Insurance Accounting NewsletterRefining divergent positions and a gleamof hope from IFRS 9 planned revisions

Issue 23 – December 2011

Introduction

Since our last newsletter, the International AccountingStandards Board (IASB) and the Financial AccountingStandards Board (FASB) continue to remain divided onthe fundamental issues of accounting for the uncertaintysurrounding insurance risk and the associated emergenceof profit from in-force business.

However, at its meeting on 15 November 2011 the IASBunanimously agreed to consider targeted improvementsto the classification and measurement requirements ofIFRS 9 “Financial Instruments” to address the issuesemerging from the accounting mismatches withininsurance businesses that the combined effect of IFRS 9and the new IFRS on Insurance Contracts could cause.

The Boards’ recent action arose from four meetings heldin September, October and November.

There was a meeting of the IASB Insurance WorkingGroup held on 24 October 2011 during which theindustry had the opportunity to formulate severalproposals which culminated in general support for anoption to use OCI for movement in certain assets andliabilities and, also, a proposal to amend IFRS 9requirements.

Whilst the debates have been at times particularly intense,the activity itself has resulted in limited progress asunsettled debates resurface. This newsletter covers thejoint meetings held on 19 September, 20 October and16 November as well as FASB meetings on 7 Septemberand 30 November. Nearly all the tentative decisionsfrom these meetings resulted in further refinements ofthe divergent positions which helped constituents intheir appreciation of the practical implications that eachmodel will have on their businesses. The IASB held itsown education session on residual margins on 15 November, whilst FASB held education sessionsbefore each of the above meetings.

Following the July revisions of the IASB Technical Plan,on which we commented in our previous newsletter,both Boards have now released their final planscovering their activity until the end of 2012. Thehighlights of the two plans are as follows:

• the target publication date of the final accountingstandard (both from an IFRS and a US GAAP standpoint)has now been pushed to beyond 2012; and

• the US GAAP exposure draft will be issued before theend of the first half of 2012.

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The IASB Technical Plan which was issued on 30 September now specifies that its next processdocument will also be issued within the same timeframeas the US GAAP exposure draft offering the potential toalign the final stages of the two standard-settingprocesses. The latest IASB plan retains the option to re-expose or to issue a “review draft”.

We have based our analysis of the Boards’ recentactivity on three themes:

• Accounting for uncertainty and profit (FASB meetingon 7 September, IASB meeting on 19 September andits education session on 15 November).

• Asset-liability accounting mismatch (Insurance WorkingGroup meeting on 24 October, IASB meeting on 15 November and FASB meeting on 30 November).

• Presentation and disclosures (joint meetings on 19 September, 20 October and 16 November).

For each theme we have added a reference to therelevant meetings on which we have already reportedvia our IASPlus news service(http://www.iasplus.com/agenda/insure2.htm) andInsurance Contracts Project Insight newsletters(http://www.iasplus.com/insight/insurancecontracts.pdf).

In addition, we have also added commentary thathighlights relevant extracts from our comments includedin the Deloitte Comment Letter on the 2010 ExposureDraft, Insurance Contracts (“ED”) as a means to showsome of the movement from the original ED comparedto our suggestions.

Accounting for uncertainty and profit

FASB refines its single margin model developingtwo separate profit earning approachesAt its meeting on 7 September, FASB reached a first setof important decisions that have provided its constituentswith a preliminary understanding of the alternative to thecurrent proposed IFRS model that FASB wishes to adopt.

Among these was the development of what is arguably atwo model approach for the recognition of profit frominsurance portfolios. FASB achieved this by deliberatingon how the single margin (composite margin in previouspapers) would be taken to profit or loss. The criteria thatinsurers will apply to account for their insurance contractsin one of the two approaches are the eligibility criteriathat the IASB and FASB failed to agree on at their jointmeeting last July to identify short duration insurancecontracts.

FASB Staff presented a comprehensive paper setting outits recommendation on the profit pattern that shouldbe adopted for short duration insurance contracts.Three options were set out:

• Option 1: retention of existing US GAAP withunearned premium liability and undiscounted claimsliabilities;

• Option 2: use of the unearned premium methodduring the coverage period with a two-building blockliability for the discounted post-claim cash flows (i.e. no margin added to claims liabilities); or

• Option 3: use of the unearned premium methodduring the coverage period with a single margin addedto the discounted claims liability based on the reducedvariability principle decided on 17-18 May 2011.

FASB Staff recommended that Option 3 be adopted,and in doing so, it provided examples to illustrate thethree options and the resulting profit pattern an insurerwould report in its financial statements. The Staff notedthat at the end of the coverage period there are smaller,compared to point of sale, but still significant variabilityof cash flows associated with the probability weighteddiscounted estimate of claims cash flows. Because ofthat characteristic, FASB Staff recommended thatinsurers should increase this liability by adding a singlemargin that captures the residual exposure to variabilityat the end of the coverage period. The Staff alsoexplained that it did not favour the retention of currentUS GAAP because, when material, the discounting ofclaims liabilities would be relevant financial information.

FASB members discussed extensively the principle ofearning the single margin over or beyond the coverageperiod. They rejected the Staff recommendation to earnthe single margin beyond the coverage period.

