IFRS 9 Financial Instruments - The Accounting Library
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for Accounting Professionals
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IFRS 4 Insurance contracts
2013
IFRS WORKBOOKS
(1 million downloaded)
Welcome to the EU Tacis IFRS Workbooks sixth (2013) edition! This is the tenth anniversary of the first edition in 2003. The changes from the 2012 edition are minimal, with no new standard issued in the past year. Major changes are anticipated to IFRS 9, IFRS 4, IAS 17 and IAS 18. Exposure drafts (proposals) have been issued, but have not yet been incorporated into the standards. To the books, we have added an article: ‘IFRS- grabbing the tiger by the tail’ which has been published by bankir.ru in Russian. This article covers IFRS teaching issues for each standard and a number of opinions and discussion points.
The set of books provides a book for every standard, plus three books on consolidation. Financial instrument bookkeeping is covered in IAS 32/39 (book 3) and in IFRS 9. IFRS 7 is complemented by FINREP, which illustrates practical use and presentation formats. An introduction to IFRS and transformation models from Russian accounting to IFRS complete the set.
Each workbook is a combination of Information, Examples, Self-Test Questions and Answers.
Thanks are due to those who made these publications possible and to you, our readers, for your continued support. I would like to express my gratitude to: Igor Sykharev and Tatiana Trifonova of the Ministry of Finance who provided a link from the Ministry’s site. Gulnara Makhmutova and Adel Valeev provided the updated Russian texts and editing. Marina Korf and Yulia Ykhanova of bankir.ru provided help, advice and space on its website. Sergey Dorozhkov and Elina Buzina of Association of Russian Bankers’ Institute of Banking ran excellent IFRS courses on all standards which enabled us to test this material and learn new insights from them and the participants. Please join us there for the best consolidation course in Russia.
World Bank courses for the Bank of Tanzania (‘BOT’) provided new IFRS and banking insights: thanks to Albert Mkenda BOT and my colleague Benson Mahenya among many others. IFRS assistance to the Bank of Mongolia (‘BOM’) with PricewaterhouseCoopers (thanks to Ekaterina Nekrasova, Jelena Pesic and Vladislav Kononenko) provided exposure to Mongolian commercial bank reporting and blending IFRS with bank prudential ratios. Oyungerel Gonchig, Project Manager at World Bank, Mongolia, and our counterparts at BOM: Oyuntsatsral Banid, Bunchinsuren Dagva, Borkhuu Gotovsuren, Batmaa Ochirbat and Gantsetseg Myagmarjay contributed to a memorable project.
On the back page are notes covering copyright details and the history of the series.
Please tell your friends and colleagues where to find our books. We hope that you find them useful.
Robin Joyce
Professor of the Chair of International Banking and Finance,
Financial University under the Government of the Russian Federation
Professor, Russian Academy of National Economy and Public
Administration under the President of the Russian Federation
Visiting Professor of the Siberian Academy of Finance and Banking Moscow, Russia 2013
CONTENTS
1. Insurance Contracts - Introduction 3
2. BACKGROUND (taken from 6
IFRS 4: The future for insurance reporting- for now (PWC)) 6
3. RECOGNITION AND MEASUREMENT 21
4. Changes in accounting policies 23
5. Discretionary participation features 25
7. DISCLOSURE 27
8. Multiple choice questions 29
9. Answers to multiple choice questions 33
10. Appendix. Similarities and Differences – A comparison of IFRS and US GAAP – PwC-September 2004 34
1. Insurance Contracts - Introduction
OVERVIEW
Aim
The aim of this workbook is to assist the individual in understanding the IFRS treatment of Insurance Contracts. This is the subject of IFRS 4.
Currently applicable IFRS does not yet contain comprehensive accounting treatment of transactions that are specific to insurance contracts. As a result, insurance groups generally tend to apply the provisions as set out under USGAAP for insurance contracts, modified as appropriate to comply with the IFRS framework and applicable standards.
OBJECTIVE
The objective of IFRS 4 is to specify the financial reporting for insurance contracts, by any insurer that issues such contracts, until the IAS Board completes the second phase of its project on insurance contracts.
In particular, IFRS 4 requires:
(i) certain improvements to accounting, by insurers, for insurance contracts.
(ii) disclosure that identifies (and explains) the amounts in an insurer’s financial statements, arising from insurance contracts, and helps users understand the amount, timing and uncertainty of cash flows from insurance contracts.
| Definitions | |
| | |
|cedant |The policyholder under a reinsurance contract. |
|deposit component |A contractual component that is not accounted for as a |
| |derivative underIFRS 9, (and would be within the scope of |
| |IFRS 9 if it were a separate instrument). |
|direct insurance contract |An insurance contract that is not a reinsurance contract. |
|discretionary participation feature |A contractual right to receive (as a supplement to |
| |guaranteed benefits), bonus benefits: |
| | |
| |(1) that are likely to be a significant portion of the |
| |total contractual benefits; |
| | |
| |(2) whose amount (or timing) is contractually at the |
| |discretion of the issuer; and |
| | |
| |(3) that are contractually based on: |
| | |
| |(i) the performance of a specified pool of contracts, or a |
| |specified type of contract; |
| | |
| |(ii) realised and/or unrealised investment returns on a |
| |specified pool of assets held by the issuer; or |
| | |
| |(iii) the income statement of the company, fund or other |
| |undertaking that issues the contract. |
|fair value |The price that would be received to sell an asset, or paid |
| |to transfer a liability, in an orderly transaction between |
| |market participants at the measurement date. (IFRS 13) |
| | |
|financial guarantee contract |A contract that requires the issuer to make specified |
| |payments to reimburse the holder for a loss it incurs |
| |because a specified debtor fails to make payment when due |
| |in accordance with the original or modified terms of a debt|
| |instrument. |
|financial risk |The risk of a possible future change in a specified |
| |interest rate, financial instrument price, commodity price,|
| |foreign exchange rate, index of prices or rates, credit |
| |rating or credit index or other variable, provided (in the |
| |case of a non-financial variable) that the variable is not |
| |specific to a party to the contract. |
| | |
| | |
|guaranteed benefits |Payments (or other benefits) to which a particular |
| |policyholder (or investor) has an unconditional right, that|
| |is not subject to the contractual discretion of the issuer.|
| | |
|guaranteed element |An obligation to pay guaranteed benefits, included in a |
| |contract that contains a discretionary participation |
| |feature. |
|insurance asset |An insurer’s net contractual rights, under an insurance |
| |contract. |
|insurance contract |A contract under which the insurer accepts significant |
| |insurance risk from the policyholder, by agreeing to |
| |compensate the policyholder if the insured event adversely |
| |affects the policyholder. |
|insurance liability |An insurer’s net contractual obligations under an insurance|
| |contract. |
|insurance risk |Risk, other than financial risk, transferred from the |
| |holder of a contract to the issuer. |
|Insured event |An uncertain future event that is covered by an insurance |
| |contract, and creates insurance risk. |
|Insurer |The party that has an obligation (under an insurance |
| |contract) to compensate a policyholder, if an insured event|
| |occurs. |
|liability adequacy test |An assessment of whether the carrying amount of an |
| |insurance liability needs to be increased (or the carrying |
| |amount of related deferred acquisition costs, or related |
| |intangible assets decreased), based on a review of future |
| |cash flows. |
|policyholder |A party that has a right to compensation (under an |
| |insurance contract) if an insured event occurs. |
|reinsurance assets |A cedant’s net contractual rights under a reinsurance |
| |contract. |
|reinsurance contract |An insurance contract issued by the reinsurer to compensate|
| |the cedant for losses on contracts issued by the cedant. |
|reinsurer |The party that has an obligation under a reinsurance |
| |contract to compensate a cedant (if an insured event |
| |occurs). |
|unbundle |Account for the components of a contract as if they were |
| |separate contracts. |
2. BACKGROUND (taken from
IFRS 4: The future for insurance reporting- for now (PWC))
IFRS 4 contains the sections outlined below:
|Scope- |
|List of contracts not covered by the standard- |
|Embedded derivatives scope exemptions- |
|Unbundling of deposit components |
|Recognition and measurement- |
|Temporary exemption from some other IFRSs- |
|Liability adequacy test- |
|Changes in accounting policies- |
|Insurance contracts acquired in a business combination or portfolio transfer- |
|Discretionary participation features |
|Disclosure- |
|Explanation of recognised amounts- |
|Amount, timing and uncertainty of cash flows |
|Effective date and transition- |
|Disclosure- |
|Redesignation of financial assets |
|Appendices- |
|Definitions- |
|Definition of insurance contract – |
|application guidance- |
|Amendments to other IFRSs |
IFRS is much more than just a technical issue, and will result in fundamental changes to the way in which the industry does business, and communicates value to analysts, investors and other key stakeholders.
