Financial instruments with participating features

In its February 2012 meeting the IASB reconfirmed the exposure draft (ED) proposal to keep financial instruments with discretionary participating features (DPF) in the scope of IFRS 4, but restricting it only to those issued by an insurer. FASB on the other hand tentatively decided to include them within the scope of their financial instruments standard.

The purpose of today’s session was to use the draft words in Paper 10A referring to participating insurance contracts and to adapt them to the financial instruments with DPF. The main area that needed clarification in the light of the ED comment letters received and subsequent tentative decision reached was the contract boundary. The IASB had tentatively re-defined the contract boundary for insurance contract was as "the point at which the contract no longer confers substantive rights on the policyholder".  Applying the same main principal to the financial instrument with DPFs the staff proposed:

The contract boundary for a financial instrument with a discretionary participation feature is the point at which the contract no longer confers substantive rights on the contract holder. This occurs when the contract holder no longer has a contractual right to receive benefits arising from the discretionary participating feature in that contract, or the premiums charged confer upon the contract holder substantially the same benefits as those that are available, on the same terms, to those that are not yet contract holders.

Following suggestions to clarify the above wording by breaking down the second sentence into two bullet points, the IASB members agreed with the proposal unanimously.

Secondly, the staff proposed recognition of financial instrument with DPFs "when, and only when the entity becomes party to the contractual provisions of the instrument", using the words of IFRS 9:3.1.1.   The IASB members clarified that this would be consistent with the post-ED decision to recognise insurance contracts from the beginning of coverage (i.e. when the contract begins), rather than from the date the insurance contract was signed as was proposed in ED. With that the IASB approved the staff recommendation unanimously.

The IASB then considered whether any further modifications are necessary to adapt for financial instruments with DPFs, in particular considering allocation of the residual margin. The Staff proposed not to make any further modifications. In particular the tentative post-ED decision to release residual margin to profit or loss in a way that best reflects the pattern of services provided should apply equally to the financial instruments with DPFs without any  specific guidance proposed earlier in the ED.  During discussion some IASB members noted that the ED guidance referring to margin release based on fair value of assets under management was potentially confusing as to when and how to apply it and welcomed its removal. Similarly, the staff paper proposed not to make any changes to guidance on unbundling as the unbundling of distinct investment components and exclusion of non-distinct investment components from volume information should apply equally to the financial instruments with DPF.

The IASB members agreed with the staff analysis unanimously.

Transition

The IASB had discussed four papers addressing transitional requirements and interaction with the requirements and effective date of IFRS 9 Financial Instruments. The effective date for IFRS 9: Hedge Accounting is expected to be for periods beginning on or after 1 January 2015. However, the staff outlined their expectations of not being able to align the effective date of the final IFRS 4 with IFRS 9 with the real possibility of the entities first having to adopt IFRS 9 for their financial instruments and then later adopting the insurance standard. Given that the two standards were developed with a view to eliminate possible accounting mismatches it was necessary to discuss how these issues could be addressed on transition.

Re-designation and Reclassification of Financial Assets

In Paper 10C the staff explained that IFRS 9 introduces new classification requirements for financial assets that the entity would apply on transition, initial application or initial recognition. Subsequently the entity can only re-designate financial assets if there is a change in its business model. Further, IFRS 9 allows at initial recognition or on transition to irrevocably designate financial assets at fair value through profit or loss (FVTPL) only if they eliminate or significantly reduce an accounting mismatch. When the entity later transitions to IFRS 4 the absence of ability to re-designate financial assets may create some new accounting mismatches. Equally, some previous accounting mismatches may cease to exist and they would no longer justify a FVTPL designation. Therefore the Staff recommended that on adoption of IFRS 4 to require insurer to follow reclassification guidance in IFRS 9, except:

• to permit designation of eligible financial assets as FVTPL to eliminate or significantly reduce new accounting mismatches created by the first application of the insurance contracts standard;
• to require the revoking of previous FVTPL designations where as a result of application of the IFRS 4 accounting mismatch no longer exists; and
• following earlier application of IFRS 9, to permit the use of FVOCI for some or all equity instruments that are not held for trading, or revoke a previous election.

The staff reminded the IASB that for participating contracts the relevant component of the liability would mirror the treatment of the assets to which they are associated thus avoiding the creation of new mismatches. One member queried whether the definition of an ‘insurer’ in IFRS 4 would award the re-designation to any entity with any number of insurance contracts issued thus creating an opportunity to re-think IFRS 9 classification even for entities that have issued only a small number of such contracts. The Staff agreed to amend wording to apply to entity as a consequence of applying the new insurance standard.

Other IASB members wondered whether the IFRS 9 classification change as a result of a change in a business model on transition to IFRS 4 should be treated as re-classification or should be allowed to be applied retrospectively. The Staff confirmed that because of the different effective dates of the standards any change in business model occurring after initial application of IFRS 9 would be accounted for under IFRS 9 prospectively. The IASB members noted that FASB have tentatively decided to permit insurers to classify financial assets at amortized cost, FVTPL or FVOCI, as if IFRS 9 had been initially applied at the same time that the insurance standard is applied. So under this approach insurers would be able to apply classification criteria of the financial instrument standard as if it was applied for the first time, rather than the reclassification criteria, as was proposed by IASB.  While acknowledging this difference the IASB members approve the staff recommendation unanimously.

