Insurance Accounting AUDIT COMMITTEE NEWS. Financial Reporting. Edition 43 / Q4 2013

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1 AUDIT COMMITTEE NEWS Edition 43 / Q Insurance Accounting Financial Reporting In June 2013 the IASB issued a revised exposure draft (ED) of its proposal for a financial reporting standard on Insurance Contracts (IFRS 4 Phase II). The proposal includes several key changes as a response to the comments received while retaining the objective of a current value basis for measuring insurance contract liabilities. A short overview of the revised exposure draft. When to apply the proposal The revised ED applies to all contracts that transfer significant insurance risks, investment contracts with discretionary participation features issued by insurers and financial guarantee contracts that are currently recognised as insurance contracts. The ED does not address the accounting by policyholders. The measurement model The proposals contain one comprehensive measurement model for all types of insurance contracts issued. The measurement of the insurance contract liabilities is based on the building blocks comprising the following elements (see also Figure 1): 1. explicit, unbiased and probability weighted estimates of future cash in- and out-flows, 2. discounting using current rates to reflect the time value of money, 3. an explicit risk adjustment to adjust for the effects of the uncertainty about the amount and timing of the future cash flows and 4. a contractual service margin to eliminate any gain at inception. The present value of fulfilment cash flows is updated at the end of each reporting period to reflect changes in circumstances, conditions and assumptions. The fulfilment cash flows do not include the risk of non-performance of the entity. Changes in the risk adjustment, differences between actual cash flows that occurred during the period and previous estimates of those cash flows, i.e. experience adjustments, and changes in future cash flows that do not relate to future coverage are recognised in. Changes in the fulfilment cash flows resulting from a change in the discount rate would be recognised in other comprehensive income (OCI). However, the unwind of the locked-in discount rate at inception would be presented in. The contractual service margin that is determined at inception is adjusted prospectively for differences between current and previous estimates of cash flows relating to future coverage or other future services. I.e. the contractual service margin is unlocked and/or allocated over the coverage period on a systematic basis that is consistent with the pattern of transfer of service provided under the contract. In addition, interest is accreted on the contractual service margin at a locked-in discount rate at inception. The proposals include a new definition of and revised accounting rules for the acquisition costs. Directly attributable Audit Committee News, Edition 43 / Q

2 Initial measurement: Building block 1 Building block 2 Building block 3 Building block 4 Zero Expected cash inflows Expected cash outflows Discounting Risk adjustment Contractual service margin Presentation of changes: Changes in cash flows unrelated to services: Changes in cash flows related to past and current services: Unwind of locked-in discount rate: Changes in discount rate: OCI Changes in risk adjustment: Release of margin: Offset changes related to future services Changes in cash flows related to future services: offset against the margin * Source: New on the Horizon: Insurance contracts, p. 3 * recognised in if no contractual margin Figure 1: The measurement model for insurance contract liabilities acquisition costs are included in the measurement of the present value of fulfilment cash flows. The premium allocation approach The proposals contain a simplified measurement approach (the premium-allocation approach, see Figure 2) to measure the liability for some short-duration contracts. This model is intended to be a proxy for the building-block measurement model. Under the premium-allocation approach, the liability for the remaining coverage is initially measured as the premium, if any, received at initial recognition less acquisition costs plus any pre-coverage cash flows and an onerous contract liability, if applicable. The subsequent measurement of the liability for remaining coverage includes the accretion of interest at the interest rate at initial recognition, the premiums received and the changes from any onerous liability. The liability for remaining coverage is reduced with the corresponding amount recognised as insurance contract revenue. If the cash flows are not discounted the onerous contract liability is calculated excluding the time value of money. The premium-allocation approach would be similar to the current accounting model for short-duration contracts under US GAAP. However, there are likely to be some significant differences, most notably the use of a risk adjustment, (included in liability for incurred claims) and the use of discounting in the measurement of the liabilities for incurred claims and in determining whether contracts are onerous. Presentation in the financial statements The ED introduces new presentation requirements in the statement of financial position and the statement of profit or loss and OCI (see Figure 3). Rights and obligations arising from insurance contracts are presented for each portfolio, as a single insurance contract asset or liability in the statement of financial position. Audit Committee News, Edition 43 / Q

