The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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The International Accounting Standards Board (IASB) released its long-awaited insurance contracts exposure draft on 30 July 2010.

After more than a decade of debate, it is without doubt the biggest accounting change to hit the insurance industry in a generation. The proposals are unlikely to be well received by all insurers, although on balance a standard providing greater transparency and comparability than what we have today presents insurers with a preferred, if imperfect, solution.

Comparability and reliability will be achieved through having one common accounting practice rather than the variability of practices in force around the globe at present. The aim of the proposals is to create a single converged global standard as the output of joint discussions by the IASB and the US Financial Accounting Standards Board (FASB). Although IASB has issued an exposure draft, FASB has yet to do so. We anticipate a draft later this year with one fundamental difference, of which more later...

Scope of the proposals
The exposure draft retains the previous definition of an insurance contract as "the contract under which one party accepts significant insurance risk from another party by agreeing to compensate the policy holder if a specified uncertain future event adversely affects the policy holder". This is a broad definition and is likely to extend the reach of the standard outside the insurance industry. The good news is that insurers are unlikely to be required to perform a further contract-by-contract review to ensure all contracts remain within the standard. Certain financial guarantee contracts are now likely to be covered by the standard and, importantly for some insurers, it is not completely clear yet whether contracts such as motor breakdown written by insurers would be within the scope of the new standard.

Risk margins
The inclusion and measurement of an explicit risk margin is one of the most controversial issues included in the board's proposals. In the coming months, there is likely to be considerable debate about the basis on which the risk margin is calculated (a fulfilment or exit value approach) and whether or not there should be prescribed or permitted techniques to calculate the adjustment. The best advice I can give to companies thinking about this issue is to field test the calculation of risk margins - not an easy task within the comment period, but at least it will help support an informed debate about the calculation methods.

The fourth building block, the residual margin, eliminates day one gains on insurance contracts. It is the only building block not subsequently re-measured, but is released in a systematic way over the life of the contract. Any initial loss on a contract is recognised immediately in profit and loss.

As a result of the debate around the risk adjustment, the exposure draft outlines an alternative measurement model - favoured by the FASB - which also eliminates any initial profit but has a single composite margin, rather than the separate explicit and residual margins. This margin is systematically released to profit and loss in the same way as the IASB's residual margin.

The property casualty exception
For property casualty underwriters, the draft requires short duration contracts of approximately 12 months or less to initially be measured as premiums less incremental acquisition costs and for this to be systematically reduced over the coverage period, with any claims that occur being measured using the building block approach described above.

The IASB should be applauded for trying to make its proposals more practical to implement. However, property casualty insurers should think twice before embracing these proposals. Firstly, it only applies to contracts of one year's duration or less. Within the commercial markets, there are many policies written with durations of far more than one year - many binders and construction type policies being just two examples. If the exemption is required, mixed model accounting, which is unhelpful, would be the norm.

Furthermore, as liabilities are incurred you will still need to adopt the building block approach. So for books that run off over long periods of time, it is unlikely that the proposals will yield the benefits the IASB imagines. I feel sure that field testing will reveal that this approach will not make the lives of property casualty insurers writing predominantly commercial books any easier. I can see big advantages in the retail sector for those insurers writing predominately household, motor and possibly smaller commercial type policies.

Acquisition cost
The proposals allow incremental acquisition on costs at the contract level to be included in the contract cash flows (and therefore in the building block 1 measurement). This will reduce the residual margin. Such acquisition costs include selling, underwriting and initiating insurance contracts. General acquisition costs in the portfolio are expensed directly to the profit loss account. An insurer's business model for acquiring contracts will therefore impact the measurement of the contract liability.

The board believes that the new draft provides a narrower definition of acquisition costs that qualify for inclusion in contract cash flows. In saying this, the board acknowledges that accounting for acquisition cost varies between companies and across territories and hopes to see greater uniformity in future.

Foreign exchange
One of the more controversial aspects of current accounting practise is the treatment of unearned premium reserves and deferred acquisition costs. As non-monetary items, foreign exchange gains and losses are taken to profit and loss, creating significant volatility. One of the more welcome aspects of the new standard will be the removal of this currency mismatch problem as all insurance contract balances will be considered monetary.

Income statement impacts
Under the current proposals the income statement will be driven by the measurement model discussed above. The standard introduces the concept of the insurance margin, which is based on the key drivers of an insurer's profitability, and as such will become a key performance indicator.

The face of the income statement will present a summarised margin approach, the components of which are:

• Changes in the risk adjustment reflecting changes in uncertainties about the amount of future cash flows
• The release of the residual margin on a systematic basis
  
• Unexpected cash flows in the period
• Interest on insurance contract liabilities
• Non-incremental acquisition costs

Familiar measures such as premium volumes, claims and expense ratios will no longer be presented on the face of the income statement. Supplemental disclosures will provide this information. A challenge for the industry going forward is to educate analysts into a different way of thinking about the business. This is likely to be a lengthy part of the conversion process. Management will first need to become familiar with the statements and the drivers of profitability under the new model. Understanding and describing these dynamics will be one of the C-suite team's biggest challenges in the conversion process.

Next steps
Given the profound changes of this standard on your business and industry - what should you do now? I strongly recommend that you immediately begin to assess the implications of the new model on your historically reported results, consider your current business practises and existing contracts. This is a discussion not to be reserved for accounting teams; the debate needs to be happening at C-suite level.

For writers of predominantly short duration contracts, I encourage you to focus your attention on the alternative measurement model. Is this good for your company, do the benefits outweigh the costs and draw backs, should it be required rather than permitted? The more modelling and field testing that can be done before 30 November, the better, in order to provide informed debate to the IASB. Typically, the board are not interested in emotional arguments, but they are responsive to genuine issues backed up by appropriate analysis.

It is vital to work closely with industry analysts to make sure they fully understand the changes in your reporting. It will take everyone time to familiarise themselves with the new look and feel to these financial statements.

Fundamental changes
The changes are profound. For European insurers already struggling with the demands of Solvency II, combine as many aspects of the conversion projects as possible in order to use already stretched resources effectively.

In conclusion, although I anticipate a mixed industry reaction, insurers should welcome the exposure draft taken as a whole. It is a significant step forward in achieving a comprehensive, transparent and comparable global accounting model. You have a vested interest in making your views heard and the exposure draft should be considered a welcome opportunity for debate.

Andrew Hill is a partner at PricewaterhouseCoopers