IFRS 4 addresses accounting and disclosures for both insurance and reinsurance contracts. It includes a new insurance contract definition that will result in many savings, and pension plans (now classified as insurance under existing accounting principles) being re-designated as investment contracts and becoming subject to the financial instrument standard IFRS 9.
The IFRS valuation criteria could have crucial implications for earnings, incentives and investor relations.
1) New definition of an insurance contract
Definition of an insurance contract Source: IASB, IFRS 4
‘A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.’
This definition covers most motor, travel, life, annuity, medical, property, reinsurance and professional indemnity contracts. However, policies that transfer no significant insurance risk (such as some savings and pensions plans) will be designated as financial instruments, and covered by IFRS 9, regardless of their legal form.
Definition of financial risk
‘The risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a nonfinancial variable that the variable is not specific to a party to the contract.
’Source: IASB, IFRS 4
Insurance contracts (as defined in IFRS 4) will continue to be covered by existing accounting policies during Phase I. This is an unprecedented exemption from the IFRS ‘framework’ (see Framework workbook) and ‘hierarchy’, which is designed to allow more time to develop a finalised Phase II for insurance contracts.
1. Insurers can use ‘current interest rates’ to value liabilities, bringing them more into line with movements in associated interest-sensitive assets. This provision is designed to meet concerns over the potential mismatch between assets and liabilities.
2. Companies can adjust their liabilities to reflect future investment margins only if this is part of a switch to a ‘widely used’ and ‘comprehensive investor oriented basis of accounting’.
3. Insurers can adopt a form of ‘shadow accounting’ that would allow them to adjust their liabilities for changes that would have arisen if any unrealised gains, or losses, on securities had been realised. Liability movements can be recognised in equity in line with the recognition of unrealised investment gains or losses.
4. Companies can elect to measure, at fair value, investment properties used to support liabilities linked to the fair value of those properties, leaving all the other investment properties at cost.
5. Insurers can recognise an intangible asset that covers the difference between the fair value and the book value of the insurance liabilities, taken on through a business combination (or portfolio transfer). This is a concession to insurers, as such an asset does not exist within IFRS.
6. Companies can continue to value insurance and investment contracts with discretionary participatory features (DPF) using their existing accounting policies.
Discretionary participatory features allow clients to share in the investment profits made by the insurer. The insurer can guarantee a minimum profit, but can then increase this at his discretion.
The fixed guaranteed element should be regarded as the minimum liability.
1. The rest of the DPF contract could be classified as an additional liability, or included in equity, or split between equity and liabilities.
2. DPF contracts without significant insurance risk still require fair value disclosure.
3. Companies are permitted to continue to report premiums from DPF investment contracts as revenue, with a corresponding expense representing the change in the liability.
The IFRS 9 minimum liability test applies to the fixed guaranteed element of DPF investment contracts, only when an equity component is recognised.
Derivative features (such as certain types of index-linked options that are embedded into a host insurance contract) may need to be separated and fair valued. An insurance contract can contain both deposit and insurance components.
An example might be a profit sharing reinsurance contract where the cedant is guaranteed a minimum repayment of its premium. Such contracts may need to be split and valued separately, as the application of existing local accounting principles to the deposit component could result in the reinsurer not fully recognising its obligations to repay amounts received, or the cedant omitting from the balance sheet (SFP) its rights to recover amounts paid.
‘Unbundling’ is designed to ensure that any rights and obligations are recorded on the balance sheet as assets and liabilities, rather than treated as expenses or revenue.
IFRS 4 requires insurers ‘to disclose information that helps users to understand the estimated amount, timing and uncertainty of future cash flows’, arising from insurance contracts.
They will also need to give more details about the risks being run including concentrations of risk, and the impact of market variables on the key assumptions used to estimate insurance assets and liabilities (sensitivity analysis).
IFRS 4-crucial changes from the disclosure requirements set out in ED 5
1. Need to disclose the gains and losses from purchased reinsurance contracts.
Insurers will need to disclose the gains and losses from purchased reinsurance contracts. If the insurer’s reinsurance rights are potentially damaged, based on the asset impairment test in IFRS 9, the cedant shall reduce the balance sheet amount accordingly.
2. New intangible asset: future investment management fees.
IFRS 4 amends IAS 18 to require companies to recognise an intangible asset representing the right to future investment management fees.
This asset is measured by the incremental transaction costs incurred to secure revenue from investment management services contracts.
This change allows insurers to capitalise in their balance sheet acquisition costs such as the commissions paid to intermediaries to secure contracts where income is earned from long-term savings being actively managed. These costs can only be capitalised to the extent they are recoverable out of future revenue.
SCOPE
An undertaking shall apply IFRS 4 to:
(i) insurance contracts (including reinsurance contracts) that it issues and reinsurance contracts that it holds.
(ii) financial instruments that it issues with a discretionary participation feature. IFRS 7 Financial Instruments: Disclosures requires disclosure about financial instruments that contain such features.
IFRS 4 describes any undertaking that issues an insurance contract as an insurer, whether (or not) the issuer is regarded as an insurer for legal, or supervisory purposes.
A reinsurance contract is a type of insurance contract. All references to insurance contracts, also apply to reinsurance contracts.
IFRS 4 does not address other aspects of accounting by insurers, such as accounting for financial assets held by insurers, and financial liabilities issued by insurers (see IAS 32 and IFRS 9 Financial Instruments).
An undertaking shall not apply IFRS 4 to:
(i) product warranties, issued directly by a manufacturer, dealer or retailer (see IAS 18 and IAS 37).
(ii) employers’ assets and liabilities under staff benefit plans (see IAS 19 and IFRS 2) and retirement benefit obligations reported by defined benefit retirement plans (see IAS 26).
(iii) contractual rights or (obligations) that are contingent on the future use of, or right to use, a non-financial item (for example, some licence fees, royalties, contingent lease payments and similar items), as well as a lessee’s residual value guarantee embedded in a finance lease (see IAS 17, IAS 18 and IAS 38).
(iv) financial guarantee contracts unless the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, in which case the issuer may elect to apply either IFRS 9, IAS 32 and IFRS 7 or IFRS 4 to such financial guarantee contracts. The issuer may make that election contract by contract, but the election for each contract is irrevocable. .
(v) contingent consideration payable (or receivable) in a business combination (see IFRS 3).
(vi) direct insurance contracts that the undertaking holds (i.e. direct insurance contracts, in which the undertaking is the policyholder). However, a cedant shall apply IFRS 4 to reinsurance contracts that it holds.
Definition of an insurance contract
Uncertain future event
Uncertainty (or risk) is the essence of an insurance contract. At least one of the following is uncertain at the start of a contract:
(i) whether an insured event will occur;
(ii) when it will occur; or
(iii) how much the insurer will need to pay, if it occurs.
In some contracts, the insured event is the discovery of a loss during the term of the contract, even if the loss arises from an event that occurred before the start of the contract.
EXAMPLE - loss from an event that occurred before the start of the contract
An insurance contract covers environmental damage. Unknown to the insurer effluent had been flowing out of the client’s mine before the contract started. It now flows into a lake, and the client claims under the contract.
In other contracts, the insured event is an event that occurs during the term of the contract, even if the resulting loss is discovered after the end of the contract term.
EXAMPLE - resulting loss is discovered after the end of the contract term
An office insurance contract expires on December 31st. The office is closed from the 28th, and the office is robbed. This is not discovered until January 1st, (after the end of the contract term) but video cameras confirm the date of the theft.
Some contracts cover events that have already occurred, but whose financial effect is still uncertain.
EXAMPLE - whose financial effect is still uncertain
A reinsurance contract covers the insurer against adverse development of claims, already reported by policyholders. In such contracts, the insured event is the discovery of the ultimate cost of those claims.
Payments in kind
Some insurance contracts require (or permit) payments to be made in kind.
EXAMPLES - payments to be made in kind
The insurer replaces a stolen article directly, instead of reimbursing the policyholder.
An insurer uses its own hospitals (and medical staff) to provide medical services, covered by the contracts.
Some fixed-fee service contracts, in which the level of service depends on an uncertain event, meet the definition of an insurance contract in IFRS 4, but are not regulated as insurance contracts, in some countries.
EXAMPLE - fixed-fee service contract 1
A maintenance contract, in which the service provider agrees to repair specified equipment (such as a washing machine), after a malfunction, passes the risk to the service provider.
The fixed service fee is based on the expected number of malfunctions, but it is uncertain how often a particular machine will break down. The malfunction of the equipment adversely affects its owner, and the contract compensates the owner (in repairs, rather than cash).
