INFORMATION FOR OBSERVERS. Project: Financial Guarantee Contracts and Credit Insurance Business Model Approach (Agenda Item 5)

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1 30 Cannon Street, London EC4M 6XH, England International Phone: +44 (20) , Fax: +44 (20) 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. Note: These notes are based on the staff paper prepared for the IASB. Paragraph numbers correspond to paragraph numbers used in the IASB paper. However, because these notes are less detailed, some paragraph numbers are not used. IASB Meeting: INFORMATION FOR OBSERVERS 19 April 2004, London Project: Financial Guarantee Contracts and Credit Insurance Business Model Approach (Agenda Item 5) Purpose 1. At the end of the March meeting the Board discussed another proposal on how to amend the ED on Financial Guarantees and Credit Insurance. Some Board Members suggested a business model-approach, ie if the issuer of a contract within the scope of the Exposure Draft had previously asserted that such contracts were insurance contracts and had used accounting applicable to insurance contracts, the issuer could apply either the approach proposed in the Exposure Draft or IFRS 4. In all other cases, the issuer should apply the approach proposed in the Exposure Draft. 2. The purpose of Agenda paper 5 is to compare the advantages and disadvantages of this business model approach. 3. In March the Board indicated that it would decide at this meeting whether it should adopt this proposal or abandon this project. Structure 4. The structure of the paper is as follows: a. not used b. Summary of staff recommendation 1

2 c. Background d. Analysis of the business model approach e. Advantages and disadvantages of the business model approach f. Re-exposure g. Timetable 5. Not used Summary of staff recommendations 6. The staff recommends that the Board discontinues this project. Background 7. In January, the Board concluded that it would permit two approaches for contracts within the scope of this project: (a) the approach proposed in the Exposure Draft, or (b) applying IFRS 4, but with a more rigorous liability adequacy test for these contracts only. 8. In March the Board decided not to pursue that conclusion. The Board also discussed a proposal that would require the issuer of a contract within the scope of the Exposure Draft to apply the approach proposed in the Exposure Draft, unless the contract contains specified features that are commonly found in credit insurance contracts and pose accounting problems that cannot be resolved in the short term. If such features are present, the issuer could elect to apply IFRS 4 Insurance Contracts, instead of the proposals in the Exposure Draft. The Board rejected this proposal. Analysis of the business model approach 9. The decision to apply either IAS 39 or IFRS 4 is based on two characteristics. The entity previously asserted that such contracts were insurance contracts and used accounting applicable to insurance contracts. 10. The Boards intention was to link the accounting to the business model the entity pursues, but it is not clear in which way the entity had to assert that such contracts were insurance contracts. It might be sufficient that the entity treated the contracts as insurance contracts 2

3 in the last financial statement or, for example, it has to prove that it sold those contracts under the name insurance contract or called itself an insurance company. 11. In practice this question will not make much difference, since in most cases entities apply specific accounting to contracts they regard as insurance contracts. Hence, it shouldn t be a problem for those companies that already accounted for those contracts to classify them in accordance with their business model. 12. However, the accounting in the past might constitute a problem, if it is regarded as the crucial criterion to qualify for the option. The following cases illustrate the issue: a. The entity used national insurance GAAP in 2004 for financial guarantee contracts as defined in the ED. If this entity prepares an IFRS financial statement in 2005, the business model approach will allow using the same accounting policy under IFRS 4. 1 b. The entity used national bank GAAP in 2004 for financial guarantee contracts as defined in the ED. If this entity prepares an IFRS financial statement in 2005, the business model approach will not allow using IFRS 4. c. The entity already applied IFRS in Hence, all of its financial guarantee contracts were accounted for under IFRS 4. If the option just relied on the previous accounting, all contracts would automatically qualify for the option, since IFRS 4 is an insurance specific accounting rule. 13. Hence, in order to qualify for the option it should not be sufficient just to apply insurance accounting, but to assert that the contract is an insurance contract due to the business model. 14. It might be difficult to apply the business model approach for entities that have not already issued financial guarantee contracts. Those entities might refer to the practice of other entities that issued similar contracts in the past. On the other hand this problem might disappear if the option is not linked to the previous accounting practice but purely to the assertion of the entity that it currently regards these contracts as insurance contracts. 1 There are some restrictions on continuing accounting policies (eg catastrophe provisions must be eliminated). Also, an insurer may make improvements that meet criteria specified in IFRS 4. 3

4 Advantages and disadvantages of the business model approach 15. A reminder: This project deals only with a very narrow class of instruments, because it is only focused on contracts that provide compensation for credit losses. Hence, all other guarantees (eg performance guarantees, guarantees based on changes in an underlying, a market value guarantee) are not addressed. 16. The benefits are: a. Banks can elect to look at IAS 39 and insurers can elect to look at IFRS 4. b. The Board does not have to find a solution for accounting issues outside IFRS 4 that are specific to insurance contracts. c. The Board concluded several times that there is no clear dividing line between banking financial guarantees and insurance financial guarantees. Tying the criteria to previous assertions by the issuer introduces some (though not total) objectivity. d. Restoring the improved guidance on financial guarantees from IAS 39 as it was amended in December e. As a by-product, the drafting of the material on loan commitments will be improved and moved out of the scope section. 17. Disadvantages of the proposed approach: a. It is not clear how preparers have to show that they previously asserted that such contracts were insurance contracts, if there was no specific insurance accounting. b. If entities previously applied IFRS 4, all financial guarantees might be regarded as insurance contracts, since they were accounted under an insurance standard. c. Entities that have not yet issued financial guarantee contracts have to refer to how similar contracts were accounted for in the past by other entities. d. For entities required to apply IAS 39 the lack of an exemption for intra-group guarantees creates a divergence from US GAAP. The Board decided in March not to create such an exemption. 4

5 e. The approach introduces considerable complexity into the standard. Also, it is not obvious why this particular class of insurance contracts needs special treatment. f. If the Board wished to restore to its literature the material developed for the December 2003 version of IAS 39, it could reissue that material as guidance. g. Entities adopting IFRSs in 2005 would not welcome changes in 2006 and might prefer to implement the changes in However, time is now very short for this. 18. The staff continues to recommend that the Board discontinue this project. Re-exposure 19. Potential grounds for re-exposure are: Any change in the principles paragraphs from the ED that go beyond editorial clarification. Material change to the application guidance contained in the ED. Additional requirements to those in the ED. Deletion of requirements in the ED. 20. The staff does not see a necessity for re-exposure, if the Board decides to implement the business model approach. 5