Insurance Contracts Phase I

Date recorded:

The Board started discussions based on comments received on ED 5. It was noted that the comments would be discussed at this and the next meeting.

The issues to be discussed at this meeting are:

  • assets backing insurance contracts
  • exemption from the hierarchy in IAS 8
  • catastrophe and equalisation provisions
  • derecognition
  • disclosure
  • reinsurance
  • loss recognition
  • insurance contracts acquired in business combinations and portfolio transfers

Assets Backing Insurance Contracts

Many commentators noted that there would be possible inconsistencies between the measurement of an insurer's assets and the measurement of its liabilities.

The possible inconsistencies arise as follows.

a. For many insurers, liabilities are a combination of deferrals of revenues, undiscounted estimates, and present-value amortisation schemes using interest rates unrelated to current market conditions. Any changes in the estimates underlying those liabilities that are recognised are reported in income of the period.

b. Most of the insurer's investment assets are debt and equity securities classified as available-for-sale (AFS).Under IAS 39 Financial Instruments: Recognition and Measurement, unrealised gains and losses on AFS assets (other than reported in equity.

The staff noted that the Board had previously taken decisions or tentative decisions or has not reached conclusions on issues that are relevant to this issue. These are:

  • The fair value of a financial liability with a demand feature (for example, a demand deposit) is not less than the amount payable on demand, discounted from the first date that amount could be required to be paid (IAS 39 revised, paragraph 39B). For insurance contracts and many investment contracts marketed by insurance companies, this means that fair value of the insurance liabilities cannot be less than cash-surrender value (for life) or refundable premium (for general).
  • The Board has not agreed on how to fair value insurance liabilities.
  • The option to fair value a financial asset or liability does not extend to fair valuing a portion (e.g. one risk) of a liability.
  • Transaction costs paid when incurring a financial liability adjust the carrying amount of the liability, if the liability is reported at amortised cost. The costs are not an adjustment if the liability is reported at fair value through profit or loss. ED5, however, does allow deferred costs to be reported as an asset when incurred in conjunction with an insurance contract.
  • Arguably, transaction costs represent the amount paid to acquire an intangible asset. However, there is some question whether that asset meets the recognition criteria of IAS 38. If the intangible asset does qualify for recognition, it almost certainly does not qualify for remeasurement at fair value under IAS 38.

The Board considered the following potential approaches:

  • Asset-based approaches
  • Liability-based approaches
  • Shadow accounting approaches
  • Display alternatives
  • Transition alternatives

Asset-based Approaches

Asset-based approaches operate by changing the measurement attribute of the asset from fair value to something that more closely resembles the measurement attribute of the liability. The phrase 'more closely resembles' is intentional. Existing insurance accounting models are not historical cost or amortised cost models. Most are a combination of measurement conventions that mix, to varying degrees, old and current information.

Most commentators have limited their suggestions for changes to an insurer's investments in debt instruments, although some have suggested that any approach should apply to investments in both equity and debt instruments.

Relax Held to Maturity

One asset-based approach would be to loosen the criteria for classification of an asset as held-to-maturity. In particular, they point to the 'tainting provisions' in IAS 39 that prohibit an entity from classifying 'any financial assets as held-to-maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity ...'. The tainting provisions are a way of ensuring that an entity only includes instruments that it has a positive intent and ability to hold to maturity.

An alternative is to retain the tainting provisions, but with one addition - an additional exception that would allow sales to meet required payments of policyholder benefits or claims.

A New Category of Assets

The second asset-based approach would be to create a new category of assets that could be reported at amortised cost - assets held to back insurance liabilities.

Liability-based Approaches

Some liability-based approaches might involve establishing a new category of 'available-forsettlement' liabilities (with changes in fair value reported in equity) or extending the fair value option available in IAS 39 to insurance liabilities. Other liability-based approaches may not necessarily be fair-value measurements, but are arguably closer to fair value than existing accounting conventions, as in the shadow accounting approach described below.

Shadow Accounting Approaches

Shadow Accounting - Part 1

The rationale for shadow accounting is that a recognised but unrealised gain or loss on an investment asset should have the same effect on the measurement of insurance assets (deferred acquisition costs) and liabilities that would have occurred had the gain or loss been realised. Stated differently, it is designed to record the knock-on balance-sheet effects of recognising unrealised gain or loss.