EXAMPLE - fixed-fee service contract 2
The insurer issues a contract for car breakdown services, in which a firm agrees, for a fixed annual fee, to provide roadside assistance (or tow the car to a nearby garage).
This is an insurance contract, even if the firm does not carry out repairs, nor replace parts.
EXAMPLE -car breakdown service
The contract will not cover malfunctions that existed prior to the start of the contract. Revenue will be recorded on an elapsed time basis, unless another method (a seasonal bias, if winter claims are high) is more appropriate.
The service provider considers whether the cost of meeting its contractual obligation to provide services exceeds the revenue received in advance.
EXAMPLE-costs exceeding revenue
A firm provides a car breakdown service. Revenue= the number of clients multiplied by the fees. Costs are the infrastructure (staff, vehicles) and the variable costs (fuel, parts), which will be incurred in providing the service. As clients pay in advance, their fees are fixed. If costs increase dramatically, they may exceed revenue.
To estimate if costs exceed revenue, the company applies the liability adequacy test (see below). If IFRS 4 did not apply to these contracts, the service provider would apply IAS 37 Provisions to determine whether the contracts are onerous.
Distinction between insurance risk and other risks
To decide whether there is an insurance contract:
1. There must be a risk (not a certainty).
2. It must not be a ‘financial’ risk (see example below).
3. It must be transferred from the holder of a contract to the issuer.
EXAMPLE-risk transfer
An insurer is the issuer of a building insurance contract. The owner (holder of the contract) has the risks of the building, but has transferred them to the insurer, by buying the contract.
A contract that exposes the issuer to financial risk, without significant insurance risk, is not an insurance contract.
EXAMPLE-financial risk
The bank provides a fixed contract to exchange 1 million Euros for Roubles in 3 months time. The bank is taking a financial risk (of changing exchange rates), but no insurance risk.
The definition of financial risk includes a list of financial, and non-financial, variables.
The list includes non-financial variables that are not specific to a party to the contract, such as an index of earthquake losses in a particular region, or an index of temperatures in a particular city.
EXAMPLE- non-financial variables
An investor has an investment portfolio in Japanese firms. He knows that the region is prone to earthquakes, and has a contract to pay $2 million, if there is an earthquake there, this year. This is not insurance, as he has no insurable interest in the property damaged. His interest is indirect: he knows that his investments will fall, in the event of an earthquake.
The risk of changes in the fair value of a non-financial asset is an insurance risk, if the fair value reflects not only changes in market prices for such assets (a financial variable), but also the condition of a specific non-financial asset held by a party to a contract (a non-financial variable).
Some contracts expose the issuer to financial risk, in addition to significant insurance risk.
EXAMPLE- contracts with both financial and insurance risk
Many life insurance contracts both:
-guarantee a minimum rate of return to policyholders (creating financial risk) and
-promise death benefits, that may significantly exceed the premiums paid to date (creating insurance risk in the form of mortality risk).
Such contracts are insurance contracts.
Under some contracts, an insured event triggers the payment of an amount linked to a price index. Such contracts are insurance contracts, provided the payment (that is contingent on the insured event) can be significant in relation to the premium.
EXAMPLE- contracts linked to a price index
A life-contingent annuity, linked to a cost-of-living index, transfers insurance risk, as payment is triggered by an uncertain event—the survival of the annuitant. After the annuitant dies, no payment is made.
In this example, the beneficiary has bought an annuity for (say) 100.
Each year after retirement age, he will receive a pension.
It may start at 6 in the first year.
The second year, it will be 6 plus the increase in the cost of living index.
The payments will cease on his death.
The insurer is taking the risk for the initial payment of 100.
The link to the price index is an embedded derivative, but it also transfers insurance risk.
If the resulting transfer of insurance risk is significant, the embedded derivative meets the definition of an insurance contract, in which case it need not be separated and measured at fair value.
Insurance risk is the risk that the insurer accepts from the policyholder. Insurance risk is a pre-existing risk, transferred from the policyholder to the insurer. Thus, a new risk created by the contract is not insurance risk.
The definition of an insurance contract refers to an adverse effect on the policyholder. The definition does not limit the payment, by the insurer, to an amount equal to the financial impact of the adverse event.
EXAMPLE-no limit to the insurer’s payment
Insurance contracts can offer ‘new-for-old’ coverage, that pays the policyholder sufficient funds to replace a damaged old asset with a new asset.
Similarly, the definition does not limit payment (under a term life insurance) contract to the financial loss suffered by the deceased’s dependants, nor does it preclude the payment of predetermined amounts to quantify the loss, caused by death (or an accident).
EXAMPLE- insurer’s payment not limited to provable loss
An insurer has insured his client’s life for $1 million. The deceased’s dependants will not have to prove their financial loss in order to claim this amount.
Some contracts require a payment if a specified uncertain event occurs, but do not require an adverse effect on the policyholder (as a precondition for payment). Such a contract is not an insurance contract, even if the holder uses the contract to mitigate an underlying risk exposure.
EXAMPLE – no adverse effect, but payment will be made
The client uses a derivative to hedge property values. The derivative is based on a national property index. The client holds investment property, which is rarely sold.
The derivative is not an insurance contract, as payment is not conditional on whether the holder has realised a loss from the sale of the asset.
Conversely, the definition of an insurance contract refers to an uncertain event for which an adverse effect on the policyholder is a contractual precondition for payment.
This contractual precondition does not require the insurer to investigate whether the event actually caused an adverse effect, but permits the insurer to deny payment, if it is not satisfied that the event caused an adverse effect.
EXAMPLE –adverse effect needed for payment to be made
The client has property insurance. A fire destroys the property, and the client claims under the policy.
The insurer can deny payment, until investigations confirm the value of the claim, and that there has been no contributory negligence by the client.
Lapse, or persistency risk (the risk that the client will cancel the contract earlier (or later) than the issuer had expected in pricing the contract) is not insurance risk, as the payment to the client is not contingent on an uncertain future event that adversely affects the client.
EXAMPLE – lapse risk
An insurer has priced his product liability insurance, based on an expected life of 5 years for a new product. The product is withdrawn after 3 years and the insurance is cancelled. The early termination of the policy is not insurance risk.
Similarly, expense risk (the risk of unexpected increases in the administrative costs associated with the servicing of a contract, rather than in costs associated with insured events) is not insurance risk, as an unexpected increase in expenses does not adversely affect the client.
EXAMPLE – costs increasing
An insurer provides a car breakdown service. Its costs are the infrastructure (staff, vehicles) and the variable costs (fuel, parts), which will be incurred in providing the service. If administration costs increase dramatically, this is not an insurance risk, as this does not adversely affect the client.
Therefore, a contract that exposes the issuer to lapse risk, persistency risk, or expense risk, is not an insurance contract, unless it also exposes the issuer to insurance risk.
If the issuer of that contract mitigates that risk by using a second contract to transfer part of that risk to another party (reinsurance), the reinsurance contract exposes that other party to insurance risk.
An insurer can accept significant insurance risk from the client only if the insurer is an undertaking, separate from the client. In the case of a mutual insurer, the mutual accepts risk from each policyholder and pools that risk.
Although policyholders bear that pooled risk collectively (in their capacity as owners) the mutual has still accepted the risk that is the essence of an insurance contract.
EXAMPLE-mutual insurer
A group of businesses form an insurance mutual organisation to insure their vehicle risks. The organisation is jointly-owned by the participants. Though the participants are trading with themselves, pooling their risks (and receiving any profit), the mutual has still accepted the risk that is the essence of an insurance contract.
Examples of insurance contracts
The following are examples of contracts that are insurance contracts, if the transfer of insurance risk is significant:
(i) insurance against theft (or damage) to property.
(ii) insurance against product liability, professional liability, civil liability or legal expenses.
(iii) life insurance and prepaid funeral plans (although death is certain, it is uncertain when death will occur or, for some types of life insurance, whether death will occur within the period covered by the insurance).
(iv) life-contingent annuities and pensions (i.e. contracts that provide compensation for the uncertain future event—the survival of the annuitant (or pensioner)—to assist the annuitant (or pensioner) in maintaining a given standard of living, which would otherwise be adversely affected by his survival – the longer he lives, the less money he will have as his savings diminish).
(v) disability and medical cover.
(vi) surety bonds, fidelity bonds, performance bonds and bid bonds (contracts that provide compensation, if another party fails to perform a contractual obligation, for example an obligation to construct a building).
EXAMPLE-fidelity bonds
A client runs a company. The insurer provides fidelity insurance to cover losses from fraud, or misbehaviour by his staff.
EXAMPLE-performance bonds
A client is building a shopping mall. The insurer provides a performance bond, guaranteeing completion of the project on time, by the client.
(vii) credit insurance that provides for specified payments to be made to reimburse the holder for a loss it incurs, because a specified debtor fails to make payment when due, under the original (or modified) terms of a debt instrument.
EXAMPLE-credit insurance
A client is an exporter, selling goods on credit. He buys insurance against non-payment by clients.
These contracts could have various legal forms, such as that of a financial guarantee, letter of credit, credit derivative default product, or insurance contract.
However, although these contracts meet the definition of an insurance contract, they also meet the definition of a financial guarantee contract in IFRS 9 and are within the scope of IFRS 7. and IFRS 9, not IFRS 4.
Nevertheless, if an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply either IFRS 9 and IFRS 7 or IFRS 4 to such financial guarantee contracts.
(viii) product warranties. Product warranties issued by another party for goods sold by a manufacturer, dealer or retailer are within the scope of IFRS 4.
However, product warranties issued directly by a manufacturer, dealer or retailer are outside its scope, because they are within the scope of IAS 18 Revenue and IAS 37 Provisions.
(ix) title insurance (i.e. insurance against defects in title to land that were not apparent when the insurance contract was written). In this case, the insured event is the discovery of a defect in the title, not the defect itself.
(x) travel assistance (i.e. compensation in cash, or in kind, to policyholders for losses, suffered while they are traveling).
(xi) catastrophe bonds that provide for reduced payments of principal, interest (or both), if a specified event adversely affects the issuer of the bond (unless the event does not create significant insurance risk, for example if the event is a change in an interest rate, or foreign exchange rate).
EXAMPLE- catastrophe bonds
A client is building a sports complex. The insurer insures his property against earthquakes, floods and land subsidence.
(xii) insurance swaps, and other contracts that require a payment based on changes in climatic, geological or other physical variables, that are specific to a party to the contract.
EXAMPLE- changes in climate, that are specific to a party to the contract
A client is a farmer. He is insured against bad weather in the area of his farm.
(xiii) reinsurance contracts.
The following are examples of items that are not insurance contracts:
(i) investment contracts that have the legal form of an insurance contract but do not expose the insurer to significant insurance risk,
EXAMPLE-life assurance with no mortality risk.
When life insurance contracts are written in which the insurer bears no significant mortality risk, such contracts are non-insurance financial instruments or service contracts.
The client pays premiums, and will receive a lump sum at the end of the policy. His death will result in the repayment of premiums, plus some interest.
The contract is merely one of investment.
(ii) contracts that have the legal form of insurance, but pass all significant insurance risk back to the policyholder, through non-cancelable and enforceable mechanisms, that adjust future payments by the policyholder as a direct result of insured losses.
EXAMPLE- legal form of insurance, but pass all significant insurance risk back to the policyholder
These include some financial reinsurance contracts, or some group contracts (such contracts are normally non-insurance financial instruments, or service contracts). Here the client keeps all the risks, as any claims paid will be reimbursed by the client through higher premiums, in the future.
(iii) self-insurance, in other words retaining a risk that could have been covered by insurance (there is no insurance contract, as there is no agreement with another party).
EXAMPLE- self-insurance
A firm has an internal insurance department. It has a large number of vehicles. The firm decides that to meet all claims internally, rather than insure with a third party. The firm retains the risks. There is no insurance contract, as there is no agreement with another party
(iv) contracts (such as gambling contracts) that require a payment if a specified uncertain future event occurs, but do not require, as a contractual precondition for payment, that the event adversely affects the policyholder.
EXAMPLE- gambling contracts
A client signs a contract with an insurer. The insurer will pay a fixed amount for every point gained by a stock exchange in the next year, excluding the first 100 points. This enables the client to benefit from the gain, without buying shares. (The insurer can buy shares to cover the risk, if he wishes.) This is a gambling contract, not an insurance contract.
However, this does not preclude the specification of a predetermined payout to quantify the loss caused by a specified event, such as death (or an accident).
v) derivatives that expose one party to financial risk, but not insurance risk, because they require that party to make payment based solely on changes in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating (or credit index) or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (see IFRS 9).
EXAMPLE- changes in an index
A client buys a derivative. He will receive a fixed amount for every point gained by a stock exchange in the next year, excluding the first 100 points. This enables the client to benefit from the gain, without buying shares. (The insurer can buy shares to cover the risk, if required.) This is not an insurance contract.
vi) a credit-related guarantee contract (or letter of credit, credit derivative default product, or credit insurance contract) that requires payments, even if the holder has not incurred a loss on the failure of the debtor to make payments when due (see IFRS 9).
EXAMPLE-no-loss financial guarantee contract
An insurer insures a shipment of oil against credit default. The client defaults, but the oil is resold at a profit to another client. Under this contract, the insurer still has to make payment, even though holder has not incurred a loss.
(vii) contracts that require a payment based on a climatic, geological or other physical variable that is not specific to a party to the contract (commonly described as weather derivatives).
EXAMPLE-weather derivatives
Purely for speculation, a speculator gambles on how many hurricanes will hit the USA in the next year. The speculator has no commercial interest in the USA.
(viii) catastrophe bonds that provide for reduced payments of principal, interest (or both), based on a climatic, geological or other physical variable that is not specific to a party to the contract.
EXAMPLE- catastrophe bonds - variable that is not specific to a party to the contract
A client finds that the insurer sells catastrophe bonds relating to Japan.
The client has no business interest in Japan, but learns that he can reduce his interest payments (by buying this bond), if Japan is hit by an earthquake.
For the client, this is a gambling contract.
If the contracts (described above) create financial assets or financial liabilities, they are within the scope of IFRS 9.
In summary, the parties to the contract use deposit accounting, which involves the following:
(i) one party records the consideration received as a financial liability, rather than as revenue.
(ii) the other party records the consideration paid as a financial asset, rather than as an expense.
If these contracts do not create financial assets or financial liabilities, IAS 18 applies. Under IAS 18, revenue associated with a transaction (involving the rendering of services) is recorded by reference to the stage of completion of the transaction, if the outcome of the transaction can be estimated reliably.
Significant insurance risk
A contract is an insurance contract, only if it transfers significant insurance risk.
Insurance risk is significant, only if an insured event could cause an insurer to pay significant additional benefits.
If significant additional benefits would be payable, the condition in the previous sentence may be met, even if the insured event is extremely unlikely, or even if the expected (probability-weighted) present value of contingent cash flows is a small proportion of the expected present value of all the remaining contractual cash flows.
The additional benefits refer to amounts that exceed those that would be payable if no insured event occurred. Those additional amounts include claims handling and claims assessment costs, but exclude:
(i) the loss of the ability to charge the policyholder for future services.
EXAMPLE-exclusion from additional benefits (costs to the insurer)
In an investment-linked life insurance contract, the death of the policyholder means that the insurer can no longer perform investment management services, and collect a fee for doing so.
However, this economic loss for the insurer does not reflect insurance risk, just as a mutual fund manager does not take on insurance risk in relation to the possible death of the client.
Therefore, the potential loss of future investment management fees is not relevant in assessing how much insurance risk is transferred by a contract.
(ii) waiver on death of charges that would be made on cancellation (or surrender). As the contract brought those charges into existence, the waiver of these charges does not compensate the policyholder for a pre-existing risk. Hence, they are not relevant in assessing how much insurance risk is transferred by a contract.
(iii) a payment conditional on an event that does not cause a significant loss to the holder of the contract.
EXAMPLE-exclusion from additional benefits (costs to the insurer)
A contract requires the issuer to pay $1million, if an asset suffers physical damage, causing an insignificant economic loss of one currency unit to the holder.
In this contract, the holder transfers (to the insurer) the insignificant risk of losing one currency unit. At the same time, the contract creates non-insurance risk that the issuer will need to pay $999,999, if the specified event occurs.
As the issuer does not accept significant insurance risk from the holder, this contract is not an insurance contract.
(iv) possible reinsurance recoveries. The insurer accounts for these separately.
An insurer shall assess the significance of insurance risk contract by contract, (rather than by reference to materiality to the financial statements). For this purpose, contracts entered into simultaneously with a single client (or contracts that are otherwise interdependent) form a single contract.
Thus, insurance risk may be significant, even if there is a minimal probability of material losses for a whole book of contracts. This contract-by-contract assessment makes it easier to classify a contract as an insurance contract.
However, if a relatively homogeneous book of small contracts is known to consist of contracts that all transfer insurance risk, an insurer need not examine each contract to identify a few non-derivative contracts, that transfer insignificant insurance risk.
If a contract pays a death benefit exceeding the amount payable on survival, the contract is an insurance contract, unless the additional death benefit is insignificant (judged by reference to the contract, rather than to an entire book of contracts).
The waiver on death of cancellation (or surrender charges) is not included in this assessment, if this waiver does not compensate the policyholder for a pre-existing risk.
