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Insurance contracts

Date recorded:

Application of the general model to contracts with participation features (agenda paper 2A)

This paper is a reminder of the IASB’s tentative decisions to date, but was not discussed.

Variable fee approach for direct participation contracts (agenda paper 2B)

This paper considers whether the IASB should modify its general model when an insurance contract can be viewed as creating an obligation to pay to the policyholder an amount equal in value to specified underlying items, less a variable fee for service.

Depicting the gains and losses on the entity’s share of the investment portfolio in the same way as a standalone investment could be viewed as reflecting the entity’s control of the investment portfolio. Also, reporting the entity’s interest in the investment portfolio on a consistent basis with other investments controlled by the entity would result in more transparent and understandable reporting of the changes in circumstances affecting both the investment portfolio and the entity’s obligations to policyholders.

Alternatively the returns to the entity arising from a participating contract and the associated investments could be viewed as part of the compensation that the entity charges for the service it provided. Changes in the estimate of the share of returns from such investments should therefore be regarded as a change in the entity’s compensation for its service obligation. This income should then be recognised in the periods during which the service is provided. Any benefits received by the entity from its share of the investment portfolio would thus arise only as a consequence of it holding those items on behalf of the policyholder. A fact that confirms this conclusion is that the entity is often constrained from exercising control over these investments. Consequently, the entity’s interest in the investment portfolio should be regarded as a variable fee that the entity charges to the policyholder. 

Staff recommendation

The Staff recommends that:

  1. For contracts with direct participation features, the IASB should modify its general measurement model so that changes in the estimate of the fee the entity expects to earn from the contract are adjusted in the CSM. That fee is the entity’s expected share of the returns on underlying items less any expected cash flows that do not vary directly with the underlying items.
  2. Contracts with direct participation features should be defined as contracts for which the contractual terms specify that the policyholder participates in a defined share of a clearly identified pool of underlying items; the entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items; and a substantial proportion of the cash flows that the entity expects to pay to the policyholder should be expected to vary with the cash flows from the underlying items.

IASB discussion

Recommendation 1

An IASB member felt that the IASB should adopt the variable fee approach, which she viewed as an extension of the unlocking decision, and that this should be mandatory.

Another IASB member stated that re-measuring a guarantee would affect the measurement of the variable fee and hence the amount recorded in the CSM. A further IASB member considered that as the existence of guarantees would be disclosed and, given that these are intermingled with other cash flows, they should not be unbundled. However, another IASB member felt that the re-measurement of a guarantee should be explored further, and a further IASB member stated that it was important that a guarantee does not dominate at inception of an insurance contract.

An IASB member considered that a contract with participating features is essentially a risk-sharing arrangement, and consequently it was inappropriate to draw parallels with revenue recognition. He felt that the variable fee approach weakens the use of profit or loss because of the extensive use of the CSM. When an entity also elects the use of the OCI accounting policy the disclosures that an investor needs to pull together to see the overall position will be sourced from three different components of the financial statements. This adds complexity to the new IFRS.

The Staff stated that the consequences of applying the variable fee approach where there are derivatives will need to be considered at a future meeting.

Tentative decision

Thirteen IASB members voted in favour of Staff recommendation 1, with one member against.

Recommendation 2

An IASB member stated that the proposed approach is quite rules-based, and another IASB member stated that objectives, criteria and guidance would be helpful.

An IASB member felt that the variable fee approach should be regarded as a practical expedient to be applied to the general model, rather than as a separate model. The Staff did not agree that this was a practical expedient, but reflected the features of the contract.

Another IASB member stated that scoping and reassessing whether the definition still applied is important in the effort to achieve the same accounting treatment for insurance contracts that are economically similar. The Staff stated that reassessment is not required for other parts of the new IFRS for example whether a contract is eligible to be measured under the premium allocation approach or whether it transfers significant insurance risk, and felt that it was also unnecessary in these circumstances.   

Tentative decision

Nine IASB members voted in favour of Staff recommendation 2, with five members against.

Recognition of contractual service margin in profit or loss for contracts with participation features (agenda paper 2C)

The distinguishing feature of contracts with participation features is that the contract provides policyholders with payments that vary with the returns on assets, therefore such contracts could be viewed as providing investment-related services in addition to insurance coverage.

