In this article, IASC Convenor Grant Robinson illustrates the historical developments of a common way of reporting insurance contracts which started in 2005. He also shares details of future plans and potential impacts of the new process.
The Coming Change in Accounting for Insurance Contracts
The amazingly long journey to a common way of reporting insurance contracts, which began way back in 1997, is finally drawing to close. We can be pretty confident that we will see the final standard released in 2017, with a 2021 mandatory effective date the most likely.
This means that some of those who will be doing the reporting under the new standard for the first time will not have been born, when this standard was first conceived.
The following sets out the journey and outcomes.
2005 – Phase One
Under its first phase, with the issue of IFRS4 Insurance Contracts, effective from 2005, the IASB:
- defined what are insurance contracts and investment contracts with discretionary participation features;
- grandfathered existing accounting treatments for these contracts (i.e. AASB 1023 and AASB 1038 in Australia), subject to liabilities held meeting an adequacy test; and
- improved disclosures.
Since then the IASB, has been working to replace the wide variety of grandfathered accounting practises with one accounting approach or model that would apply to any type of insurance, be it – general, health or life insurance, as well as for participating investment contracts.
2007 – Discussion Paper
The IASB set out in its 2007 discussion paper, its initial thoughts on an accounting model for insurance, to be based on three building blocks:
- unbiased current estimates of expected contractual cash flows;
- adjusted for the time value of money at current market discount rates; and
- a margin that market participants require for bearing risk;
Plus a margin for the provision of any other services, if any, a ‘service margin’.
2010 – Exposure Draft
The exposure draft issued in 2010 kept the three building blocks – current estimates, current market discount rates and adjustment for risk.
The service margin was replaced with a ‘residual margin’ calibrated to remove profit at contract inception based on incremental acquisition costs, and released over the life of the contract.
Under this model the following items would go through profit and loss:
- Release of residual margin for the period (similar to MoS);
- Interest on the liability in the current period (similar to MoS);
- Unexpected cash flows – actual cash receipts or payments that were not as expected (similar to MoS); and
- Changes in estimates of future cash flows (differs from MoS in not remeasuring the residual margin for changes in future estimates)
- Change in risk adjustment over the period reflecting both release from risk and changes in the uncertainty of future cash flows (no MoS equivalent);
2013 – Revised Exposure Draft
Responding to concerns about profit volatility, from taking changes in current estimates and discount rates straight to the profit and loss, and the adverse impact of contract boundaries on health insurance, the IASB, revamped the proposed accounting model in number of significant ways:
- The ‘contract boundary’ (i.e. the point at which the insurance contract ends for the purposes of calculating the balance sheet liability) to be set, not only when it can be fully repriced at the individual contract level but also if it can be at the portfolio level, which makes the next renewal date the contract boundary for stepped premium life insurance sold on yearly renewable premium terms (a substantial change from MoS);
- The ‘contractual service margin’ (formerly the residual margin) could now be remeasured for changes in estimates relating to future coverage albeit at inception discount rates (more akin to MoS), but previous losses could not be reversed and changes in risk margins relating to future coverage could not be included the remeasurement;
- Profit and loss to be based on inception discount rates with the impact of current discount rates to go through other comprehensive income not profit and loss;
- Investment contracts with insurance riders not to be unbundled and reported as insurance unless both components can lapse independently of each other (very different to MoS and current insurance IFRS);
- Very complex accounting for participating and investment linked business involving identifying those elements of contractual cashflows driven by guarantees, options and underlying assets and applying different accounting for each element.
