Insurance Contracts

Date recorded:

Presentation from the Chair, IAIS Insurance Contracts Subcommittee

Robert Esson made a short presentation on behalf of the International Association of Insurance Supervisors. He stressed that the supervisors were increasingly concerned about the boards' approach to considering issues on theoretical grounds on an individual basis. He acknowledged that this was a necessary step; however, the IAIS believed that the boards should also consider the impact of their tentative decisions made on the totality of financial reporting by insurers. In his view, the boards ought consider the business structure for insurers and determine whether, in totality, the tentative decisions made so far would lead to useful information for users of the financial reports of insurers.

In particular, he stressed that any financial reporting model introduced by the boards would involve some degree of pragmatism. What was important is that the financial reporting should reflect the economics of the business and not introduce volatility that is not reflective of the economics of the business.

Throughout the presentation, Mr Esson noted that the IAIS had identified a key principle that should prevail: that a model using unbiased, probability-weighted cash flows would provide an answer to many of the problem in the insurance contracts project. In particular, he noted the problems created by forcing the residual margin to calibrate the profit or loss on inception of the contract to zero. If the model were permitted to weight acquisition costs as a '1.0' (that is, certain) cash flow, the residual margin would be lower, acquisition costs would still be expensed, but the deferred profit embedded in the residual margin would not be distorted. He acknowledged that unbiased probability-weighted cash flows were not perfect, but they were significantly better than the direction that the boards were taking.

Board members asked for clarification of certain issues, but it seemed that many of the more vocal board members were not persuaded by the presentation.


Insurance contracts - unbundling

The boards discussed whether an insurer should recognise and measure those components of a contract as if they were separate contracts (unbundling). The staff introduced the technical discussions by noting that the IASB and FASB staffs were split on the issue.

The IASB staff were largely supportive of the following positions:

An insurer should unbundle a component of an insurance contract if that component is not interdependent with other components of that contract. This would also apply to those components of insurance contracts that are embedded derivatives.

If components are interdependent, an insurer:

  • should not be permitted to unbundle those components of the contract for recognition and measurement.
  • should not separate any deposit element from the remainder of the premium for presentation in the performance statement.

The FASB staff had prepared an Alternative View:

  • the notion of interdependency should apply only to situations in which the components cannot function independently, that is, only to those situations where a truly symbiotic relationship is necessary for the individual components to function;
  • embedded derivatives in an insurance host contract should continue to be subject to existing guidance for derivative instrument accounting and bifurcated when appropriate. There should not be an exception from [IFRS] for insurance-the general notion in the insurance contracts project should be to address insurance specific issues; and
  • contracts subject to unbundling should be presented on an unbundled basis on both the balance sheet and income statement.
The discussion that followed was often difficult to follow as board members flipped between agenda papers at will. However, it was clear that there was a lack of consensus between the FASB and the IASB - although some IASB members were supportive of the FASB staff view. One IASB member noted six significant problems with the proposed model and felt that the notion of 'interdependency' was at the root of all of them.

An IASB member noted that the notions of independence versus interdependence were difficult to analyse, but that he was sympathetic to using a unitary whenever possible: he was uncertain that it was worth the effort to separate the components of an insurance contract. What was important to users was the aggregate measure, not the individual components and he urged the boards not to over-engineer the IFRS. An IASB staff member noted also that the additional work implied by the FASB view would entail significant effort without much additional benefit (especially in jurisdictions outside the US and European Union).

In an attempt to achieve some direction, the IASB staff suggested a modified proposition:

Unbundling for recognition and measurement should not be required if the components are significantly interdependent.

Board members objected to this because there was no consensus on what 'interdependent' meant in this context. The meeting agreed on examples that demonstrated the extremes of the spectrum (for example, term life (interdependent) and investment contracts (unbundled)) but were uncomfortable with the contracts those two extremes. A bare majority of the IASB (8-7) supported this proposition; but none of the FASB members present did.


Embedded derivatives

The boards discussed the effects of the unbundling approach on the accounting for embedded derivatives. A major concern, particularly for FASB members, was that derivatives masquerading as insurance (e.g. credit default swaps) should not be treated as if they were insurance contracts.

The IASB staff noted that the definition and elaboration of the term 'insurance contracts' was critical to this issue and opted to defer further discussion and return to the boards with modified proposals at a later date.


Financial statement presentation

The Board discussed the presentation of insurance contracts in the statement of comprehensive income. The staff presented three examples:

  • (a) the summarised margin presentation;
  • (b) the expanded margin presentation; and
  • (c) the 'traditional' premium allocation presentation.

These approaches were presented to the boards in December 2009.

The IASB staff noted that the measurement approach adopted by the project drives the fundamental structure of the presentation model. To achieve this, the statement of comprehensive income should give the following information (as a minimum) on the face of the statement:

  • (a) the release of the expected margin during the period flowing from the measurement model, showing the release of the risk adjustment separately from the release of the residual margin either on the face of the statement of comprehensive income or in the notes
  • (b) the difference between the expected and the actual cash flows
  • (c) changes in estimates (remeasurements)
  • (d) results from investments, showing separately
    • (i) interest income; and
    • (ii) interest on the insurance liability
The Boards discussed various aspects of these principles and the examples provided. All alternatives had supporters, although some thought that removing the notion of premiums written/ received from the statement of comprehensive income might be confusing to users, even if it was consistent with the measurement approach.

The IASB and the FASB agreed that the measurement approach should drive the presentation model for the performance statement. The boards also agreed that they should not select a 'traditional' premium allocation approach as the presentation model for all types of contracts (although it may still be used as a basis for the presentation for a simplified measurement approach based on premium allocation [e.g. for non-life contracts]).

In addition, the IASB had a strong preference for the 'expanded margin' presentation approach, while the FASB preferred the 'summarised margin' approach - although the FASB would want disclosure of 'key business drivers'.


Variable and unit-linked contracts-separate accounts

The boards discussed the accounting for account-driven contracts generically referred to as 'unit-linked' or 'variable insurance' and annuity contracts. In particular, they considered questions about whether the invested fund into which the premium is deposited represents an asset and corresponding liability of the insurance entity. The staff noted that the fundamental question to this discussion was identifying appropriately 'whose assets and liabilities' were involved. The staff introduced and the boards discussed some of the models of separation and segregation that exist in various jurisdictions, noting that the US notion of 'separate accounts' was probably the most extreme example, because the account has a separate legal existence and is insulated legally from the general account liabilities of the insurance entity.

The boards agreed that assets and related liabilities associated with unit linked contracts, including those defined as separate accounts, should be reported as the insurer's assets and liabilities in the statement of financial position.

In addition, the boards agreed that issues involving the consolidation of investment funds associated with unit-linked contracts (including separate account contracts) be addressed in the consolidations project rather than in the insurance contracts project.

The boards did not discuss or vote on whether unit-linked contracts should be measured in the same manner as other account-driven contracts.

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