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MSc Insurance and Risk ManagementFull Time 2001-2002
Dissertation Topic:
New International Accounting Standard forInsurance Industry
(Life Insurance)
Humaida Banu Samsudin
Supervisor: Prof. Gerry M Dickinson
Co-Written by: Humaida Banu Samsudin Li Hon Wai Anthony
City University Business SchoolMSc Insurance and Risk Management
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Acknowledgements
First of all, I would like to express my gratitude to my supervisor, Prof. Gerry M
Dickinson for his instructions, suggestions, ideas and help that he provided for this
dissertation.
Moreover, I would also like to thank Ms Fee Kuen Kow, who had guided and helped
me a lot for the completion of this dissertation. And not forgotten my colleague,
Anthony who has been very supportive and co-operative throughout the completion of
this dissertation.
And finally I would like to thank my family in Malaysia and friends especially, Diara
Md. Jadi and Khor Chooi Lian for all their support and encouragement throughout my
master’s course.
By,
……………………………………..
Humaida Banu Samsudin
MSc Insurance and Risk Management
City University, London
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Contents
ACKNOWLEDGEMENTS..................................................................................................II
LIST OF FIGURES AND ILLUSTRATIONS .......................................................................V
ABSTRACT.................................................................................................................... VI
1.0.......................................................................................... INTRODUCTION....................................................................................................................................... 1
1.1 HISTORY.................................................................................................................................................1
1.2 STRUCTURE AND ORGANISATION OF THE IASC...................................................................................3
1.3 AIM OF IAS............................................................................................................................................6
1.4 STEERING COMMITTEE..........................................................................................................................7
2.0 ASSET AND LIABILITY APPROACH.........................................................................12
2.1 ANALYSIS OF THE FOCUS ON THE ASSET LIABILITY APPROACH UNDER IAS. THE CASE OF FOR AND
AGAINST. ....................................................................................................................................................12
2.2 IN THE CASE OF THE “ASSET AND LIABILITY” APPROACH, HOW SHOULD ASSETS AND LIABILITIES
BE VALUED: FAIR VALUE OR ENTITY-SPECIFIC VALUE?.........................................................................13
2.3 IN THE “ASSET AND LIABILITY” APPROACH, SHOULD DISCOUNTING RATES USED TO EVALUATE THE
PRESENT VALUE OF CONTRACTS BE LINKED TO THE RELATED INVESTMENT PORTFOLIO OR NOT? ........16
2.4 IN THE CASE OF THE “ASSET AND LIABILITY” APPROACH, WHAT WOULD BE THE COMPONENTS OF
THE INCOME STATEMENT?.........................................................................................................................17
3.0 FINANCIAL INSTRUMENTS AND INSURANCE CONTRACTS ...................................19
3.1 DISCUSSION OF WHY FINANCIAL INSTRUMENTS ARE TREATED DIFFERENTLY UNDER IAS. ............19
3.2 DIFFERENCES BETWEEN INSURANCE CONTRACTS AND FINANCIAL INSTRUMENTS...........................22
3.3 HOW DO INSURANCE AND BANKS DIFFER? NOTING THAT ASSET AND LIABILITIES BANKS ARE
INCLUDED IN IAS39 ..................................................................................................................................24
3.4 IS THERE A CASE TO SEPARATE OUT INSURANCE CONTRACTS FROM IAS 39. DISCUSSION OF THIS
FOR LIFE AND NON-LIFE INSURANCE CONTRACTS. .................................................................................25
4.0 FAIR VALUE.............................................................................................................28
4.1 THE PROBLEMS WITH CURRENT ACCOUNTING..................................................................................28
4.2 THE FAIR VALUE ISSUE........................................................................................................................29
4.3 SHOULD INSURANCE CONTRACTS BE INCLUDED IN A FAIR VALUE STANDARD?.............................31
5.0 LIFE INSURANCE.....................................................................................................34
5.1 CHARACTERISTIC OF INSURANCE TRANSACTIONS.............................................................................34
5.2 LIFE INSURANCE CONTRACTS.............................................................................................................34
5.2.1 Termination of the Contract .......................................................................................................37
5.2.2 Claims Arising from Events That Have Occurred....................................................................38
5.2.3 Claims during the Period Covered by the Current Premium - Events Have Yet to Occur ....38
5.2.4 The Insurance Contract...............................................................................................................39
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5.2.5 Acquisition Costs ........................................................................................................................39
5.2.6 Summary of Assets and Liabilities ............................................................................................40
5.3 LIFE INSURANCE MODEL.....................................................................................................................40
5.3.1 Policyholder-Benefits (Prospective) Model ..............................................................................41
5.3.2 Policyholder-Deposit (Retrospective) Model ...........................................................................43
5.3.3 Models Compared.......................................................................................................................45
5.3.4 The Steering Committee’s view, Financial Statements at Fair Value .....................................46
5.4 LIFE INSURANCE FORMATS.................................................................................................................49
6.0 CASH FLOW ESTIMATION AND DISCOUNT RATE...................................................54
6.1 CASH FLOW ESTIMATION....................................................................................................................54
6.2 ESTIMATING CASH FLOWS AND ADJUSTING FOR RISK AND UNCERTAINTY.....................................54
6.3 EXPECTED PRESENT VALUE OF ALL FUTURE CASH FLOWS..............................................................55
6.4 DISCOUNT RATES .................................................................................................................................60
6.5 FOREIGN CURRENCY CASH FLOWS ....................................................................................................65
7.0 HEDGING INSTRUMENTS.........................................................................................67
7.1 QUALIFYING INSTRUMENTS ................................................................................................................67
7.1.1 Designation of Hedging Instruments .........................................................................................67
7.1.2 Designation of Financial Items as Hedged items......................................................................69
7.1.3 Designation of Non-Financial Items as hedged items ..............................................................69
7.2 HEDGE ACCOUNTING..........................................................................................................................69
7.2.1 Assessing hedge effectiveness ...................................................................................................71
7.2.2 Fair Value Hedges.......................................................................................................................73
7.2.3 Cash Flow Hedges ......................................................................................................................74
7.2.4 Net Investment Hedges...............................................................................................................76
8.0 CONCLUSION...........................................................................................................78
8.1 THE OVER VIEW OF IAS.......................................................................................................................78
8.2 INSURANCE CONTRACTS .....................................................................................................................81
8.3 THE FAIR VALUE DEBATE ..................................................................................................................83
8.4 INSURANCE POLICY.............................................................................................................................86
8.4.1 Life Insurance..............................................................................................................................87
APPENDICES.................................................................................................................88
REFERENCES................................................................................................................97
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List of Figures and Illustrations
FIGURE 1: Structure Of IASC ...................................................................................... 5
FIGURE 2: The Customers Need From Banks And Insurance Companies ........25
ILLUSTRATION L1: Simple Prospective Model.........................................................42
ILLUSTRATION L2: Policyholder-Deposit Approach ...............................................44
ILLUSTRATION L3: Policyholder-Benefit And Policyholder-Deposit ApproachesCompared....................................................................................................................45
ILLUSTRATION L4: Steering Committee View ..........................................................47
ILLUSTRATION L5: Liability Computation, Asset-Based Discount Rate...............48
ILLUSTRATION L6: Asset-Based Discount Rate ......................................................48
ILLUSTRATION L7: Income Statement – Life Insurance .........................................51
ILLUSTRATION L8: Balance Sheet – Life Insurance................................................52
ILLUSTRATION L9: Cash Flow Statement – Life Insurance ..................................53
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Abstract
This dissertation provides the views in the Insurance Paper 1999 developed by
International Accounting Standard Committee’s (IASC) Steering Committee. By the
time the project is complete, a fair value accounting system for assets will be in place
because as a result, liabilities should also be measured at fair values. Insurance
contracts are either financial instruments or should be treated as if they were financial
instruments. Fair value should be based on pools of similar contracts. Given the long-
term nature of insurance contracts and the inherent uncertainties in the projection of
the cash flows, the fair value measurement of insurance liabilities should include
provisions for risk and uncertainty and thereby reflect the risks as perceived by the
market. This dissertation has been divided into two categories (the difference), life
insurance and non-life (general) insurance. No distinction should be made between
general insurance and life insurance in designing a set of accounting standards for all
insurance contracts. It is premature at this stage to recommend disclosure and
presentation details before a better view of the accounting approach to be applied
become available.
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1.0 INTRODUCTION
Our aim of this dissertation is to discuss about the importance of the International
Accounting Standard (IAS) to the insurance industry. We will review the
fundamental factors of the IAS to the insurance industry such as the different
accounting needs between financial institutions, ie, bank and insurance companies,
the fair value, matching and hedging issue and the debate of the insurance contracts
accounting treatment. Also, we will focus into the life and non-life insurance
company separately in order to compare the impact of the IAS to the whole business.
After reading this dissertation, the readers should have a clear picture about the pros
and cons of the IAS to the insurance industry and potential problem when it applies in
reality.
1.1 History
Most of the accounting abuses of recent years, such as off balance sheet finance,
‘window dressing’, the presentation of debt as equity and the abuse of reorganisation
provisions, were practised in areas of accounting where there were no authoritative
accounting standards. From the 1920’s experience has shown that, in the absence of
regulation, financial reporting may not give the information that users need to make
informed assessments of companies. Accounting standards aim to promote
comparability, consistency and transparency, in the interests of users of financial
statements. Good financial reporting not only promotes healthy financial markets, it
also helps to reduce the cost of capital because investors can have faith in companies’
reports.
The International Accounting Standards Committee (1973-2001) was the predecessor
body of the IASB. Statements of International Accounting Standards issued by the
Board of the International Accounting Standards Committee (1973-2001) are
designated ‘International Accounting Standards’ (IAS).
IASC was founded in June 1973 as a result of an agreement by accountancy bodies in
Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United
Kingdom and Ireland and the United States of America, and these countries
constituted the Board of IASC at that time.
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The Commission’s Communication, EU Financial Reporting Strategy: The Way
Forward, proposes the all EU companies listed on a regulated market (including banks
and other financial institutions) should be required to prepare consolidated accounts in
accordance with IAS. It is intended that this requirement will be effective by 2005 at
the latest.
The international professional activities of the accountancy bodies were organised
under the International Federation of Accountants (IFAC) in 1977. In 1981, IASC
and IFAC agreed that IASC would have full and complete autonomy in the setting of
international accounting standards and in the issue of discussion documents on
international accounting issues. At the same time, all members of IFAC became
members of IASC. This relationship continued until the IASC’s Constitution was
changed in May 2000 as part of the reorganisation of the IASC at which time this
membership link was discontinued.
In April 1997 the Board of the International Accounting Standards Committee (IASC)
approved a proposal the IASC should start a project on Insurance Accounting. This
paper is the result of the first stage in that project. Later on, the International
Accounting Standards Board announced in April 2001 that its accounting standards
would be designated ‘International Financial Reporting Standards’.
In many countries, stock exchange listing requirements or national securities
legislation permits foreign companies that issue securities in those countries to
prepare their consolidated statements using International Accounting Standards.
Principal capital markets in this category are Australia, Germany, and the UK.
Certain countries do not permit companies to use IAS without a reconciliation to
domestic generally accepted accounting principles. Most notable among these
countries are Canada, Hong Kong, Japan and United States.
The IAS regulation represents the biggest change in European financial reporting for
30 years and will make the EU the world's first region to have one common set of
accounting standards. This very important step towards international convergence of
accounting standards will improve the transparency of companies' reported
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information and provide a key plank in the EU's drive for a single European capital
market.
1.2 Structure and organisation of the IASC
In November 1999, the IASC’s Strategy Working Party presented its final report,
‘Recommendations on Shaping IASC for the Future’, to the IASC Board. The Board
subsequently adopted its recommendations, which were then approved by the member
bodies of the International Federation of Accountants. Under the recommendations,
the IASC has been reorganised as a separate body, somewhat like a Foundation, and is
governed by a board of Trustees. The standard setting part of the restructured IASC is
the International Accounting Standards Board (IASB) which is governed by the Board
of Trustees. The Trustees were appointed during the second half of 2000 by a
Nominating Committee that was set up for that sole purpose under the Chairmanship
of the then US SEC Chairman, Mr. Arthur Levitt. There are nineteen Trustees from
diverse geographic and career backgrounds, under the Chairmanship of Mr.Paul A.
Volcker, a Former Chairman of the US Federal Reserve Board.
The first act of the Board of Trustees was to appoint Sir David Tweedie (who had just
completed a highly distinguished period of ten years as the Chairman of the UK’s
Accounting Standards Board) as the first Chairman of the IASB. Subsequently in
February 2001 the Trustees appointed the other members of the IASB. The Trustees
are responsible also for appointing the members of the Standing Interpretations
Committee (SIC) and Standards Advisory Council. The Trustees will also monitor the
IASC’s effectiveness, raise funds for the IASC, approve the IASC’s budget and have
responsibility for constitutional changes.
Set out below is a graphical representation of the new IASC structure, which is
expected to come into effect on or about 1April 2001:
The IASB, which is based in London, comprises fourteen individuals (twelve full-
time Members and two part-time Members), including the Chairman, and has sole
responsibility for setting International Accounting Standards. The foremost
qualifications for Board membership are technical expertise and independence. The
Board Members have representative backgrounds as accounting standard setters,
practising auditors, preparers of financial statements, users of financial statements, or
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as academics. Seven of the fourteen Board Members have a direct responsibility for
liaison with one or more national standard setters. The publication of a standard,
exposure draft, or final SIC interpretation will require approval by eight of the
Board’s total of fourteen votes.
The Trustees have emphasised their commitment to achieving a broad and
representative balance of perspectives, both professionally and geographically,
through the creation of a Standards Advisory Council. The Advisory Council will
meet regularly with the IASB to advise the Board on priorities and to inform the
Board of implications of proposed standards for users and preparers of financial
statements.
The Standing Interpretations Committee was originally formed in 1997 to consider,
on a timely basis, accounting issues that are likely to receive divergent or
unacceptable treatment in the absence of authoritative guidance. In developing
interpretations, the SIC consults similar national committees which have been
nominated for the purpose by Member Bodies. The SIC has up to 12 voting members
from various countries, including individuals from the accountancy profession,
preparer groups, and user groups. If no more than three of its voting members have
voted against an interpretation, the SIC asks the Board to approve the final
interpretation for issue. The SIC considers the following criteria for taking issues on
its agenda:
• the issue should involve an interpretation of an existing Standard within the
context of the IASC Framework;
• the issue should have practical and widespread relevance;
• the issue should relate to a specific fact pattern; and
• significantly divergent interpretations must either be emerging or already exist in
practice.
The SIC’s function is to give guidance that is generally applicable where existing
Standards are unclear or silent, but not to rule on individual cases. However,
contentious cases brought to the SIC can lead to the issuance of an Interpretation
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which is applicable on a general basis. As discussed more fully below, full
compliance with all SIC Interpretations is a necessary component of the presentation
of IAS financial statements.
The following diagram is a visual representation of the structure of IASB. The
structure is designed to support those attributes considered desirable to establish the
legitimacy of a standard setting organisation: the representativeness of the decision
making body, the independence of its members, and technical expertise.
IASB's structure provides a balanced approach to legitimacy based upon
representativeness among members of the Trustees, the International Financial
Reporting Interpretations Committee (IFRIC), and the Standards Advisory Council,
and technical competence and independence among Board Members. Also, this is an
analysis of the large body of Information produced by IAS, FASB and external
comments and critiques through letters, email all over the world.
Figure 1: Structure of IASC
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1.3 Aim of IAS
International Accounting Standard on Insurance Accounting is a need because the
insurance industry is an important, and increasingly international, industry. There is
currently great diversity in accounting practices for insurers. Insurance industry
accounting practices in a number of countries also differ significantly from
accounting practices used by other enterprises in the same countries.
International Accounting Standards do not currently address specific insurance issues
and it is not obvious how an enterprise should deal with these issues under
International Accounting Standards. And certain International Accounting Standards
contain specific scope exclusions in these areas, in recognition of the need for further
study of these issues. Although these gaps cause difficulty for all insurers applying
IAS, they cause a particularly urgent problem in the European Union (EU), where it is
proposed that International Accounting Standards will become mandatory for all
listed enterprises (including listed insurers) by 2005. The existence of such a standard
may help insurance supervisors in their efforts to approach certain aspects of
insurance regulation in ways that are consistent both between countries and with
regulation of the banking and securities sectors.
The Board of IASC (International Accounting Standards Committee) uses IASC’s
Framework for the preparation and presentation of Financial Statements to assist in
the development of International Accounting Standards and in its review of existing
International Accounting Standards. It is also for promoting harmonisation of
regulations, accounting standards and procedures relating to the presentation of
financial statements by providing a basis for reducing the number of alternatives
accounting treatments permitted by International Accounting Standards. The objective
of financial statements is to provide information about the financial position,
performance and changes in financial position of an enterprise that is useful to a wide
range of users in making economic decisions.
Moreover, since May 2000, there have been a number of developments promoting the
use of IAS. These include: (i) the decision of the EU Council of Ministers (ECOFIN
Council) requiring the use of IAS by 2005; (ii) the completion of the reconstitution of
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the IASB into a full-time independent standard setter, and (iii) the formation of the
Committee of European Securities Regulators with a special sub-group devoted to
these issues.
The International Accounting Standards Board (IASB) published proposals for public
comment in the form of an exposure draft, Improvements to International Accounting
Standards, on which comments are invited by 16 September 2002.
This exposure draft is the first product of the IASB’s Improvements project, which
aims to raise the quality and consistency of financial reporting by drawing on best
practice from around the world, and removing options in international standards. The
Improvements project is a first step by the IASB to promote convergence on high
quality solutions in its objective to establish a globally accepted set of accounting
standards.
1.4 Steering Committee
In 1997, the International Accounting Standards Committee (IASC) set up a Steering
Committee on Insurance. The Steering Committee has published this Issues Paper in
December 1999 for comment by professional accountancy bodies, standard setting
bodies, members of the IASC Consultative Group and other interested individuals and
organisations. The Steering Committee welcome comments on the basic issues and
sub-issues set out in this paper, even if they deal only with a limited number of those
issues. Comments are particularly helpful if they:
(a) indicate the specific basic issues and sub-issues to which they relate;
(b) explain the issues clearly;
(c) provide supporting reasoning; and
(d) indicate which issues are interdependent.
The Steering Committee requests comments by 31 May 2000. The Issues Paper:
• identified the different forms of insurance contract and those specific
characteristics that were considered relevant in determining the appropriate
accounting treatment;
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• identified the accounting and disclosure issues and arguments for and against
possible solutions to those issues;
• identified the tentative views of the Steering Committee at the early stage of
the project; and
• was published together with an accompanying booklet that contained 82
illustrative examples, summarised relevant national standards and requirements
in 17 countries, summarised the main features of the principal contracts found
in eight countries, contained a glossary of terms used in the paper and
summarised the tentative views expressed in the paper.
The Steering Committee and the Board will review the public response to the Draft
Statement of Principles (DSOP). The Steering Committee will then develop the final
Statement of Principles and submit it to the IASC Board for approval. The Steering
Committee will use the approved Statement of Principles to develop an Exposure
Draft of a proposed International Accounting Standard. On approval by the Board, the
Exposure Draft will be issued for public comment. The Steering Committee will
consider responses to the Exposure Draft and then prepare an International
Accounting Standard for Board approval.