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Although a number of members had previously voted forthe single margin to be earned on the basis that allocatesit to the changes in the cash flow variability (see issue 21of this newsletter), they explained at this meeting theyhad voted with a reservation that such decision wouldnot apply to the short duration contracts. Furthermore,the debate on the short duration contracts eligibility lastJuly and at the October meeting (see further detailsbelow) highlighted that for FASB, this group of contractsshould be accounted for as what is arguably a separatemodel. The underlying principle of this earning approachis that the fulfilment of the stand ready obligation iscomplete when the coverage expires; any activity tosettle the incurred claims does not qualify as a provisionof service (some FASB members believe that this shouldalign more with the Revenue Recognition project).Instead it is “an expense optimisation activity”, as described by one of the FASB members. FASB viewsthe service of providing a “stand ready obligation” ascomplete once the insurer no longer has an obligationto take new claims under that policy even if it may takeseveral years to receive the notification and completethe settlement of the incurred claim.

During the debate, FASB Staff noted that its soundingsin the past few months suggested that users would notlike additional complexities introduced for the shortduration contracts accounting model which shouldremain as closely aligned as possible to US GAAP. FASBmembers noted that Option 2 appears to achieve thisobjective better than the other two options because itwould simply require a more transparent and principlebased claims liability measurement, i.e. the measure ofclaims liability using a discounted probability weightedcash flow estimate. As far as the cash flow variability isconcerned, FASB members noted that users would havethe information they needed by analysing the lossdevelopment tables provided in the financialstatements.

This decision gives a clearer view of the separate modelfor short duration contracts FASB has been pursuingsince May. It also increases the focus on developing aset of eligibility criteria that delivers a relevant andreliable basis for separating a sub-set of insurancecontracts. As noted above, another unsuccessfulattempt to achieve this took place at the October jointmeeting (commented in more detail below).

The fundamental difference with the IASB approach toaccount for short duration contracts is that the claimsliability for the IASB includes a remeasured riskadjustment liability that is released after the coverageperiod expires. Similarly to what was decided by FASBon the single margin approach, the IASB had decidedthat its approach would earn the residual margin overthe coverage period.

Accounting for a single margin approach – FASBgeneral principles for earning the margin under thebuilding blocks approachFASB Staff presented a comprehensive paper setting outits recommendation on the subsequent accounting andearning of the single margin under the building blocksapproach. The recommendation was based on theprinciple that the margin would be earned as theunderlying uncertainty of the probability weighted cashflows decreases – this was defined as the “variability ofthe cash flows of a specified uncertain future event”:

• for contracts where the variability is primarily due totiming, the release to profit would be based on thereduced uncertainty in the timing of the specifiedevent; and

• for contracts where the variability is primarily due tothe frequency and severity of the event, the release toprofit would be based on the reduced uncertaintythat follows the emergence of information about theexpected cash flows throughout the life cycle of thecontract.

The debate highlighted that these principles could applyto certain insurance contracts that are issued by non-lifeinsurers only if they are not captured under the eligibilitycriteria for short duration contracts. FASB thereforedetermined that it would be appropriate to approve bothcategories irrespective of the number of applicationpoints that these categories will have in practice.

The FASB chair commented that eligibility criteria arestill subject to debate and it is possible that some of theinsurance contracts that are currently issued by the non-life insurance industry may not be captured by theeligibility criteria for short duration contracts oncefinalised. In this case, the earning of the single marginwould follow the principle of the building block approach,with no separate measurement model between pre andpost claim accounting.

FASB supported unanimously the Staff recommendation.The application guidance was also approved unanimouslywhich included references to events that an insurerwould need to consider for the implementation of thetwo principles. Another area of application guidancethat the FASB approved unanimously was relating tothe points in the life cycle that should be considered forexamination in assessment of this decrease in the cashflow variability. The points should include among others:

• when an insurer incurs a claim that has not yet beenreported;

• when a claim has been reported;• when additional information becomes known;• when the parties to the contract have agreed to settle

the amount and;• when the claim is paid.

These are the typical phases of a claim cycle.

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Deloitte view on the accounting for the single marginThe FASB decision to abandon the basis for the accountingof the single margin published in the Discussion Paper inSeptember 2010 introduces two features that move ittowards the Deloitte recommendations set out in ourcomment letter: 1) the use of the cash flow variability torelease the single margin rather than a benefit and claimspayment approach is more reflective of the economics ofassembling and managing insurance portfolios and it linksthe release to income to the prospective changes in theexpected present value of future cash flows; and 2) theacceptance that variability of cash flows is common to thepre and post claim phases of an insurance portfolio andthe consequential requirement that only an integratedapproach to changes in the variability of cash flows acrossthe whole life of an insurance portfolio could produce arelevant and reliable release of the single margin toincome.

Our preference is for a risk adjustment and a residualmargin model. However we commented that theaccounting model for the residual margin and the singlemargin cannot be reliable if it does not recalibrate againstthe expected present value and if its release to income isbased on incurred benefits and claims over time:

“We believe that the residual margin should berecalibrated in subsequent reporting periods to reflectchanges in assumptions affecting the expected presentvalue of fulfilment cash flows. In essence, this means thatall prospective changes in building blocks 1 and 2 are firstoffset against any remaining residual margin. Actualexperience, i.e. the difference between cash flowsanticipated at inception and actual cash flows, would berecognised directly in profit or loss for the period.

“The systematic release of the residual margin is governedby paragraph 50 of the ED which requires that the residualmargin be amortised based on the "passage of time" orthe "expected timing of incurred claims and benefits" if itdiffers significantly from the passage of time. For many lifeinsurance products, the pattern of claims and benefits will,in fact, be substantially different from the passage of timebecause the probability of having to pay benefits tends toincrease in the later policy years. For example, whilst thedeath benefit under a whole life policy is often levelthroughout the life of the policy, the value of that benefittypically increases with duration as the probability ofdeath increases with age. As another example, most of thebenefits under a short-term endowment policy are paid atpolicy maturity. As compared to the "passage of time", anamortisation pattern based on the "expected timing ofincurred claims and benefits” will result in a substantialback-loading of residual margin amortisation. For thesereasons, we recommend that the Board modifiesparagraph 50 to require that the systematic residualmargin release be computed on the basis of passage oftime, or another rational basis.

“In addition, we believe that the proposal in the ED torelease the residual margin over the period of coverageunder the insurance contract establishes an arbitrarybright line. Instead, we recommend that the period for therelease of the residual margin be the combined coverageand claims handling period.”

The combined effect of the decisions for short durationcontracts and for contracts accounted for under thebuilding blocks approach produces two very differentprofit patterns for equivalent sets of cash flows with theformer being front ended in recognising profit and thelatter back ended.

In addition the earnings volatility for claims liabilities fromshort duration contracts could be substantial under theFASB proposals given the requirement to use a statisticalmean for the estimate of the expected present value ofcash flows with no margin carried forward from thepre-claim phase of the life of the portfolio.

The IASB refines its requirements for riskadjustment liabilitiesWithout FASB participation, the IASB at its meeting on19 September refined the measurement model for therisk adjustment by reaching three important decisions,one of which was against the Staff recommendation.

The first recommendation was to define the objective ofthe risk adjustment as the “compensation the insurerrequires for bearing the uncertainty inherent in the cashflows that arise as the insurer fulfils the insurancecontract”. The Staff also asked the IASB to ratify twoprevious decisions, the first of which was to include inthe final IFRS guidance on this objective using thefollowing example:

“The risk adjustment would measure the compensationthat the insurer would require to make it indifferentbetween (1) fulfilling a liability that has a 50 per centprobability of being 90 and a 50 per cent probability ofbeing 110 or (2) fulfilling a liability of 100.”

The second decision the Staff asked the IASB to ratifywas that an insurer should perform the risk adjustmentcalculation considering both favourable and unfavourableoutcomes within the probability distribution of theexpected cash flow estimates. The IASB approved theserecommendations unanimously.

Deloitte view on the objective of the risk adjustmentWith these decisions the IASB has adopted therecommendations from our comment letter and it hasintroduced language to confirm the neutrality in theassessment of the additional liability that captures thestatistical uncertainty that surrounds the mean used tocalculate the probability weighted net present value offuture cash flows and to reinforce the entity specificnature of the assessment which should link the process tothe particular risk appetite of the reporting insurer.

The IASB has also agreed with the Deloitterecommendation to include an illustrative example toclarify circumstances under which the risk adjustmentwould be zero.

The second recommendation from the Staff was toremove the requirement from the ED to disclose theequivalent confidence interval percentage that would bederived from re-computing, using the confidence intervaltechnique, all risk adjustment liabilities calculated with adifferent technique. This was a disclosure requirementthat many commentators, including Deloitte,recommended to be removed. However, the IASB wasuncomfortable with the Staff’s proposal and rejected itbecause its retention would offer a disclosure referencethat could assist investors in comparing differentinsurers. Only 4 Board members out of 15 were infavour of the Staff’s recommendation.

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The third recommendation was to remove therequirement from the ED that the risk adjustmenttechnique has to be chosen from the three techniques ofconfidence interval, cost of capital and conditional tailexpectation. The Staff recommended that these techniquesand the associated application guidance are retained asexamples only. The majority of the IASB was supportiveof the Staff’s recommendation although a few Boardmembers voiced the concern that this would make theIFRS liabilities less comparable (12 in favour, 3 against).

It appears that many of the IASB members believe thatthe previous decision on a disclosure that would requirea company to disclose an equivalent confidence intervalin instances where it has chosen to use another measurefor the risk adjustment would alleviate their concernson comparability. However, it would appear that thereis insufficient appreciation amongst some members ofthe IASB as to the difficulty, and potentially lack ofusefulness, in developing and showing equivalents.

IASB prepares for further refinements of its modelto unlock the residual margin liabilitiesThe IASB met on the 15 November for an educationalsession on residual margin. During the meeting, theIASB Staff presented the papers and asked the Board itsviews on certain questions without formally asking fordecisions to be taken. Although FASB Staff joined byteleconference, it did not participate in the discussionsas FASB prefers the route of a single margin.

The IASB discussed only two of the four papers tabledfocussing on the paper that presented the reassessmentof the June tentative decision to unlock against theExposure Draft’s position not to unlock and the paperthat attempted to answer the question “Which changesin estimate adjust the residual margin?”. The outcomeof this important test on the tentative decision tounlock reached last June could be summarised asfollows:

• a narrow IASB majority continues to support theconcept of unlocking the residual margin forassumptions that depend on non-financial variables.The balance of IASB members remain unconvinced thatthis decision would deliver benefits in excess of thecosts that the complexity of unlocking would create;

• there was an acknowledgement that both non-financial and financial variables affect certainassumptions (e.g. lapse rate assumptions) and morework would be required to establish whether theproposed split could be used to develop a reliableunlocking model; and

• the final decision on allowing financial variables withinthe unlocking model or not will be taken in parallelwith the targeted improvements on IFRS 9 that theIASB decided to consider at the same meeting.

