Accounting for Insurance Contracts

Background

Before the IASC ceased existence, it undertook a major project to address the accounting for insurance contracts. This focuses on accounting for insurance contracts rather than on all aspects of accounting by insurance companies, and so might be better described as dealing with a specialized accounting topic and not a specialized industry. An extensive Issues Paper was published in December 1999, and a Draft Statement of Principles was developed in 2001, covering all aspects of this highly complex topic. Soon after its creation, the IASB indicated that it would continue this project, and has had numerous discussions on and reached many tentative decisions about matters raised in the DSOP over the past year.

In the following paragraphs, the various definitions and accounting treatments that have been discussed, and about which tentative agreement has been achieved by the IASB, will be set forth. Caution is urged since these are all tentative and can change (indeed, the IASB has rejected some of the positions taken in the DSOP, which is available on the IASB website), and a final standard will likely not be forthcoming until 2004, although the EU adoption of mandatory IAS-compliant reporting in 2005 is putting some pressure on IASB to complete this.

Insurance Contracts

An insurance contract is an arrangement under which one party (the insurer) accepts an insurance risk by agreeing with another party (the policyholder) to compensate the policy-holder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary (other than an event that is only a change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable—which would continue to be accounted for under IAS 39 as derivative contracts). A contract creates sufficient insurance risk to qualify as an insurance contract only if there is a reasonable possibility that an event affecting the policyholder or other beneficiary will cause a significant change in the present value of the insurer's net cash flows arising from that contract. In considering whether there is a reasonable possibility of such significant change, it is necessary to consider the probability of the event and the magnitude of its effect. Also, a contract that qualifies as an insurance contract at inception or later remains an insurance contract until all rights and obligations are extinguished or expire. If a contract did not qualify as an insurance contract at inception, it should be subsequently reclassified as an insurance contract if, and only if, a significant change in the present value of the insurer's net cash flows becomes a reasonable possibility.

A range of other arrangements, which share certain characteristics with insurance contracts, would be excluded from any imposed insurance contracts accounting standard, since they are dealt with under other IAS. These include financial guarantees (including credit insurance) measured at fair value; product warranties issued directly by a manufacturer, dealer or retailer; employers' assets and liabilities under employee benefit plans (including equity compensation plans); retirement benefit obligations reported by defined benefit retirement plans; contingent consideration payable or receivable in a business combination; and contractual rights or contractual obligations that are contingent on the future use of, or right to use, a nonfinancial item (for example, certain license fees, royalties, lease payments, and similar items).

Insurance assets and liabilities would be subject to recognition when contractual rights and obligations, respectively, are created under the terms of the contract. When these no longer exist, derecognition would take place.

Measurement Principles under Consideration

The DSOP had proposed that, while IAS 39 remains in place, insurance liabilities and insurance assets should be measured at entity-specific value. Entity-specific value represents the value of an asset or liability to the enterprise that holds it and may reflect factors that are not available (or not relevant) to other market participants. In particular, the entity-specific value of an insurance liability is the present value of the costs that the enterprise will incur in settling the liability with policyholders or other beneficiaries in accordance with its contractual terms over the life of the liability. The DSOP concluded that, when (and if) a successor standard to IAS 39 introduces fair value measurement for the substantial majority of financial assets and liabilities, IASB should consider introducing fair value measurement for all insurance liabilities and insurance assets. Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's-length transaction. In particular, the fair value of a liability is the amount that the enterprise would have to pay a third party at the balance sheet date to take over the liability.

Pending resolution of the fair value accounting issue, the IASB has largely focused its attention at insurance contract accounting matters that transcend this concern. It has considered whether the starting point for measuring insurance assets and insurance liabilities should be the expected present value of all future pre-income-tax cash flows arising from the contractual rights and contractual obligations associated with the closed book of insurance contracts. Also addressed was whether cash flows arising from the contractual rights and obligations associated with the closed book of insurance contracts should include cash flows from future renewals only to the extent that their inclusion would increase the measurement of the insurer's liability, or alternatively to the extent that policyholders hold uncancelable renewal options that are potentially valuable to them. (A renewal option is potentially valuable only if there is a reasonable possibility that it will significantly constrain the insurer's ability to reprice the contract at rates that would apply for new policyholders who have similar characteristics to the holder of the option.) No decisions have been made on these issues.

The IASB did however, conclude as working hypotheses that in determining entity-specific value, each cash flow scenario used to determine expected present value should be based on reasonable, supportable, and explicit assumptions that reflect all the future events, including statutory and technological changes, that may affect future cash flows from the closed book of existing insurance contracts included in the scenario. Inflation is addressed by estimating discount rates and cash flows both consistently in either real or in nominal terms. All entity-specific future cash flows that would arise in that scenario for the current insurer must be included, even cash flows that would not arise for other market participants if they took over the current insurer's rights and obligations under the insurance contract.

