International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  position as the investment is valued at CU 116 and the liability at CU 106. The current market return on the

  assets funding the insurance contract at the time of performing the liability adequacy test (LAT) is no longer

  6%. It is now 5.2% (CU 6 ÷ CU 116).

  The increase in shareholders’ equity could be used for, or considered available for, dividend payments. Part

  of the cash value of the investment is no longer allocated to the insurance liability, but to shareholders’ equity.

  This is not correct because the entire investment, regardless of its carrying amount, is needed to provide the

  annual investment return (CU 6) to fund the growth of the liability (CU 6).

  The bond’s unrealised gain results in a decline in its market interest yield to below 6%. Therefore the liability

  needs to increase (in other words a higher amount of the investment needs to be allocated to it) to the level

  where the nominal CU 6 is earned.

  IFRS 4 states that any increase in the liability needs to be charged to profit or loss. However, in this case the

  increase is caused by a market interest movement that has produced an unrealised gain on an investment. This

  unrealised gain has been credited to other comprehensive income rather than profit or loss. If the liability

  increase is charged to profit or loss there will be a mismatch between this and the related unrealised gain in

  other comprehensive income.

  To the extent that the increase in the liability is related to other causes, the insurer should recognise a loss in

  the income statement.

  This example assumes that the effect of the change in market interest rates on the fair value of investments is

  recorded in other comprehensive income and was exactly the same as the opposite change in the fair value of

  the liability. In reality these two effects may not match exactly, so there could be a difference between the

  change in the fair value of the available-for-sale (AFS) assets and the change required in the carrying amount

  of the liability before the LAT is performed. The impact of shadow accounting needs to be limited to the

  change in value that was directly recorded in other comprehensive income arising from changes in the fair

  value carrying amount of the AFS assets.

  7.2.3

  Insurance liability derecognition

  An insurance liability, or a part of such a liability, can be removed from the statement

  of financial position (derecognised) when, and only when, it is extinguished i.e. when

  the obligation specified in the contract is discharged, cancelled or expires. [IFRS 4.14(c)].

  This requirement is identical to that contained in IAS 39 or IFRS 9 for the derecognition

  of financial liabilities. [IAS 39.39, IFRS 9.3.3.1]. The IASB said it could identify no reasons for

  the derecognition requirements for insurance liabilities to differ from those for financial

  liabilities. [IFRS 4.BC105].

  Accordingly, insurance liabilities should not normally be derecognised as a result of

  entering into a reinsurance contract because this does not usually discharge the insurer’s

  liability to the policyholder. This applies even if the insurer has delegated all claims

  settlement authority to the reinsurer or if a claim has been fully reinsured.

  Derecognition should be distinguished from remeasurement. The carrying amounts of many

  insurance liabilities are estimates and an insurer should re-estimate its claims liabilities, and

  hence change their carrying amounts, if that is required by its accounting policies.

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  However, in certain situations the distinction between the two concepts can be blurred, for

  example where there is a dispute or other uncertainty over the contractual terms of an

  insurance policy.

  IFRS 4 contains no guidance on when or whether a modification of an insurance contract

  might cause derecognition of the assets and liabilities in respect of that contract.

  7.2.4

  Offsetting of insurance and related reinsurance contracts

  IFRS 4 prohibits offsetting of:

  (a) reinsurance assets against the related insurance liabilities; and

  (b) income or expense from reinsurance contracts against the expense or income from

  the related insurance contracts. [IFRS 4.14(d)].

  This prohibition broadly aligns the offsetting criteria for insurance assets and liabilities

  with those required for financial assets and financial liabilities under IAS 32, which

  requires that financial assets and financial liabilities can only be offset where an entity:

  (a) has a legally enforceable right to set-off the recognised amounts; and

  (b) intends to settle on a net basis, or to realise both the asset and settle the liability

  simultaneously. [IAS 32.42].

  Because a cedant normally has no legal right to offset amounts due from a reinsurer

  against amounts due to the related underlying policyholder the IASB considers a gross

  presentation gives a clearer picture of the cedant’s rights and obligations. [IFRS 4.BC106].

  As a result, balances due from reinsurers should be shown as assets in the statement of

  financial position, whereas the related insurance liabilities should be shown as liabilities.

  Because of the relationship between the two, some insurers provide linked disclosures

  in the notes to their IFRS financial statements as discussed at 10.1.2.A below.

  The IFRS 4 requirements, however, appear to be less flexible than those in IAS 32 in

  that they provide no circumstances in which offsetting can be acceptable. So, for

  example, ‘pass through’ contracts that provide for reinsurers to pay claims direct to the

  underlying policyholder would still have to be shown gross in the statement of financial

  position. IAS 32 also does not address offsetting in the income statement.