3 Initial measurement Liability for the remaining coverage Initial premium Directly attributable + acquisition costs * Pre-coverage cash flows + Onerous contract liability ** * That are not expensed as incurred. ** An onerous contract test would be performed if facts and circumstances have changed, indicating that a contract is onerous. Subsequent measurement Liability for the remaining coverage Previous Premium received carrying amount + in period Revenue recognised for coverage in period + Change in onerous contract liability + Time value of money Source: New on the Horizon: Insurance contracts, p. 69 Figure 2: Premium allocation approach Premiums and benefits are presented in by applying an earned-premium presentation: a. Insurance contract revenue is the transfer of promised services arising from the insurance contract at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those services. By applying this allocation approach, an entity would avoid recognising insurance contract revenue before any coverage has been provided. b. Directly attributable acquisition costs are presented over the coverage period. c. Insurance claims and other expenses are recognised in profit or loss when they are actually incurred. The proposed standard does not contain a prescribed income statement format and the IAS 1 Presentation of Financial Statements requirements apply as for any other entity. In addition, the ED proposes extensive disclosure requirements for quantitative and qualitative information in respect of the amounts recognised in the financial statements arising form insurance contracts, significant judgements and changes in judgements and the nature and extent of risks arising from insurance contracts. How KPMG sees it Overall increase in volatility in and equity The IASB s proposals will affect the way in which entities report their profitability and financial position and will likely result in an overall increase in volatility in and equity for most entities. In particular, life insurers issuing long-duration insurance contracts that currently use locked-in estimates of cash flows in measuring their contracts will be likely to experience shifts in earnings patterns. Non-life insurers will discount claims provisions at a current discount rate, and will recognise the unwind of a locked-in discount rate in profit or loss over the settlement period of the contract, resulting in a significant change in practice for many entities. Some of the re-measurement will be through OCI and the extent to which this mitigates volatility in will be highly influenced by whether financial assets that are linked to the insurance contract liability under proposed revisions to IFRS 9 Financial Instruments are measured at fair value through OCI, fair value through or amortised cost. The need to «Biggest ever financial reporting change for most insurers.» Patricia Bielmann consider the implications for asset-liability management will be accelerated, as the requirements of IFRS 9 are currently expected to come into effect before the insurance proposals. In addition, those entities writing long-term life business with options and guarantees may need to report changes in these items value in the statement of and OCI. As a result, there may be debate as to whether other changes in the insurance liability should also be presented in OCI, and about the residual volatility expected in both earnings and equity. Audit Committee News, Edition 43 / Q

4 Figure 3: Example statement of and OCI Example statement of and OCI Insurance contract revenue 475 Claims and benefits incurred (320) Expenses incurred (60) Amortisation of acquisition costs (20) Changes in estimates of future cash flows (if not offset against the contractual service margin) (10) Unwind of previous changes in estimates 5 Underwriting result (gross margin) 70 Investment income 60 Interest on insurance liability (54) Profit or loss 76 Other comprehensice income: Change in insurance contract liability due to changes in discount rate 9 Fair value movements on FVOCI assets (10) Total comprehensive income 75 Source: New on the Horizon: Insurance contracts, p. 91 A new presentation approach The proposed approach for presenting revenues and expenses will be unlike presentations used today for long-duration contracts. Insurance contract revenue ( earned premiums ) will likely be based on the initial expected pattern of claims and benefits, revised to reflect revisions in estimates. This approach for estimating insurance contract revenue is drastically different from presenting premiums when they are due. For shortduration contracts using the premium-allocation approach, premiums will be allocated over the coverage period in a way that best reflects the transfer of services. Claims and expenses will be presented on the face of the statement of and OCI as and when incurred. The amounts recognised for insurance contract revenue and incurred claims will exclude amounts that the entity is obliged to pay to the policyholder or a beneficiary regardless of whether an insured event occurs i.e. any investment component. Although this new form of reporting for insurance would result in greater consistency in reporting revenues of multi-line insurers and with other industries, it would also require significant education for both entities and users. Reporting of premiums and claims in would take on a whole new meaning for analysts and users. The top line revenue Audit Committee News, Edition 43 / Q

5 Conclusion The IASB has made great efforts to address the key concerns of constituents while retaining the objective of a current value basis for measuring insurance contract liabilities. The length of the debate on the insurance project indicates there is not a single model that will please everyone. The proposals are likely to be complex and this is the last chance for insurers and users to influence the outcome of the project. number and some of the other line items presented in the statement of and OCI would not be taken straight from the current chart of accounts and may not be straightforward to derive under the proposals. As a result, the way in which performance is communicated will be likely to change. Traditional performance and volume metrics will be less familiar, and multi-line business may become more complex to explain. Non-GAAP measures may be used to explain financial performance, while greater emphasis will be placed on the entire statement of and OCI. The new accounting model for insurance contracts will introduce more volatility to the profit and loss account but will more accurately reflect the risks and liabilities undertaken by insurers. Estimating the value of the four individual buildings blocks at the portfolio level will require a significant amount of actuarial analysis. Actuarial models and actuarial reporting process will need to be updated to reflect the new requirements. A big change is expected for life insurers: current vs. locked in assumptions, discount rates, risk adjustment, options and guarantees, acquisition costs, presentation of revenues and changes to profit recognition. We expect the non-life insurers to be much less affected by the new rules. Patricia Bielmann Audit Financial Services Thomas Schneider Audit Financial Services The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG Holding AG/SA, a Swiss corporation, is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss legal entity. All rights reserved. Printed in Switzerland. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. Audit Committee News, Edition 43 / Q