For example, in US GAAP the amortisation of deferred acquisition costs is based (for some contracts) on the gross profits expected to be earned over the life of a book of contracts. One element of gross profits is the total investment return from assets notionally held to back the policyholder liabilities. Realisation of an investment gain has the effect of accelerating some of that return from future periods to the current period and, as a result, accelerating amortisation of deferred acquisition costs. A realised investment loss may have the opposite effect, recapturing costs previously amortised. An unrealised gain or loss, in the rationale of shadow accounting, should produce the same result.

If an entity adopted shadow accounting, an unrealised gain or loss might affect the measurement of:

  • Deferred acquisition costs;
  • Policyholder liabilities; and
  • Any liability recorded for participating (with-profits) contracts.

Shadow accounting extends the accounting for an unrealised gain or loss to mirror, or shadow, the accounting for a realised gain or loss. However, it cannot shadow accounting that is not there. ED5 leaves existing accounting models for insurance assets and liabilities in place. Many of those existing models do not include the effects of realised investment gains and losses in measuring insurance assets and liabilities. For example, shadow accounting would not result in any adjustment in the following situations:

  • The insurance accounting model includes a lock-in requirement. The measurement of deferred acquisition costs or benefit/claim liabilities does not change when the entity realises gains and losses from investment assets, except for loss recognition when expected asset earnings will not support contract guarantees.
  • The insurance model does not include any discounting of expected claim payments on general insurance contracts.
  • The insurance model does not recognise any liability to distribute additional amounts to holders of participating contracts until the insurer declares a dividend to policyholders.

It was noted that if an insurer has net accumulated losses on available-for-sale securities. The insurer may be unable to 'share' those losses with holders of participating contracts. If so, there would be no shadow adjustment.

Shadow Accounting - Part 2

Some have suggested that a recognised but unrealised gain or loss on investment assets should be accompanied by an adjustment to the reported amount of insurance liabilities that would have been included in the measurement had the liabilities been recorded at fair value. If the unrealised gain or loss on investment assets is caused by a change in market interest rates, then one would expect an opposite (but by no means identical)effect on the fair value of insurance liabilities. This approach might be described as fair valuing for only one risk, interest rates, an approach that the Board rejected in its deliberations of IAS 39. It also may produce a liability measurement that is less than the deposit floor.

In support of this extension of shadow accounting, one might argue that it is a step toward fair value. If the Board settles on a fair-value measurement in phase 2, that measurement certainly will include current interest rates. However, insurance liabilities seldom represent fixed cash flows. A change in market interest rates may affect expectations about policyholder lapse. Unless the 'shadow' adjustment to liabilities included all of the effects of a change in interest rates, it might move the measurement away from fair value.

This extension of shadow accounting is not available under IAS 39 for investment contracts issued by insurers. An insurer company could, however, change its accounting policies to adopt a measurement of insurance liabilities based on current interest rates if it concludes that this change would satisfy the requirements in ED5.The accounting change would reduce the mismatch in equity, but might still leave a mismatch in profit or loss unless the effects of changes to investment assets and insurance liabilities reside in the same place - both in equity or both in income.

Display Alternatives

Some suggested an enhanced display of amounts arising from the mismatch. IFRSs already require that the amount of unrealised gains and losses on available-for-sale be presented as a separate item in the statement of changes in equity. It is there for all to see and evaluate.

Transition Alternatives

Some constituents have suggested that insurance enterprises should be exempted from IAS 39, pending completion of Phase 2 of the insurance project. They maintain that, until Phase 2 is completed, any changes to insurers' accounting should be kept to a minimum. In the extreme, this would involve a specific scope exemption for both an insurer's investment assets and its liabilities that do not meet the definition of insurance contracts (investment contracts). A more limited transition exemption might apply to investment assets only.

Permitting wider use of amortised cost models for some of an insurer's financial assets would be a step backwards. However, for an entity that has not yet taken the step forward onto IAS 39 from largely cost-based models, there might be an argument for considering a phased transition in some tightly constrained areas. Specifically, a first-time adopter might be permitted in phase I to use an amortised cost for fixed maturity investments that back insurance contracts and meet specified restrictions, provided that the first-time adopter did not measure those investments at fair value under its previous GAAP. Entities already on IFRSs could not use this approach.

The Board discussed each approach and identified potential concerns. A number of comments appeared to indicate that the Board would seek to require similar disciplines that are required for hedge accounting. It was also noted that any approach would be to cater for interest rate caused mismatches and consequently would not be available for equity security assets.

