Insurance Accounting Alert
March 2012
Overview
During February, the International Accounting Standards Board and the Financial
Accounting Standards Board (respectively, the IASB and the FASB, collectively,
the Boards) each held meetings to re-deliberate tentative decisions in the IASB’s
Exposure Draft, Insurance Contracts (ED) and in the FASB’s Discussion Paper
Preliminary Views on Insurance Contracts (DP). The following topics were discussed:
• Eligibility for and certain mechanics of the premium allocation approach
• Measurement of liabilities for infrequent, high-severity events
• Onerous contracts
• Treatment of non-insurance goods and services
The IASB and FASB separately discussed whether fi nancial instruments with
discretionary participation features (., contracts where the amount or timing of profi t
sharing is at the discretion of the issuer) should be within the scope of the insurance
standard, or to treat those instruments under the fi nancial instruments standard.
Premium allocation approach – eligibility criteria
At their January education sessions, the Boards held an extensive educational
debate on proposals prepared by both staffs on eligibility for the PAA. It emerged
from this debate that many IASB members preferred to see the PAA as an
approximation for the BBA, while the FASB members tended to see it as a separate
model that best refl ects the characteristics of the contracts to which it is applied. The
staff was asked to prepare revised eligibility criteria derived from the Boards’ input
from the educational sessions - in a way that those criteria would not necessarily
depend on whether one sees the PAA as an approximation for the BBA or, instead, as
a separate model next to the BBA.
In February, the IASB tentatively decided that contracts should be eligible for the PAA
if the approach would produce measurements that are a reasonable approximation
to those produced by the building block approach. As a practical expedient, contracts
should be deemed to satisfy that principle without further consideration if the
coverage period is one year or less. For other contracts, the IASB agreed that
contracts would not produce measurements that are a reasonable approximation to
What you should know
• The Boards have agreed on conditions
for determining whether the PAA or
the BAA should be applied to contracts
that are eligible. But they remain
divided on what PAA represents.
• The Boards decided on several
aspects of the PAA, including the
measurement of an onerous contract.
• The Boards agreed to use guidance
from the ED Revenue from Contracts
with Customers as the basis to
determine whether non-insurance
goods and services included in
an insurance contract should be
presented and measured separately.
• The IASB tentatively decided to
keep fi nancial instruments with
discretionary participation features
within the scope of the standard, but
will seek to limit this to such contracts
that are issued by insurers only. The
FASB tentatively decided that fi nancial
instruments with discretionary
participation features should not
be included within the scope of the
insurance contracts standard, unless
the contract meets the defi nition of
insurance.
Boards make decisions on the
premium allocation approach
2
those produced by the BBA. Therefore,
the contracts would not be eligible for
PAA if, at the contract inception date:
i. It is likely that, during the period
before a claim is incurred, there
will be a signifi cant change in the
expectations of net cash fl ows
required to fulfi l the contract
Or
ii. Signifi cant judgement is required
to allocate the premium to the
insurer’s performance obligations
for each reporting period. This
may be the case if, for example,
signifi cant uncertainty exists about:
1. The premium that would refl ect
the exposure and risk that the
insurer has for each reporting
period
Or
2. The length of the coverage period
As the PAA would refl ect an
approximation of the BBA, the IASB
concluded that an insurer should be
permitted, but not required, to apply
the PAA to contracts that are eligible
for the approach. The IASB noted that
it would review whether it will need to
update these criteria after its future
discussions on the BBA.
The FASB also adopted the conditions
in (i) and (ii) above, but as part of an
approach that treats the PAA as a
separate model: insurers are required
to apply the BBA rather than the PAA
if, at the contract inception date, either
of the conditions in (i) or (ii) are met.
The FASB selected the same practical
expedient (., coverage period is one
year or less) as the IASB. As the FASB
sees the PAA as a separate model,
it decided that the PAA should be
required for contracts that qualify for
that approach.
How we see it
For the most part, the staff succeeded
in developing a common set of
conditions that clarifi es when to
apply either the PAA or the BBA. This
indicates that the Boards have similar
ideas on the types of contracts that
should fall under the PAA.
