revenue recognition project a view from the insurance industry

Revenue Recognition ProjectA view from the insurance industry

Kevin Griffith3rd November 2008

Introduction

What is Revenue Recognition and why is it important?► About how revenue is earned and disclosed► Asset and liability approach means that it is all about liability

measurement for ordinary business transactions► Liabilities can fall under IAS 37 Provisions, Contingent Liabilities

and Contingent Assets► Impacts on the insurance project

This presentation discusses developments in the Revenue Recognition project. For insurance there appears to be more questions than answers. Actuaries should follow the debate and comment on developments.

Revenue recognition

The IASB and FASB are jointly developing a new standard for Revenue Recognition

Discussion Paper planned for November 2008

Under IFRS the new standard will at least replace IAS 18 Revenue and IAS 11 Construction Contracts

Proposed models► Current exit price► Customer consideration

This is a priority project under the revised Memorandum of Understanding between the IASB and the FASB

Possible Timetable

June 2009End of comment period

Nov 2008IASB - Discussion paper

2013Implementation date

May 2011Final standard

Oct 2009 Exposure draft

Why issue a new standard?

Objective is to develop a single, principles-based model to deal with all types of contracts and business sectors.

To eliminate weaknesses in existing IFRS standards►IAS 18 and IAS 11 principles are not consistent and difficult toapply beyond simple contracts ►Insufficient guidance on multiple element service contracts►Not clear on agency revenue

To converge IFRS and US GAAP requirements

►US GAAP has some 200 sets of requirements

►Economically similar transactions treated differently

The proposed solution

Focus on recognition & measurement of assets and liabilities► Consistent with definitions of revenue► No overrides (eg earnings, risks and rewards)► Increases/decrease in assets and liabilities in the period –performance

Not abandoning ‘earnings’ :► Answers questions: ‘how much revenue earned?’ – with assets and liabilities as the book-ends► Provides coherent framework for complex transactions

Proposed solution (cont)

Performance obligation: the promise in a contract to transfer economic resources to a customer

Performance obligation not satisfied until resources transfer to customer► Goods – when enforceable rights or access to goods transfer to customer► Services – when a service or access to a service is provided

Revenue reflects ‘delivery’ not ‘activity’

The contract asset or contract liability

Exchange promisesgiving rise to:

(net) contract assetif rights > obligations

(net) contract liabilityif obligations > rights

Entity

Rights and performance obligations

resulting in either

OR

Customer

When is revenue recognised?

Revenue is recognised when contract asset increases or contract liability decreases.

Revenue could be recognised in two situations►when the contract is obtained (if a contract asset is recognised)►when a performance obligation is satisfied

When are obligations satisfied?

Performance obligation: the promise in a contract to transfer economic resources to a customer

Performance obligation not satisfied until resources transferto customer► Goods – when enforceable rights or access to goods transfer to customer► Services – when a service or access to a service is provided

Revenue reflects ‘delivery’ to customer not ‘activity’

Measurement of performance obligation, two possibilities under consideration:

Revenue Recognition

REVENUE RECOGNITION

PROJECT

Current Exit Value – Consistent with fair value

Customer Consideration approach – Measure performance at transaction price

Current exit price approach

InitialMeasure performance obligations at exit price= price third party would charge to assume remaining obligations

Price to fulfil remaining performance obligationsexcludes direct/indirect costs of obtaining a contract

SubsequentMeasure remaining performance obligations at the exit price at reporting date= Current measure

Like current exit value in insurance DP.

Customer consideration approach

Initial Measure performance obligations at contract price►Assumes contract price only for goods/services yet to be provided►Allocate portion of contract price to each performance obligation on basis of standalone sales price►Measurement includes any amounts in pricing that are to recover direct/indirect costs of obtaining a contract►Like UPR with no DAC

SubsequentMeasure remaining performance obligations at the amount of contract price allocated at inception

►Initial measure locked in – updated only if performance obligation onerous (Liability Adequacy Test)

The Boards’ preliminary views

Focusing on the customer consideration approach.

For multiple element arrangements, the total transaction price allocated to individual performance obligations is based on observed or estimated stand-alone price.

Performance obligations may need to be remeasured during the contract period. This applies where uncertainty is a key characteristics of the obligation and/or obligation is long termso changes in circumstances highly likely.

Would insurance lead the way for a different approach?

Illustration of Customer Consideration approach for Non life Insurance

Good Insurance and a group of customers contract for householder cover for 1 year for premiums totalling €10,000 at 31 Dec.

Good insurance incurs acquisition costs of €1,000.

Year end is 30 June.

An insurance example – Non LifeCustomer consideration

At 31 Dec Good insurance estimates its standalone sales price for the portfolio for insurance cover is €8,000 and for claims handling is €500.

At 31 Dec recognise:The performance obligations at allocated amounts insurance: 10,000 x 8,000/(8,000 + 500) = €9,412; claims handling: €588. Revenue = 0.Dr Cash 10 000Cr Performance obligation: insurance 9 412Cr Performance obligation: claim handling 588

An insurance example – Non Life Customer Consideration (cont)

At 30 June, it is estimated that half of insurance obligation has been performed and 30% of claims handling service. At 30 June recognise:Net insurance contract liability now €4,706 (ie. €9,412/2), net claims handling liability now €412. (ie. 70% x €588). Revenue €4,882 [(9,412 + 588) - (4,706 + 412)]Dr Performance obligation: insurance (9 412- 4 706) 4 706Dr Performance obligation: claim handling (588 - 412) 176Cr Revenue 4 882

At 31 December, the insurance obligation has been fully performed. It is estimated that 85% of claims handling service has been performed. Recognise performance obligation of €88 (ie. 15% x €588).Dr Performance obligation: insurance 4 706Dr Performance obligation: claim handling (412 - 88) 324Cr Revenue 5 030Total Revenue recognised to date €9,912. Deferred €88.