The Steering Committee emphasises that the views expressed in this paper are,
inevitably, tentative at this early stage of the project. Before proceeding to the next
stage of the project, the Steering Committee will review these tentative views
carefully in the light of comment letters received and will assess whether those views
are appropriate. The Steering Committee has not yet discussed its tentative views with
the Board of IASC. The Steering Committee’s tentative views may be summarised
briefly as follows:
(a) the project should deal mainly with accounting for insurance contracts (or groups
of contracts), rather than all aspects of accounting by insurance enterprises. In
particular, the project should not deal with accounting for investments held by
insurance enterprises;
(b) an insurance contract should be defined as a contract under which one party (the
insurer) accepts an insurance risk by agreeing with another party (the
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policyholder) to make payment if a specified uncertain future event occurs (other
than an event that is only a change in a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, a credit rating
or credit index, or similar variable);
(c) the objective should be to measure the assets and liabilities that arise from
insurance contracts (an asset-and-liability measurement approach), rather than to
defer income and expense so that they can be matched with each other (a
deferral-and-matching approach);
(d) insurance liabilities (both general insurance and life insurance) should be
discounted;
(e) the measurement of insurance liabilities should be based on current estimates of
future cash flows from the current contract. Estimated future cash flows from
renewals are:
(i) included if the current contract commits the insurer to pricing for those
renewals; and
(ii) excluded if the insurer retains full discretion to change pricing;
(f) in the view of a majority of the Steering Committee, catastrophe and equalization
reserves are not liabilities under IASC's Framework. There may be a need for
specific disclosures about low-frequency, high-severity risks - perhaps by
segregating a separate component of equity;
(g) the measurement of insurance liabilities should reflect risk to the extent that risk
would be reflected in the price of an arm’s length transaction between
knowledgeable, willing parties. It follows that the sale of a long-term insurance
contract may lead in some cases to the immediate recognition of income. The
Steering Committee recognises that some may have reservations about changing
current practice in this way;
(h) overstatement of insurance liabilities should not be used to impose implicit
solvency or capital adequacy requirements;
(i) acquisition costs should not be deferred as an asset;
(j) all changes in the carrying amount of insurance liabilities should be recognised
as they arise. In deciding what components of these changes should be presented
or disclosed separately, the Steering Committee will monitor progress by the
Joint Working Group on Financial Instruments;
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(k) the Steering Committee is working on the assumption that IAS 39, Financial
Instruments: Recognition and Measurement (refer: Appendix A1), will be
replaced, before the end of the Insurance project, by a new International
Accounting Standard that will require full fair value accounting for the
substantial majority of financial assets and liabilities. The Steering Committee
believes that;
(i) if such a standard exists, portfolios of insurance contracts should also be
measured at fair value. IASC defines fair value as “ the amount for which
an asset could be exchanged or a liability settled between knowledgeable,
willing parties in an arm’s length transaction”;
(ii) in a fair value accounting model, the liability under a life insurance
contract that has an explicit or implicit account balance may be less than
the account balance; and
(iii) determining the fair value of insurance liabilities on a reliable, objective
and verifiable basis poses difficult conceptual and practical issues, because
there is generally no liquid and active secondary market in liabilities and
assets arising from insurance contracts. To avoid excessive detail, this
Issues Paper discusses measurement issues in fairly general terms. The
Steering Committee will develop more specific guidance on measurement
issues at a later stage in the project;
(l) pending further discussion, the Steering Committee is evenly divided on the
effect of future investment margins. Some members believe that future
investment margins should be reflected in determining the fair value of insurance
liabilities. Other members believe that they should not;
(m) for participating and with-profits policies:
(i) where the insurer does not control allocation of the surplus, unallocated
surplus should be classified as a liability; and
(ii) where the insurer controls allocation of the surplus, unallocated surplus
should be classified as equity (except to the extent that the insurer has a
legal or constructive obligation to allocate part of the surplus to
policyholders). Liability classification is the default, to be used unless
there is clear evidence that the insurer controls allocation of the surplus;
(n) for investment-linked insurance contracts, premiums received may need to be
split into a risk component (revenue) and an investment component (deposit);
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(o) the accounting for reinsurance by a reinsurer should be the same as the
accounting for direct insurance by a direct insurer;
(p) amounts due from reinsurers should not be offset against related insurance
liabilities; and
(q) most of the disclosures required by IAS 32, Financial Instruments: Disclosure
and Presentation, and IAS 37, Provisions, Contingent Liabilities and Contingent
Assets, are likely to be relevant for insurance contracts. Some of the disclosures
required by IAS 39, Financial Instruments: Recognition and Measurement, may
not be needed in a fair value context. Other items that may require disclosure are
regulatory solvency margins, key performance indicators (such as sum insured in
life, retention / lapse rates), information about risk adjustments and information
about value-at-risk and sensitivity.
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2.0 ASSET AND LIABILITY APPROACH
2.1 Analysis of the focus on the Asset Liability Approach under IAS.
The case of for and against.
There should be a single recognition and measurement approach for all forms of
insurance contracts and the approach should be an asset and liability measurement
approach, rather than a deferral and matching approach (refer Appendix B1).
Most insurance accounting models used in practice today follow the deferral and
matching approach. Examples of deferral and matching approaches are US GAAP and
Margins on Services (used primarily in Australia). The objective of a deferral and
matching approach is to relate claim and expense costs to premium revenue. This
generally has the effect of spreading profits over the lifetime of a contract as services
are provided. In particular, acquisition costs are often deferred and amortised against
future premium receipts.
The asset and liability approach is consistent with the IASC framework, which
establishes criteria for evaluating whether an item should be recognised as an asset or
liability. An asset is defined as “a resource controlled by the enterprise as a result of
past events from which future economic benefits are expected to flow to the
enterprise”. A liability is defined as “a present obligation of the enterprise arising
from past events, the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits”. Based upon these definitions,
some believe the deferral and matching approach violates these basic principles and
results in deferred costs which do not meet the definition of an asset and deferred
revenues or gains which do not meet the definition of a liability. Strict application
would preclude the deferral of premiums and acquisition costs, or the establishment of
equalisation or catastrophe reserves. As the name would suggest, an asset and
liability measurement approach is one that measures the assets and liabilities of an
entity and recognises profit through the relative change in these two quantities from
one year to the next. The embedded value method would be an example of such an
approach.
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The June 2001 draft DSOP (Draft Statement of Principles) proposes an asset and
liability approach. The reasons for this are as follows (essentially these refer back to
the original objectives of the IASB project):
• an asset and liability approach will provide greater transparency
• an asset and liability approach will produce accounts that are more understandable
• an asset and liability approach will make it easier for users to make comparisons
between different sets of accounts.
This approach would create major changes in financial reporting for all insurers in the
world, which currently apply some variation of the deferral and matching approach.
Significant issues arise as to the contents and format of the statement of financial
performance and ensuring that the information is relevant to the users of financial
statements. Under this approach, a main component of the income statement for
insurers would be the change in financial assets and financial liabilities.
2.2 In the case of the “Asset and Liability” approach, how should assets
and liabilities be valued: Fair Value or Entity-Specific Value?
Insurance assets and liabilities should be measured on a prospective basis, reflecting
the present value of all future cash flows and arising from the closed book of
insurance contracts in existence at reporting date. The prospective approach is
defined in contrast to the retrospective approach, which is the current method used by
the majority of insurers when evaluating insurance liabilities. The retrospective
approach focuses on an accumulation of past transactions between policyholders and
insurers. It relies primarily on objectively recorded transactions. In contrast, the
prospective approach would focus on expected future cash inflows and outflows from
an insurance contract. The objective is consistent with the IASC framework of
providing information that helps users to evaluate the ability of an enterprise to
generate cash and cash equivalents. It is proposed that present value principles could
be used in measuring all insurance assets and liabilities, except where the time value
of money and uncertainty do not have a material effect (e.g. cash flows less than 1
year). This is based on the following assertions:
a) Present value measures are more relevant to investors;
b) Most life insurance measurements use present value calculations;
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c) It is consistent with rational pricing decisions;
d) It matches revenues and expenses by measuring them in terms of a common
measuring unit.
This DSOP prescribes two methods of prospective measurement, without indicating a
preference at this stage for one or the other. The Standard should require only one of
these methods.
Under the first method, insurance liabilities and insurance assets should be measured
at entity-specific value. Entity-specific value represents the value of an asset or
liability to the enterprise that holds it, and may reflect factors that are not available (or
not relevant) to other market participants. In particular, the entity-specific value of a
liability is the present value of the costs that the enterprise will incur in settling the
liability in an orderly fashion over the life of the liability.
Under the second method, insurance liabilities and insurance assets should be
measured at fair value. Fair value is the amount for which an asset could be
exchanged or a liability settled between knowledgeable, willing parties in an arm’s
length transaction. In particular, the fair value of a liability is the amount that the
enterprise would have to pay a third party at the balance sheet date to take over the
liability.”
IAS currently does not use the term entity-specific value. In developing a definition of
entity-specific value, the Insurance Steering Committee referred to two precedents.
The June 2001 draft DSOP adopted the definition proposed by the former IASC
Present Value Steering Committee. This Steering Committee defined entity-specific
value as “the value of an asset or liability to the enterprise that holds it”. This is a
generalisation of the notion of value in use, defined in IAS 36, Impairment of Assets,
as “the present value of estimated future cash flows from the continuing use of an
asset and from its disposal at the end of its useful life”. The Steering Committee also
defined entity-specific value of a liability as “the present value of the costs that the
enterprise will incur in settling the Liability in an orderly fashion over the life of the
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liability”. This definition builds on a statement in the IASC Framework that the
present value of liabilities is “the present discounted value of the future net cash
outflows that are expected to be required to settle the liabilities in the normal course
of business.”
IAS define fair value as “the amount for which an asset could be exchanged or a
liability settled between knowledgeable, willing parties in an arm’s length
transaction”. The fair value of a liability is its fair value in exchange, i.e. the amount
that the enterprise would have to pay a third party at the balance sheet date to take
over the liability. Entity-specific value allows the use of an enterprise’s own costs,
assumptions and experience. Fair value by comparison, requires that an enterprise use
assumptions and expectations inferred from market data.
Even if the insurer and the market have the same level of knowledge about the asset
or liability, the entity-specific value of an asset or liability may differ from its fair
value if:
a) The insurer has superior management skills that enable it to maximise cash
inflows from an asset or minimise cash outflows from a liability
b) They form different estimates about the timing or amount of future cash flows
c) They have different liquidity needs or have different views about the relevance of
their own credit standing.
The fair value concept revolves around the principle of a “transaction”, whereas the
entity-specific value concept is based on the principle of “normal course of business”.
• Usually given arguments for entity-specific value are:
a) Most insurance liabilities are settled by payments to policyholders, rather than
by an exchange transaction with a third party;
b) Management has better information than other market participants about their
company’s future cash flows;
c) Most insurance liabilities are not traded; hence their fair value will not be
observable in the market.
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• Usually given arguments for fair value are:
a) Market prices are more informative and neutral predictors of future cash flows;
b) Entity-specific value is not determinable on a reliable basis, except by
reference to market data;
c) Fair value should be independent of the entity performing the measurement,
which improves comparability;
d) Future IAS (if based on the JWG draft) could require full fair value accounting
for financial instruments;
e) Fair value of insurance liabilities may not generally be observable directly in
the market, but their fair value can be estimated using reliable models, which
can use observable market data.
What does it mean for the income statement?
The profit or loss will vary based on whether the insurance liability is evaluated under
fair value or entity-specific value. In entity-specific value, the profit or loss for the
year will reflect management’s estimate of future cash flows, based on their unique
circumstances. Fair value would be based on industry averages or market estimates of
future cash flows. The main point is that while results will reflect the impact of
management’s decisions, results will also be impacted significantly by differences
between the actual experience of the company and the market’s expectations. This
will include differences between the assumptions used in the valuation models (e.g.,
interest rates) and the actual variables.
2.3 In the “Asset and Liability” approach, should discounting rates used
to evaluate the present value of contracts be linked to the related
investment portfolio or not?
If substantially all of an insurer’s financial assets are measured consistently on one
basis, that basis should also be adopted for its insurance liabilities. However the
entity-specific value or fair value of insurance liabilities should not be affected by the
type of assets held or by the return on those assets (except where the amount of
benefits paid to policyholders is directly influenced by the return on specified assets,
as with certain participating contracts and unit-linked contracts). With fair value or
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entity-specific value, the discount rate used will be an adjusted “risk free rate” rather
than the investment return expected over the life of the policy. The conclusion is
based on the belief that the measurement of liabilities should be independent of an
enterprise’s investment strategy, except for participating, unit-linked and variable
contracts. The valuation of insurance contracts will include adjustments for risk and
uncertainty. This may be incorporated into the valuation process by adjusting the
interest rate or the cash flows, but not both. It is consistent with the concept of entity-
specific value, where the measurement of the liability would be dependent on the
enterprise’s cost structure.
What is the impact on the income statement?
For assets invested in interest bearing instruments whose cash flows exactly match the
cash flows of the insurance portfolio, the impact of any movement in the market rates
could be zero. An exception might of course arise from differences in credit quality.
Nevertheless, it is usually hard to achieve a matched cash flow, therefore the profit or
loss of the insurer will also be impacted by any mismatch in duration. Some portion
of the present value of the investment margin may be taken at inception. The income
statement will be impacted by any mismatch in duration between interest-bearing
investments and the related liabilities. For certain participating, unit-linked, and
variable contracts, the June 2001 draft DSOP indicates that the related investments
will be taken into consideration when determining the contract liability. The June
2001 draft DSOP does not currently provide much detail, however, exactly how this is
to be implemented.
2.4 In the case of the “Asset and Liability” approach, what would be the
components of the income statement?
Each year, the income statement could contain the following items:
• For the year then ended the impact of the difference between the actual investment
return and the risk-free discount rate from prior year.
• For the year then ended the impact of the change in the risk free rates year to year.
• Modifications of assumptions, if any, that affect the expected amount or timing of
future cash flows.
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• Present value of part of expected profit or loss of new business for the year (the
level of profit or loss will be linked to the level of risk and uncertainty).
• The impact of differences between market expectations and actual results.
• The variation on the appreciation/depreciation of risk and uncertainty each year
would impact the income statement directly.
• In order to be understandable and useful for the users, financial statements would
need to be very detailed. Hence the format of the income statement and related
disclosure is a significant unresolved issue. The June 2001 draft DSOP to date has
a strong balance sheet focus, with less consideration having been given to the
income statement presentation.
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3.0 FINANCIAL INSTRUMENTS AND INSURANCE CONTRACTS
3.1 Discussion of why Financial Instruments are treated differently
under IAS.
IAS applies to financial instruments. Under this Standard, financial assets are
classified into 4 areas: loans and receivables originated by the enterprise, available-
for-sale, trading and held-to-maturity. Given the definition of held-to-maturity
financial assets, there is a high probability that this category has limited use for
insurance companies in practice. Also, loans and receivable originated by insurance
enterprises usually do not represent a significant portion of their financial assets.
A fundamental issue is whether the project should cover all aspects of accounting by
insurers (in other words, insurance enterprises) or whether it should focus mainly on
insurance contracts of all enterprises. Some argue that the project should deal with all
aspects of financial reporting by insurers to ensure that the financial reporting for
insurers is internally consistent.
Also some argues that the project should cover insurance contracts of all enterprises
because it would be extremely difficult, and perhaps impossible, to create a robust
definition of insurance enterprise that could be applied consistently from country to
country. Also, it would be undesirable for an insurer to account for a transaction in
one way and for a non-insurance enterprise to account in a different way for the same
transaction. Besides, a set of internally consistent accounting requirements for
insurers will be obtained if the accounting requirements for insurance contracts are
consistent with other International Accounting Standards.
The specific Standard for insurance would be restricted to prescribe accounting for
insurance contracts only, and would not apply to other aspects of insurance
companies’ operations. Accounting for insurance contracts should be consistent
among issuers (including insurers and reinsurers) and policyholders.
IAS 32 defines a financial instrument as ‘any contract that gives rise to both a
financial asset of one enterprise and a financial liability or equity instrument of
another enterprise.’ It defines a financial asset as ‘any asset that is: a) cash, b) a
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contractual right to receive cash or another financial asset from another enterprise, c)
a contractual right to exchange financial instruments with another enterprise under
conditions that are potentially favourable or d) an equity instrument of another
enterprise.’ It defines a financial liability as ‘any liability that is a contractual
obligation: a) to deliver cash or another financial asset to another enterprise or b) to
exchange financial instruments with another enterprise under conditions that are
potentially unfavourable.’
The following definition of insurance contracts is currently used in IAS 32, Financial
Instruments (Disclosure and Presentation), IAS 39, Financial Instruments
(Recognition and Measurement) and the March 1997 Discussion Paper, Accounting
for Financial Assets and Financial Liabilities. An insurance contract is a contract
under which one party (the insurer) accepts an insurance risk by agreeing with another
party (the policyholder) to compensate the policyholder or other beneficiary if a
specified uncertain future event (the insured event) adversely affects the policyholder
or other beneficiary (other than an event that is only a change in one or more of a
specified interest rate, security price, commodity price, foreign exchange rate, index
of prices or rates, a credit rating or event or similar variable).
Insurance assets and insurance liabilities are assets and liabilities arising under an
insurance contract. An insurer or policyholder should recognise:
(a) an insurance asset when, and only when, it has contractual rights under an
insurance contract that result in an asset; and
(b) an insurance liability when, and only when, it has contractual obligations under an
insurance contract that result in a liability.
It is also a contract that exposes the insurer to identified risks of loss from events or
circumstances occurring or discovered within a specified period, including death, (in
the case of an annuity, the survival of the annuitant), sickness, disability, property
damage, injury to others and business interruption. Most insurance contracts are
financial instruments, as defined in International Accounting Standards, because they
create contractual rights or obligations that will result in the flow of cash or other
financial instruments.
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This definition draws out the important distinction between insurance risk and
financial risk. Contracts, which currently have the legal form of insurance contracts,
can have quite different levels of insurance and financial risk. At one end of the
spectrum a non-linked term assurance product has significant insurance risk, through
the level of life cover offered, but little financial risk. This product would clearly meet
the IASB definition of an insurance contract. At the other end of the spectrum a UK-
style regular premium unit-linked personal pension product has significant financial
risk, but no obvious insurance risk. According to the IASB definition this type of
product would not be an insurance contract. Between these two extremes lie a
multitude of other products. For example, unit-linked contracts with guaranteed death
benefits have both financial and insurance risk and would probably be classed as
insurance contracts.
The meaning of this statement depends greatly on the meaning attributed to the word
‘significant’. The definition’s interpretational sensitivity raises a number of interesting
possibilities. For example, one could envisage a situation where an insurance
company has some of its products classified as insurance contracts, and reports for
them under the insurance accounting standard, and other similar products that do not
meet the definition of insurance contracts and are therefore reported under a different
accounting standard (presumably IAS 39).
It follows that the definition of insurance contracts will serve two functions to provide
a demarcation from other financial instruments on the basis of some attribute that
suggests the need for a separate standard and to distinguish insurance contracts from
other items that are not financial instruments (for example, provisions cover by IAS
37 and intangible assets covered by IAS 38).
