18-19 November 2003, London

Tuesday, 18 November 2003

Business Combinations Phase I

Definition of Joint Control

In June 2003, the Board considered whether to modify the amendments it proposed in ED 3 to the definitions of joint control in IAS 28, Accounting for Investments in Associates, and in IAS 31, Financial Reporting of Interests in Joint Ventures. The Board noted that the definition proposed in ED 3 might be too narrow because it could be viewed as suggesting that a joint venture exists only when unanimous consent is required for all financial and operating decisions. On the other hand, the current definition may make it easier for an entity to structure a business combination as a joint venture to circumvent the proposals in ED 3, Business Combinations.

The Board considered the definition joint control from a G4+1 paper:

Joint control over an enterprise exists when no one party alone has the power to control its strategic operating, investing, and financing decisions, but two or more parties together can do so, and each of the parties sharing control (joint venturers) must consent.

The Board noted that based on the current definitions in IAS 31 of 'joint venture' and 'joint control', a business combination would be excluded from the scope of the IFRS resulting from ED 3, and therefore from the purchase method requirement, only if that combination results in the formation of reporting entity over which the owners of the combining entities or operations contractually agree to share control such that no single party is in a position to control the activities of the reporting entity.

The G4+1 definition of joint control differs from the existing IAS 31 definition in three respects:

• The G4+1 definition reflects the view that joint control can sometimes exist without a contract or even an explicit agreement.
• The IAS 31 definition applies broadly to economic activities while the G4+1 definition refers to enterprises.
• The G4+1 definition contemplates unanimous consent to strategic operating, investing and financing decisions while IAS 31 allows for the possibility that some such decisions might require only a majority of the venturers.

The staff recommended that the Board retain the existing definition of joint control in IAS 28 and IAS 31 and the related commentary in paragraph 6 of IAS 31, pending a more fundamental review of those Standards.

Some Board members expressed concern that not including a 'unanimous' criterion could lead to a combination being effectively accounted for as a pooling of interests. It was agreed to include this criterion in respect of the venturers and not any other shareholders.

Subsequent Measurement of Contingent Liabilities

ED 3 proposed that:

• Contingent liabilities recognised as part of allocating the cost of a combination should be measured after initial recognition at fair value, with changes in fair value recognised in profit or loss.
• The acquirer should measure the fair value of a contingent liability as the amount that a third party would charge to assume that contingent liability. Such an amount should reflect all expectations about possible cash flows and not the single most likely or the expected maximum or minimum cash flow.

The Board agreed to clarify that this requirement did not apply to certain items as follows:

The requirement in paragraph 46 does not apply to the following items assumed in a business combination:

• Financial instruments within the scope of IAS 39.
• Financial guarantees excluded from the scope of IAS 39 and required to be accounted for under IAS 37 as set out in paragraph 2(f)of IAS 39.
• Commitments to provide loans at below-market interest rates and required to be accounted for under paragraph 2(i)of IAS 39.

The staff recommended that the Board proceed with the proposal in paragraph 46 of ED 3 that contingent liabilities recognised as part of allocating the cost of a combination be measured after initial recognition at fair value, with changes in fair value recognised in profit or loss.

Some Board members had previously noted that this proposal is inconsistent with the accounting for financial guarantees under the proposed improvements to IAS 39, Financial Instruments: Recognition and Measurement, and suggested that contingent liabilities should be subsequently measured at the higher of their initially recognised amount or their value determined in accordance with IAS 37, Provisions, Conntingent Liabilities and Contingent Assets.

As there was uncertainty as to the future accounting under Phase II it was agreed to use the latter in the Phase I standard. This would not apply to contracts accounted for under IAS 39.

Measuring Value in Use

Where the price paid for the unit (part of the acquired entity) was based on projections that included a major restructuring expected to result in a substantial increase in the net cash inflows derived from the unit and there is no observable market from which to estimate the unit's net selling price, there is some concern that if the net cash inflows arising from the restructuring are not reflected in the unit's value in use, comparison of the unit's recoverable amount and carrying amount immediately after the acquisition will result in the recognition of an impairment loss.

Although the Board acknowledged the problem, they did not believe it could be adequately addressed at the moment. They concluded that the Basis for Conclusions should note that the best evidence of net selling price is the past transaction.

The second issue relates to an asset or unit that has been held for some time, but which the entity plans to abandon as part of a restructuring. The issue arises because of what some believe is a conflict (more precisely, a timing conflict) between the requirements in paragraphs 27(b)and 37 of IAS 36, Impairment of Assets. If a planned restructuring includes plans to abandon an asset or unit and the effects of that planned restructuring have been reflected in the financial budgets approved by management, but they have not yet met the criteria in IAS 37 Provisions, Contingent Liabilities and Contingent Assets for recognition as a liability, at issue is whether the value in use of the asset or unit:

a. should reflect the effects of the restructuring, which would give rise to an immediate impairment loss for the asset or unit; or

b. should reflect the continuing use of the asset or unit until the entity is committed to the restructuring. This would result in the impairment loss for the asset or unit being recognised at the same time as any restructuring provision is recognised under IAS 37.

