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The Actuary The magazine of the Institute & Faculty of Actuaries

Accounting for insurance contracts: phase 1

In June this year the EU mandated that all listed companies must report under international accounting standards (IAS) for financial years beginning on or after 1 January 2005. This article summarises the background to this 2005 deadline, and its implications for insurance companies.

Current legislation
The EU mandate has been passed directly into UK law, and so IAS will apply to all UK listed companies. Under current legislation, unlisted UK companies will still report under UK generally accepted accounting principles (UK GAAP). However, the Accounting Standards Board (ASB) has already announced that UK GAAP should converge as much as possible towards IAS in the period up to 2005 and has issued a number of FREDs (financial reporting exposure drafts) in recent months to start this process. As discussed below, it is possible that some of the key standards will be incorporated into UK GAAP before 2005.
Under the proposals for the first time application of international financial reporting standards (IFRS), this means that all listed companies will require an opening IFRS balance sheet as at 31 December 2003. IAS may be coming earlier than you expected!

IASB adopts two-phase approach for insurance contracts
The IAS Board (IASB) is currently devoting considerable resources to the development of a full accounting standard for insurance contracts. The current proposals are set out in the draft statement of principles, but these have proved to be controversial and the industry has successfully lobbied for a delay. The timetable for the release of a final standard hence remains uncertain, and the IASB has acknowledged that the final standard is unlikely to be released in time for adoption and full implementation by 2005.
Therefore, in May 2002 the IASB announced a two-phase implementation. The first phase will develop an interim standard for 2005 and will involve the following:
– Presentation and disclosure for insurance companies, which may result in increased information which would be ‘useful to a wide range of users in making economic decisions’.
– The application of IAS39 Financial Instruments: Recognition and Measurement to some contracts issued by insurers that do not qualify as insurance contracts for accounting purposes.
– The elimination of a limited number of existing practices that are incompatible with the IASB Framework, for example the elimination of catastrophe and equalisation provisions that do not meet the definition of liabilities.
– Consideration of the extent to which insurance companies should take account of other pronouncements and guidance in the absence of an IFRS for insurance contracts.
One of the objectives of phase I is to accelerate those parts of the project that will be needed for phase II but which can be put in place by 2005. The IASB expects to release an exposure draft of the phase I implications in the first quarter 2003. Phase II, which will be the full recognition and measurement standard for insurance contracts, is not likely to come into force until 2007 or later, although the opening balances required will mean that the impact of phase II will be felt earlier than that.
It would be nice to think that phase I should not result in wholesale changes. Unfortunately, the application of the current IAS in 2005 could, in practice, result in significant changes in accounting for insurance contracts unless further guidance or clarification is provided by the IASB.

How have European insurers reacted?
The European Insurance Group (EIG), which is a group of 15 major insurers, issued a letter in September 2002 setting out its views on phase I. Its overriding belief is that any changes required to insurance contracts accounting should only be those that would also be required to be implemented in phase II. In this letter the group outlined what it would wish to disclose within the financial statements, and gave its view of the key issues surrounding the accounting for insurance contracts in 2005.

What is likely to be in place in 2005?
The key standards that insurance companies will need to implement in 2005 will be IAS32: Financial Instruments: Disclosure and Presentation, and IAS39. In the UK, FRED30 Financial Instruments: Disclosure and Presentation; Recognition and Measurement has been released and is largely equivalent to IAS32 and IAS39. This proposes that new rules apply to all UK companies to accounting period beginning on or after 1 January 2004 rather than 2005! Luckily, most practitioners recognise that this is impractical, and lobbying of the ASB has already started.
These standards will affect the way that insurance companies value their assets and liabilities.
Assets will need to be categorised into one of four classes. This categorisation affects how assets are shown on the balance sheet and in the income statement. If a debt instrument such as a bond is classified as ‘held-to-maturity’ or as an ‘originated loan’, they will be measured at ‘amortised cost’, which broadly means that the premium or discount paid, relative to the redemption amount, is spread over the lifetime of the debt. These categories are quite restrictive, and it is expected that the majority of bonds held by insurers will not meet the definition. Assets considered to be ‘held for trading’ or ‘available for sale’ will be counted on the balance sheet at fair value, which is broadly the market value for quoted assets. Most insurers’ assets are hence likely to be shown at market value. The EIG has asked for certain relaxations and exemptions from the rules by which members of the group need to classify their assets in order that they can be treated in a manner consistent with the liabilities.
On the other hand, there is more uncertainty on how insurance liabilities will be valued. The current requirement is to classify insurance contracts into two groups: those that will need to be accounted under IAS39 and those that will not. The EIG has stated that it would wish to avoid this classification and continue to account for all contracts issued by insurers under local GAAP. The extent to which this is adopted will be debated vigorously in the next few months.

What does local GAAP mean in the UK context?
If local GAAP is adopted for some or all of the contracts issued by insurers then, in the UK, this method could be based on the modified statutory basis with certain adjustments. The adjustments required depend on whether certain accounting liabilities and assets can be recognised.
For example, it is unclear whether a deferred acquisition cost asset can be recognised under IAS, although the IASB appeared to indicate in September 2002 that such an asset can be recognised, provided it is not impaired. Furthermore, as stated above, certain provisions such as catastrophe and equalisation reserves are deemed to be incompatible with the IAS Framework and may need to be removed.
For long-term business, the recognition of the Fund for Future Appropriation (FFA) needs to be addressed. The FFA represents surpluses for which the allocation between policyholders and shareholders has not yet been determined. This may need to split between policyholders as a liability and shareholders as part of the equity. The split could be based on ‘constructive obligations’ such as policyholders’ reasonable expectations, although the split might in turn influence those expectations.
However, reporting under local GAAP is further complicated if, for example, a subsidiary of an international company calculates local GAAP, the parent company’s consolidated GAAP and/or say an international GAAP such as US GAAP. It is not clear which GAAP should apply in this case.
A number of bancassurers currently disclose achieved profits results in the consolidated group accounts: this approach may not be permitted under IAS. However, the achieved profits results shown by some insurers in the supplementary information to the primary statement may continue to be disclosed in the interim period.

The disclosures that are likely to be needed for insurance business could be enhanced as part of phase I. For example, more disclosure about risk management procedures, sensitivity analysis, and key performance indicators could be required.

Impact studies
Many insurers have recognised that IAS is not just a reporting issue but could fundamentally affect the way that they do business. They have now begun projects to understand the impact of IAS on all aspects such as their earnings, competitive position, products pricing, and asset and liability management. These projects will normally consider the systems and resource implications of implementing IAS and will draw up detailed plans to meet the phase I and phase II deadlines.

IAS just around the corner
Applying IAS in 2005 is likely to lead to a number of significant accounting changes, and the proposal to change UK GAAP suggests that all UK companies will be affected. The insurance industry, accounting, and actuarial professions are working with the IASB and ASB to push for the changes required. As many of these changes will require opening balances at the end of 2003, it is important that actuaries keep abreast of the changes and assess the impact on their reported results.