Insurance Contracts Phase I

Definition

The staff proposed that insurance contracts be defined as follows:

An insurance contract is a contract under which one party (the insurer) accepts significant insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary (other than an event that is only a change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or other variable).

The definition was discussed and the following points were made:

• Once the definition is finalised, it will replace the definition of insurance or insurance contracts in other Standards. Any Standard that scopes out insurance entities will be amended to scope out insurance contracts where relevant.
• A previous version of the definition referred to "similar variable" at the end. Comment was made that the change to "other variable" created a circular definition with the exclusion of insurance contracts in the financial instruments Standards. It was proposed that the previous wording should be used.
• An alternative proposal was that the definition should exclude "financial risks", which would be those variables that affect everyone when they change as opposed to variables that only affect one party (or a small group) when they change.

The definition will be examined by the staff and submitted back to the Board at a future meeting.

Insurable Interest

For a contract to be classified as an insurance contract, there needs to be an insurable interest. Some Board members expressed concern that this should only arise on inception to avoid a requirement to constantly examine for an insurable interest thereafter. Thus if a payment under the contract is not linked to an actual loss, the contract would not be an insurance contract but would more likely be a financial instrument.

Insurable Risk

To qualify as an insurance contract, there should be a reasonable chance of insurance risk arising. This will be defined based on factors such as the probability of the risk arising and the possible amount of the effect.

Reinsurance

Reinsurance contracts will be treated as insurance contracts subject to their meeting the definition. No special traetment is proposed for reinsurance contracts.

Reclassifications

A contact will be treated as an insurance contract from when it meets the definition of an insurance contract and for as long as it meets the definition.

Scope Exclusions

The Board agreed that the following would be excluded from being insurance contracts:

• financial guarantees, including credit insurance. The reasons for this exclusion need to be articulated and compared to the final definition of insurance contracts;
• product warranties issued directly by a manufacturer, dealer or retailer. Those issued by a third party would be included;
• employers' assets and liabilities under employee benefit plans, including equity compensation plans;
• retirement benefit obligations reported by defined benefit retirement benefit plans;
• contingent consideration payable or receivable in a business combination;
• contractual rights or contractual obligations that are contingent on the future use of, or right to use, a non-financial item (for example, certain licence fees, royalties, contingent lease payments and similar items), as well as a lessee's residual value guarantees embedded in a finance lease. Residual value guarantees under operating leases would be classified as insurance contracts;
• contracts for which the issuer is permitted or required to settle its obligations by:
  — acquiring new financial liabilities or equity instruments to be issued by the holder of the contract if the insured event occurs, or
  — issuing equity instruments as defined in IAS 32.
  (This is subject to the final wording of the definition of insurance contracts).

Recognition and Measurement

The Board agreed that paragraphs 5 and 6 of IAS 8, which state how accounting policies should be determined in the absence of a Standard, would be scoped out for insurance contracts.

Existing Practices

• Catastrophe Provisions - Will not be allowed.
• Loss Recognition Costs - It is proposed that if there is a loss recognition requirement in local GAAP that does not smooth the effect of the loss and that is based on a current estimate of future cash flows, that requirement should be applied. Otherwise IAS 37 should be applied to determine a minimum liability.
• Embedded Value - If it is acceptable in local GAAP, then it can be used.
• Offsetting of Reinsurance - Reinsurance should be accounted for on a gross basis and not offset.
• Measurement Basis on Reinsurance - The taking of reinsurance would not change the measurement basis of the original insurance contract, but it may provide greater information in determining measurement.
• Uniform Accounting Policies - An entity's use of uniform accounting policies for all insurance contracts will not be required if its past practice has been otherwise; but there will be a requirement to disclose the different components subject to the differing policies.

Thursday, 24, October 2002:

Concepts: Asset and liability approach - is linkage needed?

The Board characterised its discussion as educational and focused on whether a definitive principle on linkage could be developed whereas contracts that should be linked and contracts that shouldn't be linked are accounted for appropriately. That is, the Board acknowledged that there are circumstances when separate contracts should be linked (e.g. brag-a-watt energy contracts) and circumstances when separate contracts should not be linked even though they are in contemplation of one another (e.g. variable rate debt with an interest rate swap to fixed).

The Board noted that a principle on linkage should require that the transferor look also to the rights of the transferee to determine whether the separate contracts have economic substance apart from each other. One member noted (and several others agreed) that linkage may be too broad and that a more appropriate principle would be one of identifying "interdependent transactions".

