Accounting for Insurance Contracts 2012 ACLI Executive Roundtable Marc Siegel, FASB Board Member This presentation has been prepared by the staff of the FASB to help constituents understand the preliminary views in the Discussion Paper, Preliminary Views on Insurance Contracts. The views expressed in this presentation are those of the presenters, not necessarily those of the Financial Accounting Foundation or the FASB. Official positions of the FASB are reached only after extensive due process and deliberations.
Setting the stage GAAP today Life insurance financial reporting black box for analysts Balance sheet and income statement not reflective of often long-term and uncertain obligations or economic mismatches between assets and liabilities Patchwork of different accounting approaches depending on type of product Situation exacerbated by variety of accounting around the world Different accounting for insurance contracts issued by non-insurance entities Objective of Insurance Contracts Project: Provide investors and analysts with information reflecting all elements of the contract to allow them to understand the sources of an insurer s earnings and their financial position Increase consistency of accounting approaches and comparability of insurers financial statements globally The FASB is working toward an Exposure Draft proposal in H1, 2012. The IASB has yet to decide whether to issue a revised Exposure Draft or finalize as a new standard
Global Landscape Why FASB is Involved Status of International Accounting Rules on Insurance SEC Workplan Condorsement Possible Roles of FASB Three priorities of FASB: Independence, Improvement for US investors, International Convergence 3
Why Can t US GAAP be exported? 4 Problem Insurance entity orientation Wide range of accounting for different types of contracts and/or product features, which limits understandability Estimates for traditional long duration contracts locked in at inception Investment-type contracts recorded at account value with changes in expected gross profits reflected in amortization of deferred acquisition cost (DAC) asset Economic mismatches between assets and liabilities Proposed solution An accounting model that applies to insurance contracts not just insurance entities A single (or limited number of) accounting model(s) for all insurance contracts Assumptions updated to reflect current information Not yet determined. Objective will be to ensure that balance sheet and income statement reflect long-term and uncertain obligations Not yet determined. Objective will be to capture economic mismatches but limit accounting mismatches.
Capturing the objectives in the measurement model What are we trying to do: Updated measurement of insurance contract liabilities that captures all features of the contract Measurement model: Key features New and updated information is more relevant than old information Updated estimates and assumptions Current measurement of risk 5 Reflects the diff. between an uncertain liability and a liability whose amount is certain (IASB only) Disclosures about inherent risk and uncertainty Presentation that gives information about drivers of performance Market consistent estimates Reflect time value of money Reflects best available objective information Investors are not indifferent to time value of money
Key investor feedback on the proposals 6 We support developing a single global accounting framework for insurance contracts. Convergence Better to have two distinct but internally consistent and robust insurance contracts standards than nothing at all or an IFRS which is an unsatisfactory hybrid.
Key investor feedback on the proposals 7 Volatility Stakeholders are concerned that reflecting changes in expectations and interest rates in the income statement will increase reported volatility A measurement reflecting changes in management s expectations and market interest rate movements does not portray the true economic performance of the insurer. Stable earnings should not be an end in and of itself. Format of the income statement Do not remove volume information, like premiums, from the face of the income statement. Underwriting margin is important, but it could be in the disclosures.
Total Insurance Liability (Premiums) Present Value of Fulfillment Cash Flows FASB Approach IASB Approach Summary of building block approach for liability Present value of expected cash flows plus margin(s) 8 Single Margin An amount to eliminate any gain at initial contract recognition representing profit at risk. Recognized as the insurer satisfies its performance obligation to compensate the policyholder; as it is released from exposure to risk as evidenced by a reduction in the variability of cash flows. May be released over time or as information becomes known. Residual Margin An amount to eliminate any gain at initial contact recognition Recognized in earnings over the coverage period; adjusted for favorable and unfavorable changes in the estimates of future cash flows on a prospective basis Risk Adjustment Margin The compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfils the insurance contract Remeasured each reporting period with changes recognized in earnings Present value of the current, explicit, unbiased estimate of expected net cash flows The net amount that the insurer expects to collect from premiums and pay out for claims, benefits, and expenses, estimated using current information Discounted to reflect the time value of money based on the characteristics of the liability (re-measured each reporting period) Bottom up approach: risk free plus liquidity Top down approach: reference or asset portfolio adjusted to reflect characteristics / duration of liability less default risk and other asset risks not reflected in the liability
Time value of money (discount rate) One of most controversial elements of the proposal Two camps : Use a rate consistent with the characteristics of the insurance contract liability Use a rate consistent with the assets held which back the liability 9 The Boards have opted for the latter: The discount rate should adjust the future cash flows for the time value of money and reflect the characteristics of the insurance contract liability The rate should be consistent with observable market prices for cash flows with the same characteristics of the insurance liability (timing, currency and liquidity) but exclude the effect of the insurer s non-performance risk Be updated at each measurement date for all contracts (not locked in) Change from DP/ED: Earlier proposal focused on a risk free rate plus a liquidity adjustment. Further discussions have resulted in permitting a top down approach: reference or asset portfolio adjusted to reflect characteristics/duration of liability less default risk and other asset risks not reflected in the liability Volatility concern: updated on a regular basis through the income statement -Boards decided that a locked-in discount rate was not appropriate -Boards will be discussing whether changes in discount rate could be reported in OCI
What really changes for life contracts? 10 Account Change in statement of financial position Impact on statement of comprehensive income Premiums receivable DAC Separate account assets Future policyholder benefits Conditional rights to any premiums or other consideration are netted against the insurance liability, thus reducing premiums receivable Not recorded as separate asset; netted with insurance liability and therefore reduces single/residual margin Balance could be different (direct or incremental; all or just for successful contracts) Not yet decided: potentially included with appropriate category of financial instruments (although could be identified separately as well) Different balance as a result of different discount rate Updated assumptions each reporting period will result in different balance Depending on treatment of policyholder account balances could increase due to recording expected cash flows of guarantees and options previously not recognised (or recognised using a smoothing model) No change Not explicitly amortized Implicitly included in amortization of single/residual margin although will be different pattern Not yet decided: investment income on separate account assets may be included in statement of comprehensive income Additional volatility due to updated assumptions Premiums due/written could be different depending on treatment of account balances
What really changes for life contracts(cont.)? 11 Account Change in statement of financial position Impact on statement of comprehensive income Policyholder account balances and separate account liability Risk adjustment and residual margin (IASB ONLY) Single margin (FASB ONLY) Disclosures No decisions reached but could: Include separate account liability balance (versus recording separately) Be expanded to include additional account balances for contracts accounted for today at the present value of expected cash flows (e.g., included in future policyholder benefits) Be measured the same as today (account value) or could be measured using expected cash flow or financial instruments Explicit measurement of risk adjustment or current provision for adverse deviation (PfAD or PAD) using different methods and therefore resulting in different balance; expected to be minimal Explicit measurement of expected profit previously included in future policyholder benefit account Explicit measurement of expected profit previously included in future policyholder benefit account Changes in expected gross profits will be transparent (rather than a mechanism for determining DAC amortization) Not yet decided: could recognize expense for pass-through of investment income Additional volatility due to remeasurement of risk adjustment; expected to be minimal Recognition of residual margin could be significantly different than today s accounting, especially if unlocked for changes in expected cash flows Recognition is expected to be similar to today s accounting but could have different earnings pattern More information about assumptions and effects of assumptions in the audited financial statements
Key performance indicators: life 12 KPI Available from new standard? Our proposals Investment returns Investment results highlighted separately from Benefit and expense ratio underwriting results (including premiums and policyholder benefits) on the face of the P&L Premiums written/due Interest accretion from unwinding of discount on liabilities included with investment income thus changing measurement of investment returns and benefit and expense ratio Actual to expected experience measures for mortality, morbidity Not yet decided: premiums written/due could be different Disaggregation of information about the effect of experience adjustments and changes in estimates required in the notes or in the P&L Value of new business Information will be disclosed in the notes Value of existing book
FASB and IASB: Main differences Difference Measurement and presentation of premiums in excess of present value of expected cash flows FASB: record as single margin IASB: split between measurement of explicit risk adjustment and residual margin FASB s view 13 Premium is priced to cover expected cash flows with a targeted profit Risk adjustment is: Split of profit priced for in the premium Mixing reserve concepts with capital concepts used for regulatory purposes Concern of comparability given various methodologies could be used, each which produce different results Unlocking the margin FASB: Adjust amortization of single margin IASB: Unlock the residual margin for favourable and unfavourable changes (shock absorber) Acquisition costs FASB: limit to costs of acquiring successful contracts within a portfolio IASB: include both successful and unsuccessful costs of acquiring portfolio Margin represents profit which should be recognized as the amount of profit becomes more certain (e.g., uncertainty in the cash flows is reduced and the insurer is released from risk) Margin could become new black-box if unlock: Unlocking the margin locks-in the income statement until there is no margin Could split change in expected cash flows between offset to margin and loss; or if favourable change after margin is written off between income and re-establishment of margin Portfolio inherently limits the costs that would be included to those costs related to contracts acquired Costs relating to unsuccessful efforts cannot be considered to provide a future economic benefit to warrant recognition and cannot be considered to be recoverable Consistent with other projects (at contract level)
Timeline to completion 14 2011 2012 2013 2015 2017 Continue deliberations Continue deliberations attempt to reconcile differences IASB: Review draft or re-exposure decision FASB: Exposure draft Continue redeliberations Revised insurance contracts standards become effective no sooner than 2015 for IASB or 2016 for FASB FASB: Comment letter review, roundtables and begin re-deliberations