Furthermore, market assumptions would need to be consistent with current market prices and other market-derived data, unless there is reliable and well-documented evidence that current market experience trends will not continue. This evidence would exist only if a single objectively identifiable event causes severe and short-lived disruption to market prices, in which case the assumptions would be based on this reliable evidence. Nonmarket assumptions would have to be consistent with the just-noted market assumptions, and with the most recent financial budgets and forecasts that have been approved by management. If budgets and forecasts are not current and not intended as neutral estimates of future events, the insurer would need to adjust those assumptions. If the budgets and forecasts are deterministic, rather than stochastic (i.e., based on probability distributions on the occurrence of future events), the entire package of scenarios should be consistent with the budgets and forecasts.

IASB concluded that if fair value were not observable directly in the market, it would have to be estimated as just stated, except that it would not reflect entity-specific future cash flows that would arise for other market participants if they took over the current insurer's rights and obligations under the insurance contract, and any contrary data indicating that market participants would not use the same assumptions as the insurer, fair value would have to reflect that market information.

It was decided that the entity-specific value of an insurance liability should not reflect the insurer's own credit standing. This decision was taken not because of any conceptual disagreement, but rather because this raises wider issues that will be dealt with in a separate context.

Another tentative conclusion was that, until rights to recoveries qualify for recognition as an asset, the insurer should include potential recoveries from salvage and subrogation in estimated future cash flows from existing insurance contracts and not recognize those rights as separate assets. The rights would qualify as an asset only

1. When the insurer controls those rights as a result of past events,

2. It is probable that the economic benefits associated with those rights will flow to the insurer, and

3. The insurer can measure those rights reliably.

An insurer would then measure those rights at entity-specific values if insurance liabilities are measured at entity-specific value, and at fair values if insurance liabilities are measured at fair value (which has yet to be resolved).

Either the entity-specific or the fair value of insurance liabilities and assets would have to reflect risk and uncertainty—preferably in the cash flows, or alternatively in the discount rate(s), which are mutually exclusive techniques. Estimates under either approach would reflect the market's risk preferences, inferred from observable market data, using consistent methodology over time. Changes in the inferred level of risk preferences would be made only in response to observable market data. The risk of changes in exchange rates would only be taken into account when future cash inflows and outflows are denominated in more than a single currency.

Several tentative decisions were made regarding the discount rate to be applied to projected future cash flows. The starting point for determining the discount rate for insurance liabilities and insurance assets would be the pretax market yield at the balance sheet date on risk-free assets. It would be adjusted to reflect risks not reflected in the cash flows from the insurance contracts. The currency and timing of the cash flows from the risk-free assets—those having readily observable market prices whose cash flows are least variable for a given maturity and currency—would be consistent with the currency and timing of the cash flows from the insurance contracts. Estimated cash flows in foreign currency are discounted using the appropriate discount rate for the foreign currency, with the resulting present value being translated into the measurement currency using the spot rate at the reporting date. Special rules would apply to reinsurance situations.

IASB concluded that policyholders would measure contractual rights and obligations as follows:

1. Prepaid insurance premiums at amortized cost, adjusted for any impairment or uncollectibility;

2. Virtually certain reimbursements of expenditures required to settle a recognized provision at the present value of the reimbursement but not more than the amount of the recognized provision; and

3. Valid claims for an insured event that has already occurred at the present value of the expected future receipts under the claim, but if it is not virtually certain that the insurer will accept the claim, the claim is a contingent asset and would, under IAS 37, not be recognized as an asset.

The DSOP concluded that insurers should be required to account for investment property at fair value, plant assets at revalued amounts, and deferred tax assets and liabilities at discounted values. The IASB has countermanded these positions, however, and will not prohibit accounting for investment property at cost and plant assets at amortized cost. It will not endorse the discounting of deferred tax assets and liabilities (prohibited by IAS 12) at this time. Illustrations in the DSOP were found objectionable, in part, by IASB and accordingly will not be included in its standard.

IASB is continuing its discussions on several key topics, including

1. Whether the measurement objective for insurance contracts should be measured at entity-specific value, fair value, or some other basis;

2. The possible implications of the proposed approach for other long-term contracts such as investment management contracts, bank core deposits, credit card receivables, prepayable mortgages, mortgage servicing rights, construction contracts, long-term supply contracts, and customer loyalty programs;

3. The criteria that should be used to determine when it is appropriate to include the additional cash flows;

4. The possible implications of this approach for the recognition of gains at the inception of an insurance contract; and

5. Whether an insurer should report, as a separate asset or as a reduction of the liability, the debit that could result from the expected present value (probability-weighted and risk-adjusted) of the additional cash flows.