As part of its continuing deliberations surrounding the IASB’s Insurance ED (and FASB’s Discussion Paper Preliminary Views on Insurance Contracts), the Boards held a joint meeting to discuss several topics including:
- defining investment components to be disaggregated from insurance contracts
- defining a portfolio of insurance contracts including consideration to the level at which insurance contracts should be aggregated for measurement and presentation purposes.
The Boards discussed three papers on accounting for investment components in insurance contracts. The joint IASB and FASB session followed from the education sessions each Board held separately. Investment components exist in many long term contracts, especially in various life policies.
The Insurance ED proposed to unbundle investment components not closely related to insurance coverage but the respondents’ feedback to that proposal was mixed. Some, mainly from Australia, supported it as allowing continuing existing practice. Some viewed it as useful to allow comparison with other insurers and financial institutions. Others thought the costs of unbundling outweighed the benefits and resulted in non-comparable information. The Boards discussed this issue in their May 2011 meeting and tentatively agreed to unbundle only explicit account balances.
The first paper presented by the staff summarised the approach taken. The staff presumed past decisions on no unbundling and proposed disaggregation instead. The disaggregation would result in separate presentation of investment components while still recognising and measuring them as part of the insurance contract. In developing their recommendations, the staff proposed three possible objectives for disaggregation:
- to ensure relevance of the total aggregated premiums presented in comprehensive income (the volume information) and to exclude from premiums the deposit components
- to improve comparability of financial statements (e.g., insurers and non-insurers)
- to provide users with a liquidity measure (e.g., amounts payable on demand).
The staff recommended objective a) as the most important – to disaggregate investment balances to insure relevance of premium volume information in comprehensive income.
The staff then proposed the definition of the investment component to be disaggregated:
- An investment component in an insurance contract is an amount that the insurer is obligated to pay to the policyholder or a beneficiary regardless of whether an insured event occurs, and
- Insurers should exclude from the aggregate premium presented in the statement of comprehensive income the present value of those amounts to be paid to policyholder or their beneficiaries regardless of whether an insured event occurs, measured consistently with the measurement of the overall insurance contract liability.
In formulating their recommendation to the Boards, the staff considered several other alternatives:
- Alternative A: no separation of investment components – an approach previously rejected by the Boards
- Alternative B: separation of explicit account balances only
- Alternative C: the staff recommendation presented above, and
- Alternative D: separation of the amount of premium an insurer estimates will be returned to policyholder.
The Boards discussion focussed on the wording of the staff recommendation. It was important to clarify that the ‘regardless of insured event’ would includes a portion of the cash flows that gets paid out on the insured event but would have been paid out anyway, if the policy, say lapsed at that time. The Boards agreed to delete the words ‘measured consistently with overall insurance liability’ to make it clear that the cash flows had to be probability-weighted rather than assuming that 100 per cent of cash flow on the insured event was insurance and 100 per cent of cash flows in absence of insured event was the investment component.
One FASB member expressed a concern that there was a potential for structuring and wanted to make sure that those transactions that could be entered separately but instead were entered as one contract would still result in unbundling of the financial instrument contract if they are distinct from the insurance coverage.
The unbundling versus disaggregation debate was re-opened at this point and highlighted the lack of clarity among the Boards members as to whether explicit account balances would get disaggregated or not. Many IASB and FASB members felt that if the investment components are in fact distinct, they should be unbundled.
One member felt that the premium figure would include a lot of estimates making it less reliable. One IASB member raised a concern that insurance contracts even if they include investment components are priced on the basis of pooling of risks (resulting in some cross subsidies among the bundled components) and the resulted separated investment elements will not be comparable with similar financial instruments not offered as part of insurance thus not being distinct components. Others countered the fact that similar issues had been successfully overcome in the revenue recognition project.
Another concern raised was that financial instruments with discretionary participation features were included under the insurance contracts scope if they were managed together with insurance contracts and the principle of unbundling investment components would contradict that decision.
