INFORMATION FOR OBSERVERS

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30 Cannon Street, London EC4M 6XH, England International

Phone: +44 (20) 7246 6410, Fax: +44 (20) 7246 6411 Accounting Standards

Email: [email protected] Website: http://www.iasb.org.uk Board

This document is provided as a convenience to observers at IASB meetings, to assist them in following the Board’s discussion. It does not represent an official position of the IASB. Board positions are set out in Standards.

INFORMATION FOR OBSERVERS

BOARD MEETING: SEPTEMBER 2004, LONDON

PROJECT: INSURANCE CONTRACTS (PHASE II)

_________________________________________________________________________

As preliminary preparation before restarting phase II later this year, the Board will continue its discussion of general educational material on the nature of insurance contracts and current accounting models for insurance contracts. The material is attached. The same material was used for the July meeting. No decisions are expected.

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INTRODUCTION

1. The Board last discussed issues in Phase 2 of the insurance project in January 2003. In this paper, we plan to place the important recognition and measurement issues in the context of two simple examples. We plan to avoid arguing the issues in this meeting, at least, to the extent that we can resist the temptation. Our objective is to use two very basic (primary school) examples to highlight both computations and conceptual issues. We hope that this basic introduction will provide grounding for the discussions that follow and initial meetings with the working party appointed to help on this project. 2. Board members who wish to supplement their reading (and gain extra credit) should

review Volume 2 of the IASC Issues Paper on Insurance, especially Appendix A, and the FASB publication, A Primer on Accounting Models for Long-Duration Life Insurance Contracts under U.S. GAAP. The staff has copies.

3. A word of warning before we proceed. The two examples presented in this paper are very basic and sometimes include unrealistic terms or assumptions. There are several reasons why we chose to simplify. The most important of those was our desire to focus on the accounting dynamics. We wanted to show the accounting effects of different decisions that the Board might make. Our experience is that simple, even unrealistic, examples are the best way to illustrate the basic debits and credits.

4. We have received a number of studies that examine the impact of different accounting models on reporting by both general and life insurance entities. We are currently

considering how the groups that commissioned those studies might best discuss them with the Board. The staff designed the illustrations in this paper as a foundation for studies of real-world effects. We have found that one cannot appreciate the complicated without first understanding the simple.

5. In the staff’s view, the Board must resolve recognition and measurement issues in 11 topic areas to move this project forward. Those issues are:

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a. Model. Should the Board create a single model for all contracts, or different models for different types of contracts? Should the accounting model be based on direct measurements of contract assets and liabilities, on deferral and matching of contract revenues and expenses, or some combination of the two? In previous discussions, some Board members questioned the usefulness of this distinction. The staff considers it important to keep the two opposing philosophies in clear focus, especially in view of developments in the revenue recognition project. b. Measurement. Should an asset-and-liability model use measurements based on

fair value, entity-specific value, or some combination of measurement attributes? If the measurement attribute is fair value, should it be a business-to-customer measurement (customer consideration) or a business-to-business measurement (legal layoff). Should the measurement address options or guarantees embedded in a contract?

c. Discounting. Should the measurement of some or all amounts recognised in the balance sheet be based on their present values?

d. Asset/Liability interaction. Should the measurement model incorporate expectations about asset performance in determining the carrying amount of the contract liability?

e. Risk/Service adjustment. How should the accounting model approach the question of risk (or service) adjustment?

f. Gain or loss on initial measurement/liability recognition. Should the accounting model be constructed in a manner that prohibits or significantly limits the recognition of net profit or loss on initial recognition?

g. Policyholder behaviour. Should the accounting model incorporate expectations about cash inflows and outflows that are a consequence of policyholder renewals or cancellations of an insurance contract?

h. Acquisition costs. Should the accounting model require costs incurred to acquire new insurance contracts to be capitalised as assets and amortised?

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i. Unbundling. Should the measurement model unbundle the individual elements of an insurance contract and measure them individually?

j. Participating contracts. How should the insurer’s liability to holders of participating contracts be recognised and measured?

k. Credit standing. Should the measurement include the effects of the entity’s credit standing?

6. Most of the issues above are present in either an asset-and-liability or matching accounting model. If the Board adopts a formula-based or deferral-and-matching model, there are two additional issues:

a. Attribution model. How should the accounting model attribute revenues and expenses to individual periods covered by the contract?

b. Changes in estimate. How should the accounting model deal with changes in interest rates and estimates of future cash flows? Should a different approach be applied to differences between amounts realised in the current period and amounts previously estimated?

7. This paper touches on all of the above issues except for unbundling, participating contracts, and credit standing.

CASE 1, A SIMPLE GENERAL INSURANCE CONTRACT

8. The insurer sells 1,000 contracts for a premium of $1,000 each. For purposes of illustration, all premiums are collected and sales commissions paid on 1 July X1. All claims are paid on 30 June X2. The insurer pays commissions of $100 for each contract and expects claims (on average) of $800 per contract. Any individual policyholder may have several claims (or none) during the contract period—the contract has no maximum payout. The contract is not cancellable by either the insurer or the policyholder (an unrealistic assumption to be corrected later). For now, we will ignore discounting in the measurement of amounts reported in the balance sheet.