Where an insurance contract creates an obligation to pay the policyholder an amount equal to the value of the underlying items, less a variable fee for service, the contract provides both investment-related services and insurance coverage. Conversely, where an insurance contract does not create that obligation, the entity arguably undertakes all investment-related activity for its own account and provides a discretionary return to the policyholder.

Applying the principle that the CSM should be recognised in profit or loss in a systematic way to reflect the transfer of services provided requires the consideration of the pattern of delivery of the investment-related services, and how the CSM should be recognised when there is more than one type of service provided by the insurance contract.  

Staff recommendation

The Staff recommends that, for contracts with participation features, an entity should recognise the CSM in profit or loss on the basis of the passage of time.

IASB discussion

An IASB member commented that the mix of services provided by an insurance contract can vary from period to period but this would be difficult to measure, therefore he felt that the passage of time is a good compromise and is consistent with the earlier tentative decision for contracts without participation features.

Another IASB member favoured recognising the CSM in profit or loss taking into account the different pattern of services provided, and a third member suggested that passage of time should be applied unless an entity can demonstrate that another method would more faithfully represent the provision of services in each reporting period.

An IASB member agreed that ideally each performance obligation should be measured as proposed in the 2013 ED, but the feedback was that there is no consistent way of measuring these obligations; therefore more guidance would be required.

Tentative decision

Twelve IASB members voted in favour of the Staff recommendation, with two members against.

Hedging of risks related to insurance activities (agenda paper 2D)

If the general measurement model is modified so that changes in the estimate of the fee the entity expects to earn are adjusted in the CSM (the variable fee approach), that fee is equal to the value of the share of the expected returns on underlying items less any expected cash flows that do not vary directly with underlying items.

The CSM would be adjusted by the effect of changes in financial market variables under this approach. However, if the risks arising from such variables were hedged using a derivative that was not part of the group of underlying items associated with the portfolio of participating contracts, an accounting mismatch would arise because the effect of the changes in the value of the derivative would be recognised in profit or loss in accordance with IAS 39 and IFRS 9.

The Staff has identified three approaches that address these mismatches, which are:

  1. Limited application of the variable fee approach
  2. Recognition of changes in the value of guarantees and the entity’s share of the underlying items in profit or loss instead of the CSM
  3. Designation of the derivative as an underlying item.

These approaches could be applied unconditionally, or conditional on specified criteria.

IASB discussion

Several IASB members expressed a preference for approach 3. One stated that this was the approach that appeared to be the most consistent with the variable fee approach, and he felt that hedge accounting should not be considered further.

The Staff stated that the biggest problem with the variable fee approach arises where there are guarantees within an insurance contract and the entity shares in the underlying items.

Application of IFRS 9 Financial Instruments before the new insurance contracts Standard (agenda paper 2E)

In May 2015 EFRAG issued a Draft Endorsement Advice (DEA) that expressed a view that applying IFRS 9 prior to the effective date of the new IFRS on insurance contracts may disrupt the financial reporting of insurance activities, and make financial reporting less understandable for users of financial statements whilst increasing the costs for preparers. Consequently, EFRAG proposed in the DEA that the European Commission should ask the IASB to defer the effective date of IFRS 9 for insurance businesses and align it with the effective date of the new insurance contracts Standard. EFRAG emphasised that its preliminary position is subject to further in-depth understanding of the potential effects of applying IFRS 9 prior to applying the new insurance contracts Standard and asked constituents for more insights on this issue.

Some parties have expressed the view that IFRS should be applied without delay, and that any temporary measures proposed to address concerns should be optional rather than mandatory.

The Staff has conducted outreach with interested parties to better understand the issues that could arise. Common concerns include a temporary increase in accounting mismatches and other sources of volatility in profit or loss created by the change in the classification of financial assets when IFRS 9 is applied without a change to the accounting for insurance liabilities at the same time, and the need to undergo two consecutive sets of accounting changes in a short period of time, which could create confusion for users, and more cost and effort for both preparers and users of financial statements.

Delaying the application of IFRS 9 could diminish the relevance of the financial statements of the entities that issue insurance contracts, even if this results in temporary increases in accounting mismatches. Such increases could be addressed on the liability side of the balance sheet by exploring accounting policy options available under the current version of IFRS 4, or permitting additional options. The alternative to a liability-based solution is for the IASB to consider deferring the effective date of IFRS 9 for entities that issue insurance contracts (see Agenda Papers 2F and 2G).