The Board addressed a situation where a series of contracts were structured so that for tax purposes the contract was a liability at the subsidiary level and equity at the consolidated level. While the Board did not conclude, there was significant opposition to the fact that the classification could be different between entities in the same consolidated group. The Board will discuss this further at a future meeting.

The Board then focussed on the following situations and expressed individual views on whether the criteria developed by the staff appropriately linked or appropriately did not link the transactions:

• Forward to buy a fixed number of own shares and a second forward to deliver a fixed number of own shares for a variable amount of own shares based on the value of the shares:
  —Without linkage, both contracts are individually accounted for as derivative instruments under proposed amendments to IAS 39. With linkage, the combined package is equity; however, the portion related to the present value of cash flows would be carved out of equity and recorded as a liability (under the proposed amendments to IAS 39).
• Non-financial asset is sold to a third party with a repurchase option on that specific asset for sales price plus interest:
  —Board determined that this series of transactions is not substantive as the transferee does not truly own the asset, but in substance has received collateral for its receivable.
• Non-financial asset is sold to a third party with a repurchase option on a similar asset for sales price plus interest.
• Sale of energy forward to buy and sell at the same price:
  —The Board stated this is a gross vs. net issue and should be addressed in the concepts on revenue recognition, not linkage.
• Company A makes a fixed loan to Company B, while Company B makes a variable loan to Company A. The substance of this agreement is that both have entered into an interest rate swap:
  —The Board recognised that this model occurs from the mixed attribute model in current IFRS literature. That is, the loans are at cost, but the swap is a fair value. Several members believe these two contracts should not be linked.
• Company A issues floating rate debt to Bank B and at the same time enters into a contract with Bank B to swap the floating rate debt to fixed:
  —The Board expressed concern that linkage may be used to override a derivative being accounted for under IAS 39. Therefore, several Board members believe these contracts should not be linked.

The Board concluded that the next step in this project would be to develop a general principle out the criteria noted by the staff. The Board asked the IFRIC to continue to work on this project so that such principle developed can be tested during the IAS 32/39 re-deliberations. The intention, however, is that at some point, the IASB will take the project over from the IFRIC.

Consolidation and Special Purpose Entities

The IASB staff updated the Board on decisions made by the FASB at its recent meetings. A summary of such meetings can be found on the FASB's Website. Notably, the FASB has moved away from its previous position that an entity needs a "majority" of the risks and rewards to consolidate, changing instead to "significant" risks and rewards. The FASB also decided to remove the scope exception for entities consolidated by other entities. The IASB Board and Staff initially concurred with these decisions.

The Board noted that the tension points in this project are in the leasing literature and in the derecognition model in proposed amendments to IAS 32/39. However, the leasing model cannot be fixed as part of this project. The Board also discussed whether risk is measurable in order to make the significance test or majority test workable. The Board eventually concluded that risk is measurable; however, such measurements could be impractical and may be applied inconsistently.

The Board noted that there are the following 4 models that could be developed independently:

• Who has the risks,
• Who has the rewards (or combination of these two),
• Continuing involvement, and
• Components approach.

Several Board members raised the question of whether a guarantee of the risks of an SPE by an insurance company or other unrelated entity would force de-consolidation by the parties to the SPE or consolidation by the guarantor. No conclusions were reached; however, several members expressed views that would not require consolidation on these terms.

Board members also noted that the model developed for recognition of an SPE is inconsistent with the model for normal asset recognition. That is, a company would record the assets and liabilities of an SPE when it has the risks of ownership, but would record an asset when it has probable future benefit. The Board acknowledged that this inconsistency would remain under any of the proposed models.

The Board noted that SIC 12 currently uses, in combination, several of the models noted above. However, SIC 12 uses the term majority. The Board stated that the intent of SIC 12 was not on who has the majority, but on the notion of probable future losses and the sensitivity to losses. The Board decided to request that the IFRIC clarify the use of majority in a limited project on the application of SIC 12. This IFRIC interpretation should be completed in the near term (timing may be potentially consistent with the FASB's issuance of their SPE project).

Convergence

The Board addressed the logistical challenges to be faced by companies adopting IFRS in 2005 based on the large number of changes to existing standards and the issuance of new standards. The Board will attempt to stagger the effective dates up to 2005 to ease this concern.

The Board noted that several items in the convergence project conflict with the improvements project and will attempt to work with the FASB to address these issues. The staff noted that the Board will address specific issues during its November 2002 meeting.

Business Combinations Phase II

The IASB approved expanding the scope of its Business Combinations Phase II project to include the following minority interests issues:

• Decreases in the parent's ownership interest after a business combination (both with and without loss of control).
• Display of minority interests in the consolidated income statement or statement of changes in equity.

