Reinsurance contract accounting
Retroactive insurance contracts
The first issue considered was the period over which the FASB single margin and IASB residual margin on profitable retroactive reinsurance contracts should be released by both the cedant and the reinsurer.
The key point being that for a retroactive reinsurance contract the risk transferred is often related to liabilities from contracts in the post-claims phase where the residual/single margin has already been fully released. The Staff explained that, without explicit guidance, it could be argued that the all or part of the residual or single margin on the reinsurance asset could be released on inception of the retroactive reinsurance contract to produce a day 1 gain on inception. The Staff proposed that for retroactive contracts the period of cover should be deemed to be the period from inception of the reinsurance contract until the end of the settlement period of the underlying insurance contracts and that the residual margin (IASB) should be earned over the remaining settlement period based on the pattern of services or single margin (FASB) should be earned over the remaining settlement period based on the release from risk.
The Staff paper noted that the proposal would mean a different margin release pattern for retrospective and all prospective reinsurance contracts (IASB) and prospective reinsurance contracts accounted for under the premium allocation approach (FASB only). Two Board also members noted this difference.
The Staff proposal was agreed unanimously by both FASB and IASB.
Loss sensitive features
The paper noted that many reinsurance contracts contain various provisions that are contingent on claims experience and affect the premium and commissions payable under the reinsurance contacts.
The first Staff proposal was that all obligatory provisions that reduce the risk to the reinsurer by penalising the cedant for adverse loss experience or rewarding the cedant for favourable loss experience should be accounted for as part of claims and benefits by both cedant and reinsurer and not as premiums or commissions regardless of the form in which such provisions are set out in the reinsurance contracts.
The second Staff proposal was that such provisions should be recognised by both cedant and reinsurer to the extent that they are triggered by loss experience to date under the contract (i.e. based on incurred claims).
The third related proposal was to confirm that loss sensitive provisions that are not obligatory should be treated in the same way by both cedant and reinsurer as other changes in premium under the contract. For example, if a reinstatement premium provision gives the cedant the right (but not the obligation) to continue the coverage, it is not considered to be a loss sensitive feature that is required to be accounted for as a reduction in claims and benefits but an election to purchase future insurance coverage.
All three proposals were agreed unanimously by both IASB and FASB.
Application of the Building block approach or Premium allocation approach
There is a fundamental difference between IASB and FASB on the criteria for these two approaches. IASB have agreed that an insurer may opt to use the premium allocation approach (PAA) only where it provides a reasonable approximation to the building blocks approach (BBA) liability measurement whereas FASB have agreed that the PAA should be required where certain criteria are met.
Consequently, the Staff proposed slightly different proposals for cedant accounting for FASB and IASB.
For FASB, the Staff proposed that the cedant should follow the approach used for the underlying insurance contracts even where it means splitting a reinsurance contract into two components if it relates to underlying contracts some of which are accounted for under the PAA and others accounted for under the BBA.
For IASB, the Staff proposed that the cedant should be allowed to use the PAA for the reinsurance contract if would produce measurements that are a reasonable approximation to the BBA.
For both IASB and FASB, the Staff proposed that the reinsurer should evaluate whether the reinsurance contract should be accounted for under the PAA or BBA in the same way as for insurance contracts.
A member of the IASB noted a preference under the FASB proposals for the cedant to evaluate which approach is appropriate rather than being required to follow the accounting approach used for underlying contracts. This was noted as being particularly relevant to retroactive reinsurance where facts and circumstances at the inception of the reinsurance contract may differ from those prevailing when the underlying contracts were written resulting in the eligibility criteria producing different outcomes. Another member noted that if the reinsurance is accounted for under a different approach from the underlying contracts it may cause a negative impact on the clarity of link between reinsurance income and expenses and those from the reinsured contracts in their presentation in the statement of comprehensive income.
The Staff proposals were agreed with a majority of 6 for FASB and 12 for IASB.
The Staff noted that there is currently diversity in the presentation of policy loans with some insurers accounting for them as financial instruments and others accounting for them as a component of the insurance contract.
The Staff proposal is that policy loans should be accounted for as part of the insurance contract and included within the insurance contract balance rather than disclosed and accounted for as a separate asset. If the investment component of an insurance contract is unbundled from the insurance contract then the policy loan would be treated as a part of the investment component.
As accounting for policy loans was not explicitly covered in the exposure draft a member of IASB suggested that the boards should not be asked to reach a decision before outreach and/or discussion with the IWG has taken place. Staff disagreed as policy loans are implicitly covered in the exposure draft and other board members did not express support for specific outreach on this issue.