An insurance example – Term LifeCustomer Consideration (1/5)

Good Insurance and a group of customers contract for 10 year term assurance cover at 31 Dec. First annual premiums received total €10,000 at 31 Dec. Good insurance incurs acquisition costs of €4,000. Automatic annual renewal.

What performance obligations does Good Insurance have?A - Obligation to provide insurance cover for one yearB - Obligation to provide claims handling cover for just over a yearC - Obligation to accept premiums in future years and provide coverage

How much would Good Insurance charge if it sold these services separately? Use this to allocate the premium of €10, 000.

An insurance example – Term LifeCustomer Consideration (2/5)What could the selling price for each obligation be?A - Obligation to provide insurance cover for one year. Presumably expected claims cost for one year plus a margin, say €2,500B - Obligation to provide claims handling cover for just over a year. Assume that this service was worth €500C - Obligation to accept premiums in future years and provide coverage. It is not clear how this obligation will be valued. In future years the premium should offset most of the ‘cost’ to the insurer of this obligation. So this may have a standalone price of nil or may be negative as it could represent a valuable customer relationship. It is not clear how the model would deal with such a negative value. It seems like it may be a right, but since it is not contractual or enforceable it is unlikely to qualify for recognition as an asset. Dr Cash 10 000Cr Performance obligation A (2.5/3 x 10) 8 333Cr Performance obligation B (0.5/3 x 10) 1 667


Presumably most of the €10,000 will be earned by the end of year 1. The one year’s worth of cover will have been provided and most of the claims handling service as well. However this is not the end of the story.

Insurers know that a portion of the premiums received in the early years when claims on these policies are low will offset the increased claims in future years. Therefore under traditional models an additional claims liability is set up related to future claims. The revenue recognition standard requires an onerous contract test to determine whether the liability is sufficient. This could require an additional liability to be set up. It is not clear how this would be determined for a portfolio of insurance contracts. Should profitable contracts offset unprofitable contracts. This could inhibit the provision of decision-useful information.

An insurance example – Term LifeCustomer Consideration (4/5)An alternative approach might be to allocate a value to Obligation C

A - Obligation to provide insurance cover for one year. Presumably expected claims cost for one year plus a margin, say €2,500B - Obligation to provide claims handling cover for just over a year. Assume that this service was worth €500C - Obligation to accept premiums in future years and provide coverage. On the basis that future claims costs could exceed premiums as claims tend to be higher in future years, we might put a value on this obligation of say €5,500. Then revenue entry on Day 1 would be:

Dr Cash 10 000Cr Performance obligation A (2.5/8 x 10) 3 125Cr Performance obligation B (0.5/8 x 10) 625Cr Performance obligation C (5.5/8 x 10) 6 250


Now presumably most of the €2,500 and €500 (Obligations A and B) will be earned by the end of year 1. Obligation C might not be earned until future years. So the entry at the end of year 1 might be:

Dr Performance obligation A 3 125Dr Performance obligation B 625

Cr Revenue 3 750

In future years a smaller proportion of the current year’s premium might be allocated to Performance obligation C. Perhaps in year 5 a proportion of the liability for Performance obligation C may begin to be released as the increased claims expenses exceed the stand alone selling price of providing one year’s coverage to remaining policyholders.

An insurance example – Annuity ContractCustomer Consideration

On 31 Dec Good Insurance sells single premium annuity contracts to ten customers aged 60 for €100,000 providing regular payments €7,500 per annum each. Good insurance charges €1m in total and incurs acquisition costs of €10,000.

What performance obligations does Good Insurance have?A - Obligation to make payments to annuitants that survive

Allocate the performance obligation and earn revenue over time. A pure customer consideration model will simply spread the revenue over the average period (on average maybe 20 years). However it is likely that the insurer’s estimates of what interest rates will be and who will die willchange over time. Will this make the locked in information no longer decision useful?

An insurance example – Annuity Contract Customer Consideration (cont)On Day 1 allocate the total premium received to the performance obligations

Dr Cash 1mCr Performance obligation 1m

At the end of year 1, assume that all annuitants had survived and that the insurer had paid out €75,000. The insurer also estimates that at the end of year 1 it has fulfilled 1/20th of its obligation to the portfolio of policyholders. Journal entries would be as follows:

Dr Performance obligation (1/20 x 1m) 50 000Cr Revenue 50 000

Dr Claims expense 75 000Cr Cash 75 000

Problems, Issues, Questions for the IASB

Insurance is different because we earn revenue not by providing goods or services, but by standing ready to provide indemnity or financial compensation.

Insurance only makes sense from a portfolio perspective, so needrecognition of this in measuring liabilities.

Life insurance is long term which makes lock in complicated and potentially less relevant (especially when the assets backing liabilities are held at fair value on the balance sheet). The portfolio approach and the fact that customers can renew without risk profile reconfirmation introduces questions about whether future non contractual cash flows can or should be considered.

Is it the onerous contract test that would result in the booking of claims liabilities (in addition to UPR on non-life contracts)?

Comments and Questions

Call to action

►Discussion Paper out by year end

►IASB will seek feedback on:► appropriateness of a single model► level of guidance► use of estimated sales prices► treatment of contract origination costs► which obligations should be remeasured?

►Insurance industry should comment on why it is or is not appropriate for insurance

Kevin GriffithErnst & Young

Insurance Working GroupLondonTel: +44 207 951 0905Email: [email protected]

Thank You

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revenue recognition project a view from the insurance industry

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