However, deferring the effective date of IFRS 9 could also create added costs and complexities for both preparers and users of financial statements. This is because: new accounting guidance would be required that could be complex and create operational challenges for preparers and confusion for users of financial statements; it would reduce comparability in the accounting for financial instruments that would probably need to be mitigated by enhanced disclosures; and create a risk of earnings management if both IAS 39 and IFRS 9 were simultaneously applied within one reporting entity. Deferring the effective date of IFRS 9 would still involve two consecutive sets of accounting changes, i.e. the application of the deferral guidance followed by the application of IFRS 9 in conjunction with the new insurance contracts Standard.

IASB discussion

An IASB member stated that it may be operationally easier to apply IFRS 9 before the new insurance contracts Standard because of the limited resources that some insurers will have at their disposal for the implementation of complex and expensive new IFRS requirements such as those from IFRS 9 and from the new insurance contracts Standard. Another IASB member stated there was a risk of inappropriate accounting resulting from a transfer of assets where two different Standards are used by the same reporting entity e.g. a financial conglomerate with both insurance and other non-insurance subsidiaries.

Another IASB member stated that it would be helpful to distinguish between changes that will survive on adoption of the new insurance contracts Standard and those that will not, in order to understand how useful the temporary solution might be.

It was stated that most of the feedback that had been received was from preparers, with little feedback from users, and that some jurisdictions outside of Europe considered that any permitted deferral in the application of IFRS 9 should be optional.

Use of IFRS 4 Insurance Contracts to address the consequences of applying IFRS 9 Financial Instruments before the new insurance contracts Standard (agenda paper 2F)

Under existing accounting requirements accounting mismatches could arise between insurance contract liabilities measured on a cost basis and financial assets measured at FVPL that the entity holds to back those assets. The application of IFRS 9 could change the extent to which accounting mismatches arise. Some debt instruments that are classified as AFS under IAS 39 would not qualify for measurement at FVOCI under IFRS 9, and an entity may find it unattractive to classify equity instruments classified as AFS under IAS 39 at FVOCI in accordance with IFRS 9 because gains and losses on equity instruments would not be recycled to profit or loss, and might therefore classify them at FVPL under IFRS 9. However, there are also situations in which accounting mismatches could be reduced when IFRS 9 is applied, e.g. some bonds previously classified as AFS could qualify for amortised cost, or an entity could revoke the fair value option on its initial application of IFRS 9 if this allows the elimination or reduction of an accounting mismatch created by the adoption of the new insurance contracts Standard (e.g. because the entity elects the use of the OCI accounting policy option for its insurance contracts).

If the IASB decides to permit entities to choose an accounting policy in respect of contracts with participation features that present all changes in the value of an insurance contract in profit or loss, or to present the effect of changes in discount rate in OCI, the application of the new Standard would reduce accounting mismatches in profit or loss and in equity that would otherwise arise between insurance contract liabilities measured on a cost basis, and assets that are measured at FVPL or FVOCI.

The application of IFRS 9 may result in a change in classification of assets from AFS or amortised cost to FVPL. When IAS 39 is applied, changes in the value of the entity’s share of underlying items may be reported in OCI (if AFS) or not re-measured (if amortised cost). Such volatility would be recognised as an adjustment to the CSM on application of the variable fee approach. This scenario shows that the new insurance contracts Standard would effectively address the temporary mismatches that arise from the application of IFRS 9 ahead of its later effective date.

It should be taken into account that insurers currently have the ability to reduce accounting mismatches using shadow accounting and/or the elective use of current interest rates. In addition, IFRS 4 permits an entity to change its accounting policies for insurance contracts if the change makes the financial statements more relevant to the economic decision-making needs of users. It could be argued that these methods could equally be applied to the additional temporary accounting mismatches that arise after IFRS 9 is applied and before the application of the new insurance contracts Standard. However, there are limitations on the contracts to which shadow accounting could apply, and many entities would prefer not to use current interest rates to measure insurance contracts only a couple of years ahead of the requirement being adopted in the context of the full implementation of the new insurance contracts Standard.

