1 March 2012ILS

Insurance accounting: a changing landscape

There are several ongoing joint projects being undertaken by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB)—collectively, the Boards— that are likely to have a significant impact on insurance companies, regardless of whether financial statements are prepared in accordance with US generally accepted accounting principles (US GAAP) or with International Financial Reporting Standards (IFRS).

Conversion, convergence, condorsement

The IASB and the FASB have sought to work together since 2002 when they entered into a memorandum of understanding known as the Norwalk Agreement. This was updated in 2008, and emphasised the goal of the joint projects to produce common, principle-based standards intended to achieve convergence between US GAAP and IFRS. By the end of 2011, the Boards had experienced delays in achieving some of the milestones, as a result of the large number and far-reaching nature of responses received by each Board on earlier exposure drafts. While the most significant changes for insurance companies are not likely to be effective before 2015, the effect of the proposals in the key convergence projects will need to be planned for well in advance.

Meanwhile, the US Securities and Exchange Commission (SEC) has been considering how to incorporate IFRS into the US financial reporting system for several years. The possible approaches that have been considered include:

• Full conversion by all companies to IFRS on a specified date;

• Full conversion by all companies to IFRS following staged transition;

• Optional full conversion to IFRS for certain companies; or

• Retention of US GAAP, with continued convergence and endorsement activities by the Boards.

It is the last, relatively new, approach, known as ‘condorsement’, that has most recently been proposed by staff at the SEC. In a condorsement setting, the FASB would refrain from separately engaging in standard-setting for projects that are on the IASB’s agenda, but would retain its standard-setting authority in the US. Following the completion of the current joint projects with the IASB, the FASB will conduct a review of remaining differences between US GAAP and IFRS and identify international standards which could potentially be incorporated into US GAAP.

The SEC’s 2008 work plan contemplated a decision on IFRS by the end of 2011. However, at the time of writing, a decision has not yet been made. Irrespective of which path is chosen, there are two ongoing convergence projects related to insurance contracts and financial instruments that will significantly impact on accounting for insurance companies, under both IFRS and US GAAP.

On February 9, 2012, the IASB officially announced a significant change to its current work plan for several projects, including insurance. Both the IASB and the FASB are now aiming to re-expose or issue a revised draft of an insurance contracts standard in the second half of 2012. An effective date has not yet been proposed but it is unlikely that it will be before the effective date of a new financial instrument standard. The IASB announced at the end of 2011 that its proposed financial instruments standard (IFRS 9) would not be effective until January 1, 2015 (previously January 1, 2013).

Insurance contract accounting

The IASB and the FASB have differences of opinion regarding several aspects of insurance contract accounting. The Boards are striving to resolve their differences prior to re-submitting exposure drafts. Some of the more significant differences of opinion include the measurement model, the treatment of deferred acquisition costs, and the unlocking of the residual margin (IASB).

The measurement model

The IASB’s position is that at initial recognition, an insurer would measure the liability for an insurance contract on a fulfilment basis, using four building blocks:

• Expected future cash flows—An explicit, unbiased and probability weighted estimate (ie, expected value) of the future cash outflows less the future cash inflows that will arise as the insurer fulfils the insurance contract;

• Time value of money—A discount rate that adjusts the expected future cash flows for the time value of money;

• Risk adjustment—An explicit estimate of the effects of uncertainty about the ultimate amount and timing of the expected future cash flows; and

• Residual margin—A residual margin that eliminates any gain at inception of the insurance contract.

The FASB’s position on the measurement of an insurance contract liability is also fulfilment-based, but includes only three building blocks.

Acquisition costs

The FASB has indicated that deferred acquisition costs (DAC) should be recognised only for those costs incurred in relation to successful acquisition efforts. In contrast, the IASB believes that in measuring insurance contract liability, the acquisition costs should include the costs of both successful and unsuccessful efforts of the insurance portfolio.

Locking versus unlocking the residual or composite margin

The IASB’s current view is that the residual margin should not be locked in at contract inception. An insurer should adjust the residual margin prospectively for favourable and unfavourable changes in the estimates of future cash flows. These experience adjustments are to be recognised in profit or loss when the change in estimate is made. The FASB’s position is that the composite margin should be determined on day one and not remeasured.

While the IASB and FASB proposals should achieve the same result upon the extinguishment of the liability, there will probably be significant differences and volatility reported through net income during the performance of the contract, depending on the model adopted.

Financial instruments convergence joint project

As previously noted, the IASB issued an amendment to IFRS 9, Financial Instruments, at the end of 2011 that delays its effective date to annual periods beginning on, or after, January 1, 2015. The original effective date was for annual periods beginning on, or after, January 1, 2013. The amendment to IFRS 9 is a result of the IASB extending its timeline for the completion of the remaining phases of its project to replace International Accounting Standard (IAS) 39, Financial Instruments: Recognition and Measurement.

The purpose of the financial instruments joint project is to improve the usefulness of financial statements by simplifying the classification and measurement requirements for financial instruments. The plan consists of three main phases: classification and measurement, impairment methodology and hedge accounting. The IASB is issuing exposure drafts and final standards as each stage is completed; the FASB’s approach is to issue one piece of guidance at the conclusion of all three phases.

"IFRS would allow for reclassification changes in financial instruments based on changes to the company's business strategy; US GAAP would not allow such reclassifications."

Some of the differences between IFRS 9 and the US GAAP proposed accounting include the classification and measurement of debt instruments. Debt instruments would be required to utilise the amortised cost and fair value through net income categories under IFRS, instead of the fair value through other comprehensive income and fair value through net income categories under US GAAP. Also, IFRS would allow for reclassification changes in financial instruments based on changes to the company’s business strategy; US GAAP would not allow such reclassifications.

On impairment, the Boards are more in harmony in their proposals and, significantly, both are recommending an expected loss model. This is considered likely to lead to earlier impairment charges than under the current incurred loss approach.

There is a strong relationship between financial instruments and insurance contracts, and it is expected that any final insurance contract amendments are most likely to become effective simultaneously with the IFRS 9 effective dates.

Practical consequences for insurance companies

In addition to the financial statement impacts of the insurance contract joint project, there are other noteworthy implications that will result from the eventual adoption of new standards.

Systems and processes

Insurance companies may need to re-engineer their current information technology systems to be able to capture additional information. An analysis should be performed to identify which systems will be affected by the changes, and whether to revise or design new templates for data gathering. The greatest impact is expected to be on actuarial modelling, valuation, and financial reporting systems. Policy administrative systems will also need to be adapted to reflect the requirements related to contract boundaries, which will change when contracts are recognised.

Increased actuarial involvement

The requirements of the joint project will place significant demands on insurance companies’ actuarial resources. Companies may need to hire additional resources, or outsource certain actuarial functions to third parties, and will need to provide training to actuarial staff on the new requirements.

People and training

Personnel will require technical training on new requirements. An assessment of the impact of changes on performance measures, and on incentive compensation plans, may also be needed.

Stakeholder communications

Insurance companies will have to communicate with their various stakeholders, to assist them in understanding how the accounting and financial statement presentation will affect reported results.


The potential changes, some of which have been noted above, are pervasive, and may require significant expenditure to evaluate and implement.

There are numerous uncertainties surrounding the Boards’ insurance contract joint project. The only certainty is that significant change is on the horizon. It is important for insurance companies to continue to monitor the Boards’ publications, including re-exposure drafts, and be alert to all ongoing IASB/FASB projects to understand their impact.

Angela Taylor is senior manager, insurance, at KPMG. She can be contacted at: