FASB s Proposed Model for Insurance Contracts

Transcription

1 FASB s Proposed Model for Insurance Contracts

2 Table of Contents BACKGROUND & OVERVIEW... 4 SCOPE... 5 GUARANTEES... 6 UNIT OF ACCOUNT... 8 CONTRACT BOUNDARY RECOGNITION & DERECOGNITION... 8 MEASUREMENT MODELS... 9 BUILDING BLOCK APPROACH (BBA)... 9 BBA Model Components BBA Recognition & Measurement PREMIUM ALLOCATION APPROACH (PAA) PAA Initial Recognition PAA Subsequent Measurement OTHER ITEMS ACQUISITION COSTS Recognition Qualifying Direct Acquisition Costs Direct Response Advertising PARTICIPATING CONTRACTS, CONTRACTS WITH PARTICIPATION FEATURES & SEGREGATED FUNDS Participating Contracts Participation Features Segregated Fund Arrangements UNBUNDLING SEPARATING COMPONENTS OF AN INSURANCE CONTRACT Embedded Derivatives Investment Components Performance Obligations Cash Flow Allocations REINSURANCE Ceding Commissions Loss-Sensitive Features CONTRACT MODIFICATIONS BUSINESS COMBINATIONS & PORTFOLIO TRANSFERS Business Combination Portfolio Transfers Acquisition Through Combination of Entities or Businesses Under Common Control FOREIGN CURRENCY

3 PRESENTATION & DISCLOSURE PRESENTATION Statement of Financial Position Statement of Comprehensive Income DISCLOSURES Insurance Contract Liabilities & Liabilities for Incurred Claims Margin Insurance Contract Revenue & Premiums TRANSITION CONTACT US CONTRIBUTORS

4 Background & Overview The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working together for several years developing a comprehensive accounting standard for insurance contracts. The goal was to improve financial reporting by providing a consistent basis for the accounting for insurance contracts and to make it easier for users of financials statements to understand how insurance contracts affect an entity s financial position, financial performance and cash flows. The boards sought to enhance comparability across entities, jurisdictions and capital markets. FASB s September 2010 issuance of a discussion paper was followed by an extensive outreach program, public roundtable discussions and several years of deliberation. IASB issued its exposure draft (ED) on June 20, 2013; FASB issued its exposure draft on June 27, The two EDs have similar fundamentals but differ in key areas that impact the timing of earnings recognition. This paper will focus solely on the FASB proposal. Insurance Contracts Project Timeline /5 2017/8 August Invitation to comment September Discussion paper June FASB exposure draft, 120-day comment period Deliberations Final standard? Effective date? Current U.S. GAAP guidance comprehensively addresses accounting for insurance contracts, having evolved over many years to address new products and features. The scope of the guidance currently is limited to insurance companies, with multiple accounting models depending on the type of insurance product. The ED is applicable to any entity that issues insurance contracts or holds reinsurance contracts, whether or not it is a licensed insurance entity. The impact of the proposal will vary, depending on the nature of the insurance contract. An entity would recognize revenue in proportion to the value of coverage or services provided. The ED has only two accounting models for insurance contracts. Most life and annuity contracts will follow the building block approach (BBA), where the revenue recognition of premium will be based on the expected pattern of benefits to be provided. This means revenue will be recognized later in the contract life than under the current when due approach. Earning will be more volatile because of the requirement to update assumptions each period. In addition, insurance contracts with deposit or returnable amount features, such as cash surrender life insurance, will exclude those amounts from revenue and expenses. For most property and casualty contracts, FASB s premium allocation approach (PAA) is similar to the unearned premium approach used today, although the new model will require discounting of the liability where material. 4

5 The chart below highlights the impact of the proposed insurance model on the timing of revenue recognition for a portfolio of term-life contracts. Example Term-life contract Portfolio of 25-year life insurance contracts issued to 40-year-olds. Premiums of $1,000 are due annually. No investment component. Expected claims are proportional to current mortality rates. No lapses and no discounting. Comparision of revenue recognition patterns for a portfolio of term-life contracts $ Dollars Years of contract Current GAAP - Premiums Due method Proposed ASU - BBA model The ED s proposed changes to the accounting for insurance contracts would have significant financial and operational implications. Significant time and cost would be required to assess and update various processes to comply with the proposed requirements, including internal controls, risk management, contract redesign and pricing and investment and hedging strategies. International Financial Reporting Standards (IFRS) do not have a comprehensive standard relating to insurance contracts, unlike U.S. GAAP. While the FASB ED proposed an entirely new model, FASB could ultimately decide to make only certain changes to the existing U.S. GAAP guidance. Scope Current U.S. GAAP for insurance contracts is industry-specific. Contracts issued by noninsurance companies that contain identical or similar economic characteristics are accounted for under separate guidance (contingencies, guarantees or financial instruments). The ED is applicable to any entity that issues insurance contracts, whether or not it is a licensed insurance entity. The new model would apply to public and nonpublic entities, with limited disclosure relief for nonpublic entities. The proposal would apply to all insurance contracts an entity issues and reinsurance contracts an entity holds. Entities holding insurance policies that are not reinsurers would not be covered by the proposal. The ED defines an insurance contract as a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder. 5