The IASB could seek to reduce these remaining accounting mismatches and other sources of volatility by making amendments to the current IFRS 4. These amendments are: to allow an adjustment similar to that in shadow accounting that would result in the recognition of gains and losses on insurance contract liabilities that would offset any unrealised gains and losses on the assets (subject to meeting certain criteria); and to permit entities to recognise a liability adjustment to reflect the differences between the change in the value of the assets under IAS 39, and the change in their fair value under IFRS 9, to the extent that those changes are recognised in profit or loss. Applying these amendments may require an entity to implement systems and other changes that may not be justified from a cost-benefit perspective given the relatively short period between the application dates of IFRS 9 and the new insurance contracts Standard. However, the IASB could make any modifications optional. It goes without saying that any changes to IFRS 4 would be subject to IASB’s usual due process, including public consultation.

IASB discussion

Two IASB members commented on the need to distinguish between economic and accounting mismatches as far as practicable, with appropriate disclosures to explain these.

An IASB member questioned whether there could be flexibility in the application of shadow accounting such that this was applied to 100% of the backing assets, not just to the policyholders participation, or to extend shadow accounting to contracts without participation features that are not contractually linked, but are economically linked. Another IASB member expressed the view that an interim approach is needed, and that shadow accounting is directionally consistent with the variable fee approach.

Another IASB member felt that developing the variable fee approach, with companies early adopting this prior to fully implementing the new insurance contracts Standard, would be a more elegant approach than the solutions set out in agenda paper 2F.

The complexity of deferring the effective date of IFRS 9 Financial Instruments for the insurance industry (agenda paper 2G)

If the IASB was to defer the effective date of IFRS 9 for the insurance industry it would need to determine the scope of the deferral, assess whether there is a need for particular presentation and disclosure requirements, and identify where there are any accounting consequences of the deferral that need to be addressed.

The Staff has identified three broad approaches to deferring IFRS 9, which are:

  1. Deferral at the reporting level
  2. Deferral at the legal entity level
  3. Deferral for insurance activities

Approach 1 – reporting entities

This is the least complex approach, which would not contradict the existing provisions in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors and IFRS 10 Consolidated Financial Statements. However, this could result in some insurance activities not being eligible for the deferral and/or some banking activities being eligible for the deferral.

Under this approach the IASB needs to consider what conditions are relevant, which are: whether the entity issues insurance contracts in the scope of existing IFRS 4; whether those activities are significant to the entity; and/or whether the entity is a regulated insurance entity. Guidance would need to be issued on the first two conditions. It also needs to consider what presentation and disclosure requirements are likely to be needed if there is a mandatory or an optional deferral of IFRS 9 for reporting entities.

Approach 2 – legal entities

This is significantly more complex to develop, for entities to apply and for users of financial statements to understand. In addition to considering similar issues that arise under approach 1, the IASB would also need to consider, and for entities to apply, requirements that address the co-existence of IAS 39 and IFRS 9 in consolidated financial statements.

The IASB would also need to consider presentation and disclosure requirements that address: how the reporting entity applied the deferral; the use of two different accounting Standards for financial instruments within a single reporting entity; transfers of assets between those entities within the reporting entity where different Standards for financial instruments apply; and the different time of the initial application of IFRS 9 by legal entities within the reporting entity.

Approach 3 – insurance activities

This is the most complex approach. It may not require a significant assessment as part of the qualifying conditions for the deferral because it purports to capture just insurance activities. However, in addition to all of the complexities discussed under approach 2, this approach could also require the IASB to determine how to capture insurance activities below the level of a legal entity and which particular financial assets belong to those activities.

IASB discussion  

An IASB member stated that difficulties would arise if there were disclosures about seven categories of assets that would arise if IAS 39 and IFRS 9 were applied at the same time.

Another IASB member stated that Regulators may be concerned at the creation of a competitive disadvantage if different dates were permitted for the adoption of IFRS 9.

An IASB member noted that although transfers of financial assets between insurance and banking activities are rare they are known to have occurred. The IASB cannot prevent these transfers from taking place by prohibiting them in an IFRS. Another IASB member stated that the requirements needed to be set out for such transfers.

Next steps

The IASB is expected to consider the remaining technical decisions during the remainder of 2015. In particular, as the IASB has tentatively decided to modify the general model as proposed in agenda papers 2B and 2C, the differences between the general model and the variable fee approach, and whether those differences can be/need to be eliminated, will be considered at future meetings.

The new Standard is not expected to be published before the end of 2015, and its mandatory effective date will not be considered until after the IASB has concluded its deliberations.

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