Deloitte position on the compulsory disclosure ofconfidence intervalsThe statement from our comment letter continues to fullycapture the essence of this issue in our view:

“We believe clarification of paragraph 90 (b) of the ED iscritical because there are two incompatible interpretationsof this disclosure requirement: (1) when the Cost ofCapital (CoC) or Conditional Tail Expectation (CTE)methods are used to measure the risk adjustment, aninsurer must solve for what the confidence interval (CI)would be to arrive at the same result; or (2) if the CoC orCTE methods are used, an insurer must disclose theconfidence level used in those techniques. We believe thatthe basis for conclusion BC117 (c) confirms thatinterpretation (1) is what the IASB intended. On that basis,we do not agree with that disclosure requirement.

“The disclosure of how an insurer measures the riskadjustment should be sufficient to provide users withuseful and transparent information. We do not agree that the disclosure proposed in paragraph 90 (b) of the ED would enhance comparability because, as the Boardacknowledges, there are instances where the CLmethodology is not appropriate, and thus if the CoC orCTE were chosen as the most appropriate technique tomeasure a particular risk, it would be meaningless to then try to reproduce the same amount under a lessappropriate technique.

“Furthermore, there is currently limited experience inconverting CTE and/or CoC results into CL amounts and the resulting disclosures would likely be preparedinconsistently for a number of periods. For example,paragraph B82 of the ED refers to a risk such as anearthquake exposure – in that case the CoC and CLmethods would take into account the possibility of low-frequency high-severity losses in all but the extremetail of the probability distribution curve and it is likely thatinsurers would not deem them appropriate. It would bemeaningless to compare the resulting risk adjustmentcalculated using CTE (or another more relevant technique)to an “equivalent” risk adjustment using the CL technique.”

Deloitte view on the objective of the risk adjustmentThe IASB decision to remove the narrow choice on riskadjustment techniques adopts the Deloitte’srecommendation.

However retaining the three original techniques(confidence interval, conditional tail expectations or CTEand cost of capital) as examples of techniques should becoupled with an expanded application guidance to includethe characteristics that would indicate a high versus a lowpercentile for the Confidence Level and CTE techniques;and the characteristics that an insurer would need toconsider to determine a higher or lower amount of capitaland cost of capital rate for the Costs of Capital technique.

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Asset-liability accounting mismatch

Industry proposes its “OCI solutions” to the asset-liability accounting mismatchThe discussion around an “OCI solution” dominated theInsurance Working Group meeting on 24 October whentwo industry groups presented their views on how touse the OCI section of the Statement of ComprehensiveIncome to deal with the accounting volatility that thecombined effect of the new IFRS for insurance contractsand the requirements for financial assets under IFRS 9would produce.

OCI is the section of the Statement of ComprehensiveIncome that follows the net results after tax and it isused under IFRS to recognise all gains and losses thatan IFRS requires to be recognised outside the profit orloss of a reporting period.

The Hub Global Insurance Group and the EuropeanInsurance CFO Forum in conjunction with the ComitéEuropéen des Assurances (CEA) presented theirrespective proposals. These have several commonstatements. Both argued that the insurance businessmodel is one that unfolds over a longer period of timeand that the short term fluctuations of financialvariables that the current IFRS proposal require to berecognised in the profit or loss of an insurer do notaffect the actual cash flows from the assets thatinsurers need to settle their liabilities. Including thesegains and losses in the profit or loss of the periodobfuscates the underlying financial performance in thatperiod. Separating from the profit or loss those gainsand losses that are caused by such fluctuations wouldproduce more relevant performance information andleave the balance sheet unchanged from the currentproposals given that assets and liabilities would still beadjusted by those gains and losses albeit recognised viathe OCI.

The Hub Global Insurance Group’s proposal articulatedthe necessary amendments to IFRS as follows:

1. Introduce a category of “assets backing insuranceliabilities” that operates across all types of financialinstruments (i.e. both derivative and non-derivatives)and includes also real estate investments (i.e. investment properties). A second best optionwould be to reintroduce the “available for sale”category for non-derivative financial instruments;

2. Introduce the accounting option that would allow aninsurer to designate these assets to be accounted forat fair value through OCI or at fair value throughprofit or loss;

3. Apply to the relevant financial instruments at fair valuethrough OCI the impairment principles currentlydeveloped for financial assets at amortised cost.Develop impairment principles for equity instrumentswhen measured at fair value through OCI;

4. Require the “recycling” through profit or loss of gainsand losses initially recognised in OCI on the groundsof realisation and impairment decisions;

5. Reflect through OCI all subsequent changes to theinsurance liabilities that are caused by the alignment ofthe initial discount rate to the level of current marketinterest rates. The interest expense from insuranceliabilities would be based on the discount rateselected at the initial recognition of the liability; and

6. Require the “recycling” through profit or loss of gainsand losses initially recognised in OCI when insuranceliabilities are derecognised and when options andguarantees embedded in the insurance liabilities are“in the money” (i.e. current market interest rateshave fallen below a minimum guaranteed ratefeature embedded in an insurance liability).

The European CFO Forum proposals were supportive ofa principle that allows the designation of assets to beaccounted for at fair value through OCI but were not asdetailed as those summarised above. Instead they werelimited only to the discussion of how the amendmentsto IFRS would apply to different types of policyholder’sparticipation features.

The European CFO Forum noted that there are broadlytwo forms of policyholder’s participation commonlyfound in the insurance market and that these wouldrequire different types of “OCI solutions”.

One form of participation would use the principle ofrealised gains and losses to distribute surplus betweenthe insurer and its policyholders (defined as “continentalstyle” participation). In this case the Hub GlobalInsurance Group’s proposal would operate effectively.

