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This article was first published in the November/December 2010 edition of Accounting and Business magazine.
The International Accounting Standards Board (IASB) introduced IFRS 4, Insurance Contracts as an interim standard to allow insurance companies to comply with International Financial Reporting Standards (IFRSs) and a European directive requiring the use of IFRS by 2005.
It represented the first phase of the insurance project. At that time, the IASB sought to minimise the amount of change required to current accounting policies and practices so as to avoid changes that might be reversed in the second phase of the project. It allowed insurers to continue most of their current accounting policies for insurance contracts.
The second phase of the insurance project was published as the Preliminary Views on Insurance Contracts discussion paper in May 2007, which focused on an exit value measurement approach for insurance contracts.
On 30 July 2010 the IASB published its latest insurance contracts exposure draft, which proposes a comprehensive standard to address recognition, measurement, presentation and disclosure for insurance contracts.
It is expected to affect significantly the financial reporting of all insurers. In addition to the change in accounting policies and practices, the proposals may heavily impact systems, data and tax, reporting and control processes. The proposals apply to all entities that issue insurance contracts.
The exposure draft retains the IFRS 4 definition of an insurance contract as 'a contract under which one party accepts significant insurance risk from another party by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder'.
As in IFRS 4, insurance risk is defined as any risk other than financial risk. The IASB has continued to exclude certain contracts that meet the definition of insurance contracts from the scope of the standard, such as product warranties, residual value guarantees and contingent consideration payable in a business combination.
IFRS 4 permitted insurers that issued financial guarantee contracts to treat them as insurance contracts, although other companies treated them as financial instruments. The IASB will now require all contracts that meet the insurance contract definition to be accounted for as insurance contracts. As a result, financial guarantee insurance, mortgage guarantee insurance and trade credit insurance will all now be within the scope of the standard.
The proposals will require an insurer to measure insurance contracts using a current measurement model where current estimates are remeasured each reporting period.
The model is based on a fulfilment objective, which reflects the fact that an insurer generally expects to fulfil its liabilities over time by paying benefits and claims to policyholders as they become due, rather than transferring the liabilities to a third party.
This is based on the principle that insurance contracts create rights and obligations that work together to create a package of cash inflows such as premiums, and outflows such as benefits and claims.
Current assessment will be required of the amount, timing and uncertainty of the future cashflows that the insurer expects its existing insurance contracts to generate as it fulfils its rights and obligations under the contract. This measure is referred to as the present value of the fulfilment cashflows, which is measured using the following:
- current estimate of future cashflows
- discount rate that adjusts those cashflows for the time value of money
- explicit risk adjustment
- residual margin that eliminates any gain at the inception of the contract.
The IASB has concluded that there should not be any initial profit recognition for insurance contracts. If the above calculation results in an asset, a residual margin is added to eliminate the gain, so the contract is measured initially at zero. If the present value of the cashflows is greater than zero, then there is a loss recognised, which represents an onerous contract. As the insurance contract unwinds, an insurance asset or liability is created.
One of the most controversial issues is whether an explicit risk adjustment should be included in measuring the contract liability to reflect the effect of uncertainty inherent in the estimated future cashflows.
The risk adjustment is the maximum amount the insurer would be willing to pay to be relieved of the risk that the ultimate cashflows exceed those expected. In the model preferred by the Financial Accounting Standards Board (FASB), there is no explicit risk adjustment; instead, a margin is established to eliminate any gain at recognition. Any excess of expected cash outflows over expected cash inflows would be recognised immediately as a loss.
The benefits of the risk adjustment are that it reflects risk included in the liability at every reporting period, reflects subsequent changes in risk and ensures that an insurance liability includes a margin.
This is consistent with the pricing of financial instruments. The main issues are the reliability and consistency of the risk adjustment measurement, which may vary between countries, depending on whether similar risk adjustment techniques are used. Profit may vary according to the technique used.
At the end of each reporting period, the liability will reflect current estimates of cashflows, current discount rates and a risk adjustment that reflects the remaining risk of uncertainty about the amount and timing of the cashflows.
Changes in estimates are recognised immediately in the income statement. However, recognising changes in estimates in the income statement will lead to an increase in volatility of reported results for many insurers that currently use fixed assumptions.
The residual margin is recognised over the period in a systematic way that reflects the exposure from providing insurance coverage. Thus the residual margin is unwound, not remeasured.
Under the proposals, incremental acquisition costs (ie, the costs of selling, underwriting and initiating an insurance contract) that would not have been incurred if the insurer had not issued that particular contract are included in the present value of the fulfilment cashflows of a contract.
All other acquisition costs should be expensed when incurred in profit or loss. This is more restrictive than current accounting in many countries, which may allow an element of direct costs to be treated as deferred acquisition costs. The proposals require that reinsurance business assumed should be measured using the same block measurement approach as for other insurance contracts.
An insurer recognises an insurance contract when it is bound by the terms of that contract or when it is exposed to the risk under the contract - whichever is earlier. An insurer derecognises an insurance contract liability when the contract obligations are discharged, cancelled or expire. At this point the insurer is no longer at risk and no longer has to transfer resources to satisfy the obligation.
Whether an insurer is bound by an insurance contract will depend on the legal requirements in the country concerned. The recognition criteria could mean that contracts will be recognised earlier than the date on which the insurance coverage commences.
During the gap period, the insurer is required to perform a liability adequacy test, which could result in recognising a loss in the income statement or recognising changes in assumptions and discount rates, but the amortisation of the residual margin does not commence until the insurance coverage starts.
Some insurance contracts contain one or more elements that would be within the scope of another IFRS if the insurer accounted for those elements as if they were separate contracts - for example, an investment component of a contract. If a component is not closely related to the insurance coverage specified in a contract, it is proposed that an insurer unbundle and account separately for that component.
The following are examples of components that are not closely related to the insurance coverage and that would result in unbundling:
- an investment component reflecting an account balance credited with an explicit return at a rate based on the investment performance of a pool of underlying investments; the rate should pass on all investment performance, but may be subject to a minimum guarantee
- an embedded derivative separated from its host contract under IAS 39
- contractual terms relating to goods and services that are not closely related to the insurance coverage but have been combined in a contract with that coverage for reasons that have no commercial substance.
The insurance measurement model differs from other measurement models, so unbundling is important. However, the unbundling requirements are not accompanied by application guidance, so some terminology will be open for interpretation. It seems there may be an intention to unbundle life contracts into separate insurance and financial instrument components.
The proposals also require short-term contracts of 12 months or less that do not contain embedded derivatives or options to be measured initially at premiums less any incremental acquisition costs. Any claims that arise on these contracts will be measured at the present value of the cashflows using the model as for all other insurance contracts.
The income statement is determined by the measurement model. Premiums will no longer be recognised except for the short-term approach as revenue. There will be separate disclosure of:
- underwriting margin
- gains and losses at initial recognition
- non-incremental acquisition costs
- experience adjustments and changes in estimates
- interest on insurance liabilities.
Users will need to be educated in the new presentation format and the implication of the new approach on reported earnings. Some adjustment will be needed to become used to the non-disclosure of premiums and claims on the face of the income statement.
Insurers will need to assess the impact of the proposed changes and there is only a short time available to influence the final standard, which is due in the summer of 2011.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School