07 September 2011

FASB's meeting on insurance contracts

The FASB discussed a follow-up analysis on the mechanics of a single margin approach, and the measurement basis for the liability for incurred claims in the post claim period for those contracts meeting the eligibility requirements for using the premium allocation approach.

At the May 2011 joint meeting, the FASB staff (the staff) presented a single margin approach for measuring insurance contracts (previously referred to as the composite margin in the FASB’s Discussion Paper 'Preliminary Views on Insurance Contracts'). The staff presented the single margin approach as an alternative to the proposal to use a risk adjustment with a residual margin. At that meeting, several board members requested further analysis on:

(a) The profit realisation of the margin. In particular, how the “reduction in variability of cash flows” would work practically;

(b) How the single margin approach would work for those contracts that meet the eligibility requirements for using the premium allocation approach; and

(c) Accounting for the single margin when there is a significant increase in risk.

To facilitate the analysis of the mechanics of a single margin approach, the staff examined four primary areas:

(a) Mechanics under a building block approach – for purposes of this discussion the staff assumed that uncertainty in timing would drive the assessment of the reduction in the variability of cash flows.

(b) Mechanics under a premium allocation approach – for purposes of this discussion the staff assumed that uncertainty in frequency and severity would drive the assessment of the reduction in the variability of cash flows.

(c) Accounting for a significant increase in risk resulting in an onerous contract – for purposes of this discussion the staff assumed the contract in question becomes onerous thereby affecting future profitability. The staff believes the accounting for a single margin under either the building block or the premium allocation approach would be the same for this situation.

(d) Accounting for a significant increase in risk subsequent to complete margin recognition – for purposes of this discussion the staff assumed the increase in risk occurred subsequent to recognition of the entire single margin amount. As was the case for (c), the staff believes the accounting for a single margin under either the building block or the premium allocation approach would be the same for this situation.

The discussion that follows is for illustrative purposes only. For instance, the discussion is not meant to preclude the use of frequency and severity as a driver of the reduction in the variability of cash flows for those contracts using a building block approach and vice versa. However, the staff believes it is likely that those contracts using the building block approach would be subject to timing uncertainty, while those contracts using the premium allocation approach would likely experience uncertainty in frequency and severity, given the potential differences in the nature of the risks covered. Selecting the driver for the reduction in the variability of the cash flows is a matter of judgment exercised by the insurer.

The staff assumed for the purposes of FASB´s analysis that the driver of a reduction in the variability of cash flows for those contracts measured with a full building block would likely be timing. As part of that analysis, the staff analysed a life contract and determined that profit recognition could occur (1) in a straight-line fashion as a simple function of the passage of time, or (2) in a pro-rata fashion over the life of the contract.

The staff recommends that for those contracts in which the variability of the cash flows is primarily a result of timing of the specified event, a reduction in the variability of cash flows is evidenced by the passage of time or a pattern that reflects the reduction in the uncertainty of that timing. This reduction of variability in cash flows signifies a release from risk, thereby triggering profit recognition.

Full paper

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