The insurance revolution

THE INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) insurance contract project could be historic for many reasons. The first is the length of time it has taken to complete after the project started back in 1997. Another is that this would be the first comprehensive set of International Financial Reporting Standards (IFRS) rules governing insurance contracts accounting.

Over recent months, the IASB has picked up pace, with a new exposure draft due this spring, so FDs will need to carefully consider the new rules. Insurers reporting under IFRS are familiar with IFRS 4 requirements to classify contracts as insurance, which allows the grandfathering of virtually all pre-existing practices under an IFRS label. Under the new IFRS, the classification rules will not change. However, everything else will.

The new IFRS introduces a single accounting model for all types of insurance contracts, as classified under IFRS 4, called the “current fulfilment value” (CFV). The CFV makes insurance accounting more transparent, requiring the disclosure of the building blocks of an insurance liability.

The first block is a probability-weighted, discounted net present value of all future cashflows, premiums and benefits/claims. The new IFRS treats the contract as the unit of account measured as a bundle of rights and obligations. Additionally, insurers must calculate this block by using the mean of the probability distribution underpinning the insurance risks. In other words, they must state what the “50-50” liability is. Another novelty in this block is the requirement to discount the cashflows unless the impact of discounting is immaterial (which is presumed to be the case if all cashflows come in within 12 months from selling the contract). General insurers could find this demanding since it isn’t common practice.

The final new requirement on this block is the split of the effect of discounting between balance sheet and the income statement. All insurance contracts will be discounted using current market interest rates on the balance sheet. However, the unwinding of the discounting that affects the earnings will be based on the discount rate selected at the time the policy was sold. The difference between the balance sheet liability and that computed using the “locked in” discount rates is booked directly in equity. This measure is meant to address the issue of interest rate volatility on insurers’ earnings. Arguably, insurance businesses, which focus on long-term asset-liability cashflow matching, may not be able to provide a faithful representation of their performance if significant gains or losses from interest rates fluctuations are part of their earnings.

Other CFV blocks are two separate liabilities to reflect the insurer’s measure of the uncertainty implicit in the “50-50” liability and to defer its expected profits. One is called the risk adjustment and the other is the residual margin. The latter defers any accounting profit (but not losses) at the point of a new insurance contract sale.

Technique selection

Insurers must select a technique to measure the risk adjustment that best reflects the underlying probability distribution used in the first (probability-weighted) block. Some insurers may want to use a cost of capital approach, as it would allow IFRS earnings to be linked with the economic capital view or the FSA-imposed solvency capital. The new IFRS allows multiple techniques if the diversity of the risks insured justifies this. The risk adjustment must be current at each reporting date and its changes always affect the insurer’s earnings.

The residual margin’s role is critical in the new IFRS because it drives the shape of the IFRS earnings for two reasons. First, the residual margin will be adjusted to absorb any prospective changes in the assumptions underpinning the first block. Only if expected future net cashflows deteriorate so much to exhaust the residual margin would they affect an insurance company’s earnings. This mechanism of “unlocking” would be transparently reported in the accounts. Second, the margin would be released to earnings as the insurer fulfils its policyholder obligations. The insurer’s obligations are delivered when the coverage sold ends and no residual margin is carried forward on claims liabilities. When the coverage period is short enough (i.e. 12 months or less), the insurer can avoid calculating the CFV with the building blocks approach for the coverage period.

The last change is on the presentation of revenue and expenses when the building blocks approach is used. Insurers would need to decompose the insurance contract liability to report as revenue the expected claims/benefits as well as all of the margins released in the period and, as expense, the actual claims/benefits incurred in the period. This new approach requires the removal from both revenue and expense lines of any investment component bundled within the insurance contract (e.g. the surrender value of many life insurance policies).

There will be other, more detailed and specific rules not covered in this article, which would clearly contribute to making the adoption of this new IFRS a genuine insurance reporting revolution. ?

Francesco Nagari is a partner and the global IFRS leader at Deloitte