However, the different viewpoints on
the nature of the PAA remain. As
noted by one Board member during
the meeting, this disparity may stem
from the Board’s differing views on
measurement, and on margins, in
particular. Whether the Boards will
be able to reconcile their differences
and come to a consistent overall
eligibility approach to PAA may
depend on the Boards converging on
measurement.
Based on the eligibility guidance
determined by each of the Boards
during this meeting, we expect the
types of contract that are measured
using the PAA to be fairly consistent
between those applying IFRS and
those applying US GAAP. However,
the Boards’ divergence on the use
of “require” versus “permit” may
have a signifi cant impact on whether
the PAA or the BBA is applied.
For example, some life insurance
contracts may meet the eligibility
criteria for the PAA.
The future US GAAP on insurance
contracts would then require
application of the PAA for those
contracts, while the future IFRS
would allow application of the BBA to
be consistent with the treatment of
all other life products. Therefore, we
expect that companies applying IFRS
will start looking at their contracts
and begin the process of deciding
where they may elect BBA when the
PAA criteria are met.
Premium allocation approach –
mechanics
As a follow-up to their January meeting,
the Boards discussed the use of time
value of money and the treatment of
acquisition costs under the PAA.
The Boards tentatively decided that
discounting and interest accretion to
refl ect the time value of money should
be required to measure the liability for
the remaining coverage in contracts
that have a signifi cant fi nancing
component. The characteristics of
what constitutes a signifi cant fi nancing
component will be consistent with the
exposure draft Revenue from Contracts
with Customers. The Boards noted that
time value of money is a fundamental
aspect of insurance contracts. Hence,
it would be diffi cult to explain that
time value of money would not be
considered within the insurance model.
However, as a practical expedient,
insurers need not apply discounting
or interest accretion in measuring the
liability for remaining coverage - if the
insurer expects at contract inception
that the period of time between
payment by the policyholder of all
or substantially all of the premium,
and the satisfaction of the insurer’s
corresponding obligation to provide
insurance coverage will be one year
or less. While making this decision,
the Boards noted, that the practical
expedient also present within the
revenue recognition proposals, and the
proposed wording for insurance could
be used to resolve uncertainty that
exists around the practical expedient in
the revenue recognition exposure draft.
On measurement of acquisition costs,
the Boards tentatively decided:
• The measurement of acquisition costs
should include directly attributable
costs (for the FASB limited to
successful acquisition efforts only)
3Boards make decisions on the premium allocation approach
• Insurers should be permitted to
recognise all acquisition costs as an
expense if the contract coverage
period is one year or less
The Boards also agreed to explore
a presentation approach in which
acquisition costs would be netted
against the single/residual margin
under the BBA, and netted against the
liability for remaining coverage under
the PAA.
How we see it
Netting the acquisition costs against
the liability for remaining coverage
as a presentation method is not new,
as it is used under the PAA method
in the IASB’s ED. However, exploring
such a presentation for the BBA
means investigating a new concept
and a change to the ED in which
acquisition costs are treated as
one of the cash fl ows. If acquisition
costs are thought of as a separate
item, then the Boards would have
to consider whether the acquisition
costs should follow the amortisation
pattern of the residual margin or
whether a separate amortisation
pattern would be needed.
Measurement of liabilities for
infrequent, high-severity events
The Boards received comments from
insurers that sought clarifi cation on
when and how to measure a potential
future insured event that is impending
at the end of the reporting period. This
concern was raised particularly in the
context of infrequent, high-severity
events such as a hurricane or other
catastrophes. For example, a storm is
building up before the reporting date,
but does (or does not) make landfall
after the reporting date. The Boards
tentatively confi rmed that insurers
should measure the insurance contract
liabilities taking into account estimates
of expected cash fl ows at the reporting
date, both when measuring the BBA
and the onerous contract liability for
the PAA.
