Insurance Accounting Alert www.ey.com/insuranceifrs November 2012 IASB and FASB continue to deliberate the insurance contracts standard What you need to know 1. The Boards decided that when measuring contracts under the premium allocation approach, the discount rate used to accrete or discount should be the rate at inception. 2. Premiums and claims presented in an insurer s statement of comprehensive income should be determined by applying an earned premium presentation approach. 3. The IASB expects the period between the issuance of the final insurance contracts standard and the mandatory effective date to be around three years. Effects of changes in discount rates Premium Allocation Approach The Boards revisited the premium allocation approach (PAA) as a result of the decision to allow changes in the insurance contract liabilities attributable to interest rate changes to be recorded in Other Comprehensive Income (OCI). The Boards first discussed the rate used to discount or accrete interest on the liability for remaining coverage and agreed with the staffs proposal that the interest rate used should be the rate at contract inception, not the current rate. The FASB and IASB staff proposed different alternatives for presenting the discounting effect of incurred claims. The FASB staff supported using the rate at inception of the contract for determining the amount of the claims and interest expense in profit or loss, the IASB staff proposed using the rate at the time the claim is incurred. The FASB staff believes using the rate at the time the claim is incurred would introduce unnecessary complexity, but the IASB felt that using this rate was conceptually correct. The FASB and IASB Boards initially supported their respective staffs proposals, but ultimately the IASB agreed to converge with the FASB. Although the Boards recognise that certain aspects of the models they ultimately propose will differ, they seem to have a desire to avoid creating new differences wherever possible. Although the Boards agreed on a concept, there may need to be further clarification of whether contract inception was intended to mean individual contracts or the inception of a portfolio (e.g., an underwriting year). Effects of changes in the discount rate Participating contracts During previous meetings, the Boards adopted a mirroring approach for certain participating contracts. Under this approach, the part of the insurance liability that relates to the underlying assets will be measured and presented on the same basis as those underlying assets. The IASB would apply this approach to all types of participating contracts, while the FASB would only apply this approach in case of accounting mismatches that reflect certain timing differences.
During the October meeting, the Boards considered how previous tentative decisions, particularly those on OCI, would work for contracts with participating features in which the mirroring approach would apply. The Boards clarified that the mirroring decision would take precedence over the tentative decision that insurers should present the effect of changes in the discount rate in OCI. As illustrated by the staff example in the Board paper, this implies the effect of changes in discount rates would be presented in the following manner: The effects related to liability cash flows that depend on the performance of underlying assets would follow the treatment of the underlying assets; for example, if the assets are measured at FVPL, then the discount rate effect is also recorded in profit and loss. The effects related to liability cash flows that are not asset-dependent ( fixed cash flows) are presented in OCI. The effects related to options and guarantees are presented in profit and loss. The FASB s mirroring approach would not apply to some types of contracts where the contractual obligation to the policyholder is based on the fair value of the underlying assets, such as unit-linked and variable contracts. To stay in line with the current treatment under US GAAP, the FASB tentatively decided that for those types of contracts the changes in the insurance liability should be presented in profit or loss, if the underlying assets are measured at fair value through profit and loss. The Boards decided to adopt a mirroring approach in order to mitigate the effect of accounting mismatches between participating insurance liabilities and the investments backing those liabilities. However, in the Boards view, the application of the mirroring approach only applies to discount rate effects for cash flows that depend on the underlying assets. This application requires splitting the cash flows of a contract into those that do depend on the assets, and those that do not depend on them. Making the split may result in practical application issues. Presentation in the Statement of Comprehensive Income Whilst the ED had proposed a summarised margin presentation approach for the statement of comprehensive income, at previous meetings, the Boards tentatively decided that insurers should present volume information. They referred specifically to premiums, claims and benefits in the statement of comprehensive income. Three alternative volume presentations (premiums written, due and earned) have been proposed by the staffs. The Boards tentatively decided that the earned premium presentation should be used for volume information in the building block approach. Under this presentation, earned premiums are allocated to periods based on the driver and claims should be presented when incurred. The example in the staff paper allocated premiums in proportion to the incurred claim, but noted that another driver could be in proportion to the value of coverage, and any other services that the insurer has provided in the period. Some of the reasons provided for this approach were: (i) the method is consistent with the revenue recognition standard; (ii) it compares well with other industries measures and; (iii) some of the components of the earned premium presentation would automatically link into balance sheet roll-forward. Some Board members were concerned about how this method would work under the proposed retrospective transition approach, and whether the premiums earned addressed 2 Insurance Accounting Alert
the respondents request for volume information. In addition, they asked the staff to consider including application guidance about other drivers that may be appropriate, to avoid being overly prescriptive. The Boards also discussed how to present non-claims fulfilment costs in the statement of comprehensive income. Non-claims fulfilment is in addition to the expected claims and benefits costs that an insurer expects to incur in fulfilling their insurance contract obligation, and are included in the measure of the building block liability. These costs include policy administration and maintenance costs and claims handling costs. The Boards tentively decided the following: (i) A portion of the premium should be allocated to cover non-claims fulfilment costs, the amount allocated presented as the originally expected non-claims fulfilment cost. (ii) The premium allocated should be included in the insurance contract revenues in the periods in which the costs are expected to be released from the liability of remaining coverage. (iii) Amounts represented as expenses should be the actual incurred cost for the period (i.e. the expenses paid in the period adjusted for any changes in the provision for expenses included in the liability for incurred claims). The earned premiums presentation introduces the