TECHNICAL RELEASE Guidance ACCOUNTING IMPLICATIONS OF CHANGES TO THE FINANCIAL SERVICES AUTHORITY S RULES FOR CALCULATING TECHNICAL PROVISIONS FSF 02/07
ACCOUNTING IMPLICATIONS OF CHANGES TO THE FINANCIAL SERVICES AUTHORITY S RULES FOR CALCULATING TECHNICAL PROVISIONS Guidance for accountants and auditors of life assurers on the accounting implications of changes to the rules for calculating the technical provisions, set out in the FSA s Policy Statement PS 06/14. FSF 02/07 is issued as guidance to assist accountants and auditors of life insurers make judgements in light of the changes in the FSA rules covering technical provisions. It has no formal or mandatory status since the ICAEW is not responsible for setting the prudential capital rules or accounting standards, or for issuing the Statement of Recommended Practice on Accounting for Insurance Business, which are the responsibilities of the FSA, ASB/IASB and ABI respectively. It replaces the interim guidance contained in FSF 01/07. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this Technical Release can be accepted by the ICAEW. The Institute of Chartered Accountants in England and Wales, 2007
TECHNICAL RELEASE FSF 02/07: Accounting implications of changes to the Financial Services Authority s rules for calculating technical provisions Page 1 Contents Paragraph Numbers Introduction 1 2 Background 3 6 Summary of the changes 7 9 Accounting implications 10 Implications of changes in technical provisions 11 13 Accounting for any change 14 18 Other accounting implications 19 24
Page 2 TECHNICAL RELEASE FSF 02/07: Accounting implications of changes to the Financial Services Authority s rules for calculating technical provisions INTRODUCTION 1 The purpose of this Technical Release is to provide assistance to accountants and auditors in determining the appropriate accounting treatment of certain matters in light of recent changes introduced by the Financial Services Authority ( FSA ) to the rules for calculating the technical provisions of UK life insurers. It does not purport to deal with all aspects of the changes to the FSA rules or all accounting questions related to this, only certain areas where it is considered that additional guidance would be helpful. 2 The ICAEW is not responsible for setting Financial Reporting Standards, which are set in the UK by the Accounting Standards Board ( ASB ), or International Financial Reporting Standards promulgated by the International Accounting Standards Board ( IASB ) or the Statement of Recommended Practice ( SORP ) on Accounting for Insurance Business, which is issued by the Association of British Insurers ( ABI ). Our role includes providing guidance to members on issues where we consider such guidance is necessary and is not provided elsewhere in order to enhance the consistency and/or quality of financial reporting. The guidance in this Technical Release has no formal status beyond that of guidance to members of the ICAEW on an emerging issue. BACKGROUND 3 In September 2006 the Financial Services Authority issued, inter alia, proposals to allow life insurers to change the calculation of technical provisions for the purpose of reporting those provisions to the FSA in determining solvency in accordance with the EU Solvency 1 Directive. These were confirmed in Policy Statement 06/14 Prudential Changes for Insurers ( PS 06/14 ), issued in December 2006. The changes came into force on 31 December 2006. 4 UK life insurers preparing their financial statements under the Companies Act 1985 ( CA85 ) on a UK GAAP basis adopt the modified statutory solvency basis ( MSSB ) which uses the regulatory determination of technical provisions as a basis for determining the long-term business provisions ( LTBP ). 1 5 UK life insurers preparing such financial statements on an IFRS basis may also be using MSSB as it represented their existing accounting policy in respect of insurance contracts at the date of adopting IFRS 4. 6 Accordingly the changes introduced by the FSA in respect of UK life insurers provisioning requirements are likely to have implications for CA85 financial statements whether prepared under UK GAAP or IFRS. This Technical Release considers those implications. 2 SUMMARY OF THE CHANGES 7 The changes to the FSA rules allow life insurance technical provisions calculated for regulatory reporting to the FSA ( technical provisions ) to incorporate further economic realism than under the previous regulatory basis. In particular this would be achieved by: setting technical provisions for expenses not directly attributable to one particular contract at a homogenous risk group level and not, as currently, at an individual contract level for all non-profits business; recognising the economic effect of making a prudent lapse rate assumption within technical provisions for all classes of non-profit long-term business. Previously no lapses were assumed; and 1 The ABI SORP, as updated in December 2006 provides a fuller explanation. 2 The analysis in this Technical Release is relevant for contracts accounted for as insurance. These changes in regulation should not lead to any changes in the measurement of investment contracts under FRS 26 / IAS 39. Implications for embedded value reporting are not considered in this Technical Release.
