UK: Insurance Accounting newsletter – Progress continues, Divergence Remains

Last Updated: 7 July 2011
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Introduction

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) resumed their joint deliberations after the April pause for reflection and the announcement that the work on the new accounting standard will continue beyond the end of June 2011.

Several joint meetings were held, as well as the Insurance Working Group (IWG) meeting on 16 May. Several crucial topics were discussed at the various meetings with a number of tentative decisions made, some which delivered disappointing disagreements between the two Boards. Amongst others, the topics covered included short-term duration contracts, accounting mismatch, unbundling, margins and purchased reinsurance accounting.

This Insurance Accounting Newsletter covers the joint IASB and FASB meetings held on 27 April, 4, 11-12, 17-18 and 31 May, as well as the Insurance Working Group (IWG) meeting that took place on 16 May. The most critical development in this period is the unfortunate disagreement between the Boards on the accounting for the uncertainty of the cash flows expected from an insurance portfolio.

An extensive debate took place at the 17-18 May meeting, on whether the insurance contract liability should be measured on the basis of expected cash flows plus an explicit risk margin or a single composite margin with both elements of risk and deferred profits. The exposure draft (ED) proposed the former approach, i.e. an explicit risk adjustment. In contrast, the FASB's discussion paper had proposed a composite margin. Following extensive analysis of both approaches from the Staff the Boards were called to make an informed decision. Unfortunately, their respective views did not converge. The IASB asked the Staff to refine the wording in the ED to ensure the nature and objectives of the risk adjustment are better explained.

The rest of this newsletter offers our views on other key issues that emerged from the debates held at the various meetings without necessarily following the chronology of the individual meetings. We focus instead on the decisions and issues that in our opinion have a more significant impact on the development of the final IFRS and on its implementation within insurance business. Deloitte continues to report on the outcome of each insurance session immediately after every IASB meeting; you can find those on our IFRS website IASPlus (www.iasplus.com).

Accounting for risk and profit – divergence on margins (17-18 May)

The joint Board's discussion on margins (risk adjustment and residual margin vs. the composite margin) spanned the two sessions on 17 and 18 May with an attempt to resolve the divergence the two Boards had on this key model characteristic since March last year.

The majority of the discussions on 17 May focused on two papers that attempted to summarise the months of preparatory work the two Boards had undertaken on this issue (paper 3A for the risk adjustment and paper 3F for the composite margin).

Risk adjustment

Board members noted that one of the primary differences between the risk adjustment and the composite models is the objective of the margins. In the risk adjustment model, the margin measures the variability of the cash flows. In the composite margin model, the entire margin represents deferred profit that should not be recognised until the service of standing ready to meet claims has been performed. Selecting the most important objective for the development of the accounting standard remained the key task at hand for the Boards.

Clearly polarised views emerged between the Boards and the assessment of the two objectives went on to colour much of the discussion over the two days. In addition, the Staff pointed out a distinct geographical split between the constituents as far as the support for each of the two approaches was concerned. This is based largely on current or emerging industry practice in each geographical region. Some Board members commented that the new standard should improve current practice, rather than aiming to maintain the status quo, and that the drivers of the final decision should be based on conceptual correctness and practical applicability rather than preservation of current practices or the assessment of the amount of education required in a particular jurisdiction.

Although some Board members objected to the level of subjectivity the risk adjustment approach might allow, other members pointed out that as long as the level of subjectivity was disclosed it would provide valuable information regarding the risk levels of the entity's liabilities. No specific disclosures were suggested, but references to the subjectivity and disclosures relating to level 3 fair values for financial instruments and IAS 37 disclosures were mentioned.

Finally, a Board member commented on the remeasurement differences between the two models, noting that the lack of remeasurement in the composite margin model was likely to conceal developments in risk, making it less transparent than a risk adjustment model.

Composite margins.

Although Papers 3E, 3F and 3G were referred to, the majority of the Staff's presentation revolved around Paper 3F on the realisation of the composite margin. As before, the Staff introduced the paper describing the development of the composite margin model and presenting arguments for and against the use of this model.

Several of the issues raised during the discussion on the risk adjustment model were raised again. In particular, concerns about the transparency of the composite margin and whether the objective of liability measurement was truly being met, with the composite margin model being compared with a Revenue Recognition approach rather than focusing on liability measurement.

Board members also argued back and forth about which model was "simpler" to implement, measure and apply, and whether that simplicity resulted in transparent and decision-useful information.

Ultimately, very few new arguments were raised compared to those we have previously reported on this subject. These discussions resulted in a general consensus amongst the Board members that the results (if not the presentation) of the two models was largely similar and that there were probably only a few areas or circumstances where significant differences would remain.

