www.pwc.com/us/insurance Insurance alert FASB Board Meeting Contracts March 7, 2012 Insurance Since a variety of viewpoints are discussed at FASB and IASB meetings, and it is often difficult to characterize the FASB and IASB's tentative conclusions, these minutes may differ in some respects from the actions published in the FASB's Action Alert and IASB Observer notes. In addition, tentative conclusions may be changed or modified at future FASB and IASB meetings. Decisions of the FASB and IASB become final only after completion of a formal ballot to issue a final standard. PwC summary of meeting: Investment contracts with discretionary participation features Education session: o Definition of portfolio and unit of account o Separation of investment component Highlights The FASB had a board meeting on March 7 where they decided that an investment contract with discretionary participation features should not be included within the scope of the insurance contracts standard unless the contract meets the definition of insurance. This conclusion differs from the decision reached by the IASB at its board meeting the preceding week in which the IASB voted for the inclusion of these instruments within the scope of the insurance contracts standard when they are written by insurers. The FASB staff noted that these instruments are very uncommon in the U.S. but widespread elsewhere in the world. In addition, the FASB had an education session on the same day where they discussed several topics scheduled for the March 21 IASB/FASB board meeting. The first topic was a revised definition of a portfolio and the unit of account for various insurance contract measurements. The second topic at the education session was the latest staff proposal on the accounting for the investment component of an insurance contract. The staff papers prepared for the March 21 meeting proposed that the investment component of an insurance contract should be "disaggregated" for purposes of income statement presentation but not for balance sheet presentation or for measurement purposes. That is, the investment component of an insurance contract would be measured using the building block approach rather than unbundled and accounted for under financial instrument guidance. To alleviate concerns with presenting deposit elements as revenue, the investment component would not be presented as premium in the proposed volume information disclosed on the face of the income statement..
Investment contracts with discretionary participation features The FASB staff paper provided as background included the definition of an investment contract with discretionary participation feature (DPF). It is a contract with insignificant insurance risk for which the DPF is a contractual right to receive, as a supplement to guaranteed benefits, additional benefits whose amount or timing is contractually at the discretion of the issuer. The additional benefits may be based on the performance of a specified pool of insurance contracts, realized and/or unrealized investment returns on a specified pool of assets held by the issuer or the profit or loss of the company, fund, or entity that issues the contract. Insurance entities that issue such contracts typically also issue insurance contracts with DPF. The FASB staff noted that the prior week, the IASB voted for the inclusion of the investment contracts with DPF within the scope of the insurance contracts standard when they are written by insurers. These instruments are widespread in certain parts of the world such as France, Germany, and the UK, but uncommon in the U.S. Non-U.S. preparers subject to IFRS currently record such contracts under IFRS 4, and as such are permitted to account for them on a basis consistent with insurance contracts with DPF. The FASB staff recommended to the FASB board that investment contracts with DPF should be excluded from the scope of the insurance contracts standard unless they meet the definition of insurance. The staff expressed the view that such contracts should instead be accounted for under financial instruments guidance, which in their analysis would result in classification as financial liabilities, with recording of the DPF feature to the extent that such feature represented a contractual or constructive obligation. They noted that under the proposed FASB guidance for financial instruments, such instruments would most likely be accounted for at fair value. A board member observed that given the IASB's recent decision, the IASB would need to come up with a definition of an "insurer" since they had now brought in an insurer-specific notion to the definition. They questioned how a non-insurance company parent would account for the DPF investment contracts issued by its insurance subsidiary under the IASB proposal. The staff brought up a concern that given the broad definition of an investment contract with DPF, there could be unintended consequences if financial instruments meeting the definition were included in the insurance standard. For example, concern was expressed by some Bermuda companies that certain hedge funds that invest in special purpose reinsurance vehicles would need to follow the insurance model. A board member questioned this point, observing that if a hedge fund invested in a reinsurance vehicle, that would not be covered since the insurance model only addresses issuer accounting, not investor accounting. However, another board member explained that their concern is that the hedge fund could be viewed as having written an investment contract with DPF. However, he noted that his understanding of the IASB model, after the revision to limit its application to insurers, would be that if the hedge fund issued the contract, it would be scoped out of insurance, but if an insurance company issued the contract, it would be scoped in. Another board member struggled with how a contract that lacks significant insurance risk could ever be considered insurance subject to the insurance standard. He noted that investment contracts with DPF seemed like special equity securities, i.e., the discretionary component is like equity, similar to a preferred stock with a fixed return plus a chance of an additional dividend. The staff paper, which was not discussed in great detail during the meeting, noted that other current U.S. GAAP literature contains guidance for financial instruments with features similar to investment contracts with DPF, including structured notes, mandatorily redeemable preferred stocks, and participating mortgages. The view in the staff paper is that under current and proposed U.S. GAAP, investment contracts with DPF would be considered to be financial liabilities and not equity. After a rather brief discussion, the board voted unanimously with the FASB staff proposal that investment contracts with discretionary participation features should not be included within the scope of the insurance contracts standard unless the contract meets the definition of insurance. Definition of "portfolio" and unit of account for certain insurance contract measurements - FASB education session The staff provided the FASB board with background on a paper to be discussed with the IASB at the March 21 meeting. PwC Page 2 of 6
