Insurance Contract Accounting
Given the complexity of accounting for insurance contracts, the International Accounting Standards Board (IASB) is taking a two-phase approach to issuing an accounting standard for insurance contracts (IFRS 4).
The first phase of International Reporting Standards (IFRS) 4 is an interim standard that was issued in 2005. It introduces a universal definition of an insurance contract which distinguishes insurance risk from financial risk. Insurance policies that do not meet the definition of an insurance contract under IFRS are to be recorded as either "investment contracts" or "service contracts". Canadian Generally Accepted Accounting Principles (GAAP) has no similar definition or distinction. Policies that do not meet the insurance contract definition will be accounted for differently under IFRS. Investment contracts will be treated as financial instruments and accounted for in accordance with IAS 39 – Financial Instruments: Recognition and Measurement. Service contracts will be accounted for in accordance with IAS 18 – Revenue. As such, premium income and actuarial liabilities will no longer be reported for these policies.
For Canadian insurers transitioning to IFRS, the first phase of IFRS 4 will be effective in 2011. This phase does not address the measurement and recognition of insurance contracts and therefore the valuation methodology currently followed under Canadian GAAP (i.e. CALM) will continue to apply
On July 30, 2010, the IASB issued an exposure draft for a revised comprehensive standard for insurance contracts. The exposure draft retains the definition of an insurance contract developed in the first phase and provides new rules for measurement and recognition. A final standard is expected to be issued in mid-2011 with an anticipated effective date of 2014 at the earliest.
Insurance Contract Accounting Change May Adversely Affect 2011 Taxable Income
Actuarial liabilities or policy reserves are specifically allowed as a deduction for income tax purposes; whereas other contingent liabilities are generally not deductible. The allowable policy reserve deductions are largely based on actuarial liabilities in the financial statements. As such, changes to the definition of an insurance contract and the valuation of actuarial liabilities under IFRS will directly affect the amount of allowable tax reserves.
As noted above, the proposed measurement and recognition rules in the exposure draft will not be effective on the initial adoption of IFRS in 2011. However, the reclassification of life insurance policies to investment or service contracts could have a significant impact on a life insurer's actuarial liabilities. In addition, actuarial liabilities may be impacted by changes to the treatment of assets supporting insurance liabilities on the adoption of IFRS (e.g. fair value vs. amortized cost). Such changes to actuarial liabilities would have a consequential impact on allowable tax reserves and taxable income.
On transition to IFRS, changes to insurance reserves will apply retrospectively, with any required adjustment booked to opening retained earnings. For tax purposes, changes to reserves may only be applied prospectively. Taxable income for the year is calculated by adding back the reserve deducted in the prior year, and claiming a new reserve based on current year actuarial liabilities. Absent transitional relief, the adoption of IFRS could cause adverse tax consequences. If policy reserves are reclassified as investment or service contract liabilities under IFRS a tax reserve related to these contracts would not be allowed, resulting in a net taxable income inclusion for the 2011 transition year.
Proposed Tax Legislation to Provide Relief
On August 27, 2010, the Department of Finance issued proposed legislation to address certain adverse consequences on the adoption of IFRS, effective for a life insurer's first taxation year commencing after 2010. For life insurance policies that do not meet the definition of insurance contracts under IFRS, proposed transitional rules provide a one-time deduction to offset the add back prior year tax reserves in respect of those policies. Subsequently, tax reserves are allowed only in respect of insurance policies that meet the definition of insurance contracts under IFRS.
For life insurance policies that are considered insurance contracts under IFRS, the proposed legislation provides transitional rules to address changes in the valuation of tax reserves arising on IFRS implementation. Effectively, the change in deductible reserves will be amortized into taxable income over a five year period, though the amortization period commences two years after the transition. This delay is intended to align the amortization period with the anticipated effective date for the second phase of IFRS 4 (thus assuming an effective date of 2013). The proposed legislation does not address changes in reserves that are expected to arise in the year that a finalized IFRS 4 comes into effect.
As of the time of writing, the proposed transitional rules have not been enacted. Under IFRS, the impact of these rules cannot be reflected for accounting purposes until substantively enacted. As such, if these rules have not become substantively enacted by the end of the insurer's first quarter following the adoption of IFRS, the insurer will be required to determine its tax position based on currently enacted law. The insurer would be required to reflect a subsequent adjustment in the period the rules become substantively enacted. As such, this adjustment would not be included as part of the restatement of opening retained earnings upon adoption of IFRS in 2011.
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