The Boards agreed to provide
application guidance to clarify whether
an insured event, that was impending
at the end of the reporting period
and eventually occurs or not after
that date, constitutes evidence of a
condition that existed at the end of the
reporting period. Consequently, such
an event would be a non-adjusting
event, to which IAS 10 Events after the
Reporting Period applies, and a non-
recognised event to which ASC Topic
855-10-25 applies.
How we see it
The Boards concluded that estimates
should be made solely based on
conditions present at reporting date.
This will lead to volatility between
reporting periods because the
expected severity of pending wind
related storms often change daily.
This raises the question whether
the outcome is a fair refl ection of
the actual circumstances around
infrequent, high-severity events, or
an artifi cial result from the model.
During the meeting, the Board
members made it clear what their
answer to this question would be:
they commented this would refl ect
real economic volatility that comes
with estimating future cash fl ows
at a particular point in time. In any
case, disclosure will be paramount in
explaining the effects of such events.
Onerous contracts
At the December 2011 meeting, the
Boards tentatively decided on the
defi nition of onerous contracts and
when insurers should perform onerous
contract tests. They also discussed
the basis for measuring onerous
contracts and requested the staff to
make further considerations in light of
their tentative decision to introduce
a practical expedient that would
permit insurers not to discount claims
incurred, and are expected to be paid
within 12 months of the insured event.
At the February meetings, the Boards
continued their discussions on onerous
contracts in the following areas.
When to re-measure an onerous
contract liability
The Boards unanimously agreed with
the staff recommendation that onerous
contract liabilities should be updated at
the end of each reporting period.
Should the risk adjustment be
considered when identifying and
measuring onerous contracts
(IASB only)
A majority of the IASB members
were in favour of considering the risk
adjustment when identifying onerous
contracts, and the measurement of
the onerous contract liability should
include a risk adjustment. This decision
was supported by the staff analysis,
although including the risk adjustment
in identifying onerous contracts would
make the onerous test more diffi cult.
However, this diffi culty would be
alleviated by a previous decision that
insurers perform onerous contract
test calculation only when facts
and circumstances indicate that the
contract may be onerous.
Application of the practical expedient
to identifi cation and measurement of
onerous contracts
During the session on the PAA (see
above), the Boards confi rmed their
intention to provide a practical
expedient for contracts accounted
under the premium allocation
approach. The practical expedient
would permit insurers not to discount
portfolios where the incurred claims
4
are expected to be paid within 12
months of the insured event.
A number of Board members felt that,
if an insurer applies this practical
expedient and, hence, elects not to
discount the liability for incurred
claims, then there is a potential
inconsistency between the approach
for measuring onerous contracts and
one for measuring incurred claims
liability. The Boards followed that
logic and tentatively decided that, if
an insurer elects not to discount the
liability for incurred claims expected to
be paid within 12 months, the insurer
should use an undiscounted basis for
both identifying whether contracts are
onerous and measuring the liability for
onerous contracts.
How we see it
The Boards made signifi cant
progress in determining the onerous
contract test. However, one critical
aspect of the test that still needs
to be addressed is the aggregation
level. In the exposure draft Revenue
from Contracts with Customers,
the Boards require the onerous
test be performed at the level of an
individual performance obligation
(which would be more granular than
an individual contract if more than
one performance obligation were to
be identifi ed within the contract).
For the proposed insurance model,
the level of aggregation is principally
at the portfolio level since pooling
of homogeneous risks through
grouping of individual contracts is
a fundamental aspect of insurance.
Therefore, we expect that the Boards
will get comments that question if
the aggregation level for the onerous
contract test from their proposed
revenue recognition model is
appropriate for insurance contracts.
Treatment of non-insurance
goods and services
At prior meetings, the Boards had
tentatively decided that goods and
services should be unbundled from
insurance contracts in accordance
with the guidance for identifying
separate performance obligations in
the revenue recognition project, and
that unbundled goods and services
should be accounted for in accordance
with whatever guidance is relevant,
based on the characteristics of the
unbundled component. The staff
noted that this discussion does not
address asset management services,
which will be considered separately at
a future meeting.