  7.2.5

  Impairment of reinsurance assets

  If the IASB had required that the impairment model in IAS 36 be applied to

  reinsurance assets (as proposed in ED 5) many cedants would have been compelled to

  change their accounting model for reinsurance contracts in a way that was

  inconsistent with the accounting for the underlying direct insurance liability. This

  would have required the cedant to address matters such as discounting and risk,

  together with the attendant systems implications. Consequently, the IASB concluded

  that the impairment test should focus on credit risk (arising from the risk of default by

  the reinsurer and also from disputes over coverage) and not address matters arising

  from the measurement of the underlying direct insurance liability. It decided the most

  appropriate way to achieve this was to introduce an incurred loss model based on that

  contained in IAS 39. [IFRS 4.BC107-108].

  Insurance contracts (IFRS 4) 4333

  Consequently, a reinsurance asset should be impaired if, and only if:

  (a) there is objective evidence, as a result of an event that occurred after initial

  recognition of the asset, that the cedant may not receive all amounts due to it under

  the terms of the contract; and

  (b) that event has a reliably measureable impact on the amounts that the cedant will

  receive from the reinsurer. [IFRS 4.20].

  Where a reinsurance asset is impaired, its carrying amount should be reduced

  accordingly and the impairment loss recognised in profit or loss.

  IAS 39 provides various indicators of impairment for financial assets, such as the
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  significant financial difficulty of the obligor and a breach of contract, such as a default

  in interest or principal payments. IFRS 4 does not provide any specific indicators of

  impairment relating to reinsurance assets. In the absence of such indicators, it would

  seem appropriate for insurers to refer to those in IAS 39 as a guide to determining

  whether reinsurance assets are impaired.

  The use of this impairment model means that provisions cannot be recognised in respect

  of credit losses expected to arise from future events.

  IAS 39 permits a portfolio approach to determining impairment provisions for financial

  assets carried at amortised cost. More specifically, IAS 39 permits a collective

  evaluation of impairment for assets that are grouped on the basis of similar credit risk

  characteristics that are indicative of the debtors’ ability to pay all amounts due according

  to the contractual terms (for example on the basis of a credit risk evaluation or grading

  process that considers asset type, industry, geographical location, collateral type, past-

  due status and other relevant factors). [IAS 39.AG87].

  It is questionable whether an insurer’s reinsurance assets would normally exhibit

  sufficiently similar credit risk characteristics to permit such an approach to determining

  impairment. That said, IAS 39 is clear that impairment losses recognised on a group basis

  represent an interim step pending the identification of impairment losses on individual

  assets in the group of financial assets that are collectively assessed for impairment. As

  soon as information is available that specifically identifies losses on individually

  impaired assets in a group, those assets are removed from the group. [IAS 39.AG88].

  IFRS 9 does not contain any consequential amendments to IFRS 4 in respect of impairment

  of reinsurance assets. Therefore, if an insurer applying IFRS 4 adopts IFRS 9 it must continue

  to use an incurred loss impairment model for reinsurance assets notwithstanding the fact that

  an expected loss model will be used for financial assets within the scope of IFRS 9.

  7.2.6

  Accounting policy matters not addressed by IFRS 4

  7.2.6.A

  Derecognition of insurance and reinsurance assets

  IFRS 4 does not address the derecognition of insurance or reinsurance assets. The IASB

  could identify no reason why the derecognition criteria for insurance assets should differ

  from those for financial assets accounted for under IAS 39 or IFRS 9, but declined to

  address the issue ‘because derecognition of financial assets is a controversial topic’.

  [IFRS 4.BC105]. Consequently, derecognition of insurance assets should be dealt with under

  existing accounting practices which may differ from the requirements of IAS 39 or IFRS 9.

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  7.2.6.B

  Impairment of insurance assets

  IFRS 4 is silent on the impairment model to be used for receivables arising under

  insurance contracts that are not reinsurance assets (discussed at 7.2.5 above). An

  example of these would be premium receivables due from policyholders. Receivables

  arising from insurance contracts are not within the scope of either IAS 39 or IFRS 9

  (see 2.2.2 above). Insurers should therefore apply their existing accounting policies to

  determine impairment provisions for these assets. Any changes in accounting policy

  (e.g. to move from an incurred loss model to an expected loss model on adoption of

  IFRS 9) must satisfy the criteria for changes in accounting policy discussed at 8.1

  below and should be applied retrospectively as required by IAS 8 since IFRS 4 has no

  specific transitional rules. Impairment of financial receivables not within the scope of

  IFRS 4 are subject to either IAS 39 or IFRS 9 requirements (depending on which

  standard is being applied).