The paper discusses both the definition of portfolio, and the appropriate unit of account to be used in (1) the determination of the residual/single margin, (2) the performance of the onerous contract test as well as (3) the release of the residual/single margin. There were two alternative staff views mentioned in the paper. The FASB discussion focused on the second alternative, which recommended that the unit of account used to determine the residual/single margin, release that margin, and perform the onerous contract test should be the portfolio. The portfolio would be defined as contracts that: are subject to similar risks are managed together as a single pool are priced similarly relative to the risk taken on have similar duration and expected patterns of release of the margin. Under the other staff proposal there would be no prescribed unit of account for the release of the residual/single margin (it would be a principles based decision) and the fourth criterion above would not exist. The definition of portfolio used in the IASB exposure draft and FASB discussion paper was a carryforward of the IFRS 4 definition of portfolio: "insurance contracts that are subject to broadly similar risks and managed together as a single pool." The staff explained that this was subject to varying interpretations, with some considering their entire line of property/casualty contracts as having similar risks. To add clarity to this definition, the criterion that contracts be priced similarly relative to the risk taken on was added. Thus, contracts with widely different expected profit margins such as, for example workers compensation and surety business, would not be combined. As another example, the staff explained that in practice today, some property/casualty writers might consider their split for premium deficiency purposes to be commercial versus personal lines, but this split would need to be broken down further into products with different expected profit margins under the proposal. A board member was concerned that the new criteria, if read as a step by step set of criteria, might be interpreted to require too many portfolios. For example, would auto insurance (considered to be a particular type of risk) then need to be broken down into geographical regions managed separately (such as New Jersey versus Connecticut), and then within those geographic pools, would a company be required to consider auto insurance for 16 year olds to be a different portfolio than auto insurance for 45 year olds because of the potentially different pricing and higher risk of the first category of driver versus the second? The staff responded that it wasn't their intention to require that discreet a grouping level. In the example, it would be the staff's expectation that while the price charged might differ between the two classes of policies in each of the examples, the pricing would be commensurate with the risk, and thus the relative profit margins would be the same. As far as geographic location, while they did not expect companies to necessarily disaggregate based on different city or state offerings of the same product, they could see instances where geographic portfolios might exist between say, the U.S. and Europe for auto insurance. The staff noted that the point of the additional criteria was to avoid having too high of an aggregation. One of the key outcomes was to ensure that loss leader products were not inappropriately grouped with profitable contracts to avoid day 1 losses or onerous contract charges. However, they also noted that the criteria were not meant to prevent insurers from determining a portfolio at a much lower level of aggregation if desired, given that the individual contract level was still the theoretical accounting unit. Several FASB members questioned whether the criterion that the contracts be managed together as a single pool was necessary, observing that the criteria relating to similar risks and similar pricing relative to the risk seemed adequate. In addition, several questions were raised at first as to why the fourth criterion on similar duration and expected patterns of release of the margin was necessary. However, members eventually came to the view that in the FASB model, where the single margin would be released as the insurer was released from risk, which could very well not be straight line, it would make sense that contracts with different risk release patterns belonged in different portfolios. In contrast, in the IASB model, where the residual margin for many contracts might be released on a straight line basis, it would be easier to group contracts even if they were of a different duration, as they could potentially be amortized on a straight line basis using a weighted average duration. Separation of investment component of insurance contract - FASB education session The staff noted that their latest proposal considered prior board discussions as well as constituent comments on the topic of whether or not and to what degree the deposit/investment component of an PwC Page 3 of 6