6 Entities that self-insure are not in scope since there is no agreement with a third party. For captive entities that only issue insurance contracts to other entities within a group, the parent would not be required to account for those contracts as insurance contracts in the consolidated financial statements; however, the captive s standalone financial statements would reflect the contracts as insurance. An insurer would assess the significance of insurance risk at the individual contract level. Contracts entered into simultaneously with a single party for the same risk, or otherwise interdependant contracts that are entered into with the same or related party, would be considered a single contract for the purpose of determining risk transfer. A contract exposing the issuer to financial risk without significant insurance risk is not an insurance contract. For example, investment contracts with discretionary participation features would not be covered by the insurance proposal but rather by the financial instruments standard. Credit-related contracts that pay out regardless of whether the counterparty holds the underlying debt instrument or that pay out on a change in credit rating or credit index would continue to be accounted for as derivatives. A life insurance contract with a guaranteed minimum rate of return has financial risk but also has significant mortality risk and therefore is considered an insurance contract. The table below highlights the more explicit guidance on assessing contracts for significant insurance risk than exists under current U.S. GAAP, which is limited to reinsurance contracts only. Current U.S. GAAP There must be a significant chance of significant loss (currently applicable only to reinsurance contracts ) Expansion of Significant Insurance Risk Proposed Model Only one of the estimated cash flow outcomes must have a significant loss (applicable to insurance and reinsurance contracts) Guarantees The proposed standard would apply to guarantee contracts within the scope of insurance guidance, such as mortgage insurance and financial guarantee insurance contracts, but not to guarantee contracts currently accounted for as derivatives. Entities regularly issuing guarantees to third parties that are accounted for under ASC (formerly FIN 45) will be subject to the new insurance requirements. Guarantees specifically addressed by other accounting guidance, such as leasing guidance, will not be in the scope of the proposal. An exception also is provided for guarantees that are both unusual or nonrecurring and unrelated to the type of risk that is the subject of other guarantees issued by the entity. For example, a seller s indemnification relating to a nonrecurring transaction such as the sale of a business or an asset will be considered a one-off transaction excluded from the scope. Guarantees between related parties or entities under common control will be exempt from the proposal if they are typically transacted only with those parties and the entity has no similar guarantee transactions issued to third parties. However, the standard will be applicable to intercompany guarantees issued by entities that also issue guarantees to third parties. 6

7 The table below highlights some of types of arrangements included in and excluded from the scope of the new insurance proposal. Scope Included Product warranties issued by third parties Catastrophe bonds and weather derivatives Performance bonds or surety bonds Residual value guarantees by third parties Self-insurance captive s standalone financials Mortgage insurance Financial guarantee insurance contracts Guarantees on securitized assets Standby letters of credit if obligation is: To repay money borrowed To make payment on any evidence of indebtedness To make payment due to any default Whole loan sale guarantees Trust-preferred securities Indemnities Auction-rate securities guarantees Merger and acquistion guarantees Minimum revenue guarantees Liquidity facilities Title insurance Travel insurance Life-contingent annuities Life insurance (whole, term, universal and prepaid funeral) Excluded Product warranties issued by a manufacturer, dealer or retailer Guarantee contracts accounted for as derivatives (ASC 815) Guarantees of companies own performance Residual value contracts provided by a manufacturer, dealer or retailer Self-insurance parent company Employer-provided health care to employees (continue to apply employee compensation guidance) Fixed-fee service contracts if: Price is not based on risk assessment Service is provided with no cash settlement Risk is related to frequency of service Commercial letters of credit that do not guarantee payment of a money obligation Contingent consideration in business combination License fees, royalties, contingent lease payments Investment contracts with discretionary participation features (covered by financial instruments standard) Charitible gift annuities within scope of 958 Not-for- Profit Entities Contractual rights/obligations contingent on future use of nonfinancial item Direct insurance contracts where the entity is the policyholder Retirement benefit obligations reported by defined benefit retirement plans Guaranteed investment contracts Administration services only 7

