iasb compares the general model and variable fee …...insurance accounting alert november 2015 iasb...
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Insurance Accounting AlertNovember 2015
IASB compares the general model and variable fee approach and agrees to retain differences
What you need to know• The IASB decided that, rather
than move towards one remeasurement model, a limited number of differences between the general measurement model and variable fee approach should remain.
• These differences relate to:
• The treatment of changes in the value of options and guarantees - recognised in the Statement of Comprehensive Income under the general model, while regarded as part of the variability of fees for future service and thus recognised in the CSM under the variable fee approach
• Interest accretion on the CSM - the variable fee approach results in the CSM being remeasured for current market interest rates, whereas the general model uses an interest rate curve that is locked in at inception to accrete interest
• The IASB did not agree with a staff proposal on how, in the general model, to distinguish changes in expected future cash flows that result from the application of discretion in participating contracts (recognised in the CSM) from those that arise from market movements (reflected in the SCI). They will revisit this topic in future meetings.
OverviewDuring its November meetings, the International Accounting Standards Board (IASB or the Board) continued its discussions on the new insurance contracts standard (IFRS 4 Phase II). The IASB compared the general measurement model that applies to all contracts in the scope of the standard (general model) and the variable fee approach (that only applies to contracts with direct participation features). It focused on evaluating two aspects that cause differences between the models and decided to retain these differences. The Board also addressed a few narrow issues relating to the mechanics of the variable fee approach. It also discussed, but did not decide upon, how to account for changes in estimates of future cash flows arising from the exercise of discretion on participating contract liabilities under the general model.
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The story so farThe IASB’s website provides information about tentative decisions made on the insurance contracts accounting model prior to this meeting, including:• The cover note for the Board’s papers
on insurance for the November meeting which contains a summary of progress so far: www.ifrs.org/Meetings/MeetingDocs/IASB/2015/November/AP02-Insurance-contracts.pdf
• Further information on the project and the proposed model: www.ifrs.org/Current-Projects/IASB-Projects/Insurance-Contracts/Pages/Insurance-Contracts.aspx
General model versus variable fee approachThe IASB compared the general model and the variable fee approach and assessed the extent to which they could be regarded as a single model to deal with the continuum of insurance contracts. The variable fee approach applies to participating contracts that meet certain criteria (direct participating contracts).Whereas, the general model applies to all other types of contracts (indirect participating contracts and non-participating contracts). Assessing whether participating contracts are in scope of the variable fee model or will be
accounted for under the general model will require judgement.
The staff reminded the Board of the differences between the two methods, based on the tentative decisions made to date. These differences reflect the different perspectives on the entity’s obligation to policyholders. Table 1 below provides an overview of similarities and differences.
The Board evaluated two aspects that cause measurement differences between the two methods, notably: (i) the treatment of options and guarantees; and (ii) the accretion of the CSM after initial recognition. Although a third difference exists between the accounting under the two approaches, Board members did not regard the adjustment of the CSM for the changes in the shareholder’s share under the variable fee model as a measurement difference between the two models. Rather, the unlocking for the shareholder’s share is seen as a specific application of the general model that reflects the particular nature of direct participating contracts.
i) Treatment of changes in the value of options and guarantees
The effect of changes in market variables on the value of options and guarantees embedded within insurance contracts will
be recognised in the statement of comprehensive income (SCI) under the general model, either in profit or loss or other comprehensive income (OCI), depending on the accounting policy chosen by the entity. Under the variable fee approach, these effects are regarded as part of the variability of fees for future service and thus are recognised as underwriting activity in the contractual service margin (CSM) (unless the CSM has become negative, in which case, the effects will be recognised in profit or loss).
The variable fee approach is for contracts in which the entity shares the returns on identified underlying items with policyholders. If a financial guarantee becomes “in the money”, the entity does not ”share” the returns that are needed to pay these guarantees as these flow solely to the policyholders with guarantees. Since these flows are more like non-investment cash flows, they should not be seen as part of the returns on underlying items. The majority of Board members agreed with the staff that it would not be consistent with the logic of the variable fee approach to recognise the change in market variables on financial guarantees in the SCI in the same way as a change in value of underlying items would be recognised. Therefore, these changes should be recognised against the CSM.
