INSURANCE ACCOUNTING MIND THE UK GAAP

INSURANCE ACCOUNTING MIND THE UK GAAP This is a paper prepared by the staff of the UK Accounting Standards Board in order to invite comments from constituents on the options for the future of insurance accounting in the UK. It does not purport to represent the views of the ASB. Section 7 of this paper sets out the questions for constituents. Comments should be sent to asbcommentletters@frc-asb.org.uk at the latest by 30 April 2012. 1 Introduction Background to the Staff Paper 1.1 A number of proposed changes due in the coming years are likely to have a direct effect on the accounting for insurance contracts in the UK. These changes include: (a) (b) (c) a likely delay in the finalisation and implementation of International Financial Reporting Standard (IFRS) 4 Insurance Contracts Phase II; a likely implementation date of 1 January 2014 for the Solvency II regime; and the ASB s proposals on the future of financial reporting in the UK and the Republic of Ireland (RoI). 1.2 This paper outlines: (a) (b) the impact of these changes, and the resulting issues arising, for accounting for insurance contracts in the UK and RoI in the short and longer term; and the possible short and longer term solutions for accounting for insurance contracts in the UK and RoI. 1.3 This paper should be read in conjunction with the UK ASB s financial reporting exposure drafts on the future of Financial Reporting in the UK and the RoI 1 published on 30 January 2012. 1 References in this document to UK GAAP or the future of UK GAAP should be read as references to current or the future of financial reporting in the UK and RoI, respectively. Page 1 of 15

1.4 The ASB proposes in the Financial Reporting Exposure Draft (FRED) 46 The Application of Financial Reporting Requirement to: (a) (b) replacing all extant FRSs, Statements of Standard Accounting Practice and Urgent Issues Task Force Abstracts with a single FRS, an adapted version of the IFRS for SMEs ; and introducing a reduced disclosure framework for the financial reporting of certain qualifying entities. Invitation to Comment 1.5 Section 7 of this paper invites constituents to comment on the impact of the possible solutions (identified in section 6) for their particular circumstances. It will help future decision-making on this issue if constituents provide some context to their arguments e.g. by means of examples. 1.6 Some likely costs and benefits of the individual solutions are also noted in section 6. Constituent views on these are welcomed and will be helpful in arriving at the best way forward. 2 Scope 2.1 We believe that the following types of entities will be impacted by any decisions on the future of insurance accounting in the UK and RoI. (a) (b) Unlisted life and general insurance companies and subsidiaries of listed companies that comply with UK GAAP. All these companies currently apply UK GAAP, including Financial Reporting Standard (FRS) 27 Life Assurance and the Association of British Insurers (ABI) SORP 2. Any changes to insurance accounting requirements under UK GAAP will have a direct impact on insurance accounting by these reporting entities in the short and long term. Listed consolidated insurance companies, some of their subsidiaries, and unlisted insurance companies 3, that prepare financial statements in accordance with IFRS. 2 The reference to the SORP and ABI SORP in this paper are to the Statement of Recommended Practice (SORP) issued by the Association of British Insurers (ABI) 3 Listed consolidated groups are required to prepare financial statements in accordance with IFRS as adopted in the EU. Some unlisted insurance companies have elected to apply IFRS as permitted by the member state option. Page 2 of 15

IFRS 4 currently grandfathers in the reporting entities pre-existing insurance accounting practices so long as they meet certain parameters, although it also allows improvements. By default, this group of reporting entities are currently applying FRS 27 and/or the ABI SORP. Any changes to insurance accounting requirements under UK GAAP will impact accounting for insurance contracts by these reporting entities in the short term, to the extent that their accounting refers to FRS 27 and/or the ABI SORP. 3 Current insurance accounting and regulatory requirements UK GAAP Requirements 3.1 Currently, UK GAAP has one dedicated SORP, issued by the ABI, providing comprehensive accounting guidance for insurance business, both life and non-life. The accounting standard, FRS 27, sets out specific accounting requirements for entities engaged in the with-profits business. 3.2 FRS 27 was implemented after the criticism of insurance accounting in the UK by the Penrose report on Equitable Life, issued in 2004. At the time, the only precedents for insurance accounting were the regulatory requirements applicable to all insurance companies. As a result, the requirements in FRS 27 and the ABI SORP are largely based on, and at times refer directly to, the current regulatory rules (the Financial Services Authority s (FSA) realistic capital regime and Solvency I). IFRS 4 Requirements 3.3 UK listed insurance groups are required by European Regulation 1606/2002 to produce their financial reports in accordance with IFRS. IFRS 4 sets out the accounting requirements for insurance contracts under IFRS. IFRS 4 was issued in 2004 as a first step towards a comprehensive IFRS on insurance accounting. At the time of issuing IFRS 4, the IASB stated that the complete recognition, measurement and presentation requirements for insurance contracts would be produced in Phase II of the IASB s insurance accounting project. 3.4 As a result, IFRS 4 grandfathers a number of accounting practices that were common in the market at that stage (e.g. on the measurement of insurance Page 3 of 15

