UNDER current International Financial Reporting Standards (IFRS), insurance liabilities are mainly measured in accordance with accounting policies using other accounting regime, e.g., local generally accepted accounting principles of GAAP, US-GAAP or UK-GAAP. Additionally, the policies used in consolidated financial statements are not to be consistently applied. Consequently, there is no comparability. For the first time, the International Financial Reporting Standard or IFRS 4 Phase II will require consistent accounting for insurance contracts. An exposure draft was issued for public comment in June 2013. The final standard is expected published in 2015. The effective date of the final standard is expected to be for reporting periods beginning on or after January 1, 2018. Under the exposure draft, the starting point for measuring the insurance liability is the expected future cash flows for fulfilling the contract. The fulfillment of the obligation is based on the entity’s perspective (fulfillment value, i.e., no exit value or fair value) and current assumptions are used.
In measuring the insurance liability, the expected future cash flows are discounted to reflect the time value of money. A risk adjustment that reflects the uncertainty about the amount and timing of the cash flows is added to the discounted expected future cash flows. These three “building-blocks” are remeasured at each reporting date using current information. Another building block, the contractual service margin (CSM), is applied to remove any day-one gains. Contrary to what some might expect, fulfillment value is not the same as or may not be largely similar to a market-consistent value, such as the values that a Solvency II Statement of Financial Position is based on.
The CSM represents the unearned profit that the entity will recognize in profit or loss over the coverage period. It will be recognized in a systematic way that best reflects the transfer of services provided under the contract. Profit is recognized over the coverage period because the promise to provide coverage is the relevant service. The claims settlement period is not included. Generally, the allocation of profit over the coverage period is current practice. Different is how the underlying assumptions for the other three building blocks and accounting for changes are treated.
Discounting the expected future cash flows reflects solely the time value of money. Uncertainty about the amount and timing of the cash flows is considered when estimating the expected cash flows and the risk adjustment. Conceptually, the International Accounting Standards Board (IASB) considers the appropriate discount rate to be the rate that is consistent with observable current market prices for instruments with cash flows whose characteristics are consistent with those of the insurance contract in terms of timing, currency and liquidity. This may be either a risk-free rate adjusted for illiquidity (called the bottom-up approach, generally, this rate is expected to be used for nonlife insurance) or a rate based on actual assets or a reference portfolio adjusted to remove the market risk premiums for expected and unexpected losses (called the top-down approach, generally, this rate is expected to be used for life insurance). Under the exposure draft, nonlife claims provisions, with certain exceptions, are discounted and profit is recognized earlier than under current accounting, where nonlife claims provisions generally are not discounted, unless the risk adjustment exceeds the effect of discounting.
To the extent that the amount, timing or uncertainty of the cash flows arising from the insurance contract depends wholly or partially on returns on underlying items (participating contracts), the discount rate should reflect that dependency. This concept does not apply for the measurement of minimum guarantees. For minimum guarantees, the building-block approach is applied. Under the exposure draft, for certain participating contracts the measurement of the insurance liabilities mirrors the carrying amount of the underlying items. However, the relevant guidance is complex and, in some circumstances, difficult to apply. It remains to be seen whether the measurement and presentation exceptions for this kind of business will be retained in the final standard.
Due to the long durations of insurance contracts and the resulting effect of leverage, the determination of the discount rate and changes in the discount rate have a major impact on equity and net income. The exposure draft does not prescribe how to determine the discount rate, rather, giving a broad objective as discussed above. Depending on the type of entity and business segment, different discount rates will be applied. The disclosure requirements for discount rates or ranges of discount rates are intended to achieve transparency and market discipline.
Many concerns have been expressed with respect to volatility in profit or loss resulting from short-term interest-rate fluctuations that may be inconsistent with the long-term nature of the insurance business. The exposure draft proposed the presentation of changes in insurance liabilities arising from changes in discount rates in other comprehensive income (OCI) as opposed to profit or loss. This achieves a stable presentation in profit or loss, while the financial assets and liabilities in the Statement of Financial Position are measured using current assumptions. Under the exposure draft, changes in the value of minimum guarantees are presented in profit or loss resulting in volatility.
The IASB published an exposure draft of limited amendments to IFRS 9 in November 2012. One of the objectives was to improve the interaction between the accounting for insurance liabilities and for financial assets. This exposure draft proposed that changes in the fair values of some debt instruments should be presented in OCI. However, many investments held by insurers may not meet the criteria for the presentation of changes in the fair values in OCI, e.g., derivatives, structured products or those with participating rights. Accordingly, inconsistencies between the presentation of gains and losses on assets and liabilities may result. The IASB has recently decided to allow insurers an option to present the effects of changes in discount rates for insurance liabilities in profit or loss or OCI in order to reduce accounting mismatches. In addition, the IASB has recently decided that the effective date of IFRS 9 will be January 1, 2018 and it is possible that entities will be able to apply both the new insurance and financial instruments standards at the same time.
For short-term contracts, in particular one-year insurance contracts, the exposure draft permits the application of a simplified approach that is broadly consistent with unearned premiums under current accounting practices for short-term duration contracts.
The exposure draft includes a new presentation of the statement of profit or loss and OCI. Under current accounting practices, premiums are used as a volume measure for revenue and benefits as a volume measure for expenses. These measures are replaced by a presentation that is based on the concepts in the revenue recognition standard that is nearing issuance. The new presentation of premiums and benefits in life and health insurance is significantly different from the current presentation because the timing of recognition differs and all investment components have to be excluded.
For ceded reinsurance, the initial CSM for the reinsurance asset is determined to remove any gain or loss at inception. The reinsurance premiums are reduced by ceding commissions. As a result, for proportional reinsurance the reinsurance asset does not necessarily equal the contractual share in gross insurance liabilities. Profit recognition from the underlying insurance contract and reinsurance contract may diverge if, for example, losses from the underlying insurance contract need to be anticipated in an onerous portfolio.
Impacts of the IASB’s proposals
IN the exposure draft, the IASB has addressed many insurers‘ concerns and brought the publication of an international insurance standard closer to realization. Allowing the presentation of volatility resulting from short-term interest rate fluctuations in OCI may be more consistent with the insurers’ long-term business model and makes concessions to analysts who want to project long-term distributable profits. From our perspective, the critical areas within the current proposals and related impacts include:
• The volatility that may be created by certain proposals. For example, volatility in profit or loss and equity may be created due to the use of current assumptions in measuring insurance liabilities or when changes in the values of minimum guarantees due to short-term interest-rate fluctuations are presented in profit or loss.
• The interaction between accounting requirements for financial instruments and insurance contracts. The interaction needs to be considered comprehensively to enable users to compare financial results over time. The IASB’s recent decision that the mandatory effective date of IFRS 9 will be January 1, 2018, incentivizes the IASB to progress expeditiously on the insurance contracts project with a view to having aligned effective dates.
• Concerns about the presentation of the statement of profit or loss and OCI, including the new proposed measure of volume and new definition of the term “revenue” for insurance contracts. These proposals could result in a major change in practice. The IASB needs to consider whether the presentation proposals, including the different presentations of the effects of changes in profit or loss, OCI or CSM, will provide the information that users consider most relevant. In any case, complexity for insurers—and users—will increase and represent an operational challenge.
• Contracts with participating features. The current proposals are complex, and difficult both to understand and to apply consistently. The final standard should include a clearly defined, overall principle in accounting for contracts with participating features.
The article is taken from KPMG’s publication, entitled Evolving Insurance Regulation: The Kaleidoscope of Change-March 2014.
R.G. Manabat & Co., a Philippine partnership and a member-firm of the KPMG network of independent firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
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