8 Scope Only insurance companies Current U.S. GAAP Proposed Model All entities; includes financial, mortgage and trade credit guarantees Unit of Account Under the proposal, insurers would measure insurance contracts at the portfolio level. The release of the margin and the performance of the onerous test would be at the portfolio level. (An onerous insurance contract is defined as a contract where the cost of fulfilling the contract exceeds the liability for remaining coverage.) A portfolio of insurance contracts would be defined as contracts that: Are subject to similar risk and price similarly relative to the risk taken on Have a similar duration and expected patterns of release of the margin Similar risks would consider the type of risk insured (theft, fire or mortality), the product line (annuity or income protection), the type of policyholder (commercial or personal) and the geographic location. Similar pricing means similar compensation is required to take on similar insurance risks. The table below highlights the appropriate unit of account for various attributes of an insurance contract. Attribute Scope Onerous Test Contract Measurement Margin Release Disclosures Unit of Acount Contract Portfolio Portfolio Portfolio Reportable Segment Portfolio Definition Current U.S. GAAP Portfolio Contracts should be grouped to be consistent with the insurer s manner of acquiring, servicing and measuring the profitability of its insurance contracts. Proposed Model Portfolio Contracts subject to similar risks and priced similarly and have similar durations and expected patterns of release from risk. An entity s portfolio definition can have a significant impact on initial and subsequent measurement of margin. Contract Boundary Recognition & Derecognition Contract boundaries are not explicitly defined or addressed in current U.S. GAAP. Under the proposal, the contract boundaries determine the time period used in estimating the cash flows for an insurance contract. The boundary can arise from the contract, from law or from regulation and should be reassessed each reporting period. Insurance contract assets and liabilities initially would be recognized when the coverage period begins. The boundary of an insurance contract is the point at which the insurer is no longer required to provide coverage or when the existing contract does not confer any substantive rights to the policyholder. The liability can be extinguished through discharge, cancellation or expiration. 8

9 A contract renewal would be treated as a new contract when the insurer is no longer required to provide coverage or when the existing contract does not confer any substantive rights on the policyholder. Measurement Models Insurance contract revenue would reflect the amount to which an entity expects to be entitled and recognized in proportion to the value of coverage or services provided. The measurement model is based on a fulfillment objective that reflects the fact that an insurer generally expects to fulfill its liabilities over time by paying benefits and claims to policyholders as they become due, rather than transferring the liabilities to third parties. The proposal contains two approaches to measure insurance liabilities: Building Block Approach (BBA) Fulfillment value method using probability-weighted, expected cash flows Premium Allocation Approach (PAA) Similar to the current unearned premium approach for short duration contracts in the preclaims period The proposed model minimizes the number of models for measuring insurance contracts and better aligns with the soon to be issued Accounting Standard Update Revenue Recognition (Topic 606). The table below highlights the multiple models currently available for recognizing revenue on insurance contracts compared to the single principal-based approach in the proposed standard. Recognition & Measurement Current U.S. GAAP Traditional life insurance Revenue is recognized on policy s contractual due dates (premium due method). Universal life, deferred annuities, variable and equity-based life and annuity products Revenues are based on actual amounts assessed against the policyholder account balance. Limited-payment contracts A portion of the premium is deferred and recognized in a constant relationship with insurance in force. Proposed Model Revenue shall reflect the transfer of promised services arising from the insurance contract in an amount that reflects the consideration to which the entity expects to be entitled. Building Block Approach (BBA) The model uses a building block approach to measure the insurance contract liability, including: Projection of future cash flows, discounted to reflect the time value of money Application of margin 9

10 Measurement of Liability Margin Removes any profit at inception; quantifies the unearned profit the insurer expects to earn as it fulfills the contract; interest is accreted on the margin Total Liability Discounted Cash Flows Amount expected to be collected from premiums and paid out as it acquires, services and settles the contact, estimated using up-to-date information; cash flows would be discounted using current rates to reflect the time value of money BBA Model Components Margin The margin represents the unearned profit the insurer expects to earn as it fulfills the contract, or deferred revenue. The margin is the difference between the present value of expected cash inflows and outflows. The margin represents profit at risk (due to the uncertainty of the expected cash flows), which is deferred and recognized as income as it is released from exposure to risk as evidenced by a reduction in the variability of cash outflows. The margin does not serve as a buffer to absorb changes in expected cash flows. No adjustments are allowed to the margin for changes in actual or estimated cash flows; such changes would be immediately reported in net income. The margin would include the present value of expected qualifying acquisition costs to be incurred less any qualifying acquisition costs not yet recognized as an expense. An entity would accrue interest on the margin and qualifying acquisition costs to reflect the time value of money for the period between premium receipt and provision of the corresponding service. An entity would use the same yield curves to accrue the interest as it previously used to discount the cash flows. The yield curves would be locked in at contract inception and not subsequently adjusted. This results in similar amounts being recognized as premiums in net income regardless of whether the premiums are paid in advance or over time. The final profitability from an insurance contract needs to equal the excess of cash inflows over cash outflows; therefore, the increase in revenue from the interest accretion on the margin would be offset by a decrease in interest expense as the margin is unwound. The interest expense would be reflected in net income. Current U.S. GAAP Margin is implicitly included as part of the insurance contract liability for long-duration contracts. Margin Proposed Model Explicit margin for contracts would be presented in the financial statements. Cash Flows The projection of future cash flows as the insurer fulfills its contractual obligation would include all incremental cash inflows and outflows, such as premiums, claims and benefits paid and expected to be paid, claim handling costs, persistency and surrender benefits, participation benefits, incremental acquisition costs and other costs of servicing the contract arising from the portfolio. 10