In an effort to achieve convergence, the Boards directed the Staffs to prepare a number of examples for discussion on the following day. These examples were presented to the Boards on 18 May as a new paper was produced overnight (paper 3K).

Model comparison

The IASB Staff noted that the FASB Staff disliked the model used as it did not appear to be in line with the latter's proposed objective for the composite margin, lending further weight to the argument that this issue will not be resolved unless the Boards can agree on the objective of the margins, either the IASB's approach to account for uncertainty via risk adjustments or the FASB's approach to defer and subsequently allocate profit based via a composite margin.

A significant amount of time was spent discussing and understanding the examples presented, and reconsidering the arguments raised during the previous days discussions.

At the end of this intense debate a fundamental disagreement between the two Boards appeared to remain on the purpose of the margins, with the IASB arguing that the risk adjustment represents a measure of the uncertainty in the cash flows of the liability, while the FASB argued that the uncertainty was already captured in the probability weighted average cash flows.

The IASB argued that a contract with a 50% chance of a £100 loss and a 50% chance of a £0 loss has a fundamentally different risk profile than a contract that had a 100% chance of a £50 loss, even though they both have a weighted average cash flow value of £50. The IASB was, however, unable to persuade the FASB of the relevance and reliability of an accounting model that recognises and discloses some measure of that variability.

Eventually, the Boards' Chairmen indicated that a decision (even if tentative) was required and called the vote. The IASB voted strongly for (only two opposed) retaining an explicit risk adjustment, while FASB voted equally strongly (five for) the composite margin. Board members expressed dissatisfaction with this result and indicated a preference for a single standard to be developed and suggested that the topic could be reconsidered after later meetings (e.g. finalisation of the proposed treatment for the residual margin) had provided additional clarity on the exact extent of divergence.

Disagreement on the measurement of short-term contracts (27 April)

The Boards discussed extensively a set of recommendations aimed at dealing with "short term insurance contracts"; although the discussions left a few areas where further clarification work will be necessary several decisions were reached. In this area the progress was also tainted by disagreement but, unlike the disagreement on margin, we are of the view that the practical implications of divergence in this area are less serious.

Eligibility requirements

The ED definition of short-duration contracts is based on two criteria: the first testing that the duration of the coverage period (i.e. the period during which an insurer stands ready to pay claims) is one year or less and the second checking that the contract does not embed features that make the cash flows vary significantly. The ED required that, during the pre-claims period, all short term insurance contracts be accounted for using a modified approach. Beyond the coverage period, the claim liability arising from short-term insurance contracts would be accounted for using the main building blocks model.

The Staff noted that a number of comment letters were particularly critical of the first eligibility criterion which appeared to introduce a bright line instead of being principle-based. To address this comment, the Staff recommended the eligibility criteria to be the following:

  • the contract does not include a significant financing element, i.e:
  • the time between the receipt of premium and the provision of coverage is insignificant; and
  • the amount of premium charged is not substantially different if the policyholder paid at the beginning of the coverage period.
  • the contract does not contain embedded options or other derivatives that significantly affect the variability of the cash flows, after unbundling any embedded derivatives (this criterion being substantially the same as what was proposed in the ED).

Using a recent decision from the Revenue Recognition project, the Staff also recommended including a statement whereby a contract is not considered to have a significant financing element if the coverage period is one year or less substantially keeping the original first criterion from the ED as pure guidance for the application of a principle based criterion.

Most IASB members were uncomfortable with the "significant financing" criterion because it seemed to open the modified approach to a wider subset of contracts than anticipated. The joint discussion did not appear to generate a tentative decision on the recommendation other than a statement that the Boards intend to have a modified approach based on the unearned premium method. Instead it appeared to have highlighted a number of differences that the Boards will have to deal with as they finalise this issue.

"One" or "two" models?

Most of the debate revolved around the conceptual justification for a modified approach for pre-claims liability of short-term insurance contracts. The Boards disagreed as to whether the modified approach would be a proxy for the single existing model or whether it represents a new separate model.

It transpired from the debate that the FASB would prefer to consider the modified approach as a separate model from the building block approach rather than its proxy. Although this departs from the position put forward by the ED, it seems to have little practical impact for the discussion on the pre-claim measurement of short-duration contracts.

The IASB position remains to have a single measurement model, with a modified approach that delivers substantially the same information when certain criteria are in place.

The Boards asked the Staff to focus on identifying these criteria going forward.

Discounting of the pre-claims obligation

The debate continued on the Staff recommendation to leave the unearned premium liability undiscounted if the eligibility criteria are met. The debate noted that the absence of a clear consensus on the eligibility criteria had made the discussion on this point more difficult to progress at this meeting.

