Background and Scope of Phase I Project
In May 2002, the IASB agreed to split the insurance contracts project into two phases, so that some components of the project can be put in place by 2005 without delaying the rest of the project. The first phase addresses the application of existing IFRSs to entities that issue insurance contracts. The Board discussed whether each of the following issues should be identified as matters to be addressed in the first phase:
1. Agree on a definition of insurance contracts. The existing definitions in IAS 32 and IAS 39 are not consistent with those in IAS 37 and IAS 38, and also are not consistent with certain aspects of the definition of insurance contracts used in US GAAP.
2. Presentation and disclosure, including consideration of how insurers might give the disclosures about measurement assumptions proposed by the Improvements Project to be added to IAS 1.
3. Implementation guidance for applying IAS 39 to those contracts issued by insurers (as well as other financial institutions) that do not qualify for the insurance contracts scope exclusion of IAS 39 -- particularly guidance with respect to embedded derivatives such as renewal options and participation features.
4. Provide guidance on identifying and measuring derivatives that are embedded in insurance contracts, including guidance on which such derivatives are 'closely related' to their host insurance contract.
5. Elimination of a limited number of existing practices that are incompatible with the IASB Framework, for example, the elimination of catastrophe and equalisation provisions that do not represent liabilities as defined in the Framework.
6. A review of the implications to insurance entities of the hierarchy of pronouncements that an entity is required to consider in the absence of an IFRS. The IASB has proposed to add that hierarchy as part of its improvements to IAS 8.
7. Derecognition -- guidance on applying the proposed 'no continuing involvement' derecognition approach to insurance contracts.
8. Guidance on accounting by policy holders.
Summary of ED 5
On 31 July 2003, the IASB issued ED 5, Insurance Contracts, setting out the Board's proposals in Phase I of a two-part project. ED 5 provides guidance on applying existing IFRS to accounting insurance contracts and requires additional disclosures. This publication summarises the proposals in ED 5.
Background
When the IASB took over from the IASC in April 2001, it inherited a comprehensive project on accounting for insurance contracts that the IASC started in April 1997. The IASC had published an issues paper in November 1999.
The IASB continued the work that the IASC had begun but realised that it was not feasible to complete the comprehensive project in time for the adoption of IFRS by European listed companies in 2005. Nonetheless the IASB recognised that some guidance is needed before 2005 because accounting for insurance contracts under IFRS at the moment is diverse and quite unique relative to other industries. Also, the existing IFRS that are most relevant to accounting for insurance contracts (IAS 32, 37, 38, and 39) exclude insurance contracts from their scopes.
So in May 2002 the IASB split its insurance contracts project into two phases. Phase I, from which ED 5 emanates, will provide guidance in time for the 2005 changeover to IFRS in Europe. Phase II will be the comprehensive project. The comment deadline on ED 5 is 31 October 2003.
Proposed effective date
Periods beginning on or after 1 January 2005, except the fair value disclosure requirement would be deferred until 31 December 2006 (and comparative 31 December 2005 fair value disclosures would not be required).
Definitions
An insurance contract is a contract under which an insurer accepts significant insurance risk by agreeing to compensate the policyholder or other beneficiary for the adverse effect of a specified uncertain future event. An insurance risk is a risk other than a financial risk. A financial risk is a risk of a possible future change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable.
Scope of ED 5
- Applies to all insurance contracts, including reinsurance contracts. That is, this standard does not relate just to insurance companies.
- Does not apply to other assets and liabilities of issuers of insurance contracts, although other IFRS would apply.
Recognition and measurement of insurance liabilities
Catastrophe and equalisation provisions. These are prohibited because they do not reflect loss events that have already occurred and, therefore, are inconsistent with IAS 37.
