) based on either the passage of time or the timing of expected claims and benefits incurred. Also, unlike the composite margin, the release of the residual margin should include the accretion of interest. The ED indicates that an insurer should not adjust the residual margin in subsequent reporting periods for changes in cash flow estimates. Therefore, the residual margin is only adjusted for amortization and interest. IASB Topics The DP does not address all of the proposed guidance in the ED. For example, the DP does not address the following: Portfolio transfers Business combinations Transition Although the DP does not address these areas, the FASB is encouraging that respondents comment on these topics. Transition for insurance entities, especially life insurance entities, should be a critical factor in assessing the proposals for the accounting for future insurance contracts. We believe that transition will be critical for the insurance industry because the duration of insurance contracts can be very long and the future operating results of insurers will be affected for a number of years based on how the transition provisions measure in-force contracts. Therefore, all interested parties should be commenting to the FASB on the IASB s transition proposal. Modified model Notwithstanding the fact that the IASB decided on a measurement model based on the present value of the fulfillment cash flows plus a residual margin, the ED requires a modified measurement model for certain contracts in the pre-claim. While the DP provides a summary of the decisions reached by the IASB, the FASB has not determined whether a modified measurement approach should be applied to some insurance contracts. Therefore, the DP requests input from respondents on whether a modified model should be allowed for some insurance contracts and, if so, what criteria should be used to determine those contracts. The ED requires an insurer to measure insurance contracts using the modified model if the contract meets both of the following criteria: The coverage period is approximately one year or less. The contract does not contain embedded options or other derivatives that significantly affect the variability of cash flows. We expect that the majority of insurance contracts that meet these criteria would be traditional property and casualty insurance contracts and simple 1-year term life insurance. The modified model measures the pre-claim obligation as the premium received at inception, if any, plus the expected present value of future premiums less the incremental acquisition costs. The pre-claim obligation is released over the coverage period in a systemic may that best reflects the exposure from providing insurance coverage. It should be noted that interest should be accreted on the pre-claim liability. The ED requires that an insurer, initially and subsequently, assess whether an insurance contract measured under the modified model is onerous. An insurance contract is onerous if the pre-claim obligation is lower than the present value of the fulfillment cash flows. If the insurance contract is deemed onerous, the insurer should recognize an additional liability and recognize the loss in earnings. The additional liability should be re-measured each reporting period and reversed when the pre-claim liability exceeds the present value of the fulfillment cash flows. Insurance Accounting Alert, 17 September

6 While the IASB has provided what might appear to be relief from requiring insurers to determine the present value of the fulfillment cash flows in the preclaim period, those that use this approach will have to perform an onerous contract test. This test requires an estimate of the present value of the fulfillment cash flows to determine whether the insurance contract is in a loss scenario. Reinsurance A reinsurance contract is an insurance contract issued by one insurer (the reinsurer) to compensate another insurer (the cedant) for losses on one or more contracts issued by the cedant. The DP proposes that a cedant measure the reinsurance contract initially at the expected present value of the future cash flows. The DP indicates that the cedant should estimate the expected present value of the future cash flows for the reinsurance contract in the same manner as the corresponding part of the expected present value of the future cash flows for the underlying insurance contract. If the expected present value of the future cash flows for the reinsurance contract is greater than zero (i.e., future cash inflows plus the risk adjustment [reinsurance recoverable] exceeds the future cash outflows [premiums minus ceding commission]) than a gain should be recognized in earnings. However, if the expected present value of the future cash flows for the reinsurance contract is less than zero (i.e., future cash inflows plus the risk adjustment [reinsurance recoverable] is less than the future cash outflows [premiums minus ceding commission]) than the cedant should record the difference as a composite margin. Performance statement Statement of financial position The DP proposes that the net insurance contract asset or liability be presented in the statement of financial position. Statement of comprehensive income The FASB considered three different approaches to presenting income and expenses arising from insurance contracts. The three approaches considered are: Margin presentation approach Written premium approach Allocated premium approach The DP provides an example that illustrates each of the three approaches. The DP indicates that the FASB is in favor of using the margin presentation approach for insurance contracts measured under the building block approach. Although the FASB has not determined which contracts would be measured under the modified model, it has indicated a preference for the allocated premium approach for those contracts that qualify for the modified model. The FASB is concerned with having two different presentations for insurance contracts and is requesting input from respondents on the usefulness of the information provided by each approach. Disclosures The DP proposes a high-level principle for its disclosure requirements, supplemented with some specific disclosures to meet the principle. Some of the specific disclosures proposed by the DP include: A reconciliation of the opening and the closing aggregate contract balances The methods and inputs used to develop the measurements Comparison of current US GAAP, the IASB s ED and the FASB s Preliminary Views The DP includes an Appendix that compares current US GAAP, the IASB s proposed approach and the FASB s preliminary views. The FASB included the Appendix to help respondents focus on some of the significant differences. The Appendix is not intended to be a complete comparison of US GAAP to the IASB s ED and FASB s Preliminary Views. Instead the Appendix is designed to illustrate some of the major differences between current US GAAP and the proposed standard. The Appendix includes comparisons of: Scope The definition of insurance contract, including the definition of insurance risk The definition of acquisition costs Initial measurement of an insurance contract (long and short-duration) Subsequent measurement of an insurance contract (long- and short-duration) Reinsurance 6 Insurance Accounting Alert, 17 September 2010

7 Area IFRS insurance contacts Global Centre of Excellence James Dean Kevin Griffith Christine Holmes Americas Kenneth Marshall Richard Lynch Actuarial Liam McFarlane (Property and Casualty) Mark Freedman (Life) Japan Kenji Usukura usukura-knj@shinnihon.or.jp Peter Gaydon gaydon-ptr@shinnihon.or.jp Far East Kieren Cummings kieren.cummings@hk.ey.com Oceania Mark Raumer mark.raumer@au.ey.com Europe, Middle East, India and Africa Cornea De Villiers (South Africa) cornea.devilliers@za.ey.com Gabriele Pieragnoli (Italy) gabriele.pieragnoli@it.ey.com James Lenton (UK) jlenton@uk.ey.com Loic Moan (France) loic.moan@fr.ey.com Nicole Verheyen (Belgium) nicole.verheyen@be.ey.com Niek de Jager (The Netherlands) niek.de.jager@nl.ey.com Pedro Garcia Langa (Spain) pedro.garcialanga@es.ey.com Ralf Widmann (Germany) ralf.widmann@de.ey.com Rohan Sachdev (India) rohan.sachdev@in.ey.com Rolf Bächler (Switzerland) rolf.baechler@ch.ey.com Actuarial Alex Lee (Property and Casualty) alee6@uk.ey.com Brian Edey (Life) brian.edey@ch.ey.com Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 144,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a member firm serving clients in the US. For more information about our organization, please visit Ernst & Young is a leader in serving the global financial services marketplace Nearly 35,000 Ernst & Young financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, Ernst & Young is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Office today includes more than 4,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. Ernst & Young professionals in our financial services practices worldwide align with key global industry groups, including Ernst & Young s Global Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, Ernst & Young s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. It s how Ernst & Young makes a difference. About Ernst & Young s Insurance and Actuarial Advisory Services Ernst & Young s North American Insurance and Actuarial Advisory Services (IAAS) practice includes 175 professional staff throughout the United States, Mexico, Bermuda and Canada. IAAS helps clients address risk, reporting, capital management, merger and acquisition due diligence and integration, retirement income and actuarial department transformation issues, and provides insurance risk management and claims advisory services Ernst & Young LLP All Rights Reserved. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. SCORE no. BB2008