Insurance Spotlight — Transition: Is the finish line in sight? (Issue 6)
The Bottom Line
- The FASB and IASB (the “boards”) recently agreed on significant components of the revised transition proposals, including measurement of the margin; insurers would be required to apply current tentative decisions about transition measurement to all in-force insurance contracts for all periods unless it is impracticable to do so.
- The IASB decided to reexpose the insurance contracts exposure draft (ED)1 in the first half of 2013 and confirmed that the reexposed draft’s questions for respondents will be limited to aspects of the ED that have “significantly changed” as a result of the IASB’s redeliberations. The decision to reexpose, rather than issue a review draft, was made despite some board members’ concerns that such a decision would further delay the issuance of a final standard, which is now targeted for 2014. The IASB also confirmed that approximately three years would be allowed for implementation; thus, the mandatory effective date would be no earlier than January 1, 2017.2
- The FASB recently published the revised timetable for its ED, which has been delayed to coincide with the issuance of the IASB’s ED in the first half of 2013. However, the FASB still has not projected a date for finalization of the project. In addition, unlike the IASB, the FASB has not addressed its revised standard’s effective date and provisions for early adoption. The FASB’s ED is expected to be effective no earlier than the IASB’s ED (i.e., January 1, 2017, at the earliest).
- In October 2012, executives from some of the largest insurance companies worldwide, a cross-section of property and casualty, life, and health insurers, gathered for Deloitte’s 13th Insurance Contracts Roundtable. While the participants’ backgrounds were diverse, they unilaterally expressed their concerns and frustrations with the project’s continued delays related to both the timing of key tentative decisions and the finalization of the project.
Beyond the Bottom Line
This Insurance Spotlight summarizes the boards’ recent decisions on the transition provisions related to the insurance contracts project and highlights industry perspectives on these decisions and other matters affecting the industry following Deloitte’s October 2012 Insurance Contracts Roundtable discussion.
Despite the recent announcement that the FASB’s and IASB’s guidance on insurance contracts would not be converged, the boards confirmed their previously expressed intent “to converge wherever possible” and jointly discussed and voted on the revised transition requirements. The staffs noted that the alternatives considered were analyzed on the basis of three key objectives:
- Providing a consistent measurement of the insurance liability.
- Allowing comparability of earnings at transition and subsequently.
- Considering practical needs and meeting cost/benefit tests.
The boards considered various alternatives, including an option to (1) write off any margin at inception; (2) record the margin as the difference between the new measurement and the carrying value as of the earliest period practicable; (3) estimate the margin by using the historical assumptions or an adjusted average of the periods; or (4) record the contract at its full fair value at transition. While each of these alternatives was in line with the three stated objectives to varying degrees, none fully met all three objectives.
While the boards’ recent discussions focused on the main transition issue — how to retrospectively measure the margin3 on in-force contracts — they reached tentative decisions on all significant aspects of transition, including measurement, the discount rate, and disclosures.
The boards decided that at the beginning of the earliest period presented, an insurer should (1) measure the present value of the fulfillment cash flows by using current estimates as of the transition date (i.e., as of the earliest period presented in the insurer’s financial statements4); (2) account for acquisition costs in accordance with existing tentative decisions and derecognize any existing balances related to deferred acquisition costs; and (3) determine the margin as follows:
- Retrospectively apply the new accounting principle to all prior periods for which retrospective application is practicable.5
- For contracts issued in earlier periods for which retrospective application is impracticable, estimate what the margin would have been if the insurer had been able to apply the new standard retrospectively.
- If retrospective application is impracticable for other reasons, apply the general requirements of ASC 250-106 (i.e., “measure the margin by reference to the carrying value before transition”).
The retrospective approach would allow entities to use a practical expedient for portfolios of older contracts for which all necessary data may not be available. While this practical expedient still requires insurers to use all objective information that is reasonably available to them, the boards agreed that efforts to obtain such objective information for this estimate should not be “exhaustive.” The boards asked the staffs to consider introducing constraints to mitigate the risk of any profit manipulation, including the potential to explicitly define the length of the time for which companies would be required to determine the margin at transition.
The boards also agreed that insurers should determine the discount rate in accordance with existing tentative decisions. For periods considered impracticable, the discount rate should be determined by using a period of at least three years leading up to the transition date. The top-down or bottom-up rates would be compared with an observable market rate, thereby establishing a relationship for those respective years to determine the best corresponding discount rate used at transition. Further, the transition discount rate that is determined is deemed to be the “locked-in” rate for recognition of future interest expense, accretion of the discount, and determination of the amounts to be recorded in other comprehensive income (OCI) (as part of the “OCI solution” that was previously approved by the boards).
