Preliminary Views on Insurance Contracts
Comments from ACCA
November 2007
ACCA is pleased to have this opportunity to comment on the above discussion paper (DP) on preliminary views on insurance contracts, which was considered by ACCA's Financial Reporting Committee .
ACCA welcomes the publication of the DP as being a significant step in the development of a much needed accounting standard in the area of insurance accounting. We view the DP as setting a sound basis with which to develop a high quality standard and to facilitate the convergence of the varying practices that are applied to accounting for insurance contracts, both within the insurance industry and other sectors.
We believe there are some issues raised by the DP which need further scrutiny by the Board, and these are discussed in detail in our responses to the questions raised by the Board.
We do note here however, that the DP offers quite limited guidance on disclosure requirements. The nature of insurance accounting and in particular the high level of subjectivity in terms of assumptions and processes employed, we believe will necessitate significant disclosure requirements in order to ensure that the financial statements of insurers retain their usefulness.
ACCA's responses to questions raised for comment by IASB
Q1. Should the recognition and derecognition requirements for insurance contracts be consistent with those in IAS 39 for financial instruments?
We believe that there are no specific reasons why there should be any differences in the recognition and derecognition requirements for insurance contracts and other financial instruments.
Q2. Should an insurer measure all its insurance liabilities using the following three building blocks:
(a) explicit, unbiased, market-consistent, probability-weighted and current
estimates of the contractual cash flows.
(b) current market discount rates that adjust the estimated future cash flows
for the time value of money.
(c) an explicit and unbiased estimate of the margin that market participants
require for bearing risk (a risk margin) and for providing other services, if
any (a service margin)?
If not, what approach do you propose, and why?
We would agree in principle with the building blocks approach to measuring insurance liabilities. We believe this approach provides an appropriate measure for the current value of insurance liabilities and should ensure that they are consistently valued over time.
We do not have specific concerns with parts (a) and (b) of the building blocks. However, we do have reservations over the use of service margins and the requirement of market participants as part of this model. Whilst the Board considers that the current exit value (CEV) of other services provided should be included in the estimate of the insurance liability, we believe that in practice charges for such services as investment management are implicitly included within some insurance contracts anyway. It may be quite difficult to separately identify this investment service element in for example life assurance contracts which incorporate both investment and risk elements.
We would also emphasise that although the CEV is a reasonable model in principle, the fact that there is no observable market means that it may not necessarily be practical. We certainly believe that this would mean the building blocks would use the insurer's own pricing data to give an entity specific value, rather than a notional CEV to transfer the liability.
Our concerns over CEV are further elaborated upon in our responses to questions 4 and 5.
Q3. Is the draft guidance on cash flows (appendix E) and risk margins (appendix F) at the right level of detail? Should any of that guidance be modified, deleted or extended? Why or why not?
We believe that the guidance set out in Appendix E is well structured and helpful in general.
In relation to risk margins, we believe that it would be more helpful for users to be provided with a preferred technique for determining the risk margin and the rationale behind that choice. Thus by reducing the range of options to establish the risk margin, this would enable the related guidance to be more specific and aid users.
Specifically we would draw attention to the work being carried out by the International Actuarial Association (IAA) in response to requests from the International Association of Insurance Supervisors (IAIS) for further guidance in this area. Clearly the proposals by the CRO Forum (F9.b) regarding the use of estimated cost of holding capital is gaining favour in the insurance industry, and therefore could be one that should be preferred by the Board.
Q4. What role should the actual premium charged by the insurer play in the calibration of margins, and why? Please say which of the following alternatives you support.
(a) The insurer should calibrate the margin directly to the actual premium (less relevant acquisition costs), subject to a liability adequacy test. As a result, an insurer should never recognize a profit at the inception of an insurance contract.
(b) There should be a rebuttable presumption that the margin implied by the actual premium (less relevant acquisition costs) is consistent with the margin that market participants require. If you prefer this approach, what evidence should be needed to rebut the presumption?
(c) The premium (less relevant acquisition costs) may provide evidence of the margin that market participants would require, but has no higher status than other possible evidence. In most cases, insurance contracts are expected to provide a margin consistent with the requirements of market participants. Therefore, if a significant profit or loss appears to arise at inception, further investigation is needed. Nevertheless, if the insurer concludes, after further investigation, that the estimated market price for risk and service differs from the price implied by the premiums that it charges, the insurer would recognize a profit or loss at inception.
(d) Other (please specify).
As a matter of principle, we have reservations about the recognition of profit at inception. However, we understand that theoretically, this gain or loss at issue is an intrinsic part of a current exit value model. Our concerns with using CEV for measuring insurance liabilities are outlined in our response to question 5.