Under this definition, many contracts currently sold by insurance enterprises and
accounted for as insurance contracts could fail to meet the proposed new definition of
insurance. For example, a contract that exposes the issuer to financial risk with
insurance risks would not be accounted for as an insurance contract. This could mean
that a significant portion of existing European products might have to be accounted
for as financial instruments in accordance with IAS 39. Most investment-oriented
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products would no longer be accounted for as insurance. This would mean that
premium received will be a financial liability rather than recognised as revenue by the
issuer and premium paid will be a financial asset (deposit) of the owner.
An insurance contract specifies the contractual rights and contractual obligations that
give rise to insurance assets and insurance liabilities. The event that creates insurance
assets and insurance liabilities is becoming a party to the insurance contract. This
gives the insurer and the policyholder control over their contractual rights and creates
contractual obligations that allow them little, if any, discretion to avoid the net cash
outflows resulting from their contractual obligations.
Also, the new definition includes the notion of ‘uncertain future event.’ It means
uncertain at the inception of a contract whether: a future event specified in the
contract will occur, when the specified event will occur and how much the insurer
will need to pay if the specified future event occurs.
3.2 Differences between insurance contracts and financial instruments.
There would seem to be a number of important differences between insurance
contracts and financial instruments:-
1) Insurance contracts operate on the pooling principle,
2) Financial instrument are normally traded actively on a market and financial
instruments that are assets can be sold at any time and financial instruments that
are liabilities can be redeemed at any time. This is not the case with insurance
liabilities,
3) The amount of administration or servicing required on financial instruments is
normally small or practically non-existent but insurance contracts have a
significant servicing element throughout their lives. In the UK some 40% of the
yearly expenses of insurance companies go on servicing existing contracts,
4) Taking out most of the profits up-front at point of sale in respect of a financial
instrument with minimal servicing requirements (which is the effect of a
measurement at fair value) seems reasonable since the financial instrument can
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be sold and the profit realised. It seems more debatable whether to take out most
of the potential future profits (i.e. all profits apart from a ‘systematic risk
margin’ or ‘market value margin’) at the point of sale of an insurance contract
when a significant percentage of the cost or work involved with the contract
occurs during the course of its lifetime,
5) Fees earned as services are provided, even for financial instruments, are
recognised as revenue as the services are provided. This would seem to support
the case for not taking out too much of the profits on an insurance contract at
point of sale,
6) The provision of insurance coverage can be regarded as a form of service
provided by the insurer to the policyholder over the term of the contract,
7) The terms of insurance contracts can include services to the policyholder, in
addition to the risk cover. Additional services can be delivered by managing the
investments relating to a life insurance contract where the benefits are linked to
investment performance. The service and financial instrument aspects cannot be
objectively separated in many contracts,
8) The underlying risk from holding insurance contracts is different from most
financial instruments, whereas the holding of a financial instrument usually
results in market and credit risk only, the insurer is also exposed to insurance
risk over a period of time until the contracts expire and claims are settled.
The Issues Paper is predicated on the assumption that IAS 39 will be replaced by a
new standard for financial instruments requiring fair value for the substantial
majority. Insurance contracts would then follow on behind being designated financial
instruments and therefore measured at fair value. It would seem that adoption of this
stance could leave the Steering Committee on Insurance with a difficulty if the new
Financial Instrument Working Group proposed fair value except for those cases which
had the closest parallel with insurance contracts. It is perhaps revealing that FASB’s
document ‘Preliminary Views on major issues related to Reporting Financial
Instruments and Certain Related Assets and Liabilities at Fair Value’ says in
paragraph 4 “….the Board has not yet decided when, if ever, it will be feasible to
require essentially all financial instruments to be reported at fair value in the basic
financial statements”
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The cases which appear to have been causing FASB most concern are credit card
relationships and demand deposit relationships. The reason that they question the use
of fair value in these cases is the absence of a market for trading the financial
instrument parts of these relationships independent of the value (goodwill or franchise
value) of selling new business and other ancillary benefits to the new customers
acquired. Exactly the same situation applies to insurance contracts where the
published prices for the acquisition of a portfolio of policies (where further policies
can be sold to existing or new policyholders) are included in the purchase price.
3.3 How do Insurance and Banks differ? Noting That Asset and
Liabilities Banks are Included in IAS39
Typical exposures to some risks are sometimes offsetting between banking and
insurance, as in the case of interest-rate risk. Being intermediaries between depositors
and borrowers, banks by nature have a mismatched position with respect to interest
rates; they tend to have long-term assets (loans) and short-term liabilities (demand
deposits). Consequently, banks have developed considerable skill in managing short-
term interest-rate risk, and in profiting from it.
Conversely, insurance companies generally issue long-term liabilities in connection
with life insurance and for retirement savings and income products. Available assets
are often shorter in duration that the liabilities, creating an exposure to long-term
interest-rate risk, or reinvestment risk. In contrast with banks, insurance companies
traditionally have seen the interest risk as something to be eliminated by matching
rather than as a source of profit, so they have developed expertise in hedging the risk.
Banks and insurance companies can provide each other a partial hedge of their natural
mismatch position.
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Customer Demand Banks Insurance companies
1 Protection against interest risk
2 Protection against personal risk v
3 Safekeeping of assets v v
4 Asset portfolio Management
5 Information on Financial Markets
6 Inform and Trustworthy advises v v
7 Financial Solution and reducing taxes v
8 Funding for monetary needs v
9 Convenient financial transactions v
Figure 2: The customers need from banks and insurance companies
3.4 Is there a Case to Separate out Insurance Contracts from IAS 39.
Discussion of this for Life and Non-life Insurance Contracts.
In many countries, it is mandatory for prudential reasons to make a distinction
between general insurance (sometimes known as property and casualty insurance or
short-term insurance) and life insurance (sometimes known as long-term insurance).
General insurance contracts typically provide insurance protection for a fixed period
of short duration and enable the insurer to cancel the contract or to adjust the terms of
the contract at the end of any contract period, such as adjusting the amount of
premiums charged and cover provided. General insurance contracts are sometimes
classified as long tail (where claim may not be settled for many years) or short tail.
Life insurance contracts are often of long duration and the insurer often has little or no
ability to adjust the level premiums during the term of the contract.
Some people argue that it is important to develop separate requirements for general
insurance and for life insurance because, although both categories expose an insurer
to risk, the nature of the risks is very different. They also feel that users, preparers
and regulators are familiar with such a distinction and would be surprised if it were
removed.
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Others argue that it is not helpful to distinguish between general insurance and life
insurance, on the grounds that that:
a) the differences between general insurance and life insurance are more a matter of
degree than of principle. Some general insurance contracts have characteristics
that are more often associated with life insurance contracts. For example, some
general insurance contracts require that insurer to provide coverage for ten years
at rates specified at inception. Similarly, a one-year non-renewable term
insurance contract may resemble a typical general insurance contract rather than a
typical life insurance contract;
b) it is important that the same principles should be used for both general insurance
and life insurance;
c) it is not always clear whether a particular type of contract should be classified as
life insurance or general insurance. Indeed, different jurisdictions draw the
boundary between general insurance and life insurance in different places. This
may make it difficult to make the distinction in a consistent way.
Some argue that a distinction between general insurance and life insurance is less
relevant that a distinction between short-term contracts and long-term contracts,
perhaps using a twelve-month cut off.
The Steering Committee proposes to make the distinction for financial reporting
purposes where insurance should be treated as general insurance for financial
reporting purposes if the insurer is committed to a pricing structure for not more than
twelve months. And insurance should be treated as life insurance for financial
reporting purposes if the insurer is committed to a pricing structure for more than
twelve months. The (financial instruments) Steering Committee has concluded that
the general principles proposed are relevant to insurance, and that their financial
assets and financial liabilities should be recognised and measured on the same basis as
those of other enterprises.
There is also argument that the IAS 39 should deal with investments and other
financial instruments (other than insurance contracts) held by insurers, to ensure that
the financial reporting for insurers is internally consistent.
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Other argue that the IAS 39 should not deal with financial instruments (other than
insurance policies) because:
a) it would be undesirable for an insurance enterprise to account for a transaction in
one way and for a non-insurance enterprise to account in a different way for the
same transaction;
b) the project should not re-open issues addressed by other IASC standards, unless
there are specific features of insurance that justify a different treatment;
c) a set of internally consistent accounting requirements for insurers will be obtained
if the accounting requirements for insurance contracts are consistent with the
International Accounting Standard on the recognition and measurement of
financial instruments.
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4.0 FAIR VALUE
4.1 The problems with Current Accounting
First, in current practice many derivative financial instruments are not recognised.
This is the result of using historical cost accounting for derivatives that have no initial
cost (for example, financial forward contracts, including interest rate swaps). Since
their initial cost is nil, if no recognition is given to changes in their fair values, these
derivatives are effectively invisible. Depending on underlying price movements, such
derivatives can have substantial values and can represent significant risk position that
may transform an enterprise's financial risk profile. Their lack of recognition results
in financial statements that are incomplete.
Second, enterprises increasingly recognise the need to actively manage financial risks
to avoid being excessively exposed to loss as a result of sudden price changes (for
example, in interest rates). The historical cost of financial assets and financial
liabilities has little relevance to financial risk management decision. A system of
accounting that reports the historical costs of these assets and liabilities in published
financial statements lacks relevance and information value for investors attempting to
evaluate enterprise performance, liquidity, and financial risk exposures.
Third, as noted earlier, current practice in many countries uses some form of mixed
measurement, under which some financial instruments are carried at historical cost
and some on a fair value basis. This has caused a series of interrelated problems.
a. It has not been possible to define a sound principle for distinguishing those
financial instruments that are appropriately carried on a cost basis and those that
should be carried at fair value. Instruments to be held for the long term or to
maturity would be measured at cost, those to be held for hedging purposes based
on the hedged position, and other instruments at fair value. Many respondents to
the exposure draft strongly criticised this reliance on management intent. There
was particular concern that it would be inconsistently applied, difficult to audit
and not operational, and that it would not have any sound economic basis. These
criticisms have been borne out by the experiences of national standard setters that
have attempted approaches along these lines.
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b. A mixed measurement system provides opportunities for abuses, such as selective
recording of sales to manage reported income (sometimes referred to as ‘cherry
picking’). For the reasons stated above, it has proved to be very difficult to
develop a mixed measurement system that is not susceptible to the problem.
c. A mixed measurement system inevitable leads to mismatches, for example, when
an investment portfolio carried on a fair value basis is financed by debt carried on
a cost basis, or when derivatives measured at fair value are used to hedge financial
risk positions that are not recognised or are carried on a cost basis.
4.2 The Fair value issue
The International Accounting Standards Board is in the process of developing a
standard for the reporting of insurance contracts. This standard is commonly referred
to as fair value. The International Accounting Standards definition of fair value is as
follows:
"the amount for which an asset could be exchanged or a liability
settled between knowledgeable, willing parties in an arm's length
transaction"
Over the past year or so fair value accounting has become one of the most topical
subjects for discussion within the insurance industry. The development of this
important subject has been rapid and there has been much discussion in recent months
on the technical issues surrounding fair value and how it should be applied in the
context of insurance business. Fair value is likely to affect many aspects of the
management of a Life Insurance Company and intended to be of use to a variety of
people. These will range from those responsible for performing fair value calculations
to those responsible for solvency reporting, profit forecasting, product design, asset
allocation and the general management of the business. Although the theoretical parts
generally apply to life and non-life business, the practical sections concentrate on life
insurance business.
Although there are some conceptual and practical issues involved in determining the
fair value of an asset, it is reasonably clear what this definition means for an asset. It
is less clear what the fair value of a liability is. There are three possibilities:
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(a) fair value as an asset (the amount at which others are willing to hold the liability
as an asset);
(b) fair value in settlement with the creditor (the amount that the enterprise would
have to pay to the creditor to extinguish the liability); and
(c) fair value in exchange (the amount that the enterprise would have to pay a third
party at the balance sheet date to take over the liability).
Some argue that the definition of fair value refers to a single amount – the price of a
transaction. On this basis, they believe that the fair value of a liability from the
perspective of the debtor is the same as its fair value (as an asset) from the perspective
of the creditor. In other words, they believe that the fair value of a liability is the
same as its fair value as an asset (the amount at which others are willing to hold the
liability as an asset). Some argue that the fair value of an insurance liability is its
fair value in settlement with the policyholder (the amount that the enterprise would
have to pay to the policyholder to extinguish the liability). They argue that:
(a) because many insurance liabilities are not, and perhaps cannot be, traded, it is
more meaningful to refer to a hypothetical transaction with an actual counter party
– the policyholder – than to a hypothetical transaction with another party; and
(b) IAS 37, Provisions, Contingent Liabilities and Contingent Assets, states that a
provision is measured by reference to “the amount that an enterprise would
rationally pay to settle the obligation at the balance sheet date or to transfer it to a
third party at that time”. This appears to permit reference to either fair value in
settlement or fair value in exchange.
This DSOP takes the view that the fair value of a liability is its fair value in exchange
The definition of fair value in International Accounting Standards implies a
transaction with a party other than the policyholder because:
(a) if the insurance contract permits the insurer or policyholder to terminate its
obligations under the contract for an agreed surrender value, any such termination
reflects a price agreed at the time of entering into the contract, not a current
transaction price;
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(b) if the insurance contract does not permit the insurer or policyholder to terminate
its obligations under the contract, any settlement will require negotiation with the
other party to the contract. An insurer or policyholder is unlikely to be a willing
party, because it would commence such negotiations only for compelling reasons
that would weaken its bargaining position;
(c) the definition of fair value refers to a hypothetical transaction in which the debtor
transfers its liability to another party, not one in which the creditor transfers its
asset to another party; and
(d) premature settlement with the policyholder contradicts the economic rationale for
insurance, which is based on the insurer’s ability to pool and diversify risks.
4.3 Should Insurance Contracts be Included in a Fair Value Standard?
Many in the insurance industry have expressed concerns about extending fair value
concepts to financial reporting of insurance activities. Some argue that introducing
fair values, which are always current measurements of assets and liabilities, will lead
to reported net profit or loss and equity that are more volatile and less predictable and
manageable than the amounts produced by traditional accounting conventions. In
their view, insurance is a long-term undertaking and the current fluctuations of
financial markets are not representative of that fundamental characteristic of the
industry. They maintain that financial statement users will find financial reporting
more useful if it reflects long-term expectations rather than current information.
Finally, some suggest that year-to-year volatility produced by a fair value approach is
preferable to the large adjustments sometimes produced by long-term approaches.
This group observes that a long-term approach requires the use of accounting
conventions to defer realised and unrealised gains and losses. Those deferrals can
accumulate until the amount is no longer sustainable, even over the long term. The
large adjustments that then become necessary often come as a surprise to financial
statement users.
Insurance contracts are usually settled through performance, rather than transfer, so
some maintain that a measurement based on expected performance over the contract
term is more relevant than fair value. They favour an entity-specific measurement or
Chapter 4: Fair ValueNew International Accounting Standard of Insurance Industry
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value in use that incorporates the insurer’s expectations about future cash flows rather
than the market’s expectations. In their view, the insurer’s internal expectations are
more relevant than those of a market that may not exist.
Others disagree because they observe that similar arguments could be made for many
financial assets and liabilities. In their view, any argument for applying value in use
concepts to financial instruments should be applied to all financial instruments, rather
than only to insurance contracts. They also contend that observed market prices, when
available, are more relevant and useful than a company’s internal estimates. They
acknowledge that experience may prove that the company’s estimates were correct
and the market was wrong. However, they suggest that the results of that experience
should be recognised when it happens rather than anticipated in an entity-specific
measurement of the liability.
Some argue that introducing fair value measurements may cause the stockholders of
insurance companies and insurance consumers to behave inappropriately. This group
is concerned that insurance stockholders may conclude that asset gains (whether
realised or unrealised) allow them to receive higher current dividends. Insurance
consumers may conclude that asset losses indicate that they should terminate or not
renew existing insurance contracts, thus creating a “run on the bank.” Those who are
concerned with solvency and confidence point to situations in which apparently weak
companies were able to survive market reverses.
Those who favour use of fair-value measurements argue that financial reporting is one
of many tools that managers, stockholders, and consumers use in decision making.
Good managers know that investments must provide the cash flows necessary to meet
policyholders’ claims, and that changes in fair value may not alter the cash flows
provided by a particular investment portfolio. However, this group also observes that
the failure to use fair value measurements often masks financial difficulty from
financial statement users.
Many industry commentators have remarked on the importance of a consistent
measurement approach for an insurer’s assets and liabilities. However, some
commentators question whether fair value provides the most relevant measurement
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for either assets or liabilities of an insurance enterprise. They argue that IASC should
consider exemptions from fair value accounting. Such exemptions might apply to
insurance enterprises, insurance liabilities and related assets or insurance liabilities.
The Steering Committee holds the following views, all in the assumed context of a
future International Accounting Standard that requires all financial instruments to be
measured at fair value:
(a) if the other enterprises use fair value for financial instruments, insurers should not
be excluded;
(b) if all other financial assets and financial liabilities of an insurer are at fair value,
insurance contracts should be at fair value;
(c) movements in the fair values of an insurer’s financial assets and liabilities should
be reported in a consistent manner. For example, if some movements in the fair
value of assets are excluded from net profit or loss for the period and reported as a
component of equity, accompanying movements in liabilities should be reported
in the same fashion; and
(d) accounting for insurance contracts at fair value should be covered in the insurance
standard, not in the financial instruments standard.
The Steering Committee assumes that, on the completion of this project, IASC will
have adopted a comprehensive approach to reporting all financial instruments at fair
value, with all movements in fair value reported in the income statement. The
Steering Committee considers consistency between the treatment of assets and
liabilities of an insurance enterprise a precondition for proper reporting. Therefore,
the assets and liabilities arising out of insurance contracts should be measured at fair
value, with all movements in fair value reported in the income statement.
The Steering Committee acknowledges that, at this time, it is often difficult to
estimate the fair value of assets and liabilities created by insurance contracts on a
reliable, objective, and verifiable basis. Therefore, the Steering Committee intends to
develop further guidelines to address estimation.
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5.0 LIFE INSURANCE
5.1 Characteristic of Insurance Transactions
The purchaser of insurance (the policyholder) makes a payment (the premium) to the
insurer for the insurance contract, with the payment usually made at the inception of
the contract (in general insurance) or periodically throughout the contract term (for
life insurance). The insurer, in turn, promises to pay policyholders if specified events
occur during a period of time defined in the contract. The policyholder usually has
the right to cancel a contract at any time, but may or may not receive any refund of
premiums paid. The insurer usually cannot cancel during its term. While the contract
is in force, the insurer typically provides additional services that include investment
management, claim servicing, litigation support, and loss-control counselling.
Every insurance contract, then, has selling, financial, servicing, and risk elements.
The insurer receives an advance payment- the selling element- that can be invested
until needed to pay claims- the financial element. The insurer also accepts the
obligation to make payments based on uncertain future events and to provide other
services- the risk and servicing elements. The relative importance of those elements
varies between different insurance contracts, but they are always present.
The several differences between general and life insurance contracts create different
accounting problems. The contracts provide different coverage, over different periods
and with different premium structures. Moreover, the accounting models and
conventions for these two categories of insurance have developed separately,
reflecting the historical prohibition (in many jurisdictions) against sales of general and
life insurance contracts by the same enterprise.
