25 September 2009

Published in: Accounting - tax

Insurance contracts timetable looks optimistic

The IASB brought forward its target date to produce an exposure draft on this subject from April 2010 to the end of 2009 but time is running out to resolve a number of issues. KPMG explains.

The International Accounting Standards Board wants to publish an exposure draft (ED) on a replacement for IFRS 4 for insurance contracts reporting by the end of the year. But that looks unlikely, given the failure of the board to reach agreement on a number of issues and also its failure to iron out some differences with the US Financial Accounting Standards Board.

The key issue is the measurement approach to be adopted for insurance contracts. There are two candidates for this approach. One emanates from the FASB: on 21 July it decided that the objective of insurance contract liability measurement should be to report a value based on the insurer's fulfilment of its contractual obligations to its policyholders and that fulfilment value should include only a composite margin with no explicit risk margin.

The other approach is based on the updated IAS 37 (Liabilities) model, modified to exclude day one gains. (The IASB had agreed at its meeting in June 2009 to remove the current exit value (CEV) approach from its list of candidate measurement models.)

The main difference between the two approaches under consideration is that the approach based on the updated IAS 37 model would include both a margin (as yet unspecified) that would be re-measured at each balance-sheet date and a residual margin (representing the amount required to remove any profit at the inception of a contract) that would not be re-measured. The current fulfilment approach would include a single composite margin that would not be re-measured at each balance-sheet date.

The IASB tentatively agreed on 22 July 2009 to include a more detailed measurement objective in the amended IAS 37. This would require an entity to measure an obligation at the value to the entity of not having to fulfil the obligation if there is no evidence that it could cancel or transfer the obligation to a third party. The board could not agree how to measure the fulfilment value, in particular what margins should be included in measuring the obligation, and directed staff to undertake further work in this area. This has always been one of the main barriers to progress in the phase II discussions. Although resolution of this issue has effectively been moved to the IAS 37 project, the problem has not gone away and the debate has not moved very far forward.

Although the IASB appears to be leaning towards the modified IAS 37 approach because it is generally in favour of achieving consistency with IAS 37, a number of board members have been unwilling to endorse an approach for insurance contracts based on IAS 37 when they have not yet agreed on the approach to the IAS 37 amendment projects.

For short-duration contracts, the IASB has agreed by a significant majority (at its 22 July meeting) that an unearned-premium approach should be applied to pre-claims liabilities arising from them.

Unearned premium approach

The board also discussed at its July meeting whether an unearned-premium approach should be applied to pre-claims liabilities arising from short-duration contracts. Under an unearned-premium approach, the premium paid is earned over the coverage period. Separate liabilities, determined using the measurement approach to be selected for other insurance liabilities, would be recognized for claims.

A number of IASB members have been unwilling to endorse an approach for insurance contracts based on IAS 37 when they have not yet agreed on the approach to the IAS 37 amendment projects. 

The board agreed, by a significant majority, to adopt this approach. The board then debated whether the approach should be required, or permitted. A small majority of the board indicated that they would rather it was explicitly required as the measurement approach for short-duration contracts.

Role of residual (or composite) margins

Some observers believe that it is inconceivable that both boards could make a decision on the measurement model without having a clear understanding of how the residual (or composite) margin would be released after initial measurement. Other than the IASB acknowledging at its July meeting that this is an important issue, this issue has not yet been discussed by either board.

What would happen after initial recognition if an insurer changes its estimate of future cash flows? One possible approach is that the residual (or composite) margin would not be affected and the change to the estimated future cash-flows would be reflected immediately as a change in the value of the insurance liability and in profit and loss. An alternative approach would be to adjust the margin for the change in the estimated future cash-flows so that the value of the liability would be unchanged and there would be no immediate impact on profit and loss (the so called ‘shock absorber' approach). Another possible approach would be to reflect changes in estimated future cash-flows that arise from changes in financial market inputs in profit and loss but to adjust the margin for changes in estimated future cash-flows that arise from changes in non-financial market inputs with no immediate impact on profit and loss.