Many observers point out that the level of profits recognised at inception would not be significant, especially as insurance markets are generally competitive. However, we believe that insurance markets are not necessarily ‘perfectly' competitive, with high barriers to entry and significant economies of scale. This coupled with the view that the general insurance markets in particular are subject to pricing cycles which when there is an up turn, we believe will result in profits at inception.
Accordingly we prefer the principle set out in (a), as we believe that profit at inception should be avoided in particular and also given our concerns over the use of CEV in general.
Should the Board retain CEV as the measurement attribute for insurance liabilities, we could lend support to method (b) where initial gains would be limited to those verified by positive evidence on available information, this being consistent with IAS39.
Q5. This paper proposes that the measurement attribute for insurance liabilities should be the amount the insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another entity. The paper labels that measurement attribute ‘current exit value&Rsquo;.
(a) Is that measurement attribute appropriate for insurance liabilities? Why or why not? If not, which measurement attribute do you favour, and why?
(b) Is ‘current exit value&Rsquo; the best label for that measurement attribute? Why or why not?
The implications of using CEV is a key area of concern given the bearing on other related issues in non-insurance financial reporting. Central to the insurance liability measurement debate is the conclusion on the Fair Value Measurement (FVM) discussion paper, and whether fair value is always equivalent to exit value.
We believe that CEV may work in highly traded markets, but insurance contracts are extremely specific, with no one contract being the same as another, and this makes the use of an exit value near impossible to observe.
As echoed by the CFO Forum, we believe that given that there is no market to offer a consensus view of future experience, the most relevant estimate is that developed by management who have non-financial data such as claim frequency and amounts. However this then points to the use of ‘entry' price at day one, as based on the actual premium, in a model aimed at being founded on exit price.
Given that the valuation will need to be done with reference to a management model for valuation of risks and projected settlement costs in the absence of a liquid transfer market, the term CEV would be better replaced by ‘current value&Rsquo;. This use of management information in the measurement of the insurance liability would mean increasing importance placed on disclosure and additional guidance in the insurance standard would be required.
Q6. In this paper, beneficial policyholder behaviour refers to a policyholder's exercise of a contractual option in a way that generates net economic benefits for the insurer. For expected future cash flows resulting from beneficial policyholder behaviour, should an insurer:
(a) Incorporate them in the current exit value of a separately recognized customer relationship asset? Why or why not?
(b) Incorporate them, as a reduction, in the current exit value of insurance liabilities? Why or why not?
(c) not recognize them? Why or why not?
We believe there are some merits to the approach described in (a). This view seems consistent with the general concept of presenting assets and liabilities separately.
However, we are of the opinion that all cash flows used in the measurement of the insurance liability should reflect all expected cash flows, including the impact of beneficial policyholder behaviour. As both the inflows and the outflows are contingent on the same event (the existence of the contact) we support approach (b).
Q7. A list follows of possible criteria to determine which cash flows an insurer should recognise relating to beneficial policyholder behaviour. Which criterion should the Board adopt, and why?
(a) Cash flows resulting from payments that policyholders must make to retain a right to guaranteed insurability (less additional benefit payments that result from those premiums). The Board favours this criterion, and defines guaranteed insurability as a right that permits continued coverage without reconfirmation of the policyholder's risk profile and at a price that is contractually constrained.
(b) All cash flows that arise from existing contracts, regardless of whether the insurer can enforce those cash flows. If you favour this criterion, how would you distinguish existing contracts from new contracts?
(c) All cash flows that arise from those terms of existing contracts that have commercial substance (i.e. have a discernible effect on the economics of the contract by significantly modifying the risk, amount or timing of the cash flows).
(d) Cash flows resulting from payments that policyholders must make to retain a right to any guarantee that compels the insurer to stand ready, at a price that is contractually constrained, (i) to bear insurance risk or financial risk, or (ii) to provide other services. This criterion relates to all contractual guarantees, whereas the criterion described in (a) relates only to insurance risk.
(e) No cash flows that result from beneficial policyholder behaviour.
(f) Other (please specify).
We would lend support to criterion a), for although agreeing with an allowance for future premiums, this has to be very much within the constraints of the contract. Thus any premiums as a result of, for example, renewal of the contract and which are not otherwise guaranteed, should not be recognised.
Q8. Should an insurer recognise acquisition costs as an expense when incurred? Why or why not?
We would support the Board approach whereby acquisition costs are fully expensed at inception with appropriate allowance then made in the prospective measurement of the contractual obligations.