Ancillary issues

The IASB turned to the treatment of changes in estimated future cash flows and experience adjustments when determining the residual margin on transition (Paper 10D). At the last September meeting IASB agreed on the retrospective restatement of residual margin on transition, while previously it agreed on prospective unlocking of the residual for changes in expected future cash flows. The staff recognised that it would be too difficult for insurers to conduct a retrospective estimation of experience adjustments and changes in expected cash flows in each of the prior periods and proposed that insurers are allowed to use the benefit of ‘hindsight’ ‘assuming that all changes in estimates of cash flows between initial recognition and the beginning of the earliest period presented were already known at initial recognition’.

The IASB agreed that this was a practical simplification. One member asked to remove the guidance suggesting that in the absence of available information the entity could estimate residual margin by reference to return on equity, saying it was not an appropriate proxy. This was noted by the staff. The IASB approved staff recommendation unanimously.

With regards to the initial application of IFRS 4 the Staff proposed that the same transitional requirements should apply to IFRS first time adopters. The IASB approved staff recommendation unanimously.

Lastly the IASB considered whether re-designation guidance may be required for investment properties and property plant and equipment held by insurer. IAS 40 and IAS 16 allow the option to designate such assets at fair value and allow switching between cost or fair value accounting policies if such change enhances reliability and relevance of financial standards via the application of IAS 8. Therefore the staff proposed that no additional guidance is drafted. One member queried the proposal exploring if ‘OCI type’ solution could be reached for investment properties linked to changes in discount rates, however it was acknowledged that investment properties typically do not amount to a significant portion of insurers’ balance sheet and that IAS 40 does not have a concept of elimination of mismatches. The Board approved the staff recommendation unanimously.

Transition – effective date, comparative financial statements and early application

This was perhaps, the most anticipated part of the meeting where an indication of the future effective date could be given to address the current uncertainty of timeline faced by insurers. The staff indicated that they do not expect to publish the final standard earlier than 2014. Usually the IASB allows at least 18 months between the date of the standard’s initial publication and its mandatory effective date to allow the entities to transition. However given the complexity of the proposed insurance model, the degree of date and tracking required the staff felt that 18 months would not be enough. Of respondents to the ED some (mainly from jurisdictions already applying updated estimates and assumptions) stated that 2-3 years would be feasible while others asked for a period greater than 3 years between the issuance of the standard and effective date. The staff then mentioned the results of the Deloitte Global IFRS Insurance Survey conducted on Deloitte’s behalf by Economist Intelligence Unit. The survey of over 200 senior finance executives from insurers operating  in various countries across the world showed that half of the respondents expected to need 3 years to transition to the new standard after its publication, and another 21% estimated they would need four years.

Based on all this information the staff recommended a minimum of three full years between the date of the final standard’s publication and its mandatory effective date. This would push the effective date to 2017, at the earliest. However, the staff acknowledged that they would prefer it to be even as late as 2018.

The staff also recommended for entities applying the standard at the mandatory effective date that they would have to restate comparatives, and that early application of the standard should be permitted. In Paper 10E, use for this session, the staff had proposed not to require the restatement of comparatives on early adoption because the restatement for insurance standard in the absence of early adoption of IFRS 9 would not result in comparable results.

However subsequent to the release of the paper they changed their recommendation following informal targeted feedback that convince them that restating comparatives for IFRS 4 with financial assets still accounted for under IAS 39 would still produce meaningful information and comparable financial statements. Therefore the staff proposed that IFRS 4 always require the restatement of comparatives, including on early adoption.

As anticipated the IASB discussion on the staff recommendation was intense with many expressing regret that IFRS 9 and IFRS 4 cannot be aligned. Many IASB members including the Chairman wanted adoption of IFRS 4 as soon as possible and they did not want to limit themselves by putting words ‘minimum of 3 years’. Instead, they preferred a softer wording indicating that there will be a significant amount of time allowed for transition and that this would be approximately three years long (although some suggested that two years would be sufficient). One member opposed both the misalignment of the effective date with IFRS 9 and on the early adoption because the ability to early adopt would put pressure on those companies that chose to wait till mandatory date suggesting to the market that they may have ‘something to hide’ when in fact they may be having legitimate systems issues. In addition early adoption by some would reduce financial statements comparability across the entities until the mandatory effective date is passed. Others countered that there is no such comparability across the world now and therefore these concerns were difficult to support. The Chairman noted that the ability to adopt the new IFRS 4 as soon as possible is of utmost importance to preparers, even if there would be some decrease in comparability given the pressure from investors and peers.

The IASB voted 12 vs. 2 in favour of the staff recommendation (including the requirement to always restate comparatives), subject to the words ‘minimum of three years from publication date’ being changed to “approximately three years” or similar wording in order to allow the IASB to make the new IFRS 4 effective as soon as practicable given all the circumstances noted in the staff paper.