15 January 2014

EFRAG: Report on the findings from the field test on the revised IASB ED Insurance Contracts

On 20 June 2013, the IASB published the revised ED 'Insurance Contracts'. From July to October 2013, EFRAG and the National Standard-Setters from France, Germany, Italy and the UK (ANC, ASCG, FRC and OIC respectively), in coordination with the IASB staff, carried out a field test on whether the new requirements are operational, what their impact would be and the costs and benefits associated with introducing them.

The exercise was focused on the practical application of the new requirements and was intended to gather solely facts and objective data, rather than views and opinions. The participants were asked questions relating to the 2013 ED's five targeted proposals as well as further questions on other areas of the 2013 ED.

The most commonly stated areas of concern related to:

• applying the 'mirroring approach' to contracts that specify a link to the returns on underlying items;
• applying the revenue proposals to life insurance contracts; and 
• the mandatory requirement to use other comprehensive income for presenting the effects of changes in the discount rate on insurance liabilities.

Adjusting the contractual service margin

Unlocking the contractual service margin was considered technically feasible by many participants. The ED did not propose that changes in the risk adjustment be set-off against the contractual service margin on the ground of operational and reporting complexity. Participants in the field test were split on whether changes in the risk adjustment, which relate to future coverage, could be separated from changes in risk that relate to incurred claims without significant costs or operational complexity.

Most participants considered that, for participating contracts, splitting the changes in estimates of cash flows that depend on investment returns, when those changes arise as a result of changes in the value of underlying items, from the changes in other estimates, which relate to future coverage and other future services, would be operationally burdensome. Almost all participants suggested a fully unlocked contractual service margin, which in their view is not just more appropriate, but also easier and less costly to implement.

Most participants also expressed concerns about the proposal that the contractual service margin be calculated and tracked at a very granular level. This granularity adds significant operational complexity and cost without necessarily enhancing the reliability and quality of the accounts.

Mirroring approach

Almost all participants reported that they have experienced significant operational difficulties in applying the proposals to contracts that specify a link to the returns on underlying items. This was mainly due to the ED proposal to split the cash flows into those that vary directly and those that do not; a process that was identified as complex, impracticable and often arbitrary by participants. A majority reported that current actuarial models that are used for regulatory, financial and embedded value reporting use a combined projection of all cash flows. In addition, the scope of the exemption was unclear as the requirement to hold specific assets was open to broad interpretation. This uncertainty would likely lead to inconsistent application.

Almost all participants used approximation techniques, which they considered would lead to inconsistencies in their application. A majority of participants found the ED proposals unclear in relation to the types of contracts that could be categorised as those that specify a link to returns on underlying items.

A majority of participants mentioned that they were considering an alternative proposal that was being developed by the European insurance industry. Most of them noted that this alternative would result in a more faithful representation of underlying economics and performance of participating contracts without adding complexity. This alternative is based on a ‘fully unlocked contractual service margin’ model and is consistent with the overall building blocks model in the IASB ED. One participant reported that they had tested the alternative industry proposal on several portfolios, and had concluded that it was operationally feasible. Furthermore, they noted that the related benefits outweighed the costs.

Several participants reported that there was a lack of information in the proposals on how to reflect changes in the value of options and guarantees embedded in insurance contracts.

Presentation of revenue and expenses

Many participants reported that they were unable to test the revenue proposals because of their complexity. This was mainly attributed to: (a) the exclusion of the investment component, considered highly interrelated with the other components; and (b) the need to upgrade IT and actuarial systems in order to perform the testing. In their view, the costs to implement the changes outweigh the benefits.

Two participants reported that for non-life insurance, the estimation of revenue under the simplified approach would not be operationally difficult because no investment components are included in the premiums and the approach is consistent with current practice. 

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