International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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IFRS 4 on 1 January 2005.
7.1
The hierarchy exemption
Paragraphs 10-12 of IAS 8 provide guidance on the development and application of
accounting policies in the absence of a standard or interpretation that specifically
applies to a transaction. In particular, it explains the applicability and relative weighting
to be given to other IFRS sources, the use of guidance issued by other standard-setting
bodies and other accounting literature and accepted industry practices.
An insurer is not required to apply paragraphs 10-12 of IAS 8 for:
(a) insurance contracts that it issues (including related acquisition costs and related
intangible assets); and
(b) reinsurance contracts that it holds. [IFRS 4.13].
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What this means is that an insurer need not consider:
• whether its existing accounting policies are consistent with the Framework;
• whether those accounting policies regarding insurance contracts are consistent
with other standards and interpretations dealing with similar and related issues; or
• whether they result in information that is ‘relevant’ or ‘reliable’.
This exemption was controversial within the IASB and resulted in five members of
the IASB dissenting from the issue of the standard. It was also opposed by some
respondents to ED 5 on the grounds that it would permit too much diversity in
practice and allow fundamental departures from the Framework that could prevent
an insurer’s financial statements from presenting information that is understandable,
relevant, reliable and comparable. The IASB admitted that the exemption is ‘unusual’
but believed that it was necessary to minimise disruption in 2005 for both users and
preparers. [IFRS 4.BC79].
7.2
Limits on the hierarchy exemption
In order to prevent insurers continuing with accounting policies that the IASB
considered would either not be permitted by what became IFRS 17 or which conflict
too greatly with other standards, such as IAS 39 or IFRS 9, or IAS 37, IFRS 4 imposes
several limits on the hierarchy exception. These are in respect of:
• catastrophe and equalisation provisions;
• liability adequacy testing;
• derecognition of insurance liabilities;
• offsetting of reinsurance contracts against relating direct insurance contracts; and
• impairment of reinsurance assets. [IFRS 4.14].
These are discussed below.
7.2.1
Catastrophe and equalisation provisions
Catastrophe provisions are provisions that are generally built up over the years out of
premiums received, perhaps following a prescribed regulatory formula, until an amount,
possibly specified by the regulations, is reached. These provisions are usually intended
to be released on the occurrence of a future catastrophic loss that is covered by current
and future contracts. Equalisation provisions are usually intended to cover random
fluctuations of claim expenses around the expected value of claims for some types of
insurance contract (such as hail, credit guarantee and fidelity insurance) perhaps using
a formula based on experience over a number of years. [IFRS 4.BC87]. Consequently, these
provisions tend to act as income smoothing mechanisms that reduce profits in reporting
periods in which insurance claims are low and reduce losses in reporting periods in
which insurance claims are high. As catastrophe and/or equalisation provisions are
normally not available for distribution to shareholders, the solvency position of an
insurer can be improved.
The recognition of a liability (such as catastrophe and equalisation provisions) for
possible future claims, if these claims arise from insurance contracts that are not in
existence at the end of the reporting period, is prohibited. [IFRS 4.14(a)].
Insurance contracts (IFRS 4) 4327
The IASB considers there is no credible basis for arguing that equalisation or
catastrophe provisions are recognisable liabilities under IFRS. Such provisions are not
liabilities as defined in the Framework because the insurer has no present obligation for
losses that will occur after the end of the contract period. Therefore, without the
hierarchy exemption discussed at 7.1 above the recognition of these provisions as
liabilities would have been prohibited and the requirement described in the paragraph
above preserves that prohibition. [IFRS 4.BC90].
The IASB views the objective of financial statements as not to enhance solvency but to
provide information that is useful to a wide range of users for economic decisions.
[IFRS 4.BC89(d)]. Present imperfections in the measurement of insurance liabilities do not,
in the IASB’s opinion, justify the recognition of items that do not meet the definition of
a liability. [IFRS 4.BC92(a)].
Although the recognition of catastrophe and equalisation provisions in respect of claims
arising from insurance contracts that are not in force at the end of the reporting period
are prohibited, such provisions are permitted to the extent that they were permitted
under previous accounting policies and they are attributable to policies in force at the
end of the reporting period.
Although IFRS 4 prohibits the recognition of these provisions as a liability, it does not
prohibit their segregation as a component of equity. Consequently, insurers are free to
designate a proportion of their equity as an equalisation or catastrophe provision.
