30 Cannon Street, London EC4M 6XH, England Phone: +44 (0)20 7246 6410, Fax: +44 (0)20 7246 6411 Email: iasb@iasb.org.uk Website: http://www.iasb.org International Accounting Standards 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. INFORMATION FOR OBSERVERS IASB Meeting: Project: July 2005, London Risk Transfer in Insurance and Reinsurance Contracts U.S. GAAP (Agenda Paper 2) EDUCATION SESSION BY STAFF OF THE FINANCIAL ACCOUNTING STANDARDS BOARD Background 1. Threshold question: how to determine when significant insurance risk is transferred? Answer impacts accounting for the contract insurance vs. other financial contract (deposit or derivative). (a) Certain insurance and reinsurance contracts include contractual features that limit the amount of risk transferred in the contract e.g., experience refunds, adjustable features, multi-year arrangements, or cancellation provisions. Contracts with these terms are often called finite risk or financial insurance or reinsurance contracts. (b) Many believe that certain of these insurance contracts are more akin to financing than insurance and should be accounted for as such. (c) In some cases the complex contract terms may obfuscate true nature of contract. (d) A concern of some is whether additional guidance is needed or whether the problem is a few characters abusing existing criteria?
2. Current U.S. guidance for determining whether insurance contracts and reinsurance contracts are insurance or financing arrangements is based on paragraph 44 of FASB Statement No. 5, Accounting for Contingencies (1975): to the extent that an insurance contract or reinsurance contract does not, despite its form, provide for indemnification of the insured or the ceding company by the insurer or reinsurer against loss or liability, the premium shall be accounted for as a deposit by the insured or ceding company. 3. FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises (1982), established the basic insurance enterprise accounting framework for U.S. GAAP. (a) Defined short-duration (generally nonlife) and long-duration (generally life) insurance contracts based on period contracts are expected to remain in force and inability of insurer to unilaterally modify certain provisions of the contract, e.g., noncancellable or guaranteed renewable contracts. (b) Indemnification language from Statement 5 carried forward to Statement 60 as reinsurance guidance. 4. Current conditions for evaluating risk transfer in reinsurance contracts are in paragraph 9 of FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts (1992): (a) Reinsurer must assume significant insurance risk under the reinsured portions of the underlying insurance contracts. (b) Must be reasonably possible that the reinsurer may realize a significant loss from the transaction. (i) Guidance considered by some to be principles based. (ii) Conditions appear sound but the second criterion devolved in practice to a 10% chance of a 10% loss (or 1% expected value of possible loss not the expected value of the outcome of the contract). 5. Current guidance in U.S. GAAP for evaluating risk transfer in insurance contracts is virtually nonexistent Recent AICPA Technical Practice Aid, Accounting by Noninsurance Enterprises for Property and Casualty Insurance Arrangements That Limit Risk, compiles the current guidance addressing accounting by policyholders the TPA points out that EITF Issue No. 03-08, Accounting for Claims-Made Insurance and Retroactive Insurance Contracts by the Insured Entity, suggests: That insureds may want to analogize to Statement 113 criteria for assessing risk transfer in an insurance contract. 6. Risk Transfer Project will address risk transfer for both insurance and reinsurance contracts 2
7. National Association of Insurance Commissioners (the NAIC U.S. state insurance regulators) also is studying the evaluation of the transfer of significant insurance risk in finite reinsurance contracts. The American Academy of Actuaries is studying current approaches to evaluating risk transfer for the NAIC (scheduled to be completed in August). 8. Issues to be addressed (a) Definition of insurance contract (including reinsurance contract), insurance risk, and related terms very little to nil exists in U.S. GAAP (i) Need to distinguish between insurance and (other) financial instruments e.g., loans (lack of risk transfer) and derivatives (loss must be incurred by insured). (ii) Currently evaluating IFRS 4, Insurance Contracts, for potential adaptation to US GAAP or, as a minimum, for use as a template/model Recently subject to IASB due process and deliberations Potential for early convergence on part of the IASB s Insurance Contracts Phase II project. (b) Options for simple bifurcation (unbundling) (i) Split insurance contracts into segments Account for segments that transfer risk as insurance Account for segments that do not transfer risk as deposits (financing or loans accounting) (ii) Major questions: How to determine risk and nonrisk transfer segments of a contract? Can a simple approach be developed? (c) Review wording of Statement 113 to strengthen criteria. (d) Review wording of Statement 113 for applicability to insurance (now applies only to reinsurance). (e) Explore expanded disclosures. 