Life insurance accounting models: Overview of papers (agenda paper 9)

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1 30 Cannon Street, London EC4M 6XH, England International Phone: +44 (0) , Fax: +44 (0) Accounting Standards Website: Board This document is provided as a convenience to observers at IASB meetings, to assist them in following the Board s discussion. It does not represent an official position of the IASB. Board positions are set out in Standards. These notes are based on the staff papers prepared for the IASB. Paragraph numbers correspond to paragraph numbers used in the IASB papers. However, because these notes are less detailed, some paragraph numbers are not used. INFORMATION FOR OBSERVERS IASB Meeting: Project: December 2005, London Insurance contracts (phase II) This note covers agenda papers 9, 9A, 9E and 9G Life insurance accounting models: Overview of papers (agenda paper 9) Objective of the discussion at this meeting 1. At this meeting, the staff will: give the Board an overview of various accounting models for life insurance contracts. That discussion will be preparation for more detailed discussion of the components of the approaches over the next two or three meetings. seek provisional agreement from Board members that we should not give further consideration to two of the approaches discussed in these papers. 2. The papers for this meeting address the following matters: Overview of possible accounting approaches (agenda paper 9A) Table summarising possible accounting approaches (agenda paper 9B) (c) Illustrations of possible accounting approaches (agenda paper 9C) and explanations of those illustrations (agenda paper 9D). These illustrations are for background V:\IASB\Meeting Files\2005\1205\Observer Notes\0512ob09.doc :38

2 information and we do not plan to discuss them in the Board meeting. If Board members have questions about the illustrations, we suggest that they ask the staff outside the meeting. These papers were used at the Insurance Working Group in September and are unchanged. (d) Embedded value (agenda paper 9E) (e) Summary of Phase II principles suggested in July 2005 by insurers (agenda paper 9F) (f) Project planning (agenda paper 9G) Background 3. Since restarting phase II of this project, the Board has held two decision-making sessions on the project plan (January 2005) and non-life insurance contracts (May 2005), as well as various educational sessions. The rest of this paper summarises the Board s conclusions on non-life insurance, as background for the discussion on life insurance. 4. In May 2005, the Board discussed various approaches to accounting for non-life insurance contracts. The Board decided to explore two approaches in parallel for the time being, until it determines the basis on which one should be selected. The two approaches: are identical in their treatment of the claims liability, in other words, the liability to pay valid claims for insured events that have already occurred, including claims incurred but not reported (IBNR). differ in their treatment of the stand-ready obligation to pay valid claims for future insured events arising under existing contracts, in other words, the obligation relating to the unexpired portion of risk coverage. For convenience, this paper describes that obligation as the pre-claims liability. (c) apply existing IFRSs (eg IAS 39) for assets held by insurers. 5. Under both approaches, non-life insurance claims liabilities would: reflect current unbiased estimates of future cash flows. The Board decided that the project should clarify the measurement objective for insurance liabilities and give high 2

3 level guidance on techniques for estimating the number and amount of claims arising under insurance contracts, but should not give detailed operational guidance. reflect the time value of money. In other words, discounting would be required for all non-life claims liabilities. There would be no specific exemption for liabilities that meet particular criteria. Normal materiality criteria would apply. (c) include adjustments to reflect risk. Further discussion will be required on methods for determining these adjustments. 6. We have not yet attempted to clarify the precise measurement attribute for non-life insurance claims liabilities. Applying the terminology used in the papers for this meeting in a life insurance context, the two obvious possibilities to consider are current entry value and current exit value. 7. The two approaches differ in their treatment of the pre-claims liability: The unearned premium approach measures the pre-claims liability as the unearned portion of the premium, less deferred acquisition costs. The Board has not yet discussed whether the deferred acquisition costs would be presented as an asset or as a deduction from the liability. The unearned premium (with related deferred acquisition costs) would be subject to a liability adequacy test. This test would involve discounting and include adjustments to reflect risk. The unexpired risk approach would measure the pre-claims liability in the same way as claims liabilities. This approach reflects both downside and upside adjustments, whereas the unearned premium approach reflects only downside adjustments. 8. In assessing the next steps for non-life insurance, we will consider recent developments in the joint IASB/FASB project on revenue recognition. 9. We plan further discussion of non-life insurance at the January 2006 meeting of the Insurance Working Group (IWG). 3