[IFRS 4.BC93].
When a catastrophe or equalisation provision has a tax base but is not recognised in the
IFRS financial statements, then a taxable temporary difference will arise that should be
accounted for under IAS 12 – Income Taxes.
7.2.2
Liability adequacy testing
Many existing insurance accounting models have mechanisms to ensure that insurance
liabilities are not understated, and that related amounts recognised as assets, such as
deferred acquisition costs, are not overstated. However, because there is no guarantee
that such tests are in place in every jurisdiction and are effective, the IASB was
concerned that the credibility of IFRS could suffer if an insurer claims to comply with
IFRS but fails to recognise material and reasonably foreseeable losses arising from
existing contractual obligations.
Therefore, a requirement for the application of a ‘liability adequacy test’ (an assessment
of whether the carrying amount of an insurance liability needs to be increased, or the
carrying amount of related deferred acquisition costs or related intangible assets
decreased, based on a review of future cash flows) was introduced into IFRS 4. This
assessment of liability adequacy is required at each reporting date. [IFRS 4.BC94].
If the assessment shows that the carrying amount of the recognised insurance liabilities
(less related deferred acquisition costs and related intangible assets such as those
acquired in a business combination or portfolio transfer discussed at 9 below) is
inadequate in the light of the estimated future cash flows, the entire deficiency must be
recognised immediately in profit or loss. [IFRS 4.15].
The purpose of this requirement is to prevent material liabilities being unrecorded.
7.2.2.A
Using a liability adequacy test under existing accounting policies
As many existing insurance accounting models have some form of liability adequacy
test, the IASB was keen to ensure that insurers using such models, as far as possible, did
not have to make systems changes. Therefore, if an insurer applies a liability adequacy
test that meets specified minimum requirements, IFRS 4 imposes no further
requirements. The minimum requirements are the following:
(a) the test considers current estimates of all contractual cash flows, and of related
cash flows such as claims handling costs, as well as cash flows resulting from
embedded options and guarantees; and
(b) if the test shows that the liability is inadequate, the entire deficiency is recognised
in profit or loss. [IFRS 4.16].
If the insurer’s liability adequacy test meets these requirements then the test should be
applied at the level of aggregation specified in that test. [IFRS 4.18].
The standard does not specify:
• what criteria in the liability adequacy test determine when existing contracts end
and future contracts start;
• at what level of aggregation the test should be performed;
• whether or how the cash flows are discounted to reflect the time value of money
or adjusted for risk and uncertainty;
• whether the test considers both the time value and intrinsic value of embedded
options and guarantees; or
• whether additional losses recognised because of the test are recognised by
reducing the carrying amount of deferred acquisition costs or by increasing the
carrying amount of the related insurance liabilities. [IFRS 4.BC101].
Additionally, IFRS 4 does not state whether this existing liability adequacy test can be
performed net of expected related reinsurance recoveries. However, the liability
adequacy test discussed at 7.2.2.B below explicitly excludes reinsurance.
IFRS 4 provides only minimum guidelines on what a liability adequacy test
comprises. This was to avoid insurers having to make systems changes that may have
had to be reversed when what became IFRS 17 was applied but allows the
continuation of a diversity of practice among insurers, for example in the use (or not)
of discounting. However, some existing practices may not meet these minimum
requirements, for example if they use cash flows locked-in at inception rather than
current estimates.
An example of the details of a liability adequacy test can be found in the financial
statements of Allianz.
Insurance contracts (IFRS 4) 4329
Extract 51.6: Allianz SE (2016)
Notes to the consolidated financial statements [extract]
2 – Accounting policies and new accounting pronouncements [extract]
Summary of significant accounting policies [extract]
Insurance, investment and reinsurance contracts [extract]
Liability adequacy tests
Liability adequacy tests are performed for each insurance portfolio on the basis of estimates of future claims, costs,
premiums earned, and proportionate investment income. For short-duration contracts, a premium deficiency is recognized
if the sum of expected claim costs and claim adjustment expenses, expected dividends to policyholders, DAC, and
maintenance expenses exceeds related unearned premiums while considering anticipated investment income.
For long-duration contracts a premium deficiency is recognized, if actual experience regarding investment yields,
mortality, morbidity, terminations or expense indicates that existing contract liabilities, along with the present value
of future gross premiums, will not be sufficient to cover the present value of future benefits and to recover DAC.