5.2 Life Insurance Contracts
Life insurance products include medium to long-term savings products with life cover
attached, whole life products and pure protection products such as term assurance and
critical illness insurance. Savings products include investment bonds and endowment
plans. Each of these products provides a death benefit in addition to the savings
feature. The majority of the business written is with-profits.
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The traditional life insurance product offered by United Kingdom life insurance
companies was a long-term savings product with a life insurance component and
provided tax advantages in comparison to other savings products. The gradual
reduction of these advantages and increasing sale of single premium life products has
resulted in the distinction between life insurance and other long-term savings products
becoming less important. In the late 1970s or early 1980s insurance companies
introduced unit-linked policies that are becoming increasingly popular.
Life insurance contracts cover mortality, and include life insurance, annuity,
disability, and pension contracts. These contracts usually provide for insurance
coverage over a period of several years and may be financed through periodic
premiums or a single payment on inception. Payments by the insurer on the death of a
policyholder are usually fixed by the contract, although annuity and similar contracts
may require payments over an extended period or until death.
This is different from most general insurance contracts, which are for a fixed period
of short duration, usually one year or less. General insurance contracts do not
typically create rights and obligations in the contract beyond the end of the period
covered by the current premium. In contrast, many life insurance contracts grant the
policyholder valuable rights not usually found in general insurance contracts. The
insurer usually has no right to cancel these policies during their term, although it may
have the right to change the price of some elements of the contract.
The Steering Committee concluded that it should develop accounting models for
general insurance and life insurance that are separate, but based on the same
underlying principles. The Steering Committee also concluded that, for financial
reporting purposes:
(a) insurance should be treated as general insurance if the insurer is committed to a
pricing structure for not more than twelve months. Most general insurance
contracts are for a short term and the insurer is free to change premiums after the
end of the period covered by the current premium, or even to decline to renew the
contract; and
(b) insurance should be treated as life insurance if the insurer is committed to a
pricing structure for more than twelve months. For many life insurance contracts,
Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry
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the insurer has limited or no ability to reset premiums and is required to continue
to provide cover if the policyholder continues to pay premiums. This requirement
to continue providing cover is a source of additional that does not arise in
contracts that do not have this feature.
Life insurance accounting models differ from one another in three ways. They build
on different views of the contract and relationship between the insurer and
policyholder; build on different views of the source and pattern of income earned by
the insurer; and use different assumptions about the inflows and outflows from a book
of contracts and, in some cases, adjustments to those assumptions.
Accounting for life insurance contracts has developed separately from accounting for
general insurance contracts, the Steering Committee began its analysis of life
insurance accounting by considering an insurer’s rights and obligations under a life
insurance contract and whether those individual rights and obligations meet the
definition of an asset or a liability found in the IASC framework. During the term of a
life insurance contract, an insurer may do some or all the following:
a) pay commissions and other costs to initiate the contract
b) receive periodic premiums from policyholders
c) make payments to policyholders who have terminated their contracts, either
through payments of cash surrender value or refunds of unexpired premiums
d) make payments to the estate of policyholders who have died and submitted
claims and payments to surviving annuitants
e) pay costs of administering the contract
f) credit policyholders with increases I contract value and charge policyholder’s
contracts for current-period mortality coverage and administration
g) credit policyholders with dividends or bonuses on participating contracts
The Steering Committee found it useful to evaluate the several features of a life
insurance contracts by considering two sample contracts. Each contract is non-
participating, that is, it does not credit policyholders with dividends.
a) A single-premium whole-life insurance contract. The contract has a single
premium of 18,000 and promises a payment on death of 100,000. The
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contract cash value accrues interest at a fixed rate of 5.5 percent and is paid
to policyholders on termination of the contract before death.
b) A term-life insurance contract with a fixed annual premium of 900. The
contract pays a death benefit of 100,000, and policyholders who survive to
age 100 receive a 100,000 payment. The contract does not provide for any
accumulated value to the policyholder. A policyholder who misses one
premium payment terminates the contract and loses all rights. The insurer
cannot cancel a contract as long as the policyholder pays premiums.
Various items that some consider to be candidates for recognition as assets or
liabilities are:
(a) an obligation to make payments on termination of the contract by the
policyholder before the death of the insured;
(b) an obligation to make payments as a consequence of insured events that have
occurred;
(c) an obligation to make payments as a consequence of insured events that may
occur during the future period covered by the premium already received;
(d) an obligation to make payments as a result of insured events that may occur in
a period that will be covered by future premiums under existing contracts;
(e) a contractual right to receive future premiums under an existing insurance
contract;
(f) a net contractual right or obligation to receive or pay cash as a result of
existing insurance contracts; and
(g) policy acquisition costs.
5.2.1 Termination of the Contract
Both contracts discussed above require the insurer to make some payment if the
policyholder terminates the contract before the death of the insured. The single
premium contract requires the insurer to pay a cash-surrender value. The term-life
contract requires a pro rata return of the unearned premium for the current period.
(Some term-life contracts do not provide for a refund of premiums.) In each contract,
the insurer has a present obligation that arises as a consequence of a past event. In the
Steering Committee’s view, payments that an insurer is required to make on
Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry
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termination of the contract by the policyholder meet the definition of a liability. The
insurer’s liability on the termination of a contract is relatively clear, whether through
action by the policyholder or the death of the insured party. The insurer’s obligation
to make payments in those situations clearly meets the Framework’s definition of a
liability.
5.2.2 Claims Arising from Events That Have Occurred
In the Steering Committee’s view, payments (including related claim handling costs)
that the insurer is required to make as a consequence of insured events that have
occurred (policyholder deaths) clearly meet the definition of a liability, even though
the claims may not have been reported to the insurer.
5.2.3 Claims during the Period Covered by the Current Premium - Events Have
Yet to Occur
Insurers adopt a variety of contractual arrangements for the payment of premiums.
The typical arrangement involves the payment of a premium at or near the initiation
of insurance coverage, although some contracts provide for deferred or instalment
payments. In exchange for the premium, the insurer agrees to pay claims that arise
during a defined period, referred to the “current premium period”, which is defined as
until death or cancellation and thus covers several years into the future. For the term-
life contract, the current premium period is the remaining term of the one-year
premium. In each case, the insurer has an unavoidable obligation to pay any valid
claim presented by a policyholder or policyholder’s estate.
Some consider the liability for unearned premiums recorded in existing insurance
accounting as an attempt to capture this liability for a written option or service
obligation. Others maintain that unearned premiums are a matching device and that
the balance does not satisfy the definition of a liability. They argue that the event that
triggers the insurer’s obligation for future claims during the premium period is the
death of a policyholder. In their view, until that triggering event occurs, the insurer’s
contractual commitment does not satisfy the definition of a liability. In the Steering
Committee’s view, an insurer’s obligation for claims (including related claim
Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry
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handling costs) arising from insured events that may occur during the period covered
by the current premium meets the definition of a liability and should be recognised as
such.
5.2.4 The Insurance Contract
Many insurance contracts require the policyholder to pay periodic premiums, often
monthly or yearly. Other contracts may not require periodic premiums, but
policyholders routinely renew. However, as a matter of law and contract, an insurer
usually cannot compel policyholders to pay future premiums and the insurer has no
obligation for an insured event that may occur during a period beyond the current
premium period. In the usual case, a policyholder’s failure to pay a renewal premium
simply terminates the contract. In the Steering Committee’s view, the combination of
future premiums, expenses, and claims beyond the current premium period from
contracts create assets or liabilities, which exist as a consequence of a past transaction
(signing the contract) that imposes benefits or sacrifices on the insurer. In the Steering
Committee’s view, contracts that guarantee the policyholder’s right to renew the
contract and that restrict the insurer’s ability to change the amount of renewal
premiums create an asset or liability that would not exist in the absence of such
guarantees or restrictions. These are more common in life insurance than general
insurance contracts and as a result, the Steering Committee observes that most general
insurance contracts do not give rise to assets and liabilities related to premiums and
claims after the end of the current premium period.
5.2.5 Acquisition Costs
The accounting treatment of acquisition costs in life insurance is closely linked to the
measurement of policy liabilities. Some accounting conventions for life insurance
include acquisition costs as part of an integrated approach. In those cases, the
capitalisation and amortisation of acquisition costs is part of the measurement of a net
liability, rather than a separate recognition of acquisition costs as assets.
Steering Committee concludes that acquisition costs for life insurance contracts
should be recognised as an expense, on the basis that they do not meet the
Framework’s definition of an asset. Also, the measurement of insurance liabilities
Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry
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already reflects the future cash flows to be generated by the insurance contract, so the
recognition of an asset would lead to double counting.
5.2.6 Summary of Assets and Liabilities
The Steering Committee concludes that the following assets and liabilities are created
by a non-participating life insurance contract:
a) a liability for payments that an insurer is required to make on termination of the
contract by the policyholder
b) a liability for payments that the insurer is required to make as a consequence of
insured events that have occurred
c) a liability for payments of claims that may occur during the period covered by
the current premium
d) a net contractual right or obligation to receive or pay cash as a result of existing
insurance contracts.
The terms of some life insurance contracts allow for a different decomposition of the
life insurance contract. For example, some contracts such as universal life, variable ,
and indexed contracts allow separate identification of future charges against the
contract for administration and mortality coverage, future interest credits, and future
charges for early termination. The ability to separately identify contract components is
a prerequisite for the policyholder-deposit accounting model discussed later in this
section. However, many contracts (including the term-life contract) do not allow for
this level of analysis.
5.3 Life Insurance Model
Life insurance use accounting models that generally fall into one of two categories
that is the policyholder-benefits (prospective) and the policyholder-deposit
(retrospective). Policyholder-benefits (prospective) models measure the liability for
policyholder benefits by focusing on future premium inflows and outflows for
policyholder benefits and expenses. Policyholder-benefit models usually report the
entire amount of premium as revenue when received and report payments to
policyholders as benefits. As they are used in current practice, most applications of
policyholder-benefit models are consistent with a deferral-and-matching view. The
Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry
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assumptions and techniques are designed to produce a particular pattern of reported
income. The resulting liability balance is the amount necessary to produce that
pattern. As a result, policyholder-benefit models are usually considered consistent
with a deferral-and-matching approach. However, prospective techniques can be used
to provide a direct measurement of the insurer’s liability that is consistent with an
asset-and-liability-measurement approach. Policyholder-deposit (retrospective)
models measure the liability to policyholders based on the accumulation of past
transactions between the insurer and policyholders. Policyholder-deposit models
usually report premiums as increases in a deposit liability. Payments to policyholders
are divided between return of that deposit and net benefit in excess of the deposit.
Policyholder-deposit models are consistent with the asset-and-liability-measurement
view. The insurer’s liability is characterised as a deposit and the pattern of reported
income is largely governed by explicit contractual provisions and reporting to the
policyholder.
Sources: All the illustrations from L1 to L9 are from the Insurance Paper 1999.
5.3.1 Policyholder-Benefits (Prospective) Model
In a policyholder-benefits model, premiums are recognised as revenue on receipt,
with a corresponding entry to record a liability for policyholder benefits and an
expense. Payments on the death of a policyholder or on contract surrender are
reported as benefit expense. The liability for policyholder benefits is a present value,
and it increases as interest accrues to the balance. The liability is increased or
decreased at the end of each period based on the number and, in some applications of
this model, the actuarial expectations of contracts in the book that remain in force.
Policyholder-benefits models are usually applied in a manner consistent with a
deferral-and-matching view. However, there is significant disagreement about the
pattern in which income should be attributed to individual years. Appendix E1, E2,
E3 and E4 portrays the workings of a simple policyholder-benefits model.
Illustration L1 shows financial statements for the first five years of the book’s life,
using the simple prospective method developed in the preceding paragraphs. This
approach is also referred to as a premium method or as premium-driven. If the
Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
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insurer’s expectations emerge as originally projected, net income will equal a constant
percentage of premium revenues. Accountants who are more familiar with
commercial accounting than insurance accounting may see a similarity between this
method and the instalments sale method sometimes applied in non-insurance
situations in some countries.
Year 1 Year 2 Year 3 Year 4 Year 5
Cash and investments
Beginning balance -1,255 6,009 12,356 18,388
Premiums received 14,000 11,194 9,845 9,051 8,502
Policy expenses -12,277 -1,270 -1,117 -1,027 -965
Benefits and related expenses -421 -1,126 -1,530 -1,687 -2,145
Investment earnings 121 607 1,032 1,426 1,815
Contribution (Distribution) -2,678 -2,141 -1,883 -1,731 -1,626
Ending balance -1,255 6,009 12,356 18,388 23,969
Balance sheets
Cash and investments -1,255 6,009 12,356 18,388 23,969
Deferred acquisition costs 9,712 9,014 8,433 7,909 7,416
Benefit liability -8,457 -15,022 -20,787 -26,295 -31,382
(Equity)/Deficit - 1 2 2 3
Income statements
Premium revenue -14,000 -11,194 -9,845 -9,051 -8,502
Investment income -121 -607 -1,032 -1,426 -1,815
Policy expenses 12,277 1,270 1,117 1,027 965
Change in deferred acquisition
costs -9,712 698 581 524 493
Benefits and related expenses 421 1,126 1,530 1,687 2,145
Change in benefit liability 8,457 6,565 5,765 5,508 5,087
Net (income)/loss -2,678 -2,142 -1,884 -1,731 -1,627
Net income as a percentage of
premium revenue 19.13% 19.14% 19.14% 19.12% 19.14%
Illustration L1 - Simple Prospective Model
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The financial statements shown above include a line labelled distribution. This
convention removes the assets and liabilities not required by the ongoing book of
business, in this case, the amounts reported as net income. Actuaries use a different
convention in their illustrations to achieve the same purpose, but most accountants
find the fictional “dividend” easier to understand. If actual events occur as expected,
an insurer that uses the prospective or premium model described above will report net
income in a declining pattern, reflecting the declining number of policyholders that
remain in the book and pay premiums.
5.3.2 Policyholder-Deposit (Retrospective) Model
This model is used in some jurisdictions instead of the policyholder-benefit model.
Premiums are recognised as a deposit liability rather than as revenue and this deposit
balance represents the policyholder’s equity in the contract. In some cases, the amount
is communicated in annual reports provided to policyholders. In others, an aggregate
deposit balance is computed for financial reporting purposes, but individual deposit
balances are not communicated to policyholders. In other cases, the policy surrender
value is deemed to represent the policyholder’s deposit balance.
The policyholder deposit model became popular with the advent of policies that
include variable terms and grant a measure of discretion to both the insurer and the
policyholder, while retrospective approaches have existed for some time. Those
policies are variously known as universal life, unit-linked, variable, and indexed
policies. They each include a policyholder account that is used to communicate
activity from period to period and functions much like an account with a bank or
broker, while their terms differ. The policyholder’s premiums are credited to this
account, as are investment earnings, and the account is charged for administration and
mortality protection. If the policyholder surrenders the contract, he or she is entitled to
the balance of the account, less any surrender charges.
A policyholder-deposit model may also have implications for the amounts reported as
revenues and expenses. In some jurisdictions, premiums received by the insurer are
not reported as revenues. Instead, premiums are reported as additions to liabilities.
Revenues include amounts that the insurer charges against the policyholder’s account
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for mortality coverage, administration, and early termination of the contract. This
form of accounting is similar to the accounting that most banks use for their deposit
liabilities. Appendix E5, E6 and E7 of the accompanying booklet portrays the
workings of a simple policyholder-deposit model. A policyholder-deposit approach
requires a different approach to amortising deferred acquisition costs.
Illustration L2 shows five years of financial statements prepared using a policyholder-
deposit approach. Charges against policyholders are reported as revenue, while
receipts are reported as additions to the policyholder deposit.
Year 1 Year 2 Year 3 Year 4 Year 5
Cash and investments
Beginning balance - 2,707 10,826 18,213 25,370
Premiums received 14,000 11,194 9,845 9,051 8,502
Policy expenses -12,298 -1,280 -1,123 -1,031 -969
Benefits and related expenses -400 -1,116 -1,524 -1,683 -2,141
Investment earnings 121 884 1,369 1,837 2,303
Contribution (Distribution) 1,284 -1,563 -1,180 -1,017 -963
Ending balance 2,707 10,826 18,213 25,370 32,102
Balance sheets
Cash and investments 2,707 10,826 18,213 25,370 32,102
Deferred acquisition costs 9,718 9,087 8,691 8,385 8,104
Benefit liability -8,391
-
15,089
-
21,311
-
27,369
-
32,993
(Equity)/Deficit -4,034 -4,824 -5,593 -6,386 -7,213
Income statements
Mortality, surrender, and expense charges -6,199 -4743 -3,798 -3,342 -3,102
Investment income -121 -884 -1,369 -1,837 -2303
Recurring policy expenses 1,589 1270 1117 1027 965
Death benefits in excess of account
balance 417 402 393 386 381
Amortization of deferred acquisition costs 970 631 396 306 281
Interest credited to policyholder balances 594 971 1,312 1,649 1,988
Net (income)/loss -2,750 -2,353 -1,949 -1,811 -1,790
Illustration L2-Policyholder-deposit approach
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5.3.3 Models Compared
The policyholder-benefit and policyholder-deposit approaches are compared and both
approaches lead to an answer that can be analysed as the present value of future cash
flows, but the elements of that computation differ between the approaches.
Cash Flow Policyholder-BenefitApproach
Policyholder-DepositApproach
1. Future premiums Included - computed net
premium in traditional
attribution methods (see
Appendix E2) but may use
gross premium.
Not included (do not affect
account balance) - Gross
premium is credited to
account balance as it
arises.
2. Future amounts assessed
against policyholder's
account for administration
and mortality
Included through the
estimate of benefit
outflows.
Not included (do not affect
account balance) - but
reduce the amount of any
premium deficiency.
3. Future expenses
incurred by the insurer for
policy maintenance,
renewal premiums, claim
handling, etc.
Included. Not included (do not affect
account balance) unless a
premium deficiency exists.
4. Future surrender charges Included through the
estimate of benefit
outflows.
Included to the extend that
they (a) affect the account
balance or (b) where there
is no account balance,
affect the cash surrender,
value.
5. Payments on death of
the insured that represent a
return of policyholder's
account balance
Included through the
estimate of benefit
outflows.
Included.
6. Payments on death of
the insured in excess of the
policyholder's account
balance
Included through the
estimate of benefit
outflows.
Not included (do not affect
the account balance)
unless a premium
deficiency exists
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7. Discount rate Depends on objective and
attribution method.
Rate credited to
policyholder accounts.
Illustration L3: Policyholder-Benefit and Policyholder-Deposit Approaches
Compared
5.3.4 The Steering Committee’s view, Financial Statements at Fair Value
In the Steering Committee’s tentative view, a prospective (policyholder-benefit)
approach is consistent with its view of a life insurance contract as a single set of
interrelated assets and liabilities. The Steering Committee expects that a prospective
approach, applied without restriction based on the retrospective approach, would be
more consistent with an estimate of fair value.