4 Life insurance: Overview of possible accounting approaches (agenda paper 9A) Purpose of this paper 1. This paper summarises four possible accounting approaches for one particular category of life insurance contracts, namely non-participating term life insurance contracts. 2. The objectives of the discussion in December are: to give Board members an overview of these approaches, before starting detailed discussion of the components of two of these approaches over the next two or three meetings. to seek provisional agreement from Board members that we should not give further consideration to two of these approaches (A and B, the two cost-based approaches). Overview of this paper 3. This paper: (d) (e) reviews what we learned by discussing earlier versions of this paper with the Insurance Working Group (IWG) (paragraph 4). identifies four possible approaches to accounting for non-participating annual nonlife insurance contracts and describes their most important components (paragraphs 5-36). Agenda paper 9B summarises those approaches in a table, and agenda papers 9C and 9D provide illustrations of them. identifies possible implications for forms of life insurance contract (including annuities and health) not covered in this paper (paragraphs 37 and 38). invites Board members to narrow down the range of approaches to be considered (paragraphs 39-49). Paragraphs present the staff s recommendations. 4

5 What we learnt in previous discussions 4. The Working Group discussed life contracts in January, April, July and September Here is a brief summary of what we believe we heard from participants: (c) (d) (e) (f) Participants were generally concerned about the possibility of accounting mismatches between insurance liabilities and the assets that back them (see paragraphs for further discussion of this notion). The reporting system should track the main drivers of profitability in life insurance: investment, expense, mortality, lapse, perhaps by generating a source of earnings analysis. Information about the level of new business, and its estimated profitability, is important. However, participants had different views on whether gains should be recognised at inception. On the other hand, losses should be recognised at inception of contracts are expected to be unprofitable (or, perhaps, insufficiently profitable). Estimates should be reviewed every year and would reflect a blended mix of previous estimates and all available new evidence, weighted by their degree of credibility. In principle, the discount rate should not reflect expected returns on the actual assets (if different from the replicating portfolio). It may be appropriate to reflect liquidity factors, but further discussion is needed on whether and how to do this. Some participants view risk margins as a shock absorber, some view them as a measure of compensation for bearing risk and some view them as having elements of both. Supporters of the latter view (compensation for bearing risk) believe it gives a clearer picture of the risks at the reporting date. However, opponents (and some supporters) of that view have concerns about reliability and about recognising additional risk margins following an adverse change in assumptions, followed inevitably by income in future years as the additional risk margin is released. 5

6 (g) (h) (i) (j) (k) More discussion is needed on how to determine risk margins. Participants have different views on whether cost of capital approaches are appropriate methods for determining margins. Another important aspect to consider is whether margins should reflect diversification benefits. To the extent an insurer regards acquisition costs as recoverable from cash flows, that recovery would be considered in calibrating the initial measurement of the insurance liability. That calibration should consider both incremental and some (to be defined) non-incremental costs. To avoid arbitrary amortisation methods, recoverable acquisition costs should probably be considered in measuring the insurance liability, not recognised as a separate asset. At the September meeting, most participants favoured one of two current value approaches, (current entry value and current exit value), although some participants favour cost-based approaches and some participants were unable to attend the meeting. Most of the participants favouring current value approaches need more information (particularly on risk margins) before they can assess whether they prefer current entry value or current exit value. In measuring insurance liabilities, an insurer should consider the impact of embedded options and guarantees, which many insurance liabilities contain. Some consider that the measurement should reflect the intrinsic value of the embedded options and guarantees, but not their optionality (time value) because policyholders cannot always realise the optionality, while others consider that measurement should reflect both intrinsic value and optionality. For this purpose, the measurement should reflect estimated policyholder behaviour even if it appears irrational. Separating embedded options and guarantees may be arbitrary and complex. Most participants do not view embedded value as an appropriate measurement attribute in the primary financial statements, but some believe embedded value may provide useful supplementary information about long duration contracts. In the light of those comments, this paper does not present embedded value as one of 6

7 the candidate models. Agenda paper 9F describes embedded value methodology and compares it with the approaches described in this paper. 5. In January 2005, the Board reviewed a project plan. As noted in the project plan, we have so far attempted to identify appropriate accounting treatments for particular types of insurance contract, rather than trying to identify one accounting model for all accounting contracts. We can then attempt a reconciliation exercise to review, understand and assess any inconsistencies between our preferences for different types of contract. We plan to carry out that reconciliation exercise at the IWG meeting in January. At that meeting, we also plan to seek more precise definition of suitable measurement attributes for insurance liabilities. Overview of possible approaches 6. In the light of our discussions with the IWG, this paper presents for consideration four possible approaches to accounting for non-participating life insurance contracts (two costbased approaches and two current value approaches). Cost-based approaches Lock-in approach (including a liability adequacy test): approach A (paragraphs 17-27) Lock-in approach (including a liability adequacy test and coupled with some limited extension of the use of amortised cost for assets): approach B (paragraphs 28-30) Current value approaches (c) Current entry value approach: approach C (paragraphs 31-35) (d) Current exit value approach: approach D (paragraph 36) 7. This paper summarises the most significant high-level features of each approach, and agenda paper 9B summarises them in tabular form. Agenda papers 9C and 9D contain and explain illustrations of the four approaches. 7