Some of the IASB members noted that the new standard will apply to markets where high inflation exists and thus the allowance of an undiscounted approach over a twelve month periods would need to be assessed carefully. They also noted that reassessing the merit of the "significant financing" criterion in light of this comment could offer the way forward on this issue.

Treatment of acquisition costs

In the Revenue Recognition project, the Boards recently decided to account for incremental costs as assets when they are incurred on a contract likely to generate sufficient revenue to recover them. This approach had previously been rejected by the Boards for the insurance contracts project in favour of the ED proposal to include the incremental acquisition costs in the measurement of the insurance liability. As a result of the revenue recognition decision, the staff reintroduced the deferred acquisition cost assets option in the options presented to the Boards.

The IASB members were in favour (9 out of the 10 board members in attendance) of retaining the ED principle in line with the building blocks approach and to use a single definition of contract acquisition costs based on costs that directly relate to the contract acquisition activity – on a portfolio basis.

The FASB members instead challenged the proposals of the Staff and noted that there was an opportunity for the new insurance standard to be aligned with the Revenue Recognition project, particularly as they reiterated that they would look at this approach as a separate model that should clearly be closer to the revenue accounting model.

FASB argued that the presentation of the acquisition costs as an asset would enhance the comparability with the other industries where the new requirement from the Revenue Recognition project would apply. The chairs of the two Boards asked the Staff to bring this issue back for discussion in the near future to seek a convergent outcome.

Premium allocation patterns and onerous contract Test

The Staff reconfirmed the ED proposal to release the unearned premium to income either on the basis of time, or on the basis of the timing of cash flows if significantly different from the time basis. Both Boards agreed with the recommendation. The final standard will require the liability to be released to income based on the passage of time over the coverage period, subject to a test that another basis that utilises the expected timing of incurred benefits and claims is not significantly different.

The final session on this topic aimed at setting out the criteria for the testing whether a portfolio of unexpired short term insurance contracts has become onerous.

The fundamental issue of the role of the risk adjustment returned with the Staff recommending an onerous contract test based on the first two building blocks only (expected cash flows and discount rate). A number of IASB members contended that, contrary to the Boards intention, this approach would result in the modified approach being similar in complexity to the main model. They argued that if the simplified approach represents a proxy, the liability test should be done against a full building block calculation, not one that is curtailed of the component that captures the uncertainty which often causes the onerous contract situation. An additional concern was expressed as the unearned premium liability is undiscounted whereas the onerous contract test uses a discounted amount.

Eventually the Boards found some common ground by agreeing that the onerous contract test (to be defined at a future meeting) should be undertaken when the insurer judges that there are certain indicators suggesting the insurance liability for the unexpired short-term contracts is not sufficient. These indicators were presented as "qualitative factors" and included deteriorations in the loss ratio or the increase in the severity and/or frequency of the insured events.

Pending further work on the definition of the portfolio, the Staff had not recommended the level at which the onerous contract test should be performed and this issue will be addressed at a future meeting.

Finally the decision as to whether to make the modified approach a requirement or an accounting policy choice was deferred to a future meeting.

Reactions from the IWG on 16 May 2011

In support of the dual model approach we noted that one of the IWG members expressed a firm view that the logical development of the separate model for short duration contracts is to introduce undiscounted claims liabilities without a risk margin. He also noted that a common response from outreach activities regarding the discounting of claims liabilities arising from short term contracts was that it would complicate financial reporting for investors in that sector due to the difficulty in assessing short term insurers' ability to set sufficient claims liabilities and measure them consistently from period to period.

Other IWG members agreed that non-life insurance is often managed and priced using underwriting metrics rather than metrics that reflect future investment margins although taking into account discounting in short term insurance pricing is more common in high interest rate environments.

The observer from the International Association of Insurance Supervisors noted that irrespective of whether the one or two model approach was used, the consideration of time value of money for claims liabilities must be retained in the final accounting model because in some countries current economic conditions and the associated higher level of interest rates makes it a material factor for financial reporting.

Deloitte observations

Deloitte recommended that a modified accounting approach for short duration contracts' pre-claims liabilities is permitted rather than required, as a practical approximation of the building blocks measurement. It would allow the presentation of these contracts along the lines of the statement of comprehensive income presentation widely accepted by investors in insurers that sell these types of contracts.

In our comment letter we recommended that the Board adopts an accounting approach for short duration contracts similar to the unearned premium approach currently used under US GAAP. A provision for onerous contracts based on the building blocks model would be recognised if the measure of the portfolio using the building blocks approach exceeds the unearned premium liability at each reporting date.

