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Purchase Accounting

Business Combinations

Insurance IFRS Seminar

December 2, 2016

Eric Lu

Session 30

1

Purchase Accounting – General

(IFRS 3)

2

Purchase Accounting (“PA”)

• A “fresh start” - prior accounting becomes irrelevant

– Existing reserves, DAC, etc., under IFRS 4 or US GAAP become irrelevant.

– Under IFRS 17, existing CSM become irrelevant.

• All assets and liabilities are re-valued to fair value

3

PA Fundamental Principle

• The value of the acquired business on the books of the acquirer is the

amount paid for it.

• The purchase price is a fair price, negotiated between the seller and buyer.

• The purchase is merely an exchange of assets of equal worth.

– For the consideration paid (e.g. cash), the acquirer receives an asset or

assets of equal value (e.g. all outstanding shares of the acquired

company.)

4

IFRS 3-Acquisition Method

• Identify acquirer

• Determine acquisition date

• Recognize/measure assets acquired and liabilities assumed at fair value

• Recognize/measure goodwill or gain from bargain purchase

5

Some Intangibles to Consider

Type

• Customer-related

• Technology-based

• Contract-based

Example

• Customer Lists

• Software licenses

• Insurance contracts in force, but

NOT insurance contracts

expected to be written in the

future. This does NOT meet the

definition of an asset.

6

Goodwill

• Let NAA = value of net assets acquired

– Tangible and intangible assets less liabilities acquired measured at fair

value

– For purchase of an insurance company, fair value of insurance contracts

is required (IFRS 13)

• Let PP = purchase price

• Goodwill = PP – NAA, an asset on the books of the acquirer. The total value

of the acquired business is therefore NAA + GW = PP

7

Goodwill

• Goodwill is typically positive as part of the price may relate to future new

business.

• If Goodwill is Negative,

– Review identification and valuation of assets acquired and liabilities

assumed;

– If still negative, taken as a gain in the income statement.

8

Portfolio Transfers (Assumption Reinsurance)

• The selling company transfers a portfolio of insurance contracts and the

supporting assets.

• On the books of the acquirer, the fair value of the liabilities assumed is equal

to the fair value of the assets transferred.

• There is no goodwill.

9

IFRS 4 -

Insurance Contracts

10

IFRS 4, Paragraph 31

• Permits an insurer to split the fair value of acquired insurance contracts

between:

(a) A liability under insurer’s existing accounting policies, and

(b) An intangible asset equal to the difference between the FV of the

rights/obligations assumed and (a)

• The intangible asset goes by many names – VOBA, VIF, PVIF

11

IFRS 4, Paragraph 31

• Subsequent measurement of the intangible asset shall be consistent with

the measurement of the related insurance liability.

• Many companies use US GAAP principles for their insurance contract

accounting. In this case VOBA would be amortized based on premiums,

gross profits, etc.

• Historically, VOBA calculated bottom up, consistent with liabilities held

• IFRS guidance - VOBA may be balancing item to FV net liability

• In theory, two approaches should be consistent

12

IFRS 17 Tentative Decisions

13

Initial Measurement

• The purchase date is the date of initial recognition for acquired contracts i.e.

a fresh start.

• The consideration received is a pre-coverage cash flow (initial premium).

• The consideration received is equal to

– The cash received in a portfolio transfer

– The fair value of the contracts in a business combination

14

Relationship to Fair Value

• Case 1: FV > Fulfillment Cash Flow

– Then FCF – FV < 0 and CSM = FV – FCF

– Total initial liability = FCF + CSM = FV

• Case 2: FV < Fulfillment Cash Flow

– Then FCF – FV > 0 and CSM = 0

– Total initial liability = FCF + CSM = FCF

• This is an exception to the general purchase accounting rules and

requires IFRS 3 be amended

15

Guidance

• In a business combination, the initial liability measurement is used to

determine goodwill.

• 2013 ED gets to same answer as the 2010 ED.

• An insurer shall measure a portfolio of insurance contracts acquired in

a business combination at the higher of the following:

(a) the fair value of the portfolio.

(b) the present value of the fulfillment cash flows, i.e. best estimate plus risk

margin, but not residual margin.

16

Guidance (cont’d)

In the case of (a):

• The excess of that fair value over the present value of the fulfillment

cash flows establishes the CSM at initial recognition.

In the case of (b):

• The excess of fulfillment cash flows over the fair value increases the

initial carrying amount of goodwill recognized in the business

combination.

17

Example

• Example 9– Measurement of a portfolio of insurance contracts acquired in a

portfolio transfer

• An insurer acquires a portfolio of insurance contracts in a business combination. The fair

value of the portfolio is CU30. Present value of fulfillment cash flows is

• In Example 9A, CU20, which is lower than the fair value. FCF + PCCF = (10). The

contractual service margin is CU10

• In Example 9B, CU45, which is higher than the fair value. FCF + PCCF = 15. The

contractual service margin is zero

• At initial recognition, the insurer measures the insurance contract liability as follows:

Example 9A Example 9B

Present value of the fulfillment cash flows 20 45

Contractual Service Margin 10 0

Liability at initial recognition 30 45

Loss at initial recognition 0 15

18

Example

• Example 10– Measurement of a portfolio of insurance contracts acquired in a

business combination

• An insurer acquires a portfolio of insurance contracts in a business combination. The fair

value of the portfolio is CU30. Present value of fulfillment cash flows is

• In Example 10A, CU20, which is lower than the fair value. FCF + PCCF = (10). The

contractual service margin is CU10

• In Example 10B, CU45, which is higher than the fair value. FCF + PCCF = 15. The

contractual service margin is zero. Goodwill is CU15 higher than it would have been had

fair value been used as the initial measurement

• At initial recognition, the insurer measures the insurance contract liability as follows:

Example 9A Example 9B

Present value of the fulfillment cash flows 20 45

Contractual Service margin 10 0

Liability at initial recognition 30 45

Loss at initial recognition 0 0

19

Implications

• No more VOBA

• FV calculation

– Insurance contracts are exempted from FV measurement

– However, comparison to FV needed

– Also needed for goodwill analysis

• Other intangible assets remain, e.g. bank assurance distribution rights

Thank You