8 8. At the joint IASB/FASB meeting in October 2005, the Boards established three objectives for improving financial reporting for financial instruments to help the boards evaluate and prioritise future projects on financial instruments. One of those objectives is to require all financial instruments to be measured at fair value, with realised and unrealised gains and losses recognised in the period in which they occur. The Boards noted that fair value measurement would produce more relevant information and solve many problems caused by using different measurement attributes for different instruments. However, before the Boards could establish such a requirement, a number of issues remain to be resolved including which instruments and related assets and liabilities should be subject to the requirement, how to estimate fair value for instruments that are not traded or are traded in government-controlled or illiquid markets, how to present the components of the net changes in fair values, and what information to disclose about past changes in fair values and exposures to future changes in market factors. 9. In the light of that decision, Board members may wonder whether it is a productive use of our time to consider any cost-based approaches. We have included those cost-based approaches for two reasons: Insurance professionals often describe insurance as a liability-driven business. Therefore, they argue that standard setters should first determine the appropriate accounting for the insurance liabilities before determining the accounting for the related assets. If this is not done, they fear that the asset accounting could predetermine a form of liability accounting that might not be optimal. Although a substantial proportion of IWG participants appear to favour current value approaches, that view is not unanimous. We have emphasised throughout our discussions with the IWG that is important for us to understand the range of views in the Insurance Working Group and to report the full range of views to the Board. 10. We would need further discussion before any of the approaches could be implemented. In particular, this paper does not discuss the following topics, and nothing in this paper is intended to prejudge the outcome of future discussions on them: 8

9 (c) (d) continuation, cancellation and renewal options (to be discussed separately at the December Board meeting). unit of account. the credit characteristics of insurance liabilities. what components of income and expense should be reported as a result of changes in rights and obligations arising under insurance contracts, and how those changes should be presented and segmented. 11. This paper identifies some possible variations of the approaches, but other variations could be possible. Accounting mismatch and economic mismatch 12. IWG participants have consistently told us that eliminating accounting mismatch should be an important objective of phase II of this project. It costs time and money for insurers to explain volatility caused by accounting mismatches even to sophisticated users. Less sophisticated users may not understand these effects at all. 13. In assessing ways to eliminate accounting mismatches, it is important to distinguish them from economic mismatches. The Basis for Conclusions on IFRS 4 describes these notions as follows: accounting mismatch arises if changes in economic conditions affect assets and liabilities to the same extent, but the carrying amounts of those assets and liabilities do not respond equally to those economic changes. economic mismatch arises if the values of, or cash flows from, assets and liabilities respond differently to changes in economic conditions. 14. Accounting mismatch may arise if interest-sensitive financial assets are carried at fair value but related insurance liabilities are carried on a basis that does not reflect current interest rates. If interest rates change, the carrying amount of the assets changes but the carrying amount of the insurance liabilities does not change, and this has the following consequences: 9

10 (c) If the assets are classified as available for sale, there is no accounting mismatch in the income statement (unless the assets are sold), but there is an accounting mismatch in equity. If the assets are classified as at fair value through profit or loss, there is an accounting mismatch in the income statement. If assets are sold, an accounting mismatch occurs not only for available-for-sale assets, but also for assets carried at amortised cost. 15. The Basis for Conclusions on IFRS 4 argues that: Ideally, a measurement model would report all the economic mismatch that exists and would not report any accounting mismatch. This is one of the criteria the staff used in selecting possible models to discuss with the IWG, as a means of contributing to the overall objective of providing relevant and reliable information about an insurer s financial position, performance and cash flows. Suggestions from industry groups and from regulators 16. In July 2005, we received two submissions from industry groups suggesting possible principles for phase II. One submission was from the (European) CFO Forum. The other was from the Group of North American Insurance Enterprises (GNAIE) and four major Japanese life insurers. Both submissions suggest approaches that are broadly similar to approach C (or possibly approaches A or B, depending on the treatment for some items, particularly estimates). Agenda paper 9F summarises these submissions. Approach A: Lock-in approach (with liability adequacy test) 17. Approach A uses the assumptions determined at inception and retains them unchanged, unless loss recognition is required. Specifically, approach A: measures the insurance liability as the expected (ie probability weighted) present value 1 of future cash flows arising from the contract. However, because assumptions and discount rates are locked in at inception, this prospective measurement is typically also equivalent to a retrospective measurement built up 10

