The current IFRS 4 insurance contracts enable only limited comparability between peers within the insurance industry because it allows insurance contract liabilities to be measured in accordance with accounting policies grandfathered from local accounting regimes. Nonuniform accounting policies may be used in consolidated IFRS financial statements if this was permitted under the group’s previous accounting policies, such as in financial statements prepared in accordance with European Union (EU) directives.
During 2015, the International Accounting Standards Board (IASB) made significant progress in its insurance contracts project to deliver a standard that will provide comparability within the insurance industry. It has now completed planned technical deliberations and has begun drafting the forthcoming insurance contracts standard. It expects to issue the final standard around the end of 2016, meaning an expected mandatory effective date of January 1, 2020 or 2021, with early adoption permitted. A final decision regarding an effective date will be taken by the IASB later this year.
Regardless of the timing of the practical application of the standard, it is clear that the IAIS cannot wait for its issuance to meet its own challenging timeline for progressing toward a final insurance capital standard (ICS). However, now that the technical decision-making has been completed, the IAIS could revise its proposals and potentially incorporate some of the key requirements of the standard, where meaningful to do so, to ensure greater harmonization between accounting and regulatory valuation bases at a later date. For this reason, it is important to recognize that the changes to be introduced to the IFRS may also have regulatory impacts.
Measurement basis
The forthcoming insurance contracts standard will include a comprehensive measurement model for all types of insurance contracts issued by entities. However, a simplified form of the model, the premium-allocation approach, may be used for some short-duration contracts, and modifications will be made to the model for direct participating contracts.
The measurement model is based on the current “fulfilment” objective, which reflects the fact that an entity generally expects to fulfill its liabilities over time as claims become due. Accordingly, the starting point for measuring an insurance contract liability will be the expected future cash flows for fulfilling the contract. The fulfillment of the obligation is based on the entity’s perspective (not exit value or fair value).
In measuring an insurance contract liability, the expected future cash outflows less inflows (building block 1) are discounted to reflect the time value of money (building block 2). A risk adjustment that reflects the uncertainty about the amount and timing of the cash flows when fulfilling an obligation to the policyholder (building block 3) is added to the expected discounted future cash flows. These three “building-blocks” are remeasured at each reporting date using current information. If the sum of the three building blocks is negative at the inception of the contract (i.e., the present value of cash outflows plus the risk adjustment is less than the expected present value of cash inflows), a contractual service margin (CSM) is added to remove any day one gains.
The CSM represents the unearned profit at the inception of the contract. It is recognized evenly over the coverage period. The subsequent claims settlement period is not included.
At subsequent measurement, the CSM is adjusted for changes in future cash flows and changes to the risk adjustment that relates to future coverage and other future services, provided that the CSM does not become negative. Consequently, there is no impact on net income or equity for these changes.
Discounting the future cash flows reflects the time value of money. Due to the long durations of some insurance contracts, the determination of the discount rate and changes in the discount rate can have a major impact on equity and net income.
The forthcoming insurance contracts standard will not prescribe how to determine the discount rate, but rather provide a broad principle of being consistent with observable current market prices for instruments with cash flows whose characteristics are consistent with those of the insurance contracts in terms of timing, currency and liquidity. Hence the rate will conceptually be risk-free and illiquid. Depending on the currency and type of insurance contracts issued, and the methodology adopted to determine the appropriate discount rate (or rates), a number of different discount rates might be applied.
The disclosure requirements for discount rates, or ranges of discount rates, are intended to achieve comparability, transparency, and market discipline.
Simplified approach
As stated previously, the standard will permit the application of a simplified “premium-allocation” approach to measure the liability for remaining coverage for certain short-duration contracts—in particular, those with a coverage period of one year or less.
The approach is broadly consistent with current unearned premium accounting practices applied in most jurisdictions for non-life, short-duration contracts.
Incurred claims liabilities will be measured using the building block approach, meaning that (with certain exceptions) cash flows will be discounted. Profit will be recognized earlier than under most current accounting models, because incurred claims liabilities are generally not currently discounted, although if the risk adjustment exceeds the effect of discounting, which may be the case, in particular for liability insurance, profit will be
recognized later.
Participating contracts
A direct participating contract is defined as a contract for which:
- the policyholder participates in a defined share of a clearly identified pool of underlying items;
- the entity expects to pay the policyholder a substantial share of the returns from those underlying items; and
- the cash flows the entity expects to pay the policyholder are expected to vary significantly with the performance of the underlying items.
For direct participating contracts, the CSM is adjusted for changes in the shareholders’ share of the returns on underlying items in the current period (the variable fee approach).
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The article was taken from KPMG’s publication, entitled “The impact of accounting changes on regulation.”
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