Application guidance for risk adjustment techniques

The Boards discussed the draft application guidance for measuring risk adjustment, to be included in the forthcoming exposure draft on insurance contracts. In their 18 May 2010 joint meeting, the Boards decided that, if the measurement model for insurance contracts were to include a separate risk adjustment, the range of available techniques for measuring that risk adjustment should be limited.

The Board reconsidered the articulation of the objective and characteristics of the risk adjustment. After a significant discussion the Board agreed to modify the objective of the risk adjustment to 'the maximum amount the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows may exceed those expected'.

The Boards considered whether the risk margin might be negative. The staff noted that it might be theoretically possible to have a negative margin, but such occurrences should be rare.

Some Board members expressed their preference for an exit price notion for measurement of insurance contracts. Some of these Board members noted that the new objective came close to the exit price notion without calling it that name. Other Board members disagreed and noted that the difference to the exit price (fair value) would remain in the absence of service margin and own credit risk. The majority of the Boards rejected the exit price notion as in their opinion there is not enough transactions on the marketplace to calibrate the exit price. As such entity-specific perspective inputs into measurement cannot be avoided.

The FASB chairman expressed his view that the high level guidance on the risk adjustment techniques supplemented with disclosures should be the middle ground between the various alternatives.

The majority of Board members agreed to emphasise the one-sided nature of the risk (exceed the expected cash flows rather than differ from the expected cash flows). For those members, the risk margin is compensation for the uncertainty and reflects risk aversion (as a pricing mechanism) of the reporting entity. Some Board members also noted that the risk aversion is a broader concept than one-sided risk.

Finally, the Boards considered whether to include more discipline in the objective of the risk adjustment. Nonetheless, most of the Board members were concerned that any tightening would lead to additional complexity and introduction of new concepts that would lead to additional rules. As such the Boards confirmed the objective of risk adjustment as 'the maximum amount the insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows may exceed those expected'.

The Boards also continued their discussion (from their 10 June 2010 meeting) on which methods should be permitted to measure risk adjustment. After a discussion, in which several Board members expressed their concerns about application of the confidence level method and its limitations (applicable only to normal distributions whereas distribution of losses for insurance contracts is usually skewed, ignoring the tail risk) as well as limitations of the other methods (for instance, the assumption of the $ for $ liability compensation for relieving from potential risk under the conditional tail expectation approach) the Boards agreed to provide description of three methods as part of the proposed application guidance: confidence level, conditional tail expectation and cost of capital.

Although some Board members suggested limitation of use of any of the methods, the Boards decided not to prescribe any method as they believed that each technique covers a specific part of risk distribution and its use depends on particular circumstances.

One Board member noted that these methods should include both quantity and price of the risk and noted that the methods as proposed encompass only the quantity element. Nonetheless, the Boards did not agree to prescribe any method that includes price of risk due to its complexity and the fact that it would lead to exit price measurement.

As such the Boards approved the proposed draft application guidance on risk adjustments, containing characteristics of techniques that can be used as well as description of three techniques that might be used - confidence level, conditional tail expectation and cost of capital and their comparison. The Boards agreed not to include any additional methods in the draft application guidance.

Reinsurance

The Boards considered several follow-up issues related to reinsurance that were raised at the 10 February 2010 meeting.

The Boards also agreed that at inception of the reinsurance contracts the reporting entity should re-measure the underlying reinsurance asset, as the risk profile might have changed from the last reporting date. The Boards agreed that a cedant shall not recognise any negative residual or composite margins when measuring a reinsurance asset, but instead if the consideration paid by the cedant for the reinsurance contract is less than the measurement of the reinsurance asset the cedant shall recognise that difference as a gain in profit or loss at inception of the reinsurance contract.

The IASB agreed that a cedant should recognise any ceding commissions arising from reinsurance contracts as reduction in the premium paid to the reinsurer.

The FASB agreed that these commissions should be recognised as a gain in profit or loss, to the extent that these ceding commissions refer to the reinsurer's share of the cedant's incremental acquisition costs. The cedant shall recognise that gain at the earlier of the day on which it recognised the reinsurance contract and the day on which it incurred the incremental acquisition costs. The cedant shall treat the remaining share of ceding commissions as a reduction of the premium ceded to the reinsurer.

Even though the FASB members agreed with the proposal on ceding commissions they noted that that tentative decision might change as a result of reconsidering the treatment of acquisition costs.