liabilities), and largely permits entities to continue with their existing accounting practices or make changes that render the financial statements more relevant and no less reliable or more reliable and no less relevant, whilst at the same time largely exempting them from the criteria in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors 4. One significant change however was to define more narrowly contracts qualifying as insurance contracts; many others are accounted for as financial instruments under IFRS. 3.5 As a result, UK listed insurance groups are largely applying the requirements of FRS 27 and the ABI SORP although some have made improvements to their accounting policies, as permitted by IFRS 4. A number of users surveyed by ASB staff commented on this lack of consistency in accounting practice between comparable companies, stating that it erodes the confidence placed by users on financial reports issued by insurers. 3.6 Once the IASB has finalised and implemented its proposals for IFRS 4 Phase II and these have been adopted in Europe, the listed groups would be required to comply with that standard leading to greater consistency of financial information produced by the listed insurers. 4 Pipeline changes to insurance accounting and regulatory requirements Status of IFRS 4 Phase II 4.1 The IASB project on accounting for insurance contracts has been on-going for a number of years. During 2008, the project was added to the list of projects that the IASB was jointly undertaking with the US Financial Accounting Standards Board (FASB). Subsequently, the IASB published an exposure draft of its proposals in 2010 which was issued by the FASB as a discussion paper in the US. Comments from respondents to that document were discussed jointly by the IASB and FASB with a view to taking joint decisions. However, based on the tentative decisions by the two Boards to date, it is clear that differences still exist and unless resolved prior to the finalisation of the standard would lead to different accounting standards being issued. 4 Paragraphs 10-12 of IAS 8 sets out these criteria which requires that: accounting policies developed by management should result in information that is relevant and reliable; and should adhere to the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the IASB s Conceptual Framework for Financial Reporting. Page 4 of 15

4.2 One consequence of these discussions is that the tentative decisions made appear to suggest that, in some respects, the requirements in the final standard may be significantly different from those proposed in the ED. Another consequence is that the IASB s work plan 5 indicates that it would re-expose its proposals or issue a consultation document in the form of a staff draft during the second quarter of 2012 for further comments by constituents. This would indicate an optimistic publication date for the new IFRS of end of 2012 in the case of a staff draft and rather later (because of due process requirements) for a re-exposure. 4.3 However, the final publication date could be delayed even more depending on how much weight the IASB places on insurance contracts as a priority convergence project with the FASB. The FASB has yet to expose its proposals in the US and disagrees on a number of critical areas with the IASB. The IASB might re-expose its revised proposals at the same time as the FASB, and seek to eliminate areas of significant differences between the two Boards before issuing the final standard. Under this scenario, it seems doubtful whether an IFRS will emerge until well into 2013 at the earliest. This and other standard development work is likely to have a consequential impact on the implementation date of the final standard. 4.4 One such related standard development project is the IASB s work to replace IAS 39 Financial Instruments: Recognition and Measurement. To date this has resulted in new classification and measurement requirements in IFRS 9 Financial Instruments but not as yet a comprehensive new standard, because work on impairment and hedge accounting are on-going. This standard is clearly important to insurers give the asset/liability matching underpinning their business models. Here also, convergence with US GAAP has been hard to achieve. The IASB s current work plan does not commit it to finalising IFRS 9 as a comprehensive standard before the end of 2012. The IASB also issued an exposure draft in August 2011 proposing to delay the effective date of IFRS 9 from 2013 until 2015, partly in recognition of the interaction with IFRS 4 s replacement. This would indicate 2015 as the earliest possible effective date for IFRS 4 Phase II as well. In addition, during November 2011 the IASB tentatively decided to consider making targeted improvements to IFRS 9, acknowledging the interaction with insurance accounting. 5 Dated 20 December 2011. The IASB work plan can be accessed via its website here http://www.ifrs.org/current+projects/iasb+projects/iasb+work+plan.htm Page 5 of 15

