Insurance Accounting Alert www.ey.com/insuranceifrs January February 2013 Boards discuss allocation of insurance contracts revenue, and consider sweep changes What you should know The Boards decided that revenue should be re-allocated prospectively to reöect the latest estimates of expected future claims The IASB determined that the risk adjustment at contract inception is assumed to be equal to the risk adjustment as of the earliest period presented It also agreed that any gains or losses should adjust retained earnings at transition when applying the standard to insurance contracts previously acquired through business combinations The IASB s exposure draft will be open for comment for 120 days Overview During the January 2013 joint meeting, the International Accounting Standards Board and the Financial Accounting Standards Board (respectively, the IASB and the FASB, and collectively, the Boards) re-deliberated the decisions made in the IASB s Exposure Draft Insurance Contracts (ED) and the FASB s Discussion Paper, Preliminary Views on Insurance Contracts (DP). The Boards discussed the following: Allocation of insurance contract revenue when there are changes in the pattern of expected claims and transition proposals for insurance contract revenue Estimating at transition the amount of insurance contract revenue that will be recognised in future periods Separately, the IASB considered several sweep issues that were raised by respondents to the ED or arising from the unintended consequences of tentative decisions made to date. During the February 2013 meeting, the IASB discussed transition for business combinations and the exposure period for the targeted exposure draft that is expected to be issued this summer. Allocation of insurance contract revenue upon a change in pattern of expected claims The Boards have previously tentatively decided that under the building block approach (BBA), insurance contract revenue would be based on an earned premium concept in the statement of comprehensive income. Under the proposed model, earned premiums are measured by the amount of reduction in the liability of remaining coverage as a result of the insurer satisfying its obligations to provide coverage or other services. This amount is the sum of: Expected (probability-weighted) claims and associated expenses for the period of coverage Release of the risk adjustment in the period (IASB only) Amortisation of deferred acquisition costs Release of the single or residual margin in the period The staff presented two possible approaches for how revenue would be allocated between periods:
Treat each coverage period as a separate performance obligation, and allocate revenue to each period based on the original estimates of the expected claims and the release of the margin for that period Or Treat the contract as a single performance obligation and allocate remaining revenue prospectively, referring to the most-up-to-date estimates of expected claims The Board discussed how dif cult it would be to justify the use of the most-up-to-date estimates of expected claims patterns as the only criteria for allocating insurance contracts revenue. They drew an analogy based on the percentage of completion method under IAS 11 Construction Contracts where three different criteria can be used to determine contract revenue. Ultimately, the Boards were comfortable using the most-up-to-date estimates for determining earned premiums because the insurance contract model considers other current inputs. The Boards also agreed with the staff recommendation that if there is a change in the expected pattern of future claims, the remaining insurance contract revenue should be re-allocated prospectively to re ect the latest estimates of that pattern. They noted that this treatment is consistent with the revenue recognition principles of the draft revenue standard. Prospective re-allocation of the remaining revenue to re ect the latest estimates of claims patterns aligns with the IASB s unlocking of the residual margin for changes in estimates of cash ows relating to future coverage. For the FASB, any expected changes in the pattern of reduction in variability are recognised as revenue prospectively through the release of the single margin. Prospective reallocation should also be easier to implement because the change should mirror the changes of the BBA components. Determining the risk adjustment at transition In light of the recent decision to recognise earned premium in the BBA, the staffs discussed how to determine the amount of remaining future premiums to be earned for contracts in force at transition. The Boards agreed that premium should be earned based on assumptions used to determine the liability for remaining coverage. For the IASB, this would be the sum of the expected claims, risk adjustment plus the residual margin. For the FASB, it would be the expected claims plus the single margin. The IASB staff voted to modify the retrospective application guidance so an insurer can assume that the risk adjustment at the earliest period presented is the same amount at contract inception. One Board member voted against the proposal because he was concerned that it would result in an overstatement of the residual margin at transition. While the Board expressed concerns about the use of hindsight, it felt that hindsight at transition would be more reliable than at contract inception which could be more than 20 years back. The IASB also agreed that, if retrospective application is impractical, insurers should not calibrate the residual margin to the previously 2 Insurance Accounting Alert