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Deferral-and-Matching Analysis

9. On initial recognition, the insurer has deferred (or unearned) revenue of $1,000,000 and deferred acquisition costs of $100,000. The journal entries are reproduced below:

Asset-and-Liability Analysis

10. The insurer has no obligation to pay refunds, because policyholders cannot cancel their contracts. The insurer has an obligation to stand-ready to pay all valid claims submitted by policyholders. As analysed in the revenue-recognition project and the Board’s work on IAS 37, a stand-ready obligation meets the Framework’s definition of a liability. It is a present obligation (to stand ready), arising from a past event (the contract), that will result in an outflow of resources embodying economic benefits (the services required by the contract). While the payment of claims is conditional, and the payment to any individual policyholder is not probable, the services required by the contract (standing ready) are 100% probable. The liability thus passes the Framework’s first recognition criterion. The obligation is measurable, although the selection of measurement attributes is an open issue.

11. When a policyholder submits a claim, a new obligation to deliver cash is created, but the unexpired stand-ready obligation remains in place.

12. The acquisition costs do not represent an asset per se; costs are not assets. Arguably, the costs represent the amount paid to acquire a customer-relationship intangible asset. We will return to acquisition costs shortly.

13. Assuming, for the moment, that the insurer’s stand-ready obligation is measured at the expected amount of claims paid, the journal entries on initial recognition are as follows:

dr. cr.

Cash 1,000,000

Unearned premium revenue 1,000,000

To record receipt of premiums

Deferred acquisition costs 100,000

Cash 100,000

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Issue in Context: Gain on Initial Recognition/Liability Measurement

14. The $100,000 net profit shown above is a “gain on sale” or “selling profit,” but it is incomplete. Board members and constituents have expressed concern about the up-front recognition of profit, especially in a business as fundamentally uncertain as insurance. However, from an asset-and-liability perspective, recognition of net profit on initial recognition is a symptom. The problem, if there is one, lies in the measurement of the insurer’s obligation to stand ready.

15. Under some interpretations of IAS 37, Provisions, Contingent Liabilities and Contingent Assets, $800,000 represents the amount that the insurer would “rationally pay to settle” this obligation. (FASB pronouncements describe this as the cost accumulation

measurement of the obligation.) However, no rational reinsurer would accept the obligation in exchange for a payment of $800,000. Nor would the insurer sell new contracts for a net premium of $800,000. There is always the chance, maybe the significant chance, of claims in excess of $800,000. The value of the obligation must be something more than $800,000.

16. The DSOP proposed a “bottom-up” approach to the liability measurement. To measure the insurer’s stand-ready obligation, the insurer would estimate the expected amount of claims ($800,000) and add a market-based risk margin. For example, the insurer might study the market and determine that most insurers demand a margin or markup (referred to in the DSOP as a market value margin or MVM) equal to 1.5 standard deviations above the expected amount of claims. If the result of that exercise was $875,000, the insurer would recognise profit on initial recognition of $25,000. If the result was $925,000, the insurer would recognise a loss on initial recognition.

dr. cr.

Cash 1,000,000

Stand-ready obligation 800,000

Premium revenue 200,000

Acquisition cost expense 100,000

Cash 100,000

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17. There are several strong arguments in favour of the bottom-up approach.

a. It is generally consistent with the measurement guidance (on risk) in IAS 37 and FASB Concepts Statement No. 7. The notion of measurement using a risk-adjusted cash-flow estimate is familiar and has intuitive appeal.

b. The resulting liability measurement is independent of the insurer’s acquisition costs.

c. Some companies interviewed in field visits said that implementing a similar approach for financial reporting has also improved management information. 18. However, constituents have a number of strong objections:

a. Computing a market value margin of this sort is unfamiliar to many insurers. Many will not know where to begin.

b. In the absence of observed prices, the “right” margin is hard to determine. Any IFRS will therefore require considerable implementation guidance.

c. The nature and objective of the market value margin is not clear, especially if the measurement attribute is other than fair value. Is the margin based on a capital market notion that includes only unsystematic risk, or a broader concept that encompasses all types of risk, servicing, and profit margin?

19. In the earlier round of insurance deliberations, Board members and staff discussed a “top-down” approach. To measure the liability, the insurer would assume, absent information to the contrary, that the net premium charged (gross premium less acquisition costs) represents the fair value of the liability at initial recognition. This assumption is based on the premise that no other insurer would accept the obligation for less than the amount charged by the insurer. We note that this approach is similar to proposals for

measurement in the revenue recognition project (when there is no information about the legal layoff amount).

20. The principal advantage of the top-down approach is simplicity, at least on initial recognition. In particular, the approach does not attempt to identify components of the

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markup inherent in the price (premium) of the contract. However, this approach also has several pitfalls:

a. Some might argue that it places undue emphasis on pricing policy, which is often the most aggressive part of the business. Pricing changes over the course of an insurance cycle, even though expected claims may not.

b. Some constituents have expressed concern that preparers might use the top-down approach as a shield against recognising losses on initial recognition. This is especially true when pricing incorporates expectations about future asset earning rates.

c. The liability measurement is not independent of the insurer’s acquisition cost structure.

d. In some jurisdictions, pricing is subject to significant regulatory intervention. 21. We will return to measurement several times in the course of our discussions. Assuming,

for now, that the insurer determines that the markup in this contract is 12.5%1 on expected claims of $800,000 (a measurement of $900,000), the insurer’s journal entries on initial recognition would be as follows:

22. A note on the revenue line is in order here. We have adopted an approach that reports revenue in a manner similar to the traditional presentation by non-life insurance

1_{We will use this 12.5% markup throughout this paper, in order to keep the illustrations comparative.}

dr. cr.