When the Boards opened their decision making session, they first looked at the question which defined an investment component as an amount that the insurer is obligated to pay to the policyholder or a beneficiary regardless of whether an insured event occurs. There was unanimous support for the principle at the FASB, in particular there was support for the recommendation to unbundle the distinct components first and then to disaggregate those components that are not distinct based on the staff recommendation. The IASB had 9 members in favour of the recommendation. This was referred to as “alternative C+”. However as that was not the question asked and due to some other concerns raised, no formal vote was taken.
On the second question proposing exclusion of present value of investment components as defined from the aggregate premiums in comprehensive income, the IASB voted unanimously in support of the staff recommendation. The FASB did not vote asking instead to discuss this issue further in a separate meeting.
The staff will bring back the issue whether disaggregation should be permitted or required and how to incorporate the wording proposing to unbundle those investment components that are distinct and with no interdependencies.
The next issue was balance sheet presentation of investment components. After giving 6 alternative views, the staff recommended not to separate investment components in the statement of financial position. Instead, the insurer would disclose the amounts payable on demand and the portion of insurance liability that represents the aggregated portions of premiums received (and claims/benefits paid) that were excluded from the statement of comprehensive income because they represented investment components as defined by previous recommendation (amounts payable to policyholder/beneficiary regardless of insured event occurring).
These were the alternative proposals to disaggregate investment component on:
- An amortised cost basis
- A fair value basis
- An amount equal to account balance
- A current amount payable on demand
- An amount calculated using the insurance contract model (BBA)
- No separation on the balance sheet with disclosures
A lively debate took place at both Boards. One IASB member was concerned whether the staff recommendation was to prohibit the splitting on the balance sheet. The staff replied that they did not intend to recommend prohibition.
A few members questioned why separate presentation on the balance sheet was not recommended. The staff view was that the objective for the balance sheet was comparability whereas the objective for comprehensive income statement was relevance of premium volume information. The amounts on the balance sheet, if separated would not be comparable with similar financial instruments issued by non-insurers or similar insurance coverage only products because of the inter-dependencies and difficulties in allocating acquisition costs and some other cash flows. To assign one element as a residual in the calculation was also not attractive. Instead the information would be disclosed to inform the readers about the timing of the cash flows.
One other IASB member raised the issue that users focus on the return on assets measure and that symmetry with insurer’s assets in the presentation of insurer’s liabilities was important. Further, this same member pointed out that in most life/long term business insurance models, the business is worth more as an ongoing business than as a run-off model. Looking at cash surrender values only assumes that all policies were cancelled which is not a relevant measure unless the assets are performing really badly and there is a liquidity concern.
One other IASB member followed this point further noting that since more than one measure is relevant and there is no one clear answer it is not appropriate to separate the amounts on the balance sheet and the disclosure is the most appropriate route. So the Boards proposed that adequate disclosures had to be provided for account balances and surrender values in addition to the disclosures proposed by the staff.
FASB was split on the proposal. There was support for disaggregation but at the same time concerns were raised about the resulting impact on accuracy and the need to provide reconciliations year-on-year with explanations for the movements. Some FASB members, in line with the IASB majority, preferred the staff recommendation not to disaggregate, as there was no one obvious answer.
The IASB voted 11 in favour (including the additional disclosures).
The initial FASB vote had only 3 in favour and it was only after a second vote that a majority of 4 emerged in favour of achieving convergence.
In the continuation of a joint session held on 16 December 2011, the Boards were asked to consider the definition of a portfolio of insurance contracts and the level at which insurance contracts should be aggregated for measurement and other purposes. The staff recommended that the unit of account used to determine the residual / single margin and perform the onerous test should be the portfolio and the following components should be included in the definition of portfolio:
- subject to similar risks,
- managed together as a single pool, and
- priced similarly relatively to the risk taken on.
The unit of account used to release the residual / single margin should not be prescribed. However, the release of the residual / single margin should be performed in a manner consistent with the objectives for releasing the residual / single margin. The paper noted that a minority of members of the staff recommended instead that the definition of portfolio used to determine the residual / single margin, release the residual / single margin, and to perform the onerous contract test should also include the concept of similar duration and expected pattern of release of the residual / single margin in conjunction with the other indicators noted above.