Similarly, an annuity contract that pays out regular sums for the rest of a policyholder’s life is an insurance contract, unless the aggregate life-contingent payments are insignificant.
Additional benefits could include a requirement to pay benefits earlier, if the insured event occurs earlier, and the payment is not adjusted for the time value of money.
EXAMPLE-early deaths- a requirement to pay benefits earlier
A whole-life insurance that is for a fixed amount (insurance that provides a fixed death benefit, whenever the policyholder dies, with no expiry date for the cover).
It is certain that the policyholder will die, but the date of death is uncertain. The insurer will suffer a loss on those individual contracts for which policyholders die early, even if there is no overall loss on the whole book of contracts.
If an insurance contract is unbundled into a deposit component, and an insurance component, the significance of insurance risk transfer is assessed by reference to the insurance component.
The significance of insurance risk, transferred by an embedded derivative, is assessed by reference to the embedded derivative.
Changes in the level of insurance risk
Some contracts do not transfer any insurance risk to the issuer at the start of a contract, although they do transfer insurance risk at a later time.
EXAMPLE- transfer insurance risk at a later time
A contract provides a specified investment return, and includes an option for the policyholder, to use the proceeds of the investment on maturity, to buy a life-contingent annuity (at the current annuity rates charged by the insurer to other new annuitants, when the policyholder exercises the option).
The contract transfers no insurance risk to the issuer until the option is exercised, as the insurer remains free to price the annuity on a basis that reflects the insurance risk transferred to the insurer, at that time.
However, if the contract specifies the annuity rates (or a basis for setting the annuity rates), the contract transfers insurance risk to the issuer at start.
A contract that qualifies as an insurance contract, remains an insurance contract, until all rights and obligations are extinguished (or expire).
Embedded derivatives
IFRS 9 requires an undertaking to:
- separate some embedded derivatives from their host contract,
- measure them at fair value, and
- include changes in their fair value in the income statement.
IFRS 9 applies to derivatives, embedded in an insurance contract, unless the embedded derivative is itself an insurance contract.
EXAMPLES-embedded derivatives
1. A put option attached to a share, or bond.
2. A call option attached to a share, or bond.
3. An option to extend the term of a bond.
4. Equity-indexed interest, or principal payments.
5. Commodity- indexed interest, or principal payments.
6. Option to convert a bond into shares.
7. Credit derivatives, relating to credit risk, that enable a guarantor to assume the risk, without owning the related asset.
As an exception to IFRS 9, an insurer need not separate (and measure at fair value) a policyholder’s option to surrender an insurance contract for a fixed amount (or for an amount based on a fixed amount, plus an interest rate), even if the exercise price differs from the carrying amount of the host insurance liability.
However, IFRS 9 does apply to a put option (or cash surrender option) embedded in an insurance contract, if the surrender value varies in response to the change in a financial variable (such as an equity, or commodity price, or index), or a non-financial variable that is not specific to a party to the contract.
That requirement also applies if the holder’s ability to exercise a put option (or cash surrender option) is triggered by a change in such a variable (for example, a put option that can be exercised if a stock market index reaches a specified level).
This applies equally to options to surrender a financial instrument containing a discretionary participation feature.
Unbundling of deposit components
Some insurance contracts contain both an insurance component and a deposit component. In some cases, an insurer is required (or permitted) to unbundle those components:
(1) unbundling is required if both the following conditions are met:
(i) the insurer can measure the deposit component (including any embedded surrender options) separately (without considering the insurance component).
(ii) the insurer’s policies do not otherwise require it to record all obligations and rights arising from the deposit component.
(2) unbundling is permitted, but not required, if the insurer can measure the deposit component separately as in (1)(i) but its policies require it to record all obligations (and rights) arising from the deposit component, regardless of the basis used to measure those rights (and obligations).
(3) unbundling is prohibited if an insurer cannot measure the deposit component separately as in (1)(i).
EXAMPLE- policies that do not require an insurer to record all obligations
An insurer’s policies do not require it to record all obligations arising from a deposit component. A cedant receives compensation for losses from a reinsurer, but the contract obliges the cedant to repay the compensation in future years.
That obligation arises from a deposit component. If the cedant’s policies otherwise permit it to record the compensation as income, without recognising the resulting obligation, unbundling is required.
To unbundle a contract, an insurer shall:
(i) apply IFRS 4 to the insurance component.
(ii) apply IFRS 9 to the deposit component.
3. RECOGNITION AND MEASUREMENT
Temporary exemption from some other IFRSs
IAS 8 provides criteria for an undertaking to use in developing a policy if no IFRS applies specifically to an item. However, IFRS 4 exempts an insurer from applying those criteria to its policies for:
(i) insurance contracts that it issues (including related acquisition costs and related intangible assets); and
(ii) reinsurance contracts that it holds.
Nevertheless, IFRS 4 does not exempt an insurer from some of the criteria of IAS 8. Specifically, an insurer:
(1) shall not record as a liability any provisions for possible future claims, if those claims arise under insurance contracts that are not in existence at the reporting date (such as catastrophe provisions and equalisation provisions).
(2) shall carry out the liability adequacy test (see below).
(3) shall remove an insurance liability (or a part of an insurance liability) from its balance sheet only when it is extinguished—when the obligation specified in the contract is discharged (or cancelled, or expires).
(4) shall not offset:
(i) reinsurance assets, against the related insurance liabilities; or
(ii) income (or expense) from reinsurance contracts, against the expense (or income) from the related insurance contracts.
(5) shall consider whether its reinsurance assets are impaired.
Liability adequacy test
An insurer shall assess (at each reporting date) whether its recorded insurance liabilities are adequate, using estimates of cash flows under its insurance contracts.
If that assessment shows that the carrying amount of its insurance liabilities (less related deferred acquisition costs, and related intangible assets) is inadequate, in the light of the estimated cash flows, the entire shortfall shall be recorded in the income statement.
If an insurer applies a liability adequacy test that meets the minimum requirements, IFRS 4 imposes no further requirements. The minimum requirements are the following:
(i) The test considers estimates of all contractual cash flows (and of related cash flows, such as claims handling costs), as well as cash flows resulting from embedded options, and guarantees.
(ii) If the test shows that the liability is inadequate, the entire shortfall is recorded in the income statement.
If an insurer’s policies do not require a liability adequacy test, the insurer shall:
(1) determine the carrying amount of the relevant liabilities**less:
(i) any related deferred acquisition costs; and
(ii) any related intangible assets, such as those acquired in a business combination (or portfolio transfer). However, related reinsurance assets are not considered, as an insurer accounts for them separately.
* The relevant liabilities are those insurance liabilities (and related deferred acquisition costs and related intangible assets) for which the insurer’s policies do not require a liability adequacy.
(2) determine whether the amount described in (1) is less than the carrying amount, if the relevant insurance liabilities were within the scope of IAS 37 Provisions.
If it is less, the insurer shall record the entire shortfall in the income statement, and decrease the carrying amount of the related deferred acquisition costs (or related intangible assets), or increase the carrying amount of the relevant insurance liabilities.
If an insurer’s liability adequacy test meets the minimum, the test is applied at the level of aggregation specified in that test.
If its liability adequacy test does not meet those minimum requirements, the comparison shall be made at the level of a portfolio of contracts that are subject to broadly-similar risks, and managed together as a single portfolio.
The result of applying IAS 37 shall reflect future investment margins only if the amount described in (1) also reflects those margins.
Impairment of reinsurance assets
If a cedant’s reinsurance asset is impaired, the cedant shall reduce its carrying amount, and record that impairment loss in the income statement.
A reinsurance asset is impaired only if:
(i) there is objective evidence, as a result of an event that occurred after initial recording of the reinsurance asset, that the cedant may not receive all amounts due to it under the terms of the contract; and
(ii) that event has a reliably measurable impact on the amounts that the cedant will receive from the reinsurer.
4. Changes in accounting policies
An insurer may change its accounting policies for insurance contracts only if the change makes the financial statements more relevant for users. An insurer shall refer to the criteria in IAS 8.
To justify changing its accounting policies for insurance contracts, an insurer shall show that the change brings its financial statements closer to meeting the criteria in IAS 8, but the change need not achieve full compliance with those criteria. The following specific issues are discussed below:
(i) current interest rates;
(ii) continuation of existing practices;
(iii) prudence;
(iv) future investment margins; and
(v) shadow accounting (see below).
Current market interest rates
An insurer is permitted (but not required) to change its accounting policies, so that it remeasures designated insurance liabilities to reflect current interest rates, and records changes in those liabilities, in the income statement.
Insurance liabilities include related deferred acquisition costs, and related intangible assets. It may also introduce policies that require other current estimates (and assumptions) for the designated liabilities.