Cash 1,000,000

Acquisition cost expense 100,000

Cash 100,000

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companies. This is similar to the approach taken in the revenue-recognition project, but not by design.

Issue in Context: Policyholder Behaviour

23. The scenario for Case 1 built on a contract that is not cancellable by either the insurer or the policyholder. Suppose instead that the policyholder could cancel the contract at any time and receive a refund of 95% of unexpired premiums, based on straight-line expiration of premiums over the one-year contract term. On initial recognition, the refundable premium ($950,000) exceeds the asset-and-liability method’s measurement of the stand-ready obligation and the deferral-and-matching method’s net liability (unearned premiums less deferred acquisition costs).

24. To date, the Board has discussed policyholder behaviour in the context of future premium payments in a life insurance contract. In the staff’s view, future premiums and

policyholder cancellations of existing prepaid contracts raise the same question. Can the liability (gross or net) be less than the amount that would be payable if policyholders exercise their option to cancel the contract? Taken another step, if the policyholder has no right to cancel, can the measurement of the contract ever be a debit?

25. The Issues Paper recommended that the liability for life insurance contracts should never be less than the amount that policyholders could demand on surrender, referred to as the

deposit floor. It did not include a similar recommendation for general insurance, but this was due to oversight rather than intent. The DSOP reversed that recommendation. IAS 39, if extended to insurance contracts, would require a deposit floor.

26. A liability measurement with a deposit floor raises some interesting recognition questions, including:

a. The deposit-floor measurement reflects the fair value of the obligation in a particular transaction, cancellation, between the insurer and an individual policyholder. It does not reflect the value at which one would expect the book of contracts to exchange between the insurer and another insurer.

b. The deposit-floor measurement has the effect of recognising the entire possible surrender penalty as income on initial recognition.

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c. Despite b., the deposit-floor measurement produces a loss on initial recognition whenever the gross amount of the possible surrender penalties is less than the insurer’s acquisition costs.

d. Owing to c., deposit-floor measurements focus attention on acquisition costs and their possible capitalisation.

Issue in Context: Acquisition Costs

27. Both the Issues Paper and the DSOP recommended that acquisition costs be charged to expense when incurred. The Steering Committee reasoned that the costs do not meet the

Framework definition of an asset.

28. Capitalising acquisition costs and amortising them over the premium term is consistent with the underlying rationale for a deferral-and-matching system. Capitalising recognises costs and revenues over the period covered by the contract.

29. The argument for capitalisation in an asset-and-liability system is less obvious. Some arguments for capitalisation include:

a. The Insurance Working Group of the German Accounting Standards Board argued that acquisition costs should be capitalised, “Due to their character as prepaid expenses, . . .”

b. While acquisition costs are not assets in their own right, they represent investment in the insurance contract. As long as the contract is expected to produce a net profit, that investment should be reported as an asset.

c. Acquisition costs represent an intangible asset—the insurer’s relationship with the policyholder.

d. Financial statement users are very interested in the insurer’s cost structure. Acquisition costs are an important indicator of how the insurer conducts its activities.

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CASE 1A, SUBSEQUENT RECOGNITION AND MEASUREMENT

30. At December 31, the insurer estimates incurred claims for 6 months at $400,000. Based on available information, the insurer concludes that nothing has changed that would cause it to revise either its expectations about the remaining contract term or the prices it would charge for new contracts with a six-month period. The insurer invests net premiums in corporate bonds that pay interest at 10%, with a semi-annual coupon. For purposes of illustration, the insurer does not reinvest the coupon payment.

31. At June 30 of the following year, actual claim payments on claims for the full year equal $800,000.

Deferral and Matching Analysis

31.32. Under most deferral-and-matching approaches, the insurer amortises unearned

premium and deferred costs rateably over the period, unless the pattern of exposure is not level over the period. Claims are recognised as incurred. The deferral-and-matching journal entries at December 31 and June 30 are:

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A Note on Names

32.33. The Insurance Issues Paper observed that most accounting systems include a mixture

of conventions. The label deferral-and-matching, then, is not completely descriptive. In the example above, claims payable is a liability, not a deferral, and the measurement is based on claims incurred. If the incurred claims had been $425,000 or $375,000, the insurer would have recorded that amount as the liability. The staff is not aware of any situation in which existing accounting models would allow the insurer to defer a $25,000

At December 31

dr. cr.

Cash and investments 45,000

Interest income 45,000

To record interest earned on investments

Unearned premium revenue 500,000

To record premium revenue earned

Acquisition costs 50,000

To record amortisation of acquisition costs

Claims expense 400,000

Claims payable 400,000

To record claims incurred

At June 30

To record claims paid

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loss or to record additional claims of $25,000 in an attempt to normalise expense over the year.