The staff recommended that paragraph 27(b) be reworded as follows:

"Cash flow projections shall be based on the most recent financial budgets/forecasts that have been approved by excluding any estimated future cash inflows or outflows expected to arise from future restructurings or capital expenditure as described in paragraph 37. Projections based on these budgets/forecasts shall cover a maximum period of five years, unless a longer period can be justified; and...."

Measuring Value in Use Using Pre-Tax Cash Flows and Discount Rates

In July the Board considered respondents' and field visit participants' concerns regarding the requirement in IAS 36 to use pre-tax cash flows and pre-tax discount rates when measuring value in use. Many participants and respondents stated that using pre-tax cash flows and pre-tax discount rates will represent a significant implementation issue for companies because typically a company's accounting, corporate finance, planning/budgeting, and strategic decision making systems are fully integrated and use post-tax cash flows and post-tax discount rates to arrive at present value measures. The participants and respondents believe that the IAS 36 requirement to use pre-tax cash flows and pre-tax discount rates would prevent companies from integrating the value in use calculations with their existing internal management systems, and instead would oblige them to develop additional 'pre-tax' systems, separate from their existing integrated 'post-tax' systems. Although IAS 36 currently requires the use of pre-tax cash flows and pre-tax discount rates, the companies believe this issue is exacerbated by the proposal for the recoverable amount of cash-generating units containing goodwill and/or intangible assets with indefinite useful lives to be calculated at least annually.

The staff recommended that no amendments be made at this time to the requirement in IAS 36 to use pre-tax cash flows and pre-tax discount rates when measuring value in use. Any decision on the treatment of tax in value in use calculations should be considered as part of the conceptual project on measurement.

The Board agreed, and also agreed to include a discussion of the different ways this can be achieved in the Basis for Conclusions.

Treatment of Forward Contracts in a Business Combination

During the pre-ballot process for IAS 39, one Board member suggested that when an acquirer and vendor in a business combination agree the cost of the combination before the acquisition date (that is, before the date the acquirer obtains control of the acquiree), a forward contract arises that, in theory, should be accounted for under IAS 39, Financial Instruments: Recognition and Measurement. Board members considered this issue and agreed that it should not be dealt with as part of the Financial Instruments project. Instead, the issue should be considered by the Board in finalising Phase I of the Business Combinations project.

The staff recommended that the following amendment be added to the scope of IAS 39:

This Standard shall be applied by all entities to all types of financial instruments except:

"g. contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date."

A number of Board members expressed concern that this could be abused in other areas. Others believed that the reference to a business combination provided the necessary limitation. The Board agreed with the staff (11-3).

The Definition of an 'Operation'

The Board considered additional guidance on identifying when an entity or a group of assets or net assets constitutes an 'operation'. The staff recommended that the references to 'operations' should be replaced with references to 'business' and the term 'business' should be defined.

The staff proposed the following definition and related guidance:

Definition

A business is an integrated set of activities and assets conducted and managed for the purpose of providing:

a. a return to investors; or

b. lower costs or other economic benefits directly and proportionately to policyholders or participants.

A business generally consists of (a) inputs, (b) processes applied to those inputs, and (c) resulting outputs that are, or will be, used to generate revenues.

Guidance

The elements of a business will vary by industry and by how an entity structures its operations, but would normally include the following:

Inputs

Long-lived assets, including intangible assets, or rights to the use of long-lived assets.

Intellectual property.

The ability to obtain access to necessary materials or rights.

Employees.

Processes

The existence of systems, standards, protocols, conventions, and rules that act to define the processes necessary for normal operations, such as (i) strategic management processes,(ii) operational processes, and (iii) resource management processes.

Outputs

The ability to obtain access to the customers that purchase, or will purchase, the outputs of the transferred set.

If goodwill is present in a transferred set of activities and assets, the transferred set shall be presumed to be a business.

The assessment of whether a transferred set is a business shall be made without regard to how the transferee intends to use the transferred set. In other words, it is not relevant to the evaluation of whether the transferred set is a business whether the transferee will actually operate the set on a stand-alone basis or intends to continue using the transferred set in the same manner as the transferor.

The staff further proposed to relocate paragraph 14 of ED 3 to the beginning of the section in ED 3 titled 'Identifying a Business Combination' and amend it as follows:

The result of nearly all business combinations is that one entity, the acquirer, obtains control of one or more other businesses, the acquiree. If an entity obtains control of one or more other entities that are not businesses, the bringing together of those entities is not a business combination.