A number of Board members said that, for now, they did not support any solution proposed but would accept the staff exploring the issues further.

Exemption from the Hierarchy in IAS 8

The staff proposed that the exemption be retained but that the expiration in 2007 be removed. Concern was expressed that this was inconsistent with the approach in Extractive Industries project. The Board asked the staff to investigate the inconsistency and bring the issue back to the Board

Catastrophe and Equalisation Provisions

The staff recommended retaining the proposal that an insurer should not recognise as a liability any catastrophe provisions or equalisation provisions relating to possible future claims under future insurance contracts.

The Board agreed with the staff.

The staff proposed the following wording change to clarify that the phrase 'future insurance contracts' refers to contracts that are not in existence at the reporting date, rather than contracts that are not in existence at the date when an insurer first applies the IFRS on insurance contracts:

An insurer shall not recognise a liability for possible future claims under insurance contracts that are not in existence at the reporting date.

The Board agreed with the wording proposal.


The staff proposed that there be no changes in this area. The Board concurred.


The staff proposed to delete the requirement that an insurer should disclose the fair value of its insurance liabilities and insurance assets. The ED had proposed to require this disclosure starting in 2006. The Board agreed.

The staff proposed clarifying the status of the Implementation Guidance on disclosure, by adding the following paragraph:

The guidance in paragraphs [IG7-61 ] suggests possible ways to apply the disclosure requirements in paragraphs 26-30 of the IFRS. An insurer would decide in the light of its circumstances how much detail it would give to satisfy those requirements, how much emphasis it would place on different aspects of the requirements and how it would aggregate information to display the overall picture without combining information that has materially different characteristics. To satisfy the requirements, an insurer would not typically need to disclose all the information suggested in the guidance. Paragraphs [IG7-61 ] do not create additional requirements.

The Board agreed.

Reinsurance - Restrictions on Gains at Inception of Reinsurance Contracts

Paragraph 18 of ED 5 attempted to limit the reporting of gains when an insurer buys reinsurance for insurance liabilities that are measured on an undiscounted basis or with excessive prudence. The gains would arise from the fact that the reinsurance premium is likely to reflect the time value of money and a realistic assessment of the cash flows.

The staff proposed that paragraph 18 be deleted and replaced with a specific requirement for a cedant to disclose the extent to which profit or loss includes gains that arose at inception of reinsurance contracts. If it is impracticable to determine the amount of some of those gains, the cedant should disclose that fact and disclose the amount of those gains that it can determine practicably.

The staff noted that this needed further research and would be brought back for future consideration. The Board indicated some support for the proposal.


The staff will recommend that paragraph 19 of ED 5 should be replaced by the following, based on the impairment test in IAS 39:

If a cedant's rights under a reinsurance contract are impaired, the cedant shall reduce their carrying amount accordingly. Those rights are impaired if, and only if:

a. there is objective evidence as a result of an event that occurred after initial recognition of the rights that the cedant may not receive all amounts due to it under the terms of the contract; and

b. that event has a reliably measurable impact on the amounts that the cedant will receive from the reinsurer.

The Board agreed.

Loss Recognition

The staff proposed adding explicit confirmation that:

a. If an insurer's loss recognition test meets the minimum requirements specified in paragraph 11 of ED 5,the test is carried out at the level of aggregation specified in that test.

b. If insurer's loss recognition test does not meet those minimum requirements so that it has to use IAS 37 Provisions, Contingent Liabilities and Contingent Assets as the loss recognition test, the comparison of carrying amounts with IAS 37 is made at the level of a portfolio of contracts that are subject to broadly similar risks.

Some commentators requested more guidance on the cash flows to be considered in an acceptable loss recognition test, and the discount rate to be used. In addition, some suggested that the Board should specify that the cash flows considered in a loss recognition test should include the effect of embedded guarantees and options.

The staff proposed that the Board should not add further guidance on cash flows and discount rates. The Board agreed.

It was noted that some commentators suggested that the inclusion of embedded options and guarantees in the cash flows used for a loss recognition test could permit the Board to exempt some embedded derivatives from fair value measurement under IAS 39. The staff will prepare an example for further discussion in December.

Insurance Contracts Acquired in Business Combinations and Portfolio Transfers

The staff proposed retaining the fair value approach in ED5. The Board concurred.

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