Loss recognition testing. An insurer is required to carry out a loss recognition test relating to losses already incurred at each balance sheet date. If the test shows that the measurement of its insurance liabilities (net of related deferred acquisition costs and intangible assets) is insufficient, adjustment of the liabilities is recognised in net profit or loss. While the ED would require that current estimates of future cash flows be used in the loss recognition test, it does not specify which cash flows should be included and whether and how to discount them:
- If the insurer's existing accounting policies use this type of loss recognition test, ED 5 won't change the policies.
- However, if the insurer's existing accounting policies have not required this type of loss recognition test, then the ED would require that the principles of IAS 37 be followed. Guidance for doing so is included.
Applying IAS 39
Embedded derivatives. IAS 39 applies to derivatives embedded in an insurance contract unless the embedded derivative is itself an insurance contract. ED 5 would not change that. However, ED 5 expressly provides an exception that an insurer need not separate, and measure at fair value, a policyholder's option to surrender an insurance contract for a fixed amount. That exception does not apply if the surrender value varies based on the change in an equity or commodity price or index.
Unbundling deposit components of insurance contracts. If an insurance contract contains both an insurance component and a deposit (investment) component, the deposit component must be treated as a financial liability or financial asset under IAS 39. As a result, the insurer would not recognise premium receipts for the deposit component as revenue. ED 5 clarifies that the measurement at fair value of a demand feature (such as a demand deposit) is no less than the amount payable on demand and that cash surrender and maturity values of many traditional insurance contracts would not generally be classified as a deposit component.
Derecognition. The derecognition provisions of IAS 39 should be applied to insurance liabilities. Therefore such liabilities cannot be removed from the entity's balance sheet until discharge, cancellation, or expiry.
Applying the requirements on offsetting in IAS 1 and IAS 32
- Assets under reinsurance contracts cannot be offset against related insurance liabilities.
- Income and expense from reinsurance contracts cannot be netted against related expense or income from the underlying insurance contracts.
Accounting policies: issues relating to IAS 8 (as proposed to be revised in the Improvements Project)
One purpose of the IFRS that will result from ED 5 is to lay some groundwork that will help insurers in their future transition to a Phase II standard (see last section of this newsletter) and, at the same time, discourage accounting changes that may need to be reversed when Phase II is completed. With those objectives in mind, ED 5 would:
- Suspend until 2007 the hierarchy of authoritative guidance on IFRS that will be added to IAS 8. The reason for the suspension is that, given the diversity of existing accounting practices for insurance contacts and the inconsistency of those practices with accounting in other sectors, the Board feared that the hierarchy might impose unintended and potentially undesirable changes in insurance accounting before Phase II is finished.
- Prohibit changes in accounting policies for insurance contracts unless the change clearly makes the financial statements more understandable, relevant, reliable, and comparable as judged by the criteria in IAS 8.
Other things ED 5 does not do:
- Does not require discounting or prohibit the use of a discount rate that reflects the estimated return on the insurer's assets to measure the insurer's liabilities.
- Does not try to eliminate excessive prudence (the existing result of influence of regulatory reporting on GAAP).
- Does not prohibit or require deferral of policy acquisition costs.
- Does not require all insurance subsidiaries of a single parent to use same accounting policies.An insurer cannot change the measurement basis for its insurance liabilities simply by the purchase of reinsurance.
Disclosure
ED 5 proposes the following disclosures, among others:
- Accounting policies for insurance contracts and related assets, liabilities, income, and expense.
- Amounts and other details of assets, liabilities, income, expense, and cash flows relating to insurance contracts.q Fair values of insurance assets and insurance liabilities (starting 1 January 2006).
- Significant assumptions and changes in them.
- Risk management policies.
- Those terms and conditions of insurance contracts that have the most significant effect on cash flows.
- Information about insurance risk, including the sensitivity of reported profit or loss and equity to changes in key variables, significant risk concentrations, and actual claims compared to previous estimates.
- Information about interest risk and credit risk, including risks related to embedded derivatives.
What is the Board's leaning in Phase II?