The Board agreed to incorporate the definition into the standard and include the presumption that if goodwill is present in a transferred set of activities and assets, the transferred set shall be presumed to be a business.

The staff indicated they would be proceeding with a pre-ballot draft of the three standards.

Three Board members indicated they would be dissenting to the package of standards.

Business Combinations Phase II

Earnings Per Share and the Effects of Transactions with Minority Interests

At its October 2003 meeting, the Board considered whether companies that present earnings per share information should be required also to disclose an additional per share metric that includes in the numerator the effects of equity transactions with minority interests. The Board considered this issue in the light of the FASB's decision to require such a per share measure. The Board agreed to discuss disclosure of the proposed additional per-share measure further at the November meeting.

The Board agreed to allow such an additional per share metric provided the same denominator used for the mandatory earnings per share is used. It was noted that this is required by IAS 33 although some rewording may be necessary.

Leases

The Board discussed the basis of a conceptual model for leases. It was proposed that the basis for lease accounting should be the analysis of contractual rights and obligations and the identification of resulting changes to assets and liabilities.

The staff, based on the above, made the following recommendations:

• Application of consistent asset and liability recognition principles in respect of assets owned, assets held under finance leases, and assets held under operating leases should provide more relevant, reliable, and comparable financial information than recognition principles that result in assets and liabilities only being recognised in respect of finance leases.
• Conceptually, the recognition of changes in assets and liabilities should not be limited to contracts that convey ownership rights or rights that are economically similar to outright ownership. The conveyance of rights to future economic benefits should be the focus of the conceptual model.
• Legal performance or transfer of legal ownership are not the most relevant points for recognising changes in assets and liabilities. The transfer of control of future economic benefits to the lessee, usually by delivering the leased property, is an economically significant act of performance by the lessor and an appropriate recognition point for changes in assets and liabilities.
• Assets and liabilities that arise from contractual rights and obligations under a lease should reflect the conveyance of the right of use and control of associated future economic benefits for the period of the contract (rather than conveyance of the whole of the physical property). It was recommended that only those future economic benefits controlled by the lessee are recognised (being the right to use the property for the lease term) and not to use the whole of asset approach (where the lessee recognises an asset equal to the entire value of the leased property and a liability being the obligation to return the leased property at the end of the lease term.)
• If a lease contract is freely cancellable by the lessee, the asset and liability amounts recognised by lessor and lessee should reflect both (i)the conveyance of the right of use up to the date at which the lease can be cancelled by the lessee and (ii)the lessee's option in respect of periods beyond that date.
• If a lease contract is freely cancellable by the lessor, the asset and liability amounts recognised by lessor and lessee should reflect both (i)the conveyance of the right of use up to the date at which the lease can be cancelled by the lessor and (ii)the lessor' s option in respect of periods beyond that date.

The Board agreed that the staff should continue researching the project based on the above recommendations.

The staff noted that they would anticipate an exposure draft in early 2007, although a discussion paper may be issued.

Share-based Payment

During the October joint meetings the Board considered the following:

• Whether, in the context of situations in which the measurement date for tax purposes is later than the measurement date for accounting purposes, the tax effects relate to an income statement item only, or to both an income statement item and an equity item, or to an equity item.
• If it is accepted that the tax effects relate to both an income statement and an equity item, how the tax effects should be allocated between the income statement and equity.

On the first issue, the Board agreed that the tax effects relate to both an income statement item and an equity item. This conclusion is based on what is often described as the 'two transaction view', i.e.. the tax deduction relates to two transactions or events, being:

a. a transaction in which the employees render services as consideration for options or shares, which gives rise to remuneration expense (an income statement item), and

b. an equity transaction/event.

The Board considered various allocation methods proposed by FAS 123, the FASB staff and the IASB staff. It was noted that the differences between the methods are:

a. The interpretation of tax legislation that bases the tax deduction on the difference between the share price and the exercise price at exercise date, i.e. whether this represents an intrinsic value or a fair value measurement basis for tax purposes. In addition a method that allocates tax benefits received, up to the tax benefits on the recognised expense (at a particular point in time), are recognised in the income statement and any excess tax benefits are recognised in equity.

b. The treatment of tax effects where the application of a later measurement date for tax purposes results in a lower tax deduction than would have occurred had that tax deduction been measured at grant date.

c. The recognition of the deferred tax asset between the date when the expense is recognised and the date when the tax deduction is received, including whether the current share price should be considered in measuring that deferred tax asset (for either recognition or impairment purposes)and whether a deferred tax asset should be recognised for the expected future tax benefits relating to the equity item.

The Board agreed as follows:

• The allocation is based on the tax benefit method.

• The write-down is charged to the income statement (9-4).

• The current share price should be used to determine the deferred tax asset and the deferred tax asset is recognised for the expected future tax benefits relating to both the income statement item and equity item.