4.5 However, the actual implementation date for IFRS 4 Phase II could be even further away if issuance of IFRS 4 Phase II is delayed to 2013 or 2014. That would possibly indicate effective dates as far away as 2016 or 2017. 4.6 There is another factor that can potentially further delay the adoption of IFRS 4 Phase II in the UK. The adoption of the revised IFRS 4 by the European Commission could take anywhere between nine months to several years after the final standard is issued by the IASB. This process could hypothetically add several years to the actual date on which the standard becomes effective for use in the EU. Interactions between IFRS 4 requirements and provisions of the European Directives 4.7 The provisions of the European Insurance Accounts Directive (IAD) (91/674/EEC) are applied in the UK in the Companies Act 2006, specifically in Schedule 3 of SI 2008/410 The Large and Medium-size Companies and Groups (Accounts and Reports) Regulations 2008. The Regulations prescribe the basis of measurement of insurance technical provisions, including: (a) (b) long-term business provisions must be determined with due regard to the actuarial principles laid down in Directive 2002/83/EC. (Solvency I basis) general insurance claim liabilities cannot be discounted unless the period between claim and settlement is greater than four years. This requirement directly contravenes the discounting requirements that were included in the IASB s ED for insurance contracts and which are expected to be carried forward to the final standard. 4.8 In addition, the IAD prescribes formats for the accounts of insurance companies that may conflict with the presentation requirements of IAS 1 Presentation of Financial Statements and IFRS 4 Phase II; for example, presentation of the income statement and of unit-linked assets and liabilities. 4.9 There are likely to be other requirements in the directive and Companies Act 2006 that would need to be considered before a decision on the future accounting for insurance companies can be finalised. Page 6 of 15

Solvency II 4.10 The Solvency II regime represents a huge step change in how insurance companies are regulated. These requirements are currently being drafted and many of the details have yet to be finalised. However, once it is implemented, it is expected to replace the FSA s realistic capital regime and the basis of measurement of long-term business provisions in the IAD and Companies Act 2006 will cease to exist. 4.11 Solvency II is now likely to be effective for European insurance companies from 1 January 2014, as announced recently by the FSA 6. Interaction between IFRS 4 Phase II and Solvency II 4.12 The starting points for IFRS 4 Phase II and Solvency II had commonalities so that the development of both initially followed a similar path. Up until the IASB s 2010 ED on insurance contracts was issued there were few differences between proposals in IFRS 4 Phase II and those being considered for inclusion in the Solvency II regime. One of the main areas of difference related to the treatment of day 1 gains on recognition of an insurance contract, Solvency II permits it but IFRS 4 Phase II is likely to require deferral of these gains with recognition over time. 4.13 However, more recently the Solvency II requirements have been developing at a faster pace than those for IFRS 4 Phase II and other differences are emerging. As a result, it is a distinct possibility that the final regulatory requirements and the requirements in IFRS 4 Phase II will be significantly different (see appendix A). 5 The Gap in UK GAAP 5.1 The ASB s proposals on the future of UK GAAP were published in the FREDs 46, 47,48, issued on 30 January 2012. 6 FSA s announcement can be found here http://www.fsa.gov.uk/pages/about/what/international/solvency/policy/index.shtml Page 7 of 15