concept of revenue in the statement of comprehensive income for insurance contracts measured under the building block approach. Whilst this presentation is consistent with the proposals in the joint revenue recognition project, it is a new concept within the context of many long-term life contracts. Therefore, we expect that some users may find that the information adds value to the statement of comprehensive income while others may not share this view. Accordingly, insurers will need to ensure that readers of their financial statements understand the information presented and are interpreting that information appropriately. Presentation of acquisition costs Because of previous tentative decisions on how certain amounts in the insurance model will be amortised into the statements of comprehensive income, the IASB and FASB staff proposed different alternatives for presenting acquisition costs in the statement of comprehensive income. The IASB staff recommended, and the IASB tentatively agreed, that cash flows relating to acquisition costs should be recognised in the statement of comprehensive income over the coverage period of the contract (rather than when costs are incurred). Furthermore, acquisition costs should be recognised in the statement of comprehensive income in a manner that is consistent with the proposed allocation of the residual margin. The FASB staff recommended that acquisition costs should be treated as part of the insurance contract liability and presented separately as part of the margin component and then recognised in the statement of comprehensive income consistently with the proposed allocation of the single margin. The majority of the FASB voted in favour of the FASB staff recommendation. The FASB also decided that in the statement of financial position, an insurer should disaggregate the insurance contracts liability into the expected cash flows to fulfil the insurance obligation and the margin. These decisions imply that the mechanics of how to include the acquisition costs in the insurance liability are similar, but the difference between the Boards is in disclosure: the IASB would not show the Insurance Accounting Alert 3
acquisition costs separately after inception, while the FASB wants to separately display the roll-forward of the acquisition costs amount over the life of the contract. Financial instruments with discretionary participation features (DPFs) (IASB only) The IASB s ED proposes principles for recognition and contract boundaries that refer to the notion of insurance risk. Because financial instruments with DPF s do not contain significant insurance risk, the ED includes an adapted recognition principle and contract boundaries for those contracts to reflect their specific characteristics. The IASB staff presented the IASB with changes to the guidance on recognition and the contract boundaries of DPFs to align with changes to the general principles made since the ED for insurance contracts was issued. (Note: The FASB has decided specifically not to scope DPFs into the insurance contract standard.) Previously, the IASB decided to require the recognition of insurance liabilities at the beginning of the coverage period, in contrast to the proposal in the ED, which required recognition when the insurer became a party to the contract. The IASB agreed with the following staff proposals: An entity must recognise a DPF asset or liability only when the entity becomes party to the contractual provisions of the instrument. The contract boundary for a DPF is the point at which the contract no longer confers a substantive right to the holder, i.e., they no longer have a contractual right to receive benefits arising from the discretionary participating features in the contract; or the premiums charged confer substantially the same benefits as those that are available on the same terms to those that are not yet contract holders. The ED proposes to amortise the residual margin on the basis of the fair value of the assets under management. IASB members agreed that this basis is still appropriate. Effective date and other transition issues The Boards held separate sessions to discuss issues related to transition in light of the decisions made at their September meetings, including the potential for shortterm accounting mismatches between the measurement of insurance liability and financial instruments. Furthermore, the IASB also discussed several other transition and effective date issues. Re-designation of financial instruments The Boards discussion focused on identifying a manner to best deal with the complexities created by the expected different effective dates for the financial instrument and insurance contracts standard. The IASB decided that an insurer should be: Permitted to designate eligible financial assets under the fair value option (FVO) where new accounting mismatches are created by the first application of the insurance contract standard. Required to revoke previous designations under the FVO where the accounting mismatch no longer exists. Permitted to use OCI for presenting changes in the fair value of some or all equity instruments that are not held for trading, or revoke previous election. The FASB decided that upon adoption of the insurance contract standard, an insurer could re-designate financial assets designated to insurance business by either legal entity or internal designation and relating to funding of insurance contracts. Although the IASB made several decisions concerning transition, they decided that these transition decisions may not apply to participating contracts, and they would have to specifically discuss transition for participating contracts at a subsequent meeting. Other transition issues (IASB only) The other decisions made by the IASB with respect to the effective date and other transition issues were: First-time adopters of IFRS would be subject to the transition requirements of the insurance contracts standard. The guidance will not include specific guidance regarding redesignation of plant, property and equity or investment properties on transition. The effective date of the standard will be around three years after the issuance of the final standard, rather than selecting a very specific transition period at this stage. Entities will be required to restate comparative financial statements. Adoption of the final standard prior to the mandatory effective date would be permitted. 4 Insurance Accounting Alert
The IASB s next step will be to issuing a revised exposure draft. They felt it would not have to be conclusive on the exact transition period, or a particular mandatory effective date at this stage. Instead, the IASB concluded it could set the mandatory effective date during its re-deliberations of the revised ED. The Boards believe that it is likely that the effective dates for the insurance contracts standard and the financial instrument standard will not be aligned. By agreeing to find a solution (i.e., the re-designation of financial instruments for insurers) will mean that it is unlikely there will be a separate effective date for insurers with respect to the financial instrument standard. Next Steps The Boards will continue their discussions in November; the topics have not yet been announced. The IASB plans to issue a revised exposure draft in the first half of 2013 and it will establish a publication date for the final standard in due course. The FASB currently aims to issue its exposure draft in the same period as the IASB. Insurance Accounting Alert 5
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