The IASB met to discuss and decide on the residual margin measurement of insurance contracts and the impairment of reinsurance contracts in the financial statements.
Four papers were provided covering:
- unlocking the residual margin (paper 2A);
- proposals relating to the margin for participating contracts (paper 2B),
- impairment of reinsurance contracts held by insurer (paper 2C), and
- recent decisions the FASB has made in its insurance contracts project during meetings held in November 2012 (paper 2D) — an informative session to provide an overview on the recent decisions the FASB has made on its insurance contracts project without IASB involvement.
The IASB had tentatively decided that the residual margin recognised when applying the building block approach should be ‘unlocked’ for changes in estimates of future cash flows. This means that changes in estimates of future cash flows would not be recognised in profit or loss immediately. Instead, they would be added to, or deducted from, the residual margin, and thereby recognised in profit or loss in future periods when the residual margin is released to profit.
This paper examines some consequences of this tentative decision and recommends that the decision is refined to avoid some unintended consequences.
The staff recommended that the residual margin should be unlocked for differences between current and previous estimates of cash flows relating to future coverage or other future services.
The staff are of the view that unless the decision is refined, problems could arise because the proposed tentative decisions seeks to distinguish purely between past cash flows and future cash flows. All differences in past cash flows (i.e., experience adjustments) are recognised immediately in profit or loss, whereas all changes in estimates of future cash flows are added to or deducted from the residual margin. Although this distinction works well for changes in estimates of claims for future insured events, it could have unintended consequences for other changes in estimates.
The Staff are of the view that the objectives of the unlocking decision could be met, and the unintended consequences avoided, by refining the tentative decision. Instead of distinguishing between past and future cash flows (i.e., experience differences versus estimates of future cash flows), the requirements should distinguish between past and future coverage, and between investment and service components.
After a short debate, the Board voted unanimously and has supported the Staff’s recommendations to refine the tentative decision as noted above.
Paper 2B covered the proposals for adjusting and allocating the margin for participating contracts.
The Staff asked the Board to vote on its recommendations that:
- the margin for participating contracts is adjusted for changes in the value of the premiums by adjusting the margin for changes in the value of the underlying items as measured using IFRS; and
- the constraint on recognising revenue that is proposed in the revenue recognition project should not be applied to the allocation of the residual margin for insurance contracts.
The Staff explained that in their view the method of allocating changes in cash flows resulting from asset returns to the residual margin will actually treat the margin consistently from a day one. To estimate the margin on day one the insurer will need to forecast its cash flows including the future assets return which will fund the discretionary cash flows to the participating policyholders. As a result, the residual margin would be affected by the assumptions on future asset returns thus suggesting that when expected asset returns change the margin should be adjusted.
This argument distinguishes participating contracts from other contracts. However a number of IASB members noted that an insurer is exposed to the risk for the performance of underlying assets to some extent irrespective of the type of contract it issues. For participating contracts the recognition in the residual margin of the insurer portion of an investment return rather than in the earnings of the current period was rejected on conceptual grounds by these IASB members
Another IASB member supported the Staff view that the proposed allocation of the residual margin for participation contracts should be performed in accordance with the services provided, thus requiring the unlocking of the margin over the period during which services are provided based on changes in all cash flows including those from the expected asset returns. This IASB member added that the insurance business is not similar to an asset management business because the presence of guaranteed returns makes participating contracts economically different and adds risk to the insurer’s obligations compared to those of an asset manager. Revenue recognition guidance is not appropriate for insurance given that recognition and measurement is based on an expected value approach.
When the Board voted the majority rejected the Staff recommendations with 8 voting against it and only 7 in favour.
The Staff asked the Board to discuss and decide on its second recommendation of paper 2B regarding the allocation of the margin according to the services provided noting that the IASB tentatively decided that an insurer allocates the residual margin consistent with the pattern of transfer of the services provided. The staff recommended that a reasonable pattern for the allocation of the margin:
- views the provision of services as satisfied over the life of the contract;
- is based on the insurer’s expectations of total unearned profit and allocates that unearned profit in a reasonable, systematic way; and
- if the bonuses are allocated in the same pattern as the estimate of the provision of services, the pattern of bonuses may be an acceptable proxy for the provision of services under those contracts.
Thus, the staff recommended that the IASB confirm the present decisions:
- that the allocation of the margin for participating contracts is done according to the services provided; and
- not to apply the Revenue recognition guidance on constraints to the allocation of the residual margin for all insurance contracts.
If necessary, application guidance could be developed on the appropriate pattern of allocating the margin. There was no further debate and this recommendation was unanimously approved by the Board.
At its meeting in June 2011 the IASB tentatively decided that the cedant should apply the impairment model being proposed under IFRS 9 Financial Instruments (Impairment project) to the reinsurance asset.
The Staff are of the view that there is now a conflict between the IASB’s most recent proposals on impairment of reinsurance assets and the IASB’s decision on the unlocking of the residual margin and hence have provided paper 2C to discuss the two different alternatives that in their view could avoid this conflict.
- Under alternative 1 the cedant should account for the initial estimate and subsequent changes in estimates of expected credit losses in accordance with the insurance contract decisions, with the cedant adjusting the residual margin for changes in cash flows as a result of expected credit losses.
- Under alternative 2 the cedant will account for a portion of the initial estimate and subsequent changes in estimates of the expected credit losses in accordance with the impairment project decisions and would recognise upon initial recognition of the reinsurance contract a portion of the initial estimate or 12 month expected loss and subsequently the cedant should recognise in profit and loss changes in estimate of cash flows resulting from changes in expected credit losses
Staff recommended alternative 1.
A lively debate followed amongst the IASB members in which one member suggested that he would favour a combination of the two approaches which would involve unlocking the residual margin for changes in estimates of expected credit losses upon initial recognition of the reinsurance contract and then with any subsequent changes to the cash flows relating to the expected credit losses going to the profit and loss.
Another IASB member was in favour of alternative 1 since in his view changes in the cash flows resulting from expected credit losses should be treated consistently in the same way as changes in other cash flows and that alternative 1 is effective in avoiding double counting under the two different approaches.
Other Board members noted that the combined approach will need to be clearly articulated in the revised exposure draft and that the Staff should focus on this an important next step.
The combined approach suggested by the first IASB member received support from several more board members and also from the Staff. This resulted in the IASB voting unanimously to support the combined approach as discussed above.