Table 1: General model vs Variable fee approach
Topic General model Variable fee approach
Cash flows Expected future fulfilment cash flows within contract boundary
Discount rate Yield curve reflecting the characteristics of the liability
Risk adjustment Reflecting required compensation for bearing risk
CSM at inception Net difference of fulfilment cash flows, floored to nil
CSM at release Passage of time, reflecting number of in-force contracts
Level of aggregation Objective is individual contract, contracts can be aggregated as long as objective is met
Subsequent measurement - Non-market variables
Relating to past coverage: profit or loss Relating to future coverage: CSM
Subsequent measurement - Market variables
All changes in SCI (profit or loss or OCI)
Changes in shareholder’s share (including guarantees) in CSM
Market variables - when risk mitigated All changes in SCI (profit or loss or OCI)
Changes in shareholder’s share (excl. guarantees) in CSM, guarantees in profit or loss (optional)
Accretion of interest on CSM Locked-in rate Current rate
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ii) Accretion of interest on the CSM after initial recognition
Several Board members noted the rate used for accreting interest on the CSM is at the heart of the two different methods. The CSM accretes interest over time at a locked in discount rate under the general model, with any adjustments to the CSM for changes in the expected future cash flows measured at the locked in rate. (Fulfilment cash flows are remeasured with current assumptions, but adjustments to the CSM are made using the locked in discount rate). Under the variable fee approach, the CSM is remeasured using current discount rates. This arises because the CSM under the variable fee approach is determined as the shareholders’ share of the fair value of underlying items, so fulfilment cash flows and the shareholder’s share in underlying items are remeasured consistently.
The Board discussed amending the general model to bring it in line with the variable fee approach: remeasuring the CSM under the general model using current rates would be equivalent to remeasuring the shareholder’s share of the underlying items under the variable fee approach and would minimise differences between the two methods.
Some Board members noted that they would prefer to make every effort to have only one measurement model. This would prevent a ”cliff effect” whereby economically similar contracts could be accounted for very differently and would reduce complexity for users and preparers of financial statements. One Board member argued that remeasurement on a current basis would not necessarily be more complex for preparers of financial statements who choose to reflect the impact of changes in market interest rates of the best estimate liability through profit or loss. Rather, it would be more complex for these preparers to collect historical discount rates and use a locked in rate for the CSM adjustment and a current rate for other parts of the insurance contract liability.
Many Board members observed that these measurement differences are the result of decisions taken as part of the development of the variable fee model and believe that removing them would result in additional complexity, when there is already considerable complexity in measurement of the CSM. For example, using current rates in the general model would also involve computing a catch-up adjustment to the opening balance of the CSM as if the current discount rate had always applied, and it would not simply equate to remeasurement to fair value since pricing would not change based on market changes. One Board member also highlighted that accreting interest on the CSM at a locked in discount rate under the general model is consistent with IFRS 15 Revenue from Contracts with Customers. Under IFRS 15, the effect of time value of money on revenue is determined using the discount rate at contract inception. For these reasons, the majority of the Board agreed with the staff proposal to retain the two differences between the general measurement model and variable fee approach.
Treatment of discretion in participating contracts under the general modelThe Board discussed whether, under the general model, they should provide guidance on the treatment of changes in the insurance contract liability that may arise from the exercise of discretion relating to participating contracts. An implicit assumption in the Exposure Draft (Insurance Contracts ED/2013/7 (2013 ED)), further discussed in the May 2015 meeting, was that changes in cash flows arising from the exercise of discretion would be recognised in the CSM, as they relate to future service.
The Staff proposed that the IASB should provide guidance on how to distinguish between changes in cash flows caused by changes in market variables (which should be recognised in SCI) and those arising from the exercise of discretion recognised in CSM. Guidance would improve comparability between entities because the distinction would impact on the relative size of amounts recognised as underwriting rather than investment activity.