TECHNICAL RELEASE FSF 02/07: Accounting implications of changes to the Financial Services Authority s rules for calculating technical provisions Page 3 changing the calculation of technical provisions for all classes of long-term business to allow contracts that do not include guaranteed surrender values in the contract wording to be valued as negative reserves. Previously such contracts were recognised at a zero value. 8 The revised FSA rules do not allow a net overall asset to be recognised where the negative technical provisions for contracts with positive discounted net future cash flows exceed the mathematical reserves for other contracts. 9 The revised FSA rules set out the minimum basis for determining technical provisions. For FSA purposes, methods and assumptions that produce reserves greater than those calculated on the minimum basis may also be used. ACCOUNTING IMPLICATIONS 10 This Technical Release considers the following accounting issues: whether there is any obligation for changes to the technical provisions to flow through to the financial statements; whether such a change in the financial statements would represent a change in accounting policy or a change in an estimation technique; and whether there are other accounting implications. IMPLICATIONS OF CHANGES IN TECHNICAL PROVISIONS UK GAAP 11 For those insurers reporting under UK GAAP, the ABI SORP should be followed in respect of insurance contracts. Accordingly the MSSB applies and there is a presumption that the changes to technical provisions if adopted in the FSA returns would flow through to the LTBP unless such changes represent reserves which have already been adjusted for i.e. they are in accounting terms already classified as reserves rather than provisions (see SORP paragraphs 16 and 183). 12 The ABI SORP was previously aligned with the previous FSA rules and stated that no policy may have an overall negative provision (paragraph 182). The ABI has now amended its SORP with effect from 31 December 2006 as a consequence of the changes introduced by PS 06/14. Paragraph 182 now states that in determining the long term business provision no policy may have an overall negative position except as permitted by FSA rules. Following this change, the adoption of the changes to technical provisions in the calculation of the LTBP is consistent with the guidance set out in the ABI SORP. IFRS 13 For those UK insurers reporting under IFRS, the insurer will need to assess its existing accounting policy. If that policy, as will often be the case, is based on the regulatory basis of determining technical provisions then it will follow that the impact of the FSA changes will flow through to the LTBP. If the company wishes to change its accounting policy to establishing its LTBP on a different basis (than regulatory reserves adjusted under the MSSB) then that change in accounting policy would need to be justified in accordance with IFRS 4.
Page 4 TECHNICAL RELEASE FSF 02/07: Accounting implications of changes to the Financial Services Authority s rules for calculating technical provisions ACCOUNTING FOR ANY CHANGE UK GAAP 14 As noted above, for UK GAAP life insurers the accounting policy adopted will continue to be to prepare their financial statements under the MSSB. Changes in the methodology in determining the LTBP have previously generally been recognised as a change in estimation technique rather than a change in accounting policy, for example the change from a net premium basis to a gross premium basis. 15 Distinction should be made between an accounting policy of setting technical provisions on a particular basis, for example MSSB, and the detailed techniques and assumption sets that underlie that basis. The MSSB embraces a variety of alternative assumption sets and valuation methodologies but the important feature is that the UK GAAP policy is based firmly on the approach adopted in the regulatory returns of the entity. Whilst there may be some modification, for example to address the ABI SORP requirement to eliminate contingency reserves, the principle is that the GAAP provision and regulatory reserves will be broadly aligned. 16 The revision to the regulatory basis in PS 06/14 allows changes to assumptions which previously would not have been regarded as appropriate. The revised assumption set may in certain circumstances remove only part of the available regulatory prudence as there remains a choice in the hands of preparers not to take maximum advantage of the relaxation of regulatory constraints. In some circumstances, the regulatory basis will result in some contracts being attributed what is akin to negative liability values as part of the overall provision for the total portfolio of liabilities. That is as a consequence of valuing the contract cash flows with less constraint and adopting assumptions within the range of possible assumptions allowed by the regulations and therefore within the ambit of the MSSB. 17 It is therefore appropriate to account for the change in value of provisions in the financial statements, arising from the revision to the regulatory basis, as a change in estimate as a result of a change in assumptions and not as a change in policy. Nonetheless, a clear disclosure of the effect of the change in estimates should be made in a note to the financial statements. IFRS 18 For UK insurers reporting under IFRS, the conclusion under UK GAAP that the change in arising from the adoption of PS 06/14 represents a change in accounting estimate remains the same. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is relevant. IAS 8 defines a change in accounting estimate as an adjustment of the carrying amount that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors (paragraph 5). Conversely, IAS 8 states that, when a change in measurement basis is applied, it is a change in an accounting policy, and is not a change in an accounting estimate (paragraph 35). As noted above, the revisions introduced by PS 06/14 allow changes in assumptions underlying the basis of measurement rather than changes to the measurement basis itself. Furthermore, IAS 8 usefully clarifies that when it is difficult to distinguish a change of accounting policy from a change in an accounting estimate, the change is treated as a change in an accounting estimate (paragraph 35). Thus under IFRS, it would be appropriate to treat any resulting change in the methodology of determining the LTBP as a change in accounting estimate.
