Insurance Contracts IFRS 4

INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA

IFRS CERTIFICATION TRAINING PROGRAMME

Segun Ilori FCA

Contents

• IFRS 4 Background– Major issues covered in the first phase

• Scope• Insurance Contracts new definition• Contracts not recognised as Insurance contracts• Income recognition• Changes in Accounting policies• Waivers under IFRS 4• Acquisition of Insurance entities

Contents

• Deferred acquisition cost• Liability adequacy test

– Loss reserving – Actuary’s role– Discounted cash-flows

• Phase II overview• Disclosures

• Case Studies and Reference materials– IFRS FAQs

• References

IFRS 4 Background

IFRS 4 Background• The IASB issued the first standard on insurance contracts in 2005. Prior to

now, insurance accounting practices follow the provisions of the local GAAP, SAS 16 (in Nigeria) and other applicable SORPs in other jurisdictions, particularly, The Association of British Insurers(ABI) SORPs. Some of the provisions of SAS 16 are in tandem with the ABI SORPs.

• The standard seeks to make limited improvements to insurance accounting practices and also provides users with an insight into the grey areas in accounting for insurance contracts such as liability estimation.

• The standard also applies to financial instruments with discretionary participating features.

Scope

• Entities that issue policies that fit into the new definition of insurance and reinsurance contracts are to apply IFRS4.

• The standard also applies to financial instruments with discretionary participating features, IFRS 7 also applies to such financial instruments.

• IFRS 4 does not cover other assets and liabilities of an insurance entities, such as financial assets and liabilities which are more specifically covered under IAS 39.

• There are new disclosure requirements for insurance contracts, including profiles of future cash-flows.

Definition of Insurance Contracts

What is insurance contract ?

• “An insurance contract is signified by acceptance of significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event)adversely affects the policyholder. “ – Key phrases

Significant insurance risk Compensation

Uncertain future event

Adverse effects on

policyholder

Insurance and Financial risks differentiated

• In contrast to insurance risk, financial risk is the risk of possible change in one or more of the following:– Interest rate– Foreign exchange rate– Commodity price– Price index– Credit rating – Credit index– Financial instrument rate; and – Other variableProvided in the case of nonfinancial variable that the variable is not

specific to a party to the contract.

Insurance and Financial risks differentiated

• IAS 39 covers policies that transfer no significant insurance risks and the principal risk components are financial risks as stated above.

Some examples of Insurance Contracts

• Property or material damage• Business interruption consequent upon material damage• Product liability, professional indemnity, third party

liability and legal expenses or legal protection insurance• Life insurance, life-contingent annuities or pensions• Product warranties, provided the warranty is issued by

another party for goods sold by a manufacturer, otherwise, IAS 18 and IAS 37 will apply.

• Reinsurance contracts

Contracts not recognised as Insurance Contracts

Contracts not classified as insurance Contracts

• Investment contracts with no significant insurance risk (for example, life policies with no significant mortality risk)

• Credit guarantee that engages Insurer’s liability if a debtor defaults notwithstanding whether the policyholder has incurred a loss.

Income recognition.

Changes in income recognition??

• Income recognition bases have not changed for insurance contracts. However, reclassification (unbundling) of contracts will impact revenue for both short-term and long-term insurance contracts

• Annual accounting is still the recommended accounting treatment for all kinds of insurance business, deferred annual accounting has been outlawed in some jurisdictions, while the funded basis became acceptable for 2, 3 or 4 year funds: only in restricted circumstances.

Insurance and deposit components

• Unbundling the components:– Scenarios

• Compulsory unbundling• Permitted but not compulsory• Prohibited

Unbundling scenarios

Insurer can measure deposit component

Insurer’s accounting policies do not otherwise require it to

recognise all rights and Obligations arising from

deposit component

Compulsory Unbundling

Unbundling scenarios

Insurer can measure deposit

component

Insurer’s accounting policies require it to recognise all rights

and obligations arising from deposit components regardless

of the basis used to measure the rights and obligations

Unbundling permitted but

not compulsory

Unbundling scenarios

Insurer cannot measure deposit

component

Unbundling is prohibited

•Concessions in IFRS 4•Changes in Accounting Policies

Concessions

• IFRS 4 permits temporary waiver of full compliance with the criteria for selecting accounting policies (where no specific IFRS is available) relating to insurance contracts. IAS 8 specifies the criteria but the overarching principle is that of reliability and relevance of the financial statements.

