The IASB’s proposed new accounting standards aim for improved consistency and transparency. However, we should expect more volatility in insurers’ results, and the market will need time to adjust to the changes to income statements

After six years and several missed deadlines, new standards for insurance contracts were proposed in July by the International Accounting Standards Board (IASB). They are expected to have a significant effect on insurers and reinsurers. The new International Financial Reporting Standards (IFRS) 4 will replace a confusion of GAAPs (generally accepted accounting principles) on all new contracts.

The latest draft of the standards requires all entities that issue contracts that contain insurance risk to use a model of the present value of expected cash flows; such flows are to be measured from the issuer’s perspective rather than a market price to determine insurance liabilities, although any market variables should be consistent with market prices.

The IASB maintains its definition of an insurance contract as “a contract under which one party accepts significant insurance risk from another party by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder”.

While the definition is unchanged, one refinement – a requirement that all cash flows used to test for a transfer of risk are discounted to reflect their present value – could negate the effectiveness of finite reinsurance contracts. Deloitte’s global IFRS insurance leader Francesco Nagari says this could affect some finite reinsurance contracts and means they could no longer be classified as reinsurance. He says: “They would be out of the accounting standard and instead would have to be accounted for as loans.”

Reinsurance contracts are subject to the same rules as general insurance contracts, but there are implications for reinsurance buyers – the only type of policyholder within the scope of the new standards. They will have to measure the asset they assume by buying reinsurance with reference to their own liabilities.

“That is going to be the only instance where the buyer of these insurance contracts will make use of this model,” Nagari says.

For insurance contracts with a duration of more than one year, the new measurement model is based on four building blocks: probability-weighted future cash flows; a separate discount to reflect the present value of future cash flows (in other words, reflect the time value of money); a risk adjustment; and a residual margin to eliminate any initial profit (see box). However, those writing only short-duration contracts are able to sidestep the building-block approach.

Nagari says: “What the IASB has done is to adopt a short-cut approach for these short-duration contracts, which is a version of the current method that is used in a number of general insurance accounting policies.”

Insurers and reinsurers are encouraged to start planning for the introduction of the new standards and to prepare management, shareholders and others for the new style of income statement.

For European companies, the standards are expected to be more in line with requirements under Solvency II. “Solvency II within the EU is based on a valuation model for insurance liabilities that is very similar to the one preferred by the IASB, and the Solvency II regulations require a reconciliation between the IFRS and the Solvency II valuations to be published every year,” Nagari says.

The aim of the standards is to make the financial reporting of insurance contracts more consistent and transparent. “Previously, insurers have been permitted to use very different methods to report insurance contracts, based on a variety of national practices,” Nagari explains. “This has reduced the comparability of insurers’ financial reports, penalising them when they accessed capital markets with a higher cost of capital than most other industries.”

According to PricewaterhouseCoopers, the proposals are likely to result in more volatility in the income statement and may also put more pressure on data and modelling systems.

“Industry reaction will be divided,” says PwC partner Gail Tucker. “They will create increased volatility in insurers’ reported results, as market movements will now affect reported profit. There will also be significant changes to the presentation of the income statement, which stakeholders will need to take time to understand. The developments will also cast their net wider than the insurance industry, affecting all companies that issue contracts with insurance risk, such as financial guarantee contracts.”

There will be a four-month comment period on the draft, which ends on 30 November. The final standard is due for publication in mid-2011. GR