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Insurance contracts

Date recorded:

The joint Boards discussion on margins (risk adjustment and residual margin vs. the composite margin) spanned the two sessions on 17 and 18 May with an attempt to resolve the divergence between the two Boards. The Boards also had planned to discuss reinsurance and cross-cutting disclosure issues but these have not been debated yet.

The majority of the discussions on 17 May focused on Paper 3A (for risk adjustment) and Paper 3F (for composite margin). These discussions resulted in a general consensus amongst the Board members that the results (if not the presentation) of the two models was largely similar and that there were probably only a few areas or circumstances where significant differences would remain. In an effort to achieve convergence, the Boards directed the staffs to prepare a number of examples for discussion on 18 May. These examples were presented to the Boards on 18 May as Paper 3K.

Ultimately, after reviewing the examples prepared by the staffs, the IASB voted strongly for (only two opposed to) retaining an explicit risk adjustment, while FASB voted equally strongly (five for) the composite margin. Board members expressed dissatisfaction with this result and indicated a preference for a single standard to be developed and suggested that the topic could be reconsidered after later meetings (e.g. finalisation of the proposed treatment for the residual margin) had provided additional clarity on the exact extent of divergence.

The staff also provided a brief summary of the IWG meeting held on 16 May 2011, with no significant questions asked by the Board members.

Risk adjustment (Paper 3A)

The staff introduced the paper, discussing the history of the insurance project with a focus on the origins and development of the risk adjustment model and presenting arguments for and against the use of a risk adjustment.

Board members noted that one of the primary differences between the risk adjustment model and the composite model as described appears to be the objective of the margins. In the risk adjustment model, the margin measures the variability of the cash flows. In the composite margin model, the entire margin represents deferred profit that should not be recognised until the service of standing ready to meet claims has been performed.

This issue was not adequately resolved, and went on to colour much of the discussion over the two days. In addition, the staff pointed out a distinct geographical distinction between those two approaches based largely on current industry practice in each geographical region. During the discussions, some Board members raised concerns that the standard being developed should be based on improving current practice, rather than aiming to maintain it, so the drivers of the final decision should be based on conceptual correctness and practical applicability rather than current practice or the amount of education required in a jurisdiction.

Although some Board members objected to the level of subjectivity the risk adjustment approach might allow, other members pointed out that as long as the level of subjectivity was disclosed it would provide valuable information regarding the risk levels of the entity's liabilities. No specific disclosures were mentioned, but references to the subjectivity and disclosures relating to level 3 financial instruments and IAS 37 were mentioned.

Finally, a Board member commented on the remeasurement differences between the two models, noting that the lack of remeasurement in the composite margin model was likely to conceal developments in risk and is therefore less transparent than a risk adjustment model.

Composite margins (Paper 3F)

Although Papers 3E, 3F and 3G were referred to, the majority of the staff's presentation revolved around Paper 3F on realisation of the composite margin. As before, the staff introduced the paper describing the development of the composite margin model and presenting arguments for and against the use of this model.

Several of the issues raised during the discussion on the risk adjustment model were raised again. In particular, concerns about the transparency of the composite margin and whether the objective of liability measurement was truly being met, with the composite margin model being compared with a revenue recognition approach rather than focusing on liability measurement.

Board members also argued backwards and forwards about which model was "simpler" to implement, measure and apply, and whether that simplicity resulted in transparent and decision-useful information.

Ultimately, very few new arguments were raised and the Boards concluded that the results arising from the two models may well be very close in a significant number of cases. The Boards therefore instructed the staff to review this consideration and prepare examples for discussion.

Model comparison (Paper 3K)

The staff prepared the examples that the Boards had requested, and presented them to the Boards during the 18 May discussion. The staff noted that the FASB staff disliked the model used as it did not appear to be in line with their proposed objective for the composite margin, lending further weight to the argument that this issue will not be resolved unless the Boards can agree on the objective of the margins, either for the IASB's approach to account for uncertainty via risk adjustments or the FASB's approach to defer and subsequently allocate profit based via a composite margin.

A significant amount of time was spent discussing and understanding the examples presented, and reconsidering the arguments raised during the previous days discussions.

At the end of this intense debate a fundamental disagreement between the two Boards appeared to remain on the purpose of the margins, with the IASB arguing that the risk adjustment represents a measure of the uncertainty in the cash flows of the liability, while the FASB argued that the uncertainty was already captured in the probability weighted average cash flows.

The IASB argued convincingly that a contract with a 50% chance of a £100 loss and a 50% chance of a £0 loss has a fundamentally different risk profile than a contract that had a 100% chance of a £50 loss, even though they both have a weighted average cash flow value of £50. The IASB were, however, unable to persuade the FASB of the relevance and reliability of an accounting model that recognises and discloses some measure of that variability.

Eventually, the Boards' Chairmen indicated that a decision (even if tentative) was required and called the vote. The IASB voted clearly in favour of the risk adjustment model, while the FASB voted strongly for retaining the composite margin model.

As noted above, the Board members indicated dissatisfaction with this result and indicated that this topic should be reconsidered to achieve a convergent decision once additional elements of the model had been discussed and finalised.