One IASB member asked about the presentation of these commissions. The staff clarified that according to the expanded margin presentation model (that was tentatively agreed) these commissions would be presented as revenue in the same amount as the acquisition costs incurred. Several IASB members expressed their concerns about such accounting outcome. As a result the Boards will re-address the issue at a later stage.

Overview of the insurance model

The staff presented a paper summarising the package of tentative decisions made in the Insurance project. As the FASB indicated that it will be reconsidering the treatment of the acquisition costs what could have a significant impact on further parts of the project, the Boards decided not to continue their debate. The Boards observed that the objective of the insurance contracts seem to evolve over time from the fulfilment value approach to the contract activity approach that include all the direct and incremental cash flows. Both Boards seem to agree with such characterisation. As such the Boards observed they might want to revisit some decisions to see whether they are consistent with the changed objective.

The Board also observed that they will need to revisit several aspects of the proposed model - treatment of acquisition costs, unbundling, contracts with participating features and presentation of the performance statement (mainly the expanded margin approach).

IASB/FASB Differences in tentative decisions - reconciliation

The Boards turned to discuss a summary of issues for which the two Boards had come to different conclusions, with the view that they attempt to come to a common view, so as to limit the number of divergent positions in the forthcoming ED to as few as possible.

Acquisition costs

The IASB proved that it remains split among itself, and even with the staff characterisation of their previous decisions, in particular whether it would be more appropriate to describe the 'expense as incurred' approach as 'contract cash flows'.

Other Board members disagreed. The staff tried their best to clarify what the agenda paper was attempting to achieve, but with only limited success.

After a vigorous debate, the IASB voted 8-7 in favour of retaining the approach that expenses acquisition costs at inception, but recognises a revenue offset to the extent of the incremental acquisition costs.

The FASB confirmed their position, that acquisition costs are excluded from the initial margin.

Margin: risk adjustment

The IASB confirmed their preference to include a risk adjustment plus a residual margin in the initial measurement of the insurance contract (9 in favour). The FASB confirmed that they still favoured using a composite margin, which they see as more relevant for the fulfilment approach adopted.

Margin: should interest be accreted on the residual/composite margin?

Another interesting debate occurred. However, after it became evident that two senior IASB staff members disagreed on this issue, the IASB agreed not to conclude on this matter and the staff will return with a coordinated recommendation. The FASB confirmed that they preferred not to accrete interest on the composite margin (3 in favour).

Participating contracts

The IASB confirmed (2 opposed) that they would include participating payments in the same way as any other contractual cash flow within the expected present value. The FASB confirmed that they would include participating payments to the extent that the insurer has an obligation to pay.

Definition: when does insurance risk exist?

The IASB agreed (10 in favour) to conform to the FASB's tentative decision (and thus amending the current IFRS 4 definition with a new test): insurance risk would exist if there is at least one scenario in which the present value of net cash flows could exceed the present value of premiums.

Embedded derivatives

The IASB agreed (14 in favour) to conform to the FASB's tentative decision that the unbundling principle in the Insurance Contracts standard should be followed for derivatives embedded in an insurance contract - i.e., that such items should be unbundled unless the components are so interdependent that they cannot be measured separately. The staff believed that this would lead to the same outcome as using the principle expressed in IAS 30 AG33(h).

Derecognition

The IASB and FASB conformed their decisions (no votes): the derecognition principle in IAS 39 should be used-i.e., derecognise a liability when extinguished (i.e., when the obligation is discharged, cancelled or expires)-but with an explanatory comment that when an insurance contract is extinguished, the insurer is no longer at risk and no longer required to transfer any economic resources for that obligation.

Portfolio transfers

The FASB agreed (3 in favour) to align to the IASB's tentative decision, that a loss should be recognised on a portfolio transfer if the present values of the cash flows (including any risk adjustment) exceeds the consideration received.

Indication of intention to dissent

The IASB chairman asked whether any of the IASB intended to present an Alternative View in the exposure draft. Mrs McConnell and Messrs Engstrom, Leisenring and Smith indicated that they would do so (Mr Leisenring's dissent would have effect only if the ED is balloted before 30 June 2010, which seems unlikely).

Mr Herz noted that the FASB still had several issues to resolve before they were in a position to know what form their due process document would take. They would be discussing these issues in the week of 20 June 2010.

All other insurance issues scheduled for this meeting were cancelled.