9. Other insurance related projects (a) Accounting for financial guarantee insurance (also including mortgage guarantee insurance and credit insurance) an FASB project to provide guidance on accounting for premiums, losses and deferred acquisition costs. Project results from diversity in practice. (b) Proposed FASB Staff Position No. TB 85-4-a, Accounting for Life Settlement Contracts by Investors i.e., accounting for life insurance contracts purchased as investments. This FSP proposes changing the current cash surrender value guidance to a cost accumulation approach (the investment method). Proposed FSP posted to website for comment on June 17, 2005 (comments due August 1, 2005). 3
(c) AICPA proposed Statement of Position, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts would establish criteria for determining when a modified or exchanged insurance contract is substantially unchanged, thereby allowing unamortized acquisition costs and related balances to be carried forward for accounting purposes. 10. Project Updates from the FASB s website for the Risk Transfer and Financial Guarantee projects are attached. Also attached is the proposed FSP on life settlements. 4
Project Updates Insurance Risk Transfer Last Updated: June 2, 2005 The staff has prepared this summary of Board decisions for information purposes only. Those Board decisions are tentative and do not change current accounting. Official positions of the FASB are determined only after extensive due process and deliberations. Objective Decisions Reached at the Last Meeting Related Links Immediate Plans Summary of Tentative Decisions Board Meetings/Public Meeting Dates History and Background Contact Information Objective The objective of this project is to clarify what constitutes transfer of significant insurance risk in insurance and reinsurance contracts first by defining insurance contracts and related terms. Simple approaches to bifurcation of insurance contracts that include both insurance and financing elements also will be explored. The project is intended to improve the representational faithfulness of accounting for insurance and reinsurance contracts by more clearly defining which contracts or portions thereof should be accounted for as insurance and which should be accounted for as deposits (financings). The resulting increased transparency in accounting and reporting by insureds should help users of financial statements better understand the economic impact of those contracts. Decisions Reached at the Last Meeting At its June 1, 2005 educational session, the Board directed the staff to begin drafting for Board consideration definitions of insurance contract, insurance risk, and related terms based on the IASB's IFRS 4, Insurance Contracts, definitions and related descriptive material. Related Links Insurance policyholders, including noninsurance enterprises, are subject to FASB Statement No. 5, Accounting for Contingencies, paragraph 44, which requires that an insurance contract indemnify the insured against loss. The guidance in the AICPA Technical Practice Aid, Accounting by Noninsurance Enterprises for Property and Casualty Insurance Arrangements That Limit Insurance Risk, provides additional information to assist noninsurance enterprise policyholders in assessing whether an insurance contract provides such indemnification. Immediate Plans The staff will draft for Board consideration definitions of insurance contract, insurance risk, and related terms based on the IASB's IFRS 4, Insurance Contracts, definitions and related descriptive material. Summary of Tentative Decisions At the April 6, 2005 meeting, the Board decided to add a project to consider risk transfer in insurance and reinsurance contracts. The project will include developing a definition of insurance contracts and exploring simplified approaches to bifurcating insurance contracts. At the June 1, 2005 educational session, the Board 5
directed the staff to draft for Board consideration definitions of insurance contract, insurance risk, and related terms based on the IASB's IFRS 4, Insurance Contracts, definitions and related descriptive material. Board Meetings/Public Meeting Dates The Board meeting minutes are provided for the information and convenience of constituents who want to follow the Board s deliberations. All of the conclusions reported are tentative and may be changed at future Board meetings. Decisions become final only after a formal written ballot to issue a final Statement or Interpretation. The following are links to the minutes for each meeting. April 6, 2005 Board Meeting Discussion of (a) whether to add a project on risk transfer and (b) the approach to the project. History and Background Recently, a number of issues have arisen concerning the determination of whether an insurance or reinsurance contract transfers significant insurance (reinsurance) risk. The determination of significant risk transfer is necessary to determine whether the