The discount rate is a key assumption in the measurement of an insurance contract liability at inception and subsequently. See the diagram in the Transition Method — Illustration section below for additional information about this concept and its impact on insurers.
Insurers should provide the disclosures consistent with ASC 250-10 (or IAS 87) as well as the following, more specific, insurance-related disclosures:
- The earliest practicable date to which the insurer applied the guidance retrospectively.
- The “method used to estimate the expected remaining [margin] for insurance contracts issued before that earliest practicable date, including the extent to which the insurer has used [objective or nonobjective information in determining the margin].”
- The “method and assumptions used in determining the initial discount rate during the retrospective period.”
The following diagram is a sample illustration created for a single portfolio of life insurance contracts issued at t-x, with a contract boundary extending beyond the effective date, presumed to be January 1, 2017 (reflected as t0). This diagram was simplified by illustrating a single cohort but would be replicated for each cohort issued in each period after t-x.
The illustration above is designed to portray the effects of current tentative decisions on determination of the discount rate and cash flows at transition, including consideration of the appropriate number of financial reporting periods (not only in relation to the effective date but also with regard to presentation). These considerations are outlined in more detail as follows:
- Assuming an effective date of January 1, 2017, public companies issuing insurance contracts will be required to present comparative information for the 2016 and 2015 income statements and the 2016 balance sheet within the 2017 financial statements. In addition, opening balance sheet information will need to be established as of 2015 so that the earliest period presented for transition is t-3 or three years earlier than the effective date of the final insurance contracts standard. Moreover, because of the requirements associated with the five-year historical table, an entity will need to present data dating back to 2013.
- Unless it is impracticable to do so, insurers will be required to retroactively apply the standard’s measurement provisions, resulting in a “look back” to historical cash flows from a contract’s inception date for all periods. This look back will result in significant complexity for insurers for which many in-force contracts are related to insurance policies issued a number of years before the transition date and for which all data may not be available.
- Insurers will need to estimate the cash flows for any periods considered impracticable (the period between t-3 and tx) in determining the margin at transition and how this margin is subsequently released. Depending on the nature of an insurer’s business, this estimation process most likely will result in significant management estimates for many insurers.
- Insurers will need to collect data between finalization of the standard (t-6) and transition (t-3) to effectively create an opening balance sheet as of the earliest period presented. Complexities will arise for insurers that are not prepared to present the financial statements as of transition (t-3) as actual experience (between t-3 and t0) begins to affect estimates that should have otherwise been known and made as of the transition date.
- As a result of the recent transition decisions and the “OCI solution” offered by the boards, a transition OCI adjustment for the difference between the rate at inception of the contract (t-x) and that at transition (t-3) would be recorded and would now be effectively unwound at the “locked-in” rate.8
- As the insurance liability is subsequently remeasured, changes from the transition discount rate forward to the current measurement rate (t+x) would also be recorded in OCI in a manner consistent with current tentative decisions. Unlike insurance contracts issued during the post-transition period for which the “locked-in” rate is also the discount rate at inception of the contract,9 the boards acknowledged that entities need additional guidance to determine how the initial amount recorded in OCI at transition will be adjusted for contracts for which full retrospective application was considered impracticable.
After months of uncertainty regarding what the next milestone document would be, the IASB has confirmed that it will reexpose its ED rather than issue a review draft. The IASB has also decided that this reexposed ED will contain questions addressing the following five aspects of the project:
- Treatment of participating contracts.
- Presentation of premiums in the statement of comprehensive income.
- Treatment of the unearned profit in an insurance contract (including unlocking the residual margin).
- Presentation of the effect of changes in the discount rate used to measure the insurance contract liability within OCI (i.e., the “OCI solution”).
In addition to making this decision, the IASB discussed including in the reexposed ED a “stern warning” against commenting on topics other than the five specified above; the purpose of this warning would be to emphasize that the next reexposure is intended to generate the final round of comments. The IASB also updated its projection for issuance of the revised ED to the first half of 2013, which is consistent with the targeted date for issuance of the FASB’s ED. The IASB has now confirmed that insurers will need approximately three years10 to properly implement the new standard and has further elected to permit early adoption in an effort to achieve comparability as soon as possible. Thus, the mandatory effective date would be no earlier than January 1, 2017, or possibly January 1, 2018. The FASB has not yet addressed the timeline for issuance of the final standard, effective date, or whether to permit early adoption, but the effective date of the FASB’s final standard will most likely not be earlier than that of the IASB’s.