5.2 In the FREDs the ASB proposes: (a) (b) replacing all extant FRSs, Statements of Standard Accounting Practice and Urgent Issues Task Force Abstracts with a single FRS, an adapted version of the IFRS for SMEs ; and introducing a reduced disclosure framework for the financial reporting of certain qualifying entities. 5.3 The ASB has proposed that draft FRS 102 Financial Reporting Standard applicable in the UK and Republic of Ireland, when finalised, will not include requirements on accounting for insurance contracts, instead referring to the IFRS 4 requirements. This would mean that when IFRS 4 Phase II is implemented by the IASB and adopted by the EU, it can be adopted under UK GAAP using the same reference without the need for further amendments to UK GAAP. 5.4 However, until then the shortcomings of the current version of IFRS 4 (highlighted in section 3 above) mean that entities will still need to grandfather their existing accounting policies for measurement of insurance contracts (unless they choose to amend these) until IFRS 4 Phase II can be adopted. 5.5 As already mentioned, current UK GAAP is based on FSA s realistic capital regime (largely based on Solvency I). The implementation of Solvency II in 2014 will render it obsolete. As a result, there is likely to be a gap in the accounting requirements for insurance contracts under UK GAAP until IFRS 4 Phase II becomes effective. Given the current IASB timetable and the time it takes for EU adoption this gap could be between two and seven years. 5.6 The next section explores a number of possible solutions. 6 Possible Solutions 6.1 This section outlines the long-term solution for accounting for insurance contracts under UK GAAP. It also highlights a number of possible solutions that could be used to bridge the gap in accounting for insurance contracts until the long-term solution can be implemented. Page 8 of 15

The Long-Term solution - Incorporate the requirements of IFRS 4 Phase II into UK GAAP 6.2 When finalised, IFRS 4 Phase II will set out comprehensive requirements for accounting for insurance contracts in IFRS for the first time. Once IFRS 4 Phase II is adopted by the EU, is also the ASB s preferred long-term solution under UK GAAP. As mentioned in section 5 above, this is currently envisaged by the inclusion of references to IFRS 4 in draft FRS 102, although in practice the ASB would consult its constituents before implementing IFRS 4 Phase II. 6.3 The requirements in the IFRS for SMEs, which forms the basis of draft FRS 102, were not written with insurance companies in mind. This is because the IASB has taken the view that all insurers are publically accountable and should apply full IFRS. The IFRS for SMEs also does not cover insurance contracts issued by non-insurers, and relies instead on guidance on the selection of accounting policies in which management may consider the requirements and guidance in full IFRS. As a result, the IFRS for SMEs (and consequently the draft FRS 102) is unlikely to adequately deal with insurance contracts. 6.4 The incorporation of references to IFRS 4 Phase II into draft FRS 102 also complies with the ASB s overall aim to maintain consistency with international accounting standards, unless an alternative solution better meets its objective of high-quality, understandable financial reporting proportionate to the size and complexity of the entity and users informational needs. 6.5 The alternative to this approach would be to develop a comprehensive UK specific alternative to IFRS 4 Phase II. The cost of establishing a UK specific alternative is likely to be heavy for preparers as well as users. In the long term, this approach would mean that recognition, measurement or reporting under UK GAAP by insurers may be significantly different to that for IFRS reporters. This would also make it difficult for users to compare results of listed companies to those of unlisted ones (ones issuing debt or those looking to make the move to becoming listed on a regulated market). Possible solutions for the gap period 6.6 The gap period represents the period between the implementation of Solvency II (which will render the requirements of FRS 27 and the ABI SORP obsolete) and IFRS 4 Phase II being adopted in UK GAAP. As noted above, this period is likely to be a minimum of two years and could be up to seven years. Page 9 of 15

There are a number of ways that accounting for insurance contracts could be dealt with during this gap period. I Incorporate the current version of IFRS 4 into UK GAAP 6.7 This solution would be achieved by dispensing with both FRS 27 and the ABI SORP, and instead requiring the use of the current IFRS 4. This solution is included in the ASB s current proposals (see section 5 and draft FRS 102). 6.8 This approach would enable insurers to grandfather existing accounting practices and then also to make improvements, as permitted by IFRS 4 (mentioned in section 3 above). This approach also reduces the standardsetting resource requirements. 6.9 For preparers, this approach may require additional work for companies not currently applying FRS 26 Financial Instruments: Recognition and Measurement, such as, considering the application of the insurance contract definition in IFRS 4 and how it applies to the contracts in the preparer s portfolio, writing accounting policies for measurement of insurance liabilities, etc. The experience of first time IFRS adopters in 2005 suggests that considerable implementation time may be needed by insurers in making these changes. It would enable preparers to take advantage of the option under IFRS 4 to make improvements in their accounting policies. 6.10 From a users perspective this approach comes with a potential cost of reduced comparability and the consequences of even more inconsistencies creeping into financial reporting by insurers (e.g. when they adopt differing accounting policies) than is currently the case. None of the users surveyed by ASB staff in advance of publishing this paper opted for this option, describing it as the least desirable from their current experience of adoption by listed companies. II Embed the relevant rules of FSA s Realistic Capital regime into UK GAAP 6.11 Under this option the ASB would retain FRS 27 and the ABI SORP as part of UK GAAP. Both would then be re-written so that rather than referring to the rule numbers in the FSA s Realistic Capital regime, the actual rules will be embedded into FRS 27 and the ABI SORP. Page 10 of 15