11 as a sum of contract activity (unless estimates are unlocked as a result of applying a liability adequacy test). (c) (d) (e) (f) separates embedded derivatives from the host insurance contract. The embedded derivatives are measured at fair value, and changes in their fair value are recognised in profit and loss. The remaining comments in this description of approach A relate solely to the host insurance contract. Paragraphs discuss embedded derivatives. recognises recoverable acquisition costs as an asset, and amortises them on a systematic and rational basis over the life of the contract (see paragraphs for more discussion). recognises no gain at inception. As result, the initial measurement of the contractual liability (less recoverable acquisition costs, if recognised separately) at inception includes an explicit or implicit margin. That margin compensates the insurer for contractually assuming risks and providing services. That margin is recognised on a systematic and rational basis as the insurer is released from risk under the contract and provides services under the contract. Paragraph 25 discusses how that basis might be determined. recognises a loss at inception (i) to the extent that acquisition costs are not considered in the initial calibration of the liability and do not qualify for recognition as an asset or (ii) if a liability adequacy test reveals that a contract is likely to generate overall losses (eg if a contract is used as a loss leader to build market share). uses unbiased estimates that are locked in at inception, and not changed subsequently (unless a liability adequacy test reveals the need to recognise an additional liability). 1 At the September IWG meeting, participants did not object to the notion that expected values result in a better measurement than point estimates. 11

12 (g) uses a risk-free discount rate 2 that is locked in at inception and not changed subsequently (unless a liability adequacy test reveals the need to recognise an additional liability). In July, participants suggested that some liquidity adjustment should be added to the risk-free discount rate. We plan to examine that suggestion later. (h) requires a liability adequacy test at each reporting date (see paragraphs 26 and 27). (i) (j) reflects, at least at inception and arguably subsequently, the credit characteristics of the contract, to the extent that this is implicit in the pricing. Previous discussions have revealed different views about whether pricing does implicitly reflect the credit characteristics of the contract. We have not yet discussed this topic with the IWG, but plan to do so in January. uses existing IFRSs to measure assets. Embedded derivatives 18. Paragraph 17 refers to embedded derivatives. Under IAS 39, if a liability is not classified as at fair value through profit or loss, any embedded derivative must be separated from the host contract and measured at fair value, unless the economic characteristics and risks of the embedded derivative are closely related to those of the host contract. However, IFRS 4 Insurance Contracts: created specific exemptions for an embedded derivative that (i) itself meets the definition of an insurance contract or (ii) is an option to surrender an insurance contract for a fixed amount (or for an amount based on a fixed amount and an interest rate). The Board created these exemptions because it would be contradictory to require a fair value measurement in phase I of an insurance contract that is embedded in a larger contract when such measurement is not required for a stand-alone insurance contract. 2 Part of the margin discussed in (d) might be included in the discount rate as an adjustment to the risk-free rate, rather than as a separate margin. This paper does not express any preference between these two implementations. The important point is that the margin should be included once, and only once. 12

13 added to IAS 39 a statement that an embedded derivative is closely related to the host insurance contract (and, hence, exempt from separation and classification as at fair value through profit or loss ) if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately. Without this conclusion, paragraph 12 of IAS 39 would have required the insurer to measure the entire contract at fair value, unless the contract could not be measured reliably at fair value in its entirety. The Board created this exemption to avoid requiring fair value measurement for insurance contracts in phase I. 19. For the following reasons, the Board will need to consider in phase II whether these exemptions should be narrowed or eliminated: These exemptions mean that insurers need not, during phase I, recognise some potentially large exposures to items such as guaranteed annuity options and guaranteed minimum death benefits. This raises several issues: (i) (ii) (iii) These items create risks that many regard as predominantly financial, but if the payout is contingent on an event that creates significant insurance risk, these embedded derivatives meet the definition of an insurance contract. The liability adequacy test in IFRS 4 requires an entity to consider these items and IFRS 4 requires specific disclosures about them. However, the liability adequacy test requirements are not very specific, and disclosure is not an adequate substitute for appropriate recognition and measurement. Many existing measurement approaches for these items consider only their intrinsic value, and not their time value (optionality). Excluding their time value could make an entity s financial statements less relevant and reliable. (c) In the Board s view, fair value is the only relevant measurement basis for derivatives, because it is the only method that provides sufficient transparency in the financial statements. The requirement to separate embedded derivatives already applied to a host contract of any kind before the Board issued IFRS 4. The temporary exemptions 13

14 for host insurance contracts were designed to avoid causing systems changes that might not be needed for phase II. However, a more permanent exemption could cause an unacceptable loss of transparency. 20. IWG participants generally oppose the separation of embedded options and guarantees, because they believe that this exercise may be arbitrary and complex. Acquisition costs 21. Paragraph 17(c) refers to acquisition costs. These are the costs that an insurer incurs to sell, underwrite, and initiate a new insurance contract. Different accounting models deal with acquisition costs in various ways: Some models defer acquisition costs that meet specified criteria. Some models measure the insurer s contractual rights initially at cost, with the (specified) acquisition costs being regarded as equal to that cost. (c) Some models measure an insurance liability initially at a market price calibrated to the entry value, with the entry value being regarded as the initial premium received at inception, less the (specified) acquisition costs. (d) Some models recognise all acquisition costs. 22. At the IWG meetings in July and September, participants generally seemed to agree on the following points: The item traditionally called deferred acquisition costs should be viewed as a contractual right to recover costs incurred, rather than as a deferral of those costs. For convenience, we now describes that right as recoverable acquisition costs. If that contractual right is measured initially at cost: (i) its cost is more than just the incremental cost. Incremental costs are costs that the insurer would not have if the contract had not been issued, such as commission to intermediaries or employees. 14