  7.2.6.C

  Gains and losses on buying reinsurance

  Some local accounting requirements often define reinsurance contracts more strictly

  than direct insurance contracts to avoid income statement distortion caused by

  contracts that have the legal form of reinsurance but do not transfer significant

  insurance risk. Such contracts are sometimes described as financial reinsurance. One

  such source of distortion is caused because many local GAAPs do not require the

  discounting of non-life insurance claims liabilities. If the insurer buys reinsurance, the

  premium paid to the reinsurer reflects the present value of the underlying liability and

  is, therefore, potentially less than the existing carrying amount of the liability. This could

  result in a gain on the initial recognition of the reinsurance contract (a ‘day 1’ gain) where

  a reinsurance asset is recognised at an amount equivalent to the undiscounted liability

  and this is less than the premium payable for the reinsurance contract. This day 1 gain

  arises largely because of the inability to discount the underlying liability. Initial

  recognition of gains could also arise if the underlying insurance liability is measured with

  excessive prudence. [IFRS 4.BC110].

  IFRS 4 defines a reinsurance contract using the same terms as an insurance contract.

  The IASB decided not to use the definition of a reinsurance contract to address the

  problems described above because it found no conceptual reason to define a

  reinsurance contract any differently to a direct insurance contract. It considered making

  a distinction for situations where significant distortions in reported profit were most

  likely to occur, such as retroactive contracts, but eventually considered that developing

  such a distinction would be time-consuming and difficult, and there would have been

  no guarantee of success. [IFRS 4.BC111, 113].

  Consequently, IFRS 4 does not restrict the recognition of gains on entering into

  reinsurance contracts but instead requires specific disclosure of the gains and losses that

  arise (see 11.1.3 below).

  Insurers are therefore permitted to continue applying their existing accounting policies

  to gains and losses on the purchase of reinsurance contracts (which may or may not

  prohibit gains on initial recognition) and are also permitted to change those accounting

  policies according to the criteria discussed at 8 below.

  Insurance contracts (IFRS 4) 4335

  7.2.6.D Acquisition costs

  IFRS 4 is silent on how to account for the costs of acquiring insurance contracts.

  ‘Acquisition costs’ are not defined within the standard, although the Basis for

  Conclusions states that they are ‘the costs that an insurer incurs to sell, underwrite and

  initiate a new insurance contract’, [IFRS 4.BC116], a description that would appear to

  exclude costs associated with amending an existing contract.

  IFRS 4 neither prohibits nor requires the deferral of acquisition costs, nor does it

  prescribe what acquisition costs should be deferred, the period and method of their

  amortisation, or whether an insurer should present deferred acquisition costs as an asset

  or as a reduction in insurance liabilities. [IFRS 4.BC116].

  The IASB decided that the treatment of acquisition costs was an integral part of existing

  insurance models that could not easily be amended without a more fundamental review

  of these models in IFRS 17. [IFRS 4.BC116].

  Insurers are therefore permitted to cont
inue applying their existing accounting policies

  for deferring the costs of acquiring insurance contracts.

  Under IFRS 15 only incremental costs that are associated with obtaining an investment

  management contract are recognised as an asset. An incremental cost is one that would

  not have been incurred if the entity had not secured the investment management

  contract. [IFRS 15.91-93].

  7.2.6.E

  Salvage and subrogation

  Some insurance contracts permit the insurer to sell (usually damaged) property acquired

  in settling the claim (salvage). The insurer may also have the right to pursue third parties

  for payment of some or all costs (subrogation). IFRS 4 contains no guidance on whether

  potential salvage and subrogation recoveries should be presented as separate assets or

  netted against the related insurance liability. [IFRS 4.BC120].

  Royal & SunAlliance is an example of an entity which discloses that its insurance

  liabilities are stated net of anticipated salvage and subrogation.

  Extract 51.7: RSA Insurance Group plc (2016)

  Basis of preparation and significant accounting policies [extract]

  4) Significant accounting policies [extract]

  Gross claims incurred and insurance contract liabilities [extract]

  Gross claims incurred represent the cost of agreeing and settling insurance claims on insurance contracts underwritten

  by the Group. Provisions for losses and loss adjustment expenses are recognised at the estimate ultimate cost, net of

  expected salvage and subrogation recoveries when a claim is incurred.

  7.2.6.F Policy

  loans

  Some insurance contracts permit the policyholder to obtain a loan from the insurer with

  the insurance contract acting as collateral for the loan. IFRS 4 is silent on whether an

  insurer should treat such loans as a prepayment of the insurance liability or as a separate

  financial asset. This is because the IASB does not regard the issue as a priority. [IFRS 4.BC122].

  Consequently, insurers can present these loans either as separate assets or as a

  reduction of the related insurance liability depending on their local GAAP requirements.

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  7.2.6.G

  Investments held in a fiduciary capacity