The Board favours an asset and liability model that requires an entity to identify and measure directly individual assets and liabilities arising from insurance contracts, rather than deferrals of inflows and outflows. Under that model, insurance contract assets and liabilities would be measured at fair value (which involves discounting), except that:
- entity-specific assumptions and information may be used to determine fair value if market-based information is not available; and
- the estimated fair value of an insurance liability shall not be less, but may be more, than the entity would charge to accept new contracts with identical terms and remaining term from new policyholders.
Click for A PDF Version of this Summary of ED 5 (PDF 46k).
Executive Briefings on ED 5
In August 2003, Deloitte Touche Tohmatsu published three Executive Briefings on IASB Exposure Draft ED 5, Insurance Contracts:
Initial Consideration of Comments on ED 5 - November 2003
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 discussed at this meeting were:
- 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 are 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.
Discussion at IASB Meeting December 2003
Assets backing insurance liabilities
The staff noted that the Board had requested the staff to research why insurers cannot classify a higher proportion of their fixed-maturity investments as held-to-maturity. The staff reported that there appeared to be two main reasons:
- If the asset liability management (ALM) involves duration matching, the portfolio needs to be rebalanced periodically to remain within the ALM targets. This would involve, for example, selling bonds that have deteriorated beyond the level the insurer has undertaken or is required to maintain.
- For a life insurer, lapses could change at any duration. Thus, the insurer needs to keep an adequate buffer as available for sale at each duration. For example, for a twenty-year liability, a 2.5%buffer for each year would add up to 50%.
In addition the staff noted the Board had requested research into three potential approaches, these being:
- (a) Relax the criteria for classifying a fixed-maturity asset as held-to-maturity and the related 'tainting provisions' in IAS 39. The tainting provisions are a way of ensuring that an entity classifies a financial asset as held-to-maturity only if the entity has a positive intent and ability to hold the asset to maturity.
- (b) Create a new category of fixed-maturity assets that could be reported at amortised cost - Assets Held to Back Insurance Liabilities.
- (c) Adjust the measurement of interest-sensitive insurance liabilities to reflect changes in interest rates that also have a corresponding effect on the fair value of fixed-maturity financial assets that are designated as backing those liabilities (and are carried at fair value and meet various restrictions to be determined).
The staff recommended the Board reject approach a and b above and continue discussions with insurers to assess whether approach c can be made workable.
It was noted that certain Board members believed there was no evidence insurers were matching insurance liabilities with assets at the level discussed and consequently no mismatch problem existed for which a solution was necessary.
The Board indicated a preference for a liability-based solution rather than an asset based solution (10-4).
The staff noted they would be meeting with representatives of certain insurance entities to pursue any potential solution taking the Board's guidelines into account.
Shadow accounting
The staff noted that 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.
The staff recommended that the Board confirm explicitly that an insurer may (but is not required to) change its accounting policies so that a recognised but unrealised gain or loss on an asset affects the measurement of related insurance liabilities (and deferred acquisition costs) in the same way that a realised gain or loss does. If the unrealised gains or losses are recognised directly in equity, the related adjustment to the insurance liability or deferred acquisition costs should also be recognised in equity.
The staff further recommended that the Basis for Conclusions clarifies that shadow accounting is not the same thing as fair value hedge accounting and will not usually have the same effect.
The Board agreed with the staff's recommendations.
Temporary exemption from the hierarchy
The staff noted that the Board had previously requested clarification as to why ED 5 and the draft Exposure Draft on Exploration for and Evaluation of Mineral Resources take different approaches to the hierarchy.
The Board did not discuss this in detail but agreed with the staff recommendation that the Board should:
- Maintain the temporary exemption from paragraphs 5 and 6 of IAS 8.
- Delete the 'sunset clause', so that the exemption would not expire in 2007.
Changes in accounting policies
The staff noted that the exposure draft proposed that accounting policies for insurance contracts may be changed subject to certain conditions and subject to certain limitations on unacceptable policies.