Deloitte view on the unlocking of the residual marginThe statement from our comment letter captures ourposition on this issue:

“We therefore recommend that if an insurer measures therelated financial assets at amortised cost, it shouldrecalibrate the residual margin at each reporting date anduse the prospective changes in the building blocks todetermine the subsequent measurement of the residualmargin component of the insurance liability, afterdeducting the systematic release.

“The final IFRS should also require that when a portfoliobecomes onerous, the insurer must release to profit or lossany remaining aggregate residual margin in full or in part(to the extent needed).

“We also recommend that if an insurer measures therelated financial assets at fair value through profit or loss,it should remove from the recalibration of the residualmargin financial variables like interest rate risk, thusallowing the change in discount rates caused bymovements in market interest rates to flow directly toprofit or loss.”

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Another form of participation uses the principle ofexpected long term asset return to determine the amountthat is credited to policyholders and, at the same time,the amount distributed to shareholders in a given period(defined as “UK-style” participation). This participationmechanism would not operate effectively with the HubGlobal Insurance Group’s proposal.

The European CFO Forum key recommendation was forthe IASB to reflect this fact in the consideration of itsadoption of an “OCI solution”.

IASB unanimously decides to reopen IFRS 9 toaccommodate insurers’ asset-liability mismatchSome may remember the opening remarks of the thenchairman of the IASB, at one of the 2010 InsuranceWorking Group meetings when he stated that the IASB was not planning to reopen IFRS 9 to address thefinancial reporting issues of insurers.

At its meeting on 15 November the IASB, under thechair of Hans Hoogervorst, unanimously decided toconsider targeted improvements to IFRS 9 which would,among other things, address the issues from asset-liability mismatches that would affect insurers.

Although the IASB was briefed by its Staff that, based onfeedback received to date, the IFRS 9 was fundamentallysound and operational, there are issues that support alimited reconsideration of IFRS 9. The Staff noted thatthe primary reason for the reconsideration of IFRS aspresented by the Staff was the interaction with theinsurance contracts project and classification andmeasurement of financial assets under IFRS 9.Specifically, the decisions to date in the insurance projectwould recognise the re-measurement of insuranceliabilities with components through profit or loss andother components through other comprehensive income.Meanwhile the financial assets backing those insuranceliabilities would either be recognised at either amortisedcost or fair value through profit or loss resulting in anaccounting mismatch with the associated liabilities.

Additional reasons to reopen IFRS 9 are some earlyadoption issues encountered and the establishment ofthe proper standard setting environment for the IASB toconsider FASB re-deliberations on financial instrumentclassification and measurement which are due to bereleased in the near future.

However, the Staff acknowledged that anyreconsideration of IFRS 9 should be as targeted aspossible such that they could be developed with duerespect for those entities which have already earlyadopted IFRS 9 as well as those other entities havealready dedicated significant time and resources to theimplementation of IFRS 9.

All of the IASB members generally agreed that a“targeted” reconsideration of IFRS 9 was appropriate.However the reasons the Board members gave for itssupport and the level of its support varied. Most of themembers acknowledged the issue arising from theinteraction with the insurance contracts project and theneed to reconsider how best to facilitate that interaction.

The opportunity for further convergence with FASB wasseen by some IASB members as an important benefit ofa reconsideration of IFRS 9 while other members weremore sceptical of reopening IFRS 9 for the sake ofconvergence citing past difficulties in the joint financialinstrument projects and expressing concern over theFASB's decision to release a very different exposuredraft in 2010 after IFRS 9 had already been issued.

FASB decides to converge with the IASB’s decisionon the measurement of participating liabilities in away that mitigates accounting mismatchesAt its meeting on 30 November FASB deliberated on themeasurement of participating insurance liabilities. This decision was focussed on a particular situation thatIASB had already considered last May and it is notablebecause it represents the first instance where FASB hassubsequently converged with a prior IASB decision sincethe publication of the exposure draft in 2010.

The scope of the decision impacts insurance liabilitieswhere some or all of the cash flows arise from “nondiscretionary performance-linked participating featuresthat both contractually depend wholly or partly on theperformance of other assets or liabilities recognised onthe insurer’s statement of financial position, or theperformance of the insurer itself, and are a componentof an insurance contract’s obligations”.

The IASB decision was to require the insurer to measurethese cash flows by reference to the carrying amounts ofthe related assets. In addition, the insurer would presentthrough profit or loss the changes in that component ofthe insurance liability only if the changes in the associatedassets are also presented through profit or loss. In theevent that the assets’ changes were presented throughOCI then the changes in the insurance liability wouldalso follow the same presentation.

FASB discussed the merit of this approach and decidedthat it was a practical solution to address a clear case ofaccounting mismatch. This decision would only apply tothose cash flows that present these characteristics andno further measurement would be required for them.With a unanimous vote FASB approved a set ofdecisions that aligns its position to that of the IASB.

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Presentation and disclosurerequirements

Converged balance sheet presentation requirementsAt the joint meeting on 20 October, the Staff presentedsix recommendations on the Statement of FinancialPosition (SoFP) presentation requirements in theexposure draft.

The first recommendation was to disaggregate theexpected future cash flows, risk adjustment (only IASB),residual margin (only IASB), the single margin (onlyFASB) and the effect of discounting (‘the building blockcomponents’) either in the SoFP or in the notes tofacilitate reconciliation to the SoFP. Both Boardsapproved this recommendation, with 9 out of 15 fromthe IASB in favour and 6 out of 7 from FASB in favour.