15 (ii) the right should be amortised (and related revenue recognised) on a basis that is not arbitrary. However, methods of amortising recoverable acquisition costs are likely to depend on arbitrary splits of premium, or arbitrary grossing up from net profit figures. It seems to follow that recoverable acquisition costs should not be presented as a separate asset. (c) There might be an argument for reporting some of an insurer s contractual rights separately from some its contractual obligations. However, the unamortised portion of recoverable acquisition costs is unlikely to be a representationally faithful measurement of those particular rights, except by coincidence. Thus, it seems unlikely that recoverable acquisition costs will play any role in identifying contractual rights or obligations that might be reported separately. 23. The illustrations in agenda papers 9C and 9D show two forms of presenting recoverable acquisition costs: The illustrations of approaches A and B present recoverable acquisition costs as a separate asset, and amortise them by splitting each premium into these three components in fixed proportions. This approach (based on the US standard FAS 60) regards premiums as the main profit driver. The illustrations of approaches C and D consider recoverable acquisition costs in calibrating the initial measurement of the liability and adopt expected benefit payments as the profit driver (ie the basis for allocating margins to individual periods). 24. Recoverable acquisition costs may be one piece of evidence that helps calibrate the initial measurement of the liability. When we look at that calibration in more detail, we may need to look at whether non-incremental costs affect the calibration. 15

16 Basis for recognising margins 25. Paragraph 17(d) refers to a systematic and rational basis (or bases) for determining when, and how, an insurer should recognise margins. This paper does not discuss what the basis should be. However, possibilities might include: as a proportion of premiums. We note in passing that a premium-based approach is difficult to apply to some types of contract. For example, for a single-premium contract, a premium-base approach would recognise the present-value of all estimated contract margins in the period when the insurer receives the single premium. as a proportion of some measure of estimated profitability (for example, the estimated gross profits measure used in the US for contracts within the scope of FAS 97). * (c) based on profit drivers identified by management (for example, as in the Australian margin on services method). * (d) (e) (f) with the unwinding of implicit or explicit margins that were previously added to unbiased assumptions. For example, if mortality assumptions include an explicit loading of 20% on top of unbiased assumptions, that loading will be released automatically as mortality assumptions unwind. in proportion to insurance coverage provided. (In this respect, the illustrations of approaches C and D in agenda papers 9C and 9D might be viewed as an example of this, because they use expected benefit payments as the main profit driver. Of course, in some other important respects, approaches C and D differ from approach A) some combination of the above. For example, in US GAAP for products within the scope of SFAS 60, * a portion of the margin is recognised as a constant proportion of premiums ( above) and another portion is recognised as * It is beyond the scope of this discussion to consider the exact nature of these methods. For now, the important point is that several methods are used in practice. * It is beyond the scope of this discussion to consider the exact nature of these methods. 16

17 provisions for adverse deviation unwind ((d) above). A method similar to SFAS 60 is used, for illustration only, in the illustrations of approach A in agenda papers 9C and 9D. Liability adequacy test 26. The liability adequacy test compares the carrying amount of insurance liabilities (less related recoverable acquisition costs, if recognised separately, or related intangible assets, such as the value of in force business acquired externally) with a current unlocked estimate of future cash flows. If this comparison reveals a loss: estimates and the discount rates are unlocked and adjusted to reflect current conditions. The revised assumptions and discount rates are then relocked and remain unchanged until maturity (or a subsequent loss). the loss is recognised immediately in profit and loss. 27. Devising such a test would require an answer to questions such as the following: What would be the appropriate level of aggregation? Would the current estimates include margins for risk and/or profit? (i) (ii) (iii) (iv) If such margins are excluded, that is arguably inconsistent with the original measurement basis, which does include margins that are implicit or explicit in the pricing. If such margins are included, losses in one period are followed by profits in future periods when the margins unwind. Some view the reporting of losses followed by apparently automatic profits as counter-intuitive. If such a margin is included, how would it be calibrated? In May, the Board directed the staff to pursue two approaches for non-life insurance, until the Board determines which of those approaches to select. One of those approaches involves the deferral of unearned premiums, combined with a liability adequacy test. The Board decided in May that 17