The staff recommended that the absolute prohibition on introducing measurements that reflect future investment margins be replaced with a rebuttable presumption. The staff noted that the main purpose of this is to avoid blocking a switch to comprehensive methods of accounting for insurance contracts that involve asset-based discount rates.
The staff further recommended that changes in accounting policy for insurance contracts should be permitted if they make the financial statements more relevant and reliable, as proposed in ED 5.
The staff noted that it would follow from these recommendations that insurers would be able to introduce embedded value measurements, but only if:
- They show that this results in more relevant and reliable information. This is not an automatic decision and will depend on a comparison of the insurer 's existing accounting with the way in which it intends to apply embedded value.
- This increase in relevance and reliability is sufficient to outweigh the rebuttable presumption against including future investment margins.
- The embedded value includes contractual rights to future investment management fees at an amount that does not exceed their fair value as implied by a comparison with current fees charged by other market participants for similar services.
The Board agreed with the staff's recommendations.
Discounting
The staff recommended that there should be no change to the proposal in ED 5 that discounting should not be required in phase I, but an insurer should continue discounting of insurance liabilities that it already discounts.
The Board agreed.
Excessive prudence
The staff recommended that phase I should not try to define or eliminate excessive prudence.
The Board agreed.
Redesignation of financial assets
The staff recommended retaining the approach in ED 5, in particular to not restrict the redesignation to assets backing the insurance contracts for which the accounting policies were changed.
Certain Board members noted that this could be affected by any potential solution to the mismatch problem. Other than in this area, which was left pending, the Board agreed with the staff's recommendations.
Scope
The staff proposed clarifying in the implementation guidance and scope that:
- Premiums paid by an employer on behalf of the employee where the employer issues the contract are employee benefits.
- Policy holders of insurance contracts are not included.
The Board agreed.
The staff noted that commentators queried whether entities that provide services and/or parts whenever a breakdown occurs falls within the insurance contract scope. The Board believed they did but because Phase 1 does not require current practice to be changed this would be addressed in Phase 2.
Weather derivatives
The staff recommended no substantive changes in this area. The Board agreed.
Definition of an insurance contract
The staff recommended retaining the definition. The Board agreed.
Insurable interest
The staff recommended no changes in this area. The Board agreed.
Pure endowment
The staff recommended that there be no change in principle in this area but that it be reworded. The Board agreed.
Significance of insurance risk
The staff recommended that there be no change in principle in this area but that it be reworded to refer only to significant, insignificant and commercial substance. In addition the staff proposed adding further clarification in the areas of the basis for the significance test and surrender charges.
The Board agreed.
Embedded derivatives
The staff recommended the following changes:
- (a) Changes to IG Examples 2.4, 2.6(a) and 2.11, which identify embedded derivatives that are interdependent with the host insurance contract; this interdependence suggests that they are closely related to the host contract.
- (b) An explicit new exemption from the requirement to separate, and measure at fair value, options to surrender a contract with a discretionary participation feature.
- (c) Permit unit-denominated payments to be measured at current unit values, for both insurance contracts and investment contracts, thus avoiding the apparent need to separate an 'embedded derivative'.
Concern was expressed as to the changes in a above. The staff were requested to consider this further.
Further concern was expressed that the loss recognition test does not require an entity to consider cash flows from all guarantees and options. The staff were requested to consider this further.
The Board agreed with recommendations b and c above.
Unbundling of deposit components
The staff recommended that:
- Unbundling should be permitted if the deposit component (including any embedded surrender options) can be measured without considering the insurance component.
- Unbundling should be required if some rights and obligations under the deposit component would otherwise remain unrecognised.