Applying the Steering Committee view, it requires the insurer to compare the amount
computed using a policyholder-deposit (retrospective) approach with the amount
computed using a policyholder-benefit (prospective) approach. In implementing this
approach the policyholder-deposit amount (the minimum liability) is equal to the
account balance that accrues to the benefit of policyholders, after deducting any
surrender charges that would apply if the contracts were terminated prior to the death
of the insured. Unless the insurer has the ability to recover additional amounts from
policyholders who terminate contracts before the death of the insured, the minimum
amount computed under the policyholder deposit approach is zero.
The policyholder-benefit amount represents the present value of expected premium
receipts, less the present value of expected payments to policyholders, payments for
contract administration, and payments for claim handling.
In the Steering Committee’s tentative view, the fair value of a life insurance liability
should be computed using a policyholder-benefit approach, without the policyholder-
deposit limitation.
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Illustration L4 shows financial statements for the first five years of the book. The
liability in Year 1 is computed using the policyholder-deposit computation because
that generates a higher liability (in this case, nil) than the policyholder-benefit
approach, which generates an asset balance of 309.
Year 1 Year 2 Year 3 Year 4 Year 5
Cash and investments
Beginning balance - 8,951 16,314 23,254 30,100
Premiums received 14,000 11,194 9,845 9,051 8,502
Policy expenses -12,298 -1,280 -1,123 -1,031 -969
Benefits and related expenses -400 -1,116 -1,524 -1,683 -2,141
Investment earnings 121 1321 1,753 2,189 2,635
Contribution (Distribution) 7,528 -2,756 -2,011 -1,680 -1,588
Ending balance 8,951 16,314 23,254 30,100 36,539
Balance sheets
Cash and investments 8,951 16,314 23,254 30,100 36,539
Deferred acquisition costs - - - - -
Benefit liability - -9,174 -17,289 -24,803 -31,744
(Equity)/Deficit -8,951 -7,140 -5,965 -5,297 -4,795
Income statements
Premium revenue -14,000 -11,194 -9,845 -9,051 -8,502
Investment income -121 -1321 -1,753 -2,189 -2,635
Policy expenses 12,298 1,280 1,123 1,031 969
Change in deferred acquisition
costs - - - - -
Benefits and related expenses 400 1,116 1,524 1,683 2,141
Change in benefit liability - 9,174 8,115 7,514 6,941
Net (income)/loss -1,423 -945 -836 -1,012 -1,086
Benefit liability
Benefit method 309 9174 17289 24803 31744
Deposit method -5244 -12907 20081 -27288
Illustration L4 - Steering Committee View
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The Steering Committee did not reach a conclusion about the discount rate to be used
or the role of the insurer’s credit standing in the estimate of fair value. Illustration L5
shows the computations of liability balance using an asset-based discount rate of 7
percent, adjusted for risk to 6 percent.
Year 1 Year 2 Year 3 Year 4 Year 5
Present value of future
Premiums 78,899 74,287 69,826 65,482 61,392
Commissions and expenses -8,953 -8,429 -7,923 -7,430 -6,966
Death and surrender benefits -62,634 -67,450 -71,153 -74,455 -77,456
Liability balance 7,312 -1,592 -9,250 -16,403 -23,030
Illustration L5 – Liability Computation, Asset-Based Discount Rate
Illustration L6 shows the resulting financial statements for Years 1 - 5
Year 1 Year 2 Year 3 Year 4 Year 5
Cash and investments
Beginning balance - 8,951 16,314 23,254 30,100
Premiums received 14,000 11,194 9,845 9,051 8,502
Policy expenses -12,298 -1,280 -1,123 -1,031 -969
Benefits and related expenses -400 -1,116 -1,524 -1,683 -2,141
Investment earnings 121 1,321 1,753 2,189 2,635
Contribution (Distribution) 7,528 -2,756 -2,011 -1,680 -1,588
Ending balance 8,951 16,314 23,254 30,100 36,539
Balance sheets
Cash and investments 8,951 16,314 23,254 30,100 36,539
Deferred acquisition costs - - - - -
Benefit liability 7,312 -1,592 -9,250 -16,403 -23,030
(Equity)/Deficit 16,263 14,722 14,004 13,697 13,509
Income statements
Premium revenue -14,000 -11,194 -9,845 -9,051 -8,502
Investment income -121 -1,321 -1,753 -2,189 -2,635
Policy expenses 12,298 1,280 1,123 1,031 969
Change in deferred acquisition costs - - - - -
Benefits and related expenses 400 1,116 1,524 1,683 2,141
Change in benefit liability -7,312 8,904 7,658 7,153 6,627
Net (income)/loss -8,735 -1,215 -1,293 -1,373 -1,400
Illustration L6 - Asset-Based Discount Rate
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5.4 Life Insurance Formats
Illustrations L7-L9 shows how a life insurer might present its balance sheet
(Illustration L7), income statement (Illustration L8) and cash flow statement
(Illustration L9). They present four different approaches - a deferral and matching
approach (based on amounts in Illustration L1), an asset and liability approach (based
on amounts in Illustration L4) and two versions of a fair value approach (based on
amounts in Illustration L6). One fair value approach uses a risk-free discount rate and
the other uses an asset-based discount rate. (The Steering Committee is evenly
divided on whether the fair value of an insurer’s liabilities incorporates the expected
return on the insurer’s assets.)
There are small rounding differences in some Illustrations. Other noteworthy points
are as follows:
(a) the amounts in Illustrations L1, L4 and L6 have been adjusted to include share
capital of 5,000 and additional investment return of 350 (5,000 at 7%) in 1999. No
additional investment return is included in 2000, because total equity in 2000
reflects the amount of capital required by the regulatory regime;
(b) the contribution / distribution amount for 1999 and 2000 is the amount needed to
bring investments held to the amounts of 8,951 and 16,341 respectively, which the
amount is assumed to be required under the hypothetical regulatory regime
underlying Illustrations L4 and L6. It is assumed that this amount is not changed
by the accounting method adopted for external financial reporting. It is also
assumed that no cash is held;
(c) under the asset and liability model, the policyholder-deposit balance in 1999 (nil)
is a higher liability amount than the negative amount (asset) that arises on a
policyholder-benefit basis. In 2000, the policyholder-benefit balance (9,174) is
recognised, because it is higher than the policyholder-deposit balance (5,244) –
see Illustration L4;
(d) Illustration L7 shows the presentation of other operating expenses and of income
taxes (both assumed to be zero in this case); and
(e) this example does not split investment return into portions attributable to
policyholders and portion attributable to stockholders. To illustrate one possible
presentation, the financing section of the income statement includes a line for
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stockholders’ investment return. The “unwinding” of the discount on policyholder
liabilities is included in the change in policyholder assets (in the operating section
of the income statement); and
(f) the income statement (Illustration L7) assumes that there are no changes in
assumptions.
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L7 Illustrative Income Statement – Life Insurance
INCOME STATEMENT Deferral/Matching Asset/Liability Fair value (1) Fair value (2) (Risk-free
rate) (Asset-based
rate)31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00
Premiums written 14,000 11,194 14,000 11,194 14,000 11,194 14,000 11,194
Claims expense (421) (1,126) (421) (1,126) (421) (1,126) (421) (1,126)
Expenses incurred (12,277) (1,270) (12,277) (1,270) (12,277) (1,270) (12,277) (1,270)
Deferred acquisition costs 9,712 (699) - - - - - -
Change in policyholder liabilities/ assets (8,457) (6,566) - (9,176) 309 (9,485) 7,312 (8,904)
Other operating expenses - - - - - - - -
Investment return 471 1,321 471 1,321 471 1,321 471 1,321
Net operating income 3,028 2,854 1,773 943 2,082 634 9,085 1,215
Financing:
Stockholders' investment return - - - - - - - -
Profit before tax 3,028 2,854 1,773 943 2,082 634 9,085 1,215
Income Taxes - - - - - - - -
Net profit for the period 3,028 2,854 1,773 943 2,082 634 9,085 1,215
Notes:
1. Other operating expenses and income taxes are nil in this example, but lines are included to illustrate possible presentation
2. This example does not split investment return into portions attributable to policyholders and portion attributable to stockholders.
To illustrate one possible presentation, a line for stockholders' investment return is included in the financing section.
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L8 Illustrative Balance Sheet – Life Insurance
BALANCE SHEET Deferral/Matching Asset/Liability Fair value (1) Fair value (2) (Risk-free
rate) (Asset-based
rate)31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00
Assets
Investments 8,951 16,314 8,951 16,314 8,951 16,314 8,951 16,314
Rights under life insurance contracts - - - - 309 - 7,312 -
Deferred acquisition costs 9,712 9,014 - - - - - -
Total Assets 18,663 25,328 8,951 16,314 9,260 16,314 16,263 16,314
Liabilities and Equity
Share capital 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000
Contribution/ distribution 2,178 (576) 2,178 (576) 2,178 (576) 2,178 (576)
Retained earnings:
Brought forward - 3,028 - 1,773 - 2,082 - 9,085
Current year result 3,028 2,854 1,773 943 2,082 634 9,085 1,215
Total equity 10,206 10,306 8,951 7,140 9,260 7,140 16,263 14,724
Policyholder liabilities 8,457 15,022 - 9,174 - 9,174 - 1,590
Total equity and liabilities 18,663 25,328 8,951 16,314 9,260 16,314 16,263 16,314
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L9 Illustrative Cash Flow Statement – Life Insurance
CASH FLOW STATEMENT
31/12/99 31/12/00
Cash flows from operating activities:
Gross premiums received 14,000 11,194
Investment earnings 471 1,321
Gross claims paid (421) (1,126)
Acquisition costs paid (12,277) -
Other operating costs paid - (1,270)
Net cash flows from operating activities 1,773 10,119
Cash flows from investing activities:
Purchase of investments (3,951) (7,365)
Net cash flows from investing activities (3,951) (7,365)
Cash flows from financing activities:
Contribution (distribution) 2,178 (2,754)
Net cash flows from financing activities 2,178 (2,754)
Net increase in cash and cash equivalents - -
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6.0 CASH FLOW ESTIMATION AND DISCOUNT RATE
6.1 Cash Flow Estimation
The starting point for measuring insurance assets and insurance liabilities should be
the expected present value of all future pre-tax cash flows arising from the closed
book of insurance contracts. Expected value should be the probability weighted
average of all cash flows at a given date, without adjustment for risk and uncertainty.
It is the present value of expected cash flows determined for different scenarios. It
includes probability of lapses and surrenders, as appropriate. Until now, insurance
liabilities were evaluated with a “deterministic” approach. They discounted a single
best estimate of the most likely cash flows using a single discount rate intended to
reflect the risks specific to the asset or liability. The proposed approach in the June
2001 draft DSOP is a “stochastic” approach. This allows the valuation process to
separately address the uncertainty around the amount and timing of cash flows and the
term structure of interest rates. It is supposed to capture the full range of possible
outcomes and the shape of their probability distribution. The expected present value
approach is a much more sophisticated approach than that previously used in
accounting models. Implementation issue: It may be a challenge for some insurance
companies to implement such methodology within the required time frame.
6.2 Estimating Cash Flows and Adjusting for Risk and Uncertainty.
Liability valuation begins with projections of expected cash flows under an insurance
contract. The present value of those cash flows, discounted at the risk-free rate, is the
liability value before any adjustment for risk and uncertainty. Both fair value and
entity-specific value should always contain a market-based adjustment for risk. Under
the DSOP, that risk adjustment is made by adjusting the cash flows (the preferable
approach), adjusting the discount rate, or both, without double counting.
The risk adjustments are referred to as "market value margins" and should be
consistent with market-risk preferences. The market-based adjustment for risk and
uncertainty effectively acts as a market mechanism for pricing uncertainty and will
have an impact on liability valuation levels. However, there is no guidance in the
DSOP on how these margins should be determined.
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6.3 Expected Present Value of All Future Cash Flows
The starting point for measuring insurance assets and insurance liabilities should be
the expected present value of all future pre-income-tax cash flows arising from the
contractual rights and contractual obligations associated with the closed book of
insurance contracts. Those cash flows include estimates of future:
(a) payments to policyholders (including payments to other parties on behalf of
policyholders) under existing contracts, and related claim handling expenses;
(b) premium receipts from policyholders under existing contracts, including
retrospective adjustments to premiums;
(c) future policy loans to policyholders, and repayments by policyholders of
principal and interest on current and future policy loans;
(d) transaction-based taxes and levies relating to existing contracts;
(e) policy administration and maintenance costs; and
(f) recoveries, such as salvage and subrogation, on unsettled claims and potential
recoveries on future claims covered by existing insurance contracts.
These principles refer to contractual rights and contractual obligations. Such rights
and obligations may be:
(a) legal rights and obligations arising from the explicit terms of the insurance
contract;
(b) legal rights and obligations arising from the explicit terms of the insurance
contract in conjunction with legislative, regulatory or other legal requirements;
(c) constructive obligations flowing from the legal obligations in (a) or (b). Some
refer to constructive obligations of this kind by such terms as “policyholders’
reasonable expectations”. Under IAS 37, Provisions, Contingent Liabilities and
Contingent Assets, a constructive obligation arises when:
i) by an established pattern of past practice, published policies or a
sufficiently specific current statement, the enterprise has indicated
to other parties that it will accept certain responsibilities;
ii) as a result, it has created a valid expectation on the part of those
other parties that it will discharge those responsibilities.
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Rights or obligations that make up financial instruments are derived from the
contractual provisions that underlie them. The term “contractual” refers to an
agreement between two or more parties that has clear economic consequences that the
parties have little, if any, discretion to avoid, because the agreement is enforceable at
law. Contractual rights and obligations, and thus financial instruments, are created by
contracts that may take a variety of forms including written or oral agreements and
contracts implied by an enterprise’s actions or by virtue of custom or practice.
These principles also refer to a starting point because the principles do not address
adjustments that could be made to cash flows to reflect risk and uncertainty.
Sometimes, an insurer stops writing some or all types of contract and allows the
existing books of insurance contracts to run off. When a book of insurance contracts
goes into run-off, the cash flows from that book may change because of, for example,
changes in expense levels, lapse rates, claims management procedures or tax status.
Although the principles and other parts of this DSOP refer to the closed book,
measurement of a closed book reflects run-off assumptions if, and only if, this is a
reasonable and supportable estimate of what will occur. Those principles address all
the future cash flows that may arise from existing insurance contracts. This DSOP
takes the view that the contractual rights and contractual obligations under a book of
insurance contracts form components of a single net asset or liability, rather than
separate assets and liabilities.
Accounting applications of present value have traditionally been deterministic. In
other words, they discounted a single point estimate of the most likely cash flows,
using a single discount rate intended to reflect the risks specific to the asset or
liability. Those who support a deterministic approach argue that it is the most
common method used today, is simple to understand, does not require statistical
training and may be easier to develop than the stochastic approaches. It also captures
uncertainties in amount and timing by simple methods that refer to observable market
returns on comparable assets and liabilities and leads to informative and concise
disclosure because disclosure of the deterministic discount rate reveals the overall
effect of assumptions about uncertainties of amount and timing and this discount rate
can be compared with observable market benchmarks.
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The expected present value is the estimated probability-weighted arithmetic average
(also known as the expected value or mean) of the present values arising from each
scenario, without considering any adjustment for risk and uncertainty. This may differ
from the single most-likely result. This DSOP requires an expected present value
approach for the following reasons:
(a) it is a stochastic approach, in other words it captures the full range of possible
outcomes and the shape of their probability distribution;
(b) it differs from the traditional approach by focusing on direct analysis of the
cash flows and on more explicit statements of the assumptions used in the
measurement;
(c) unlike deterministic approaches, which must make an arbitrary assumption
about timing, it can deal with uncertainties about the timing of cash flows;
(d) a deterministic approach has no ready means of capturing correlations
between cash flows and interest rates, for example where lapse rates for life
insurance contracts are sensitive to interest rates. The expected present value
approach captures such correlations by generating various scenarios and
applying a different set of discount rates for each scenario;
(e) it is consistent with IAS 37, Provisions, Contingent Liabilities and Contingent
Assets, which suggests an expected value approach to deal with uncertainties
in amount. IAS 37 is silent on the question of uncertainties in timing.
In some cases, deterministic methods may provide a reasonable and cost-effective
approximation to the expected present value. For example:
(a) for the normal (or Gaussian) distribution, and for other symmetrical
distributions of cash flows that are centred on the most likely cash flows with
no uncertainty in timing, the most likely cash flows are the same as the
expected cash flows, and a single point estimate of cash flows may provide a
reasonable approach;
(b) for short periods, low discount rates, a flat yield curve and cash flows that are
not time-sensitive or interest-rate-sensitive, using the average timing may give
approximately the same result as the expected present value approach.
And in many cases, relatively simple modelling may give a reasonably reliable
answer that falls within a tolerable range of precision, without the need for a large
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number of detailed simulations. However, in some cases, the cash flows may be
driven by complex underlying factors and respond in a highly non-linear fashion to
changes in economic conditions, for example if the cash flows reflect a series of inter-
related implicit or explicit options. In such cases, more sophisticated stochastic
modelling may be required.
In applying those principles, cash flows arising from the contractual rights and
obligations associated with the closed book of insurance contracts should include cash
flows from future renewals to the extent, and only to the extent, that their inclusion
would increase the measurement of the insurer’s liability and policyholders hold
uncancellable renewal options that are potentially valuable to them. A renewal option
is potentially valuable if, and only if, there is a reasonable possibility that it will
significantly constrain the insurer’s ability to reprice the contract at rates that would
apply for new policyholders who have similar characteristics to the holder of the
option.
In determining entity-specific value, each cash flow scenario used to determine
expected present value should be based on reasonable, supportable and explicit
assumptions that:
(a) reflect:
(i) all future events, including changes in legislation and future technological
change, that may affect future cash flows from the closed book of existing
insurance contracts in that scenario;
(ii) inflation by estimating discount rates and cash flows either both in real terms
(excluding general inflation, but including specific inflation) or both in nominal
terms; and
(iii) all entity-specific future cash flows that would arise in that scenario for the
current insurer, even cash flows that would not arise for other market
participants if they took over the current insurer’s rights and obligations under
the insurance contract;
(b) in relation to market assumptions, are consistent with current market prices and
other market-derived data, unless there is reliable and well-documented evidence that
current market experience and trends will not continue. Such evidence is likely to
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exist only if a single, objectively identifiable, event causes severe and short-lived
disruption to market prices. In such exceptional cases, the assumptions should be
based on this reliable evidence; and
(c) in relation to non-market assumptions, are consistent with the market assumptions
discussed in (b) and with the most recent financial budgets/forecasts that have been
approved by management. To the extent that those budgets and forecasts are not
current and not intended as neutral estimates of future events, the insurer should
adjust those assumptions. If the budgets and forecasts are deterministic, rather than
stochastic, the entire package of scenarios should be consistent with the budgets and
forecasts.
When fair value is not observable directly in the market, fair value should be
estimated by using the assumptions above, but with two differences, fair value should
not reflect entity-specific future cash flows that would not arise for other market
participants if they took over the current insurer’s rights and obligations under the
insurance. And if there is contrary data indicating that market participants would not
use the same assumptions as the insurer, fair value should reflect that market
information. Some argue that estimates of future cash flows should exclude certain
specified categories of future event, such as changes in legislation, including changes
in tax rates and tax law; technological change (which might be divided into
refinements of existing technology and development of completely new technology);
and regulatory approval, for example of a new drug that may affect the cost of
providing medical benefits.