The IASB’s decision to limit reexposure to the five topics listed above has generated mixed reactions. Many acknowledge that, from the IASB’s perspective, the need for a new standard remains critical because of the various existing insurance accounting models under IFRS 4.11 From the FASB’s perspective, the need to issue a standard is arguably less urgent because the insurance accounting guidance is established under U.S. GAAP and any changes (whether broad or limited to targeted improvements) need to be balanced against the desire to have a single set of global accounting standards. Yet because the boards have decided against complete convergence for insurance contracts and the SEC has not yet made a decision on the status of convergence, uncertainty remains.
Insurance Contracts Roundtable and Industry Views
At the recent insurance contracts roundtable, participants expressed frustration with the project’s uncertainties, which has led many to take a more cautious, “wait and see” approach to preparing for the changes. Because the exact nature and timing of the required changes are so uncertain, many companies indicated that it was difficult for them to engage key company personnel and, ultimately, to determine whether the benefits will outweigh the costs. Some participants fear that the requirements for businesses, which “work well now under U.S. GAAP,” will confuse investors. Many insurers continue to want an aligned set of global accounting standards, but only if key core principles remain intact. One of the fundamental difficulties has been to agree on what the core principles should be.
Participants also discussed the board’s recent transition-related decisions made in the week before the roundtable discussion. During the discussion, participants expressed initial concerns not only with the complexity of the specific transition proposals but also with the overall magnitude of changes that the project introduces. Some participants compared implementation of the proposed insurance standard with recent implementation issues associated with the adoption of the guidance in ASU 2010-2612 on deferred acquisition costs, noting that ASU 2010-26 was a microcosm of the types of changes that would be necessary to implement the proposed insurance contracts standard. Also, while industry professionals raised concerns related to complexity, costs, and the uncertainty about the measurement and presentation changes to the financial statements, no other alternatives were identified. Many also acknowledged that industry perspectives on critical decisions such as transition are often provided only in response to tentative decisions reached. To avoid further delays to the project, many participants would prefer more up-front collaboration with stakeholders as alternatives are explored.
The Future of Insurance — Multiple Reporting Bases
The following diagram illustrates the multiple financial reporting bases that will exist for the U.S. parent insurance company and its foreign subsidiaries:
Despite uncertainties in the project, the recent announcements that the two standards on insurance contracts would not be converged have suggested that insurers can now expect to deal with multiple financial accounting and reporting bases for the foreseeable future.
Given the magnitude of the potential changes, insurance companies and entities that issue insurance contracts should continue to:
- Monitor the project’s status and exchange views with others in the industry to better assess the ramifications of tentative board decisions for their financial accounting and reporting processes.
- Actively participate in discussions with the boards and their staffs and in public forums to ensure that their voices are heard by the standard setters.
- Evaluate the ability of existing processes to capture the information needed for compliance and assess the impact on current business practices.
Watch for additional publications on the insurance contracts project as we continue to explore the practical and business implications of the decisions reached by the boards.
Other Deloitte Resources
- November 2012, Insurance Accounting Newsletter, “Greater Certainty on the Roadmap to New IFRSs Comes With a Likely End of IFRS-US GAAP Convergence on Insurance.”
- August 2012, Insurance Spotlight, “The Sun Sets on Direct-Response Advertising.”
If you have questions about this publication, please contact the following Deloitte industry professional:
1 IASB Exposure Draft, Insurance Contracts.
2 At the October 2012 IASB-only meeting, the IASB confirmed its intention to allow about three years between issuance of the final standard and the standard’s mandatory effective date
3 The margin refers to the single margin for the FASB and the residual margin for the IASB.
5 The IASB tentatively decided that an insurer may factor the effects of known outcomes into its assumptions to determine the margin at transition (i.e., an insurer would be able to include the effects of known changes in estimates of cash flows from a contract’s inception date through its transition date — or the earliest period presented in its financial statements upon adoption of the revised standard). The objective of the IASB’s decision to allow the use of hindsight is to avoid unnecessary complications associated with the IASB’s decision to unlock the residual margin.
6 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
7 IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.
8 The boards decided that, in accordance with the standard, the discount rate at transition would be calculated for a minimum of three years. However, the boards did not address whether this three-year minimum was in relation to the effective date (t0) or the transition date (t-3).
9 In November 2012, the boards decided that an insurer should reset the locked-in discount rates that are used to present interest expense for cash flows that are not subject to mirroring but that are affected by asset returns (e.g., features consistent with a universal life contract). This reset would occur consistently with any change in the crediting rates used to measure the insurance contract liability.
10 The three-year timetable is consistent with results from Deloitte’s Global IFRS Insurance Survey, “Winning the Waiting Game?” conducted by the Economist Intelligence Unit.
11 IFRS 4, Insurance Contracts.
12 FASB Accounting Standards Update No. 2010-26, Accounting for Costs Associated With Acquiring or Renewing Insurance Contracts.