To implement these recommendations, the staff recommended that paragraphs 7 and 8 be reworded as follows:
7. Some insurance contracts contain both an insurance component and a deposit component (a component that would, if it were a separate instrument, be within the scope of IAS 39). An insurer may unbundle those components (ie account for those components separately) if it can measure the deposit component (including any embedded surrender options) independently without considering the insurance component. Furthermore, if the insurer can measure the deposit component independently, unbundling is required if the insurer 's accounting policies do not otherwise require it to recognise obligations or rights arising under the deposit component. If all obligations or rights under the deposit component are recognised, unbundling is not required, regardless of the basis used to measure those rights and obligations.
7A. The following is an example of a case when an insurer 's accounting policies do not require it to recognise all obligations under a deposit component. An insurer receives a payment from a reinsurer to compensate it for losses, but the terms of the contract mean that the insurer is compelled to make additional payments in future years as a direct result of the receipt from the reinsurer. The obligation to make those additional payments arises under a deposit component. If the insurer 's accounting policies do not capture that obligation, unbundling is required.
7B To unbundle a contract, an insurer shall:
(a) treat the insurance component as an insurance contract.
(b) treat the deposit component as a financial liability or financial asset under IAS 39.
8. Many traditional contracts provide surrender or maturity benefits that could be regarded as deposit components. Nevertheless, paragraph 7 does not require an insurer to unbundle those benefits if the insurer recognises its obligations to pay those benefits.
The Board agreed.
Discussion at IASB Meeting January 2004
The Board continued its review of comments received on ED 5, Insurance Contracts.
Measurement of Investment Contracts
The Board discussed which costs should be capitalised for investment contracts and concluded that there should be symmetry between the final standard on insurance and the requirements in IAS 39. That is, only items that are integral to the effective yield should be recognised. The asset should be written-off over the life of the contract.
Discretionary Participation Features
The Board discussed the accounting for discretionary participation features. The Board concluded that a minimum liability be recorded equal to the determinable participation amount. The Board further noted that the remainder should also be recorded as a liability-unless an entity can prove that an amount relates to equity. The Board noted that consideration of whether a constructive obligation exists should be considered.
There was concern about how to measure the liability under IAS 39 after initial recognition (which requires fair value or amortised cost). The Board concluded that companies can continue using the method used for initial recognition (similar to an IAS 37 amount). The Board noted that a company should disclose its accounting policy for discretionary participation features.
Assets Backing Insurance Contracts
The staff provided a summary of the potential approaches previously discussed. The staff noted that discussions with a number of insurance entity CFOs had indicated that they did not want to use the held to maturity classification for investments with credit risk exposure as these may need to be sold if there was an anticipated deterioration in the credit rating of the investment. In addition they were concerned about potential sales to meet cash flows arising from a high level of unanticipated lapses or a catastrophe.
The staff recommended that the Board not pursue further any specific treatments to eliminate the effect of the 'mismatch' caused by the use of fair value for some assets backing insurance liabilities and cost-based measurements for some insurance liabilities.
The Board agreed with the staff recommendation (11 - 3).
They further agreed to incorporate guidance on alternative treatments, which would be directionally towards fair value for liabilities, in line with the allowance to adopt a better accounting treatment assessed in accordance with the framework. It was discussed that this may include applying a current interest to some but not all of the insurance liabilities. The Board agreed that this could be done.
The staff proposed an amendment to IAS 40, Investment Property, to allow a different election to be made between the cost and fair value models in respect of investment property backing contracts that pay a return linked directly to the fair value of, or returns from, assets including that investment property and other investment property.
The Board agreed and noted that this did not need to be re-exposed.
The staff noted that if an insurer elects to use shadow accounting in respect of owner-occupied property, changes in the liability relating to revaluations of the property would be recognised directly in equity, through the statement of changes in equity.
The staff proposed that no exemption should be provided in respect of the elimination of internal transactions. The Board agreed.
Financial Guarantees and Credit Insurance
The staff proposed that a financial guarantee contract should be within the scope of IAS 39 if it is not an insurance contract. A financial guarantee will qualify as an insurance contract if it requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument, provided that the resulting risk transfer is significant. The Board agreed with the staff proposal but required the accounting treatment stipulated for financial guarantees in IAS 39. (Initially at fair value and subsequently under IAS 37 if higher.)