11 Expected cash flows, determined on a portfolio basis, would: Reflect the insurer s perspective Reflect all available information that relates to the cash flows of the contract Be current and consistent with market prices Include only cash flows arising from existing contracts within the contract boundaries Cash flows would include all costs the insurer would incur in fulfilling contracts and that: Directly relate to the fulfillment of the contracts in the portfolio Are directly attributable to contract activities and can be allocated to that portfolio Are chargeable separately to the policyholder under the terms of the contract Costs not related directly to the insurance contract would be excluded and recognized as expense in the period incurred. Claims, benefits, claims processing and non-claims fulfillment cost would be recognized when incurred. Features that enable policyholders to change the amount, timing or nature of an insurance contract i.e., surrender options, conversion options, some interest rate and minimum benefit guarantees should be included in the estimated cash flows. Options, forwards and guarantees not related to the existing insurance coverage would be excluded from the measurement of that contract and would be recognized and measured as new insurance contracts or other standalone instruments according to their nature. The measurement of insurance contracts would use the expected value of future cash flows rather than a single, most likely outcome and would be based on current estimates. The measurement objective for expected value would refer to the mean value, considering all relevant information, but would not require all possible scenarios to be identified and quantified, provided the measure is consistent with the objective of determining expected value. No adjustment should be made for the risk of nonperformance by the entity. Cash flows can be estimated at the portfolio level or the aggregate of individual contracts. The present value of the fulfillment cash flows would be remeasured at each reporting period using all available current information. An insurer would not include expectations about future changes in coverages (cancellations) in the cash flows for measuring the liability for remaining coverage or the gross premium received. The table below provides examples of the cash flows included and excluded from the calculation of the contract liability. Included Premiums Claims Claim handling costs Policy administration and maintenance costs Policy loans Potential recoveries Participation features Embedded derivative not separately accounted for surrender options, conversion options, interest rate guarantees and minimum benefit guarantees Deposits Loss-sensitive features Cash Flows Excluded Investment returns Abnormal amounts of wasted labor Acquisition costs Insurance related assessements Product development and training costs Income and transaction taxes 11

12 Cash Flow Assumptions Current U.S. GAAP For long-duration contracts, assumptions are locked in at contract inception unless onerous. Proposed Model Updated each reporting period Discount Rate An insurer would adjust future cash flows for the time value of money using a discount rate that is consistent with the cash flows whose characteristics reflect those of the insurance contract liability, including timing, currency and liquidity. The rate should reflect the characteristics of the contract liability and not the expected return on assets (except for certain participating contracts; see below). The proposal does not prescribe a method for determining the rate, so management judgment is required in selecting the most appropriate approach. Entities may use a topdown or bottom-up approach as long as the objective is achieved. A top-down approach starts with yield curve based on actual or reference asset portfolio and adjusts for asset credit risk (both expected defaults and credit risk premium). A bottom-up approach starts with a risk-free rate and adjusts for liquidity risk of the insurance portfolio. Asset Yield Rate (Actual Assets/Reference Portfolio) Top- Down Remove Expected Defaults Default Risk Premium Discount Rate Illiquidity Premium Bottom -Up Add Risk-Free Rate Under current U.S. GAAP, assumptions for discounting of liabilities on traditional long-duration contracts are based on estimated investment yields (net of related investment expenses) expected at the contract issue date. The discount rate would reflect the yield curve for instruments with no or negligible credit risk, adjusted for differences in liquidity between those instruments and the contract. Because the fulfillment value measurement model does not represent fair value, an entity s own credit risk should not be factored into the discount rate. The discount rate would reflect only the effect of risks and uncertainties that are not reflected in other building blocks in the measurement of the liability. The appropriate yield curve would be determined by an insurer based on current market information and reflecting current market returns either for the actual portfolio of assets that the insurer holds or for a reference portfolio of assets with similar characteristics to those of the insurance contract liability. A single set of yield curves might be appropriate for measuring the time value of money for all cash flows in a portfolio, as long as that set of yield curves appropriately reflects the characteristics of the blended cash flows. 12

