Insurance contracts

Date recorded:

The Boards discussed extensively a set of recommendations aimed at dealing with the subset of insurance contracts that the Exposure Draft (ED) defined as "short term insurance contracts" on the basis that they had a coverage period (i.e. the period during which an insurer stands ready to pay claims) of one year or less and did not contain features that made the cash flows vary significantly.

The ED required that all the short term insurance contracts are accounted for using a modified approach prior to any claims being incurred. Beyond the coverage period the claim liability arising from the short term insurance contracts would be accounted for using the main building blocks model.

Eligibility requirements

The Staff noted that a number of comment letters were particularly critical of the ED because the proposed criterion based on coverage appeared to introduce a bright line and it was not principle-based.

To address this approach the Staff recommended that an insurer would be eligible to use the modified approach based on a new set of criteria which required that (a) the contract does not include a significant financing element and (b) the contract does not contain embedded options or other derivatives that significantly affect the variability of the cash flows, after unbundling any embedded derivatives. The latter criterion is substantially the same as in the ED and the first one being the innovation proposed by Staff.

The new criterion (a) was further explained when two additional criteria are met: (i) the time between the receipt of premium and the provision of coverage is insignificant, and (ii) the amount of premium charged is not substantially different if the policyholder paid at the beginning of the coverage period. Using a recent decision from the Revenue Recognition project, the Staff also recommended including a statement whereby a contract is not considered to have a significant financing element if the coverage period is one year or less. This was the original first criterion from the ED which now is used to underpin the attempt of a broader principle based criterion.

The joint discussion did not appear to generate a tentative decision on the recommendation other than a statement that the Boards intend to have a modified approach based on the unearned premium. Instead it appeared to have highlighted a number of differences that the Boards will have to deal with as they finalise this issue.

FASB noted their preference to treat the modified approach as a separate model from the building block approach rather than a proxy to achieve the same measurement objective of a current measurement of the contractual fulfilment. This departs from the position in the ED and may seem to have little practical impact on the discussion on the pre claim measurement of the short term contracts.

Most IASB members were uncomfortable with the significant financing criterion because it seemed to open the modified approach to a wider subset of contracts that they had anticipated. The IASB position remains on the concept that there is a single measurement model with a simplified approach that delivers substantially the same information when certain criteria are in place. The identification of these criteria should be the focus of the Staff work going forward.

Discounting of the pre-claims obligation

The debate continued on another area where a number of comment letters offered recommendations to the ED proposals to apply an accretion interest expense on the unearned premium release to income.

The Staff recommendation suggested leaving the unearned premium liability undiscounted if the eligibility criteria are met.

The debate noted that the absence of a clear consensus on the detailed eligibility criteria had made the discussion on this point more difficult to progress at this meeting.

Some of the IASB members noted that the new standard will apply to markets where high inflation exists and thus the allowance of an undiscounted approach over a twelve month periods would need to be assessed carefully. They also noted that the reassessment of the significant financing criterion in light of this comment could offer the way forward on this issue.

Treatment of acquisition costs

The ED required the acquisition costs incurred for the contract to be treated as a component of the contractual cash flows. The same principle was retained for the modified approach and the Staff recommended this option to be taken to the final standard. However the recent decision in the Revenue Recognition standard to account for an asset when incremental costs are incurred for a contract with a customer that can generate sufficient revenue to recover them was taken into account and an alternative proposal tabled for discussion.

The IASB members were in favour (9 out of the 10 board members in attendance) of retaining the ED principle in line with the building blocks approach and to use a single definition of contract acquisition costs as recently approved (based on costs that directly relate to the contract acquisition activity — on a portfolio basis).

The FASB members instead challenged the proposals of the Staff and noted that there was an opportunity for the new insurance standard to be aligned with the Revenue Recognition project. The presentation of the acquisition costs as an asset would enhance the comparability with the other industries where the new requirement from the Revenue Recognition project would apply.

The chairs of the two Boards asked the Staff to bring also this issue back in the near future to seek a convergent outcome.

Premium allocation patterns and onerous contract test

The Staff reconfirmed the ED proposal for the release to income of the unearned premium liability and both Boards agreed with the recommendation. The final standard will require the liability to be released to income based on the passage of time over the coverage period subject to a test that another basis that utilises the expected timing of incurred benefits and claims is not significantly different.

The final session on this topic aimed at setting out the criteria for the testing that a portfolio of unexpired short term insurance contracts has become onerous.

The fundamental issue of the role of the risk adjustment liability returned to the fore with the Staff recommending a test based on the first two building blocks (expected cash flows and discount rate) and a number of IASB members highlighting that this would depart from the concept of the modified approach being a simplification of the main model. They argued that if the concept of the proxy prevails the liability test should be done against a full building block calculation not one that is curtailed of the component that captures the uncertainty which often is the cause of the onerous contract situation.

An additional reservation came from the fact that the unearned premium liability is undiscounted and the onerous test uses a discounted amount.

Eventually the Boards found some common ground on the agreement that the onerous contract test (to be defined) will be undertaken when the insurer judges that there are certain indicators that may suggest the insurance liability for the unexpired short term contracts is not sufficient. These indicators were presented as qualitative factors and included deteriorations in the loss ratio or the increase in the severity and/or frequency of the insured events.

Pending further work on the definition of the portfolio the Staff had not recommended the level at which the onerous contract should be performed and they will cover this issue in one of the future meetings.

Finally the decision as to whether to change the ED from requiring the use of the modified approach to one that allows it as an accounting policy choice was deferred to a future date when the other issues left unresolved at the end of this meeting would have been addressed satisfactorily.

This concluded the 27 April IASB meeting.

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