• Should businesses or other non-monetary assets exchanged for an interest in a subsidiary be accounted for at fair value at the date of the transaction or at previous carrying amounts?
• How should any gain or loss arising on the transaction be reported?

A discussion by the FASB whereby they agreed to provide the following guidance to clarify that recording a loss allowance for the estimated uncollectible amounts is not appropriate at the date of acquisition was noted: "Acquired receivables (including loans) would be measured at fair value at the date of acquisition; thus, a separate allowance for uncollectible amounts would not be established upon initial recognition of those receivables." The Board agreed that this direction would be followed in the IASB project.

The Board noted a FASB decision that acquired assets should be measured at fair value less costs to sell if, at the date of acquisition, the assets meet the criteria in paragraph 32 of FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, for classification as assets held for sale. The IASB believed this arose out of the US "assets held for sale" concept, which does not exist in IAS literature. Consequently the IASB does not plan to follow the same route.

Performance Reporting - Post Employment Benefits

The IASB agreed that in presenting returns on plan assets all returns would be included in the "valuation adjustments" column of the performance reporting project. This would be subject to final decisions in that project. Presentation of items arising under the liability calculation would be finalised later but there appeared to be a preference to include service costs and interest costs in the "initial measurement" column with other changes going to the "valuation adjustments" column.

The IASB agreed that unvested benefits in post employment benefit plans should be allocated over the vesting period on a straight-line basis prior to discounting.

Wednesday 23 October 2002:

Concepts: Revenue Recognition

All members of the Board were present for much of this discussion. Joining the discussion were two staff members from the US Financial Accounting Standards Board. The basis for the Board's paper was a FASB paper presented to the FASB Board earlier. It is the intention of both the FASB and IASB to look at case studies in their November meetings.

The purpose of this project is to develop criteria for revenue recognition that are based on changes in assets and liabilities that are consistent with the definitions of assets and liabilities in the current IASB Framework. A potential result of this project is that the definitions of assets and liabilities may be amended.

This meeting was a first step in the deliberations and focussed on developing a "working definition" of revenue. Broadly, revenues are defined as activities that either (1) increase assets and net equity, or (2) decrease liabilities and increase net equity. [As the Board papers were not available to the observer, this definition does not represent the actual drafting in the paper, but a paraphrase of that definition.]

Some members noted that, under the working definition of revenue that sales of receivables could be considered revenue at the gross amount, while sales of inventory at a negative margin would not be considered revenue as it would decrease net equity. The staff noted these observations and will adjust the working definition of revenue in a future Board paper.

One Board member noted that under the proposed model, the percentage of completion method would not be appropriate unless the buyer records an asset for the item being constructed or improved. The Board concurred with this observation and was satisfied with the result.

The Board discussed the notion of deferred revenue and concluded that the obligation to perform services that result in deferred revenue meets the definition of a liability. However, the Board noted that the amount at which the obligation should be recorded would not necessarily equal the amount of cash received. The Board did not discuss what the balancing account would be when, for example, cash of 100 was received, but the obligation to perform was 75 (or 125).

The Board noted that at a future meeting, gains must be distinguished from revenue. One Board member suggested that the UK ASB's project on revenue should be used as a basis for this research.

The Board concluded that each standard would identify the relevant attribute method for recognition and measurement of assets and liabilities (cost or value). The Board also concluded that, in order for revenue to be recorded, it must be measured with "sufficient reliability".

After analysis of case studies at the November 2002 meeting, the IASB and the FASB will work together on formulating a series of joint papers for the respective Boards.

Performance Reporting

The Board discussed the columnar distinction (income flows vs. valuation adjustments) that is fundamental to the IASB/ASB proposed statement of comprehensive income. One Board member noted his strong objection to the proposed model, as he viewed it as institutionalising pro forma reporting. The Board directed the staff to prepare a paper based on that Board member's proposed alternative to be discussed at a future meeting.

The Board discussed the current staff proposal and answered the following presentation issues:

Some Board members expressed concern with the current labels on the columns and were clear to state that the current labels are a work-in-process and may be revised in the future. One suggestion was to have column 1 be initial measurement and column 2 to be remeasurement.

The Board also discussed where an item should be presented when it is not clear which column it should go into. The staff noted that it is discussing a predominance test (what is the item predominately made of — value change or initial measurement). The ASB staff noted that when in doubt, the staff believes the item should be recorded in column 1.

This summary is based on notes taken by observers at the IASB meeting and should not be regarded as an official or final summary.