18 this test for non-life insurance would include margins, but the Board has not yet discussed whether that would also apply to life insurance. (c) (d) (e) (f) Would a current discount rate be used, or should the discount rate be locked in at inception? Would estimated cash flows include current, realistic estimates of lapses? This question is one aspect of the treatment of continuation, cancellation and renewal options (see separate discussion at this meeting). Would the estimated cash flows include the full time value (ie optionality) of those embedded options (if any) that are not measured separately at fair value, or only their intrinsic value? If additional losses are recognised as a result of a liability adequacy test, would those losses be reversed if new estimates reveal that the losses are no longer expected? Approach B: Lock-in approach (with some limited extension of amortised cost for assets) 28. Approach B is identical to approach A, with one exception: approach B would permit (or perhaps require) amortised cost measurement for financial assets that provide fixed or determinable payments and are held to back insurance liabilities. The notion that assets are held to back insurance liabilities would need clearer definition. Paragraphs 42 and 43 discuss the arguments for and against this extended use of amortised costs. 29. Some proponents of approach B might argue for a further extension of a cost basis so that equity investments could also be measured at cost (less impairment, if any). However, any mismatch between non-participating insurance liabilities and equity investments is likely to arise from economic mismatch rather than accounting mismatch. Therefore, approach B does not extend the use of a cost basis for equity investments. 30. The papers for the April IWG meeting included one approach that would have measured insurance liabilities at amortised cost, as defined in IAS 39 Financial Instruments: 18

19 Recognition and Measurement. 3 IWG participants expressed no interest in pursuing that approach for insurance liabilities and this paper does not discuss it further. Approach C: Current entry value approach 31. Approach C aims to measures the insurance liability at the amount that the insurer would charge to a policyholder today for entering into a contract with the same remaining rights and obligations as the existing contract. At inception, the measurement would be calibrated to the actual premiums incurred (and recoverable acquisition cost incurred). That calibration would act as a starting point for determining risk margins at later dates. 32. For comparison with the other approaches, approach C may be summarised as follows. Approach C: (c) (d) measures the insurance liability as the expected present value of future cash flows arising from the contract. separates embedded derivatives from the host insurance contract. (Arguably, this might not be necessary if a current entry value measurement of the whole contract would, in effect, measure the embedded derivative at amount close to its fair value.) The remaining comments in this description of approach C relate solely to the host insurance contract. does not recognise recoverable acquisition costs as a separate asset, because the estimated cash flows that will recover the costs are considered in measuring the liability. recognises no gain at inception. As result, the initial measurement of the contractual liability at inception includes an explicit or implicit margin. (i) At inception, that margin is calibrated to the actual premium charged, less recoverable acquisition costs incurred. 3 The papers for the April IWG meeting labelled that approach as approach B. However, this paper uses the label approach B for a different approach. 19

20 (ii) (iii) That margin is recognised as revenue on a systematic and rational basis as the insurer is released from risk under the contract and provides services under the contract. Discussion is needed on whether and how the rate of the margin should be changed when an insurer changes its estimates of (1) the amount of risk and (2) the per-unit price for risk. (e) (f) (g) (h) (i) uses current unbiased estimates that are unlocked at each reporting date. uses a current risk-free market discount rate (possibly with some liquidity adjustment, a topic we plan to discuss further with the IWG in January). does not include a liability adequacy test, provided that the estimates and discount rates reflect current conditions. (arguably, a loss recognition test might be required at inception. Paragraphs 26 and 27 discuss some of the considerations for such a test.) does not explicitly reflect the credit characteristics of the contract, but may reflect them implicitly if this is explicit or implicit in the original pricing. We plan to discuss this topic with the IWG in January. uses existing IFRSs to measure assets. Changes in insurance liabilities 33. At the July meeting, an IWG participant asked whether we should consider permitting or requiring insurers to recognise changes in the carrying amount of insurance liabilities directly in equity, by analogy to the treatment of available-for-sale financial assets. For the following reasons, no approach in this paper includes this suggestion: Conceptually, it is appropriate to recognise all recognised income and expense in profit or loss, as this provides full transparency. Although existing standards create some exceptions to this principle, it is undesirable to create new exceptions. If the objective of this suggestion is to parallel the treatment of available-for-sale financial assets, cumulative changes in the carrying amount of insurance liabilities 20