The Board agreed that in the cash flow statement, the tax cash flows should be classified in a manner that is consistent with the recognition of the tax effects in the income statement and equity. This results in any tax income recognised in the income statement being classified in the cash flow statement as operating cash inflows and tax effects recognised directly in equity should be classified as cash inflows or outflows from financing activities.

The Board agreed that for the purposes of EPS calculations, the tax effects that would be credited or debited to equity should be included in the calculation of the assumed issue proceeds.

No Board member indicated they would be dissenting based on decisions to date.

Reporting Comprehensive Income

The Board discussed a review of the project. It was noted that there was growing support amongst users for the project. It was proposed that a discussion document setting out the reasons for the project and some of the significant issues being considered in the project should be issued. Some Board members queried what the purpose of the discussion document was meant to be. It is meant to be a discussion of all views and why the Board has tentatively concluded what it has in some areas. The Board agreed that a discussion paper should be developed for issue.

[See also the comments on this project under Improvements - Employee Benefits below.]

Wednesday, 19 November 2003

Amendments to IAS 32 and IAS 39, Financial Instruments

The Board discussed whether to include additional guidance to clarify what contracts to buy or sell non-financial items are within the scope of IAS 32 and 39. The Board agreed to include the following wording in paragraph 6 and 7.

There are various ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. These include:

a. when the terms of the contract permit either party to settle it net in cash or another financial instrument;

b. when the non-financial item that is the subject of the contract is readily convertible to cash.

A written option to buy or sell a non-financial item that can be settled in cash or another financial instrument, or by exchanging financial instruments, in accordance with paragraph 6(a) or 6(d) is within the scope of this Standard. Such a contract cannot be entered into for the purpose of making or taking delivery of the non-financial item in accordance with the entity's expected purchase, sale or usage requirements, because the option writer does not have the ability to require delivery.

Improvements to IFRS

Improvements - IAS 40, Investment Property and IAS 17, Leases

The Board discussed whether entities can classify property interests held under operating leases that qualify as investment property on a property-by-property basis. The staff proposed that this allowance be retained provided all investment properties are carried under the fair value option.

Some Board members queried whether the property by property operating lease choice should dictate the accounting policy choice for all investment properties.

In addition it was proposed that this would only be available at inception of the lease, to prevent operating leases over property that was owner occupied from being classified as investment property if there was a change in circumstances. In addition IAS 40 already deals with transfers between categories.

The Board agreed with the restriction in accounting policy but did not include the restriction on classification at inception only.

The Board previously decided to clarify that the fair value of a property interest held under a long-term lease, and classified as an investment property asset under the fair value model in IAS 40, should be determined by reference to the rights given by the lease, and that the obligation under the lease should be accounted for as a liability.

The staff proposed that IAS 40 clarify that a leasehold property interest is valued by reference to expected cash flows – both inflows and outflows – but without deduction for any outflows that are separately recognised in the balance sheet as a liability.

The Board agreed to include this in the standard.

Improvements to IAS 19, Employee Benefits

The Board considered how to proceed with the improvements to IAS 19 given that an exposure draft on Other Comprehensive Income will be delayed.

The staff proposed that IAS 1 should be amended to create a second performance statement similar to the statement of other comprehensive income (OCI) in the US and the statement of total recognised gains and losses (STRGL) in the UK. In addition IAS 19 should be amended to reflect both the Board's decisions in the project to date, including the immediate recognition of actuarial gains and losses, and also to require particular actuarial gains and losses to be recognised in OCI rather than in the income statement.

It was noted that this is not just a presentation issue but that other issues such as recycling and some measurement issues would also be addressed. Concern was also expressed that this may give the impression that the main Other Comprehensive Income project is halted.

It was proposed to allow entities to record the IAS 19 unrecorded smoothing effects in the IAS 1 alternate comprehensive income statement provided agreement can be achieved on the separation between amounts recorded in the income statement and those in the other comprehensive income statement.

Some Board members expressed concern as to the affects this may have. The Board asked the staff to consider the issue further and bring it back to the next meeting.

Improvements - General

The Board was asked to consider removing the references to 'benchmark' and 'allowed alternative' when standards are revised. The Board agreed that these references would be removing whenever possible and replaced with appropriate wording.

It was noted that IAS 31.33 expressed a preference for the benchmark treatment. Some Board members disagreed with this preference. The Board agreed that this could not be removed without due process but that it should be noted that this may change when accounting for joint ventures is considered.

