IFRS convergence: does anybody care, and should they?
It feels as though we’ve been talking about the convergence of International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) for a long time. In fact, it’s been over a decade since the fi rst Memorandum of Understanding (MoU) was signed in 2002 between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). The MoU emphasised the goal of the IASB and the FASB to produce common, principle-based standards intended to achieve convergence between US GAAP and IFRS.
Since the signing of the MoU in 2002, discussions have evolved from full adoption of IFRS by all US companies, to optional adoption for certain companies and, more recently, to a convergence and endorsement approach. Throughout the years, there have been multiple delays and changes in scope. People are understandably weary of discussing convergence, and some may be asking themselves: “Given all of these changes and numerous delays, shall I adopt a ‘wait and see’ approach, and do I even really care about convergence?”
The answer to those questions is: yes and no. Let’s explore which convergence projects are most relevant and impactful for insurance companies. There are two convergence projects between the boards which are relevant to insurance companies: a financial instruments project and an insurance contracts project.
Financial instruments project
For the past few years, the IASB has been working to replace its current fi nancial instruments standard, IAS 39, Financial Instruments: Recognition and Measurement, with a simplified standard. The IASB has structured its replacement project into three distinct phases:
- Phase 1: Classification and measurement of financial assets and financial liabilities;
- Phase 2: Impairment methodology; and
- Phase 3: Hedge accounting.
The FASB has added a similar project, but they have not followed the same phased approach as the IASB.
Phase 1: Classification and measurement
In early 2012, the boards worked successfully together on certain aspects of their classification and measurement models in order to reduce or eliminate variances in numerous key areas. The IASB proposed some amendments to IFRS 9, Financial Instruments, to implement the changes agreed to by the boards. There remain some differences between the IASB’s amended IFRS 9 and the FASB’s proposed guidance.
Under the boards’ proposed amendments, a company would classify and measure its financial assets on the basis of cash flow characteristics as well as business model assessments. The boards’ models each contain three classification and measurement categories for financial assets:
- Fair value through profit and loss;
- Fair value through other comprehensive income; and
- Amortised cost.
Under certain circumstances, however, the application of the business model assessment in the FASB’s proposal could result in different classification outcomes when compared with the proposed amendments to IFRS 9.
Phase 2: Impairment methodology
Current US GAAP and IFRS use an incurred loss credit impairment model that includes an initial recognition threshold. Similarly, when credit losses are measured under current IFRS, an entity generally only considers past events and current conditions in measuring the incurred loss.
The boards are attempting to address perceived weaknesses in the current guidance relating to the delayed recognition of credit losses. Most recently, the boards jointly developed an expected loss approach using a three-bucket impairment model. Sicne July 2012, the IASB has continued to develop the three-bucket impairment model, and an exposure draft (ED) on this model is expected to be issued in the near future. The FASB recently issued a proposed Accounting Standards Update with a single impairment model for financial assets.
Phase 3: Hedge accounting
The IASB has split the hedge accounting phase into two parts: general hedging and macro hedging. A review draft of a general hedging standard was published in September 2012, and a discussion paper on macro hedging will be issued in the first half of 2013. The IASB proposals present a more principles-based approach that more closely aligns hedge accounting with risk management. Entities will have to ensure that risk management and hedge accounting processes are robust enough to enable them to take advantage of the new opportunities to apply hedge accounting.
IASB work plan
The current IASB work plan, as shown below, is based on significant progress being made in 2013, which will be necessary to maintain an effective date of January 1, 2013. It is anticipated that the FASB will adopt a similar timeline.
Convergence and financial instruments
Upon initial application, there will be designation elections to consider for existing financial instruments and changes to how a company classifies and measures newly acquired financial instruments, both of which could have significant financial statement impacts. Companies will also need to modify the way in which they assess impairment, moving from an incurred loss method to an expected loss method. There will also be additional disclosures required on the transition from IAS 39 to IFRS 9 for companies preparing IFRS financial statements.
Insurance contracts project
Planning for the adoption of the standards on insurance contracts will not be simply an accounting exercise or a regulatory issue, but a business issue as well. Insurance companies will need to take a company-wide approach that consider the needs and interconnections between accounting and reporting, and its systems and processes, over the next few years.
The adoption of the proposed insurance standard is expected to have a significant effect on the perception and comparability of financial performance. The top accounting and reporting issues expected to impact insurance companies as a result of adopting the proposed insurance standard are:
- Unfamiliar metrics/changes to performance reporting;
- Increased complexity and additonal actuarial involvement; and
- Volatility of profit and loss.
One of the proposed presentation changes is to show financial results using a margin-based approach, rather than using traditional measures of premiums, claims and benefits. Some insurance companies may find this unhelpful as they manage their businesses using measures such as written and earned premiums, benefits and claims expenses, and underwriting profit.
If the ultimate model adopted is consistent with the current proposal, many insurance companies expect to provide additional non-GAAP disclosures to accompany their financial statements. Should the final insurance standard include the loss of traditional volume measures, insurance companies may need to identify new key performance indicators on which to manage their business.
The most significant impact is expected to be on actuarial and finance staff carrying out new processes and using new systems. Actuarial staff will need to determine how the risk margins will be quantified, and may also need to carry out more model iterations and experience investigations. Insurance companies may need to hire additional resources, or outsource certain actuarial functions to third parties.
Volatility of profit and loss
There have been concerns that under the requirements of the new insurance standard, there could be increased volatility of profit and loss, as assumptions would be updated at each reporting period, and there would be immediate recognition of changes in estimates and assumptions in profit or loss.
"Insurance companies should continue carefully to review the proposals being published, analyse the expected impacts to their business and provide comments to the boards."
Long-tail lines of business, such as longer-term liability insurance, accident and disability insurance and workers’ compensation insurance—which tend to have higher deviations in ultimate losses— will most likely display greater earnings volatility. As insurance companies investigate how to manage increased volatility from the adoption of the insurance standard, they will need to evaluate how best to explain the impact of market value movements on their results in the statement of comprehensive income.
Systems and processes
Converting to the proposed insurance standard will affect insurance companies’ IT systems and processes, including actuarial modelling and valuation systems and financial reporting systems. Many insurance companies currently do not have the system capabilities to capture information that will be required as a result of the proposed insurance standard.
Restructuring of the technology landscape is expected to be complex and costly. Complying with these IT requirements will have hard deadlines, and will compete for the time, attention and resources needed for other technology priorities affecting customer service.
IASB and FASB work plan
The IASB is expected to complete deliberations on tentative proposals contained in the ED early in 2013. It recently announced plans to issue a targeted re-exposure document in the first half of 2013. Based on this timetable, the IASB has indicated that the earliest a final insurance contracts standard could be issued is May 2014.
The IASB intends to allow at least three years between the date of issue and the effective date, meaning that the effective date would not be before 2018. It is expected that the FASB will follow a similar timeline.
Should you care about convergence with respect to insurance contracts?
Yes and no. There is no need for extensive system changes and stakeholder education to occur immediately. However, insurance companies should continue to carefully review the proposals being published, analyse the expected impacts to their business and provide comments to the boards.
With respect to the insurance contract joint project, it is too soon to spend significant efforts given the differences that still exist between the boards and the effective date so far in the future. Insurance companies should focus their immediate attention on the financial instruments project, which will become effective January 1, 2015.
Angela Taylor is senior manager, insurance, at KPMG. She can be contacted at: firstname.lastname@example.org