• IFRS 4 forbids an insurer to introduce the following accounting practices but can continue using policies that involve them: – Measuring insurance liabilities on a non-discounted basis;– Measuring contractual rights to future investment management

fees at an amount that exceeds their fair value; and– Using non-uniform accounting policies for the insurance liabilities

of a subsidiary

Concessions cont’d

• Key learning points– Insurers can apply current market rate as against risk-free rate to

value liabilities, thus the liabilities at par with movements in attaching assets that are interest sensitive;

– The above treatment may not generally apply to all liabilities except those liabilities with assets that are sensitive to market interest rate;

– Insurers can neither eliminate excessive prudence nor introduce additional prudence where current practice is sufficiently prudent;

– Insurers cannot adjust for future investment margins in liabilities estimation except there is a switch to a comprehensive investor-based accounting

Concessions cont’d

• Not withstanding the temporary waiver in the application of IAS 8, an Insurer:– shall not recognise as a liability any provisions for possible future claims, if

those claims arise under insurance contracts that are not in existence at the end of the reporting period (such as catastrophe provisions and equalisation provisions).

– shall carry out the liability adequacy test as prescribed by the standard– shall not remove an insurance liability (or a part of an insurance liability)

from its statement of financial position until it is extinguished, that is when the obligation specified in the contract is discharged or cancelled or expires.

– Shall not offset reinsurance assets against insurance liabilities or income or expense of reinsurance contracts against related income or expense of insurance contracts; and

– Shall test for impairment of reinsurance assets

Acquisition of Insurance entities

Business combinations• An insurer entity may acquire another entity in part or whole, or the

portfolio of another insurance entity such as a composite company acquiring the life portfolio of another insurer.

• The standard provides for the assets and liabilities to be measured at fair value,

• An insurer may adopt split accounting which measures liabilities in line with current accounting policies and the attaching insurance assets on fair value.

• Insurers can recognise intangible asset, that is the difference between the fair value and book value of liabilities assumed by the acquiring entity. Such intangible asset is excluded from the scope of IAS 36 ( impairment of Assets) and IAS 38 (Intangible Assets)

Deferred Acquisition Cost (DAC)

Deferred Acquisition cost

Deferred acquisition

cost

•To be deferred against future revenue or investment margin•Insurer is required to test for recoverability annually

Cost not allowed for deferment

• Recurring commission except for renewal contracts.

• Recruitment of sales staff and agents• Advertising cost• Training and conferences• Product design cost

Deferred cost amortisation bases

• Expense immediately• Gross premium• Estimated gross profits over contracts life• Projection of fees collected over contract life

•Liability Adequacy Test (LAT)

Liability adequacy

• An insurance entity is required under IFRS4.15 to assess adequacy of its liabilities at the end of each reporting date. The import is to test whether its obligations to policy holders, excluding any attaching deferred acquisition cost and intangibles is adequate based on the estimated future cash-flows (including claims handling cost and embedded options and guarantees)

• If the test reveals a deficiency, such is charged to Profit and loss.

• Application of the test is at portfolio level provided the Insurance entity’s accounting policy meets the minimum requirements

Liability Adequacy

Type of claimClaim reserverequired

Common name ofreserve

Paid None NoneCase reserve Case reserveIBNER reserve

Not yet reported True IBNR reserve

Reported, not yetpaid IBNR reserve

(company-widereserve calculated byactuary)

U

ltim

ate

loss

• IBNER = Incurred but not enough reported; global adjustment to company-wide case reserves

• IBNR = Incurred but not reported

Adapted from paper presented at Loss Reserving Seminar, by Chye Pang-HsiangF.I.A., M.A.A.A. 16 January 2009

Best Estimate Claim Liability

Liability adequacy

• Loss reservingPremium written during the year

Earned Premium

Claims incurred

Reported and Paid

Reported not yet paid(movement)

Not yet reported (IBNR)(movement)

Unearned Premium

Outstanding Claims

PROFIT AND LOS S ACCOUNT

BALANCE SHEET

Liability adequacy

• Actuary’s role – The Actuary’s primary role is to determine the impact of reserve

studies on the balance sheet. Actuary estimates future claims and expenses

– Expenses include claims related expenses– In theory, also maintenance expensesThe Actuary applies a basic three building block approach to obtain fair

value of insurance liabilities.