Insurance Contracts Phase II

The Board considered a review of the project. Certain issues in measurement that remain troublesome to Board members, constituents, or both were noted. They are:

Deposit Floor

In finalising IAS 39, the Board concluded that the fair value of a liability with a demand feature cannot be less than the amount that a holder can demand. While the computation of this amount is straightforward, the resulting measurement would be unanimously rejected by the industry and the actuarial profession. Their arguments would be similar to those expressed by some banks in the context of macro hedging. The insurance industry is, however, in a somewhat different position than other financial institutions:

a. The accounting for insurance contracts is done on a closed-book basis. While the issue of renewal premiums (below) is difficult, insurers limit their computations to future inflows from a closed book of contracts. In contrast, banks argue that the fair value of deposit liabilities extends beyond the runoff of existing account balances.

b. Insurers incur significant costs in selling and underwriting contracts - well in excess of the costs incurred by other financial institutions. While this does not overcome the conceptual arguments for the deposit floor, it does magnify the effects of that floor.

c. Insurers recognise the risks of allowing early withdrawal, and the accompanying risks of allowing renewal at a fixed premium. They price their contracts with those risks in mind. However, they expect that policyholders will not all demand their surrender values at one time. They consider that possibility as unlikely – as unreasonable as the possibility that all policyholders will die tomorrow or file claims tomorrow equal to the maximum allowed under the contract.

d. The Board will have to consider the application of a deposit floor to insurance contracts and, if it decides that the floor does not apply, how insurance contracts differ from other financial contracts.

Intangible and Deferred Acquisition Costs (DAC)

Existing deferral-and-matching accounting models often record an amount equal to front-end costs as deferred acquisition costs or DAC. The Board previously rejected capitalisation, reasoning that those costs do not meet the definition of an asset. That decision was framed in the context of a measurement that was not constrained by a deposit floor. The significant initial costs incurred by an insurer might be characterised as an investment in an intangible asset. The intangible asset is unlikely to satisfy the recognition requirements of IAS 38. The Board will have to consider whether it should be constrained by those requirements in resolving the issues in this project.

Accounting for a separate intangible poses a number of practical and conceptual problems. Prospective measurement systems developed by actuaries treat the insurance contract as a single set of cash flows, the present value of which produces a single net amount. Allocating that amount to separate asset and liability balances, as in US GAAP or embedded value conventions, is an arbitrary process. Neither balance can be said to be the 'right' amount.

Instead, an accounting convention governs the liability, and the asset is the amount necessary to produce a net amount equal to the present value.

Renewal Premiums

Most existing measurement models for long-duration contracts are based on the present value of future premium inflows and claim outflows. As highlighted in the Issues Paper, the DSOP, and several Board discussions, those inflows and outflows do not meet the definition of assets and liabilities when considered alone. In January, the Board tentatively concluded that a measurement model should include those flows. However, some Board members expressed concerns about the implications of that decision for other accounting measurements.

Risk Premiums

Given the absence of observable market information, most measurements of insurance liabilities will be derived from estimates of the present value of future cash flows. The insurance industry and actuarial profession are accustomed to such measurements and should have the ability to make the estimates in most situations. However, an estimate of fair value includes the amount that marketplace participants demand for accepting risk. Many constituents have complained that the very absence of market information that leads to use of present value also makes it difficult or impossible to develop reliable estimates of the risk premium. In January, the Board concluded that this amount should be determined by calibrating the measurement against amounts that would be charged for new contracts with similar exposures and characteristics. Some may see this as an answer to a 'which market' issue, while others see it as a practical expedient. Either way, this answer has been criticised by actuaries as inconsistent with their understanding of the conceptual model.

Discount Rates and Investment Margins

The Board previously concluded that the measurement of an insurance contract should not include estimates of future investment margins. In effect, this means that the discount rate used to compute the present value of future cash flows cannot be based on expected asset returns. The rate, therefore, is the risk free rate, adjusted by the credit standing of the book of contracts. Again, most insurers and actuaries criticise this conclusion as inconsistent with the pricing of their contracts and the amounts at which observable prices for transfers (usually in business combinations) are computed.

Participating (with Profits) Contracts

In much of the world, long-duration contracts include a participating feature that requires the insurer to apportion its income between policyholders and shareholders. However, this feature works in a variety of ways, depending on the contract and the jurisdiction. For example:

a. The amount that must be apportioned varies with contracts and jurisdictions and, in some cases, is 100 percent.(In those cases, the shareholders, usually a parent company, benefit by charging the insurance subsidiary for services provided.)

b. An insurer may choose to apportion more than required by the contract and may be constrained to do so by competitive pressures, past practices, or promises communicated to policyholders.

c. Once apportioned, the amount may not be declared as a dividend to individual policyholders for some years. As a result, some policyholders may benefit from income earned before they entered into their contracts. Policyholders who die or surrender their contracts may or may not have rights to part of the apportioned amount.

d. In some jurisdictions, a dividend declared to individual policyholders cannot be taken back. In others, amounts may be allocated to individual contracts but can be taken back in the face of losses.

e. The basis for apportioning between policyholders and shareholders is often based on regulatory computations that do not mirror financial-reporting requirements.