33.34. At December 31, the insurer has two liabilities. The first is a stand-ready obligation for the remaining six months of the contract. The second is a liability for incurred claims arising between July 1 and December 31. The insurer demands a markup on both liabilities, but in different ways. After examining available information, the insurer concludes that it would demand a markup on incurred claims equal to one third of the amount demanded for the stand-ready obligation. Just as the insurer would not accept new policies at the amount of expected claims, it would not accept an obligation for incurred claims at their expected amount. The insurer, or another insurer assuming this obligation, would demand a markup. This produces a measurement for incurred claims of $416,667 ($400,000 expected plus $16,667 markup of 4.1667%2) and for the stand-ready obligation of $450,000 ($400,000 expected plus $50,000 markup of 12.5%). The insurer’s journal entries (still ignoring discounting) at December 31 and June 30 are:

2_{One-third of 12.5%.}

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At December 31 dr. cr.

To record premium revenue

Incurred claims obligation 416,667

At June 30

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Case 1A, Financial Statements Compared

1-Jul 31-Dec 30-Jun

Cash and investments

Beginning balance - 900,000 945,000 Premiums received 1,000,000 - -Sales commissions paid (100,000) - -Claims paid - - (800,000) Investment earnings - 45,000 45,000 Ending balance 900,000 945,000 190,000

Balance sheets

Cash and investments 900,000 945,000 190,000 Deferred acquisition costs 100,000 50,000 -Unearned Premium (1,000,000) (500,000)

Claims payable - (400,000) -(Equity)/Deficit - (95,000) (190,000)

Income statements

Premium revenue - (500,000) (500,000) Investment income - (45,000) (45,000) Acquisition cost expense - 50,000 50,000 Claims expense - 400,000 400,000 Net (income)/loss - (95,000) (95,000)

Deferral and Matching, Case 1A dr. (cr.)

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1-Jul 31-Dec 30-Jun Cash and investments

Balance sheets

Cash and investments 900,000 945,000 190,000 Deferred acquisition costs - - -Stand-ready obligation (900,000) (450,000) -Incurred claims obligation - (416,667) -(Equity)/Deficit - (78,333) (190,000)

Premium revenue (100,000) (450,000) (450,000) Investment income - (45,000) (45,000) Acquisition cost expense 100,000 - -Claims expense - 416,667 383,333 Net (income)/loss - (78,333) (111,667)

Stand-ready obligation

Beginning balance - (900,000) (450,000) Expected claim payments (800,000)

Addition to markup (100,000)

Adjustment to remeasure obligation - 400,000 400,000 Release of markup - 50,000 50,000 Addition to markup - - -Ending balance (900,000) (450,000)

-Incurred claims obligation

Beginning balance - - (416,667) Incurred claims - (400,000) (400,000) Addition to markup - (16,667) (16,667) Claims paid - - 800,000 Release of markup - - 33,334 Ending balance - (416,667)

-Analysis of insurance liabilities Asset and Liability, Case 1A

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Observation

34.35. In practice, an insurer following traditional approaches might (or might not) measure the incurred-claims liability at the same $416,667 portrayed above. Management might argue that the additional $16,667 is necessary to produce a “prudent” measure of the liability, especially if the $400,000 is the most likely amount rather than an expected value. Such an explicit adjustment is contrary to US GAAP (FASB Statement No. 5,

Accounting for Contingencies).

Issues in Context: Discounting and Asset/Liability Interaction

35.36. Cases 1 and 1A use measurements that ignore the time value of money. The Issues

Paper and DSOP both recommend that liabilities be measured at the present values of expected cash flows. IAS 37 and FASB Concepts Statement No. 7 also require liabilities to be measured at their present value. Existing deferral-and-matching systems usually ignore discounting in the amortisation of unearned revenue and deferred costs, although it could be incorporated in the amortisation scheme.

36.37. Applying discounting leads naturally to the question of a rate and of the interaction between asset and liability discount rates. In Case 1A, we assumed that the insurer invests available cash in instruments earning 10%. Many would argue that the same rate should be used to apply present value techniques to the insurance liabilities. The Issues Paper, DSOP, IAS 19, IAS 37, and FASB Concepts Statement 7 all argue that the rate earned on assets held by the entity should not be used to measure liabilities.

CASE 2, ADVERSE DEVELOPMENT

37.38. Insurance executives often say that there are few good surprises in general insurance. Estimates turn out to have been over-optimistic far more often than they turn out to have been over-pessimistic. In Case 2, we examine a situation in which incurred claims at December 31 are estimated at $450,000. The insurer estimates that this experience is likely to persist and at June 30 that revised estimate proves to be correct; the insurer pays $900,000 of claims.

38.39. Most deferral-and-matching schemes include a loss-recognition principle, similar to the onerous-contract provisions of IAS 37. However, this case does not present the

Formatted: Bullets and Numbering

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insurer with a loss; it is a break-even scenario. Accordingly, the insurer would continue the accounting described in Case 1A, with the exception of the higher incurred claims at December 31. The insurer’s journal entries are:

39.40. The insurer concludes that the incurred claims, while higher than expected, would demand the same percentage markup as those described in Case 1A. Accordingly, the

At December 31

dr. cr.