This approach is certainly consistent with the use of CEV and therefore our support of this approach depends on the retention of the use of a CEV or current value model for valuing insurance liabilities.
Q9. Do you have any comments on the treatment of insurance contracts acquired in a business combination or portfolio transfer?
We do not see any need to treat the valuation of insurance contracts acquired in a business combination or portfolio transfer differently than other insurance contracts. Any additional asset should be recognised at fair value and goodwill calculated accordingly.
There could be a gain or loss on acquiring a block of insurance contracts, although there may be some implications for the risk margin depending on the approach taken to question 4. Any such gains or losses, after risk margins have been reassessed by the acquiring insurer, should be separately disclosed.
Q10. Do you have any comments on the measurement of assets held to back insurance liabilities?
We would agree with the Board's view that current estimate approaches for the measurement of insurance liabilities are the most appropriate as they provide more relevant and reliable information to users and essentially eliminates the potential for accounting mismatches that do not reflect the economic substance. Thus we believe that both financial assets and liabilities should be measured based on current values, with changes in value being recognised in a consistent way.
Q11. Should risk margins:
(a) be determined for a portfolio of insurance contracts? Why or why not? If yes, should the portfolio be defined as in IFRS 4 (a portfolio of contracts that are subject to broadly similar risks and managed together as a single portfolio)? Why or why not?
We believe that risk margins should be considered on a portfolio basis that are subject to similar risks and that are managed as a single portfolio.
With regards the subsequent question as to what level of aggregation should be used. Again we believe that the definitions used in IFRS4 when referring to a liability adequacy test for a ‘portfolio of contracts that are subject to broadly similar risks and managed together as a single portfolio' are appropriate. In practice risk margins for similar insurance risks are often managed by insurers at an aggregate level rather than on a contract by contract basis in order to stabilise expected cash flows.
(b) reflect the benefits of diversification between (and negative correlation between) portfolios? Why or why not?
We are also in agreement with the points made by the Board relating to some insurers reducing their risk through diversification between portfolios and therefore benefiting from negative correlation with other portfolios they manage (e.g. annuity versus term life insurance). The conclusion, that risk margins should not be adjusted to reflect these effects because CEV should be independent of the entity that holds the asset or liability, is reasonable.
Having accepted in part (a) that risk margins should be determined on a portfolio basis, then clearly those risk margins should be determined for each portfolio in isolation.
Q12.
(a) Should a cedant measure reinsurance assets at current exit value? Why or why not?
In principle we believe that reinsurance ceded assets should be measured consistently with the measurement of the underlying contract in order to ensure that the benefits and costs to the insurer are appropriately matched.
Therefore if the Board retains the use of the CEV approach to valuing insurance liabilities, it would be appropriate to measure the reinsurance asset accordingly.
(b) Do you agree that the consequences of measuring reinsurance assets at current exit value include the following? Why or why not?
(i) A risk margin typically increases the measurement of the reinsurance asset, and equals the risk margin for the corresponding part of the underlying insurance contract.
(ii) An expected loss model would be used for defaults and disputes, not the incurred loss model required by IFRS 4 and IAS 39.
(iii) If the cedant has a contractual right to obtain reinsurance for contracts that it has not yet issued, the current exit value of the cedant's reinsurance asset includes the current exit value of that right. However, the current exit value of that contractual right is not likely to be material if it relates to insurance contracts that will be priced at current exit value.
We agree that the above are the consequences of applying an exit value model to reinsurance assets.
Q13. If an insurance contract contains deposit or service components, should an insurer unbundle them? Why or why not?
We believe that a practical approach should be taken to the issue of unbundling insurance contracts. Whilst we understand the basic rationale for the Board favouring the approach of separating out the deposit and service components in insurance contracts, we believe that this is necessary in only certain types of insurance contracts and even in those cases is not always practicable.
Insurance products that lack significant insurance risk should be accounted for under existing IFRS4 as deposit/investment contract products and treated as financial instruments.
The type of products that are likely to carry significant insurance risk and also include a deposit component are primarily legacy life insurance business. Whilst this may be an area where unbundling allows for the substance of the contract to be more appropriately reflected in the financial statements, we believe that this will create significant complexity if indeed they must be unbundled. In addition to the burden on preparers we are unconvinced as to the benefits for users of such information.
We believe that the default position should in fact be to not unbundle, and would only support unbundling where the components are clearly not interdependent.
Q14.
(a) Is the current exit value of a liability the price for a transfer that neither improves nor impairs its credit characteristics? Why or why not?
(b) Should the measurement of an insurance liability reflect (i) its credit characteristics at inception and (ii) subsequent changes in their effect? Why or why not?
