Release of residual margins and recognition of revenue
The Boards discussed how a residual margin, determined at inception, should be released to profit or loss subsequently. The staff explained that in preparing their recommendations, they had focused on the insurer's performance under the contract by delivering an asset to the policyholder. The staff also reminded the Boards that the proposed insurance model is a hybrid of:
- a direct liability measurement, using current estimates of expected cash flows, time value of money and a risk adjustment; and
- an allocation element (the residual margin) that eliminates a day one gain and is subsequently released as income over an appropriate period. The staff proposed that this 'appropriate periods' was the period over which the insurer performed under the contract.
The residual margin
In outlining their recommendations, the staff suggested that 'for subsequent reporting periods the residual margin...will accrete interest.' This suggestion generated a significant amount of discussion among Board members. Some Board members saw the residual margin as a 'plug' designed to avoid a 'Day 1' gain or loss. As such, it was much the same as deferred income, on which no one usually accretes interest. Others disagreed, seeing the residual margin as part of the larger present value computation that is performed by the insurance company when pricing the contract. As such, accreting interest was totally consistent with the revenue recognition model being developed by the Boards. Still others disagreed with this second analysis, noting that in insurance the premium is received on Day 1 unlike most revenue recognition situations in which the interest accretion acknowledges the implicit financing given by the entity between the time of performance and the receipt of customer consideration.
The Boards and staff attempted to clarify the issue by using the staff examples, but these only added confusion - even to those Board members who had tried to audit the examples.
The Boards agreed that it was vital that the model not be lost for the sake of the disagreement about whether interest is accreted. A Board member noted that he would not like to see the Boards revert to a composite margin approach. The risk and residual margins were related but distinct, and the accounting model proposed by the Boards should recognise this fact.
The staff agreed to withdraw the issue of whether interest was accreted on the residual margin over the period of time that it was released. Revised proposals will be presented either later in this meeting cycle or in April.
Period of release
The Boards then discussed the period over which the risk margin should be released. Board members were again concerned that the staff proposal seemed to be more complicated than was necessary. In particular, they thought that the recommendation sought to frame the principle around the extreme rather than the general (for example, hurricane or winter storm damage, in which the window for claim events is relatively narrow, rather than claims occurring evenly over a period).
A FASB member suggested an alternative approach, which the staff preferred to the formulation of their original recommendation. Consequently, the Boards were asked to vote on a recommendation that the residual margin should be released on a straight-line basis unless another pattern reflected better the exposure to risk over the coverage period.
A comfortable majority of the IASB and FASB separately supported this recommendation.
One FASB member thought that it was premature to commit to this approach. This FASB member thought that the inbound and outbound cash flows and margins were inextricably linked and that using composite margin that is remeasured over the performance period is the best way to portray that.