The Board has yet to consider questions of participating contracts in depth. The issues described in the preceding paragraph suggest to some that those contracts may have characteristics of equity instruments, not unlike those of a non-controlling ownership interest.

Unbundling

Every insurance contract has elements of insurance and investment. An insurance contract always has a time element, in that premiums are 'invested' by the insurer in advance against the possibility of claims for future events. The insurer's ability to invest premium inflows in advance of claim outflows is a major part of its profitability. In some contracts, including most long-duration contracts, the cash flows attributable to the investment element are predominant. This suggests to some that the best accounting solution would be to separate, or unbundle, the contract into pure insurance and investment elements.

It was noted that there will be sufficient staff and Board resources to complete the project, and it is anticipated that there would be an exposure draft in June 2005.

The staff proposed to develop a 'knowledge book', which compares and contrasts the model developed to date (the fair value model) with other insurance accounting models currently employed in various national jurisdictions. This document would initially be compiled from materials developed by the IASC Steering Committee and by staff during the course of the project to date. It would then be added to over to time.

The Board accepted that proposal.

Staff noted that the Board would devote a block of two to three days to a re-education of the issues.

The Board agreed that some form of field visits should take place during the project.

Insurance Contracts Phase I

The Board started discussions based on comments received on ED 5. It was noted that the comments would be discussed at this and the next meeting.

The issues to be discussed at this meeting are:

• assets backing insurance contracts
• exemption from the hierarchy in IAS 8
• catastrophe and equalisation provisions
• derecognition
• disclosure
• reinsurance
• loss recognition
• insurance contracts acquired in business combinations and portfolio transfers

Assets Backing Insurance Contracts

Many commentators noted that there would be possible inconsistencies between the measurement of an insurer's assets and the measurement of its liabilities.

The possible inconsistencies arise as follows.

a. For many insurers, liabilities are a combination of deferrals of revenues, undiscounted estimates, and present-value amortisation schemes using interest rates unrelated to current market conditions. Any changes in the estimates underlying those liabilities that are recognised are reported in income of the period.

b. Most of the insurer's investment assets are debt and equity securities classified as available-for-sale (AFS).Under IAS 39 Financial Instruments: Recognition and Measurement, unrealised gains and losses on AFS assets (other than reported in equity.

The staff noted that the Board had previously taken decisions or tentative decisions or has not reached conclusions on issues that are relevant to this issue. These are:

• The fair value of a financial liability with a demand feature (for example, a demand deposit) is not less than the amount payable on demand, discounted from the first date that amount could be required to be paid (IAS 39 revised, paragraph 39B). For insurance contracts and many investment contracts marketed by insurance companies, this means that fair value of the insurance liabilities cannot be less than cash-surrender value (for life) or refundable premium (for general).
• The Board has not agreed on how to fair value insurance liabilities.
• The option to fair value a financial asset or liability does not extend to fair valuing a portion (e.g. one risk) of a liability.
• Transaction costs paid when incurring a financial liability adjust the carrying amount of the liability, if the liability is reported at amortised cost. The costs are not an adjustment if the liability is reported at fair value through profit or loss. ED5, however, does allow deferred costs to be reported as an asset when incurred in conjunction with an insurance contract.
• Arguably, transaction costs represent the amount paid to acquire an intangible asset. However, there is some question whether that asset meets the recognition criteria of IAS 38. If the intangible asset does qualify for recognition, it almost certainly does not qualify for remeasurement at fair value under IAS 38.

The Board considered the following potential approaches:

• Asset-based approaches
• Liability-based approaches
• Shadow accounting approaches
• Display alternatives
• Transition alternatives

Asset-based Approaches

Asset-based approaches operate by changing the measurement attribute of the asset from fair value to something that more closely resembles the measurement attribute of the liability. The phrase 'more closely resembles' is intentional. Existing insurance accounting models are not historical cost or amortised cost models. Most are a combination of measurement conventions that mix, to varying degrees, old and current information.

Most commentators have limited their suggestions for changes to an insurer's investments in debt instruments, although some have suggested that any approach should apply to investments in both equity and debt instruments.

Relax Held to Maturity

One asset-based approach would be to loosen the criteria for classification of an asset as held-to-maturity. In particular, they point to the 'tainting provisions' in IAS 39 that prohibit an entity from classifying 'any financial assets as held-to-maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity ...'. The tainting provisions are a way of ensuring that an entity only includes instruments that it has a positive intent and ability to hold to maturity.

An alternative is to retain the tainting provisions, but with one addition - an additional exception that would allow sales to meet required payments of policyholder benefits or claims.

A New Category of Assets

The second asset-based approach would be to create a new category of assets that could be reported at amortised cost - assets held to back insurance liabilities.