By voting for the use of the unearned-premium approach for short-duration contracts it would appear that the IASB Board has effectively agreed that the residual (or composite) margin would be earned over the cover period for this type of contract. 

It will be interesting to see the direction that the boards take when they discuss this issue. When it published its discussion paper in May 2007, the IASB rejected the shock absorber approach. But this decision was taken at a time when the majority of the IASB favoured a current exit value approach. The subsequent decisions not to allow the recognition of day-one profits and to remove current exit value from the list of candidate measurement approaches, and the changes in the composition of the board since that date, mean that it is possible that there may now be more support within the IASB for a shock absorber approach (or a partial shock absorber approach). Although the FASB has agreed that estimates of expected cash-flows and discount rates should be updated at each measurement date, this does not necessarily mean that it might not agree to a shock absorber approach, which would have the effect of locking in assumptions.

By voting for the use of the unearned-premium approach for short-duration contracts it would appear that the IASB has effectively agreed that the residual (or composite) margin would be earned over the cover period for this type of contract. This issue has not yet been considered by the FASB.

Resolving differences between the IASB and the FASB

At a joint meeting on 23 July 2009, the IASB and FASB met to discuss their current views on the measurement approach for insurance contracts and the treatment of acquisition costs.

The boards had previously reached different positions on the treatment of acquisition costs. The IASB had agreed that the value of an insurance contract at inception should be calibrated to the premium, less incremental acquisition costs, and that an amount of revenue should be recognized equal to the incremental acquisition costs. The FASB had decided that the initial calibration should be made to the value of the premium alone and that no revenue should be recognized at the inception of a contract.

There is still clearly much to do before an ED can be issued. The IASB has been discussing the measurement approach since February 2009 and has still not yet reached a decision. 

The IASB members made no attempt to hide the fact that they do not all share a common view on these issues, whereas the FASB Board members presented a more united front. It was interesting how closely wedded the FASB is to the proposed approach included in the Revenue Recognition Discussion Paper, which provides rules and guidance on when, and at what value, to recognize revenue in the income statement. In arriving at its decisions to date, the FASB appears to have given little weight to the approach under existing US GAAP for insurance contracts, although for the pre-claims period of short-duration non-life contracts (which it has not yet discussed) the approaches would be similar.

Project timetable

The IASB staff prepared an updated project timetable for consideration by the board at its July meeting but it was not discussed. The timetable identifies a number of important issues that the board has not yet had the opportunity to discuss. These include:

• discount rates;
• recognition and role of margins;
• presentation; and
• participating and unit-linked contracts; investment contracts; and universal life contracts

Although the project timetable was not specifically discussed, at either the IASB meeting or the joint meeting with the FASB, the IASB is still working towards issuing an ED by the end of this year. Sir David Tweedie indicated that, if the boards could not reach agreement on an issue, both views would be included in the ED.

Although this is probably the only practical approach that the IASB (and FASB) could adopt if an ED is to be issued before the end of the year, this approach would store up problems for the future, since any unresolved issues would still need to be eliminated prior to the issue of the final standard and this approach would make it more difficult for the staff to draft the ED and subsequently to analyze the responses.

There is still clearly much to do before an ED can be issued. The IASB has been discussing the measurement approach since February 2009 and has still not yet reached a decision. It is difficult to see how the board can find sufficient time to discuss and resolve all the remaining issues in the limited time that they are likely to have available to them. Although the insurance contracts project is a joint project, it is not a financial crisis project, nor is it included in the memorandum of understanding between the IASB and the FASB, so it is unlikely to be a priority project for the boards over the next six months.

Field testing

At its June 2009 Board meeting the IASB tentatively agreed to perform targeted field- testing of the proposals being developed. The staff's intention was to perform a significant part of the field-testing before the publication of the ED, but this was based on the assumption (at the time) that the ED would not be published before April 2010. In practice, however, it is unlikely that constituents would be willing to participate in field- testing in the period between January and March 2010, so the field-testing would have had to be carried out in the period between September and November 2009, which would also be the case if the ED is to be issued in December 2009. This leaves a very small window for carrying out any tests.

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