2016 – Tentative Decisions on Final Standard Completed
In February 2016, the IASB completed reviewing issues arising from feedback on the 2013 revised exposure draft and decided that the staff could now proceed to drafting the final standard, with some further changes:
- In remeasuring the contractual service margin (CSM), previous losses can now be reversed (similar to MoS) and changes in risk margins relating to future coverage can also be included in the remeasurement of the CSM;
- The use of Other Comprehensive Income for changes in current discount rates is no longer mandatory, which means the impact of changes in current discount rates can generally go through the profit and loss if preparers so elect;
- A ‘variable fee’ model is proposed for participating business where participation is based on a clear pool of underlying items, in which case the CSM can be adjusted for changes in the entity’s expected share of returns on underlying items, net of any expected cash flows that do not vary with the underlying items (akin to MoS).
- The release of CSM has been simplified to “passage of time” for both non-participating insurance and participating insurance (e.g. conventional business) with only participating investment business able to use “transfer of investment service” (making profit release even more different to MoS).
- Restricting the ability to group insurance contracts for purposes of determining onerous contracts and allocating the CSM to contracts that at inception have both:
- Cash flows expected to respond in similar ways (amount and timing) to changes in key assumptions; and
- Similar expected profitability (ie similar CSM as a percentage of the premium).
Further Field Testing – 2H16
In conjunction with the drafting, the IASB has invited a limited number of insurers around the globe to participate in field testing on the drafting on five topics:
- Aggregation of contracts – focus on the number of groups required for CSM – the restriction on grouping to contracts with similar profitability that react in similar ways to changes in key assumptions is likely to cause a huge increase in the number of groups. Even if this results in a group having only one contract in it, it may not be combined with other groups;
- Scope of variable fee approach – focus on understanding types of participating business that qualifies and judgements involved – we believe that most, if not all Australian participating business will qualify for the variable fee approach;
- Derivatives used to mitigate financial market risk – focus on understanding how these are used for participating business eligible for variable fee model and if the option to match their reporting in profit and loss works as intended;
- Determining insurance finance income or expenses in OCI – understanding how disaggregation methods would work for OCI accounting – our focus has been on lobbying to avoid the complexity of OCI for those who prefer current accounting in the profit and loss;
- Recognition of changes in estimates – understanding how experience and changes in estimates flow through – some similarities with MoS in that the CSM is remeasured for changes in estimates relating to future coverage. Also some significant differences in that:
- the remeasurement uses inception discount rates for the CSM vs current for the change in fulfilment value;
- changes in current estimates for IBNR and outstanding claims reserves go straight to profit and loss as they do not relate to future coverage;
- some items that would previously have been recognised as experience variances under MoS may now be recognised through an adjustment to the CSM.
- Transition – understanding when and how the three transition options (full retrospective, simplified transition and fair value transition) might be utilised;
The questionnaire, which includes relevant extracts from the draft standard, is publically available on the IFRS website.
The IASB is currently expected to consider feedback from the field testing and set the implementation date for the final standard late this year, with the final standard being released in first half of 2017.
Overview of the coming standard
There is a weekly series of webinars, over April and May, by Darrel Scott, member of the IASB, which provides a good overview of the forthcoming Standard, which can be found here.
The following provides a quick summary of key potential change impacts:
- Stepped premium yearly renewable term insurance becomes short term business resulting in:
- large write down in DAC on transition, as acquisition costs can only be deferred till next contract renewal;
- potential improved ROE for mature insurance businesses, reflecting reduction in equity from DAC write down;
- significant new business strain for a start-up insurance business
- uncertainty about tax treatment of the DAC write off.
- Increase in profit volatility due to:
- Changes in assumptions for IBNR and open claims reserve estimates going to P&L instead of against future profit margins;
- Reduction in profit margins (CSM) available to absorb assumption changes due to the introduction of the risk adjustment;
- Much lower level of grouping for loss recognition (onerous contracts); and
- Mismatch in discount rates used for measuring impact of assumption changes on CSM (inception discount rates) vs fulfilment value (current discount rates), unless using the option to put the impact of discount rates changes through Other Comprehensive Income
- Individual yearly renewable risk business profit less sensitive to changes in lapse assumptions and market interest rates due to significant reduction in implicit DAC.
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