Whether to unlock the residual margin (Paper 3B)

The staff introduced the paper, discussing the ED, the comments and responses to the ED and the results of the field testing. The IASB staff recommended that the residual margin should not be locked in from inception, and should be adjusted for changes in the estimated cash flows. The FASB staff did not support this proposal as they had concerns that unlocking the residual margin risks concealing movements and noted the current US GAAP methodology.

IASB members raised concerns that the proposal to unlock the residual margin necessitates a redefinition of what the residual margin is meant to be. Originally, the residual margin represented the difference between premium and the insurance liability which cannot be recognised on day one. Some considered it to be the "expected profit" on the contract. The staff concluded that their proposal is an attempt to make the residual margin represent the unearned profit remaining on the contract. Board members raised concerns about this approach, as the insurance contracts project was focused on liability measurement, not profit recognition.

Additional concerns were raised that this approach could conceal movements on the face of the balance sheet and profit and loss, rendering the financial statements less transparent. Unlocking could also potentially break the link between assets and liabilities, resulting in additional accounting mismatches.

Members also raised concerns that unlocking could increase the complexity of the new standard even further and noted comparisons to the corridor approach that was applied to pensions accounting.

Supporters of the staff proposal noted that, even though they agreed with the staff proposal, additional work would need to be done in order to make this proposal workable.

At the vote, the IASB members voted marginally in support (8 vs. 7) for the staff proposal. The FASB members did not appear to vote formally, but the majority of the members did not seem to support this proposal.

How to unlock the residual margin (Paper 3C)

Continuing from the discussion in paper 3B, the staff turned the discussion to how the residual margin would be unlocked and raised a number of questions for the Boards consideration.

Q1: 'Consume' or 'float'

The first topic raised by the staff was whether the residual margin should be "floated" (i.e. adjusted for positive and negative changes) or "consumed" (i.e. adjusted only for negative changes). The staff recommended that the residual margin should be floated, and that no limits should be applied to the adjustments.

Board members raised a number of concerns about the practicality of this approach and the potential complexities involved in implementing it. Staff responded that companies were already doing something similar under Australian GAAP. Comments were also made that, having decided to support the unlocking of the residual margin, the decision to support floating over consuming the residual margin was a more logical conclusion

The IASB then voted (11 vs. 4) to support the staff recommendation to float the residual margin and to impose no limitations to the adjustments made. The FASB, unsupportive of unlocking the margin, elected not to vote on this topic.

Q2: What changes should adjust the margin & Q3: Changes in discount rates

The next topic considered was which changes should be reflected in the residual margin, with the staff recommending that:

• all changes in the estimates of the cash flows should be recognised in the adjustment to the residual margin; and
• insurers are permitted, but not required, to recognise the adjustments arising from changes in the discount rate in profit and loss when recognising the adjustment in the residual margin would result in an accounting mismatch.

The IASB discussed any limitations in the residual margin, with the IASB voting (12 vs. 3) to not limit increases in the residual margin. The IASB then discussed whether changes in discount rate should be recognised as an adjustment to the residual margin or in profit or loss in the period of the change to the extent that these changes create an accounting mismatch. No decision was made, as Board members commented on the complexities that would arise, with some commenting that the issue was not fully understood and that they would prefer to defer the decision until more work had been done.

Q4: Changes in risk adjustment

The first item being assessed was the changes in the risk adjustment. The staff recommended that all changes to the risk adjustment should always be recognised in profit and loss.

Boards' members commented that this approach was inconsistent with previous staff recommendations to recalibrate the prospective remeasurement of the building blocks against the residual margin. Several members indicated at this point that they were reconsidering their votes to previous recommendations.

However, the IASB still voted 9 vs. 6 to support the staff recommendation.

Q5: Adjust prospectively or retrospectively

The staff recommended that changes to the residual margin should be made only on a prospective basis. With fairly minimal discussion, the IASB voted (10 vs. 5) to support the staff recommendation.

In conclusion, these decision suggest that the future IFRS will have a recalibration approach that takes into account the prospective remeasurement of the probability weighted cash flows (building block 1) but excludes those arising from the risk adjustment (building block 3). It would also appear to suggest that prospective changes in the discount rate (building block 2) would not be taken against the residual margin given the narrow rejection of the recommendation to link recalibration with accounting mismatch. This last decision could mean that insurers with assets at amortised cost would be exposed to the accounting mismatch arising from the fluctuation of their discount rate used to measure their insurance liabilities. This has been described as the "cost-current" mismatch (from the fact that the assets are at cost and the liabilities are on a current basis) or liability driven mismatch.

Allocation of the residual margin (Paper 3D)

The staff presented their paper to the Boards and recommended that:

• the residual margin should not be negative
• the residual margin should be allocated over the coverage period on a systematic basis using a pattern reflective of the transfer of the services provided
• the residual margin should be determined on a level that aggregates similar contracts.

A Board member queried whether a change in the earning pattern would be considered a change in accounting policy, to which the staff responded affirmatively.

Some members raised concerns that if the residual margin was meant to represent the unearned profitability on the insurance contract (as indicated in papers and decisions earlier in the day), earning of the full amount over the coverage period was inconsistent. Other members were concerned that this topic had implications for day one gains and onerous contracts that had not been adequately explored.

No opposition was raised to the proposal that the residual margin should not be negative.

The IASB voted (9 vs. 6) in support of the proposal to recognise the residual margin over the coverage period. This means that for post-claims liabilities insurers would not have any residual margin for the recalibration to be performed against prospective changes of cash flows.

No decision was taken on the third recommendation, as the Boards felt that decisions on the definition of a portfolio should be taken prior to considering this issue.

Acquisition costs revisited (Paper 3E)

The staff presented the paper to the Boards and highlighted the current position as well as the divergent opinion previously expressed by the two Boards. The staff also asked the question of whether the Boards wanted to retain the tentative decisions previously taken or to follow some other approach to acquisition costs (e.g. based on an approach consistent with the Boards' tentative decisions on leases or revenue recognition).

Principally, the Boards' debate focused on the unit of account (i.e. at what level acquisition costs should be measured) and on whether the acquisition costs to assemble a portfolio, however defined, should include the costs associated with unsuccessful attempts to issue a contract.

Some Board members commented that all acquisition costs incurred in assembling the portfolio are considered by the insurance company and priced into the consideration charged for issuing new contracts thus confirming the logic of including all acquisition costs. Other members rebutted this argument on the basis that a) the portfolio includes only the product of successful efforts, and b) no other industry is permitted to defer acquisition costs on unsuccessful efforts to sell a contract with a customer even though they also price their contracts accordingly, even if all acquisition costs are necessary to assemble a portfolio the justification to have a different approach for insurance contracts appears to be controversial.

The Boards voted (IASB — 14 vs. 1; FASB — unanimous) that only direct acquisition costs should be included within the insurance contract cash flows and remained divergent (IASB — 6 vs. 9; FASB — unanimous) on the proposal to include only costs associated with successful sale activity.