The second recommendation was to present separatelythe liability for unexpired coverage from the liability forincurred claims for those contracts measured under thepremium allocation approach in the SoFP, instead of inthe notes. The Staff believes that separate presentationwould increase the transparency of an entity’s financialstatements, since separation of the performanceobligation and the obligation to pay an amount in theSoFP would enhance a user’s ability to assess theamount, timing, and uncertainty of the entity’s futurecash flows. Similar treatment for the liability is consistentwith separate presentation of the components in theStatement of Comprehensive Income (SoCI). Both Boardsunanimously approved this recommendation.

The combined third and fourth recommendations were:

a) to present in the SoFP the unconditional right toreceive a premium as a receivable separately fromthe insurance asset or liability; and

b) the conditional right to receive a premium under thepremium allocation approach should be deductedfrom the liability for unexpired coverage presented inthe SoFP.

The Boards unanimously agreed with both proposals forthe building block approach but unanimously rejectedthe treatment of conditional premium under thepremium allocation approach, preferring that under thepremium allocation approach, all premium should betreated as an asset separate from the insurancecontract’s carrying amount. The Boards overruled theStaff on the grounds that this would be a departurefrom the existing practice to account for the unearnedpremium liability as if all premiums have been receivedat the inception of the policy irrespective of whetherpayment has been collected or a premium receivable isrecognised instead. This practice appears to havesupport from many users and the Boards decided thatthe benefit of retaining a practice that has users’support is preferable to approving the Staff commonprinciple across the premium allocation and the buildingblocks approaches.

It was noted that where there are significant conditionalpremium payments (e.g. for a short duration contractwhere premiums are paid by instalments and thepolicyholder has a right to cancel the policy and stopany future payments), both the asset and the unearnedpremium liability would be lower than they would befor the same policy with a premium paid in full upfront.The reduction of the asset and liability carrying amountreflects the potential cancellation of the policy.

The fifth recommendation was to present separately theliability (or asset) for insurance contracts measuredusing the building block approach from those measuredusing the premium allocation approach. The Staffrecommendation was initially rejected by the IASB as itwas perceived as being a vote favouring the twoapproaches being distinct accounting models, whichthe IASB had rejected at a previous meeting. Afterfurther discussion which clarified that there was noattempt to introduce a two or single accounting modelprinciple with this decision it was approved by the IASBwith a majority of 12 in favour and 2 against, whileFASB unanimously approved it.

The sixth recommendation was not to allowaggregation of portfolios in an asset position with thosein a liability position in the SoFP. This recommendationapplies to both the premium allocation and the buildingblock approach. However it is highly unlikely that it willapply to short duration contracts given the decision topresent separately the rights to receive premiums forthese contracts that the Boards reached earlier.

The proposal on the presentation of asset-portfolioswas approved on the grounds that there will be afuture debate on the presentation of acquisition costsgiven the interest expressed by a few IASB and FASBmembers to consider presentations of these costsalternative to the current decision to treat them as ifthey were part of the contract’s cash flows and thusdeducted from net present value of cash flows. TheseBoards’ members noted that in certain cases a portfoliobecomes an asset mainly because of the deduction ofupfront acquisition costs from a small net present valueof future cash flows. Indeed this is typical for regularpremium contracts where most of the future inflows arepart of the net present value. FASB unanimouslyapproved this decision and 13 out of 15 IASB membersreached the same conclusion.

No progress on the income statement presentationrequirementsAt the same October meeting discussed above theBoards also attempted to reach converged decisions onthe income statement presentation. The objective wasto resolve the conundrum of keeping a margin basedpresentation that is also capable to produce volumeinformation on the insurer’s activity during the period.The attempts to evolve the past tentative decisions in amore complete set of requirements were not productiveand the subject will be tabled again at a future meeting.

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It is important to note that Stephen Cooper, a memberof the IASB, put forward at this meeting a newproposal on this subject that in his view would producea shorter income statement compared to that lastapproved (see issue 22 of this newsletter) and couldfacilitate the comparison of insurers’ performance withthat of reporting entities from other sectors.

The Boards were interested in exploring in detail thisnew proposal and this fact contributed to their decisionto defer any conclusion on this important subject to afuture meeting.

Disclosure requirementsAt the joint meeting on 19 September, the Staffpresented five recommendations on the disclosureprinciples proposed in the exposure draft.

The first recommendation was to delete therequirement that an insurer should not aggregateinformation if this is arising from different operatingsegments. The Staff explained that the general principleof aggregation and disaggregation to ensure that“information that is useful is not obscured by either theinclusion of a large amount of insignificant detail or theaggregation of items that have different characteristics”is sufficient to obtain the relevant disclosures. Theoverlap of the requirement to avoid aggregation of datareported in different operating segments could createan unnecessary conflict and the response letters hadpointed out these internal conflicts. The Staff confirmedthat this was the case and therefore proposed theremoval. Both Boards approved unanimously theamendment to the exposure draft.

The combined second and third recommendations wereto retain the requirement that an insurer should disclosechanges to inputs used for the measurement of theinsurance contract and, in addition to that, introduce arequirement to disclose the changes in methods used tocalculate the insurance contracts amounts. In addition theinsurer would need to disclose the full yield curve usedto discount cash flows of non-participating contracts.

The addition of the requirement to disclose changes inmethods recognises the need to inform investors on thequalitative characteristics of the models used. Theaddition of the yield curve disclosure for the discountrate ratified a decision already taken last March on thediscount rate deliberations for non-participatingcontracts. All of these disclosures will be developedwithin the overriding materiality principle informing IFRSand US GAAP, and all of the recommendations receivedunanimous support from FASB, and 14 out of 15 infavour from the IASB.