The election permits an insurer to change its policies for designated liabilities, without applying those policies consistently to all similar liabilities, as IAS 8 would otherwise require.
If an insurer designates liabilities for this election, it shall continue to apply interest rates (and, if applicable, the other current estimates and assumptions) consistently, in all periods, to all these liabilities, until they are extinguished.
Continuation of existing practices
An insurer may continue the following practices, but the introduction of any of them does not satisfy IFRS:
(i) measuring insurance liabilities on an undiscounted basis.
(ii) measuring contractual rights to future investment management fees, at an amount that exceeds their fair value (as implied by a comparison with current fees, charged by others for similar services). It is likely that the fair value, at the start, equals the origination costs paid (unless future investment management fees, and related costs, are out of line with market comparables).
(iii) using non-uniform policies for the insurance contracts (and related deferred acquisition costs, and related intangible assets, if any) of subsidiaries.
If those policies are not uniform, an insurer may change them, if the change does not make the policies more diverse, and also satisfies the other requirements in this IFRS.
Prudence
An insurer need not change its policies for insurance contracts, to eliminate excessive prudence. However, if an insurer already measures its insurance contracts with sufficient prudence, it shall not introduce additional prudence.
Future investment margins
An insurer need not change its policies for insurance contracts to eliminate future investment margins. However, there is a rebuttable presumption that an insurer’s financial statements will become less relevant (and reliable) if it introduces a policy that reflects future investment margins in the measurement of insurance contracts, unless those margins affect the contractual payments.
EXAMPLES- future investment margins
(i) using a discount rate that reflects the estimated return on the insurer’s assets; or
(ii) projecting the returns at an estimated rate of return, discounting those projected returns at a different rate, and including the result in the measurement of the liability.
An insurer may overcome the presumption only if the other components (of a change in policies) increase the relevance (and reliability) of its financial statements sufficiently to outweigh the decrease in relevance (and reliability) caused by the inclusion of future investment margins.
EXAMPLE- future investment margins
An insurer’s existing policies for insurance contracts involve excessively prudent assumptions set at start, and a discount rate (prescribed by a regulator), without direct reference to market conditions, and ignore some embedded options and guarantees.
The insurer might make its financial statements more relevant (and no less reliable) by switching to a comprehensive investor-oriented basis of accounting that is widely used and involves:
(i) current estimates, and assumptions;
(ii) a reasonable (but not excessively prudent) adjustment, to reflect risk and uncertainty;
(iii) measurements that reflect both the intrinsic value, and time value, of embedded options and guarantees; and
(iv) a current market discount rate, even if that discount rate reflects the estimated return on the insurer’s assets.
In some measurement approaches, the discount rate is used to determine the present value of a future profit margin. That profit margin is then attributed to different periods, using a formula.
In those approaches, the discount rate affects the liability only indirectly. In particular, the use of a less-appropriate discount rate has a limited (or no) effect on the measurement of the liability, at the start.
However, in other approaches, the discount rate determines the measurement of the liability directly. In the latter case, as the introduction of an asset-based discount rate has a more significant effect, it is highly unlikely that an insurer could overcome the rebuttable presumption.
Shadow accounting (adjustments taken to equity)
In some accounting models, realised gains (or losses) on an insurer’s assets have a direct effect on the measurement of some (or all) of
i) its insurance liabilities,
ii) related deferred acquisition costs and
iii) related intangible assets.
An insurer is permitted (but not required) to change its policies, so that a recorded but unrealised gain (or loss) on an asset affects those measurements, in the same way that a realised gain (or loss) does.
The related adjustment to the insurance liability (or deferred acquisition costs, or intangible assets) shall be recorded in equity only if the unrealised gains (or losses) are recorded directly in equity. This practice is sometimes described as ‘shadow accounting’.
Insurance contracts acquired in a business combination or portfolio transfer
To comply with IFRS 3, an insurer shall, at the acquisition date, measure at fair value the insurance liabilities assumed, and insurance assets acquired, in a business combination.
However, an insurer is permitted (but not required) to use a presentation, which splits the fair value of acquired contracts into two components:
(i) a liability measured in accordance with the insurer’s policies for contracts that it issues; and
(ii) an intangible asset, representing the difference between (i) the fair value of the contractual rights acquired, and obligations assumed, and (ii) the amount described in (i).
The subsequent measurement of this asset shall be consistent with the measurement of the related insurance liability.
An insurer acquiring a portfolio of insurance contracts may use this presentation.
The intangible assets are excluded from the scope of IAS 36 Impairment of Assets and IAS 38 Intangible Assets.
However, IAS 36 and IAS 38 apply to customer lists (and customer relationships) reflecting the expectation of future contracts that are not part of the contractual insurance rights, and contractual insurance obligations that existed at the date of a business combination (or portfolio transfer).
5. Discretionary participation features
Discretionary participation features in insurance contracts
Some insurance contracts contain a discretionary participation feature (DPF), as well as a guaranteed element. An example of a DPF might be a profit-sharing reinsurance contract, where the cedant is guaranteed a minimum repayment of its premium, and a share of the profits, at the reinsurer’s discretion. The issuer of such a contract:
(i) may (but need not) record the guaranteed element separately from the discretionary participation feature.
If the issuer does not record them separately, it shall classify the whole contract as a liability. If the issuer classifies them separately, it shall classify the guaranteed element as a liability.
(ii) shall, if it records the discretionary participation feature separately from the guaranteed element, classify that feature as either a liability or a separate component of equity.
IFRS 4 does not specify how the issuer determines whether that feature is a liability, or equity. The issuer may split that feature into liability and equity components, and shall use a consistent policy for that split.
The issuer shall not classify that feature as an intermediate category, which is neither liability nor equity.
(iii) may record all premiums received as revenue, without separating any portion that relates to the equity component.
The resulting changes in the guaranteed element, and in the portion of the discretionary participation feature classified as a liability, shall be recorded in the income statement.
If part (or all) of the discretionary participation feature is classified in equity, a portion of the income statement may be attributable to that feature (in the same way that a portion may be attributable to minority interests).
The issuer shall record the portion of the income statement, attributable to any equity component, as an allocation of the income statement, not as expense or income (see IAS 1).
(iv) shall, if the contract contains an embedded derivative within the scope of IFRS 9, apply IFRS 9 to that embedded derivative.
(v) shall, in all other respects, continue its existing policies for such contracts, unless it changes those policies.
Discretionary participation features in financial instruments
The requirements above also apply to a financial instrument that contains a discretionary participation feature. In addition:
(i) if the issuer classifies the entire discretionary participation feature as a liability, it shall apply the liability adequacy test to both the guaranteed element and the discretionary participation feature.
The issuer need not determine the amount that would result from applying IFRS 9 to the guaranteed element.
(ii) if the issuer classifies part (or all) of that feature as a separate component of equity, the liability recorded for the whole contract shall not be less than the amount, that would result from applying IFRS 9 to the guaranteed element.
That amount shall include the intrinsic value of an option to surrender the contract, but need not include its time value that option is exempted from measurement at fair value.
The issuer need not disclose the amount that would result from applying IFRS 9 to the guaranteed element, nor present that amount separately. Furthermore, the issuer need not determine that amount, if the total liability recorded is clearly higher.
(iii) although these contracts are financial instruments, the issuer may continue to record the premiums for those contracts as revenue, and record (as an expense) the resulting increase in the carrying amount of the liability.
(iv) although these contracts are financial instruments, an issuer applying IFRS 7 (disclosing total interest income and total interest expense for financial assets and liabilities that are not at fair value through profit and loss) to contracts with a DPF shall disclose the total interest expense recorded in the income statement , but need not use the effective interest method.
7. DISCLOSURE
Explanation of recorded amounts
An insurer shall disclose information that identifies (and explains) the amounts in its financial statements, arising from insurance contracts.
An insurer shall disclose:
(1) its policies for insurance contracts and related assets, liabilities, income and expense.
(2) the recorded assets, liabilities, income and expense (and, if it presents its cash flow statement using the direct method, cash flows) arising from insurance contracts. Furthermore, if the insurer is a cedant, it shall disclose:
(i) gains (and losses) recorded in the income statement on buying reinsurance; and
(ii) if the cedant amortises gains (and losses) arising on buying reinsurance, the amortisation for the period, and the amounts remaining unamortised, at the beginning and end of the period.
(3) the process used to determine the assumptions, that have the greatest effect on the measurement of the recorded amounts described in (2). Where practicable, an insurer shall also give quantified disclosure of those assumptions.
(4) the effect of changes in assumptions used to measure insurance assets and insurance liabilities, showing separately the effect of each change that has a material effect on the financial statements.