TECHNICAL RELEASE FSF 02/07: Accounting implications of changes to the Financial Services Authority s rules for calculating technical provisions Page 5 OTHER ACCOUNTING IMPLICATIONS Deferred acquisition costs UK GAAP 19 A consequence of changing the methodology for calculating the LTBP is that it might be necessary to reassess the calculation of deferred acquisition costs. Any reduction in the LTBP as a result of PS 06/14 may reduce future margins recognised in the recoverability test required under the SORP (paragraph 175). IFRS 20 For those UK insurers reporting under IFRS, most have continued to defer acquisition costs in accordance with the SORP. Accordingly the considerations outlined above apply. Disclosure 21 UK insurers reporting on a UK GAAP or IFRS basis will need to give careful consideration to adequacy of disclosure as to the basis of determination of the LTBP, and disclose key assumptions and factors affecting the LTBP. 22 Under UK GAAP, FRS 18 requires disclosure of the material estimation techniques. As outlined in paragraphs 14 to 17 above, it is expected that the decision on whether to adjust the LTBP as a result of PS 06/14 for financial reporting purposes will represent a material estimation technique. This has not been considered material in the past as there had not previously been as much flexibility in the FSA s prescribed methodology. The changes set out in PS 06/14 introduce the potential for material differences of approach between UK insurers in the future, increasing the importance of disclosure. 23 Under IFRS, IFRS 4 requires the disclosure of the process used to determine the assumptions that have the greatest effect on liabilities arising from insurance contracts. These changes to the FSA rules introduce the potential for material differences in approach between UK insurers, increasing the importance of disclosure. Taxation 24 In general, UK life insurers are taxed on the basis of results reported on a regulatory basis rather than a CA85 basis. However, in advance of the 2006 year end, HMRC laid regulations (SI 2006/3387) to avoid what is referred to as an inappropriate tax charge arising from these changes. Subsequently, further regulations (SI 2007/1031) were laid to ensure profits arising as a result of valuation changes and deferred to later years unwind properly. To the extent that differences arise between the accounting basis and the tax basis (taking account of the changes to the tax legislation) there will be deferred taxation consequences. August 2007
ACCOUNTING IMPLICATIONS OF CHANGES TO THE FINANCIAL SERVICES AUTHORITY S RULES FOR CALCULATING TECHNICAL PROVISIONS Guidance for accountants and auditors of life assurers on the accounting implications of changes to the rules for calculating the technical provisions, set out in the FSA s Policy Statement PS 06/14. FSF 02/07 is issued as guidance to assist accountants and auditors of life insurers make judgements in light of the changes in the FSA rules covering technical provisions. It has no formal or mandatory status since the ICAEW is not responsible for setting the prudential capital rules or accounting standards, or for issuing the Statement of Recommended Practice on Accounting for Insurance Business, which are the responsibilities of the FSA, ASB/IASB and ABI respectively. Financial Services Faculty The Institute of Chartered Accountants in England and Wales Chartered Accountants Hall PO Box 433 Moorgate Place London EC2P 2BJ T: +44 (0)20 7920 8417 F: +44 (0)20 7638 6009 E: financialservicesfaculty@icaew.com DX 877 London/City www.icaew.com/fsf TECPLM6635 8/07