Under the proposal, an insurance contract is de-fined 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 uncer-tain future event (the insured event) adversely affects the policyholder. This definition is consistent with the current definition of an insurance contract under IFRS 4.
Under the proposals, insurers should begin recognising the contract when they are bound by the coverage, which could be prior to the effective date or the date on which a contract is signed (i.e., when there is an unconditional offer extended for coverage) and may be heavily influenced by local regulatory requirements.
Classification of insurance contracts in India:
There is no specific standard for the purpose of classifying Insurance contracts under Indian GAAP. Currently, traditional, unit-linked insurance plan and pension products are sold by insurance companies and premium received on all these policies are accounted as premium income in revenue account.
This will be a significant shift in the method of accounting for premium for life insurance companies as pension products having zero death benefits will not fall under the purview of insurance contracts and have to be accounted as Investment contracts and investment component pertaining to ULIP contracts would have to be accounted separately.
However this will be a P/L neutral adjustment as currently they are adjusted as part of provision for insurance liabilities at the period end.
Measurement of insurance contracts — The building-block approach?:
The proposed model uses a building- block ap-proach to the measurement of insurance contracts The measurement model includes a ‘fulfilment’ objective which reflects the fact that an insurer generally expects to fulfil its liabilities over time by paying benefits and claims to policyholders as they become due, rather than transferring the li-abilities to a third party.
An insurer measures a contract as the sum of
the present value of the fulfilment cash flows, being the expected present value of the future cash outflows less future cash inflows that will arise as the insurer fulfils the contract, including a risk adjustment for the effects of uncertainty about the amount and timing of those future cash flows; and
a residual margin that eliminates any gain at inception of the contract. A residual margin arises when the present value of the fulfilment cash flows is less than zero. If the present value of the fulfilment cash flows at inception is positive (i.e., the expected present value of cash outflows plus the risk adjustment is greater than the expected present value of cash inflows), then this amount is immediately recognised as a loss in profit or loss.
The residual margin is determined on initial recognition at a portfolio level for contracts with a similar inception date and coverage period. This residual margin amount is ‘locked-in’ at inception. The residual margin is recognised in profit or loss over the coverage period in a systematic way that best reflects the exposure from providing insurance coverage, either on the basis of the passage of time or on the basis of the expected timing of incurred claims and benefits if that pattern differs significantly from the passage of time. Also, the insurer accretes interest on the carrying amount of the residual margin using the discount rate determined on initial recognition to reflect the time value of money.
The present value of the fulfilment cash flows contains the following ‘building blocks’ and is re-measured at each reporting period.
an explicit, unbiased and probability-weighted estimate (i.e., expected value) of the future cash outflows less the future cash inflows that will arise as the insurer fulfils the insurance contract;
a discount rate that adjusts those cash flows for the time value of money; and
a risk adjustment — an explicit estimate of the effects of uncertainty about the amount and timing of those future cash flows.
Measurement of insurance liabilities by Indian insurance companies?:
The Gross Premium Methodology for life insurance contracts is governed by the IRDA (Assets, Liabilities and Solvency Margin of Insurers), Regulations, 2000 and Guidance Notes GN1, GN2 and GN7 issued by the Institute of Actuaries of India (IAI). The regulations govern the valuation of liabilities for both non -linked and linked business with some additional requirements for linked business.
Mathematical reserves are determined separately for each contract. The valuation method primarily takes into account all prospective contingencies including cost of any options that may be available to the policyholder. The reserves have to be at least as large as any guaranteed surrender value and never less than zero.
In addition, for unit-linked business?:
The value to be placed on the unit reserve shall be the current value of the assets underlying the unit fund determined in accordance with the IRDA Regulations.
If unit liabilities are not matched, a mismatch reserve shall be created.
Separate unit and non-unit reserves shall be held. The sum of these reserves would represent the total reserve for a unit-linked policy.
The total reserve in respect of a policy shall not be less than the guaranteed surrender value on the valuation date. Neither the unit reserve nor the non-unit reserve in respect of a policy shall be negative.
- The proposed IFRS measurement model focusses on the key drivers of insurance contract profit-ability, and would provide users with a clearer insight than they gain from today’s patchwork of different models for different types of contract. The same model would apply to all insurance contracts. However a modified version would apply to short duration insurance contracts.
Insurers would present information in the financial statements that focusses on the drivers of performance, i.e.,?:
- release from risk, as the risk adjustment decreases
- what insurers expect to earn from providing insurance services
- investment returns on invested premiums, and
- the investment returns provided to policyholders (either implicitly through pricing or explicitly) differences between expected and actual cash flows and changes in estimates and the discount rate.
The current problem in cash flow estimates is that insurers use ‘locked in’ estimates which do not provide current information about insurance liabilities. However the proposed changes in ED would require changes in cash flow estimates to be reflected in profit or loss in the period in which they arise. This would enhance transparency and provide more relevant information for users.