The concept of similar risks, as described by the staff, considers the type of risk insured, (e.g., theft, fire, mortality, etc.), the product line (e.g., annuity or income protection, etc.), the type of policyholder (e.g., commercial or personal, etc.) and the geographic location (e.g., across continents, states, provinces).
The concept of management of contracts in a single pool considers the manner in which the contracts are acquired (e.g., broker channels or direct, etc.), the manner in which contracts are serviced, the business unit within which the contracts are managed (based on the organisational form of the insurer) and the geographic location of management activities.
The concept of similar pricing considers similar compensation required for taking on similar insurance risks as opposed to similar pricing by number of currency units.
The Boards were unsure if there is a need for the entire set of indicators (i.e., similar risks, managed together and priced similarly) set out in the staff recommendation and whether they should be analysed collectively. In addition, they suggested giving more consideration to the release of the residual / single margin against the proposed portfolio definition.
One FASB member suggested that the recommended application guidance on the definition of a portfolio of insurance contracts was redundant. He noted that the staff proposed application guidance inferred a need to disaggregate under each indicator (i.e., similar risks, managed together and priced similarly) separately thereby reducing the size of a portfolio. He suggested that considering all such indicators collectively was more relevant. The staff confirmed that the intention of the proposal was to consider all indicators collectively to attempt putting a cap on the maximum level of contract aggregation an insurer could use prior to calculating the margin and evaluating onerous contracts.
This same FASB member argued that similar duration and expected pattern of release of the single margin should be included in the definition of the portfolio; effectively viewing it as an indicator in application of the core principle underlying the expected pattern of release of the single margin. He noted that in accordance with the FASB model, where release of the single margin would be on a risk basis, the guidance on similar duration and expected pattern of release would be necessary given that the risk release would need to be at the same level as the onerous contract test.
Finally, argued that the ‘managed together as a single pool’ indicator was not necessary. However, multiple IASB members rebutted this final view in stating that even if investment and insurance components of a contract are truly distinct, they can still be managed together as a single pool and therefore should be considered in defining a portfolio.
FASB members generally supported these arguments and expressed tentative support for applying the portfolio as the unit of account to determine the single margin, release the single margin and perform the onerous test. A portfolio of insurance contracts would be defined as contracts that are:
- subject to similar risks,
- priced similarly relative to the risk taken on, and
- have similar duration and similar expected patterns of release of the single margin
with all such indicators viewed collectively to avoid a narrowing effect.
However, in the interest of avoiding divergence with the IASB, the FASB accepted also including the ‘managed together as a single pool’ as a fourth indicator in the definition of a portfolio.
Many IASB members, considering the proposals outlined by the staff questioned whether the indicators underlie a broader principle. These Board members argued that the basic principle underlying the unit of account determination was to prevent grouping loss-making and profitable contracts to avoid failing the onerous contract test. Utilising this basic principle in the new accounting standard with or without inclusion of the above indicators would limit structuring opportunities.
When put to a vote, the IASB tentatively decided that the unit of account used to determine the residual margin and perform the onerous test should be the portfolio. A portfolio of insurance contracts should be defined as contracts that are:
- subject to similar risks,
- managed together as a single pool, and
- priced similarly relative to the risk taken on
with all such indicators viewed collectively to avoid a narrowing effect.
The unit of account used to release the residual margin would not be prescribed. However, the release of the residual margin should be performed consistently with the objective of releasing the residual margin over the coverage period to reflect the service provided.
Given that the above tentative decisions resulted in non-convergence between the IASB and FASB, the FASB chair attempted to stimulate the identification of a converged solution. While both Boards accepted that the differences in their respective tentative decisions should not yield significantly different results, neither Board was willing to change its tentative decisions out of concern of unintended consequences and related implications on other decisions taken. The Boards eventually retained their respective tentative decisions as set forth above. However, the IASB and FASB staff agreed to work together in drafting to ensure that while the language in both proposals may offer certain variances, the objectives achieved were as much as possible the same.