Insurance contracts

The FASB and IASB have been working together for several years to develop a standard on accounting for insurance contracts that would address recognition, measurement, presentation, and disclosure. In June, both the FASB and IASB issued exposure drafts that have 120-day comment periods. The boards plan to jointly redeliberate in 2014, with a goal of issuing final guidance in late 2014 or early 2015.

Key developments

  • The FASB and IASB have been working together for several years to develop a standard on accounting for insurance contracts that would address recognition, measurement, presentation, and disclosure. However, based on deliberations that followed the FASB’s 2010 discussion paper and the IASB’s 2010 ED, it is unlikely the boards will achieve a converged standard based on the nature and totality of differences between the FASB’s and IASB’s views.

  • In June, both the FASB and IASB issued exposure drafts that have 120-day comment periods. The boards plan to jointly redeliberate in 2014, with a goal of issuing final guidance in late 2014 or early 2015. The likely outcome of the IASB project is a standard addressing all aspects of insurance contract accounting, given that IFRS currently has no comprehensive insurance standard. While the FASB exposure draft also proposes an entirely new model, the FASB could decide that only certain changes to existing U.S. GAAP for insurance accounting are warranted.

  • The proposed guidance would apply to "insurance contracts," which are broadly defined, rather than insurance entities. Thus, the guidance could have implications for companies that are not insurers. Goods and services that are distinct from the insurance coverage and embedded derivatives would be unbundled from the insurance contract and measured under other applicable standards. The FASB has decided that financial guarantee contracts issued by insurance entities that are not derivatives would be in the scope of the insurance contracts proposal.

  • An insurer would measure its net obligation to pay claims and benefits and its right to future premiums using an expected value discounted cash flow approach, remeasured each period (referred to as the building block approach). At inception, there would be no immediate gain recognition for the expected excess of premiums over cash outflows. Under the FASB’s model, any such excess would be recorded as "margin" and amortized over the settlement period. Expected losses (excess of expected cash outflows over inflows) would be recognized immediately. The IASB approach would differ in that the IASB would include a currently updated explicit risk adjustment to reflect the compensation the insurer requires for bearing the uncertainty inherent in the cash flows. The expected profit (less the explicit risk adjustment) would be earned over the coverage period.

  • Under both proposals, a modified approach for certain short duration contracts that meet specified criteria (the premium allocation approach) would apply. Like the unearned premium approach used today for short duration contracts, the premium allocation approach would recognize premiums as revenue over the coverage period. However, incurred losses would be measured using the building block approach, including discounting of expected cash flows. A non-discounting practical expedient would be available for claims or the portion of claims expected to be paid within twelve months of the claim occurrence date.

  • In 2010 the boards advocated a "summarized margin" approach for income statement presentation under the building block approach, which is significantly different from the current gross presentation of premium revenue and benefit expense. The boards have since decided that volume information, such as premiums, claims, and underwriting margin, should be presented on the face of the statement of comprehensive income. The “earned premium” amount would be recognized in each period in proportion to the relative value of insurance coverage and other services expected to be provided in that period, and claims would be recognized as incurred. Deposit elements would be excluded from premium and claim information presented in the income statement.

  • Reacting to criticism about income statement volatility caused by the current value approach, the boards have decided that the effect of changing discount rates should be recorded through other comprehensive income (OCI), rather than earnings. Amounts recorded in OCI would then naturally reverse into income as the liabilities mature.

  • The IASB continues to believe that the net liability should include an explicit risk adjustment for the uncertainty about the amount and timing of future cash flows, while the FASB does not. The FASB is concerned that the methodologies for developing such estimates are not time tested, are subjective, and may not be comparable across companies without further field testing and guidance.

  • The boards also disagree on whether direct acquisition costs to be included in the model should only include those relating to successful acquisition efforts (FASB) or to both successful and unsuccessful efforts (IASB). The FASB’s approach is consistent with recently issued U.S. GAAP on deferred acquisition costs, except that the insurance proposal would prohibit any direct response advertising from being capitalized.

  • At transition, companies would apply a full retrospective adoption method, with a practical expedient to estimate margin and discount rates where observable data is not available. The FASB decided that a full redesignation of financial assets would be permitted, while the IASB will limit redesignation to the fair value option only.

  • The FASB and IASB proposals would represent a transformational change in the way that insurance contracts would be measured and reported in the financial statements, given that the model is more of a balance sheet-focused, current value measurement approach rather than a model based on deferral and matching of revenue and expenses.

  • Even if the FASB made only targeted improvements to U.S. GAAP rather than write a new comprehensive standard, the resulting differences from existing GAAP could be significant. Amendments could include a requirement to discount all insurance liabilities (except for those qualifying for the practical expedient), update all assumptions each period (rather than locking them in, as is done for traditional life insurance and annuity contracts), recognize margin on a “release from risk” basis, and estimate cash flows using an “expected value” or mean versus a deterministic best estimate.

  • Under the proposals, there would likely be more earnings volatility due to the updating of market and insurance-specific assumptions each period instead of those assumptions being locked-in at inception as is currently done for traditional life insurance. Even with the decision to record changes in the discount rate through other comprehensive income, potential discount rate mismatches between assets and liabilities could still exist. Adoption would have wide-ranging, significant impacts on investor education, underlying processes, systems, internal controls, valuation models, and other fundamental aspects of the insurance business.

What's next

  • The boards plan to jointly redeliberate in 2014, with a goal of issuing final guidance in late 2014 or early 2015. The likely outcome of the IASB project is a standard addressing all aspects of insurance contract accounting, given that IFRS currently has no comprehensive insurance standard. While the FASB exposure draft also proposes an entirely new model, the FASB could decide that only certain changes to existing U.S. GAAP for insurance accounting are warranted.
 

Point of view

Insurance contract accounting: The path forward

11/21/13 | Assurance services

If a single global insurance accounting standard is not achieved, PwC believes the FASB should only make targeted enhancements to its existing standards. Read more