6.12 This approach would also require further work by both the ASB and the ABI, involving consultation and some re-deliberation to ensure the requirements continue to be relevant for UK and Irish insurers. 6.13 This approach would limit the burden for users and preparers by retaining the status quo during the gap period. However, if the gap period extends beyond a couple of years then preparers will likely suffer an additional burden in terms of producing financial information based on an obsolete regulatory regime which may be significantly different to the information they produce for solvency purposes. 6.14 For users of financial statements, this approach would facilitate continued consistency in reporting, although based on an outmoded regulatory basis. This option also precludes the incremental adoption of improvements that would otherwise be available under IFRS 4. III Update FRS 27 and the ABI SORP for Solvency II requirements 6.15 Under this option the requirements in FRS 27 and the ABI SORP will be changed so that rather than references to the FSA s realistic capital regime rules the requirements would refer to the relevant Solvency II requirements. 6.16 This option could entail additional work by the ASB and the ABI as well as requiring further consultations. This is because Solvency II, although dealing with the measurement of the balance sheet elements, does not currently address income recognition issues for insurance contracts, e.g. it permits day 1 gains to be recognised, etc. More generally, Solvency II is not geared to meeting the needs of investors to understand and compare the financial performance of insurers (either between them or with other industries). It focuses instead solely on the need for prudential supervisors to consider whether policyholders are protected. Solvency II also says nothing about any presentation issues, including the very significant ones that the IASB and its constituents have spent much time addressing such as what should be reported as revenue and whether anything should be taken through the Other Comprehensive Income (OCI). 6.17 If this approach is adopted then work would need to begin on updating the FRS 27 and the ABI SORP as soon as the requirements of Solvency II are finalised which might not be before the end of 2012. This could mean that the period available for transition to this new standard may be as short as three to Page 11 of 15

six months. As a result, transition to UK GAAP in 2015 may be difficult (but not impossible) to achieve 7 with this option. 6.18 This approach has the significant advantage of offering reporting entities a common base from which to develop their accounting and regulatory numbers. 6.19 From both the user and the preparers perspective, this approach would not preclude further changes in accounting requirements once IFRS 4 Phase II is implemented (if this is accepted as the long-term solution). This is because there are likely to be differences between Solvency II and IFRS 4 Phase II (see the summary in Appendix A). 6.20 From the users perspective this approach would mean that the quality of financial information increases (as it would be based on up-to-date requirements that include defined measurement bases for the assets and liabilities). This approach will also ensure that, to the extent that the insurance companies comply with the UK GAAP requirements, financial information is prepared on a consistent basis. IV Incorporate IFRS 4 Phase II into UK GAAP 6.21 This option would entail adoption of IFRS 4 Phase II into UK GAAP as soon as it becomes available as part of draft FRS 101 and 102 (perhaps adapted as appropriate to recognise the different requirements of unlisted insurance companies in the UK and Irish context). This approach also opens up the possibility of the ASB adapting the presentation and disclosure requirements to those appropriate for UK companies. 6.22 Failing the availability of the final standard in time, this option would look to adapt the requirements of the most recent due-process document e.g. a ballot draft or an ED for implementation into UK GAAP. 6.23 For both preparers and users, the advantage of this approach is that accounting requirements for insurance contracts change only once, rather than the two-step approach of some of the other solutions listed above (assuming that IFRS 4 Phase II is the long-term solution for UK GAAP and IASB makes no substantial changes after the issuance of the next due process document). 6.24 From the users perspective, this approach delivers better quality financial reporting and enhanced consistency of financial reporting across all insurance 7 As a comparison, the work on FRS 27 took nine months to complete. Page 12 of 15