contract is accounted for as an insurance or reinsurance arrangement or whether it is accounted for as a financing arrangement (similar to a loan). Also, certain finiterisk or financial insurance and reinsurance contracts contain risk-limiting features that can make the risk transfer analysis difficult. Statement 5, paragraph 44, requires that all insurance and reinsurance contracts indemnify the insured against loss or liability. FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, provides further guidance for determining the transfer of significant insurance risk for reinsurance arrangements. Those contracts that do not transfer significant insurance risk are accounted for as deposits (similar to a financing or loan, with loan repayments taking the form of periodic insurance premium payments). Regardless of whether a policyholder is a noninsurance or insurance enterprise, only to the extent that an insurance (or reinsurance) contract indemnifies or transfers significant insurance risk from the policyholder to the insurer does it qualify for insurance accounting. This project s objective is to define an insurance contract and provide further assistance in identifying those contracts that transfer significant insurance risk. In addition, the project will explore the notion of bifurcation of insurance contracts into risk transfer and financing segments for purposes of establishing the appropriate accounting for those contract segments. Contact Information Jeffrey Cropsey Project Manager jdcropsey@fasb.org 6
Project Updates Financial Guarantee Insurance Project Summary Last Updated: June 24, 2005 The staff has prepared this summary of Board decisions for information purposes only. Those Board decisions are tentative and do not change current accounting. Official positions of the FASB are determined only after extensive due process and deliberations. Objective Decisions Reached at the Last Meeting Immediate Plans Board Meetings/Public Meeting Dates Summary of Tentative Decisions History and Background Contact Information Objective The objective of this project is to provide guidance in respect to the timing of the recognition of claim liabilities, specifically for financial guarantee contracts issued by insurance companies that are not accounted for as derivative contracts under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. A financial guarantee contract guarantees the holder of a financial obligation the full and timely payment of principal and interest when due and is typically issued in conjunction with municipal bond offerings and certain structured finance transactions. The goal is to reduce diversity in accounting by financial guarantee insurers, thereby enabling users to better understand and more readily compare the insurers financial statements. Decisions Reached at the Last Meeting (June 8, 2005) The Board added a project to consider the accounting by insurers for financial guarantee insurance. The scope will be limited to contracts issued by insurance companies that indemnify the holder against losses from payment default on a financial obligation that are not considered derivative contracts due to meeting the exception in paragraph 10(d) of FASB Statement No. 133. The project will be confined to contracts written by insurance companies currently within the scope of FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises. However, consideration of the accounting model will not be limited to the short- and long-duration models described in Statement 60. The Board will consider claims liability recognition, premium recognition, and the related amortization of deferred policy acquisition costs. In determining the appropriate accounting model for financial guarantee contracts, the Board also will examine the appropriate accounting model for other insurance products with similar characteristics, such as mortgage guarantee contracts and credit insurance. Immediate Plans The Board plans to meet in August to consider the accounting model for insurers for financial guarantee insurance. Summary of Tentative Decisions See Decisions Reached at the Last Meeting. 7
Board Meeting and Public Meeting Dates The Board meeting minutes are provided for the information and convenience of constituents who want to follow the Board s deliberations. All of the conclusions reported are tentative and may be changed at future Board meetings. Decisions become final only after a formal written ballot to issue a final Statement or Interpretation. The following are links to the minutes for each meeting. (The minutes of the June 8 Board meeting will be posted within one week of that meeting.) June 8, 2005 Board Meeting Addition of project to agenda and discussion of the project s scope. History and Background Recently, the FASB has been made aware of diversity in practice with respect to the timing of the recognition of claim liabilities for financial guarantee contracts issued by insurance companies. Although FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, provides the primary source of accounting and reporting guidance for all insurance