There was considerable discussion on the complexity of including policy loan cash flow assumptions within the overall insurance contract estimation of cash flows and whether policy loans would be likely to have a material effect on the cash flow estimates. The general opinion expressed was that policy loans are likely to be issued at an effective rate that is at or close to market rates, are unlikely to have a material effect on the overall measurement of cash flows and are only one of many factors that insurers will take into account in estimating insurance policy cash flows.
One board member asked for a specific disclosure requirement for policy loans offset against insurance balances or unbundled investment components and another board member noted that such disclosure would assist users in understanding interest income earned on policy loans if separately disclosed. Staff agreed to consider including a disclosure requirement for policy loans when disclosure is considered at a subsequent meeting.
The Staff proposals were agreed unanimously by FASB and with a majority of 12 for IASB.
Staff proposed that policy riders added to a policy at inception should be treated as an integral part of the contract rather than as a separate stand-alone contract and thus the general decisions on disaggregation and unbundling would apply to riders in the same way as for other contract terms.
The Staff proposal was agreed unanimously by both FASB and IASB.
Policy modifications, amendments and commutations
This paper considered 4 issues:
- The criteria for substantial modifications requiring derecognition and recognition of a new contract;
- The consideration to be used in determining the gain / loss on derecognition and the margin or day 1 loss applicable to the new contract;
- Accounting for non-substantial modifications; and
- Reinsurer and cedant accounting for reinsurance contract commutations.
Substantial modification criteria
Staff proposed that modifications that meet any one or more of three criteria would be considered substantial modifications requiring derecognition and recognition of a new contract. The three criteria establish that a modification is substantial if, had the modification been part of the original terms and conditions of the contract, it would have resulted in a different assessment of whether the original contract:
- would be in the scope of the insurance standard;
- should or may be accounted under the BBA or PAA, and
- would be included in a different portfolio.
Several board members noted that many modifications are likely to affect the nature of the risk or the term of the contract and thus would require inclusion in a different portfolio even though the modification may not be considered substantial.
Board members agreed (by majorities of 6 for FASB and 12 for IASB) with the first two criteria but requested that Staff reconsider the third criteria as it is too broad and would require too many modifications to be classified as substantial.
Substantial modification derecognition mechanics
Staff noted three alternative proposals for determining the modification consideration used to determine the gain or loss on derecognition and margin or day 1 loss on the new contract.
- current entity specific valuation of the hypothetical new contract;
- fair value of the new contract; and
- roll-forward of the modified existing contract without derecognising any margin remaining on the existing contract.
Staff recommended the use of the current entity specific valuation of the hypothetical new contract.
One board member suggested a revision to option 3 on roll-forward to include derecognition of the part of the margin on the old contract that relates to obligations that are not carried forward to the new contract.
One board member noted that if the boards subsequently agree to including some part of the change in insurance liabilities in OCI rather than in net income the derecognition proposals will need to consider recycling of any such amounts from OCI.
The Staff proposal was agreed by majorities of 6 for FASB and 12 for IASB.
Accounting for non-substantial modifications
Staff proposed that where a non-substantial modification extinguishes obligations of the existing contract (including any related portion of the residual or single margin) they should be accounted for as a partial derecognition. The partial derecognition would also release to income the relevant portion of residual/single margin. Non-substantial modifications that create new obligations and any related consideration should be accounted for as a new stand-alone contract.
Several board members noted that they did not favour release of margins for these modifications.
Staff agreed to redraft the proposal to clarify that the reference to release of margins refers only to any release that is an inherent part of the normal release mechanism as part of provision of services or release from risk rather than a specific release of margins as it would be applicable to a substantial modification.
Subject to this clarification the Staff proposal was agreed unanimously by both IASB and FASB.
Staff noted that there is currently diversity of practice in that some entities present the commutation gross with a component included in both premiums and claims but other entities present the commutation net with the overall result of the commutation included within claims and benefits.
The Staff proposed a net presentation should be required as it is a more faithful presentation of the commutation as a settlement of the reinsurer’s liability rather than a reversal of the original premium received and claims recognised. This proposal would also reduce diversity.
One board member noted that disclosure of the effect of commutations on the claims and benefits line should be required and noted that because commutations are likely to be infrequent and the amounts readily available such disclosure should not be deemed onerous. There was discussion of whether the general requirements in IAS 1 or the general requirements on disclosure of insurance and reinsurance balances to be included in the forthcoming insurance standard would be sufficient to generate sufficient disclosure of material commutations.
Staff agreed to consider whether to include a specific disclosure requirement for commutations when disclosure is considered at a subsequent meeting.
The Staff proposal was agreed unanimously by FASB and with a majority of 12 for IASB.