(5) reconciliations of changes in insurance liabilities, reinsurance assets and, if any, related deferred acquisition costs.
Nature and extent of risks arising from insurance contracts
An insurer shall disclose information that helps users to understand the amount, timing and uncertainty of cash flows from insurance contracts.
An insurer shall disclose:
(1) its objectives in managing risks arising from insurance contracts, and its policies for mitigating those risks.
(2) information about insurance risk (both before and after risk mitigation by reinsurance), including information about:
(i) the sensitivity of the income statement and equity to changes in variables that have a material effect on them.
(ii) concentrations of insurance risk including a description of how management determines concentrations and a description of the shared characteristic that identifies each concentration (such as type of insured event, geographical area, or currency).
(3) actual claims compared with previous estimates (i.e. claims development).
The disclosure about claims development shall go back to the period when the earliest material claim arose, for which there is still uncertainty about the amount (and timing) of the claims payments, but need not go back more than ten years.
An insurer need not disclose this information for claims for which uncertainty about the amount (and timing) of claims payments is normally resolved within one year.
(4) the information about liquidity risk, market risk and credit risk that IFRS 7 would require, if the insurance contracts were within the scope of IFRS 7.
(5) information about exposures to interest rate risk (or market risk under embedded derivatives) contained in a host insurance contract, if the insurer is not required to (and does not) measure the embedded derivatives at fair value.
To comply with the need to explain the sensitivity to insurance risk, an insurer shall disclose either (1) or (2) as follows:
1 a sensitivity analysis that shows how the incme statement and equity would have been affected had changes in the relevant risk variable that were reasonably possible at the balance sheet date occurred;
the methods and assumptions used in preparing the sensitivity analysis; and any changes from the previous period in the methods and assumptions used.
However, if an insurer uses an alternative method to manage sensitivity to market conditions, such as an embedded value analysis, it may meet this requirement by disclosing that alternative sensitivity analysis and the disclosures required by IFRS 7 on sensitivity analysis.
2. qualitative information about sensitivity, and information about those terms and conditions of insurance contracts that have a material effect on the amount, timing and uncertainty of the insurer’s future cash flows.
Disclosure
An undertaking need not disclose information about claims development, which occurred earlier than five years before the end of the first financial year, in which it applies this IFRS.
Furthermore, if it is impracticable, when an undertaking first applies this IFRS, to prepare information about claims development, that occurred before the beginning of the earliest period for which an undertaking presents full comparative information that complies with this IFRS, the undertaking shall disclose that fact.
Redesignation of financial assets
When an insurer changes its policies for insurance liabilities, it is permitted (but not required) to reclassify some (or all) of its financial assets as ‘at fair value through the income statement’.
This reclassification is permitted if an insurer changes policies, when it first applies IFRS 4, and if it makes a subsequent policy change. The reclassification is a change in policy, and IAS 8 applies.
8. Multiple choice questions
1. IFRS 4 is:
1. A draft for discussion.
2. In force until the IAS Board completes the second phase of its project on insurance contracts.
3. The final conclusion of the IAS Board on the reporting of insurance contracts.
2. A cedant is:
1. The policyholder under a reinsurance contract.
2. The policyholder under an insurance contract.
3. An insurer.
4. An overseas insurer.
3. A direct insurance contract is:
1. A contract sold directly to the public by an underwriter.
2. A contract for tangible assets only.
3. An insurance contract that is not a reinsurance contract.
4. Financial risk is the risk (not specific to a party to the contract) of a possible future change in a:
i) specified interest rate,
ii) financial instrument price,
iii) commodity price,
iv) foreign exchange rate,
v) index of prices or rates,
vi) credit rating or credit index,
vii) weather pattern.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
6. (i)-(vi)
7. (i)-(vii)
5. Liability adequacy tests are based on a review of:
1. Long-term liabilities.
2. Short-term liabilities.
3. Profit forecasts.
4. Cash flows.
6. IFRS 4 addresses accounting and disclosures for:
1. Insurance contracts.
2. Reinsurance contracts.
3. Both insurance and reinsurance contracts.
7. As a result of IFRS 4, many savings and pension plans will be:
1. Re-designated as insurance contracts.
2. Re-designated as investment contracts.
3. Re-designated as re-insurance contracts.
8. Under IFRS 4, insurance contracts will continue to be covered by existing accounting policies during Phase 1. This allows firms to do the following:
1. Insurers can use ‘current interest rates’ to value liabilities, bringing them more into line with movements in associated interest-sensitive assets.
2. Companies can adjust their liabilities to reflect future investment margins ‘if and only if’ this is part of a switch to a ‘widely used’ and ‘comprehensive investor oriented basis of accounting’.
3. Companies can elect to measure, at fair value, investment properties used to support liabilities linked to the fair value of those properties, leaving all the other investment properties at cost.
4. Insurers can recognise an intangible asset that covers the difference between the fair value and the book value of the insurance liabilities, taken on through a business combination, or portfolio transfer.
5. Insurers can adopt a form of ‘shadow accounting’ that would allow them to adjust their liabilities for changes that would have arisen if any unrealised gains or losses on securities had been realised.
6. Companies can continue to value insurance and investment contracts with discretionary participatory features using their existing accounting policies.
7. Insurers that do not report comparative performance for prior years may continue this practice.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
6. (i)-(vi)
7. (i)-(vii)
9. A profit sharing reinsurance contract where the cedant is guaranteed a minimum repayment of its premium is an example of a:
1. Embedded derivative.
2. Discretionary participatory feature.
3. Fixed guaranteed element.
10. Subject to the conditions of the contract, an insured event can happen (and the insurer will be liable):
i) During the term of the contract.
ii) Before the contract starts.
iii) After the contract ends.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
11. To decide whether there is an insurance contract:
(i) There must be a risk (not a certainty).
(ii) It must not be a ‘financial’ risk.
(iii) It must be transferred from the holder of a contract to the issuer.
(iv) It must require an adverse impact on the policyholder as a precondition for payment.
(v) The contract must state that it is an insurance contract.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
12. Examples of insurance contracts are:
(i) insurance against theft (or damage) to property.
(ii) insurance against product liability, professional liability, civil liability or legal expenses.
(iii) life insurance and prepaid funeral plans (although death is certain, it is uncertain when death will occur or, for some types of life insurance, whether death will occur within the period covered by the insurance).
(iv) life-contingent annuities and pensions (i.e. contracts that provide compensation for the uncertain future event—the survival of the annuitant (or pensioner)—to assist the annuitant (or pensioner) in maintaining a given standard of living, which would otherwise be adversely affected by his survival).
(v) disability and medical cover.
(vi) surety bonds, fidelity bonds, performance bonds and bid bonds.
(vii) catastrophe bonds, not specific to the policyholder.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
6. (i)-(vi)
7. (i)-(vii)
13. Significant insurance risk involves the payment of additional benefits. These include:
i) Claims handling and claims assessment costs.
ii) A requirement to pay benefits earlier.
iii) The loss of the ability to charge the policyholder for future services.
iv) Waiver on death of charges that would be made on cancellation (or surrender).
v) A payment conditional on an event that does not cause a significant loss to the holder of the contract.
vi) Possible reinsurance recoveries.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
6. (i)-(vi)
14. Examples of embedded derivatives are:
i) A put option attached to a share, or bond.
ii) A call option attached to a share, or bond.
iii) An option to extend the term of a bond.
iv) Equity-indexed interest, or principal payments.
v) Commodity- indexed interest, or principal payments.
vi) Option to convert a bond into shares.
vii) Credit derivatives, relating to credit risk, that enable a guarantor to assume the risk, without owning the related asset.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
6. (i)-(vi)
7. (i)-(vii)
15. If both of the following conditions are met:
(i) the insurer can measure the deposit component (including any embedded surrender options) separately (without considering the insurance component).
(ii) the insurer’s policies do not otherwise require it to record all obligations and rights arising from the deposit component.
Unbundling is:
1. Required.
2. Permitted
3. Prohibited.
16. If the liability adequacy test is inadequate, the shortfall is:
1. Recorded as a provision.
2. Recorded in the income statement.
3. Taken directly to reserves.
17. The following practices:
(i) measuring insurance liabilities on an undiscounted basis.
(ii) measuring contractual rights to future investment management fees, at an amount that exceeds their fair value (as implied by a comparison with current fees, charged by others for similar services). It is likely that the fair value, at the start, equals the origination costs paid (unless future investment management fees, and related costs, are out of line with market comparables).
(iii) using non-uniform policies for the insurance contracts (and related deferred acquisition costs, and related intangible assets, if any) of subsidiaries.