The future cash flows used to determine entity-specific value or fair value should
include overheads that can be directly attributed to a book of insurance contracts, or
allocated to it on a reasonable and consistent basis. These overheads should include a
reasonable charge for the consumption of all assets used to generate the cash flows
concerned. All other overheads should be excluded.
Some argue that the future cash flows included in present value computations should
be only incremental cash flows that relate directly to the asset or liability under review
and should not include allocation of overheads. They believe that allocations of
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overheads have no place in cash flow measurements. This DSOP takes the view that it
is appropriate to include allocations of all overheads that can be directly attributed to a
book of insurance contracts, or allocated to it on a reasonable and consistent basis,
because overheads represent just as great an economic burden as incremental cash
outflows and should, therefore, be included in present value computations in the same
way; and the inclusion of overheads does not imply that notional cash flows are
included in a forecast of actual cash flows. Their inclusion is a means of pricing the
actual cash flows on a basis that is consistent with market prices.
Cash flows that are not directly incremental at one level of aggregation or up to one
time horizon may become incremental when viewed at a higher level of aggregation
or up to a longer time horizon. For example, salaries are often not adjustable directly
over a few days or even weeks. Thus, the staff costs attributed to processing a single
transaction may not result in additional salary payments (if the processing does not
result in overtime payments), but the processing of a large number of transactions
may well increase the total number of staff employed.
Consistent with the requirements of IAS 36, Impairment of Assets, for value in use,
this DSOP proposes that estimates of fair value and entity-specific value should be
based on cash flows that include overheads that can be directly attributed to an asset
or liability, or allocated to it on a reasonable and consistent basis. All other overheads
should be excluded. This restriction is necessary to ensure consistent and comparable
application in practice. The inclusion of overheads on such a basis does not justify the
recognition of future operating losses.
6.4 Discount rates
The starting point for determining the discount rate for insurance liabilities and
insurance assets should be the pre-tax market yield at the balance sheet date on risk-
free assets. That starting point should be adjusted to reflect risks not reflected in the
cash flows from the insurance contracts. The currency and timing of the cash flows
from the risk-free assets should be consistent with the currency and timing of the cash
flows from the insurance contracts. Risk-free assets are those assets with readily
observable market prices whose cash flows are least variable for a given maturity and
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currency. In certain cases, the amount of future cash flows is correlated with interest
rates. The expected cash flow approach captures such correlations by generating
various scenarios and applying a different set of discount rates to each scenario,
consistent with the cash flows for that scenario.
a) Benchmark for the Risk-Free Component of Discount Rates
Although no assets provide certain cash flows, the risk of default is regarded as
minimal for some securities issued by highly creditworthy governments. In addition,
it is not usually possible to find other assets that provide more certain cash flows in
the same currencies than these securities. Although those government securities may
carry other risks, for example, interest rate risk (the risk that interest rates will change)
or inflation risk, such securities are sometimes described as risk-free and the interest
rate paid on such securities is often called the risk-free rate.
The risk-free discount rate reflects the time value of money, without considering the
effect of risk. The Joint Working Group (JWG) Draft uses the term “basic (or ‘risk-
free’) interest” to refer to the amount of interest that compensates the lender for the
time value of money. It may be necessary to determine risk-free discount rates either:
(a) to use directly as the discount rate, if adjustments for risk and uncertainty are made
in the cash flows rather than in the discount rate
(b) as a starting point for determining risk-adjusted discount rates if risk-adjusted rates
are not observable directly in the market.
Some argue that central government securities are the assets that carry the lowest risk
in most economies. Therefore, they believe that government securities are the
appropriate benchmark for determining the risk-free component of discount rates.
Some argue that an insurer should use high-quality corporate bonds as the primary
benchmark for the risk-free component. They accept that some default risk is present
in corporate bonds, but argue that this is likely to be relatively low in high-quality
corporate bonds. In countries where active markets do not exist for corporate bonds,
they would use government securities as a proxy for high-quality corporate bonds.
Others argue that the primary benchmark should be high-quality bonds that have the
most active market in the currency under consideration. In some currencies, this might
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be central government bonds and in other currencies it might be high-quality
corporate bonds.
Central government securities will often be the most appropriate benchmark for
determining the risk-free component of discount rates. This is because government
securities are generally regarded as carrying the lowest level of default risk in a
particular economy. If there is no active market in government securities, yields on
other high-quality securities would be used as a benchmark
This DSOP takes the view that the discount rate for a liability should reflect the
characteristics of that liability, not the characteristics of some other instrument with
different features. Accordingly, this DSOP does not permit a discount rate for
insurance liabilities based on any of the following:
(a) an insurer’s incremental borrowing rate. Among other things, in many
jurisdictions, policyholders enjoy legal priority over lenders and general creditors.
Thus, an instrument with an observable market yield would not have similar
characteristics, including security, to an insurance liability. It follows that an
incremental borrowing rate derived from such an instrument would not reflect the
characteristics of an insurance liability;
(b) an insurer’s cost of capital. Some argue that using the cost of capital would help
investors by aligning financial reporting with new performance reporting
techniques that focus on shareholder value. However, the cost of capital is
effectively the weighted-average return that investors require across the current
mix of all the insurer’s assets, liabilities and operations. It is highly unlikely to
reflect the risk profile of any individual liability; and
(c) returns on assets held, except where the return on specified assets directly
influences the amount of benefits paid to policyholders, as for certain participating
contracts and unit-linked contracts.
b) Market Yield at the Balance Sheet Date
Discount rates are one type of market assumption. The principles in cash flow
estimation propose that market assumptions should be consistent with current market
prices and other current market-derived data, unless there is reliable and well-
documented evidence that current market experience and trends will not continue.
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Such evidence is likely to exist only if a single, objectively identifiable, event causes
severe and short-lived disruption to market prices. In such exceptional cases, the
market assumptions should be based on this reliable evidence.
c) Yield Curve
The definition of risk-free assets refers to the maturity of the assets. It follows that a
different risk-free asset, and hence risk-free discount rate, may exist for each maturity.
Nevertheless, some propose the use of a single discount rate for each closed book of
insurance contracts, to avoid complex calculations for cash flows that are expected to
occur in different periods. This DSOP takes the view that the discount rates should
incorporate yield curve effects by reflecting the estimated timing of the cash flows
from an insurance liability. Using the expected present value approach, in principle a
separate discount rate is used for each future time at which a cash flow may occur. In
practice, it may sometimes be acceptable to use a single rate that is believed to result
in a reasonable approximation to the use of separate rates for each period.
In some countries, the central government’s bonds may carry a significant credit risk
and may not provide a useful, stable benchmark basic interest rate for enterprises
issuing financial statements in that reporting currency. Some enterprises in these
countries may have better credit standings and lower borrowing rates than the central
government. In such a case, basic interest rates may be more appropriately determined
by reference to interest rates for the highest rated corporate bonds issued in the
currency of that jurisdiction. There can occasionally be real practical difficulties in
extrapolating the yield curve to the distant future. For example, interest rates in Japan
have been abnormally close to zero for the last few years. Some insurance liabilities
mature many years after the final maturity of the instruments for which market prices
can be readily observed. This has made it extremely difficult to assess at what future
date it would be reasonable to assume a return to market conditions that are more
typical of experience over the past several decades.
In some cases, there may be no deep market in bonds with a sufficiently long maturity
to match the estimated maturity of all the benefit payments. In such cases, an
enterprise uses current market rates of the appropriate term to discount shorter term
payments, and estimates the discount rate for longer maturities by extrapolating
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current market rates along the yield curve. The total present value of a defined benefit
obligation is unlikely to be particularly sensitive to the discount rate applied to the
portion of benefits that is payable beyond the final maturity of the available corporate
or government bonds. The Steering Committee does not believe that it is practicable
for this DSOP to offer further guidance on this difficulty.
d) Consistency with Cash Flows
It is important to use consistent assumptions in determining discount rates and cash
flows. For example, suppose that the lowest-risk instrument with an observable
market price has a yield of 6%, including a premium estimated at 0.5% in total to
cover both expected defaults of 0.3% and the risk that defaults may exceed 0.3%. This
yield of 6% equates the contractual cash flows with the current market price of the
instrument. These contractual cash flows include cash flows that will not be received
in the 0.3% of cases when there is a default. Therefore, the expected return from the
instruments is 5.7%.
In measuring the insurance liability, an insurer will discount the expected cash flows
(using the expected present value approach) at a discount rate that does not include
the premium for expected defaults. If the discount rate did not exclude this premium,
the discount rate would effectively overstate the expected return on the instruments. It
is also appropriate to exclude the further premium (0.2% in this example) that covers
the risk that actual defaults may exceed 0.3%. This risk relates to the instrument used
as a benchmark and does not reflect the characteristics of the insurance liability. It
follows that the yields used to determine discount rates should be determined after
deducting the estimated premium for expected defaults. To the extent that it is
practicable to estimate them, the yield should also exclude risk premiums for bearing
the risk of variability in defaults or other variations in returns from the instrument
used as a benchmark. The exclusion of the total premium of 0.5% would result in a
risk-free discount rate of 5.5% in this example.
e) Income Taxes
DSOP proposes that insurance liabilities and insurance assets should be measured by
discounting pre-tax cash flows at a pre-tax discount rate. Interest rates and yields
observed in the capital markets are generally expressed on a pre-tax basis. In some
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markets, interest rates for certain instruments (for example, municipal bonds) have
special tax treatment that may distort market returns on those instruments. If such
instruments are used as a benchmark for determining the risk-free rate, it is important
to eliminate the effect of any such distortions.
6.5 Foreign Currency Cash Flows
Estimated cash flows in foreign currency should be discounted using the appropriate
discount rate for the foreign currency. The resulting present value should be translated
into the measurement currency using the spot rate at the reporting date. If a currency
is freely convertible and traded in an active market, the spot rate reflects the market’s
best estimate of future events that will affect that currency. Therefore, the only
available unbiased estimate of a future exchange rate is the current spot rate, adjusted
by the difference in expected future rates of general inflation in the two currencies.
A present value calculation already deals with the effect of general inflation, since it
is calculated by estimating future cash flows in either nominal terms (i.e., including
the effect of general inflation and specific price changes) and discounting them at a
rate that includes the effects of general inflation; or real terms (i.e., excluding the
effect of general inflation but including the effect of specific price changes) and
discounting them at a rate that excludes the effect of general inflation.
Using a forward rate to translate present value expressed in a foreign currency would
count part of the time value of money twice (first in the discount rate and then again
in the forward rate). This is because a forward rate reflects the market’s adjustment
for the differential in interest rates. In some cases, a currency is not freely convertible
or is not traded in an active market. In consequence, it can no longer be assumed that
the spot exchange rate reflects the market’s best estimate of future events that will
affect that currency. Nevertheless, even in such cases, IAS 36 indicates that an
enterprise uses the spot exchange rate at the balance sheet date to translate value in
use estimated in a foreign currency. The argument for this approach is that it is
unlikely that an enterprise can make a more reliable estimate of future exchange rates
than the current spot exchange rate, adjusted by the difference in expected future rates
of general inflation in the two currencies.
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An alternative to estimating the future cash flows in the currency in which they are
generated would be to estimate them in another currency as a proxy and discount
them at a rate appropriate for this other currency. This solution may be simpler,
particularly where cash flows are generated in the currency of a hyperinflationary
economy (in such cases, some would prefer using a hard currency as a proxy) or in a
currency other than the currency that an enterprise uses for measuring items in its
financial statements (the measurement currency). However, this solution may be
misleading if the exchange rate varies for reasons other than changes in the
differential between the general inflation rates in the two countries to which the
currencies belong. In addition, this solution is inconsistent with the approach under
IAS 29, Financial Reporting in Hyperinflationary Economies. If the appropriate
measurement currency is the currency of a hyperinflationary economy, IAS 29 does
not allow translation into a hard currency as a proxy for restatement in terms of the
measuring unit current at the balance sheet date. This is confirmed by SIC-19,
Reporting Currency - Measurement and Presentation of Financial Statements under
IAS 21 and IAS 29.
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7.0 Hedging Instruments
7.1 Qualifying Instruments
IAS39 does not restrict the circumstances in which a derivative may be chosen as a
hedging instrument. Sometimes, a non-derivative financial asset or non-derivative
financial liability may be designated as a hedging instrument only for a hedge of a
foreign currency risk. Because there is a different measure standard for derivatives
and non-derivatives.
The potential loss on an option an entity writes could be significant greater than the
potential gain in value of a related hedged item. In other words, a written option is
ineffective in reducing the exposure on profit or loss. Hence, a designated as an offset
to a purchased option, including one that is embedded in another financial instrument
unless it is designated as an offset to a purchased option, including one that is
embedded in another financial instrument. For example, a written call option used to
hedge a callable liability. In contrast, a purchased option has potential gains equal to
or greater than losses and therefore has the potential to reduce profit or loss exposure
from changes in fair values or cash flows. Accordingly, it can qualify as a hedging
instrument.
An investment in an unquoted equity instrument that is not carried at fair value
because its fair value cannot be reliably measured or a derivative that is linked to and
must be settled by delivery of such an unquoted equity instrument cannot be
designated as a hedging instrument. If an entity's own equity securities are not
financial assets or financial liabilities of the entity and, therefore, cannot be
designated as hedging instruments.
7.1.1 Designation of Hedging Instruments
There is normally a single fair value measure for a hedging instrument in its entirety,
and the factors that cause changes in fair value are co-dependent. Thus, a hedging
relationship is chosen by an entity for a hedging instrument in its entirety. Separating
the intrinsic value and the time value of an option and designating only the change in
the intrinsic value of an option as the hedging instrument, and excluding the
remaining component of the option (its time value) and separating the interest element
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and the spot price on a forward are the only exceptions permitted. Generally, the
intrinsic value of the option and the premium on the forward can be measured
separately. Therefore, a dynamic hedging strategy that assesses both the intrinsic
value and the time value of an option can qualify for hedge accounting.
A single hedging instrument may be called as a hedge of more than one type of risk
provided that the risks hedged can be identified clearly, the effectiveness of the hedge
can be established and there is possibly to ensure the specific designation of the
hedging instrument and different risk positions.
Sometimes, two or more derivatives may be viewed in combination and jointly
designated as the hedging instrument. However, an interest rate hedging or other
derivative instrument that combines a written option component and a purchased
option component does not qualify as a hedging instrument if it is, in effect, a net
written option.
A hedged item can be a recognised asset or liability, an unrecognised firm
commitment, or an uncommitted but highly probable anticipated future transaction
(forecast transaction), or a net investment in a foreign operation. Unlike originated
loans and receivables, a held-to-maturity investment cannot be a hedged item with
respect to interest-rate risk or prepayment risk because designation of an investment
as held-to-maturity requires an intention to hold the investment until maturity without
regard to changes in the fair value or cash flows of such an investment attributable to
changes in interest rates. However, a held-to-maturity investment can be a hedged
item with respect to risk from changes in foreign currency exchange rates and credit
risk.
A firm commitment to acquire a business in a business combination cannot be a
hedged item, except for foreign exchange risk because the other risks being hedged
cannot be specifically an identified measured. It is only a hedge of a general business
risk.
An equity method investment cannot be a hedged item in a fair value hedge because
the equity method recognises in profit or loss the investor's share of the associate's
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accrued profit or loss, rather than fair value changes. For a similar reason, an
investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge
because consolidation recognises the parent's share of the subsidiary's loss. A hedge
of a net investment in a foreign operation is different because it is a hedge of the
foreign currency exposure, not a fair value hedge of the change in the value of the
investment.
7.1.2 Designation of Financial Items as Hedged items
A financial asset or financial liability maybe a hedged item with respect to the risks
associated with only a portion of its cash flows or fair value (such as one or more
selected contractual cash flows or portions thereof a percentage of the fair value),
provided that effectiveness can be measured. For example, an identifiable and
separately measurable portion of the interest rate exposure of an interest-bearing asset
or interest-bearing liability may be designated as the hedged risk (such as a risk-free
interest rate or benchmark interest rate component of the total interest rate exposure of
a hedged financial instrument.)
7.1.3 Designation of Non-Financial Items as hedged items
If a hedged item is a non-financial asset or non-financial liability either for foreign
currency risks or in its entirety for all risks, then it shall be designated as a hedged
item, because of the difficulty of isolating and measuring the appropriate portion of
the cash flows or fair value changes attributable to specific risks other than foreign
currency risks.
Because changes in the price of an ingredient of component of a non-financial asset or
non-financial liability generally do not have a predictable, separately measurable
effect on the price of the item that is comparable to the effect of a non-financial asset
or non-financial liability is a hedged item only in its entirety.
7.2 Hedge Accounting
For hedge accounting purposes, only derivatives that involve a party external to the
entity can be designated as hedging instruments. Although individual entities within a
consolidated group or divisions within an entity may enter into hedging transactions
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with other entities, any gains and losses on such transactions are eliminated on
consolidation. Therefore, such intra-group or intra-entity hedging transactions do not
qualify for hedge accounting in consolidation.
Hedge accounting recognises the offsetting effects on profit or loss of changes in the
fair values of the hedging instrument and the hedged item. Hedging relationships are
of three types:
a) fair value hedge: a hedge of exposure to changes in fair value of a recognised asset
or liability or a previously unrecognised firm commitment to buy or sell an asset at a
fixed price, or an identified portion of such an asset, liability or firm commitment, that
is attributable to a particular risk and could affect reported profit or loss. An example
of a fair value hedge is a hedge of exposure to changes in the fair value of fixed rate
debt as a result of changes in interest rates. Such a hedge could be entered into either
by the issuer or by the holder.
b) cash flow hedge: a hedge of the exposure to variability in cash flows that a) is
attributable to a particular risk associated with a recognised asset or liability (such as
all or some future interest payments on variable rate debt) or a forecast transaction
(such as an anticipated purchase or sale) and b) could affect report profit or loss. An
example of a cash flow hedge is use of a swap to change floating rate debt to fixed
rate debt (i.e. a hedge of a future transaction; the future cash flows being hedged are
the future interest payments.)
c) hedge of a net investment in a foreign operation as defined in IAS21. A hedge of a
firm commitment (for example, a hedge of the foreign currency risk in an
unrecognised contractual commitment by an airline to purchase an aircraft for a fixed
amount of a foreign currency or a hedge of the change in fuel price relating to an
unrecognised contractual commitment by an electric utility to purchase fuel at a fixed
price), is a hedge of an exposure to a change in fair value. Accordingly, such a hedge
is accounted for as a fair value hedge. When a previously unrecognised firm
commitment is designated as a hedged item, the subsequent cumulative change in the
fair value of the firm commitment attributable to the hedged risk is recognised as an
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asset or liability and changes in the fair value attributable to the hedged risk are
recognised in profit or loss.