We do not believe that credit characteristics form part of the building blocks detailed in the DP, and therefore should not be used in the measurement of the insurance liability at inception.
ACCA have strongly opposed the inclusion in reported profits of the effects of changes in a company's creditworthiness reflected via the fair value of its liabilities. We therefore do not agree that credit characteristics should be reflected in the measurement of subsequent changes to insurance liabilities, and that this does not provide useful information to users.
Q15. Appendix B identifies some inconsistencies between the proposed treatment of insurance liabilities and the existing treatment under IAS 39 of financial liabilities. Should the Board consider changing the treatment of some or all financial liabilities to avoid those inconsistencies? If so, what changes should the Board consider, and why?
We are generally in favour of reducing the inconsistencies between accounting standards. Consistent treatment between the proposed treatment of insurance liabilities and the existing treatment of financial liabilities under IAS39 could be achieved by unbundling insurance contracts into their investment and insurance components. As set in our response to question 13 we are generally not in favour of this approach.
We would rather lend support to eliminating the differences in the accounting treatment of investment and insurance contracts which we consider as being some of the causes for current accounting mismatches. We believe that the Board's initiative on fair value is critical here. As this debate is currently in progress, we refrain from making any detailed comments on amendments we believe should be made to IAS39.
Q16.
(a) For participating contracts, should the cash flows for each scenario incorporate an unbiased estimate of the policyholder dividends payable in that scenario to satisfy a legal or constructive obligation that exists at the reporting date? Why or why not?
We believe that amounts relating to future policyholder distributions in respect of both the guaranteed and discretionary elements of participating contracts should be treated as liabilities based upon the expected future cash flows. Without this requirement it is likely that significant profits may be recorded at issue, which we are not in favour of.
(b) An exposure draft of June 2005 proposed amendments to IAS 37 (see paragraphs 247–253 of this paper). Do those proposals give enough guidance for an insurer to determine when a participating contract gives rise to a legal or constructive obligation to pay policyholder dividends?
We previously agreed with the proposed amendments relating to constructive obligations in IAS37 and that insurance liabilities should include a reasonable estimate of future dividends. However, we believe that further clarification is required on the guidance on constructive obligations and indeed whether the IAS37 proposals are sufficient and appropriate for contracts containing policyholder participation rights.
We also believe that this guidance would be equally well placed in the insurance contracts standard.
Q17. Should the Board do some or all of the following to eliminate accounting
mismatches that could arise for unit-linked contracts? Why or why not?
(a) Permit or require insurers to recognise treasury shares as an asset if they are held to back a unit-linked liability (even though they do not meet the Framework's definition of an asset).
(b) Permit or require insurers to recognise internally generated goodwill of a subsidiary if the investment in that subsidiary is held to back a unit-linked liability (even though IFRSs prohibit the recognition of internally generated goodwill in all other cases).
(c) Permit or require insurers to measure assets at fair value through profit or loss if they are held to back a unit-linked liability (even if IFRSs do not permit that treatment for identical assets held for another purpose).
(d) Exclude from the current exit value of a unit-linked liability any differences between the carrying amount of the assets held to back that liability and their fair value (even though some view this as conflicting with the definition of current exit value).
We believe that the Board should ensure that the view taken does not conflict with other IFRS requirements, thereby effectively ruling out (a) to (c). The Board's argument as outlined in paragraphs 282 to 284 for adjusting the liability appears to be reasonable, and does not necessarily over-ride the CEV approach. We therefore support (d).
Q18. Should an insurer present premiums as revenue or as deposits? Why?
An insurer should present premiums as revenues since insurance premiums are revenue or earnings received by the company in return for commitment to provide an insurance benefits that may become payable currently or in the future. We believe that in other circumstances, the provision of other services is accounted for as revenue, and so see no reason for this to be any different to insurance companies.
Q19. Which items of income and expense should an insurer present separately on the face of its income statement? Why?
We believe that it should be left to industry to prescribe in detail what should be shown on the face of the income statement. However we note that certain key items would necessarily have to be reflected in the income statements, such as revenue from premiums, claims, investment gains and losses, and other material items that may require separate disclosure.
More detailed disclosure in terms of net investment income that would separately report the investment income on assets supporting surplus and assets supporting liabilities would be useful to readers, as would more detailed information on changes in CEV liabilities as discussed in Question 20.
Q20. Should the income statement include all income and expense arising from changes in insurance liabilities? Why or why not?
We would agree with the Board that there does not seem to be a practical reason for excluding any changes in the carrying amounts of insurance liabilities from the income statement. We believe that this is consistent with the recommendations for assets held for sale under IAS39, as being valued at fair value through income statement.