7.2.2.B
Using the liability adequacy test specified in IFRS 4
If an insurer’s accounting policies do not require a liability adequacy test that meets the
minimum criteria discussed, it should:
(a) determine the carrying amount of the relevant insurance liabilities less the carrying
amount of:
(i) any related deferred acquisition costs; and
(ii) any related intangible assets. However, related reinsurance assets are not
considered because an insurer assesses impairment for them separately
(see 7.2.5 below);
(b) determine whether the amount described in (a) is less than the carrying amount
that would be required if the relevant insurance liabilities were within the scope
of IAS 37. If it is less, the entire difference should be recognised in profit or loss
and the carrying amount of the related deferred acquisition costs or related
intangible assets should be reduced or the carrying amount of the relevant
insurance liabilities should be increased. [IFRS 4.17].
This test should be performed at the level of a portfolio of contracts that are subject to
broadly similar risks and managed together as a single portfolio. [IFRS 4.18].
Investment margins should be reflected in the calculation if, and only if, the carrying
amounts of the liabilities and any related deferred acquisition costs and intangible assets
also reflect those margins. [IFRS 4.19].
IAS 37 was used as a basis for this liability adequacy test as it was an existing
measurement basis that minimised the need for exceptions to existing IFRS principles.
[IFRS 4.BC95, 104].
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IAS 37 requires an amount to be recognised as a provision that is the best estimate of the
expenditure required to settle the present obligation. This is the amount that an entity
would rationally pay to settle the obligation at the reporting date or transfer it to a third
party at that time. [IAS 37.36-47]. Although IAS 37 refers to ‘expenditure’ there appears to be
no specific prohibition from considering future premiums. This might be appropriate if it
can be argued that the expenditures are a function of the future premiums.
The end result is that the IAS 37 requirements are potentially more prescriptive and
onerous than those applying if an insurer has an existing liability adequacy test which
meets the minimum IFRS 4 criteria discussed above.
7.2.2.C
Investment contracts with a discretionary participation feature
As discussed at 6.2 above the accounting requirements for investment contracts with a
DPF depend on whether the entity has classified the DPF as a liability or as equity.
Where the DPF is classified entirely as a liability then the liability adequacy test is
applied to the whole contract, i.e. both the guaranteed element and the DPF. Where the
DPF is classified in part or in total as a separate component of equity then IFRS 4 states
that the amount recognised as a liability for the whole contract should be not less than
the amount that would result from applying IAS 39 or IFRS 9 to the guaranteed element.
IFRS 4 does not specify whether the IAS 39 or IFRS 9 measurement basis should be
amortised cost or fair value. It is also not clear if this requirement relates to the gross
liability or to the net carrying amount, i.e. less any related deferred acquisition costs or
related intangible assets. [IFRS 4.35(b)].
7.2.2.D
Interaction between the liability adequacy test and shadow accounting
IFRS 4 does not address the interaction
between the liability adequacy test (‘LAT’) and
shadow accounting (discussed at 8.3 below). The liability adequacy test requires all
deficiencies to be recognised in profit or loss whereas shadow accounting permits
certain unrealised losses to be recognised in other comprehensive income.
We believe that a company can apply shadow accounting to offset an increase in
insurance liabilities to the extent that the increase is caused directly by market interest
rate movements that lead to changes in the value of investments that are recognised
directly in other comprehensive income. Although IFRS 4 does not specify the priority
of shadow accounting over the LAT, because the LAT is to be applied as a final test to
the amount recognised under the insurer’s accounting policies, it follows that shadow
accounting has to be applied first. This is illustrated in the example below.
Example 51.30: Shadow loss recognition
An insurer has classified certain investments backing insurance liabilities as available-for-sale financial
assets. It has issued a guaranteed single premium product backed by an investment in a government bond
with the same effective interest rate, duration and currency.
The opening position in the statement of financial position, perfectly matched in currency, interest rates and
duration is as follows:
CU
CU
Bond @ 6% effective rate, initial value
100
Equity
10
Other assets
10
Contract @ 6% guarantee
100
Total assets
110
Total liabilities and equity
110
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The position in the statement of financial position, one year after issuance, after a significant decline in market
interest rates is as follows:
CU
CU
Bond @ market value
116
Equity
20
Other assets
10
Contract @ 6% guarantee
106
Total assets
126
Total liabilities and equity
126
Given the market interest rate movement, the ‘matched’ situation no longer shows in the statement of financial