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The Actuary The magazine of the Institute & Faculty of Actuaries

Accounting for insurance contracts

From 2005, all EU-listed companies will report under the same accounting system, defined by international financial reporting standards (IFRS). This is more than just a technical matter: if the current proposals prevail, the implementation of IFRS will lead to fundamental changes in the insurance industry.
On 31 July 2003, the International Accounting Standards Board (IASB) published its phase 1 exposure draft on insurance contracts, ED5. This is the first stage of the move to IFRS for insurers, and a bridge to the final phase II standard, which is expected to be published in the next 18 months. There is a three-month consultation period on ED5; insurers have an important opportunity to comment on the proposals (see timeline in figure 1).

Contract classification
The IASB has defined an insurance contract as ‘one under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary’. This new classification makes a clear distinction between insurance risk, which is linked to an uncertain (insurable) event, and financial risk, which relates to routine movements in market indices such as interest rates or equity values.
The definition of an insurance contract requires the insurance risk to be ‘significant’. This criterion is met if, and only if, it is plausible that an insured event would cause a significant adverse change in the present value of the insurer’s net cashflows arising from that contract, tested on a contract-by-contract basis. However no guidance is given on the amount of the change in present value required to meet the criteria. This does imply, though, that if there is no credible chance of an event happening then it cannot be significant.
It is likely that the insurance contract classification will cover motor, travel, life, annuity, medical, property, reinsurance, and professional indemnity insurance. However, some savings, pensions and other investment plans will be designated as financial instruments (referred to as ‘investment contracts’), as they transfer no significant insurance risk even though they may take the legal form of insurance. Similarly, certain administration contracts operated by insurers that do not transfer insurance risk (for example, because of the use of claims-based rebates) will need to be accounted under IAS18, the standard that covers service contracts.
Many of today’s hybrid and customised products occupy a corridor of uncertainty between insurance, financial instruments and services. Insurers will need to examine the terms and characteristics of their contracts to establish whether the risks have a significant insurance element, or are almost totally financial. In addition, contracts will need to be examined to assess whether, as described below, they need to be unbundled or whether they contain embedded derivatives. This examination of the contracts must be well controlled and closely documented.

Deconstructing a contract
An insurance contract can include deposit, insurance and possibly derivative components, despite its overall insurance classification. ED5 clarifies that in certain circumstances, the deposit component may need to be separated from the remainder of the contract and accounted for under IAS39.
In addition, derivative features ‘embedded’ in an insurance contract, such as surrender options linked to equity indices, may need to be split out and accounted for separately. All embedded derivatives must be ‘fair-valued’, and any changes in this fair value included as profit or loss for the insurer.
It is possible that unit-linked contracts will be considered as contracts containing equity derivatives, which will either require separating out and fair-valuing, or the entire obligation under the contract will need to be fair valued. Life-contingent annuity options or guaranteed minimum death benefits would not need to be separated because, although they are acknowledged to be derivatives, they also carry significant insurance risks and meet the definition of an insurance contract.
Accounting for insurance contracts under phase 1
Companies can continue to use their existing accounting procedures to measure liabilities and report cash flows from policies meeting the insurance contract definition. Acquisition costs can still be deferred and discounting of general insurance liabilities will not be required at this stage. All this is achieved through an exemption from key passages in IAS8.
However, the IASB regards these exemptions as a temporary expedient. It has pledged to move towards phase II as quickly as possible and to remove the crucial IAS8 exemption at the start of 2007. Accordingly, companies will not be allowed to change their accounting policies between 2005 and 2007 unless this would ‘result in more relevant or reliable presentation’.
ED5 also includes a number of ‘improvements to existing practices’ designed as a bridge to the implementation of the phase II standard. Catastrophe and equalisation reserves will no longer be recognised, which may result in increased taxation if the margins cannot be reflected more directly in provisions.
Companies will also be required to test the provisions based on local GAAP against current estimates of the value of future cash flows, to ensure potential losses are recognised as soon as possible. If the loss recognition policy under UK GAAP is at least as rigorous as the IASB requirement, it is unlikely that further adjustment will be necessary.
Reinsurance contracts are essentially treated in the same way as direct written business, but will be shown separately. When a reinsurance contract is established, the insurer is not permitted at that point to take full credit in its financial statement of the resulting release of margins from its local GAAP provisions. These margins must be deferred and recognised over the lifetime of the reinsurance treaty.

Accounting for participating business
With-profits and unitised with-profits contracts granting participation rights to policyholders may continue to be valued under existing ‘local’ accounting practice for phase I. This applies to both insurance and investment contracts, although for investment contracts, ED5 has introduced a minimum liability test on the guaranteed element.
However, the fund for future appropriations cannot be recognised. It must be treated as either liability or equity, or split between the two. If split, the interaction with other forms of reporting, such as realistic balance sheets and embedded value reporting, will need to be considered carefully.

The interaction with IAS39
Investment contracts, such as some pension plans, savings contracts and some financial reinsurance treaties, will be subject to IAS39. Under IAS39, companies can choose at outset to measure financial liabilities in the balance sheet at amortised cost, or elect to fair value them. Premiums and claims will be treated as deposits rather than as revenue, and taken straight to the balance sheet. This may have considerable systems implications for insurers and will certainly significantly change the apparent revenue generated by insurers.
The proposals are that the fair value of the contract should be based on the best estimate of future cashflows, taking lapses into account. However, at this stage it is not clear which cash flows should be recognised in the calculation, and whether any cash surrender value payable should be applied as a minimum to the fair value liability.
The application of IAS39 to investment contracts in 2005 represents a major challenge for insurers, comparable to phase II, but without the extra time afforded, and without the additional principles relating to the measurement of fair value expected in phase II.
Under current proposals, the assets backing insurance contracts will be accounted for under IAS39. It is likely most assets backing insurance liabilities will be held in the balance sheet at market value. Many insurers have argued this could lead to inconsistent measurement of assets and liabilities. In the UK, we are already subject to market value of assets and we may need to move to more consistent measures for liabilities.

Enhanced disclosure
Although the accounting principles for insurance contracts will remain largely unchanged under phase I, companies will need to provide far more detailed quantitative and qualitative information about the risks they run and the procedures in place to mitigate these risks, including:
– factors affecting year-on-year movements in liabilities;
– exposures to insurance and financial risks, in particular concentrations of risk;
– sensitivity analyses to show the impact of different risk scenarios and market variables on cashflows;
– asset, liability, and risk management procedures.
The IASB has published detailed implementation guidance on disclosure. This sets a high standard, and insurers will need to think hard about how best to produce the additional information required.
Controversially, the IASB have requested the disclosure of the fair value of assets and liabilities in 2006, although they have not yet defined what they mean by the ‘fair value’ for insurance contracts! In practical terms, this means that insurers will need to keep a close eye on the development on phase II of the insurance standard and ensure they are ready to value these contracts in 2006.

Next steps
The publication of ED5 allows insurers a clearer view of the reporting requirements for insurance contracts from 2005 as a stepping stone to phase II. However, there is considerable work required under phase I and it is imperative insurers are ready in time.