Insurance Accounting Newsletter - Issue 18 (Feb-11) - Gearing Up For The Last Mile

The five months since our last Insurance Accounting Newsletter mostly coincided with the comment period on the International Accounting Standard Board (IASB) Exposure Draft (ED) on the new International Financial Reporting Standard (IFRS) for Insurance Contracts. At the end of this period the IASB received over 250 comment letters from insurance companies, accounting and actuarial firms, insurance and security regulators and several other stakeholders around the world.

In parallel with the IASB comment period, the US Financial Accounting Standard Board (FASB) published the ED under the cover of a FASB Discussion Paper (FASB DP) which attracted an additional 74 comment letters from a similarly extensive range of US stakeholders.

The IASB and FASB (the Boards) followed the closure of the comment period with a series of roundtable meetings to talk directly to their constituents and engage them openly on the more salient comments that had been raised in the voluminous feedback received. These roundtables were held in Tokyo (9 December), London (16 December) and Norwalk, US (20 December) with a common agenda focussed on six topics which encapsulate the key issues on the road to the finalisation of the new IFRS and a potentially convergent new US accounting standard.

We use these topics to brief readers on the outcome of the roundtables and other recent associated events described below.

As they completed their roundtables, the Boards also held a joint meeting in London to discuss the insurance contract project on 15 December 2010. At this meeting the Boards approved their plan for delivering a new IFRS and a US GAAP exposure draft with an ambitious 30 June 2011 target completion date. This meeting was followed by three additional joint sessions on 18 and 19 January and 2 February 2011.

At these meetings the Boards also received reports from their Staff on the outreach activity they carried out during the four-month long comment period (15 December meeting) and on the key themes emerging from the comment letters and roundtables (18 January meeting). The Boards received on 19 January three external presentations on "top down" methods to select discount rates for non-participating insurance contracts and discussed the issue of acquisition costs at their 2 February meeting. Some key joint tentative decisions were made at the last of these meetings.

We also observed two brief FASB only meetings on 3 and 9 February when a fourth external presentation on discount rates was delivered followed by a key strategic discussion on the approach that FASB will take on this project. At their 9 February meeting the FASB voted in favour of working with the IASB to converge US GAAP with the new IFRS. This option, defined as the "overhaul or convergence" was selected over the options of "no change" and "tweaks".

Topic 1 – Volatility and discount rates

This topic dominated the debate at each roundtable and came across as the biggest issue raised in the majority of comment letters.

The issue stems from the ED requirement to reflect the time value of money in the accounting for all insurance contracts using a discount rate that is determined from market interest rates matching the characteristics of the estimated insurance cash flows. The ED explains that, unless the cash flows are affected by the value of the assets backing the insurance contracts, the discount rate is built using risk free market rates adjusted with a market consistent illiquidity premium. This approach has been referred to by the Staff as a "bottom up" approach.

The roundtables and the comment letters noted that insurers would invariably experience a volatility in their accounting results when this measurement basis is used in conjunction with that available under the recently finalised IFRS 9 pronouncement for debt instruments.

When an insurer accounts for its investments in debt instruments at amortised cost, volatility would follow from the mismatch between constant investment incomes from the cost-accounted assets against a fluctuating interest expense from the current-accounted liabilities caused by the use of current market risk free interest rates. Some observers define this instance the "cost-current volatility".

An equally volatile result would be reported if the insurer had fair valued through income its investments in bonds. Insurers' holdings in corporate bonds would expose their reported profits to the short term volatility of credit spreads without a compensating impact on the liabilities' interest expense based on risk free interest rates. This has been defined as the "current-current volatility".

Respondents to the ED and roundtable participants demanded an alignment of accounting models between assets and liabilities with a number of solutions being proposed.

One proposal recommended an alignment of the ED to IFRS 9 by introducing a locked in discount rate that would mirror the amortised cost model on the asset side. Proponents of this approach noted that the other building blocks would remain on a current basis (probability weighted cash flows estimate and the risk adjustment – for those who supported this latter approach over the composite margin model) thus mitigating any need for liability adequacy testing. The views on how the locked in discount rate should be determined varied, with suggestions including the use of a common reference rate or to use the same "bottom up" basis set out in the ED as determined on initial recognition of the insurance contract.

A second group of solutions recommended the simplification of the ED using a prescribed reference discount rate for all non participating insurance contracts. The reference to a high quality corporate bond rate currently used to discount pension liabilities was the most frequent choice of the proponents in this group. This approach would have the benefits of practical implementation and would deliver a highly consistent measure of time value of money for insurance contracts. We find interesting to note the request that Stephen Cooper, a member of IASB, put to the participants of the second London roundtable to indicate if there were any objections to a scenario where the final IFRS adopted this simplified approach to the discount rate selection. We did not record any such objections.

A third set of solutions to the issue of accounting profit volatility made reference to the use of Other Comprehensive Income (OCI) as the more appropriate location in the financial statements to display the fluctuations in market variables that cause the "currentcurrent volatility" described earlier. This "OCI solution" would require an amendment to both IFRS 9 and the new insurance contract standard because, as currently drafted, the OCI accounting for changes in assets and liabilities is prohibited in both standards, except for certain investments in equity securities. The IASB gave an indication in the roundtables that they are not considering an amendment to IFRS 9 to allow more accounting through OCI. However the overall IFRS9 model is being reassessed under the convergence discussion with FASB and we will observe in the coming weeks if this brings any change.

Another group of solutions recommended the use of a "top down" discount rate selection on the grounds it would be practical to implement and it would still be aligned to the principles of the ED. Deloitte was among these proponents (see text box). The...

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