Pre-claims liabilities for short-duration contracts (General Insurance Contracts):
The proposals contain a modified measurement approach for pre-claim liabilities of short duration contracts. This model is intended to be a proxy for the building-block measurement model in the pre-claims period. In the proposals ‘short-duration’ contracts are defined as insurance contracts with a coverage period of approximately 12 months or less that do not contain any embedded options or derivatives that significantly affect the variability of cash flows.
In this measurement approach an insurer is required to measure its pre-claims obligation at inception as premiums received at initial recognition plus the present value of future premiums within the boundary of the contract less incremental acquisition costs.
This pre-claims obligation is reduced over the coverage period in a systematic way that best reflects the exposure from providing insurance coverage, either on the basis of the passage of time or the expected timing of incurred claims and benefits if this pattern differs significantly. Pre-claims liabili-ties are the preclaims obligation less the present value of future premiums within the boundary of the contract. The insurer is also required to accrete interest on the carrying amounts of the preclaims liabilities. If the contract is onerous, the excess of the present value of the fulfilment cash flows over the carrying amount of the pre-claims obligation is recognised as an additional liability and expense.
Liabilities for claims incurred are measured at the present value of fulfilment cash flows in accor-dance with the general measurement model.
Measurement of general insurance contracts by Indian insurance companies:
For short-duration contracts the IRDA regulations specifies
- reserve for unexpired risks as a percentage of the premium, net of reinsurances, received or receivable during the preceding twelve months, and
- reserve for outstanding claims reasonably estimated according to the insurer, on a ‘case-by-case method’ after taking into account the explicit allowance for changes in the settlement pattern or average claim amounts, expenses and inflation.
The ED on insurance contract gives a comprehensive measurement model for general insurance contracts as against the existing practice currently followed.
Acquisition costs:
- Incremental acquisition costs (costs of selling, underwriting, and initiating an insurance contract that would not have been incurred if the insurer had not issued that particular contract) are included in the present value of the fulfilment cash flows of a contract. All other acquisition costs are expensed when incurred in profit or loss.
- Non-incremental acquisition costs would be recognised as an expense.
- Indian insurers recognise acquisition costs as an expense immediately. This would result smaller losses at inception than they do today.
Unbundling:
Insurance contracts may include multiple elements, such as insurance coverage, investment compo-nents and embedded derivatives i.e., insurance contracts contain one or more components that would be within the scope of another IFRS if the insurer accounted for those components as if they were separate contracts, e.g., an investment (financial) component or a service component.
If a component is not closely related to the in-surance coverage specified in a contract, the ED proposes that an insurer does unbundle and ac-count separately for that component.
This would require Indian life insurance companies to unbundle the investment component from ULIP contracts from total premium and disclose it sepa-rately since inception. Currently the deposit portion is unbundled only at the end of the reporting period by way of including them in the actuarial reserves and then disclosing them in provision for linked liabilities.
Moreover, the pension and annuity products which are having no risk cover i.e., zero death benefits would not be under the purview of insurance contracts. These would have to be accounted as investment contracts under IAS 39 and the premium received on such contracts would have to separately shown in the balance sheet.
Embedded derivatives
Under the proposals, IAS 39 applies to an embed-ded derivative in an insurance contract unless the embedded derivative itself is an insurance contract. If the economic characteristics and risks of the embedded derivative are not closely related to those of the host insurance contract, the insurer is required to separate the embedded derivative and measure it at fair value with recognition of changes in fair value in profit or loss if the embed-ded derivative meets the following criteria?:
a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host insurance contract
b) a separate instruments with the same terms as the embedded derivative would meet the definition of a derivative and be within the scope of IAS 39 (e.g., the derivative itself is not an insurance contract).
Derecognition
An insurer shall remove an insurance contract liability (or a part of an insurance contract liability) from its statement of financial position when, and only when it is extinguished, i.e., when the obligation specified in the insurance contract is discharged or cancelled or expires. At that point, the insurer is no longer at risk and is therefore no longer required to transfer any economic resources to satisfy the insurance obligations.
The insurance liability ceases as soon as the policy lapses i.e., if the premium is not honoured on the due date including grace period provided by the insurance company.
However the Indian life insurance companies carry out an analysis of lapsed unit-linked policies not likely to be revived and likely to be revived. For policies not likely to be revived, the insurance reserves are transferred to funds for future appropriation and then to the profit and loss account after a period of two years and for policies likely to be revived the insurance liabilities are still maintained though the policy has lapsed and the risk cover has expired.
It appears that the ED on insurance contracts would require the risk reserves to be derecognised as soon as the policy lapses. Only the deposit component would be maintained as a liability for such policies with corresponding investments.
Reinsurance
At initial recognition, a cedant measures reinsurance contract as the sum of:
- the present value of the fulfilment cash flows, which is made up of the expected present value of the cedant’s future cash inflows plus a risk adjustment less the expected present value of the cedant’s future cash outflows less any ceding commissions received; and
- a residual margin that eliminates any loss at inception of the contract.
The expected present value of losses from default by the reinsurer or coverage disputes are incorporated in the measurement of reinsurance assets.