The fourth recommendation was to delete therequirement that an insurer should disclose an analysisthat measures the underlying uncertainty and to replaceit with a cross-reference to the requirements set in IFRS13 Fair Value Measurement. This is an area where theBoards decided to disagree and ended up in differentpositions. The IASB approved the proposal (14 in favour,1 against) from the Staff. FASB instead rejected it, with2 in favour (5 against) and decided not to adopt thesame approach for US GAAP.

The requirements are very similar in both bodies ofliterature. What is in IFRS 13 is also found in ASC 275-10-50-6, which is the equivalent standard on fair valuemeasurement under US GAAP. The types of disclosuresthat may be found in IFRS 13, which focus particularlyon the “level 3” fair values, include quantitativedisclosure on the nature and changes in theunobservable inputs and sensitivity of the “level 3”values to changes in the unobservable inputs thatreflect reasonably possible alternative assumptions.

FASB was uncomfortable relying on the US GAAPequivalent of IFRS 13 and rejected the proposal on thegrounds that the accounting standard on insuranceshould contain all the relevant requirements for thedisclosure of the uncertainty surrounding ameasurement basis that is clearly not on a fair valuebasis.

The fifth and final recommendation was to remove theoptional disclosure on expected maturities leaving onlya requirement to disclose a table based on expectedmaturities with a mandatory minimum five yearprospective analysis. The requirement of a five yearsminimum table aligns this requirement to the leasesdisclosures current draft in an effort to improveconsistency of disclosure across the different standards.The Staff also proposed removing the disclosure of theamount payable on demand for outstanding insuranceliabilities which was part of the exposure draft.

FASB did not agree with this recommendation andexpressed its preference for a recent decision it took onthe same topic which defined financial institutions as agroup of entities including insurers that would berequired to disclose the liquidity table inclusive of assetinformation and with narrative commentary on thefungibility of liquidity across the group entities. Having reached that decision on 7 September, FASB wasunanimous in rejecting the Staff’s recommendation. The IASB was supportive with a majority of 14 in favourand 1 against.

Insurance Accounting Newsletter 10

Disaggregation of explicit account balancesAt their meeting on the 16 November, the IASB andFASB discussed the disaggregation of explicit accountbalances. This topic had previously been referred to asthe unbundling of non-insurance components. The Staffhighlighted its recommendation that an accountbalance was explicit if it was an accumulation of themonetary amount, credited with an explicit return. Theyalso clarified that they would distinguish betweenunbundling and disaggregating non-insurancecomponents. The disaggregation of an explicit accountbalance would be for presentation purposes only andthe insurer would measure the cash flows of the explicitaccount balance together with all the other cash flowsfrom the insurance contract under the building blocksapproach. Subsequently to the completion of themeasurement it would present any explicit accountbalance separately. The Staff asked five questions to theBoards on this subject:

1. Do the Boards agree that all explicit accountbalances should be presented separately from theinsurance contract liability?

2. Do the Boards agree with the following criteria foridentifying explicit account balances? A contract hasan explicit account balance if both of the followingconditions are present:

a) The balance is an accumulation of the monetaryamount of transactions between the policyholderand the insurer.

b) The balance is credited with an explicit return. A return is explicit if it is determined by applyingeither of the following to the balance: (1) acontractual formula in which the insurer may havethe ability to reset the return rate during the life ofthe contract or (2) an allocation determineddirectly by the performance of specified assets.

3. Do the Boards agree that all explicit accountbalances and the related assets should be recognisedin an insurer’s financial statements and that theyshould not be offset against each other?

4. Do the Boards agree that an insurer shall measureexplicit account balances and services associatedwith the explicit account balances, if any, togetherwith the other components of insurance contracts?

5. Do the Boards agree that explicit account balancesshould be presented separately from the insurancecontracts liability on the face of the Statement ofFinancial Position (rather than the notes) to anamount equal to the sum of:

i. the explicit account balance; and

ii. an accrual for all fees and returns though thereporting date.

The FASB chair asked for a vote on the first questionnoting that they would need to assume that the Staffproposal would be a de minimis in terms ofdisaggregation of account balances and conceding thatmembers may wish to expand it. Both Boards agreed,some said that other items would need to be consideredand explored further. The Boards decided to avoid thesecond question because of the underlying issues aroundwhat should be included and how it should be measuredand preferred to consider the other questions. The Staffreiterated that explicit account balances would not beunbundled with a separate measurement from theinsurance component of the contract. Instead they wouldbe measured together with the other components of aninsurance contract’s cash flows. However theirdisaggregation from the insurance contract carryingamount would result in a separate presentation from iton the face of the statement of financial position. Such an approach would not require the explicit accountbalances to be discounted. Following inconclusivediscussions among Board members, the IASB Staffattempted to survey the Boards with some differentquestions. When asked if the Board members believe thewhole contract should be measured using the buildingblocks (excluding embedded derivatives, etc. and otheritems already unbundled) 9 IASB members said they didwith 6 members preferring unbundling to disaggregation.However the IASB members were unanimous that atleast disaggregation would be needed in the final IFRS.Finally the same majority of 9 indicated that they wouldbe comfortable to restrict the disaggregationrequirements to explicit account balances only asdefined in the Staff paper. The other members wereprepared to go further in disaggregating depositcomponents. When asked similar questions, only twoFASB members believed that the whole contract shouldbe measured using the building blocks.

The IASB chairman declared that no tentative decisionscould be recorded at the end of the session and askedthe Staff to explore other approaches.

