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Insurance contracts — through 2003

Project Summary

At its May 2002 meeting, the IASB agreed to split the insurance contracts project into two phases, so that some components of the project can be put in place by 2005 without delaying the rest of the project. The first phase, completed in March 2004, addressed the application of existing IFRSs to companies that issue insurance contracts. Click for Information About the Insurance Contracts - Phase I Project.

In September 2004 the IASB announced a 'fresh start' to this project. It appointed a new working group on financial reporting by insurers.

Although the IASB's predecessor produced an Issues Paper and a Draft Statement of Principles, and the IASB itself has discussed the project at many Board meetings, other priorities had forced the IASB to suspend work following the January 2003 meeting. Therefore, the IASB will regard the past work as a useful resource, but will not feel bound by it. "The only restrictions on a fresh look are the IASB's Framework and the general principles established in the IASB's existing standards", the Board's announcement said.

We have begun a New Web Page for the 'Fresh Start' Project.

Background

Insurance is an increasingly global business and insurance accounting varies considerably across jurisdictions. A number of jurisdictions have little or no guidance on the accounting for insurance contracts in general-purpose financial statements. This project will seek to develop a standard on accounting for insurance contracts that is consistent with the conceptual framework definitions of assets and liabilities.

The project focuses on accounting for insurance contracts rather than all aspects of accounting by insurance companies. Therefore it is not limited to insurance companies alone. An issues paper was published in December 1999. The steering committee is developing a draft statement of principles (sort of a pre-exposure draft) that will take into account the views expressed in the responses to the issues paper.

The project does not address accounting for investments held by insurers.

The project covers both general insurance and life insurance entities.

IASB Discussions

IASB has discussed issues related to accounting for and disclosure of insurance contracts at several of its meetings, but these were essentially educational sessions. The basis for the Board's discussions is a Draft Statement of Principles (DSOP) that was prepared by an IASC Steering Committee and approved for transmission to the Board in June 2001. Portions of the DSOP have been completed; others are nearing completion. IASB is releasing chapters from the DSOP piecemeal on its website. You can download the draft at IASB's Website.

CONTENTS OF IASB DRAFT STATEMENT OF PRINCIPLES

Chapter

Title

1

Introduction, scope, definition of insurance contract

2

Recognition and derecognition

3

Measurement objectives

4

Estimating the amount and timing of future cash flows

5

Adjustments for risk and uncertainty

6

Discount rates

7

Performance-linked insurance contracts

8

Reinsurance

9

Measurement of direct insurance contracts by policyholders

10

Other assets and liabilities

11

Reporting entity and consolidation

12

Interim financial reporting

13

Presentation

While the draft is not a formal IASB discussion document, IASB has invited those who wish to comment to send their views directly to Peter Clark, the project manager: pclark@iasb.org.

In the fourth quarter of 2001, the IASB staff undertook some field visits to a number of insurers to discuss the proposals in the DSOP. These have continued in 2002. The field visits are intended to assess the practical and conceptual issues that arise in measuring insurance contracts at entity-specific value or fair value.

Board Discussion of DSOP

As a summary of the key decisions made:

  • An insurance contract is a contract under which one party (the insurer) accepts an insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary (other than an event that is only a change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable). Certain investment-linked contracts may be called insurance contracts but they do not meet the above definition because there is little or no insurance risk. These are covered by IAS 39 rather than this project.
  • Insurance contracts should be measured at entity-specific value.
  • The deferred and fund methods of accounting for insurance contracts should not be used.

The IASB has accepted a number of working hypotheses to guide its future work and during the last quarter has agreed in broad terms with a number of the principles contained in chapters 4-6 and 8-12 of the DSOP. These include:

  • In determining entity-specific value, each cash flow scenario used to determine expected present value should be based on reasonable, supportable and explicit assumptions that reflect: (i) all future events, including changes in legislation and future technological change, that may affect future cash flows from the closed book of existing insurance contracts in that scenario; (ii) inflation by estimating discount rates and cash flows either both in real terms (excluding general inflation, but including specific inflation) or both in nominal terms; and (iii) all entity-specific future cash flows that would arise in that scenario for the current insurer, even cash flows that would not arise for other market participants if they took over the current insurer's rights and obligations under the insurance contract;
  • The following future cash flows should not be included in determining the expected present value of future pre-tax cash flows arising from the closed book of insurance contracts: (a) income tax payments and receipts; (b) cash flows arising from future insurance contracts; (c) payments to and from reinsurers; (d) investment returns from current or future investments (except for certain performance-linked contracts); and (e) cash flows between different components of the reporting entity.
  • Should insurance liabilities be measured at fair value and fair value is not observable directly in the market, fair value should be estimated by using the above principles, but with the following two differences: (a) fair value should not reflect entity-specific future cash flows that would not arise for other market participants if they took over the current insurer's rights and obligations under the contract; and (b) if there is contrary data indicating that market participants would not use the same assumptions as the insurer, fair value should reflect that market information.
  • The entity-specific value of an insurance liability should not reflect the insurer's own credit standing. Conceptually fair value should reflect the insurer's own credit standing, but this would have practical implications that need further investigation that the IASB did not want to undertake at this time.
  • An insurer should not recognise catastrophe provisions relating to possible future claims beyond the end of the contracts included in the closed book. Similarly, an insurer should not recognise equalisation provisions to cover random fluctuations of claim expenses around the expected value of claims.
  • Acquisition costs should be recognised as an expense when they are incurred.
  • The entity-specific value and fair value of insurance liabilities and insurance assets should always reflect risk and uncertainty. Adjustments for risk and uncertainty should be reflected preferably in the cash flows, or alternatively in the discount rate(s), without any double counting.
  • In the exceptional cases when no reliable estimate can be made of the market value margin at initial recognition of an insurance liability or insurance asset, an insurer should set the market value margin at a level that leads to no net underwriting profit or loss from the contract, until a reliable estimate of the market value margin becomes possible.
  • A reinsurance contract should be defined as an insurance contract issued by one insurer (the reinsurer) to indemnify another insurer (the cedant) against losses on an insurance contract issued by the cedant.
  • Reinsurers and cedants should apply all the recognition, derecognition and measurement requirements in principles 2.1-7.6 to all reinsurance contracts.
  • If a reinsurance transaction doesn't qualify for derecognition of the related direct insurance liability under principle 2.3, a cedant should present: (a) an insurance asset arising under reinsurance contracts as an asset, not as a deduction from the related direct insurance liability; and (b) reinsurance premiums as an expense and the reinsurer's share of claim expense as income.
  • The Board rejected the principle that a policyholder should apply principles 3.1 to 7.6 in measuring its contractual rights and obligations under a direct insurance contract. The Board felt that there were acceptable approximations to measure contractual rights and obligations under direct insurance contracts, therefore it was decided that these approximations should always be used, rather than introducing arbitrary dividing lines. It was decided that more work and research needed to be done in this area, especially with regard to any investment components of the contracts.

More information about the Board's deliberations on specific principles proposed in the insurance DSOP can be found in the meeting notes of the IASB meetings as follows:

At its meeting in March 2002, the Board considered two alternative approaches to performance reporting:

  • The traditional insurance reporting model, which separates underwriting and investing and financing activities; and
  • The reporting model developed by the Insurance Steering Committee, which would report three components of performance: profit or loss from new business, ongoing profit or loss from prior years' business, and profit or loss from investing and financing activities.

The two approaches are illustrated as follows:

Income Statement: Traditional insurance reporting model:

Premiums earned

xxx

Claims incurred

(xxx)

Amortisation of acquisition costs

(xxx)

Maintenance costs

xxx

Profit (loss) - underwriting business

xxx

Investing and financing activities:

Investment income

xxx

Net profit (loss)

xxx

Income Statement: Steering Committee reporting model:

New business-new policyholders:

EPV of premiums

xxx

EPV of claims

(xxx)

Provision for risk and uncertainty

xxx

EPV of maintenance costs

(xxx)

Acquisition costs

(xxx)

Profit (loss) - new business

xxx

Previous years' business:

Changes in estimates/assumptions

xxx

Release of risk

xxx

Change in adjustment for risk and uncertainty

xxx

Profit (loss) - insurance business

xxx

Investing and financing activities:

Unwinding of discount - insurance provisions

(xxx)

Effect of changes in discount rate

xxx

Return on investments

xxx

Profit (loss) - investing and financing activities

xxx

Net profit (loss)

xxx

The two approaches to performance reporting differ not only in presentation format but more fundamentally with respect to when profit or loss from insurance contracts should be recognised. The traditional model is a deferral and matching approach. The Steering Committee proposal is to recognise more profit or loss at the time the contract is entered into. The Board felt that further educational sessions are needed on these issues and made no tentative decisions at this meeting.