Embedded Derivatives
The staff proposed that the loss recognition test should not require an insurer to consider cash flows from all embedded guarantees and options. The staff noted that they believed this was consistent with the interpretation of ED 5. Certain Board members expressed concern that this was not what they believed had been proposed in ED 5.
The Board agreed with the staff's proposal provided there is disclosure of whether they have been included or not.
In addition the staff proposed that a derivative embedded in an insurance contract should be regarded as closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (ie without considering the host contract).
The Board agreed.
Discretionary Participation Features
The staff recommended giving no specific guidance on the treatment of unallocated deficit. The Board agreed.
The staff recommended that the continued presentation of the premium for contracts with discretionary participation features, as revenue, both for insurance contracts and for investment contracts be permitted.
It was noted that this would allow the inclusion of the receipt of a premium in respect of a financial instrument in Revenue. The Board agreed.
It was also noted that this would allow the inclusion of both the liability and equity component in revenue. The Board agreed that the equity component should not be in Revenue.
Disclosures
The staff tabled proposed disclosures as currently drafted (see IASB observer notes). It was noted that further changes would be made.
Income Tax
The staff recommended that standard not deal with issue of the tax on the 'policyholder portion' of investment income being included within income taxes in the income statement. The Board agreed.
The staff recommended that the standard not allow discounting of deferred tax relating to insurance contracts. The Board agreed and noted it was already discounted.
Transition and Effective Date
The staff recommended the following for both entities already applying IFRSs and first-time adopters:
- The standard should be mandatory for annual periods beginning on or after 1 January 2005. Early adoption should be encouraged.
- There should be an exemption from applying the standard to comparative information that relates to annual periods beginning before 1 January 2005. Entities should be permitted to adopt the recognition and measurement components of the proposed standard early as a complete package.
- An entity need not disclose information about claims development that occurred earlier than five years before the end of the first financial year in which it applies the standard. Furthermore, it may be impracticable to disclose information about claims development that occurred before the beginning of the earliest period for which an entity presents full comparative information under the standard. If so, an entity should disclose that fact. IAS 8 (revised) explains the meaning of the term 'impracticable'.
- When an insurer changes its accounting policies for insurance liabilities, it should be permitted, but not required, to reclassify some or all financial assets as 'at fair value through profit or loss'. This reclassification should be permitted if an insurer changes accounting policies when it first applies the standard and if it makes a subsequent policy change permitted by the standard. The reclassification is a change in accounting policy and IAS 8 should apply.
The Board agreed but would only apply the exemption in respect of comparative information to certain limited items and would add an impracticable allowance.
The Board considered the changes to ED 5 both individually and collectively and decided that no re-exposure was necessary (13-1).
Five Board members indicated that they would dissent from the standard and one Board member indicated uncertainty as to whether they would dissent or not.
Discussion at IASB Meeting February 2004
The staff noted that the Board had previously decided that if a financial guarantee contract meets the definition of an insurance contract and was not incurred or retained on transferring financial assets or financial liabilities to another party, the contract is within the scope of the IFRS on insurance contracts. However, as decided by the Board in finalising IAS 39, the issuer should initially recognise it at fair value, and subsequently measure it at the higher of (i) the amount recognised under IAS 37 and (ii) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18. The issuer is subject to the derecognition provisions of IAS 39.
The staff requested the Board to consider whether this decision should be re-exposed and in the meantime the issue should revert to what was exposed in ED 5.
Some Board members expressed concern that such a change would equally be a change to what was exposed and considered in finalising the financial instrument standards.
It was agreed to revert to the proposal in ED 5 in finalising the Insurance Contract standard and to expose the issue as soon as possible as part of an Omnibus exposure draft arising from recently approved or soon to be approved standards.
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