Insurance Accounting Newsletter 11

Other decisions – Fixed fee servicecontracts scope exclusion

At their joint meeting held in March 2011, the Boardstentatively decided to exclude certain types of fixed feecontracts from the definition of an insurance contract(see issue 19 of this newsletter).

At the meeting held on 20 October, the Staffrecommended that fixed-fee contracts that provide aservice as their primary purpose should be excluded ifthey exhibit all of the following characteristics:

• the contracts are not priced on the basis of anassessment of the risk associated with an individualcustomer;

• the contracts compensate customers by providing aservice, rather than cash payment; and

• the type of risk transferred by the contracts areprimarily related to the use (or frequency) of servicerelative to the overall risk transferred.

The Staff assessed various contracts that provide aservice for a fixed fee, and identified the features ofthose contracts that distinguished them from traditionalinsurance contracts. The focus for the analysis was onthe rationale for the exclusion, on the difference inapplying revenue recognition rather than the insurancepremium allocation approach and on anyimplementation concerns.

The Staff’s analysis confirmed that the results for fixed-fee contracts under both proposals are comparable andcosts associated with applying the insurance guidanceto these contracts impose an additional burden onpreparers relative to the application of revenuerecognition.

The Staff’s recommendation was unanimously approvedby both Boards, subject to redrafting certain languageand inclusion of application guidance or examples.

Timetable and next steps

As noted earlier, the target publication date of the finalaccounting standard for both Boards is now no longerexpected to be before the 2012 calendar year-end.

It is our expectation that a re-exposure of the draft IFRSwill take place together with the publication of the US GAAP exposure draft aligning the two timetables.

With publication of the final IFRS and US GAAP at somepoint in 2013, the pressure to move the effective datebeyond 1 January 2015 will be significant. The same fatehas been suffered by the financial instruments projectwith both impairment and macro-hedging targetpublication dates beyond 2012. The EU accountingbody EFRAG has proposed in its draft response letter to change the effective date of IFRS 9 from 1 January2015 to “a three year period from the later of thepublication dates of IFRS 4 Phase II and IFRS 9”.

The decision to carry out targeted improvements of IFRS 9 with the potential introduction of an “OCI solution”could defuse certain industry stances but it would absorbtime at the Boards to have this unplanned activitycompleted in parallel with the deliberations on the fewmatters that have not been discussed as yet.Furthermore, the IASB announced via its webpage on the8 December that it is seeking feedback on four specificareas (cash flows, discount rate, risk adjustment,disclosure) using working drafts of implementingdecisions taken to date.

During the joint meeting planned for 15-16 Decemberthe Boards will have a fairly extensive session oninsurance that will cover two of the remaining majorissues except for the transitional provisions:

• definition of a portfolio; and

• unit of account for risk adjustment and residualmargin and for the single margin.

Deloitte viewIn our comment letter we did not agree with the proposedamendment to the scope exclusions leaving out fixed feeservice contracts. This scope exclusion is not well definedand it could result in less relevant information than ifthese contracts were in the scope of the final IFRS.

The Boards’ decision appears to have addressed this issue.

Insurance Accounting Newsletter 12

Deloitte will report on the outcome of this jointmeeting shortly after its completion via our IASPlusnews service (http://www.iasplus.com/agenda/insure2.htm) followed by our post meeting InsuranceContracts Project Insight newsletter(http://www.iasplus.com/insight/insurancecontracts.pdf).Finally, James L. Kroeker, the US Securities andExchange Commission (SEC) chief accountant,announced in a speech he gave at a AICPA NationalConference on 5 December that the SEC Staff finalreport on the incorporation of IFRS for US issuers will bedelayed by a “few additional months”. This documentwas expected to clarify the direction and pace of IFRSadoption within the US with an obvious influence onthe tone of the convergence activities that the Boardshave undertaken for the last couple of years and that isbeing extensively reopened and re-exposed.

We will observe the developments that this SEC delay mayhave on the specific insurance contracts deliberations. A number of commentators speculated that the slowpace of the joint deliberation activity in the second halfof the year was also influenced by the need to wait fora clarification from the US Government as to whetherand how it would deliver on its commitments to theG20 group to support Global GAAP.

The influence on the insurance joint work would dependin particular on whether this commitment would befulfilled by a US acceptance of a form of IFRS adoptionwithin the US or by demanding the achievement ofconvergence between IFRS and US GAAP prior toendorsement of IFRS in the US capital market regulations.

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Deloitte Insurance contacts

Global insurance networkJoe GuastellaGlobal Insurance LeaderU.S. +1 212 618 4287 jguastella@deloitte.com

Asia PacificKumiko AsoJapan +81 90 3910 2898kumiko.aso@tohmatsu.co.jp

Simon WalpoleHong Kong+852 2238 7229siwalpole@deloitte.com.hk

Francesco NagariGlobal IFRS Insurance LeaderU.K. +44 20 7303 8375 fnagari@deloitte.co.uk

EMEAFabien Sauvage France +33 1 55 61 41 63 fsauvage@deloitte.com

Mark FitzPatrickU.K.+44 20 7303 5167mfitzpatrick@deloitte.co.uk

Mark Ward Switzerland +41 44 421 62 72maward@deloitte.ch

Peter Wright Czech Republic +420 246 042 888 pewright@deloitte.com

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North AmericaRebecca Amoroso U.S. +1 973 602 5385 ramoroso@deloitte.com

Aniko SmithU.S. +1 213 688 4110anikosmith@deloitte.com

Neil HarrisonCanada+1 416 601 6307nharrison@deloitte.ca

John Johnston Bermuda +441 292 1500 jojohnston@deloitte.com