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CPD technical article
Are we nearer an accounting solution to the problem of insurance contracts, asks Graham Holt
Members will find the illustrative examples in the 2013 ED of assistance when tackling MCQs.
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Work on a new accounting standard for insurance contracts started in 1997. Since then, there have been many obstacles in the path of a finalised accounting standard. IFRS 4, Insurance Contracts, was issued in 2004 as an interim standard that largely permitted the continued use of existing accounting standards. In July 2010, the International Accounting Standards Board (IASB) published an exposure draft (ED) built around a current measurement model with all of the effects of measurement changes recorded in profit or loss.
One of the main criticisms of the 2010 ED was that it would force insurers to measure both assets and liabilities using a current balance sheet measurement approach with the effects of re-measurements reported in profit or loss. A significant concern was that earnings volatility would occur because changes in market conditions would affect financial assets and insurance liabilities differently. The long-term performance of the insurer would not be reflected, but instead short-term market fluctuations would be highlighted.
Another key comment on the ED was the presentation of the statement of comprehensive income, particularly as regards the non-disclosure of such information as premiums and claims as a result of the focus on summarised margin information. The comment letters also raised other concerns such as the unbundling and identification of individual components of an insurance contract and the treatment of reinsurance.
In June 2013,the IASB released an ED to replace IFRS 4, which would apply to all insurance contracts. The IASB's intent is to provide a single principle-based framework that would eliminate inconsistencies and weaknesses in current accounting practices. The IASB and US Financial Accounting Standards Board (FASB) have worked towards a joint insurance contracts standard, but there are a few areas where there are differences in opinion. The insurance contract measurement principles are similar to those in the 2010 ED as it still uses a current measurement model, a risk adjustment and a residual margin, which is renamed 'contractual service margin'.
A simplified measurement, the premium-allocation approach is permitted for short-duration pre-claims liabilities and is similar to existing unearned premium approaches. Although aspects of the revised measurement model may not appear to have changed, the IASB has made key changes relating to addressing earnings volatility and the presentation of the statement of comprehensive income.
The IASB has asked for comments on five key areas, which are to be submitted by 25 October 2013.
- The liability component that represents the unearned profit as adjusted for future assumption changes.
- A new definition of insurance revenue and expenses.
- Interest expense to be presented separately between profit or loss and other comprehensive income.
- Insurance contracts where cashflows are contractually linked to underlying items.
- A modified full restatement approach on transition.
At the date of recognition of the insurance contracts, the contractual service margin (CSM) is determined. This represents the unearned profit on the contract(s) at a portfolio level. It is the excess of the expected present value of the cash inflows less outflows plus any adjustment for risk. Any excess of outflows over inflows is recognised in profit or loss as an expense. The CSM is recognised in profit or loss in a way that best reflects the insurance coverage under the contract.
The CSM should be revised for any subsequent changes in the cashflow estimates as long as the CSM can absorb any unfavourable changes. If the margin is exhausted and the contract becomes onerous, all changes in estimates are recognised in profit or loss as they occur. The decision to adjust the CSM for changes in estimates of future cashflows effectively allows the impact of updating assumptions to be spread over the remaining life of the contracts. This is consistent with the IASB's approach to revenue recognition.
The unlocking of the CSM will have a significant impact on performance indicators and will raise the question as to how the margin should be released. The release of the contractual service margin should be on a systematic basis consistent with the pattern of transfer of services provided.
The 2013 ED says that the release should be sufficient to determine that all margin has been released to profit or loss by the end of the coverage period. Changes in the uncertainty or riskiness of the cashflows are measured separately by the risk adjustment and flow directly to profit or loss.
The IASB has decided that premium revenue information should be presented in the income statement, as is common in current reporting for non-life business. The 'earned premium' approach aligns itself with the revenue recognition project. The 'earned premium' for a period represents the sum of the latest estimate of the expected claims and expenses for the period excluding any recognised in profit or loss, any change in the risk adjustment, the amount of contractual service margin released, and an allocated portion of the premium for the recovery of acquisition costs.
The proposals on the presentation of revenue will significantly affect life business, as the 'earned premium' approach is completely different to the 'premiums due' approach used by many entities. Insurers will still need to disclose margin information. The extraction of the required 'earned premium' from underlying systems will be challenging and the volumes reported would need additional explanation. The insurance revenue figure reported in profit or loss would most likely not correspond to the amount of premium received in the period. Thus 'earned premium' is a new concept, which may not be fully understood and therefore misinterpreted initially by users.
Another significant change is requiring the use of Other Comprehensive Income (OCI) and not profit or loss to present the impact of changes in interest rates on the measurement of many insurance liabilities.
Under the proposed approach, the statement of financial position would always show a current measure of insurance liability. The income statement, on the other hand, would reflect the historical time value of money locked in at inception with changes in discount rates reflected in OCI.
The difference between discounting the cashflows in the insurance contract using a current discount rate and the discount rate when the insurance contract was initially recognised, is shown in OCI. This is helpful for contracts where backing assets are measured in a similar manner. However, there are several types of business where this decision could cause a material accounting mismatch, with changes in backing assets having to be measured through profit or loss.
Some observers feel that if the use of OCI were optional, it would give companies greater flexibility to minimise accounting mismatches. It is unlikely to be an option supported by the IASB. The requirement for insurance contract liabilities to be determined using both interest rates locked in at inception and current rates will increase workloads.
The 2010 ED proposed that when the cashflows arising from an insurance contract depend to some extent on the returns from specific assets, the dependency should be reflected in the discount rate used to measure the insurance contract.
Different types of insurance contracts have cashflows that vary with the returns on underlying items either through a contractually specified link or indirectly. These are referred to as 'participating', 'with-profits' and 'index-linked' contracts, along with many other variants. This principle is retained, but the ED sets out criteria to be met.
The insurer is required to hold the underlying assets, and an underlying pool of insurance contracts, or the assets and liabilities of an insurer as a whole. Secondly, the contractual terms need to include a link between the payments to the policyholder and those underlying items. This approach will reduce accounting mismatches, but in a number of markets it will be challenging to implement and interpret the resulting profit.
As a result of the ED, some of the effects of discount rate changes where contract cashflows vary with underlying items would be reported in OCI and other effects in profit or loss.
This mirroring approach would likely require a breakdown of cashflows between those that vary with returns and those which are fixed. The resulting profit from this approach is unlikely to have a link with the bonuses being declared and indeed it may be difficult to understand what the profit actually represents. In markets where there are sizeable terminal bonuses on 'with-profits' policies, this could lead to an acceleration of 'accounting' profits relative to 'distributed' profits, which may lead to some unintended consequences.
The 2013 ED proposes to allow preparers approximately three years from the date of the standard being published to the date of mandatory implementation.
Early application would be permitted and the entity would be required to restate comparatives. Given the significant accounting changes proposed, an entity would need this period of time to ensure that it could apply the standard.
The standard will apply retrospectively, which means that on transition entities would have a current measure of their insurance liabilities still outstanding which would include a contractual service margin to the extent that the coverage period has not yet expired. The impact of changes in the time value of money from inception of contracts to the transition date would be reflected in accumulated OCI. In order to help transition, the IASB has proposed a number of simplifications.
Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School
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