insurance contract should be separated (the remainder of this discussion uses the terms "deposit" and "investment" interchangeably). Two different types of "separation" were identified as potential alternatives by the staff in the past: disaggregation versus unbundling. The difference between the two is that "unbundling" separates the deposit component and measures it under the financial instrument model whereas disaggregation measures all components under the insurance model and then disaggregates the deposit component subsequent to that measurement for purposes of financial statement presentation. Under the current staff proposal, two important points were noted: (1) separation of deposit components would be based on the concept of disaggregation rather than unbundling, and (2) the primary objective of separation would be to determine the amount of consideration to be shown as premium in the statement of comprehensive income (SCI) as opposed to balance sheet comparability or provision of liquidity information. To alleviate board member concerns with presenting deposit elements as revenue, the deposit component would not be presented as premium in the proposed volume information disclosed on the face of the income statement. Disaggregation was suggested as a means to alleviate some preparer concerns with the cost and complexity of the ED and DP proposal to unbundle and separately measure as financial instruments the deposit components of insurance contracts, as well as any fees and costs that might be associated with the deposit component. The staff proposal would not break out the deposit component balance (measured under the insurance model) separately on the balance sheet, under the theory that users had not commented strongly on the need for separate presentation in the balance sheet. Also, because the deposit component would be measured in accordance with the insurance model rather than financial instrument accounting, there would be no comparability between these expected value balances and, say, the deposit balances of a bank stated at amortized cost or fair value with a cash value floor. The staff introduced 4 alternatives for determining and separating deposit components within insurance contracts: a) No separation b) Separation of explicit account balances c) Separation of amounts which the insurer is obligated to pay to the policyholder regardless of whether an insured event occurs (which would include cash surrender value of traditional whole life contracts as well as period certain annuity payments and property/casualty experience accounts) d) Separation of the amount of premium received that the insurer estimates it will return (including for claims and benefits) to the policyholder. The staff paper supports alternative (c) and provides an appendix with examples of the investment components of typical life and non-life contracts under this alternative. Alternative (c) reflects suggestions by some board members at prior meetings that cash surrender values and other contracts where the policyholder can obtain cash absent the occurrence of an insurable event in substance represent deposit elements and that such deposits should not be limited to only explicit account balances. Alternative (d) is viewed as an extreme consideration of deposit elements that would be complex and difficult to implement, and would undermine the presentation of volume information that users had requested in SCI. One FASB board member questioned whether this proposal was inconsistent with the boards' previous tentative decision that embedded derivatives should be unbundled and measured as financial instruments while deposit components would, under this latest proposal, merely be disaggregated and excluded from SCI but not separately measured or presented on the balance sheet. The staff responded that for derivatives, the boards' decision was to unbundle (as is required by current GAAP), and under that unbundling, there was no consideration given to allocating any related costs (such as acquisition costs). For a deposit element, unbundling and separate measurement would be assumed to require allocation of acquisition costs and investment management fees, which would be very difficult. The board member responded that he was troubled with treating deposit elements and related fees and costs of insurance contracts differently than deposit contracts issued by other financial institutions. For example, if a bank issued a deposit contract that had investment management fees, those fees would need to be accounted for under revenue recognition guidance, not using a present value of all expected cash flows approach as the insurance model would require. The staff responded that investment management fees embedded in an insurance contract would be difficult PwC Page 4 of 6
to objectively separate from the administrative fees and mortality fees also embedded in the contract. Another board member observed that the board had decided not to try and separate out administrative fees embedded in yields on bank liabilities either when discussing financial instrument accounting previously. Another board member agreed with the exclusion of deposit components from SCI, but thought that perhaps the amounts should be disaggregated on the balance sheet as well. Another echoed this concern, observing that information about deposit liability components could help a user analyze asset/liability mismatches and liquidity issues. The staff responded that liquidity information, including amounts payable on demand, could be part of the note disclosure. The staff noted that the positive points of keeping the deposit component in the insurance measurement model would include the current valuing of options and guarantees associated with the component, including minimum interest rate guarantees and surrender charges, which would not necessarily be valued under the financial instruments model. Other members acknowledged that the most important objective was to exclude the deposit element from the SCI and that balance information was of lesser concern and could be handled through note disclosures as suggested by the staff. The board member arguing for potential unbundling of the deposit element and treatment as a financial instrument questioned why for bank deposits companies are forced to recognize the amount payable on demand, while for insurance the deposit elements would be discounted. The member noted that it would be problematic though, to have an insurer present the investment component as the amount payable on demand because this would most likely result in recording an asset for the remaining insurance component of the contract. Another board member said that if they were to require an insurer to record the deposit component at the amount payable on demand rather than at a discounted expected amount, taking this point to an extreme, they might as well require the death benefits to be recorded at the amount payable on demand if everyone immediately died, also without discounting. PwC Page 5 of 6
Additional information Questions on this summary and the FASB/IASB joint project can be directed to: Mary Saslow (860-693-4407) a Managing Director in the National Professional Services Group, who is part of both the U.S. and Global Accounting Consulting Services groups 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.