21 would need to be recycled to profit or loss when the liability is discharged or extinguished or expires. Identifying the appropriate amounts to recycle could impose significant systems requirements for limited benefit. Previous version of approach C 34. The papers for the April IWG meeting presented a slightly different version of approach C. The April papers used the same definition of the objective of approach C ( Approach C measures the insurance liability at the amount that the insurer would charge to a policyholder today for entering into a contract with the same remaining rights and obligations as the existing contract ). However, the detailed description placed more emphasis on the particular insurer s own pricing methodology. The measurement would have reflected items such as changes in estimates and changes in discount rates only to the extent that the insurer s own pricing methodology reflects them. 35. IWG participants did not generally favour that description, and some of them preferred a description along the lines given in this paper. The revised description was included in the models discussed at the September IWG meeting. Approach D (Current exit value approach) 36. Approach D measures the insurance liability at the amount that the insurer would expect to have to pay today to another entity if it transferred all its remaining contractual rights and obligations immediately to that entity (and excluding any payment receivable or payable for other rights and obligations, such as renewal rights). Because there is no secondary market for most insurance liabilities, that amount would need to be estimated. Specifically, approach D would be the same as approach C, with the following differences: approach D does not separate embedded derivatives from the host insurance contract, because the whole contract is measured at current exit value, with changes recognised in profit and loss. (Approach C might not separate embedded derivatives if current entry value is close to current exit value.) conceptually, approach D recognises a gain or loss at inception if the insurer concludes that the estimated market price for risk and profit differs from the price 21

22 that is explicitly or implicitly embedded in the premiums that it charges. In practice, some constraints might be put on recognising such gains or losses if there is little or no observable market data. As noted below in paragraph 44(iv), IAS 39 includes such constraints. Approach C does not permit the recognition of a gain at inception (although, arguably, a loss might be recognised in some cases). (c) (d) (e) approaches C and D both recognise income on a systematic and rational basis as it is released from risk under the contract and provides services under the contract. In Approach D, the margin after inception is an unbiased estimate of the margin that market participants would require for the remaining contractual obligations, contractual rights and related risks. The margin would vary over time if there are changes in the estimate of the margin that market participants would require. Approach C calibrates the margin at inception to the observed transaction price with the policyholder. Put differently, approach C reflects changes over time in the amount of risk, but does not reflect changes in the per-unit price of risk (which is frozen at inception). approach D reflects the credit characteristics of the liability explicitly. Approach C reflects those characteristics implicitly or, perhaps, not at all. We plan to discuss this topic with the IWG in January. approach D does not include a liability adequacy test, because none is needed. Arguably, approach C needs such a test at inception, though not later. Implications for other types of life insurance contract (including annuities and health) 37. This paper deals specifically with conventional non-participating term insurance contracts, but the discussion here ought to be equally relevant for conventional nonparticipating contracts of the following types: whole life contracts (ie contracts that pay a death benefit whenever death occurs, unlike a term contracts, which pays out only if death occurs during a period specified in the contract) immediate life-contingent annuities (ie contracts that pay regular benefits for a period linked to the life of a specified person or persons) 22

23 (c) (d) (e) (f) pure endowments (ie contracts that pay a benefit only if the policyholder survives until the contract matures). health insurance contracts. both single premium and regular premium versions of each of these contracts. life reinsurance contracts. 38. There may be additional considerations for the following types of contract, and we will consider them later: (c) (d) conventional non-participating endowments (ie contracts that pay a death benefit if death occurs during a period specified in the contract and pay a maturity benefit if the policyholder to the end of the specified period). These might be viewed as a combination of a financial instrument and a term insurance contract. We will consider this view separately when we discuss unbundling. conventional non-participating deferred life-contingent annuities with separate accumulation and payout phases (eg some pension contracts). Some of these might be viewed as (i) financial instruments in the accumulation phase and (ii) then insurance contracts in the payout phase. We will consider this view later. fixed (ie non-contingent) annuities. These are financial instruments. We have no specific plans to discuss them immediately. Once the Board begins to develop tentative conclusions for life-contingent annuities, we will identify differences, if any, between those conclusions and the existing treatment of fixed annuities. If any differences arise, we will consider the implications. participating (with profits) and unit-linking (variable) features. We will discuss these separately. 23

24 Narrowing the range of approaches 39. The following paragraphs discuss the choice of approaches in two stages: choosing between cost-based approaches and current value approaches once that initial choice is made, choosing a particular approach. Arguments for cost-based approaches 40. Cost-based approaches attempt to reduce accounting mismatches by extending the use of cost measurements for assets held to back insurance liabilities. Arguments sometimes given for cost-based approaches: Liability-related arguments (c) (d) (e) (f) Cost-based approaches minimise the need for subjective estimates. This reduces volatility and minimises preparation cost. Most existing approaches contain some, and generally many, cost-based elements. Cost-based approaches do not recognise gains at inception, but some current value approaches (for example, approach D) do in some cases (paragraph 44 discusses this further in the context of choosing between approaches C and D). For some participating contracts, changes in estimates may be borne, in substance by policyholders. If so, it may cause unnecessary cost to require detailed estimates, if the only effect is to change the split between the fixed portion of policyholder liabilities and the participating portion of those liabilities. Short-term fluctuations in experience and in market prices are of limited relevance for long-duration contracts that insurers generally do not (and cannot) transfer to a third party. Proponents of current value measurements argue that such approaches give an early warning signal of deteriorating experience and expectations. However, those insurers with the least robust risk management and risk measurement might be the last to identify such deterioration. In other words, the early warning signal might fail when it is most needed. 24