13 The current discount rate is used each period to discount expected future cash flows for purposes of insurance liability measurement. Interest expense in net income would reflect the unwinding of the discounted contract liability using the rate locked in at contract inception. In order to reduce income statement volatility, changes in the insurance contract measurement due to change in the discount rate must be reported in other comprehensive income (OCI) rather than in profit or loss. The table below highlights how changes in the discount rate are reflected in the financial statements. OCI Current period equals interest expense at current rate, less interest expense at locked-in rate** Net Income Interest expense at locked-in rate Cumulative difference between liability discounted at current rate and the liability discounted at locked-in rate at inception Changes in cash flow assumptions ** There is an exception for the treatment of contracts with participation features (see below). BBA Recognition & Measurement Under the BBA approach, entities would measure all expected cash flows and update assumptions each reporting period to reflect all available information. The table below highlights changes from current GAAP. Current U.S. GAAP Long-Duration Contracts Traditional Assumptions used to measure the liability are set at contract inception and not updated each reporting period, unless a contract becomes onerous. Nontraditional The liability generally reflects the account balance that accrues to the policyholders. Some guarantee and option features may not be accounted for or may be measured at amounts less than the present value of expected cash flows. Current U.S. GAAP Long-Duration Contracts Margin is implicitly included as part of the liability of a long-duration contract. Contract Liability Margin Proposed Model BBA The measurement of insurance contract liabilities would reflect all costs of fulfilling the obligations based on updated assumptions that reflect all available information. Expected cash flows would reflect all features of an insurance contract. Proposed Model BBA Margin would be presented explicitly in the financial statements. BBA Initial Recognition The BBA provides transparent information about the way changes in the different components of the insurance contracts liability affect the measurement of the liability. Changes in expectations of cash flows are identified separately from changes that arise from the discount rate. 13

14 Fulfillment cash flows (discounted) Margin (including acquisition costs) Initial measurement of contract liability BBA Subsequent Measurement An entity satisfies its performance obligation as it is released from exposure to risk, as evidenced by a reduction in the variability of cash outflows. The determination of when the reduction in the variability of cash flows releases the entity from risk is a matter of judgment. An entity would consider specific facts and circumstances, including the entity s experience with the types of contracts, past experience in estimating expected cash flows and the relative homogeneity of the portfolio. An entity should consider the timing, frequency and severity of the insured event. Different insurers may define a reduction in variability of cash flows in different ways as further information is obtained about the expected cash flows during the life cycle of an insurance portfolio. The methodology used to determine release from risk for each portfolio should be applied consistently throughout the portfolio s life. Methodologies may be based on time or frequency/severity. Margin at start of year Interest accretion Revenue recognized for coverage Remaining margin (Insurance contract asset) Premium Allocation Approach (PAA) The model includes a simplified measurement approach for short duration contracts, where the application of the BBA would not generate sufficient benefits to justify the costs. PAA is required if the coverage period is one year or less or if, at inception, no significant changes in estimation are likely to occur before claims are incurred. The following indicators should be considered when assessing if significant variability in the expected fulfillment cash flows is likely in the period before a claim is incurred: Minimum guarantees of benefits Significant expected change in premium pricing for future contracts written with similar risks during coverage period Length of coverage period PAA Initial Recognition Using PAA, an insurer would measure its preclaim obligation at inception as the premiums within the boundaries of the contract (premiums received plus expected future premiums, discounted if material). If the initial measurement results in a Day One loss (the expected premiums are insufficient to cover expected losses, i.e., an onerous contract), the insurer would recognize that Day One loss in net income and establish a liability for the onerous contract. 14

15 Premiums Onerous contract liability Preclaims liability at inception Qualifying acquition costs > 1year PAA Subsequent Measurement Preclaim obligations would be reduced over the coverage period in a systematic way that best reflects the transfer of services, either on the basis of the passage of time or on the basis of the expected timing of incurred claims and benefits if this pattern differs significantly form the passage of time. When insured events occur, an entity would measure a separate liability for incurred claims as the expected value of the future cash flows to settle the claims and related expenses. The liability for incurred claims should be updated at the end of each reporting period with any changes reported in net income. Portfolio acquisition costs may be expensed as incurred if contracts are less than one year in duration. An entity shall reduce the liability for remaining coverage as qualifying acquisition costs are incurred. Discounting and interest accrual are required in measuring the liability for remaining coverage and premiums receivable where a significant financing component exists, with the discount rate used at the contract inception. As a practical expedient, discounting and accrual is not required if the impact is immaterial or when the incurred claims are expected to be paid within one year of the insured event. PAA Onerous Test An onerous insurance contract is defined as a contract where the cost of fulfilling the contract exceeds the liability for remaining coverage. The onerous contract liability would be updated at the end of each reporting period. If the undiscounted incurred claims practical expedient has been elected, the onerous test would be on an undiscounted basis. Here are the components of the balance in the liability for remaining coverage at year-end. Liability at start of reporting period Interest accretion on liability Revenue recognized for coverage provided Change in onerous contract liability Liability for remaining coverage at end of reporting period For infrequent, high-intensity events such as Hurricane Sandy, FASB clarified that such an event impending at the end of the reporting period does not constitute evidence of a condition that existed at the end of a reporting period when it happens or doesn t happen after that date. Such an event is a nonrecognized event, and ASC applies. 15

