As the EU prepares for a single accounting language, Gary Hibbett and Mukesh Mittal translate the Phase 1 Exposure Draft on Insurance Contracts.

From 2005, all EU-listed companies will report under the same accounting language, International Financial Reporting Standards (IFRS). On 31 July 2003, the International Accounting Standards Board (IASB) published its Phase 1 Exposure Draft (ED5) on Insurance Contracts. ED5 is a major step in the move to IFRS for insurers and a bridge to the final Phase II Standard, which is expected in the next 18 months. Phase I is set to run until 2007, at which time Phase II will become effective.

Contract classificationThe IASB essentially treats reinsurance business in the same way as direct written business. However, the key concern will be distinguishing between insurance and non-insurance contracts. ED5 defines 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."

For insurance risk to be "significant", it must be "plausible that an insured event would cause a significant adverse change in the present value of the insurer's net cash flows arising from that contract." No clear quantitative guidance is given, so this definition is open to interpretation.

The insurance contract classification will probably cover most traditional reinsurance contracts and a large proportion of direct business. However, some financial reinsurance and direct savings and investment plans will be designated as financial instruments (investment contracts), even though they may take the legal form of insurance.

Modern hybrid contracts such as weather derivatives, credit derivatives and catastrophe bonds do not fit cleanly into either classification. Companies will need to examine the terms and characteristics of their contracts to establish whether the risks are predominantly insurance or almost entirely financial. A key determinant will be whether triggering events under the contract necessarily cause the `insured' party to suffer a loss.

Deconstructing the contractEven once the contract has been classified, it may need to be split further. ED5 requires certain deposit components to be separated from the remainder of the (insurance) contract. The insurer would be required to recognise obligations to repay amounts received (or rights to recover amounts) under the deposit component, whereas under existing accounting treatment they may not. This could reduce the attractiveness of certain types of financial reinsurance contracts.

In addition, certain derivative features `embedded' into an insurance contract may have to be split from the contract and accounted for separately. Such features must be fair valued and any changes in this fair value counted towards profit or loss.

Accounting methodProfit recognition for some types of business will change markedly. For policies meeting the definition of an insurance contract, companies can continue to use their existing accounting procedures to measure liabilities and report cash flows during Phase I.

However, contracts classified as investment contracts will be subject to IAS 39, under which companies must choose at outset whether to measure financial liabilities at amortised cost or to fair value them. It is not clear how these liabilities will be measured and which margins and costs will be reflected in the income statement. Premiums and claims will be treated as deposits rather than revenue and taken straight to the balance sheet, which could significantly change the apparent revenue generated.

ED5 also includes a number of "improvements to existing practices" as a bridge to the implementation of Phase II. Catastrophe and equalisation provisions can no longer be recognised. Some restrictions are also introduced on accounting for reinsurance:

  • cedants must not change their measurement basis for direct liabilities - for example, from an undiscounted to a discounted basis - when buying reinsurance; and
  • if the amount paid by the cedant is less than the related liability it holds, the gain must be deferred and recognised over the lifetime of the reinsurance treaty. This could be an important change in the way reinsurance is accounted.
  • DisclosureThe IASB has published very detailed implementation guidance on quantitative and qualitative disclosures. Much thought and effort will be needed to provide the required high standards of detailed information about the insurance and financial risks being run across the whole business and procedures in place to mitigate them.

    The IASB has requested the disclosure of the fair value of assets and liabilities in 2006. It is difficult to understand how this can be achieved when it has not yet defined what it means by the "fair value" for insurance contracts.

    The publication of ED5 gives a clearer view of the reporting requirements for insurance contracts from 2005 as a bridge to Phase II. Reinsurers will not only need to start implementing IFRS and consider how it affects their financial statements, but also how it affects their clients and the type of business that they write in future.

    Gary Hibbett and Mukesh Mittal are principal consultants in the actuarial and insurance management solutions practice at PricewaterhouseCoopers.