At June 30

To record claims paid

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liability for incurred claims is $468,750 ($450,000 plus a 4.1667% proportional risk adjustment of $18,750). The liability for unexpired risk presents a different problem. The insurer would not write new contracts at a net premium of $900,000 if it expected claims of the same amount. Assuming again that the expected claims are higher than in Case 1A but otherwise similar, the insurer would demand an annual net premium of $1,012,500 (expected claims of $900,000 plus a 12.5% markup). For a six-month contract, this would be a premium of $506,250. To aid in understanding, we have presented the adjustment to the stand-ready obligation as a separate account. The insurer’s journal entries are:

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At December 31 dr. cr.

Addition to stand-ready obligation 56,250

To record remeasurement of obligation

At June 30

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Case 2, Financial Statements Compared

1-Jul 31-Dec 30-Jun

Balance sheets

Cash and investments 900,000 945,000 90,000 Deferred acquisition costs 100,000 50,000 -Unearned Premium (1,000,000) (500,000)

Claims payable - (450,000) -(Equity)/Deficit - (45,000) (90,000)

Premium revenue - (500,000) (500,000) Investment income - (45,000) (45,000) Acquisition cost expense - 50,000 50,000 Claims expense - 450,000 450,000 Net (income)/loss - (45,000) (45,000)

Deferral and Matching, Case 2, Adverse Development dr. (cr.)

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1-Jul 31-Dec 30-Jun Cash and investments

Balance sheets

Cash and investments 900,000 945,000 90,000 Deferred acquisition costs - - -Stand-ready obligation (900,000) (506,250) -Incurred claims obligation - (468,750) -(Equity)/Deficit - 30,000 (90,000)

Premium revenue (100,000) (450,000) (506,250) Investment income - (45,000) (45,000) Addition to stand-ready obligation 56,250

Acquisition cost expense 100,000 - -Claims expense - 468,750 431,250 Net (income)/loss - 30,000 (120,000)

Stand-ready obligation

Beginning balance - (900,000) (506,250) Expected claim payments (800,000) (50,000)

Addition to markup (100,000)

Adjustment to remeasure obligation - 400,000 450,000 Release of markup - 50,000 56,250 Addition to markup - (6,250) -Ending balance (900,000) (506,250)

-Incurred claims obligation

Beginning balance - - (468,750) Incurred claims - (450,000) (450,000) Addition to markup - (18,750) (18,750) Claims paid - - 900,000 Release of markup - - 37,500 Ending balance - (468,750)

-Analysis of insurance liabilities

Asset and Liability, Case 2, Adverse Development dr. (cr.)

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Issue in Context: Measurement

40.41. Case 2 raises a fundamental measurement issue. Does the measurement of a liability

always include the compensation (the markup) that an entity demands for assuming an obligation?

41.42. Before answering that question, we need to be clear about what we mean by a

markup. We assume that the unadjusted measurements presented throughout this paper reflect expected cash flows; the probability-weighted average of various scenarios. The idea of a markup is predicated on the notion that an insurer (or any other entity) would not willingly accept an obligation for an amount equal to its expected value. Even if actual results equal the expected cash flows, the insurer would demand an additional amount for issuing the contract, including a price for the risk involved and providing the service of diversifying risks that an individual policyholder cannot diversify.

43. In the deferral-and-matching financial statements on page 20, the answer to the question posed in paragraph 41 is “No.” Neither the liability for incurred claims nor unearned revenue is adjusted for a markup (beyond the amount that was implicit in the original premium). This is consistent with a general, though rarely articulated, accounting convention that an entity should not record losses in one period in the expectation of profits in a future period. For example, paragraph 36 of FASB Statement No. 60 includes the following injunction, “No loss shall be reported currently if it results in creating future income.”

44. In the asset-and-liability example on page 21, the answer to the question posed in paragraph 41 is “Yes.” While the result may seem contrary to traditional accounting intuition, the result portrayed in this example is consistent with liability measurements based on market transactions (either premiums that would be charged by the insurer or amounts that would be demanded by an assuming company). It is also consistent with the conceptual measurement framework in FASB Concepts Statement 7. The argument, more fully articulated elsewhere, is that an uncertain liability should be reported at an amount that does represents either:

a. the amount at which the obligation could be settled, or

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b. the amount that the insurer would demand to accept that liability from a policyholder or another insurer.

CASE 3, A MULTI-PERIOD CONTRACT

45. In this case, the insurer enters into a contract for 3 years. It sells 1,000 contracts for an annual premium of $1,000. We make the following assumptions about this contract:

a. Expected average claims are $800, $950, and $1,150 per contract in force in years 1, 2, and 3 respectively.

b. The insurer cannot cancel or reprice the contract, but policyholders can cancel at any anniversary date. A policyholder who cancels receives no refund. The insurer expects 15% of policyholders to cancel each year.

c. Premiums are paid on January 1 of each year. Claims are paid on December 31 of each year.

d. Case 3 ignores both discounting and the insurer’s investment of available assets. 46. In the multi-period contract, we have dropped the journal entries and substituted

computations of the insurance liability and, if necessary, deferred acquisition costs.

