The International Accounting Standards Board is in the process of issuing IFRS 4 Insurance Contracts Peter Clark explains the implications for the insurance market.
Before IFRS 4, there was no International Financial Reporting Standard (IFRS) on insurance contracts, and such contracts were excluded from the scope of existing IFRSs that would otherwise be relevant (IFRSs on provisions, financial instruments, intangible assets). In addition, accounting practices for insurance contracts have been diverse and have often differed from practices in other sectors. The International Accounting Standards Board (IASB)'s project on insurance contracts is intended to fill these gaps.Because many entities will be required to adopt IFRSs in 2005, the IASB split the project into two phases. The board will complete phase I when it issues IFRS 4 this spring. Entities reporting under IFRSs should apply IFRS 4 for annual periods beginning on or after 1 January 2005, but earlier application is encouraged.The objectives of IFRS 4 are:- to make limited improvements to accounting for insurance contracts until the board completes phase II; and- to require any entity issuing insurance contracts to disclose information about those contracts. For ease of reference, IFRS 4 describes any entity that issues an insurance contract as an insurer, whether or not the issuer is regarded as an insurer for legal or supervisory purposes.
ScopeIFRS 4 will apply to all insurance and reinsurance contracts that an entity issues and to reinsurance contracts that it holds, except for specified contracts covered by other IFRSs. It will not apply to other assets and liabilities of an insurer, such as financial assets and financial liabilities within the scope of IAS 39 Financial Instruments: Recognition and Measurement. Furthermore, it will not address accounting by policyholders.IFRS 4 defines an insurance contract as: "A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder."Many insurers and reinsurers issue contracts that have the legal form of an insurance contract but do not transfer significant insurance risk to the issuer, and hence do not meet the definition of an insurance contract.A reinsurance contract is a type of insurance contract. Accordingly, all references in IFRS 4 to insurance contracts will also apply to reinsurance contracts.
Limited improvementsThe board wished to avoid compelling the many insurers adopting IFRSs in 2005 to make changes then that could become obsolete in phase II. Therefore, IFRS 4 will:- create a temporary exemption from the hierarchy in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors that specifies the criteria an entity uses in developing an accounting policy if no IFRS applies specifically to an item;- limit the impact of that exemption from the hierarchy by specific requirements summarised below; and- permit some existing practices to continue but prohibit their introduction.The temporary exemption means that insurers need not apply the criteria in IAS 8 to their accounting policies for insurance and reinsurance contracts.An exemption from these criteria, which include relevance and reliability, is highly unusual and the board contemplated it only as part of an orderly and relatively fast transition to phase II. The exemption applies to insurers, but not to policyholders.To limit the effect of that exemption, IFRS 4 will:- prohibit provisions for possible claims under contracts if the contracts are not in existence at the reporting date (such as catastrophe and equalisation provisions);- require a test for the adequacy of recognised insurance liabilities and an impairment test for reinsurance assets; and- require an insurer to keep insurance liabilities in its balance sheet until they are discharged or cancelled, or expire, and to present insurance liabilities without offsetting them against related reinsurance assets.
Accounting policiesIFRS 4 will permit an insurer to change its accounting policies for insurance contracts only if, as a result, its financial statements present information that is more relevant and no less reliable, or more reliable and no less relevant. In particular, an insurer cannot introduce any of the following practices, although it may continue using accounting policies that involve them:- measuring insurance liabilities on an undiscounted basis;- measuring contractual rights to future investment management fees at an amount that exceeds their fair value as implied by a comparison with current fees charged by other market participants for similar services; and- using non-uniform accounting policies for the insurance liabilities of subsidiaries.IFRS 4 will permit the introduction of an accounting policy that involves remeasuring designated insurance liabilities consistently in each period to reflect current market interest rates (and, if the insurer so elects, other current estimates and assumptions). Without this permission, an insurer would have been required to apply the change in accounting policies consistently to all similar liabilities.An insurer need not change its accounting policies for insurance contracts to eliminate excessive prudence. However, if an insurer already measures its insurance contracts with sufficient prudence, IFRS 4 will not permit it to introduce additional prudence.There is a rebuttable presumption that an insurer's financial statements will become less relevant and reliable if it introduces an accounting policy that reflects future investment margins in the measurement of insurance contracts (for example, by using an asset-based discount rate). When an insurer changes its accounting policies for insurance liabilities, it may reclassify some or all financial assets into the category of financial assets that are measured at fair value, with changes in fair value recognised in profit or loss.
Other pointsIFRS 4 will also:- require an insurer to unbundle (i.e. account separately for) deposit components of some insurance contracts, to avoid the omission of assets and liabilities from its balance sheet;- clarify the applicability of the practice sometimes known as 'shadow accounting';- permit an expanded presentation for insurance contracts acquired in a business combination or portfolio transfer; and- address limited aspects of discretionary participation features (for example, with-profits features) contained in insurance contracts or financial instruments.
Embedded derivativesIAS 39 requires an entity to separate some embedded derivatives from their host contract, measure them at fair value and include changes in their fair value in profit or loss. This requirement still applies to a derivative embedded in an insurance contract, unless the embedded derivative:- meets the definition of an insurance contract within the scope of ED 5; or- is an option to surrender an insurance contract for a fixed amount (or for an amount based on a fixed amount and an interest rate).However, an insurer must still separate, and measure at fair value:- a put option or cash surrender option embedded in an insurance contract if the surrender value varies in response to the change in an equity or commodity price or index; and- an option to surrender a financial instrument that is not an insurance contract.IFRS 4 will require disclosure to help users understand:- the amounts in the insurer's financial statements that arise from insurance contracts; and- the amount, timing and uncertainty of future cash flows from insurance contracts.Phase I was a stepping stone to phase II, rather than a separate project in its own right. The board intends to resume work on phase II in May 2004.
Implications of IFRS 4 for reinsuranceA reinsurance contract is an insurance contract (as defined in IFRS 4) issued by one insurer (the reinsurer) to compensate another insurer (the cedant) for losses on one or more contracts issued by the cedant.Some financial reinsurance contracts do not meet the definition of an insurance contract, but are financial instruments within the scope of IAS 39.Some financial reinsurance contracts contain deposit components that must be unbundled, with IAS 39 applied to the deposit component.Some reinsurance contracts contain embedded derivatives that must be reported at fair value to comply with IAS 39.A cedant must disclose information about gains and losses arising when it buys reinsurance.Reinsurance assets (i.e. the cedant's rights under the reinsurance contract) must be reported as assets, not offset against the cedant's liabilities under the related direct insurance contracts.Reinsurance assets must be tested for impairment (e.g. because of credit risk or disputes).Source: IASB
Implications of IFRS 4 for captivesContracts between a captive and other entities in the same group are reported in the individual financial statements of the captive and of the other entities.Contracts between a captive and other entities in the same group are eliminated from the group's consolidated financial statements. From the group's perspective, these contracts do not create assets or liabilities.Contracts between a captive and third parties are reported in both the captive's own financial statements and the consolidated financial statements of its group.Source: IASB
IASB and IFRSsThe International Accounting Standards Board (IASB) is an independent, privately-funded accounting standard setter based in London, UK. Board members come from nine countries and have a variety of functional backgrounds.The board is committed to developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. In addition, the board cooperates with national accounting standard setters to achieve convergence in accounting standards around the world.The IASB's standards are known as International Financial Reporting Standards (IFRSs) and also include International Accounting Standards (IASs) issued by its predecessor organisation, the IASC.Source: IASB.