enterprises, many financial guarantors contend that this standard was adopted before the financial guarantee industry came into prominent existence and does not comprehensively address the unique attributes of financial guarantee insurance. Statement 60 provides different revenue and expense recognition guidance depending on whether a contract fits within the Statement 60 definition of a short- or long-duration contract. Financial guarantee contracts have attributes of both. Because of the perceived uncertainty in the application of Statement 60, many financial guarantee insurers do not believe that Statement 60 alone provides sufficient guidance. The diversity in practice results, in part, from the variety of accounting models that exist for similar products to which these insurers analogize. Contact Information Amie Thuener Practice Fellow anthuener@fasb.org 8
PROPOSED FASB STAFF POSITION No. TB 85-4-a Title: Accounting for Life Settlement Contracts by Investors Comment Deadline: August 1, 2005 Introduction 1. The Board directed the FASB staff to issue this FASB Staff Position (FSP) to provide initial and subsequent measurement guidance for investments in life settlement contracts. Background and Scope 2. A life settlement contract for purposes of this FSP is a contract between the owner of a life insurance policy (the insured) and a third party (life settlement provider) and has the following characteristics: (a) the life settlement provider does not have an insurable interest (an interest in the survival of the insured, which is required to support the issuance of an insurance policy), (b) the life settlement provider pays the insured an amount in excess of the current cash surrender value of the life insurance policy, and (c) the contract pays the face value of the life insurance policy to the life settlement provider when the insured dies. This FSP addresses transactions in which a broker facilitates settlement transactions between the insured and the life settlement provider, as well as transactions that do not involve a broker. 3. Prior to the issuance of this FSP, life settlement providers accounted for life settlement contracts in accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance, which requires the use of the cash surrender value for investments in life insurance. Adherence to the accounting guidance in Technical Bulletin 85-4 resulted in life settlement providers expensing, on the date of purchase, the difference between the purchase price of life settlement contracts and their cash surrender value. Issue 4. Questions have arisen as to the appropriateness of applying the guidance in Technical Bulletin 85-4 to life settlement contracts because it requires the immediate expensing upon purchase of the difference between the purchase price of life settlement contracts and their cash surrender values. FASB Staff Position 5. The Board believes that the application of the guidance in Technical Bulletin 85-4 to life settlement contracts is inappropriate given the investing activity that the life settlement provider is conducting. The Board believes that the use of a cost accumulation 9
model (investment method) is more appropriate for this activity and better reflects the economic substance of life settlement contracts. Under the investment method the initial investment costs and continuing costs (policy premiums and direct external costs, if any) are capitalized. No income is recognized until the insured dies, at which time the difference between the carrying cost of a life settlement contract and the face value of its underlying life insurance policy should be recognized. When the carrying amount of the life settlement contract equals the underlying life insurance policy s face value, all future premiums and direct external costs shall be expensed. Disclosures 6. The objective of the disclosures required by this FSP is to provide users of financial statements with information about the composition of a life settlement provider s portfolio of life settlement contracts and its evaluation of that portfolio. 7. The Board believes that the following disclosures should be provided as of the date of the statement of financial position and that these disclosures should be grouped by remaining expected term from that date, as well as in the aggregate: a. The number of life settlement contracts in the grouping b. The carrying value of the settlement contracts c. The face value (death benefits) of the life insurance policies underlying the contracts. 8. The maximum life insurance premiums required to be paid for these life settlements, within 1 year from the date of the most recent statement of financial position presented, also should be disclosed in total. Effective Date and Transition 9. The guidance in this FSP shall be applied to fiscal years beginning after [the date the FSP is finalized]. Earlier application is permitted. Upon adoption of this FSP, the measurement guidance should be retrospectively applied. 10. The disclosure requirements of this FSP shall be applied as of the most recent statement of financial position presented. 10