47. Many deferral-and-matching models (like US GAAP) are designed to report net profit that equals a constant percentage of premium inflows. Future premium inflows and claim outflows are inherent in that design. The computations necessary to implement this approach are presented below:

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Acq. Costs Liability

Total expected claims 2,437,800

Costs incurred 100,000

Total premiums expected 2,572,000 2,572,000

Amortisation rate 3.888% 94.782%

1-Jan-02

Premiums received (1,000,000) (1,000,000)

Times percentage 94.782% (947,823) 3.888% (38,880) 31-Dec-02

Claims paid 800,000

-Balance at year end (147,823) 61,120

1-Jan-03

Premiums received (850,000) (850,000)

Claims paid 807,500

1-Jan-04

Claims paid 830,300

-Balance at year end - (0)

Contract Liability Deferred Acq. Costs Development of Percentages -- Case 3

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48. The resulting financial statements are:

1-Jan-02 31-Dec-02 31-Dec-03 31-Dec-04

Contracts in force 1,000 1,000 850 722

Claims per Contract 800 950 1,150

Beginning balance - - 100,000 142,500 Premiums received 1,000,000 1,000,000 850,000 722,000 Sales commissions paid (100,000) (100,000) - -Claims paid - (800,000) (807,500) (830,300) Investment earnings - - - -Ending balance 900,000 100,000 142,500 34,200

Balance sheets

Cash and investments 900,000 100,000 142,500 34,200 Deferred acquisition costs 61,120 61,120 28,072 -Contract liability (947,823) (147,823) (145,972)

- - -(Equity)/Deficit (13,297) (13,297) (24,600) (34,200)

Premium revenue (1,000,000) (1,000,000) (850,000) (722,000) Investment income - - - -Acquisition cost expense 38,880 38,880 33,048 28,072 Addition to contract liability 947,823 947,823 805,649 684,328

- - -Net (income)/loss (13,297) (13,297) (11,302) (9,600)

As a percentage of premium revenue 1.33% 1.33% 1.33%

Deferral and Matching -- Case 3 dr. (cr.)

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CASE 3A: DISCOUNTING AND INVESTMENT

49. Of course, no insurer would sell a product that returns only 1.33% of premiums. Indeed, if Case 3 had ignored policyholder cancellations, the contract would have been breakeven on an undiscounted basis. That is, expected claims and acquisition expenses would have equalled gross premiums. An insurer prices a policy like this one in expectation of investment earnings and deferral-and-matching systems incorporate discounting into the accounting model. In Case 3A, we make two additional assumptions:

a. The insurer invests available cash in risk-free bonds paying an annual coupon of 8% (remember rates that high?) and the accounting model applies discounting at that rate.

b. The insurer distributes cash equal to reported earnings from the book at the end of each year. This assumed distribution should not be confused with a dividend distribution to owners. It is a computational device designed to eliminate reinvestment of earnings from the illustration.

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Acq. Costs Liability

Present value of expected claims 2,092,161

Present value of expected premiums 2,406,036 2,406,036

Amortisation rate 4.156% 86.955%

1-Jan-02

Premiums received (1,000,000) (1,000,000)

Interest accretion (69,564) 4,675

Claims paid 800,000

1-Jan-03

Interest accretion (70,258) 2,223

Claims paid 807,500

1-Jan-04

Interest accretion (61,504)

-Claims paid 830,300

-Balance at year end - (0)

Contract Liability Deferred Acq. Costs Development of Percentages -- Case 3A, Discounting

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51. The resulting financial statements are:

1-Jan-02 31-Dec-02 31-Dec-03 31-Dec-04

Beginning balance - - 75,998 110,976 Premiums received 1,000,000 1,000,000 850,000 722,000 Sales commissions paid (100,000) (100,000) - -Claims paid - (800,000) (807,500) (830,300) Investment earnings - 72,000 74,080 66,638 Distribution - (96,002) (81,602) (69,314) Ending balance 900,000 75,998 110,976

-Balance sheets

Cash and investments 900,000 75,998 110,976 -Deferred acquisition costs 58,438 63,113 30,008 (0) Contract liability (869,547) (139,111) (140,983)

- - -(Equity)/Deficit (88,891) (0) - 0

Premium revenue (1,000,000) (1,000,000) (850,000) (722,000) Investment income - (72,000) (74,080) (66,638) Acquisition cost expense 41,562 36,887 33,105 30,008 Addition to contract liability 869,547 939,111 809,373 689,317

- - -Net (income)/loss (88,891) (96,002) (81,602) (69,314)

Deferral and Matching -- Case 3A, Discounting dr. (cr.)

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Issue in Context: Asset/Liability Interaction

52. Many insurance professionals and actuaries argue that insurers rarely invest in risk-free instruments. They maintain that the computations portrayed here should reflect the rates that the insurer expects to earn on investments. Stated differently, they view the

accounting objective as one that encompasses all of the flows that are connected with the insurance activity, including assets and liabilities, rather than one that focuses on the matching of contract revenues and costs alone.

53. Computationally, using asset-based discount rates poses no particular problem. If the insurer invests in bonds that pay an annual coupon of 10% rather than the 8% risk-free rate, we simply use the higher rate in applying the computations.3 The resulting net income would then be a constant 11.65% of premiums received.

