Practical Guide To IFRS - PwC
www.pwc.com/ifrsPractical guide toIFRSRevised exposure draft willsignificantly change accountingfor insurance contractsJuly 2013
www.pwc.com/ifrsPractical guide to IFRSRevised exposure draft will significantly changeaccounting for insurance nd3Definition, scope andcombining contracts3Separating componentsfrom an insurancecontract5Current measurementmodel7Simplified measurementfor liability forremaining coverage16Presentation18Contracts with cashflows that vary withreturns on tion andderecognition26Business combinationsand portfolio transfers27Foreign exchange28Disclosures28Transition29Next steps30Appendices31On 20 June 2013, the IASB (‘the Board’) published a revised exposure draft (ED) onthe accounting for insurance contracts reflecting its response to the comments receivedon the 2010 ED (‘previous ED’). The comprehensive proposals will fundamentallychange the accounting by insurers and other entities that issue insurance contracts.The Board has attempted to address the concerns of constituents regarding theperceived ‘artificial’ volatility caused by the proposals in the previous ED, but thesechanges add complexity. The proposed standard will replace IFRS 4, which currentlypermits a wide variety of accounting practices for insurance contracts.This practical guide summarises the key proposals and their implications. Appendix 1compares these proposals with the previous ED. Appendix 2 compares the proposalswith the FASB ED that was issued on 27 June 2013. Appendix 4 provides a high-levelcomparison of the revised ED with Solvency II. The questions in the IASB ED targetfive key areas that have significantly changed since the previous ED as set out below: The use of other comprehensive income (‘OCI’) for changes in discount rates. Unlocking the contractual service margin (previously known as theresidual margin). Contracts that require the entity to hold underlying items and specify a link toreturns on those underlying items. Presentation in the statement of comprehensive income. Transition.It is important for insurers and other entities issuing insurance contracts to assess howall the requirements in the measurement model fit together. It will be critical forinsurers to work closely with stakeholders to make sure that they understand theimpact of the significant changes being proposed. This could be the last opportunity forthe industry to influence the debate before the expected effective date of 2018. Insurersneed to act now in assessing the implications of the new proposals on both theircontracts and business practices and to assess the additional demands of the proposalson resources, data and modelling systems.At a glance The proposals continue to require entities to measure their insurance contractsusing a current measurement model, where current estimates are re-measuredeach reporting period. Consistent with the previous ED, the measurement approach is based on thebuilding block approach of a current, discounted and probability-weighted averageof future cash flows expected to arise as the insurer fulfils the contract; an explicitrisk adjustment and a contractual service margin. A simplified approach is permitted if the coverage period is one year or less or ifthe measurement provides a reasonable approximation to applying the buildingblock approach.PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 2
www.pwc.com/ifrsBackgroundThe IASB has concluded its re-deliberations on the insurance contracts project. TheBoard has been working together with the FASB for several years on developing acomprehensive, converged standard on accounting for insurance contracts thataddresses recognition, measurement, presentation and disclosure.In 2010 the IASB issued an exposure draft and the FASB issued a discussion paper onthe subject. Since early 2011 the IASB and FASB (‘the Boards’) have been redeliberating the issues using comments received from constituents. Based on thedifferences in views expressed during the re-deliberations, it has become apparent thatthe Boards will likely not achieve a converged standard.The comment period for the IASB as well as the FASB ends on 25 October 2013.PwC observationThe IASB’s predecessor body initiated the development of a standard for insurancecontracts in 1997. Due to delays, many insurers may have lost interest in the project.However, the IASB is determined to finalise this project. The proposed standard is animportant opportunity to comment on the requirements before a final standardis issued.The likely outcome of the IASB project is a comprehensive IFRS standard oninsurance, while the ultimate result of the FASB project is less certain. This is becauseunlike U.S. GAAP, IFRS currently has no comprehensive insurance contractsstandard. Therefore, despite the fact that the FASB exposure draft proposes anentirely new model for insurers, the FASB could ultimately decide to introduce onlysome of the proposed changes. The high-level differences between the IASB and FASBproposals are included in Appendix 2 to this practical guide.Definition, scope and combining contractsThe proposals apply to all entities that issue insurance contracts, not just insurers. Theproposals continue to define an insurance contract as “a contract under which oneparty (the issuer) accepts significant insurance risk from another party (thepolicyholder) by agreeing to compensate the policyholder if a specified uncertainfuture event (the insured event) adversely affects the policyholder”. The definition ofan insurance contract has been clarified compared to current IFRS 4 to require theevaluation of insurance risk to be done using present values rather than absoluteamounts. This is not specified in current IFRS 4, although most entities apply this newrequirement already in practice. In addition, a contract does not transfer insurance riskif there is not a scenario with commercial substance in which the insurer couldincur a loss.The scope of the proposed standard includes insurance contracts that an entity issues.Insurance contracts that an entity holds as a policyholder are not in scope, although acedant will apply the proposals to reinsurance contracts that it holds.PwC observationCurrent IFRS 4 allows a wide variety of accounting practices as entities are allowedto continue their previous practice from their local GAAP. Given the scope changes asset out below, many contracts issued by non-insurers will be outside of the scope ofthe proposed standard. Nevertheless, non-insurers should assess whether theircontracts contain significant insurance risk and therefore are within the scope of theproposed standard.PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 3