At this meeting, the Boards
considered how to incorporate the
criteria for identifying separate
performance obligations from
the exposure draft Revenue from
Contracts with Customers into the
insurance contracts project, so they
can be used to unbundle goods and
services components from insurance
contracts. Under this approach, an
insurer should identify whether any
promises to provide goods or services
in an insurance contract would be
performance obligations as defi ned
in the exposure draft Revenue from
Contracts with Customers. If such a
performance obligation to provide
goods or services would be considered
distinct, an insurer shall apply the
applicable IFRS or US GAAP guidance
in accounting for that performance
obligation.
The Boards asked the staff to evaluate
whether some of the revenue
recognition guidance would actually be
relevant to insurance. Several Board
members also noted that a follow-up
is needed to address how to allocate
premiums and costs, considering
the measurement bases under the
insurance contracts model and the
revenue recognition model is different.
How we see it
The fact that asset management
services will be considered
separately may indicate that the
staff sees this as a more prominent
issue than other goods and services
because it is present in many
long-term life contracts and may
potentially be more integrated with
the insurance component.
Allocation of premiums and costs
between the insurance and other
components of a contract may come
with challenges; in the past, the staff
already made the observation that
this ultimately requires an approach
that involves some arbitrariness.
Financial instruments with
discretionary participation
features
Separately, the Boards discussed
whether fi nancial instruments with
discretionary participation features
(DPF) should be included in the scope
of the insurance contract standard.
The IASB also discussed how the term
DPF should be defi ned.
The IASB staff recommendation was
to include fi nancial instruments with
DPF within the scope of the insurance
contracts standard, as opposed to
including them within the scope of the
fi nancial instrument standards. The
IASB staff provided arguments for
and against applying the insurance
contracts model to all fi nancial
instruments with DPF, and argued that
the benefi ts of applying the insurance
contracts model to all fi nancial
5Boards make decisions on the premium allocation approach
instruments with DPF outweighed
those for application to insurance
contracts only.
The majority of the IASB supported
the staff recommendation to include
fi nancial instruments within the
insurance contracts standard, but to
limit the application to the insurance
industry. Regarding the defi nition
of DPF, the Board agreed it should
take into account the different ways
of limiting contracts to those written
within the insurance industry. The staff
was instructed to draft another paper
to address the defi nition issues noted.
In a separate meeting on 7 March
2012, the FASB staff recommended
to exclude fi nancial instruments with
DPF from the scope of the insurance
contracts standard. The FASB agreed
with their staff and tentatively decided
not to scope in fi nancial instrument
contracts with DPFs into the insurance
contracts standards, regardless of
whether those contracts were issued
by an insurer.
How we see it
The choice for the IASB is a diffi cult
one. On one hand, these contracts
are not insurance contracts.
On the other hand, they share
many features with life insurance
contracts containing DPF. Two
important questions remain. First,
will the IASB be able to fi nd an
appropriate principle to limit this
scoping to fi nancial instruments
with DPF issued by insurance
companies only. Second, will this be
an interim solution that gives the
IASB time to modify its fi nancial
instruments guidance, or will it
prove to be a more permanent
solution. Meanwhile, the FASB will
have to focus on the measurement
of fi nancial instruments with DPF
within the constraints of its Financial
Instruments Project.
The IASB has tried not to make this
an industry specifi c standard, but
a standard on insurance contracts.
However, the IASB has put itself
in a position where the insurance
standard will be an industry specifi c
standard in at least one aspect.
With each of the Boards taking
fundamentally different routes on
fi nancial instruments on DPF, we
expect that this issue will be re-
debated at least one more time
before the Boards will publish their
documents. However, it is impossible
to predict the outcome of this debate.
Next steps
The IASB plans to issue a revised
exposure draft or a review draft of
the fi nal standard in the second half
of 2012. It will establish a publication
date for the fi nal standard in due
course. The FASB currently aims to
issue its exposure draft in the same
period.
The Boards will have their next
discussion on insurance at the March
Board meetings, when they will
address the defi nition of a portfolio
of insurance contracts and separation
of investment components from
insurance contracts.