Liability-based Approaches

Some liability-based approaches might involve establishing a new category of 'available-for­settlement' liabilities (with changes in fair value reported in equity) or extending the fair value option available in IAS 39 to insurance liabilities. Other liability-based approaches may not necessarily be fair-value measurements, but are arguably closer to fair value than existing accounting conventions, as in the shadow accounting approach described below.

Shadow Accounting Approaches

Shadow Accounting - Part 1

The rationale for shadow accounting is that a recognised but unrealised gain or loss on an investment asset should have the same effect on the measurement of insurance assets (deferred acquisition costs) and liabilities that would have occurred had the gain or loss been realised. Stated differently, it is designed to record the knock-on balance-sheet effects of recognising unrealised gain or loss.

For example, in US GAAP the amortisation of deferred acquisition costs is based (for some contracts) on the gross profits expected to be earned over the life of a book of contracts. One element of gross profits is the total investment return from assets notionally held to back the policyholder liabilities. Realisation of an investment gain has the effect of accelerating some of that return from future periods to the current period and, as a result, accelerating amortisation of deferred acquisition costs. A realised investment loss may have the opposite effect, recapturing costs previously amortised. An unrealised gain or loss, in the rationale of shadow accounting, should produce the same result.

If an entity adopted shadow accounting, an unrealised gain or loss might affect the measurement of:

• Deferred acquisition costs;
• Policyholder liabilities; and
• Any liability recorded for participating (with-profits) contracts.

Shadow accounting extends the accounting for an unrealised gain or loss to mirror, or shadow, the accounting for a realised gain or loss. However, it cannot shadow accounting that is not there. ED5 leaves existing accounting models for insurance assets and liabilities in place. Many of those existing models do not include the effects of realised investment gains and losses in measuring insurance assets and liabilities. For example, shadow accounting would not result in any adjustment in the following situations:

• The insurance accounting model includes a lock-in requirement. The measurement of deferred acquisition costs or benefit/claim liabilities does not change when the entity realises gains and losses from investment assets, except for loss recognition when expected asset earnings will not support contract guarantees.
• The insurance model does not include any discounting of expected claim payments on general insurance contracts.
• The insurance model does not recognise any liability to distribute additional amounts to holders of participating contracts until the insurer declares a dividend to policyholders.

It was noted that if an insurer has net accumulated losses on available-for-sale securities. The insurer may be unable to 'share' those losses with holders of participating contracts. If so, there would be no shadow adjustment.

Shadow Accounting - Part 2

Some have suggested that a recognised but unrealised gain or loss on investment assets should be accompanied by an adjustment to the reported amount of insurance liabilities that would have been included in the measurement had the liabilities been recorded at fair value. If the unrealised gain or loss on investment assets is caused by a change in market interest rates, then one would expect an opposite (but by no means identical)effect on the fair value of insurance liabilities. This approach might be described as fair valuing for only one risk, interest rates, an approach that the Board rejected in its deliberations of IAS 39. It also may produce a liability measurement that is less than the deposit floor.

In support of this extension of shadow accounting, one might argue that it is a step toward fair value. If the Board settles on a fair-value measurement in phase 2, that measurement certainly will include current interest rates. However, insurance liabilities seldom represent fixed cash flows. A change in market interest rates may affect expectations about policyholder lapse. Unless the 'shadow' adjustment to liabilities included all of the effects of a change in interest rates, it might move the measurement away from fair value.

This extension of shadow accounting is not available under IAS 39 for investment contracts issued by insurers. An insurer company could, however, change its accounting policies to adopt a measurement of insurance liabilities based on current interest rates if it concludes that this change would satisfy the requirements in ED5.The accounting change would reduce the mismatch in equity, but might still leave a mismatch in profit or loss unless the effects of changes to investment assets and insurance liabilities reside in the same place – both in equity or both in income.

Display Alternatives

Some suggested an enhanced display of amounts arising from the mismatch. IFRSs already require that the amount of unrealised gains and losses on available-for-sale be presented as a separate item in the statement of changes in equity. It is there for all to see and evaluate.

Transition Alternatives

Some constituents have suggested that insurance enterprises should be exempted from IAS 39, pending completion of Phase 2 of the insurance project. They maintain that, until Phase 2 is completed, any changes to insurers' accounting should be kept to a minimum. In the extreme, this would involve a specific scope exemption for both an insurer's investment assets and its liabilities that do not meet the definition of insurance contracts (investment contracts). A more limited transition exemption might apply to investment assets only.

Permitting wider use of amortised cost models for some of an insurer's financial assets would be a step backwards. However, for an entity that has not yet taken the step forward onto IAS 39 from largely cost-based models, there might be an argument for considering a phased transition in some tightly constrained areas. Specifically, a first-time adopter might be permitted in phase I to use an amortised cost for fixed maturity investments that back insurance contracts and meet specified restrictions, provided that the first-time adopter did not measure those investments at fair value under its previous GAAP. Entities already on IFRSs could not use this approach.

