Definition of an Insurance Contract
The Boards agreed to retain the definition of insurance contract in IFRS 4. This definition contains both the concepts of compensation accompanied by the requirement for significant risk and a specified uncertain future event that adversely affects the policyholder. (US GAAP uses the terms indemnification and compensation.) Insurance risk and financial risk
After some debate, the Boards agreed that the description of 'significant insurance risk' (IFRS 4.B22-B28) be carried forward to the exposure draft. The Boards were concerned about the practical application of 'commercial substance', but were ultimately convinced that the Application Guidance in IFRS 4 had proved operational.
The role of timing in insurance risk
The Board analysed the role of timing risk in the definition of insurance risk. Currently, the FASB's definition of insurance risk requires the presence of both underwriting and timing risk. The definition in IFRS 4 contains both elements, but does not require both to be present. The staff analysis suggested that the 'equal prominence' requirements contained in US GAAP led to inappropriate results at the margins; however IFRS 4 would produce more logical results.
After discussion, the Boards agreed that the role of timing risk in the definition should be a disqualifying, rather than a primary condition for judging insurance risk in a contract. The role of timing risk should be emphasised by:
- Adding the following (or very similar words) to IFRS 4 paragraph B2:
- Contractual provisions that delay timely reimbursement to the policyholder can eliminate or significantly reduce uncertainty because they prevent the insurer's payments from directly varying with the claims.
- Changing the evaluation of insurance risk from absolute amounts to present values.
The Boards subsequently debated the application of these decisions by using a simple example. A majority of the IASB and a minority of the FASB accepted that in applying the analysis of insurance risk to possible outcomes under a contract, should the focus be on the range of possible outcomes and the significance of reasonably possible outcomes relative to the mean. A majority of the FASB thought that the focus should be on the existence of a possible outcome in which the present value of the net cash flows is negative (although it was acknowledged that this might be a subset of the first alternative).
The background to this discussion is a key difference in the scope of existing IFRS and US GAAP for insurance contracts. IFRS 4 addresses insurance contracts; US GAAP addresses insurance entities.
The Board noted that IFRS 4 takes the position that all product warranties meet the definition of an insurance contract, but distinguishes two categories:
- Product warranties issued by another party for goods sold by a manufacturer, dealer or retailer are within the scope of IFRS 4.
- Product warranties issued directly by a manufacturer, dealer or retailer are outside the scope of IFRS 4.
After a tortured debate, the Boards agreed that product warranties issued directly by a manufacturer, dealer or retailer should remain outside the scope of the Insurance Contracts IFRS.
Fixed-fee service contracts
The Boards were not in favour of including fixed-fee service contracts within the scope of the Insurance Contracts exposure draft. Some Board members thought that this type of contract was often very difficult to classify and judgement was required, consequently the IFRS should not be explicit. Some Board members were concerned that to scope such arrangements into the IFRS would be to separate normal business from insurance on an arbitrary basis.
The Board agreed that the following contracts should be excluded from the scope of the insurance contracts exposure draft:
- residual value guarantees embedded in a lease*;
- employers' assets and liabilities under employee benefit plans and retirement benefit obligations reported by defined benefit retirement plans;
- contingent consideration payable or receivable in a business combination. *If the residual value guarantee was issued by a third party and was specific to the property leased, that would be an insurance contract; if the residual guarantee was issued by a third party and was a guarantee of the price of a generic item of property (for example, a car of that model and year), that would be a derivative.