16 PAA Current U.S. GAAP Short-Duration Model Liability for incurred claims best estimate of undiscounted* cost of the claims *SEC guidance allows discounting on an individual claim basis if payment patterns and costs are fixed and determinable. Proposed Model Liability for incurred claims probability-weighted expected amount of cash outflows reflecting the time value of money, if material The table below highlights which model might be appropriate for some common insurance offerings. Type of Contract BBA PAA Whole life insurance One-year term life Five-year term life Universal life Annuity life Personal auto insurance Contract surety bond Catastrophe insurance (one year) Workers compensation insurance Long-term disability Directors and officers insurance One-year health insurance 30-year fire insurance x x x x x x X X X X X X X 16

17 The table below highlights some of the differences and commonalities of the BBA and PAA models. Topic BBA PAA Scope All other insurance contracts Required for all contracts less than one year or if at inception it is unlikely the expected fulfillment cash flows will vary significantly Time Value of Money Interest accreted on premiums received Not reflected in the measurement of the liability for remaining coverage or premiums received if: Time between payment and coverage is less than one year or If claims payment is within one year of insured event Acquisition Costs Release of Acquisition Costs No practical expedient; qualifying costs are included in the margin Release pattern consistent with the single margin amortization Practical expedient; can expense all acquisition costs if the coverage period is less than one year Release pattern consistent with the liability for remaining coverage Onerous Contracts N/A Recognize loss at initial inception for the excess of future cash flows over liability for remaining coverage; update each period, reversal allowed Participating Contracts Measurement of liability would reflect participation features Measurement of liability would reflect participation features Estimated Returnable Amounts Exclude from revenue & expense Exclude from revenue & expense Incurred Claims Expense when incurred Expense expected fullfillment cash flows discounted to PV Change in Cash Flows due to OCI OCI Change in Discount Rate All Other Changes in Cash Flows Net income Net income Other than Discount Rate Interest Expense Related to Net income Net income Accretion of the Discount Release of Margin Coverage & settlement period Coverage period 17

18 Other Items Acquisition Costs Recognition Insurers incur costs in acquiring and originating insurance contracts. These costs can be substantial at contract inception but are expected to be recovered through premiums, surrender charges or trailing commission payments over the life of the contract. Because the insurance business model expects most portfolios to be ultimately profitable over the contract term with a full recovery of acquisition costs, FASB rejected expensing acquisition costs as incurred. Rather, the amount of any qualifying acquisition cost paid would reduce the measurement of the contracts liability. This assumes an insurer would require an identical margin for similar contracts regardless of the distribution channel and related acquisition costs, as noted below. Contract A Contract B Fulfillment cash flows 8,400 8,400 Margin 2,400 2,400 Amount recognized as liability 10,800 10,800 Acquisition costs (1,200) (500) Premium charged 12,000 11,300 Acquisition costs incurred before a contract s coverage period begins would be recognized as part of the insurance contract s liability for the portfolio contracts, where the contract will be recognized once the coverage period begins. If the acquisition costs related to a portfolio purchase exceed the margin on the portfolio, an expense should be recognized immediately for the excess. Having qualifying acquisition costs reduce the contract liability has the same effect as capitalizing the costs. However, qualifying acquisition costs wouldn t be explicitly amortized; rather, they would be reflected in net income as the margin is released over the coverage and settlement periods. Qualifying Direct Acquisition Costs Only direct incremental costs would be included in the cash flows used to determine the margin e.g., commissions, sales force contract selling, medical and inspection charges and policy issuance and processing costs. In addition, executive compensation related to review and approval of successful contracts may be a qualifying acquisition cost. Acquisition costs included in the cash flows would be limited to those costs related to successful acquisition efforts. As a practical expedient under the PAA approach, all acquisition costs can be expensed immediately if the coverage period is one year or less. Indirect costs, such as general overhead, software costs, equipment maintenance, agent recruitment and training, administration, rent and utilities, would not be included in acquisition costs and would be expensed as incurred. 18