The Project Manager reported on some of the field visits they are making to insurance companies. Several companies in Canada are using a form of the Steering Committee model. They said it causes substantial added costs and the information content is worth the added cost, not only for the benefit of managers running the business but also directors who are not insurance experts.

At the Board's May 2002 meeting, the staff presented:

  • A paper highlighting the issues associated with the accounting of performance-linked contracts. The Board acknowledged that these issues were complex and that further research was needed;
  • A paper considering the application of 4 models to a basic insurance contract, including the US GAAP treatment, the proposed treatment under the Insurance DSOP, and a model where the level of risk and uncertainty to measure the insurance liability would be set (and adjusted with subsequent events) so that no profit or loss would be recognised on initial recognition of the insurance contract. The Board rejected to continue research on this latter model, since it would prevent, among other things, recognition of losses on initial recognition of a contract which is expected to be at loss at inception by the insurance company. Instead, the Board directed the staff to continue research based on the Insurance DSOP proposals and consideration of a principle that would say that, at inception of a contract and in the absence of the contrary, the premium charged for the contract is the best evidence of its fair value.

Renewal Premiums

the Board discussed renewal premiums at its June 2002 meeting. Board discussions began by noting that, conceptually, there are two sorts of insurance contracts: year-to-year and long-duration contracts. The view among the Board members was unanimous that premiums on year-to-year contracts should be recognised as income for the period. The Board was less clear on how to treat premiums received on long-duration contracts.

The Board considered an example known as a 'term-to-100' contract, under which the policyholder pays a fixed premium annually until age 100. If the policyholder dies before age 100 or lives to age 100, the policy will pay $100,000. However, if at any point the policyholder decides not to pay the annual premiums any more, the insurer will not be obliged to pay anything.

The Board considered two possible ways of analysing the issue:

1. The premium received is accounted for the same way as under a year-to-year contract, that is, as current income. No further asset and no further liability is recognised. The rationale is that, since there is no enforceable right to receive future premiums, and thus no asset, there cannot be a liability beyond the current period either. This view was rejected by the Board.

2. Under the second view, a liability covering the 'standing ready to pay' would be assumed. During the discussion an issue emerged as to whether there are in fact two liabilities: a liability covering the mortality risk, and a second liability which is similar to a written (continuation) option. The project manager pointed out that, if this route were to be followed, it would deviate from the principles on which IAS 37, Provisions, Contingent Liabilities and Contingent Assets is based.

There was considerable debate over several issues under the second view. Firstly, some Board members raised doubts as to whether the 'standby' constitutes a liability in terms of the Framework. Under the contract, the insurer does not have an obligation to pay unless the policyholder pays the annual premium. Nevertheless, the insurer does have an obligation to provide a service. After some discussion, the Board agreed that a liability exists.

A second issue arose on whether in setting up a liability to cover the continuation risk an asset embodying the expected future premiums would have to be recognised as well. One Board member pointed out that the insurer had no enforceable right to receive future cash flows, since it would be left to the discretion of the policyholder if the contract continues. Thus, it would not be justified to recognise an asset for the premiums to be received in future periods. On the other hand, there may well be an asset in terms of an internally generated intangible asset (such as a customer list). A majority of Board members seemed to agree that (a) an asset existed, (b) the asset was linked to the liability incurred, and (c) once the liability is recognised, the asset should simultaneously be recognised. There also seemed to be a consensus that the asset and liability should be presented net. The Board members were less clear about income statement presentation (gross or net).

However, when asked to vote formally on the proposals, several Board members said that they would not have enough information to decide on whether the route proposed was the one to follow. Two issues were of primary concern: the distinction between insurance and non-insurance contracts and the differentiation between certain types of insurance contracts. It was suggested that typical contracts be exemplified and brought before the Board to see whether the proposals could be sustained as a working basis.

The Board tentatively decided that further research be needed and directed to project manager to devote resources to the following points:

  • Whether the measurement objective of the DSOP should be retained (that is, a risk-adjusted cash flow-based measurement technique).
  • The relation between insurance and non-insurance contracts (the outcome of the research could well lead to major changes in accounting for other types of contracts involving future promises, such as airline loyalty programs).
  • The dividing line within the population of insurance contracts (at which point a liability would have to be recognised).
  • Whether an instant gain or loss would have to be recognised on initial recognition.
  • Possible alternatives to the approach suggested.