Our proposed short duration contract accounting model would also include the following elements:

  • As premiums are earned over the period of coverage, a liability would be recognised for losses incurred in the period of coverage including reported losses, incurred but not reported losses and claims handling and settlement costs. The liability would be recognised using the principles of the building blocks approach including the present value of the probability weighted cash flows and a specific risk adjustment to address the uncertainties in the ultimate amount and timing of the cash flows.
  • A residual margin liability would be determined and established as the premiums are earned and as the claims liability is recognised for the losses and claims expenses incurred.
  • A portion of the residual margin would be attributed to the period of coverage and such portion would be part of the premiums earned. The remaining portion of the residual margin would be accounted for consistent with the recalibration model we described in our response to Question 6 above. As discussed in that response, we believe the residual margin release should include the claim settlement period. To recognise the entire residual margin only over the period of coverage seems inconsistent with the continuation of the exposure for the uncertainty in the cash flows after the period of coverage ends.

Divergence on how to deal with the accounting mismatch for participating contracts (11 May)

The ED proposed to reduce the accounting mismatch which exists for participating contracts under current IFRS and US GAAP by implementing exceptions in the rules for measuring assets. The ED allowed the assets to follow the measurement approach applied to the associated insurance liability. The new proposal for dealing with the accounting mismatch put forward by the staff links the measurement of the liability to that applied to the associated assets. The staff argued that this proposal more effectively reduces accounting mismatches and was more in line with the Boards' first axiom.

The Staff also clarified that the two asset solutions in the ED would remain in place allowing the recognition of an asset measured at fair value through profit or loss whenever an insurer holds its own shares or an owner occupied property within a fund that is linked to a unitlinked insurance contract.

In more detail the recommendations to the Boards were:

  • the cash flows expected to result from the policyholder participation should be included in the insurance liability on the same basis as the measurement of the underlying items in which the policyholder participates;
  • the measurement of the participating contract should reflect the asymmetric risk sharing between the insurer and the policyholder resulting from the minimum guarantee;
  • the changes in the insurance contract liability shown in the statement of comprehensive income should be consistent with the presentation of the changes in the items from which the participating liability is dependent; and
  • the same measurement approach should apply to unit-linked ("UL") and contracts with a discretionary participating feature ("DPF").

The Staff noted that the main difference between UL contracts and those with a DPF is often associated with the nature of the asymmetric risk sharing between the insurer and the policyholders. UL contracts directly pass all investment performance through to policyholders using an equivalent to a total return swap approach. DPF contracts frequently embed minimum guarantees as well as only sharing a percentage of the return on the fund, doing so on a basis that is not necessarily in line with the fair value accounting of the participating assets.

The Staff noted that the same accounting mismatch resolved with the asset-based provisions in the ED for UL business applies to DPF contracts and respondents asked if the consequential amendments could be extended beyond assets backing UL contract liabilities. However the Staff identified additional issues that would follow with the expansion of this option, e.g. deferred tax assets and liabilities could not be measured at fair value, thus concluding that a better way to reduce the accounting mismatch is the measurement of the liability using the same attribute as the underlying item, i.e. if the underlying assets are measured at cost or they are not recognised (e.g. treasury shares), the measurement of the liability relating to this asset should also be measured in the same way.

FASB members were uncomfortable to abandon the current measurement of the building block for the liability. Although they acknowledged that this creates an accounting mismatch in the situation where the underlying item is measured on a different basis or it is not recognised at all they would prefer to deal with the mismatch in a second step which could produce some amendments to the accounting treatment of the assets. In conclusion, the FASB rejected the new Staff recommendations.

The IASB on the other hand generally supported the Staff recommendation to measure participating liabilities on a basis consistent with the underlying items. This would further eliminate undesired accounting mismatches leaving a significant portion of the remaining volatility in the financial statements associated with economic mismatches. Some IASB members asked for the introduction of disclosure requirements whenever assets at other than fair value had been used to measure participating liabilities.

Divergence on this important issue was formalised with the FASB unanimously rejecting the Staff recommendations and a large majority of the IASB members supporting the Staff recommendations (nine in favour, four against, one abstention and one absentee).

Reactions from the IWG on 16 May 2011

Members were generally supportive of the fact that the linkage between the assets and liabilities is recognised, however, we noted that IWG members were generally cautious on this very recent proposal and suggested that it would benefit from more analysis, refinement of the wording and more worked examples.

A few IWG members commented that the proposal seemed to have an implicit contract template that would appear to ignore the contractual structures usually found in the US participating contracts.

Other IWG members noted that the Phase I shadow accounting would seem a superior accounting solution. These IWG members expressed a view against measuring the liability at cost in order to avoid the mismatch in favour of a "current-current" approach where changes in both assets and liabilities associated with fluctuations of market variables are reflected through OCI.

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