19 Current U.S. GAAP A cost to acquire an insurance contract that has both of the following characteristics: Results directly from and is essential to the contract transaction(s) Would not have been incurred by the insurance entity had the contract transaction(s) not occurred Costs directly related to successful contracts shall be capitalized. Current U.S. GAAP Statement of Financial Position Presented as a separate asset for deferred acquisition costs Current U.S. GAAP Several methods depending on the product percentage of the premiums or percentage of estimated gross profits or the interest method Direct Response Advertising Definition of Qualifying Acquisition Costs Presentation of Qualifying Acquisition Costs Proposed Model Costs directly related to entity s selling efforts that result in obtaining the insurance contracts in the portfolio Proposed Model Statement of Financial Position Included with the margin Statement of Comprehensive Income Amortization of Qualifying Acquisition Costs Amortization of acquisition costs broken out separately Released with margin Proposed Model Direct response advertising is designed to generate an immediate response from customers that can be attributed to individual advertisements. Currently, insurers capitalize the cost for the marketing (mailing materials and mailing lists, TV air time or newspaper ad space) as well as the costs of the call centers that receive the response associated with those advertisements. The final revenue recognition standard, which is expected to be issued in the fourth quarter of 2013, limits acquisition costs to be capitalized to those costs that are incremental to the contract. Direct response advertising costs do not meet this criterion, and after careful deliberations, FASB decided not to offer an exception. 19

20 Direct Response Adveristing Current U.S. GAAP Direct response advertising costs are included in deferred acquisition costs if the primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and the advertising results in probable future benefits. Expensed as incurred Proposed Model Participating Contracts, Contracts with Participation Features & Segregated Funds Insurance contracts often contain participation features that provide the policyholder with an investment return that is affected by the performance of assets in addition to insurance coverage. Some of these contracts contain a contractual right to share in the return of specified underlying assets held by the insurer, known as participating contracts. The diagram below shows the overlapping relationship between insurance contracts with participation features. Participation features Participating contracts Qualified segregated funds Participating Contracts For participating contracts, the liability for the participation feature would be measured in a way that reflects how those underlying items are measured under U.S. GAAP the mirroring approach. For example, if the underlying assets are measured at amortized cost, the contract liability would be adjusted to eliminate any unrealized gains or losses. The mirroring approach takes precedence over requirement to present discount rate changes in OCI. The effect of discount rate changes related to the contractual participating feature will be presented consistently with the impact of interest rate changes on the underlying assets in the statement of comprehensive income, either net income or OCI. This eliminates accounting mismatches between measurement of the contractually linked participating contract cash flows and the underlying assets. Disclosure & Presentation for Participating Contracts Disclosures for participating contracts that do not qualify for special accounting treatment as segregated funds (see section below): 20

21 General description of the participation features and the amounts accrued to the benefit of the policyholders in the period For nondiscretionary obligations: Participation Features How participation features are measured Amount for which asset or liability was adjusted and whether the amount is included in net income or OCI Some contracts have investment returns that are affected by asset performance, but the credited interest is at the insurer s discretion, i.e., a universal life contract. An index-linked policy provides a contractual right to the performance of specified assets (the index), but the underlying assets are not held by the insurer. While these contracts both contain participating features, they would not be considered participating contracts. For these types of insurance contracts where the cash flows are not subject to mirroring but are affected by asset returns the discretionary payments would be included in the expected present value of fulfillment cash flows in measuring an insurance contract; the discount rate should reflect the extent to which the estimated cash flows are affected by the return from those assets. When there is a change in the insurance contract s liability caused by an expected change in crediting rate, an insurer should reset the locked-in discount rate to the expected crediting rate to determine the interest expense in net income. Since this expected crediting rate also would be applied to the liability measurement, the effects of changes in discount rates for the participating cash flow portion of contracts would be presented in profit or loss instead of OCI. Using this approach, the interest expense reflects the variable-rate nature of the financing implicit in the insurance contract cash flows. The table below highlights the commonalities and differences in the treatment of participating contracts and contracts with participation features. Mirror underlying items PARTICIPATING CONTRACTS Discount should reflect asset dependency Combination of locked-in rate and current rate Either OCI or net income Segregated Fund Arrangements Liability Measurement Discount Rate Interest Expense Change in Discount Rate PARTICIPATION FEATURES Liability adjusted to reflect measurement of underlying item Discount should reflect asset dependency (expected crediting rate) Rate based on expected crediting rate Net income Some insurance contracts are structured so the insurer s obligation to the contract holder is directly linked to the performance of segregated funds, the investments of which are determined by the contract holder. Examples include separate accounts, variable contracts, unit-linked contracts and super annuitization funds. These accounts typically are maintained by a life insurance entity to fund obligations to individual contract holders under fixedbenefit or variable-annuity contracts and pension plans. Both of the following criteria must be met for a participation feature to be considered a segregated fund: 21

