06 September 2013

IASB/Finnegan: The long and winding road - The IASB's project on insurance contracts

These include:

1. how to report discount rate changes.
2. how to present insurance contract revenue and expenses.
3. how to report changes in estimates of contract cash flows.

The first major proposal that investors and entities that issue insurance contracts need to understand is the presentation of the effects of using a current interest rate to discount the cash flows of an insurance contract.

One of the main criticisms of current accounting in many jurisdictions is that the interest rate used to discount an insurance contract is set at contract inception and is not updated unless there is evidence of loss.

The IASB proposes that an insurance contract would be discounted using a current rate at the end of every reporting period. However, the effects of using a current value measure for the balance sheet would be separated into two elements for presentation in the statement of comprehensive income.

• The first element, which would be presented in profit or loss, represents the rate applied to discount the insurance contract liability at the date that a contract is initially recognised (the original rate).
• The second element would be presented in other comprehensive income (OCI). It represents the difference between the effects of discounting the insurance contract using a current rate in the balance sheet and the effects of discounting the insurance contract using the original rate in profit or loss.

The second major proposal deals with the presentation of revenue and expenses in the statement of comprehensive income. The question for investors is whether it is useful for an insurer to present information about revenues and expenses (gross performance metrics) and, if so, whether the presentation of revenue from insurance contracts should be consistent with the way revenue is presented for other kinds of businesses.

Investors may recall that the 2010 Exposure Draft proposed a summarised margin approach in the statement of comprehensive income. This meant that premiums were not shown separately on the face of that statement and, hence, there was no top-line or insurance contract revenue reported. Our modifications to the presentation of the statement of comprehensive income respond to feedback from the investor community. Revenue reflects the underlying economics of service delivery.

The revised proposals would require that an insurer present insurance contract revenue in the statement of comprehensive income. This reporting is likely to differ materially from what investors are accustomed to seeing today for entities that issue life insurance or other long-term insurance contracts.

The concept underpinning our proposal is that, at any balance-sheet date, when an insurer determines its liability for remaining coverage, it represents the value of the obligation to provide coverage and services.

Therefore, the IASB believes that the reduction in that liability is a reasonable representation of the value of coverage and services provided in a period, and hence revenue should be recognised on that basis. Most significantly, the revenue measure would reflect the value of services provided in each period, not the amount of cash collected or the amount of cash due from a customer.

A principal advantage of this approach is that it aligns the reporting of revenue by insurers with the principal concepts that the IASB and the FASB have adopted for recognising revenue in other kinds of contracts with customers. Another advantage of the proposed presentation is that insurance contract revenue would be shown consistently across all kinds of insurance contracts, life and non-life alike.

The third major proposal that will be of interest to investors deals with the accounting for the margins embedded in the measurement of the insurance contract liability. The current value measurement approach identifies two components to the measurement of an insurance contract. The first component, known as the ‘fulfilment cash flows’, is determined by estimating the future cash inflows (premiums) and the future cash outflows (benefits, claims, expenses) that the insurer expects the contract to generate as it is fulfilled, adjusted for risk (also known as a ‘‘risk margin’’) and the time value of money.

The second component, known as the ‘contractual service margin’, is recognised to eliminate any day 1 gain and is essentially the unearned profit in a contract. If the initial estimate (or subsequent estimates) of the expected present value of cash outflows exceeds the estimate of the expected present value of cash inflows, an immediate loss would be recognised.

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