www.pwc.com/ifrsPwC observation (continued)The implementation guidance in current IFRS 4 will not be carried forward in theproposed standard. The Board thinks now that IFRS 4 has been in place for manyyears, there is less need for the implementation guidance. However, first-timeadopters and other parties new to insurance accounting may have found theguidance useful.Investment contracts with discretionary participation features are in scope of theproposed standard if the entity also issues insurance contracts, even though they arenot insurance contracts. These are considered further in the section on contracts withcash flows that vary with returns on underlying items.Financial guarantee contracts such as credit derivatives or mortgage guaranteeinsurance are not in scope, unless the issuer has previously asserted explicitly that itregards such contracts as insurance contracts and has used accounting applicable toinsurance contracts. In this case the issuer can choose to apply the standards forfinancial instruments or the proposed standard for insurance contracts. The entity canmake that election contract by contract, but the election for each contractis irrevocable.PwC observationThe choice offered for financial guarantee contracts will enable both banks andinsurers to account for these contracts in the way they view them within theirbusiness. However, consistent with current IFRS 4 it is unclear how entities thatissue such contracts for the first time are required to account for financialguarantee contracts.The Board has continued to exclude certain contracts that meet the definition of aninsurance contract from the scope of the proposed standard. The scope exclusionscarried forward from IFRS 4 include: Product warranties issued by a manufacturer, dealer or retailer. Contractual rights or contractual obligations that are contingent on the future useof, or the right to use, a non-financial item (for example, some licence fees,royalties, contingent lease payments and similar items). Employers’ assets and liabilities under employee benefit plans. Residual value guarantees provided by a manufacturer, dealer or retailer as well asa lessee’s residual value guarantees embedded in a finance lease. Contingent consideration payable or receivable in a business combination.In addition, fixed-fee service contracts that provide services as their primary purpose,and that meet all of the following conditions are also excluded from the scope: The entity does not reflect an assessment of the risk associated with an individualcustomer in setting the price of the contract with that customer; The contract compensates customers by providing a service, rather than by makingcash payments; and The insurance risk that is transferred by the contract arises primarily from thecustomer’s use of services.PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 4
www.pwc.com/ifrsPwC observationThe Board intends that many fixed-fee service contracts (such as roadside assistancecontracts and repair services) are outside of the scope of the insurance contractproposals. Instead an entity has to apply the proposed standard for revenue fromcontracts with customers. The accounting under this proposed standard wouldgenerally not be very different from the proposed insurance contracts standard as thepremium-allocation approach would apply to such contracts in most circumstances(which we discuss later in this practical guide).The distinction between fixed-fee service contracts and insurance contracts can becomplex to assess in practice. In the re-deliberations, certain fixed-fee servicecontracts were contrasted to show which contracts would meet the scope exclusion.For example, capitation agreements were discussed. These are healthcare plans thathave a payment of a flat fee for each patient covered. Under a capitation agreement,a healthcare organisation pays a fixed amount of money for its members to the healthcare provider. The healthcare provider is paid a set monthly amount to see patientsregardless of how many treatments or the number of times the physician or clinicsees the patient. Whether or not the patient needs services for a particular month, theprovider will get paid the same fee.Capitation agreements and maintenance and repair contracts (not in scope of theproposed standard) were contrasted with traditional health insurance contracts andboiler breakdown insurance respectively (in scope of the proposed standard).However, the proposed standard does not provide additional guidance on how toapply the conditions for fixed-fee service contracts to address those contracts wherethe assessment is less clear.Insurance contracts should be combined and accounted for as one insurance contract ifthe insurance contracts are entered into at, or near, the same time with the samepolicyholder (or related policyholders) and if one or more of the following criteriaare met: insurance contracts are negotiated as a package with a single commercial objective; the amount of the consideration to be paid for one insurance contract depends onthe consideration or performance of the other insurance contract(s); or the coverage provided by the insurance contracts to the policyholder relates to thesame insurance risk.PwC observationThe proposals for combining contracts may have an impact on frontingarrangements, where an entity enters into an insurance contract with a directinsurer who enters into a back to back reinsurance contract. If these contracts arecombined they may not meet the definition of an insurance contract and result in anet presentation in the income statement.Separating components from an insurance contractAn insurer is required to separate components from an insurance contract (previouslyreferred to as ‘unbundling’) that would be within the scope of another standard if theywere separate contracts.Embedded derivatives have to be separated from the insurance contract if they are notclosely related to the economic characteristics of the insurance contract. In that casethey should be accounted for under IFRS 9, ‘Financial instruments’. Derivatives thatthemselves meet the definition of an insurance contract are considered to be closelyrelated and are not separated.PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 5
