With the exception of Daryl Buck from the FASB all members of the Boards attended the three hour session on insurance contracts where the following issues were deliberated:
The meeting considered the second and third proposals in the Discounting paper – proposal one having been considered the previous day.
The second proposal in the Staff paper was
"... that no specific guidance was required on determining when the effect of discounting of the liability for incurred claims would be immaterial"
It was noted that there is a general principle in IFRS and US GAAP that the requirements of accounting standards are not applied to immaterial items. The members of both Boards present agreed unanimously to the Staff proposal.
The third Staff proposal was
".. that for contracts to which the insurer applies the premium allocation approach, not to require discounting of incurred claims that are expected to be paid within 12 months of the claim occurrence date"
After noting that this determination would be made on the basis of a portfolio of contracts, Staff confirmed their intention to have application guidance that would require discounting of all cash flows within those portfolios that were expected to be paid after 12 months, unless the effect was immaterial.
The recommendation would require an insurer to determine at each reporting date whether the 12 months expedient is applicable. For those liabilities with a settlement period beyond 12 months from the claim occurrence date discounting would always be applied, unless immaterial.
Staff noted that the shortcut on immaterial discounting for claims settled over a short period only applies only to portfolios of contracts to which the insurer applies the premium allocation approach. This practical expedient is not proposed for contracts where the building blocks approach is applied where only the general materiality principle applies. This recommendation is so designed because the main beneficiaries of the practical expedient will be insurers applying the premium allocation approach who may find that all of their business falls within the characteristics described for the application of the practical expedient.
The members of both Boards agreed unanimously with the Staff proposal.
Paper 7I/77I was made available to observers just before the meeting and diagrammatically illustrates the Staff proposal to group contracts in a portfolio if they share similar risks, have similar expectations of profitability and are managed together.
The risk margin is the component of the measurement model that is calculated based on this unit of account.
The most important news to highlight from this set of papers is that the Staff of the two Boards decided to recommend a departure from the proposals contained in the ED and suggested that the risk adjustment liability is reduced for any diversification across portfolios that exist within the same reporting entity (covered in paper 7C/77C). The ED had introduced the concept of pooling of risks but limited it to the portfolio as defined with an explicit prohibition to allow cross-portfolio diversification to be taken into account in the setting of the insurance liabilities.
The Staff proposed that the diversification within the same entity once computed is allocated to each individual portfolio and the residual margin is then increased accordingly to prevent the recognition of accounting profit. Staff recommended that an insurer determines components within a portfolio to classify different elements of the overall residual margin liability of that portfolio and applies to each of these components the appropriate earning model that would release the residual margin component to profit. These components would also be used for the unlocking of the residual margin.
Contracts are grouped together in these components or sub-portfolios if they have similar inception dates, a similar contract boundary (economic duration) and similar expected patterns of release of the residual or single margin.
Staff noted that the definition of residual margin sub-portfolios is important because it determines the extent to which day 1 losses are offset against positive residual margins rather than expensed on day 1.
Many members from both Boards commented that they were uncomfortable with the "similar profitability" criterion in the portfolio definition as it may require many separate portfolios due to varying levels of profitability. Others noted that the profitability criterion would prevent profitable and unprofitable contracts being offset within a portfolio. Staff responded that their intention was that the criterion would only require separating portfolios where profitability was significantly different.
Several members commented that the proposals were over-engineered and that there should only be one concept of portfolio and insurers should develop appropriate entity–specific methods to earn residual margin over the life of their contracts.
After considerable discussion it was agreed that the Staff would be asked to delete the sub-portfolio proposal and revise the portfolio definition so that it focussed on the criteria of similar risks, similar duration and pattern of release of margin. For the premium allocation approach the second criteria would be a similar pattern of release from risk or a similar pattern for the provision of services.
Based on this tentative decision contracts would not require to be managed together or have similar estimated profitability in order to be grouped into a portfolio.
When the Boards were taken through paper 7C/77C the Staff explained that the calculation of the risk adjustment although allocated to each portfolio would take into account the benefit of diversification across portfolios up to the level of the reporting entity.
In order to achieve this aim Staff proposed:
"... not to prescribe the unit of account for determining the risk adjustment but instead to specify the principle that the risk adjustment should measure the compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfils the insurance contracts"
After much discussion as to whether prescribing a unit of account greater than the portfolio may lead to possible double counting of the effect of diversification and Staff noting that there will be guidance to explain that entity-wide diversification should be taken into account in determining the risk adjustment the Staff recommendation was agreed unanimously by the IASB. FASB is not supportive of a risk adjustment liability and did not vote on this paper.
An onerous contract test is required under the building blocks approach and premium allocation approach during the pre-coverage period (as insurance contracts are only to be recognised in the financial statements when coverage starts) and additionally for the premium allocation approach during the coverage period given that the premium is allocated and not remeasured.
The Staff made three recommendations covering
- What is an onerous contract?
- When should an onerous contract test be carried out initially and subsequently?
- Should the basis of measuring an onerous contract be consistent with the measurement of the liability for incurred claims?
During the discussion it became clear that Staff and the members of both Boards had not had chance to consider these proposals in the light of the earlier agreement that for the premium allocation approach discounting would not be required where a claim was expected to be settled within 12 months of the occurrence. It was therefore agreed that this paper would be considered at a later date.