Insurance Contracts

Date recorded:

Draft application guidance on future cash flows

The Boards have discussed the application guidance proposed by the staff about what expected future cash flows should be included in the measurement of insurance contract. The aim of the discussion was to seek feedback for staff to take away and update the drafting.

The proposed principle is to include future cash flows from the fulfilment of an insurance contract. The cash flows should reflect the insurer's estimate of its cost to fulfil, so except for market variables the inputs are entity specific, and the emphasis is on the cash flows of existing contracts rather than from potential new contracts. The guidance specifies that insurer should include among the costs necessary to fulfil the contract all of the costs directly associated with it (direct costs) and a systematic allocation of costs that relate to the contract or contract activities (indirect costs). An appendix to the guidance provides examples of direct and incremental costs that are to be included and those costs to be excluded as not relevant to the fulfilment of obligation notion.

The guidance discusses a replicating portfolio for all or part of the insurance liability cash flows. While not mandating a replicating portfolio method, the staff paper suggests if such portfolio exists to calibrate the estimates calculated by insurer using another method to it.

Further the guidance explains that in estimating cash flows at the reporting date the measure should be current reflecting the probabilities and expectations as at that date and should not use the benefit of hindsight, nor should it include possible cash flows under possible future contracts.

The staff later clarified that cash flows can be estimated at their nominal or real value (i.e. adjusted for future inflation) as long as the assumptions are used consistently.

Overall many members felt the guidance was drafted well, however, there were few comments and clarifications proposed. The focus of the comments from FASB members was that some of the proposed costs to be included in the cash flows did not tie in well with the fulfilment notion. For example, the costs of insurer in paying on-going commissions to intermediaries for policies remaining in force would not be a cost of fulfilling an obligation to a policyholder. Equally policy administration and maintenance costs proposed to be included are not costs of fulfilling an obligation. This discussion highlighted the difference in the way IASB and FASB viewed the fulfilment notion. The IASB approach was more focused on whether the costs were direct and incremental to the contract rather than on whether they were directly linked to meeting the obligation to a policyholder.

On the application of a replicating portfolio the Board members asked the staff to clarify whether it needs to be calculated in all cases to enable the calibration to it, even if a different method is used by insurer.

Further, the Board members suggested clarification of the guidance on the impact of future events on the estimates of cash flows, to make the distinction clearer between the types of future events that need to be considered because they impact cash flows of the existing contracts and those future events that need to be ignored because they do not impact existing contracts.

Finally, the staff were asked to tighten the wording of the overall principle to link it more closely to the more detailed guidance that follows it.


Foreign currency cash flows

After a high level theoretical debate whether components of insurance liability meet the definition of a monetary item, the Boards have unanimously approved the staff proposal to treat insurance contracts in their entirety, including all the components, as monetary items. This would mean that insurance contracts with expected foreign currency cash flows would be subject to the foreign currency retranslation rules. The Boards further agreed with the staff that pre-claims liabilities of short-duration contracts measured an unearned premium approach would also be considered monetary items. This is because the unearned premium approach is viewed as a shortcut measurement method to the full building blocks looking at the underlying cash flows approach and therefore there should not be a difference in the foreign currency treatment. This would differ from the current treatment of such contracts. Currently they are viewed as prepayments of future services and therefore non-monetary.


Recoverability of the acquisition costs

The Boards held a long and ultimately inconclusive discussion on acquisition costs. In many insurance contracts, the commission is obtained from the premium, almost as a premium add-on. The question then becomes, if they're going to be recovered (for example, from a broker, in the event of a policy lapsing), why are such costs expensed; should they not be an asset? FASB members noted that there is no actual guarantee of recoverability (dependant on lapse), so the contingent right to recover costs does not meet the criteria of an asset, which is why the FASB wishes to expense all acquisition costs.

Some IASB members noted that there appeared to be a disconnect between the way acquisition costs were treated depending on whether they were received from policyholders via gross premiums and then paid to brokers, or whether the premium was paid net via the broker. These members argued that there was no inherent difference in the economics of the situation, only in the presentation, so there was no reason to treat them differently. The reason for different presentation arises largely from the broker not having an account with the insurer (hence an asset raised), where a policyholder would have an account (likely an investment policy of some sort, as this is primarily an issue in life insurance where acquisition costs are significant) where the payout would be reduced by some sort of lapse-penalty, hence a reduction in the underlying liability.

The boards discussed the possibility of expensing acquisition costs as incurred unless recoverable, possibly limited only to broker recoveries (as lapse-penalties are likely to be included within the contract cash flows, hence within the liability if it relates to a policyholder). This did not receive significant support, as Board members argued that there still isn't any contractual right to receive cash, so no asset (dependent on some future event - the lapse - so a contingent asset at best).

The next question related to whether (assuming recoverability), the acquisition costs should be recognised in profit or loss as an expense. If not, what was the appropriate accounting? The initial proposal that P&L treatment was not appropriate and that broker recoveries should be recognised as prepayments and insured recoveries included with the liability were not well received. Board members argued that this is just another way of deferring and amortising the expense - just like DAC - which the Boards had already agreed not to do.

The boards then argued that, as acquisition costs are defined as incremental, the insurer is effectively using revenue (through the release to P&L) to create an asset that will generate future revenue streams - which seems counterintuitive.

The boards then tried to work through an example, but there were disagreements about the parameters for the example. The Chairman decided to terminate today's discussion - to be continued Wednesday.

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