If all the following conditions are met a hedging relationship can only qualify for
hedge accounting under this Standard:
a) at the inception of the hedge there is formal documentation of the hedging
relationship and the entity's risk management objective and strategy for undertaking
the hedge. That documentation shall include identification of the hedging instrument,
the related hedged item or transaction, the nature of the risk being hedged, and how
the entity will assess the hedging instrument's effectiveness in offsetting the exposure
to changes in the hedged item's fair value or the hedged transaction's cash flows that is
attributable to the hedged risk
b) the hedge is expected to be highly effective in achieving offsetting changes in fair
value or cash flows attributable to the hedged risk, consistently with the originally
documented risk management strategy for that particular hedging relationship
c) for cash flow hedges, a forecast transaction that is the subject of the hedge must be
highly probable and must present an exposure to variations in cash flows that could
ultimately affect reported profit or loss
d) the effectiveness of the hedge can be reliably measured, i.e. the fair value or cash
flows of the hedged item and the fair value of the hedging instrument can be reliably
measured
e) the hedge is assessed on an ongoing basis and determined actually to have been
highly effective throughout the financial reporting period.
7.2.1 Assessing hedge effectiveness
A hedge is normally regarded as highly effective if, at inception and throughout the
life of the hedge, the entity can expect changes in the fair value or cash flows of the
hedged item to be almost fully offset by the changes in the fair value or cash flows of
the hedging instrument, and actual results are within a range of 80 percent to 125
percent. For example, if the loss on the hedging instrument is 120 and the gain on the
cash instrument is 100, offset can be measured by 120/100, which is 120 percent, or
by 100/120, which is 83 percent. In this example, the entity would conclude that the
hedge is highly effective.
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The method an entity adopts for assessing hedge effectiveness depends on its risk
management strategy. In some cases, an entity adopts different methods for different
types of hedges. If the principal terms of the hedging instrument and of the hedged
asset or liability or hedged forecast transaction are the same, the changes in fair value
and cash flows attributable to the risk being hedged may be likely to offset each other
fully, both when the hedge is entered into the thereafter. For instance, an interest rate
swap is likely to be an effective hedge if the notional and principal amounts, term,
repricing dates, dates of interest and principal receipts and payments, and basis for
measuring interest rates are the same for the hedging instrument and the hedged item.
On the other hand, sometimes the hedging instrument offset the hedged risk only
partially. For instance, a hedge would not be fully effective if the hedging instrument
and hedged item are denominated in different currencies that do not move in tandem.
Also, a hedge of interest rate risk using a derivative would not be fully effective if
part of the change in the fair value of the derivative is attributable cannot be measured
because those risks are not measurable reliably.
To qualify for hedge accounting, the hedge must relate to a specific identified and
designated risk, and not merely to overall business risks, and must ultimately affect
the entity's profit or loss. A hedge of the risk of obsolescence of a physical asset or
the risk of expropriation of property by a government would not be eligible for hedge
accounting; effectiveness cannot be measured because those risks are not measurable
reliably.
In the case of interest rate risk, hedge effectiveness maybe assessed by preparing a
maturity schedule for financial assets and financial liabilities that shows the net
interest rate exposure for each time period, provided that the net exposure associated
with a specific asset or liability (or a specific group of assets or liabilities or a specific
portion thereof) giving rise to the net exposure and hedge effectiveness is assessed
against that asset or liability.
This Standard does not specify a single method for assessing hedge effectiveness. An
entity's documentation of its hedging strategy includes its procedures for assessing
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effectiveness. Those procedures state whether the assessment included all of the gain
or loss on a hedging instrument or whether the instrument's time value is excluded.
Effectiveness is assessed, at a minimum, at the time an entity prepares its annual or
interim financial statements. If the critical terms of the hedging instrument and the
entire hedged asset or liability or hedged forecast transaction are the same, an entity
could conclude that changes in fair value or cash flows attributable to the risk being
hedged are expected to offset each other fully at inception and on an ongoing basis.
For example, an entity may assume that a hedge of a forecast purchase of a
commodity with a forward contract will be highly effective and that there will be no
ineffectiveness to be recognised in profit or loss if:
a) the forward contract is for the purchase of the same quantity of the same
commodity at the same time and location as the hedged forecast purchase
b) the fair value of the forward contract at inception is zero
c) either the change in the discount or premium on the forward contract is excluded
from the assessment of effectiveness and included directly in profit or loss or the
change in expected cash flows on the forecast transaction is based on the forward
price for the commodity
In assessing the effectiveness of a hedge, an entity generally consider the time value
of money. The fixed interest rate on a hedged item need not exactly match the fixed
interest rate on a swap designated as a fair value hedge. Nor does the variable interest
rate on an interest-bearing asset or liability need to be the same as the variable interest
rate on a swap designated as a cash flow hedge. A swap's fair value derives from its
net settlements. The fixed and variable rates on a swap can be changed without
affecting the net settlement if both are changed by the same amount.
7.2.2 Fair Value Hedges
If a fair value hedge meets the conditions as mentioned before, it shall be accounted
for as follows:
a) the gain or loss from remeasuring the hedging instrument at fair value (for a
derivative hedging instrument) or the foreign currency component of its carrying
amount (for a non-derivative hedging instrument) shall be recognised immediately in
profit or loss; and
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b) the gain or loss on the hedged item attributable to the hedged risk shall adjust the
carrying amount of the hedged item and be recognised immediately in profit or loss.
This applies even if a hedged item is otherwise measured at fair value with changes in
fair value recognised directly in equity. It also applies if the hedged item is otherwise
measured at cost.
If only particular risks attributable to a hedged item have been hedged, recognised
changes in the fair value of the hedged item unrelated to the hedge are recognised in
one of the two ways. An entity shall discontinue prospectively the hedge accounting if
it is regarded as an expiration or termination if such replacement or rollover is part of
the entity's documented hedging strategy or the hedge no longer meets the criteria for
hedge accounting
An adjustment to the carrying amount of a hedged interest-bearing financial
instrument shall be amortised to profit or loss. Amortisation may begin no later than
when the hedged item ceases to be adjusted for changes in its fair value attributable to
the risk being hedged. The adjustment is based on a recalculated effective interest
rate at the date amortisation begins and shall be amortised fully by maturity.
7.2.3 Cash Flow Hedges
If a cash flow hedge meets the condition during financial reporting period, it shall be
accounted for as follows:
a) the portion of the gain or loss on the hedging instrument that is determined to be an
effective hedge shall be recognised directly in equity through the statement of changes
in equity; and
b) the ineffective portion of the gain or loss on the hedging instrument shall be
recognised:
i) immediately in profit or loss if the hedging instrument is a derivative; or
ii) in accordance with a recognised gain or loss arising from a change in the
fair value of a financial asset or financial liability (that is not part of a hedging
relationship shall be recognised as follows:
a) a gain or loss on a financial asset or financial liability held for trading
shall be recognised in profit or loss for the period in which it arises
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(in this regard, a derivative trading unless it is a designated hedging
instrument)
b) gain or loss on an available-for-sale financial asset shall be
recognised directly in equity, through the statement of changes in
equity, except for impairment losses, until the financial asset is
derecognised at which time the cumulative gain or loss previously
recognised in equity shall be recognised in profit or loss for the
period. However, the amortisation using the effective interest method
of any difference between the amounts recognised initially and the
maturity amount of an available-for-sale financial asset represents
interest and is recognised in profit or loss)
in the limited circumstances in which the hedging instrument is not a derivative
More specifically, a cash flow hedge is accounted for as follows:
a) the separate component of equity associated with the hedged item is adjusted to the
lesser of the following (in absolute amounts):
i) cumulative gain or loss on the hedging instrument and
ii) the cumulative change in fair value (present value) of the expected future cash
flows on the hedged item from inception of the hedge;
b) any remaining gain or loss on the hedging instrument (which is not an effective
hedge) is included in profit or loss or directly in equity
c) if an entity's documented risk management strategy for a particular hedging
relationship excludes a specific component of the gain or loss or related cash flows on
the hedging instrument from the assessment of hedge effectiveness that excluded
component of gain or loss is recognised.
If a hedge of a forecast transaction subsequently results in the recognition of an asset
or a liability, then the associated gains or losses that were recognised directly in
equity. It should be reclassified into profit or loss in the same period or periods
during which the asset acquired or liability incurred affects profit or loss (such as in
the periods that depreciation expense, interest expense, or cost of sales is recognised).
However, if an entity expects at any time that all or a portion of a net loss recognised
directly in equity will not be recovered in one or more future periods, it shall
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reclassify immediately into profit or loss the amount that is not expected to be
recovered.
An entity shall discontinue prospectively the hedge accounting of the cash flow hedge
if any one of the following occurs:
a) the hedging instrument expires or is sold, terminated, or exercised (for this
purpose, the replacement or a rollover of a hedging instrument into
another hedging instrument is not regarded as an expiration or termination
if such replacement or rollover is part of the entity's documented hedging
strategy.) In this case, the cumulative gain or loss on the hedging
instrument that initially had been reported directly in equity when the
hedge was effective shall remain separately in equity until the forecast
transaction occurs.
b) the hedge no longer meets the criteria for hedge accounting as we
mentioned before. In this case, the cumulative gain or loss on the hedging
instrument that initially had been reported directly in equity when the
hedge was effective shall remain separately in equity until the forecast
transaction occurs.
c) the forecast transaction is no longer expected to occur, in which case any
related cumulative gain or loss that had been recognised directly in equity
shall be recognised in profit or loss for the period. A forecast transaction
that is no longer highly probable may still be expected to occur.
7.2.4 Net Investment Hedges
Hedges of a net investment in a foreign operation, including a hedge of a monetary
item that is accounted for as part of the net investment, shall be accounted for
similarly to cash flow hedges:
a) the portion of the gain or loss on the hedging instrument that is determined to
be an effective hedge shall be recognised directly in equity through the
statement of change in equity; and
b) the ineffective portion shall be recognised;
c) immediately in profit or loss if the hedging instrument is a derivatives
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The gain or loss on the hedging instrument relating to the effective portion of the
hedge that has been recognised directly in equity shall be recognised in profit or loss
at the disposal of the foreign operation.
If a hedge that do not qualify for hedge accounting because it fails to meet the criteria,
gains and losses arising from changes in the fair value of a hedged item that is
measured at fair value after initial recognition are recognised in one of the two ways
in a gain or loss on a financial asset or financial liability held for trading or gain or
loss on an available-for-sale financial asset. Fair value adjustments of a hedging
instrument that is a derivative would be recognised in profit or loss.
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8.0 Conclusion
8.1 The over view of IAS
The former IASC Board started a project on Insurance Accounting in 1997. An
Insurance Steering Committee was set up and, in December 1999, they published an
Issues Paper on Insurance. The IASC received 138 comment letters in response to this
Issues Paper worldwide. The Steering Committee met in September 2000 and
November 2000 to review the comment letters and to develop a report to the former
IASC Board in the form of a first draft of a Draft Statement of Principles (DSOP).
In April 2001, a new International Accounting Standards Board was appointed
(IASB), to replace the former IASC Board. The new Board decided to allow the
Insurance Steering Committee to complete its work on the Insurance DSOP. In June
2001, the Insurance Steering Committee met in Paris and discussed the last draft of
the DSOP, which they aim to finalise by October 2001 as a report to the IASB. At the
September 2001 IASB meeting, the IASB agreed to the Steering Committee’s
proposal to carry out field visits with insurance companies, to discuss practical issues
on the basis of the current proposals in the DSOP but did not otherwise discuss the
June 2001 draft DSOP.
In accordance with the IASC framework, the future standard on insurance contracts
will prescribe the accounting and disclosure in general financial statements by
insurers and policyholders for all insurance contracts, regardless of the industry of the
enterprise concerned. The assets and liabilities of an insurance company not directly
linked to insurance contracts should be evaluated and accounted for in accordance
with other relevant standards (e.g., IAS 39, Financial Instrument: Recognition and
Measurement, for financial assets and liabilities, IAS 40, Investment Property, for
investment property).
As a consequence, a significant part of the assets could be measured at fair value. As
it is sometimes difficult to distinguish an insurance contract from other financial
instruments, it is important to define what an insurance contract is and to highlight the
principal elements of differentiation. An insurance contract would be defined as “a
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contract under which one party (the insurer) accepts an insurance risk by agreeing
with another party (the policyholder) to compensate the policyholder or other
beneficiary if a specified uncertain future event adversely affects the policyholder or
other beneficiary (other than an event that is only a change in one or more of a
specified interest rate, security price, commodity price, foreign exchange rate, index
of prices or rates, a credit rating or credit index or similar variable)”. The new
definition includes the notion of “uncertain future event”. That is, it is uncertain at the
inception of a contract whether:
• a future event specified in the contract will occur,
• when the specified event will occur, and
• how much the insurer will need to pay if the specified future event occurs.
This definition should result in the classification of, and accounting for, some
insurance products as financial instruments (especially a great majority of saving-
oriented products). As there should be a single definition of an insurance contract,
there should be a single recognition and measurement approach for all forms of
insurance contracts, and as a consequence for the insurance assets and liabilities,
regardless of the type of risk underwritten (i.e., life insurance or non-life insurance).
That approach would be an “Asset and Liability” measurement approach rather than
the traditional “Deferral and Matching” measurement approach. The “Deferral and
Matching” approach is the most common approach applied today, under which
revenues and expenses are deferred and matched accordingly.
Within this context and following the Joint Working Group (JWG) proposals,
insurance assets and liabilities should be measured on a prospective basis, reflecting
the present value of all future cash flows arising from the closed book of insurance
contracts in existence at reporting date. Two methods of prospective measurement
could be considered:
• fair-value, and
• entity-specific value.
The first method, fair value, is the amount for which an asset could be exchanged or a
liability settled between knowledgeable, willing parties in an arm’s length transaction.
This corresponds to an exchange value. The second method, entity-specific value,
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represents the value of an asset or a liability to the enterprise that holds it, and may
reflect factors that are not available (or not relevant) to other market participants. This
corresponds to a “value in use”. Whatever the final measurement approach might be,
it should reflect risk and uncertainty either in the discount rate or in the amount of
cash flows. The June 2001 draft DSOP is currently leaning towards a “stochastic
method” to estimating future cash flows. The stochastic approach captures the full
range of possible outcomes and the shape of their probability distribution, in
comparison with a “deterministic approach”, which has no ready means of capturing
correlation between cash flows and interest rates. The June 2001 draft DSOP
expresses the view that the value of an insurance contract should be independent of
the investing strategy of an enterprise. Consequently, the insurance liabilities should
not be affected by the type, or by the yield, of the financial assets held by an
enterprise.
Within this context, insurance liabilities should be linked to risk-free rates and not to
the yield of the financial assets. A different approach should nevertheless be used for
some specific insurance contracts such as unit-linked and participating contracts. The
future Standard would introduce some major changes in the current measurement and
financial reporting for insurance contracts: variations in the present value would be
reflected in the income statement, present value of some part of the future margins
would be recognised in the income statement at inception (the amount taken will
depend on certain variables), some technical reserves that would not meet the
definition of a liability would not be recognized (such as unearned premiums or
equalisation reserves).
Nevertheless, no final decisions have yet been made. The new IASC Board, the IASB,
had planned to study the June 2001 draft DSOP for the first time during the meeting
that took place on 13 September 2001. This discussion was subsequently cancelled
and has been postponed to the October 2001 IASB meeting. Before resolving the key
issues raised by the June 2001 draft DSOP, the Board will probably attempt to define
clearly what the overall objectives of financial reporting should be.
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City University Business SchoolMSc Insurance and Risk Management
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8.2 Insurance Contracts
The objective of the IAS board should in a neutral position, however, the funding of
the IAS board mostly come from the US accounting firm. Although, there are
different countries’ members in the committee in order to receive a lot of different
countries’ accounting opinion, there is always an argument that the IAS are very
favour to the US standard. That is the main reason why there are many European
companies standing up and oppose about the 2005 acts. European companies have
their own traditional system; if they need to follow the IAS they will need to change
their whole accounting structure eventually. But not the US companies, because they
are used to work on something very similar.
The Steering Committee’s decision to focus on insurance contracts is better rather
than to focus on insurance enterprises. To ensure fair, comparable and equitable
treatment across industry lines, the ultimate accounting principles developed should
not be dictated by the nature nor the legal form of a company but rather the economic
characteristics of the product sold and the risks assumed. In recent years the financial
services industry has changed greatly and insurers now find themselves competing
with other financial service providers on similar financial products. An accounting
standard should not penalise insurance companies relative to the others by creating
“arbitrage” opportunities to the insurance industry’s disadvantage. Equally as
important is the underlying conceptual consistency of the accounting standards within
our industry. Insurance companies sell a broad spectrum of products with varying
economics features and degrees of risk. While the accounting principles for all
products sold by insurance companies should not be identical, the accounting
principles employed should be based on the same fundamental underlying foundation.
The use of a substantively different accounting model for products that cross a
subjective line, i.e. significant insurance or mortality risks, would be inconsistent with
the principle of comparability between industries and products.
The definition of insurance contracts should be broadened in order to cover a
comprehensive variety of products sold by insurance companies and as permitted by
regulators, at the moment and in the future. Furthermore, insurance contracts should
not be unbundled for the different components therein, particularly life contracts. This
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view is based on the premise that insurance risk and investment aspects are closely
linked together. To separate the various components of insurance contract would be
artificial and misleading, and the comparability would be difficult because the
subjectivity of the unbundling criteria is unavoidable.
Using the IASC Framework as a basis for building an insurance accounting standard
will help to achieve consistency between insurers and other enterprises. The asset and
liability approach, which has the favour of the Steering Committee, is consistent with
the Framework. But the asset and liability approach needs to be amended by the
deferral and matching approach. As for other industries, which use some deferral
mechanisms, insurance performance reporting needs to take into consideration in a
dynamic way the features of the insurance service rendered over policy lives.
Financial information provided to investors should be compatible with that used by
management of the company to assess operational performance and to make strategic
decisions. The main objective is to ensure that the financial statements are
economically sound, i.e., accurately reflect an insurance enterprise’s creation of value
and its financial position. As for other service industries, the overall profitability can
only be determined after all obligations out of the contracts have been met. Another
unique aspect of insurance is its combination of individual contracts and pooling of
risks into portfolios, thereby diversifying risk. The outcome of a portfolio can be
predicted much more reliably than the outcome of individual contracts. Therefore, we
believe that the ultimate model proposed should emphasize a portfolio-based
approach as opposed to an individual contract approach.
In particular, the life insurance and general insurance accounting should focus on the
renewal rights, the right to receive future premiums and the policyholder’s right to
cancel the contract. It is important to establish whether the assets or liabilities meet
the definitions contained in the IASC framework in order to recognise them in the
balance sheet. The principle in accounting for policy, whether life or general, with a
duration of more than one year, all expected cash flows for the remaining period of
the contract should be taken into account in valuing the liability.
Chapter 8: ConclusionNew International Accounting Standard of Insurance Industry
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8.3 The Fair Value Debate
There is strong momentum at the IASC toward measuring all financial instruments at
their fair value. The fair value concept is difficult to apply particularly to insurance
contracts because transactions by which to judge fair values are confined to relatively
infrequent acquisitions of insurance companies or insurance portfolios. Even in such
transactions, acquisition costs cannot be considered as an absolute fair value because
they depend on the judgment of the buyer and its overall interest in the deal.
For insurance contracts, fair value cannot be a market value but a constructed value
using expected future cash flows and present value techniques, and generated from an
assessment of the entire portfolio-in-force using management data with some
parameters driven by the market. A fair value approach for accounting for insurance
liabilities should be rejected since there is no active market for insurance contracts,
the valuation of insurance contracts could be only an estimation and it would
introduce volatility in earnings due to the judgmental aspects in assumptions to be
made in the fair value of liabilities since the insurance markets, which are specifically
regulated, rely on the assumption that liabilities to policyholders will be met.