used IFRS standard. Instead, they should estimate the residual margin at the earliest period presented, maximising the use of objective data. The FASB adopted a similar proposal that was modi ed for differences between their model and the IASB s model (i.e., the use of a single margin rather than a risk adjustment and residual margin). This decision is another example of how the Boards balance comparability and complexity. They sacri ce comparability between business in force at transition and that written subsequently, while minimising the complexity of determining the risk adjustment, or in the case of the FASB, the single margin at transition. Since the risk adjustment generally decreases over time, the residual margin (the difference between cash in ows and the sum of the out ows plus the risk adjustment) will likely be greater at contract inception under the revised transition guidance. Determining an initial residual margin, assuming the transition risk adjusted was the initial amount, will likely alter pro t emergence patterns for the life of the contracts. Therefore, pro t emergence for future business may not be fully comparable to business in-force at transition. Additionally, with the expectation of a reduced risk adjustment at inception, in most cases, it less likely for an onerous contract liability to be recorded in the pre-transition period. Sweep issues The IASB staff presented sweep issues that the IASB discussed on an exception basis. The Board tentatively agreed it would not be necessary to provide explicit guidance in the forthcoming revised ED for the following items: 1. Policyholder accounting 2. randfathering the de nition of an insurance contract 3. Takaful arrangements (i.e., those that offer participants protection that is comparable with conventional insurance, while adhering to Shariah principles) 4. Discounting deferred taxes (i.e., not to address discounting of deferred taxes within the insurance contracts project) 5. Tacit renewals or cash bonuses 6. Implementation guidance that currently accompanies IFRS 4 Insurance Contracts (i.e., not to carry forward the implementation guidance that currently accompanies IFRS 4 Insurance Contracts to the future standard) The IASB also con rmed the following two items from the 2010 exposure draft: 1. An insurer should treat ceding commissions as a reduction of premium ceded to the reinsurer 2. Separate requirements should apply to business combinations and portfolio transfers. If the consideration to be treated as the premium received at initial recognition is less than the present value of the ful lment cash ows, the insurer would recognise: a) An immediate expense in a portfolio transfer Or b) An increase in the amount of goodwill recognised in the business combination Insurance Accounting Alert 3
While the discussion on these items was limited, the Board spent most of the time on the treatment of ceding commissions and the de nition of an insurance contract. Some of the IASB members were concerned that presenting ceding commissions as a reduction of premiums would distort key ratios of the cedant. This was due to the inconsistent treatment of commissions on inward and outward business, especially on proportional reinsurance. The staff explained that this inconsistency is dif cult to overcome because some reinsurance contracts are written on a net basis and others are not. The Board also decided to clarify that the recognition point for deferred annuities is the earlier of the start of the coverage period or the date when the rst premium becomes due. If a contractual premium due date does not exist, then premium is deemed to be due when received. The IASB believes that the proposed change to the de nition of an insurance contract would not change current practice for IFRS. Therefore, they believe that, in most cases, there would be no need to reassess whether contracts that met the de nition of insurance contracts in IFRS would meet the de nition in the future standard. As such, the IASB concluded that it will not be necessary to include in the guidance an explicit statement that the existing de nition conclusions would be grandfathered. Based on feedback from Board members prior to the meeting, the staff decided to draft a separate paper for future discussion of business combination issues (see the next section). By not providing explicit guidance on some of the matters included in the sweep issues, the IASB tries to strike a balance between providing a model that is principles-based and avoiding being too prescriptive in certain areas. The revised ED and subsequent comment period will provide an opportunity for users to see how the overall model will look, taking into account all tentative decisions made to date. Transition for business combinations The IASB had previously decided that when an insurer rst applies the new standard, it should measure insurance contracts that it has originated using a modi ed retrospective approach. At its February meeting, the IASB staff presented two questions on how this modi ed retrospective approach should be applied to insurance contracts acquired through business combinations that are in force at the transition date. First, the IASB staff proposed that the insurer should use the date of the business combination as the date of inception, and the insurer should use the fair value of those contracts as a premium component in the ful lment of cash ows. Second, the IASB staff proposed that any gain or loss recognised from applying the new standard to the previously acquired insurance contracts should be an adjustment to retained earnings and not to goodwill. The staff considered that any transition to a new standard under IFRS would not allow a change in goodwill, even if that new standard required retrospective application to measure the assets and liabilities at transition. The IASB members unanimously agreed to the staff s proposals. On transition insurers need to determine the fair value of insurance contracts acquired in a previous business combination. While the original fair value calculation would have included a larger population of contracts, companies will need to use judgement to determine what portion of the fair value to allocate to the remaining contracts in force at transition. 4 Insurance Accounting Alert
Exposure draft The IASB recon rmed that when it issues the revised exposure draft this summer, it will be seeking comment only on the following issues: Treatment of participating contracts Presentation of premiums and claims in the statement of comprehensive income Treatment of the unearned pro t in an insurance contract Presenting, in other comprehensive income, the effect of changes in the discount rate used to measure the insurance contract liability The approach to transition The IASB gave approval for the staff to begin the ballot process for the revised exposure draft, and tentatively decided that the draft should be open for comment for 120 days. One IASB member noted its intention to vote against this draft. Next Steps The FASB is nearing completion of deliberations, with nal meetings in April. The IASB has already completed deliberations. Both Boards are expected to issue exposure drafts in the rst half of 2013. Insurance Accounting Alert 5
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