Accounting for global consensus
The joint insurance contracts project
Over the past several years, momentum has been gathering towards global adoption of a single set of accounting standards that could be consistently applied by companies and understood by investors around the world. In this context, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have been collaborating on a number of joint projects (there are about a dozen ongoing right now) and this article focuses on one of those projects—a single converged insurance standard that addresses recognition, measurement, presentation and disclosure for insurance contracts. When finalised, the standard will apply to all entities that issue insurance contracts, not just insurers.
The building blocks
The proposals set out in the FASB discussion paper and IASB exposure draft would create a single measurement model for all insurance contracts. This model portrays a current assessment of the amount and timing of future cash flow that the insurer expects its existing insurance contracts to generate as it exercises its rights and fulfils its obligations under the contract. This full model consists of the following building blocks:
1. An explicit, unbiased and probability-weighted estimate (i.e. expected value) of future cash outflows less future cash inflows. Incremental contract acquisition costs (such as commissions) would be included in the net cash flows, effectively deferring and amortising them over future periods, although not as an explicit asset. All other acquisition costs would be expensed as incurred.
2. A risk-free discount rate applied to the cash flows to reflect the time value of money.
3. The IASB approach would also include a third building block—an explicit risk adjustment to reflect the estimate of the effects of uncertainty about the amount and timing of those future cash flows, while the FASB proposal would not. For comparability/consistency purposes, the IASB proposal limits the range of permitted techniques for calculating the risk adjustment to certain value-at-risk techniques (such as confidence levels) or cost of capital.
4. At contract inception, both proposals would defer and amortise any excess of expected cash inflows over outflows to eliminate any initial profit, but would recognise any losses immediately. This amount is referred to as the composite margin under the FASB approach and as the residual margin under the IASB approach. Under the IASB proposal, the residual margin is recognised over the coverage period in a systematic way that reflects the insurance coverage provided. Under the FASB proposal, the composite margin would be recognised in proportion to the ratio of premium collections (to total premium) and claims payments (to ultimate losses).
At each subsequent measurement date, the liability will reflect current estimates of cash flows, current discount rates and a risk adjustment that reflects the remaining risk of uncertainty about the amount and timing of those cash flows. Any changes in the estimates are recognised immediately in the income statement.
Short-duration model
The IASB’s proposal requires a ‘simplified model’ to be used for measurement of short-duration contracts of approximately 12 months or less using the present value of premiums as a proxy for the contract liabilities. Premiums would be recognised in the income statement in a systematic way over the coverage period and any reported claims would be measured using the buildingblock approach outlined above (including risk adjustment). An onerous contracts test (analogous to the premium deficiency test) is required for contracts that are measured using the simplified model and, under this approach, the income statement presentation is akin to current insurance industry practice. The FASB has not settled on a view on this matter.
For captive insurers, which commonly issue 12-month contracts, being able to use the simplified model (if also adopted by the FASB) would clearly reduce the impact of the changes.
Impact for captive insurance companies
The measurement and presentation aspects of the insurance contracts project are certain to receive the most attention in the captive insurance arena. The following observations outline some of the implications and issues for captive insurance companies:
Measurement:
• The use of probability-weighted cash flows is not currently a common element of estimates of insurance liabilities. The objective of this approach is to incorporate variability in the estimate of cash flows by identifying all possible scenarios (even those that are remote) and making unbiased estimates of the probability of each scenario. Such an approach results ina statistical mean, rather than a ‘best estimate’ or ‘most likely’ outcome. For contracts providing coverage of low-frequency/ high-severity claims, the approach may well result in more conservative reserves when compared to ‘expected level’ in the current approach. This change will also require actuaries to modify the methodology used to value claim liabilities.
• The requirement to discount will achieve consistency across companies by requiring all companies to use risk-free rates. This will be a departure from many captives reporting under US GAAP (especially those owned by SEC registrants) that presently do not discount loss reserves.
• The use of an explicit risk adjustment in the IASB model may be one of the more controversial aspects (and is one of the areas that the FASB was unable to reach consensus on), especially given that it is in addition to the probability-weighted cash flows that will have already given ‘weight’ to some of the more remote possible outcomes of the contract.
• The proposed FASB model for recognition of the composite margin will have the effect of delaying recognition of any contract profits over an extended period (because of the weight given to the claims payout period). For profitable captives, this will introduce a further layer of conservatism.
• As captives commonly have policies that don’t extend beyond 12 months, the simplified model for short-duration contracts will lower the impact of the measurement changes, and the presentation will be also more familiar to users. Additionally, the IASB short-duration model is mandatory for contracts that meet the criteria; accordingly, captives with contracts that meet both criteria will be using two different measurement and presentation models, which is cumbersome. This could be an issue for captive programmes that purchase multi-year excess coverage, which the proposals would currently require application of the full model even if the underlying policies were 12 months or less.
Presentation:
• For almost all captives applying the full model buildingblock approach, the income statement presentation will be a significant change from the way results are presented today.Companies will not recognise premiums as revenue (except where the short-duration simplified model is used), but would separately show an underwriting margin and changes in cash flow estimates and experience variances. Supplemental disclosures will provide the more traditional premium and claims-incurred information.
• The IASB short-duration simplified model results in a similar presentation to current industry practice for insurers where companies recognise premium review and claim other expenses on the face of the income statement. However, the current proposals mandate the simplified model for contracts that qualify; therefore, companies with both types of contracts would have to report under both of the two different presentation styles.
Solvency II
Companies with a captive based in Europe or other jurisdictions that are adopting Solvency II or equivalent frameworks (for example, Bermuda) will have been closely monitoring the impact of Solvency II on their capital requirements. In so far as the measurement aspects of Solvency II , there are some synergies with the insurance contracts project, but there will remain some differences too. The key measurement differences (specifically relevant to insurance liabilities) under Solvency II are:
• Risk adjustment using a prescribed 6 percent cost of capital
• No residual margin
• Acquisition expenses are expensed on day one
• No short-duration model.
Effective date
The IASB expects to issue a final standard in mid-2011. An effective date has not been proposed yet, although it is acknowledged that the IASB standard would not be effective before 2013 and general consensus is that 2014 will be the implementation year. The FASB’s next step, after gathering comments on the discussion paper and considering public feedback received by the IASB, will be to determine whether its exposure draft of a proposed standard should use some version of the models described in its discussion paper, or instead make targeted changes to existing US GAAP.
The proposals represent a fundamental change for the insurance industry and, if implemented in their current form, will have a significant impact on measurement and presentation. While the timeline leaves a good amount of breathing room to take stock of the joint project and any changes from the comment phase, given the potential impact of the changes being considered, companies will soon want to begin assessing the implications of the possible changes on existing contracts and current business practices and systems.
Damian Pentney is a partner at PricewaterhouseCoopers. He can be contacted at: damian.pentney@ky.pwc.com