companies complying with the UK GAAP requirements (whether listed or unlisted). 6.25 A difficulty for preparers would arise from the short implementation timetable, leading to issues around resource constraints and increased costs of implementation. Indeed, it is possible that a suitable due-process document (either a final review draft or an Exposure Draft outlining the full recognition, measurement and disclosure requirements) would not be available from the IASB in time to ensure full consultation with constituents in UK and The RoI. 6.26 Another difficulty is that either (i) the IASB may make changes to the requirements in the due-process document before issuing the final IFRS or (ii) that the IFRS is not adopted in full for use in the EU 8. Corresponding changes made to maintain consistency of the UK standard would lead to additional changes for UK companies complying with the requirements at that stage. 6.27 Further, this option would require insurers applying UK GAAP to apply IFRS 4 Phase II ahead of insurers applying IFRS, adding to their resource requirements as well as reducing comparability between the two groups of companies. 7 Next steps and Invitation to Comment 7.1 This is an opportunity for constituents to make suggestions and share views at an early stage on the potential short and long-term solutions for accounting for insurance contracts under draft FRS 102 and permit reduced disclosures in accordance with draft FRS 101. Please send all comments to asbcommentletters@frc-asb.org.uk by 30 April 2012. 7.2 Constituents are invited to comment on the impact of the possible solutions (identified in section 6) for their particular circumstances. It will help future decision-making on this issue if constituents provide some context to their arguments e.g. by means of examples. 7.3 Some likely costs and benefits of the individual solutions are also noted in section 6. Constituent views on these are welcomed and will be helpful in arriving at the best way forward. Please tailor your answers to the questions in the following paragraphs. 8 The European Commission has only ever once not adopted an IFRS in full, when in 2005 it carved out certain requirements from the hedge accounting sections in IAS 39 Financial Instruments: Recognition and Measurement. Page 13 of 15

Long-term solution 7.4 Do you agree that the long-term solution for accounting for insurance by reporting entities in the UK (listed and unlisted) is to incorporate IFRS 4 Phase II into UK GAAP, when issued by the IASB and adopted for use in the EU? Short-term solution 7.5 When providing comments on the short-term solutions please comment on: (a) whether you agree that all aspects of the problem have been identified? If not, what is missing and how do you see it impacting the accounting for insurance contracts? (b) what is your preferred solution (whether one of those set out in section 6 above or not) for insurance accounting in the UK during the gap period? (c) (d) what is the your rationale for proposing that solution, including the balance of cost and benefits? what is the likely impact of any changes in accounting for insurance contracts under UK GAAP on the entity you have in mind. It would be helpful if your response clarifies the current position of the reporting entity you have in mind (listed, unlisted, reporting in accordance with IFRS/grandfathering/own accounting policies/uk GAAP/other). Page 14 of 15

APPENDIX A SUMMARY OF THE MAIN INCONSISTENCIES BETWEEN IASB ED INSURANCE CONTRACTS AND SOLVENCY II (as of November 2011) Topic IFRS 9 Solvency II 10 Scope & Definition Investment contracts excluded except for those having discretionary participation features All contracts issued by an (re)insurance undertaking Insurance contract defined Unbundling of account balances, embedded derivatives and goods and services required No definition of insurance contract No unbundling required Recognition Model Date coverage begins (plus onerous contract test) Party to contract Measurement Model Current fulfilment value Current exit value Contract boundary Cash flows Wider definition based on providing coverage / conferring substantive rights to policyholders Incremental at portfolio level (including direct, incremental acquisition costs) Narrower definition based on terms amended to fully reflect risk Prescribed (and excluding acquisition costs which are expensed as incurred) Discount Rate Top down or bottom up Prescribed (Bottom up) Risk Adjustment Residual Margin No prescribed method (three techniques permitted) Margin to eliminate gains at inception (update for certain subsequent changes) Prescribed (percentage of cost of capital) No margin 9 IFRS based on the IASB Exposure Draft and tentative views expressed in IASB s meetings to November 2011 10 Solvency II based on QIS 5 and some current matters being discussed by the European Commission Page 15 of 15