25 Mismatch arguments (g) (h) (i) If insurer s assets and liabilities are tightly matched, fluctuations in current values of assets and liabilities should roughly balance out. In some cases, cost-based approaches are consistent with the basis used to determine dividends to participating policyholders. (This argument is not directly relevant for non-participating contracts, but might have indirect relevance if the aim is to develop a coherent package of approaches for all insurance contracts.) Banks may use amortised cost for loans and receivables and for the liabilities that finance those assets. Cost-based approaches would give insurers the same benefits. 41. Current-value approaches attempt to reduce accounting mismatches by extending the use of current value for insurance liabilities. Arguments sometimes given for current-value approaches: Liability-related arguments (c) Current value approaches require explicit, current estimates at each reporting date. Therefore, they give an early warning of possible changes in cash flows. Given the uncertainty associated with insurance liabilities and the long duration of many insurance contracts, such early warning signals are particular important. Selection of an appropriate basis for recognising margins (see paragraph 25) may be difficult and arbitrary (though this may also be true, to some extent, for some current value approaches). Cost-based approaches do not require an insurer to make explicit estimates of cash flows in each period, unless it considers that a liability adequacy test is likely to be relevant. Therefore, insurers may rely too much on implicit cushions from previous measurements, and so they may not pay enough attention to identifying changes in circumstances. Moreover, although a loss recognition test may reveal some losses, the rigour of such a test depends heavily on the level of aggregation, 25

26 which is unavoidably arbitrary. If the level of aggregation is high, gains on some contracts are implicitly offset against losses on other contracts. (d) (e) (f) (g) Cost-based approaches are not consistent with the treatment under IFRSs of other financial liabilities (see IAS 39) and non-financial liabilities (see IAS 37). Current-value approaches reduce (and may eliminate) the need to separate embedded derivatives. Separating embedded derivatives may be arbitrary if features of the embedded derivatives and of the host contract are interdependent, and may be costly. Cost-based approaches might need anti-abuse rules to prevent cherry picking of unrecognised economic gains through financial reinsurance. Sometimes, existing insurance contracts are replaced by new insurance contracts, or riders are added to existing contracts. A cost approach model may need criteria for distinguishing new contracts (with new estimates and a new discount rate) from amendment to an existing contract (with unchanged estimates and an unchanged discount rate). Such criteria may be arbitrary. Mismatch arguments (h) Current value approaches reveal economic mismatches that are masked by costbased approaches. In a current value approach, no accounting mismatch arises if the insurer classifies its financial assets as at fair value through profit or loss and if it elects to use the fair value model for investment property. 4 Economic mismatches would generally be reported. Financial analysts often observe that information about economic mismatch is very important to them: in its response to 4 IAS 40 permits an entity to use a fair value model for investment property, but IAS 16 does not permit this model for owner-occupied property. An entity may measure its owneroccupied property at fair value using the revaluation model in IAS 16, but changes in its fair value must be recognised in revaluation surplus rather than in profit or loss. Some insurers regard their owner-occupied property as an investment and prefer to use a fair value model for it. 26

27 ED 5 Insurance Contracts, the CFA Institute 5 strongly urged the Board not to extend the use of amortised cost in IAS 39. Which cost-based approach? 42. Arguments sometimes given for favouring for approach B over approach A: (c) Approach B may reduce some of the accounting mismatch that can arise if interest-sensitive financial assets are carried at fair value but related insurance liabilities are carried on a basis that does not reflect current interest rates. Insurers often follow a strategy that involves holding fixed maturity investments to maturity, though with some flexibility to sell investments if insurance claims or lapses are unusually high. A precedent exists in Japan for creating a new category of assets carried at amortised cost: assets held to back insurance liabilities. 43. Arguments sometimes given for favouring for approach A over approach B: (c) Approach B might eliminate some accounting mismatch, but only at the cost of obscuring some economic mismatch, particularly if assets and liabilities are not matched tightly. Obscuring the economic mismatch would not make an insurer's financial statements more relevant and reliable. Accounting mismatches for insurers arise today more from imperfections in existing measurement models for insurance liabilities than from deficiencies in the measurement of assets. A cost basis for assets permits entities to manage income by realising gains and losses. To limit the scope for this, some jurisdictions have adopted artificial smoothing mechanisms to spread realised gains, but these mechanisms do not enhance transparency. In discussions with individual Board members and staff in relation to the finalisation of IFRS 4, insurers generally indicated that they wished to keep the 5 The CFA Institute is an international, nonprofit organisation of more than 70,000 investment practitioners and educators in over 100 countries. When it commented on ED 5, it was known as the Association for Investment Management and Research. 27