The Board discussed each approach and identified potential concerns. A number of comments appeared to indicate that the Board would seek to require similar disciplines that are required for hedge accounting. It was also noted that any approach would be to cater for interest rate caused mismatches and consequently would not be available for equity security assets.

A number of Board members said that, for now, they did not support any solution proposed but would accept the staff exploring the issues further.

Exemption from the Hierarchy in IAS 8

The staff proposed that the exemption be retained but that the expiration in 2007 be removed. Concern was expressed that this was inconsistent with the approach in Extractive Industries project. The Board asked the staff to investigate the inconsistency and bring the issue back to the Board

Catastrophe and Equalisation Provisions

The staff recommended retaining the proposal that an insurer should not recognise as a liability any catastrophe provisions or equalisation provisions relating to possible future claims under future insurance contracts.

The Board agreed with the staff.

The staff proposed the following wording change to clarify that the phrase 'future insurance contracts' refers to contracts that are not in existence at the reporting date, rather than contracts that are not in existence at the date when an insurer first applies the IFRS on insurance contracts:

An insurer shall not recognise a liability for possible future claims under insurance contracts that are not in existence at the reporting date.

The Board agreed with the wording proposal.

Derecognition

The staff proposed that there be no changes in this area. The Board concurred.

Disclosure

The staff proposed to delete the requirement that an insurer should disclose the fair value of its insurance liabilities and insurance assets. The ED had proposed to require this disclosure starting in 2006. The Board agreed.

The staff proposed clarifying the status of the Implementation Guidance on disclosure, by adding the following paragraph:

The guidance in paragraphs [IG7-61 ] suggests possible ways to apply the disclosure requirements in paragraphs 26-30 of the IFRS. An insurer would decide in the light of its circumstances how much detail it would give to satisfy those requirements, how much emphasis it would place on different aspects of the requirements and how it would aggregate information to display the overall picture without combining information that has materially different characteristics. To satisfy the requirements, an insurer would not typically need to disclose all the information suggested in the guidance. Paragraphs [IG7-61 ] do not create additional requirements.

The Board agreed.

Reinsurance - Restrictions on Gains at Inception of Reinsurance Contracts

Paragraph 18 of ED 5 attempted to limit the reporting of gains when an insurer buys reinsurance for insurance liabilities that are measured on an undiscounted basis or with excessive prudence. The gains would arise from the fact that the reinsurance premium is likely to reflect the time value of money and a realistic assessment of the cash flows.

The staff proposed that paragraph 18 be deleted and replaced with a specific requirement for a cedant to disclose the extent to which profit or loss includes gains that arose at inception of reinsurance contracts. If it is impracticable to determine the amount of some of those gains, the cedant should disclose that fact and disclose the amount of those gains that it can determine practicably.

The staff noted that this needed further research and would be brought back for future consideration. The Board indicated some support for the proposal.

Impairment

The staff will recommend that paragraph 19 of ED 5 should be replaced by the following, based on the impairment test in IAS 39:

If a cedant's rights under a reinsurance contract are impaired, the cedant shall reduce their carrying amount accordingly. Those rights are impaired if, and only if:

a. there is objective evidence as a result of an event that occurred after initial recognition of the rights that the cedant may not receive all amounts due to it under the terms of the contract; and

b. that event has a reliably measurable impact on the amounts that the cedant will receive from the reinsurer.

The Board agreed.

Loss Recognition

The staff proposed adding explicit confirmation that:

a. If an insurer's loss recognition test meets the minimum requirements specified in paragraph 11 of ED 5,the test is carried out at the level of aggregation specified in that test.

b. If insurer's loss recognition test does not meet those minimum requirements so that it has to use IAS 37 Provisions, Contingent Liabilities and Contingent Assets as the loss recognition test, the comparison of carrying amounts with IAS 37 is made at the level of a portfolio of contracts that are subject to broadly similar risks.

Some commentators requested more guidance on the cash flows to be considered in an acceptable loss recognition test, and the discount rate to be used. In addition, some suggested that the Board should specify that the cash flows considered in a loss recognition test should include the effect of embedded guarantees and options.

The staff proposed that the Board should not add further guidance on cash flows and discount rates. The Board agreed.

It was noted that some commentators suggested that the inclusion of embedded options and guarantees in the cash flows used for a loss recognition test could permit the Board to exempt some embedded derivatives from fair value measurement under IAS 39. The staff will prepare an example for further discussion in December.

Insurance Contracts Acquired in Business Combinations and Portfolio Transfers

The staff proposed retaining the fair value approach in ED5. The Board concurred.

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