Insurance contracts (IASB only)
On 14 June, the IASB members held an education session to discuss the treatment of acquisition costs (Agenda paper 2D) to give a directional steer to the staff.
The discussion followed on from the May meeting where the IASB members expressed a view that they prefer to include acquisition costs as part of the cash flows of an insurance contract instead of recognising them as an expense or a separate deferred costs asset. At the same May meeting, the FASB expressed a strong preference for recognising acquisition costs as an asset. To achieve convergence, the FASB members also voted to consider an approach that would on occurrence of acquisition costs recognise a reduction in the insurance contract residual/single margin with no impact on the statement of comprehensive income.
This educational session produced a lively debate on several issues surrounding this topic. Board members asked staff to explain whether the inclusion of acquisition costs as a component of the contract’s cash flows would not implicitly adjust the residual margin and therefore the emergence of profit from the release of the residual margin. They also asked whether, if this interpretation was confirmed, it would not be preferable for the new accounting standard to require a separate run-off model for the acquisition costs component. The staff, supported by other members of the Board, clarified that while inclusion of acquisition costs would always reduce the margin irrespectively of whether these costs were treated as a component of the contract’s cash flows or as a direct deduction from the residual margin, the pattern of release of the margin could be determined essentially out of three possible options.
To illustrate these options, the staff invited the IASB to consider a simple example where premium is CU 100, acquisition costs are CU 50 and residual margin is CU 50:
- Option 1 – would recognise acquisition costs of CU 50 as an incurred expense and immediately recognise revenue of CU 50 from the premium received. The net result would be no profit or loss at the point of sale of the insurance contract but with revenue and expenses recognised at initial recognition. The remaining CU 50 or residual margin would be earned subsequently over time
- Option 2 – would recognise revenue over time as CU 50. The impact on the net result would be the same as under option 1 but the accounting would not result in revenue and expenses being recognised at initial recognition because the acquisition costs would be treated as the first actual payout of the contract expected liability (balance sheet transaction) or as a direct deduction from the initial residual margin
- Option 3 – would recognise revenue of CU 100 and release acquisition costs of CU 50 over time. Also, in this case, there would be the same impact on the result at initial recognition as in options 1 and 2 and the same impact on the initial recognition of revenue and expenses as in option 2. However the subsequent revenue and expense would be greater than option 2 given that the acquisition costs are amortised separately from the earning of the premium.
One member noted that he would like to avoid distorting volume information and he would not favour options that do not reflect premiums received. Option 1 to release some of the margin and recognise revenue as the acquisition costs are incurred would result in revenue being recognised before in many cases there is coverage. Many considered this counter-intuitive.
At this point, some members suggested reopening the debate on expensing the acquisition costs, especially because the inclusion of costs incurred for unsuccessful efforts makes it hard to find an amortisation driver. The question of successful and unsuccessful efforts was then explored further. Some felt that given the latest decision on unit of account result in more granular level of aggregation of insurance contracts, it may be preferable for acquisition costs to be accounted for with reference to individual contract rather than a portfolio. This would eliminate the need to include acquisition costs of unsuccessful efforts and align the IASB to the FASB preferred model. Others noted that the term unsuccessful efforts was misleading because only the total acquisition expenses incurred faithfully represent the insurer’s contract acquisition activity and the cost of the successful efforts is only faithfully reflected by the total acquisition expenses incurred. If all the efforts were unsuccessful, there would be no portfolio so those efforts would be expensed. The staff reminded the IASB that acquisition costs relate only to acquisition efforts and not to other expenses arising in the course of service, such as claims handling. Further, the treatment would be the same regardless of whether all acquisition costs were paid upfront or spread and paid over the term of the coverage.
A few members noted that expensing these costs is more natural and the more exceptions are made the more complicated the issue becomes. Others felt that if expensing is not an option than a contract asset similar to revenue recognition project would keep the two standards aligned.
A new comparison was then made with existing accounting literature for financial instruments where for instruments at fair value through income the transaction costs are expensed. Some members and staff reminded the IASB that the decision to treat acquisition costs as contract’s cash flows was primarily driven by the objective of producing the proper measurement of liability and to prevent the recognition of day one losses for economically profitable contracts. The prohibition of day one profit and the accounting for a residual margin could be argued to be a departure from liability recognition in other accounting standards. The treatment of acquisition costs is then consistent with the treatment of the residual margin under the current fulfilment value approach the IASB has selected for insurance contracts.
The staff concluded their education session presenting the arguments for and against recognising an asset. The “pros” included that it would be easier to amortise and present, it reflects the value of intangible relationship and that any form of deferral is essentially akin to recognition of an asset explicitly or implicitly. The “cons” are that if recognised separately it will still need to be considered together with liability for onerous contracts testing, the pattern of release should still be linked with service provided and have no impact on the net result but with the added cost of reporting the associated amortisation expense.
Some Board members felt that the amortisation should be different from the earning of the residual margin and a straight line over the coverage term should be required while others felt that it should always be done in the same manner as the earning of the residual margin.
This was an educational session so no decisions were taken. However the Board members indicated to the staff by a majority of 9 votes that they would prefer to explore treating acquisition costs in a way that they do not result in incurred expense at initial recognition and that are taken to income with a pattern of release yet to be determined but that would avoid the recognition of revenue upfront. This conclusion seems to suggest that the final debate would be to finalise the choice between options 2 and 3 as presented above.