54. The asset-and-liability approach proposed in the Issues Paper and DSOP measures the contract liability at the present value of risk-adjusted cash flows, including future premium inflows and claim outflows arising from policyholder renewals. In this paper, we have replaced the risk-adjustment with a markup. Present value is computed using a risk-free discount rate, regardless of the insurer’s investment strategy. For purposes of comparability, we have assumed that the insurer invests at the same rate used to compute the liability. As in earlier illustrations, the insurer uses a 12.5% markup on expected claims. Computations of the liability are:

3

A logically consistent application of this approach would use the coupon rate net of expected defaults. The staff understands that practice in many cases does not make that adjustment.

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With Without

Markup Markup

1-Jan-02

PV of expected claims (2,353,681) (2,092,161) PV of expected premiums 1,406,036 1,406,036

(947,645)

(686,125) 31-Dec-02

PV of expected claims (1,641,975) (1,459,534) PV of expected premiums 1,518,519 1,518,519 Balance at year end (123,457) 58,985 31-Dec-03

PV of expected claims (864,896) (768,796) PV of expected premiums 722,000 722,000 Balance at year end (142,896) (46,796)

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The resulting financial statements are:

1-Jan-02 31-Dec-02 31-Dec-03 31-Dec-04

Expected claims, incl markup (900,000) (908,438) (934,088)

-Balance sheets

Cash and investments 900,000 123,457 142,896 -Deferred acquisition costs - - - -Stand-ready obligation (947,645) (123,457) (142,896)

- - -(Equity)/Deficit 47,645 - -

-Income statements

Premium revenue (1,000,000) (1,000,000) (850,000) (722,000) Investment income - (72,000) (77,877) (69,192) Acquisition cost expense 100,000 100,000 - -Change in stand-ready obligation 947,645 123,457 19,439 (142,896) Claims paid - 800,000 807,500 830,300 Net (income)/loss 47,645 (48,543) (100,938) (103,788)

Beginning balance - (947,645) (123,457) (142,896) Premiums received (1,000,000) - (850,000) (722,000) Interest accretion - (75,812) (77,877) (69,192) PV of expected claim payments (2,092,161) - - -PV of expected premiums 2,406,036 - - -Addition to markup (261,520) - - -Claims paid - 800,000 807,500 830,300 Release of markup - 100,000 100,938 103,788 Ending balance (947,645) (123,457) (142,896) (0)

Asset and Liability, Case 3A dr. (cr.)

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Observation

55. During Board discussions in 2002, some Board members observed that the example did not show the now-infamous “debit” that has troubled some Board members. That is, the illustrations do not introduce the possibility that measurement of the insurance contract might result in a net debit, rather than the expected credit. The sequence of transactions obscures the fact that the illustration does show the debit (future premiums in excess of future claims). At time zero, before receipt of the first annual premium, the present value of expected future premiums is $2,406,036. The present value of expected future claims (including markup) is $2,353,681 (2,092,161 plus 261,520). The loss shown in the first column represents the acquisition costs of $100,000 less the difference between the $2,406,036 and the $2,353,681 or $47,645.

56. The contract measurement changes from debit to credit as soon as the first premium is received, but the computation (and the underlying recognition principles) remain. If we had illustrated a contract with 36 monthly premiums rather than 3 annual premiums, the contract measurement would have been a debit for several months before turning to a net credit.

CASE 3B: ADVERSE DEVELOPMENT

57. Case 3B shows the effect of adverse development in a multi-period model. The contract is the same as portrayed in Case 3A. At the end of 2003, the management revises its estimates of 2004 (the last year of the contract). Management now estimates that lapse rates will decline. Instead of 722 continuing policyholders, management now expects 800 to continue. Management also expects claims to exceed the earlier estimates. Instead of an average of $1,150 per contract, management now expects claims to average $1,225 per contract. In insurance jargon, policyholders have selected against the insurer.

Management does not expect any change in interest rates and would not demand a markup different from the original 12.5 percent, despite the changing circumstances.

58. As mentioned in earlier Board papers, there are a variety of approaches to changes in estimate in a deferral-and-matching framework. The Insurance Issues Paper (sub-issue 6G, paragraphs 247-273) listed four approaches consistent with a deferral-and-matching framework—prospective, catch-up, retrospective, and lock-in. Depending on the type of

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contract, U.S. GAAP requires catch-up, retrospective, or lock-in. We have illustrated application of the lock-in approach in this paper. Changes in estimates are not recognised in the current period unless the change would result in a reported loss in some future period.

59. As in Case 2 (page 16), if the revised estimates come to pass (and we assume here that they do), the insurer will not show a loss in any year. Accordingly, the carrying amount of the contract liability and deferred acquisition costs are not adjusted. The effects of increased policyholder persistency (fewer lapses) and increased claims are reported as they occur in 2004. The resulting financial statements are:

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1-Jan-02 31-Dec-02 31-Dec-03 31-Dec-04 Contracts in force 1,000 1,000 850 800

Beginning balance - - 75,998 110,976 Premiums received 1,000,000 1,000,000 850,000 800,000 Sales commissions paid (100,000) (100,000) - -Claims paid - (800,000) (807,500) (980,000) Investment earnings - 72,000 74,080 72,878 Distribution - (96,002) (81,602) (3,854) Ending balance 900,000 75,998 110,976 0

Balance sheets

Cash and investments 900,000 75,998 110,976 0 Deferred acquisition costs 58,438 63,113 30,008 -Contract liability (869,547) (139,111) (140,983)

- - -(Equity)/Deficit (88,891) (0) - (0)

Premium revenue (1,000,000) (1,000,000) (850,000) (800,000) Investment income - (72,000) (74,080) (72,878) Acquisition cost expense 41,562 36,887 33,105 30,008 Change in contract liability 869,547 139,111 1,873 (140,983) Claims paid - 800,000 807,500 980,000 Net (income)/loss (88,891) (96,002) (81,602) (3,854)

Deferral and Matching -- Case 3B, Adverse Development dr. (cr.)