22 An entity must invest the funds as directed by the policyholder (Investing a portion of the contract holder s fund would not meet this criteria). All of the net investment performance must be passed through to the policyholder. For contracts qualifying as segregated funds, the related assets would get specialized accounting measurement similar to current U.S. GAAP for separate account assets. Assets would be measured at fair value through income, and controlling interests held by the structures on behalf of policyholders would not be subject to consolidation. Unlike current U.S. GAAP, qualifying criteria for this specialized accounting would exclude legal insulation from general account creditors. FASB felt jurisdictional laws should not affect accounting for insurance contract liabilities and related assets. Criteria for Specialized Treatment Current U.S. GAAP Subtopic , Financial Services Insurance Separate Accounts Specialized Treatment a. The separate account is recognized legally b. Legal insulation from general account liabilities c. Entity must invest funds as directed by policyholder d. All net investment performance must be passed through to the policyholder Proposed Model Direct peformance-linked insurance contracts a. Entity must invests funds as directed by the policyholder (investing a portion of the contract holder s funds would not meet this criteria) b. All net investment performance must be passed through to the policyholder Presentation & Disclosure for Qualified Segregated Fund Arrangements Assets in qualifying segregated fund arrangements would be required to be presented either separately in the statement of financial position or disclosed in the notes. Entities would disclose: The amount of assets in the qualifying segregated fund arrangements that are: Legally insulated from the general account and those that are not Representative of the entity s proportionate interest The portion of the liability related to segregated funds Interest credited to policyholders if not presented separately in the statement of comprehensive income Investment income generated from assets and returns credited to policyholders would be required to be presented gross on the face of the income statement, versus the current practice of offsetting to zero. However, this revenue and expense, along with other revenue and expense generated by the arrangement, may be commingled with other similar revenue and expense items. Current U.S. GAAP Segregated funds assets and liabilities are required to be disclosed separately on the face of the balance sheet. Presentation of Segregated Funds Proposed Model Assets in qualifying segregated fund arrangements would be required to be presented either separately in the statement of financial position or disclosed in the notes. 22

23 Unbundling Separating Components of an Insurance Contract Insurance contracts may provide the policyholder with goods, services or investment opportunities other than insurance coverage. In order to improve comparability between companies and across industries, entities would be required to unbundle components of a contract if a component is not closely related to the specified insurance coverage. This would apply only at inception or if there is a substantial contract modification. The insurer would apply other U.S. GAAP, as appropriate, to the unbundled portion. The unbundling principle would not require an exhaustive search of noninsurance components in every insurance contract. Entities only are required to separate embedded derivatives, distinct investment components and distinct performance obligations. Insurance contracts can contain additional features, as illustrated below: Service Component Insurance Coverage Embedded Derivative Investment Component Embedded Derivatives Embedded derivatives separated from the host contract under existing bifurcation requirements should be unbundled. An example would be a minimum accumulation benefit in a nontraditional variable annuity contract. Investment Components An investment component in an insurance contract would be an amount that the insurer is obliged to pay the policyholder or a beneficiary regardless of whether and insured event occurs. Unbundling of investment components is expected to be uncommon. Nondistinct investment components would not be presented separately from the insurance contract. However, entities would disclose both of the following: The portion of the insurance contract liability that represents the aggregated premiums received that were excluded from the statement of comprehensive income The amounts payable on demand If an investment component is distinct, an insurer would unbundle the investment component and apply applicable U.S. GAAP in accounting for the investment component. Insurers would be prohibited from applying revenue recognition or financial instrument standards to components of an insurance contract when unbundling is not required. An investment component may not be distinct if: The value of the insurance component depends on the value of the investment component The policyholder cannot benefit from one component unless the other component is also present The investment component and the insurance component are not sold separately 23

24 Returnable Amounts An insurance contract may contain a feature requiring an entity to pay amounts to policyholders regardless of whether an insured event occurs. Any such returnable amount should be excluded from revenue and expenses. Performance Obligations Performance obligations can be implied by business practice, published policies or specific statements. Contract setup activities would not be considered separate performance obligations. A performance obligation is distinct if either of the below criteria is met: The policyholder can benefit from the good or service either on its own or with other readily available resources. The entity s promise to transfer the good or service to the policyholder is separable from the insurance component of the contract, including: Cash Flow Allocations Limited integration of the good or service into the combined insurance contract Purchase of good or service does not significantly affect cash flows or risk of insurance After excluding any cash flows related to embedded derivatives and distinct investment components, cash inflows would be allocated between the insurance component and distinct performance obligations based on the revenue recognition standard. Cash inflows and outflows that relate to more than one component would be allocated on a rational and consistent basis as if they were separate contracts. The table below highlights the applicable accounting standard for the various components of an unbundled insurance contract. Insurance Contract Component Applicable Standard 1. Insurance Component Insurance Contract Standard 2. Non-Distinct Investment Component Insurance Contract Standard + Disclosure 3. Distinct Investment Component Financial Instrument Standard 4. Embedded Derivatives Financial Instrument Standard 5. Distinct Service Component Revenue Recognition Standard A title insurance carrier would unbundle a title insurance contract into a service component (title search) and an insurance component (indemnification). 24