Liability adequacy

• Discounted cash-flows

– The Building block approach• Explicit, unbiased, market-consistent, probability-

weighted and current estimates of contractual casf flows, (BLOCK 1)

• Current market discount rates that adjust the estimated future cash flows for the time value of money, (BLOCK2) and

• An explicit and unbiased estimate of margin that market participants require for bearing risk( a risk margin) and for providing other services, if any (service margin) (BLOCK 3)

Overview of Phase II• Discussions have centered on the move to fair values (also known as

prospective provisioning). This will bring an end to the deferral of acquisition costs and the spreading of premiums over the duration of the contract.

• Both premiums and expenses will be recognized immediately as a contract is signed, with the accounting focused on the present value of expected future cash flows. For example, on writing a new policy, all present and future expected cash flows will be recorded. The net present value (NPV) of relevant contractual premiums will be recorded as assets (and as premium income) whilst the future expected cashflows for claims and expenses will be discounted to their NPV and recorded as liabilities (and claims/expenses)

Overview of Phase II• In addition to reserving for the best estimate of the present value of

future cash flows, it is expected that insurers will also have to include a market value margin (MVM) on top. This margin aims to take total reserves to the level that would be sufficient to encourage a third party to accept the relevant liabilities and therefore represent a proxy for fair value in the absence of a liquid market.

Overview of Phase II• Conceptually straightforward in the case of non-life contracts where a single

premium is paid at the start of the contract.

• The concept is more complex for policies where premiums may be received over a long period (e.g. life assurance policies). The IASB has indicated that future premiums will be able to be recognized if policyholders have “non-cancellable continuation or renewal rights that significantly constrain the insurer’s ability to re-price the contract to rates that would apply for new policyholders whose characteristics are similar to those of the existing policyholder” and that “those rights will lapse if the policyholders stop paying premiums.” For example, insurers would typically charge lower premium rates on an existing life assurance policy compared with a new policy for an individual of the same age. Assuming that the definitions included above are met, the insurer would recognize the expected cash flows (including premium and payments) allowing for projected lapse experience

Disclosures

Disclosures• Detail information about insurance risk exposures, possible risk

concentration and the impact of changes in key variables on the key assumptions used;

• Information about amount, timing and uncertainty of future cash-flows• Terms and conditions of contracts that have material; effect on the

timing, amount and uncertainty of future cash-flows• Information about actual claims compared to previous estimates• Information about interest and credit rate risks in line with IAS 32,

Financial instruments Presentation;• Disclosure of gains and losses from purchasing reinsurance contracts

such as Profit commission.• Disclosure is not required of the fair value of their contracts for now

(see phaseII)

PRACTICAL INSIGHT A typical insurer's statement of financial position might comprise these assets and liabilities and be covered by the following IFRS: Assets IAS/IFRS Investments IAS 39Property IAS 16/40Investments contracts IAS 18Insurance contracts IFRS 4Other assets Various

Liabilities Equity IAS 32/39Insurance liabilities IFRS 4Investment contract liabilities IAS 39Other liabilities Various

Case StudyCASE STUDY

Facts Entity A writes a single policy for a N1,000,000 premium and expects claims to be made of N600,000 in year 4. At the time of writing the policy, there are commission costs paid of N200,000. Assume a discount rate of 3% risk-free. The entity says that if a provision for risk and uncertainty were to be made, it would amount to N250,000 and that this risk would expire evenly over years 2, 3, and 4. Under existing policies, the entity would spread the net premiums, the claims expense, and the commissioning costs over the first two years of the policy. Investment returns in years 1 and 2 are N20,000 and N40,000respectively. Required

Show the treatment of this policy using a deferral and matching approach in years 1 and 2 that would be acceptable under IFRS 4.

How would the treatment differ if a "fair value" approach were used?

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References• Understanding IFRS Fundamentals, Nandakumar Ankarath, Kalpesh J. Mehta,Dr. T.P. Ghosh and

Dr. Yass A. Alkafaji, wiley 2010

• Practical Implementation Guide and Workbook for IFRS, Third Edition, Abbas Ali Mirza and Graham J. Holt, Wiley 2011

• International Financial Reporting Standards. A practical guide, 5th Edition, Hennie Van Greuning, International Bank for Reconstruction and Development and the world Bank, 2010

• Loss Reserving Seminar, by Chye Pang-Hsiang F.I.A., M.A.A.A. 16 January 2009

• Excerpts from Fitch Ratings view on IFRS Phase I and II