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Home / 2007 / August 2007 / Pushing the Boundaries

Fergus Condon, Director in Ernst & Young’s Financial Reporting Advisory Group, examines the issues at the heart of the IASB’s new insurance discussion paper.

The International Accounting Standards Board (IASB) is developing a new international financial reporting standard (IFRS) for insurance contracts. To this end, it has published a discussion paper entitled “Preliminary Views on Insurance Contracts”. The discussion paper contains the IASB’s preliminary views on the various recognition and measurement issues to be considered in accounting for insurance contracts, and also sets out the issues still under consideration. The discussion paper raises a number of important wider issues as it seeks to implement a fair-value like measure to insurance accounting.

The IASB has invited comment on the discussion paper by 16 November 2007. Following consideration of the comments received, the IASB will develop an exposure draft and eventually a final standard to replace the current interim standard IFRS 4.

Due to the need for wide consultation, and the time allowed for the various formal steps of the standard setting process, a new standard is unlikely to be effective before 2010 or 2011.

The Financial Accounting Standards Board (FASB), the US accounting standard setter, may also join the project. It intends to seek input from its constituents by issuing an Invitation to Comment containing the discussion paper. Support from the FASB will add significant stature to any new standard.

1. Measurement model

The discussion paper proposes a single measurement model for liabilities arising from insurance and reinsurance contracts. The single model will apply to both life and non-life insurance. It will apply to both claims liabilities and the liability to stand ready to pay future claims from insurance contracts currently in issue. The IASB is proposing that insurance liabilities be measured at what it calls “current exit value”.

Current exit value is defined as the amount that an insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another party. Due to the fact that there is no observable secondary market for insurance liabilities, current exit value has to be estimated using a number of building blocks. These are:

- Current, unbiased, market consistent, probability weighted estimates of the future cash flows that will be required to settle the obligations in the insurance contracts being valued. These include probable outflows resulting from embedded options and guarantees, such as guaranteed interest rates, that are included in some insurance products. - The estimated cash flows will then be discounted to reflect the time value of money. The rate used to discount these cash flows should be based on current discount rates observed in market prices for cash flows in the same currency, and with the same timing as the weighted average insurance cash flows. The discounted value of the cash flows constitutes the ‘best estimate liability’. - The value of the best estimate liability will be increased by the addition of a risk margin. The risk margin is an explicit and unbiased estimate of the amount that market participants would require to compensate them for the risks inherent in the cash flows being valued. If there is a very low risk that the eventual cash flows will differ substantially from the estimate made then a small risk margin will be added to determine the amount of the liability. On the other hand if there is a large risk that the amount of the liability will differ from the estimate (e.g. greater volatility) then the risk margin will increase the value of the liability by a greater amount. - Service Margin. The IASB believes that the liability may sometimes need to be further increased by a service margin. It regards the service margin as being the amount that market participants would require to compensate them for the provision of other services in addition to the service of bearing risk. Many unit-linked contracts, for instance, require the insurer to provide the services of an investment manager. The current exit value of these services (in this case the wholesale management fees) should be included in the measurement of the liability.

The following diagram shows the components of the current exit value model:

[ILLUSTRATION OMITTED]

2. Major implications of the measurement model

The following are some of the major implications of the current exit value model as outlined in the discussion paper.

Non-life insurance liabilities will be valued using explicit estimates of future cash flows discounted for the time value of money. This is different to many existing models which do not allow for the discounting of claims liabilities and currently use the unearned premium as an estimate of the liability to stand ready to meet future policyholder claims.

- For life insurance liabilities, the IASB has proposed that in estimating the current exit value limits should be placed on the inclusion of future premiums in the valuation models. - Acquisition costs are to be expensed as incurred, rather than deferred as an asset representing a customer relationship. - The credit characteristics of an insurance liability should affect its value. This means that, in the absence of regulation, a liability of a weak insurer may be reflected at a lower value than the equivalent liability in the books of an insurer on a stronger financial footing. - Risk margins are to be determined for portfolios of contracts subject to broadly similar risks and managed together, rather than for each individual insurance contract.

3. Difficult issues

Some of the issues that the IASB is considering in this project are linked to, and are likely to impact on, some of the their other projects. Indeed, the IASB is having to address in the insurance accounting project many of the longer-term issues it must face in its efforts to develop an improved generally applicable financial reporting framework. These include issues about fair value measurement, revenue recognition, and when to recognise liabilities for future obligations.

Fair value

In 2006 the IASB issued a discussion paper containing a copy of the US accounting standard FAS 157 Fair Value Measurements. The IASB was seeking comments on whether the guidance for measuring fair value contained in FAS 157 would be suitable in an IFRS context.

The insurance contracts discussion paper notes that since the IASB has not yet completed its work on fair value measurement, it is too early to determine whether current exit value is equivalent to fair value. However, it goes on to say that the IASB has not identified any significant differences between current exit value and fair value. The insurance contract discussion paper is therefore providing the IASB an opportunity to test the concepts of fair value in an industry where there is not a large amount of observable market data available to estimate fair values.

It is therefore likely that the responses received to the insurance discussion paper will have an impact on the fair value measurement project. Indeed, respondents are quite likely to comment on the insurance discussion paper in light of their views on fair value generally.

Risk Margins

Risk margins are probably the most difficult of the building blocks to estimate in the current exit value model. The IASB has noted that it will not prescribe specific techniques for calculating risk margins. Instead it will explain what attributes risk margins should contain and leave it to industry practitioners to develop guidance on calculating them.

One approach determines the value of the liability that is expected to be sufficient to cover expected cash flows in 75% of future scenarios. The best estimate liability would be expected to be sufficient in 50% of possible future scenarios, so the difference between the two values is the risk margin – this is called a confidence level approach.

Another approach, which is currently gaining favour in the industry, determines the cost of holding capital required to underwrite the insurance business being valued. This cost is then used as an estimate of the risk margin.

Some members of the IASB feel that because risk margins are difficult to estimate, and because there is a lack of observable market data to use in developing estimates, the risk margin should be calibrated to the premium on inception. This means that the risk margin would be set a level at which the total insurance liability is equal to the premium charged to the policyholder on inception of the contract (net of the amount charged to recover acquisition costs). This would mean that there could be no recognition of a gain on inception of the contract. Without such a calibration to premium, a gain on inception would arise if the amount charged to the policyholder in the form of a premium was more than the estimated current exit value of the liability assumed.

The IASB members who support such a limit are opposed to recognising gains on inception because they contend that their existence may be an indication that the valuation model used does not include appropriate assumptions for all required inputs. They are also concerned about recognising revenue on the sale of a contract if the related expenses (future claims) can not be reliably estimated. However, the discussion paper does not propose such a limit because the view of a majority of IASB members is that, while that the observed price at inception of the contract is an important check on the reasonableness of the estimated current exit value, it should not override an unbiased estimate of the risk margin.

The IASB faces a similar question in its Revenue Recognition project where it has to choose between two approaches to the recognition of revenue and the related liability for future services.

Currently there are two models being considered – the customer consideration approach and the fair value model. The first approach recognises revenue and service obligations based on the amount charged to the customer. This is similar to the approach in the insurance project in which risk margins are calibrated to the premium. The fair value approach recognises revenue and service obligations based on the fair value of the services to be rendered. This is similar to the pure current exit value model with no calibration to premium as proposed in the discussion paper.

Discretionary participation liabilities

Many life insurance contracts contain features which allow policyholders to receive additional dividends, bonuses or benefits, based on the income from a designated pool of assets. In paying these benefits insurers usually have some discretion over the amount and timing of payment. The discussion paper notes that insurers should recognise a liability for these benefits to the extent that they have a constructive obligation to pay them.

Traditionally, the classification of amounts as liabilities or equity has been based on the identification of enforceable contractual obligations. This could result in future discretionary bonus payments being included in equity rather than liabilities. However, insurers have argued that showing only contractual amounts in liabilities would not be representative of the true position. Thus the discussion paper introduces the notion of constructive obligation to the distinction between liabilities and equity. This could have an impact on the IASB’s projects on liability and equity classification, as well as on their project to revise the accounting standard IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

4. Conclusion In many respects the insurance project is pushing the boundaries of current international accounting practice. The IASB has issued a discussion paper which calls for insurance contract liabilities to be measured at something that is very close to an estimated fair value. This raises a number of issues in an industry where, due to the lack of a liquid and active secondary market, a number of significant variables have to be estimated. It is therefore likely that the discussion paper will generate a large amount of interest and comment. It is also likely that much of this comment will be unsupportive of certain aspects of the proposed model.

Members of the industry are unlikely to be in favour of a model which could generate increased complexity and volatility in their results. The outcome of the project is also likely to have a profound impact on the direction of other IASB projects and is set to be a testing ground for determining whether the IASB will succeed in making the concept of fair value more widely used and accepted.

Any idea of the numbers that this would be affected by this in Ireland?