The Board's discussion of insurance contracts at its July meeting was entirely to an educational session. Two simple insurance contracts were highlighted, in order to:

  • Focus on the interaction between different parts of the contracts and hence to demonstrate how profits can arise from insurance business.
  • Illustrate how different accounting models deal with such contracts.

That Board agreed that at its meeting in September 2002 it would discuss:

  • Approaches to deriving risk margins under the DSOP.
  • How the different accounting models behave when faced with changes from the initial assumptions (in particular, it was agreed that there would be some discussion of how the US FAS 97 approach would operate if the lock-in requirement was removed).
  • The impact of applying the DSOP model to non-insurance business, such as airline frequent flyer programs.

The Board discussed various recognition and measurement issues related to insurance contracts the staff will use to develop the project further. The issues were as follows:

Model

Should the accounting model be based on direct measurements of contract assets and liabilities, on deferral and matching of contract revenues and expenses, or some combination of the two?

Most Board members believed that the asset and liability approach, or more basically recognition of the rights and obligations under the contracts, should be the approach adopted. They noted that it could also be seen as a matching and deferral approach based on, amongst other things, risk factors or exposure. There was a concern expressed that the matching and deferral approach had not been fully explored, but this was not supported. The Board voted unanimously to pursue an asset and liability approach.

Measurement

Should an asset-and-liability model use measurements based on fair value, entity-specific value, or some combination of measurement attributes?

The staff proposed that both initial and subsequent measurement should be based on fair value based on market observations and data. Where there was no market data the fair value should be determined based on the entity's data and observations. It was noted that there was an expectation that the fair value would not differ from an entity specific value. The staff proposal was accepted by vote of 12-2.

Discounting

Should the measurement of some or all amounts recognised in the balance sheet be based on their present values?

This was not discussed as it would fall away because of the earlier decision about measurement at fair value.

Asset/Liability interaction

Should the measurement model incorporate expectations about asset performance in determining the carrying amount of the contract liability?

The staff view was that there should not be an interaction between asset and liability measurement. The Board believed that an interaction approach was inconsistent with a fair value approach and consequently supported the staff's views by vote of 14-0.

Risk/Service adjustment

How should the accounting model approach the question of risk (or service) adjustment?

The Board believed that a fair value approach would include these adjustments, although there was a concern among some Board members that these would be subjective and could have a significant effect on valuation and consequently net income. The Board concluded to include this adjustment within fair valuation by vote of 13-1.

Gain or loss on initial measurement/liability recognition

Should the accounting model be constructed in a manner that prohibits or significantly limits the recognition of net profit or loss on initial recognition?

This was not discussed at it was dealt with as a result of previous decisions.

Policyholder behaviour

Should the accounting model incorporate expectations about cash inflows and outflows that are a consequence of policyholder renewals or cancellations of an insurance contract?

The staff proposed that these fair value should take into account any non-cancellable, renewable, and extendable rights that restrict the issuer's rights to re-price whilst premiums are paid. A number of Board members believed that these valuation adjustments should be taken into account where they place constraints on the issuer and provide value to the customer such that further business will flow. They acknowledged that this needs to be restrictively worded. A Board member disagreed, stating that these features should be treated separately as a series of in-the-money options. The Board agreed (by vote of 11-2-1) that the staff should proceed to explore the approach of adjusting the fair value for these features in limited circumstances.

Acquisition costs

Should the accounting model require costs incurred to acquire new insurance contracts to be capitalised as assets and amortised?

The staff proposed that these costs should be expensed as incurred. Some Board members believed that these would be intangible assets but that they would not be initially measured at the cost of the costs. The Board concluded that these costs would be subsumed within the measurement of the liability and should, therefore, not be shown separately as assets. Consequently, they should be expensed. The vote was 9-4-1.

Unbundling

Should the measurement model unbundle the individual elements of an insurance contract and measure them individually?

This was deferred to a later meeting.

Participating contracts

How should the insurer's liability to holders of participating contracts be recognised and measured?

This was deferred to a later meeting.

Credit standing

Should the measurement include the effects of the entity's credit standing?

The staff believed that this would be reflected in the fair value of the liability, because the terms of the contract - including are any regulatory or other specific guarantees - would affect the valuation. It was noted that this would require an assessment of the effectiveness of the guarantees. The Board agreed by vote of 13-1.

Correction list for hyphenation

These words serve as exceptions. Once entered, they are only hyphenated at the specified hyphenation points. Each word should be on a separate line.