1. Are prohibited.
2. Are allowed.
3. May be continued, but not introduced.
18. A comprehensive investor-oriented basis of accounting, that is widely used, involves:
(i) current estimates, and assumptions;
(ii) a reasonable (but not excessively prudent) adjustment, to reflect risk and uncertainty;
(iii) measurements that reflect both the intrinsic value, and time value, of embedded options and guarantees;
(iv) a current market discount rate, even if that discount rate reflects the estimated return on the insurer’s assets;
(v) increased prudence.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
4. (i)-(iv)
5. (i)-(v)
19. Shadow accounting records:
1. Unrealised gains in the same manner as realised gains.
2. Realised gains in the same manner as unrealised gains.
3. Realised gains directly in equity.
20. The issuer of a DPF contract:
may (but need not) record the guaranteed element separately from the discretionary participation feature.
If the issuer classifies them separately, it shall classify the guaranteed element as a liability and
it records the discretionary participation feature as:
1. A liability.
2. A separate component of equity.
3. Either 1 or 2.
21. The issuer of a DPF contract may record premiums received as:
1. Revenue.
2. A split between revenue and the equity component.
3. A credit to the equity component.
9. Answers to multiple choice questions
|Question |Answer |
| |2 |
| |1 |
| |3 |
| |6 |
| |4 |
| |3 |
| |2 |
| |6 |
| |3 |
| |3 |
| |4 |
| |6 |
| |2 |
| |7 |
| |1 |
| |2 |
| |3 |
| |4 |
| |1 |
| |3 |
| |1 |
10. Appendix. Similarities and Differences – A comparison of IFRS and US GAAP – PwC-September 2004
Insurance and reinsurance contracts – definition
IFRS introduces a definition of an insurance contract based on the concept of insured event and significant insurance risk transfer. This definition applies to both insurance contracts issued and reinsurance contracts held.
US GAAP does not provide a single definition of insurance contract. The classification of contracts is performed by reference to the combined requirements of FAS 60, FAS 97 and FAS 120. Reinsurance contracts are subject to the definition contained in FAS 113. FAS 97 also covers investment contracts that would be accounted for under IFRS 9 in IFRS financial statements.
The resulting population of insurance contracts under US GAAP is a subset of the IFRS classification. In addition, ‘universal life-type contracts’ within FAS 97 contain significant insurance risk under IFRS but are required to be accounted for under US GAAP using the deposit method of accounting rather than the deferral and matching accounting model used for all other insurance contracts (see below).
Reinsurance contracts that compensate the ceding party for losses but contain a timing delay in reimbursement (i.e., the loss will certainly occur but its timing is uncertain) are subject to deposit accounting under FAS 113 but are classified as insurance contracts under IFRS.
One of the results of applying the IFRS insurance contract definition is that companies can no longer analogise to FAS 97 measurement principles with respect to their accounting for deferred acquisition costs (DAC).
IFRS preparers with investment contracts under IFRS 9must look to IAS 18 for accounting guidance related to the recognition and measurement of DAC.
IFRS also recognises that the fair value of an investment contract cannot be less than the amount payable on demand (the ‘deposit floor’); under US GAAP, the account value may fall below this level.
Discretionary participation feature (DPF)
This is a new term under IFRS relating to the right of holders of certain insurance contracts and/or financial instruments to receive a supplemental return (in addition to guaranteed benefits) arising from certain components of the residual interest of the entity that has issued contracts with DPF.
IFRS defines insurance contracts and financial instruments with DPF as compound instruments. IFRS does not require but permits the separation of the DPF equity component.
The use of hybrid categories classified between equity and liabilities is prohibited.
IFRS requires entities to perform an adequacy test for those financial instruments with DPF. This liability adequacy test is different for those financial instruments with DPF that have an equity component. In this case, the liability adequacy test is based onIFRS 9. In all other cases, IFRS 4 applies.
Other accounting and reporting topics
This type of participation is described under US GAAP as policyholder dividends, and guidance is provided on accounting for dividends paid out of insurance contracts.
Entities must recognise a liability for the expected dividend payout based on an estimate of the amount to be paid.
There are no requirements to disclose the portion of equity that arises from contracts that pay dividends. However, any dividend payments or declarations in excess of the liability are charged to profit or loss when paid or declared.
The possibility of such dividends being paid on financial instruments is not contemplated in US GAAP. Current US GAAP reporters have adopted the insurance accounting guidelines for measuring the obligations under such contracts.
Insurance and reinsurance contracts – measurement
The existing accounting policies for insurance contracts issued and reinsurance contracts held (including related intangible assets like deferred acquisition costs) are exempt from IFRS hierarchy and need not be changed on adoption of IFRS 4, except for the following five requirements:
1. Provisions for possible claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions) are prohibited;
2. Insurance liabilities must be tested for adequacy;
3. Reinsurance assets must be tested for impairment;
4. Insurance liabilities can be de-recognised only when they are discharged or cancelled or expire;
5. Insurance liabilities and income should not be offset against related reinsurance assets and expenses.
US GAAP has specific measurement guidance for insurance contracts and reinsurance contracts. As explained above, IFRS allows entities to continue with their accounting policies developed under another GAAP. There are several differences between US GAAP and the entity’s insurance and reinsurance accounting policies that have been developed from another GAAP basis. These are not covered by this publication.
Under IFRS, the liability adequacy test requirement is met by the FAS 60 premium deficiency test. However, any deficiency resulting from the assumed realisation of unrealised gains or losses is always reflected through the income statement under IFRS because IFRS does not have the option to reflect this type of liability adequacy loss through equity.
This type of loss is known in US GAAP as a ‘shadow’ premium deficiency adjustment. In addition, IFRS requires guaranteed options to be considered in the liability adequacy test. In US GAAP these are provided for under
SOP 03-01 and are not explicitly considered in the premium deficiency test.
1 Insurance and reinsurance contracts – deposit accounting and unbundling of deposit components
IFRS requires the unbundling and separate measurement of the deposit component bundled in an insurance contract only if the deposit can be reliably measured and the entity’s accounting policies do not recognise all rights and obligations arising from it.
This requirement is limited in practice to situations in which the insurer or reinsurer has established experience accounts that refund the policyholder or cedant but has not appropriately reflected this obligation in its balance sheet.
IFRS also allows the unbundling of deposit components on a voluntary basis if the deposit component can be reliably measured. This right would allow preparers to use the FAS 97 deposit accounting approach for universal life-type contracts (these contracts most likely qualify as insurance contracts under IFRS because they usually transfer significant insurance risk).
For these contracts, US GAAP requires the recognition of the liability representing the policyholder’s account balance with the insurer. The account balance concept is equivalent to the deposit component concept in IFRS.
Other accounting and reporting topics
2 Insurance contracts sold by an insurer to its own defined benefit plan
Insurance contracts sold by an insurer to its own defined benefit plan will generally be eliminated on consolidation, as outlined in IFRS 4 implementation guidance. The financial statements will then include:
• the full amount of the pension obligation under IAS 19, Staff Benefits, with no deduction for the plan’s rights under the contract;
• no liability to policyholders under the contract; and
• the assets backing the contract.
Under US GAAP, these contracts are recorded by including the value of the insurance contract as plan assets in the calculation of the company’s net defined benefit liability, and reflecting the insurance contract liability in accordance with the applicable insurance accounting guidance.
Insurance and reinsurance contracts – embedded derivatives
Under IFRS, embedded derivatives that also meet the definition of insurance contracts are not required to be separated and fair valued. Options to surrender the insurance contract are exempted from separation and fair value measurement if the option price is a fixed amount or a fixed amount plus interest. This exemption also applies to derivatives embedded in financial instruments with DPF.
Under US GAAP, these embedded derivatives are not subject to exemptions from the general principle of separation and fair value measurement when they are not closely related to the host contract.
IFRS classifies persistency bonuses as embedded derivatives; US GAAP treats them as an effective yield adjustment and does not require them to be separated and fair valued.
Disclosures
IFRS Requires extensive disclosures to allow the users of financial statements to understand the measurement bases adopted, the materiality of the reported amounts arising from insurance contracts and the factors that affect the uncertainty of amount and timing of the cash flows arising from insurance and reinsurance contracts.
US GAAP Disclosures are less demanding than IFRS. However, similar disclosures are included in other sections of the annual report (for example in the MD&A section). An example of such disclosure is the claims development table.
Separate accounts
IFRS Does not permit a single line presentation.
US GAAP FAS 60 and SOP 03-01 allow single line presentation in the balance sheet and offsetting of investment results, with changes in policyholder liabilities in the income statement.
REFERENCES:
IFRS: IFRS 4.
US GAAP: FAS 60, 97, 120 and 113, SOP 03-1, SOP 95-1 for insurance contracts and FAS 91 for financial instruments, FAS 133.
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