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60. The asset-and-liability approach demands that the insurer measure its liabilities in terms of a price. That price may be the amount that the insurer would demand for new contracts with similar estimated claims and policyholder persistency or the price that others would demand to relieve the insurer from its obligation; the Board has yet to decide. In either case, the measurement is a fresh-start that does not incorporate previous carrying amounts or accounting conventions.

61. In this case, as in Case 2A, we have assumed that the insurer would charge a different premium when confronted with the new information about 2004. We have also assumed that the insurer would demand the same 12.5 percent markup in setting that premium. In previous discussions, some Board members observed that this approach has the effect of recognising a loss in the current year and normalising gross profit in a future year. That is the effect, but not the objective. The objective is to find a relevant price at which the liability would transact in a marketplace. Any price would include a markup, because rational business people do not accept uncertainty and provide service for free.

62. The financial statements resulting from an asset-and-liability approach (with explanatory note following are:

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1-Jan-02 31-Dec-02 31-Dec-03 31-Dec-04 Contracts in force 1,000 1,000 850 800

Risk adjusted claims (900,000) (908,438) (1,102,500)

-Balance sheets

Cash and investments 900,000 123,457 220,833 -Deferred acquisition costs - - - -Contract liability (947,645) (123,457) (220,833)

- - -(Equity)/Deficit 47,645 - -

-Income statements

Premium revenue (1,000,000) (1,000,000) (850,000) (800,000) Investment income - (72,000) (77,877) (81,667) Acquisition cost expense 100,000 100,000 - -Change in contract liability 947,645 123,457 97,377 (220,833) Claims paid - 800,000 807,500 980,000 Net (income)/loss 47,645 (48,543) (23,000) (122,500)

Beginning balance - (947,645) (123,457) (220,833) Premiums received (1,000,000) - (850,000) (800,000) Interest accretion - (75,812) (77,877) (81,667) PV of expected claim payments (2,092,161) - (138,611) -PV of expected premiums 2,406,036 - 78,000 -Addition to markup (261,520) - (17,326) -Claims paid - 800,000 807,500 980,000 Release of markup - 100,000 100,938 122,500 Ending balance (947,645) (123,457) (220,833) (0)

Asset and Liability, Case 3B dr. (cr.)

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63. The effect of changed estimates appears over three lines in analysis of the obligation. a. The present value of expected premiums equals the increased number of

policyholders—from 722 to 800—times the premium $1,000, totalling $78,000. Premiums are received on the first day of 2004, so discounting does not alter the number.

b. The expected present value of expected claims is an exercise in cost and volume variances. The increased number of policyholders accounts for part of the difference—78 additional policyholders times the original estimated claims of $1,150 with a present value of $83,056. The increase in average estimated claims accounts for the balance—800 policyholders times the increase in estimated claims of $75 with a present value of $55,555. The total of the two amounts is $138,611.

c. The addition to the markup is 12.5 percent on the present value of expected claims.

CONCLUDING NOTES

64. The contracts used in this paper are not realistic. They are not intended to be. Our previous attempts to produce more realistic illustrations had several failings. The complications of real life obscured the underlying accounting issues and made it hard for Board members to understand the overall picture. The necessary simplifications meant that the previous illustrations were not real enough to satisfy insurance professionals and the illustrations were criticised accordingly. The previous illustrations didn’t provide a general-purpose framework for considering different accounting approaches.

65. The two simple contracts used in this paper address the first and third failing; we probably won’t ever alleviate the second. However, the simple contracts do capture the important characteristics of an insurance transaction that raise accounting issues. In particular:

a. The insurer accepts a cash payment in exchange for accepting a liability that is uncertain in amount and/or timing.

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b. The amount that the insurer demands for that cash payment (or the amount that another insurer would demand for accepting an existing obligation) reflects the insurer’s expectations about future cash inflows and outflows, the ability to invest proceeds during the intervening period, and the price that the insurer demands for risks and services inherent in the contract.

c. Payment of the liability will take place in the future, perhaps far in the future. d. The insurer incurs significant costs when it sells the contract.

e. Multi-period contracts may create rights for policyholders and impose obligations on the insurer. The value of those rights and obligations changes over the life of the contract.

f. Real life inevitably differs from expectations.

66. Other contract features are embellishments on those six characteristics.

67. During future sessions, Board members will doubtless want to see other accounting alternatives or situations. For example, we have not portrayed a situation in which the single-period contract has better-than-expected experience or any variation from assumptions in the multi-period contract. We plan to let Board members set the content of additional variations, rather than to produce (and complicate) this paper with several pages of additional illustrations.