www.pwc.com/ifrsOnly distinct investment components have to be separated. Unless the investmentcomponent and insurance component are highly interrelated, an investmentcomponent is distinct if a contract with equivalent terms is sold, or could be sold,separately in the same market or same jurisdiction, either by entities that issueinsurance contracts or by other parties. The investment and insurance component arehighly interrelated if one of the following criteria is met: The entity is unable to measure either the insurance or the investment componentwithout considering the other component. Hence, if the value of one componentvaries according to the value of the other component, an entity applies theproposed insurance contracts standard to the whole contract containing theinvestment component and the insurance component; or The policyholder is unable to benefit from one component unless the other ispresent (that is the lapse or maturity of one component in a contract lapses ormatures the other component).A performance obligation to provide a good or service has to be separated if it isdistinct. Performance obligations can be implied by an entity’s customary businesspractices, published policies or specific statements if those promises create a validexpectation held by the policyholder that the entity will transfer a good or service.However, tasks such as setting up a policy do not transfer a service to a policyholderand do not represent a performance obligation. A performance obligation to provide agood or service is distinct if either of the following criteria is met: The entity (or another entity that does or does not issue insurance contracts)regularly sells the good or service separately in the same market or samejurisdiction taking into account all information that is reasonably available inmaking this determination; or The policyholder can benefit from the good or service either on its own or togetherwith other resources that are readily available to the policyholder. Readily availableresources are goods or services that are sold separately (by the entity or by anotherentity that might not issue insurance contracts), or resources that the policyholderhas already obtained (from the entity or from other transactions or events).A performance obligation to provide a good or service is not distinct if the cash flowsand risks associated with the good or service are highly interrelated with the cashflows and risks associated with the insurance components in the contract, andthe entity provides a significant service of integrating the good or service with theinsurance components.PwC observationThe Board has not responded to the request for optional separation of componentsfrom an insurance contract. In certain cases, determining if services, such as assetmanagement services, should be separated will require significant judgment. If it isdetermined that components have to be separated, a number of practical applicationissues may arise, such as how to allocate acquisition costs.The illustrative examples 1-3 to the proposed standard are helpful in determiningwhether components have to be separated. We expect that separating investmentcomponents will be uncommon in many contracts as the components are highlyinterrelated, although these examples suggest that asset management and otherservices have to be separated in certain cases.PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 6
www.pwc.com/ifrsCurrent measurement modelThe proposals require an entity to measure its insurance contracts using a currentmeasurement model, where current estimates are re-measured each reporting period.The measurement approach (‘building block approach’ or ‘BBA’) is based on thebuilding blocks of a current, discounted and probability-weighted average of futurecash flows expected to arise as the insurer fulfils the contract; an explicit riskadjustment and a contractual service margin (previously called the residual margin)representing the unearned profit of the contract.The graph1 below shows how the changes in the building blocks flow into the incomestatement and into OCI in shareholder’s equity on the balance sheet. The changesrelated to future services will be recognised against the contractual service margin aslong as it has a positive balance (that is, the contract is not onerous).Changes related tofuture abilityweighteddiscountedexpectedpresentvalue of cashflowsRelease of contractualservice marginIncome statementUpdate for currentestimatesInterest on insuranceliability at locked in rateUpdate currentmarket ratesOCIChanges related to pastand current servicesThe measurement model contains a liability for incurred claims and a liability forremaining coverage that have to be disclosed separately in the notes to the financialstatements. A simplified approach exists for the liability for remaining coverage, whichis discussed later in this practical guide.The contractual service margin and the performance of the onerous contract test arecalculated at the portfolio level, but the level of aggregation for releasing thecontractual service margin and determining the risk adjustment is not prescribed.A portfolio of insurance contracts is defined as a group of insurance contracts that: provide coverage for similar risks and are priced similarly relative to the risk takenon; and are managed together as a single pool.In the re-deliberations, the staff provided factors to consider in determining whethercontracts are subject to similar risks. These included the type of risk insured (forexample, longevity, mortality, fire), the product line (for example, annuity, terminsurance, motor), the type of policyholder (for example, commercial, personal,individual, group), and the geographic location. However, the proposed standard doesnot provide further guidance on this topic.Separate requirements apply to contracts that require the entity to hold underlying items and specify a linkto returns on those underlying items. These are discussed in a separate section in this practical guide.1PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 7
www.pwc.com/ifrsPwC observationThe application of the portfolio definition is important, as it will affect the contractualservice margin, day one loss recognition and the ongoing onerous contract test forcontracts under the simplified approach. The Board has attempted to define aportfolio in a way that is clear enough to apply without being overly prescriptive.However, this remains a judgmental area that may have different interpretationsin practice.Cash flowsThe cash flows are an explicit, unbiased and probability weighted estimate of the futurecash outflows less future cash inflows that w
PwC: Practical guide to IFRS – Revised exposure draft on insurance contracts– 5 PwC observation The Board intends that many fixed-fee service contracts (such as roadside assistance contracts and repair services) are outside of the scope of the insurance contract proposals. Instead an entity has to apply the proposed standard for revenue from contracts with customers. The accounting under .
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