While financial markets are volatile, effective asset-liability management prevents
such volatility from impairing an insurer’s ability to fulfil its promises. If the new
accounting standards fail to reflect accurately the compensating effects of an insurer’s
asset-liability management, what insurers consider “fictitious” volatility will emerge
and the accounting standards will quickly lose credibility. While it is difficult to be
judgmental when the concept of fair value of an insurance contract is yet to be
defined, an accounting model whereby all changes in fair value are recorded in
income will produce such “fictitious” volatility.
The fair value cannot mean pure market value. This is because from a practical point
of view a narrower interpretation (which considers the two value measurements as
interchangeable) would be untenable where there is no active market for the asset or
liability in question. This would be a particular problem in relation to insurance
liabilities. However, rather than concluding from this that a fair value approach would
be inappropriate, the IASC should continue to recognise that there are other methods
Chapter 8: ConclusionNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
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for measuring fair value. The methods adopted must be sufficiently well defined and
tested to provide assurance that measurement will be implemented on a consistent
basis. Achievement of this objective will result in the provision of more relevant and
subjective information to users than would be available to them under alternative
bases of accounting.
Asset-liability management, which must be based on long-term duration according to
the life of the contracts, cannot be accurately measured by short-term measurements
like fair values. For example, insurance companies prudently invest in equity
securities based on long-term perceptions of value that are unaffected by short-term
volatility. However, even though changes in the stocks markets could cause dramatic
volatility, most insurance contract fair values (other than certain life insurance
contracts, i.e., participating and unit-linked) will likely be unaffected by these market
movements. Despite such shortfalls, the fair value model provides key information to
investors. But reporting changes in the fair value of investments owned by insurance
companies (financial assets, i.e., equities or fixed maturities, as well as real estate) and
insurance liabilities in the income statement would be generally unacceptable. The
reasons are:
(i) those assets and liabilities are not held for trading purpose
(ii) the lack of well tried and harmonized methodologies to estimate the fair
value of insurance liabilities
(iii) a fair value basis accounting would introduce a rather fictitious volatility
into the financial statements
This fictitious volatility leads to a higher cost of capital putting insurance companies
at a disadvantage compared to other industries. With respect to the insurance contracts
and other instruments non traded on active market, fair value is a subjective concept
and debates are sure to ensue not only when defining the concept, but also when
applying it in practice. As well, the introduction of such a subjective notion would
jeopardize the comparability with other industries, which is one of the aims of the
accounting standardisation. When and if a full fair value model is adopted for all
activities (including insurance), we consider that a (long) transition period should be
necessary as a testing phase for preparers and auditors and as an educational phase for
users. Only a later step would have the balance sheet on a fair value basis and
Chapter 8: ConclusionNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
85
changes in fair value directly in equity (with specific consideration relating to
participating life policies earnings, which would be better presented in income
statement). In any case, net income should be presented by separating the adjustments
of fair value from the other operating components.
Instead, if the accounting for insurance contracts is to go down the fair value route it
would seem preferable to define fair value of liabilities according to a set of principles
discussed and agreed between the accounting and actuarial professions. It is suggested
possible principles could be as follows: -
(1) Assets and liabilities should be valued on a consistent basis,
(2) The rates of interest used for discounting should take into account prevailing
financial conditions. For example, if assets are available to hedge the liabilities
then the current yield on these assets should be used,
(3) The expected present value of the future payments (less future premiums)
under the insurance contract should be calculated using the company’s own
best estimate of its likely future experience. This would apply to expenses,
mortality, morbidity, longevity, lapses etc. The company should use the best
available econometric market data (e.g. for inflation) and demographic data
(e.g. for mortality, morbidity, rate of improvement of longevity) but the value
would not be based on some perceived ‘market rate’ for expenses, mortality or
morbidity since
(a) a market does not exist and
(b) it is appropriate to measure the profitability of the company concerned
and not some hypothetical ‘market’ company,
(4) It should be permitted to increase the expected present value as calculated by a
‘risk margin’ to allow for two economic facts
(a) even if the econometric and demographic parameters were correctly
estimated the payments never work out exactly as expected and
payments could be more or less depending on the actual state of the
world which transpires (i.e. there is statistical variation about the
mean) and
(b) it is not possible to estimate the value of the econometric and
demographic parameters with certainty. In addition it should be
permissible to add a shareholder ‘profit margin’ to the above value in
Chapter 8: ConclusionNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
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order to avoid an emergence of profit at the point of sale, which was
not acceptable to the accounting bodies in the country concerned. The
flexibility to include such a profit margin should facilitate the
alignment of the accounting treatment of insurance and investment
contracts,
(5) Indirect methods equivalent to the above should also be acceptable
(6) If a company was not using an embedded value method to determine profits
and balance sheet totals, the company should be permitted to publish an
embedded value each year as a note to the Accounts. The above principles
would seem to be contained within the ‘Discounting Issues Paper’ produced
by the IASC Discounting Steering Committee. It is a desirable aim that the
principles for discounting cash flows are uniform across the range of
accountancy applications.
8.4 Insurance Policy
The principle in accounting for a policy, whether life or general, with a duration of
more than one year, all expected cash flows for the remaining period of the contract
should be taken into account in valuing the liability. However, in respect to
recognition of profit at inception of a contract, the Steering Committee needs to
consider whether the recognition of profit arising from cash flows in periods covered
by future renewal premiums is consistent with the principles on the recognition of
contingent assets in IAS 37 and the surrender value floor for life insurance business. It
is not appropriate to take profits at inception on such long term general insurance
contracts as there is normally a contractual obligation for the policyholder to pay
future premiums, but this is not an enforceable obligation as the policyholder can
cancel the policy.
The asset or liability model provides a good starting point for developing accounting
standards. This does not preclude the incorporation of the technique of accrual and
deferral accounting where these techniques may help in measuring a meaningful
figure of income from operations for a period. The IASC needs to ensure that there is
no inconsistency between the requirements of the insurance standard, IAS 1 (accruals
and matching concept) and the principles of revenue recognition in IAS 18. It may
Chapter 8: ConclusionNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
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possible to develop a set of principles to apply the asset or liability model, which
recognises some of the earning process principles, included in other IASC standards.
8.4.1 Life Insurance
The conclusion reached by the Steering Committee and the prospective approach to
the valuation of liabilities is supported. But they have the following observations
under and asset or liability model:
a) The conclusion that the insurance contract as a whole can result in the
recognition of a net asset arising from future cash flows are nor agreed. The
net asset arises in cases where future premiums exceed claims and expenses. If
the Steering Committee has decided that future premiums cannot be
recognized as an asset because the insurer does not have control, it is therefore
inappropriate to recognise the asset.
b) It is not clear whether the surrender value floor is applied on a contract-by-
contract basis or a portfolio basis. Therefore the portfolio approach should be
adopted.
c) In certain circumstances, particularly where a company has incurred high
front-end acquisition costs, the proposed asset and liability approach will lead
to the recognition of losses in the early years of the contract. It is clearly
undesirable to report losses on contracts that are expected to be profitable.
--END--
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APPENDICES
AppendixNew International Accounting Standard of Insurance Industry
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Appendix A1
The disclosures required by IAS 39 are:
The following should be included in the disclosures of the enterprise’s accounting
policies as part of the disclosure required by IAS 32:
(a) the methods and significant assumptions applied in estimating fair values of
financial assets and financial liabilities that are carried at fair value, separately for
significant classes of financial assets;
(b) whether gains and losses arising from changes in the fair value of those financial
assets and financial liabilities that are measured at fair value subsequent to initial
recognition, other than those held for trading, are included in net profit or loss for the
period or are recognised directly in equity until the financial asset is disposed of or the
liability is extinguished; and
(c) for each of the four categories of financial assets defined, whether ‘regular way’
purchases of financial assets are accounted for at trade date or settlement date.
In applying paragraph 167(a), disclosure would include prepayment rates, rates of
estimated credit losses, and interest or discount rates.
Financial statements should include all of the following additional disclosures relating
to hedging:
(a) describe the enterprise’s financial risk management objectives and policies,
including its policy for hedging each major type of forecasted transaction;
For example, in the case of hedges of risks relating to future sales, that description
indicates the nature of the risks being hedged, approximately how many months or
years of expected future sales have been hedged, and the approximate percentage of
sales in those future months or years;
(b) disclose the following separately for designated fair value hedges, cash flow
hedges, and hedges of a net investment in a foreign entity:
(i) a description of the hedge;
(ii) a description of the financial instruments designated as hedging instruments for
the hedge and their fair values at the balance sheet date;
(iii) the nature of the risks being hedged; and
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(iv) for hedges of forecasted transactions, the periods in which the forecasted
transactions are expected to occur, when they are expected to enter into the
determination of net profit or loss, and a description of any forecasted transaction for
which hedge accounting had previously been used but that is no longer expected to
occur; and
(c) if a gain or loss on derivative and non-derivative financial assets and liabilities
designated as hedging instruments in cash flow hedges has been recognised directly in
equity, through the statement of changes in equity, disclose:
(i) the amount that was so recognised in equity during the current period;
(ii) the amount that was removed from equity and reported in net profit or loss for the
period; and
(iii) the amount that was removed from equity and added to the initial measurement of
the acquisition cost or other carrying amount of the asset or liability in a hedged
forecasted transaction during the current period.
Financial statements should include all of the following additional disclosures relating
to financial instruments:
(a) if a gain or loss from remeasuring available-for-sale financial assets to fair value
(other than assets relating to hedges) has been recognised directly in equity, through
the statement of changes in equity, disclose:
(i) the amount that was so recognised in equity during the current period; and
(ii) the amount that was removed from equity and reported in net profit or loss for the
period;
(b) if the presumption that fair value can be reliably measured for all financial assets
that are available for sale or held for trading has been overcome and the enterprise is,
therefore, measuring any such financial assets at amortised cost, disclose that fact
together with a description of the financial assets, their carrying amount, an
explanation of why fair value cannot be reliably measured, and, if possible, the range
of estimates within which fair value is highly likely to lie. Further, if financial assets
whose fair value previously could not be measured reliably are sold, that fact, the
carrying amount of such financial assets at the time of sale, and the amount of gain or
loss recognised should be disclosed;
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(c) disclose significant items of income, expense, and gains and losses resulting from
financial assets and financial liabilities, whether included in net profit or loss or as a
separate component of equity.
For this purpose:
(i) total interest income and total interest expense (both on a historical cost basis)
should be disclosed separately;
(ii) with respect to available-for-sale financial assets that are adjusted to fair value
after initial acquisition, total gains and losses from derecognition of such financial
assets included in net profit or loss for the period should be reported separately from
total gains and losses from fair value adjustments of recognised assets and liabilities
included in net profit or loss for the period (a similar split of ‘realised’ versus
‘unrealised’ gains and losses with respect to financial assets and liabilities held for
trading is not required);
(iii) the enterprise should disclose the amount of interest income that has been accrued
on impaired loans and that has not yet been received in cash;
(d) if the enterprise has entered into a securitisation or repurchase agreement, disclose,
separately for such transactions occurring in the current financial reporting period and
for remaining retained interests from transactions occurring in prior financial
reporting periods:
(i) the nature and extent of such transactions, including a description of any collateral
and quantitative information about the key assumptions used in calculating the fair
values of new and retained interests;
(ii) whether the financial assets have been derecognised;
(e) if the enterprise has reclassified a financial asset as one required to be reported at
amortised cost rather than at fair value, disclose the reason for that reclassification;
and
(f) disclose the nature and amount of any impairment loss or reversal of an
impairment loss recognised for a financial asset, separately for each significant class
of financial asset.
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Appendix E1
The simplest form of prospective life insurance model builds on the assumptions just
described to compute the present values of individual inflows and outflows, as shown
below.
Projected asset earning rate 7.00%
Present value of gross premiums 92,882 100.00%
Present value of death & surrender benefits (55,049) -59.27%
Present value of costs & expenses (21,228) -22.85%
Present value of net income 16,605 17.88%
Appendix E1 – Prospective Computations
Appendix E2
The amounts derived in Appendix E1 are then applied to compute a liability for
policyholder benefits, as shown below. This approach is familiar to most accountants and
actuaries refer to this computation as a retrospective computation of the liability.
dr. (cr.)
Year 1 Year2
Premiums received 14,000 11,194
Beginning balance - (8,458)
Addition to liability -59.27% of premiums (8,298) (6,635)
(8,298) (15,093)
Interest at 7.00% (581) (1,057)
Benefits paid Surrenders - 716
Deaths 400 400
Processing 21 10
Ending balance (to balance sheet) (8,458) (15,024)
Appendix E2 – Benefit Computation
AppendixNew International Accounting Standard of Insurance Industry
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Appendix E3
Alternatively, the liability can be computed using the approach below and this approach
is perhaps more familiar to most actuaries.
dr. (cr.)
Year 1 Year 2
Present value of remaining premiums 84,404 78,334
Times percentage needed to fund benefits 59.27% 59.27%
50,026 46,429
Present value of remaining benefits (58,482) (61,449)
Liability balance (8,456) (15,020)
Appendix E3 – Benefit Computation
Appendix E4
If the insurer recognises acquisition costs as an asset, the same techniques can be used to
amortise that asset over the life of the book, as shown below:
dr. (cr.)
Year 1 Year 2
Premiums received 14,000 11,194
Beginning balance - 9,713
Costs incurred Commissions 7,000 560
Other 1st year 4,388 -
Recurring expenses 889 711
Amortisation -22.85% of premiums (3,199) (2,558)
9,078 8,426
Interest at 7.00% 635 590
Ending balance (to balance sheet) 9,713 9,016
Appendix E4 – Amortisation of Acquisition Costs
AppendixNew International Accounting Standard of Insurance Industry
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Appendix E5
Appendix E5 shows the computation of the benefit liability using a policyholder-deposit
method.
dr. (cr.)
Year 1 Year 2
Beginning balance - (8,391)
Premiums received (14,000) (11,194)
Amounts assessed against policyholders
Mortality charges 1,730 1,504
Contract maintenance 2,370 1,895
(9,900) (16,186)
Interest at the credit rate of 6.00% (594) (971)
(10,494) (17,157)
Contract balances of policyholders
deceased during the period 4 9
Contract balances of policies
surrendered during the period 2,099 2,060
Ending balance (8,391) (15,088)
Appendix E5 – Policyholder Deposit Computations
AppendixNew International Accounting Standard of Insurance Industry
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Appendix E6
A policyholder-deposit approach requires a different approach to amortising deferred
acquisition costs. Because the approach looks to contract margins as the source of
earnings, deferred acquisition costs are amortised based on present value of estimated
margins, as shown in Appendix E6 and E7.
Present value (at credited rate of 6%) of:
Charges for early surrender (4,862)
Mortality assessments (16,548)
Mortality benefits paid
in excess of contract balances 6,605
Contract maintenance assessments (15,831)
Recurring contract expenses 10,679
Investment income related to policy balances (59,556)
Interest credited to policyholders 51,048
Present value of gross profits (28,465)
Present value of capitalized acquisition costs 10,688
Amortisation costs -37.548%
Appendix E6 – Policyholder-deposit Approach,
Computation of Amortisation Factor
AppendixNew International Accounting Standard of Insurance Industry
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Appendix E7
dr. (cr.)
Year 1 Year 2
Beginning balance - 9,717
Nonrecurring costs incurred 10,688 -
10,688 9,717
Interest at 6.00% 641 583
(a) 11,329 10,300
Gross profits 4,292 3,233
times amortization factor -37.55% -37.55%
(b) 1,612 1,214
Ending balance, (a) + (b) 9,717 9,086
Appendix E7 – Policyholder-deposit Approach,
Amortisation of Deferred Acquisition Costs
ReferencesNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
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References
1) The International Accounting Standards Board Draft Insurance Paper, (Chapter 2
- Overall Approach, Recognition and Derecognition), Page 3-8, 11-16-2001
2) Deloitte Touche Tohmatsu. (Future International Accounting Standard on
Insurance Contracts), Page 8-17,2001
3) Michel Abbink and Matt Saker, (Getting to grips with fair value), The Staple Inn
Actuarial Society, Page 7-56, 5-30-2002
4) The International Accounting Standards Board Draft Insurance Paper, (Chapter 3
- Overall view), Page 2-22, 11-16-2001
5) The International Accounting Standards Board Insurance Paper, (Introduction),
Page: 1-35, 2001
6) Basel Committee On Banking, (Report to G7 Finance Ministers and Central Bank
Governors on International Accounting Standards), Page 1-39, 4/2000
7) The International Accounting Standards Board Insurance Paper, (Fair Value
Issue), Page: 146-177, 2001
8) Casualty Actuarial Task Force on Fair Value Liabilities, (Cas Task Force on Fair
Value Liabilities White Paper on Fair Valuing Property/Casualty Insurance
Liabilities), Page 1-70, 2000
9) The International Accounting Standards Board Insurance Paper, (Fair Value
Issue, Appendix), Page: 1-37, 2001
10) The International Accounting Standards Board Draft Insurance Paper, (Chapter 4
– Estimating the Amount and Timing of Cash flows), Page 1-52, 12-07-2001
11) Peter Duran, Mark Freedman, and Emma McWilliam, (IAS: Some Pain, Much
Gain for Insurers), Ernst and Young, Page 1-4, 2001
12) The International Accounting Standards Board Draft Insurance Paper, (Chapter 6
– Discount rate), Page 1-7, 12-07-2001
13) The International Accounting Standards Board Draft Insurance Paper, (Chapter 2i
– Table of Overview of Different Approaches), Page 1-8, 12-07-2001
14) Investment Support Systems, Inc, (FAS 133 and IAS39 Derivative Hedge
Accounting), Page 1, 2002
ReferencesNew International Accounting Standard of Insurance Industry
City University Business SchoolMSc Insurance and Risk Management
98
15) D.O. Forfar, FFA, FSS, FIMA, CMath, Senior Lecturer in Actuarial Science,
Heriot-Watt University, Edinburgh. (Submission to Steering Committee on
Insurance of IASC, Comments on the issues Paper of Nov 1999), Page 1-11, 2000
16) The International Accounting Standards Board Comment Letter, Julian Hance,
Group Finance Director, Royal & Sun Sunalliance, (Insurance: An issues paper
issued for comment by the Steering Committee on Insurance), Page 1-9, 05-06-
2000
17) The International Accounting Standards Board Comment Letter, written together
by Aegon, Allianz, Assicurazion Generali, AXA, Fortis, ING groep, Munich
Reinsurance, Swiss Life, Swiss Re, (Observations on the Document: 'Insurance-
Issues paper' of the IASC), Page 1-15, 31-05-2000
18) The International Accounting Standards Board Comment Letter, D R Leighton,
Head of Legal & Fiscal Affairs Association of British Insurers, (Response to the
IASC Issues paper on Insurance Accounting), Page 1-3, 10-06-2000
19) The International Accounting Standards Board Comment Letter, KPMG, (IASC
Insurance - Issues paper), Page 1-2, 13-06-2000
20) The International Accounting Standards Board Comment Letter, Dr Richard
Macve, FCA, Professor of Accounting LSE, (Insurance Issues Paper, November
1999), Page 3-34, 26-05-2000
Recommended