Insurance Contracts – Accounting consequences of mitigating risks related to insurance contracts (Agenda Paper 2E)

An entity may have accounting mismatches between changes in the value of the guarantee embedded in a direct participating contract. Under the variable fee approach the changes in the expected cash flows from that embedded guarantee will adjust the CSM. However, the changes in fair value of a derivative that the entity holds to mitigate the risks arising from this guarantee would be recognised in profit or loss. These mismatches could not be eliminated using existing hedge accounting requirements in IFRS 9. Consequently three approaches were explored, being:

Approach 1 – allow entities to account for contracts with direct participation features using the general model of accounting for insurance contracts instead of the variable fee approach;

Approach 2 (the recommended approach – see below); and

Approach 3 – allow entities to recognise in profit or loss changes in the fair value of the guarantee embedded in the insurance contracts.

Approach to eliminate an accounting mismatch

The Staff explained that their recommended approach 2 would state that if an entity uses the variable fee approach to measure insurance contracts and uses a derivative measured at Fair Value through Profit or Loss to mitigate the financial market risk from the guarantee embedded in the insurance contracts, an entity should be permitted to recognise in profit or loss the changes in the value of the guarantee embedded in an insurance contract, determined using fulfilment cash flows.

The Staff confirmed that, based on their outreach, insurers could separate and measure guarantees, and noted that this approach would be optional. One Board member expressed a preference for Approach 1 as this was consistent with the treatment for contracts without participation features and would be simpler to apply. Changes in the value of guarantees would be spread over the coverage period in the variable fee approach, but not for contracts without participation features. Another Board member felt that approach 2 most closely represented the economics when hedging, and did not support approach 1 as this did not take into account the shareholders share. A further Board member commented that needing to consider the issue was a consequence of previous decisions which resulted in hedged activities appearing to be unhedged and vice versa, so an adjustment is needed. Two Board members felt that nothing should be done, but another member considered that a realistic measure of performance needed to be achieved.

IASB members voted unanimously in favour of the Staff recommendation.

When an entity should be permitted to apply approaches to minimise accounting mismatches

The Staff noted that recognising changes in the value of guarantees in profit or loss instead of adjusting the CSM will result in a different measurement of the insurance contract and will therefore decrease comparability depending on whether the contract is hedged or not. The Staff had considered methods for specifying criteria for when an entity would be permitted to recognise such changes in profit or loss, being:

Method A: premised on reflecting the risk management activities (similar to the objective for hedge accounting); and

Method B: premised on mitigating anomalies that result from different measurement attributes (similar to the objective for the fair value option).

On balance, the Staff recommended method A because they believe that this method is closer to the objective of recognising changes in the value of guarantees in profit or loss.

Limiting criteria

Based on that analysis the Staff recommended that an entity that mitigates the financial market risk from the guarantee using a derivative should be permitted to recognise in profit or loss the changes in the value of the guarantee embedded in an insurance contract, determined using fulfilment cash flows only if that mitigation is consistent with the risk management strategy and an economic offset exists between the guarantee and the derivative. An entity should not consider accounting measurement differences in assessing the economic offset, and credit risk ought not to dominate the economic offset.

An entity should be required to document its risk management objective and its strategy for using the derivative to mitigate the financial market risk embedded in the insurance contract, and to discontinue recognising in profit or loss changes in the value of the guarantee prospectively from the date on which the economic offset does not exist anymore.

There was general support for the Staff recommendation. The IASB members voted unanimously in favour of the Staff recommendation.

Cumulative effect of recognising changes in the value of the guarantee in profit or loss

An entity should disclose as part of the reconciliation of the CSM the cumulative effect of recognising changes in fulfilment cash flows of the guarantee in profit or loss instead of an adjustment to the CSM.

Several Board members expressed concern with the Staff recommendation as this disclosure could be misleading as the changes do not adjust the CSM. The Staff intend to present an amended recommendation for discussion at a future meeting.

The next steps

The IASB is expected to consider the remaining technical issues during the meetings scheduled for the remainder of 2015. In particular, the differences between the IASB’s general model and the variable fee approach, the accounting for indirect participating contracts and the overall presentation and disclosure requirements will be considered.

Comments on the proposed changes to the current version of IFRS 4 will be requested late in 2015. The comment period (which will be less than the 120 days needed for a new Standard) will be decided during the October IASB meeting.

Tentative decisions reached by the IASB may be changed or modified at future IASB meetings, and decisions become final only after the IASB has completed a formal ballot to issue the final insurance contracts Standard.

The IASB expects to complete its re-deliberations on insurance contracts in 2015 and the Staff will draft the new insurance contracts Standard in 2016 with the intention of issuing the final Standard in 2016. Its mandatory effective date will not be considered until after the IASB has concluded its deliberations, but if the new insurance contracts Standard is issued in 2016, this could result in 1 January 2020 being the effective date.