The ED on insurance contract requires reinsurance assets and reinsurance liabilities to be shown separately.
However the current practice in India is that the insurance companies net-off the reinsurance receivable and payable and disclose only the net amount as receivable or payable, as the case may be.
Presentation in the statement of financial position and the statement of comprehensive income
Statement of financial position
The ED proposes that an insurer present each portfolio of insurance contracts as a single-line item within insurance contract assets or insurance contract liabilities. It also proposes that an insurer present a pool of assets underlying unit-linked contracts as a single- line item separate from the insurer’s other assets and that the portion of the liabilities linked to the pool be presented as a single-line item separate from the insurer’s other liabilities. Reinsurance assets are not offset against insurance contract liabilities.
Statement of comprehensive income
The ED proposes a presentation model that focuses on margins and other key insurance performance information. The ED proposes a new presentation for the statement of comprehensive income which follows the proposed measurement model. The underwriting margin is subject to disaggregation requirements (in the notes or on the face of the financial statements), disclosing the change in risk adjustment and release of the residual margin. The margin presentation requires insurers to treat all premiums as deposits and all claims and benefits as repayments to the policyholder. An insurer is expected to present at a minimum, the following items?:
- Change in the risk adjustments;
- The release of the residual margin during the period;
- The difference between the expected and the actual cash flows;
- Changes in estimates; and
- Interest on insurance liabilities.
Other items to be presented in the statement of comprehensive income include?: gains and losses at initial recognition (further disaggregated on the face or in the notes into losses at initial recognition of an insurance contract, losses on insurance contracts acquired in a portfolio transfer, and gains on rein-surance contracts bought by a cedant); acquisition costs that are not incremental at the level of an individual contract; experience adjustments and changes in estimates (further disaggregated on the face or in the notes into experience adjustments, changes in estimates of cash flows and discount rates, and impairment losses on reinsurance as-sets); and interest on insurance contract liabilities. Income and expense from unit-linked contracts are presented as a separate single-line item.
Premiums and claims generally are not presented in the statement of comprehensive income on the basis that they represent settlements of insurance contract assets or liabilities rather than revenues or expenses. However, for short-duration contracts subject to the alternative measurement approach for pre-claims liabilities, the underwriting margin is disaggregated into line items reflecting each of pre-mium revenues, claims and other expenses, amortisation of incremental acquisition costs and changes in additional liabilities for onerous contracts.
Presentation of insurance accounts by Indian insurance companies
The financial presentation format currently comprises the Revenue Account, Profit and Loss Account and Balance Sheet. The Revenue account contains all insurance-related captions and income earned from investments out of policyholders’ funds.?The?Profit and Loss account includes deficit funding if any, profit transfers from revenue account and investment income earned out of shareholders’ funds.
The proposed method of accounting is a complete paradigm shift as compared to the existing financial reporting model.
Disclosures:
To help users of financial statements understand the amount, timing and uncertainty of future cash flows arising from insurance contracts, extensive disclosures are required that include qualitative and quantitative information about the amounts arising from insurance contracts, including?: the reconciliation of contract balances; methods and inputs used to develop the measurements; and the nature and extent of risks arising from insurance contracts.
Currently the insurance disclosures are not very extensive for Indian insurance companies. The current actuarial disclosures merely give basic assumptions, interest rates and references to mortality and morbidity tables published by Life Insurance Corporation of India.
Effective date, transition and impact on other aspects:
The ED does not include an effective date for the proposals or state whether they may be adopted early. The IASB plans an additional consultation, in conjunction with the FASB, on the effective dates of these proposals and other proposed standards to be issued in 2011, including consideration of IFRS 9 Financial Instruments. The Board will con-sider delaying the effective date of IFRS 9 (annual periods beginning on or after 1 January 2013) if the new IFRS on insurance contracts has a mandatorily effective date later than 2013 so that an insurer would not have to face two major rounds of change in a short period.
Additionally, an insurer is exempt from disclosing previously-unpublished information about claims development that occurred earlier than five years before the end of the first financial year in which it applies the proposals. An insurer is required to disclose if it is impracticable to prepare information about claims development that occurred before the beginning of the earliest period presented.
The ED requires that an insurer should measure each portfolio of insurance contracts at the present value of the fulfilment cash flows, starting at the beginning of the earliest period presented. If there is a difference between the new measure-ment amount and the amount under the insurer’s previous accounting policies, the difference should be recognised in retained earnings.
The insurer also should derecognise any existing balances of deferred acquisition costs.
The transition requirements apply both to a first-time adopter of IFRS and to an insurer currently reporting under IFRS.
Example measurement of insurance contracts — Indian GAAP v. IFRS ED:
An insurer issues an insurance contract, receives Rs.50 as the first premium payment and incurs acquisition costs of Rs.70, of which incremental acquisition costs are Rs.40. The insurer estimates an expected present value (EPV) of subsequent premiums of Rs.950 and a risk adjustment of Rs.50. In the example the insurer estimates that the EPV of future claims is Rs.900.
Measurement under Indian GAAP