The Board did not agree with the staff proposal and asked the staff to bring this issue back at a future meeting as soon as possible, considering expanded examples and alternative ways to provide guidance on determining the remeasurement effects of discretion. Some Board members were hesitant about being too prescriptive and asked staff to check consistency with other elements of the model where they have specified approaches.
Consequential topics applying to the variable fee approachThe Board considered three narrow issues arising from the variable fee approach that was tentatively decided at the June 2015 Board meeting:
1) Measurement exception for underlying items in contracts with direct participation features
The Board confirmed that an entity will be permitted to recognise and measure at fair value through profit or loss (FVPL) the following items if they are underlying items relating to direct participating contracts: investment properties, investments in associates, owner occupied property, own debt and own shares.
This is an extension of the existing option to measure at FVPL assets supporting unit linked contracts to avoid accounting mismatches.
The Board agreed with the approach, but asked staff to clarify in drafting how this exception should be applied to assets that would not be clearly identifiable as assets underlying direct participating contracts in their entirety. For example, how would the approach apply to a proportion of a large property that also backs other types of insurance contracts.
2) Estimation of the CSM on transition for contracts measured using the variable fee approach
The Board agreed on a simplified retrospective transition approach for contracts measured under the variable fee approach, focusing on the key transition issue of estimation of the CSM. Entities would be able to apply this simplified approach if full retrospective application is not possible (e.g., because it requires the use of hindsight).
4 | Insurance Accounting Alert November 2015
Under the simplified retrospective transition approach (and assuming the time value of money is not significant), an entity should, at the date of initial application, measure the CSM of a contract accounted for using the variable fee approach as:
a. The fair value of the shareholder’s share of the returns from underlying itemsLessb. The current estimate of the remaining net cost of providing the contract plus costs already incurredLess c. The accumulated fee for service provided in past periods, determined by comparing the remaining coverage period with the total coverage period of the contract
An entity should then restate the CSM in comparative periods by adjusting the CSM at the date of initial application, assuming the total fee for the contract has not changed since the beginning of the earliest period.
Whilst agreeing with the principle of adopting a simplified approach, the Board asked the staff to improve the guidance on the prescribed approach, in particular on how to deal with prior distributions made from underlying items before the date of transition.
3) How the option to recognise changes in the value of the guarantee in profit or loss instead of the CSM applies on transition
At a previous meeting, the Board decided that an entity that hedges the value of options and guarantees with the use of derivative instruments could take an
option, under the variable fee approach, to recognise in profit or loss (rather than CSM) changes in the value of options and guarantees embedded in the insurance contract. At the meeting, the IASB decided that an entity making use of this option should apply it prospectively from the date of initial application of the new standard. Comparatives would not be adjusted.
In order to be able to apply this option, an entity will have to document both its risk management objectives and risk mitigation strategy. The IASB has previously concluded that it will not be possible to designate a hedging relationship retrospectively without the use of hindsight on transition. Therefore, the option will apply prospectively from the date of initial application of the new standard.
How we see it
The Board appears to be aware that differences between the variable fee approach and general model will result in a “cliff effect” between contracts that qualify for the variable fee approach and those that do not, but sees this as an unavoidable consequence of addressing accounting issues related to participating contracts. Whilst many Board members may have preferred a single model in a perfect world, they expressed both a pragmatic will to complete the standard and to continue in line with the agreed reasoning behind the tentative decisions reached in recent months.
The decision not to allow interest accrual on the CSM at current rates under the general model means that insurance groups who are intending to report the impact of changes in market interest rates in profit or loss would, nevertheless, have to retain information about rates prevailing on the date of contract issuance in order to accrue interest on the CSM at these locked in rates.
What’s next?The Board’s next meeting on insurance contracts is expected to be in December 2015. The topics for that meeting have not yet been announced. At the November meeting, the Board asked the staff to bring the treatment of discretion in participating contracts accounted for under the general model back to a future meeting as soon as possible.
The IASB expects to finalise redeliberations and review the due process steps undertaken to date in developing the new standard in early 2016. It expects to issue the new insurance contracts standard in the second half of 2016.
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